Financial Cryptography

US Banks lobby to enter Real Estate - Hubris or an Invitation to end the Franchise?

In a stunning display of hubris, the American Banking Association is lobbying to let banks enter into the real estate business.

Quick refresher: banking is the business of borrowing and lending money to and from the public. Unlike almost all other goods, loans can go south due to circumstances beyond the control of the parties, to whit the economy. For this reason banks are regulated in a special way, because, so the theory goes, if they are not regulated they will be tempted to ignore the future dangers of an unbalanced balance sheet in pursuit of short term profits. In banking there are always short term profits there for the taking...

Banks therefore are granted a franchise. In economic terms, a subsidy. Banks are protected from competitors so as to make the regulation easier. This also makes it easier to make profits, as there are no nasty little upstarts coming to cherry pick and make trouble. But such a subsidy comes with limits - banks are supposed to only be in the business of banking.

Which then turns on the definition of banking. As I suggested, banking is the borrowing of demand deposits and lending them out as loans to the public. If it is not the public, then it is a building society, S&L, credit association or the like - the members only borrow and lend to themselves, so that's not banking, nor is it so deserving of special treatment. If they are not taking deposits or not making loans, then they are not entering the special risk scenario where the term nature of the deposit does not match the term nature of the loan. That is, the bank borrows funds on demand terms and loans them out on long terms. Clearly a mismatch there, and that's part of the rationale for the regulation and subsidy.

The problem with this is that banks then grow big and powerful within their communities and also come to know a little about lots of things. They have dramatic power over their community in that they have access to the balance sheets of their borrowers. Where does this lead? Of course it leads to cherry picking.

Banks know that real estate can be profitable. They figure that with their local knowledge they could swipe those lucrative percentage fees - generally from 5 to 10% of the house sale price around the world. A very rich, luscious juicy cherry, that.

Problem is, it flies in the face of the subsidy. And in order to get around that, enter 'definition of banking, number two!' In many countries, the practical, de facto and sometimes legal definition of banking is not as I described it above, but it is this: Banking is what banks do. And, banks are those that do banking.

Whoops! A circular definition, which means there is no definition. And this is what is happening in the US banking structure at the moment:

"Duke said that the Realtor's insistence that Congress block banks from entering the real estate market would reverse the progress made by the 1999 Gramm- Leach-Bliley Act. The act adopted a process where the Federal Reserve and Treasury Department would determine which activities are financial in nature and therefore allowable for banks to pursue."

In a sentence, the Fed and the Treasury determine banking as "activities [that] are financial in nature!" Which of course is everything, pretty much, as anything with a price sticker is financial at some level.

As an invitation to drop the banking subsidy and give all businesses the right to enter into banking, it doesn't get much clearer than that. If the subsidy is to have any meaning, it must be tightly curtailed. If not, then it should be dopped as a matter of public policy. You simply don't let one group do A & B, but another group only do B.

It may seem even odder, but this is indeed the way things are going in the US. Several institutions can enter parts of banking already:

"Duke said that combining real estate brokerage and banking services is not a new concept in the marketplace, citing that real estate firms, insurance companies, and securities firms already have the authority to do so. She added that state-chartered banks in more than half the states also can offer real estate services."

And the theory of banking - especially that of Free Banking - decidedly supports the notion that there is no economic rationale for the subsidy, only the combined weight of historical mistakes.

Maybe, then, this is what we are seeing: the long term dismantling of US banking as a franchise.

Posted by iang at June 20, 2005 09:17 AM | TrackBack