History of U.S. Banking

Colonial Period to 1863

Banking in the United States began in the 18-th century, when individuals, merchants, and colonial governments loaned money to one another. In 1781 the new Continental Congress chartered the Bank of North America, primarily to aid in the financing the Revolutionary War. Both chartered and private banks financed trade by extending credit to merchants to buy inventories, which, when sold, provided funds to repay the loan. Loans were ordinarily made in currency-notes issued by the lending bank; checks (demand deposits) were not yet an accepted medium of exchange.

In 1791 Congress established the First Bank of the United States with a 20-year charter. The First Bank served as the fiscal agent for the U.S. Treasury. It competed effectively with state banks, making them redeem their notes at full value. State bankers' objections led to the First Bank's termination in 1811, when Congress failed to renew its charter. Its dissolution complicated the financing of the War of 1812 and contributed to wartime inflation, since an important restraint on state banks' note issuance had been removed.

In 1816 Congress created the Second Bank of the United States. Under the aggressive direction of Nicholas Biddle, the Second Bank restored redemption values to bank notes and limited credit expansion. Biddle's success antagonized state bankers. Andrew Jackson vigorously opposed the bank and, as president, vetoed its charter extension in 1836.

Before 1837, when Michigan enacted free bank chartering, state bank charters could be obtained only by special acts of state legislatures. Under the free banking system anyone could open a bank who provided a minimum amount of capital and deposited a specified amount of bonds with a state agent to repay holders of the bank's notes. By 1860, 18 of the 32 states had passed such laws. States that allowed banks to issue notes in amounts greater than the market value of assets backing the notes experienced failures among the free banks; the other states did not. Losses suffered by the public from holding worthless or depreciated bank notes through 1860, however, were less than 2% of the money stock. (More than half were in Michigan which allowed banks to back notes with unmar-ketable mortgages.) In any event, free bank financing contributed significantly to westward expansion.

National Bank System

The problem of financing the Civil War led Congress, in 1863, to pass the National Banking Act. The act created a system of federally chartered banks supervised by a federal agency, the Office of the Comptroller of the Currency. Civil War financing was enhanced by the act's requirement that all national banks' notes be backed by U.S. Treasury bonds. Because national bank charters required more capital than state charters, national banks tended to be established in larger communities. Unlike the First Bank of the United States and its successor, banks with national charters were not permitted to branch, even within states.

To expedite the development of the national banking system, Congress levied a 10% tax on all new state-bank note issues. By 1866 the number of nationally chartered banks had increased to more than 1,600 and accounted for 75% of all bank deposits. Circulation of state banks notes declined, although the result was the rapid development of demand deposit banking (checking). Although local currency-redemption panics ended, the act made no allowance for seasonal currency needs, nor did it provide a flexible national or even regional lending mechanism. By supporting decentralized unit (nonbranch) banking the act restricted the movement of excess bank funds in New England into the credit-starved South and West. Limits on real estate lending prevented national banks from effectively supporting migration to the West.

The total number of banks increased from 2, 000 in 1866 to 13,000 in 1900, and to 27,000 in 1913. The typical new bank was state chartered. It was located in a small rural community and supplied credit to farmers. National banks grew more in size than in number. The largest of these banks, located in financial centers, supplied credit to an expanding industrial empire centered on railroads.

The initial stability imparted by the national banking system did not endure. Financial panics in 1893 and 1907 stimulated Congress to appoint a National Monetary Commission, the recommendations of which led to the Federal Reserve Act of 1913. The Federal Reserve System. The Federal Reserve Act was initially designed as a system of bankers' banks that could avoid the state-imposed prohibition against interstate branching that constrained check clearance across state boundaries. The act required all national banks to become members and invited state banks to join, provided they met minimum capital requirements. Each member bank had to maintain reserves in cash or as noninterest-bearing deposits with its federal reserve bank. The reserve deposits facilitated a national check-clearing and fund-transfer arrangement. The member bank could also borrow (discount) at its federal reserve bank when it needed currency or loanable funds. President Woodrow Wilson turned the Federal Reserve into the nation's first true central bank.

The federal reserve banks helped finance World War I by purchasing government securities for federal reserve notes, thereby financing the war by printing money. Large state banks joined the system so that they could participate in wartime financing.

The 1920s

By 1921 some 31,000 banks operated in the United States—more than at any other time in history. The trend toward small banks reversed somewhat thereafter, as banks formed holding companies as a means of avoiding states' prohibitions and limitations on branching. Holding companies and banking chains allowed banking companies to operate multiple units within and even across state lines. In 1927 Congress passed the McFadden Act, which allowed national banks to branch within the cities of their main offices, as permitted to state-chartered banks.

By the mid-1920s many commercial banks had become financial department stores. Banks in the larger cities underwrote and traded insecurities, sometimes directly but more often through subsidiaries and holding-company affiliates. In 1927, commercial banks underwrote only 22% of bonds issued. By 1929 this percentage had increased to 61%. Banks also failed in the 1920s; 5,712 banks suspended operations during the decade. Most (76%) were unit banks in the agricultural regions of the western grain states and southwestern states, failing chiefly because of the agricultural depression. Improvements in roads and automobile transportation also reduced the demand for independent banks. Losses to depositors from failures during this period averaged only 0.15% of deposits.

The Stock Market Crash of 1929 and the Great Depression

The stock market crash in 1929 had only a small direct effect on the banking system. Indeed, the market recovered fairly quickly then, much as it did after the 1987 stock market crash. In 1929, however, unlike in 1987, the Federal Reserve Board reacted to the crash (and the prior inflation) by reducing or allowing a reduction in the growth of the money stock. From 1929 through 1933 the stock of money fell by over one-third; commercial bank deposits fell by over 42%, in large part because bank suspensions and fears about future failures led the public to convert deposits into currency and gold, resulting in a multiple contraction of the money supply that was not offset by the Federal Reserve. The consequence was a severe economic depression and the suspension of 9,096 banks between 1930 and 1933, as borrowers defaulted on their loans.

Some 90% of the banks that failed during the Great Depression were small banks (holding assets under $2 million), located in small, predominantly rural, towns. Almost all of these banks were unit banks. Banks that were involved in securities transactions (underwriting, sales, and investment) failed at considerably lower rates than similar-sized banks that were not so involved. Annual losses to depositors between 1930 and 1933 averaged 0.81% of deposits, 5.4 times the 1920s' rate.

The Banking Act of 1933 and the Recovery

Among its principal provisions, the Banking Act of 1933 (also called the Glass-Steagall Act) separated commercial and investment banking, created federal insurance of deposits by establishing the Federal Deposit Insurance Corporation (FDIC), prohibited interest payments on demand deposits (checking accounts), allowed the Federal Reserve to limit interest on savings accounts (Regulation Q), and permitted national banks to branch to the extent permitted to state banks.

Deposit insurance dispelled customers' fears of losing deposits and ended currency "runs" on insured banks. The insurance premiums were levied on all deposits, insured or not. Consequently, larger banks that served customers with accounts well over the $5,000 insured amount paid for most of the deposit insurance. These banks, however, also had tended to pay interest on demand deposits, including the deposits of smaller banks (called correspondent bank deposits). It is estimated that the cost to larger banks of deposit insurance was almost exactly offset by their savings in deposit interest. Although the state-limited unit-banking system unique to the United States was responsible for most of the bank failures of the early 1930s (given the drastic decline in the money supply), interstate branching still was not permitted.

Recovery came slowly, and banks extended a minimum of credit during the Great Depression, in part because the FDIC and the other federal banking agencies closely monitored and closed weak banks. The recovery was reversed in 1937, when the Federal Reserve, incorrectly fearing inflation because banks held more reserves than were required, sharply increased reserve requirements. As banks, still fearing runs, rebuilt their "excess" reserves, money supply growth once more declined, and the economy contracted During World War II commercial and Federal Reserve banks together purchased $100 billion in government securities—nearly half of all bonds sold—as the government paid for the war (much as governments have always done) by expanding the money supply. Banks' holdings of U.S. government bonds increased from 40% of total bank investments at year-end 1939 to 73% at year-end 1945.

Post-World War II through 1980. In the postwar period, existing banks prospered; demand for banking services expanded, and bank charters were very difficult to obtain, in large measure because of the (incorrect) perception that the bank failures of the 1930s were due to "over-banking." Banks supplied various types of credit to a diverse group of borrowers. Retail banking flourished, particularly consumer credit. Credit (charge) cards were first offered by banks in 1950, although large-scale operations did not start until 1966, when the Visa card was introduced, followed by MasterCard in 1967. Nonetheless, industrial credit dominated bank lending during the continuing prosperity of the mid-1960s. Mortgage lending, too, expanded after 1963, when Congress allowed national banks to offer terms similar to those offered by savings and loan associations.

Bank loans to foreigners increased from 0.9% of assets in 1945 to 17.4% in 1975, and to 24.5% in 1981. A large part of the increase was fueled by the deposits in sizable U.S. banks by oil producers following the upsurge in prices in 1973, which the receiving banks loaned to borrowers in developing countries. Regional banks followed the larger banks' lead in the mid-1970s. Total bank loans to less developed countries (LDCs) amounted to some $100 billion by 1980, setting the stage for large losses in the 1980s, when many of these debtors could not repay their obligations.

Demand deposits declined from 75% of total bank assets in 1945 to 26% in 1980, despite the fact that individual checking accounts increased during this period from 34% to almost all households. This change occurred as banks increasingly funded their loans with negotiable certificates of deposit (first introduced in 1961) and businesses and consumers shifted their funds to interest-bearing accounts. This change was due largely to increases in market interest rates in the late 1960s and 1970s, combined with banks' inability to pav interest on demand deposits, owing to the prohibition enacted in 1933. As inflation-driven market rates of interest increased in the late 1970s above the legal ceiling permitted on savings and time deposits (Regulation Q), con-sinners transferred funds to money-market mutual funds, which grew from holdings of $4 billion in 1977 to $220 billion in 1982, and businesses managed their deposit accounts carefully. Banks were permitted to pay interest on savings accounts that could be transferred by check (negotiable order of withdrawal, or NOW, accounts) held by individuals, but not on ordinary demand deposits. Deregulation of interest on savings and time deposits began at year-end 1980 with the passage og the Depository Institutions Deregulation and Monetary Control Act. This law also made demand deposits at all banks and thrifts subject to Federal Reserve reserve requirements and increased deposit insurance from $40,000 to $100,000 per account.

Since expansion of banks across state lines was limited by the Bank Holding Company Act of 1956, banks attempted to offer additional products through affiliates were restrained by a 1966 amendment limiting bank holding-company affiliates essentially to financial services.

Only about five banks a year failed from 1960 through 1981; most were small. Depositors )even those with more than the insured maximum) did not lose their funds, since the failed banks were taken over by other banks, often with FDIC assistance.

The 1980s

The very high inflation-driven interest rates of the late 1970s decline in 1982. The prices of oil, farmland, and commercial real estate increased and then plummeted. The result was the greatest number of commercial bank and thrift failures since the 1930s. In 1982, 46 banks failed; the number climbed each year, and more than 200 banks a year failed from 1987 through 1990. Many were very large, beginning with the giant Continental Illinois Bank in Chicago, which collapsed in 1984. During this decade some 1.200 savings and loan associations failed, at a cost of perhaps $200 billion.

The primary cause of the failures was undercapitalization combined with federal deposit insurance. When oil producers, farmers, real estate developers, and foreign governments could not repay their loans, the losses were too great to be absorbed fully, and depositors, since they were insured, did not close banks by withdrawing funds. Large banks' losses were made worse when the authorities were slow to close insolvent banks. The prohibition of interstate branching, too, was important, since losses from one area could not be offset by gains from another.

In the late 1980s most states alloewd regional interstate banking. By 1992 most states will permit any holding company to have banks (but not branches) anywhere.

After 1984 U.S. banks were displaced by Japanese and other foreign institutions as the world's largest banks, largely because of losses on LDC loans and restrictions on mergers and products not faced by foreign banks. The size rankings, though, do not reflect U.S. banks' development of sophisticated financial products and off-balance sheet obligations not reflected in the usual measures of size.

In December 1991, legislation estavlished a system of structured early resolution that requires banks to maintain their capital, other reforms were not enacted.

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