Why Banks Should Never Become Utilities

Once again the idea of converting America's largest banks to public utilities has been raised — most recently in a speech by newly named Minneapolis Federal Reserve Bank President Neel Kashkari. This is an old idea that has never gained traction in the U.S., nor should it now.

The notion of reducing the role of banks — particularly the largest banks — to the traditional role of financial intermediation has been discussed for at least as long as bank deposits have been federally insured, which is now over 80 years.

Financial intermediation — that is, converting checking and saving deposits to consumer and commercial loans, is a vital function in maintaining a healthy economy. That is the historic and fundamental role of banks. Thus the idea of limiting banks to that exclusive role keeps resurfacing.

But a more thorough analysis of the issue raises important questions. The term "public utility" is often used synonymously with the term "natural monopoly," since most public utilities are accorded monopoly status in order to develop the infrastructure required to provide a needed public service. Electric and gas utilities are common examples as are providers of cable services in some markets.

But with a public utility there needs to exist an important quid pro quo. The utility needs to be accorded product or distribution protection within a given market in order to remain financially viable. This is particularly true when the public utility is operated as a private corporation as opposed to a government institution.

Kashkari's brief description of how he envisions large banks becoming public utilities is limited to describing them as "holding so much capital they virtually can't fail." While a fortress balance sheet is a typical minimal expectation, it falls far short of any full, realistic description of a public utility and vastly oversimplifies how banks of any size could fit that description.

If the "quid" is for banks to be protected from failure, presumably by requiring massive capital support, the "quo" would need to be either product or market protection allowing exclusive access to either financial products or delivery capability. It is very difficult to envision how that could be achieved.

There are no significant financial products offered by banks that are not also offered by the securities industry or other even less regulated financial entities. And as financial innovation has developed, it is often outside of the banking industry and usually at the expense of commercial banks.

Perhaps the best example of this progression is the fate of the short-term commercial loan. Until the middle to latter part of the last century, banks were the only significant source for large businesses to make short-term (90-to-180 day) commercial loans. But at some point the securities industry developed commercial paper, which instantly became a significant competitive product. Although banks and securities firms were providing virtually the same function, the underlying economics and funding for the two industries were very different. Banks were funding their commercial loans with their deposits — both checking and savings. Commercial paper was funded through either the discounting of that paper or funding it with other leveraging tools.

So while the banks were required to hold capital in support of their deposit base and relied on an interest rate margin to earn a market return on capital, the securities companies could fund the commercial paper with a lower capital requirement and reduced funding cost.

The development of the commercial paper market brought important efficiencies to funding the cash flow requirements of America's businesses. But it was a major encroachment on what had been a relatively exclusive market for the banking industry. This pattern has since been repeated numerous times with both credit and deposit products developed outside the banking industry. It is happening right now with the emergence of peer-to-peer, marketplace lenders, shadow banks, etc. Incredible growth is taking the market share away from the banks as we speak.

Thus bankers are understandably concerned that a designation — even informally — of large banks as public utilities would lock them into a product mix and capital requirements that would jeopardize the ability of the historic bank business model to achieve the capital returns necessary to attract investors.

Even if policymakers wanted to give banks monopoly status in certain product areas, the political fallout from that would be insurmountable. Such an effort would require legislation to put all of the other players out of business, and there has been no precedent in recent history of Congress being even remotely inclined to grant any banks exclusive access to products or markets.

So before any serious discussion develops of giving large banks public utility status, several important conditions and implications must be carefully considered.

Mark W. Olson is chairman of Treliant Risk Advisors LLC and can be reached at molson@treliant.com. He formerly has held positions as governor on the Federal Reserve Board, chairman of the Public Company Accounting Oversight Board, president of the American Bankers Association and bank CEO.