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Money and U.S banking

Reviewing the balance sheets of major US banks and policy measures of the Federal Reserve, this essay analyzes a few fundamental causes of the current demise of the banking sector in the United States. The most similar crisis to the current one took place in the 1980s when banks in the US, challenged by non-banking intermediaries and open market sources of credit faced declining profits- the 80s was the time when the number of failing banks rose steadily as the years progressed.

However, when the current demise of the US banking sector is analyzed, two factors emerge as the most important- both linked in one way or the other with the stature of the biggest US banks. The two factors identified for the collapse of the banking sector by John Boyd (Federal Reserve Bank of Minneapolis) and Mark Gertler (National Bureau of Economic Research) in 1994 were: 1) Deregulation and lack of stringent checks leading to financial innovation which in turn led to increased competition between banks, and

2) Subsidizing of the risk-taking of larger banks by the regulatory bodies, under the presumption that the giants of the thriving banking industry were robust enough to withstand most losses (Boyd, John H. , and Mark Gertler , 1994). However, there are certain similarities that can be drawn from that period to the current demise of the sector, and the paper talks about those.

Boyd and Gertler, in their research, analyzed the performance of the larger banks of the United States as compared to smaller banks, in order to determine whether the larger banks fared more or less poorly than the smaller ones when it came to loan losses. They also check for the possibility that the relatively poor performance of large banks could be explained by the fact that these banks tended to be clustered in the hard-hit regions.

However, through their statistical analysis they inferred that, even when this particular fact has been accounted for, large banks still performed worse than other banks. Moreover, the fact that large banks keep relatively small cushions in case a severe loan crisis strikes also explains some of the major banking failures that rose during the previous year. Up to a certain size of assets, a negative relationship between the capital ratio and size might be explained by gains accruing from diversification and increased access to purchased money markets owing to the fact that the bank is larger.

But the alarming fact that Boy and Gertler point out is that the above discussed ratio tended to decline even further than could be normally explained by the size factor. Hence, it is clear from this relationship that the biggest US banks, suffering from the ‘too-big-to-fail’ illusion, over stepped the risk barrier and took on more risk than their balance sheets and physical assets could sensibly support. Another reason that these banks were able to take on such risks by buying risky assets was the availability of cheap credit.

In 2001, following a massive stock market and capital spending bubble, Federal Reserve Chairman Alan Greenspan became worried that the U. S. faced a severe recession. Thus in order to thwart the looming recession Greenspan began cutting interest rates down to 1% and kept them at that level until 2004, raising them slowly only 0. 25% at a time thereafter. As a direct response, the financial industry (accompanied by the rest of America) went into a spending spree, taking on ever-larger portions of debt and taking on ever-riskier assets in real estate.

The first shocks to the hunky dory financial world arrived in February 2007, when HSBC issued the first major warning- writing down tens of billions of dollars in losses from their acquisition of the United States Company named Household International. The change in banks’ attitudes towards risky lending may be observed in the chart provided in the essay’s appendix, which indicates the trend in the type of lending that banks decided to undertake (Heffernan , 2005).

Worth noting in the chart is the rise in the share allocated to loans and the fall in the shares allocated to securities and to cash and reserves. This again reflects a shift in the policy- this time regarding the reserve requirements for banks, which were further relaxed in order to make available cheaper credit to borrowers. The development of money markets (such as the federal funds and large certificate of deposit markets) increased banks’ access to short-term money, thus allowing them to further undertake more risky lending.

In order to study the relationship between bank size and risky lending, Boyd and Gertler divide banks in the US in to four classes with respect to their asset holdings (according to the Federal Reserve Bulletin), namely: small (those with assets less than $300 million), medium (those with assets between $300 million and $5 billion), large (those with assets greater than $5 billion), and money center (the 10 banks with the largest assets) using data from 1987 to 1991.

It was observed that C&I (Commercial and Industrial) and commercial real estate lending had a positive correlation with bank size, while consumer and residential real estate shares had a negative correlation. Hence from this data Boyd and Gertler infer the obvious, stating that “since business lending generally accounts for the substantial majority of loan losses, the general picture is that larger institutions hold riskier asset positions” (Boyd, John H. , and Mark Gertler , 1994).

The too-big-to-fail presumption of the regulatory authorities which were implicit in their policy settings were made explicit in 1984 by the Comptroller of the Currency, by virtue of its testimony to the United States Congress that 11 bank holding companies were too big to fail. This, apart from giving banks a non-technical incentive to swell, also resulted in laxer policies (such as protection of uninsured creditors) towards the larger ones. However, one may point out and argue that, the riskier lending by the bigger banks may have resulted from technological advantages gained by the largest in the industry through diversification gains.

Boyd and Gertler, though, question this argument on the basis of their research which indicates that the largest banks (with assets worth more than 10 billion) performed considerably worse than the next largest ones (with assets worth 1 billion to 10 billion) stating that it is highly dubious that significant differences in economies of scale exist between the above two classes of bank, allowing the former to take on risks that the latter can not take on.

In the conclusion to this paper, it is essential to note that the lack of oversight on the financial sector was not the sole cause of the current, demise (albeit a principal one). Other factors such as greed at the higher levels of management accompanied by excessive financial engineering and innovation were chief causes of the rollercoaster decline as well.

However, lax regulation (especially with regards the banking giants) was responsible in producing a conducive environment for the greed and innovation to flourish and thus was an equally culpable factor (Dilley, 2008).


Boyd, H. John & Mark Gertler (1994). The Role of Large Banks in the Recent U. S. Banking Crisis. [PDF Document]. Retrieved from < www. minneapolisfed. org/research/QR/QR1811. pdf >. Books Heffernan, S. (2005). Modern Banking. USA: John Wiley & Sons. Dilley, D. K. (2008). The Essentials of Banking. Wharton School Publishing

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