Heading Toward a National Bank?

The late great Supreme Court Justice Antonin Scalia was often in dissent in key legal cases during his long career. Almost thirty years ago, he wrote that “Day by day, case by case, the Supreme Court is busy designing a Constitution for a country I do not recognize.” This quote comes to mind because it seems that crisis by crisis – the Federal Reserve, lawmakers, and regulators – are busy designing a financial system that looks a great deal like a national bank.

We aren’t calling this a hidden political conspiracy, nor do we believe there are some sort of puppet-masters pulling the strings behind the scenes. We are not wearing tin foil hats. What we are asserting is that the more the government tries to take risk out of the financial system, the more they are moving the country in the direction of a national bank, whether intentionally or not.

After the absolutely awful monetary policy of the 1970s, and the Fed’s fight against the inflation that it caused, S&L’s and banks failed across the country. One regulatory response to this mess was risk-based capital rules. Different loans or bonds had different capital requirements based on “riskiness.” Included with this was a much lower capital requirement on Treasury debt. This worked fine as long as interest rates were falling, but clearly doesn’t make sense when rates are rising. Banks had an incentive to hold more Treasury debt, which subsidized government borrowing and encouraged more spending.

Then came the bailout of Long-Term Capital Management (LTCM) in the late 1990s, which showed that policymakers considered some financial firms, whether regulated or not, too big or too intertwined with other institutions to be allowed to fail without government intervention.

Then the Financial Panic of 2008 caused massive changes in our monetary and banking system. These changes included a huge increase in the size of the Fed, the Fed paying banks interest on reserves, extremely low short-term interest rates for an extraordinary period of time, and even more stringent regulations on banks.