There was a time when Citigroup (NYSE:C) was the leading bank in America. And during its time at the top, which spanned from the Great Depression of the 1930s to the Financial Crisis of 2008-09, it transformed the way that banks do business.
As The Motley Fool's Gaby Lapera and John Maxfield discuss in the video below, Citigroup spearheaded multiple financial innovations during the 1970s in particular that are now widely used and taken for granted by bankers and investors today.
A transcript follows the video.
This podcast was recorded on March 28, 2016.
Gaby Lapera: So, OPEC. There's this manufactured oil and energy crisis in the Unites States in the 1970s. This is what people think about when they think about the cars lining up at the gas stations and oil rationing. People could only go in depending on what your license plate number ended in, and stuff like that.
John Maxfield: What's so funny is that people ... I don't know how well-known the oil crisis of 1973, that was the first one, there was another oil shock and lit later 1970s. The oil shocks in the 70s, they fundamentally transformed the financial industry in the United States. The reason that happened was, you had these really strict regulations coming out of financial crisis that, among other things, limited ... They set a cap on the interest rate that banks could pay on deposits. When you had the oil shoot up ... I mean, I can't remember exactly ... I mean, it went up from what, $1 a barrel... Don't quote me on exactly ... I'm just saying this to illustrate the magnitude. It went up from $1 a barrel to something like $80 a barrel. It was a huge, huge increase. That triggered very rapid inflation in the United States. When you have inflation, you also have interest rates increasing and increasing and increasing. The banks were stuck in this position where they were having to pay 20% to borrow money. They were then lending out on these fixed rate 30-year mortgages that were on their books for 8%.
It created this really bad situation for banks that caused them to do multiple different things. The leader of the group that was really pushing change and transformation in the bank industry was a guy named Walter Wriston at what is now Citigroup. What he did is, he said, look, we need to unchain the interest rates that banks pay to borrow money from what was the Regulation Q which was the cap. He came up with all these innovations that unchained that. Then he also was pushing ...
Lapera: Hold on, go back a second.
Maxfield: Go for it.
Lapera: What was Regulation Q for? Why did this cap exist in the first place?
Maxfield: The theory behind Regulation Q, there's a couple different things, but the main theory behind Regulation Q is that if you go back all the way to the gilded age and before that, banks that would pay at a high rate of interest for their deposits were generally more susceptible to failure. Because then, if they got into trouble, the reason that people had money there was almost as an investment. So they would pull it out very quickly, as opposed to just putting it there and forgetting about it. The other reason that Regulation Q was in effect was that the United States wanted to promote local lending by savings banks, or savings and loans. What they did is they allowed savings and loans to charge a higher interest rate to gather deposits, then they allowed commercial banks, because commercial banks would then theoretically take the money that was deposited in rural areas and bring it to money centers, which would then drain that money out of there.
Lapera: This leads us back to the energy crisis and these banks that are paying out these interest rates on the deposits that are 20%+ and then having these loans that are 8%. This is what led to the savings and loans crisis of the 1980s, which is where a ton of these small banks just collapsed. They just disappeared. They got bought up by bigger banks, because they just couldn't function anymore.
Maxfield: Literally, many, many thousands of savings and loans thrifts and banks failed during the 1980s in particular as a result of that. You can think about it like this. It would be like if you run a book store and you are buying books for $20 a book and selling them for $8 a book. Not a very good business model.
Lapera: Then you get to Walter Wriston who says "I think that we can do better than this."
Maxfield: He says look, there's two ways that we can get around these interest rate caps. The first way is that we can issue negotiable certificates of deposits, CDs. Negotiable CDs that were not capped by those interest rate requirements. They could bring in all this money from big corporations that needed to get interest on their money, but they wanted it in safe big banks. The second thing that Wriston and Citigroup did was they said, look, we can go to what's called the Euro dollar market, which after you had that explosion in the energy crisis, you have all these dollars, because oil trades in dollars, all these dollars accumulating abroad because Saudi Arabia was accumulating, Venezuela, all these other countries were accumulating these dollars. Those dollars stayed in Europe and stayed overseas but they were not susceptible to those interest rate caps, so banks could borrow those dollars for either, they could pay more to borrow those dollars, or they could pay less depending on what it was. What mattered was that they were not limited by Regulation Q.
They did one other thing at Citigroup that allowed them to finance the bank through ways other than your poor deposits. They started issuing commercial paper at the bank holding company level. Basically what this did to banks, is it transformed them from these depository institutions, to basically highly leveraged financial funds that deposits only provided some of the funding for.
Gaby Lapera has no position in any stocks mentioned. John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.