Politicians Vs. Bankers

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Steagall was right that deposit insurance would end runs on banks; FDR was right about the moral hazard.

Sen. Carter Glass of Virginia was an advocate of limited government (he opposed most of the New Deal) and a firm friend of Wall Street. He, too, favored developing a national banking system with institutions strong enough to survive bad times. When he was first elected to the House, in 1902, and assigned to the House Committee on Banking and Currency, he had been ignorant of both economics and banking. However, he was a very quick study. In 1913, by then chairman of the House banking committee, Glass was responsible for the legislation creating the Federal Reserve. From then on he took pride in being called the father of the Federal Reserve System.

Appointed to a vacant seat in the Senate in 1920, he would remain there for the rest of his life. But while friendly with Wall Street, he recognized the reality of the Street's reputation in 1933. Racist even by the standards of the Jim Crow South, he once wise-cracked that “one banker in my state attempted to marry a white woman and they lynched him.”

The third major force was Rep. Henry B. Steagall, who had practiced law in Ozark, Alabama, before moving into politics. Elected to Congress in 1914, he was deeply concerned with protecting the interests of people, and bankers, in such areas as his own native, and deeply rural, Dale County, Alabama. His main interest was in ending the runs that had devastated so many small banks and the small towns they served.

His proposed means for doing so was deposit insurance. The idea was that if depositors were sure their money was not at risk should the bank fail, they would not rush to withdraw their funds at the first rumor of trouble, giving weak banks time to get their affairs in order and sparing sound banks the devastating effects of a run.

Deposit insurance was opposed by many, including the American Bankers Association, Senator Glass, and President Roosevelt himself. The bankers opposed the idea because they would have to pay insurance premiums, but Roosevelt opposed it because of the moral hazard such insurance created. He thought that insuring deposits put a premium on sloppy banking and penalized good banking.

But if Roosevelt personally opposed deposit insurance, his political antennae, picking up every whisper of public opinion, persuaded him to go along with it. Steagal, with the help of a flood of supporting letters and the Republican senator Arthur Vandenberg of Michigan, was thus able to make the creation of the Federal Deposit Insurance Corporation one of the major provisions of the Glass-Steagal bill. He was certainly right that it would cure the problem of bank runs—there has not been a serious one since—but Roosevelt was also right about the moral hazard. Much enlarged and extended, deposit insurance would be a leading cause of the S&L debacle of the late 1980s.

The concept of deposit insurance created another problem besides moral hazard, however. The biggest banks were usually both depository banks and investment banks. In other words, they were in the securities business as well as the banking business. And while deposit insurance was very popular, no one wanted to insure the securities affiliates of these banks.

The only solution was to command the separation of deposit and investment banking. The big banks fought this tooth and nail. The Morgan Bank pointed out that the already enacted Securities Act of 1933 had corrected most of the poor practices that investment banks had used in the 1920s, such as concealing loans to companies and countries whose bonds they underwrote. It was also argued that investment banks without commercial banking would be capital poor and thus vulnerable in bad times. This often turned out to be the case.

But no one was listening to bankers, especially big bankers, right then. As the Morgan partner Russell Leffingwell explained, “There is so much hunger and distress that it is only natural for the people to blame the bankers and to visit their wrath on the greatest name in American banking.”

That great name in American banking, J.P. Morgan and Company, had to spin off Morgan, Stanley under the new law. It was never quite the same again. Meanwhile, thousands of small institutions that dotted the landscape survived, ensuring that the American banking system would remain the most trouble-prone in the world, even as the American economy reached new heights.