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Competition for profits also drives bankers and other financiers to look for regulatory loopholes, a process sometimes called loophole mining. Loophole mining is both legal and ethical and works better in nations, like the United States, with a permissive regulatory systemA system that allows financiers to engage in any activities they wish that are not explicitly forbidden. It is easier for financial innovation than a restrictive regulatory system. rather than a restrictive one, or, in other words, in places where anything is allowed unless it is explicitly forbidden.Doug Arner, Financial Stability, Economic Growth, and the Role of Law (New York: Cambridge University Press, 2007), 263. During the Great Inflation, banks could not legally pay any interest on checking deposits or more than about 6 percent on time deposits, both far less than going market rates. Banks tried to lure depositors by giving them toasters and other gifts, attempting desperately to skirt the interest rate caps by sweetening the pot. Few depositors bit. Massive disintermediationThe opposite of intermediation, when investors pull money out of banks and other financial intermediaries. ensued because depositors pulled their money out of banks to buy assets that could provide a market rate of return. Financiers responded by developing money market mutual funds (MMMFs), which offered checking account–like liquidity while paying interest at market rates, and by investing in short-term, high-grade assets like Treasury Bills and AAA-rated corporate commercial paper. (The growth of MMMFs in turn aided the growth and development of the commercial paper markets.)
To work around regulations against interstate banking, some banks, particularly in markets that transcended state lines, established so-called nonbank banks. Because the law defined banks as institutions that “accept deposits and make loans,” banks surmised, correctly, that they could establish de facto branches that did one function or the other, but not both. What is this type of behavior called and why is it important?
This is loophole mining leading to financial innovation. Unfortunately, this particular innovation was much less economically efficient than establishing real branches would have been. The banks that created nonbank banks likely profited, but not as much as they would have if they had not had to resort to such a technicality. Moreover, the nonbank bank’s customers would have been less inconvenienced!
Bankers also used loophole mining by creating so-called sweep accounts, checking accounts that were invested each night in (“swept” into) overnight loans. The interest earned on those loans was credited to the account the next morning, allowing banks to pay rates above the official deposit rate ceilings. Sweep accounts also allowed banks to do the end around on reserve requirements, legal minimums of cash and Federal Reserve deposits. Recall that banks earn limited interest on reserves, so they often wish that they could hold fewer reserves than regulators require, particularly when interest rates are high. By using computers to sweep checking accounts at the close of business each day, banks reduced their de jure deposits and thus their reserve requirements to the point that reserve regulations today are largely moot, a point to which we shall return.
Bank holding companies (BHCs), parent companies that own multiple banks and banking-related service companies, offered bankers another way to use loophole mining because regulation of BHCs was, for a long time, more liberal than unit bank regulation. In particular, BHCs could circumvent restrictive branching regulations and earn extra profits by providing investment advice, data processing, and credit card services. Today, bank holding companies own almost all of the big U.S. banks. J. P. Morgan Chase, Bank of America, and Citigroup are all BHCs.www.ffiec.gov/nicpubweb/nicweb/top50form.aspx
Not all regulations can be circumvented cost effectively via loophole mining, however, so sometimes bankers and other financiers have to push for regulatory reforms. The Great Inflation and the decline of traditional banking, we’ll learn below, induced bankers to lobby to change the regulatory regime they faced. Like loophole mining, lobbying in and of itself is legal and ethical so long as the laws and social mores related to such activities are not violated. The bankers largely succeeded, aided in part by a banking crisis.