“ To Establish a More Effective Supervision of Banking:” How the Birth of the Fed Altered Bank Supervision A Return to Jekyll Island The Origins, History.

“To Establish a More Effective Supervision of Banking:”

How the Birth of the Fed Altered

Bank Supervision

A Return to Jekyll IslandThe Origins, History and Future of the

Federal ReserveNovember 5-6, 2010

Eugene N. WhiteRutgers University and NBER

The Dilemma of 1910• Panic of 1907---Begins Outside “Safety Net”

– New, more leveraged and lightly regulated intermediaries

• No Central Bank---Standard Remedies Fail– Efforts by Treasury to Increase Liquidity– Rescue Organized by J.P. Morgan– Clearing House Loan Certificates– Panic Halted by a Suspension of Payments

• Recession, 1907-1908– Mild Contraction until Panic hits– Net national product fell 11%

• Reform---the “National Banking System”– Monetary Policy---Michael Bordo– Financial Stability (Reg/Sup)---Eugene White

National Banking System• National Bank Act of 1864

– Desire for deeper market for U.S. bonds– Collapse of state free banking systems

• A Federal “Free Banking” System. – Free Entry & Bond-Back Banknotes– High standards for reserve requirements,

minimum capital, lending, prohibit branching– Office of the Comptroller of the Currency– Objective: create a nationwide federal system,

absorbing state banks. – After 1865 10% on state banknotes, most join.

National Banking System• Initial Success

– Federal regulation coverage almost universal– Uniform, safe currency [Most of bank liabilities

are guaranteed as banknotes are backed by U.S. government bonds]

• 1880s States Revise Banking Codes– Weaker regulationsState-Chartered Banks

grow rapidly in rural areas– Weaker regulationsTrust Companies grow

rapidly in major cities – Uninsured Deposit-based banking

The Number of Bank by Charter Type

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1863

1865

1867

1869

1871

1873

1875

1877

1879

1881

1883

1885

1887

1889

1891

1893

1895

1897

1899

1901

1903

1905

1907

1909

1911

1913

Nu

mb

er

National Banks State Banks Trust Companies

Shares of Banking Assets

0%

20%

40%

60%

80%

100%

1886

1887

1888

1889

1890

1891

1892

1893

1894

1895

1896

1897

1898

1899

1900

1901

1902

1903

1904

1905

1906

1907

1908

1909

1910

1911

1912

1913

Pe

rce

nt

National Banks State Banks Trust Companies

Regulation IncentivesIncreased Fragility

• Fragmented Banking Structure– Easy Entry, Low Minimum Capital, Branching Prohibited– Thousands of Single Office Banks– 1907: 17,869 NBs, SBs, & TCs– Many are small, undiversified, higher failure frequency.

• “Pyramiding of Reserves”– High Reserve Requirements & No Central Bank– Reserves held at City Correspondent banks, “Pyramiding

of Deposits” in NYC, Chicago– Increases potential for incipient panic to become

nationwide, country bank reserves quickly withdrawn

• Frequent Panics: 1873, 1884, 1890, 1893, 1907

Frequent Costly Financial Crises• Panics Worsen Recessions:

– Romer (1999): Frequency and severity of recessions greater before the Founding of the Fed

– Miron (1986) : Panics lowered economic growth– Jalil (2009): Recessions with Panics are more severe

and longer in duration

• BUT these panics are primarily Liquidity Events NOT Solvency Events---even if a bank failure started a panic, no large system-wide losses from bank insolvencies.

• Regulation and Supervision provide incentives that limit losses from insolvencies.

Percentage of Bank Insolvencies, 1864-1913

0

1

2

3

4

5

6

7

1864

1866

1868

1870

1872

1874

1876

1878

1880

1882

1884

1886

1888

1890

1892

1894

1896

1898

1900

1902

1904

1906

1908

1910

1912

Pe

rce

nt

National Banks" State Banks Trust Companies

Supervision by the OCC• Objective: Supervision Should Reinforce

Market Discipline

• Disclosure: 3 Yearly Surprise Call Reports

• Examination: 2 Yearly Surprise Exams

• Examiners & National Banks– 1889: 30 examiners/ 3,239 banks– 1907: 100 examiners/6,422 banks

• Enforcement: – Mark-to-Market & Prompt Closure– Only Tool: Revocation of Charter

Examination• “Supervision by examination does not, however,

carry with it control of management and can not, therefore, be held responsible for either errors of judgment or lapses of integrity. Examination is always an event after the act, having no control over a bank’s initiative, which rests exclusively with the executive officers and directors”– James Forgan, President, First National Bank of

Chicago (1910)

• “It is scarcely to be expected, if a robber or a forger is placed in control of all its assets, that a national bank can be saved from disaster by the occasional visits of an examiner.”– Comptroller Knox, Annual Report (1881)

Incentives from Regulation• Capital

– Minimum Capital Requirements for entry– No Capital Ratios (but C/A > 20% for NBs)

• No Federal Deposit Insurance• Double Liability: If a bank failed, shareholders

could be forced to pay an assessment up to the par value of the stock to compensate depositors– Senator John Sherman (1864): Added guarantee for

bank’s creditors & “tends to prevent the stockholders and directors of a bank from engaging in hazardous operations.”

– If bank is weak, incentive to liquidate bank before losses growVoluntary Liquidations= 4x Insolvencies

Percentage of National Bank Voluntary Liquidations and Insolvencies,1864-1913

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

1864

1866

1868

1870

1872

1874

1876

1878

1880

1882

1884

1886

1888

1890

1892

1894

1896

1898

1900

1902

1904

1906

1908

1910

1912

Pe

rcen

t

Voluntary Liquidations Insolvencies

State Banks and Trust Companies?• Capital

– Lower Minimum Capital Requirements– No Capital Ratios

• Deposit Insurance, seven states after 1907

• Shareholder Liability—weaker regime– 1900: 11 states—single liability, 32 states—

double– Creditors enforce Double Liability via courts—

not State Regulator and only after assets completely liquidated

Costs of Failures• National Banks: 1864-1913:

– 540 suspended. (39 restored & 501 fail).– Proven Claims: $191.0 million– Payments to Depositors: $146.9 million or 77%– Total losses $44 million for this 50 year period.

Total deposits 1890=$2 billion

• State Banks: 1864-1896– 1,234 state banks fail, payout 50% (1/3 assets

of NBs). Loss $50-$100 million– 330 national banks fail, payout 68%

Cost of Failures

• Total Losses 1865-1913 – $100 million/1% of 1890GDP/$3.6 billion in 2009

• Great Depression (F&S): – $2.5 billion/2.4% of GDP/$39 billion in $2009.

• S&L/Banking failures early 1980s:– $126 billion/3.4% of GDP/$200 billion in $2009.

• Estimate for 2008-2009?– $1.7 trillion?/11.6% of 2008 GDP

Assessment of 1864-1914• “Microprudential” Rules Work Well to Limit

Losses from Insolvencies

• But Panics are Frequent and Severe:

• Problem 1: Fragmented Banking System—small, undiversified banks with reserves at correspondents, pyramiding

• Problem 2: Absence of a Central Bank to act as LOLR

Federal Reserve Act of 1913

• Problem 2 “solved”: Fed to prevent panics by providing liquidity through the discount window and reduce seasonality of interest rates.

• Problem 1 remains. Unable to challenge unit bankers lobby and chartering authority of the states.

• Unlike Civil War, no sticks only carrots to state-chartered institutions to join the Fed

• Fed Reserve Era begins to change bank supervision

Conflict emerges betweenMonetary Stability and Financial Stability

• High Inflation World War I• Fed raises rates in 1920Deflation & Recession• Number of bank failures rise

– Most severe for small state banks with longer term agricultural loans

– Failures 1921-1929: 766 out of 8,000 NB banks fail. – Payout is lower than in 1865-1913: 40¢ per $. – Total loss for all banks $565 million ($6.9 billion in

2009$) or 0.6% of 1925 GDP– BUT This is a one time shock from which the

system could have recovered

Percentage of Banks Failing and Inflation 1866-1929

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1866 1869 1872 1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929

Perc

ent o

f B

ank

Failu

res

-20

-15

-10

-5

0

5

10

15

20

25

30

Infla

tion-

-Per

cent

National Banks State Banks Inflation

World War I

Incentives to Take More Risk

1. Fed promises to end panics by smoothing interest rate fluctuationsrisk-taking

2. Discount window: Some banks rapidly become dependent on discount window—voluntary liquidations decline In 1925,

593 banks borrowing for more than one year

239 borrowing continuously since 1920

Fed est. 259 of failed banks since 1920 were “habitual borrowers.”

0

2

4

6

8

10

12

14

1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929 1932

Perc

ent

Time Loans Commercial Paper

January 1914

Supervision Split Between the Fed, the OCC and the States

• The problem of state bank membership– 1917: 53 state members of 19,000– Regulations eased1,648 members in 1922

• Fed given control of Call Reports– End of year surprise call reported eliminated– 19181926 Call Reports Reduces 52

• Examination– OCC refuses to share examination reports with

the Fed

Burgess (1927): The Fed on Supervision• Key function of examination to “prevent too constant or too

large use of borrowing facilities.” • [Troubled banks] “bring all their good paper to the Federal

Reserve Bank to rediscount. Shall the Reserve Bank take it and lend them the money? If the Reserve Bank refuses, failure may follow. If it makes the loan, it assumes the responsibilities of continuing in operation a bank probably insolvent. If failure should then come the depositors might find much of the good assets re-discounted at the Reserve Bank and unavailable to pay depositors.”

• “The Reserve Bank must consider not only the safety of its loan, but the interests of the depositors. Can the bank be saved by a loan? If not, will the depositors be better off under an immediate liquidation, a later liquidation, when the bank may have dissipated many of its best assets? These are some of the questions the Reserve Bank has to face. The answer depends on a careful scrutiny of each bank, in constant cooperation with state and national supervisory authorities.”

What Hath the Fed Wrought?• First fifteen year of the Federal Reserve:

– Some banks became dependent on the discount window

– Voluntary liquidations fell, suspensions increased, and payouts declined.

– Continued fall in the capital-asset ratio • Changes did not de-stabilize the existing system

• Absence of the Great Depression?

– Burgess’ optimism correct? If “competition in laxity” had been brought under control and supervision reduced the number of borrowers at the discount window, bank failures and payouts might have returned to the lower levels of the pre-1913 era.

– Burgess wrong? then the American banking system was stuck with a more costly supervisory regime.

The Regime Shift to the New Deal

• Great Depression 1929-1933 – Unexpected Deflationary Shock, Prices drop

23%– Real GDP falls 39%

• Banking Shrinks– Deflationary Shock Hits Fragile Unreformed

Banking Structure– July 1929: 24,504 commercial banks, $49

billion deposits– Bank Holiday March 1933 (“Stress Test”)

11,878 banks with $23 billion.

The New Deal’s Misdiagnoses

• Regulation: Competitive Market Government-Regulated Cartel.

• (Erroneously Assume Competition Failed---not Deflationary Shock)

• Supervision: Reinforcing Market Discipline Discretion-Based Supervision & Forbearance

• (Erroneously Assume Markets Can’t Value Assets because of Volatile Price Expectations—”Intrinsic” not Market Value)

• Deposit Insurance ends Double Liability

The New Deal: 1933-1970 and beyond 1. Monetary/Financial Policy Conflict?

Supervision Subordinated to Monetary Policy--Eccles

2. Supervision independent of central bank? Contested Supervision

3. More than one agency? More agencies---one for each segment of industry: OCC, FR, FDIC, SEC, FRHBB….+ StatesOpportunities for Regulatory Arbitrage

4. Political Independence /Transparency /Oversight:More agenciesless transparency and less oversight

5. Philosophy of Supervision? End of Market Discipline & Market ValuationDiscretion-Based Supervision until 1991

New Deal, 1933-1970: Golden Age?• Why so few bank failures?• Macroeconomic Stability, 1945-1970• Number of bank failures: tiny

– Weak banks eliminated in 1930s– WWIIConservative asset mix

• Anti-Competitive Regulation– Increases Profits

• Deposit Insurance Coverage Rises• Capital to Asset Ratio Falls Moral

Hazard• Set-Up for Banking Crises of 1980s

and 2000s

Bottom Line: Why did pre-New Deal Supervisory Regime work?: Set correct incentives—even though regulations created a fragile banking structure