Download Lecture: 12 The National Banking System

The National Banking Era
1863-1914
Macroeconomics:Civil War to World War I
• Civil War, 1861-1864
– Fiscal: Huge DeficitsHuge Increase in Federal Debt
– Monetary: Abandon the Bimetallic (Effectively Gold)
Standard
– Monetary: Inflation in North, Hyperinflation in the
South
• Greenback Period, 1864-1879
– Fiscal: SurplusReduction in the Debt
– Monetary: Deflation
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Financial
• “Resumption” 1879
Policy: The
– Monetary: Return to the Gold Standard
National
• The Gold Standard, 1879-1914
Banking Era
– Fiscal: SurplusReduction in the Debt
1863-1914
– Monetary: Continued Deflation and Silver Politics,
1879-1897
– Monetary: Gold Inflation, 1897-1914
Banking
• STRUCTURE
– Regulation and Organization of the Banking
Industry
• CONDUCT
– How do banks operate? Commercial Banks?
Savings Banks? Investment Banks?
• PERFORMANCE
– Competitive markets? Integrated Markets?
– Risk/Failures? Losses/Profits? Returns to
Banking?
FIRST----STRUCTURE
• WHAT WERE THE FACTORS SHAPING THE
STRUCTURE OR ORGANIZATION OF THE
BANKING SYSTEM?
• Key---Return of the Federal Government to the
Regulation of banks
• During the Civil War
– Partial collapse of state banking systems
– Opportunity for Federal Government to create a new
system---after it had abandoned an intervention in the
system in 1836.
The National Banking System---a banking
system without a central bank
• National Currency Act 1863
• National Banking Act 1864 —
creation of the Office of the
Comptroller of the Currency
(OCC)
• http://www.occ.treas.gov/
• Result: a federally-chartered
system of “free banking.” Free
entry upon meeting minimum
rules and a bond-backed
Salmon P. Chase, U.S. Secretary
currency
of the Treasury, 1861-1864, free
men, free soil, free banking
• Never important in wartime
finance—too late.
• REGULATIONS?
Justification for Regulation and
Supervision: Asymmetric Information
• Difficult for individuals to select and monitor borrowers.
• Banks specialize and lower costs, but then the problem
becomes how can depositors monitor the bank.
– Adverse Selection Problem—to pick the right bank
– Moral Hazard Problem—how to monitor bank’s behavior
– Free Rider Problem
• If not solved----less than optimal financial intermediation,
less credit than economy needs.
• If not solved---high propensity for depositors to panic and
run
• Potentially high costs to the economy
• Desire for Reputation may control problems
• If not sufficient may need to impose Regulations and
Supervision to increase flow of information, monitor and
discipline banks.
Taxonomy of Regulation and Supervision
(9 factors with some justification)
1.
2.
3.
4.
5.
6.
Entry Controlled to screen out dishonest or excessive
risk-taking entrepreneurs.
Capital requirements Control moral hazard by limiting
leverage.
Limits on economies of scale restrict branching and
horizontal mergers.
Limits on economies of scope and diversification
constrain banks’ portfolio choices or activities to
constrain risk-taking or conflicts of interest.
Limits on pricing: Interest rate restrictions to control
predatory behavior.
Liability (deposit) insurance: free customers from
monitoring banks and the incentive to panic.
Taxonomy of Regulation and Supervision
7.
Disclosure requirements Reinforce market discipline
if information is made public.
8. Examinations
• Government-supplied auditing to examine
proprietary information.
• Complements disclosure and ensures compliance
with regulations.
9. Bank supervision
• Enforce regulations and control risk by imposition of
penalties.
• Rules-based or Discretion-based.
Five U.S. Policy Regimes
•
•
•
•
•
National Banking Era 1864-1913
Early Federal Reserve Period, 1914-1932
New Deal, 1933-1970
Demise of the New Deal, 1971-1990
The Contemporary Era, 1991-2008
1. Supervision under the National Banking System, 1864-1913
National Banking Era 1864-1913
1. Entry
Free Entry; Minimal Discretion
2. Capital Requirements
Low Fixed Minimum; Double Liability
3. Limits on Economies of Scale
Branching Virtually Prohibited
4. Limits on Economies of Scope
& Diversification
Banks Narrowly Defined; Loans
Restricted
5. Limits on Pricing
Usury Laws, vary state by state
6. Liability Insurance
Bond-Secured Banknotes,
Reserve Requirements
7 States Deposit Insuranceafter1907
7. Disclosure
3 Yrly Surprise "Calls" after 1869
8. Examination
2 Yrly Surprise Exams: “Bottom Up”
9. Supervision & Enforcement
Mark to market—Prompt Closure
OCC--the federal regulator and each state has regulatory agency
Two Elements of a Free Banking
System?
6. National Banknotes
• National banks must buy federal bonds, which
are deposited with the government. They are
allowed to issue up to 90% of the par value of
the bonds in banknotes.
• If a bank fails, the bonds can be sold to
guarantee value of its banknotes.
• Collateral---safer than state bonds---default free.
• Banknotes are “uniform” because collateral is
uniform.
• Banknotes are given uniform appearance.
• No longer subject to bank run or doubt
From bondbacked state
chartered
banknotes to
bond-backed
national
bank notes
Requirements for a national bank
• 2. Minimum capital requirements---$50,000 (for
big cities $200,000)
• 2. Double liability------Why?
• 4. Loans---maximum of 25% of capital in real
estate loans ensures that most are short-term
commercial loans (real bills doctrine)---Why?
• 6. Reserve requirements---graded by city:
–
–
–
–
Country banks 15% (3/5 on deposit with..)
Reserve city banks 25% (1/2 on deposit with.)
Central Reserve City Banks 25%--all cash
Contributes to a pyramiding of reserves.
National bank regulations
• 3. National banks may not have branches
(concern about wildcat banking). Not
considered a problem until 1890s.
• 8. & 9. OCC operates system of
examination, sends out regular bank
examiners to enforce rules.
What Happens to the State Banks?
• Do they join?
• Hardly---rules are more onerous than state
rules.
• 1865 U.S. slaps 10% tax on state
banknotes---forcing them to join
Revival of state banking
• State banks find it prohibitive to issue banknotes---helps
to encourage the growth of deposit banking
• States begin to adjust their regulations and set lower
requirements for capital and reserve requirements, loans
• Result the “Dual Banking System” with “competition in
laxity”. And 51 regulators!
• Still no branching is permitted
• Increased demand for banking services met by new
banks---in suburbs or on the frontier---not new branches
States try to increase their state-chartered
banks advantages and charter more banks
Thousands of Banks and few branches
1910, there are over 19,000 banks
But, even state banking
systems find competition
from new intermediaries--the Trust Companies
who have even lighter
regulation than state
banks
Trust Companies
become major banks
(especially NY and MA)
with very low regulations
An increasingly complex
set of institutions
DEPOSITS ARE PYRAMIDED because of (1)
reserve requirements, clearing and collection of
checks, and transfer of investment funds
Problems of a fragmented banking system
• Payments System Problems: Most of clearing
and collection of checks cannot be done
internally. Banks must form relationships---the
rise of “correspondent banking”— Result
“Pyramiding” worsens panics
• Allocation of Funds Problem: Interregional
transfers of bank funds from region to region
cannot be done internally. Need for
correspondents— Result “Pyramiding”
worsens panics
• Portfolio Diversification Problem: Many banks
cannot fully diversify sources of deposits or
loans– Result: More Prone to Failure
What do banks do
with their surplus
funds: brokers
loans---call and
time loans to the
stock market, the
equivalent of
federal funds
Compounds
pyramiding of
reserves and
investment
especially in NYC
Effects of Structure on Banking, 1864-1913
• (Factors 1, 2, 3) Free entry, low minimum capital
requirements, branching prohibitedthousands of small
undiversified banksMore likely to fail and fragile in a panic
• (Factors 3, 6) No branching and reserve
requirementsFragmented banking system for payments
and interregional transfersleads to development of
correspondent in big cities with pyramiding of reserves and
other fundsFragile in a panic
• (Factors 2, 6) Double liability, no deposit insuranceMake
shareholders and depositors monitor bank management
carefully
• (Factors 7,8) Surprise disclosure and examinationImprove
monitoring of management
• (Factor 9) Prompt closure of failed banksLower Losses
• Factor 5, little effect; Factor 4 Leads to growth of investment
banking
How important were Banks?
Financial Intermediaries Shares of Assets (%)
Commercial
Banks
Insurance
Companies
Other
Intermediaries
1880
86.5
10.5
3.1
1900
81.1
10.7
8.2
1922
75.7
11.6
12.7
1950
64.1
21.1
14.8
1990
38.0
11.1
50.9
Structure, and now CONDUCT
• HOW DID COMMERCIAL BANKS
OPERATE?
• HOW DID INVESTMENT BANKS
OPERATE?
What makes commercial banks “special?”
• Banks have a special capacity to collect
information on borrowers and monitor them
– Monitor their checking accounts etc.
– Interview them & ask them to disclose information
– Result lots of information—proprietary information
• It is generally difficult to market loans to
outsiders without access to banks proprietary
information. They can’t be valued by someone
else
• Many loans are not marketed and are held until
maturity with banks managing risk. (Subprime
disaster proves this point.
How did banks screen their
customers in the 19th century?
•
•
•
•
Little formal standardized information.
No financial statements, income taxes etc.
For individuals or for companies.
Accounting only begins to develop late in the
19th century
How to be a banker in the 19th century:
a case study, the Bank of A. Levy
• A small town bank in Ventura, California, the Bank of
A. Levy, was founded in 1885 by Achille Levy
• Mostly short-term loans to landowners for farming.
• The “character loan” method.
• If an applicant was “of good character, a loan was
forthcoming. If the borrower’s reputation was
flawed, the offer of thousands of dollars worth of
collateral could not persuade him to make a loan.”
• He did take on questionable borrowers and if they
faithfully repaid small loans, the size of the loans
increased and the interest rate fell.
• Case of the Chinese laundryman.
Levy carefully
monitored his
customers’
activities,
watching their
banking
activities in his
office, and
traveling
around the
county on
horseback,
recording
information in
his pocket
notebook.
Bank Lending
• More generally, a 1918 Journal of Political
Economy study offered the following advice on
how to judge a potential borrower:
“The amount that may be safely loaned….can be
ascertained only from an intimate personal
acquaintanceship with the borrower and his business
or from a study of a balance sheet or financial
statement setting forth the condition of the business.”
• Banks were dominant intermediaries because
they gained special knowledge of borrower that
was not marketable.
Investment Banking: Structure
• No Federal Regulations (Some state laws”Blue Sky” laws)
• But, Factors 3 & 4 for commercial banking
limit ability of commercial banks to make
large long-term loansalternative issue
stocks and bonds
• Banks are agents not principals
– Primary markets: Issue of new securities
(IPOs and Seasoned)
– Secondary Markets: Brokerage
Growth of Investment Banking
• Securities (stock and bond) markets were limited before
the Civil War. Most businesses were relatively small.
• In 1860, the average firm produced value added of only
$6,000 a year.
• Beginning in 1890s, there was a huge merger wave that
put together huge integrated firms: U.S. Steel, Standard
Oil, AT&T, International Harvester—giant firms.
• These firms cannot rely on funding of banks, which
remain, relatively small. Result is alternative source of
funding.
• 1901-1912: Corporations obtain $18 billion in outside
funds
– Bank loans 24%
– Stocks 31%
– Bonds 45%
Problem:
• How to market securities when there is little
reliable financial information
• Accounting profession in early stages of
development. Financial documents hard to
compare and interpret.
• New industries were very difficult to analyze.
• WHO ARE YOU GOING TO CALL?
The Money Trust: Condut
•Several dominant investment banks: J.P.
Morgan, Kuhn Loeb, Kidder, Peabody, and
Lee, Higginson and Company
•They assist companies with the sale of
large issues of new securities in the
primary markets
•Leading investment bankers also sit on the
Boards of Directors of large industrials,
commercial banks and insurance
companies
•Conflicts of Interest: Critics charged that
these bankers colluded to force these firms
to use their services to issue securities and
then force banks and insurance companies
to buy them---raising profits of the
investment banks
J. P. Morgan
Money Trust:
Evil Bloodsucking Monster
(Vampire Squid?)*
or Agent of Modern Capitalism?
• Muckraking journalists and politicians
denounced the conflicts of interest that caused
investment banks to prosper at expense of
clients and investing public.
• Pujo Commission 1912-1913: Congressional
investigation into money trust
• John Moody, founder of Moody’s argued in
1904 that control of corporations by financiers Rep. Arsene Pujo
was necessary to direct funds to them and let
investors know which firms were worthy of
investment.
*Rolling Stone: “The world's most powerful investment bank is a great vampire squid
wrapped around the face of humanity, relentlessly jamming its blood ...”
Did the Money Trust Exploit
Conflicts of Interest or Overcome
Asymmetric Information?
• De Long offers case studies
– International Harvester
– AT&T
• Econometric Analysis
– If conflicts of interest are dominant then presence of
Morgan partner should lower stock prices
– If monitoring and signaling are dominant then
presence of Morgan partner should raise stock prices.
Conclusion?
• On balance, De Long concludes that the
monitoring and signaling effects were
dominant.
• Why did the Money Trust decline?
What changed securities markets?
• Financial markets can only thrive with the
development of standardized accounting methods
that began to be developed in the late 19th
century.
• For securities markets to flourish investors must
have a means to compare investments-----these
are provided today by the credit rating industry.
• The earliest credit agencies like Dun’s or
Bradstreet’s responded to the need of suppliers of
goods to judge how much trade credit to extend to
customers.
• But, these are qualitative assessment—lawyers,
other businesmen.
The Arrival of the Rating Agency
• Investors require cheap available
information on changing quality of bonds.
• 1890 Poor’s Publishing Company first
published Poor’s Manual, which analyzed
bonds.
• Its competitor Moody’s Manual of Industrial
and Miscellaneous Securities followed in
1900.
• Notice the timing….
The Rating Agencies: Aaa, Aa, A,
Baa, Ba, and so on…
• How to rank investments?
• Innovation in 1909. John Moody introduced
the rating system by letter as a means to
combine all the statistical information on
credit quality into a single easy to interpret
symbol.
• First applied to Railroads----they protested--but eventually a good rating meant that it
was easier to raise money.
• This innovation allowed investors to
subscribe to a service and purchase bonds,
thereby decreasing the demand for
intermediation.
• But, note, this was a 20th century
development.