On June 17, the U.S. Treasury Department released a comprehensive plan to reform the financial services regulatory system in the United States. The plan, Financial Regulatory Reform: A New Foundation, identifies causes of the current crises in the financial markets and proposes changes to the current system of financial services regulation in the United States in an effort to prevent similar events in the future.


Among other things, Treasury proposes to eliminate federal savings banks and would require all existing federal savings banks to convert to national banks. Treasury makes four arguments to support its position: (1) federal savings banks are obsolete, (2) they are redundant, (3) their existence fosters regulatory “arbitrage,” and (4) they are especially vulnerable to downturns in the housing market. The proposal is misguided on each of these points. 





Obsolescence


Congress first authorized the chartering of federal savings banks in 1933 for the purpose of making home loans more widely available. While a specialized depository institution focused on home mortgage lending “made sense” in 1933, according to Treasury, the “case for such specialized institutions has weakened considerably in recent years” as commercial banks have increased their mortgage lending activities, securitization markets have grown, and Federal Home Loan Banks have expanded their membership.


It is hard to see how the case for specialized home mortgage lenders has weakened in a time of unprecedented demand for housing finance. In the midst of a financial crisis brought on by an unprecedented demand for home loans, does it make sense to eliminate the one type of deposit-taking institution whose primary mission is making home loans? And while the securitization market certainly grew, it also became cancerous, having been fed a diet of high-yield, poor-quality home loans, the vast majority of which were originated by mortgage lenders other than federal savings banks.





Redundancy


Treasury believes that, over the past few decades, the powers of national banks and federal savings banks have “substantially converged.” Because the national bank charter and the federal savings bank charter are redundant, Treasury reasons, one of them – the more limited, specialized one – should be eliminated.


However, to this day, at least 65% of a federal savings bank’s assets are required by law to consist of “qualified thrift investments” which include mostly home mortgage loans. In addition, federal savings banks remain subject to fixed, relatively conservative limits on a variety of other types of loans including commercial and industrial loans, and commercial real estate loans. No other bank is subject to similar limits because no other bank is chartered for the primary purpose of making home mortgage loans.





Regulatory Arbitrage


Treasury is also troubled by regulatory “arbitrage.” The availability of the federal savings bank charter has created “opportunities for private sector arbitrage of our financial regulatory system.” One “clear lesson learned from the recent crisis was that competition among different government agencies responsible for regulating similar financial firms led to reduced regulation in important parts of the financial system,” Treasury says.


Depository institutions have been able to choose between federal and state charters since 1864, and between different federal charters since 1933, and the resulting “arbitrage” – many refer to it as “charter choice” –has been an important strength, not a weakness, of the system. If the conduct of the agency that regulates federal savings banks deserves criticism, then aim the gun at the agency – not federal savings banks themselves.





Special Vulnerability


Finally, Treasury states that the “fragility” of federal savings banks has become “readily apparent during the [current] financial crisis.” In part because federal savings banks “are required by law to focus more of their lending on residential mortgages,” Treasury argues that federal savings banks were “more vulnerable” to the recent housing downturn.


If the powers of commercial banks and federal savings banks have substantially converged, as Treasury claims, it is hard to see how federal savings banks would be especially “fragile” or any more fragile than national banks. Treasury’s positions on these two issues are inconsistent.


In any event, at various times in the past, downturns in other markets have resulted in financial troubles among other classes of financial institutions. 


Natural disasters can devastate property and casualty insurers, commercial real estate downturns can devastate commercial banks, and downturns in residential real estate certainly can devastate residential lenders such as federal savings banks. But eliminating federal savings banks is not the solution – it will merely exacerbate the problem the next time we have an overheated housing market and there are fewer home mortgage lenders to meet the demand.