A New Deal for Banking and Finance

andWorld War II

The “New Deal”• 1920s---boom time for economy and financial markets.

Innovations– Traditional loans insufficient for giant firms, further development

of bond and equity markets.– Commercial banks enter investment banking and compete with

investment banks via their securities affiliates.– New methods of investment: Investment Trusts

• Crisis of 1929-1939 leads to a huge change in regulation of banks and financial markets.

• Reaction to the 1929 stock market boom and bust---the markets continue as the recession deepens.

The Great Depression and the Collapse of the Financial System

• The Collapse of the Commercial Banks– July 1929: 24,504 banks with $49 B of deposits. – December 1932: 17,802 banks with $36 B– March 1933: 1,878 banks with $23 B

• The Collapse of the Savings and Loans– 1929: 12,342 S&Ls-----1933: 10,596– They are permitted to limit withdrawals

• The Collapse of the Insurance Companies– 1929: 438 companies----1933: 375 companies– Insurance “holidays”

• Investment banks and Brokerages fall in number.

Who is to Blame?The Former Masters of the Universe are Scapegoated

• President Hoover demands Senate Banking and Currency Committee investigate trading practices on Wall Street.

• The Pecora Hearings (1931) discovers “abuses” by investment affiliates (subsidiaries) of big commercial banks– Blamed for selling “unsound and speculative securities” to public– Blamed for converting bad loans into security issues sold to

public and investment funds– Blamed for conducting “pool operations”

• Single out National City Bank (Citibank) and Chase National Bank.

• Not an impartial examination but fear of financial capitalism heightened by economic collapse

• NO ONE TALKS ABOUT THE FED’S FAILURES IN THESE HEARINGS!

The “New Deal”---a wave of legislation hammered out in the

1930s

A New Deal for Commercial

Banking:Banking Acts of 1933 and 1935

• Legislation was “conservative.” Structure of banking system not altered. Position of unit banks was strengthened, innovations of big banks eliminated. Barriers to entry and limits on pricing and activities create a loose cartel.

• Legislation shaped by Senator Carter Glass, Chairman of Senate Banking Committee and Representative Henry Steagall Chairman of House Banking Committee.

• A deal is cut--Glass wants to implement “real bills” doctrine by separating commercial and investment banking and Steagall gets deposit insurance demanded by small town bankers

Bank Act of 1933 • Federal Deposit Insurance Corporation (FDIC)

established. • All Federal Reserve members required to join

and nonmembers can join if FDIC approves---98% join.

• A mutual guarantee fund to pay depositors of failed banks

• Insured banks pay a premium = a percentage of deposits

• Each depositor insured up to $2,500, raised to $5,000 in 1935.

• Insures only 43% of all deposits—only small depositorS

Banking Act of 1933• The “Glass-Steagall Act” produced a virtually complete

separation of commercial and investment banking.• Unlawful for any person or firm to engage in business of

issuing, underwriting, selling or distributing securities and to engage in business of receiving deposits.

• Commercial banks eliminate their “securities affiliates” that had gained 50% of investment banking business and allowed them to compete for big business, providing range of services.

• National City Bank eliminates its affiliate, the affiliates of Chase and First National Bank of Boston separate and form First Boston Corporation.

• The Morgan Bank opts to become a commercial bank, while some its partners now form Morgan Stanley & Co.

The Reduction of Competition—pricing and entry restricted

• Interest on Demand Deposits is prohibited on grounds that there was “excessive” competition

• Regulation Q---fixes and regulates interest rates on savings deposits and time deposits.

• No more “free” entry—banking agencies—Comptroller of the Currency and FDIC determine whether there is a “need” for a new bank.

Branching? • Congress gave national banks the same

branching rights as those of the state-chartered bank within their states. No significant expansion, few states allow branching.

• Bank Holding Companies regulated. Placed under supervision of Federal Reserve that regulates their ability to acquire new banks and enter new lines of business.

• BOTTOM LINE: New Deal legislation for commercial banks restricts entry and competition by price, geographic and products. Who benefits?

A New Deal for the Securities Markets

• Philosophy behind the laws. • Justice Louis D. Brandeis:

“Sunshine is the best disinfectant”

• Investors are not to be protected from making mistakes but government will intervene to provide adequate information and ensure there is no misleading information.

Securities Act of 1933• Full and Fair Disclosure of securities sold in

interstate commerce. • All publicly offered securities must be registered.• Specific information on the issuer and the

securities on file and available to public in a prospectus.

• No sales until 20 days after filing to allow public to absorb information.

• Each underwriter held liable. If information false, buyers refunded.

Securities Exchange Act of 1934• Securities Exchange Commission (SEC) established to

administer legislation. Five members. SEC has wide discretionary authority for setting rules and regulating exchanges. First chairman is Joseph P. Kennedy.

• Issuing corporations required to register and file periodic reports.

• Stock exchanges required to register and their trading systems subject to government scrutiny.

• Manipulative practices outlawed and others regulated• Any individual owning more than 10% of a company

must report these holdings.• Federal Reserve may impose margin requirements.

And more securities regulation…

• 1938 Maloney Amendment extends control of SEC to over-the-counter market (OTC). Brokers given option of direct registration with SEC or through trade organization---they form the National Association of Securities Dealers (NASD).

• 1940 Investment Advisors Act requires professionals giving advice or analysis to register with the SEC. Act subjects investment trusts and mutual funds to regulation of the SEC.

Savings and Loan Industry• Federal Home Loan Bank Act (1932) modeled on the

Federal Reserve—12 regional home loan banks owned by member thrifts and supervised by the Federal Home Loan Bank Board. Lend to distressed members.

• 1933 Home Owners Loan Corporation (HOLC) created to buy delinquent home mortgages from banks and S&Ls and offer better terms.

• Standardization of mortgages---30 year fixed rate amortized mortgage

• National Housing Act 1934 provides federal mortgage insurance to be handled by the Federal Housing Administration (FHA)—aid the lender.

• 1938 creation of the Federal National Mortgage Association (FNMA) or “Fannie Mae” to borrow funds and buy mortgages from lenders.

• Federal Savings and Loan Insurance Corporation (FSLIC) created to insure thrift accounts

Results of the New Deal?• Banks winnowed by crises, hugely liquid now,

and improved profitability—losses few after 1933—easily handled by FDIC

• Cost---limited interest, services, branches and new banks for the public.

• By 1933 primary and secondary securities markets are dead.

• In spite of disclosure requirements, average returns to investors from buying and holding newly issued securities largely unchanged.

• Mortgage market---30 year insured mortgage becomes common.

World War II: The Great Patriotic War

The Magnitude of the War

Another View

The Human Cost to the U.S.Combat Deaths Other Deaths Wounded

WWI 4/1917-11/1918

53,402 63,114 204,002

WWII 12/1941-9/1945

291,557 113,842 670,846

Korea6/1950-7/1953

33,629 20,617 103,284

Vietnam8/1964-1/1973

47,356 10,795 153,303

The Policy Debate on How to Finance the War

• Both President Roosevelt and his Treasury Secretary Henry Morgentheau want to tax the wealthy and corporations, closing loopholes and imposing an excess profits tax.

• Congress resisted– Imposed highly progressive personal and corporate

tax rates– Income taxes were extended to most of the labor

force– Weaker excess profits tax and loopholes remained. – War finance did not strictly follow nineteenth century

style bond financed-tax smoothing,

Financing War

Civil War WWI WWI WWII WWII Korea Korea

Percent$

Billions Percent$

Billions Percent$Billions Percent

Taxation 21 7.3 22 139 42 115 120

Borrowing 56 24.0 58 110 34 0 0

Money Creation 23 6.4 20 78 24 0 0

Total Cost of War 100 33 100 326 100 115 100

Higher Taxes, Paid by More People

Selling Bonds• Consumer spending reduced by mandated reduction in consumer durables production—production of automobiles, refrigerators, and most appliances virtually banned.

• Shortages regulated by wage and price controls and by rationing.

• Banks, etc. no longer finance private industry---induced to buy bonds 90% of new investment is in U.S. government bonds.

• New corporate issues disappeared, housing construction stopped and margin requirements set at 100%, trading collapses on the exchanges.

Bond Drives

U.S. Federal Debt to GDP, 1900-2005

0

20

40

60

80

100

120

140

1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

The Federal Reservemore money, more inflation

• The Fed relinquishes its independence (again! when before?) and announces in April 1943 that it will buy all Treasury bills to support maximum rate of 3/8 of 1% and bonds at 2.5%

• Why? Treasury sells bonds?• The Fed remains subservient to the Treasury

until after the Korean War.• Treasury-Federal Reserve Accord 1951, allows

the Fed to abandon support of bond prices (interest rate ceilings).

Huge Patriotic Work Effort

50

52

54

56

58

60

62

64

66

68

70

1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955

mill

ions

Civilian Labor Force Military Plus Civilian Civilian Labor Adjusted for Hours