History of Banking Regulation in the USA
The following excerpt provides a historical synopsis of the development of the banking system in the USA.
[SYSTEMS PRECEDING THE FEDERAL RESERVE ACT OF 1913]
The United States began life in fiscal and monetary disarray. Lacking power to tax, the Continental Congress had difficulty paying the revolutionary government's bills--except through an outpouring of paper money. This money lost so much of its purchasing power as to elicit the gibe "not worth a continental." The lack of reliable, uniform currency impeded commerce. To make payments, people used a mishmash that included federal and state paper money, foreign and domestic coins, and (after 1781) bank notes. Specie (i.e., gold or silver), the most trusted store of value, remained chronically scarce.
The Constitution of 1787 contained several clauses designed to bring order to the nation's fiscal and monetary affairs. It empowered the federal government to "coin Money, regulate the Value thereof, and of foreign Coin." It forbade the states to "coin Money; emit Bills of Credit; [or] make any Thing but gold and silver Coin a Tender in Payment of Debts." (The prohibition against "Bills of Credit" --i.e., paper money -- did not affect circulating bank notes because contemporaries regarded such notes not as paper money but as paper convertible into money.) The Constitution also empowered the federal government to regulate interstate and foreign commerce. It said nothing about whether Congress could charter a bank or other corporation. However, under the principle that the federal government has only those powers expressly granted in the Constitution, silence was generally understood to mean that Congress lacked such power.
As of 1790, Philadelphia, New York, and Boston each had its own state-chartered bank, with another about to open in Baltimore -- giving the new nation a total of four banks. That year Treasury Secretary Alexander Hamilton sent Congress hi "Report on a National Bank," in which he proposed that Congress create a Bank of the United States modeled on the Bank of England -- a privately owned bank with important public functions. He explained how such a bank could provide a uniform paper currency good for all payments due to the government; help the government better administer public finances by making loans to the Treasury and facilitating the collection of taxes; and, more broadly, augment the productive capital of society and thus help create a strong and prosperous nation.
Hamilton proposed that the bank have an authorized equity capital of $10 million, enough to support an extensive circulation of bank notes. The government would subscribe $2 million, paying with its own bonds. The public would subscribe the rest, paying one-fourth in specie (to assure adequate specie reserves) and three-fourths in the government's 6 percent bonds, thus strengthening the government's credit by increasing the demand for government bons. The bank would operate under private management, with government oversight -- a governance structure designed to foster public confidence in the bank's notes. Private management, seeking to maintain the bank's reputation and thus also the value of the bank's stock, would recognize the importance of promptly redeeming teh bank's notes in specie; only when truly necessary would it refuse to redeem notes (suspend redemption). Government oversight would prevent the management from running amok.
Hamilton's proposal encountered considerable opposition. James Madison, who had played a key role in drafting the Constitution, led those in Congress who regarded the bank as unconstitutional. The Constitution, he argued, had granted the federal government only certain specific powers. These did not include the power to incorporate a bank. The bank would, moreover, interfere with the states' sovereign right to decide for themselves whether to establish or prohibit banks in their territory. Others in Congress -- the agrarians -- opposed the bank on much simpler grounds: they viewed all corporations as evil instruments of an antidemocratic elites. Thomas Jefferson later encapsulated the agrarian hostility to bankers (as well as merchants industrialists) when he affirmed states' right to "exclude them . . . , as we do persons afflicted with disease."
Despite the opposition, the bank garnered a two-thirds majority in each congressional house, with northerners and Federalists voting overwhelmingly for it and southerners and Republicans voting overwhelmingly against. The charter was more detailed and restrictive than prior state bank charters. It prohibited the bank from trading in goods and from holding land other than forfeited collateral. The charter would expire after 20 years.
Upon receiving the bill from Congress in 1791, President Washington faced a difficult decision. Jefferson, his secretary of state, argued that the bank, although perhaps convenient, was not strictly necessary and hence was unconstitutional. Treasury Secretary Hamilton countered that the Constitution sought to establish a workable government and permitted Congress to use any means "fairly applicable" to achieving the purposes of that government. The difference between Jefferson and Hamilton was simple but fundamental. Jefferson feared concentrated power in any form; Hamilton feared the lack of it. Jefferson wanted a weak government that would leave the people to their own devices; Hamilton wanted a strong government that would lead the nation to prosperity. Hamilton won the battle (and ultimately the war). Washington signed into law the charter for the Bank of the United States.
In December 1791, with its public stock heavily oversubscribed, the Bank of the United States opened its doors in Philadelphia, then the nation's capital and largest city. Eventually it established eight branches despite Hamilton's protestations that dividing the bank's operations would weaken it. Some branches met with hostility; Georgia imposed a tax on the Savannah branch and forcibly entered the bank's vaults to collect it. The bank sued to regain its specie, but lost on jurisdictional grounds. Bank of the United States v. Deveaux, 9 U.S. (5 Cranch) 61 (1809).
Viewed as a commercial bank, the Bank of the United States operated conservatively. It needed to keep available a large reserve of specie to ensure the government a ready source of loans. The bank also initially sought, through conservative management, to minimize interference with state bank business and thus allay state bank hostility. It failed of this second objective; through its sheer size, the bank quickly came to dominate commercial lending.
In its "official" functions the bank was an unqualified success. It efficiently managed tax collections, government disbursements, and foreign exchange. By issuing 20 percent of all bank notes in circulation, it provided a uniform currency for transactions with the government. It enjoyed a near monopoly in government loans, though the Treasury occasionally spread tokens to state banks. This monopoly became ever less important, however, as the government began retiring its debt after 1800, and the bank held fewer and fewer government obligations. Indeed, the government became the bank's largest net depositor. Thus one of the bank's originally intended functions -- bolstering the government's credit -- proved unnecessary.
The bank achieved its greatest success by evolving into a central bank regulating the nation's money supply -- a result neither anticipated nor intended. Indeed, in 1791 Congress had perceived no need for a central bank. The Constitution, authorizing Congress to coin money and set its value, envisioned a self-adjusting specie mechanism that required no outside monetary control.
Nevertheless, the Bank of the United States became a central bank. Two factors were critical in this development: the proliferation of state banks, which helped make a banking system out of the few, scattered banks that had existed in 1790; and the sheer size of the Bank of the United States, which enabled it to play the central role in that system. The bank received a large and continuous flow of state bank notes. This flow permitted the bank to regulate credit nationwide. When the bank wanted to restrain credit, it redeemed the notes it received promptly, thereby forcing the other banks to keep greater specie reserves to meet the redemptions. Conversely, when the bank wanted to stimulate credit, it showed forbearance. It complemented this strategy by decreasing or increasing its own lending activities, as the case required -- and because it controlled so much specie (by 1811 fully 50 percent of bank-held specie), this had a great added effect. Needless to say, the bank's activities however useful, made it few friends among state bankers.
The national political scene changed dramatically during the bank's 20-year existence. Republicans replaced Federalists in power. Yet the bank flourished. Jefferson, although never wavering in his dislike for the bank, simply ignored it as president, delegating responsibility for it to his Treasury secretary, Albert Gallatin. When the time came to renew the bank's charter, James Madison, who had succeeded Jefferson as president actually led the fight for the bank. He argued that history had proved the bank a near necessity, and that two decades of annual legislative Acts tacitly recognizing it had persuaded him of its constitutionality. The bank had some friends in Congress who agreed with Madison. But their advocacy was uninspiring: as a rallying cry, "near necessity" rights hollow when the opposition screams "abomination." Meanwhile, the bank's insiders remained passive. Its directors were politically inept, and felt no duty to lobby for the bank. Its shareholders, overwhelmingly foreign, believed that prudence dictated silence.
The bank's opponents felt no such constraints. Some were hardened agrarians venting their usual rage. Most werw businessmen with interests in state banks. They emphasized how the landscape had changed since 1791. Now there were state banks everywhere capable of rendering the government any service that the Bank of the United States provided. Thus by definition the bank was unnecessary. These businessmen had a mercenary aim: they knew that the bank's business would have to go to state banks. They also knew that the bank's demise would tend to loosen credit, reduce competition with state banks, and generally increase state banks' profitability. The states joined in with the businessmen; they held large ownership stakes in their banks and coveted the gains to be had from destroying the federal bank.
The congressional debates of early 1811 suppressed the real issues in favor of the idealism of constitutionality. Fully 35 of the 39 speeches on the bank's recharter centered on the constitutional issue. Debate also focused on the bank's assumption of central banking functions and its alleged interference with state banks and states' rights. In addition, opponents assailed the alleged dominance of the bank by its foreign (largely British) stockholders -- even though foreign stockholders could not vote their shares. Vote or no, the foreigners benefitted from a government monopoly, and the dividends paid to them were but a degrading tribute.
In the face of this opposition, bills to recharter the bank failed. The House postponed action indefinitely by a one-vote margin. The Senate defeated a bill by a one-vote margin. Given the virulence of the antibank rhetoric, the bank had won a moral victory of sorts. But it was still dead, and its dissolution began almost immediately.
. . .
The bank was dead, but banking flourished. Many of the bank's operation continued in private hands after 1811. The Philadelphia office, acquired by businessman Stephen Girard, carried on as a private banking firm housed in the same building and operated by the same staff. Entrepreneurs also opened many new banks under state charters. Accordingly, the total volume of banking operations increased dramatically between 1811 and 1816 -- the interregnum between the two United States banks -- with bank notes in circulation and commercial loans each more than doubling.
But the new banking system soon ran into trouble. When the British burned Washington in 1814 and the government fled in disarray, banks across the country experienced runs on specie and stopped paying it out. State authorities proved unable or unwilling to force banks to redeem their notes in specie or close. Bankers reaped a windfall, as they no longer had to maintain large specie reserves; they could treat their bank notes as indefinite, interest-free loans from the public. But noteholders incurred losses and commerce suffered as bank notes depreciated. The federal government, forced to accept depreciated state bank notes as payment for taxes, defaulted on some of its bonds. Government debt now depreciated as well, and the Treasury had great difficulty selling additional bonds.
These chaotic conditions stimulated renewed calls for a national bank. Holders of government bonds saw such a bank as improving their prospects of repayment. State banks feared that the measure would increase competition in banking and force them to resume specie redemption. But given the nation's manifest fiscal and financial disorders, the state banks lacked the political muscle to prevail. In 1816 Congress granted a new Bank of the United State a 20-year charter.
The bank was dead; long live the bank. The second bank was just as powerful as the first and much bigger. Moreover, the economy boomed as the nation industrialized, holding forth the prospect of ever-increasing demand for the bank's services. The bank's rechartering after 20 years seemed inevitable.
But things quickly soured. The bank's original directors were incompetent or worse. The bank suffered all sorts of financial chicanery, insider loans, and outright frauds. The worst abuses occurred at the Baltimore branch, where the cashier, one James McCulloch, lent himself half a million dollars on non collateral as part of a fraudulent conspiracy that eventually cost the bank more than $1.5 million.
Within two years after its resurrection, the bank found itself financially prostrate and politically unpopular. State governments began to enact punitive taxes aimed at driving the bank out of business or at least out of state. McCulloch, whose misdeeds had yet to be exposed, refused to pay the Maryland tax and the state promptly sued him for nonpayment.
The case eventually reached the Supreme Court, giving rise to in one of the leading constitutional decision of the nineteenth century: McCulloch v. Maryland, 17 U.S. 94 Wheat.) 316 (1819). Chief Justice Marshall's opinion sustaining congressional power to charter a bank, and precluding Maryland from taxing a bank so chartered, is best known today for its sweeping interpretation of the federal commerce power. At the time, however, the opinion was equally important for its practical consequences. If a state could impose hostile taxes on the bank or its branches, then the bank could not survive as a national institution. The McCulloch decision granted the bank a reprieve from execution at the hands of the state governments.
Eventually the bank came under responsible management. Frauds and chicanery ceased. The bank evolved into a central bank in the modern sense under the leadership of the brilliant but politically inept Nicholas Biddle, who became its president in 1823. Under Biddle's guidance the bank regulated the money supply by redeeming state bank notes for specie. It stabilized the currency, protected credit markets, and assisted the Treasury Department's operations. It encouraged state banks to maintain adequate specie reserves, thus assuming a de facto regulatory role in the banking system nationwide.
Despite (or perhaps because of) these accomplishments, the bank remained unpopular in many circles. State bankers, financial speculators, and business entrepreneurs saw the bank as a threat to profits and a stumbling block to economic growth. Western farmers who had purchased land on credit blamed the bank for difficulties they had in repaying the loans, even though they had usually borrowed from state banks. State politicians saw the bank as an unwarranted intrusion of federal power into areas reserved for state autonomy.
These interests had little in common besides disliking the bank. For several years opposition remained sporadic and disorganize. But in President Andrew Jackson the bank's foes gained a leader whose courage and determination were exceeded only by his implacable hatred of the bank. Jackson associated banking with fraud, monopoly, and special privilege. He believed that the Constitution prohibited state banks from issuing bank notes, generally prohibited Congress from chartering banks, and thus precluded any money except gold and silver. He welcomed that result, as he believed that paper money harmed ordinary people by promoting speculative booms and busts. And he had his own name for the bank: "the Monster."
When Congress passed a bill rechartering the banking 1832, Jackson vetoed it, issuing a veto message destined to become one of the leading state papers in American history. For all its fame, that message today appears as a jumble of contradictory ideas and distorted analysis. The bank's existence unconstitutionally infringed on state's rights, the president declared -- despite Supreme Court decisions and decades of broad consensus to the contrary. The bank was a tool of the rich -- even though the bank's most influential opponents were at least as rich as the bank's shareholders. The bank could not be trusted to serve American interests because "more than a fourth part of the stock is held by foreigners" -- even though foreign investors could not vote their shares. Whatever his logic, Jackson had scored a political triumph, which help secure his reelection. The bank was doomed.
Jackson followed up his advantage by transferring the government's deposits from the bank to specially favored state banks -- derided by his critics as the "pet bank." The bank, mortally wounded, died quietly when its charter expired in 1836. Its main office in Philadelphia continued under Biddle's leadership with a state charter but, after initial successes failed in 1841, leaving Biddle ruined and disgraced.
. . .
With the fall of the Bank of the United State, the nation embarked on an extended and often turbulent voyage of banking without a central bank. The central bank's demise had two principal effects. First, it unleashed powerful entrepreneurial forces eager to enter the lucrative banking business. These entrepreneurs pressed for state legislation allowing "free banking" -- that is, easy entry into banking without having to obtain a special legislative charter. Between 1837 and 1863, more than half of the states enacted free banking statutes, facilitating the formation of many new banks. Second, the bank's demise left the states alone responsible for overseeing the safety and soundness of banks. Although some states such as New York proved effective regulators, other states were much less capable.
The combination of free entry and state regulation helped define the era between 1836 and 1863, commonly known as the "free banking era." Currency consisted of bank notes issued by state banks. The holder of such a note generally had a legal right to redeem it instantly in specie at face value. But to do so the holder needed to present the note at the offices of the issuing bank -- a formidable task if those offices lay far from a major city. Moreover, even when presenting a note, the holder could have no assurance that the bank actually would redeem it in specie. The bank might have failed after issuing the note, or might simply be conserving its specie by suspending redemption. Either way, the holder would get no specie.
Accordingly, the bank notes traded at discounts from par (i.e., face) value reflecting the issuing bank's location and credit. For example, in 1845 in Philadelphia, New York bank notes traded for 99.25 cents per dollar of par value (a discount of 0.75 percent), but notes of some Michigan banks traded for 35 cents per dollar (a 65 percent discount). "Bank note reporters" published lists of these discounts showing the current value of state bank notes in different financial centers. The lack of a uniform currency trading at par created obvious difficulties for commerce because for each transaction merchants had to calculate into the price the value of the bank notes used to make payment.
"Wildcat banking" aggravated the problem of currency values. Wildcat banks located their offices inaccessibly -- so far from civilization that the only noises to be heard were the cries of the wildcat and other forest denizens. The owner of a wildcat bank would issue a flood of bank notes backed by minimal specie, calculating that few noteholders would ever find their way out to the wilderness to redeem the obligations. Although wildcat banking could occur under the old system of special charters, it was easier to perpetrate in free banking states because the entrepreneur could obtain a charter without having to convince the state legislature of his financial probity. Not surprisingly, wildcat banks failed at a far higher rate than their domesticated urban cousins.
Until recently most historians judged the free banking era a failure. They pointed to the problems of currency valuation as well as the large incidence of free bank failures. In Indiana, for example, 86 of the 104 free banks opened between 1852 and 1862 failed; even in New York, generally regarded as the most successful free banking state, 160 of the 449 banks established between 1838 and 1863 failed.
Some revisionist scholars have debunked this negative view of the free banking era. They observed that despite the high failure rate, noteholders usually received payment in full. One study estimates the total losses from bank failures in free banking states between 1837 and 1860 at less than $2 million, with more than half the losses occurring in only one state, Michigan. Some have also claimed that wildcat banking was not nearly as serious a problem as many believed. Others have noted that most free bank failures resulted not from fraud but from sharp declines in the market value of the banks' bond portfolios.
The debate between traditional and revisionist historians of the free banking era has obvious implications for banking policy today: viewing free banking as a failure, as in the traditional view, strengthens the case for governmental regulation of banking today; viewing free banking as a moderate success, as in the revisionist view, weakens that case.
. . .
Whatever its other merits, free banking did not readily lend itself to financing government operations. After some unsatisfactory dealings with state banks, the federal government withdrew from the banking system altogether in 1846 and established the independent Treasury system. Congress prohibited the government from using bank notes and required it to keep public funds in the custody of government officials rather than depositing them in banks.
The independent Treasury system served the nation's fiscal needs adequately in a time of domestic tranquility and limited, passive government. But the outbreak of the Civil War in 1861 highlighted the system's defects. President Lincoln found the Treasury empty when he took office. Worse yet, the federal government could not legally turn to banks for emergency credit. Moreover, even after Lincoln's Treasury secretary, Salmon P. Chase, obtained congressional authorization to borrow $150 million from northern banks, he found himself legally bound to demand payment in specie rather than bank credit, thus constricting the money supply and prompting massive hoarding of old -- a monetary effect exactly the opposite of what eh Union needed to sustain itself through a long, costly conflict. The shortage of gold and silver eventually forced banks and the federal government to suspend specie payments altogether.
Chase responded to the crisis by proposing a system that combined state free banking statutes with aspects of the old Bank of the United States. He essentially advocated a federal free banking regime, with federally chartered banks issuing a uniform national currency. The proposal did not affect state banks' legal status, but Chase expected that all or most state banks would convert to federal charters. State banks correctly viewed the proposal as portending federal regulation. But it proved politically popular because the public believed it necessary to finance the war and because businessmen wearied of the inconveniences of relying on state bank notes. Congress enacted Chase's proposal in the National Currency Act of 1863 and refined it in the National Bank Act of 1864.
Contrary to Chase's expectations, however, state banks did not rush to convert to national charters; the vast majority of national charters issued during the first few years went to new start-ups rather than converted state banks. Something of the stick was needed to supplement the carrot. Congress provided the stick in 1865 by imposing a punitive and constitutionally suspect 10 percent taxon state bank notes. State banks challenged the tax in court, but the Supreme Court sustained it in 1869, thus establishing an important constitutional precedent for the federal government's power to discriminate for regulatory purposes against an otherwise lawful industry. Veazie Bank v. Fenno, 75 U.S. (8 Wall.) 533 (1869). Salmon Chase, now chief justice, wrote the Court's opinion sustaining the tax, despite his own leading role in devising the national banking system.
. . .
Over the next half-century, three fundamental structural features came to mark the banking industry: (1) dual banking -- the system of overlapping state and federal chartering; (2) unit banking -- the principle that banks should conduct their business from only one office or, at most, from a few geographically proximate offices; and (3) market segmentation--the splintering of banking into commercial banks, on the one hand, and thrift institutions (savings and loans and savings banks), on the other. None of these features represented any conscious or deliberate choice by the political system. But once in place, they became deeply embedded political realities that have fundamentally shaped the regulation and politics of banking up to the present day.
a. The Dual Banking System
The tax on state bank notes sustained in Veazie Bank threatened the very existence of state banks because it effectively precluded them from issuing bank notes. For a while state bank seemed headed for extinction. The number of national banks grew from 66 in 1863 to 1,640 in 1868, even as the number of state banks fell from 1,466 to 247. Ultimately, however, the federal tax proved ineffectual. By the 1860s banks had developed the checking account into an effective substitute for bank notes. When making a loan a bank could simply credit the borrower's checking account instead of issuing the borrower bank notes. The borrower could then transfer money to others by writing them checks instead of giving them bank notes. The check, like the bank note, was redeemable at the bank on demand (assuming the customer had not overdrawn). The checking account represented an advance over the bank note because it gave the customer greater security and flexibility. And it avoided the prohibitory 10 percent tax because checks were not bank notes.
Thus even after Veazie Bank many banks retained state charters by simply replacing bank notes with checking accounts. After a low point in 1868 the number of state banks rebounded rapidly until, by the 1890s, it roughly equaled the number of national banks. Sates won the race for new banking charters because they offered banking entrepreneurs more desirable terms than the national bank charter; typically, much lower minimum capital requirements; no minimum reserve requirements; and less stringent investment restrictions (e.g., restrictions on a bank's power to make loans secured by real property). By 1914 state banks number 14,512 and national banks 7,518.
Thus the National Bank Act unintentionally created a "dual banking system" -- in which banks could choose between state and national charters and in which state and federal authorities compete to attract bank charters. The dual system has remained a pervasive feature of American banking law and regulation up to the present day, although by now the accident of its birth is often forgotten.
b. Unit Banking
The early history of U.S. banking would not have suggested that the industry would coalesce into a pattern of unit banking. As we have seen, the Bank of the United States operated a nationwide branching system. State banks' branching practices varied by region. New England banks almost never branched. In the South many banks operated branches in the modern sense, although the number of branches was never very large. The western (new midwestern) state of Indiana, Missouri, Ohio, and Iowa established state banks with monopoly powers and extensive branching networks; the State Bank of Ohio, established in 1845e, operated 36 branches by 1863. But unlike modern branch banking, in which branches are merely arms of the main bank, these early branching networks appear to have been loose confederations of separate institutions, in which the so-called branches actually enjoyed considerable autonomy in organization, capitalization, and operation. These western branching networks may have functioned as de facto cartels, with the main bank exercising authority to assure solvency, restrict interbank competition, and maintain monopoly profits.
Thus at the outbreak of the Civil War, branching practice followed three regional patterns, with branching virtually unknown in the Northeast; involving loose confederations of local institutions in the West; and involving limited branch networks -- of a type recognizable today -- in the South. Rarely, however, did laws specifically outlaw branching.
The National Bank Act profoundly changed this pattern. The Act contained two provisions that seemingly required a national bank to conduct its business at a single location. In fact these provisions sought not to outlaw branching but to suppress wildcat banking by requiring banks to have a fixed and permanent abode. Nevertheless, the comptroller of the currency quickly ruled that the National Bank Act prohibited branching by national banks.
The Act did not affect branching by state banks and, as amended in 1865, allowed state banks converting to national charter to retain their branching networks. Yet as a practical matter the statute also helped extinguish the state branching networks. The Civil War destroyed southern state banks and their old branch networks. The new banks that took their place had national charters and thus could not branch. In the West, national chartering destroyed the monopoly position -- and therefore the raison d'être--of the state branch banking networks. Most branch banks in the western states declared their independence and converted to federal charter. In the Northeast where branching had never taken hold, unit banking remained the norm among state banks after the Civil war as before.
The unit banking system, like the dual banking system, appears to have arisen by accident. Yet once established unit banking, like dual chartering, created vested interests that in subsequent years would vigorously contest legislative efforts to permit liberalized branching. Small banks, mostly with state charters, came to fear competition from big "money center" banks. They developed the ideology of the independent local bank that, they asserted, served the financial needs of small communities much better than would the urban leviathans, which would seek only to siphon capital and maximize profits.
A coalition of country bankers warned against branch banking at an American Bankers Association convention in 1902. Branch banking by national banks, they declared, would "create a brood of two hundred or three hundred great central banks, with 10,000 to 15,000 branches in large cities as well as small, and as such branches would have no capital and only figure-head management, individualism in management would cease, local taxes [would] be evaded, [there would be ] no home distribution of profits, local progress [would be] retarded, in short, the great central banks would skim the cream from the whole country to enrich [their own] exchequers."
This ideal of local autonomy became a fundamental tenet of banking policy and even today retains a powerful influence inbanking politics.
The charge that big-city banks would drain capital from rural areas range true insofar as the burgeoning cities then could make the most efficient -- and therefore the most profitable -- use of capital. But unit banking hardly precluded such capital flows. Small banks tended to have more deposits to invest than they could profitably lend in their localities. A system of correspondent banking evolved to reallocate capital across the nation. Small banks developed relationhships with big urbn banks in which the small bank kept part of its funds on deposit at the large bank, and the large bank, in return, provided check-clearing, investment brokerage, and advice, and other services for the small bank. Thus capital flowed to the cities from small towns and rural areas -- just as the unit bankers claimed would occur if branching were allowed.
The unit banking system -- coupled with the low minimum capital requirements typical for state banks -- profoundly affected the structure of the American banking industry by decentralizing it and multiplying the number of banks, as shown in the table below.
Year Number of Banks
1865 1,643
1880 2,696
1890 5,585
1900 8,100
1910 19,304
1914 22,030
The resulting U.S. system of decentralized small banks stood in sharp contrast to the system developing in other countries, such as Canada, with banking systems dominated by a small number of large banks operating nationwide branching networks.
c. Market Segmentation
The period from 1865 to 1913 witnessed the growth of a new species of banking institution. For whatever reason, banks had long defined their role as eserving the needs of commerce. Nineteenth century banks did not adequately nmeet the banking needs of individuals -- other than the wealthy and privileged few. The thrift industry arose to redress this deficiency and help the less privileged realize teh American dreams of financial security and home ownership.
As originally conceived, thethrift institution served a charitable rather than a profit-making purpose. The goal was social welfare, not private gain. Traditional thrift values received classic exposition in Frank Capra's 1946 film It's A Wonderful Life, in which Jimmy Stweart, as the local building and loan president, struggles to assist working people fend off the greedy machinations of the local commercial banker.
Two types of thrift institutions developed during the nineteenth century. Savings banks, located primarily in the Northeast, arose to help workers save part of their wages. Savings and loans (or building and loans) developed to help people of modest means save enough money to buy a home. Both types of institutions typically organized themselves in "mutual" form: they were owned by depositors rather than shareholders. Despite the difference in their original purposes (savings versus home ownership), savings banks and savings and loans exhibits no clear-cut functional distinction. But the legal distinction between the two became deeply embedded, giving rise to important differences in regulation.
The first savings bank was established in 1819 and thefirst savings and loand in 1831, but the great growth of thrift institutions occurred after teh Civil War. By 1887 the nation had more than 500 thrifts; by 1900, more than 5,000. The thrift industry ultimately became a political interest group with its own sophisticated lobby, sseeking special regulatory favors not available to commercial banks (such as federal and state tax exemptions).
The segmentation of the banking industry into commercial banks and thrifts profoundly affected the politics and economics of banking regulation, and some its consequences continue to the present.
[THE FEDERAL RESERVE ACT OF 1913]
The National Bank Act provided a uniform national currency and enabled the comptroller of the currency to exert some regulatory sway over the banking system as supervisor of national banks. However, the country still had no central authority like the Bank of England, with power adequate to soften macroeconomic ups and downs by regulating the money supply and to quell financial panics by serving as banks' lender of last resort. Perhaps for lack of such an authority, financial panics afflicted the U.S. economy in 1873, 1884, 1890, 1893, and 1907.
During the Panic of 1907, for example, the stock market crashed, interest rates on unsecured loans to stockbrokers reached 150 percent, and banks nationwide refused to redeem bank notes or allow significant deposit withdrawals, much less make loans. Such financial chaos caused pain throughout the economy. It also stood in sharp contrast to the order and rationality that business, led by such financiers as J. Pierpont Morgan Sr., sought through consolidation. True, the redoubtable Morgan had played a crucial role in stemming the panic. But people increasingly questioned the wisdom of depending so heavily on the sagacity of private financiers. Populists took an even dimmer view, charging that a Wall Street "money Trust" ruthlessly used such crises to aggrandize its own wealth and power.
Support for monetary reform grew across the political spectrum, with many bankers, business leaders, editorial writers, and Progressive politicians flocking to the cause. Congress established a National Monetary Commission, which exhaustively examined the U.S. banking system and foreign central banking experience. The commission eventually proposed creating a "Federal Reserve Association" -- a banker-owned, banker-run syndicate that would regulate the money supply (while freeing it from its narrow base of specie and government securities) and act as lender of last resort to the banking system. Large banks supported that plan. Progressives criticized the plan as oligopolistic, and advocated that the government itself perform the functions in question.
Woodrow Wilson championed monetary reform. During his 1912 presidential campaign, he echoed populist themes: "The great monopoly in this country is the money monopoly. . . . A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation . . . and all our activities are in the hands of a few men . . . who, necessarily, . . . chill and check and destroy genuine economic freedom. This is the greatest question of all. . . .
He sided with the Progressives in pledging to oppose "any plan which concentrates control in the hands of the banks." He also stressed the importance of keeping monetary power decentralized. Upon taking office, Wilson made monetary reform his highest legislative priority. Under his leadership, Congress in 1913 enacted the Federal Reserve Act -- the most revolutionary development in banking regulation since the National Bank Act of a half century earlier.
The new Federal Reserve System represented a hybrid of the competing approaches. The system included 12 regional Federal Reserve banks, modeled on bankers' clearinghouses -- private arrangements by which city banks cleared checks and made each other emergency loans. Each reserve bank enjoyed some autonomy; its member banks owned its stock and elected a majority of its directors. But a Federal Researve Board, appointed by the president and confirmed by the Senate, oversaw the reserve banks and could adjust their policies. Thus the system blended decentralization, private ownership, and governmental control.
The system facilitated efficient check clearing through bookkeeping entries at the reserve banks; stood ready to make emergency loans through its "discount window" and thus help banks survive runs; and provided some federal control over the money supply, especially after the system began conducting coordinated open-market operations in the early 1920s. Banks that joined the system (member banks) generally had to keep reserves on deposit at their reserve bank.
The Federal Reserve Act required all national banks to join the system, and gave state banks the option of joining. . . .
Macey, Miller, Carnell, Banking Law and Regulation, Third Edition, at pp 2-17 (Aspen Publishers 2001) (providing a simple synopsis of the legal history of banking regulation in the U.S.A.).
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