Understanding The S&L Mess

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And while the Fed itself was insulated from politics, the dual banking system, with some banks under state regulation and the others under federal, positively invited political intervention. Interested parties manipulated state and federal governments one against the other to further their own interests, while the two systems competed for influence in the banking business. Although American banking history showed the need for discipline provided by a central bank, it would be 1980 before all commercial banks were required to adhere to the Federal Reserve requirements regarding minimum reserves and capital.

After World War I, rural banks lost both theirdeposit monopolies and their loan business. They began swiftly to decline and then fail.

Still, for all its faults, it was by far the best banking system the country had ever had. After the First World War, however, the system unraveled. From the late 1890s until 1919, American agriculture and small-town life flourished as never before or since, and small-town banks flourished too. In 1921 there were 29,788 commercial banks in the country, the overwhelming majority of them state-chartered, one-branch institutions with assets under a million dollars. But agriculture suffered greatly in the recession that followed the First World War and did not share in the prosperity of the 1920s. This, of course, adversely affected the small-town banks dependent on making agricultural loans. Further, the automobile began to allow people far more mobility. They could shop—and bank—much farther afield. The small-town banks, losing their local deposit monopolies on one side of the ledger and their loan business on the other, began swiftly to decline and then to fail. There were, on average, more than 550 bank failures a year in the United States in the 1920s, most of them in small towns.

The steady stream of bank failures in the 1920s turned into a torrent with the start of the Great Depression. More than 1,300 banks collapsed in 1930; more than 2,000 in 1931. In 1932 another 5,700 had to close their doors, unable to meet their depositors’ demand for cash. Most of these were state banks, but even many national banks went under when the Fed, laboring under legal restrictions, could not lend on large parts of the banks’ loan portfolios. The ultimate banker’s nightmare seemed to be coming true. The magical ability to create money was vanishing. Depositors were taking their money out of banks fast, and business loans declined in consequence, from $36 billion in 1929 to $16 billion in 1933.

Virtually the first act of the new Roosevelt administration was to close the banks and stop what was rapidly becoming a nationwide panic. Sound banks were allowed to reopen in a few days, and once they had been examined and declared healthy by the government, people trusted them once again and deposits flowed back into the system. It had been a near thing, but the Ameriran banking system had survived.

Again, it took a grave crisis to achieve real reform. The Federal Reserve System was reorganized and given broad new powers to regulate money and credit. The restrictions on what the Fed could take as collateral were removed, and it became much more effective as a lender of last resort. The national bank notes disappeared, and finally only the U.S. government was allowed to print money.

The most important reform for everyday banking was the formation of the FDIC (the Federal Deposit Insurance Corporation) in 1933 and the FSLIC (the Federal Savings and Loan Insurance Corporation) the following year. These government corporations insured bank deposits in case of failure. By doing so, they removed any reason for depositors to panic and suddenly withdraw their funds. The idea had been around for a long time (New York State had been the first to institute deposit insurance, in 1829), and several states had instituted their own insurance plans in the late nineteenth century. But these had folded up one by one as the small-town banks began failing in large number in the 1920s.

President Roosevelt was himself none too keen on the idea of deposit insurance because he saw very clearly the fatal flaw. What had always been the most powerful impetus to sound banking since the days of the goldsmiths had been the need of the bankers to retain the trust of their depositors. “We do not wish to make the United States government liable for the mistakes and errors of individual banks,” Roosevelt said, “and put a premium on unsound banking in the future.” The 1980s would prove Roosevelt’s fears well founded.

Still, as originally designed, the insurance system was funded by the banks themselves and protected individuals’ deposits only up to twenty-five hundred dollars, less than twice the average annual household income in 1934. Also, banks that joined the system had to submit to rigorous examinations by the new agencies. The state and national commercial banks flocked to join the system, as did most of the larger mutual savings banks. The S&Ls, however, were much slower to sign up. In the first year only 8 percent joined. As late as 1960 only 28 percent of the S&Ls were members of the FSLIC; they remained poky, small-town institutions.