In Pre-Antitrust U.S. Banking, Networks (Clearinghouses) Arose; Collusion Was Checked by the Threat of Network Withdrawal

In the pre-antitrust U.S. banking industry, then, networks known as clearinghouses arose to reduce transactions costs and bolster reputations. “An essential feature of the banking industry was the endogenous development of the clearinghouse, a governing association of banks to which individual banks voluntarily abrogated certain rights and powers normally held by firms.” Membership requirements and monitoring enhanced the public’s trust in the redeemability of members’ bank notes and the overall soundness of their business practices. As Gorton and Mullineaux (1987) explain:

The clearinghouse required, for example, that member institutions satisfy an admissions test (based on certification of adequate capital), pay an admissions fee, and submit to periodic exams (audits) by the clearinghouse. Members who failed to satisfy [commercial-bank clearinghouse] regulations were subject to disciplinary actions (fines) and, for extreme violations, could be expelled. Expulsion from the clearinghouse was a clear negative signal concerning the quality of the bank’s liabilities. . . . 

An additional check against collusion was banks’ credible threat to withdraw from the network or refuse to join. As Dowd recounts:

A good example of banks “voting with their feet” even when the market could only support one clearinghouse is provided by the demise of the Suffolk system. The Suffolk system was a club managed by the Suffolk Bank of Boston, but some members found the club rules too constraining and there were complaints about the Suffolk’s highhanded attitude toward members. Discontent led to the founding of a rival, the Bank of Mutual Redemption (BMR), and when the latter opened in 1858 many of the Suffolk’s clients defected to it.

—Bryan Caplan and Edward P. Stringham, “Networks, Law, and the Paradox of Cooperation,” in Anarchy and the Law: The Political Economy of Choice, ed. Edward P. Stringham (New Brunswick, NJ: Transaction Publishers, 2007), 305-306.

Cowen Maintains that the Historical Evidence on Collusion under Laissez-Faire Cannot Be Extended to Network Industries

Cowen’s case is almost wholly theoretical. The usual historical evidence on collusion under laissez-faire, he maintains, cannot be credibly extended to network industries: “Although private cartels usually collapse of their own accord, most historical examples of cartel instability do not involve the benefits of joining a common network.” But Cowen provides little in the way of empirical counter-examples to support his belief that networks industries are different.

This section takes a preliminary look at modern and historical network industries. While they definitely standardize products in beneficial ways, there is little evidence that network industries are more prone to collusion than non-network industries. Instances of attempted and temporarily successful collusion do surface. But collusive efforts in network industries appear neither more common nor more successful than in other sectors of the economy. A full-blown comparative history of collusion in network and non-network industries is beyond the scope of this paper. On Cowen’s account, however, the contrast should be too large to miss. . . .

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The market for credit cards has all the defining characteristics of a network industry. The value of a credit card increases with the number of participating consumers, merchants, and banks. As Evans and Schmalensee (1999) observe, “[P]ayment cards are provided through a network industry in which participants are linked economically in unusual ways. Payment cards are useless to consumers unless merchants accept them, but merchants have no reason to accept cards unless consumers carry them and want to use them.” Consumers value widely accepted payment cards more, so issuers typically belong to large networks. But competition persists. The market sustains inter-network competition between networks owned by member banks, such as Visa and MasterCard, proprietary networks like Discover and American Express,and store-specific cards. What is more striking is the scope of intra-network competition. Visa and MasterCard, the two leading networks, are non-profit membership corporations with thousands of member firms. They provide infrastructure and a large network of users, and finance their services with membership fees. Despite strong network features, there is vigorous intra-network competition.

—Bryan Caplan and Edward P. Stringham, “Networks, Law, and the Paradox of Cooperation,” in Anarchy and the Law: The Political Economy of Choice, ed. Edward P. Stringham (New Brunswick, NJ: Transaction Publishers, 2007), 303-304.

In Banking, Scale Is Crucial for Success Because You Can Spread Your Technology and Network Costs over a Broader Base

In 2000, Baillie told me in an interview for a documentary called Titans, based on Peter C. Newman’s book of the same name, that he had wanted to run a large corporation ever since he was a young boy. He got his chance in 1995, becoming president of TD when Robin Korthals left, adding the CEO title in 1997 and the chairman’s title a year later, which he kept into 2003.

Baillie’s analytical mind had come to the conclusion that scale was crucial for success in banking. If you got bigger, you could spread your technology and network costs over a broader base. In Canada, that meant mergers of the big banks made sense. Beyond that, it meant planting the TD flag around the United States.

It had been decades since the last significant bank combinations in Canada. In the early 1960s, there was the marriage of the Imperial Bank and the Commerce Bank that created CIBC. Before that, there was the merger of the Bank of Toronto and the Dominion Bank in 1955 that had given birth to TD. Now, in the late 1990s, the Big Five banks were huge, with their tentacles reaching into all aspects of the economy. By and large, even though Canadians invested in them and liked their boring, stable ways, the banks were unpopular. No one liked the big fees they charged and people fumed when they saw how much money they made. They were also big employers. Mergers would mean closing branches and firing people. The banks were political dynamite.

—Howard Green, Banking on America: How TD Bank Rose to the Top and Took on the U.S.A. (Toronto: HarperCollins Publishers, 2013), 99-100.

Toronto-Dominion Bank’s CEO, Ed Clark, Prudently Distanced Himself from Subprime-Related Structured Products

It’s said the mark of a truly smart person is not being afraid to say he or she doesn’t understand something. That’s what Ed Clark said about subprime mortgage-related structured products in 2005. This was Clark’s epiphany and perhaps his most important decision as CEO. It was his view that these products were far too complicated for anyone to understand, and if he didn’t understand them, TD was clearing out any exposure and not buying them. He no doubt resisted pressure from within saying he was being too conservative. But by being a prudent banker and distancing himself from subprime-related structured products, Clark would position TD as one of the strongest banks on the planet.

Purdy Crawford, Clark’s old boss at Canada Trust, pinpoints Clark’s best quality: “He’s smart as hell, of course. I think it’s judgment—plus getting good people around him.”

Crawford says he knows a lot of people tried to talk Clark into buying what turned out to be toxic asset-backed commercial paper. Third-party asset-backed commercial paper, or ABCP, as it became known, was Canada’s own brush with subprime chaos. Commercial paper is a financial product that allows issuers to borrow money and lenders to park money for a set number of days—for periods less than a year. Government-issue treasury bills provide a similar function, but are backed by governments. Commercial paper is not. It’s backed by creditworthy corporations that need to borrow. In the case of ABCP, assets such as consumer loans and credit card receivables were pooled together like mortgages to create a stream of cash that could be paid out to an investor. The paper was also backed by synthetic assets, or derivatives, making it highly complex. Most importantly, assets and liabilities were not properly matched. Once again, however, a credit rating agency, this time Canada’s DBRS [Dominion Bond Rating Service], gave the ABCP a top rating.

Unfortunately for those in Canada who had invested $32 billion in ABCP, the market for it froze up along with the credit crunch. Commercial paper that matured could not be rolled over into a new investment. Holders were stuck and couldn’t get their money. Ironically, it was Purdy Crawford who was recruited, in his late seventies, to help solve the ABCP crisis and restructure the market, a daunting task.

—Howard Green, Banking on America: How TD Bank Rose to the Top and Took on the U.S.A. (Toronto: HarperCollins Publishers, 2013), 145-146.