What Is a Bank?

When President Obama announced his "Volcker Rule" proposals -- named for former Federal Reserve Board Chairman Paul Volcker -- to restrict banks from engaging in proprietary trading and principal investment activities, he immediately recast the debate over the proper function of banks in the U.S. financial system. Vowing to close loopholes, raise capital requirements and increase oversight, the president declared, "Never again will the American taxpayer be held hostage by a bank that is 'too big to fail.' "

Obama's proposal would restrict banks from investing in or sponsoring hedge funds and private equity funds "unrelated to serving customers" or engaging in proprietary trading. As Volcker himself put it in a New York Times op-ed on Jan. 31, "The point of departure is that adding further layers of risk to the inherent risks of commercial bank functions doesn't make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets."

In a bid to prevent financial firms from getting too large -- that is, too large to be allowed to fail -- the proposal also called for a market share cap on liabilities in line with the 10% deposit-market-share ceiling. How that would be accomplished wasn't sketched out.

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Reform proposals floated by the administration and Congress suggest a distinctly nostalgic idea of banks as conservative deposit-taking and lending enterprises. But is that realistic and viable? What is the proper role of banks in a system that has undergone decades of convergence, consolidation and innovation?

This idealized model, which goes by terms like "narrow" or "utility" banking and extends to an odd enthusiasm for Mr. Potter's bank in "It's a Wonderful Life," seems to have little role in global finance, where distinctions among entities as different as Goldman Sachs, Citigroup Inc. and GMAC Financial Services have blurred. As one banking lawyer says, "There seems to be a desire to force banks to only make loans and take deposits, while everything else gets pushed outside banking, where it can blow itself up without hurting the system. It's almost the triumph of wishful thinking."

That may be a little unfair, but the government is clearly struggling to make distinctions between "banks" that it needs to protect and closely oversee versus financial firms that can engage more freely in risky activities. Drawing that distinction has proven difficult, if partly because we've spent decades systematically erasing it. At the heart of the regulatory reform process today is an attempt to define what it means to be a bank and what that implies about the proper role of regulation. The questions are fundamental, the implications enormous.

One of the more significant events of the panic phaseof the financial crisis occurred on Sept. 21, 2008, when Goldman Sachs and Morgan Stanley announced they were becoming bank holding companies. The move marked the "end" of Wall Street, at least as it had been constituted for several decades. The last remaining major "independent" investment banks surrendered their lightly regulated status and sought the protection and supervision of the Fed, the primary regulator of U.S. banking.

The banks said they made the decision to shore up market confidence, which had been crumbling and threatening both firms with liquidity runs like those that swept under Bear Stearns Cos. and Lehman Brothers Holdings Inc. and forced Merrill Lynch & Co. to merge with Bank of America Corp.

As Morgan Stanley CEO John Mack put it in the press release announcing the move, "It also offers the marketplace certainty about the strength of our financial position and our access to funding."

The move clearly helped the two firms. Bank holding company status gave Goldman and Morgan Stanley access to the discount window and other government protections. These included $10 billion each in funds from the U.S. Department of the Treasury through the Troubled Asset Relief Program and access to the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program, which allowed banks to raise funds by issuing government-guaranteed bonds.

But it also seemed to complete the convergence of commercial and investment banking symbolized by the repeal of the Glass-Steagall Act a decade earlier. And it raised serious questions: What does it mean to say that trading powerhouse Goldman and, say, retail-oriented Fifth Third Bancorp were regulated under the same rules? If we can't protect every entity known as a bank, which is more important, more necessary to safety and soundness, and to the efficient functioning of the real economy?

Although both banks scrambled to pay back TARP, with Goldman CEO Lloyd Blankfein insisting that the firm had never really needed the money, both Morgan Stanley and Goldman took full advantage of the FDIC guarantee. According to Bloomberg, Morgan Stanley used the program to issue $25 billion of debt, while Goldman raised $21.2 billion. It was an important backstop in light of frozen commercial paper markets and the skepticism of longer-term investors.

Despite obvious advantages during the crisis, converting to BHC status wasn't a step to be taken lightly. As one source pungently remarks, "If it was so good, why do you think Goldman spent the first 140 years of its existence not being a bank?"

Which raises the question: What is a bank anyway? The Bank Holding Company Act of 1956 labels a bank as any institution that "accepts demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others; and is engaged in the business of making commercial loans."

But there's more to banking than deposits and loans. E. Gerald Corrigan, former president of the New York Fed and current Goldman managing director, tried to get to the essence of banking in an essay "Are Banks Special?" first published in 1982 and updated in 2000. Corrigan wrote that banks constitute a bulwark for the financial system, acting as a backup source of liquidity for other institutions. They serve as the central bank's proxy in the markets and maintain the payment system. As the central node in a complex network, banks help regulate the economy's orderly functioning by controlling the flow of credit. These functions make banks special enough to gain government protection, which comes with a price: stringent capital requirements and oversight. The Fed has the right to deny banks that fail to meet capital requirements the ability to make management changes, pay dividends or undertake acquisitions, putting any noncompliant bank at their mercy.

In light of Corrigan's definition, what did conversion to BHC mean to the two firms? What really changed?

Technically, it was remarkably straightforward. Both firms, exploiting a loophole in existing rules, owned nonbank industrial loan companies in Utah-based subsidiaries. The ILCs had the right to FDIC insurance on demand deposits and made commercial loans but weren't legally classified as banks. With that structure in place, it was easy for Morgan Stanley to convert its ILC into a national bank. Goldman chose to get a New York state bank charter for its subsidiary, albeit one with access to the Fed's payment system, putting it under the Fed's supervisory jurisdiction.

With bank subsidiaries in place, both firms could now be officially classified as BHCs under the Gramm-Leach-Bliley Act of 1999, which allowed such firms to house separate securities, insurance and merchant banking units under the same consolidated entity's umbrella.

Following the conversion, many analysts expected them to transform their business models. After all, risk-taking investment banking and principal investing are very different from traditional commercial banking. Many expected them to buy commercial banks (Goldman was mooted as a buyer for failing Wachovia Corp. before it was bought by Wells Fargo & Co. in October 2008) to provide them with larger deposit bases and divest subsidiaries involved in commodities trading or real estate, although there were enough loopholes and grandfather clauses to expect that the impact of those changes would be limited. Everything from compensation to recruitment to culture was expected to change over the two years (with three possible extensions of one year each) the banks had to come into compliance with the Bank Holding Company Act.

Sixteen months later, those expectations remain largely unmet. While Morgan Stanley took several steps to rein in risk, including shuttering some prop trading desks and raising deposits, Goldman did relatively little. To be sure, both firms reduced leverage to around 15 times, down from the 22-times ratio Goldman shouldered a year earlier, and from Morgan Stanley's 28 times recorded at the end of March 2008. Some of this had to do with a general decline in asset values, however.

The firms did raise deposits, with Morgan Stanley increasing its deposit base to $62.2 billion as of Dec. 31, 2009, from about $35.26 billion as of June 30, 2008. Goldman, for its part, hasn't broken out deposits for the fourth quarter, but it reported $42.4 billion in deposits for the third quarter of last year, up from $27.6 billion in November 2008.

None of this suggests that deposits are about to become primary funding sources. Those numbers represent about 8% of Morgan Stanley's total liabilities and only 5% of Goldman's third-quarter liabilities. Compare those figures to a more traditional bank, J.P. Morgan Chase & Co., which had about $938.37 billion in deposits at year's end, representing about half of its $1.9 trillion in total liabilities.

Goldman also reported in the fourth quarter that trading and principal investments brought in $34.4 billion, accounting for 76% of its revenue. The numbers were smaller, but still sizable, for Morgan Stanley, which reported full-year revenue of about $7.45 billion from trading and principal investing, equal to 31.8% of total revenue.

Although the changes at Morgan Stanley were more significant than at Goldman, the bank reversed that risk-averse attitude by fall, when CFO Colm Kelleher said it would take on more risk and hire 350 traders to man its trading businesses.

In general, the absence of fundamental changes in Goldman's and Morgan Stanley's business models begs the question: Was the traditional distinction between nonbank financial companies and those with bank status simply semantics?

The answer to that lies in the changing nature of banking. Indeed, definitions of banking hark back to a time when both small-scale consumer lending and the largest loans to corporate borrowers were still done face-to-face. In a system still ruled by Glass-Steagall, traditional banking functions were separated from riskier investment banking and other nonbank financial services. In that world, the archetypal commercial banker was a conservative figure who carefully monitored his loan book, was stingy with capital and was decently, if not lavishly, paid. Securities firms were risk takers, a breed apart.

It's almost impossible to envision that staid banking model in a post-Glass-Steagall, high-velocity, disintermediated and globalized world where homebuyers in Kansas can get mortgage loans from Amsterdam-based ING Groep NV without ever having to visit a physical branch, where savers don't stuff their money in savings accounts but in markets through mutual funds or 401(k) plans or in alternative investments through pension plans that are among the largest investors in multibillion-dollar private equity funds.

Today banks such as Citigroup compete with Bank of America, Credit Suisse Group, Goldman Sachs, J.P. Morgan, Morgan Stanley and UBS not to lend money directly to corporate borrowers, but to funnel it from collateralized loan obligations to corporate borrowers and then transfer the debt obligations the other way, working not for interest income, but fees, and freeing up capital for more profitable principal investment businesses.

"It's a volatile and risky business," admits one banker.

The volatility and risk are in many ways a reflection of the market-driven ethos that has overtaken banking over the past 30-odd years. One of the salient features of that period has been the progressive shifting of lending responsibilities away from banks to capital markets. According to Fed flow-of-funds data, total bank-based lending in the second quarter of 2007, the height of the credit boom, totaled $12.8 trillion. On the other hand, market-based lending, characterized as lending via asset-based securitization vehicles, broker-dealers, finance companies and mortgage pools, totaled $16.6 trillion.

It's telling, as several market observers note, that the firm that triggered the first phase of the crisis, Bear Stearns; the firm that almost brought market collapse, Lehman; and the one that prompted the biggest bailout, American International Group Inc.; were not classified as banks and not overseen by the Fed. This implied that regulators didn't see them as central enough to warrant privileges such as access to the discount window. Also telling is the fact that neither of the investment banks, the two smallest of then five large broker-dealers, would have been classified as too big to fail in more normal times.

As one former Fed official says, the crisis forced regulators to conform the supervisory structure to changes transforming financial services for over 20 years -- changes many now question. "It doesn't seem to make a lot of sense to have very different regulatory and supervisory regimes for institutions that are in many ways directly competing with each other," he says, noting that the Fed's move to open the discount window to primary dealers amid Bear's death throes showcased the limitations of existing regulation.

Before 2008, financial regulation was still split between one regime for commercial banks and another for investment banks. This was never simple. The former were regulated by the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Federal Deposit Insurance Corp. and various state regulators, the latter by the Securities and Exchange Commission, self-­regulatory bodies such as the National Association of Securities Dealers and state regulators.

The Bank Holding Company Act made this regulatory apparatus look even more confused by putting the Fed in charge of holding companies that controlled subsidiaries of growing universal banks but still forced each of the units to defer to primary regulators. This created a tangled hodgepodge of oversight where a firm as complex as Citigroup was overseen by the Fed, the OCC, the FDIC, the SEC and state insurance regulators, not to mention myriad sovereign regulators in each of the 140 countries where Citi does business.

Ironically, Obama's most recent proposals seem designed to push some larger banks to drop their holding company status. According to The New York Times, Treasury officials have already offered banks that don't like the Volcker Rule the option of giving up BHC status. Of course, under existing proposals, firms as large as Goldman or Morgan Stanley would still be deemed systemically important, which would keep them under the Fed's supposedly watchful eye.

Adding to the confusion over Obama's plan are questions over how regulators will define nebulous concepts such as proprietary trading. The effect on all banks -- not just Goldman or Morgan Stanley -- will vary depending on that definition. "If it's [being defined] as a strict unit in your trading group that takes your own money, that's just a few percentage points for J.P. Morgan, and the company will live without it," says one source. A J.P. Morgan spokesman declined to comment.

J.P. Morgan, for instance, manages the $10 billion Highbridge Capital Management LLC hedge fund, which is "all client money" and could presumably remain with the firm under the Volcker Rule, the source says. However, the firm's private equity business, One Equity Partners LLC, is completely funded by the bank, he adds.

Citi, also a deposit-taking machine with about $835 billion in deposits at the end of 2009, would likely spin out what remains of its prop trading. Citi's principal transactions business, having sold the highly profitable Phibro commodities trading unit, suffered a revenue loss of about $1.8 billion in the fourth quarter. Its total trading business had about $343 billion in assets at year's end, about 18.5% of its total $1.85 trillion in assets. A source close to Citi says prop trading comprises less than 5% of its revenue mix. A Citi spokeswoman declined comment.

BofA, the largest BHC by assets, does not identify prop trading assets in public filings, but its Global Principal Investments unit, through which it invests in private equity, real estate and other alternative investments, had roughly $14 billion under management as of year's end. A source said roughly 1% of the bank's total revenue, about $120 billion in 2009, is derived from prop trading. BofA's total trading assets were about $182 billion at the end of the year, a sliver of the firm's $2.2 trillion in overall assets. Its deposits measured about $992 billion at the end of 2009.

The debate thus rages about the Volcker Rule's fixation on prop trading. "Prop trading did not get our banks into trouble -- securitization and mortgage lending did," says Tony Plath, a finance professor at the University of North Carolina at Charlotte's Belk College of Business. "I don't understand how limiting the size and scope of banks' operations prevents reckless lending and helps to build capital."

Plath argues that, instead of targeting investing activities, regulators could limit risk by modifying risk-based capital standards requiring banks to hold more capital against activities defined as risky.

Transparency is another key to limiting risk, Plath says, adding that "if you're trading in proprietary stuff, you must have a clearinghouse in which counterparty risk is both known and measurable."

Some of those prescriptions are already expected by the industry; the Basel Committee, which formulates international banking standards, is expected to set higher capital requirements whenever it settles on its Basel III accounting rules. The creation of an over-the-counter derivatives clearinghouse is already included in the Wall Street Reform and Consumer Protection Act, which was passed by the House of Representatives in December, and is contained in the bill still being debated by the Senate Banking Committee.

Instead of restricting investment activities and putting limits on growth to prevent too-big-to-fail, Tim Yeager, professor of finance at the University of Arkansas Sam M. Walton College of Business and a former St. Louis Federal Reserve economist, suggests that banks beyond a defined asset threshold be forced to hold extra capital and to pay higher deposit insurance premiums. This would make it cost prohibitive to become too large while contributing to an FDIC war chest to be tapped in case of failure.

University of Illinois finance professor George Pennacchi advocates a model in which banks are required to have "separately capitalized subsidiaries" and deposits collateralized by "extremely safe securities" including Treasuries, "top-rated commercial paper or top-rated bank CDs." His proposal is reminiscent of narrow banking theory, which would restrict banks to holding liquid and safe securities while loans are made by other financial intermediaries.