View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.


The Goals of Bank Regulation
An Address by
Leonard Lapidus
Beforte the
Federal Bar Association

The world is not born new every morning.
a direction which determines its near future.

It has a character and
We often have the sense

we can make it over, but that sense usually proceeds from a delusion
of youth or the arrogance of rationalism.

Nonetheless, if we spend an evening addressing the issue of appro­
priate goals for bank regulation, it is a harmless waste, intellectual
jogging which, if nothing more, will tone up our mental musculature.
And if we discover that bank regulation, in fact, is misguided in seeking
the goals it seeks or wrongheaded in the methods it uses, one gets a
bonus for an evening's effort “■! that delicious sense of superiority
of sharing with a small elite a truth which, even if given broad public
notice, would have precious little effect.

It is a cult pleasure to

know one is right in a world gone wrong.

Broadly there are two ways to approach the issue, what are the
appropriate goals for bank regulation.

One is to examine what law has

required of banks and why the law has so required as revealed by legis­
lative intent and judicial interpretation.

The other is to address the

issue frontally as a problem in social philosophy and social engineering.

The first method, the exegesis of legislative intent, is the
traditional and highly favored one.

The method grows from the research

necessities of litigation; that is to win a case it helps to argue that
your client’s position is four-square with the letter, spirit and intention


of the law.

2 -

But that method is ill suited to the task of establishing

what we as a people should be striving to accomplish in any collective
political undertaking.

The divining of legislative intent is backward­

looking; the analysis of appropriate goals looks forward.

The method presupposes that legislatures and courts somehow express
social wisdom.

Much effort and time is spent incanting over the records

of legislative deliberations to distill quintessential motives.


legislators of yesteryear suddenly grow to the stature of statesmen who
collectively are thought to have a rational structure of social values
and an articulated theory of social process unerringly expressed in statute

And it is thought, by means of Talmudic dedication that strucutre

of values and that theory of process may be seen as through a glass

In fact, of course, those legislators of yesteryear have no more

an orderly social philosophy than legislators today, and the group dynamics
of the legislative process typically provides no more than a Delphic state­
ment of intention.

The courts, bless them, out of sheer necessity provide

sensible dimension and order to statute law.

The judges, as medieval

doctors before them, lend an intellect to text it would otherwise lack.

No, we are stuck with the second approach, making a frontal attack on
issues such as we face tonight, if we are to say anything meaningful about
the proper goals and their priority.

This approach asks what social bene­

fits are we seeking, what costs do we incur if we use one means rather
than another and who gains, who loses and how much from the choice of one
method or another.

To be sure, 15 minutes will not do justice to that

assignment, but I shall attempt a sketch in the spirit of that approach
in any case.


The primary forms of regulation of financial institutions are:
(1) control of entry;
(2) Control of

mergers and acquisitions; and

(3) regulation of portfolios (lending, investing and borrowing
powers and restraints).

The two most important goals of regulation have been "competition”
and "safety".

The concern for competition has manifested itself most

clearly in public policy toward

The concern

bank mergersand holdingcompany

with safety has been the more dominant


theme in the

regulation of entry— branching and chartering policies— and in the regula­
tion of portfolios of depository institutions.

The public support for

competition among depository institutions has rarely been positive, to
encourage competition, but rather, to discourage monopoly, market power,
or excessive concentration of resources.

The concern with safety has been

motivated primarily by a desire to protect the banking system and other
depositories from breakdown in order to contain the severity of economic
dislocation and secondarily, to safeguard the liquid capital of depositors
of small means.

While both safety and competition considerations have been important
in shaping the character of the regulation of depository institutions,
it was only after the Great Depression that the two goals were thought to
be in irreconcilable conflict.

The economic collapse of the 1930s was so


severe that considerations of safety became paramount.

Indeed, most of

the restrictive legislation and regulation governing depository institutions
dates from the Depression, perhaps more than is generally realized.


checkered performance of the banking system earlier in our history resulted
over time in a slow development of restraining regulation, but the regula­
tion introduced in the 1930s makes all that preceded appear modest by

Government has also sometimes intervened to encourage or direct insti­
tutions to make socially desirable investments or perform socially desirable

Early in American history, banks were organized to finance

major public utilities, such as roads, canals and railroads.

More recently

residential housing has drawn major support from government programs to
induce or require financial institutions to provide an ample flow of funds
at less than market rates to finance residential construction.

The social

priority of housing has assumed such singular importance in recent years
that it may prove ultimately to be as important a shaping force as safety
and competition have been to date.

Other social motives have also played a role in the regulation of
depository institutions.

One notable example is market intervention on

behalf of buyers or selleis who are weak or disadvantaged.
legislation and usury ceilings are cases in point.
protection of investors.

Consumer protection

Another motive is the

For sometime it was thought that banks would be

exempt from the full force of investor protection safeguards.

It is now

clear that such is not the case.

Still another motive has been to assure a ’’fair" distribution of

This motive was important early in our history when, in a savings-

poor country, credit was in particularly short supply.


Finally, bank regulation also is charged with preventing irresponsible
or fraudulent banking.

This function, of course, has been a high profile

issue for the past year since the Lance hearings.

Interest in the issue

has been maintained by the introduction and fluctuating vitality of the
Safe Banking Act and the report on insider loan and overdraft practices of
American bankers.

While some argue that the regulation of insider dealing

is simply an aspect of regulating for safety, I believe that it is a
separate and distinct goal and seeing it as an aspect of regulating for
safety is significantly misleading.

This brief review of the goals which have at one time or another in
American history determined, and continue to determine, the letter and the
spirit of bank regulation appears to make one simple statement.

There is

a social willingness to regulate banks for whatever reason seems appropri­
ate, and I might add, to fail to regulate in the face of splendidly
appropriate reasons for so doing.

(Perhaps most notable in that respect

was the failure to establish a central bank in face of a century or so of
recurrent banking panics.)

While safety and competition have been the most

important goals, there are, as I have indicated, many others as well.

Only one of these goals, the safety goal, is uniquely related to

The rest are goals which are more broadly rooted in American

economic and social philosophy which makes them no less legitimate, simply
not sui generis.

Implementing such goals in banking simply represents another

manifestation of social purpose.

For example, the stimulation of housing

credit, primarily through the thrift industry, has analogs in a broad
range of financing, subsidy and public housing programs which make up
national housing policy.



Protection of bank investors is no more than the application to
banking of securities statutes and regulations applicable to business in

Consumers are protected in their dealings with vendors in other

industries in ways different in detail, but not in principle, from the
ways they are protected in banking.

And the control of abusive dealing

by insiders has venerable sources in common law to which all corporations
are subject.

Indeed, excluding the implementation of the "safety” goal, to the
extent that one can meaningfully compare the substance and character of
law and regulation among industries, banking law and regulation is not
notably dissimilar from law and regulation applicable to other industries.
Where the difference lies is in enforcement.

The examination which is in

the first instance an instrument of the safety goal is a convenient vehicle
for enforcing law and regulation in pursuance of other goals as well.


a result with respect to such other goals banks are subject to much more
comprehensive and effective enforcement of law and regulation than other

The sense of bankers that they are overregulated with respect

to other industries, ignoring their endemic paranoia, is, I would judge,
justified to that extent.

In any case, there appears to be no ji priori arguments for limiting
the goals of bank regulation.

However, I believe that there are good

arguments for examining how we implement those goals because the cost of
implementation, I would judge, are high relative to the social benefits
which have flowed from our efforts.

In the brief time available to me

this evening I would like to focus on the goal of bank safety.

It is the

most important goal and what we understand it to mean has important impli­
cations for the extent and character of regulation.


Precisely what is that we are trying to make safe when we say that
safety in banking is an important goal?

What is it we are trying to

secure as a public benefit - the safety of the individual institution, the
safety of deposits in any single institution, the safety of the system of
financial institutions, with safety of the payment mechanism.


belaboring the argument the appropriate goal is the safety of the system
of financial institutions so as to maintain the economic life of the nation
and the limitation of depositor losses.

The special place afforded to

limiting the losses of individual depositors derives from a concern about
the "little man".

The first correlary is that there is no social obligation to prevent
a bank failure or for that matter 10, 20, or 30 bank failures.


obligation is to prevent a failure of the banking system and to indemnify
"small depositors" as defined by the extent of deposit insurance.


such social concern as we have about individual bank failures should be
based on the relation of individual bank failures to systemic stability
and to the protection of depositors.

An individual bank failure would have the potential of systemic
failure only if such a failure resulted in a liquidity panic among depositors
and other bank creditors.

Clearly, the small depositor is insured and is

largely indifferent to the prospects of an insured bank.

Large depositors —

the corporate treasurer, the municipal finance officer, and banks, whether
as respondents or as sellers of fed funds —

are the channels through

which an individual bank failure might become epidemic.

The only defenses

against such a liquidity crisis is 100% insurance or the provision of
emergency liquidity to keep essentially balance-sheet solvent banks from
succumbing to a cash unsolvency.

We in fact use both these methods.





we do not insure deposits or other bank liabilities to their full amounts,
the FDIC has favored "purchase and assumption" transactions to liquidation,
the effect of which is to eliminate losses by depositors and other bank

Moreover, the Federal Reserve stands prepared to float the

system in the event of incipient liquidity panic, as it demonstrated when
the Penn Central failure threatened to close down credit without which
commercial paper issuers could not meet their obligations to frightened

To be sure, a liquidity crisis may conceivably arise from a systemic
credit crisis and we have had some intimations of such crises —
tanker loans, and international loans, to name a few.

REITS loans,

And a crisis may be

aggravated by a financially fragile banking system, one in which bank
capital is low relative to assets, and short term assets are low relative
to long term assets and to short term liabilities.

Such a banking system

is less able to resist shock irrespective of its source.

Bank regulation attempts to address these factors broadly in two

first, with respect to the quality of credit, law and regulation

tends to limit the riskiness of some individual contracts by restriction
on the maturities, and down payments, or by limiting the amount a bank
may hold in portfolio . Also concentrations to individual borrowers are
typically limited; finally, there is a broad influence of unknown effect
of moral suasion to limit generally the risk-taking propensities of bankers.
Moral suasion is also the principal tool for influencing banks to maintain
a conservative financial structure.

Indeed, the bulk of regulatory costs are expended on such endeavors,
which can be characterized as preventative.

The logic as it relates to the

objective of maintaining a stable banking system is that if banks in general


are held to conservative credit, capital and liquidity practices, the
chances of systemic failure will be diminished.

To what degree does the

massive regulation of loan contracts, asset choice, interest rate restrictions
(such as Regulation Q and the prohibition of interest payment as dividend
deposits), jawboning about the adequacy of capital, and liquidity and
about the appropriate structure of asset and liability, contribute to the
safety of the entire system and at what cost.

I would judge that the impact

on the system is small and may not be positive at all and to the extent
that preventative regulation is at all successful in making banks more
conservative, it results in some social loss as riskier (read, small and
new) businesses and less credit worthy (read, poor) borrowers are closed
out of the market, and depositors are deprived of the full return of their

Why is the impact likely to be small in any case and perhaps perverse?
First, bankers do not plan to make bad loans.

At the time the first REIT

loans were made it is highly unlikely that the even the most astute examiner
could foresee inherent default.

And if he had, he could not in any event

have classified the loan at that time or otherwise deterred the banker
from making such loans.

With respect to heading off developing fragility

in the banking system, much the same can be said.

There are no standard

ratios that are so honored by the tests of experience that an examiner
may use them as clubs to beat a banker back into line.

Indeed, the post

war rise in loan-deposit ratios and in purchased money ratios was heralded
as the "new banking"; it developed a respectable intellectual rationale and
ultimately drew on the force of custom.

At best, an examiner might slow

down the front runner; he could not dictate the pace of run.

Indeed, the evolving fragility of the financial system reflected broad
trends in financial practices in general.

Banks, it must be remembered,

are not exogenous to the system; their assets are someone else’s liabilities
and their liabilities, someone else's assets.

The economic pathology of

the seventies affected everyone, directly and indirectly.

Real economic

shocks and ineffective national economic policies were potent forces
which distorted the balance sheets of individuals and businesses and, of
course, banks, too.

To expect examiners to stand against such forces is

simply unrealistic.

Bank supervision, in a word, is a "microeffective" technique and
the problems of financial fragility require "macroeffective" techniques.
Moreover, bank supervision is most effective with banks whose problems
are realized, not with banks whose problems are potential.

What effect

preventative bank regulation has on maintaining the stability of the
banking system is unclear.

I think that it is a real question, worthy

of much more serious attention.

What is clear is that by comparison the

"postventative" techniques are relatively effective in providing protection
against systemic collapse and are relatively inexpensive.

Indeed, the

lesson we learned from the time of troubles may have been precisely the
wrong one.

We might have conlcuded that since we were already expending

a great deal in real resources without achieving satisfactory results, we
might best have reduced the preventative effort and cut the social cost,
instead of redoubling our efforts in that direction .

Let me return to my original point, that the essential safety goal
we seek is the stability of the banking system and trace its implications
down a different path.

While that is the actual goal, the operational goal

of regulation is the prevention of bank failure.

It is so because (1) there




is no accepted operational definition of the stability of the banking
system against which regulation might be measured, and (2) legislators
and the public tend to get upset when banks fail.

In fact, the number

of bank failures or the dollar volume of assets in failed banks do not
bear a certain relation to the essential social goal.
number of bank failures in the country is very low.

Moreover, the
Even at its recent

high point the bank failure rate was only about one-quarter the rate for
businesses in general.

And finally the depositors and creditors of banks

have generally not been injured; generally only shareholders, who put
their money at risk, have incurred losses.

And so the system protects

the innocent, while still providing that sometimes capital punishment
which keeps the free enterprise system viable.

We should be quite satisfied, but instead when the failure rate
rises, legislators hold hearings and propose changes in legislation to
reduce further the incidence of failure.

A case in point is the concern

over insider abuse and the proposals that we increase our surveillance of
all banks, at increased private and public cost, or that we limit credit
available to bank insiders.

The safety argument is that most banks fail

because of insider abuse and controlling such activities will contribute
to bank safety.

To be sure, most banks do fail because of insider abuse,

that is more a reflection of the fact that the natural failure rate of
banks is low so that non—economic factors, such as fraud, are likely to
be relatively important.

In any case reducing the number of failures from

10-15 banks to 5-10 banks per year will not secure for us the goal we seek,
but it will certainly cost us a great deal to do.

If we are morally out­

raged by the breach of fiduciary responsibility of bank officers or bank
directors, then legislate, for heavens sake, but understand that the motive
is not safety and the costs are high.




I have failed to discuss a number of important questions for the
lack of time, because I wanted to focus on the safety issue which is the
linch-pin of bank regulation.

The issue, I believe, has been misunderstood

and led us more and more into increasing the public and private costs of
regulation with uncertain social benefits.
appraisal of our position and our direction.

I think it is time for a close