Bank Industry Loses as Consumers Win

What’s really going on with the banks? The Federal Deposit Insurance Corp. last week moved to raise the premiums banks must pay for government insurance on savings deposits.

As well it should, you may say, considering that FDIC Chairman L. William Seidman told Congress only two weeks ago that the federal insurance fund would lose $2 billion this year as 200 banks fail--the third straight year of 200 or more banks going under.

The problem, Seidman told Congress, is that banks have made commercial real estate lending a bigger part of their business in recent years as they have lost other customers. And now they’re encountering problem loans in “the weakest real estate markets in many years.�

Seidman however foresaw no sequel to the savings and loan debacle. The FDIC was raising premiums prudently to beef up the insurance fund, and might take other steps to restrict the loans banks could make with insured deposits. But “we’re making a reasoned judgment; I see no panic here,� he said.

And there’s no need for panic. The banking system’s finances are not nearly as precarious as were those of the S&L; industry, and its troubles stem from a lack of business competitiveness rather than fraud or foolishness.

The real story in banking is the decline of its influence in our lives and in American business. One statistic speaks volumes: At the end of World War II, banks held 60% of the financial deposits in the United States. Today they hold less than 30%. The business of finance has grown much faster in the capital markets, where all sorts of companies and institutional investors borrow and lend money these days.

It’s a massive development in the financial system--and yet one that practically everybody understands. Anybody who has bought a television set at a discount electronics store--or financed a car through a dealer or invested in a money market mutual fund--has participated in the capital markets.

The TV dealer’s inventory typically is financed by a company such as GE Capital, the $58-billion (assets) subsidiary of General Electric that is larger than most banks. Such finance companies raise money through commercial paper--debt notes that are traded in the capital markets. There is now $550 billion in commercial paper outstanding, compared to $2.2 trillion in bank loans. But loan totals are growing slowly while commercial paper is growing more than 15% a year.

The largest auto lender in America is General Motors Acceptance Corp., which, at $100 billion in assets, is larger than almost all banks and long ago expanded into more than car loans.

Money market mutual funds now hold $380 billion in deposits. That’s still a long way from $2.2 trillion in total bank deposits--but money funds are only part of the more than $1 trillion total investments in all mutual funds.

Capital markets now finance home mortgages and student loans with the government’s blessing and guarantees. And they finance consumer credit--in the form of credit card receivables.

The point is that banks, despite their government insurance, consistently have lost customers to capital markets. Why is that?

Obviously because banks are more expensive and less efficient than the markets in serving depositors and borrowers.

With few exceptions, bank expenses--for branches and staffing--are still geared to the days when they paid a regulated limit on savings accounts and nothing on checking and had little competition making loans at a good margin.

But when all that changed more than a decade ago, banks had trouble being cost-competitive with money funds--which serve depositors through telephone 800 numbers and the mails. And on the loan side, the banks’ higher expenses have prevented them from lending at competitive rates to big corporations, or even to the TV retailer or tractor dealer.

So the banks have been relegated to less credit-worthy borrowers, such as real estate developers. And now they’re in a downward spiral because reserves against real estate loan losses will only make their rates less competitive.

In truth, the outlook is for banks to make fewer loans, because the government wants it that way. Seidman suggested to Congress that banks should only use insured deposits for “conservative and safe� investments such as home mortgages. Banking expert Robert Litan of the Brookings Institution has testified to Congress that banks might also be allowed to invest insured deposits in government or high-grade corporate bonds, but not much more. “Why should they take risks with insured deposits,� asks Litan rhetorically.

For any other business, including proposed diversification into securities and insurance, banks would operate through separate subsidiaries, and finance through the capital markets--not insured deposits.

The upshot is that banks will merge to cut staff and spread expenses, on computer systems and such, and today’s 12,600 U.S. banks could be reduced by half. It will be a drastic weeding out of uncompetitive businesses, not a takeover bonanza, cautions analyst George Salem of Prudential-Bache Securities. Most banks will suffer, he says.

There will be some regrets as banking shrinks. “Keep in mind that banks are the lenders to small business,� says Julius Loeser, senior vice president of First Interstate Bancorp. Small businesses will now be forced to put up more collateral for loans.

But the ability of consumers to shop for the highest interest will be undiminished. “The trend favors the consumer,� says Michael Morrow, a partner in Sheshunoff & Co., a bank consultancy firm. Banks, needing your deposits to stay in business, will offer market rates and services at various prices. And if a bank can’t offer what you want, some other institution will.

“The feeling today is if our money is working hard, earning the most it can, that’s the right way,� says Morrow. Deposit insurance is important, but secondary for most consumers, he says.

The result is a sophisticated, intensely competitive financial system. It’s a system that American consumers voted for with their pocketbooks. And what we’re seeing today is that a lot of banks didn’t read the election returns.