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The great deposit insurance debate.

Glass agreed to support a deposit guaranty in exchange for provisions for significantly expanded Federal Reserve authority:

With these provisions, dependent upon them in fact, the Senate bill drafters were willing to accept the new Steagall bill for the insurance or guaranty of bank deposits in Federal Reserve member banks--but in member banks only.(141)

In the second stage, the dual banking supporters obtained several concessions, most notably: immediate insurance coverage for non-member banks under the temporary plan, and In the stress of the recent banking crisis ... there was a very definite appeal from bankers for the United States Government itself to insure all bank deposits so that no depositor anywhere in the country need have any fear as to the loss of his account. Such a guarantee as that would indeed have put a premium on bad banking. Such a guarantee as that would have made the Government pay substantially all losses which had been accumulated, whether by misfortune, by unwise judgment, or by sheer recklessness, and it might well have brought an intolerable burden upon the Federal Treasury.

Sen. Robert Bulkley (D-OH), Address to the U.S. Chamber of Commerce, May 4, 1933.(1)

The only danger is that having learned the lesson, we may forget it. Human nature is such a funny thing. We learn something today, it is impressed upon us, and in a few short years we seem to forget all about it and go along and make the same mistakes over again.

Francis M. Law (1934), p. 41.

THE ONGOING PROLIFERATION of bank and thrift failures is the foremost current issue for financial regulators. Failures of federally insured banks and thrifts numbered in the thousands during the 1980s. The problem is especially important for public policy, because of the potential liability of the federal taxpayer. For example, by 1989, the Federal Savings and Loan Insurance Corporation (FSLIC) was so deeply overextended--on the order of $200 billion--that only the U. S. Treasury could fund its shortfall. The significance of insurance is seen elsewhere as well: economists are quick to point to flat-rate deposit insurance as a factor in causing the high failure rates. Flat-rate deposit insurance is said to create a moral hazard: if no one charges bankers a higher rate for assuming risk, then bankers will exploit the risk-return trade-off to invest in a riskier portfolio.

Why, then, do we have taxpayer-backed, flat-rate deposit insurance?(2) A simple answer would be that the legislators who adopted federal deposit insurance in 1933 did not understand the economic incentives involved. This simple answer seems wrong, however. It has been pointed out that certain observers articulated the problems with deposit insurance quite clearly in 1933. In this view, the fault lies with the policymakers of 1933, who failed to heed those warnings.

This fails to answer why policymakers would ignore these arguments. Moreover, it does not explain why it should have taken almost 50 years for the flaws in deposit insurance to take effect. This paper examines the deposit insurance debate of 1933, first to see precisely what the issues and arguments were at the time and, secondarily, to see how those issues were treated in the legislation. Briefly, I conclude that the legislators of 1933 both understood the difficulties with deposit insurance and incorporated in the legislation numerous provisions designed to mitigate those problems.

The Banking Act of 1933 separated commercial and investment banking, limited bank securities activities, expanded the branching privileges of Federal Reserve member banks, authorized federal regulators to remove the officers and directors of member banks, regulated the payment of interest on deposits, and increased minimum capital requirements for new national banks, among numerous lesser provisions. It also established a temporary deposit insurance plan lasting from January 1 to July 1, 1934, and a permanent plan that was to have started on July 1, 1934.(3) Although this paper focuses on deposit insurance, it is important to bear in mind that both the deposit insurance provisions of the bill and the debate that surrounded them each had a larger context. The various provisions of the Banking Act of 1933 constituted an interdependent package.

The deposit guaranty provisions of the bill were initially opposed by President Roosevelt, Carter Glass (Senate sponsor of the bill and Congress's elder statesman on banking issues), Treasury Secretary Woodin, the American Bankers Association (ABA), and the Association of Reserve City Bankers, among others.(4) Despite this opposition, on June 13, 1933, the bill passed virtually unanimously in the Senate, with six dissents in the House, and was signed into law by the President on June 16.(5) Not surprisingly then, the public debate preceding and surrounding the adoption of federal deposit insurance was active and far-reaching.

This paper is organized around the major themes of the debate: the actuarial questions concerning the effects of deposit insurance, the philosophical and practical questions of fairness to depositors and of depositor protection as an expedient means to financial stability, and the political and legal questions surrounding bank chartering and supervision. Much of the debate was motivated by economic and political self-interest and was structured rhetorically in terms of morality and justice. Considerable attention is paid here to rhetorical detail.(6) As much as possible, I have attempted to report the debate in its own terms--liberal use is made of quotations and epigraphs--rather than risk misconstruing the meaning through inaccurate paraphrase.

BACKGROUND TO THE DEBATE

The banking debate in 1933 covered not only deposit insurance and the separation of commercial and investment banking, but the full catalogue of financial matters: the gold standard, inflation, monetary policy and the contraction of bank credit, interstate branching, the relative merits of federal and state charters, holding company regulation, etc. By 1933, nearly anything to do with banks or banking was an important political issue.

The Great Contraction

The people know that the Federal Reserve octopus loaned ... to the gamblers of this Nation in 1928 some sixty billion dollars of credit money--bank money--hot air ... and then when the crisis came in the last 3 months of 1929, cut that credit money--bank money--hot air--down to thirteen billion.

No nation, no industry, can survive such an expansion and contraction of money and credit. Give to me the power to double the money at will, and then give me the power to cut it square in two at will, and I can keep you in bondage.(7)

It is reasonable to begin a recollection of the debate over deposit insurance with the price collapse on the New York Stock Exchange of October 29, 1929. The stock market crash was popularly recognized as the start of the Great Depression. The remainder of the Hoover administration's tenure witnessed historic declines in national economic activity. By the beginning of 1933, industrial production and nominal GNP had both been cut in half; unemployment had topped 24 percent. Bank failure rates, which had already been high throughout the 1920s, had increased fourfold, while both money supply and velocity had plummeted. The price level fell accordingly.

For contemporary economic commentators, the stock market crash was more than a marker between historical eras. For many, there was a causal relationship between the stock market's collapse and subsequent real economic activity. In most cases, this causality was more elaborate than post hoc ergo propter hoc. A prescient Paul Warburg, for example, warned in March 1929:

If orgies of unrestrained speculation are permitted to spread too far, however, the ultimate collapse is certain not only to affect the speculators themselves, but also to bring about a general depression involving the entire country.(8)

The logic was that stock market speculation "absorbs so much of the nation's credit supply that it threatens to cripple the country's regular business."(9) A more radical theory was advanced by the "liquidationists," who held sway in influential circles of government and the academy.(10) For them, the cyclical contraction was a good thing: it reflected the liquidation of unsuccessful investments that crept in during the boom years, thus freeing economic resources for a more efficient redeployment elsewhere.

Crisis and Unlimited Possibility

We are confused. We grasp, as at straws, for the significance of events and of proposed government action. Never before in our lives have we had such great need for someone to interpret underlying movements for our guidance.(11)

By 1933, the correlation between economic activity and bank credit was lost on no one. During the interregnum between Hoover's electoral loss in November 1932 and Roosevelt's inauguration in March 1933, what had been a debilitating banking malaise became a desperate crisis. Starting with Michigan, on Valentine's Day, whole states began to declare official bank holidays; elsewhere, individual banks in scores were suspending withdrawals. By inauguration day, March 4, most states had declared a holiday.(12) Even much earlier, bank failures had left whole towns without normal payment services, relegating them to barter.(13)

Theories of the connection between bank failures, monetary contraction and the more general macroeconomic torpidity were widespread and varied. Roosevelt, in his inaugural address, suggested that the set of people who correctly understood the nation's economic problems did not overlap with the set of people who had held the reins:

Their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.(14)

To some extent, such a suggestion was accurate; Treasury Secretary Mellon and the liquidationists had initially refused even to admit that there was a problem.

Some proposed that complex intrigues were at work to sap the nation's wealth. Rep. Lemke, for example, advanced a monetarist thesis that both the boom of 1929 and the Depression were the intentional result of Federal Reserve policy. More conspiratorial still was Rep. McFadden's belief, advanced on the House floor, that "money Jews" lay behind the banking crisis.(15) Rep. Weideman, offering the metaphor that "the most dangerous beasts in the jungle make the softest approach," claimed that "international money lenders" had duped the Congress into creating a system for skimming bank gold reserves into a central pool "to feed the maw of international speculation."(16)

Alarm generated by the crisis and frustration at the lack of a remedy combined to expand the political horizons. Radical solutions were suggested. Informed by the political experiments under way elsewhere, relatively sober proposals were submitted to scrap the inefficient bureaucracies of representative democracy in favor of a fascist dictatorship or state socialism.(17) More popular was a flirtation with government by "technocracy,"a small panel or cabinet of experts to replace the congressional and executive branches. Relative to alternatives such as these, federal deposit insurance--which had failed in Congress more than 150 times in the preceding 50 years--was a remarkably moderate option.(18)

Moral Overtones to the Debate

The money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.(19)

Both proponents and opponents of the deposit guaranty features of the Banking Act took the rhetorical high ground in arguing their point. Indeed, recourse to morality in public debate was widespread. The "noble experiment" with the prohibition of liquor was still an issue in the 1932 election.(20) Oratory was laden with biblical imagery. Sen. Vandenberg (R-MI) referred to "B. C. days--which is to say, Before the Crash. ..."(21) A. C. Robinson saw fit to lecture subscribers to the ABA Journal on the "Moral Values of Thrift," advising bankers of the need for "an unshakeable conviction of these ideals |truth and morality~ and their ultimate triumph. 'If thou faint in the day of adversity, thy strength is small.'"(22)

For many, the Depression represented an atonement for the excesses of the bull market. By all accounts, 1929 was characterized by stock market speculation.(23) As the extent of the avarice became clear with hindsight, the notion of economic depression as punishment for economic transgression took hold:

We are passing through chastening experiences, as severe for the banker as for anyone else, many of the illusions have disappeared and the trappings of a meretricious prosperity have been stripped from most persons.(24)

The notion of recession as a necessary purgative unfortunately extended to policymakers as well. Mellon's advice to Hoover exposes the pious foundations to the liquidationist view of the Depression:

It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.(25)

This fluency with righteousness revealed itself on all sides of the deposit insurance debate. Both proponents and detractors of the deposit guaranty provisions of the Banking Act argued that their position was ultimately a matter of simple justice, which dare not be denied. The bankers declared that well-managed banks should not be forced to subsidize poorly run banks. Supporters of the legislation maintained that depositors should not have to bear the losses accruing to their bankers' mistakes. Those who felt that deposit insurance was a ploy to destroy the dual banking system painted a picture of the unit bank as the pillar of the national economy, untainted by corruption. The remainder of the paper is organized around these three loosely defined constituencies.

ACTUARIAL DIFFICULTIES

Opposition to deposit insurance can be roughly organized into two classes: objections on technical actuarial grounds, and objections to its anticipated impact on bank structure. The core constituency in the former category consisted of the money-center banks, with ABA President Francis Sisson, himself a Wall Street banker, taking the lead.(26) The economic motivation for their opposition was the belief that insurance meant a net transfer from big banks, where the bulk of deposits lay, to state-chartered unit banks, where they expected the bulk of the losses.

Insurance and Guaranties

In the law as written the guaranty plan is referred to not as a guaranty of bank deposits, but as an insurance plan. There is nothing in this plan that entitles it to be classed as insurance.(27)

I think you gentlemen are all wrong to call this a guarantee of deposits. There is not a thing in the bill that talks about guarantee. It is an insurance of deposits.(28)

The actuarial correctness of the term "deposit insurance" as a description of the proposed legislation was a point of contention. The alternative label, offered by opponents, was "deposit guaranty." One's choice of terms usually revealed where one stood on the issue, and the semantic controversy became a microcosm of the actuarial issues involved.(29) By labeling the various schemes as plans to "guaranty" deposits, opponents were able to associate the plans immediately with the infelicitous recent experience with state deposit guaranty schemes (discussed in the next subsection). The natural response for supporters was to insist on a different label.

Both proponents and opponents devoted energy to identifying the desirable "insurance principle," which then either accurately described or failed to describe the proposed legislation.(30) Like blind men describing an elephant, however, few agreed on a definition for the insurance principle. This was so, despite Rep. Steagall's claim that the principle of insurance was "the most universally accepted principle known to the business life of the world."(31)

Deposit insurance was clearly similar in many respects to other types of insurance, which had been in widespread use in the United States for decades. Even the most ardent detractor recognized some resemblance:

The general argument employed to promote the guaranty plan began with the premises that property can be insured and bank deposits are property. It travelled to the broad assumptions that the principle of the distribution of risk through insurance could be applied to bank deposits.(32)

The salient principles here, espoused repeatedly by supporters of the legislation, were the diversification of risk and the diffusion of losses. In this respect, a national plan would differ from the state plans, which had "violated the primary insurance tenet that risks must be decentralized and sufficiently spread so as to avoid concentrated losses."(33)

For others, the distinction between government and private backing defined the difference between insurance and guaranty. Both Sen. Glass and Rep. Steagall were adamant that coverage be provided privately, not by the government:

This is not a Government guaranty of deposits. ... The Government is only involved in an initial subscription to the capital of a corporation that we think will pay a dividend to the Government on its investment. It is not a Government guaranty.(34)

I do not mean to be understood as favoring Government guaranty of bank deposits. I do not. I have never favored such a plan. ... Bankers should insure their own deposits.(35)

The argument against government backing was outlined by Sen. Bulkley.(36)

An insurance feature included in both the Steagall and Glass bills and in Sen. Vandenberg's temporary insurance amendment to the Glass bill was a provision for depositor co-insurance.(37) The Glass and Steagall bills called for a progressive depositor copayment schedule: the first $10,000 would be covered in full, the next $40,000 would be covered at 75 percent, and only 50 percent of amounts over $50,000 would be covered; the Vandenberg amendment set a single coverage ceiling at $2,500. Some proponents saw no need for such mitigating features. Rep. Dingell (D-MI), for example, offered bankers no quarter; his idea was "to guarantee every dollar put in by the depositor from now on and to make the banker and the borrower pay the cost."(38) For Sen. Vandenberg, on the other hand, co-insurance was crucial; he complained angrily when Treasury Secretary Woodin proposed "not a limited insurance such as is included in the amendment which the Senate adopted, but a complete 100% guarantee."(39)

Opponents in the banking industry were unimpressed by such arguments. Although all of the proposals achieved a spreading of losses and many had other familiar features of insurance, such as co-insurance or provision for a large reserve fund, they still were not "insurance."(40) Francis Sisson was obstinate: "Detailed and technical differences in this bill as compared with former guaranty schemes do not differentiate it in essential principle from them."(41) For all their trouble, crafters of the legislation had failed to meet the bankers' standard for insurance, the principle of selected risks:

Insurance involves an old and tried principle. The essence of insurance is the payment by the insured of premiums in actuarial relation to the risk involved. Under the terms of the permanent plan, however, the costs or premiums are not charged according to the risk.(42)

Roosevelt made a similar connection. In his first presidential press conference, he asserted:

I can tell you as to guaranteeing bank deposits my own views, and I think those of the old Administration. The general underlying thought behind the use of the word 'guarantee' with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the Government starts to do that the Government runs into a probable loss.(43)

Although he associates the "guaranty" terminology with government backing, its defining characteristic is clearly the absence of selected risks.

Despite the attention given to selected risks in the debate, no significant attempt appears to have been made to include a risk-based premium in legislation. Emerson, for one, thought such an arrangement could work.(44) The ABA, on the other hand, thought it impossible:

The apparently unsurmountable actuarial difficulty in the guaranty plan appears to be the impossibility of placing it on the basis of selected risks;

the risks involved were "wholly unpredictable," and banks were subject to "internal deterioration" when their deposits were guaranteed.(45)

History and Geography

As to the history of the guaranty plan, a wave of guaranty of state bank deposits laws swept over the seven contiguous western states of Oklahoma, Kansas, Texas, Nebraska, Mississippi, South Dakota and North Dakota and the Pacific Coast state of Washington in the period 1908-17. ... The laws establishing it were repealed or allowed to become inoperative as one after another of the plans became financially insolvent and was recognized as serving to make banking matters worse.(46)

As in the case of branch banking, Nation-wide diversification of insurance risks would secure banking against any eventuality except such a national calamity as would destroy the Government itself.(47)

The "guaranty" terminology connoted the defunct state deposit guaranty plans, a specter that terrorized the bankers. The mere mention of deposit guaranties could induce a banker to show "every sign of incipient apoplexy."(48) At the same time, the unvarying failure of the state plans provided a trove of evidence for foes of the federal scheme.(49) Release of the ABA report coincided with the introduction of the Glass and Steagall bills in Congress. It found perverse delight in the failure of all eight of the state plans:

Eight large scale tests, by practical working experience, of the guaranty of bank deposits plan as a means for strengthening banking conditions and safeguarding the public interest are a matter of record. Each one of these attempts failed of its purpose.

Taken separately, special circumstances such as technical defects in the plan or faulty administration might be held accountable for the breakdown in any given instance, leaving it an open question as to whether the idea might not be successful under different circumstances. Taken as a composite whole, however, the failures of the various plans not only confirm one another in their defects, but each one also supplies added special features that were tested and found wanting.(50)

This unbroken string of failures demanded an explanation from supporters of federal legislation. Proponents chose to distinguish clearly the new plan from the state schemes: "there is no logical relationship between these old State Guarantees and this new Federal Insurance; no analogy; no parallel; and no reason to confuse the mortality of the former with the vitality of the latter."(51)

To make this case, supporters emphasized foremost the much broader geographic--and therefore industrial--diversification of a federal insurance fund. "The fact that bank-deposit-guaranty projects have failed in local, restricted areas only proves one of the fundamental principles of insurance, that is, that there must exist wide and general distribution and diversification."(52) In particular, the old plans were said to have suffered from a "one-crop" problem, that is, their application in states overwhelmingly dependent upon agriculture:

There is a vast difference between what can be accomplished by a small number of banks in one State dependent upon a single crop and what can be successfully accomplished by the banking system of this great Nation that holds the financial leadership of the world in its hands.(53)

On this point, at least, the bankers were forced to concede.(54)

The bankers revealed the geographic breadth of the federal plan to be a two-edged sword, TABULAR DATA OMITTED however, and used it to fight back. They exploited the well-known fact that bank failures throughout the 1920s had occurred disproportionately among small, rural banks.(55) This information was used to argue that, with insurance premia assessed against deposits, the burden of funding federal deposit insurance--had it existed during the 1920s--would have been borne in large measure by the money center banks of the Northeast, where much of the industry's deposit base lay. The benefits of insurance, however--the payments to cover losses in failed banks--would have gone south and west.

Subsidy and Discipline

For it is to be remembered that the weak banks get the same insurance as the strong ones, and, unlike the situation in other kinds of insurance, the bad risk pays no more for its insurance than the good one. This means competition among banks in slackness in the granting of loans. The bank with the loose credit policy gets the business and the bank with the careful, cautious credit policy loses it. The slack banker dances and the conservative banker pays the fiddler. If the conservative banker protests, the slack one invites him to go to a warmer climate. Soon all are dancing and the fiddler, if paid at all, must collect from the depositors or from the taxpayers.(56)

For those who opposed deposit insurance on actuarial grounds, such technicalities were merely manifestations of a more fundamental issue. As a matter of principle, deposit insurance was held to be unjust. It involved the forced subsidization of poorly managed banks by well managed institutions; it subsidized the "bad" banker at the expense of the "good." This moral point provided substantial emotional force. Opponents concluded that only good bank management could ultimately assure safe and sound banking.

Their argument, founded in actuarial theory and the experience of the state plans, proceeded in two steps. First, by protecting depositors against loss, a deposit guaranty would destroy discipline; insured depositors would take no interest in the quality of their bank's management. Recalling the state plans, the guaranty had created "a sense of false security and lack of discrimination as between good and bad banking."(57) In many minds, this dichotomy between good and bad bankers was the central issue.(58) Bankers Magazine editorialized that "the surest reliance of good banking is to be found in the men who manage the banks rather than in the laws governing their operations."(59) In 1931, ABA President Rome Stephenson contended

that, a large element in the internal conditions of the banks that failed was bad management and that a predominant element in the internal conditions of the bank that remained sound in the face of the same external conditions was good management.(60)

What was needed was to teach "the conception of scientific banking."(61)

The second step in the logic of opposition was an objection to the subsidy implicit in a guaranty. In the tones of a prudish parent, the ABA complained that the beneficiaries of state systems had been the "bankers with easier standards," who gained competitive advantages over those with "sounder but less attractive methods."(62) The subsidy was especially problematic among those banks "which have little chance of ultimate success."(63)

A bank which does not earn a fair average rate of return over a period of years not only is unable to build up reserves against bad times, but, in order to improve profits, is under constant temptation to take risks which in the end are likely to lead to failure.

The tendency of a guaranty plan will be to nurture these unprofitable units and keep them going temporarily in the knowledge that upon failure the losses can be shifted to other banks.(64)

Thus, the subsidy was seen to extend beyond the simple protection of unsound institutions from the competitive pressures of vigilant depositors. Given their contention that, "no provision is made for building up a reserve fund," losses charged to the insurer by failing banks would have to be recouped after the fact from the survivors.(65) Such a system would necessarily entail transfers of wealth from surviving to failed banks.

There was no consensus in Congress on the importance of discipline; some members pointed out that life insurance was no incentive for suicide.(66) The framers of the Glass and Steagall bills, however, recognized the validity of the bankers' objections and addressed the issue directly. Both bills, as well as the temporary insurance amendment in the Senate, were careful to limit coverage. Sen. Vandenberg stated explicitly the rationale for coverage ceilings:

the State Guarantees involved complete protection for all banking resources. ... Federal Insurance, on the other hand, leaves the individual bank and banker so seriously responsible for such a preponderance of their resources that there is no appreciable immunity at all.(67)

Sen. Glass noted a second source of discipline inherent in the plan. Because the banks insured each other, deposit insurance would "lead to the severest espionage upon the rotten banks of this country that we have ever had."(68)

Under both the temporary and permanent plans, the small depositor was to be covered in full, in recognition of his inability to monitor bank management adequately:

At present the depositor is at the mercy of his fellow depositors, over whom he has no control, and of the management of the bank, about which he is not usually in a position to be well informed. The depositor takes the risks, and the banks take the profits.(69)

A survey conducted by the Comptroller of the Currency and the Federal Reserve in May 1933 revealed that the ceiling of $2,500 under the temporary plan would fully cover 96.5 percent of depositors and 23.7 percent of total deposits in member banks.(70)

PROTECTING DEPOSITS

While most industry opponents fought the deposit insurance plan on actuarial grounds, supporters argued that deposits per se required protection, to stabilize the medium of exchange and promote a renewed expansion of bank credit. More significantly, proponents responded with an argument of powerful simplicity: the losses to innocent depositors in a bank failure were a plain injustice. Given the status of banks in the political climate of 1933, this was a charge that the bankers ultimately could not counter.

The Agglomeration of Deposits for Speculation

The use of banking funds for speculation became a stench in the nostrils of the people.(71)

There was a strong sense that the banking industry in the 1920s had functioned as an elaborate network to collect savings at the local level and funnel them into lending on securities speculation:

Another cause for many banking collapses was the domination of smaller banks by their large metropolitan correspondents, which drained funds from the country districts for speculative purposes and loaded up the small bank with worthless securities.(72)

Indeed, this was a primary motivation for those sections of the Banking Act requiring a separation of commercial and investment banking. Similar arguments were brought against proposals for nationwide branch, chain and group banking.(73)

A sensitivity to such a possibility was doubtless nurtured by the popularity of Ponzi schemes in the 1920s, including the infamous Florida land swindles.(74) With such analogies in mind, banks came to be seen as

merely fueling departments in enterprises run not by bankers concerned with operating banks but by promoters whose object was to exploit the credit resources of the bank. ...

The primary evil in our banks for many years has been the incessant efforts of promoters to get control of the funds which flow into the banks. The bank is the depository of the community's funds and as such is the basis of the available credit of the community. The promoter-banker needs nothing so much as access to these credit pools.(75)

Such accusations were inevitably tinged with at least a hint of the conspiratorial.(76)

In keeping with this theme, the issues were framed for popular consumption as a morality play in which the naive depositor is pitted against the sophisticated banker. The depositor tucks away the hard-earned wages of his honest labor, only to be systematically duped by the cunning intrigues of the banker. At the extreme, some politicians played the religious card face up: "We discovered that what we believed to be a bank system was in fact a respectable racket and so many connected with it only cheap, petty loan sharks and Shylocks."(77) In the end, a providential government was seen to intercede on behalf of the depositor, and deposit insurance was trumpeted as "the shadow of a great rock in a weary land."(78)

The notion of the small depositor as an innocent victim had immense popular appeal. McCutcheon's 1931 political cartoon celebrating the blamelessness of the depositor in a failed bank won the Pulitzer Prize. Such popularity, of course, was plainly evident to politicians, who responded by introducing deposit insurance legislation in Congress. Rep. Steagall is reported to have told House Speaker Garner in April 1932, "You know, this fellow Hoover is going to wake up one day soon and come in here with a message recommending guarantee of bank deposits, and as sure as he does, he'll be re-elected."(79)

For obvious reasons, bank failures concentrated the attention of large numbers of voters, and Congressmen were anxious to associate themselves with the legislation. Sen. Vandenberg, up for re-election in 1934, was always careful to call his temporary insurance amendment to the Banking Act of 1933 "The Vandenberg Amendment." Rep. Dingell announced: "guaranty of bank deposits is my baby in Michigan."(80) A petition circulated in the House in June 1933 to postpone adjournment indefinitely until a deposit insurance bill was made law.(81) Figure 1 reveals that the number of guaranty bills introduced in Congress correlated neatly with the number of bank failures.

Theatrics aside, the central point for proponents of the legislation remained, and it was difficult to refute: "The main point is always this--the depositor owns the money. If he puts it in for safe-keeping it should be safely kept."(82)

Indeed, opponents conceded directly that depositor losses in bank failure were unjust.(83) Instead, they tried to redirect the debate to the question of "whether the guaranty plan will in fact cure the defects in our banking system and give depositors the safety which they seek and to which they are entitled."(84) On this latter question, the bankers remained obstinately negative; they favored "reform methods for banking that really strengthen banking," and therefore opposed deposit guaranties.(85)

The Stabilization of the Medium of Exchange

We think of the busy bee and the ant as tireless, but they are loafers compared with the activity of a busy dollar.(86)

We got the guarantee of bank notes after having had wildcat banking in connection with State bank notes and after having had people injured who held notes of the State banks. ...

It is much more important in principle to guarantee bank deposits, because the real circulating medium of the country is bank deposits.(87)

Although, as a strictly political matter, depositor protection was the central motivation responsible for the progress of deposit insurance in Congress, other forces were at issue. Chief among these was the role of banking in the real economy. Regarding bank failures, it was recognized that causality ran two ways: just as the general drop in real incomes had caused loan defaults and thus widespread bank failures, bank failures and the concomitant restriction of bank services had caused real incomes to fall. The latter effect was seen to operate both directly and indirectly.

Bank suspensions and failures could trap depositors' wealth for a period of months or even years until the bank either reopened or its bankruptcy was resolved. The direct result was reduced consumption and investment spending by the affected depositors. In the extreme case, when a town's lone bank failed, even the simplest forms of exchange could be hopelessly encumbered:

|The unacceptability of failure~ would perhaps not be so if they were grocery stores or butcher shops, where failure would be disastrous to only a few people at most; but bank failures paralyze the economic life of whole communities, not only through the loss of money accumulations but by the destruction of the deposit currency which is the principal medium of exchange in all business activity.(88)

Under such circumstances, some affected regions instituted scrip currencies, wooden coinage or systematic barter arrangements, the most elaborate of which was the Emergency Exchange Association in New York, headed by Leland Olds.(89)

A depositor's natural response to these possibilities was to withdraw his funds before failure occurred. Both bank runs and the hoarding of currency received considerable attention.(90) Withdrawals for the purpose of safeguarding one's wealth were deemed unpatriotic; legislation was even proposed to outlaw the practice. Banks had a natural response to the threat of runs: "Credit was tightened in the desire to remain as liquid as possible to meet the emergencies of runs."(91) Bankers maintained large cash reserves rather than lend:

It is estimated that banks now have available billions of dollars of collateral for use in extending loans, but the plain fact is that for more than 3 years bankers have given little thought to anything except to keep their banks in liquid condition. ... The fear that grips the minds and hearts of bankers, keeping ever before them the nightmare of bank runs, makes it impossible for them to extend the credits that are indispensable to trade and commerce.(92)

This analysis is confirmed by the facts. The aggregate excess reserves of Federal Reserve member banks, for example, had ballooned from $42 million in October 1929 to a peak of $584 million in January 1933, even though the number of member banks had fallen from 8,616 to 6,816 over roughly the same period.(93) Thus, bank failures were seen to have an indirect effect on output, as both depositors and bankers in solvent institutions prepared for the possibility of runs and failures.

In the final analysis, depositor protection and stabilization of the medium of exchange were recognized as opposite sides of the same coin:

We may talk about percentage of gold back of our currency, we may discuss technical provisions of legislation ... The public does not understand these technical discussions, but from one end of this land to the other the people understand what we mean by guaranty of bank deposits; and they demand of you and me that we provide a banking system worthy of this great Nation and banks in which citizens may place the fruits of their toil and know that a deposit slip in return for their hard earnings will be as safe as a Government bond. |Applause.~

They know that banks cannot serve the public until confidence is restored, until the public is willing to take money now in hiding and return it to the banks as a basis for the expansion of bank credit. This is indispensable to the support of business and the successful financing of the Treasury. It will bring increased earnings, higher incomes, and make it possible to balance the Government's Budget without resort to vicious and vexatious methods of taxation.(94)

As such, they should be considered inseparable; it is clear that supporters of the legislation intended it to achieve both ends. Attempts to rank the two issues according to their relative importance are likely to be inconclusive.(95)

The Chastening of Wall Street

One banker in my state attempted to marry a white woman and they lynched him.(96)

The opposition to federal deposit guaranties emanated largely from the nation's bankers. This fact was a crushing liability to their cause in the political climate of 1933. The introduction of the Glass and Steagall bills came on the heels of the banking panic and, not entirely coincidentally, amid the daily revelations of self-dealing and other cupidities from the Pecora hearings.(97) The banker had become a pariah.

Roosevelt fired the opening volley for his administration in his inaugural address:

Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply. Primarily this is because the rulers of the exchange of mankind's goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.(98)

He went on to demand safeguards against the "evils of the old order": strict supervision of banking, an end to speculation with "other people's money," and provision for an adequate but sound currency.(99)

Others were happy to follow this lead. It was commonplace to hold the bankers, and particularly their "speculative orgy" of 1929, responsible for the nation's woes:

You brought this country to the greatest panic in human history! ... There never was such an economic failure in the history of mankind as your outfit has brought upon us at this time, and it is due to this same speculation that you are defending here more than any other one thing.(100)

But these affiliates, I repeat, were the most unscrupulous contributors, next to the debauch of the New York Stock Exchange, to the financial catastrophe which visited this country and was mainly responsible for the depression under which we have been suffering since.(101)

In the previous year, Huey Long had announced his intent to campaign for Roosevelt under the slogan: "Rid the country of the millionaires."(102) A popular ditty mocked:

Mellon pulled the whistle, Hoover rang the bell, Wall Street gave the signal, And the country went to hell.(103)

In short, the bankers were vilified.

Although some felt such indiscriminate abuse was slanderous, they fought against the tide.(104) One of the casualties of the anti-banker sentiment was the bankers' battle against deposit insurance. Some in Congress announced that the bankers' opinions should be openly ignored:

I believe that the myopic banker as an adviser should receive about as much consideration at the hands of the House as a braying jackass on the prairies of Missouri. They proved by their inability to maintain their own business that they have absolutely no right to advise the House as to what course we should follow.(105)

The bankers, while they acknowledged the merit of individual aspects of the deposit insurance proposals, obstinately refused to countenance any of the schemes as a realistic reform. Even as the legislation was signed into law, Francis Sisson called a crusade, rallying ABA members to fight "to the last ditch against the guaranty provisions" of the bill.(106) That the bankers' concerns were not ignored entirely resulted largely from the presence in government of opponents of deposit guaranties who were more politically astute than the bankers themselves. Sen. Glass, for example, compromised his principles in a bid for some control over the legislation, explaining that it was "better to deal with the problem in a cautious and a conservative way than to have ourselves run over in a stampede."(107) Roosevelt held out until the very end, thus forcing Congress to concede in delaying implementation of the temporary plan until January 1934.

BANK MARKET STRUCTURE

The ramifications of deposit insurance were recognized as far-reaching. In many ways, the central and most contentious battle concerned neither actuarial feasibility nor the desirability of protecting deposits, but the regulatory issues of bank chartering and supervision. Because of the fundamental legal issues involved, it was here that the economic and political aspects of the debate became most fully intertwined. This was a fight with the weight of a long tradition behind it, and arguments were often self-consciously historical.

Regulatory Competition and Lax Supervision

Bank examinations to be effective must be made by experienced men, free from political influence. ... We will never have proper banking supervision, national or state, until it is taken entirely away from political influence.(108)

Much of the blame for high rates of bank failure throughout the 1920s was placed upon competition between state and federal authorities. Because banks could choose the less costly of federal and state charters--and the associated regulations--state and federal regulators were forced into a "competition in laxity" if they were to sustain the realm of their bureaucratic influence.(109) For example, as a prelude to recommending broader powers for national banks, Comptroller Pole emphasized that:

If congress therefore would protect itself from the loss of its present banking instrumentality, it must make it to the advantage of capital to seek the national rather than a |state~ trust company charter. ...

It is within the power of Congress to turn the advantage in favor of the national banks and thereby make it to the interest of all banks to operate under the national charter(110)

In the eyes of opponents of deposit insurance, an especially important manifestation of the competition in laxity was the "promiscuous granting of bank charters."(111) The immediate result of loose chartering was a condition called "over-banking," or

a host of weak, unreliable banks that crowd one another out of existence by being too numerously organized in places where there is no support for the multifarious institutions that have been established there.(112)

This "indiscreet indulgence of charter applicants" was held responsible for the vast numbers of bank failures throughout the previous decade:(113)

There are too many banks in the United States. The areas of greatest density of banks per capita coincide with the areas where failures are proportionately highest.(114)

The function of a deposit guaranty under such circumstances would be to exacerbate the problem by mitigating one source of public scrutiny: inspection by depositors. Opponents confirmed their contention by reference to the ill-fated state guaranty schemes:

In practice the guaranty of deposits plan generally tended to induce an unsound expansion in the number of banks ... This was clearly connected with the indiscriminate popular confidence created toward the banks under the guaranty.(115)

It is to be feared that the adoption of deposit guaranty laws may have somewhat retarded the inevitably slow and unsensational process of strengthening the banking system by strict regulation, vigilant public opinion and strict requirements.(116)

The Association of Reserve City Bankers went further, predicting that managers of the insurance fund would be slow to close troubled institutions.(117) In addition to regulatory competition, some saw political influence as a secondary force debilitating the supervisory process:

We never will have such supervision under political regulation and examination; we will never have any supervision worthy of the name that does not have real authority and heavy responsibility tied to it.(118)

Only a few supporters of insurance addressed directly the plan's implications for the regulatory process, which they presented as a counterweight to incentives for bad banking under a guaranty. Rome Stephenson felt that the additional regulatory powers in the Banking Act differentiated the FDIC markedly from the state plans:

Right there is the crux of the debate: Will banks under the federal plan be permitted the abuses which were tolerated in every one of the states where guaranty was tried? If so, then failure is inevitable. If not, success is practically certain. ... Let me assert unequivocally that the men who drew up the federal plan profited by the mistakes of the state guaranty failures and avoided them. ... None of the state laws had teeth in them. The federal law has teeth like a man-eating shark, and already has done some highly effective biting.(119)

Carter Glass, railing that "the Comptroller's office has not done its duty--its sworn duty--and has permitted this great number of banks to engage in irregular and illicit practices," argued that mutual responsibility inherent in the insurance plan implied mutual supervision: if the strong banker "knows that he has got to bear a part of the burden of my irregular banking, he is going to report me to the Comptroller of the Currency and is going to insist that his examiners come there and do their duty."(120)

The Dual Banking Question

The fact is, of course, that the deposit insurance scheme would not have been permitted by the conservative leaders in Congress if its organization could not have been so shaped as to further their idea of a unified system of banking in the country under the Reserve System. On the other hand, the more radical elements, in response to popular demand for some sort of protection for bank depositors, could not have built a nationwide guaranty system upon any other foundation than the Reserve organization.(121)

Questions about the effect of insurance on the quality of chartering and supervision were sideshows to the main event, however. At the heart of the debate lay a decades-old controversy over the dual banking system. Given its far-reaching nature, the proposed legislation was universally regarded as a prime opportunity for fundamental changes in banking policy.

Comptroller Pole had campaigned vigorously throughout his four-year tenure for some form of interstate branching for national banks. He drew a strong distinction between the small, state-chartered, rural unit bank--the "country" bank--and the large, nationally chartered institution. While he pretended to maintain great respect for the small unit bank as the "single type of institution which has contributed the most to ... the foundation of our national development," he was fighting to have them replaced by branch networks of national banks.(122) He justified this split sentiment by arguing that irreversible social changes--telephone, radio, and especially the automobile--had forever obviated the rural isolation that had made the unit bank competitively viable. Accompanied by a long parade of statistics, he emphasized the high failure rate of small, state-chartered banks during the 1920s.(123) The country bank, he said, could not survive in competition with large metropolitan institutions, which had more professional management and were inevitably better diversified.

Comptroller Pole was not alone in this crusade. The McFadden Act had already broadened the branching powers of national banks; in 1930, the House Banking Committee arranged new hearings into the possibility of national or regional branch banking.(124) The unsuccessful Glass bill of 1932 included limited provisions for statewide branching by national banks. Business Week staked out the extreme position, announcing that "what we really need is just one big bank with 20,000 branches."(125) Supporters of branch banking took heart in the Canadian experience:

Canada has branch banking, and Canada has not had any bank failures during the depression. Is this a matter of cause and effect?

'It is,' declare the advocates of branch banking in the United States.(126)

Such highly concentrated branch networks were offered as an alternative to deposit insurance as a means of geographic diffusion of loan losses and the diversification of credit risks.(127)

Comptroller Pole, of course, felt branching to be the better option:

Any attempt to maintain the present country hank system by force of legislation in the nature of guaranty of deposits or the like, would be economically unsound and would not accomplish the purpose intended.(128)

Deposit guaranties had long been advocated as a way of diversifying risk for the unit bank without a fundamental change in the ownership structure of the banking industry.(129) The various histories of Populism, "Bryanism," the Panic of 1907 and the Pujo hearings all contained elements of a deep popular mistrust of money center banks. The publicity of the Pecora hearings in 1933 clearly did not assuage this mistrust. It was not pure coincidence that the western agricultural states--the heart of the Grange and Populist movements--had been the ones to enact state deposit guaranties. In this context, then, it is ironic that, in 1933, federal deposit insurance should most often have been viewed as a lethal threat to the country bank. That it was such a threat testifies to the influence and legislative skill of Carter Glass.

Sen. Glass, who had shepherded the Federal Reserve Act through the House in 1913, was protective of his handiwork:

I took occasion to tell the Secretary of the Treasury the other day that if they pursue present policies much longer they will literally wreck the Federal Reserve System; that Woodrow Wilson in history will enjoy the distinction of having set up a banking system that fought the war for us and saved the Nation in the post-war period, and if they keep on making a doormat of it this Congress will enjoy the distinction of having wrecked it.(130)

His primary concern in the banking legislation of 1933 was to buttress that system. Thus, the Glass bill required all FDIC member banks to join the Federal Reserve System, ostensibly to give the Fed the legal right to examine FDIC members (the Fed was to be a prominent shareholder in the FDIC).(131) Because an uninsured country bank facing insured competitors was not considered viable, and because Fed membership would require at least $25,000 minimum capital, deposit insurance represented the end for the small, state non-member banks.(132) Deposit insurance would force a consolidation of banking within the Federal Reserve System.

It is instructive to note that Glass had abandoned an earlier scheme that would have forced the same consolidation within the Fed: unification of banking in the National Banking System. Comptroller Pole had sought to accomplish the same thing indirectly, by providing national banks with an undeniable competitive advantage in the form of interstate branching privileges. In 1932, Glass had requested of Gov. Meyer of the Federal Reserve a constitutional method of unifying banking:

Meyer: "Do you want to bring about unified banking?"

Glass: "Why, undoubtedly, yes."

Meyer: "I shall be glad to help you."

Glass: "I think the curse of the banking business in this country is the dual system."

Meyer: "Then the Board is entirely in sympathy with the Committee on the subject."(133)

The result was a legal opinion prepared by the General Counsel of the Federal Reserve Board on the constitutionality of such unification in the absence of a constitutional amendment.(134) While Board Counsel confirmed that such a constitutional means existed, Sen. Gore introduced a constitutional amendment.(135) Constitutionality was crucial, because champions of the rural unit bank were certain to raise the powerful specter of states' rights in opposition:

The fight regarding the American Dual System of Banking is a clear-cut issue between those who believe in the sovereignty of our states and home rule, and those who are in favor of a 'unification of our banking system' into one Washington bureau.(136)

Indeed, the political sensitivity of the states' rights issue was sufficient to force Sen. Glass to abandon such a direct assault on the state banks before it could earnestly begin.(137)

Arrayed against Sen. Glass in the battle for unification within the Fed was a coalition led by Henry Steagall in the House and Huey Long in the Senate.(138) Sen. Long had crippled Glass's banking bill in the previous Congress with a ten-day filibuster; as champion of the common man, he had objected to an envisioned concentration of power implicit in the bill's branching provisions.(139) This coalition indeed viewed deposit insurance as a means of survival for the small bank:

If there is one purpose more than another which is inherent in the amendment which is now at stake in this conference, it is the purpose to protect the smaller banking institutions, and to make the reopening of closed banks possible as speedily and as safely as it can be done.(140)

The final legislation was a two-stage compromise between Sen. Glass's push for unification and the Steagall-Long coalition's desire to preserve the dual banking system. In the first stage,
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Author:Flood, Mark D.
Publication:Federal Reserve Bank of St. Louis Review
Date:Jul 1, 1992
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