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AnnualReport1982CompleteText
AnnualReport1982
AreBanksSpecial?
[Completetext]
January1982

Introduction
TherecentevolutionofthefinancialstructureintheUnitedStateshasproducedtwocompeting
pointsofviewregardingtheproperdirectionforfurtherchange.Ontheonehand,thereistheview
thatthe"financialservicesindustry"encompassingbanks,thrifts,brokers,investmentbanks,and
insurancecompaniesshouldbelookedatasasingleentity.Accordingtothisview,effortsto
distinguishamongkindsofinstitutionsarebothfutileandunnecessary.Thisviewofthefinancial
servicesindustryisbasedonthebeliefthatmanyfinancialservicesofferedbyvariousclassesof
institutionsaresocomplementaryto(orsuchclosesubstitutesfor)oneanotherthatinstitutional
distinctionsarerendereduseless.Implicitinthisviewistheassumptionthatbanksarenotspecial.*
Thecompeting,ifnotopposing,viewisthatbanksareindeedspecial.Thisviewholdsthat
specializationoffinancialinstitutionshasworkedwelland,atleastinsomecases,specialization
maystillbemoreefficientandalsobetterservethepublicinterest.Thisviewisassociatedwiththe
historicalseparationofbankingfromcommerceandfrominvestmentbanking.Ingeneral,this
"separationdoctrine"inbankinggrewoutofconcernsaboutconcentrationoffinancialpower,
possibleconflictsofinterest,andtheappropriatescopeofrisksbanksshouldincurinthefaceofthe
specialtrusteeshipfallingoninstitutionsthatengageinthelendingofdepositors'money.Ina
shorthandway,aspertainstobanksandthebankingsystem,theseconcernsaretypicallycaptured
bythephrase,"safetyandsoundness."
Thesetwopointsofviewdonotnecessarilyrepresentmutuallyexclusiveapproachestofinancial
marketstructure.Forexample,inthecontextofalargefinancialservicesholdingcompany,banks
couldbelegallyseparatedfromnonbanks,butitisnotclearthatsuchseparationwouldnecessarily
providethekindsofprotectionsthatarecurrentlybuiltintofederalbankinglaws.
Thus,assessingthemeritsofthesetwocompetingviewsmuststartwithsomeverybasic
questions:Arebanks"special"oraretheysimplyanotherprovideroffinancialservices?Doesit
matterwhatkindsofrisksbanksincur?Doesitmatterwhoownsbanks?Is"safetyandsoundness"
acliche,orshouldithavegenuineandsubstantialmeaningforbanks,forbankregulators,andfor
thepublicatlarge?
Whilebankingpracticeshavenaturallyevolvedovertime,recentlyacombinationofeventshas
shiftedthatprocesstooneofanalmostrevolutionarycharacter.Amidstthisprocessofrapid
change,withmarketinnovationandnewsourcesofcompetition,thereisaperceptionthatbanks'
competitivepositionandpresumablytheirmarketsharehasslipped.Casualobservationofthe
growthofthecommercialpapermarket,thethriftindustrymoneymarketmutualfunds(MMMFs),
andthedefactotrendtowardownershipofbanksbysecuritiesfirmsandcommercialenterprises,
tendstosupportthatperception.Indeed,therearenumerousinstancesinwhichnonbankshave
beenabletoprovide"banklike"servicesatalowercost(orahigherrateofreturn)totheindividual
orcorporatecustomer,therebydrawingbusinessawayfrombankinginstitutions.
Highonthelistofreasonsthatarecitedforthisperceivedshiftofmarketpositionfrombanksto
nonbankcompetitorsistheextraburdenofregulationonbanks.Thefactofaheavyregulatory
burdenonbanksisbeyonddispute,butinsomecasesitisalsotruethatregulationrelatingto,for
example,depositinsuranceoraccesstothediscountwindowprovidespowerfulincentivesfor
individualsandbusinessestomaintainrelationshipswithbanks.Whileitisdifficulttojudgethenet
competitiveresultsofdifferingdegreesofregulation,itdoesseemclearthatofalltheregulatory

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burdensonbanks,therehavebeentwothatstandoutintermsoftheirimpactonbanks'competitive
positionovertime:RegulationQandlimitationsonthescopeofbankservices.Thisisnotto
suggestthatotherregulationsonbanksrangingfromreserverequirementstocommunity
reinvestmenthavenotbeencostly.But,atthecuttingedgeofmarketpositionormarketshare,itis
RegulationQandservicelinerestrictionsthathavebeenthemostcriticalrestraintsonbanks.
Despitetheseregulatoryrestraints,bankshavenotstoodstillinthefaceofchangingfinancial
marketsandnewsourcesofcompetition.ByusingtheflexibilityprovidedbytheBankHolding
CompanyAct,bydevelopingsophisticatedliabilitymanagementtechniques,bymajorexpansions
abroad,andbycreativeandinnovativeadaptationsof"conventional"bankingservices,bankshave
actuallyfaredratherwellintermsofpreservingtheiroverallmarketposition.Whileitisnoteasyto
measurewhathashappenedtotherelativepositionofbanksovertime,theappendixtothisreport
makessuchaneffort.Allowingfortheinherentmeasurementproblemsinsuchanexercisetosay
nothingofthedatalimitationstheanalysissimplydoesnotbearouttheperceptionnotedearlierthat
bankshavelostgroundinthedomesticmarketplaceoverthepastthreedecades.(Whilenot
capturedbythedata,bankshave,ofcourse,mademajorexpansionsabroadduringthisperiod.)
Theanalysisdoesnot,however,implythatheavyregulationhasnotconstrainedthegrowthof
banksandtheirmarketshare,foritisquitepossiblethatabsentsuchregulations,banks'position
wouldhaverisenratherthanessentiallyheldsteady.Nordoestheanalysisindicatewhetherarising
orfallingbankshareisgood,bad,orindifferentfromtheperspectiveofthepublicinterest.Tosome
extenttheseissuesdependuponwhether,infact,thereissomethingspecialaboutbanksthatis
worthpreserving.Indeed,ifbanksarespecialitwouldnotbeinthepublicinterestforthefeaturesor
functionsthatmakebanksspecialtobeerodedbycompetitive,regulatoryorlegislativeforces.By
thesametoken,ifwhatisspecialaboutbanksdictatesarelativelyheavydoseofregulation,public
policymakersshouldnotbegoadedintoeliminatingnecessaryregulationsimplybecausebank
marketsharemightgrowtosomehigherlevelwithoutthatregulation.

WhatMakesBanksSpecial?
Reducedtoessentials,itwouldappearthattherearethreecharacteristicsthatdistinguishbanks
fromallotherclassesofinstitutionsbothfinancialandnonfinancial.Theyare:
1.Banksoffertransactionaccounts.
2.Banksarethebackupsourceofliquidityforallotherinstitutions.
3.Banksarethetransmissionbeltformonetarypolicy.
Thesethreeessentialbankcharacteristicsandtheinterrelationshipsbetweenthemarediscussed
below.Ofnecessity,thediscussiontreatseachfactorseparately.However,itisclearthatthese
essentialcharacteristicsarehighlycomplementaryandfurthermorethatitistherelationshipamong
themthatbestcapturestheessenceofwhatmakesbanksspecial.

IssuanceofTransactionAccounts
Onlybanksissuetransactionaccountsthatis,theyincurliabilitiespayableondemandatparand
arereadilytransferablebytheownertothirdparties.Theownerofatransactionaccountcan
demandandreceivecurrencyinthefaceamountdepositedintheaccountwriteacheckinthefull
amountoftheaccountorperhapsmostimportantlytheowneroftheaccountcantransferthefull
amountoftheaccounttoathirdpartyalmostinstantaneouslybywiretransfer.Theliquidity,mobility,
andacceptabilityofbankissuedtransactionaccountspermitourdiverseeconomicandfinancial
systemtoworkwiththerelativeeaseandefficiencytowhichweareaccustomed.Moreover,in
periodsoffinancialstress,thecapacitytoquicklymovetransactionaccountbalancestothirdparties
takesonspecialsignificancebyprovidingelementsofflexibilityandcertaintyinmakingand
receivingpaymentsthathelptoinsurethatfinancialdisruptionsdonotspread.Individualbankscan
alsocreatethesehighlyliquidandmobilebalancesthroughtheirlendingfunction.Thecapacityto
"create"liabilitieswiththesecharacteristicsisvitaltotheongoingneedsofcommerce,butittakes
onspecialsignificanceinperiodsoffinancialstress.
Becauseofthepeculiaritiesoflawandregulation,notallclassesoftransactionaccountshavethe
samepreciselegalorregulatorycharacteristics.The"demanddeposit"isthepurestformof
transactionaccount,since,forexample,negotiableorderofwithdrawal(NOW)accountsandsome
sharedraftsatmutualorganizationshaverestrictionsontheextenttowhichtheyarepayableon
demand.However,fromtheperspectiveofboththeissuinginstitutionsandtheircustomers,these
differencesappeartobewithoutsubstancesincetheaccountsareperceivedandtreatedas
transactionaccountsbothbytheissuinginstitutionandbythepublic.Forthisreason,a
contemporarydefinitionof"transaction"accountsatleastforpurposesofidentifyinganddefining

specialcharacteristicsofbanksshouldfocusonfunctionalcharacteristicsratherthanexisting
legalorregulatorydistinctions.Ifafinancialassetsatisfiesthefunctionaltestofbeingpayableon
demandatparandreadilytransferabletoathirdparty,itshouldforthosepurposesbea
"transaction"balance.
Acasecanbemadethatnonbankfinancialinstitutionsincurliabilitiesthatappeartohavesomeor
allofthecharacteristicsofatransactionaccountissuedbyabank.Howeveroncloseinspectionit
appearsthatsuchinstrumentswhetherMMMFs,retailrepurchase(RPs)agreements,customer
creditbalanceswithbrokers,sweepaccounts,etc.donot,atleastinatechnicalsense,infact
possessthecharacteristicsassociatedwiththebankissuedtransactionaccount.However,asis
discussedlatermakingthedistinctionisparticularlydifficultinthecaseofMMMFs.Inallofthese
cases,includingmoneymarketmutualfunds,instrumentswhichappeartohavebanktransaction
accountcharacteristicstakeonthosecharacteristicsinpartbecausetheacquisitionordispositionof
suchassetsinvolves,atsomepoint,theuseofatransactionaccountatabank.However,
technologymakesitpossibletomanagethesefinancialassetsinawayinwhichtheirultimate
dependenceonabankaccountisnotapparenttotheindividualholderoftheasset.
Aslongasbanksissuetransactionaccountsthey,bydefinition,incuraformof"termstructure"risk.
Thatis,thepresenceoftransactionbalancesonthebooksofabankmakesitdifficult,ifnot
impossible,tomatchthematuritiesofassetsandliabilities,particularlyinacontemporarysettingin
whichbankholdingsofliquidassetshaveshrunkandinwhichsomeassets,traditionallyconsidered
asliquid,maynot,infact,beallthatliquid.Indeed,theassetsideofthebalancesheetforatleast
somebanksprovidesasmallmarginoffunctionalliquiditythatcanreadilybebroughttobearto
meetlargeandsuddendepositoutflows.Inthissetting,theinherenttermstructuremismatchonthe
booksofbanksisoneoftherealitiesthatgivesrisetoconcernsaboutstrainsonbankliquidityand
suddendrainsonbankdeposits.
Banksandbankregulatorshavelongsincerecognizedtheimportanceofbanksactinginwaysthat
preservepublicconfidenceinbanks'capacitytomeettheirdepositobligations,therebyminimizing
thelikelihoodoflarge,suddendrainsofbankdeposits.Depositinsuranceanddirectaccesstothe
lenderoflastresortareuniquelyavailabletobankstoreinforcethatpublicconfidence.Indeed,
depositinsuranceandaccesstothelenderoflastresortconstituteapublicsafetynetunderthe
deposittakingfunctionofbanks.Thepresenceofthispublicsafetynetreflectsalongstanding
consensusthatbankingfunctionsareessentialtoahealthyeconomyHoweverthepresenceofthe
publicsafetynetuniquelyavailabletoaparticularclassofinstitutionsalsoimpliesthatthose
institutionshaveuniquepublicresponsibilitiesandmaythereforebesubjecttoimplicitcodesof
conductorexplicitregulationsthatdonotfallonotherinstitutions.
Experiencesuggestsratherstronglythatpublicconfidenceinabankwithorwithoutdeposit
insuranceandtheFeds'discountwindowisultimatelyrelatedtopublicperceptionsaboutthe
financialconditionofbanksandspecificallyaboutthequalityofbankingassets,liquiditycapital,and
thecapacitytoabsorbshortrunshocks.Suddendrainsonbankdepositsoccurwhendepositors
concludethatloanlossesorothercircumstancesmightjeopardizeabanks'abilitytomeetits
depositobligations.Theevidenceisoverwhelming,forexample,thatmost"problem"bank
situationsinrecentyearsinvolvedconcernsgrowingoutoflossesorperceivedlossesassociated
withlending,securitiesactivities,foreignexchangeactivities,and/orpoormanagement.Inthis
regard,itshouldbenotedthatevenwhen"problem"banksituationshavebeenresolvedwitha
minimumofcoststotheindividualinstitution,thesesituationshave,onoccasion,involvedhigh
costsintermsofgeneralizedfinancialmarketdisruption.Thus,whiledepositinsuranceandaccess
tothelenderoflastresortmayrightlybeviewedasthepublicpolicysafetynetunderbanks'deposit
takingfunction,theintegrityofthedeposittakingprocessandthereforethestrengthofthepublic
safetynetprocessdependtoasubstantialdegreeontheprudentmanagementandcontrolofrisks
onthepartofthebankingsystemasawhole.
Lookedatinthisperspective,thecriticaldifferencebetweenbanksandotherclassesoffinancial
institutionsrestswiththecapacityofbankstoincur(andtocreate)liabilitiesthatarepayableon
demandatparandthatarereadilytransferabletothirdparties.Theresultingmismatchofthe
maturitiesofassetsandliabilitiesmakesbanksparticularlyvulnerabletosuddendrainsondeposits
thatcanjeopardizetheirsolvency.Inpractice,depositorsreinforcedbythepublicpolicysafetynet
havedemonstratedtendenciestodraindepositsfromparticularbanksonlywhenconfrontedwith
therealityortheperceptionoflossesgrowingoutofassetmanagementproblemsand/orpoor
managementofbankingorganizations.Thus,whilethedeposittakingfunctionofbanksiswhat
makesthemunique,theintegrityofthatprocessdependsupontherisks,realandperceived,
associatedwiththelendingandrelatedactivitiesofthebankingsystemasawholeanditscapacity
toabsorbshocksintheshortrun.

BackupSourcesofLiquidity
Asdiscussedabove,thefactthatbanksissuetransactiondepositsisthekeyfactorthat
distinguishesthemfromotherclassesoffinancialandnonfinancialinstitutions.However,
experiencealsosuggeststhatpublicconfidenceintheabilityofbankstomeettheirdeposit
obligationsisultimatelyrelatedtothequalityofbankassetsandtotheoverallfinancialconditionof
thebank.Thisrelationshiptakesonadditionalimportancewhenitisrecalledthatbankscanalso
create,throughtheirlendingactivities,transactiondeposits.Indeed,inaveryrealwaybanksare
theprimarysourceofliquidityforallotherclassesandsizesofinstitutions,bothfinancialand
nonfinancial.
Theextenttowhichbanksplaythisrolecannotbejudgedsimplybylookingatthenumberand
valueofloansonthebooksofbankingorganizations.Forthesepurposes,contingentcredit
obligationsofbanks,suchasloancommitmentsandstandbylettersofcredit,mustbeconsideredin
virtuallythesamelightasdirectloans.Thesestandbycreditfacilitiesare,forexample,the
arrangementswhichpermitmostfinancialmarketsandinstitutionstofunctionastheydo.Itishighly
unlikelythatthecommercialpapermarketwouldfunctionverywellwereitnotforthepresenceof
standbybankcreditfacilitiesobtainedbythosecorporationsthatissuecommercialpaper.Similarly,
itisverydifficulttoimaginethateventhebestmanagedandcapitalizedbroker/dealerscouldhandle
theirdaytodaybusinesswiththeefficiencythatisnowsocommonwithoutreadyaccesstobank
linesofcredit.Thesame,ofcourse,appliestononfinancialcorporations.Indeed,whileallsuch
institutionsmayovertime,haveaccesstoawidevarietyoffundingsources,directorstandbybank
creditfacilitiesarethecornerstoneuponwhichthesealternativesourcesofcreditrest.Ifthereare
problemsinonesegmentofthecreditnetwork,institutionswillsimplyshifttheirborrowingactivities
elsewhereinthenetwork.However,iftheproblemisinthebankingsector,banksmusteitherturnto
eachotherortothecentralbank.
Eveninthe"normal"courseofevents,thedirectandstandbycreditfacilitiesprovidedbybanksare
thefoundationuponwhichothercreditmarketsdependfortheirvitality.Thisrelationshiptakeson
specialsignificance,however,inperiodsofselectiveorgeneralizedfinancialstress.Forexample,in
virtuallyeverycaseof"selective"financialshockinthe1970sandearly1980s,troubledinstitutions
financialandnonfinancial,bankandnonbankturnedtothebankingsystemtoprovideatleasta
bridgeuntilmorelastingsolutionstotheproblemcouldbeworkedout.Attheveryleast,these
bridgingarrangementshelpedtocontainproblemsandpreventthemfromspreadingtoother
institutionsortothefinancialsystemgenerally.
Banks'abilitytosupplycreditandliquidity,particularlyinsituationswhereotherinstitutionsor
marketsmaybeunwillingorunabletodoso,arisesbecausethedepositcreatingfunctionofbanks
(intandemwithbanks'relationshipwiththecentralbank)providesanelementofcreditandliquidity
elasticitywhichisnotimmediatelyavailabletootherinstitutions.Inpointoffact,theextentand
frequencywithwhichbankshavehadtodirectlyrelyonextraordinaryfundingbythecentralbank
(eitherthroughthediscountwindoworviaopenmarketoperations)havebeenquitelimited.Inthe
normalcourseandeveninperiodsofstress,individualbanksandthebankingsystemasawhole
areabletoprovidenecessaryliquiditybecauseoftheirabilitytoquicklyfundloansthroughavariety
ofmarketsourcesincludingthedomesticandforeigninterbankmarket,RPs,theissuanceoflarge
certificatesofdeposit(CDs),andsoon.Formanybanks,accesstothesemarketshasbecomethe
primarysourceofbankliquidity.
Banks'accesstothesemarketsandbyextension,banks'abilitytofunctionasbackupsourcesof
liquidityoccursinacontextinwhichindividualsuppliersofsuchfundswhetherfederalfunds,
CDs,Eurodollars,etc.makejudgmentsaboutthestrengthandvitalityofindividualbanksandthe
bankingsystemasawhole.Experienceisclearforexample,thatindividualbanksexperiencing
problemswithclassifiedassets,earnings,andsoon,oftenseethatphenomenonfirstmanifestitself
intheformofhavingtopayariskpremiumoverthe"going"rateforfederalfundsandlargeCDs.
Similarlywhenconcernsaboutthebankingsystemarosein19741975andmorerecentlyin1982,
anearlymanifestationwasawideningoftheinterestratespreadbetweenbankandtreasury
liabilitiesofcomparablematurities.Intheextremecasesofsevereproblemswithindividualbanks,
wideningspreadsultimatelyresultinthesesourcesoffundingbeingcutoff,withaconsequentneed
toeithercontractthesizeofthebank,borrowfromtheFeds'discountwindow,orinsomecases,
closeormergethebank.
Thepointis,ofcourse,thattheabilityofabanktofulfillitsroleasabackupsupplierofliquidityto
thefinancialandbusinesscommunitiesdependsoneasyaccessnotonlytotraditionalsourcesof
depositliabilities,butalsotomarketsfornondepositsourcesoffunding.Thesameappliestothe
bankingsystemasawhole,becausewhileoneorafewbankscanturntotheLondonmarketto
fundthemselvesintimesofadversity,itisclearthatthebankingsystemasawholecannot.Thus,

aswiththepreservationoftheintegrityofthedeposittakingfunctiondescribedearlier,experience
clearlysuggeststhattheabilityofbankstoprovidetheessentialfunctionofabackupsourceof
liquidityisultimatelydependentonmarketjudgmentsastothequalityofthebanks'assetsand
overallfinancialstrength.
Lookedatinthislight,theabilityofbankstofulfilltheirroleasstandbysourcesofliquidityandcredit
restsimportantlyonthequalityandconsistencyofcreditjudgmentsmadebybanks.Thisis
particularlytrueinperiodsofstresswhenbanksmaybecalledontosupplycredittoborrowerswho,
foronereasonoranother,temporarilydonothaveaccesstoothersourcesoffundsortomakethe
evenmoredifficultdecisionsasinwhichborrowersareexperiencingproblemsofafundamentalor
irreparablenature.Itisintheseparticularcircumstancesthatbanksmustbeinapositiontomake
rigorous,impartial,andobjectivecreditdecisions,becauseitispreciselyinsuchcircumstancesthat
thepotentialforcompromiseintheimpartialityofthecreditdecisionmakingprocessisgreatestand
thepotentialforassetqualitydeteriorationisthelargest.Itisinthislightthatconsiderationsabout
thecomminglingofbankingandotherinterestsandconcernsabouttheownershipandcontrolof
banksbecomecompelling.
Tosummarize,virtuallyallotherfinancialmarketsandotherclassesofinstitutionsaredirectlyor
indirectlydependentonthebankingsystemastheirstandbyorbackupsourceofcreditandliquidity.
Bankscanfulfillthisfunctionforavarietyofreasons,includingtheirrelativeeaseofaccessto
depositandnondepositsourcesoffunding.However,experiencesuggeststhatthecapacityto
providethisfunctionormoredirectly,toprovideaccesstothesemarketsandsourcesoffunding
liketheintegrityofthedeposittakingfunctionisultimatelyrelatedtotheoverallfinancialstrength
ofbanksandthequalityofbankassets.Thisroleofbanksasastandbysourceofliquiditytakeson
specialsignificanceinperiodsofstressandinthislightunderscorestheimportanceofrigorousand
impartialcreditjudgmentsbybanks.This,inturn,providesaparticularlyrelevantcontextinwhich
concernsaboutthecomminglingofbankingandotherinterestsshouldbeevaluated.

TransmissionBeltforMonetaryPolicy
Astheprecedingdiscussionsuggests,thereisadirectlinkbetweenbanksandthecentralbank
arisinginpartfromthecentralbanks'lenderoflastresortfunction.Morebroadlythefactthatbanks
aresubjecttoreserverequirementsplacesthebankingsystemintheuniquepositionofbeingthe
"transmissionbelt"throughwhichtheactionsandpoliciesofthecentralbankhavetheireffecton
financialmarketconditions,moneyandcreditcreation,andeconomicconditionsgenerally.Toputit
somewhatdifferently,therequiredreservesofthebankingsystemhaveoftenbeendescribedasthe
fulcrumuponwhichthemonetaryauthorityoperatesmonetarypolicy.Thereservesinthebanking
systemalsoservethecomplementarypurposeofprovidingtheworkingbalanceswhichpermitour
highlyefficientfinancialmarketstofunctionandtoeffecttheorderlyendofdaysettlementofthe
hundredsofbillionsofdollarsoftransactionsthatoccuroverthecourseofeachbusinessday.
Somehavearguedthatneithermonetarypolicynorthepaymentsmechanismaredependentonthe
relationshipbetweenreservesandthebankingsystem.Therehavebeen,orare,schemesfor
conductingmonetarypolicyandoperatingapaymentsmechanismthatdonotusebankreserves
andthebankingsysteminthewaytheU.S.systemcurrentlyoperates.Howeveritisalsotruethat
anyofthesealternativearrangementswouldentailmajorinstitutionalchangesandruntheriskthat
theymightnotworkasefficientlyasthecurrentframeworkorthepossibilitythattheymightnotwork
atall.Inshort,tojustifydeparturefromthecurrentarrangementtheweightofevidenceshouldbe
overwhelmingthatthecurrentsystemisnotworkingorthatsomealternativesystemwouldwork
decidedlybetter.
Infact,thecurrentsystemseemstoworkratherwell,althoughrecentdevelopmentsmayhave
introducedelementsofslackintothetransmissionbelt.Forexample,theproliferationofclose
substitutesforbankissuedtransactionaccountsnarrowstheeffectivescopeofreservecoverage.
Thenarrowedreservecoveragecanintroducemoreslippageintotheprocessofmonetarycontrol,
anditalsomeansthatarelativelysmallerreservebaseissupportingalargerflowofpayments.
Similarlythederegulationoftheliabilitysideofbanks'balancesheetsseemstoimplythat,inorder
toachieveagivendegreeofmonetaryrestraint,ahigherlevelofmarketinterestratesisrequired
thanmightotherwisehavebeenthecase.Further,increasedleverageofbankingorganizations
mayworkinthedirectionofintroducingslippageintothemonetarycontrolprocess,inthatalarger
volumeofcreditflowsmaybeassociatedwithsomegivenrateofgrowthof"money".Finally,higher
leverageandgreaterriskexposuremayweakenthecapacityofthebankingsystemtoadjusttoand
toabsorbthechangesincreditmarketconditionsthatmustaccompanyperiodicmonetaryrestraint.
Assuggestedabove,theseandotherforcesmayalreadybeworkingtointroducealargermarginof
slackintothetransmissionbelt.Whiletheslackevidenttodayisofmanageableproportions,the
futuredesignofthebankingandfinancialsystemmustleaveintactastrongyetadaptable

mechanismthroughwhichmonetarypolicyandthepaymentsmechanismcanfunction.This
imperativeunderscoresthecaseforattemptingtosegregateessentialbankingfunctionsintoan
identifiableclassofinstitutionsandseekingtoensurethattheseinstitutionshavethefinancial
strengthandvitalitytoperformtheiressentialfunctionsandtoabsorbchangesinthecreditmarket
andeconomicconditionsassociatedwithperiodsofmonetaryrestraint.

DefiningaBank
Fromthepreviousdiscussion,itshouldbeclearthatthereareinfactcertainspecialandunique
functionsofbanksandthattheyareessentialtothefunctioningofanefficientandsafefinancialand
economicsystem.However,italsoseemslikelythatif"banks"didnotprovidetheseessential
functions,someoneelsewouldjustasitisabundantlyclearthattheprocessofmarketinnovation
hasalreadyproducedserviceswhichareclosesubstitutesforessentialbankservices.Giventhese
considerations,thethresholdquestionthatarisesiswhetheritisstilldesirable,fromapublic
interestpointofview,toattempttosegregateessentialbankingfunctionsintoanidentifiableclassof
institutionsand,ifthatisthecase,whetheritispossibletodefineabankinamannerthatisboth
functionallyandintellectuallysatisfactory
Puttingasideforthemomentpracticalproblemsofdefinition,itwouldseemthatthecasefor
segregatingessentialbankingfunctionsintoanidentifiableclassofinstitutionsiseverybitas
powerfultodayasitwasinthe1930s.Ifanything,concernsregardingfinancialconcentration,
conflictsofinterest,andthefiduciaryresponsibilitiesassociatedwithlendingdepositors'moneymay
bemorerelevanttodaythantheywere50yearsago.Tobesure,thelinesofdistinctionmaynot
havetobedrawninthesamewayandinthesameplacethattheywereinthepast,buttheearlier
discussionoftheessentialfunctionsofbanksservesasapowerfulargumentforseparationatsome
point.Indeed,torejectthenotionofseparationwouldasamatteroflogicrequirethatdeposit
insuranceandaccesstothelenderoflastresort,togetherwiththeassociatedsupervisoryand
regulatoryapparatus,eitherbedoneawaywithaltogetherorbemadeuniversallyavailabletoany
institutionthatprovidesessentialbankingfunctionsirregardlessofwhatothertypesofbusinessor
commerceitmightbeengagedin.Howeverasapracticalmatter,thecaseforseparationisonly
viableifweareabletoprovideasatisfactorydefinitionofabank.
Overtime,avarietyoftestshavebeenusedforthepurposeofdefiningabank.Thesetestsranged
fromachartertesttothefunctionaltestofissuingdemanddepositsandmakingcommercialloans.
Atonetime,eachofthesetestswassatisfactory.However,currentlyneitherexistingstatutesnor
regulationsseemtocontainadefinitionthatissatisfactory.
Asatisfactorydefinitionofabankmuststartwithaclearrecognitionoftheessentialfunctions
providedbysuchinstitutions.Fromtheearlierdiscussion,itisclearthatthesinglecharacteristicof
banksthatdistinguishesthemfromotherclassesofinstitutionsisthattheyissuetransaction
accountsthatis,accountsthatinlaw,inregulation,orinpracticearepayableondemandatpar
andarereadilytransferabletothirdparties.Apowerfulcasecanbemadethatthedefinitionofa
bankshouldstoprightthere:abankisanyorganizationthatiseligibletoissuetransaction
accounts.Ifaninstitutionmeetsthistest,itwould(1)beeligibleforgovernmentdepositinsurance
(2)havedirectaccesstothediscountwindow(3)besubjecttotheFeds'reserverequirementsand
(4)havedirectaccesstotheFederalReserves'paymentsservices,particularlythewiretransfer
system.Forthesepurposes,anappropriatestatutewouldhavetoredefinetransactionaccounts.At
aminimum,suchadefinitionwouldhavetoincludeconventionaldemanddeposits,NOWaccounts,
andsharedrafts.Itmightalsoincludethenewmoneymarketdepositaccounts(MMDAs)and,
dependingonthestandardsofdefinition,perhapsevenMMMFsorothernonbankinstitutional
arrangementsthatprovide"check"writingcapabilities.
Onthesurface,thisdefinitionofabankmayseeminadequatebecauseitcontainsnocorollary
assetorlendingtestitfocusesonlyontheliabilitysideofthebalancesheet.Thisseeming
inadequacyarisesinpartbecausethecurrentBankHoldingCompanyActs'definitionrequiresthat
abankissuedemanddepositsandmakecommercialloans.Moresubstantially,theabsenceofa
lendingtestseemstoflyinthefaceofargumentsmadeearlierconcerningthecriticallinkbetween
thedeposittakingfunctionandthelendingorassetacquisitionfunctionsofbanks.However,itis
preciselybecauseofthenatureoftherelationshipbetweendeposittakingandassetacquisitionthat
theessentialdefinitionofabankshouldbecouchedintermsofitsdeposittakingfunctionwithout
regardfortheparticulardistributionorclassificationofitsloansand/orinvestments.Takenbyitself,
thereisnothinguniqueorspecialabouttheassetsideofabanks'balancesheet,exceptforthe
limitsonthescopeofassetacquisitionpowersdiscussedbelow.Concernsaboutthenatureand
riskcharacteristicsofbankassetsariseinthecontextoftheuniquenatureofbankliabilities,the
needtopreservetheintegrityofthedeposittakingfunction,andthespecialtrusteeshipgrowingout
ofthatfunction.Thus,whileitmaybeappropriatefromthestandpointofpublicpolicytolimitthe

assetpowersofbankstocertainlessriskyactivities,thedefinitionofabankneedonlydealwiththe
liabilitysideofthebalancesheet.
Theabsenceofanassettestmight,however,createadefinitionalloophole.Thatis,"banks"could
conceivablyrefrainfromissuingtransactiondepositswhilefundingtheirassetacquisitionactivities
withinsuredtimeandsavingsdeposits.However,thisproblemcouldbeminimizedbyrelianceon
suchaninstitutions'eligibilitytoissuetransactionaccounts.Ifsoeligible,itwouldbedefinedand
regulatedasabankeventhough,inpractice,itrefrainedfromissuingtransactionaccounts.An
institutionthatwasnoteligibletoissuetransactionaccountswouldnotbeabankandwouldnotbe
eligiblefordepositinsurance,accesstotheFed,andsoon.
Bythisdefinition,existingcommercialbanks,thrifts,andcreditunionswouldbeconsidered"banks."
Similarlymostofthe"nonbank"banksformedinrecentyearsundertheBankHoldingCompany
Act(bynotengagingincommerciallending)wouldbebanks,aswould,dependingonstatelaws,
some"industrial"banks.Treatingthriftsandcertainotherinstitutionsas"banks"raisesahostof
difficultandpoliticallychargedissuesrelatingtoregulatorytreatment,taxstatus,divestiture,and
grandfatheringarrangements.However,forpurposesofthisdiscussion,thefactthatcertain
"nonbank"financialinstitutionsare,foravarietyofreasons,banksdoesnotrequireimmediateor
perhapsevenparallelregulation.Rather,thesuggestionwouldbethatthereisanessentialcoreof
regulationthatshouldapplymoreorlessequallytothisbroaderclassofinstitutionswhichprovides
essentialbankingfunctions.
Theissueofwhethermoneymarketmutualfundsfitthedefinitionofabankevenataconceptual
levelisnotsoeasytodealwith.Manysuchfundscertainlyappeartohaveallthecharacteristics
ofbanktransactionaccounts.Inthecaseofthemoneymarketmutualfund,thecriticaldistinction
relativetoabanktransactionaccountappearstobetheextenttowhichtheliabilitiesinquestionare
payableatpar.Inthecaseofabankdeposit,depositinsurance,thecapitalofthebank,andthe
banks'accesstoalternativesourcesofshortrunfundingprovideassurancesthatadepositorcan
withdrawdollarfordollarfromthebanktheprincipalamountdepositedevenwhenchangesin
interestratesmayhavereducedthemarketvalueofbankassets.
Inthecaseofthemoneymarketmutualfundtheabilitytopayoutdollarfordollartheamountofthe
initial"deposit"islesscertain.Thefunditselfdoesnothavecapitalassuch,andintheshortrunit
cannoteasilytapalternativesourcesofliquiditytopayouttosomeshareholderstherebybuying
timeforassetstomatureorforinterestratestoreversecourse.Asarelatedmatter,thefundisnot
insuredsothateventhoughtheriskoflosstotheindividualshareholderissmall,itdoesexist.The
factthatinrecentmonthsanumberofmoneymarketmutualfundshavetakenstepsinthedirection
ofsecuringsomeformofprivateinsurancewouldsuggestthatsomefundmanagersperceivethat
thereisanimportantdistinctiontobedrawnbetweenthefundsharesandbankdeposits.Theirony
ofthis,ofcourse,isthattotheextentfundsobtaininsurance,theycomeevenclosertopossessing
banklikecharacteristics.
Fromacompetitiveviewpoint,thequestionofwhetheramoneymarketmutualfundisabankisfar
lessimportanttodaythanitwasbeforetheintroductionofMMDAsatbanks.Indeed,ifbeinga
"bank"isequatedwithdepositinsurance,accesstotheFeds'discountwindowandpayments
servicesthecostsofreserverequirementsnotwithstandingsomemoneyfundsmightnotobject
atalltobeingcalledabankinthecurrentmarketsetting.Moreover,ifthepowerofbanksorbank
holdingcompanieswasexpandedtopermitsuchinstitutionstooffermutualfunds,thequestion,
fromacompetitivepointofview,wouldbeevenlesspressing.
However,intermsofintellectualconsistency,thequestionofwhethermoneymarketmutualfunds
(orsimilararrangementswhichpermit"check"writing)shouldfallwithinthedefinitionofabank
doesnotdisappearsimplybecausecurrentcompetitiveconditionsrendertheissuelesscompelling.
Ontechnicalgrounds,itwouldseemthatthedistinctionarisingfromthepaymentatparprinciple
couldjustifytreatingmoneyfundsasnonbanks.Onfunctionalgrounds,however,andparticularly
fromtheperspectiveoftheshareholderthecheckwritingfeaturesofsomefundssimplymaycreate
toomuchofa"lookalike"situationtomakeameaningfuldistinctiononthetechnicalgroundsof
paymentatpar.Itmaythereforebenecessarytoplacecertainrestrictionssuchaslimitsonthe
numberofthirdpartytransfers(aswithbankissuedMMDAs)and/orreserverequirementson
"nonbank"financialinstrumentsorinstitutionsthatprovidecheckwritingfeatures.Ofcourse,if
MMDAsweredefinedastransactionaccounts,thenthecasefortreatingMMMFsasbankswould
becomepowerful.

BankPowersandStructure
Ifabankcanbesatisfactorilydefinedalongthelinessuggestedabove,therearethreerelated
questionswhichmustbeansweredinordertosketchoutareasonableapproachtothefuture

scopeandstructureofbankingactivitiesandbanks.Theyare:(1)Whatkindsofsubsidiarypowers
shouldbankshave?(2)Whatrestraints,ifany,shouldbeplacedontheownershiporcontrolof
banks?(3)Isitimportant,fromapublicpolicyperspective,whetherthesubsidiaryactivitiesof
banksareperformedinthebank,asubsidiaryofthebank,orinasubsidiaryofabankholding
company?
Theanswerstoeachofthesequestionsmustbeguidedbytheearlierdiscussionofwhatitisthat
makesbanksspecialandtherelationshipbetweentheintegrityofthedeposittakingfunction,the
financialstrengthofthebank,andultimatelythestrengthofthefinancialsystem.Thatdiscussion
impliedthatinthinkingaboutassetpowers,ownership,andtheorganizationalstructureofbanks,
substantialweightneededtobegiventosafetyandsoundnessconsiderations,thespecial
trusteeshipofbanksandtheobjectivityandimpartialityofthecreditdecisionmakingprocess.This
isnottosuggestthatotherfactorssuchasconcentrationandpublicconvenienceandneedarenot
importantfromtheperspectiveofpublicpolicy.Indeed,thesethingsmaybeveryimportant,buttheir
importanceinthecontextofquestionsrelatingtobankingpowers,ownership,andstructureis
secondarytothesafetyandsoundnessfactors.
Havingsaidthat,acasecanbemadethatwhateverweightsafetyandsoundnessandrelated
criteriahavebeengiveninthepast,thesefactorsshouldbegivenlessweightinthefuture.Better
informationandmanagementsystems,moreefficientmarkets,greaterdisclosure,improved
supervision,andthepresenceofthepublicsafetynet,allseemtoworkinthedirectionofreducing
publicpolicyconcernsaboutthesafetyandsoundnessofbanks.
However,therearestrongforcesworkingintheoppositedirection.
Financialaffairsgenerallyaremuchmorecomplexandmoreinterdependentthantheyoncewere.
Oneconsequenceofthisisthatwhenproblemsarisetheyaremoredifficulttoisolateandcontain
thaninthepast.Perhapsmoreimportantly,thecombinationofliabilitymanagementtechniquesand
deregulationhassignificantlyalteredtheoverallliabilitystructureofbanks.Stableandlowcostcore
depositsarevirtuallyathingofthepast.Thesedevelopmentshave,incombinationwithmore
sophisticatedandinterestrateconsciouscorporatetreasurersandindividuals,increasedtheterm
structureriskatbanksandmadebanksmoresusceptibletosuddendepositshifts.Atthesame
time,"spreadmanagement"wherebybanksattempttofloattherateofreturnonassetsinsome
reasonablyfixedrelationshiptochangesinthecostoffundsmay,subtlybutinsidiously,be
workingtounderminethetraditionaldisciplinesofbothborrowersandlenders.Finally,thefarflung
internationalactivitiesofbankshaveintroducednewelementsofriskintotheequation.Whileitisa
matterofjudgmentastowhetherthiscrosscurrentofeventsisworkingtoreduceortoincreasethe
risksassociatedwiththeactivitiesofbanks,itdoesseemprudenttoconcludethattheyareworking
inthedirectionofcreatinggreaterrisks.

BankSubsidiaryPowers
Assuggestedearlier,topreserveandprotecttheessentialfunctionsofbanks,banksmustbe
competitivelyviableinstitutions.Thismeans,amongotherthings,thatbanksmustbeabletooffera
sufficientlywideandcompetitiverangeofservicestomaintainprofitability,attractcapital,and
preserveadefactomonopolyonthetransactionaccountbusiness.Withoutdelvingintothespecific
typesofpowersbanksshouldhave,theprecedingdiscussionissuggestiveofthegeneralcriteria
whichshouldbeusedinmakingjudgmentsaboutthescopeofbankingpowers.Whileanumberof
factorsmayberelevantinthisregard,theessentialfunctionsofbanksasdescribedearliersuggest
theprimacyoftwogeneralcriteria.Theyare:subsidiarybankingactivitiesshouldnotentail
excessiveriskoflossandshouldnotimpairtheimpartialityofthecreditdecisionmakingprocess.
Thisdualcriteria,whileconceptuallyuseful,isoperationallyambiguous.Tosomeextent,itbecomes
moreclearinacontextinwhichsecondarycriteriarelatingtocompetition/concentration
considerationsareintroduced.Similarly,asapracticalmatter,definingtheextentofappropriate
subsidiarybankingpowerscanbeguidedbypoliciesgoverningbankownership.Thatis,logic
wouldseemtodictatethataparticularsetofpowersbevestedinbanksonlytotheextentthatthere
isawillingnesstopermitanotherinstitutionengaginginthoseactivitiestoownand/orcontrolbanks.
Forexample,ifwearewillingtopermitbankstoengageincommercegenerally(thatis,the
acquisition,manufacture,ordistributionofgoodsandnonfinancialservices),thenweshouldbe
preparedtosaythatfirmsengagedinsuchbusiness,whetheroilcompaniesorshoestores,can
ownandcontrolbanks.Theconversealsoshouldfollow:ifweareunwillingtopermitbanksto
engageinsuchactivities,thenlogicwouldseemtodictatethatsuchcommercialfirmsshouldnot
ownbanks.Thesymmetryofthisargumentisimportant,foritlendsweighttotheapparent
consensusthattheseparationofbankingfromcommercegenerallyisappropriateandshouldbe
maintainedinbothdirections.
However,evenintherealmofsocalledfinancialservices,therisk/impartialitycriteriadonotprovide
unambiguousinsightsastohowfarbankingpowersshouldbeextended.Forexample,ifthereisa

consensusthattherisk/impartialitytestshouldnotprecludebankingorganizationsfromengagingin
thesaleanddistributionofmutualfundssharesorinthedistributionandbrokerageofsecurities,it
isbynomeansclearthatsuchaconsensuswouldextendtoactivitiesrelatingtotheunderwritingof
stocksandcorporatebondsgenerallyortotakingpositionsincommodities.Thepointis,ofcourse,
thatwhileitisafairlyeasymattertoconcludethatacontinuedseparationofbankingand
commercemakessense,itisnotnearlysoeasytoconcludeasamatterofpublicpolicythatthe
fullrangeoffinancialservicesshouldbefairgameforbankingorganizations.Attheveryleast,the
risk/impartialitycriteriasuggestedaboveandthebankownership/controlquestionsdiscussedbelow
suggestthatweshouldnotbeindifferenttothescopeoffinancialservicesofferedbybanking
organizations.

BankOwnership
Ifthereissomeagreement(1)thatthesegregationofessentialbankingfunctionsintoidentifiable
classesofinstitutionsmakessense(2)onthedefinitionofa"bank"and(3)ontheappropriate
scopeofpowerstobehousedwithinbankingorganizations,thendealingwiththequestionofbank
ownershipbecomesfairlyeasyThatis,nonbankingorganizationswouldbepermittedtoownbanks
onlyinsofarastheactivitiesofsuchentitiesmatchtheactivitiesinwhichbankingorganizations
wouldotherwisebepermittedtoengage.Forexample,asecuritiesfirmwhoseactivitiesdidnotgo
beyondtheactivitiesdirectlypermissibletobanksandbankholdingcompaniescouldownabank,
butintheprocessthatorganizationwouldbecomeabankholdingcompany.Ontheotherhand,
financialornonfinancialfirmscouldnotownabankunlesstheywerewillingtodivestthose
activitieswhichfalloutsidethelistofpermissibleactivitiesforbanksandbankholdingcompanies.
Thus,dependingonthedeterminationofthescopeofbankingpowerswhich,asnotedearlier,
shouldbeundertakenprimarilywithinthecontextoftherisk/impartialitycriteriathisapproach
wouldrequirethatanumberofexistingsituationsinvolvingtheownershipof"banks"byfinancial
andnonfinancialfirmswouldhavetobegrandfatheredor,perhapsinsomecases,divestiture
arrangementswouldhavetobeworkedoutoveraperiodoftime.

BankingStructure
Finallyinthiscontext,questionswillinevitablyariseastowhetheritmatters,fromtheperspectiveof
publicpolicy,ifparticularsubsidiaryactivitiesofbanksarecarriedoutinthebank,inasubsidiaryof
thebank,orinasubsidiaryofthebanks'holdingcompany.Giventheearlierdiscussionaboutthe
importanceofsegregatingessentialbankingactivitiesandtheimportanceoftherisk/impartiality
criteriaforpurposesofevaluatingtheappropriatescopeofbankingactivities,itwouldseemto
followthatthereisapowerfulcaseforplacingsomesubsidiaryactivitiesofbankingorganizations
intoaffiliatesofbankholdingcompanies.Thiscaseisreinforcedbytheprotectionsagainstself
dealing,whicharemadepossiblebycertainprovisionsoftheBankHoldingCompanyActandby
thedefactosegregationofcapitalthatismadepossiblebytheholdingcompanystructure.
Howeveritdoesnotfollowfromtheabovethatwecanbeindifferentastothedegreeofrisk
associatedwithsuchactivitiessimplybecausetheymaybehousedinaseparatelyorganizedand
separatelycapitalizedsubsidiaryofabankholdingcompany.Tothecontrary,experiencesuggests
ratherclearlythatintimesofperilitmaynotbepossibletoinsulatethebankfromtheproblemsof
itssisterorganizationsevenwhensuchproblemsariseinaffiliatedorganizations,including
subsidiariesofbankholdingcompanies.Whiletherearegoodandsufficientpublicpolicyreasons
forconductingthatatleastsome"nonbank"activitiesofbankingorganizationsshouldbehousedin
subsidiariesofbankholdingcompanies,suchorganizationalarrangementsarenotlikelytoproduce
asituationinwhichthebankisimmunefromtheproblems,risks,orlossesthatmightdevelopin
suchsubsidiaries.Inshort,theholdingcompanystructureisneitherasubstituteforprudent
managementnorafailsafedeviceforcontainingrisk.

InConclusion
Thisessaystartedoutwithaseeminglystraightforwardquestion:Arebanksspecial?Having
answeredthatquestionintheaffirmative,itdoesseemappropriatethatthecurrentdebateabout
thepowersandstructureofbanksbeframedinacontextthatgivesgreaterweighttotheunderlying
issuesofwhatbanksare,andwhat,fromtheperspectiveofpublicpolicy,wewantthemtobe.
Lookedatinthatlight,andwithafirmergrasponwhatitisthatmakesbanksspecial,itbecomes
somewhateasiertograpplewiththeverydifficultquestionsrelatingtothedefinitionofabank,the
scopeofbankingpowers,theownershipandcontrolofbanks,andthestructureofbanking
organizations.Thisapproachentailingasitdoesanelementofgoingbacktosquareonecan
helptoensurethatbankers,regulators,andlegislatorsapproachsuccessivestepsinthereshaping
ofourfinancialsysteminamannerwhichhelpstopreservetheuniquefunctionsandcharacteristics
ofbankswhileatthesametimeencouragingthoseelementsofcompetitionandinnovationthatwill
permitthebankingsystemandthefinancialsystemmoregenerallytosafelyandefficientlymeetthe

needsofagrowingandstabledomesticandinternationaleconomy.
*Inthisessay,theterm"bank"isusedinagenericwaythatmakesnoefforttodistinguishcommercialbanksfrom
thriftsandother"depositorsinstitutions".Thisisdonemerelytosimplifythediscussionhowever,inconsideringthe
essentialfunctionsof"banks"inlightoftheDepositoryInstitutionsDeregulationandMonetaryControlActof1980
andtheGarnStGermainDepositoryInstitutionsactof1982,itisclearthatinsubstancetherearenolonger
meaningfuldifferences.Tobesuredifferencesinpowers,inregulatorytreatment,andintaxstatusremain,butthe
basiccharacteristicsthatdistinguishbanksfromotherclassesoffinancialandnonfinancialenterprisesnowseemto
applytothriftsaswellastocommercialbanks.

Appendix

Returnto:AreBanksSpecial?

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