The Quartet and Large Systemic Financial Crises

By Robert Dan Brumbaugh Jr

In the past forty years, two financial crises in the United States have threatened economic stability worldwide. Through miraculous good luck, seven individuals directed the resolution of the crises. Four comprise the quartet that resolved the second crisis, and three directed the resolution of the first crisis. The Quartet and Large Systemic Financial Crises tells the story of both. The time between crises has shortened, and the magnitude of the crises has grown. The seeds of the next crisis are already discernable, borne of view that "big banks" caused the most recent crisis. In fact, the cause was bipartisan government policy imposed over decades on the financial system to allocate capital for political purposes in unstable ways. That phenomenon is poised to accelerate in the near future unless something is done to stop it. The Quartet and Large Systemic Financial Crises describes how to forestall the inevitable disaster that would follow.

• Language: English
• Publisher: Newman Springs Publishing, Inc.
• Release date: Oct 8, 2021
• ISBN: 9781648018534

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The Quartet

and

Large Systemic Financial Crises

Robert Dan Brumbaugh Jr.

Copyright © 2020 Robert Dan Brumbaugh Jr.

All rights reserved

First Edition

NEWMAN SPRINGS PUBLISHING

320 Broad Street

Red Bank, NJ 07701

First originally published by Newman Springs Publishing 2020

ISBN 978-1-64801-852-7 (Paperback)

ISBN 978-1-64801-853-4 (Digital)

Printed in the United States of America

To Samuel Hoch, MD

From 1990 to 2000, Dr. Hoch—whom in my mind and when discussing him I still refer to as Sam as I would any friend or loved one—was my psychiatrist.

To this day, I recall when depression hit me, a moment alone when I was ten, and everything changed. Thereafter, it was my constant companion ever ready to thwart happiness, inflict pain, and disrupt. Medications available later effected no relief with unpleasant side effects.

Our work together, as Sam put it, accomplished what I experienced as a rewiring of my brain and the rediscovery of happiness, although at times I still ask myself, What would Sam say?

This dedication is not only for Sam but also for those who suffer depression in its many manifestations. Please, never give up. Whatever form it takes, I hope you find your Sam.

Thanks, Sam.

In the 1980s, Jim Valeo was a manager of the Financial Institutions Group at Drexel Burnham Lambert to which I was an adviser. He became a dear friend. From the time this book took its first form as a distant goal, his encouragement nourished it. As an inventor of the variable rate mortgage pass-through security and with a degree in literature from Brown University, his demanding editing was a godsend. So too was the editing of my friend and philanthropist, Connie Calaway, as precise and demanding as were her performances as a soloist with Leonard Bernstein at Lincoln Center.

Preface: A Curtain Call for the Heroes

A Curtain Call for the Heroes

The Worst Financial Crisis in Human History

There have been two large systemic financial crises since the Great Depression. The United States was the epicenter of both of them, the second of which began in 2007 when home prices began to decline precipitously. Shortly thereafter and roughly through 2009, massive mortgage defaults in the United States caused an equally massive deterioration in US nonprime mortgage-backed securities held in the United States and Europe.¹ For two years or so, the world’s economy teetered as the crisis careened from one hot spot to another among almost all major financial institutions in the United States and Europe. Only massive government liquidity injections prevented financial collapse and a worldwide depression.

The Quartet

The United States led the world’s response, and four individuals—the quartet—guided it. One of them, former Federal Reserve Board Chairman Ben S. Bernanke, later wrote in his 2015 memoir that:

In public I described what was happening as the worst financial crisis since the Great Depression, but privately I thought that-given…its global scope—it was almost certainly the worst in human history.²

He was correct. The year before publication of his memoir, Bernanke had ended a fourteen-year term as a member of the board of governors of the Federal Reserve System, including two four-year terms as chairman.³ President George W. Bush first appointed him chairman in 2006, and President Obama reappointed him in 2009.

The other members of the quartet included Sheila Bair, whom President Bush nominated to be a member and chair of the board of the FDIC in 2006.⁴ She served until 2011, President Obama having reappointed her. Timothy F. Geithner joined Bernanke and Bair, first as President of the Federal Reserve Bank of New York where he served from 2003 to 2009, and then as President Obama’s Secretary of the Treasury, appointed in 2009 and serving until 2013.⁵ The final member was Henry M. Paulson Jr. who served as Secretary of the Treasury in the Bush administration from 2006 to 2009.⁶ They were as individuals, and even more so as a team, largely imperturbable and astonishingly productive.

One Harrowing Experience After Another in 2007–2008

As chronicled in their memoirs, including many details not publicly known beforehand, combating the crisis—most especially in the early phases of the resolution in 2007 and 2008—was a harrowing experience with one potential disaster after another narrowly averted. As an example, on September 18, 2008, Paulsen and Bernanke presented President Bush with a plan the two had hatched largely between themselves that would later result in Congressional approval of a nearly a trillion dollars to recapitalize the banking system.⁷ That evening, with the President’s approval, they presented the plan to leaders of the Congress at the US Capitol. Speaking without notes, Bernanke said the plan was crucial to avert a global financial meltdown…that might occur in days not weeks.⁸ Bernanke had begun that day with a doctor’s appointment. The gastroenterologist whom he saw wondered whether stress might be the cause of his upset stomach.⁹

Others proved to be equally stalwart. Without fail according to the memoirs, President Bush was cool, calm, and collected. At each juncture at which presidential advice or action was required, he was completely professional and helpful. He led the effort determined to leave his successor without the burden of a crisis out of control and succeeded. By all accounts Bush’s soon-to-be successor, Senator Obama, conducted himself likewise. As a presidential candidate, he was kept briefed, never complained, nor tried to intervene and ran his campaign in a way that never caused a headache for the quartet. Then as President Obama, naming Geithner Secretary of the Treasury provided continuity, as did the reappointment of Bernanke and Bair.

The memoirs reveal a remarkably productive working relationship between the four and the interplay of interesting personalities. Bernanke without fail and, by all accounts, was a patient gentleman who worked well with all. Geithner was fierier, given to profanity-laced moments that Bernanke, in particular, seemed to find amusing. He was also self-deprecating and seemed to find himself sometimes underestimated, though not by the other members of the quartet. Paulson was earnest with endurance and a huge capacity for work. A former Dartmouth tackle, he still revealed that due to stress and fatigue more than a few times, he had to excuse himself to conceal bouts of dry heaves. Bair, at key moments in the crisis, found herself caught between the historical legal constraints imposed on the FDIC—most specifically that the FDIC resolve bank failures at least cost—and demands her three colleagues made that stretched that boundary. Invariably, she promptly produced responses that were nuanced and balanced her constraints while achieving the goals of the requests. Her responses revealed a subtle grasp of finance.

The Crisis Began in Europe with US Mortgage-Backed Securities (MBS) and Short-Term Funding

The crisis that the four would combat began in earnest in France on August 9, 2007, when BNP Paribas, the largest French bank, barred investor withdrawals from three investment funds holding US MBS.¹⁰ The bank was unable to fund and meet redemption demands due to the declining value of its MBS holdings. The bank said, in fact, that it could not determine the value of the funds because the market for MBS had evaporated. Though not well known at the moment, BNP Paribas’ situation exemplified the crux of the entire crisis that was unfolding.

In Europe, the crisis would follow the same trajectory as in the US. Insolvency of financial institutions holding US MBS would destabilize national financial systems and cause recessions in nations throughout the continent. The stability of the eurozone and the value of the euro were compromised as a result. Although this book will not address Europe’s difficulties or its crisis response, the response of individual nations, the eurozone and the European Central Bank (ECB) largely mirrored the response in the United States.

In the States, the crisis involved the fundamental way all manner of institutions—banks, savings and loans, investment banks, and a multitude of nonbanks, most importantly Fannie Mae and Freddie Mac—were funding nonprime MBS production and securitization. In a typical transaction, an institution would borrow funds to purchase mortgages or MBS to create and sell new MBS combined with an agreement to repay the loans in a relatively short period of time. The institutions would use proceeds from the sale of MBS to raise the funds to repay the borrowing. Then they would repeat the process anew. The agreements were called reverse repurchase agreements or reverse repos.

In 2007, however, the value of mortgages and MBS was plummeting as the mortgage market in the United States faced increasing delinquencies and defaults that seemed poised to accelerate. At the same time, the short-term borrowing that had financed worldwide mortgage and MBS purchases was suddenly unavailable to large numbers of financial institutions. As a result, institutions were having difficulty finding liquidity with which to repay the loans that they had used to purchase mortgages and MBS. The entire process was coming to an abrupt halt, leaving many types of institutions on the verge of insolvency. The crisis was also evolving in the worldwide glare of a twenty-four-hour news cycle during which every doomsday scenario possible was being hawked.

Bair, Bernanke, Geithner, and Paulson comprised the quartet on whom the world would depend to solve the crisis. They careened successfully from one creative and effective patchwork project after another as some different manifestation of the crisis appeared one after another. Fourteen months following the BNP Paribas event, the most dangerous part of the crisis ended with the passage in Congress on October 3, 2008, of the $700 billion funding of what became known as TARP, funding that shored up the capital of the US financial system. That legislation resulted from the meetings Bernanke and Paulson had with President Bush and Congressional leaders on the day begun with Bernanke’s appointment with his gastroenterologist.

Although resolution of the crisis would take another year or so, the quartet had stabilized the US financial system without which the worldwide economy would have imploded. Simultaneously, Bernanke, as head of the Federal Reserve, worked with his fellow governors at the Fed to stimulate the economy more generally. They did so with wholly unconventional and previously untried techniques that not only worked to overcome the 2007–2009 recession but also had been unwound in a way that did not hamper the subsequent economic recovery. It was an extraordinary achievement.

The Heroes of the First Large Systemic Financial Crisis Since the Great Depression

The Three Who Were Anything But a Trio

Bernanke was correct that the crisis that he and the other members of the quartet faced was the worst in human history. The first large systemic financial crisis did not reach that epic level, however, not because it did not have the potential to do so, but rather because three individuals contained it. Richard T. Pratt was the Chairman of the Federal Home Loan Bank Board and hence head of the Federal Savings and Loan Insurance Corporation (FSLIC) during the onset of the savings and loan portion of the crisis that began in the early 1980s.

William Isaac was Chairman of the Federal Deposit Insurance Corporation (FDIC) from 1981 to 1985, and William Seidman, who served until 1989, succeeded him. During their terms, Pratt, Isaac, and Seidman oversaw the resolution of almost all troubled and failed US depositories that comprised the crisis.

It was never clear whether Pratt was a finance professor who happened to be a heavyweight wrestler or vice versa. Both framed his persona. From Utah on his religion’s missionary service as a young man, he became the heavyweight wrestling champion of a small country. He was a rascal not opposed to an occasional forbidden beverage and a bummed cigarette. The Reagan administration, having told him to stabilize the collapsing savings and loan industry is exactly what he did and more.

William Isaac was a dapper banking lawyer from Kentucky who has remained relevant to this day through writing and a number of entrepreneurial endeavors. When he became chair of the FDIC, FDIC-insured mutual savings banks and large commercial banks were in a crisis, just as dire as the savings and loans. In 1984, Isaac faced the largest bank failure in US history with Continental Illinois, a failure that gave rise to the term too big to fail. Seidman was diminutive, a bantam pugilist. As a Michigan neighbor of President Ford, he came to Washington and, in one capacity or another, had a hand in about every major economic and finance issue that the Ford administration addressed. His transition to FDIC chairman in the second half of the Reagan administration was seamless.

Late in the decade, Seidman held off Congress and three economists Congress had retained to assess the crisis and who requested access to highly secret money center bank examinations. Fine, he said, but any leaks of classified information, even inadvertent, would be criminally prosecuted. My two colleagues and I chose not to take that risk. Alas, L. William Seidman died in May 2009.

The Hidden Magnitude of the Crisis

The crisis was and still is universally referred to as the savings and loan crisis. Throughout the decade, however, the overwhelming majority of all US banking assets in savings and loans, mutual savings banks, commercial banks, and even credit unions were in insolvent institutions. The market value of their liabilities exceeded that of their assets. Through a remarkable ever-changing policy of regulatory forbearance in which most of the insolvent depositories were left open and operating, they navigated through the decade until a majority of the depositories regained solvency in the early 1990s.

Pratt provided the financial framework that allowed for the forbearance policies that bought time for open but insolvent depositories to recover. He also designed the diversification policies that provided opportunities for institutions to migrate away from the assets that caused the initial problems, especially for savings and loans and mutual savings banks. His framework was codified with the help of Utah Senator Jake Garn with the Garn-St Germain Act that became law in 1982.

Isaac and Seidman, as custodians of the FDIC, along with the Federal Reserve and other bank regulators successfully obscured the key ingredient that was crucial to the resolution of the crisis. It was their ability to conceal the true condition of the mutual savings banks and the large money center and regional banks. In one way, it was not a difficult task. The savings and loan crisis consumed most media and congressional attention. The bank regulators encouraged that attention. They emphasized the poor condition of the more prominently watched savings and loans in contrast to what they portrayed as the far superior condition of the mutual savings banks and large commercial banks. They also contrasted what they portrayed as the excessive risk-taking of the savings and loans with what they described as the more prudent regulatory restraints that they said reduced mutual and commercial bank risk-taking.

That portrayal was a facade behind which the FDIC, the Fed, and other bank regulators engaged in almost identical forbearance tactics and diversification as the FSLIC and savings and loans engineered. The FDIC itself documented how it did so. In 1997, it published a massive history of the 1980s in which buried in the boilerplate of FDIC relative rectitude are bits and pieces of details and data revealing the subterfuge hidden in chapter after chapter.¹¹

Were the subterfuge to have failed, and if the world were to have grasped that the majority of assets in the entire US banking system throughout the 1980s was housed in insolvent institutions, a crisis akin to the one the quartet faced in 2007 would have been the likely outcome. Panic could have ensued amid the two recessions of the early 1980s. The emergency response, whatever it might have been, to resolve the banking crisis would have derailed the Reagan-era stimulus that overcame the recessions. Whether the response to the first crisis would have equaled the genius of the quartet or been a bust, one can never know.

Even with FDIC-insured institutions tiptoeing through the rolling regional recessions of the late 1980s, the national recession of 1990–1991 left the US economy fragile. The recovery thereafter would have been derailed. The basis for the burst of prosperity that preceded the 2007 crisis would have been eviscerated. All of that is what Pratt prevented with regulatory forbearance and diversification for the savings and loans and what Isaac and Seidman prevented with forbearance and stealth for the rest of the banking system.

The resolution of the first large systemic financial crisis that Pratt, Isaac, and Seidman effected saved the prosperity that the world has enjoyed since. It should be sobering for everyone that only about seventeen years separated that miraculous resolution from the onset of the second crisis that the quartet miraculously resolved. This book provides an analysis, which if accepted, can prevent the almost certain development of similar large systemic financial crises and eliminate the need for future miracles of the type that seven Americans have conjured in the past.

A Curtain Call for the Heroes

As detailed in this book, the contribution of these seven Americans to the world’s economic well-being is incalculable and incomparable. It would seem appropriate to find a way to acknowledge their accomplishment as architects of the solution to the two worst financial crises in human history. It would seem appropriate that they be called back to a center stage where their contributions to the country can be properly acknowledged. A Congressional Gold Medal, which is awarded periodically to Americans who make conspicuously significant contributions to the nation, does not seem inappropriate.¹²

Peter J. Wallison and Edward J. Pinto of the American Enterprise Institute (AEI)

Beyond the quartet, the intellectual contribution of Wallison and Pinto to understanding the second large systemic financial crisis sets them apart from all others during the crisis. Wallison is Senior Fellow and Arthur F. Burns Fellow in Financial Policy Studies at AEI, and Pinto is codirector of the AEI Center on Housing Markets and Finance and a Resident Fellow. Wallison was General Counsel to the Department of Treasury at the beginning of the Reagan administration and later White House Counsel to President Reagan.¹³ In 1987–1989, Pinto was Executive Vice President and Chief Credit Officer at Fannie Mae, certifying him as an expert on the data he has produced.¹⁴

Were it not for Wallison and Pinto, the single most important analytical insight into the cause of the second large systemic financial crisis would have been lost. It would not have been lost because others did not understand it and its importance, but rather because they did and, as a result, had an incentive to obscure it if they could not make it disappear. Wallison and Pinto, because of their insight, diligence, and tenacity, made certain that it did not disappear. They did so against a chorus of derision from Democrats and Republicans, academics, journalists, and others wedded to the prevailing narrative that irresponsible banks caused the crisis.

Wallison and Pinto’s contribution was to be the first and only individuals to understand, explain, and denominate the evolution and effects of the affordable housing goals. Wallison did so initially in his Dissent in the Financial Crisis Inquiry Commission Report in 2011 and then in his subsequent book, Hidden in Plain Sight, in 2015.¹⁵ Pinto did so through his forensic accounting of the extent of nonprime lending required to meet the goals and other government agency purchases. An accurate official accounting and analysis of the effects of the affordable housing goals would ultimately reward their insight and tenacity.

Prologue: US Financial Crises Preceding the Systemic Crises Beginning in the Twentieth Century

US Financial Crises Preceding the Systemic Crises Beginning in the Twentieth Century

The Early Development of US Depository and Nondepository Financial Institutions

Financial intermediaries at the broadest level are comprised of depository financial firms such as commercial banks, thrifts (mutual savings banks and savings and loans), and credit unions whose liabilities include deposits and nondepository financial firms whose liabilities do not include deposits. The first commercial bank in the US was chartered in 1781, and mutual savings banks appeared in 1816.¹⁶ As of 1830, there were only 293 commercial banks with $34 million in assets and thirty-six mutual savings banks with $7 million in assets. The first savings and loan was formed in 1831. The first credit union appeared in 1909.

Commercial banks accepted mostly demand deposits and made commercial loans. They were relatively uninvolved in residential loans or savings deposits, especially in small amounts available from wage earners. Mutual savings banks were entirely dependent on savings deposits from low-income wage earners and were more flexible than savings and loans in deposit denomination, term to maturity, and ease and frequency of withdrawal. Mutual savings banks also held more diversified assets, extending consumer loans as well as mortgage loans. The first savings and loans was formed to enable their shareholders, most of whom were wage earners in the textile trade to obtain funds to build homes. Initially, the institutions were called building societies because they bought land and built homes for their members. Later, when the institutions began financing acquisition of existing homes, they were called building and loan societies.

By 1900, depositories dominated the US financial system, holding 81 percent of total US financial assets. Among non-depositories, life insurance companies predominated with a market share of 12 percent of US financial assets. The market share of other nondepository institutions—private pension funds, local government retirement plans, other insurance companies, finance companies, and money market funds—was 3 percent. Nonetheless, as early as 1900, the US financial system had evolved with diversification not only among depository institutions but also among a growing number and types of nondepository institutions.

The Financial Crises of 1893 and the Great Depression of 1929–1933

In the 204 years between 1776 and 1980, the US suffered only two periods of financial crises in which there were a large number of failures of depository institutions. Both occurred largely as a consequence of severe economic depressions, the first in 1893 and the second the Great Depression in 1929–1933.

The Effect on the Number and Assets of Depository Institutions Between the Early 1800s and 1890

There was substantial growth in the number and assets of all three types of depository institutions. By 1890, there were 7,280 commercial banks and 921 mutual savings banks with $4.6 billion and $1.7 billion in assets respectively. In 1893, the first year that reliable data was available, there were 5,598 savings and loan institutions. As a result of the 1893 depression, by 1900, there were 5,356 savings and loan, an attrition of a little over 4 percent. Over roughly the same period, the number of mutual savings banks fell from 921 to 626, a loss of 32 percent. At the same time, the number of commercial banks rose by 70 percent from 7,280 to 12,427.

These data suggests that depository institutions serving low-income groups with consumer and mortgage loans were more vulnerable to the depression than those serving businesses and higher-income groups with commercial loans and mortgages. It should be noted, however, that although the number of both savings and loans and mutual savings banks declined, their assets increased substantially over the period. As such, the financial crisis of 1893, though serious, did not rise to the level of a systemic crisis that threatened to undermine the financial system and dramatically harm the overall economy.

After the recovery from the 1893 depression through 1930, the assets of the three types of depository institutions grew substantially. As a result of the Great Depression between 1930 and 1935, however, the number of commercial banks fell 35 percent from 23,679 to 15,488, and their assets declined 24 percent from $64.1 billion to $48.9 billion. Over the same period, the number of savings and loans fell 13 percent from 11,777 to 10,266, and their assets declined 35 percent from $8.8 to $5.9 billion. Although the number of mutual savings banks declined over the same period, their assets increased $900 million or 9 percent, suggesting that the previous wage gap no longer existed or had reversed. Overall, as a result of the Great Depression, the asset size of depository institutions fell by a quarter.

The Changing Market Share of Financial Assets Between Depository and Nondepository Financial Institutions

From 1900 through 1933, the period roughly between the two recessions and for which there are data, depository and nondepository institution total assets rose sixfold from $15 billion to $90 billion, although they had declined from $110 billion to $90 billion during the 1929–1933 depression. Over the same period, the total share of US financial assets held by depositories fell from 85 percent to 70 percent while the share held by non-depositories rose from 15 percent to 30 percent. Depositories were holding a smaller share of a growing pool of US assets. Among non-depositories, life insurance companies continued to dominate with a market share of 33 percent in 1933, up from 12 percent in 1900. Yet, the market share of the other nondepository institutions rose from 3 to 6 percent. In sum, despite two significant contractions, the US financial system had grown substantially and became significantly more diversified between depository and nondepository financial institutions.

The Growth of Government Regulation of Depositories

The Growth of State Regulation of Savings and Loans Before the Crisis of 1893

At the time of the 1893 crisis, with one notable exception, there was essentially no federal regulation of savings and loan institutions. The exception was a tax exemption that Congress granted to the savings and loans in 1893 and later included in the Revenue Act of 1913 that established a federal income tax. State supervision had, however, accompanied the growth of savings and loans evolving from reports to state officials and voluntary examinations to required examinations. The states disapproved of loans not strictly within the building and loan business of financing single-family residences.

In addition, in order to maintain high earnings, the savings and loans had sought and even boasted of low cash positions. At the same time, required reserves for loan losses were relatively low. Many state laws discouraged accumulation of reserves, and some supervisory authorities practically enforced the distribution of all earnings. Over the same time period beginning in 1892, the powerful savings and loan trade association developed, initially the US League of Local Building and Loan Associations and later the US League of Savings Institutions. Thus, with the help of a powerful trade association, savings and loans received preferential tax treatment beginning in 1893 and continued thereafter.

The tax treatment resulted in higher earnings than otherwise would have existed and contributed to the growth rate of assets. Significant leverage created by low cash positions and negligible loan loss reserve requirements also increased earnings. As a result of tradition, business decisions, lobbying, and state supervision, the savings and loans had a completely undiversified portfolio made up of illiquid mortgages.

Even though the savings and loans did not accept demand deposits, they nonetheless suffered significant withdrawals as their members drew down their savings to maintain consumption during the 1893 contraction. As the depression deepened, savings and loans assets shrank as withdrawals mounted, resulting in failures and a disproportionately high decline in assets relative to commercial banks and mutual savings banks. In sum, the significant growth of an undiversified portfolio of illiquid mortgage assets that high leverage funded ran into a liquidity problem that the depression turned into a solvency problem resulting in significant failures and losses.

State supervision was the first incidence of government regulation of banking institutions in the United States. It was also the first example of the allocation of credit in ways that proved destabilizing. In the savings and loans case, state opposition to diversifying an undiversified portfolio of illiquid mortgage assets and to holding cash reserves caused the problem. As the depression worsened, many state legislatures also passed bills that temporarily suspended the rights of savings and loans to repossess properties, leading to a great number of people who had the capacity to pay but did not do so. This policy denied the savings and loans revenue during the depression.

More than six hundred commercial banks failed in 1930, and from 1930 through 1933, approximately nine thousand failed—nearly half the number existing in 1930. As with the savings and loans, as the economy deteriorated and as banks failed in greater numbers, depositors converted deposits into currency. The increased demand for liquidity from solvent banks had to come either from asset sales or liquidity provided by the Federal Reserve as lender of last resort. The Federal Reserve, however, failed to provide adequate liquidity, and a large number of banks were forced to liquidate their assets in a depressed market, thus creating severe losses and more bank failures.¹⁷

The Growth of Federal Regulation of Savings and Loans and Commercial Banks in Reaction to the Effects of the Great Depression

Although the federal government had begun chartering commercial banks during the Civil War, significant federal regulation of commercial banks occurred in reaction to the banking crisis during the Great Depression. Shortly after President Roosevelt’s bank holiday, a two-day closing of all banks, Congress passed the Banking Act of 1933, creating the FDIC and requiring all federally chartered banks to become members. A year earlier, the Federal Home Loan Bank Act created the Federal Home Loan Bank Board and the twelve district Federal Home Loan Banks to provide liquidity to savings and loan associations. The Home Owners’ Loan Act of 1933 gave the Bank Board the power to charter and to regulate savings and loans. Finally, in 1934, Congress enacted the National Housing Act that created the FSLIC. The net effect was roughly comparable federal regulatory systems for commercial banks and thrifts, and through deposit insurance, the federal government assumed responsibility for their deposits.

Economists pointed out potential problems with deposit insurance from its beginning. It might limit differences among institutions, leading to a concentration in the type of assets. Dependence on insurance could undermine good management. The careless management of some institutions could impose costs on the prudent management of other institutions. Depositors might become indiscriminate in selecting institutions because potential losses were insured.¹⁸ In hearings before Congress, the year before insurance was initiated, the economist Irving Fisher recommended a form of risk-based pricing for deposit insurance to discourage careless management.¹⁹

The Dominant Trends in the Development of Financial Institutions after the Great Depression to 1980

(A Financial System of Growing Capacity among a Smaller Number of Larger Banking Institutions and a Growing Nondepository Sector)

Four significant trends dominated financial institutions in the United States following the Great Depression until the beginning of the savings and loan, mutual savings banks, and commercial banking crisis of the early 1980s. In the first trend, each of these institutions declined significantly in number, but their assets increased dramatically. The number of these institutions from 1930 to 1980 declined 61, 24, and 37 percent respectively, but their assets grew by seventy, twenty-three, and eleven times their level in 1930. Thus, there was a thirty-year trend of consolidation in the number of banking institutions and significant growth in their assets.

Notwithstanding this trend, the average size of banking institutions remained relatively small. The average size of savings and loans, mutual savings banks, and commercial banks was $137 million, $413 million, and $107 million respectively in 1980. These averages, however, mask the second significant trend—the growth of the largest banks. The average assets held by the eight largest commercial banks, at the time referred to as money center banks, was $61 billion, and their total assets represented 31 percent of all commercial bank assets.²⁰

The third trend was the growth of nondepository financial institutions and a redistribution of the assets among a growing number of financial intermediaries in the twentieth century. From 1900 to 1985, the percentage of assets held by commercial banks and mutual savings banks as a total of all US financial assets declined by roughly 33 and 8 percentage points while the share held by savings and loans grew by a factor of 5. The other gainers included private pension funds, state and local government retirement funds, finance companies, non-life insurance companies, and money market funds whose combined share of all US financial assets grew from 3 to 33 percent. Although the share of assets held by life insurance companies fluctuated in the interim, the share was the same at the end of the period as it was at the beginning.

The fourth trend was the growth of government regulation of depositories that began with state regulation of savings and loans in the nineteenth century and increased state but particularly federal regulation of commercial banks and thrifts after the Great Depression. From the outset with savings and loans, the asset composition and liability structure—including capital levels—mirrored the fragility that would render them insolvent in 1980. The interplay of regulation and industry influence through effective lobbying was also present at the outset. When adopted in the 1930s, more comprehensive federal regulation, including deposit insurance in particular, led economists immediately to identify perverse incentives.

In the Context of the Private-Public Hybrid Structure of Financial Regulation

In the context of the private-public structure of financial regulation, the history above is one of gradual hybridization that escalated following the Great Depression. Its characteristics included increased influence of trade associations such as the US League of Local Building and Loan Associations that began to influence government regulation of savings and loans. As regulation grew, so did the incentive of regulated institutions to influence them.

A key component was the incentive to protect niches of activities from competition. A result was also buttressing allowable activities against change that, in the case of savings and loans, for example, entailed acceptance of interest rate risk in funding long-term fixed rate mortgages with shorter-term liabilities. Regulators also used regulation for political purposes almost immediately as when state legislature in the 1983 crisis suspended repossessions, creating perverse incentives.

The response to the Great Depression included a significant increase in federal regulation primarily through a proliferation of federal regulatory bodies. The result was the private-public hybrid structure of financial regulation that led to both large systemic crises first in 1980 and second in 2007. The progression of legislation and policies—from HMDA, to the CRA, to the affordable-housing goals for Fannie Mae and Freddie Mac—was different in magnitude but not substance to state regulation in the 1890s that created perverse incentives.

Conclusion and Observation

In general, a growing financial system comprised of asset growth in depository institutions and increasing diversification and asset growth in different types of financial services in nondepository institutions should be considered healthy. It represents increasing capacity to provide financial services in more specialized and diversified ways. More efficient allocation of capital should, holding all other things equal, result. In principle, in a growing economy, an increase in the asset size of depository and nondepository types should not be considered inappropriate per se. As demonstrated above, this process has characterized the US financial system for over two hundred years since the formation of the first commercial bank in 1781.

From the end of Great Depression in 1933 through the middle of the savings and loan, mutual savings bank, and commercial bank crisis in 1985, the share of US financial assets held