Stop Obsessing About Risks and Let The Banks Compete

(Illustration by Andrea Ucini)

About the author: Karen Petrou is managing partner at Federal Financial Analytics and author of Engine of Inequality: The Fed and the Future of Wealth in America.

Americans have been worrying about the risks of mixing banking and commerce since Aaron Burr shot Alexander Hamilton. Burr’s Manhattan Company at the time promised to build safe drinking-water pipes across Manhattan funded by deposits entrusted to its care. This early example of a bank that took commercial business risks didn’t produce a hit musical, but it did leave Americans with a grudge against mixing deposit-taking and business investments.

Burr and his co-conspirators absconded with the money, and it took another 40 years for New Yorkers to gain wide access to potable water. The residual anger at Burr left many firmly committed to never allow another bank to undertake commercial activities.

Worries still abound that deposit-holding institutions will take unhealthy risks if left unchecked. But the idea that banks ought not to conduct commerce is at best only a partial explanation of crises gone by. It’s also an even worse predictor of any to come.

It doesn’t make sense to divide finance into one set of seemingly safe activities that we call banking and another set of other supposedly risky activities. After all, banks that are kept rigorously within traditional barriers still blow up, thanks to risky bets in commercial real estate, foreign loans, residential mortgages, and all sorts of “banking.” Instead, the question that policymakers and regulators should ask is, how risky can a bank be? How vulnerable is it to self-dealing, business-cycle perturbations, and other high-risk bets, regardless of whether it is funded by way of loans or investments?

Banks are better regulated than ever before, but banking is still full of danger. Decades of data show that nontraditional activities actually make banks safer because they add fee revenue and make portfolios more diverse. It’s not the commercial or banking bucket in which an activity is placed that makes it risky; it’s the activity and the way in which it is conducted.

While banks are still barred from venturing outside a narrow range of activities, other companies are less constrained by regulation. Nonbanks, including technology firms, have been allowed to do business that closely resembles banking, with no constraints on manifold conflicts of interest. Digital asset and crypto companies are gaining more banking powers, such as gathering the deposits once limited only to chartered, tightly regulated banks.

As just one example, a Treasury advisory committee has estimated that payment stablecoins, which may be issued by all sorts of nonbanks, could siphon off $6.6 trillion of bank deposits. That’s about a third of U.S. deposits. On the other side of the balance sheet, U.S. banks hold about 23% of total financial assets. Nonbank financial intermediaries eclipse them with holdings of roughly 65%.

Despite the scale of this transformation, the right way to preserve sound banking isn’t to protect banks from nonbank competition. It is to make that competition as fair as possible. One of the most important ways to do that is to loosen the anachronistic barriers that unduly inhibit bank innovation, especially when it comes to technological transformations like stablecoins.

In an unusual bit of foresight, Congress understood as far back as 1999 that banking organizations needed expanded powers and, most importantly, expanded technology powers if they were to compete with nonbanks. The Federal Reserve has the authority to grant these powers, but it has only authorized five nontraditional activities in almost 30 years, and these are minor exceptions suitable only for the largest or most specialized of banks.

The Fed must loosen its grip on innovation and make use of its powers to promote bank competitiveness in concert with protecting depositors and broader financial system stability. It isn’t the Fed’s obligation to help banks make money, but it is the obligation of regulators to ensure that financial markets are fair. As a Treasury official recently noted, much of the advantage that nonbanks have gained over banks is due not to technological acumen but to regulatory arbitrage. In other words, regulators are giving unregulated firms an edge by keeping banks in a box.

Innovation is inexorable, and much of it is essential to enhance banking-system inclusion, efficiency, and pricing. But it is also inequitable and, in some cases, downright dangerous, especially when innovation comes only from firms unconstrained by any consideration other than monetizing data for still greater profit.

This is clear in areas of essential innovation. Nontraditional payment services from banks are backed by capital and deep liquidity; those from nonbank stablecoin issuers are backed by a new reserve-asset scheme that is not only unproven but also highly uncertain. Equity investments by well-governed merchant-banking subsidiaries in local businesses boost capital formation; those from private-equity companies all too often favor high-risk speculation.

It isn’t just banks that will benefit from equitable innovation. Consumers, investors, and small businesses will be offered new banking products at lower prices, thanks to greater competition. The financial system will be more stable with more providers of critical infrastructure, reducing the banking sector’s concentration and risk. Change this easy and this good for so many shouldn’t be this hard.

Guest commentaries like this one are written by authors outside the Barron’s newsroom. They reflect the perspective and opinions of the authors. Submit feedback and commentary pitches to ideas@barrons.com.