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

1. “To Establish a More Effective Supervision of Banking:”How the Birth of the Fed Altered Bank Supervision A Return to Jekyll Island The Origins, History and Future of the Federal Reserve November 5-6, 2010 Eugene N. White Rutgers University and NBER

2. The Dilemma of 1910 • Panic of 1907---Begins Outside “Safety Net” • New, more leveraged and lightly regulated intermediaries • No Central Bank---Standard Remedies Fail • Efforts by Treasury to Increase Liquidity • Rescue Organized by J.P. Morgan • Clearing House Loan Certificates • Panic Halted by a Suspension of Payments • Recession, 1907-1908 • Mild Contraction until Panic hits • Net national product fell 11% • Reform---the “National Banking System” • Monetary Policy---Michael Bordo • Financial Stability (Reg/Sup)---Eugene White

3. 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 standards for 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.

4. 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 • Weaker regulationsState-Chartered Banks grow rapidly in rural areas • Weaker regulationsTrust Companies grow rapidly in major cities • Uninsured Deposit-based banking

5. The Number of Bank by Charter Type

6. Shares of Banking Assets

7. Regulation IncentivesIncreased 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Deposits” in NYC, Chicago • Increases potential for incipient panic to become nationwide, country bank reserves quickly withdrawn • Frequent Panics: 1873, 1884, 1890, 1893, 1907

8. Frequent Costly Financial Crises • Panics Worsen Recessions: • Romer (1999): Frequency and severity of recessions greater before the Founding of the Fed • Miron (1986) : Panics lowered economic growth • Jalil (2009): Recessions with Panics are more severe and longer in duration • 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.

9. Percentage of Bank Insolvencies, 1864-1913

10. Supervision by the OCC • Objective: Supervision Should Reinforce Market Discipline • Disclosure: 3 Yearly Surprise Call Reports • Examination: 2 Yearly Surprise Exams • Examiners & National Banks • 1889: 30 examiners/ 3,239 banks • 1907: 100 examiners/6,422 banks • Enforcement: • Mark-to-Market & Prompt Closure • Only Tool: Revocation of Charter

11. 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” • 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)

12. Incentives from Regulation • Capital • Minimum Capital Requirements for entry • No Capital Ratios (but C/A > 20% for NBs) • No Federal Deposit Insurance • Double Liability: If a bank failed, shareholders could be forced to pay an assessment up to the par value of the stock to compensate depositors • Senator John Sherman (1864): Added guarantee for bank’s creditors & “tends to prevent the stockholders and directors of a bank from engaging in hazardous operations.” • If bank is weak, incentive to liquidate bank before losses growVoluntary Liquidations= 4x Insolvencies

13. Percentage of National Bank Voluntary Liquidations and Insolvencies,1864-1913

14. State Banks and Trust Companies? • Capital • Lower Minimum Capital Requirements • No Capital Ratios • Deposit Insurance, seven states after 1907 • Shareholder Liability—weaker regime • 1900: 11 states—single liability, 32 states—double • Creditors enforce Double Liability via courts—not State Regulator and only after assets completely liquidated

15. Costs of Failures • National Banks: 1864-1913: • 540 suspended. (39 restored & 501 fail). • Proven Claims: $191.0 million • Payments to Depositors: $146.9 million or 77% • Total losses $44 million for this 50 year period. Total deposits 1890=$2 billion • State Banks: 1864-1896 • 1,234 state banks fail, payout 50% (1/3 assets of NBs). Loss $50-$100 million • 330 national banks fail, payout 68%

16. 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

17. Assessment of 1864-1914 • “Microprudential” Rules Work Well to Limit Losses from Insolvencies • But Panics are Frequent and Severe: • Problem 1: Fragmented Banking System—small, undiversified banks with reserves at correspondents, pyramiding • Problem 2: Absence of a Central Bank to act as LOLR

18. 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. Unable to challenge unit bankers lobby and chartering authority of the states. • Unlike Civil War, no sticks only carrots to state-chartered institutions to join the Fed • Fed Reserve Era begins to change bank supervision

19. Conflict emerges betweenMonetary Stability and Financial Stability • High Inflation World War I • Fed raises rates in 1920Deflation & Recession • Number of bank failures rise • Most 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

20. Percentage of Banks Failing and Inflation 1866-1929

21. Incentives to Take More Risk • Fed promises to end panics by smoothing interest rate fluctuationsrisk-taking • 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.”

22. Supervision Split Between the Fed, the OCC and the States • The problem of state bank membership • 1917: 53 state members of 19,000 • Regulations eased1,648 members in 1922 • Fed given control of Call Reports • End of year surprise call reported eliminated • 19181926 Call Reports Reduces 52 • Examination • OCC refuses to share examination reports with the Fed

23. 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.”

24. What Hath the Fed Wrought? • First fifteen year of the Federal Reserve: • Some banks became dependent on the discount window • Voluntary liquidations fell, suspensions increased, and payouts declined. • Continued fall in the capital-asset ratio • Changes did not de-stabilize the existing system • Absence of the Great Depression? • Burgess’ optimism correct? If “competition in laxity” 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.

25. The Regime Shift to the New Deal • Great Depression 1929-1933 • Unexpected Deflationary Shock, Prices drop 23% • Real GDP falls 39% • Banking Shrinks • Deflationary Shock Hits Fragile Unreformed Banking Structure • July 1929: 24,504 commercial banks, $49 billion deposits • Bank Holiday March 1933 (“Stress Test”) 11,878 banks with $23 billion.

26. The New Deal’s Misdiagnoses • 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—”Intrinsic” not Market Value) • Deposit Insurance ends Double Liability

27. The New Deal: 1933-1970 and beyond • Monetary/Financial Policy Conflict? Supervision Subordinated to Monetary Policy--Eccles • Supervision independent of central bank? Contested Supervision • More than one agency? More agencies---one for each segment of industry: OCC, FR, FDIC, SEC, FRHBB….+ States Opportunities for Regulatory Arbitrage • Political Independence /Transparency /Oversight: More agenciesless transparency and less oversight • Philosophy of Supervision? End of Market Discipline & Market ValuationDiscretion-Based Supervision until 1991

28. 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 • WWIIConservative asset mix • Anti-Competitive Regulation • Increases Profits • 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 incentives—even though regulations created a fragile banking structure