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Home , Commercial bank, Financial intermediary, Mutual savings bank, Personal finance

Why does the US have a weak mutual sector?

Daniel R. WADHWANI

March 2011

World Savings Banks Institute - aisbl – European Savings Banks Group – aisbl Rue Marie-Thérèse, 11 ￭ B-1000 Bruxelles ￭ Tel: + 32 2 211 11 11 ￭ Fax: + 32 2 211 11 99 E-mail: first [email protected] ￭ Website: www.savings-banks.com WHY DOES THE US HAVE A WEAK MUTUAL SAVINGS SECTOR?

Prof. R. Daniel Wadhwani, Assistant Professor, University of the Pacific

R. Daniel Wadhwani, Assistant Professor of and Fletcher Jones Professor of Entrepreneurship at the University of the Pacific, received his B.A. from Yale University and his Ph.D. from the University of Pennsylvania before studying on a Newcomen Fellowship in History at Harvard Business School. He was a lecturer on the faculty of the Harvard Business School prior to joining the University of the Pacific in 2006. He has conducted extensive primary source research on the history of savings banks in the United States and is currently completing a book on the role of savings banks in the development of the for personal in America. He has also examined the development of savings banks from a comparative-historical perspective.

Over the last three decades, mutual savings banks have experienced a precipitous decline in their role in the American . Dozens of savings banks have failed and hundreds have chosen to convert from their traditional “mutual” form into joint- institutions that are akin to commercial banks. The 82 mutual savings banks that remain in existence today account for less than 1% of the of the American banking system (OTS 2010: 9-10).

Their was not always this weak. At their height in the late 19th century, mutual savings banks accounted for over a quarter of the assets in the American banking system and financed infrastructure and housing development that was crucial to the growth of the industrial economy (Welfling 1968). For most of the 19th century mutual savings banks were the fastest growing in the US and generally had a reputation as conservative but well-managed institutions (Kroos Hermann and Martin Blyn 1971).

59 Why, then, have mutual savings banks become so marginal in the American banking system? What caused their precipitous decline? While it is common to attribute the decline of mutual savings banks in the United States to the period of bank deregulation beginning in the 1980s, the inability of American savings banks to compete in a deregulated environment has deeper historical roots. Savings banks in some other parts of the world – Spain and Germany, for instance – have successfully competed in the deregulated bank environment that has developed in the last three decades. To understand why American savings banks were unable to compete like their Spanish and German counterparts we need to understand the historical development of savings banks in the United States and their relatively weak capabilities. Their decline holds lessons for managers in other parts of the world today.

Part of the decline of savings banks, as we shall see, was attributable to federal regulation, and especially to . By insuring and savings and deposits as well as savings bank accounts, federal deposit insurance wiped out mutual savings banks’ most significant advantage in the eyes of depositors: their reputation for safety. But deposit insurance only accounts for part of the story. Mutual savings banks in the United States also remained regional rather than national institutions, failed to aggressively innovate their products and services when given the opportunity or presented the need to do so, and refused to cooperate as a group to engage in meaningful collective action. It was these historical weaknesses in the capabilities of mutual savings banks – as much as the regulatory environment – that led to the eventual decline of the institution when deregulation no longer protected its market from competitors.

The paper is organised as a chronological account of the development and decline of mutual savings banks in the United States, focusing in particular on the weaknesses that would lead to their eventual demise in the late 20th century. Part I examines the origins and growth of savings banks in the United States. Part II considers the emergence of competitors in the market for personal savings, including commercial banks, S&Ls, and other intermediaries. Part III examines why savings banks failed to innovate and diversify their services in response to the competitive threats that emerged in the late 19th century. In part IV, I examine the lack of effort at collective action among savings banks in the United States; though they formed an association, it provided a very limited array of services when compared to similar savings bank associations around the world.

60 Part V examines the regulatory environment both before and after the New Deal and shows how it both protected savings banks from competitors while eliminating the key source of the savings banks’ competitive advantage. The sixth section examines the crisis of the last quarter of the 20th century. I conclude by considering some of the implications of the American experience for the managers of savings banks in other parts of the world today.

Figure 1: Mutual Savings Banks’ Share of Assets of Selected Financial Intermediaries

30%

25%

20%

15%

10%

5%

0% 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2009

Sources: FDIC, White, “Were Banks Special Intermediaries.” Notes: Intermediaries include savings banks, commercial banks, and savings & .

1. Origins and Early Growth, 1810s-1870s

The financial system in the United States during the 19th century was comprised of an array of institutions, each designed to provide a specific and often quite limited bundle of services. Its cornerstone was the commercial banks that state legislatures chartered to maintain a supply and extend -term commercial . Prior to the National Banking Act of 1863, commercial banks were regulated by the states; after 1863, some also came to be regulated by the federal government.

61 While commercial banks were extremely important for conducting business, they were only rarely used by individuals of modest means who wished to set aside small sums for future needs. The needs of small savers were met by a variety of other financial institutions, of which the most important were the mutual savings banks.

The first savings banks in the United States were established during the 1810s in Philadelphia, Boston, New York and Baltimore, based on the model of the British Trustee Savings Banks. These savings banks accepted small-denomination savings deposits from the general public, which they were charged with investing in prescribed “safe” classes, usually government and high-grade mortgage loans. However, since mutual savings banks were state rather than nationally chartered institutions, the rules governing their practices varied from state to state (Olmstead 1976; Wadhwani 2006).

From the outset, these institutions had been intended primarily to enable persons of modest means to save a portion of their present to meet future needs. They furnished, as the founders of the Bank for Savings in New York explained in 1819, a “secure place of deposit” for “all who wish to lay up a fund for sickness, for the wants of a family, or for old age” (Manning 1917: 125). Savings banks were state chartered institutions that were prohibited from branching, and so remained “unit banks” targeted at serving savers in the local community (Welfling, 1968; Wadhwani, 2002).

Though these early savings banks were based on a seemingly simple , it is easy to underestimate their innovative accomplishments. Prior to their establishment, no formal intermediaries existed that served the mass market for , and most “ordinary households” saved, borrowed and insured through direct personal transactions with people they knew. Over their first half-century, savings banks proved the viability and profitability of serving the mass market for personal finance. Much of their success lay in the credibility and trust they had developed among the general public, a growing portion of which entrusted their savings to the institutions (Wadhwani 2002). A critical element of the development of this credibility was the innovative corporate governance structure of mutual savings banks, which (like their British counterparts) were established as trusteeships on behalf of depositors, without a conflicting class of joint-stock shareholders (Wadhwani, forthcoming).

62 Throughout the 19th century savings banks grew extremely rapidly, buoyed by the rise of the urban, economy in which ordinary Americans found ways to manage their income and save for periods of old age, sickness and unemployment. With few competitors in this urban environment, mutual savings banks became the fastest growing in the United States between the 1820s and the 1870s. Between 1820 and 1910, the number of mutual savings banks in the country rose from 10 to 637, while their deposits soared from USD 1 million to USD 1 billion (Lintner 1948, Welfling 1968). In fact, in the 1870s, mutual savings banks controlled nearly a quarter of the assets of financial intermediaries in the United States – a moment that in retrospect represented the high water mark in their share of the American banking market.

The rapid aggregate growth of savings banks in mid-19th-century America, however, masked one significant weakness. Throughout their history, mutual savings banks remained a regional institution rather than a national one. Mutual savings banks were chartered in only 19 states, primarily in New England and the Mid-Atlantic. In fact, historically more than 95% of savings deposits in mutual savings banks were accounted for by only nine states: Connecticut, Massachusetts, Maine, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Washington (FDIC 1997, Lintner 1948). Outside the urban north-east, policymakers and local institutions remained sceptical of what was seen as an elite European-influenced institution and promoted instead the small local commercial and community banks as places for small savers. These regional limitations circumscribed the influence of mutual savings banks once banks and banking regulation became controlled at a national level. As a national banking infrastructure and regulations developed, mutual savings banks came to be seen as a regional institution rather than a national one.

63 Interior of the Bowery Savings Bank, 1870

Source: Harper’s Weekly 1870 Note: At its height in the late nineteenth century, the Bowery Savings Bank in New York was the largest savings bank in the United States. The Bowery catered to a wide cross-section of New York’s working class population.

2. The Emergence of Competition, 1870s-1920s

Despite their regional isolation, for most of the 19th century the growth of savings banks outpaced that of other intermediaries. In large part, this was because savings banks remained largely uncontested in the market for the personal savings of ordinary Americans. Beginning in the last quarter of the 19th century, however, this began to change, as commercial banks as well as a host of new intermediaries entered the market for personal savings. By 1930, savings banks’ share of financial intermediaries’ assets had slipped to below 10%, where it remained for most of the 20th century. Savings banks faced direct competition for deposits and, to some extent, for borrowers, from commercial banks. Moreover, the incumbent savings banks faced competition from a host of new entrants, including trust companies, industrial banks, savings and loan associations and insurance companies, which competed in large part based on the new financial products they introduced to the market (Lintner 1948, Welfling 1968, Wadhwani 2002). Despite a keen awareness of this competition and the new products they introduced, savings banks largely failed to offer competing products.

64 The first and most significant challenge to savings banks came from savings and loan associations, which offered innovative small-denomination amortised mortgage loans to members. While savings banks invested heavily in mortgage loans, their loans were typically not targeted at the mass market savers who comprised their depositors. In order to achieve safety and processing efficiency, their mortgage loans went typically to wealthy borrowers. Moreover, the terms of late-19th-century mortgage loans made them onerous to small borrowers; loans were typically restricted to 50% of the underlying property value, had three- to five- year maturities, and included a massive balloon payment at the end of the period. In contrast, savings and loans (or, as they were then called, building and loans) offered innovative and favourable mortgage lending to members in their mutual societies. Members subscribed to an association’s plan, in which they paid in capital that was lent on a rotating basis to other members for the purposes of building homes. The system allowed small denomination lending, lower monitoring costs, and a self- liquidating feature that eliminated the large and risky balloon payment that traditional mortgages featured. By the 1910s and 1920s, savings and loans were effectively acting much as traditional intermediaries, taking in savings deposits as well as traditional membership dues and making amortised eight- and ten-year loans to small borrowers (Mason 2001).

A second major set of competitive innovations originated from existing players and new entrants in the industry. Though life insurance companies were as old as savings banks, they had traditionally served primarily affluent customers and had remained relatively modest in size in their early years. Their first major expansion took place in the antebellum era, when they began to aggressively promote certain features of their plans as “” for middle-class . Their most rapid growth, however, began in the 1880s and 1890s with a number of product innovations that moved them directly into traditional savings bank customer and product markets. One significant innovation was the tontine , which combined an ordinary life insurance policy with deferred savings and an investment feature that benefitted surviving policyholders at a specified date. The addition of a “savings feature”, first introduced by the Equitable Life Assurance Company in 1867, proved a significant engine for growth; as much as two-thirds of insurance in force by 1905 were tontines. Another significant product innovation was industrial life insurance, small denomination insurance with face values as low as $100 targeted at the mass market.

65 In contrast to ordinary life policies, which typically have minimum face values of several thousand dollars, industrial life insurance directly targeted the mass market customers that savings banks traditionally served. Industrial life insurance was directly and aggressively marketed to homes door-to-door. Several new entrants into the industry, including the John Hancock Company (1862), the Metropolitan Life Insurance Company (1868), and the Prudential Insurance Company of America (1875) entered the market based on the introduction of industrial life. By the First World War, life insurance companies had become the leading type of financial intermediary in the United States, in large part because of the innovations they introduced in savings banks’ traditional product and customer segments (Murphy 2002, 2010, Welfling 1968).

Commercial banks and trust companies introduced yet another set of product innovations that directly challenged savings banks. Commercial banks in antebellum America had traditionally raised capital through equity offerings and issues, not deposits; though commercial bank demand deposits had been introduced and had begun to grow before the Civil War, bank balance sheets show that they were unlike the highly leveraged intermediaries with which we are familiar with today (Lamoreaux 1994). As state bank notes became taxed out of existence following the National Banking Acts (1863, 1864), state- chartered banks began to actively search for new sources of liabilities. By the 1880s and 1890s, the rapidly proliferating number of state banks in the US began to offer -bearing deposit accounts that mimicked the essential features of the savings banks’ core product: the . Though national banks were prohibited from offering similar services, many of them managed to circumvent the regulation until the law itself was relaxed by the Federal Reserve Act of 1907 (White 1983).

Trust companies, largely unregulated state-chartered intermediaries that began to proliferate in the late 19th century, presented an even greater challenge by offering not only interest-bearing deposit accounts but also a one-stop retail shop for all financing needs, from and investment to insurance to small business loans to brokerage services (Wadhwani 2002). Commercial banks and trust companies hence mimicked the basic savings while offering potential customers enhanced range of services.

66 In many ways, savings banks were in a strong position to capitalise on this wave of innovations in personal finance in the late 19th century. They had established high levels of trust among savers in the mass market, who were generally far more suspicious of malfeasance among commercial banks and other intermediaries. They had facilities and staff familiar with retail finance that could be leveraged to expand their scope of product offerings. And, in general, they were perceived favourably by regulators. Yet, American savings banks made little effort to capitalise on product innovations and made only limited efforts to respond to competitive pressures. Between 1870 and 1930 they made no efforts to establish demand accounts, serve small business, create amortised mortgage loans or consumer loans, and made late and futile efforts to offer life insurance to their savings customers.

In contrast, the savings bank sector in other industrialising countries reacted very differently to the wave of product innovations, making significant attempts to enter one or more of the product categories described above. In Great Britain, trustee savings banks and the postal savings bank began to offer life insurance and annuities relatively early (Gosden 1996). In Germany, savings banks began to offer checkable deposits, transfers, small business loans and mortgage loans (Mura 1996). In Japan, the developed extensive life insurance and products, in addition to basic savings accounts (Anderson 1990).

The most appropriate comparison for American savings banks is probably with their German counterparts. Like American savings banks, the German savings banks were seen as distinctively local institutions overseen by a federalist regulatory state. In the 1880s, their balance sheets looked very similar to those of American savings banks, as did their position in the market as institutions designed to serve the savings needs of local wage earners and middle classes. The German savings banks began experiencing competitive pressures from new entrants, such as credit and credit banks, similar to those experienced by American savings banks beginning in the 1890s. Most notably, after the turn of the century, the large credit banks began establishing deposit- taking branches that competed directly with the traditional business of the savings banks (Guinnane 2002; Fear and Wadhwani 2011).

67 Strikingly unlike their American counterparts, however, German savings banks had reacted by embracing a number of innovations and competing directly with commercial banks on local, regional and national levels. They successfully implemented a system of demand deposits and a national giro payments system. They moved aggressively into small business lending, and even underwrote and marketed securities in order to compete with the large credit banks. In the 1920s, they established building associations and expanded their mortgage lending (Fear and Wadhwani 2011).

Why did American savings banks fail to innovate and to effectively respond to competition? The following three sections examine in turn firm-level capabilities, network or associational capabilities, and regulatory institutions as reasons why American savings banks failed to innovate and to respond to competition. Their failure to deal effectively with competition in the late 19th and early 20th centuries, I will argue, would have significant implications for their demise a century later.

3. Limited Response to Innovation, 1870s-1920s

By the late 19th century, savings banks developed a number of clear capabilities and resources that served as the basis of their competitive advantage in the market. Their most significant competitive capabilities were their relatively low-cost business model, their operational ability to handle a large volume of retail customers, and their cultivated reputation as especially safe and trustworthy intermediaries. Archival evidence from savings banks and other primary sources shed light on the extent to which these factors served to inhibit savings bank managers and trustees in adopting the product innovations discussed above. While their low- cost business model and their operating capabilities do not seem to have been significant handicaps, savings bank managers’ positioning of their firms as safety-oriented institutions became a significant source of inertia. Other factors, including the trusteeship organisational form and a provincial outlook, also contributed to their inability to react to innovation.

Savings banks’ hesitant and limited entry into life insurance and annuities provides an example. Despite its establishment as a viable expansion opportunity by savings banks in the UK and Japan, savings bank life insurance (SBLI) had a slow and difficult start in the United States.

68 In fact, the concept of SBLI was first promoted not by savings banks at all but rather by Progressive Era reformers, especially Louis Brandeis, who saw an opportunity to provide wage workers with low-cost, over-the- counter life insurance through savings banks. Remarkably, the majority of Massachusetts savings banks not only opposed the measure but also fought its adoption once it was passed. Some of the savings bankers’ arguments against the adoption of SBLI rested on the weak reasoning that the provision of life insurance did not complement the capabilities of savings banks. “We have trouble enough as it is now, from depositors who are hardly able to write their names, and if an insurance department were to be added here I don’t see how we could find time or floor space to handle it”, argued one Boston savings bank manager (Welfling 1968: 189-190).

Much more common a concern, and perhaps a more reasonable one, was that the provision of life insurance might somehow compromise the savings banks’ reputation and position as especially safe financial institutions. Savings banks had developed and protected a reputation as conservatively run organisations by trustees who put safety first (Wadhwani 2006). Now, with life insurance, as with other products, savings bankers were concerned that it might compromise that position. “The main barrier in the campaign [for SBLI] was the ultra-conservatism of savings bank officials themselves”, explained one observer. “Vague apprehension prevailed lest insurance departments thus engrafted in savings banks should somehow impair the latter’s integrity” (Welfling 1968). Even after the enabling legislation was passed and major employers like Edward Filene made efforts to publicise SBLI, most savings banks showed little interest in the product. As late as 1922, 15 years after the enabling legislation was passed, only four savings banks in the state offered SBLI. Outside of Massachusetts SBLI was not adopted until the late 1930s and 1940s, by which time life insurance companies had once again regained their reputations and re-established their dominance over the product.

Life insurance provides a particularly vivid case of how savings bank managers’ focus on safety and reputation became a source of inertia that led to their failure to act on new product opportunities. Similar stories abound in mortgage and consumer lending, which expanded rapidly throughout the 1910s and 1920s owing to the proliferation of S&Ls and industrial banks.

69 Though savings banks did begin to offer slightly lower denomination mortgages, there was little effort to adapt the terms of the product as S&Ls had done. By the eve of the , when S&Ls in some cities had begun to introduce mortgage loans that were amortised, required as little as 20% down and had maturities of ten years, savings banks clung to the traditional structure of the as it had existed in the 19th century: 50% loan-to-value maximums, three- to five-year maturities, with enormous balloon payments at the end (Wadhwani 2002).

By positioning themselves as ultra-conservative institutions, savings banks had created a comparative advantage in the 19th century that served as the basis for growth of the general public’s trust in formal financial intermediaries. With the introduction of new product innovations, however, this same positioning and organisational asset became a liability to savings bank managers’ ability to react to innovations that were transforming the industry.

Relying solely on such firm-level explanations, however, make it difficult to explain why American savings bank managers were so much more conservative than their German counterparts. German savings banks, after all, were also positioned as particularly safe and trustworthy local institutions. Yet German savings bank directors and managers reacted very differently to the introduction of new innovations and the competitive threats they represented, aggressively seeking to adopt innovations that would allow them to effectively compete on the regional and national level with the large credit banks. To understand these national differences, we need to move beyond firm-level factors and consider the ways in which regulatory institutions and inter-firm networks and associations differed between the two countries.

4. Limited Efforts at Collective Action, 1890s-1930s

While firm-level factors clearly contributed to American savings banks’ apparent lack of ability to embrace product innovations, they tell us little about why these capabilities to innovate differed so much in Germany. Given their similar market positions and histories, why were American savings banks so much more conservative about engaging in innovation than their German counterparts?

70 One factor that helps us understand why German savings banks were able to integrate innovations better than American savings banks was the greater extent to which they developed stronger networks and associations. In recent years, scholars have devoted considerable attention to the role of alliances and associations in the introduction of innovation (Brandenberger and Nalebuff 1996), and in the case of German savings banks inter-firm cooperation seems to have been critical to their ability to adopt innovations. By the 1910s and 1920s, German savings banks had transformed a set of informal relationships into a “group” structure that linked autonomous local savings banks to larger regional or state level institutions (such as the Landesbanken), which were in turn members of a national savings bank association and a national-level bank (Mura 1996).

Informal cooperation between local savings banks and the state-level Landesbanken had begun in the early 19th century, but it was not until late in the century that significant levels of coordination between firms began. The impetus for the coordination was more practical than strategic: the creation of a regional and national clearing system. For decades, workers’ associations had lobbied for the creation of facilities to transfer funds across institutions at low cost, arguing that high rates of mobility combined with the difficulty of moving their savings discouraged the use of savings banks. To create a national giro-based transfer system, the savings banks created the Girozentrale to facilitate transfers and clear accounts across banks. Opposition to these moves by the larger credit banks intensified the associational movement among savings banks. By the early 20th century, the association was actively involved in fighting for legislation permitting savings banks to offer checkable accounts. The pursuit of these practical and political activities eventually led to the formation of a formal “savings bank group” or association, which coordinated activities between local banks, regional landesbanken and the national clearing bank (Guinnane 2002, Schultz 2008, Fear and Wadhwani 2011). Local savings banks remained formally autonomous but benefited from the scale that the national association offered.

The benefits of the creation of a strong association among savings banks are most apparent in the introduction of the giro system and checkable deposits by the German savings banks. The association allowed the creation of national payments capabilities that local savings banks by themselves would have found difficult or impossible to provide.

71 As German savings banks began to serve small as well as the mass market for personal finance, such regional and national transfer capabilities would prove critical. Coordination between savings banks hence facilitated product innovations that required regional and national reach.

The savings bank association aided product innovation in less direct and obvious ways as well. Though the initial impetus for the association was practical, it soon became important for its strategic value. Because of its national reach, the savings bank association could help local institutions understand how the broader competitive landscape was changing and could help transfer best practices, innovation and ideas to local institutions that were limited in their resources and their understanding of competitive threats. For instance, the association played a critical role in helping transfer practical knowledge and practices about small business lending and mortgage lending to local savings banks which might otherwise be more reluctant and less capable of taking on the risks of such product introductions. In later years, they would also play a critical role in the introduction of consumer lending to local savings banks. More broadly, the association allowed the local savings banks access to strategic information and advice that helped mitigate risks of new product introductions and better understand the liabilities of sticking to their current position (Fear and Wadhwani 2011).

In contrast, the associational and network capabilities of American savings banks were extraordinarily limited. Savings banks in a few states, including Massachusetts and New York, created state-level associations. These associations, however, served very limited roles, primarily outlining political and regulatory positions rather than aiding members in strategic decision-making or introducing innovative capabilities. At the national level, associational efforts were even weaker, perhaps in part because savings banking in the US was not as geographically dispersed as in Germany. A savings bank association was created within the auspices of the commercial bank-dominated ABA (American Bankers Association). Whereas the German savings bank association played a critical role in positioning savings banks as a group to compete against credit banks, the American savings bank association was embedded and co-opted within the commercial bankers association, inherently limiting its strategic value (Wadhwani 2002).

72 Even after a separate national savings bank association was formed around 1920, the organisation primarily served as a lobbying and marketing organisation rather than one that developed a wider range of “group- level” capabilities. Efforts during the Great Depression to expand inter- savings bank cooperation to provide liquidity and consulting services proved short-lived (Steiner 1944).

The relative weakness of associational capabilities among American savings banks also played a direct role in limiting the ability of savings banks to engage in product innovations that required regional or national coordination. One of the often repeated arguments that savings bankers launched at SBLI was that the local institutions were not capable of serving customers who moved. As one manager stated, “It appears to me that the average savings bank cannot well conduct an insurance business because the bank is a local institution only. The machinery of insurance would be costly even if there were a central association to keep us in touch with our policyholders in other parts of the state” (Quoted in Welfling 1968: 189). While American savings banks were struggling to conceive of the viabilities of such regional capabilities, German savings banks had already created the network and associational structures that made such product introductions possible.

For both German and American savings banks, deep local knowledge of customers and the economy had served as a source of competitive advantage. In the end, for American savings banks, this intensely local orientation also turned into a liability as the autonomous savings banks proved incapable of dealing with competitive changes that were regional or national in scale and incapable of introducing products that required this broader knowledge and organisational capabilities. Germany’s savings banking system was able to overcome this, not by giving up local autonomy and positioning but by associating and creating inter-firm ties that allowed them access to regional and national information networks, strategic perspectives and organisational capabilities. Lacking such associational capabilities, American savings banks hence left open such regional and national innovative opportunities to be tapped by new entrants into the field.

73 5. Political and Regulatory Constraints on Innovation

While firm-level rigidities and limited inter-firm capabilities played a significant role in inhibiting product innovation among American savings banks, so did factors beyond their control. In particular, political and regulatory constraints played a large role in inhibiting innovation among American savings banks, especially when we compare them to their German counterparts. German regulations in the late 19th and early 20th centuries supported competition through incumbent innovation, whereas American regulations worked to fragment and segment financial markets, unintentionally paving the way for innovation by new entrants.

Business historians’ comparisons between American and German management has often employed the trope of German “cooperation” to distinguish it from American “competition”. Chandler’s (1989) analysis of national differences in industrial management, for instance, distinguished between German “ managerial capitalism” and American “competitive managerial capitalism”. These broader generalisations are based largely on the notion that American and German economic regulation took different paths, with the former choosing antitrust as the cornerstone of economic policy while the latter permitted and even enforced cartelisation agreements. In the context of personal finance regulation, however, this simple distinction between pro-competition and pro-cooperation policy proves misleading (Fear, forthcoming). Rather than eliminating or reducing competition, German regulation evolved in ways that fostered “group-level” national competition between savings banks, credit banks and cooperatives, in turn permitting and even encouraging product innovation within each of these groups. In contrast, US regulations tended to enforce fragmentation and segmentation as a way of preventing concentration, channelling innovative and creative opportunities toward new entrants rather than incumbents.

Until the 1880s and 1890s, the regulation of savings banks in the two countries was remarkably similar. There was a relatively clear division of labour between savings banks and commercial or credit banks, with the former focusing on personal finance for the mass market and the latter focusing on enterprise finance and investment opportunities for the wealthy. Regulations helped enforce this division. In particular, there were asset class restrictions on savings banks in both countries, typically limiting them to investment in real estate-backed lending and government debt.

74 The restrictions were designed to help ensure the safety of the institutions on behalf of small savers who were naturally in a poor position to monitor their investments (Wadhwani 2006; Guinnane 2002). In both countries, the regulatory framework began to change when commercial banks and other intermediaries aggressively entered the market for deposits, undermining the market divisions that had previously existed. In both countries, popular and regulatory concerns grew over the possibility of banking sector concentration and the threat that regional deposits might flow to national urban centres.

In Germany, and the other large Berlin credit banks began to rapidly establish retail branches to accept deposits beginning in the late 19th century. Along with regional credit banks, they also created larger strategic groups (or konzern) and eventually a credit banking cartel to stabilise interest rates (Guinnane 2002). Regulators reacted by allowing savings banks to develop offsetting regional and national capabilities to compete with the credit banking group. It was in the process of responding to the competitive pressures created by the credit banks that savings banks made headway into innovative new products, enabled along the way by German competition policy. The savings banks’ late 19th-century development of a national giro payments system was in part aided by this policy. Similar regulatory accommodations followed in the early 20th century as savings banks made strategic moves into new products that allowed them to compete with the credit banking group. In 1909, regulators bent to pressure from the savings bank association to allow savings institutions to offer checkable deposits and current account , despite the fact that this had traditionally been the market served by commercial banks. Similarly, in 1915 and 1921, new legislation was passed allowing savings banks to underwrite and broker securities and to make loans to businesses. As Guinnane (2002) has pointed out, this regulation-supported competitive dynamic created pressures for emulation and “universalisation” among Germany’s “small banks” as well as among its big banks. From the point of view of product innovation, it created a regulatory environment that was conducive to product innovation and experimentation by the incumbent savings banks.

Like their German counterparts, American regulators and politicians grew increasingly concerned that strategic moves by larger national banks might lead to concentration and consolidation in the industry.

75 Unlike the German system that fostered the creation of competing groups of banks, however, the US system more directly intervened to enforce fragmentation, most famously by maintaining anti-branching provisions (White 1983). Well before the Great Depression-era regulations that codified banking segmentation at a national level, state- level regulations had worked to maintain local unit banking and enforce market segmentation. Though innovations and new entrants (particularly trust companies) challenged this segmentation, regulators were slow to liberalise restrictions, particularly in the case of savings banks.

In the case of savings banks, state legislatures and courts throughout the 19th century had emphasised that the institutions’ charters permitted them to engage in only a very limited set of activities, essentially empowering them to accept savings deposits and invest them in a highly restricted set of asset classes. The strict rules circumscribing manager and trustee discretion were designed largely as way to protect the safety of depositors. When a number of savings banks failed in the 1870s, state courts placed further sanctions on managerial risk-taking by holding trustees and officers personally liable for contracts and activities that extended beyond the narrow bounds of the charter. Savings bank regulations and bank competition policy hence directly restricted innovative activity in order to maintain market segmentation and exposed managers and trustees to extraordinarily high levels of personal risk if they made changes in the prescribed structure of their balance sheets (Wadhwani 2006).

The US regulatory system in turn unintentionally favoured new entrants, which were typically not subject to the same statutory restrictions and common law standards as incumbents. This pattern was most apparent in the case of trust companies in the late 19th century, which were largely unconstrained by regulation and hence moved most rapidly toward the introduction of new products and services to the point where they resembled small universal banks. While heavily regulated, commercial banks and insurance companies were somewhat less constrained by segmentation rules than savings banks because the dual state and federal regulatory structure they were subject to allowed them to play regulators off of one another (White 1983). Savings banks, which were exclusively state-chartered, did not have this luxury and were subject to the enforcement of the tight regulations discussed above.

76 Tight regulatory constraints on the scope of savings banks created a strong constraint on the ability of incumbent savings banks to innovate. Though control over these regulations were largely beyond the control of savings banks by the early 20th century, it would be inaccurate to characterise the regulatory institutions that evolved as entirely distinct from the organisational and associational capabilities described above. German savings banks and their associations were favoured with a conducive regulatory environment in no small part because they shaped local and national political institutions in the process of development. In addition to developing key market capabilities, the savings bank association developed essential political capabilities, winning allies in the labour movement and developing the ability to effectively lobby the government (Guinnane 2002). The US savings banks had shown little interest in developing these political capabilities throughout their history and by the early 20th century the rules they were subject to were largely out of their control.

6. Depression and the New Deal: Deposit Insurance & Segmented Markets, 1930s-1970s

Despite their ineffective response to competition between the 1870s and the 1920s, mutual savings banks were presented with a uniquely good opportunity to expand their role in the banking system in the 1930s. Unlike other intermediaries, savings banks performed very well during the banking panics of the Great Depression. Few mutual savings banks experienced panics and, in fact, the system experienced rapid growth in deposits as savers sought out safe havens for their money amidst the turmoil. Highlighted by the Great Depression, savings banks’ reputation for safety and remained the one core capability that truly distinguished it from other institutions (Ornstein 1985).

Ironically, however, the disaster of the 1930s would undermine savings banks’ competitive advantage despite their being the only institutions that had clearly managed the crisis well. The biggest long-term impact of the Depression on savings banks came not as a result of the financial crisis but as a result of the government reaction to it. In 1933, the federal government introduced federal deposit insurance through the newly formed Federal Deposit Insurance Corporation for any bank – federal or state- chartered – in the United States.

77 Commercial banks flocked to deposit insurance as a way of re-instilling depositor confidence and regaining its deposit base. By backing deposits in all institutions regardless of size or corporate form, deposit insurance essentially wiped out the one significant competitive advantage that savings banks had: their reputation for safety. S&Ls received a similar guarantee from a separate federal deposit insurance program, also established in the 1930s (Wadhwani 2002).

Lacking strong collective action capabilities, and content with their healthy response to the banking crises of the 1930s, mutual savings banks largely failed to take advantage of their excellent performance in the crisis to shore up their position within the banking system. Initially, few savings banks even signed up for deposit insurance, feeling that they had been essentially immune to the crisis that affected smaller institutions that experienced runs. Remarkably, savings banks also resisted efforts to enlarge their significance within the American banking system. Several proposals to manage the crisis by expanding the role of mutual savings banks into the commercial arena and by expanding them nationally failed to garner strong support from savings banks. In contrast, commercial bankers and the S&L association worked closely with the Roosevelt administration on banking reform and benefitted most from the blanket security provided by deposit insurance (Wadhwani 2002).

In addition to introducing deposit insurance, the regulatory reforms of the New Deal also sharply segmented the financial and banking market by circumscribing the roles of various institutions and by putting into place tight restrictions on both sides of the . Most New Dealers felt that the severity of the banking crisis had been largely attributable to the high level of competition between intermediaries in the previous decades. As commercial banks, savings banks and S&Ls competed for the same savers and same assets, their cost of funds had risen and their on assets had shrunk, in turn squeezing margins and leaving the institutions with vulnerably small capital and reserve accounts. New Deal regulations sought to control this competition by dividing up the markets that commercial banks, savings banks and S&Ls would be entitled to. Savings banks and S&Ls – or thrifts, as they came to be called following the New Deal – would focus on taking in savings and time deposits and investing in long-term, fixed rate assets, especially mortgage loans and (to a lesser extent) bonds (Ornstein 1985).

78 These New Deal regulations effectively controlled both sides of the balance sheet. Commercial banks were prohibited from paying interest on demand deposits, leaving savings banks to tap the market for time and savings deposits. Moreover, to prevent competition over deposits, federal regulators introduced a ceiling on the interest rates commercial banks could pay on time deposits. Savings banks and S&Ls were permitted to pay a slightly higher , guaranteeing a source of funds while controlling the overall cost of those funds from getting higher. On the asset side of the balance sheet, restrictions on the kinds of investments that savings banks could make – long a feature of state regulations – were now federalised. Savings banks were essentially limited to long-term fixed rate lending (Ornstein 1985).

The overall effect of this segmentation was that it preserved the place of existing mutual savings banks within the banking system over the following four decades and hid the underlying weaknesses in their lack of real competitive advantage over other intermediaries. With their target markets essentially protected from competition, mutual savings banks maintained a steady 10% share of financial intermediary assets between 1940 and 1970. The number of mutual savings banks also remained steady at approximately 500 institutions. New Deal regulations essentially worked to preserve the status quo in terms of the position and share of various intermediaries. It hid, however, the fact that underlying the regulation mutual savings banks had essentially lost any real competitive advantage they had enjoyed over other intermediaries.

7. Crisis and Decline

In many ways, the regulations that sheltered savings banks throughout much of the 20th century made them especially vulnerable to the rising interest rate environment that would lead to the crises of the last quarter of the 20th century. The interest rate ceilings and investment regulations that segmented the savings banks’ market and protected them from competition worked only so long as the interest rate environment remained relatively stable and as long as regulation remained effective in dampening competition. Both these conditions began to change in the 1970s, leading to the crises of the 1980s and 1990s.

79 The crisis was initiated by the rise of interest rates, especially in the late 1970s and early 1980s. In the early 1980s, interest rates on three-month treasury bills hit a high of 16%. The spike in rates prompted rapid disintermediation as savers moved their money out of low-yielding deposits and into capital markets, government securities and eventually into mutual funds. Some institutions lost as much as 30% of their deposit base in a short period of time. Mutual savings banks in New York faced particularly difficult circumstances as regulatory restrictions combined with aggressive competitors rapidly placed the city’s savings banks in a compromised financial state (FDIC 1997).

Disintermediation placed increasing pressure on savings banks to pay depositors just as the long-term, fixed rate assets held by savings banks became less valuable on the market. The result was widespread and severe losses for mutual savings banks that ate into reserve funds and left a dozen institutions on the brink of failure. Between 1980 and 1982, mutual savings banks experienced USD 3.3 billion in losses, accounting for 28% of their aggregate reserves. The FDIC was forced to step in to assist weaker institutions that were about to fail. Rather than allowing outright failures, FDIC used a programme of “assisted mergers” that effectively allowed stronger institutions to acquire weaker ones while covering losses. These savings banks had lost USD 1.8 billion or about 12% of their assets (FDIC 1997; Ornstein 1985).

The crisis also led to calls to dismantle the restrictions on mutual savings banks in order to allow them to more effectively compete. Serious discussions of deregulating the banking system, and particularly the segmentation of various intermediaries, had taken place throughout the 1970s but had been opposed by various interest groups, including the savings banks themselves. Reflecting their long history of conservatism, the savings banks, as one FDIC report noted, “were reluctant to compete directly with banks.” But the reforms gained particular urgency with the failures and mergers of the early 1980s. The Depository Institutions Deregulation and Monetary Control Act of 1980 finally instituted a phase out of Regulation Q, the nationally imposed ceiling on deposit interest rates and the favourable treatment of mutual savings bank deposits. It also liberalised restrictions on the assets that savings banks could hold, allowing modest amounts of commercial lending and other types of asset holding. Finally, it made it easier for mutual savings banks to convert into stock savings banks as a way of recapitalising savings banks. The reforms essentially allowed savings banks to act more like deregulated banks

80 The result of the deregulation was a dramatic decline in the ranks of mutual savings banks from approximately 500 in 1970 to fewer than 100 today. Some of this decline took place as scores of mutual savings banks converted themselves into stock savings banks, or even commercial banks. But the decline was also attributable to the failure of dozens of other savings banks. Between 1985 and 1994, scores of savings banks failed, many of them institutions that the FDIC had saved just a few years earlier through mergers. The net impact was a significant reduction of mutual savings banks in the United States (FDIC 1997).

Contemporary observers and social scientists often attributed the failures and decline of savings banks to proximate causes, such as deregulation and the movement of savings banks into new lines of activity that had not previously fallen within their purview. The FDIC, for instance, attributed the failures “to activities in which the banks became involved after the introduction of expanded powers.” But, as this paper has shown, the inability of savings banks to deal effectively with heightened competition in a deregulated environment actually lay in causes that were historically deeper. In their conservatism and failure to expand both geographically and in terms of product scope in the early 20th century, savings banks in the United States had undermined their ability to develop the range of capabilities needed to compete against banks, markets and other intermediaries, in stark contrast to their German counterparts. The New Deal regulatory regime both undermined savings banks single remaining competitive advantage (their superior safety record) and protected the institutions for decades by segmenting the banking market. That combination of weakened capabilities and regulatory dependence had virtually ensured that the institutions would not be able to effectively respond to competition.

8. Managerial Implications

The decline of mutual savings banks in the United States provides important lessons for the managers of savings banks in other parts of the world today.

81 First, it highlights the risks of complacent growth. Throughout the early decades of the 20th century, many of the mutual savings banks in the United States continued to grow, even though as a system mutual savings banking was rapidly losing market share to new, more innovative intermediaries and products. The relative stability and success of individual firms masked the declining competitiveness of mutual savings banking as a model of intermediation within the financial system. Ultimately, however, the long-term viability of individual savings banks was closely linked to the competitiveness and relevance of mutual savings banking as a category of financial intermediation; the success of savings banks rested on the ability of consumers to distinguish them as a unique type of intermediary and on their treatment as a group by regulators. Individual firm growth thus proved deceptive in the long run because it allowed managers to be complacent about the declining competitiveness of mutual savings banks as a group.

The importance of “group-level” competitiveness also indicates the crucial importance of collective action capabilities to the long-term success of savings banks as type of intermediary. American mutual savings banks remained intensely local firms that knew their local markets and customers well. This local knowledge, however, also became a handicap in their ability to react to changes in the market that required regional and national capabilities. Unlike their German counterparts, American managers’ efforts to “coordinate” innovations and develop regional and national capabilities remained limited and this ultimately constrained the ability of individual firms to introduce innovations that required regional and national scope.

Lastly, American mutual savings banks’ narrow adherence to their original products and markets proved detrimental to their long-run competitiveness. Unlike some of their counterparts in other parts of the world, American savings banks remained focused on their traditional customer base and products throughout their 200-year history. However, because markets and regulations changed so significantly over time, this narrow focus on providing savings accounts to small savers and investing in long-term, fixed-rate assets such as mortgages made them extremely vulnerable to changes in market conditions, disruptive innovations and shifts in consumer preferences. Their narrow vision for the scope of their role in the financial system ultimately proved harmful as the structure of American financial system itself changed.

82 Ultimately, these implications suggest that deregulation and competition by themselves did not determine the fate of mutual savings banks. Rather, the long-term effects of managerial decision-making and responses to competition ultimately undermined the survival of mutual savings banking in the United States.

“Irish Depositors of the Emigrant Savings Bank withdrawing money to send to their suffering relatives in the old country” Source: Frank Leslie’s Illustrated Newspaper (March 13, 1880). Library of Congress. Notes: Some savings banks catered to specific ethic groups. The Emigrant catered primarily to Irish immigrants, many of whom remitted large amounts of savings to relatives in the home country.

Banknote of the Somerset and Worcester Savings Bank Notes: Prior to the Civil War, some savings banks issued their own currency.

Bank Run on the Seamen’s Savings Bank During the Panic of 1857 Notes: Bank runs were a common experience in the nineteenth and early twentieth centuries in the United States, and savings banks were not immune. Source: Harper’s Weekly. Library of Congress.

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