BANKING & FINANCE Though some oppressive Depression-era regulation has been removed, there is still need for reform of the U.S. banking industry. Banking Approaches the Modern Era BY CHARLES W. CALOMIRIS Columbia University he past two decades have seen a A BRIEF HISTORY radical transformation of regulations con- In order to answer those questions, we must first recognize trolling the size, location, and activities of how unusual the prior structure of U.S. commercial banking U.S. banks. Included in those changes are was in comparison with other countries’ banking systems. state-level reforms of branching barriers, Commercial banking began in the United States, as in most relaxation of deposit interest rate ceilings, other countries, as an instrument of state intervention and eco- the passage of a nationwide bank-branch- nomic planning. Banks were chartered in the late eighteenth ing law in 1994, and the expansion of bank powers through- and early nineteenth centuries to accomplish government- Tout the 1980s and 1990s. The reforms culminated in the pas- sanctioned purposes. The scarcity of such charters created sage of the Gramm-Leach-Bliley Act of 1999, which established monopoly rent for banks, which acted as an implicit tax-and- financial holding companies — an alternative to more limit- transfer scheme that supported the activities in which the ed bank holding companies — as a platform for building the favored banks engaged. global, universal U.S. banks of the next generation. By the middle of the nineteenth century, in most states, that Prior to the sea change of the past two decades, banks most- mercantilist approach was replaced by one of “free” bank char- ly focused narrowly on deposit taking and lending in separate tering. But banks were still subject to special taxes or required local markets. Now, U.S. banks operate on an unprecedented to hold government paper as part of their extensive regulato- large scale throughout the country and the world, and are able ry mandate. to marry traditional lending and deposit-taking activities with investment banking, private equity investing, asset manage- State regulation One key feature of the U.S. system was that ment, insurance, and many other financial services. What state laws largely determined bank regulation. States were free caused the drastic changes? What barriers to efficient financial to establish barriers to entry in banking that limited new intermediation still remain? And what have we learned from the entrants from competing with existing banks. Not only was recent experience about the next wave of innovation and dereg- interstate banking forbidden, but, in most states until the 1980s, ulation in the financial services industry? competition within states was also circumscribed by regula- tions that limited branching or consolidation. Despite the Con- Charles W. Calomiris is the Paul M. Montrose Professor of Finance and Economics at the stitution’s clear mandate to ensure unfettered interstate com- Columbia Business School, the Arthur Burns Fellow in Economics at the American Enterprise merce, the Supreme Court did not interpret interstate banking Institute, and a research associate for the National Bureau of Economic Research. A prodigious writer on banking and finance, Calomiris’ most recent book is U.S. Banking Dereg- barriers as barriers to commerce. That opened the way for local ulation in Historical Perspective. He can be contacted by e-mail at [email protected]. special interest groups (including both bankers and some bank 14 REGULATION SUMMER 2002 KEVIN TUMA borrowers) to lobby for branching restrictions. The limits on writers of securities, and thus made the cost of industrial branching produced a system of thousands of banks, which finance unnecessarily high. reached nearly 30,000 by 1921. Finally, unit banking made agricultural finance more cost- ly by limiting the development of regional or national mar- Consequences The geographic fragmentation and nar- kets for bankers’ acceptances to finance the movement of rowly circumscribed powers of American banks made the U.S. crops (an instrument that was prevalent in other countries). system inferior in several respects. It limited diversification of Bankers’ acceptances worked best in the context of nation- loan risks and diversification of income from mixing differ- wide branch banking, where banks could finance crop move- ent banking services. Small, undiversified banks tended to be ments through the clearing of balances across regions with- riskier, leading to greater instability during economic down- in the same bank. turns. Small, rural banks were most vulnerable, and they responded by lobbying for deposit insurance — at both the The Depression In the wake of the agricultural banking busts state and national levels — as a means to protect themselves of the 1920s, those flaws became increasingly apparent to crit- at the expense of taxpayers and large banks (which bore a dis- ics of the American bank regulatory system. The recognition proportional share of the costs of mutual deposit insurance). of the bank fragility produced by entry barriers underlay a The perverse incentives of state-level deposit insurance sys- widespread and successful movement to permit branching and tems enacted before World War I produced banking collaps- consolidation within and across states, and to repeal deposit es in several states in the 1920s, which added further to the insurance. As banks grew in size, they also found it beneficial costs from unit banking. to increase industrial lending and develop additional services Unit banking also created a mismatch between the small for industrial borrowers, including the underwriting of secu- scale of banks and the growing scale of industrial enterprises, rities offerings. But the Great Depression cut that initial wave which increasingly came to operate regional or nationwide of bank deregulation short. networks of production and distribution during the second The Depression accentuated the weakness of many small industrial revolution of the late nineteenth and early twentiet h banks that were already distressed. Bank distress during the centuries. The mismatch made it increasingly difficult for banks Depression is a complex subject. Recent empirical research by to finance industrial activity, either as lenders or as under- Joseph Mason and me shows that, prior to 1933 (the trough of REGULATION SUMMER 2002 15 BANKING & FINANCE the Great Depression), the 1930s bank failures — like those of or shrinking banks. That led to the relaxation of branching the 1920s — were regional phenomena that mirrored deteri- restrictions, first at the state level, then regionally and nation- orating local economic fundamentals. In early 1933, sudden, ally. And fortunately, there was no Great Depression shock to economy-wide deposit withdrawals — produced in part by interrupt the new process of rationalization and reform. anticipation of President Franklin Roosevelt’s decision to aban- don the gold standard — led to a nationwide “bank holiday.” Competition An additional important influence on post- But before 1933, bank failures varied across regions in severi- 1980 deregulation was the growing competition that Amer- ty and timing, and were predictable results of changes in local ican banks faced, both domestically from securities markets economic activity. Local runs on banks (much less nationwide and non-bank intermediaries (e.g., finance companies) and runs on banks) were not important contributors to bank dis- internationally from other countries’ banks as opportunities tress prior to early 1933. for international competition expanded. The constraining From the standpoint of economic reasoning, the Great influence of American regulation became recognized both as Depression reinforced the logic of bank deregulation by show- a cause of foreign bank entry into U.S. markets and a barri- ing the vulnerability of a geographically fragmented and undi- er to the expansion of U.S. banks abroad. Technological versified banking system. Moreover, as Eugene White has changes in communications and information technology that shown, the Depression years also revealed an advantage from facilitated the development of securities markets and inter- universal banking: Banks that engaged in securities under- national capital flows played a role here, because they per- writing during the 1920s benefited from greater income diver- mitted new entrants to compete more easily with U.S. banks sification and were less likely to fail during the Depression. and thus drove reluctant politicians to act. (See “The Moti- vations Behind Banking Reform,” Summer 2001.) Backlash But the effect of the Depression on the political economy of bank regulation was to reverse the process of Regulation Q Another influence on competitive pressures deregulation and the removal of entry barriers. Populist sena- facing banks was the high inflation environment of the late tors and congressmen defended small banks and portrayed 1960s and 1970s. High inflation reduced the attractiveness of them as victims of rapacious large banks, which they accused bank deposits, whose interest rates were subject to “Regulation of dishonest practices and blamed for causing the Depression. Q” ceilings. Regulation Q — another provision of the 1933 Act The mixing of commercial and investment banking was par- — was intended in part to limit competition within banking, ticularly vilified as creating conflicts of interest within banks and thereby strengthen banks.