ALEXANDRIA, VA (Mar. 23, 1998) -- Within the lifetime of anyone over 20 years of age, the banking industry has gone from being a highly regulated industry ruled by legislation put into effect by a pro-active Depression-era Congress to operating much more freely. The change in the legislative and regulatory worldview was brought about by competitive and inflationary forces that rocked the industry in the 1970s. The cure, deregulation, killed off some live cells while wiping out the cancer of the industry's uncompetitive position, but the most of the surviving companies are much healthier for it.
As we discussed on Thursday, consumers can choose where they hold their savings. Technically, savings become investments when they go into a money market mutual fund, but few believe that the explicit guarantee of government insurance on bank deposits is that much safer than the implicit safety of a global money market. Given that large portions of money market mutual fund assets are made up of government paper (short-term debt) that carry the full faith and credit of the U.S. Treasury, a saver with large cash balances is actually safer in a money market fund that is made up entirely of that paper. If you have a million dollars you want to keep liquid, you'd have to go to 10 different banks to make deposits of $100,000 (the maximum amount the FDIC will insure in each bank account) rather than putting your cash in a money market fund that is made up entirely of obligations that are guaranteed by the government.
The traditional characteristics of what a bank is were irrevocably changed by the evolution of money markets. Accepting the premise that a bank is a depository institution that takes in deposits from savers and lends out those deposits to borrowers, both sides of the equation were hit by these developments. Large corporations and consumers have found ways to sidestep Regulation Q, or the prohibition enacted by the Federal Reserve Act. The regulation is very straightforward: "No member bank of the Federal Reserve System shall, directly or indirectly, by any device whatsoever, pay any interest on any demand deposit." The way this is accomplished, though, takes its form in legal machinations and not in the Fed backing off this regulation. Fidelity Investments and mutual fund companies avoided this prohibition by not operating as governmentally regulated depository institutions or by structuring accounts so that they were something different than a checking account.
Banks are able to avoid Regulation Q for large corporate customers by offering sophisticated treasury management services. These services get a corporation's cash into interest-bearing accounts as quickly as possible. Technically, the bank is acting as a fiduciary for corporate customers that need treasury management services because the accounts holding a corporation's cash are not insured by the government. The bank makes money on the services it provides, and the corporation is happy with the rate of return it is achieving on its cash and cash equivalents.
Small business, however, still bows to Regulation Q. In general, a corporation with less than $25,000 in average cash balances cannot cost effectively take advantage of treasury management activities. Large banks such as First Union (NYSE: FTU) are reportedly fighting against a small business lobby that wants Regulation Q repealed, according to a number of recent media reports. That would jibe with economic reality, though, as companies such as US Bancorp (NYSE: USB) and Norwest (NYSE: NOB) have a significant revenue advantage over competitors by dint of their market share among small businesses. Year-end figures or Q3-end figures show the extent to which some larger banks depend on a continuation of Regulation Q for this advantage:
deposits/ total total liabilities deposits
First Union 20.7% 69.4%
Norwest 29.1 67.0
US Bancorp 29.6 74.9
First Tennessee 25.4 70.8
Wells Fargo 32.4 83.7
The rise of money market funds in the 1970s not only hurt the ability of banks to compete for deposits, a main source of working capital, but another money market-related set of developments was also pushing down revenues and profits. Large commercial customers of banks were breaking away from the traditional relationship banking paradigm that had existed for over a century. No longer could a J.P. Morgan banker sit on a company's board and win all of its commercial lending business. Mother Morgan's investment banking relationships had already been hit earlier in the century by Glass-Steagall, a main component of Depression-era banking legislation, but now it was losing its bread and butter.
Large multinational corporations were learning how to go to the money markets for working capital financing. Commercial paper, which is another huge component of money market mutual fund assets, is very short-term debt a corporation needs to use to finance large inventory movements or slight differences in global workforce pay schedules and receipt of payments from customers. Whereas bankers got fat and lazy charging their nearly captive clients origination fees and higher interest rates than market equilibrium and could demand that the customer keep part of the loan as a deposit in the bank (this is called a compensating balance, which effectively increases the cost to the customer and decreases the bank's cost of lending), corporations were wising up.
Faster information flows and more efficient pricing mechanisms were perfecting a money market that is now measured in the trillions of dollars. As of March 19, U.S.-based money market funds alone contained assets of $1.153 trillion, according to the Investment Company Institute (www.ici.org). The implications of the evolution of money markets will become clearer when we look at the financials of financial services companies.
Tomorrow, more on "What Is a Bank?" with a look at banks as consumer brands.