Why are banks so fragile, and what role has deregulation played in getting the industry where is today? The answer starts with the nature of banking itself, and stretches back a century or more to when banks were limited to operating in a single state and, in many cases, a single location.

Senior banking specialist John Maxfield sheds some light on the issue with a look back at the economic history and human behavior that give rise to lending cycles and the panics that put an end to them, from the Great Depression to the financial crisis of just a few years back.

A full transcript follows the video.

Kristine Harjes: Too much competition in banking? This is Industry Focus.


Hello everybody, this is Kristine Harjes, coming to you from Fool HQ in Alexandria, Virginia. Welcome to the financials edition of Industry Focus. I hope everyone's doing well out there, and maybe enjoying the first signs of spring today, like I have been here!

I've got John Maxfield, our Foolish senior banking specialist, on the line. How's everything going, John?

John Maxfield: It's going great. Thank you very much, Kristine. It's great to be with you.

Harjes: Great. Our topic today is competition and no, I am not talking about March Madness, but rather the competition that goes on year-round in the banking industry.

America loves its capitalism and its competition, so many of us view competition in business quite favorably. But the question that I want to pose today is, is the banking industry different in this regard?

Now we know the banking industry is unique in many aspects, particularly its fragile nature. But how does competition affect the industry and its successes and failures? John, just to lay the groundwork here, can you give us your expert insight into more about this unique, fragile nature of the banking industry?

Maxfield: Yes. Banking is unique from the vast majority of other industries because when it goes through the business cycle, which every industry is affected by, on the back end of the business cycle when things are turning bad, you'll see hundreds of banks -- sometimes if it's a big swing in the business cycle, you'll see thousands of banks -- fail every time that happens.

We've seen this, going all the way back to the beginning of the United States. The question is, what is it about banking as opposed to, say retail or the defense industry or biopharmaceuticals, or whatever other industry you want to identify? What is it about banking that makes it so fragile relative to all the others?

Harjes: Of course. That comes from the industry itself. It's kind of inherent within it, given that these are some seriously leveraged institutions. Can you give some more insight about that?

Maxfield: The structural reasons that banks are so fragile is that these are institutions that, principally what they do is take on a lot of short-term callable debt, and they invest that short-term callable debt into long-term illiquid assets.

Harjes: John, before you go on can you define that for our listeners? What exactly is callable debt?

Maxfield: Callable debt. Let's say you go out and you get a mortgage on your house; a 30-year fixed rate mortgage. That is a non-callable mortgage, because the bank can't come in and say tomorrow, "Look, I need you to pay your $250,000 mortgage right now." What the bank can do is just make sure that it accepts your monthly payments.

Callable debt is, let's say a bank lends you $250,000 to buy a house. The next day, or any day thereafter, the bank can call you and require you to pay back that debt.

It's a really unstable source of funding, and it's particularly unstable when bad rumors about a bank, or bad rumors about the economy, start to circulate so people get worried that their debt in a bank -- because banks fail so often -- isn't safe so they'll call it and extract all those funds from banks.

Meanwhile, the banks have all these long-term illiquid assets that they're then forced to sell in order to satisfy the people who are looking to get their debts back.

So when you look at banking from a structural perspective, it's that mismatch between your short-term liabilities and your long-term assets that contributes to the innate fragileness, if you will, of the banking industry.

Harjes: Another reason that you've identified in the past that the banking industry is so fragile, is because of the way competition has evolved over the last 100 years or so. Let's talk a little bit about that. What did this transition look like, and how did some historical transitions in the landscape of competition affect banks?

Maxfield: Sure. If you go back, let's say 100 years, what you'll see in the United States, in the bank industry in particular, is so-called unit banking.

What unit banking is ... I guess you could define unit banking more by what it is not. Unit banking didn't allow interstate banking, so a bank couldn't have branches in multiple states. Even within states, only a few states allowed banks to have branches.

Basically, across the country you just had these local community unit banks that just provided services to the surrounding community. They didn't have a lot of competition. They would pay out interest rates at 3%, take in interest rates of 6%, make a 3% spread, and just move on down the road.

That all started to change after World War II, specifically in the 1960s and 1970s, when the rules against interstate banking broke down, when the rules against branch banking broke down, when all these things broke down, which augured in this enormous swell of competition in the bank industry.

Again, this is starting in the '60s and '70s, but really gained momentum in the '80s, '90s ...

Harjes: What do you think it was about the '60s and the '70s that caused that sort of transition?

Maxfield: That's a great question. When you read the noted bank historians, one of the things that they almost invariably say is that one of the reasons banks go through these cycles is because every other generation forgets the cycle of earlier generations.

When you look at this deregulatory fervor in the bank industry, it started to grow in the 1960s. That's about 30 years after the Great Depression, and particularly after the panic that led to the Great Depression.

You just had a lot of people forget what was going on that caused such a huge panic. They get too comfortable, get lulled into complacency, then push similar things, that led to the fragility prior to the Great Depression, but then to push them again as these new, great ideas, again in the '60s and onward.

Harjes: So you see the less conservative, less fearful behavior.

Also, there were a number of innovations that, at that time, began to strain the typical bank business model. Can you go into some of those?

Maxfield: That's exactly right. It wasn't just that you had, in the market in general ... because with this deregulation you had banks actually starting to compete with each other, which they didn't do in the unit banking time period.

But you also had all of these financial innovations that made it more difficult for banks to operate. A great example are certificates of deposit.

At the time, banks were prohibited from charging above a certain rate on their deposits. It was called Regulation Q. They got around that by issuing these certificates of deposit, which were not demand deposits because you couldn't call them immediately. You could call them when they actually expired

Banks started using these things to fund their assets, but they were more expensive, which cut down on profit margin for banks, which then made them compensate on the asset side by making riskier loans, which carried a higher interest rate.

You could still make the same profitability, but just in a riskier operation, and that's what banks were doing. There is any number of other small innovations that took place.

Money market funds, another great example. Money market funds pay higher interest rates than deposits, so it sucked banks' funding sources away from deposits and into money market funds, which could be run by non-bank entities.

So, not only did you have more banks competing against each other, but you had then non-bank entities competing for the same funding sources that banks were competing for. There's just an increased amount of competition. This increased amount of competition pushed banks to take more risks with their assets.

When you take more risks with your assets, as a bank, because you're so highly leveraged it can lead to aggravated cycles in the bank industry.

Harjes: Given that competition and risk-taking are two things that go so hand-in-hand, do you think we're hitting a point where there might be too much competition in this industry?

Maxfield: This is a very un-American thing to say, but I think there is a legitimate argument that there is too much competition among banks right now. Quite frankly, I think even many of the big bankers would say the same thing, and that's what's pushing this consolidation wave that's been going on for the past couple of decades.

If you can decrease competition, you can decrease the incentive for banks to take these wild risks with their asset portfolios. If you can take away the incentive for the banks to take these wild risks with their asset portfolios, then you decrease the severity of banking cycles.

I think there is a good argument that there may be too much competition in banking -- and like I said, I think a lot of leading bankers would actually agree with that.

Now, what I would say -- and we were talking about this earlier today -- is that when you look back at America's history and you say, "How is it that the United States became such an overwhelming economic power in this world?"

If you look at our GDP relative to any other country, we are just dramatically larger than any other. Now, China's catching up, but we're still categorically in the lead.

One of the reasons was that we have this incredible geography. We have incredible natural resources. If you look at the globe and you look at North America, it's pretty good real estate.

But another reason is that our banks were so willing to fund development and take on these risky behaviors, and that pushed us forward and pushed us forward throughout the last couple hundred years.

There's an argument that, over the long term, actually these lending cycles that end in panics may not be such a bad thing.

Harjes: So we're not trying to eliminate risk altogether; just maybe make sure it doesn't get too carried away.

The question that comes to my mind -- and I'm sure some of our listeners are thinking the same thing -- is more regulation the answer?

Maxfield: That's what Congress seems to think in the wake of the financial crisis, because they came in with the Dodd-Frank Act, which dramatically changed banking to the greatest extent since all the banking regulation was passed as part of the New Deal in Franklin Delano Roosevelt's administration.

That is one way that you can increase barriers to entry, and thereby decrease competition in the industry.

To answer your question, you can decrease competition and thereby presumably make banking safer by higher regulations. But then it's all about the actual nature of those regulations and whether they are in fact achieving that desired result.

Harjes: Right. As with anything there's risk, there's reward, lots of things to consider. It doesn't seem like there's any clear answer. Lots of different ideologies to consider here.

Maxfield: Yes. There are two sides of it, and there are always going to be two sides of an issue like this, particularly when you have the damage that's inflicted on a country as a result of financial crises.

But you need that interplay between the two sides at all times, to work toward what society views to be the appropriate solution.

Harjes: Right, and we're also very much still in generations that remember firsthand this past financial crisis, so it's not like we're a couple of generations out and forgetting all of our lessons quite yet.

Maxfield: Yes. I would definitely say that the financial crisis is still very much at the forefront of most financiers' minds.

Harjes: Before we sign off today, we've looked a bunch at the past so I want to focus briefly on the present, and maybe even the future a little bit, by asking you what's on your mind this week in the banking industry. What news do you have your eyes on, or what stories should our listeners be on the lookout for?

Maxfield: The big thing this week for banking is today we had the release of existing home sales. When you look at the banking industry, home sales drive mortgage production, and mortgage production is a huge part of banking.

We had that come out this morning, and that came in a little bit below the forecast, although it was better than last year. Then tomorrow we have new home sales. New home sales add an enormous amount to both the banking industry, and also to the United States financial system overall.

Really, this is a week that is, in terms of banking, very much housing-focused.

Harjes: Cool. Well folks, you've got your cue. Thanks so much, John.

Until next time everyone, thanks for listening and Fool on!

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