Are Banks Obsolete?

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What would happen to the U.S. economy if all its commercial banks suddenly closed their doors? Throughout most of American history, the answer would have been a disaster of epic proportions, akin to the Depression wrought by the chain-reaction bank failures in the early 1930s. But in 1993 the startling answer is that a shutdown by banks might be far from cataclysmic.

Consider this: though the economic recovery is now 27 months old, not a single net new dollar has been lent to business by banks in all that time. Last week the Federal Reserve reported that the amount of loans the nation's largest banks have made to businesses fell an additional $2.4 billion in the week ending June 9, to $274.8 billion. Fearful that the scarcity of bank credit might sabotage the fragile economy, the White House and federal agencies are working feverishly to encourage banks to open their lending windows. In the past two weeks, government regulators have introduced steps to make it easier for banks to lend. For instance, less paperwork will be needed to process loans, and formal appraisals are no longer required for every real estate loan.

Is the government's concern fully justified? Who really needs banks these days? Hardly anyone, it turns out. While banks once dominated business lending, today nearly 80% of all such loans come from nonbank lenders like life insurers, brokerage firms and finance companies. Banks used to be the only source of money in town. Now businesses and individuals can write checks on their insurance companies, get a loan from a pension fund, and deposit paychecks in a money-market account with a brokerage firm. "It is possible for banks to die and still have a vibrant economy," says Edward Furash, a Washington bank consultant.

The irony is that the accelerating slide into irrelevance comes just as the banks racked up record profits of $43 billion over the past 15 months, creating the impression that the industry is staging a comeback. But that income was not the result of smart lending decisions. Instead of earning money by financing America's recovery, the banks mainly invested their funds -- on which they were paying a bargain-basement 2% or so -- in risk-free Treasury bonds that yielded 7%. That left bank officers with little to do except put their feet on their desks and watch the interest roll in.

Those profits may have come at a price. Not only did bankers lose many loyal customers by withholding credit, they also inadvertently opened the door to a herd of nonbank competitors, who stampeded into the lending market. "The banking industry didn't see this threat," says Furash. "They are being fat, dumb and happy. They didn't realize that banking is essential to a modern economy, but banks are not."

The soft economy has often been used by banks as an excuse for the slowdown in extending credit. Yet evidence abounds that banks are still gun-shy about lending to business. And no wonder. More than $125 billion in failed loans to real estate buyers, developing countries, farmers and the energy industry have had to be written off in the past five years.

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