The National Banking Era Macroeconomics:Civil War to World War I Civil War, Fiscal: Huge Deficits Huge Increase in Federal Debt Monetary: Abandon the Bimetallic (Effectively Gold) Standard Monetary: Inflation in North, Hyperinflation in the South Greenback Period, Fiscal: Surplus Reduction in the Debt Monetary: Deflation Resumption 1879 Monetary: Return to the Gold Standard The Gold Standard, Fiscal: Surplus Reduction in the Debt Monetary: Continued Deflation and Silver Politics, Monetary: Gold Inflation, } Financial Policy: The National Banking Era, Banking STRUCTURE Regulation and Organization of the Banking Industry CONDUCT How do banks operate? Commercial Banks? Savings Banks? Investment Banks? PERFORMANCE Competitive markets? Integrated Markets? Risk/Failures? Losses/Profits? Returns to Banking? FIRST----STRUCTURE WHAT WERE THE FACTORS SHAPING THE STRUCTURE OR ORGANIZATION OF THE BANKING SYSTEM? Key---Return of the Federal Government to the Regulation of banks During the Civil War Partial collapse of state banking systems Opportunity for Federal Government to create a new system---after it had abandoned an intervention in the system in 1836. The National Banking System---a banking system without a central bank National Currency Act 1863 National Banking Act 1864 creation of the Office of the Comptroller of the Currency (OCC)Result: a federally-chartered system of free banking. Free entry upon meeting minimum rules and a bond-backed currency Never important in wartime financetoo late. REGULATIONS? Salmon P. Chase, U.S. Secretary of the Treasury, , free men, free soil, free banking Justification for Regulation and Supervision: Asymmetric Information Difficult for individuals to select and monitor borrowers. Banks specialize and lower costs, but then the problem becomes how can depositors monitor the bank. Adverse Selection Problemto pick the right bank Moral Hazard Problemhow to monitor banks behavior Free Rider Problem If not solved----less than optimal financial intermediation, less credit than economy needs. If not solved---high propensity for depositors to panic and run Potentially high costs to the economy Desire for Reputation may control problems If not sufficient may need to impose Regulations and Supervision to increase flow of information, monitor and discipline banks. Taxonomy of Regulation and Supervision (9 factors with some justification) 1.Entry Controlled to screen out dishonest or excessive risk-taking entrepreneurs. 2.Capital requirements Control moral hazard by limiting leverage. 3.Limits on economies of scale restrict branching and horizontal mergers. 4.Limits on economies of scope and diversification constrain banks portfolio choices or activities to constrain risk-taking or conflicts of interest. 5.Limits on pricing: Interest rate restrictions to control predatory behavior. 6.Liability (deposit) insurance: free customers from monitoring banks and the incentive to panic. Taxonomy of Regulation and Supervision 7.Disclosure requirements Reinforce market discipline if information is made public. 8.Examinations Government-supplied auditing to examine proprietary information. Complements disclosure and ensures compliance with regulations. 9.Bank supervision Enforce regulations and control risk by imposition of penalties. Rules-based or Discretion-based. Five U.S. Policy Regimes National Banking Era Early Federal Reserve Period, New Deal, Demise of the New Deal, The Contemporary Era, 1. Supervision under the National Banking System, National Banking Era EntryFree Entry; Minimal Discretion 2. Capital RequirementsLow Fixed Minimum; Double Liability 3. Limits on Economies of ScaleBranching Virtually Prohibited 4. Limits on Economies of Scope & Diversification Banks Narrowly Defined; Loans Restricted 5. Limits on PricingUsury Laws, vary state by state 6. Liability InsuranceBond-Secured Banknotes, Reserve Requirements 7 States Deposit Insuranceafter Disclosure3 Yrly Surprise "Calls" after Examination2 Yrly Surprise Exams: Bottom Up 9. Supervision & EnforcementMark to marketPrompt Closure OCC--the federal regulator and each state has regulatory agency Two Elements of a Free Banking System? 6. National Banknotes National banks must buy federal bonds, which are deposited with the government. They are allowed to issue up to 90% of the par value of the bonds in banknotes. If a bank fails, the bonds can be sold to guarantee value of its banknotes. Collateral---safer than state bonds---default free. Banknotes are uniform because collateral is uniform. Banknotes are given uniform appearance. No longer subject to bank run or doubt From bond- backed state chartered banknotes to bond-backed national bank notes Requirements for a national bank 2. Minimum capital requirements---$50,000 (for big cities $200,000) 2. Double liability------Why? 4. Loans---maximum of 25% of capital in real estate loans ensures that most are short-term commercial loans (real bills doctrine)---Why? 6. Reserve requirements---graded by city: Country banks 15% (3/5 on deposit with..) Reserve city banks 25% (1/2 on deposit with.) Central Reserve City Banks 25%--all cash Contributes to a pyramiding of reserves. National bank regulations 3. National banks may not have branches (concern about wildcat banking). Not considered a problem until 1890s. 8. & 9. OCC operates system of examination, sends out regular bank examiners to enforce rules. What Happens to the State Banks? Do they join? Hardly---rules are more onerous than state rules U.S. slaps 10% tax on state banknotes---forcing them to join Revival of state banking State banks find it prohibitive to issue banknotes---helps to encourage the growth of deposit banking States begin to adjust their regulations and set lower requirements for capital and reserve requirements, loans Result the Dual Banking System with competition in laxity. And 51 regulators! Still no branching is permitted Increased demand for banking services met by new banks---in suburbs or on the frontier---not new branches States try to increase their state-chartered banks advantages and charter more banks Thousands of Banks and few branches 1910, there are over 19,000 banks But, even state banking systems find competition from new intermediaries-- -the Trust Companies who have even lighter regulation than state banks Trust Companies become major banks (especially NY and MA) with very low regulations An increasingly complex set of institutions DEPOSITS ARE PYRAMIDED because of (1) reserve requirements, clearing and collection of checks, and transfer of investment funds Problems of a fragmented banking system Payments System Problems: Most of clearing and collection of checks cannot be done internally. Banks must form relationships---the rise of correspondent banking Result Pyramiding worsens panics Allocation of Funds Problem: Interregional transfers of bank funds from region to region cannot be done internally. Need for correspondents Result Pyramiding worsens panics Portfolio Diversification Problem: Many banks cannot fully diversify sources of deposits or loans Result: More Prone to Failure What do banks do with their surplus funds: brokers loans---call and time loans to the stock market, the equivalent of federal funds Compounds pyramiding of reserves and investment especially in NYC Effects of Structure on Banking, (Factors 1, 2, 3) Free entry, low minimum capital requirements, branching prohibited thousands of small undiversified banks More likely to fail and fragile in a panic (Factors 3, 6) No branching and reserve requirements Fragmented banking system for payments and interregional transfers leads to development of correspondent in big cities with pyramiding of reserves and other funds Fragile in a panic (Factors 2, 6) Double liability, no deposit insurance Make shareholders and depositors monitor bank management carefully (Factors 7,8) Surprise disclosure and examination Improve monitoring of management (Factor 9) Prompt closure of failed banks Lower Losses Factor 5, little effect; Factor 4 Leads to growth of investment banking How important were Banks? Financial Intermediaries Shares of Assets (%) Commercial Banks Insurance Companies Other Intermediaries Structure, and now CONDUCT HOW DID COMMERCIAL BANKS OPERATE? HOW DID INVESTMENT BANKS OPERATE? What makes commercial banks special? Banks have a special capacity to collect information on borrowers and monitor them Monitor their checking accounts etc. Interview them & ask them to disclose information Result lots of informationproprietary information It is generally difficult to market loans to outsiders without access to banks proprietary information. They cant be valued by someone else Many loans are not marketed and are held until maturity with banks managing risk. (Subprime disaster proves this point. How did banks screen their customers in the 19 th century? Little formal standardized information. No financial statements, income taxes etc. For individuals or for companies. Accounting only begins to develop late in the 19 th century How to be a banker in the 19 th century: a case study, the Bank of A. Levy A small town bank in Ventura, California, the Bank of A. Levy, was founded in 1885 by Achille Levy Mostly short-term loans to landowners for farming. The character loan method. If an applicant was of good character, a loan was forthcoming. If the borrowers reputation was flawed, the offer of thousands of dollars worth of collateral could not persuade him to make a loan. He did take on questionable borrowers and if they faithfully repaid small loans, the size of the loans increased and the interest rate fell. Case of the Chinese laundryman. Levy carefully monitored his customers activities, watching their banking activities in his office, and traveling around the county on horseback, recording information in his pocket notebook. Bank Lending More generally, a 1918 Journal of Political Economy study offered the following advice on how to judge a potential borrower: The amount that may be safely loaned.can be ascertained only from an intimate personal acquaintanceship with the borrower and his business or from a study of a balance sheet or financial statement setting forth the condition of the business. Banks were dominant intermediaries because they gained special knowledge of borrower that was not marketable. Investment Banking: Structure No Federal Regulations (Some state laws- Blue Sky laws) But, Factors 3 & 4 for commercial banking limit ability of commercial banks to make large long-term loans alternative issue stocks and bonds Banks are agents not principals Primary markets: Issue of new securities (IPOs and Seasoned) Secondary Markets: Brokerage Growth of Investment Banking Securities (stock and bond) markets were limited before the Civil War. Most businesses were relatively small. In 1860, the average firm produced value added of only $6,000 a year. Beginning in 1890s, there was a huge merger wave that put together huge integrated firms: U.S. Steel, Standard Oil, AT&T, International Harvestergiant firms. These firms cannot rely on funding of banks, which remain, relatively small. Result is alternative source of funding : Corporations obtain $18 billion in outside funds Bank loans 24% Stocks 31% Bonds 45% Problem: How to market securities when there is little reliable financial information Accounting profession in early stages of development. Financial documents hard to compare and interpret. New industries were very difficult to analyze. WHO ARE YOU GOING TO CALL? The Money Trust: Condut Several dominant investment banks: J.P. Morgan, Kuhn Loeb, Kidder, Peabody, and Lee, Higginson and Company They assist companies with the sale of large issues of new securities in the primary markets Leading investment bankers also sit on the Boards of Directors of large industrials, commercial banks and insurance companies Conflicts of Interest: Critics charged that these bankers colluded to force these firms to use their services to issue securities and then force banks and insurance companies to buy them---raising profits of the investment banks J. P. Morgan Money Trust: Evil Bloodsucking Monster (Vampire Squid?)* or Agent of Modern Capitalism? Muckraking journalists and politicians denounced the conflicts of interest that caused investment banks to prosper at expense of clients and investing public. Pujo Commission : Congressional investigation into money trust John Moody, founder of Moodys argued in 1904 that control of corporations by financiers was necessary to direct funds to them and let investors know which firms were worthy of investment. Rep. Arsene Pujo *Rolling Stone: The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood... Did the Money Trust Exploit Conflicts of Interest or Overcome Asymmetric Information? De Long offers case studies International Harvester AT&T Econometric Analysis If conflicts of interest are dominant then presence of Morgan partner should lower stock prices If monitoring and signaling are dominant then presence of Morgan partner should raise stock prices. Conclusion? On balance, De Long concludes that the monitoring and signaling effects were dominant. Why did the Money Trust decline? What changed securities markets? Financial markets can only thrive with the development of standardized accounting methods that began to be developed in the late 19 th century. For securities markets to flourish investors must have a means to compare investments-----these are provided today by the credit rating industry. The earliest credit agencies like Duns or Bradstreets responded to the need of suppliers of goods to judge how much trade credit to extend to customers. But, these are qualitative assessmentlawyers, other businesmen. The Arrival of the Rating Agency Investors require cheap available information on changing quality of bonds Poors Publishing Company first published Poors Manual, which analyzed bonds. Its competitor Moodys Manual of Industrial and Miscellaneous Securities followed in Notice the timing. The Rating Agencies: Aaa, Aa, A, Baa, Ba, and so on How to rank investments? Innovation in John Moody introduced the rating system by letter as a means to combine all the statistical information on credit quality into a single easy to interpret symbol. First applied to Railroads----they protested-- -but eventually a good rating meant that it was easier to raise money. This innovation allowed investors to subscribe to a service and purchase bonds, thereby decreasing the demand for intermediation. But, note, this was a 20 th century development.