By Bill Watkins – Previously Published in the Pacific Coast Business Times

In popular culture, there are “good” industries and “evil” industries.

Oil has held the most hated position of the evil list for generations and is likely to hold it until there is no more oil. Farming, once solidly on the good list, is moving to the evil list because its critics claim it uses too much water and its use of pesticides and herbicides hurt the environment.

Banking holds a special place on the bad list, having resided there for more than 2,000 years. Indeed, Dante had usurers condemned to the seventh of his nine circles of Hell.

Banks still exist because they serve a valuable purpose. They are intermediaries between huge numbers of savers and huge numbers of borrowers. As such, they dramatically increase the return to savers and, just as dramatically, reduce the cost to borrowers. We need banks. We need a well-functioning banking system.

Since the Lehman Brothers collapse, banks have become even more unpopular. They are blamed for the 2008 financial crisis and the terrible recession that accompanied the crisis. Much of that blame is undeserved.

Criminal bankers didn’t cause the Great Recession. Every industry has its criminals. Surely, there were criminal acts by bankers that went unpunished but they were small players on a big stage.

Banks are among America’s most heavily regulated industries. Beginning in the mid-1990s, the federal government, with bi-partisan agreement, set about to increase the percentage of the population that owned their own home. Their methods included incentivizing banks to loan to people who traditionally could not borrow. The incentives included rewards for cooperation and punishments for failure to cooperate. Banks had little choice.

Traditional lending standards existed for a reason. Many who borrowed under the new, more relaxed, standards eventually defaulted, contributing to declining real estate values and the Great Recession.

Consolidation of bank assets in ever fewer banks is the other culprit in the financial crash. For decades now, regulations on bank mergers have been incrementally relaxed, while bank operations have been increasingly regulated. Consolidation was not a stated purpose of the regulatory changes, but they have resulted in fewer banks.

The number of United States banks has collapsed from 14,400 in 1984’s first quarter to only 5,309 in 2015’s third quarter.

The decline in the number of banks has been accompanied by an increasing concentration of bank assets. Today, only five banks control almost half of all American Bank assets.

Bank failures have consequences. Big bank failures have big consequences. The government has decided that some banks are so large, and the consequences of their failure so onerous, that they cannot be allowed to fail. Those banks deemed too big to fail are bailed out. This results in terrible incentives.

When banks merge, they claim that they are diversifying and gaining economies of scale. Research is mixed on these topics. There is evidence that our largest banks are far above the cost-minimizing scale. There is also evidence that economies of scale persist throughout the size distribution. Similarly, there is evidence that banks merge with similar banks, achieving little diversification, and evidence that diversification persists through the size distribution.

The lack of consensus suggests that banks merge for other reasons. Market power and the too-big-to-fail option are prime suspects. The typical consumer and taxpayer does not benefit from these mergers. Market power allows banks to make excessive profits. Being too big to fail encourages banks to take excessive risks.

Banks did take excessive risks and we all paid a share of the costs.

Banks, being heavily regulated, have a huge incentive to try to influence their regulatory environment. Banks hire former regulators, providing an incentive for regulators to go easy on their potential future employers.

Our largest banks are heavy contributors to political campaigns and, as we’ve learned in the current presidential contests, they have found ways to directly support powerful politicians. So, we see lots of empty verbal abuse thrown at banks but little more.

What’s to be done?

• Higher capital requirements would reduce bank runs and stabilize our banking sector. Some economists recommend requiring reserves amounting to as much as 100 percent.
• A 100 percent tax on all assets over whatever is determined to be too big to fail would eliminate too-big-to-fail banks. This, in turn, would reduce banks’ incentives to take excessive risks.
• Private deposit insurance would reduce the influence of politicians and regulators, reducing the return to banks’ political spending. Banks would cut political spending.
• Limits on market share would slow the decline in bank numbers and reduce market power.
• Differential bank regulations based on asset size would further reduce the incentive for banks to merge. Small community banks have been critical contributors to local economies. We need more of them, not fewer.

A weak banking sector has contributed to the anemic recovery. A vigorous recovery needs a vigorous banking system, focused on economic growth rather than regulation. To achieve a vigorous banking system, we need to change bankers’ incentives. We need to move past demonizing to real reform.