“To Establish a More Effective Supervision of Banking:”How the Birth of the Fed Altered Bank Supervision

Jekyll Island

Eugene N. WhiteRutgers University and NBER

What Are Key Issues for Financial Stability?Agency Design?

1. Do Price Stability and Financial Stability Conflict?Countercyclical Policy for Price StabilityFinancial Instability? LOLR in Financial CrisesPrice 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 Oversight5. 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. National Banking Era 1864-19132. Early Federal Reserve Period, 1914-19323. New Deal, 1933-19704. Demise of the New Deal, 1971-19905. 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 1864-1913?– Monetary Policy– Financial Stability Policy: Regulation & Supervision &

Liability

National Banking Era, 1864-19131. No Central Bank—No Conflict

Money supply determined by gold standard2. Independent Supervision3. 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, bondedRegular Detailed ReportsOccasional Congressional Hearings

5. Philosophy: Supervision Reinforces Market Discipline/ Mark-to-Market/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 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

Num

ber

National Banks State Banks Trust Companies

Regulatory 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 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 stopSuspension 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. Sess. Begin Adjourn DaysBCC

Meetings Ratio Years

NB Insolvencies

51st 1 12/2/1889 10/1/1890 304 4 1.351st 2 12/1/1890 3/3/1891 93 ? 1890 3052nd 1 12/7/1891 8/5/1892 251 30 12.0 1891 4452nd 2 12/5/1892 3/3/1893 89 12 13.5 1892 2753rd 1 8/7/1893 11/3/1893 89 23 25.8 1893 26153rd 2 12/4/1893 3/28/1894 268 28 10.4 1894 7153rd 3 12/3/1894 3/3/1895 97 8 8.2 1895 11554th 1 12/2/1895 6/11/1896 193 27 14.0 1896 7854th 2 12/7/1896 3/3/1897 87 13 14.9 1897 12255th 1 3/15/1897 7/24/1897 131 ? 1898 5355th 2 12/6/1897 7/8/1898 215 14 6.5 1899 2655th 3 12/5/1898 3/3/1899 89 7 7.9 1900 3256th 1 12/4/1899 6/6/1900 186 11 5.9 1901 5656th 2 12/3/1900 3/3/1901 91 10 11.0

A Light Hand Upon a Light Hand?

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 growvoluntary liquidations= 4xinsolvencies

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

Perc

ent

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

Percentage of Bank Insolvencies, 1864-1913

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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

Perc

ent

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, branchingno 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 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

– 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

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; bitter complaints by

state banks about increased regulatory/supervisory burden to match NBs if they join

– 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: 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 Suspensions Vol. Liquid. Consol & Abs1921 52 12 741922 49 8 1071923 90 20 961924 122 28 961925 118 14 811926 123 12 1291927 91 9 1601928 57 7 1361929 64 3 225Total 766 113 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--Eccles2. Supervision independent of central bank?

Contested Supervision though Considerable Cooperation3. More than one agency?

More agencies---one for each segment of industry: OCC, FR, FDIC, SEC, FRHBB, NCUA….+ StatesOpportunities for Regulatory Arbitrage“Competition in Laxity” & Regulatory Capture

4. Political Independence /Transparency /Oversight:More agenciesindependent but less 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– 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