Regulatory Overhaul and the Restructuring of U.S. Banks
The costly bank failures of the 1980s, which nearly bankrupted our deposit insurance fund, were neither a passing cyclical phenomenon nor simply isolated instances of bad management decisions. They reflected deeper structural problems which have evolved to the point of threatening the very existence of our banking system. Should this crisis remain unresolved, its consequences for the U.S. economy could be quite detrimental. We need healthy and stable banks to promote economic growth. Banks collect savings and channel them back into the circular spending flow, thereby funding growth-promoting activities. In the process they create new money in support of the circulation of goods and services. The strategic position of banks is analogous to that of a human heart which pumps blood through the body to keep it going. Just as humans do not function well with a sick heart, so does the economy suffer when banks are weak.
American banks have been hit over the last two decades by a variety of adverse developments. Their traditional functions, taking deposits and making loans, have been subjected to increasing competition from less-regulated institutions. In the face of such market erosion on both sides of their balance-sheet ledger, the banks have had to find new profit opportunities. Their search for market alternatives, itself responsible for an unprecedented wave of financial innovation, was fundamentally shaped by two sources of pressure.
• Funds became significantly more expensive for banks to attract once interestrate ceilings on bank deposits were phased out in the early 1980s. Carrying costlier liabilities, the banks had to look for higher-yielding assets which could help them maintain a positive yield spread. But financial instruments are always subject to the risk-return logic of valuation; they carry higher returns because of greater riskiness. At that point, however, banks were no longer in a position to manage this trade-off between safety and profitability in a prudent manner. Ever