Issue #41: The Origins and Evolution of the Modern Monetary System
Part 6: "Liability Management" – Bank Holding Companies (BHCs)
Recall that there are a few fundamental innovations that have radically transformed our monetary and banking system in the post-WWII era:
Liability Management (a.k.a. “wholesale finance”) – the expansion of banking strategy that transformed banks from passive acceptors of deposits to aggressive operators in the money market. This includes federal funds borrowing/lending, repo, commercial paper, money market funds, eurocurrency/eurodollar banking, and much more.
Securitization (a.k.a. “market-based finance”) – the disintermediation of traditional commercial bank lending in favor of bonds and the pooling of illiquid, untradable loans to form liquid, tradable securities. This includes the proliferation of mortgage-backed securities, high-yield bonds, increased IG corporate bond issuance vs. loans, and other asset-backed securitizations. This also coincided with the advent of the pension system, which indirectly funneled America’s future retirement savings into the financial market.
OTC Derivatives and Value-at-Risk (VaR) – combined with Basel risk-weightings, these innovations introduced increasingly esoteric and mathematical definitions of “money-ness,” resulting in the redefinition of money as “bank balance sheet capacity.” This also cemented the shift of bank business models towards fee-generating, off-balance sheet banking activity as opposed to maturity transformation based on net interest margin or balance sheet expanding arbitrage.
In the first issue of this installment, I covered “asset management” (the traditional model of banking, in the form of deposit-taking and lending), which we can build upon to begin to understand exactly how and why our modern financial system is so different from the textbook description of deposits, reserve requirements, and money multiplication. In the second issue of this installment, I covered the first part of “liability management” and the re-emergence of wholesale finance, focusing on the development of the domestic federal funds market. In the third issue of this installment, I covered the second part of “liability management” and the re-emergence of wholesale finance, focusing on the development of the international Eurocurrency/Eurodollar banking system. In the fourth issue of this installment, I continued covering the development of the international Eurocurrency/Eurodollar banking system, focusing on the entrance of US banks into the Eurocurrency/Eurodollar borrowing and lending market. In the fifth issue of this installment, I covered the third part of “liability management” and the re-emergence of wholesale finance, focusing on the development of large negotiable certificates of deposit (CDs).
If you have not had a chance to read Issue #8, Issue #11, Issue #16, Issue #28, and Issue #33 of Monetary Mechanics yet, I suggest you do before continuing below, as it contains important information, but here is a brief review for you if you need it:
Commercial banks create new money (deposits) when they extend new loans. Banks are simultaneously limited by statutory reserve requirements (prior to March 2020) and, more importantly, by self-imposed liquidity constraints. Banks need reserves to settle transactions and payments with other banks, such as when deposits are transferred, or when an individual or business pays another in bank deposits. In a world without a private market for Federal Funds, daylight overdrafts on Fedwire, or the ability to regularly borrow from the Federal Reserve’s discount window, banks depended on attaining and retaining deposits to replenish their reserves.
These limitations defined the relatively more repressed financial regime of the early post-WWII era (as contrasted against that of the 1960s-2010s). Prior experiments with the liberalization of money and banking in the early 20th century, coupled with the subsequent Great Depression and the period of financial repression during WWII, left people skeptical about the benefits of a liberalized money and banking system.
The development of the private market for Federal Funds permitted large money-center banks to borrow reserves from small countryside banks, enabling large money-center banks to deliberately operate with a structural short position, where they lent more than they had reserves on hand, knowing that they could borrow the difference in the federal funds market, for the purpose of expanding their marginal lending activities. More importantly, the development of the private market for Federal Funds spearheaded the redevelopment of an informal interbank network that, together with other methods of liability management that I will soon cover in this and other issues of Monetary Mechanics, began to transform the model of banking from a deposit-facing one to an interbank-focused one.
As US dollar deposits found their way offshore and onto the balance sheets of banks in London, Paris, Frankfurt, and Zurich, the Eurocurrency/Eurodollar banking system emerged as a supranational, informal interbank network that linked the world’s various financial systems into one tightly woven web. Consequently, this evolution led to the emergence of a structure of international interest rates that were (and still are) distinct from, as well as largely independent of, national interest rates – a development that is without parallel in modern economic history.
As US dollar deposits found their way offshore, the onshore market also developed new and much more flexible forms of bank deposits that allowed banks to lock up funding/financing at flexible rates for longer periods, resulting in banks being able to “bid” for funding/financing. The development of large negotiable certificates of deposit (CDs) in 1961 transformed the traditionally illiquid retail and corporate time deposit into a truly liquid money market instrument. Consequently, this broadened and diversified the menu of liability management options offered to banks, permitting banks to better optimize their balance sheet structures, as well as permitting banks to circumvent the Federal Reserve and continue providing credit to their most important clients/customers, even in times of tight monetary policies.
In this issue of Monetary Mechanics, I will cover certain changes to the money and banking paradigm that can collectively be called “liability management” and the re-emergence of “wholesale finance.” While there is a myriad of other financial and regulatory developments that I could fill an entire book (if not several books) about, I will attempt to cover some of the most important developments that are still relevant to and required for the functioning of our monetary and banking system today.
In this issue of Monetary Mechanics, I will cover the fourth major innovation in liability management, which is the introduction of bank holding companies (BHCs) in 1956. The Bank Holding Company Act of 1956, along with subsequent amendments, clarified the legal and regulatory status of BHCs, as well as allowed BHCs to function as de facto “nonbank banks” that could conduct many of the same activities as banks, but without many of the same legislative and regulatory constraints that banks were forced to face. Since there are too many important topics to cover here all at once, in future issues of Monetary Mechanics, I will also attempt to cover:
The issuance of commercial paper (as well as other wholesale liabilities)
The development of the repurchase agreement (repo) market by government securities dealers shortly after WWII
Before I begin, I want to emphasize that I believe this is the single most important yet misunderstood transformation in the global monetary and banking system in the post-WWII era. This is perhaps due to the fact that many academics, analysts, and financial market participants choose to focus heavily on the development of the “shadow banking” sector during the 1980s and the 1990s (including securitization, ABCP conduits, OTC derivatives, the repeal of the Glass-Steagall Act, etc.).
There is no doubt that these developments profoundly transformed the nature and function of commercial banking, as well as the rest of the financial system. However, I believe that the groundwork for this monumental transition was laid long before, and, as a result, we can only tackle the problems that the financial system faces today by understanding the changing of bank behavior that facilitated banks’ shift from passive acceptors of deposits to active operators in the money markets.
Due to quantitative data limitations, I will utilize mostly qualitative data in the form of narrative exposition and evidence from reputable sources. However, I will also utilize objective numerical measures where available, accessible, and relevant.
The Bank Holding Company Act of 1956
What exactly is a bank holding company (BHC)? Why is it so important? According to the Duke Law Journal, writing in 1957, the Bank Holding Company Act of 1956 (a.k.a. the BHC Act) was “perhaps the most important banking legislation of the past two decades [since the Great Depression].”1
In Issue #17 of Monetary Mechanics, I defined and described a BHC as a legal and regulatory configuration that lets a larger nonbank corporation hold smaller bank subsidiaries within it.
The BHC Act limited the activities of multi-bank holding companies, but not the activities of one-bank holding companies, thus representing the first comprehensive congressional action targeting multiple banking through the use of the holding company.2 The primary focus of the BHC Act was to supervise the expansion of bank holding companies and to ensure the separation of banking and non-banking enterprises. I will briefly explain below some of the idiosyncrasies of US banking law, which is pivotal to a proper explanation of the importance of the BHC Act.
The BHC Act determined whether or not a given corporate entity was a “bank” based on whether or not that entity had a formal state banking charter. In 1966, however, Congress instituted a formal definition of “bank” based on whether or not an institution accepted deposits that were withdrawable on demand. In 1970, Congress then instituted an additional requirement that narrowed that formal definition of “bank” to an institution that also made commercial loans. This additional requirement allowed for a proliferation of “nonbank banks” that benefitted from federal deposit insurance while structuring their activities to avoid being defined as “banks.”
In 1987, Congress broadened that formal definition of “bank” to include all federally insured depository institutions, which effectively closed the loophole and outlawed these “nonbank banks.” In addition, at the same time, Congress also created explicit exemptions from that definition for certain categories of federally insured institutions, including industrial banks, thrifts, credit unions, credit card banks, and limited purpose trust companies.
Since the US banking system operated based on state-level banking charters, the abilities of banks to expand geographically and provide banking services within and across state lines were severely limited. Hence, the BHC Act was passed to prevent institutions from trying to use BHCs to outmaneuver and overcome those limitations. The original goal of the BHC Act was to block the geographic expansion of large banking groups and to prohibit excessive concentration in the commercial banking industry. However, over time, the primary policy goal of the BHC Act gradually moved away from preventing BHCs from monopolizing US banking and towards delineating the legal and regulatory purview of permissible banking and “closely related to banking” activities – a process that peaked with the Gramm-Leach-Bliley Act of 1999.3
The BHC Act defines a BHC as a company that owns or controls one or more US banks (an entity controls a bank when that entity owns more than 25% of any class of voting shares of that bank). All BHCs are required to register with the Federal Reserve, and become subject to regulation and supervision by the Federal Reserve, which has extensive enforcement powers over them. All BHCs are subject to capital adequacy regulation and supervision and are expected to serve as a “source of strength” for their bank subsidiaries.
The BHC configuration permits US banking institutions to participate in certain non-banking activities, but that comes at the cost of fairly intensive and intrusive group-wide policing. Moreover, the Glass-Steagall Banking Act of 1933, while forbidding banks from participating in securities dealing, affiliating with securities firms, and underwriting businesses, did not otherwise impose any particular legal and regulatory limitations on the activities of corporate entities that owned or controlled one or more commercial banks (i.e. BHCs).
The Transformation of the One-Bank Holding Company
While the initial intent of the BHC Act was to safeguard the federalist nature of the US banking system, its primary purpose soon started to shift away from the prevention of undue concentration of commercial bank credit and towards the separation of banking and commerce.
This fundamental shift is reflected in the changes in global and domestic financial markets during the tumultuous decades of the 1960s and the 1970s. Investment banks, along with other financial market actors that were not subject to the same legal and regulatory limitations as were banking institutions, took advantage of the macroeconomic volatility of those times and formed new financial instruments that offered higher returns to their investors (e.g. money market funds). In addition, these financial market actors also steered commercial companies into raising capital in commercial paper and bond markets, consequently resulting in a fundamental shift from bank-dominated finance to market-dominated finance.
BHCs started to seek expansion of permissible securities, insurance, real estate, and derivatives activities, as a reaction/response to the competitive pressure of disintermediation. Consequently, the problem of where to draw the line between permissible and impermissible non-banking activities for BHCs became the bottom line in the interpretation of the BHC Act.