The Invisible Hands of U.S. Commercial Banking Reform

This is a book about real life and big ideas. The real life is economic and institutional change in the U.S. commercial banking industry. Over the period 1975 to 2000, the regulatory barriers that strictly separated banking, insurance, and securities market activities eroded. Substantially all banking assets are now controlled by holding companies that own a broad range of financial services enterprises, prohibitions against interstate banking have fallen, and financial holding companies are now permitted to engage in a more diversified set of activities including securities underwriting, investment management, mutual funds, insurance, municipal finance, and corporate investment banking. In addition, banks have implemented a number of process innovations that change the nature of banking.

Economic and institutional change has challenged scholars and policy makers for centuries. Before there were social scientists seeking to engineer social change by writing policy prescriptions and testifying before legislative committees, there were philosophers who “whispered in the ears of princes.” Whether they were justifying the perpetuation of an existing order, like Aristotle or Hayek, explaining conflict, like Thucydides or Karl Marx, or like Adam Smith or John Maynard Keynes, searching for principles upon which one might craft change in an existing order, they have all worked in the field of political economy.

The main point to be taken from the survey in Chapter Two is that we do not understand as much as we could about economic and institutional change in banking in the United States. The theoretical literature in economics and political science attributes reform to economic change that disrupts the political “equilibrium”, which leads to interest group competition and legislative change. Case studies of regulatory change in a variety of industries including banking, attribute the stimulus for interest group competition and legislative reform to a variety of factors including changes in economic and political conditions, technological innovation, policy failure, new ideas, and political entrepreneur ship. However, the precise connection between these factors and the motivation to pursue specific types of institutional change has not been fully developed either theoretically or empirically. While scholarship in institutional political economy emphasizes the role of transaction costs and a broader range of institutional change processes than interest group competition and legislative activity, these theories have not been applied to explain banking reform in the late 20th century in the United States. In short, the linkages between economic change and institutional change have not been fully specified and the role of other governance processes has not been considered.

In this and the following chapter, the framework that is developed in Chapter Three is applied to analyze economic and institutional change in the U.S. commercial banking industry in the late 20th century. This chapter focuses on economic change. Section One, which provides background, describes the commercial banking business in the United States, including products, services, and markets. Section Two analyzes changes in the economic environment that affect beliefs about competitive opportunities and threats in the financial services industry. Section Three analyzes change in the commercial banking industry, which reflects changes in beliefs about competition that emerge as a consequence of change in the economic environment, and Section Four summarizes and concludes.

Other studies of institutional change in U.S. banking have focused on legislative and regulatory change. Certainly these processes are important aspects of institutional change however, they are not sufficient proxies. Institutions are the “rules of the game” that solve collective action problems in a particular setting by governing interaction, outcomes, and information flows.¹ They reflect the beliefs and preferences of those who design them and they shape the beliefs and preferences of those who follow them. As in other regulated industries in the United States, banking institutions exist in the public and private sectors and are quite diverse, encompassing norms, laws, regulations, contracts, charters, bylaws, policies, standard operating procedures, and so on. In toto, institutions reduce uncertainty by creating incentives to act (or not) and imposing constraints on the range of feasible activities in a particular situation.

Armed with some facts about the actual nature of economic and institutional change in the U.S. commercial banking industry, we can now return to the challenge of explaining what happened and why it happened as it did. Recall that Chapter Three set up several sets of questions and theoretical assumptions about change. The first set of questions has to do with understanding the stimulus for change in a regulated industry — what motivates the process, whether it is a response to a failure or an opportunity, and if it is in response to a failure, the source of the failure. The second set of questions has to do with the process of change, including types of economic and institutional change, participants, motivations, the role of competition, and coordination mechanisms. Integrating theory and empirical evidence on change, it was proposed that economic and institutional change is an adaptive process in response to an economic or institutional shock that involves simultaneous change in multiple sectors of activity. Successful adaptation is conditioned upon participants having the ability to conceptualize and implement change, flexible “rules of the game,” and adequate resources to implement changes in governance and economizing. This idea is expressed by four assumptions about economic and institutional change in regulated industries in the U.S.

As restrictions on scope and powers were eased in the 1980s, banks morphed into a new kind of financial services entity. The modern U.S. bank is no longer a commercial bank, an investment bank, or a merchant bank. Its main activities involve managing and financing mergers, acquisitions, and divestitures; financing equipment leasing; financing the expansion of businesses; providing cash and transaction management services; and asset management. For many of the top global firms, an increasingly greater share of income comes from trading for their own account as well as with each other, and less from fees that clients pay for services. And some traditional client services are effectively subsidized by cash and asset management services.