This entry includes 9 subentries:
Overview
Bank Failures
Banking Acts of 1933 and 1935
Banking Crisis of 1933
Export-Import
Banks Investment
Banks Private
Banks Savings
Banks State Banks
Overview
The fundamental functions of a commercial bank during the past two centuries have been making loans, receiving deposits, and lending credit either in the form of bank notes or of "created" deposits. The banks in which people keep their checking accounts are commercial banks.
There were no commercial banks in colonial times, although there were loan offices or land banks that made loans on real estate security with limited issues of legal tender notes. In 1781 Robert Morris founded the first commercial bank in the United States—the Bank of North America. It greatly assisted the financing of the closing stages of the American Revolution. By 1800, there were twenty-eight state-chartered banks, and by 1811 there were eighty-eight.
Alexander Hamilton's financial program included a central bank to serve as a financial agent of the treasury, provide a depository for public money, and act as a regulator of the currency. Accordingly, the first Bank of the United States was founded 25 February 1791. Its $10 million capital and favored relationship with the government aroused much anxiety, especially among Jeffersonians. The bank's sound but unpopular policy of promptly returning bank notes for redemption in specie (money in coin) and refusing those of non-specie-paying banks—together with a political feud—was largely responsible for the narrow defeat of a bill to recharter it in 1811. Between 1811 and 1816, both people and government were dependent on state banks. Nearly all but the New England banks suspended specie payments in September 1814 because of the War of 1812 and their own unregulated credit expansion.
The country soon recognized the need for a new central bank, and Congress established the second Bank of the United States on 10 April 1816. Its $35 million capitalization and favored relationship with the Treasury likewise aroused anxiety. Instead of repairing the overexpanded credit situation that it inherited, it aggravated it by generous lending policies, which precipitated the panic of 1819, in which it barely saved itself and generated wide-spread ill will.
Thereafter, under Nicholas Biddle, the central bank was well run. As had its predecessor, it required other banks to redeem their notes in specie, but most of the banks had come to accept that policy, for they appreciated the services and the stability provided by the second bank. The bank's downfall grew out of President Andrew Jack-son's prejudice against banks and monopolies, the memory of the bank's role in the 1819 panic, and most of all, Biddle's decision to let rechartering be a main issue in the 1832 presidential election. Many persons otherwise friendly to the bank, faced with a choice of Jackson or the bank, chose Jackson. He vetoed the recharter. After 26 September 1833, the government placed all its deposits with politically selected state banks until it set up the Independent Treasury System in the 1840s. Between 1830 and 1837, the number of banks, bank note circulation, and bank loans all about tripled. Without the second bank to regulate them, the banks overextended themselves in lending to speculators in land. The panic of 1837 resulted in a suspension of specie payments, many failures, and a depression that lasted until 1844.
Between 1833 and 1863, the country was without an adequate regulator of bank currency. In some states, the laws were very strict or forbade banking, whereas in others the rules were lax. Banks made many long-term loans and resorted to many subterfuges to avoid redeeming their notes in specie. Almost everywhere, bank tellers and merchants had to consult weekly publications known as Bank Note Reporters for the current discount on bank notes, and turn to the latest Bank Note Detectors to distinguish the hundreds of counterfeits and notes of failed banks. This situation constituted an added business risk and necessitated somewhat higher markups on merchandise. In this bleak era of banking, however, there were some bright spots. These were the Suffolk Banking System of Massachusetts (1819–1863); the moderately successful Safety Fund System (1829–1866) and Free Banking (1838–1866) systems of New York; the Indiana (1834–1865), Ohio (1845–1866), and Iowa (1858–1865) systems; and the Louisiana Banking System (1842–1862). Inefficient and corrupt as some of the banking was before the Civil War, the nation's expanding economy found it an improvement over the system on which the eighteenth-century economy had depended.
Secretary of the Treasury Salmon P. Chase began agitating for an improved banking system in 1861. On 25 February 1863, Congress passed the National Banking Act, which created the National Banking System. Its head officer was the comptroller of currency. It was based on several recent reforms, especially the Free Banking System's principle of bond-backed notes. Nonetheless, the reserve requirements for bank notes were high, and the law forbade real estate loans and branch banking, had stiff organization requirements, and imposed burdensome taxes. State banks at first saw little reason to join, but, in 1865, Congress levied a prohibitive 10 percent tax on their bank notes, which drove most of these banks into the new system. The use of checks had been increasing in popularity in the more settled regions long before the Civil War, and, by 1853, the total of bank deposits exceeded that of bank notes. After 1865 the desire of both state and national banks to avoid the various new restrictions on bank notes doubtless speeded up the shift to this more convenient form of bank credit. Since state banks were less restricted, their number increased again until it passed that of national banks in 1894. Most large banks were national, however.
The National Banking System constituted a substantial improvement over the pre–Civil War hodgepodge of banking systems. Still, it had three major faults. The first was the perverse elasticity of the bond-secured bank notes, the supply of which did not vary in accordance with the needs of business. The second was the decentralization of bank deposit reserves. There were three classes of national banks: the lesser ones kept part of their reserves in their own vaults and deposited the rest at interest with the larger national banks. These national banks in turn lent a considerable part of the funds on the call money market to finance stock speculation. In times of uncertainty, the lesser banks demanded their outside reserves, call money rates soared, security prices tobogganed, and runs on deposits ruined many banks. The third major fault was that there was no central bank to take measures to forestall such crises or to lend to deserving banks in times of distress.
In 1873, 1884, 1893, and 1907, panics highlighted the faults of the National Banking System. Improvised use of clearinghouse certificates in interbank settlements some-what relieved money shortages in the first three cases, whereas "voluntary" bank assessments collected and lent by a committee headed by J. P. Morgan gave relief in 1907. In 1908 Congress passed the Aldrich-Vreeland Act to investigate foreign central banking systems and suggest reforms, and to permit emergency bank note issues. The Owen-Glass Act of 1913 superimposed a central banking system on the existing national banking system. It required all national banks to "join" the new system, which meant to buy stock in it immediately equal to 3 percent of their capital and surplus, thus providing the funds with which to set up the Federal Reserve System. State banks might also join by meeting specified requirements, but, by the end of 1916, only thirty-four had done so. A majority of the nation's banks have always remained outside the Federal Reserve System, although the larger banks have usually been members. The Federal Reserve System largely corrected the faults to which the National Banking System had fallen prey. Admittedly, the Federal Reserve had its faults and did not live up to expectations. Nevertheless, the nation's commercial banks had a policy-directing head and a refuge in distress to a greater degree than they had ever had before. Thus ended the need for the Independent Treasury System, which finally wound up its affairs in 1921.
Only a few national banks gave up their charters for state ones in order to avoid joining the Federal Reserve System. However, during World War I, many state banks became members of the system. All banks helped sell Liberty bonds and bought short-term Treasuries between bond drives, which was one reason for a more than doubling of the money supply and also of the price level from 1914 to 1920. A major contributing factor for these doublings was the sharp reduction in reserves required under the new Federal Reserve System as compared with the pre-1914 National Banking System.
By 1921 there were 31,076 banks, the all-time peak. Every year, local crop failures, other disasters, or simply bad management wiped out several hundred banks. By 1929 the number of banks had declined to 25,568. Admittedly, mergers eliminated a few names, and the growth of branch, group, or chain banking provided stability in some areas. Nevertheless, the 1920s are most notable for stock market speculation. Several large banks had a part in this speculation, chiefly through their investment affiliates. The role of investment adviser gave banks great prestige until the panic of 1929, when widespread disillusionment from losses and scandals brought them discredit.
The 1930s witnessed many reforms growing out of the more than 9,000 bank failures between 1930 and 1933 and capped by the nationwide bank moratorium of 6–9 March 1933. To reform the commercial and central banking systems, as well as to restore confidence in them, Congress passed two major banking laws between 1933 and 1935. These laws gave the Federal Reserve System firmer control over the banking system. They also set up the Federal Deposit Insurance Corporation to insure bank deposits, and soon all but a few hundred small banks belonged to it. That move greatly reduced the number of bank failures. Other changes included banning investment affiliates, prohibiting banks from paying interest on demand deposits, loosening restrictions against national banks' having branches and making real estate loans, and giving the Federal Reserve Board the authority to raise member bank legal reserve requirements against deposits. As a result of the Depression, the supply of commercial loans dwindled, and interest rates fell sharply. Consequently, banks invested more in federal government obligations, built up excess reserves, and imposed service charges on checking accounts. The 1933–1934 devaluation of the dollar, which stimulated large imports of gold, was another cause of those excess reserves.
During World War II, the banks again helped sell war bonds. They also converted their excess reserves into government obligations and dramatically increased their own holdings of these. Demand deposits more than doubled. Owing to bank holdings of government obligations and to Federal Reserve commitments to the treasury, the Federal Reserve had lost its power to curb bank-credit expansion. Price levels nearly doubled during the 1940s.
In the Federal Reserve-treasury "accord" of March 1951, the Federal Reserve System regained its freedom to curb credit expansion, and thereafter interest rates crept upward. That development improved bank profits and led banks to reduce somewhat their holdings of federal government obligations. Term loans to industry and real estate loans increased. Banks also encountered stiff competition from rapidly growing rivals, such as savings and loan associations and personal finance companies. On 28 July 1959, Congress eliminated the difference between reserve city banks and central reserve city banks for member banks. The new law kept the same reserve requirements against demand deposits, but it permitted banks to count cash in their vaults as part of their legal reserves.
Interest rates rose spectacularly all during the 1960s and then dropped sharply in 1971, only to rise once more to 12 percent in mid-1974. Whereas consumer prices had gone up 23 percent during the 1950s, they rose 31 percent during the 1960s—especially toward the end of the decade as budget deficits mounted—and climbed another 24 percent by mid-1974. Money supply figures played a major role in determining Federal Reserve credit policy from 1960 on.
Money once consisted largely of hard coin. With the coming of commercial banks, it came also to include bank notes and demand deposits. The difference, however, between these and various forms of "near money"—time deposits, savings and loan association deposits, and federal government E and H bonds—is slight. Credit cards carry the confusion a step further. How does one add up the buying power of money, near money, and credit cards? As new forms of credit became more like money, it was increasingly difficult for the Federal Reserve to regulate the supply of credit and prevent booms.
Since 1970 banking and finance have undergone nothing less than a revolution. The structure of the industry in the mid-1990s bore little resemblance to that established in the 1930s in the aftermath of the bank failures of the Great Depression. In the 1970s and 1980s, what had been a fractured system by design became a single market, domestically and internationally. New Deal banking legislation of the Depression era stemmed from the belief that integration of the banking system had allowed problems in one geographical area or part of the financial system to spread to the entire system. Regulators sought, therefore, to prevent money from flowing between different geographical areas and between different functional segments. These measures ruled out many of the traditional techniques of risk management through diversification and pooling. As a substitute, the government guaranteed bank deposits through the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation.
In retrospect, it is easy to see why the segmented system broke down. It was inevitable that the price of money would vary across different segments of the system. It was also inevitable that borrowers in a high-interest area would seek access to a neighboring low-interest area—and vice versa for lenders. The only question is why it took so long for the pursuit of self-interest to break down regulatory barriers. Price divergence by itself perhaps was not a strong enough incentive. Rationing of credit during tight credit periods probably was the cause of most innovation. Necessity, not profit alone, seems to have been the cause of financial innovation.
Once communication between segments of the system opened, mere price divergence was sufficient to cause flows of funds. The microelectronics revolution enhanced flows, as it became easier to identify and exploit profit opportunities. Technological advances sped up the process of market unification by lowering transaction costs and widening opportunities. The most important consequence of the unification of segmented credit markets was a diminished role for banks. Premium borrowers found they could tap the national money market directly by issuing commercial paper, thus obtaining funds more cheaply than banks could provide. In 1972 money-market mutual funds began offering shares in a pool of money-market assets as a substitute for bank deposits. Thus, banks faced competition in both lending and deposit-taking—competition generally not subject to the myriad regulatory controls facing banks.
Consolidation of banking became inevitable as its functions eroded. The crisis of the savings and loan industry was the most visible symptom of this erosion. Savings and loans associations (S&Ls) had emerged to funnel household savings to residential mortgages, which they did until the high interest rates of the inflationary 1970s caused massive capital losses on long-term mortgages and rendered many S&Ls insolvent by 1980. Attempts to re-gain solvency by lending cash from the sale of existing mortgages to borrowers willing to pay high interest only worsened the crisis, because high-yield loans turned out to be high risk. The mechanisms invented to facilitate mortgage sales undermined S&Ls in the longer term as it became possible for specialized mortgage bankers to make mortgage loans and sell them without any need for the expensive deposit side of the traditional S&L business.
Throughout the 1970s and 1980s, regulators met each evasion of a regulatory obstacle with further relaxation of the rules. The Depository Institutions Deregulation and Monetary Control Act (1980) recognized the array of competitors for bank business by expanding the authority of the Federal Reserve System over the new entrants and relaxing regulation of banks. Pressed by a borrowers' lobby seeking access to low-cost funds and a depositors' lobby seeking access to high money-market returns, regulators saw little choice but capitulation. Mistakes occurred, notably the provision in the 1980 act that extended deposit insurance coverage to $100,000, a provision that greatly increased the cost of the eventual S&L bailout. The provision found its justification in the need to attract money to banks. The mistake was in not recognizing that the world had changed and that the entire raison d'être of the industry was disappearing.
Long-term corporate finance underwent a revolution comparable to that in banking. During the prosperous 1950s and 1960s, corporations shied away from debt and preferred to keep debt-equity ratios low and to rely on ample internal funds for investment. The high cost of issuing bonds—a consequence of the uncompetitive system of investment banking—reinforced this preference. Usually, financial intermediaries held the bonds that corporations did issue. Individual owners, not institutions, mainly held corporate equities. In the 1970s and 1980s, corporations came to rely on external funds, so that debt-equity ratios rose substantially and interest payments absorbed a much greater part of earnings. The increased importance of external finance was itself a source of innovation as corporations sought ways to reduce the cost of debt service. Equally important was increased reliance on institutional investors as purchasers of securities. When private individuals were the main holders of equities, the brokerage business was uncompetitive and fees were high, but institutional investors used their clout to reduce the costs of buying and selling. Market forces became much more important in finance, just as in banking.
Institutional investors shifted portfolio strategies toward equities, in part to enhance returns to meet pension liabilities after the Employment Retirement Income Security Act (1974) required full funding of future liabilities. Giving new attention to maximizing investment returns, the institutional investors became students of the new theories of rational investment decision championed by academic economists. The capital asset pricing model developed in the 1960s became the framework that institutional investors most used to make asset allocations.
The microelectronics revolution was even more important for finance than for banking. Indeed, it would have been impossible to implement the pricing model without high-speed, inexpensive computation to calculate optimal portfolio weightings across the thousands of traded equities. One may argue that computational technology did not really cause the transformation of finance and that increased attention of institutional investors was bound to cause a transformation in any event. Both the speed and extent of transformation would have been impossible, however, without advances in computational and communications technologies.
