With the passing of Professor Edward J. Kane on March 2, 2023, the economics and finance profession lost a true giant in the field. His professional accomplishments are multidimensional. He authored over 150 published articles and seven books. He served not only as the youngest president of the American Finance Association, but also as president of several other professional organizations, including the North American Economics and Finance Association and the International Atlantic Economic Society; and he was the recipient of numerous awards and academic honors. But what really set Ed apart was his true professionalism, his high ethical standards, and the care and attention he gave to his students.
I first had the opportunity to interact seriously with Ed when he visited the research unit that I headed at the FDIC in 1975. We became friends, a friendship that lasted for nearly 50 years. That visit changed my professional direction, deepened my commitment to the study of finance, and shaped my entire career. I became a member of the Shadow Financial Regulatory Committee, of which Ed was a founding member, and had the opportunity to interact with its many members, including Professors George Kaufman, George Benston, Franklin Edwards, Allan Meltzer, Franco Modigliani (Nobel Prize winner), and Kenneth Scott, just to name a few.
Perhaps Ed’s most significant and enduring contribution to the field of financial regulation, one for which I personally believe he should have received the Nobel Price in Economics, was his concept of how the financial system evolves in response to regulation, known as the “regulatory dialectic” (first described in “Good Intentions and Unintended Evil: The Case Against Selective Credit Allocation, Journal of Money, Credit and Banking,” Vol. 9. No. 1, Part 1, February 1977, and expanded upon in “Accelerating Inflation, Technological Innovation, and the Decreasing Effectiveness of Banking Regulation,” Journal of Finance, Vol. XXXVI, No. 2, May 1981). The concept, which accurately describes the evolution of financial and banking systems, has endured the test of time and has proved to have much broader application than to just financial services. The concept describes the dynamic and cyclical interactions between the incentives facing managers of financial institutions (or more broadly regulated institutions in general), the costly motivations of politicians to redirect resources to preferred ends, and the evolution of technology. Kane saw the “political processes of regulation and the economic process of regulatory avoidance as opposing forces that, like riders on a seesaw, adapt continually to each other. This alternating adaptation evolves as a series of lagged responses, with regulators and regulates seeking to maximize their own objectives, conditional upon how they perceive the opposing party to behave.” In simple terms, regulation imposes costs that reduce regulated firms’ profits and incentivizes managers to innovate ways to avoid those costs, often with unintended consequences. It is this insight that transcends financial services and applies to all regulated institutions.
A couple of examples will serve to illustrate the concept. First, the prohibition of the payment of interest on checking accounts was intended to protect banks from ruinous rate competition. However, during the 1950s and thereafter, Kane (1977) notes, interest rates rose and banks began to offer nonpecuniary services, from establishing more convenient locations to promoting free giveaways like toasters. Interestingly, the prohibition did not apply to mutual savings banks, located mostly in New England. The Consumers Savings Bank in Worcester, Massachusetts, innovated an interest-earning transaction account called a Negotiable Order of Withdrawal, or NOW account. The account changed the nature of competition for checking accounts, and Congress responded in 1974, permitting NOW accounts in Massachusetts and New Hampshire. But the pressures proved dramatic, and the accounts were extended to all of New England in 1976. Four years later, in 1980, NOW accounts were permitted to all depository institutions nationwide, with a 5% rate ceiling subject to a seven-day notice requirement. Not only was there competitive pressure from NOW accounts, competition for short term liquid funds also was spurred by the creation and growth of short term money market accounts. In 2010, in response to the pressures these outside sources of competition placed on banks, the Dodd-Frank Act eliminated the restriction of payment of interest on checking accounts for all depository institutions. Kane’s description helps explain how we got payment of interest in checking accounts; precisely illustrates the dynamic interaction among politicians, bankers, and non-bank competitors; and demonstrates how regulatory avoidance leads to changes in financial services over time.
A second example serves to illustrate the lagged dynamic of change and evolution of branch banking and restrictions on products offered through bank holding companies that Kane (1981) described. For the first half of the 20th century, banks were not permitted to branch across state lines, and individual states had different branching rules for state-chartered banks. States like Texas, for example, prohibited branching. Pennsylvania, on the other hand, permitted banks to branch in counties contiguous to the county in which they were headquartered. Not surprisingly, larger Philadelphia banks tended to place their headquarters in Bucks County but had their main operating office in downtown Philadelphia. Finally, some states like North Carolina and California permitted unlimited branching statewide.
To get around the restrictions on branching, individuals purchased ownership in multiple banks, which became known as chain banking, while others employed a holding company to own the shares of multiple banks. Additionally, holding companies also engaged in nonbanking activities. In response, Congress passed the Bank Holding Company Act of 1956, which applied to institutions owning 25% or more of two banks and imposed strict limits on the nonbanking activities so that only those activities deemed to be “closely related to banking and a proper incident thereto” were permitted. Again, to avoid the 25% requirement, bank holding companies began to limit ownership to slightly less than 25%, and independent banks soon adopted the one-bank holding company to get around the activity restrictions. In response, Congress amended the Bank Holding Company Act in 1970 to bring all bank holding companies under Federal Reserve supervision and eliminated the ability of one-bank holding companies to avoid the activity restrictions. Finally, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 permitted bank holding companies to expand across state lines and permitted affiliates to operate as branches. The act also permitted interstate branching that became effective in 1997, thus ratifying the changes that over 46 states had already enacted to permit branching within their state boundaries.
These are but two of numerous examples of the interaction between regulation and subsequent avoidance activities that have followed in what appears to be a never-ending cycle. The concepts have endured, have extended far beyond financial institutions and regulation, and have clearly stood the test of time. Indeed, the private sector and governmental avoidance responses to the sanctions that have been imposed on Russia because of the actions taken in Ukraine show the depth, breadth, and continued relevance of the “regulatory dialectic” concept.
I continue to be amazed by Ed’s insights and their durability. I know Ed has impacted the lives of his students and coauthors in many, many ways, and clearly his comments have improved all of our work. The profession will sorely miss him, as will all his close friends. In the end, however, while friends and memories of them last a lifetime, their ideas last forever.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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