Transcript To-Establish

“To Establish a More Effective Supervision of Banking:”
How the Birth of the Fed Altered Bank Supervision
Jekyll Island
Eugene N. White
Rutgers University and NBER
What Are Key Issues for Financial Stability?
Agency Design?
1. Do Price Stability and Financial Stability Conflict?
Countercyclical Policy for Price StabilityFinancial
Instability? LOLR in Financial CrisesPrice Instability?
2. Supervision: Independent of the Central Bank?
Does LOLR require Supervision Powers?
3. Central or Industry/Goal-Specific Agencies?
How to Prevent Regulatory Capture/Rogue Agencies
4. Agency Transparency and Political Oversight
5. Philosophy of Bank Supervision?
Reinforce market discipline? or Independent of the market?
If so, then Rules or Discretion-Based
Five Policy Regimes
of Bank Supervision in the U.S.
1.
2.
3.
4.
5.
National Banking Era 1864-1913
Early Federal Reserve Period, 1914-1932
New Deal, 1933-1970
Demise of the New Deal, 1971-1990
The Contemporary Era, 1991-2008
Why is this history interesting?
Previous reform efforts
• Fathers of the Federal Reserve found themselves in
very similar position to today
– Growth of new, riskier financial intermediaries outside of
federal regulation
– Panics that destabilize the economy
• How to reform the National Banking System 18641913?
– Monetary Policy
– Financial Stability Policy: Regulation & Supervision &
Liability
National Banking Era, 1864-1913
1. No Central Bank—No Conflict
Money supply determined by gold standard
2. Independent Supervision
3. Industry-Specific Agencies or Central Agency?
One federal bank agency---the OCC
State bank agencies regulate state-chartered banks
4. Independence/Transparency/Oversight:
Comptroller has 5 year terms of office, bonded
Regular Detailed Reports
Occasional Congressional Hearings
5. Philosophy:
Supervision Reinforces Market Discipline/ Mark-toMarket/Prompt Closure of Insolvent Banks
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 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
– Demand for more banking moves through the political
market: “Competition in Laxity” & Regulatory
Arbitrage
– 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
Regulatory 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 panics to become nationwide,
country bank reserves quickly withdrawn
– Bankers panics follow public panics
Frequent Costly Financial Crises
• Frequent Panics: 1873, 1884, 1890, 1893, 1907
• 1907 Biggest starts in shadow system, neither
Clearing Houses or JP Morgan or U.S. Treasury can
stopSuspension of Payment
• Modern Studies (Miron, 1986; Romer, 1999; Jalil,
2009) Panics Worsen Recessions:
• 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.
• Supervision?
Supervision by the OCC
• Disclosure: 5 Yearly Reports, 3 are Surprise Call
Reports
• Examination: 2 Yearly Surprise Exams
• Enforcement:
– Fees for late delivery of reports
– Revocation of Charter
– Mark-to-Market & Prompt Closure
• Number of Examiners & National Banks
– 1907: 100 examiners/6,422 banks (64 banks/ex)
• Washington Office paid by Congressional
appropriations/Examinations paid for by fees
• A “Light” Hand
What did contemporaries think about the
effectiveness of examination?
• “A competent examiner…cannot pass judgment on all
the loans in a bank, [but] can, after a careful
examination, or series of examinations, form a
wonderfully correct judgment as to the general
character of its assets and as to whether its
management is good or bad, conservative or reckless,
honest or dishonest”
• “The correspondence carried on by the Comptroller,
based on the examiners’ reports, does an inestimable
lot of good in the way of forcing bank officers to comply
with the law and in compelling them to face and
provide for known losses as they occur.”
– James Forgan, President, First National Bank of
Chicago (1910)
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, and depends
entirely on their business ability, judgment, and
honest of purpose”
– 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)
Oversight?
Cong.
51st
51st
52nd
52nd
53rd
53rd
53rd
54th
54th
55th
55th
55th
56th
56th
Sess.
1
2
1
2
1
2
3
1
2
1
2
3
1
2
Begin
Adjourn Days
12/2/1889 10/1/1890 304
12/1/1890 3/3/1891 93
12/7/1891 8/5/1892 251
12/5/1892 3/3/1893 89
8/7/1893 11/3/1893 89
12/4/1893 3/28/1894 268
12/3/1894 3/3/1895 97
12/2/1895 6/11/1896 193
12/7/1896 3/3/1897 87
3/15/1897 7/24/1897 131
12/6/1897 7/8/1898 215
12/5/1898 3/3/1899 89
12/4/1899 6/6/1900 186
12/3/1900 3/3/1901 91
BCC
Meetings
4
?
30
12
23
28
8
27
13
?
14
7
11
10
Ratio
1.3
12.0
13.5
25.8
10.4
8.2
14.0
14.9
6.5
7.9
5.9
11.0
A Light Hand Upon a Light Hand?
NB
Insolve
Years ncies
1890
1891
1892
1893
1894
1895
1896
1897
1898
1899
1900
1901
30
44
27
261
71
115
78
122
53
26
32
56
State Bank Supervision?
Weaker but growing stronger (1910)
• Number of reports per year: 5 (9 states), 4 (22
states) 3 (4 states), 2 (9 states), 1 (1 state)
• Examinations: 41 states authorize regular
examinations [20 states: 1 per year]; California no
state supervision until 1909!
• No discipline short of closure; state bank
examiner no power to appoint receiver—asks
courts
• 1911: 224 state examiners for 17,913 banks or 80
banks per examiner. Av salary = $2,300 [OCC
examiner = $4,356]
Incentives—What Matters?
• Capital
– Minimum Capital Requirements for entry
– No Capital Ratios
• No Federal Deposit Insurance
• Double Liability
– If a bank failed, shareholders at the time of failure
could be forced to pay an assessment up to the par
value of the stock to compensate depositors.
– If a bank is weak, incentive to liquidate bank before
losses growvoluntary liquidations= 4xinsolvencies
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
– 1870: 12 states—single liability, 18 states—double
– 1900: 11 states—single liability, 32 states—double
– Creditors enforce DL via courts—not State Regulator and only
after assets completely liquidated
– No record of voluntary liquidations.
– Grossman (2001): DL banks have lower risk profile and lower
bank failure rate
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
Costs for National Banks, 1865-1913
• 540 suspended. (39 restored & 501 fail). Implication!!!!
• Total assets of these banks on closure: $360 million
– 35.9 percent were estimated to be good
– 31.5 percent to be doubtful
– 18.9 percent to be worthless
– 13.5 percent more recovered after suspension.
– $28.6 million in offsets for these banks.
• Total Collections $206.4 Million
– $183.9 million from the sales of assets
– $22.5 in assessments on shareholders (out of $46.4 million in
assessments)
• Legal expenses & Receivers’ Salaries = 12%proven claims
• Proven Claims: $191.0 million
• Payments to depositors: $146.9 million or 77%
• Total losses $44 million for this 50 year period.
Cost for State Banks
(Comptrollers’ Studies for state, savings and private banks)
• 1876-1878
– 210 state banks fail, payout 66%
– 33 national banks fail, payout ratios 75%, 99%, 91%.
• 1864-1896
– 1,234 state banks fail, payout 50%
– 330 national banks fail, payout 68%
• 1893-1899
– state banks payout 56%
– national banks payout 75%
• Losses 1864-1913 = $50 million?
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
Insolvencies---Capital/Asset Ratio is “High”
– Double Liability/No Deposit Insurance/Supervision
Reinforces Market Discipline
• But there are Panics and they occur because:
• Key Problem 1: Fragmented Banking System—small,
undiversified banks with reserves at correspondents,
pyramiding
• Key Problem 2: Absence of a Central Bank to act as
LOLR
• [Problem 1 greater? Canada, no central bank,
branchingno frequent panics]
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—no change in branching
prohibition, system with thousands of small,
undiversified unit banks.
• 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
– More 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
2. Discount window: Some banks 12
rapidly become dependent on
discount window—voluntary
10
liquidations decline
In 1925,
8
593 banks borrowing for
more than one year
6
239 borrowing continuously
since 1920
4
Fed est. 259 of failed banks
since 1920 were “habitual 2
borrowers.”
Percent
January 1914
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; bitter complaints by
state banks about increased regulatory/supervisory
burden to match NBs if they join
– 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: FRBs overlap with state examiners
– OCC refuses to share examination reports with the Fed
– 1925 OCC: 221 examiners for 8,054 banks ( 36 ex/bank)
– 1925 FRBs: 21 examiners for 1472 banks (70 ex/bank)
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.”
Consequences:
NBS: VL = 4 x S,
FR: (VL+C&A) < 2 x S
Year
1921
1922
1923
1924
1925
1926
1927
1928
1929
Total
Suspensions
52
49
90
122
118
123
91
57
64
766
Vol. Liquid.
12
8
20
28
14
12
9
7
3
113
Consol & Abs
74
107
96
96
81
129
160
136
225
1104
What Hath the Fed Wrought?
• First fifteen years of the Federal Reserve had subtle
effects on bank behavior and outcomes.
– Small but significant minority of banks became dependent
on the discount window
– Voluntary liquidations fell, suspensions increased, and
payouts declined.
• Changes did not de-stabilize the existing system &
aggregate losses remained very modest.
• Absence of the Great Depression?
– Burgess’optimism correct? If competition in laxity and
regulatory arbitrage 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 “Great Regime Shift” to the New Deal
• Great Depression 1929-1933
– Unexpected Deflationary Shock, Prices drop 23%
– Real GDP falls 39%
• Banking Shrinks
– July 1929: 24,504 commercial banks, $49 billion deposits
– Bank Holiday March 1933 (“Stress Test”) 11,878 banks with $23
billion.
• Losses from failed banks
– Totaled $2.5 billion ($39 billion in 2009)
– Half to depositors and to half shareholders
– 2.4% of GDP.
The “Great Regime Shift” to the New Deal: A
Misdiagnosis
•
•
•
•
•
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)
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 though Considerable Cooperation
3.
More than one agency?
More agencies---one for each segment of industry:
OCC, FR, FDIC, SEC, FRHBB, NCUA….+ States
Opportunities for Regulatory Arbitrage
“Competition in Laxity” & Regulatory Capture
4.
Political Independence /Transparency /Oversight:
More agenciesindependent but less transparency and less
oversight
5.
Philosophy of Supervision?
End of Market Discipline & Market ValuationDiscretion-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
– WWIIConservative asset mix
• Anti-Competitive Regulation
– Huge Costs to Households & Business
• 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 liability incentives—even though flawed regulations
Prospects?
• “We shall deal with our
economic system as it is
and as it may be modeled
not as it might be as if we
had a clean sheet of paper
to write upon and step by
step we shall make it what
it should be.”
– Woodrow Wilson, First
Inaugural Address