Banking

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Banking During the Great Depression

The Great Depression of the 1930s dealt a severe blow to the commercial banking industry. Many banks failed (went out of business) when their loans could not be repaid. The number of commercial banks declined from 26,000 in 1928 to about 14,000 in 1933. Total deposits in these banks declined by about 35 percent. Depositors rushed to retrieve their money, a process known as a run on the banks, and the federal government was forced to close all the banks for four days in 1933 to stem the panic. It became apparent to observers that the Federal Reserve System had not solved all the problems of bank stability.

Consequently, during the Great Depression, Congress recognized the importance of a sound banking system and created a number of agencies to restore public confidence in the banking system. Among the first of these was the Federal Housing Administration, which was created in 1934 to insure payment on home loans made by private lending institutions. The guarantee helped preserve the value of bank loans and enabled banks to continue to lend money to homebuyers.

The Banking Act of 1933, also known as the Glass-Steagall Act, created the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits, increase the confidence of depositors, and therefore prevent bank runs. Federal Reserve member banks were required to join the FDIC. Membership was optional for other banks. The Glass-Steagall Act also set interest rate ceilings on deposits to reduce competition among banks, which was considered a cause of bank failures during the Great Depression. It also prevented banks from becoming too involved in investment-banking activities, such as underwriting stocks or bonds for companies. Underwriting, which typically involves selling stocks or bonds at a guaranteed price, can be risky and can cause banks to fail. The act also prevented banks from buying stock, which is a risky activity if the stock market crashes. This prohibition on investment-banking activities lasted until the 1980s.

The banking system began to recover in 1934. By 1937 deposits had reached pre-Depression levels. During World War II (1939-1945), deposits increased rapidly and more than doubled from 1941 to 1946. For the next 40 years the U.S. banking system went through a continuous expansion and modernization. In particular, there was an enormous increase in lending to consumers, through installment loans (loans for a fixed amount repaid in equal monthly payments) and credit card loans (loans for a varied amount repaid more flexibly).

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Banking After World War II

Some of the legislation enacted during the Great Depression and in the immediate postwar period began to have negative repercussions on the banking industry by the 1970s, according to some experts. Interest ceilings on deposits, which were required by the Glass-Steagall Act, prevented banks from competing with unregulated money market funds or even bonds issued by the U.S. Treasury. As people withdrew deposits to earn higher interest elsewhere (a process known as disintermediation), SLAs found it increasingly difficult to raise funds to make mortgage loans. Many SLAs went out of business. Disintermediation was not the only problem SLAs faced, however. Many SLAs decided to venture into business lending in the early 1980s with drastic consequences as commercial real estate markets collapsed. Many business loans went bad and forced even more SLAs out of business. In 1980, 3,998 SLAs existed in the United States. By 1992 the number had dwindled to only 2,039. There were 672 SLA failures from 1989 to 1992 alone and over 1,200 overall. The SLA crisis ultimately led to the collapse of the Federal Savings and Loan Insurance Corporation. It necessitated a restructuring of deposit insurance in the United States and a government bailout of the SLA industry that cost taxpayers an estimated $200 billion.

Restrictions on how banks could expand geographically also affected the industry. The Bank Holding Company Act of 1956 prohibited bank holding companies from acquiring banks across state lines. As a result of geographic limitations on expansions, banks were forced to operate primarily in local markets, which made banks particularly susceptible to local economic downturns. This act also restricted the activities of bank holding companies, limiting them to only those activities that were closely related to banking.

Legislation enacted in the 1980s and 1990s began to address these issues. The Depository Deregulation and Monetary Control Act of 1980 eliminated ceilings on interest rates. The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act legalized interstate banking, allowing banks to diversify geographically.

The most sweeping legislation, however, took place in 1999 when Congress removed most of the remaining provisions of the Glass-Steagall Act and replaced it with the Gramm-Leach-Bliley Act, named after Republican Party sponsors Phil Gramm, Jim Leach, and Thomas Bliley, Jr. The act also removed some of the restrictions of the Bank Holding Company Act of 1956 by permitting bank holding companies to engage in the full range of financial services, including lending, deposit taking, investment advising, insurance, stock and bond underwriting, and other investment banking services. The act did not, however, allow bank holding companies to own nonfinancial businesses. Many observers believe that the new law will increase the dominance of bank holding companies and lead to the establishment of so-called universal banks that offer a full array of financial services, including traditional banking services, insurance, investment advice, and stock and bond brokerage services. Critics of the law, however, caution that the new law, combined with the provisions of the 1994 act that ended restrictions on branching and allowed nationwide banking, may ultimately diminish competition for financial services in the United States.

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