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The Political Economy of Banking Regulation, 1864- 933

The Political Economy of Banking
Regulation, 1864- 933
EUGENE NELSON WHITE
The laws and regulations that shaped the structure of the banking industry from
the Civil War to the Great Depression were strongly influenced by the banking
community. In this period legal constraints on banks were weakened by competition
between state and federal regulators trying to increase membership in their
banking systems. The elimination of regulation was not completed, however,
because the politically most powerful group in the industry, the unit banks, had an
interest in preserving some regulations.
NOATIONALm oney and capitalm arketsg raduallye mergedi n the
United States from the integration of regional markets and the
circumventiono f regulatoryc onstraintsi mposedo n financiali ntermediaries.'
Regulation of the banking industry created a number of impediments
to the formation of these markets. Although economic historians
have examined the effects of this regulation, they have not given much
attention to the economic and political forces that shaped its evolution.
Changes in banking regulation were the product of protracted political
struggles among different interest groups seeking to influence the
structure of the industry. In this paper, the evolution of banking
regulation from the Civil War to the Great Depression is analyzed by
examining the actions of the three interested parties: the banks, the
public, and the government regulators. These were not homogeneous
groups but were categorized by divergent economic interests. Influence
thus depended on the political coalitions that arose. The most effective
political coalition that emerged was formed by the smaller unit banks.
The durability of some banking laws and changes in others in this period
are largely explained by the considerable influence wielded by these
banks.
Journal of Economic History, Vol. XLII, No. 1 (March 1982). ? The Economic History
Association. All rights reserved. ISSN 0022-0507.
The author is Assistant Professor of Economics, Rutgers University, New Brunswick, New
Jersey 08903. Helpful comments on an earlier draft were received from Hugh Rockoff and Richard
Keehn.
1 Studies of the development of American money and capital markets include: Lance Davis,
"The Investment Market, 1870-1914: The Evolution of a National Market," this JOURNAL, 25
(Sept. 1965), 355-99; Richard E. Sylla, The American Capital Market, 1846-1914 (New York,
1975); John A. James, Money and Capital Markets in Postbellum America (Princeton, 1978);
Richard H. Keehn, "Market Power and Bank Lending: Some Evidence from Wisconsin, 1870-
1900," this JOURNAL, 40 (March 1980), 45-52.
33
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34 White
THE DUAL BANKING SYSTEM
The point of departure from which opposing interests vied with one
another to influence regulation was the establishment of the National
Banking System. Created by the National Banking Act of 1864, this
system disrupted the existing balance of forces shaping the regulatory
environment and restructured the banking industry. The Office of
Comptroller of the Currency was established and given authority to
charter national banks that were permitted to issue banknotes backed
by government bonds. Most banks were induced to join the new system
when Congress levied a 10 percent tax on all non-national banknotes.
The National Banking Act also regulated the size and activity of
national banks by imposing minimum capital and reserve requirements,
restricting real estate loans, and prohibiting branching.2
These barriers to entry and constraints on banking activity prevented
the supply of banking services from keeping pace with the demand as
the country grew and expanded westward. The lack of adequate
banking facilities was particularly acute in agricultural areas where
communities were not large enough to support a minimum size national
bank. The unfulfilled demand for more banking services stimulated the
public to press for currency and banking reform. Although most
agrarian agitation focused on the issue of silver monetization, business
emphasized the lack of banking facilities in addition to monetary
reform. At the 1897 Indianapolis Monetary Convention, dominated by
Midwestern businessmen, it was resolved that the lack of adequate
banking facilities should be met by "a diminution of the minimum
capital required for banks in places of small population and authority for
the establishment of branch banks."3
This demand for more bank offices was answered by the states, which
began to pass "free banking" laws in the late 1880s and 1890s. These
laws permitted new banks to incorporate under general legal provisions
instead of requiring them to obtain special charters from the state
legislatures. This change made entry into the banking industry much
easier.4 To ensure the attractiveness of the reorganized state systems,
the state legislatures required banks to conform to regulations less
restrictive than those imposed on national banks. Thus, the Comptroller
of the Currency's 1895 survey of state legislation found that all but two
states' minimum capital requirements were lower, few imposed any
restrictions on their banks' real estate loans, and only sixteen states had
reserve requirements.5 Given this incentive structure, it is not surpris-
2 For a more detailed description of state and federal banking regulations, see Eugene Nelson
White, The Regulation and Reform of American Banking, 1900-1929 (Princeton, forthcoming),
Chap. 1.
3 Quoted in Sylla, The American Capital Market, p. 71.
4 James, Money and Capital Markets, pp. 233-34.
s Annual Report of the Comptrollero f the Currency( Washington,D .C., 1895).
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Political Economy of Banking Regulation 35
ing that national banks grew very slowly from 3,484 in 1890 to 3,731 in
1900, while state-chartered banks increased from 2,534 to 4,405.6 The
federal government had sought to monopolize the regulation of banking,
but the short supply of banking services drew the states back into the
business of chartering banks, breathing life into the dual banking
system.
REGULATORY COMPETITION
Confronted by vigorous competition from state banking authorities
chartering new banks and trust companies and faced with strong public
pressure, federal officials moved to improve the attractiveness of
national bank charters. The Comptrollers of the Currency in the early
1890s were favorably disposed towards legislation that would permit
some form of branching to increase banking facilities in rural areas. In
1895, Secretary of the Treasury John Carlisle and President Cleveland
both recommended that national banks be allowed to branch.7 When the
unit banks in small towns and rural areas realized that their profitable
position and perhaps even their independence was threatened by
branching that would allow the larger city banks to reach out into their
territory, they rallied to oppose these proposals. Their cause was taken
up by Charles Dawes who became Comptroller in 1898. He helped to
kill a bill in Congress that would have allowed some branching; in its
place, he promoted lower capital requirements to increase the number
of rural bank offices.8 Congress accepted this proposal, and the Gold
Standard Act of 1900 allowed national banks with a capital of $25,000 to
be established in towns of fewer than 3,000 inhabitants.
The state banking authorities quickly recognized the effect this
federal law might have on applications for state charters. By the time of
the next survey of state banking laws in 1909, all but one state
(Massachusetts) that had minimum capital requirements above the new
federall evel hadr educedt heirr equirementst o maintaint heira dvantage.9
State banking authorities were not anxious to see the number or
proportion of institutions under their control decline, the public wanted
more bank offices, and the country unit bankers did not want to see the
introduction of intrastate branching. This political alignment of interests
virtually ensured that reductions in capital requirements would be the
predominant legislative response to the insufficient supply of banking
services. The result of lower state and federal minimum capital require-
6 Data on the nationalb anks came from the AnnualR eporto f the Comptrollero f the Currency
(Washington, D.C., various years). The series on state banks was obtained from George Barnett,
State Banks and Trust Companies (Washington, D.C., 1910).
7 Annual Report of the Comptrollero f the Currency( Washington,D .C., 1896),p p. 103-04.
8 Gerald C. Fisher, American Banking Structure (New York, 1968), pp. 27-28.
9 Samuel A. Welldon, Digest of State Banking Statutes (Washington, D.C., 1909).
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36 White
ments and buoyant economic conditions before the First World War
was a rapid growth of small banks. The number of national banks rose to
7,518 in 1914 while the number of state banks climbed to 14,512. The
anti-branching lobby was further strengthened by these new and often
very small financial institutions.
The changes in banking regulation rendered by the Federal Reserve
Act of 1913 did not attempt to alter the structure of the banking system;
the aim instead was to make membership in the new Federal Reserve
System sufficiently attractive to draw in state banks. Reserve requirements
were cut, restrictions on real estate loans were reduced, and
members could obtain loans from the discount window. The states
proved to be obdurate competitors. Many legislatures refused initially
to pass legislation enabling state banks to become members of the
Federal Reserve, and by 1915 fifteen states had reacted to the reduction
of member reserve requirements by lowering their requirements. The
Federal Reserve Board criticized the states, but it did not rely on moral
suasion alone. In 1921, it secured a further reduction of member reserve
requirements. The states reacted to this change; by 1928, 12 states had
again reduced their reserve requirements.'0
The economic theory of regulation provides a general framework for
analyzing these regulatory changes. This theory posits that regulation is
a good for which there is an active market. Favorable regulation will be
supplied to the individuals or groups that have valued it most by voting
and lobbying the government." Direct evidence of bankers' influence
on legislatures is difficult to find. It does appear, however, that when
bankers argued strongly for or against a piece of legislation they could
sway the legislature. In New Jersey, the state bankers association had a
legislative committee that drew up bills to be presented to the state
assembly, and the association tried to organize its members so that they
would present a united front at hearings on banking legislation in
Trenton. Most legislation proposed by the association was passed with
few alterations. 12 The California Bankers Association also had a legislative
committee that conferred regularly with the superintendent of
banks before each session to discuss possible changes in the Banking
Act. The superintendent usually heeded their counsel; the legislature, in
turn, was inclined to accept the advice of the superintendent.'3
The economic theory of regulation typically views regulation as being
supplied by a monopoly producer and being demanded by a competing
0 Federal Reserve Bulletin (Washington, D.C., November 1928), pp. 778-805.
" George Stigler, "The Theory of Economic Regulation," Bell Journal of Economics, 2 (Spring
1971), 3-21; Sam Peltzman, "Toward a More General Theory of Regulation," Journal of Law and
Economics, 19 (August 1976), 221-40.
12 Edwin W. Kemmerer, "New Jersey Banking, 1902-1927," Journal of Industry and Finance
(May 1928), 28-30.
13 Shirley D. Southworth, Branch Banking in the United States (New York, 1928), pp. 36-37.
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Political Economy of Banking Regulation 37
public. One of the key characteristics of the American banking system,
however, has been the absence of such a monopoly regulator. The
federal and state governments have instead competed with one another
to regulate banks. It has been argued that rivalry between regulators will
lead to a dilution and finally an elimination of regulatory constraints.'4
This hypothesis is clearly supported by the gradual weakening in capital
and reserve requirements and portfolio restrictions-which most banks
favored. But what needs to be explained is why the restrictions on
branch banking remained virtually unchanged. The branching issue
divided the banking community. The unit bankers, particularly those in
small towns and rural areas, were opposed to any changes in the
branchingl aws. They had an importants take in maintainingt he existing
banking structure and feared that the city banks would penetrate their
markets. The unit bankers when threatened were able to exert considerable
political pressure. The reform legislation that came out of the
Congress clearly reflected the interests of the unit bankers, who formed
the largest block in the banking community. There was no new provison
for branching, and the decentralized character of the Federal Reserve
System was aimed at preventing the "monopolistic interest" from
gaining control.
THE BRANCHING ISSUE
At times the regulatory competition led to serious consideration of
increased branch banking. The federal authorities wanted to permit
branching by national banks to increase the number of bank offices,
meet the public's demand for banking services, enlarge existing national
banks, and prevent national banks from switching to state charters to
obtain limited branching privileges. Support for increased branching
also was found in some parts of the banking community. Led by A. P.
Giannini of the Bank of America, the larger banks that lobbied hard for
more branching believed that it would enhance their position in the
industry, increase the efficiency of money markets, and strengthen the
banking system. Loopholes for- branching by national banks appeared in
the National Bank Consolidation Act of 1918 and some of the rulings of
the Comptroller of the Currency, but the opportunities for national bank
branching nonetheless remained limited.'"
In the few states in which the law allowed state banks to open
additional offices, branching grew rapidly. Nationwide, branch offices
as a percentage of all bank offices rose from 5.7 percent in 1920 to 15.7
14 Jack Hirschleifer, "Comment," Journal of Law and Economics, 14 (August 1976), 241-44;
and RichardB . McKenziea nd HughH . Macaulay," A BureaucraticT heoryo f Regulation,"P ublic
Choice, 35 (1980), 297-313.
15 Ross M. Robertson,T heC omptrollera nd BankS upervisionA: HistoricalA ppraisal( Washington,
D.C., 1968), pp. 101-05.
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38 White
percent in 1930, and the share of branching banks, loans and investments
in total loans and investments increased from 18.6 percent to 45.5
percent.16 These rapid changes prompted the unit bankers to take
defensive action by seeking state anti-branchingle gislation. In 1909, 26
states had no statutory prohibition of branch banking, but when
branches began to appear the unit bankers were able to obtain antibranching
laws from state legislatures in all but seven of these states. 17
In most southern and western states where unit banking was well
established, the state bankers associations became the vehicles for the
opposition to branching. In Kansas, Illinois, Iowa, Minnesota, Nebraska,
and South Dakota, the state bankers associations attacked branching
and the bills they sent to their state legislatures to prohibit branching
were accepted. In other states such as California where branch banking
was already very strong, the unit bankers formed their own separate
associations. The California League of Independent Bankers tried to
arouse the public to what it perceived as the dangers of branching by
playing on their fears of monopoly control. The association's organ, The
Independent Banker, argued that "the public is more interested in the
democratic decentralization of credit control than it is in the progressively
concentrative and autocratic control of credit."'"8T his populist
theme was echoed by the local press. The San Bernadino Sun warned
that the country customer would become only a numbered account, "a
slave, lashed to the chariot of metropolitan control."'19 Although this
campaign failed to make any headway in California, it was very
successful in areas where branching was unknown or unfamiliar. In a
1924 Illinois referendum the public rejected by a two-to-one vote a law
to permit branching, and thereby protected themselves and their local
unit banks from the moguls of the big city.20
In Congress the unit bankers were able to thwart most efforts of
federal officials and the larger banks to obtain legislation allowing fullservice
branching by national banks. When in 1927 the McFadden Act
finally conceded some branching privileges, it was limited to resolving
the problem of the inequality between member banks.
Branch banking did expand in the twenties, but only in a few states.
No coalition to fight for branching appeared. Compared to the large
number of country bankers, there were relatively few bankers in favor
of branching, and they were divided among themselves. The largest
banks supported nationwide branching while regionally strong banks
16 Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1914-
1941 (Washington, D.C., 1943), p. 297.
17 Frederick A. Bradford, The Legal Status of Branch Banking in the United States (New York,
1940).
18 Quoted in Southworth, Branch Banking, pp. 70-71.
19 Ibid., pp. 71-72.
20 Ibid., p. 17.
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Political Economy of Banking Regulation 39
favored trade-area or statewide branching. Although business and the
public bore the costs of a less-than-optimal banking structure, these
costs were diffuse. This diffusion of costs impeded the formation of a
pro-branching lobby. On the other hand the unit country bankers were
keenly aware that they would bear the costs of increased branching.
Their perceived common interest made the unit bankers a cohesive
group capable of erecting legal barriers to further expansion of branching
banks.
THE GREAT DEPRESSION AND BANKING REGULATION
The massive bank failures of the 1930s initially sapped the strength of
the unit bankers' lobby by thinning their ranks and discrediting their
policies. Several states that previously had forbidden branching altered
their laws to enable surviving banks to acquire defunct banks' offices.
The Federal Reserve and some influential members of Congress thought
that it was an appropriate time to establish a uniform system of banking
regulation and to allow freer branching. The first drafts of reform bills
would have allowed statewide or trade-area branching; the unit bankers,
however, regrouped to fight the federal regulators and the pro-branching
bankers in Congressional hearings and behind the scenes. In this
struggle, the unit bankers received some support from state regulators
who were loath to see the federal authorities assume more control over
the chartering and regulation of banks. The unit bankers were successful
in their efforts and blocked the more radical changes; the Banking
Act of 1933 conceded to Federal Reserve member banks only the same
branching privileges as those allowed by state law.2' The unit bankers,
however, were able to achieve this success only because deposit
insurance presented a quick, apparently viable alternative that would
safeguard the banking system. The small town bankers always had
looked favorably upon deposit insurance as a means to protect them
from failure, and a few states had experimented with deposit guarantee
funds after the panic of 1907.22 Federal deposit insurance previously
had failed to make any headway in Congress because of the intransigent
opposition of the city bankers who lobbied vigorously against it, fearing
they would end up subsidizing the smaller banks and paying for their
mistakes. This impasse was broken after the banking panics when the
public was moved to whole-hearted support of deposit insurance. Vox
populi and the unit bankers formed a formidable political coalition that
led Congress to create the Federal Deposit Insurance Corporation, an
21 Helen M. Burns, TheA mericanB ankingC ommunitya nd New Deal BankingR eforms, 1933-
1935 (Westport, Connecticut, 1974), chapters 3 and 4.
22 Eugene N. White, "State-SponsoredI nsuranceo f Bank Deposits in the United States, 1907-
1929," this JOURNAL, 41 (September 1981).
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40 White
innovation that weakened the previous sense of urgency to modify
federal statutes regulating branching.
CONCLUSION
During the Civil War when Congress chose to rely on economic
incentives rather than coercion to draw banks into its regulatory
system, it unintentionally set the stage for the emergence of competitive
state regulators. Although the federal government faced only one
regulator in each state, it could not obtain a monopolistic settlement
because the number of state banking authorities and legislatures made
nationwide cooperation difficult if not impossible.
The competitive reduction of regulations benefited many banks, but
the greatest advantage accrued to the unit bankers whose influence was
strengthened by the increase in new unit banks. The unit bankers'
actions were largely defensive, but what they lacked in terms of
leadership or a program they made up in brute political clout. This was
not a result of their relative economic importance in the industry. By
any conventional measure of banking power their importance was
declining at the time they were able to secure many state anti-branching
statutes. Their influence may be attributed to their presence in most
rural and many urban areas, a presence that gave them a broad political
base from which to influence Congress and the state legislatures. Many
Americans were intensely suspicious of large banks and thus tended to
support local independent banks because they feared the spread of
branching into their communities. The unit bankers also found influential
allies among state banking authorities who distrusted the aggrandizing
tendencies of the federal regulators. The state regulators had an
obvious stake in preserving the dual banking system, as did the smaller
banks which preferred the looser constraints of the states' banking laws
and recognized that these were a product of regulatory rivalry. The
elimination of state charters would have left them facing a single federal
regulatory agency much more difficult to influence.
From their advantageous political position, the dominant coalition of
unit bankers was able to withstand the depression and rapid changes in
the banking industry that favored the growth of large branching banks.
Rivalry between the state and federal regulators weakened most banking
regulations and helped to facilitate the integration of money and
capital markets. But the substantial legal impediments to branch banking
remained largely unchanged at the behest of the unit bankers. They
had the most to lose by drastic changes in regulation and they worked
strenuously to influence banking laws. Owing to these efforts the unit
bankers largely succeeded in maintaining those regulations they regarded
as necessary for their survival.

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