Scott, Kenneth E.

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OHIO STATE LAW JOURNALVolume 49, Number 5 , 1989Scholarship in Banking Law: An Introductionto the SymposiumK r Nm E. Scorr*For decades, when law schools and law reviews looked at the world of banking,they seemed to see only the private law dimension of commercial transactions amongbank customers and with their banks. Law schools offered courses on bills and notes,creditors' rights, or later the Uniform Commercial Code, but nothing on the publiclaw side of bank regulation. A large industry of central importance to the functioningof the economy had been subject to an elaborate system of examination and super-vision and detailed regulation for over a century; yet that system of legal control didnot arouse much interest or attention from law school academics.That situation began to change in the 1970s, as courses or seminars on bankregulation started to appear in the legal curriculum. In due course, scholarly articlesexamining aspects of bank regulation became more noticeable in the law journals.And now, whole issues are devoted to a field that seemed arcane and scarcely visiblea mere twenty years ago. The editors of the Ohio State Law Journal are to becommended for lending emphasis to this trend.Of the eight articles comprising this issue, three represent the private lawtradition-though not necessarily in traditional ways-and five are devoted toquestions involving the public regulation of banks. I will try to provide a briefdescription of and some personal commentary on each.Professor Gerald McLaughlin of Brooklyn Law School, in Letters of Credit andIllegal Contracts: The Limits of the Independence Principle, discusses the extent towhich courts should depart from the principle that an irrevocable letter of credit mustbe paid by the issuing bank, regardless of any claims or disputes involving the partiesto the underlying sales transaction. Exceptions have already been recognized in somecircumstances when there is fraud in the underlying transaction; Professor McLaugh-lin argues for extension to situations involving other forms of illegality.But more generally, in determining whether an exception to the independenceprinciple is warranted, he advocates the use of a balancing approach that explicitlyconsiders the impact of the exception on the seller, the issuing bank, and the futureutility of the letter of credit mechanism. The balancing analysis is illustrated with anumber of specific examples, on the basis of which Professor McLaughlin proceedsto recommend the proper legal treatment of that type of situation. I find myself morepersuaded of the merits of his general approach than of his specific conclusions, for* Parsons Professor of Law and Business, Stanford Law SchoolOHIO STATE LAW JOURNALit is hard to know whether all the relevant examples have been considered and placedon the balance scales. The discussion, however, is provocative and enlightening.In the wake of commercial failures, banks in the last few years on a number ofoccasions sued to collect on their loans, only to be met with counterclaims on varioustheories seeking, and sometimes obtaining, damages for the borrower greater than theamount of the loan itself. Professor Werner Ebke, of the University of Konstanz, andJames Griffin, of the Texas Bar, consider cases (primarily in Texas) basing lenderliability on breaches of the duty of good faith and fair dealing in commercial lendingtransactions. In Good Faith and Fair Dealing in Commercial Lending Transactions:From Covenant to Duty and Beyond, they distinguish between viewing that duty asarising out of contract as an express or implied term or as arising out of tort law from"special circumstances" in the relationship between borrower and lender. Under thelatter theory, the possibility of punitive damages is opened up, so obviously it is theposition preferred by plaintiffs' attorneys.Ebke and Griffin find the trend in these cases to be disturbing. The content ofthe duty is defined by few objective standards, leaving the doctrine too vague to servewell the ends of fairness or deterrence. The distinction between contract and torttheories is being eroded, so that extraordinary damages may be imposed in almost anycase. Ebke and Griffin suggest that "defensive lending" practices may emerge. Onemight add that, to the extent the doctrine cannot be well defined or expresslycontracted around, the risks and therefore the rates of loans will inevitably beincreased for all commercial borrowers.A bridge between private law and public law is provided by Professor EdwardRubin, of the University of California at Berkeley School of Law, in Uniformity,Regulation, and Federalization of State Law: Some Lessons from the PaymentSystem. He traces the evolution of the law governing check collection from thecommon law and state enactments of the Negotiable Instruments Law and theUniform Commercial Code to a growing federal role derived from the FederalReserve Act of 1913 and the Expedited Funds Availability Act of 1987. The latterstatute partially pre-empts the UCC in certain respects by its own terms orimplications, but goes much further and gives the Board of Governors of the FederalReserve System blanket authority to regulate "any aspect of the payment system,"'potentially displacing (at a minimum) all of Articles 3 and 4 of the UCC.What has produced this extensive federalization of an area previously leftpredominantly to state law and private ordering? It is not merely the need for uniformrules governing interstate transactios-that was met by the NIL and UCC, adoptedin every state. Professor Rubin points to a need for uniform oversight andimplementing regulation, to keep up with an area in which procedures constantlychange under the impact of improved technology, and to the political ability of theconsumer movement to achieve some of its objectives in one fell swoop through a1. Rubin, Uniformity, Regulation, and Federalization of State Law: Some Lessonsfrom the Payments System, 49OHIO ST. L.J. 1251, 1258 (1989) (quoting Expedited Funds Availability Act, 12 U.S.C.A. § 4008(c)(I)(A) (West Supp.1988).1184 [Vol. 49:1183INTRODUCTION TO BANKING SYMPOSIUMnational legislature. What the consequences of this step will be, for the welfare ofeither banks or consumers, Professor Rubin does not undertake to judge.A contrasting view of the sources of bank regulation is given by ProfessorJonathan Macey, of Cornell Law School. In The Political Science of Regulating BankRisk, he adopts a "public choice" perspective and interprets bank regulation asanother example of the use of legislative power to transfer wealth from lesswell-organized consumers to better organized producers. Thus he sees the depositinsurance system as designed to subsidize banks by lowering their acquisition cost offunds and the Glass-Steagall Act as designed to benefit commercial banks andinvestment banks by restricting competition in both industries. In each instance heattacks the "public interest" view of legislation, arguing that deposit insuranceencourages excessive risk-taking and Glass-Steagall blocks diversification; the resultis not a contribution to a safe and sound banking system, but the very opposite.Professor Macey attributes this outcome to a number of factors, in addition to theadvantages in terms of stakes and organizational efficiency of small groups over largeones. Banking issues are usually too complex and ideologically boring for eithercongressional representatives or their constituents to get involved. Bank regulatorsfall into the category of narrow-spectrum administrative agencies devoted to a singleindustry and more susceptible to capture by it.If one accepts Professor Macey's description, what is his prescription? Essen-tially, gloomy resignation-the problem of giving regulators and politicians incen-tives that will cause them to act more in the public interest is "intractable," andhence "meaningful change is unlikely to occur.''2 In this regard, his articleexemplifies what has always been the least satisfying aspect of public choice theory.On the positive side, it is most helpful in understanding the basis for legislative oradministrative decisions. But on the normative side, it tends to lead to a kind offatalism: whatever is, is (politically) efficient.Two of the authors in this issue address the answer to the problem of perverserisk incentives, created by the uniform deposit insurance premium assessmentmandated under existing law, that is currently being emphasized by the bankingauthorities in the United States and elsewhere-namely, higher risk-based minimumcapital requirements for banks. Professor Joseph Norton, of the Southern MethodistUniversity School of Law, explores the concept of capital adequacy standards andreviews the history of their use in bank regulation in Capital Adequacy Standards: ALegitimate Regulatory Concern for Prudential Supervision of Banking Activities? Tobegin with, the term "capital" is given different meanings in different contexts; itsdefinition for bank capital regulation still occasions disputation. In principle, I wouldcontend, it is the market value of all realizable assets minus the market value of allliabilities that are on a parity or senior to those liabilities that the banking authoritiesare concerned to protect (presumably, deposit liabilities); the calculation should notbe based on accounting numbers or confined to on-balance-sheet items.Professor Norton provides a useful account of the history of bank capital2. Macey, The Political Science of Regulating Bank Risk, 49 Omo ST. L.J. 1277, 1278 (1989).1989] 1185OHIO STATE LAW JOURNALregulation in the United States and the issuance in July 1988 of the report onInternational Convergence of Capital Measurement and Capital Standards3 by theso-called Basle Supervisors Committee, comprising all the major banking nations.When it comes to an evaluation, however, he seems a skeptic. Many of the pertinentissues-the reality of a threat of bank runs, the degree of supervisory effectiveness,the use as a prop to a system of subsidized deposit insurance, and the cost to thebanking industry-are raised, but their treatment seems to me less than satisfactory.That is not too surprising; such matters are complex and difficult and would at aminimum demand several additional articles by themselves.The new bank capital rules are also addressed by Professor William Lovett, ofTulane Law School, in Moral Hazard, Bank Supervision and Risk-Based CapitalRequirements. The reach of the title is somewhat greater than that of the article, forhe concentrates more on the Basle Committee formula and its implications for bankentry into fields such as insurance or securities underwriting. On the moral hazardissue, he accepts (rather uncritically, in my view) the proposition that the centralgovernment must bail out all (large?) banks and their depositors. That policy createsthe moral hazard-that is, it changes the costs and profit incentives facing bankmanagement, leading them to act in a manner that increases the risks and costs to theinsuring government. There are those, myself included, who see the problem ofeliminating a subsidy to bank risk-taking as central to badly needed reform of ourdeposit insurance system; Professor Lovett simply notes that higher capital require-ments, shareholder losses, and bank supervision should be able to take care of thematter. Would that it were that straightforward!The formula of the Basle Committee is explicated in some detail, but withoutanalysis; nonetheless, the extent to which political considerations have entered into asupposed economic assessment of risk can be detected throughout. The final targetcapital figure (eight percent of risk-adjusted assets), in particular, apparently floateddown from Mt. Sinai (or Mont Blanc), for no theoretical or empirical foundation wasgiven.As for bank entry into new fields, Professor Lovett asks how risk-based capitalrequirements will or should be applied to insurance or securities underwriting, carriedon by the bank itself or through a subsidiary or an affiliate. Basically, he does notseem sympathetic to such a development, citing concerns about concentration,conflicts of interest, and supervisory competence. The prospect for or benefit ofadded competition in those fields is not considered, nor is the potential contributionof low activity covariances to the reduction of bank (and government insurer) risk.Competition is at the core of the article by Professor Peter Carstensen, of theUniversity of Wisconsin Law School, on Public Policy Toward Interstate BankMergers: The Case for Concern. His article comprises an impressive and well-nighexhaustive compendium of objections to a policy of permitting "interstate combina-3. Committee on Banking Regulations & Supervisory Practices, International Convergence of Capital Measure-ment and Capital Standards (July 1988) (copy on file with the Ohio State Law Journal).[Vol. 49:11831186INTRODUCTION TO BANKING SYMPOSIUMtions of leading banks." ' 4 Fundamental to his argument is the premise that suchcombinations do not achieve economies of scale or scope; indeed, he contends, smallbanks are more efficient than large ones. Large (a term left mostly undefined)interstate combinations are driven, therefore, not by efficiency gains, but by the questfor monopoly rents. Thus there should be a negative presumption against largeinterstate combinations, meaning they would mostly be denied approval.Despite the weight of argument, I am left unconvinced. These are, in the jargonof the antitrust economist, geographical market extension acquisitions; as such, theydo not normally create any significant change in the concentration of the market ofeither the acquiring or the acquired bank and hence do not afford opportunity for theextraction of increased monopoly rents. Then why are they being sought? ProfessorCarstensen finds the evidence of efficiency gains or losses from larger size to be weakand inconclusive, and he concludes that on balance both the benefits and costs tosociety of interstate combinations of large banks are slight. (It might seem awkwardto move from that concession to a policy and procedure of general prohibition, but hemanages-a tribute to the observation that analysis often comes out where it began.)But I would go further-'"banking" is not a single homogeneous product, buta wide variety of financial services. As to some of those services, efficient scale isobtained at relatively small size (for example, home mortgage lending), while othersare most cheaply produced by very large organizations (for example, internationaltrade financing); Citicorp and a neighborhood bank do not have the same productmix. It is very hard to disentangle the resulting cost and profit data, and most studiesof economies of scale in banking do not. There is more to the drive for efficiency thanProfessor Carstensen seems willing to credit.Legislative impediments to attaining efficiency in the banking system are thefocus of John McCoy,Chairman and Chief Executive Officer of Banc One Corpora-tion, in The Future of U.S. Banking: A Modest Legislative Agenda to EncourageCompetitiveness. Modesty, like beauty, no doubt lies in the eye of the beholder; hewants removal of the barriers to interstate banking and bank entry into securitiesactivities, insurance, and real estate.To date, responses to changing technology and correspondingly broadenedmarkets in banking have come more on the state level. Congress has left theMcFadden Act and Douglas Amendment unaltered since enactment, while the stateshave moved toward regional and even nationwide banking. Mr. McCoy urgesCongress to take more of a leading role in eliminating an outmoded tangle ofrestrictions on geographical and product expansion, leaving the definition of the"banking business" to be determined by productive efficiencies, rather than bylegislative fiat. At this point, unfortunately, Mr. McCoy and Professor Macey woulddo well to enter into dialogue with each other; the Congress is not engaged in a searchfor efficiency, nor does the banking industry call the tune by itself. Fortunately, suchdialogues will be facilitated and enriched by this issue of the Ohio State Law Journal.4. Carstensen, Public Policy Toward Interstate Bank Mergers: The Case for Concern, 49 OHIO ST. L.J.1397, 1398 (1989).1989] 1187

Scholarship in Banking Law: An Introduction to the Symposium

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