The recent interest in state-owned banks has provoked challenges on grounds that they violate state constitutional prohibitions against lending the credit of the state. The argument is not valid, for several reasons:
- The U.S. Supreme Court has already considered it and rejected it.
- A number of states have owned banks historically, and many states have infrastructure banks today, which are specifically authorized by 23 U.S. Code Section 610.
- The argument misconstrues the nature of banking. All states deposit their revenues and invest their capital in banks. This does not mean they are “lending the credit of the state.” The bank lends its own credit. If a state can put its revenues and invest its capital in Bank of America or Chase Bank, it can put them in a state-owned bank.
These arguments also apply to county-owned banks, city-owned banks and any other chartered banks owned by the people as public institutions.
The U.S. Supreme Court Has Considered the Constitutional Argument and Rejected It
State constitutions typically have provisions forbidding the government to “give or lend the credit of the state.” California’s constitution, for example, provides at Article 16 (Public Finance), Section 6:
The Legislature shall have no power to give or to lend, or to authorize the giving or lending, of the credit of the State, or of any county, city and county, city, township or other political corporation or subdivision of the State now existing, or that may be hereafter established, in aid of or to any person, association, or corporation, whether municipal or otherwise, or to pledge the credit thereof, in any manner whatever, for the payment of the liabilities of any individual, association, municipal or other corporation whatever . . . .
In the Washington State constitution, the prohibition is in Article VIII, Section 5:
CREDIT NOT TO BE LOANED. The credit of the state shall not, in any manner be given or loaned to, or in aid of, any individual, association, company or corporation.
In the Colorado state constitution, Article XI, Section 1 prohibits the state from pledging its “credit or faith thereof” in favor of “any person, company, or corporation, public or private.” Article XI, Section 3, prohibits the state from contracting “any debt by loan in any form.”
The Constitution of North Dakota has similar provisions:
ARTICLE X: FINANCE AND PUBLIC DEBT
Section 18. The state, any county or city may make internal improvements and may engage in any industry, enterprise or business, not prohibited by article XX of the constitution, but neither the state nor any political subdivision thereof shall otherwise loan or give its credit or make donations to or in aid of any individual, association or corporation except for reasonable support of the poor, nor subscribe to or become the owner of capital stock in any association or corporation.
North Dakota has had a state-owned bank since 1919, along with a state-owned granary. In 1920, the legislation that enabled the Bank of North Dakota was challenged by a consortium of Minneapolis banks on behalf of 42 North Dakota taxpayers, on grounds that it violated state constitutional provisions and the Fourteenth Amendment. In GREEN V. FRAZIER, 253 U. S. 233 (1920), the U.S. Supreme Court rejected this challenge. It held that:
[L]egislation which provides for engaging the state in the businesses of manufacturing and marketing farm products, and of providing homes for the people, and which appropriates money, creates a state banking system, and authorizes bond issues and taxation for carrying the scheme into effect is not unconstitutional as respects taxpayers.
The Court noted that the constitutionality of the legislation had been sustained by the Supreme Court of North Dakota. To the extent that the decision rested on state grounds, it was therefore conclusive. The only question left for the U.S. Supreme Court to decide was the attack under the Fourteenth Amendment, alleging a deprivation of the plaintiffs’ right to property (their taxes) without due process of law. The court observed:
This legislation was adopted under the broad power of the state to enact laws raising by taxation such sums as are deemed necessary to promote purposes essential to the general welfare of its people. . . .
[T]he Supreme Court of North Dakota held . . . concerning what may in general terms be denominated the “banking legislation,” that it was justified for the purpose of providing banking facilities . . . .
As to the Home Building Act, that was sustained because of the promotion of the general welfare in providing homes for the people, a large proportion of whom were tenants moving from place to place. It was believed and affirmed by the Supreme Court of North Dakota that the opportunity to secure and maintain homes would promote the general welfare, and that the provisions of the statutes to enable this feature of the system to become effective would redound to the general benefit.
The decision of the Supreme Court of North Dakota upholding the legislation was therefore affirmed. The Bank of North Dakota (BND) has been operating successfully ever since, serving largely as a “banker’s bank” and “mini-Federal Reserve” within the state.
Many States Already Own Banks
North Dakota is the only state to own a bank on the “mini-Fed” model today, but a number of states have owned similar banks historically; and many states, including California, own infrastructure banks today. A July 2011 release by the Council of State Governments observed:
More than 30 states and Puerto Rico have created a state infrastructure bank, a type of revolving infrastructure investment fund that can offer loans and credit assistance to public and private sponsors of certain highway construction, transit or rail projects. Five states–Florida, Georgia, Kansas, Ohio and Virginia–have established banks or accounts within their banks that are capitalized solely with state funds.
If state funds can be used to capitalize a state infrastructure bank without violating state constitutional provisions, those funds can be used to capitalize a state-owned bank on the model of the Bank of North Dakota without violating state provisions.
Banks Advance Their Own Credit, Not the Credit of Their Depositors
The contention that a state-owned bank would “lend the credit of the state” misconstrues the nature of banking. Banks do not lend the deposits of their depositors. If they did, the state would not be able to deposit its revenues in Bank of America or Chase Bank without violating state constitutional provisions. What banks lend is simply “bank credit” created on their books. As the Federal Reserve Bank of Dallas explains the process on its website:
Banks actually create money when they lend it. Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank . . . holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.
Or as Michael Sauvante explains on the website of the Commonwealth Group:
The number one privilege enjoyed by banks is their ability to create new money, in the form of credit granted to their borrowers. Banking laws permit a bank to create that credit based on the assets of the bank (generally defined by the Basel II Accord). This credit is not extracted from those assets (which remain untouched in the process), nor is it drawn from any other pool of money, but rather the assets serve strictly as the basis for calculating the total amount of new money that the bank is allowed to issue in the form of credit. That amount (usually a multiple of the assets, typically in the range of 10-12 times the value of the assets) is governed by regulators, and varies from bank to bank.
A state-owned bank would not be lending the state’s credit but would simply be accepting the state’s revenues as deposits, as Bank of America does now. The deposits would at all times remain in the bank, just as they remain in Bank of America now. They would be shifted from a deposit account in one bank to a deposit account in another bank; that is all.
A small portion of the state’s capital would also be shifted from one investment to another. Some idle rainy day fund, for example, might be used. This would be an investment in equity, not an expenditure. It would not cost the state money but would make money for the state. The Bank of North Dakota has reported a return on equity in recent years ranging from 19% to 26%.
The state-owned bank would use these resources to do what all banks do: leverage their capital into credit, backed by their deposits. And because the bank would be publicly owned and would have a mandate to serve the public, it could be expected, like the BND, to advance this credit conservatively for creditworthy local projects and needs. Banking “would become boring again.”
In North Dakota (population 647,000), the Bank of North Dakota has $2.7 billion in deposits, or $4000 per capita; and virtually all of these deposits are drawn from the state’s own revenues. The bank has nearly the same sum ($2.6 billion) in outstanding loans.
California has 37 million people. On the same scale, California might amass $148 billion in deposits. Assuming an 8% capital requirement, with $12 billion in capital this $148 billion in deposits could generate $133 billion in credit for the state (subtracting 10%, or 14.8 billion, to satisfy reserve requirements).
If that credit were used, for example, to purchase $133 billion in municipal bonds paying 5% interest, the state could make nearly $7 billion annually on its investment. This is new revenue for the state, acquired without spending a penny more in taxes.
The state of California deposits its money in private banks and invests its capital in private institutions including banks. The banking institutions receiving these public monies then leverage them for the benefit of the bank’s investors and management. If this is a constitutional use of public funds, it is constitutional for the state-owned Bank of California to leverage the public’s money for the benefit of the state and its people.
Web of Debt
– Prepared in consultation with Timothy Canova, Professor of Law, Chapman University; and Robert Bows, board of directors, Public Banking Institute