Why We Have the Bank Regulators We Have and What We Might Do Instead
My colleague Tom Hoenig wrote last week about the modern history of federal efforts to consolidate bank regulators and offered insights about why keeping three regulators appeals to the interests at the heart of the debate, namely, regulators, Congress and the industry. That inspired me to go back even further to examine why the U.S. ended up with federal regulators in the first place and to offer offer a simpler, yet equally robust, regulatory alternative.
The Early U.S. History
Policy history debates in Washington typically start with the 1980s, but to better understand the U.S. banking landscape, we have to start from the very beginning. A study by economic historians Richard Sylla, John Legler and John Wallis pointed out that the U.S. Constitution prohibited states from (1) issuing their own currency and (2) taxing out-of-state commerce. Due to the first prohibition, by the early 19th century some states began raising revenue by granting charters and investing in banks, which eventually led to bank supervision. Due to the second prohibition, states banned out-of-state banks from operating in their jurisdiction.
Instead of the U.S. having one well-integrated national banking system, each state had its own banking system and, eventually, its own regulator and supervisor. Numerous states even prohibited branch banking, and the fragmented nature of the banking system that emerged before the Civil War became increasingly volatile. Prior to the Civil War, economic historians Hugh Rockoff and Andrew Jalil identify major panics in 1819, 1833, 1837, 1839 and 1857; there were also minor panics in 1841, two in 1842, 1851, 1854-55, 1860 and 1861.
Yet, as economic historian Eugene White points out, the fiscal costs of panics during the “free banking” years from 1838-1860 were minimal by today’s standards (perhaps less than $1 billion in 2009 dollars). John Wallis also observes that banks during that time did not have maturity mismatches between assets and liabilities; banks funded short-term trade credit with short-term liabilities. Banks also funded with much more equity than today, as the graph below shows.
The Civil War and a New Type of Bank Charter
The Civil War changed the banking landscape. With the National Bank Acts of 1863 and 1864 Congress established a national currency (the “Greenback”) and established the Office of the Comptroller of the Currency (OCC) to grant charters and supervise national banks, which would hold federal bonds to finance the Union’s war efforts. National bank owner-shareholders were also subjected to double liability, and some states adopted double, triple or unlimited liability. That meant bank owner-shareholders could lose their investment as the value of their shares went to zero, and they could be made to pay additional penalties to creditors. White also notes that with this arrangement (unlike today), there was no conflict between price stability and financial stability because there was no central bank since the U.S. remained on the gold standard, and supervision was done by the OCC.
National bank charters were supposed to replace state bank charters, but as states began to fight the encroachment, the federal government attempted to tax state bank notes to end their existence. In response, states began lowering capital requirements, as depicted in the graph above. White also shows that as a result, state bank charters expanded dramatically, reaching 4,000 by the 1880s and 14,000 by the time the Federal Reserve was created.
National banks were allowed to follow suit by reducing capital, too, which is reflected by the convergence in capital to asset ratios in the graph above. With more banks and less capital across the systems, crises began to last longer, becoming more costly in terms of forgone GDP, starting with the Panics of 1873, 1893 and 1907. There were also minor panics in 1884, 1890, 1896, 1899, 1901, 1903, 1905 and 1908. Still, because both national banks and most state banks were subjected to contingent liability, the administrative costs of all these panics was about the same as during the “free banking” period at about $1 billion in 2009 dollars.
A New Regulator After the Panic of 1907
The Panic of 1907 spurred calls to establish a lender of last resort through the Federal Reserve System (Fed), which also had the task of supervising state banks that became members of the Fed. According to White, the establishment of the Fed’s discount window made distressed banks less likely to shut down early (like Silvergate in 2023), as they had traditionally done without this lifeline. Instability began to build. With two panics in 1920, one in 1926, 1927 and 1929 followed by the Great Depression, during the 1921-1933 period, the number banks fell from almost 31,000 to about 14,000 (a level that persisted until the 1980s when interstate banking first emerged).
A New Regulator After the Great Depression
After the Great Depression, Congress established the Federal Deposit Insurance Corporation (FDIC) and the Deposit Insurance Fund to put depositors at ease from concerns about bank runs. The FDIC would supervise state banks that were not Fed members. The FDIC replaced the more traditional equity capital requirements that were based on town size, with a minimum 10 percent equity capital to deposit requirement. White, however, points out that policymakers scrapped contingent liability, because they attributed the recent banking crises to its ineffectiveness rather than to the incentives from the Fed’s Discount Window that enabled struggling banks to stick around. And that’s the story of how we got three Federal bank regulators, in addition to all of the state bank regulators.
Fischer Black’s Simpler Alternative to Existing Regulation
One simpler alternative comes from Fischer Black. In an earlier post, I discussed a 1978 paper by Black and coauthors Merton Miller and Richard Posner on how to regulate bank holding companies. The authors concluded that (simple) capital regulation at the bank subsidiary level, and not the holding company level, would provide a low-cost way to regulate banks. In a 1975 paper, Black imagines how the banking system might look without all of the regulation at that time.
Many of the predictions Black imagined about banks in a competitive, “efficient” market have come true. For instance, banks in a competitive environment would (1) be larger, (2) operate across state lines, and (3) charge fees for opening, maintaining and closing accounts, as well as for depositing and withdrawing funds, based on marginal cost pricing.
He also suggested that a “reasonable,” low-cost way to protect depositors form losses during a bank failure would be to subject banks to a simple, dollar-for-dollar capital rule, where for every dollar of deposit funding (or other short-term debt today) a bank should issue a dollar of stock. That amounts to a 50 percent capital requirement. Because such a bank would have ample capital, you might not need a formal deposit insurance program, because such a bank would be far from default; that’s unlike today’s large banks, which are just about 5-7 percentage points above zero.
A Roadmap to Consolidating Bank Regulation and Supervision
Recall that about 20 percent of all bank regulation concerns capital due to the extraordinary complexity of risk-based capital regulation. That makes supervision more complex, especially for larger banks. Simpler, but higher equity capital requirements and/or contingent liability could serve as the basis for a highly effective regulatory framework: With a sound culture of supervision, if we pick a minimum equity capital requirement of 10-20 percent then adding back contingent liability could help; if we pick 50 percent, then there may be no need to add contingent liability. Under such a framework, one agency, similar to the Office of the Superintendent of Financial Institutions in Canada, would suffice.
If we have to pick a model, agency-wise, we might pick the OCC, which was the first at the federal level. It initiated double liability, which worked well historically to reduce the administrative costs of crises prior to the Fed. There’s good reason to build on this tradition.
That would free up the Fed to concentrate on the “dual mandate” for price stability and maximum employment. Since capital would be high enough, we wouldn’t need holding companies to be a “source of strength” for bank subsidiaries as the Fed currently holds. With interstate banking, we could eliminate holding companies and the Fed’s responsibility for regulating holding companies.
If capital’s high enough, we could move the Deposit Insurance Fund to the Treasury department as an emergency program; banks could also make private deposit insurance an option for customers. Bank supervision staff across the three existing agencies could be moved to the remaining agency, where we could still maintain the same distinction between large bank and other bank supervisors.