Elias van Emmerick
Pomona College

April 2021

This paper will propose that state-owned banks resolve many of the issues facing commercial banks today. To substantiate this claim, it will investigate specific areas where a state-owned bank would produce more favorable outcomes than a commercial bank, trace the steps required to establish such a bank, and evaluate a contemporary example of a state-owned bank, the Sparkassen

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1. Introduction
The financial sector increasingly takes up space in our economy. What originated as a means to an end (a middleman to collect and distribute funds) has for many become an end unto itself. Top students from prestigious universities across the globe desperately pursue jobs at investment banks, hedge funds, and private equity firms. For example, more than a third of Harvard’s class of 2017 pursued finance or consulting upon graduating. In fact, the finance, insurance, and real estate industries make up one fifth of domestic GDP, more than any other sector. At the same time, this industry has often brought us close to financial collapse. Nobel Prize winning economist Joseph Stiglitz describes the financial sector’s work as being at least partly “rent-seeking”: an economic activity that redistributes wealth (often from the poor to the rich), but does not actually generate meaningful increases in overall economic growth. As an economist would put it, they do not grow the pie, they simply take a larger slice of it.
This paper will aim to investigate to what extent state-owned commercial banks could alleviate some of the major issues related to the financial sector we see today, and how they could do so. Subsequently, the paper will detail how the creation of a public bank could happen, as well as evaluate two existing state-owned banks, the Bank of North Dakota and the German Sparkassen. Finally, it will summarize contemporary efforts to establish government-owned commercial banks in the United States.
Throughout this paper, I use a number of terms in a particular way. Specifically, I will make frequent use of the terms “liquidity,” “public,” and “bank.” I will take “liquidity” to mean the M2 money supply: the amount of cash, checkings and savings deposits, and time deposits available in the economy at a given time. “Public” will refer to ownership of an entity by the government, rather than an entity being publicly traded on the stock market. Finally, “bank” will refer to the commercial kind unless otherwise noted. This last distinction is important to draw, as many of the conclusions reached in this paper would not transfer to investment or merchant banks.

2. The Rationale Behind a Public Bank
America has had a tumultuous relationship with private financial institutions, and a number of historical figures struggled with determining the role a finance sector should play. Andrew Jackson wrote that “if Congress has the right under the constitution to issue paper money, it was given them to be used by themselves, not to be delegated to individuals or corporations.” Jackson referred to what many contemporary economists consider to be a significant flaw of the private banking system: control over the money supply. Economists traditionally assume that the federal government regulates the money supply. The Federal Reserve (the Fed) can control the money supply by trading Treasury notes with commercial banks, or the Treasury itself can physically print more bills in order to increase the money supply. It is inherently desirable to have a government without a profit motive perform this function—unchecked increases in the money supply would lead to devastating inflation and a loss of faith in our currency. Furthermore, this also means that the government is able to control the amount of money in the economy during times of crisis, and to some extent prevent liquidity from drying up. Control over the money supply is a useful policy tool that is best wielded by the state, with the interest of its constituents in mind.
The reality is that, by and large, the money supply is heavily influenced by the decisions of commercial banks. Economists have reached a consensus on what is known as the “fractional reserve theory of money creation.” This theory states that banks must lend out a percentage of each deposit they receive, equal to the total deposit minus the “reserve requirement”⁠—an amount set by the Federal Reserve that banks are required to retain of each deposit— as an insurance against bank runs. After the bank lends out this percentage of a deposit, the person who receives the loan theoretically deposits that money in another account, where a part of it is loaned out, and so on. Every person in this chain now has additional money in their account, and their spending decisions will be made accordingly. The original deposit was multiplied; thus, money was “created.” Conversely, banks may also decide to call back their loans or refuse to issue new ones. In effect, this results in a removal of money from the money supply. The diagram below illustrates how liquidity in the system increases through this process.



Image 1: Illustration of the fractional reserve theory of money creation given a 10% reserve requirement

The unfortunate truth is that this method of money creation works to exacerbate any swings in the wider economic environment. When the economy is heating up (and thus is experiencing inflationary pressures), banks will be more eager to lend money, which in turn will increase the money supply, thereby further increasing inflation. When the economy is in a rut, fewer loans will be extended, contracting the money supply and further pushing down spending and aggravating potential deflation. When banks follow “rational incentives,” meaning that they become less risk averse during periods of growth and more risk averse during economic slowdowns, the economy does not always benefit. One could argue that the Fed is tasked with preventing these swings. During economic booms they raise interest rates, which curbs lending, and during busts they lower them, which in turn boosts spending. The problem is that the government is now acting as a middleman, when this is a system they are supposed to have complete control over.
Commercial banks’ role as distributor of liquidity has other downsides. Since these banks are asked to maximize shareholder value, they are incentivized to extend capital only to those who are likely to repay it. Individuals or businesses that are deemed high-risk are penalized with high interest rates and other unfavorable loan terms. This is not incompatible with prevalent economic theories. The bank is assuming the risk, and for taking on higher risk should be eligible to receive a larger reward. However, a closer examination reveals the perversity behind this idea. Access to capital is essential for a number of activities that can lead to prosperity. Home ownership, starting a business, or going to college all typically require some form of lending. Low-income individuals are thus required to pay a higher price, both in absolute and relative terms, for these opportunities. It is morally bankrupt, as well as socially undesirable, to make loans more expensive for those who already have very little, and there is substantial evidence that this system contributes to the “poverty trap.” Studies have shown that low-income individuals on average do pay more for any kind of loan. The Federal Reserve also found a positive correlation between income and credit score, and a number of other studies have further shown that minorities typically have lower credit scores, even when the data is controlled for disparities in income. There is a strong negative correlation between credit scores and interest rates payable on loans—the lower your score, the more you are asked to pay. It is understandable that banks employ this system, but that does not mean that it is beneficial to society as a whole. In essence, the credit score system is a regressive tax—the poorer you are, the more you pay. The graph below shows the average credit score of each income group on a bar chart and superimposes the median mortgage rate for each credit score. There is a clear positive correlation between credit score and income level, and a negative correlation between credit score and median mortgage rate. This data shows that income is in turn negatively correlated with mortgage rates; that is, the lower one’s income, the higher their mortgage rate is likely to be.


Image 2: Median credit score and mortgage rate versus income.

A public bank could step in and resolve this issue. It could extend loans not with the intent of making a profit, but rather with the intent of stimulating the economy. This might mean providing loans to low-income communities at break-even interest rates, as they are likely to spend that money in a way that benefits the wider economy. A public bank could further act as a tool for policymakers. If politicians want to stimulate homeownership and reduce emissions, mortgages could become cheaper and car financing more expensive. A public bank would provide a direct way of injecting money into desirable areas of the economy.
Banks’ focus on generating returns for their shareholders costs the general public in a number of other ways as well. Most Americans have their checking and saving accounts with one of the major banks—37.6% of all deposits were placed with one of the five largest banks, and 30.82% were placed with one of the three largest. In fact, the five largest American banks control 56.9% of all assets held by U.S. banks. Today’s financial sector can be (and has been) accurately described as an oligopoly—a few key players control such a significant share of the market that they are able to work together and set rates in a way that is favorable to them. In this case, savings rates are artificially held down. As mentioned before, banks make money from each dollar they receive in deposits. Unfortunately, almost none of that money returns to their clients. Savings accounts at most commercial banks generate negligible interest, and checking accounts frequently cost money for those who deposit under a certain amount. Interest rates offered on savings accounts remain low, even as the Fed has increased its discount rate. The below graph shows the federal funds rate as compared to the average interest rate Americans received on savings below $100,000. Both were lowered after the 2008 financial crisis in an effort to discourage saving and encourage spending, but the federal funds rate has since increased significantly. In contrast, the interest rate on savings accounts has remained mostly stagnant. The profits banks make on deposits can be approximated by the difference between these two rates—the less they pay to depositors and the more they charge for loans, the more profitable lending becomes.

Image 3: Average interest rate on savings accounts versus the federal funds rate

A public bank would primarily aim to further public interest rather than make a profit, and is therefore more likely to offer a savings rate that closely mirrors the discount rate. Not only would this provide customers with a better alternative to the rates offered by commercial banks, it might also force banks to match that rate if they want to retain their clients. In effect, this would constitute a redistribution of wealth from the banks and their shareholders to the general public. Although online banks currently offer higher interest rates on savings accounts, they are rather niche and lack the visibility to threaten larger banks. An accessible, well-known public bank could succeed where these online banks have failed and significantly drive up the average interest rate on savings accounts.
A lack of profit incentive would also reduce a public bank’s exposure to risk. In the years leading up to the Great Recession, nearly every bank filled their balance sheet with subprime mortgages and risky derivatives, even though they were aware of the risks associated with these products. Banks simply could not explain to their shareholders that they were going to hold off on products that were generating sizeable returns for their competitors. Commercial banks’ profit incentive has at times generated genuine financial innovation, but more often than not has caused them to cut corners and harm communities. Wells Fargo, for example, was convicted of engaging in predatory lending throughout the US in the years leading up to 2008. The bank knowingly extended credit to those who were unlikely to pay it back, charging high upfront fees and then passing the actual debt on to other firms. Wells Fargo knew the risks involved, but ultimately decided short-term profits were more important. Unlike traditional banks, a public bank would not answer to shareholders, but rather to elected officials who represent the public’s best interest. Research has already shown that banks who answer to a large number of shareholders are more risk-averse than those who answer only to a select group of the corporate elite. These findings could be extrapolated to infer that a bank that answers to the general population would be significantly more risk-averse than current financial institutions.
Public banks clearly offer a solution to many of the issues our financial system struggles with today. A wholly different incentive structure would allow these banks to deploy capital where it would stimulate the economy, rather than where it would only generate profits for the bank. The absence of a responsibility to shareholders would lead to higher interest rates on savings accounts and the adoption of a more sustainable risk profile. As a competitor to commercial banks, a public bank would realign the industry to be more concerned with the needs of its customers.
Regardless of a public bank’s merits, the US is currently home to just one public bank, whose assets total $7 billion–about 0.004% of total commercial bank assets. The next section will investigate the steps required to create a public bank and discuss potential pitfalls in the process.

3. Creating a Public Bank
During the 2008 recession, the government could have created a national public bank simply by taking over an existing commercial bank. The value of most commercial banks’ balance sheets had dropped drastically following the collapse of mortgage-backed securities, making them an easy target for takeovers. Although this solution may have ultimately generated more returns for taxpayers and fewer for wealthy shareholders than bank bail-outs did, it would have created a set of unique and difficult-to-solve challenges. Balance sheets would have to be cleaned of toxic and risky assets, and the bank would have to gradually reduce its exposure to financial products that are not in line with the mission statement of a public bank. Entire divisions that handled these products would have had to be laid off, and many clients might find that services they used would no longer be on offer. Luckily, our current economic outlook is a lot rosier than it was a decade ago, and few banks (perhaps with the exception of the ever-troubled Wells Fargo) seem in danger of failing any time soon. A public bank would thus need to be created from scratch—something that would allow for greater control over the bank’s structure and design.
A number of states and cities (Vermont, New Jersey, Massachusetts, Los Angeles, San Francisco, etc.) have conducted or are in the process of conducting feasibility studies for the creation of regional public banks, and as such, there is a substantial range of literature available with detailed descriptions of the steps required to start such a bank. Although many studies have focused on public banks as providers of capital for infrastructure investment and providers of solutions for state financing needs, the basic principle behind their construction remains the same.
The technicalities behind a bank’s creation are simple. The bank needs to have sufficient assets to begin lending, a few employees, and physical branches. Typically, feasibility studies assume the city or state responsible for creating the bank would move its current cash reserves to the new bank, thereby providing capital without the need for loans or other costly financing techniques. The only existing American public bank—the Bank of North Dakota—was initially financed by a $2 million bond offering in 1919, which would amount to about $29 million today. Research suggests that, due to the increased complexity of the contemporary economy, the required capitalization would be closer to $325 million. Since most states hold a multiple of that amount in commercial banks currently, it is unlikely that a bond offering would be necessary today. California, for example, holds nearly $15 billion in its “rainy day” fund alone.
A public bank would have the local government as its sole shareholder, and any returns it made would be returned to the state or city in which it is located. As such, public banks would prevent capital drain to out-of-state bondholders and keep profits within the local economy.
The creation of a public bank would be relatively uncomplicated, and a variety of feasibility studies have cited high potential upsides. For example, a public bank in New Jersey would generate about $16-21 million in additional state output, and raise state income by about $3.8-5.2 million, for every $10 million lent out. Furthermore, for every $10 million lent out the bank would add roughly 60-93 new jobs. Yet, strong opposition to the idea exists. In Maine, a bill to commission a study on the effects of a public bank failed to pass the state legislature, even though 72% of small businesses and farmers in the state supported the creation of a state-owned bank. Opponents often cite currently adequate availability of credit through commercial channels and increased risk to state assets as arguments against a government-controlled bank. Internationally, the idea has also fallen out of favor with economists, who claim that public banks are often inefficient and influenced by political pressures. The next section of this paper will investigate a current example of a state-owned banking system to determine the merits of these arguments.


4. Public Banks Today

a. The Bank of North Dakota
The Bank of North Dakota (BND) is the United States’ only existing example of a government-owned bank, and it is often cited as an example of the potential benefits of such an institution. The bank certainly has reported impressive figures since its founding in 1919. As shown in the graph below, it has made a net profit every year since its founding, even during the Great Depression and the Great Recession.

Image 4: Yearly profits of the Bank of North Dakota


Additionally, the bank has managed to return much of that profit to the state government, keeping North Dakota from running a budget deficit when other revenue sources have fallen short.
The historical context surrounding the bank’s founding is oddly reminiscent of our contemporary situation—around the start of the 20th century, a populist movement in North Dakota renounced the high fees farmers were being charged by out-of-state financiers and pushed for a local bank that would be tasked with “promoting agriculture, commerce and industry.” Local commercial banks were concerned that a public bank would drive them out of business and managed to convince the legislature to impose strict limits on what would become the BND. Initially, the bank was “prohibited from opening branches, engaging in retail banking, and providing commercial lending other than farm real estate loans.” A number of these restrictions were later loosened, but the bank still is not a real substitute for a commercial bank. The BND operates conservatively, shows itself to be risk averse, and sees “maintaining a strong and stable balance sheet” as a key priority. In this sense, it has been hard to use the success of the BND as an argument for public banks in the broader United States. The bank does provide affordable loans for small businesses (albeit not for individual consumers), but “roughly 50 percent of the bank’s loan portfolio consists of loan participations and loan purchases from community banks,” rather than regular loans. During financial crises, the bank helps to maintain liquidity in the markets, but it does so by purchasing loans from smaller banks rather than by actively extending loans.
The BND is a successful experiment in state-ownership of banks, but the restrictions imposed on it by the legislature prevent it from being a truly transformative force. Its lack of access to consumers and emphasis on cooperation with commercial banks mean that most North Dakotans are still forced to obtain the majority of their financial services from for-profit companies. Furthermore, the legislature’s eagerness to use profits from the BND for state expenditures means that the bank is still required to make a profit—the only difference is that this money goes back into the local community, rather than towards mostly wealthy shareholders. The bank’s conservative approach to investments may also not produce socially optimal outcomes seeing as many investments with significant potential upsides, such as small business loans or mortgages for low-income families, have a fairly high risk profile. Instead of maintaining a low-risk balance sheet, the BND could focus on providing loans that “serve a social purpose but that the private sector would find too risky.” It is also important to note that the BND has operated independently of political forces. Rick Clayburgh, president of the North Dakota Bankers Association and former state tax commissioner and state legislator, has said: “Our legislature... has kept their politics out of the governance of the Bank of North Dakota”. The supposed interdependence between public banks and the legislature is an oft-cited criticism against public banks, and this paper will explore the veracity of this claim further in the following chapters. In the case of the BND, concerns of the legislature influencing the bank’s decisions appear to be unfounded.
The Bank of North Dakota is a successful institution, but it has hardly lived up to the disruptive potential of a public bank. More than anything else, the BND shows that merely having a state-owned bank is not enough to achieve the goals set out at the start of this paper—a bank has to provide a viable alternative to the commercial banking sector, as well as have a set goal of promoting investments that serve a social purpose, if it is to meaningfully change the way the finance sector operates today.

b. Germany’s Public Banks: The Sparkassen
Germany’s commercial financial sector consists of three “pillars”: commercial banks, cooperative banks (owned by their customers), and public banks. Examples of the last include the aforementioned Sparkassen and Landesbanken, which engage in wholesale banking, as well as the LBS Bayerische Landesbausparkasse, a public sector loan and building association. Sparkassen are a unique example of state-owned, easily accessible banks that offer basic commercial banking services to consumers and small- to medium-sized enterprises (SMEs). The Sparkassen have been operating since 1778 and were originally founded by merchants hoping to support local communities. Today, the Sparkassen have over fifteen thousand branches and control over €2 trillion in assets. The banks operate in a decentralized manner with strong geographic boundaries, meaning that each city or region has its own Sparkasse that serves local clients and provides loans for local investments. The banks are owned by the cities or regions in which they operate but are also are backed by a national organization that maintains a “rainy day fund” which Sparkassen can tap into, so that a region of Germany experiencing financial distress can obtain support from Sparkassen in prospering regions.


Image 5: Representative structure of the Sparkassen system

Germany’s Sparkassen are mandated by law to serve the public interest and promote regional development. In fact, their success is measured not by returns generated for shareholders or profit, but by their impact on the communities they serve. Stakeholder value, rather than shareholder value, is the key metric by which these banks are judged. Instead of generating profits for those who invested in the bank, the Sparkassen are required to deliver returns for local stakeholders. Such stakeholders include local residents, small businesses, and municipal governments. The banks are highly popular with their audience, with about 70% of all SMEs obtaining their financing from a Sparkasse. About 60% of all Germans interact with these banks in some way, with low-income families specifically making up the largest part of the Sparkassen’s customers. This broad reach is partly because of their indiscriminate approach to banking—they are mandated to not deny anyone a savings account, and they must provide the same rate of return for each customer. Furthermore, the legislature explicitly states that Sparkassen are supposed to “satisfy the credit demands of local businesses.”
Besides serving customers and enterprises, Sparkassen fund socially desirable projects with the express intent of promoting the public interest. The banks together provided €488 million (about $550 million) to social projects in 2018 alone, and a 2015 report estimated that the banks added about €20 billion in value to local communities that year, equal to about 0.66% of Germany’s 2015 GDP. They also provide significant funding for start-ups, infrastructure repairs, and other socially desirable activities.
Notwithstanding the several benefits associated with the Sparkassen system, the banks have been regularly criticized by European and American economists alike. Many of these critics primarily take issue with the concept of a state-owned bank rather than with a specific issue present in the system, but others have identified some salient flaws in the way the Sparkassen are run.
Political involvement in the day-to-day operations of the banks has been and remains an area of concern. A study by the Brussels-based think tank Bruegel notes that, in the eight states they surveyed, 83% of the Sparkassen’s board chairs were current county heads or municipality heads. In five out of eight states, every single board chair was a current politician. More broadly, 18% of board members were politicians. Moreover, in the only state where politicians publicly declare their income, board chair fees made up an average of 12% of a politician’s income. The mayor of Regensburg, the fourth-largest city of Bavaria, is currently standing trial for accepting significant campaign donations from a real estate developer, allegedly in exchange for a favorable loan from the Sparkasse where the mayor held a board seat. Such cases are rare, but the degree of entwinement between politicians and the public banks is certainly cause for concern. Little research has been done on inefficiencies in the Sparkassen system caused by political entanglement, so the severity of these findings remains unclear. An American public bank could certainly model itself after the Sparkassen, but it might benefit from an explicit separation between currently serving politicians and the bank itself, if only to maintain public trust in the system.

5. Looking Forward: Public Banking Initiatives in the United States
The public banking movement has seen a resurgence of sorts in the last decade, and a number of states and cities have introduced legislation to either establish a public bank or to conduct feasibility studies. Most notably, current New Jersey governor Phil Murphy ran his campaign partly on the promise of establishing a public bank, and he sponsored a bill on his first day in office to achieve that goal. Maine, Vermont, and New York have also voted on bills to establish state banks.


Image 6: Public banking efforts by state

Feasibility studies have generally predicted positive results. For example, a 2011 feasibility study predicted that a public bank would generate 3,500 new jobs in Maine, a 2013 study found that a public bank would create about 2,500 new jobs and $200 million in value added to the economy in Vermont, and a study for the city of Santa Fe found that every $1 million in lending from a public bank would generate an additional ten jobs in the local economy. Exceptions are the feasibility studies for California and DC. Both studies found that establishing a public bank would be legally difficult and capital intensive. The DC study is interesting in that it heavily relied on advice from the Federal Reserve, which stated that the income a city or state can gain by having a public bank is "relatively minor" and that the risk of losses is "real.” It is important to note that the Federal Reserve might have an inherent aversion to public banks, as these are not placed under the Fed’s supervision. Aside from this criticism, the DC study also found that public banks would spur local economic development and infrastructure investment, as well as reduce risk exposure of the financial system. The final version of the DC report is still being edited and is due to be released sometime later this year.
Feasibility studies may have produced mixed results, but there has been nothing mixed about the legislative response to the idea of public banks. Maine’s bill was sent back from committee with a majority saying it should not pass. Vermont’s bill to establish a public bank did not pass either (although the legislature did approve $350 million in local investment instead), and New Jersey seems to have put its plans for a public bank on hold. As of today, North Dakota remains the only state with a public bank. The idea is seen as overly socialist by many, and as overly complex and costly by others. The DC feasibility study claimed that direct government spending towards socially beneficial programs would be far less complex and costly than establishing a public bank, which seems to be an argument that many lawmakers have bought into.
Legal challenges also cause many legislators to view public banks unfavorably. Specifically, many state constitutions have provisions against “lending the credit of the state.” However, the Supreme Court’s ruling in Craig v. Missouri holds that such provisions “[do] not interfere with the power of a state to authorize banks to issue bank notes in the form of due-bills or of similar character, intended to pass as currency on the faith and credit of the bank itself, and not of the state which authorizes their issuance.” As such, banks (public or commercial) are able to provide credit that passes as currency. In Briscoe v. Bank of Commonwealth of Kentucky (1837), the Court held that Kentucky’s state bank did not violate the Constitution, as its loans contained “no pledge of the faith of the state for the notes issued by the institution.” The issue at hand is whether activities that are at the core of the bank’s operations (lending, investing, etc.) are explicitly backed by a government guarantee. If so, public banks would have an unfair advantage over private banks. So far, no proposal for a state bank has indicated that the bank would rely on such a state-sanctioned “pledge of faith,” and as such, it is unlikely that the constitutionality of a public bank could be challenged on these grounds. Furthermore, the Bank of North Dakota is proof that it is constitutionally permissible to operate a public bank.

6. Conclusion: An Uncertain Future
There is a strong case to be made for the establishment of regional public banks throughout the United States. Increased control over the money supply, greater access to affordable loans for low-income families and small businesses, higher returns on savings accounts, and a lower risk profile would all result from having a public bank in place. As it stands, commercial banks largely engage in rent-seeking behavior. Predatory lending practices, low interest on savings accounts, and high credit card rates serve to generate profits for large banks by taking money from the economically vulnerable. The IMF has found that, as the financial sector grows relative to the size of the economy, inequality increases. Recent research by economists at Columbia University confirms this rise in inequality, and further found that this effect is not significantly offset by the easier access to credit financial markets supposedly provide.
As it stands, encouraging progress is being made in many places. Feasibility studies are an important first step in moving this idea into the mainstream, and we might soon see a bill to establish a state bank appear in New Jersey. However, the unfortunate truth remains that lawmakers view public banks unfavorably. Beyond the practical hurdles associated with establishing one, there seems to be a general sentiment that a public bank would not fit with the capitalist ideals of the United States. Lenin’s claim that “without [public] banks, socialism would be impossible. The big banks are the ‘state apparatus’ which we need to bring about socialism [...]” has fundamentally linked the idea of a state bank with an overly leftist vision for many.
I would argue that a public bank is fundamentally American. It is a state apparatus that enables the government to more efficiently support entrepreneurship, local communities, and infrastructure. A public bank, if given proper direction, could facilitate the achievement of the elusive American Dream. The Founders vocally opposed monopolies, championed a stable currency, and believed all should be able to acquire property and benefit from public infrastructure. Stiglitz wrote that,
Rather than justice for all, we are evolving into a system of justice for those who can afford it. We have banks that are not only too big to fail, but too big to be held accountable. [...] The only true and sustainable prosperity is shared prosperity.

Commercial banks today are hurdles keeping us from innovation, wealth creation, and achieving equality. A bank should facilitate the dreams of entrepreneurs from all backgrounds, not just those from Silicon Valley. It should not charge the poor more than the rich. In many ways, commercial banks violate some of the core values on which this country was founded. In short, there is nothing un-American about a state bank.
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