Where the Banks Went Wrong: The Depositor

By Tim Holland

Ever notice that the banks no longer have depositors – they have customers. Now that may not seem like a big distinction but it represents a huge philosophical shift in the way banks approach the people and companies that have accounts with them. It signals that the obligations banks have to depositors and the value those deposits have to the banks have undergone a major adjustment.

As most people are aware, the traditional concept of a bank is one where an individual would place money with a bank, which would, in turn, take a portion of the funds and lend it to individuals and companies in the local community. It was a pretty straight forward agreement in that the bank would pay the depositor a rate of interest based upon the earnings capability the bank could achieve (the earnings it could make by lending the deposit in the community).

From a financial standpoint that deposit represented a loan of funds by the depositor to the bank, which recorded the deposit as a liability on its balance sheet. When the bank re-loaned the funds in the community the loan appeared on the financial statement as an asset. Without deposits the bank couldn’t lend and would have no earnings. Depositors were the lifeblood of the banking system.

When deregulation of the banking system began in earnest in the late 1960s, which happened to coincide with the privatizing of a federal agency called the Federal National Mortgage Association (FNMA or Fanny Mae) into a government sponsored enterprise or GSE (as a way of moving its expense out of the federal budget to make the deficit look better (see: www.tim-holland.com/Economy/Fannie_Freddie.htm), both FNMA and the banks explored (during the financial crisis of the early 1970s and again during the Savings and Loan crisis) a more aggressive way to free up funds to the banks (provide them with more liquidity). What this entailed was the expanded ability of the banks to sell mortgage loans to FNMA. The result was that the value of deposits on the bank’s books could be doubled, tripled and even quadrupled to the banks benefit.

Traditionally, a bank was limited in the loans it could make by the deposits it had on hand. However, now the bank could make the loan, sell it, get back the funds it loaned out and then make another loan, sell that one and so on. Since FNMA did not want to be in the business of collecting monthly payments from thousands of borrowers around the country, they entered into an agreement whereby the local bank would continue to receive the payments for the loan, record it, and perform all the necessary functions related to it, even though it had been sold to a third party; this they agreed to do for a fee, which represented a portion of the interest payment, with everything else going off to FNMA.

All of this is important as it opened the Pandora’s financial box that started banks thinking about alternative funding sources for loans and the concept of earnings based on fees rather than the simple spread between the interest rate on the loan versus what the bank paid the depositor for the funds. So we move from simple to complex funding systems where banks begin packaging other loans, selling general obligation preferred stocks and bonds not specifically tied to individual transactions, selling loans not eligible for purchase by FNMA to the general public in the form of collateralized debt obligations.

Along the way fees became a cash cow and were developed for everything possible and usury rates were abolished during the Reagan years permitting the banks to increase the spreads between their cost and the rate of interest they could charge.

Suddenly, people who place funds with the bank were seen, not as a needed source of lendable funds but as a purchaser of the new bank “product” concept. As depositors were now “buyers” of bank “products” (auto loans, credit cards, mortgage loans, personal loans, safe deposit boxes, foreign exchange, insurance, credit protection and on and on) the individual coming into the bank became the target of a sale rather than the lender of funds to the bank: the customer was born and the depositor died.

Now, is all of this bad? The answer, as usual, is yes and no. The concept of a secondary funding avenue for the banking industry is surely a good one as it permitted banks to expand lending at a time when trying to match a loan to a percentage of a deposit was proving to be a hindrance to economic recovery. Unfortunately, it got way out of hand and should have been put under tight control but the massive bank deregulation initiative combined with a confusing array of multiple, outdated regulation agencies and the non-interference approach to the financial marketplace was producing huge profits and great personal wealth in the financial services community.

The old caveat of “You have to be careful of what you wish for” surely applies to the banks and the congressional legislators. Yes, they cheered the expansion of their funding powers and the eventual end of the Savings and Loan crisis and the only moderate recessions that followed in 1990 and 2001 but along the way they lost sight of where they came from and changed their focus from the depositor, the employee, the shareholder to the shareholder, the customer, the stakeholder.

© 2009 Timothy Holland First Published: 11/30/2009

Note:

Tim Holland is a retired commercial banker with more than 40 years of experience in corporate lending, banking operations and corporate financial services consulting. He currently writes commentary for ToTheCenter.com, an internet news magazine. Copies of his columns and other writings may be found at www.tim-holland.com.

Comments are welcome and may be sent to: Admin@tim-holland.com

Reader Comments:

#1 | E. Doyle on November 30 2009 18:10

I feel like banks lost sight of what they are there to do. This becomes a little frightening that banks are losing focus.

#2 | D. Leader on December 5 2009 00:22

So true!