In this chapter we examine the history of the banking system, along with its structure and trends today. There are some key features of the U.S. banking system that distinguish it from the banking systems of other industrialized countries, including

• a mix of state and federal regulation of the banking system.
• a decentralized and competitive banking structure.
• restrictions on the activities of banks

I.  A Brief History

A.  A Dual Banking System

• The first banks in the United States date back to the late 1700s. Up until the Civil War all banking regulation took place at the state level, with banks issuing their own local currency (banknotes) backed by gold to raise funds. Regulations were spotty at best, and bank failures were common.
• The National Bank Act of 1863 established federally regulated banks, in part to help finance the Civil War on the Union side. State banks also survived by accepting deposits (since the law placed a heavy tax on state banknotes). The result today is a dual banking system with both federal regulation for national banks and state regulation for state banks.
• Because of the dual banking system there are multiple regulatory agencies: The Office of the Comptroller of the Currency (1863), the Federal Reserve (1913), the FDIC (1933) and state agencies. Which agency has primary control depends on whether a bank has a federal or state charter, is part of bank holding company that owns multiple banks, or is FDIC insured. And yes, it is quite confusing.

The current U.S. central bank, the Federal Reserve System, was not established until 1913. How did we go so long without one?

• There were two prior central banks: The Bank of the United States (1791-1811) and the Second Bank of the Unites States (1816-1863). In both cases the central banks were eliminated.
• There were many enemies of central banks in the U.S. Many citizens were suspicious of the bankers in the Northeast that favored central banks, especially ranchers and farmers. Some considered the central bank to infringe on states rights.
• Without a central bank the U.S. financial system experienced regular crises after the Civil War. After a bad financial panic in 1907, Wall Street and banks pressured the federal government into developing a plan for a central bank, which came to be the Federal Reserve System.

Concern over large national banks driving small state banks out of business prompted Congress to pass the McFadden Act of 1927 that severely restricted the ability of national banks to establish branches within a state and prohibited interstate branching. These restrictions were eliminated in 1994, but still affect the structure of the banking system today.

D.  The Great Depression

Despite the existence of a central bank, the United States experienced massive bank failures following the stock market crash of 1929. Between 1930-33, one third of all U.S. banks failed, and those depositors lost everything. Congress passed several pieces of legislation in an effort to increase the safety of banking system:

• The Federal Deposit Insurance Corporation (FDIC) was created to provide federal insurance for bank deposits. Banks pay premiums based on their deposits. Almost all banks in the U.S. hold this insurance today.
• The Glass-Steagall Act separated commercial banks and investment banks in terms of permissible activities. The idea was that underwriting and stock brokering was too risky. This act was repealed in 1999.
• Regulation Q prohibited interest payments on checking deposits and set ceilings on interest rates on savings and time deposits. Regulation Q was repealed in 1980.

A.  Early Decentralization and Current Consolidation

Looking at the U.S. banking system, we find it to be more decentralized than the banking systems of other industrialized nations. This means that the U.S. has many small banks (over 8500), while other nations like Canada or Germany have fewer, larger banks. How did this happen? The McFadden Act of 1927 prohibited interstate bank branching and severely restricted the ability of national banks to grow.

The idea behind this legislation was to protect small neighborhood state-chartered banks from being driven out of business by the national banks and to promote competition. However, this legislation basically protected inefficient banks from competition and limited the ability of banks to take advantage of economies of scale in the provision of banking services.

To get around this legislation, bank holding companies, a company that owns several different banks, were formed. The holding companies were often allowed to purchase banks in multiple states. Another alternative was for banks to open branches that service depositors, but do not make loans. Finally, ATMs owned by other companies also gave banks a presence in multiple states. Using all of these loopholes, banks effectively achieved some interstate branching.

In 1994, the McFadden Act was repealed with the Riegle-Neal Interstate Banking and Branching Efficiency act. As a result, we have seen a huge increase in bank merger and consolidation activity. It is expected that allowing unrestricted branching will cut the number of banks in the United States in half.

Is this consolidation a good thing? Economists believe these trends will increase efficiency by driving out inefficient bank and allowing banks to take advantage of economies of scale. Also, large banks will have a more diversified (and thus less risky) loan portfolio. However, the question remains whether larger banks will be responsive to small communities and whether banks, eager to expand, will take unwise risks in their lending.

B.  Commercial and Investment Banking

In 1933 the Glass Steagall Act banned commercial banks from brokerage, insurance, real estate, and most underwriting activities. At the same time, investment banks and insurance companies could not act a commercial banks. Again, this separation distinguished U.S. banks from those in other countries.

The motivation behind Glass Steagall was the belief at the time (held to be untrue today) that the bank failures between 1930-33 were to be blamed on the risks taken by banks in the stock market. So this regulation had the intent of making the banking system safer. In reality, restricting bank activities results in
(1) less diversification in the bank balance sheet since banks have fewer asset and liability choices,
(2) lost opportunities for reaping the economies of scale involved in the provision of financial services, not just banking services, and
(3) a competitive disadvantage for U.S. banks, since foreign banks do not face the same restrictions.

As in the case with the branching restrictions, bank holding companies used several loopholes to get around some of the Glass-Steagall restrictions. These restrictions were gradually weakened over time and finally repealed in 1999 with the Gramm-Leach-Bliley Act. This repeal has also resulted in the consolidation not just of commercial banks, but of different financial institutions. Citigroup, for example, offer a range of banking, insurance, and investment services resulting from mergers/acquisitions of Citibank, Traveler's Insurance, and Salomon Smith Barney.

III.  The Thrift Industry

There are about 1200 S&Ls in the United States. Like commercial banks, S&Ls may have a state or federal charter and their deposits are insured by the FDIC. Their chief regulation is the Federal Home Loan Bank System (FHLBS), which operates like the Federal Reserve System. As we will study in chapter 11, S&Ls experienced great difficulties in the 1980s, due in part to their structure and regulation.

Credit Unions number large (number 10,000) but are small in terms of asset size (less than 10% of commercial bank assets). They also may have state or federal charters. The National Credit Union Administration (NCUA) charters and regulates federal credit unions, and insures the deposits of all credit unions. Credit Union's nonprofit (and therefore tax exempt) status give them certain advantages.

IV. International Banking

The growth of international banking is mainly the result of the growing globalization of the economy. As more firms operate in multiple countries, the need for multinational banking services also grows. Also, the regulatory environment for overseas banking is more favorable for U.S. banks.

U.S. banks that operate overseas, or that serve foreign customers in the U.S. are allowed to operate under alternative corporate structures. Edge Act corporations are subsidiaries of U.S. or foreign banks for international banking. International banking facilities (IBFs) in the U.S. accept deposits and make loans to foreign, but not U.S., customers. They receive favorable regulatory and tax treatment and encourage banking business to remain in the U.S.

V.  The Decline of Traditional Banking

Looking at figures 3-5 (pages 271-273) we find that banks' market share of lending has declined steadily since the mid-1970s. And although bank profitability overall has risen steadily since 1992, this increase is driven by nontraditional activities. The evidence is clear: The profitability and importance of the traditional deposit-and-lending activities of banks has declined.

Why the decline?
The reasons for the decline come from both sides of the bank balance sheet: the cost of acquiring funds (liabilities) has risen, while the income generated from uses of those funds (assets) has declined. Why? the answer lies in four important financial innovations or changes in financial markets, all born in the 1970s:

• The creation of money market mutual funds. We have already discussed what these funds are. They are essentially substitutes for a checking account. They have check writing privileges, pay interest, but are not federally insured (although they are still very low-risk). In order to compete with these accounts, banks began offering their own interest-bearing checking accounts in the 1980s, which significantly increased their cost of acquiring funds
• The growth of the junk bond market. Prior to 1980, only firms with investment-grade credit rating could issue bonds--there was not a market for newly-issued junk bonds. With advances in information technology, credit risks were more easily assessed and the junk bond market grew. This gave firms an alternative to bank financing and contributed to the decline in commercial lending activity.
• The growth of the commercial paper market. Again, advances in information technology have made it easier for corporations to issue commercial paper. This activity replaced some of the short-term lending done by commercial banks. Also, commercial paper is in high demand by money market mutual funds.
• The growth of securitization. Securitization transforms illiquid loans into liquid debt securities. Loans are bundled together and debt securities are created, entitling the owners to a share of the payments in the loan bundle. Mortgages are the loans most often used in this type of security. These securities were first sold in 1970, but since then the market has grown tremendously, using all types of loans and leases. Securitization means that other financial institutions can originate mortgages and then transform them into debt securities. So both consumer and commercial borrowers have yet another alternative to bank loans.

FYI: Related Links

The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy. A more in-depth look at the decline of banking, written by Mishkin for the Federal Reserve Bank of NY.

Understanding How Glass Steagall Impacts Banking. This was written in 1997 prior to the repeal of Glass Steagall, but offers a great account of the rationale behind Glass Steagall and the consequences.