The summer of 2009 was just breaking on Lev Menand’s first day of work at the Federal Reserve Bank of New York. There was a cool breeze blowing through the narrow skyscraper canyon that’s home to what is arguably the country’s most important financial institution. The Harvard grad, who studied the history of economic thought, had found the job through a friend of a friend.
“It was trial by fire,” Menand says. While he was doing technically-complex econometric work, many of his new coworkers had strong experience in empirical economics. Menand says. “That was my first job out of college. I knew that I was getting in over my head, but I wanted the challenge, and I needed a job. It was 2009.”
Over the next decade, first at the New York Fed and then at the U.S. Treasury Department, Menand would gain an intimate understanding of the Federal Reserve system’s form and function – or rather its dysfunction, as he would come to see it.
The Federal Reserve system, made up of 12 regional banks, was created and designed to support a nation covered in thousands upon thousands of small banks, providing access to credit rooted in local markets and local conditions. And for a handful of decades, it succeeded. From the creation of the Federal Deposit Insurance Corporation in 1933 until the mid-1980s, the number of commercial banks across the country was remarkably stable at around 14,000. But today, there are fewer than 4,200 commercial banks.
Consequently, the loss of local banks starting in the 1990s led to declines in small business lending, which forced some small business closures while many surviving small businesses cut hourly shifts or laid off workers in order to survive, according to a new paper from researchers at the FDIC.
As Menand explains in his new book, “The Fed Unbound: Central Banking in a Time of Crisis,” one of the under-appreciated reasons behind the decline of traditional banking has been the rise of “shadow banks,” Wall Street institutions that effectively take deposits and make loans like a traditional bank but aren’t regulated like those other institutions. First in the 2008-2009 financial crisis, and with even more vigor in the response to the economic crisis brought by COVID-19, the Fed began to extend its support to shadow banks, which Menand believes to be directly at odds with the intent of those behind the creation of the Fed.
(Image courtesy Columbia Global Reports)
The Fed was intended to support a nation of place-based banking institutions, not a bunch of Wall Street shadow banks, Menand argues. Menand sat down with Next City to discuss how shadow banks are continuing to roil our economic system, and the role that federal regulation, political organizing and public banking can play in building a better system.
This interview has been edited for length and clarity.
Oscar Perry Abello: One of the main takeaways from your book for me was this notion that, historically, multiple generations of policymakers envisioned and enabled a financial system dominated by mostly smaller regional and community banks. But we’ve lost that. What happened?
Lev Menand: It used to be that there were major banks in many second- and third-tier American cities, and each of those cities might have a handful of very small community banks. But now businesses and municipalities in those areas are dependent on very large banks that are in New York or San Francisco or North Carolina. That earlier system was the result of a mainstream, bipartisan, political and just American commitment to federalism, diffused power, a structure for the economy that facilitated Democratic, Republican government that we had for 150-200 years, until it started to erode over the past 40 years.
The Federal Reserve was constructed to facilitate and make possible the diffused system of thousands of banks with credit and money services available to people in their communities, from people who lived in those communities. Roosevelt was explicit about this during the New Deal period, when he was trying to restore and strengthen the system after it had deteriorated in the 1920s. He talked about wanting to have that sort of legitimacy that comes from local ownership and control and wanting to retain a decentralized banking system. The Fed’s legal framework was set up for that, and the Fed’s purpose was to make that possible — that’s why there’s 12 regional banks, to provide the infrastructure so that you could have a diffuse banking system. That’s what the Fed was set up to facilitate.
But what it ultimately ended up facilitating, over the past several decades, is a very different monetary and financial system that has had devastating effects on parts of the country that have seen their access to money and credit services dramatically attenuated. And it’s not just about Houston not having a regional bank. It’s about the whole instability of the current structure.
Abello: One of the striking things to me about the narrative you give is that it involved a lot of mass politics and organizing to create the decentralized banking system we once had. There’s a very technical story behind how it was created and how it was lost, but political movements or the lack thereof are a big part of the story of what our financial system looks like.
Menand: We need many things in order to get the changes that I talk about, and organization is essential. What are the prerequisites for organization? Understanding the problem. That’s the piece of this that I’m working on.
There once were real bank politics in this country that people organized around the way they organize around issues like abortion or gun rights or LGBT rights today. These are things that you have a rally about. Nobody has a rally today around banking and money. Since Occupy Wall Street, there have been a lot of people who were involved or exposed to it have gone on to learn more and the public banking movement for example and other efforts are connected to that energy.
My hope is that we are now entering a phase where there are more specific legislative plans for and reforms that activists can embrace and advance than there were in the early years following the 2008 crisis.
Abello: Let’s talk about what it is that went wrong over the past 40 years or so. Your book centers on the rise of “shadow banks.” What are shadow banks and how are they different from regular banks?
Menand: So we had this decentralized banking system with a bunch of obligations attached to each bank, like the Community Reinvestment Act, which gives banks an obligation to lend in the communities where deposits are maintained. A bank is not supposed to maintain deposits for all sorts of people in Ohio, but then not lend in Ohio and instead do all its learning on Wall Street. So you have this ecosystem that’s set up with all these rules. It didn’t work perfectly, for instance there was still redlining, but the rules are there to enforce.
The rise of shadow banking is the rise of a group of primarily Wall Street firms that don’t have bank charters and are not subject to these obligations, but suddenly appropriate for themselves the de facto privileges of the banking business. What shadow banks do is that they create alternative forms of deposits that formally aren’t called deposits that have other names, but they function the same way.
So take your typical corporation. It has to pay its employees, and to do that it has to manage a huge cash balance. Historically, it would have done that with a bank account, but today it shifts a lot of that cash to the shadow banks, which offer a slightly higher rate of interest in exchange for investing in very short-term investments called repurchase agreements or commercial paper, which are effectively deposits or deposit-like. But these shadow banks don’t have to comply with all bank regulations — not safety and soundness regulations, not the CRA. And then that shadow bank, they’re gonna go do whatever lending on the other side that it wants. It’s going to lend heavily on Wall Street, it’s going to fuel financialization, and it’s going to undercut the bank business model.
Abello: And, as you and others have written about extensively, it’s shadow banks that were at the root of the 2008-2009 financial crisis that led to the Great Recession. It wasn’t the regular banks that had CRA obligations and safety-and-soundness regulations they had to worry about. It was shadow banks.
Menand: Mortgage finance companies are often part of shadow banking chains. They’ll originate and securitize loans and then the securities will be purchased by another non-bank entity, and that non-bank entity is the one that will finance itself with deposit alternatives. Lehman Brothers was financed with huge amounts of repurchase agreements. Corporations that were not depositing in banks, they were depositing at Lehman Brothers, and then Lehman was turning around and buying securities from mortgage finance companies. As those mortgages started to fail, the depositors came to withdraw their money, which Lehman didn’t have.
It was a run, a classic bank run, because its deposits by another name were not insured by the FDIC, and they weren’t explicitly backed by the Federal Reserve. But that quickly became the exception to the rule. After allowing Lehman to fail, the Fed nonetheless started finding ways to backstop other shadow banks — it provided them access to Federal Reserve lending to prevent their failure.
And that’s what has since allowed shadow banks to grow so big. Even though Congress didn’t explicitly set up a system to backstop shadow banks, the Fed started doing it anyway.
Abello: And by 2019, U.S. shadow banks had $15 trillion in assets, almost as large as the regular banking sector which had $17 trillion in assets. Are we still at risk of another 2008-style financial system collapse?
Menand: The problems of 2008 are still with us. We need to pursue more significant structural reforms, or else we’re going to experience another panic and we’re going to continue to live in an economic financial system that resembles the 19th century, rather than the 20th century post-New Deal period. And we don’t want to live in the 19th century. We made big, important progress. It’s imperative that we fix the problems sooner rather than later because monetary collapses can lead to political collapses. We’re lucky, the way the country was able to rebound in 1933 – other countries that were tied up in a similar set of problems at that time fell to fascist politics because of the chaos and destruction wrought by the monetary breakdowns that they experienced. There were other factors, but those were really primary driving forces.
The Federal Reserve Bank of New York. (Photo by Oscar Perry Abello)
Abello: What you propose as solutions require political will, which is really a shorthand for popular organizing to pressure legislators and bank regulators into doing what’s necessary to restore the Federal Reserve and the rest of the banking system back into a system where banks have stronger ties to the communities they serve.
Menand: You can either go to the shadow banks and say, either stop being a bank, stop using deposit-like instruments, or apply for and get a bank charter and comply with the banking regulations.
We can’t have a sensible, functional, durable, legitimate regime of bank regulation if it doesn’t apply to everybody who’s engaged in banking. That’s just a fundamental principle that we know from all sorts of regulation. How does insurance regulation work? If you’re in the business of insurance, regardless of what you call it, you can’t dress it up differently and not follow insurance regulations. Same thing is true with securities regulations.
One of the problems we’ve had in banking is that you actually can dress up like you’re banking and say it’s not banking, and not follow the banking regulations. That just has to stop.
Abello: One of the specific solutions you also mention in your book is public banking — the idea of state or municipal governments establishing banks owned by government entities. How does this movement around the country fit into your sense of what’s needed to change the banking system?
Menand: I think that one of the great possible reforms is the public banking movement and the replication of successful public bank enterprises that we have now in some places, or that we’ve had in the past. Public banking is not going to be sufficient to solve all the problems, unfortunately, but it is an important possible piece of the solution.
The public banking movement raises awareness about all of these issues, and creates a group of institutions that can organize between themselves and be a voice at the federal level for further reforms. I’m encouraged by efforts to create public banks. It’s not an easy endeavor. These state or local governments have a lot to figure out and then take on a good deal of risk in structuring an enterprise that will operate soundly and non-corruptly. Developing the right governance and getting the business model right is a very important piece of a successful public banking movement. Right now we’re in the early stages, because there’s so much work that has to be done at the state level in educating legislatures, legislators and building expertise and business models and governance plans to do it effectively.
This article is part of The Bottom Line, a series exploring scalable solutions for problems related to affordability, inclusive economic growth and access to capital. Click here to subscribe to our Bottom Line newsletter. The Bottom Line is made possible with support from Citi.
Oscar is Next City's senior economics correspondent. He previously served as Next City’s editor from 2018-2019, and was a Next City Equitable Cities Fellow from 2015-2016. Since 2011, Oscar has covered community development finance, community banking, impact investing, economic development, housing and more for media outlets such as Shelterforce, B Magazine, Impact Alpha, and Fast Company.