George Bailey, the hero of It’s a Wonderful Life, is one of the great evangelists of American finance. A building and loan president, Bailey stops a run on the society by telling his frightened customers that while their money might not be physically in the society building, it is physically in their town:
. . . [it’s] in Joe’s house . . . and in the Kennedy House, and in Mrs. Maitland’s house and a hundred others. You’re lending them the money to build and then they’re going to pay it back to you as best they can.
This scene, better than any passage in an economics textbook, explains the awesome power of banking: the ability to combine the savings of individuals and lend them to others, in a way that creates value for the community at large.
In the wake of the Great Recession, mortgage securitization, and Too Big to Fail, this vision of banking seems hopelessly out of date, even quaint. And for many Americans, it is. Their financial center has moved from the colonnaded bank on Main Street to check-cashing and payday-lending outlets of the strip mall. This "fringe banking" system, and the people who use it, are the subjects of Mehrsa Baradaran’s How the Other Half Banks.
Let’s be clear at the outset: this is not a judicious or balanced analysis of that system and population. It is a partisan work suffused with moral outrage. Baradaran, a law professor at the University of Georgia, at times sounds like a certain Harvard Law professor who recently traded Cambridge for the Senate.
This isn’t necessarily a bad thing. Academic books on financial regulation tend to be bloodless and technical. Baradaran’s polemical tone is refreshing, as is her forthrightness about the reforms she wants to adopt. Though How the Other Half Banks has major flaws, Baradaran has written a provocative work that ought to be read by anyone interested in America’s banking sector.
Baradaran’s thesis has two parts. The first is that the bank industry isn’t a member of the private sector, but is rather the beneficiary of a "social contract" with the state. The second is that this social contract has broken down, in a way that leaves the poor and near-poor without access to credit and bank services. As such, How the Other Half Banks is really two books—one on the history of American banking; the other on consumer protection.
The first of these books is better than the second. How the Other Half Banks’ survey of the banking system spans 200 years, and is both accessible and engaging. Uninitiated readers will benefit from her clear descriptions of the different types of financial institutions operating in America.
Baradaran also convincingly proves her point that banking isn’t, and never has been, a private industry. It exists with massive governmental support, which is at times hidden to consumers, like the discount window, and at others readily apparent, as with FDIC insurance or the TARP loans. In return, financial institutions lend money, collect deposits, and run the payments system—all things without which our economy would cease to function. Baradaran rightly points out that this arrangement is ultimately supposed to benefit the American people, who need access to the services that banks provide.
But, again, many Americans—Baradaran estimates roughly 70 million—don’t use or lack access to mainstream financial institutions. This is where How the Other Half Banks transitions to discuss consumer protection, and it is also where it runs into trouble.
Baradaran’s argument goes like this. Since the 1970s, banks have focused on maximizing efficiency and profit. In the same period, they captured their regulators and convinced them of the same. Basic savings accounts and small consumer loans—the services low-income people need most—are less profitable than high balance accounts and large-scale lending. So any policy that keeps the poor or near-poor out of the bank—be it through closing branches, minimum balance requirements, overdraft fees, or ending small consumer lending—is optimal. Abandoned by traditional financial institutions, the less fortunate turn to the unscrupulous check-cashing outlets and payday lenders that fill the resultant market void. With extremely high interest rates and convenience charges, these trap their customers in a spiral of debt that is nearly impossible to escape. The best way to remedy this sorry state of affairs is to make the Post Office offer basic savings and lending services.
Assuming that the banking sector operates in the way Baradaran claims it does—and that’s a big assumption—Congress just passed the Dodd Frank Act to change these practices. Yet Dodd-Frank is barely mentioned in How the Other Half Banks. Despite claims that the new law institutionalized Too Big to Fail, it actually makes life unpleasant for large financial institutions. It’s entirely possible that, facing such an enormous regulatory burden, major institutions will spin off some of their operations into independent (and smaller) financial entities. These organizations might be more willing to provide low-income people with basic banking services.
Dodd-Frank also created the Consumer Financial Protection Bureau, which is expressly charged with ending the predatory and usurious lending practices that Baradaran details. Dodd-Frank’s absence from How the Other Half Banks is thus a gaping hole in its argument.
Equally off-putting is Baradaran’s treatment of community banks, which do make an effort to provide the unbanked with financial services. After expertly distinguishing the different types of financial institutions in the book’s earlier chapters, Baradaran lumps community banks, which usually have one or just a few branches, in with their much larger cousins when she claims they aren’t a viable way to serve the poor.
This sleight of hand is unfair. Many community banks offer checking accounts with no or low fees, and actively court customers who can’t get a loan at bigger banks. Moreover, their corporate and employee identity is based on the idea that they serve a customer base that others won’t. While Baradaran pays lip service to this esprit de corps, she predicts community banks will disappear as economies of scale and technology encourage ever more consolidation. Here’s another prediction: localism is a part of American life and is enjoying a renaissance, from craft brewing to farming and manufacturing. Banking might be next.
Likewise, How the Other Half Banks’ promotion of postal banking instead of community banking is not well reasoned. Baradaran asserts that "local banking was a nineteenth-century solution to a nineteenth-century problem, but we cannot solve a twenty-first-century problem with an antique toolkit." Apparently, some antique toolkits are better than others—America first tried postal banking in 1910 and discontinued the venture in 1966.
Resurrecting postal banking would be a logistical nightmare. The Post Office is a massive organization charged with delivering mail. Assigning it savings and lending duties will necessitate many more employees and a shift in corporate culture. Baradaran says such criticisms "underestimate postal employees," and that bank tellers provide "simple financial products" without "years of skilled training." But tellers don’t make loans, and postal clerks probably shouldn’t either.
More important, making the post office a bank would turn it into a quasi-governmental entity with access to an enormous amount of funds—funds that are very important to ordinary Americans. Sound familiar? Fannie Mae and Freddie Mac, though not substantially analogous to a postal bank, had access to large amounts of money and seemed to have the state’s imprimatur. This led to all sorts of mischief in the mortgage market.
The point is not, as Baradaran tries to argue, that government involvement in the economy is a risky or inherently bad thing—it is that giving a state entity a massive source of capital will make the entity a target for people who want to use that capital to make money for themselves. While Baradaran avers that a postal bank could avoid such issues by remaining an explicitly public institution, she ignores the lessons of the first half of How the Other Half Banks: laws can change. And when money is involved, they often do.
But laws also change when the people demand reform. And public opinion, rarely positive about the banking industry, is increasingly supportive of the approach advocated in How the Other Half Banks. It deserves wide readership, if only to see what sort of financial policy will be on the agenda in the next decade.