This post is intended for students of the economy and finance to learn something about the banking system, its supervision and how the regulations came to be undone. By standards of the normal post, this is quite long and intense in its subject matter. However, I hope it brings a little insight on the history of banking and the financial crisis we’re facing in 2009. Getting out of the crisis will require different approaches from those taken during the last spectacular economic crisis that some among us still have a memory of, the Great Depression.
Bank Numbers
Currently, there are roughly 8,000 banks in the United States. The number of banks was once as high as 30,000 at the beginning of the 1920s. However, that number shrank to about 15,000 banks by 1933 as a result of the large number of bank failures that occurred during the early years of the Great Depression. The number of banks stayed relatively constant at that level through the late 1980s. Since then the number of banks decreased to the current number of 8,000.
U.S. banks and bank holding companies were restricted to operating within a single state. No interstate banking was allowed. In addition, many states did not allow banks to open branch offices throughout a given state. So if a community needed a bank to finance economic activity, a new bank would likely need to be created with its own charter to operate instead of an existing bank coming into the community and opening a branch office. This largely explains the large number of banks within the United States in the thousands compared to a few hundred in other major nations or even a handful of banks in less populous countries.
The Roaring ’20s and The Great Depression
At the turn of the twentieth century, Wall Street was not a place for the ordinary, risk averse investor. There was not a great deal of information about public companies available to the public and what information that was available was likely to be in the hands of a few stock market manipulators. One group of the market manipulators was the large “money center” banks that operated in New York City where the major stock exchanges were located. These banks had the advantage with regard to information on many public companies because they engaged in investment banking services that sold the securities, both stocks and bonds, to the public. By working with the companies to sell their securities, the banks got to know their client companies very well and they could use the information they attained to sell and purchase securities at opportune times that the rest of the investing community could not. And to encourage the purchase or sale of securities, these banks regularly made loans to securities investors, speculators, and dealers, often for the full amount of the transaction and without any collateral to protect the bank in case a transaction suffers losses.
Despite having the deck stacked against them, investors nevertheless purchased equities during the “Roaring ’20s” in one of the greatest asset bubbles in U.S. history. And not only were equity prices rising at a then unimaginable pace, but the price of real estate in places like Florida also was leaping. Of course, this was made possible by the credit that was extended to these investors and mortgage holders by commercial banks. Moreover, as these asset prices increased, the banks extended even greater amounts of credit because the equity value in both stocks and real estate gave these borrowers more “collateral.”
Needless to say, all good things must come to an end. In October of 1929 saw the beginning of one of the greatest asset deflations ever. Real estate values plummeted and equity prices lost almost 90 percent of their former value. With the value of their homes and securities having fallen in value, people understandably wanted to raise cash to assure that they had enough to pay bills and debts that might come do. So they raided the banks to take out their deposits. However, the banking system works on a fractional reserve system, meaning that only a small part of the deposits are kept by the banks and the rest is used to provide loans. The banking system continues to work so long as most depositors do not make withdrawals at the same time. But once too many depositors ask for withdrawals at the same time, the banks will need to recover at least some of the cash that they loaned to borrowers at a time when the borrowers may not be able to pay back the loan. The inability to convert assets such as loans into cash will make a bank insolvent no matter how secure the loans made were. This was the situation depositors faced in the early 1930s as they attempted to pull out their funds en masse in what are called bank runs. And as they tried to raise enough cash to keep themselves in business, the banks stopped extending further credit to otherwise good credit risks for fear they may not get the money back. This had a further depressing effect on economic activity.
As a result of the devastation of the financial system of the 1930s, the Congress enacted several pieces of legislation that were meant to protect bank depositors and securities’ investors and make the banking system and the securities industry among the most heavily regulated in the economy. Specifically with regard to the banks, the Congress passed the Banking Act of 1933, which is better known as the Glass-Steagall Act after its sponsors. Among the provision in the law, the Glass-Steagall law:
1. Separated commercial banking from investment
2. Prohibited national banks from underwriting insurance products except for certain safe lines of business, such as life insurance, that are approved by state insurance regulators
3. Gave the Federal Reserve the power to set the maximum interest rates it could pay on deposits
4. Limited the debt securities that banks could purchase to those that are approved by bank regulators
In addition, the federal government insured a certain amount of deposits held at the banks so that depositors would have confidence in the safety of the banks.
Foreign Competition
Following the Second World War the United States was the largest economy on earth and the engine of growth for most of a war-ravaged world. U.S. businesses wanted to help nations devastated by the war to rebuild and foreign businesses wanted to sell to American consumers who, after the war, would start families as American service-people returned from conflict abroad and could now start buying the goods and services that were not available because of the wartime restrictions. With U.S. businesses selling and operating overseas and foreign businesses selling and operating in the U.S., it is not surprising to find that foreign banks became competitors to U.S. banks. These foreign banks wanted to get at least some of the business of U.S. companies operating within their home territory as new clients and they also wanted as much of the business of their current clients operating in the U.S.
Imagine, if you will (to borrow a line from the TV series The Twilight Zone), two gladiators battling in the Roman Coliseum in a fight to the death and one of the gladiators has one arm tied behind his back so that he cannot hold a shield to protect himself from the blows of his opponent. This was essentially the situation facing the U.S. banks at the start of the second half of the twentieth century. Because foreign banks are chartered and domiciled outside the U.S., they escaped the financial regulatory framework that affected the U.S. banking industry for many years. In other words, foreign banks could offer services within the U.S. that their American counterparts could only dream of offering. These included interstate bank branching, investment banking operations to sell securities for their U.S. clients, and insurance products. In addition to these advantages, foreign banks operating in the U.S. did not have U.S. deposit insurance, so they avoided the expense of the deposit insurance premiums, and they were not required to hold a portion of their American deposits on reserve with the Federal Reserve System, allowing them an opportunity to lend out more credit per dollar of deposits than their U.S. counterparts.
Clearly, the banking industry was outraged. They were at a competitive disadvantage against foreign banks and they demanded that the situation be redressed by the U.S. Congress. The result was the passage of the International Banking Act (IBA) of 1978. The IBA of 1978 addressed a number of the iniquities between U.S. and foreign banks operating in the United States. Among the provisions it included were:
1. The allowance of federal chartering of foreign banking facilities
2. The prohibition of multiple state banking activities of both domestic and foreign banks
3. The imposition of reserve requirements and federal deposit insurance on the U.S. deposits of foreign banks
4. Subjecting the U.S. operations of foreign banks to the non-banking provision of the Bank Holding Act. Specifically, all banks, foreign and domestic, must adhere to intrastate and interstate bank branching restrictions
While the IBA of 1978 did much to even the playing field in the U.S. banking industry, foreign banks operating in the U.S. nevertheless escaped regulatory oversight from U.S. banking authorities. This lack of supervision was a reason for the spectacular collapse of the Bank of Credit and Commerce International (BCCI). The scandal that followed the BCCI’s collapse led to the enactment of the Foreign Bank Supervision Enforcement Act (FBSEA) of 1991, which gave the Federal Reserve the authority to oversee the activities of all foreign banks operating in the U.S. and examine each U.S. office of a foreign bank each year.
Domestic Competition
Domestic banks weren’t only facing competition from foreign banks. In the 1980s and 1990s deposit growth slowed as a result of better returns that were being provided by very safe and short-term money market funds and by more risky but more highly rewarding equities (common stocks). The growth in deposits was further impeded by the development and growth of the mutual fund industry at around that time. With mutual funds, savers and investors did not require large amounts of funds to purchase these securities individually. Instead, they could deliver their money to a mutual fund that would invest the proceeds by purchasing the securities for them in exchange for shares of ownership in the mutual fund.
Instead of seeing their deposit base deteriorate, many banks established their own mutual fund companies through non-bank subsidiaries. Furthermore, banks came to offer brokerage services so that investors might purchase stocks and bonds through the banks rather than through a traditional brokerage firm. The move toward offering securities not traditionally associated with banks was given greater impetus when in 1987 the Federal Reserve allowed banks to offer investment banking services as long as such services make up a small fraction of the banks’ revenues. Investment banks are firms that aid corporate and government clients to package and sell securities so they may be able to raise funds. By offering investment banking services, the banks could earn underwriting (selling) fees that did not depend on their traditional business of collecting interest on the loans made with depositors’ funds.
Even though these were not intended to be major operations of the bank, the inclusion of mutual funds, brokerage services, and investment banks did represent a major erosion of the intent of the Glass-Steagall Act to prohibit commercial banks from selling investment securities to the public. In addition to offering investments to the public that were not traditional to banks, the banks also were making incursions into the management of risk by offering insurance products. A firm underwriting insurance is required to keep enough reserves on hand to maintain the solvency of the firm in case a significant amount of insurable claims must be paid out. If it were to sell insurance policies, a bank is required to keep reserves on hand for the needs of depositors and separate reserves for their insurance operations. Together this represents a large capital commitment on the part of banks that many of them may not have been prepared for.
The Financial Services Modernization (Gramm-Leach-Bliley) Act
The incursions that foreign banks were making in the United States, the competition for cash that mutual funds and other financial institutions were forcing upon the financial industry, and the responses to those threats by the banking system seemed inevitably to erode much of the restrictions on the activities of banks that were imposed in the wake of the Great Depression. Indeed, by the late 1990s the industries that were threatening the banks, such as mutual funds, securities brokers, investment banks, and insurance companies claimed to be threatened by the banks. This was because since the Great Depression it had been national policy for the federal government to assure the solvency of the banks and the protection of bank depositors. No other group of financial institutions had comparable protections in place and these other institutions started to say “if the banks are allowed to compete against us, why can’t we compete against the banks?”
Since the late 1970s the mood of the country had been shifting away from an attitude favoring regulation of certain industries, in which the firms within these industries had little to no discretion on specific aspects of the firms’ operation to allowing more discretion and risk taking by the managers within these firms.
With firms within the financial services industry complaining about the competition and incursions being made by the other firms within the industry, perhaps it was a matter of time that the financial services industry was going to be “deregulated” by those who favored continued regulation and “unshackled” by those who favored the removal of most of the regulation of financial services. The removal of most of the regulations came in 1999 with the Financial Services Modernization Act (FSMA). Also called Gramm-Leach-Bliley Act after its congressional sponsors, the FSMA was enacted to allow U.S. financial institutions to offer the kinds of services and activities that were available at “universal” banks that exist in much of Europe and Asia. Specifically, the FSMA was designed to restructure the financial services industry by creating what are called financial holding companies (FHCs) that are able to offer a wide range of services that they were previously prohibited from offering. As a result of the FSMA, firms that previously offered one type of financial service (banking, mutual funds, brokerage services, etc.) became free to engage in providing services and other activities that had been the province of different types of financial firms.
Aftermath of Financial Deregulation
For most of the twentieth century, there were clear lines in which financial institutions were to operate:
1. Commercial banks and savings institutions were to be engaged in traditional banking services
2. Investment banks were to raise funds by selling new securities for their corporate and governmental clients
3. Brokerage firms were to arrange the exchange of existing securities in the securities markets
4. Insurance companies were to engage in providing risk control products and services in exchange for payment of premiums
But toward the close of the century the financial landscape became terribly blurred with any provider of one financial service now able to offer other services that were the specialty of a different type of financial services firm. If this was confusing for the consumer of financial services, the near free-for-all in the financial services industry appeared to be equally confusing for the financial services regulators. Who regulates a financial institution that engages in banking, selling and trading securities, insurance, and real estate? Even though the FSMA gave the Federal Reserve the power to oversee these new financial conglomerates, its traditional emphasis on the banking system left it ill equipped for the task.
Moreover, the last twenty years of the twentieth century were dominated by presidents of the United States who were more sympathetic with the efficacy of the free markets to regulate themselves than at any time since the first third of the century. Thus, when the competition within the financial services industry became heated, the firms within the industry attempted to make up for any decline in the profitability of a dollar’s worth of assets by taking on more leverage, either in the traditional way of borrowing money or by taking on added risk of loss on certain securities in the hope that returns would be substantially greater. And while the financial services industry was taking on this added leverage, the financial regulators either sat on their hands because of their dogmatism or were in paralysis from doing anything because of bureaucratic turf wars.
Now we are in a situation in which the American public has lost confidence in the integrity of the U.S. financial system and the free market option of leaving it alone is no longer an acceptable solution when the financial collapse is affecting industries and people well removed from the financial centers. Thus we now hear calls for re-regulation of the financial services industry. However, it would be a mistake to think that the past is prologue. The financial services industry at the beginning of the twenty-first century is very different from what it was at the beginning of the twentieth century when much of the current regulatory structure was formed. The services provided by the firms are more diverse and complex, requiring a team approach to regulating the industry in which the separate regulatory authorities must join forces to regulate firms that engage in more than one financial activity. In addition, the reach of these financial firms are now global in nature as many are engaged in provided financial services across national borders. This aspect of the modern financial landscape now requires that the regulators from different nations need to coordinate their efforts and set common financial standards to make sure of the safety and integrity of multinational financial enterprises.
Just as during the Great Depression, the current financial crisis was a failure of the system to maintain its integrity by making sure the institutions were adequately supervised and capitalized. But the current financial environment is such that the measures taken in the past are not likely to work in the present. The financial system is too broad and too complex to be treated either in a segmented fashion or by one country’s regulatory efforts alone. Coordinated regulatory efforts within and among countries are what is needed to make sure such a catastrophe doesn’t happen again in our lifetimes.
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