Magazine article Regulation

Banking Approaches the Modern Era: Though Some Oppressive Depression-Era Regulation Has Been Removed, There Is Still Need for Reform of the U.S. Banking Industry. (Banking & Finance)

Magazine article Regulation

Banking Approaches the Modern Era: Though Some Oppressive Depression-Era Regulation Has Been Removed, There Is Still Need for Reform of the U.S. Banking Industry. (Banking & Finance)

Article excerpt

THE PAST TWO DECADES HAVE SEEN A radical transformation of regulations controlling the size, location, and activities of U.S. banks. Included in those changes are state--level reforms of branching barriers, relaxation of deposit interest rate ceilings, the passage of a nationwide bank-branching law in 1994, and the expansion of bank powers throughout the 1980s and 1990s. The reforms culminated in the passage of the Gramm-Leach-Bliley Act of 1999, which established financial holding companies -- an alternative to more limited bank holding companies -- as a platform for building the global, universal U.S. banks of the next generation.

Prior to the sea change of the past two decades, banks mostly focused narrowly on deposit taking and lending in separate local markets. Now, U.S. banks operate on an unprecedented large scale throughout the country and the world, and are able to marry traditional lending and deposit-taking activities with investment banking, private equity investing, asset management, insurance, and many other financial services. What caused the drastic changes? What barriers to efficient financial intermediation still remain? And what have we learned from the recent experience about the next wave of innovation and deregulation in the financial services industry?


In order to answer those questions, we must first recognize how unusual the prior structure of U.S. commercial banking was in comparison with other countries' banking systems. Commercial banking began in the United States, as in most other countries, as an instrument of state intervention and economic planning. Banks were chartered in the late eighteenth and early nineteenth centuries to accomplish government-sanctioned purposes. The scarcity of such charters created monopoly rent for banks, which acted as an implicit tax-and-transfer scheme that supported the activities in which the favored banks engaged.

By the middle of the nineteenth century, in most states, that mercantilist approach was replaced by one of "free" bank chartering. But banks were still subject to special taxes or required to hold government paper as part of their extensive regulatory mandate.

State regulation One key feature of the U.S. system was that state laws largely determined bank regulation. States were free to establish barriers to entry in banking that limited new entrants from competing with existing banks. Not only was interstate banking forbidden, but, in most states until the 1980s, competition within states was also circumscribed by regulations that limited branching or consolidation. Despite the Constitution's clear mandate to ensure unfettered interstate commerce, the Supreme Court did not interpret interstate banking barriers as barriers to commerce. That opened the way for local special interest groups (including both bankers and some bank borrowers) to lobby for branching restrictions. The limits on branching produced a system of thousands of banks, which reached nearly 30,000 by 1921.

Consequences The geographic fragmentation and narrowly circumscribed powers of American banks made the U.S. system inferior in several respects. It limited diversification of loan risks and diversification of income from mixing different banking services. Small, undiversified banks tended to be riskier, leading to greater instability during economic downturns. Small, rural banks were most vulnerable, and they responded by lobbying for deposit insurance -- at both the state and national levels -- as a means to protect themselves at the expense of taxpayers and large banks (which bore a disproportional share of the costs of mutual deposit insurance). The perverse incentives of state-level deposit insurance systems enacted before World War I produced banking collapses in several states in the 1920s, which added further to the costs from unit banking.

Unit banking also created a mismatch between the small scale of banks and the growing scale of industrial enterprises, which increasingly came to operate regional or nationwide networks of production and distribution during the second industrial revolution of the late nineteenth and early twentieth centuries. …

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