What the Ordinary Guy must Know
About the Different Kinds of Banking

by
William Krehm

To pick ones way through the complexities of bank history and of their present troubles both here and in the US and elsewhere in this globalized world, requires understanding some distinctions between banking here and in the US.

1. In Canada our small banks - the commercial banks as distinguished from investments banks, disappeared around two decades ago, shutting their doors or being taken over by the few large investment or general banks. This does not necessarily make our few large banks less prone to adventures than the small banks and trust companies that either went broke or were taken over by our big general banks. They are, however, more likely to be bailed out by the central bank and hence the government, if they get in serious trouble.
2. When the statutory reserves were abolished in Canada, they were only vastly weakened in the US. The statutory reserves were the percentage of the deposits that banks took in from the public that they had to redeposit with the central bank depending on what notice the original depositor had to give the bank when he wished to withdraw the deposit. Beyond that the central bank had the power to vary the percentage of the original bank deposit that had to be redeposited with the bank. This lessened the dependence of the central bank on benchmark interest rates set by the central bank that determined the overnight interest rate when one private bank borrowed from another to make up their shortfall in deposits with the central bank. What is important to note, is that the central bank avoided lending the money to the private banks itself, because that in a crisis could involve the liquidity of the bank - i.e., the legal tender of the land - if the banks got into serious trouble and came to the central bank to be bailed out. That is very much the case today.

The statutory reserves served another crucially important role. They ceased making the financial system entirely dependent on the benchmark interest rate, which is the primary revenue of speculative capital. With the abolition of the statutory reserves in Canada and a few other countries between 1991-3, the speculative finance sector took over our economy.

It is important to note that in the United States the statutory reserves were scaled down to a far lesser importance, but not done with entirely. That gives you the measure of the servility of the Brian Mulroney government of the day to American policy-makers, and their desire to be holier than the financial pope of the day. In the US the statutory reserves continue but only during banking hours when they are placed in a non-interest-bearing account, but when the banks close their doors they are automatically shifted into interest-bearing accounts.

In the United States there are thousands of banks medium and small, as well as the really large investment banks. These smaller banks are “commercial banks” whose borrowing from the Fed backs short term financing of commercial deals rather than long-term and speculative investments. In Canada that distinction between one and another of our large banks hardly exists.

For Canadian readers this may be important information to grasp the article in The Wall Street Journal (24/06, “Maybe Its Time To Put Banks and Wall Street Dealers Back Together” by Dennis K. Berman): “Investment banking kills. In the carnage of the Great Depression, Congress hoped to safeguard small investors by separating stock-touting investment banks from deposit-taking commercial ones.

“Now that it is clear that one small investment bank, Bear Stearns, had the potential for ruining the financial markets, the best way to protect the public may be the most ironic one of all: to push commercial and investment banks ever closer together.”

Putting Commercial and Investment Banks Together

“ The hope would be to absorb the volatile side of investment banks with more capital and stable deposit bases. Like burying a live bomb in a sand pit.

“Around Wall Street there is a rising, albeit reluctant acknowledgment this may be the best path for the likes of Merrill Lynch, Morgan Stanley and maybe even Goldman Sachs Group.

“Speculation has in recent weeks mounted that one of the Streets brokers may even buy a commercial bank. Whether true, the rumors speak to three deep changes under way.

“First, looming Federal Reserve assistance and regulation could force brokers to keep reserve rations similar to that of deposit-taking banks. Second, short-term funding now is regarded with suspicion. It is capable of being yanked at a moments notice, sending a bank such as Bear Stearns to the brink of bankruptcy (it is now part of J.P. Morgan Chase). Third the securitization markets also have contracted, which in turn is forcing the investment banks to shrink their balance sheets.

“In theory these problems are all solved by putting a large plodding, typical bank - with stable deposits and returns - next to the speculative realms of investment banks and trading. But that would also bring investment banks closer to the Fed - the source of the countrys legal tender.

“Three or four years out, the investment-banking model is coming to an end, says Brian J. Sterling, co-head of investment banking for boutique Sandler ONeill & Partners. If it walks like a bank and quacks like a bank, its going to have capital ratios like a bank.

“Investment bank chiefs would do well to resist this change for as long as possible. The return on equity for an investment bank is typically 20%, while commercial banks generally deliver a mid-teen return. Why rush to cut your own profitability?

“The contrary answer would be to find the best partner possible before a rival snaps one up. Among the big commercial banks, troubled Wachovia is trading at slightly less than half its book value. The likes of PNC Financial Services Group may be attractive to a Wall Street firm looking for a steady deposit base. “During the stock market boom of the 1920s, one bank chief Charles Mitchell of National City (the precursor to Citigroup), rejoiced in bringing the investment banking house to the peoplein a way that is part and parcel of their everyday life.

“Today, the investment banks are so entwined with the every-day financial system that their problems belong to all of us, whether we like it or not.”

We would suggest the careful study of the banking codes that were brought into the lives with investment banking to bring on the Depression of the 1930s, which in turn contributed greatly to give us WWII. And then for much of that time the world could kid itself that it was on the gold standard, and that pretense has long since has been dropped. Our only legal tended since 1971 has been central government debt. It is therefore awfully important for the ordinary citizen to know that his central bank and his legal tender has not become subprime.