A Brief History of U.S. Banking Regulation

As early as 1781, Alexander Hamilton recognized that, “Most commercial nations have found it necessary to institute banks, and they have proved to be the happiest engines that ever were invented for advancing trade.” Since then, America has developed into the largest economy in the world with some of the biggest financial markets in the world. But the path from then to now has been influenced by a variety of different factors and an ever-changing regulatory framework. The changing nature of that framework is best characterized by the swinging of a pendulum, oscillating between the two opposing poles of greater and lesser regulation. Forces, such as the desire for greater financial stability, more economic freedom, or fear of the concentration of too much power in too few hands, are what keep the pendulum swinging back and forth.

From the establishment of the First Bank of the United States in 1791 to the National Banking Act of 1863 banking regulation in America was as an experimental mix of federal and state legislation. The regulation was motivated on the one hand by the need for increased centralized control to maintain stability in finance and, by extension, the overall economy. While on the other hand; it was motivated by the fear of too much control being concentrated in too few hands. 

Despite bringing a relative degree of financial and economic stability, the First Bank of the United States was opposed for being unconstitutional, with many fearing that it relegated undue powers to the federal government, and consequently its charter was not renewed in 1811. With the government turning to state banks to finance the War of 1812 and the significant over-expansion of credit that followed, it became increasingly apparent that financial order needed to be reinstated. In 1816, the Second Bank of the United States would receive a charter, but it too would later succumb to political fears over the amount of control it gave the federal government and was dissolved in 1836.

Not only at the federal level, but also at the level of state banking, obtaining an official legislative charter was highly political. Far from being granted on the basis of proven competence in financial matters, successful acquisition of a charter depended more on political affiliations, and bribing the legislature was commonplace. By the time of the dissolution of the Second Bank, there was a growing sense of a need to escape the politically corrupt nature of legislative chartering. A new era of “free banking” emerged with a number of states passing laws in 1837 that abolished the requirement to obtain an officially legislated charter to operate a bank, and by 1860, a majority of states had issued such laws.

In this environment of free banking, anyone could operate a bank on the condition, among others, that all notes issued were back by proper security. While this condition served to reinforce the credibility of note issuance it did not guarantee immediate redemption in specie (gold or silver), which would serve to be a crucial point. The era of free banking suffered from financial instability with several banking crises occurring, and it made for a disorderly currency characterized by thousands of different bank notes circulating at varying discount rates. It is this instability and disorder that would renew the call for more regulation and central oversight in the 1860s.

The free banking era, characterized as it was by a complete lack of federal control and regulation, would come to an end with the National Banking Act of 1863 (and its later revisions in 1864 and 1865), which aimed to replace the old state banks with nationally chartered ones. The Office of the Comptroller of the Currency (OCC) was created to issue these new bank charters as well oversee that national banks maintained the requirement to back all note issuance with holdings of U.S. government securities.

While the new national banking system helped return the country to a more uniform and secure currency that it had not experienced since the years of the First and Second Banks, it was ultimately at the expense of an elastic currency that could expand and contract according to commercial and industrial needs. The growing complexity of the U.S. economy highlighted the inadequacy of an inelastic currency, which led to frequent financial panics occurring throughout the rest of the nineteenth century.

With the occurrence of the bank panic of 1907, it had become apparent that America’s banking system was out of date. Further, a committee gathered in 1912 to examine the control of the nation’s banking and financial system and found that the money and credit of the nation were becoming increasingly concentrated in the hands of relatively few men. Consequently, under the presidency of Woodrow Wilson, the Federal Reserve Act of 1913 was approved to wrest control of the nation’s finances from banks while at the same time creating a mechanism that would enable a more elastic currency and greater supervision over the nation’s banking infrastructure.

Although the newly established Federal Reserve helped to improve the nation’s payments system and created a more flexible currency, its misunderstanding of the financial crisis following the 1929 stock market crash served to roil the nation in a severe economic crisis that would come to be known as the Great Depression. The Depression would lead to even more banking regulation instituted by President Franklin D. Roosevelt as part of the provisions under the New Deal. The Glass-Steagall Act of 1933 created the Federal Deposit Insurance Corporation (FDIC), which implemented regulation of deposit interest rates, and separated commercial from investment banking. The Banking Act of 1935 served to strengthen and give the Federal Reserve more centralized power.

The period following the New Deal banking reforms up until around 1980 experienced a relative degree of banking stability and economic expansion, but it has been recognized that the regulation has also served to make American banks far less innovative and competitive than they had previously been. The heavily regulated commercial banks had been losing increasing market share to less-regulated and innovative financial institutions. For this reason, a wave of deregulation occurred throughout the last two decades of the twentieth century.

In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act, which served to deregulate financial institutions that accept deposits while strengthening the Federal Reserve’s control over monetary policy. Restrictions on the opening of bank branches in different states that had been in place since the McFadden Act of 1927 were removed under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Finally, the Gramm-Leach-Bliley Act of 1999 repealed significant aspects of the Glass-Steagall Act as well as the Bank Holding Act of 1956, both of which had served to sever investment banking and insurance services from commercial banking. From 1999 onwards, a bank could now offer commercial banking, securities, and insurance services under one roof. 

All of this deregulation helped to accelerate a trend towards increasing the complexity of banking organizations as they moved to greater consolidation and conglomeration. Financial institution mergers increased with the total number of banking organizations consolidating to under 8000 in 2008 from a previous peak of nearly 15,000 in the early 1980s. While banks have gotten bigger, the conglomeration of different financial services under one organization has also served to increase the complexity of those services. Banks began offering new financial products like derivatives and began packaging traditional financial assets like mortgages together through a process of securitization.

At the same time that these new financial innovations were being praised for their ability to diversify risk, the sub-prime mortgage crisis of 2007 that transformed into a global financial crisis and the need for the bailout of U.S. banks that had become “too big to fail” have caused the government to rethink the financial regulatory framework. In response to the crisis, the Obama administration passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, aimed at many of the apparent weaknesses within the U.S. financial system. It may take some time to see how these new regulations affect the nature of banking within the U.S.

In antebellum America, numerous attempts at increased centralized control and regulation of the banking system were tried, but fears of concentrated power and political corruption served to undermine such attempts. Nevertheless, as the banking system grew, the need for ever-increasing regulation and centralized control, led to the creation of a nationalized banking system during the Civil War, the creation of the Federal Reserve in 1913, and the New Deal reforms under Roosevelt. While the increased regulation led to a period of financial stability, commercial banks began losing business to more innovative financial institutions, necessitating a call for deregulation. Once again, the deregulated banking system evolved to exhibit even greater complexities and precipitated the most severe economic crisis since the Great Depression. Dodd-Frank was the response but if history is any guide, the story is far from over, or perhaps, the pendulum will continue to swing.