Dimensions: 1.03'' x 9.35'' x 6.34'' 392 pages Cambridge University Press Publication Date: January 2000 Hardcover ISBN: 0521583624

January 2000
U.S. Bank Deregulation in Historical Perspective

This work examines the history of U.S. banking regulations to show how and why current deregulation is transforming the size, structure, and geographic range of U.S. banks, the scope of banking services, and the nature of bank-customer relationships. In addition, such history may serve as a helpful guide to the future of banking reform.

Charles W. Calomiris is a visiting scholar at AEI and the codirector of its Financial Deregulation Project. He is also the Paul M. Montrone Professor of Finance and Economics at Columbia Business School and a consultant to the Federal Reserve Bank of New York.

Deregulation began in the 1980s and involved a combination of changes in federal and state statutes and changes in regulatory and judicial interpretations of existing laws, culminating in the passage of the Banking Act of 1999. Over the past two decades, the characteristics that had made U.S. banks different from other banks throughout the world--the fragmented geographical structure of the industry, which restricted the scale of banks and their ability to compete with one another, and strict limits on the kinds of products and services commercial banks could offer--virtually have been eliminated. Understanding the origins and persistence of the unique banking regulations that had defined U.S. banking for more than a century lends an important perspective to the economic and political causes and consequences of the current process of deregulation. History helps to define the political constituencies for and against deregulation, the political process through which bank regulations were determined, and the way deregulation is likely to affect future bank performance and stability.

The fragmented U.S. banking industry was handicapped historically in many ways. Bank diversification and coordination were impaired by limits on bank size and geographic scope, thus making U.S. banks unnecessarily vulnerable to bank failures and to systemic bank panics in the nineteenth and early twentieth centuries. That vulnerability also set the stage for the advocacy of deposit insurance as a means of protecting small rural banks from the consequences of their inherent inefficiency. Branching restrictions also reduced the available supply of credit in rural areas. Restricting the scale and geographic scope of banks also made industrial finance by banks more difficult and made it impossible to establish an efficient bank-managed market for securities offerings of industrial firms (as in Germany). The size and geographic range of potential industrial borrowers were large relative to those of banks, which complicated the process of lending to and monitoring industrial borrowers. Banks’ focus on commercial credit in the late nineteenth century reflected these limitations on bank size and geographic scope. Limits on branching also undermined the establishment of a banker’s acceptance market nationwide, which contributed to the large, persisting differences in the cost of commercial credit among regions.

Chapter 1 reviews the origins of branching restrictions, deposit insurance, and bank powers restrictions, analyzes their costs and benefits, and traces the parallel and interrelated histories of the U.S. economy and bank regulation. Chapter 2 focuses on the peculiar U.S. propensity for banking panics during the national banking era (1863–1913) and shows that panics in the United States were traceable to defects in the design of the banking system. Fragmented banking encouraged panics by limiting bank diversification of loan risk and by making coordinated responses among banks to prevent panics much more difficult. Chapter 3 provides a detailed investigation of the passage of federal deposit insurance in 1933, a victory that was surprising in light of the opposition proponents faced and that demonstrated the political skills of deposit insurance’s advocates. Chapter 4 compares and contrasts the activities of U.S. and German banks historically in the areas of industrial lending and underwriting, which illustrates the importance of branching limits for effectively limiting the role of U.S. banks in industrial finance. Chapter 5 traces the history of equity underwriting costs in the United States over the twentieth century. The pronounced decline in those costs during the 1960s and 1970s helped to usher in an era of enlarged securities market access for U.S. corporations. The declining costs of underwriting reflected the emergence of new institutional investors (pensions and mutual funds) and their increasing role as corporate securities purchasers. Chapter 6 examines some of the recent trends in bank structure and performance, relates them to deregulation of bank branching and powers, and considers the new form of universal banking emerging in the United States.

Explanations for the origins of restrictive banking laws in the United States are mainly to be found in theories of political economy, not arguments about economic efficiency. Limits placed on banks--especially restrictions on bank consolidation from the mid-nineteenth century through the early 1990s and the separation of commercial and investment banking beginning in 1933--are artifacts of specific historical events and associated political battles in which facts and economic logic often took a back seat to special interest politics and, occasionally, to populist passions.

Economic history shaped bank regulation through its effects on the size of the gains and losses that potential regulatory changes posed for various interested parties and through the way history altered the relative power those parties enjoyed. The parallel development of U.S. economic history and banking regulation did not follow a simple rule (as would be the case if efficiency alone guided policy). The ways that economic change was reflected in regulatory changes differed over time and depended not only on shifts in the aggregate costs and benefits of regulation, but also on the ways those costs and benefits were distributed. When considering the links between economic change and regulatory change, three factors have proven particularly important: (1) the degree of concentration of the gains and losses among interest groups, (2) the implications of economic and regulatory change for the power of existing regulatory agencies, and (3) the extent to which regulatory changes could be "framed" by political entrepreneurs to produce sufficient popular support to overcome the normal inertia of the political process.

A central principle of political economy is that concentrated minority interests can be more successful in extracting concessions from the political process than majorities. In a world where forming coalitions is physically costly, concentrated minorities face stronger incentives to lobby (and pay) for their desired outcomes. That principle is reflected clearly in banking history. Ironically, it was sometimes the case that the more socially costly regulatory restrictions became for the majority, the more likely those restrictions were to succeed politically, because the benefits of restrictions to vested interests often grew alongside their costs to the majority.

When competition has threatened the growth of regulated entities, regulators have become advocates of deregulation as a means of preserving the institutions under their authority. The growth of institutional investors and securities markets since the 1960s (which reinforced one another), as well as the growth of other nonbank financial institutions and foreign bank entrants, put unprecedented pressure on U.S. banks to change their structure and customer relationships and made bank regulators cognizant of the need to repeal archaic limitations on the size, geographic scope, and powers of banks. Deregulation has also been spurred by the sometimes unseemly competition for turf among the Federal Reserve Board, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, which reflected the heightened competition among the various securities markets and financial institutions these agencies regulate.

But there was more to the success or failure of a regulatory initiative than the simple calculus of gains and losses for special interests (including regulators). Political inertia can prevent success even if the distribution of gains and losses favors it, and political entrepreneurship can achieve success even when the distribution of gains and losses makes it unlikely. In the 1930s, Henry Steagall (the father of federal deposit insurance) was perhaps the most impressive bank regulatory entrepreneur of his time. At a time when small rural banks were at their nadir of economic and political strength, he successfully combined his power in Congress with populist public attacks on big banks to push through a deposit insurance provision that was opposed initially by President Franklin Roosevelt, the Fed, the Treasury, the American Bankers Association, and Sen. Carter Glass (D-Va.). The Banking Act of 1933--a compromise between advocates of limiting banks’ powers (like Glass) and advocates of protecting small banks (like Steagall)--successfully put an end to the bank consolidation movement and the new investment banking activities of large banks that had begun in earnest in the 1920s. That "successful" political compromise postponed for over fifty years the process of consolidating banks and expanding their powers.

Despite the clear consensus among academics by the 1980s in favor of repealing branching and powers limits, the process of deregulation was protracted and Byzantine, involving struggles in the courts, progressively liberal interpretations of law by the Federal Reserve Board, and the gradual scaling back of branching restrictions at the state and federal levels. The long delay in passing the 1999 banking law resulted from the need to resolve a panoply of issues in the same act, which reflected the numerous political compromises that had to be struck to placate a variety of special interests (most notably, issues revolving around regulatory power-sharing between the Fed and the Comptroller, controversies surrounding the reform or expansion of the Community Reinvestment Act, and conflict over the future of the government-sponsored enterprises [GSEs] that provide housing credit, especially the Federal Home Loan Banks).

As we move to the next round of debate over deregulation--in which the main issues will be the removal of barriers between commerce and banking, bank customer privacy concerns, GSE reform, and deposit insurance reform--history serves as a helpful guide to the future. Because the content and form of banking bills reflect hard-to-anticipate changes in technology, the political landscape, and the existing distribution of power, history teaches us, above all, to be modest in our regulatory forecasts. Future history will be easier to understand than to predict. Nevertheless, one interesting possibility suggested by the experience of the 1980s and 1990s is that technological change and global market competition will force the full deregulation of the banking industry, whether Congress leads the way or not. Under the 1999 act, the Fed enjoys wide latitude in judging which activities are appropriate to include within a financial holding company. As new competitive pressures mount--including new potential Internet technologies for sidestepping the Fed’s payment system, which may increasingly undermine the appeal of the commercial bank charter--it is likely that regulators will continue to bend in the direction of permissive interpretations of statutes. Ten years from now, Congress may, once again, find itself in the role of codifying a result produced by market competition.