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Are Banks Special? A Re-Revisitation

The conclusion that E. Gerald Corrigan reached in 1982 – that banks are special – is still true today. It’s worth revisiting his work for a second time.

By H. Rodgin Cohen

In 1982, E. Gerald Corrigan wrote Are Banks Special?, a truly seminal article on bank regulation. He then revisited this subject in a briefer 2000 article, appropriately entitled Are Banks Special? A Revisitation. Now is the time for a re-revisitation of this work, both because so much has occurred in the financial services industry during the ensuing 17 years and as a tribute to Corrigan’s crucial role in shaping our regulatory structure. (Note: Corrigan served as the President of the Federal Reserve Banks of Minneapolis and New York, and also as the closest approximation of an “eighth” Federal Reserve Board Governor).

The fundamental conclusion that Corrigan reached – that banks are special – is still true today. As he emphasized, banks are special because they perform unique and indispensable functions in the nation’s economy; there is, in his words, “a long-standing consensus that banking functions are essential to a healthy economy.”

The original article cites, and the subsequent article endorses, three distinguishing functions that banks perform: transaction accounts (which “permit our diverse economic and financial system to work with relative ease and efficiency”); backup source of liquidity for all other companies (for which “all other financial markets and all other classes of institutions are dependent”); and the transmission belt for monetary policy. Moreover, only banks perform the dual functions of both offering transaction accounts (as well as other short-term deposits and liabilities) and then engaging in maturity transformation by utilizing those funds to provide longer-term loans to consumers, businesses of all sizes, and other organizations (which the original article describes as “‘term structure’ risk”). Corrigan posits that, ultimately, “it is the relationship among [these functions] that best captures the essence of what makes banks special.”

Should banks be regulated differently than other companies, even other financial companies? Should they be physically separated from other companies, even other financial companies?

Corrigan’s articles also discuss two fundamental questions raised by banks’ special position. First, should they be regulated differently than other companies, even other financial companies? Second, should they be physically separated from other companies, even other financial companies? This Banking Perspectives article examines each of these issues in the context of today’s regulatory environment and with the benefit of 17 years of additional experience.

Bank Regulation
As a result of the unique functions that make banks “special,” a wide-reaching legislative and regulatory structure has been developed to ensure the continued availability of these functions. This structure includes the following: (1) a comprehensive scheme of bank regulatory requirements (e.g., capital, liquidity, and stress tests) and restrictions (e.g., powers and loans to affiliates), which are designed to promote bank resilience; and (2) government programs of support (principally, federal deposit insurance and Reserve Bank credit facilities), which are designed to enable banks to incur the risks inherent in their role in the economy. As Corrigan stressed, the predominant objective of this special legislative and regulatory structure is the safety and soundness of individual banks and the banking system. The phrase “safety and soundness” appears at least five times in the original article.

At the same time, however, Corrigan recognized the need for the regulatory structure to be carefully calibrated so that banks are not so constrained as to limit their capacity to fulfill their functions. As he wrote: “[I]f banks are special it would not be in the public interest for the features or functions that make banks special to be eroded by competitive, regulatory or legislative forces.” Corrigan’s concern persists today. Rigidity or undue stringency in the bank regulatory system can prevent prudent risk-taking and create increased costs and friction that drive financial services to less-regulated providers – what is known today as the shadow banking system – that are less capable of dealing with financial or economic stress.

Unchanged since 1982 or 2000 are the functions performed by banks that make them special and the special regulatory structure for banks designed to achieve safety and soundness. In terms of functions, banks continue to perform their unique roles of creating maturity transformation, providing transaction accounts, and serving as backup sources of liquidity for the economy. Banks also acted as critical conveyors for monetary policy during the 2008 financial crisis, although the magnitude of the crisis demonstrated the limits of monetary policy.

In terms of continuing special regulation, the numerous bank failures and near failures during the financial crisis, including some of the country’s largest banks, resulted in a considerably more stringent regulatory regime. That regime was a function of both “enhanced prudential supervision” under the Dodd-Frank Act (including higher capital and liquidity requirements, stress tests, living wills, and total loss absorbency capacity requirements) and, perhaps even more so, a more rigorous supervisory approach. It is noteworthy, however, that some of the most consequential failures and near failures during the crisis did not involve banks but other financial services companies, including an insurance company (AIG), two investment banks (Lehman and Bear Stearns), and a money market fund (Reserve Fund). (Note: The Dodd-Frank Act did include a provision to subject “systemic” non-bank financial companies to special supervision.)

Corrigan recognized the need for the regulatory structure to be calibrated carefully so that banks are not so constrained as to limit their capacity to fulfill their critical economic functions.

What has changed since 2000 is the evolution of the enforcement approach to certain long-standing bank requirements that are basically unrelated to safety and soundness. This enforcement approach makes banks special in a different way, by singling them out to accomplish certain societal goals and to impose substantial penalties for failure. However laudable these societal goals may be, the severity of this enforcement approach does not advance safety and soundness, and sometimes may actually prove counterproductive. (Note: The imposition of this much more stringent enforcement regime coincides, at least in time, with a sharp decline in the public perception of banks following the 2008 financial crisis.)

One principal societal goal is a policing function to detect and prevent money laundering and the underlying criminal activity, including terrorist financing. The cost to the banking industry for assuming this policing role, which is unique in the private sector, extends well beyond the substantial expense of the requisite personnel and technology. A more significant element of cost is the enforcement actions and fines imposed on banks that are deemed by examiners to have failed to adopt and implement effective anti-money laundering programs. These penalties are not reserved just for actual money laundering events but include so-called “program violations,” even though there are not clear and comprehensive regulatory guidelines and regulators’ expectations are constantly evolving.

Perhaps the most serious cost relates to resultant limitations, indeed prohibitions, on expansion, growth, and structure. Banking organizations that are subject to enforcement actions relating to money laundering violations are typically disqualified from engaging in new activities, acquisitions, certain investments, or any other transaction requiring regulatory approval, even if the transaction would promote safety and soundness through greater efficiency, reduced complexity, diversification, or otherwise. The prohibitions include both large and small acquisitions, and even internal reorganizations and de novo branches. The disqualification period can last for years, as the bank must demonstrate not only remediation but “sustainability” over multiple examinations.

A second societal goal is the protection of consumers. Again, this is a laudable objective, which applies to virtually all commercial enterprises, and banks undoubtedly have an obligation to comply with consumer protection laws and, more broadly, to serve the interests of their customers and communities. Moreover, banks that fail to comply should be subject to appropriate penalties, although the enforcement of these laws should take into account the vast array of consumer compliance laws and the evolution of not only regulatory expectations but interpretations. Nonetheless, what is special for banks, as opposed to other companies, is an enforcement approach that directly impinges on a bank’s overall business strategy by imposing the widespread disqualifications discussed in the preceding paragraph. Of course, this has at most a tangential relationship to safety and soundness.

The scope of regulation of banks must carefully balance the need for robust safety and soundness standards with the need for sufficient flexibility.

The divorce between these new enforcement policies and safety and soundness considerations is illustrated by the ratings methodology used by the regulators to prohibit expansion, among other things. For decades, banking organizations have been rated under the so-called CAMELS rating system. The components of this system relate to safety and soundness: C = capital adequacy; A = asset quality; M = management; E = earnings; L = liquidity; and S = sensitivity to risk. (Note: The Federal Reserve has recently proposed a new rating system for large bank holding companies.) A management or capital rating, or a composite rating across the six components, of “unsatisfactory” (“3”) or below precludes expansion. (Note: Likewise, a Community Reinvestment Act rating of “needs to improve” or below is generally preclusive of expansion.)

Notably, there is no component in the CAMELS system for compliance with regulations unrelated to safety and soundness. This is logical because, except in egregious circumstances, failures with respect to such regulations would not detract meaningfully from safety and soundness. Nonetheless, the bank regulatory agencies have, in effect, not only made compliance a component of the CAMELS rating system but an often determinative component. Typically, any significant compliance failure is now deemed by the regulators to reduce the management (M) rating to “unsatisfactory,” and, as indicated, such a rating precludes a broad range of activities and transactions. This result is different from the safety and soundness regulatory regime envisioned in Corrigan’s articles. It remains to be seen whether the Federal Reserve’s proposed new rating system for large banking organizations will change that result.

Bank Affiliations
In Corrigan’s original article, a central thesis was that the special position of banks made it injudicious for them to affiliate with other companies, including most other financial companies. By the time of the revisitation article, however, the Gramm-Leach-Bliley Act had removed most of the barriers to the affiliation of banks and financial companies, while preserving the fundamental dichotomy between banking and commerce.

Corrigan concluded in 2000 that “to a very considerable degree, GLB seems to acknowledge that banks are special. Indeed, the Act is both powerful and progressive in providing a coherent framework to guide the next phase of the evolution of banking and finance in the United States.” In particular, the act preserved the bank holding company model favored by Corrigan by limiting the conduct of the new financial services activities to the holding company.

With one major exception, the Dodd-Frank Act maintained the basic structure for bank affiliations that existed after Gramm-Leach-Bliley. That exception was the Volcker Rule’s partial rollback of Gramm-Leach-Bliley’s partial repeal of the Glass-Steagall Act. Gramm-Leach-Bliley had removed Glass-Steagall’s “not engaged principally” limitation on investment banking by affiliates of banks (Section 20). The Volcker Rule eliminated the authority of bank affiliates, as well as banks themselves, to engage in proprietary trading and investments in covered funds.

More recent calls for a return to Glass-Steagall have not been couched in terms of preserving the special nature of banks. Indeed, such an argument could not legitimately be made because the Gramm-Leach-Bliley Act left untouched the Glass-Steagall restrictions on the operations of banks themselves. Of even more importance, these proposals are not grounded in an analysis of the 2008 financial crisis, because no evidence has been adduced that the partial repeal of Glass-Steagall in Gramm-Leach-Bliley contributed in any meaningful way to that crisis. This echoes the informed economic analyses of the Glass-Steagall Act itself, where there is no evidence that securities activities of banks or their affiliates were a meaningful contributor to the collapse of the banking system at the onset of the Great Depression.

Conclusion
Banks are special, as Corrigan persuasively argued, because of the unique and fundamental role they play in supporting the nation’s economy. For this reason, the scope of regulation of both banks and their affiliates must carefully balance the need for robust safety and soundness standards with the need for sufficient flexibility so that banks are capable of fulfilling that role, which requires carefully calibrated risk-taking. As Corrigan aptly concluded, this balance is crucial so that, given banks’ special role, they must be able to “maintain profitability, attract capital and preserve a de facto monopoly on the transaction account business.”

About the Author:
H. Rodgin Cohen H. Rodgin Cohen is a partner at Sullivan & Cromwell. He was Chairman of the firm from 2000, through 2009, and has served as Senior Chairman since 2010. The focus of his practice is regulatory, compliance, acquisition, enforcement, cyber, and securities law matters for banks, financial institutions, and their trade associations. He works with all the bank regulatory agencies, as well as multiple other governmental agencies, on behalf of financial institutions and trade associations, including TCH.