Should Your City Be In The Banking Business?

Two mayoral candidates have floated the idea of a municipal bank. Sounds good, but it’s more complicated than you’d think

Should Your City Be In The Banking Business?

Two mayoral candidates have floated the idea of a municipal bank. Sounds good, but it’s more complicated than you’d think

Two mayoral candidates, first Tony Williams and then Nelson Diaz, floated the idea of the city going into the banking business. What problem would a public bank solve and is this the best way to solve it?

One quick but too dismissive of a response is that a city that has trouble collecting taxes, inspecting buildings for public safety, funding schools, and keeping up with pension payments should probably stay out of the banking business and straighten out those issues first.

But candidates Williams and Diaz are pointing to an issue that deserves attention: Access to credit that can fuel economic growth. That’s an issue to take seriously.

But the discussion so far in this campaign has centered more on whose idea it was first—Williams has accused Diaz of stealing his municipal bank proposal—than on the idea itself. A “public bank” sounds good, but when you delve into the history of public banking in the United States, a whole host of questions come to the fore.

No doubt, the idea of a public bank has some popular appeal. After the banking crisis of 2007 and 2008, anti-banker populism hit fever pitch. The public investments in the large banks (some necessary, most not) and the public assumption of the Fannie Mae and Freddie Mac mortgage portfolios created a new reality. The federal government—like it or not—is the largest mortgage banker in the nation.

There is a tradition in American politics that views the expansion of credit as a central issue. Much of 19th and early 20th century American populism had the democratization of credit to struggling farmers as an important sub-theme.

This is the background to the fact that the only publicly owned bank in America is The Bank of North Dakota, a state-owned bank that grew out of rural populism. It was created in 1919 and is still an effective institution today; small by modern banking standards but effective. Its early history was portrayed in a remarkable film titled Northern Lights.

Today the North Dakota bank is an integral part of state government. It manages state deposits and works with other banks around economic development ventures. While it has its own specialty loan programs, it does not exist to compete with other banks, but to originate participation loans with private lenders.

The other example of a public banking system in the United States was the postal system, which for fifty years took deposits and offered a fixed rate of interest to American households. It provided a savings function, not a lending role.

The postal savings system began in 1911 and shut down in 1965. It is an idea that has been revived recently both as a way to potentially redefine the functions of the postal system and to meet the needs of unbanked Americans.

Postal banking is popular in many nations. The Japan Postal Savings Bank is the largest savings bank in the world. The idea was popular in the U.S. in the early twentieth century for two reasons: it was an era of large immigration (like today) by millions of people who used postal systems in other nations for savings, and in a pre-FDIC insurance period, the postal system had a security advantage.

Public sector banks exist throughout the world with mixed success. In some nations public sector banks have very large portfolios of non-performing loans. There are several banks in China in this position; in part because there were no incentives to stop financing state owned enterprises that were failing.

But that is not the whole story in China or in other parts of the world where public banks and public investment funds are significant parts of the economy. Part of the problem is defining what we mean by a public bank: variation in ownership structures and governance are significant across the globe.

In Germany public banks make up about 40 percent of all bank assets. They have very specific functions (there are actually three types of public banks in Germany) and strong regulatory safeguards. German public banks function a bit like our older tradition of savings banks (pre-1980), restricted to specific roles.

There is no substantial public banking tradition in the United States. And it is doubtful that this is going to change at least as it relates to consumer services or small business lending. It is the private sector, often in partnership with the public sector and civil society that forge institutions and partnerships to expand credit and banking services along those lines.

In the US, interventions by the public sector in credit allocation use public money to mitigate private risk or regulatory power (and monetary policy) to incent expansion. In the 1930s we stabilized the banking industry and created the modern mortgage industry through government credit insurance and a government sponsored secondary market.

In the post World War II expansion of the American middle class and homeownership society, a vital role was played by VA backed loans and FHA. Later government lending insurance was established for a variety of other loans including student and small business lending programs.

Some of the crowning achievements of the Civil Rights movement were fair housing laws and eventually the Home Mortgage Disclosure Act and the Community Reinvestment Act. These banking regulations were designed to halt past practices of racial discrimination in lending.

During the past four decades two new public and civic trends emerged to bolster credit allocation: local economic development agencies and community development financial institutions.

Here in Philadelphia, PIDC and Ben Franklin Technology Partners are strong examples of publicly-funded investors. The Reinvestment Fund (an institution I ran for many years) is an exemplary community development lender.

We now have a growing movement in the United States of socially-motivated lending institutions: Organizations with a public purpose and private market discipline. It makes sense to utilize them to expand credit options.

But if, as Williams and Diaz propose, the city is going to play a role in credit allocation, we have to know what the capital gaps are. If there are capital gaps, we then have to figure out whether it is possible to fill them in an economically sustainable way and how the city would contribute to that.

The capital gap issue is an empirical problem that is made somewhat harder to identify by the fact that we are coming out of a period when American households and small businesses were overloaded with debt.

High priced subprime mortgage debt, payday lenders, student loans, and car title lenders fueled the expansion of credit in many Philadelphia communities in the 1990s and 2000s. The problem became too much of the wrong kind of debt. Or, worse, debt became a substitute for income.

If many European nations held together their old economic arrangements by borrowing too much money to keep the social welfare state going, in the United States, the response to economic stagnation has sometimes been the accumulation of more consumer debt.

It is also harder to understand the nature of the capital gaps in the local market because the banking industry itself has gone through an extraordinary change over the past decade: Fewer banks, great concentration of bank assets in a few large national banks, the emergence of non-bank lenders including new internet platforms. This is a rapidly evolving landscape.

But it is still possible to figure this out. I have my own hunches about where the capital gaps are most severe, particularly for small businesses that need more patient debt or small amounts of early stage equity capital. But hunches have to be tested with market research.

If we agree that there are capital gaps, then the question is: Does the city have a role to play? It already does some of this by funding PIDC and some other quasi-public organizations. And it has built interesting partnerships with others in commercial corridor work with the Merchants Fund, in energy financing with The Reinvestment Fund, and in equity investments with First Round Capital and PIDC. The state-funded Ben Franklin Technology Fund has quietly been responsible for more successful startups in this region than most people realize.

A new administration has a significant number of institutions—public and civic—in the city today that work on these issues. What is the nature of the demand for debt and equity financing that is not being met by existing capacity? And can the city do anything with its balance sheet and bond capacity to help those institutions be even more effective? This has to be the starting point for the Williams and Diaz conversation.

It may just be that there is a role for public banking, but not quite in the way that Williams and Diaz imagine. We know that there is a real need for the creation of an institution that would be responsible for investing in local infrastructure. And we know there are private investment funds that are interested in making infrastructure investments in the United States. So might there be interesting opportunities in the near future for the city and its partners to become co-investors with those funds? That is an issue worth exploration in a future column.

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