Transcript Lessons from American Bank Supervision Before the Great

“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 and Future of the
Federal Reserve
November 5-6, 2010
Eugene N. White
Rutgers 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 regulationsState-Chartered Banks
grow rapidly in rural areas
– Weaker regulationsTrust Companies grow
rapidly in major cities
– Uninsured Deposit-based banking
The Number of Bank by Charter Type
14,000
12,000
8,000
6,000
4,000
2,000
0
18
63
18
65
18
67
18
69
18
71
18
73
18
75
18
77
18
79
18
81
18
83
18
85
18
87
18
89
18
91
18
93
18
95
18
97
18
99
19
01
19
03
19
05
19
07
19
09
19
11
19
13
Number
10,000
National Banks
State Banks
Trust Companies
18
86
18
87
18
88
18
89
18
90
18
91
18
92
18
93
18
94
18
95
18
96
18
97
18
98
18
99
19
00
19
01
19
02
19
03
19
04
19
05
19
06
19
07
19
08
19
09
19
10
19
11
19
12
19
13
Percent
Shares of Banking Assets
100%
80%
60%
40%
20%
0%
National Banks
State Banks
Trust Companies
Regulation IncentivesIncreased 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.
18
64
18
66
18
68
18
70
18
72
18
74
18
76
18
78
18
80
18
82
18
84
18
86
18
88
18
90
18
92
18
94
18
96
18
98
19
00
19
02
19
04
19
06
19
08
19
10
19
12
Percent
Percentage of Bank Insolvencies, 1864-1913
7
6
5
4
3
2
1
0
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
growVoluntary Liquidations= 4x Insolvencies
Percentage of National Bank Voluntary
Liquidations and Insolvencies,1864-1913
4.00
3.50
3.00
2.00
1.50
1.00
0.50
0.00
18
64
18
66
18
68
18
70
18
72
18
74
18
76
18
78
18
80
18
82
18
84
18
86
18
88
18
90
18
92
18
94
18
96
18
98
19
00
19
02
19
04
19
06
19
08
19
10
19
12
Percent
2.50
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 statechartered institutions to join the Fed
• Fed Reserve Era begins to change bank
supervision
Conflict emerges between
Monetary Stability and Financial Stability
• High Inflation World War I
• Fed raises rates in 1920Deflation & 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
4.5
30
World War I
4
25
20
3.5
10
2.5
5
2
0
1.5
-5
1
-10
0.5
-15
0
-20
1866 1869 1872 1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929
National Banks
State Banks
Inflation
Inflation--Percent
Percent of Bank Failures
15
3
Incentives to Take More Risk
1. Fed promises to end panics by
14
smoothing interest rate
fluctuationsrisk-taking
12
2. Discount window: Some banks
rapidly become dependent on 10
discount window—voluntary
liquidations decline
8
Percent
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.”
January 1914
6
4
2
0
1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929 1932
Time Loans
Commercial Paper
Supervision Split Between the Fed, the
OCC and the States
• The problem of state bank membership
– 1917: 53 state members of 19,000
– Regulations eased1,648 members in 1922
• Fed given control of Call Reports
– End of year surprise call reported eliminated
– 19181926 Call Reports Reduces 52
• 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 GovernmentRegulated 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….+ States
Opportunities for Regulatory Arbitrage
4.
Political Independence /Transparency /Oversight:
More agenciesless transparency and less oversight
5.
Philosophy of Supervision?
End of Market Discipline & Market ValuationDiscretionBased 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
– WWIIConservative 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