CHAPTER
3

The Economic Consequences of Financial Regulation

Main Street Caught in the Crossfire

The dividing line between Main Street and Wall Street is nonsense in an economy that has become so heavily finance driven as that of the United States. It feels good to punish the banks, but it always involves punishing ourselves. Accountability for individual bankers is a horse of a different color, and it remains sorely lacking, to be sure. Cutting finance down to size begs the question of what will replace it as a driver of employment and economic growth.

Since the crisis broke, public policy has alternated between attempts to reinflate the credit bubble, especially the housing finance machine, and efforts to rein in finance and effectively turn banking into a public utility. The former includes engineering rock-bottom interest rates, flooding the banks with cheap funds, and blowing up the central bank’s balance sheets with purchases of mortgage-related assets and government bonds. (Not only the Fed is playing this game, but central banks in many other countries as well.) These policies, however, have not restored the flow of credit in the Main Street economy, but have mainly resulted in banks hoarding cash in central bank reserve accounts rather than restarting the lending pump.

Another, subtler way of priming the pump has been to reinflate the value of the stock market by reducing the interest on cash deposits and government bonds to rates of return that literally force investors to accept the risks of investing in equities. None of this has made it easier for small businesses or would-be homeowners to actually secure credit, since lending standards were tightened even as rates were locked down. Meanwhile, those depending on interest income have had their spending power slashed to the bone.

Efforts to return banking to its roots as a “public utility” range from an increasing number of state attorney generals and litigators alleging predatory lending (or its opposite, lending discrimination, since banks can be attacked for both). There are also initiatives to set the price of basic services and otherwise expand oversight of the consumer side of the business, notably the Consumer Financial Protection Bureau established under Dodd-Frank, with Harvard Law School professor Elizabeth Warren as a leading advocate. However, it is on the wholesale side of the business that efforts to force a return to utility-style banking may have the largest impacts on Main Street, even if they are indirect. Basically, banking is becoming a less and less attractive place for investors to put money. Interestingly, the FDIC reported in March 2012 that last year not a single de novo bank was chartered in the United States—the first time this has happened in decades. Small banks are continuing to disappear: 140 in 2009, 157 in 2010, and 92 in 2011. As it becomes harder for banks to make money with their own balance sheets and trading books, and as banks face far higher regulatory, capital, and litigation costs, they are either going to pass those burdens on to Main Street in the form of higher prices and less service or simply exit whole market segments.

The general public and politicians seem to believe that providing basic financial services to consumers is very profitable and that banks have been gouging the little guy for years. Even some bank advertising takes this line. The truth of the matter is that providing these services is very expensive—on average as much as $350 per account. Overall deposit and related payment services account for the vast majority of bank costs, especially when you factor in regulatory compliance and fraud losses. Banks had largely been heavily subsidized by a few very profitable consumer businesses, ­notably mortgage origination and credit card lending, which themselves have incurred heavy losses since the crash. Unless banks can make a competitive return on the higher capital they are being required to keep, the market will simply not give them the capital, forcing them to shrink (as they are already doing in fact, with tens of thousands of layoffs and more to come) and defund low-return businesses such as branch banking. When the bubble was going strong, banks were making major investments in brick-and-mortar Main Street branches, creating jobs and real estate income. This can all go away very quickly.

Distortion of Bank P & Ls and Balance Sheets

Banking is often viewed by the uninformed as the very model and engine of capitalism, which is why critics of capitalism choose to occupy Wall Street and the City of London. Actually, banking has always been in many ways a creature of government and politics. Capitalism demands what the great Austrian economist Josef Schumpeter called “creative destruction.” When markets decide which firms deserve money and which don’t, the latter will fail; and along with the failure of firms, whole communities and thousands of workers may suffer real hardship. However, by trial and error, markets will tend to give capital to new, innovative companies, such as Apple, and take it away from companies with no future, such as GM. People want iPads and don’t want Chevy Volts. This capital allocation by markets has historically been a key economic strength of the United States; the birth and death of companies is far less welcome in more conservative societies such as Europe or Japan, much less socialist economies in which the government allocates capital. Even here, though, democratic politics is not really a friend of market capitalism, because voters understandably crave the economic security that dynamic market capitalism cannot provide them, and elected leaders must promise it to them even if they know better. However, the bottom line is that the freedom to fail is essential to free-market capitalism.

Banks are different. When a company that makes things goes bust, the damage is limited to its owners, employees, and suppliers. Usually they can recoup their losses with new investments, jobs, and customers. When a bank goes bust, even a relatively small one, it can undermine confidence in all banks. This can trigger a run on the banks, with depositors demanding their cash, and set off a full-blown panic leading to a collapse of economic activity on Main Street. Banks, in other words, are the one type of business that can blow up the economy overnight.

This is why, except for a few free-market fundamentalists such as Ron Paul, most sober people recognize a legitimate government interest in licensing and regulating banking companies, although the style and degree of regulation may vary greatly between jurisdictions and over time. It is also why almost all countries have established a central bank—essentially a super-bank that holds the reserves of the banking system, issues the currency, and creates money at will to bail out banks in an emergency. This lender-of-last-resort function is fundamental to central banking, but creates great risks to the taxpayer, so it logically requires that the central bank have an ability to supervise the behavior of private-sector banks. Otherwise, the very fact that someone is willing and able to bail them out of the consequences of risky behavior in fact provides incentives to the private-sector banks for that behavior—a concept knows as a moral hazard, as mentioned previously.

The second key reason why some degree of financial regulation is legitimate is that deposit money in banks forms the basis of the payments system. Payments system is an arcane term for all the institutions and mechanisms that allow one person or organization to transfer monetary claims to another. Wire transfers, checks, and plastic cards all play a role in the payments system, as does paper money. There are many parties involved, including consumers, merchants, utilities and other billers, and key infrastructure such as ATM switches and clearinghouses. At the end of the day, however, only banks can really settle financial claims by making one customer’s deposit money claim another customer’s deposit money claim. Cash, essentially a claim on the government, is the one exception to this in that it can in principle circulate from hand to hand outside the banking system. But while it makes up something like 85 percent of all payments worldwide, it represents a very small percentage of the value exchanged—5 percent or less in some countries. Compared to bank deposit money, it is a rounding error.

Your deposit money claim is the balance in your checking account. When you swipe your debit card, it is reduced by the amount of the transaction, and the party you paid has its claim increased by the same amount. If you and the person you paid are in different banks, they settle up with each other through a clearinghouse or transaction switch, but the final settlement of the claims between the banks only takes place on the books of the central bank. In other words, the banking system is ultimately a big spreadsheet or ledger on computers recording numbers representing the claims on deposit money which everyone in society owns at a given point in time. The payments system moves these blips of data around within a given banking system and also between banking systems worldwide. It is one of those things, such as power and electric light, that we take for granted until they fail to go on when we flick the switch. The government has an interest in seeing that doesn’t happen because commerce on Main Street would grind to a halt instantly if the payments system ceased to function.

The regulation of deposit taking and the regulation of payments systems are deeply intertwined. Customarily, even in the absence of a specific law, having an account on the central bank books more or less defines who is a bank. That gives central banks the power to decide the minimum qualifications to be a bank and what activities a bank can engage in. Direct regulation of payments systems has not historically been thought necessary, and fundamentally remains unnecessary, as long as the various private clearinghouses and payments networks are only open to properly licensed and regulated banks. Even before central banking, access to the clearinghouse in any market was a requirement for running a banking business. In a payments clearing, every participant depends on every other participant to pay the house what they owe. That means keeping membership confined to strong, well-managed banks is in the interest of all participants.

Having stipulated that there is a valid public interest in regulating the core, related bank functions of deposit taking and, indirectly, access to the payments system, the real question is how should it be done—though even a bad system of regulation can be executed well by talented people, and the best system is useless without them. The worst of all possible worlds is bad or contradictory rules and regulations and bad execution in compliance and enforcement. That is precisely the risk that overly complicated and prescriptive bureaucratic regulation like that created by Dodd-Frank poses. Let’s take a closer look at why.

Supervision vs. Rule Making

Before the crisis broke in 2008, there was a lively debate between banking authorities over “rules-based” vs. “principles-based” regulation, with the United States as poster child for the first and the United Kingdom for the second.

The great virtue of the rules-based approach is that the discretion of the regulator is bounded by a well-drafted rule. If a bank ticks the boxes required and stays inside the foul lines created by the rule, it is “in compliance,” and that is that. The weakness of such an approach is that a great deal of mischief can be done by players who can finesse the rules, which are almost always drafted by lawyers, not market participants, and therefore are based on existing instruments, transactions, and identified risks. Rules are always responding to yesterday’s accident, so the rule-makers and enforcers are always driving using a rearview mirror. Market players, by contrast, are always scanning the horizon for new opportunities and can find gaps in almost any set of rules, especially if they or their regulatory counsel employ the lawyers who wrote the rules in the first place, which of course they do. A second objection to a rules-based approach is that it quickly becomes a mechanical exercise of box-ticking by regulatory compliance departments staffed by specialists.

The great virtue of a principles-based approach is that broad principles of prudence and fair dealing can be designed to cover almost all future circumstances. The issue is not whether the boxes are ticked, but whether a practice or transaction conforms to well-known principles of acceptable financial conduct, such as prudence and a duty to protect the interests of customers. This of course requires business judgment, not box-ticking, and is less likely to be relegated to compliance departments. Such an approach requires fine judgments and can at times become arbitrary.

In the wake of the crisis, it is hard to maintain that either approach was terribly successful, because very little of what went wrong violated either rules or principles then in force. Bad judgment and plain-old fraud were more at fault. Sometimes, it is useful to remember that the United Kingdom was for centuries the world’s leading financial power and London the home of global finance capital without benefit of any formal regulation of either type. Instead, the United Kingdom had a culture in which unwritten rules of fair dealing, a certain clubby self-interested constraint, and informal but strong sanctions for bad behavior sufficed. In this scheme, short of common law crimes such as theft and fraud, the essentially arbitrary judgment of the Bank of England was sufficient to enforce good order. The Bank, which was a private joint-stock company up until 1946, had no legal authority over the market, but it did hold the reserves of the banking system and issue the currency in England and Wales. Access to its discount window and credit could be withheld from banks that in its judgment were doing things that were dangerous or unwholesome for the market.

When exchange control came into force in 1939, the Bank had in its sole discretion the right to extend or withdraw a foreign exchange license, the equivalent of a death sentence for banks. Only after the end of exchange control in 1979 was it felt necessary to establish a formal system of regulation presided over by an independent organization—the Financial Services Authority (FSA)—in place of the Bank. This was part of the sweeping series of reforms called Big Bang that came into force in 1986. The old clubby culture of the City of London quickly collapsed as American institutions and practices took over much of UK banking. As a result, the UK financial system balance sheet grew to over five times GDP and came to drive the entire economy, especially greater London. In the wake of the 2008 crisis, which required two trillion-pound banking groups to be bailed out by the government, it is hard to believe that this was a good bargain for the UK taxpayer.

The Shell Game

The vast expansion of both rules- and principles-based regulation at the expense of the subtler supervision of the markets and players by the Bank of England and its peers set off a game called regulatory arbitrage. At its crudest, this simply meant moving the legal locus of activities to the least-regulated jurisdictions, such as the Cayman Islands. However, there were clear limits to this. The more common practice was to game capital adequacy rules—both Basel standards and those set by national regulators. The most straightforward way of doing this was described in the last chapter, as banks put more and more emphasis on mortgages and trading activities among themselves. The development that probably caused the most damage was the asset-securitization process, in which loans were bundled, repackaged, and sold into the capital markets as securities. The mechanics of this are briefly described in my book Financial Market Meltdown, but suffice it here to say that asset securitization created a gap between the originator of a loan and its ultimate owner that provided no incentives for bankerly prudence. Moreover, the machinery of asset securitization, the sausage factory, had too many middlemen and rent seekers, all with no particular interest in the underlying credit and a great deal of interest in maximizing their fees.

Probably the most talked-about instance of conflicted interest in the securitization process is the fact that the credit-rating agencies that blessed complex asset-based securities were paid by banks seeking a rating, not by the investors in these securities, as had been the case when these firms started out rating commercial paper. This does not mean they were not honest in their judgments. I know from experience in consulting that they were quite rigorous in their financial modeling, which included scenarios that replicated the Great Depression. No, the problem was simply that the would-be issuer could work with the rating agencies to add layers of insurance and other bells and whistles to the structure of the proposed security until it passed muster. Credit insurers, consultants, lawyers, and bankers all took part in the plastic surgery that turned subprime loans into Triple A securities, and all were to some degree conflicted. What is often forgotten, however, is that throughout the Great Moderation, institutional investors from mutual funds to college endowments were clamoring for high-yielding debt to buy. It should also be remembered this was all possible within the rules-based regulation of the most heavily regulated market on earth.

The expectations of investors and the fact that bank CEOs were rewarded on achieving high returns on equity led banks to alter the mix of their ­activities to a point where Adair (now Lord) Turner of the FSA said in a speech, “a significant proportion of the activities of the investment and banking ­industries had no useful social purpose”—a credible assessment coming from a former Chase banker and senior McKinsey consultant to banks. If the purpose of banking is to maximize return on capital, and the Basel Committee and national regulators set standards that can be gamed, basic banking goes out the window because it is simply not a high return-on-equity business in competitive markets. Basic banking is the dull but steady business of taking customer deposits, providing working capital to commerce and industry through short term, self-liquidating loans, and above all providing a payment system. Basic banking was also relationship banking, where the bank manager in the branch or the owner of the community bank know the character and fortunes of their customers, not just a credit score. Once, as Niall Ferguson relates in his underappreciated recent biography of the great Sigmund Warburg, even investment banking was relationship banking. The problem is, of course, that all these things are expensive and, given the high risk-weighting given to business lending, capital intensive. They are also essentially why banks came into being in the first place, and why society has learned to live with them and on occasion save them from themselves.

What regulatory distortions and skewed management incentives both promoted were consumer products that could be securitized, especially mortgages, home equity lines, car loans, and of course credit card receivables. Banking did not really do any of this business before the 1980s, but by the early 2000s it did little but those activities. By then, commercial and industrial loans were less than a fifth of bank assets, and represented an even smaller share of profits, which were driven by a combination of the high margins and high fees associated with retail banking. In reality, it can be argued that banks ceased to be banks and lost the skills and institutional memory to do the lending to Main Street business that used to be their bread and butter. Instead, they took their lead from retailing, turning branches into “stores” and incenting sales associates for selling “products” in place of paying bankers who knew their customers. They expanded their range of products to capture more of the customer wallet through cross-sell strategies, such as giving sales goals and incentives to customer-facing staff to push specific products at anyone they interacted with. Above all, they sought to grow their fee-based revenue and, for the large banks, their treasury and trading profits.

This is not to say that regulation was responsible for these developments; other banking systems responded to Basel capital requirements differently, but it helped make aggressive expansion of a product-focused retail banking culture the path of least resistance. Perhaps more serious, and certainly close to the causes of the 2008 crisis, it favored a high-turnover, “transactional” model of wholesale banking in place of a world where market participants had to know their customers and counterparties. The globalization of capital markets and the wonder of electronic trading systems simply made it too easy to do business in financial assets with little knowledge of their risks.

Have the proposed regulations of Basel III or the Dodd-Frank Act really addressed these distorted incentives? It is hard to see how raising capital requirements encourages a return to basic banking. The notion that credit originators should retain some skin in the game while securitizing loans is appealing, but may prove impossible to implement in practice.

In 2010, the Federal Reserve Bank of New York posted a working paper on its web site that put a size on how large the “shadow banking system”—driven by securitization and market-based funding by hedge funds, institutional investors, and lending from commercial banks—had become on the eve of the 2008 crisis. The number is $20 trillion, at a time when the regulated banking system was only $13 trillion and the GDP about $14 trillion. Congress and the regulatory world worry about this vast source of financing—which has shrunk since the crisis, but is still probably larger than the “official” banking system—and the Fed did in the event have to prop it up to a degree during the panic. Since the shadow banking system has no access to the Federal Reserve discount window or federal deposit insurance, and is outside the payments system, its players can and do fail. Their investors lose money. Dodd-Frank and regulators in Europe would like to bring the shadow banking system within the same regulatory restraints that motivated its creation in the first place. The real question might be, Why isn’t more finance subject to real free-market creative destruction?

One thing we can be sure of is that the era of expanding access to credit and financial services—what has sometimes been called the retail banking revolution—is over, at least in the developed economies.

Restriction of Financial Access

When the first joint-stock banks (banks owned by shareholders) emerged in the United Kingdom nearly two centuries ago, the established banks were all private partnerships with unlimited liability (the one exception being the Bank of England, which was as a government-backed monopolist a de facto enemy of the privately owned banks and kept out of the clearinghouse). The joint-stock banks were also shunned by the clearinghouse run by the private banks, given their shocking business model: they opened branches where the general public, not just rich City of London merchants and brokers, could open accounts and make payments using checks. The fact that they were public companies allowed them to raise the capital needed to convince the public their money would be safe without unlimited liability and, of course, to put up branches on every British High Street. The business proved insanely profitable by the estimates that Bagehot gave in Lombard Street, but banks were very choosy about who was a suitable customer, and they required substantial sums to open an account (the equivalent of three or four years income for the average UK subject). Despite this, the model of branch banking spread around the world and gave the fast-growing middle and professional classes access to convenient payments, savings, and credit. This population was “banked,” a sort of economic enfranchisement that their fellow citizens did not qualify for.

The consumer culture of the United States and other high-income Western countries has been much maligned by some intellectuals, but as Ferguson points out in Civilization: The West and the Rest (Penguin, 2011), it is a “killer app” that has made the West extraordinarily successful in material terms. A “banked” population is absolutely foundational to a vibrant consumer culture. Economic historians have traced the spread of white bread, once largely restricted to the upper classes in Britain and France, in society and across Europe as people became more prosperous in the late 18th and 19th centuries.

A similar “white bread line” can be traced in access to banking. Most advanced was the white bread–eating USA, where it was widely felt that everyone should have access to the same services and conveniences. By the early 1950s, at least half the population had a financial account that could be used for payments, the bedrock definition of being banked. Being paid in cash became rare, as most companies adopted paychecks. Once people became used to cashing checks, they became more inclined to open checking accounts and paying their bills by mailing checks. The banked US population probably peaked in the 1990s at around 85 percent of households. The countries of continental Europe, or more precisely the northern European states and France, began to mandate that employees be paid directly into financial accounts. A bank account essentially became a routine condition of employment. An increasing number of services and utilities came to require or at least forcefully push mandates that allowed them to be paid automatically out of these accounts. The United Kingdom stood somewhere in the middle, with perhaps as little as 20 percent of the population properly banked in the 1960s, but up to and above American levels by the 1990s.

Now, it is possible to make a case, as historian Louis Hyman does well in Debtor Nation (Princeton University Press, 2011), for a view that almost universal access to finance led to abusive practices and helped addict the American consumer to credit. Most development economists, however, would support the view that access to finance helps drive economic growth, social inclusion, and rising living standards. The balance of regulatory and political thinking before the crisis was on the side of maximizing financial inclusion, and the World Bank and other national and multilateral development agencies made it a priority. Now, for better or worse, the pendulum has swung sharply in the opposite direction in the developed world.

There is often a presumption by well-meaning politicians and reformers that all businesses are predatory and all customers are victims if not protected by government paternalism. Private enterprise shouldn’t necessarily be abolished, but needs to be directed by government to some higher good than profits and growth. An example of this impulse to pursue social justice through regulation of industry is the Community Reinvestment Act (CRA), passed in 1977 at the height of the Jimmy Carter era of stagflation and disillusionment with government programs. The CRA was an ingenious way of empowering community activists and social reform groups to seek lending commitments to “underserved” communities, which in America were largely concentrated among racial minorities in the inner city. As expanded by subsequent legislation, the CRA required the Federal Reserve and other financial regulators to grant permissions for actions such as mergers, branch closures, expansions, and the like only to banks that had a satisfactory CRA rating. Community activists and “community organizers” such as the Association of Community Organizers for Reform Now (ACORN) not only had direct input into the process, but could orchestrate boycotts and demonstrations that few bankers were willing to stand up to, so the CRA proved potent at siphoning off shareholders’ funds into political activism. It also made some prominent activists rich and powerful.

Now, we should not overestimate the CRA’s influence. The banking industry and the regulators learned to live with it. However, it reflected a widespread notion that is almost uniquely American: that every citizen is entitled to credit and other banking services. In a homogeneous and wealthy society such as Sweden, this would be harmless. But in a radically unequal and diverse society such as the United States, it would have been fatal within a traditional banking model. To make credit judgments based on knowledge of people’s character and circumstances would run afoul of the plethora of laws and court decisions seeking to ban racial and other forms of discrimination. Credit judgments are by nature a form of discrimination between good credit risks and bad credit risks. Also, since banks only make money from people who have money, the very premise that they were serving communities rather than individuals and businesses meant that the CRA was just another tax—a cost of doing business.

What made the notion of a fundamental right to credit downright dangerous was the very business that eventually caused the 2008 crisis, subprime lending. For centuries, banks turned away all but the most creditworthy borrowers because bad loans could easily bring them down. Their shareholders’ capital, as well as their depositors’ money, was always at risk. Loan securitization changed all that. Banks learned how to package and sell off their loans. If a bank has no skin in the game, it can extend credit to liars, thieves, and deadbeats—even pets and dead people. Asset securitization took the skin out of the game. The subprime mortgage market involved lenders who created structures that required very low or no down payment, almost no documentation of assets or income, and very low initial rates of interest. This business was profitable as long as the sausage factory was humming, and was largely guaranteed and encouraged by the GSEs and their congressional patrons, notably Messrs. Dodd and Frank. In other words, the miracle of scientific financial engineering produced housing credit for all, and fat profits for everyone in the housing food chain, plus the political advantages of increasing home ownership among the less well-to-do, something that political conservatives embraced as “the ownership society.” The CRA might have been the catalyst, but the profit motive and political calculation produced the chain reaction that drove the bubble.

The expansion of two other key aspects of financial inclusion also reflected innovation by banks rather than government mandates. The most important was the development of highly sophisticated predictive models that allowed credit card issuers to profitably expand into the subprime, or non-creditworthy, segments. These models allowed them to accurately forecast default rates. It also helped them set interest rates and penalty fees according to both initial underwriting risk and behaviors that caused that risk to shoot up, such as missing payments or making late payments on almost any bill. Since banks were free to set initial rates and boost them, as well as apply penalty fees based on actual customer behavior, a much higher proportion of the populace enjoyed access to consumer credit (as opposed to loan sharks and pawn shops, the traditional resort of the unbanked) than in other societies and at any other time in our history.

The second important development was the substantial expansion of free checking, with very moderate balance requirements, as well as rewards programs offering benefits such as airline miles for using payment cards and other products. These incentives mainly reflected the intensely competitive nature of mass-market retail banking. However, as noted, maintaining a transaction account involves substantial expenses, from regulatory overhead to brick-and-mortar branches. Rewards also need cash income to fund them. In both cases, the offset came from collecting fees—for bounced checks and overdrafts from checking customers who failed to manage their accounts carefully, and for transactions involving “premium” or reward cards from merchants. These fees funded things that many consumers wanted and would pick a bank or credit card because of, but obviously the people paying them were less than happy.

In the juncture of finance and politics, no good deed goes unpunished. Consumer advocates, politicians, and lawyers all developed grievances against the institutions that had provided access to finance, choice, and differentiated value propositions on an unprecedented scale.

Consumer Protection vs. Access

There is no doubt that retail banks took an aggressive stance in expanding their subprime businesses and maximizing fee revenue. Banks did in fact maximize the number of overdrafts through manipulating the order in which debts and credits to accounts were posted, and charged penalties on bounced checks that were perhaps in excess of the direct cost of handling them. However, nobody was forced to open a free checking account, or for that matter to bounce checks. The high rates charged for subprime credit reflected real risk, a fact supported by ample statistics.

Consumer advocates would of course characterize many retail banking industry practices as predatory, and with some justice. In retrospect, banks were doing themselves no favors by expanding into and then growing dependent on consumer financial services, especially to the less affluent and creditworthy segments of the population. The basic banking model assumed that the main function of commercial banks was, well, commercial lending. Few politicians or social reformers assume that businesses can’t look out for themselves, except perhaps small businesses, which have been objects of political largesse for decades. Consumers can be presented as perpetual victims of the banks or, for that matter, any corporation providing a product or service.

For example, one of the standard accusations against banks before the CRA was redlining: the exclusion of low-income or minority neighborhoods from mortgage or other credit. Banks and insurers had in fact engaged in such practices before Congress acted to ban them. However, when banks expanded into the subprime markets in the previously redlined demographic, they opened themselves to charges of predatory lending from the same quarters that once accused them of discrimination. The only way to avoid this dilemma in the United States is to avoid involvement in retail banking completely. But once the surviving Wall Street investment banks became bank-holding companies to qualify for Federal Reserve support, they too fell under the CRA. As noted, the crisis has empowered the adversaries of the banks to impose sweeping changes in the way banks deal with consumers. For example, under the so-called Card Act (which predates Dodd-Frank), banks cannot change the terms of a customer’s credit card loan as long as they are current on their payments. This mean that banks cannot price for risky behavior, which in turn forces them to narrow the band of people they will underwrite in the first place. With risk-based pricing out the window, banks will have no choice but to increase the cost of credit to everyone. Ending or curtailing a bank’s ability to extract overdraft fees and capping what they can charge merchants for debit card transactions will make tens of millions of consumer accounts unremunerative. This has already made it difficult to fund popular rewards programs. The new, and by design, unaccountable, Consumer Protection Agency is almost certain to make things much worse for retail financial services. The agency will potentially have power to essentially dictate the design of consumer financial products, their pricing, and how they are sold. No matter how the balance of political power shifts, it is hard to see any political capital to be gained in defending the freedom of retail banks to make a profit. Equally, it may be impossible for banks to justify committing capital to the consumer sector under such restrictions.

The End of Product Differentiation

One of the great triumphs of information technology was the defeat of Fordism, the industrial logic that since it is more efficient to produce standard products, everyone gets the same thing: the consumer can have any car as long as it is black. Information technology, especially in service industries, allows almost infinite customization to the needs and preference of individuals. For example, there are web sites that allow consumers to design their own credit cards, trading off factors such as interest rate, credit limit, rewards, and other features. The vision of a “market of one” is increasingly achievable, with consumers co-designing or even dictating what they are willing to pay for and what trade-offs they are willing to make. This of course assumes a basic level of savvy among most consumers, and their basic capacity to consult their own interest and preferences and make rational choices. Of course, to admit such a thing is to refute a key tenet of the consumer protection movement, and indeed, the entire rationale for the modern regulatory state.

Clearly, to protect people from the predatory nature of bankers, only a few simple and standard products should be permitted, with simple and standard pricing. Elizabeth Warren, who created the basic structure of the Consumer Finance Protection Bureau (CFPB) before departing to run for Senate, is on record in support of such an approach. This is from the journal Democracy (issue 5, summer 2007):

So why not create a Financial Product Safety Commission (FPSC)? Like its counterpart for ordinary consumer products, this agency would be charged with responsibility to establish guidelines for consumer disclosure, collect and report data about the uses of different financial products, review new financial products for safety, and require modification of dangerous products before they can be marketed to the public. The agency could review mortgages, credit cards, car loans, and a number of other financial products, such as life insurance and annuity contracts. In effect, the FPSC would evaluate these products to eliminate the hidden tricks and traps that make some of them far more dangerous than others.

This assumes, among other things, that the financial services that people require are already set in their forms and functions, such as toasters and other appliances that are governed by consumer safety legislation. They are not. Financial technology is (or at least was before the crisis) advancing rapidly by trial and error, so prescribing what a safe and fair product would constitute would really require a sort of financial Food and Drug Administration (FDA) to test and approve innovative products. The FDA stands accused of inhibiting medical innovation, but is weighted with the issues of life and health in its care. However, it also benefits from a scientific methodology. In consumer financial services there is neither that risk nor that benefit since potential harm and objective measurement are less obvious. My fear is that, intended or not, active and intrusive consumer protection of the sort the industry seems likely be exposed to will more or less compel the end of financial innovation by banks who will seek shelter in standard government-approved products. Creators of new services outside the regulated financial services arena—essentially the Googles and PayPals of this world—may continue to attract capital and grow, but the banks themselves are unlikely to recover the costs of any service innovations they develop.

In Financial Market Meltdown, I expressed considerable skepticism abut the value or soundness of financial innovation, taking my lead from Bagehot, who said that the ways of lending money safely are few in number, easily learned, and admit of no variation. However, that really applied to wholesale market innovations that allowed credit to be turned into bonds through complex financial alchemy. Retail consumer products and services are going through a period of rapid and discontinuous change driven by the Internet and mobile communications. Many of the most promising concepts are being developed outside the regulated banks. Inhibiting banks from investing in this revolution will not halt progress entirely, but it will keep much of it in unregulated corners of the universe. Nowhere is this truer than in the critical arena of consumer payments.

Unbanking the Banked

For a high-income industrial society, America already has a staggering ­number of unbanked or underbanked households, estimated by the FDIC at a quarter of the total economically active population. Some of this reflects the high level of recent immigration, legal and undocumented, and the number of households living below the poverty line—both factors that set America apart from other rich countries and always has. Some of it reflects the suspicion of banks, much of it deserved, felt by many people without much money or education. We stand at the cusp of a much cheaper and more transparent consumer financial services model based on mobile devices. Poor countries such as Kenya have already demonstrated the potential of mobile money to improve the lives of people living on a few dollars a day. These same technologies and business models could vastly increase financial inclusion in the United States. However, the rush of post-crisis legislation—including the Card Act discussed previously; the Durbin Amendment to Dodd-Frank, which sets prices on debit card transactions; and above all, the establishment of an unaccountable CFPB with expansive powers under Dodd-Frank—could swing the pendulum in the direction of reducing the incentives of banks to operate in the consumer segment. With the two critical income streams—overdraft fees and interchange fees of debit card transactions—that permitted banks to defray the cost of providing a transaction account to middle-income and low-income households being slashed or capped by regulatory fiat, tens of millions of accounts will become hopelessly unprofitable for banks to maintain. However, the public will blame the banks, not the politicians, when free checking disappears and the price of having a bank account goes up. When Bank of America tried to recoup billions in lost debit card revenue resulting from the Durbin Amendment, public outrage forced them to back off on debit card fees. This is not a fight banks can win.

In most countries, the mass market and lower-income consumer is served by the post office, which provides basic account services such as savings and bill payment at a much lower cost than full-service commercial banks. In their wisdom, the New Dealers got the US Postal Service out of the retail banking business in the 1930s in an attempt to divert savings to the building-and-loan, or S&L, business. As a result, the United States is the only important financial market without a postal bank for the bottom income brackets. Congress would never dare try to restore postal banking in the teeth of opposition from community banks and credit unions. Congress’s preferred strategy over recent decades has been to try to place a burden on the commercial banks by forcing them to provide “life-line banking,” a profitless proposition even before a massive increase in the regulatory burden made serving the mass market even less economic.

Many banks will have no choice but to reduce their investment in retail banking and make their services more expensive. Thirty years ago, my former employer, Manufacturers Hanover, was told by McKinsey that a household in New York City making less than $65,000 a year was unprofitable to serve as a core banking customer. Today that number would be north of $250,000. Banks are kennels for money, and only people with dogs need kennels. They tend to be the “1 percent.”

If the banks are more or less forced by politicians and regulators to push the “99 percent,” or a large portion of them, out of the system (the bank analyst Meredith Whitney estimates the proportion of unbanked is going up from one in five to two in five), where will they go? As we have seen recently, the credit unions and community banks have a limited ability to absorb them, though they are a good option for many. The big winners are likely to be an increased use of cash, check-cashing services, and payday lenders.

One of the key advantages to banking essentially the whole active population, as most European countries and Japan have managed to do, is that it reduces the role of these informal and often predatory “alternative” financial service providers and the role of cash in everyday transactions. This tends to reduce the size of the informal, or gray, economy. A bank account was once essentially a luxury good until Americans more or less made it a right and the rest of the world followed suit. Now it is widely viewed as a necessity, helping countries develop and grow their economies by helping ordinary people to save, access credit, and pay their bills. America is moving in the opposite direction.

Hurting the Savers and Investors

A central fact in any society is that citizens rely on government to protect them from the theft of their property. When governments take actions that destroy the savings and therefore the retirement income of citizens, their policies—once recognized for what they in fact are—stir the deepest social unrest. The inflation that was the product of the Weimar Republic’s efforts to get out from under its debts destroyed the German middle class and led to the nightmare years of the 1930s and 1940s. The Great Inflation that followed the Johnson and Nixon years destroyed perhaps 70 percent of household savings in the United States until halted by Paul Volcker. Once begun, inflation is extremely difficult and painful to halt. Damping down inflation, which everywhere is a matter of creating too much money relative to the output of goods, is a central bank responsibility of the highest order.

After the collapse of a financial bubble, as occurred in the United States in the 1930s and Japan in the 1990s, the more immediate threat is the opposite of inflation. It is deflation, the relentless drop in the price of assets as society responds by trying to pay down debt and save. It was this “liquidity trap” Keynes was trying to cure with his advice to offset private thrift with government spending. However, vast increases in government spending and debt have proven ineffective in halting Japanese deflation. And while the United States has avoided actual deflation, the effects of massive increases in government spending, debt, and the money supply have been remarkably feeble.

At such a juncture, the retirement income and savings of households face a double threat: either the government will deliberately stoke inflation to reduce the real value of the money it must pay back its creditors, or it will try to keep interest rates as low as possible as long as possible so that the interest service on the debt is manageable. The only way out of this dilemma is if economic growth can be revived at a rate where the debt burden shrinks as a percentage of the economy. This does not appear likely given the vast increase in regulation and distortions in the allocation of capital on one hand, and the large overhang of debt that households carry. This debt burden is to a large degree a product of decades of bipartisan government policy to direct capital away from productive investment (high taxation of corporate profits and income from savings and investment) and toward sterile but popular investment in residential housing (mortgage interest deduction, the GSEs, and home-loan banks). As long as it is seen as politically important to keep mortgage interest rates low in order to reinflate the housing market and limit foreclosure, the tens of millions of responsible Americans who saved for retirement will receive almost no income from their investments. This in itself depresses spending and business activity, but it gets worse. Artificially low rates of interest threaten the ability of pension funds at the state and local level to meet trillions of dollars of contractual promises made to government employees for retirement and health care—promises that could not have been met even with historical rates of interest. Private insurance and annuities face similar challenges. It is inconceivable that the gaps can be filled by taxation without further depressing economic growth and the tax base to support future retirees.

Of course, as a reserve currency, the United States has more scope to buy time by printing money and running debt at the federal level than states that are staring into a financial abyss—such as Greece and Italy—potentially bringing down the euro zone as a whole. But several American states, such as California and Illinois, are in equally hopeless positions.

The finance-driven economy of the last quarter-century had many flaws and resulted in a financial panic of epic proportions. But the financial economy was an engine of growth in the real economy that made the burden of government spending and future retirement manageable. Until we manage to restore the broken markets to a functioning growth engine, our future is likely to be bleak indeed. It can be done; we have just been going about it in the wrong way.

The next chapter will explore what life will be like for all of us after cutting finance down to size.