CHAPTER FOUR

WHY DID NEW DEALERS BREAK UP THE STRONGEST BANKS?

ON MARCH 5, 1933, the day after FDR was sworn in, he issued Presidential Proclamation 2038, convening a special session of Congress. The next day, he cited President Woodrow Wilson’s Trading with the Enemy Act and issued Presidential Proclamation 2039, which ordered all banks—already closed—to remain closed until March 9. Then he issued Presidential Proclamation 2040 to keep the banks closed a while longer. Because the Trading with the Enemy Act applied only to wartime, what FDR had done was illegal, and he urged Congress to pass the Emergency Banking Act, which amended the Trading with the Enemy Act to apply “during time of war or during any other period of national emergency declared by the president” (revised text in italics). Title I of the Emergency Banking Act sanctioned FDR’s order extending the “bank holiday” after he had done it.

FDR’s bank holiday was little more than a symbolic gesture. Many historians and biographers have made extravagant claims about it; for instance, historian Henry H. Adams wrote that “The bank holiday proclaimed after the inauguration and the banking reform measure saved the whole system of credit and monetary exchange.”¹

FDR’s extended bank holiday made life tougher for everybody. Banks needed permission from the secretary of the Treasury to do anything. ² Businesses were undoubtedly reluctant to accept checks because banks couldn’t clear checks. “Subway tokens, stamps, and IOUs took the place of money,” observed historian Page Smith.³ By contrast, during the banking panic of 1907, when J. Pierpont Morgan himself had taken charge of a successful bank rescue operation, some banks did close their doors temporarily, but they continued clearing checks so that people could pay bills. Morgan maintained the mobility of deposits.

Title II of FDR’s Emergency Banking Act gave considerable discretionary power to the comptroller of the currency, who, as conservator of national banks, could reorganize banks without going through established bankruptcy proceedings. The Emergency Banking Act also authorized the printing of Federal Reserve notes backed not by gold but by government bonds, which meant that the government could print as much money as it wanted and wouldn’t be limited by the amount of gold available. In addition, the Emergency Banking Act authorized the Fed to lend banks money against a wider range of bank assets.⁴

Title III of the Emergency Banking Act amended the Reconstruction Finance Corporation Act, authorizing the RFC to lend as much as $1 billion to banks that, though temporarily strapped for cash, were considered basically sound.⁵

How was FDR able to move so fast with the Emergency Banking Act? Work on it had actually begun during the last days of the Hoover administration, and some of Hoover’s top officials had stayed on to help finish it, notably Treasury Secretary Ogden Mills, Undersecretary of the Treasury Arthur Ballantine, and Comptroller of the Currency Francis G. Awalt.⁶

At 10 P.M. on Sunday, March 12, 1933, the day before banks were scheduled to start reopening, FDR went on the radio to deliver the first of his “fireside chats.” With a personal manner and confident, soothing voice, he explained what he was doing about the banking crisis. The “chat” went on for thirteen minutes and established FDR as a masterful communicator. However disruptive the New Deal turned out to be, most people were glad that he was at least doing something and keeping them informed.

In this fireside chat, FDR said that only sound banks would be reopened. But, Jesse Jones reported, “It developed that probably no fewer than 5,000 banks required considerable added capital to make them sound. . . . It could easily be charged, and properly so, that a fraud was practiced on the public when the President proclaimed during the bank holiday broadcast that only sound banks would be permitted to reopen. It was not until the late spring of 1934, nearly fourteen months afterward, that all the banks doing business could be regarded as solvent.”⁷

SMALL UNIT (ONE office) banks, which accounted for about 90 percent of bank failures, began lobbying for federal deposit insurance to assure customers that they needn’t worry about their deposits.⁸ Big banks with many branches didn’t seek such insurance since they had a diversified business and were financially sound. Federal deposit insurance became the cause of Henry Steagall, who hailed from Ozark, Alabama, and was chairman of the House Banking and Currency Committee.

Because deposit insurance had been tried before in a number of states, the 1933 congressional debates revealed a good understanding of the issues involved. Fourteen state governments, every one with unit banking laws, had previously offered deposit insurance, and all but three were associated with large bank failures. The three exceptions, Indiana, Iowa, and Ohio, involved a small number of banks and an agreement that if one of them incurred losses, creditors would be paid in full by the other banks. Consequently, there was a strong incentive to minimize losses.⁹

These bank failures spurred lobbying for federal deposit insurance, an idea that had first been proposed back in 1886. As economist Eugene White noted, between then and 1933, about 150 bills for federal deposit insurance had been proposed, but they never went anywhere. The proposals typically involved a fixed rate and little regulation. In effect, high-risk banks would have been undercharged, and low-risk banks would have been overcharged. Such proposals came from unit banking states concerned about the vulnerability of their banks, whose loans and deposits could be devastated by local economic problems. But representatives and senators in branch banking states, whose banks were prudently diversified, didn’t want to be overcharged, so they successfully resisted federal deposit insurance until 1933.¹⁰

The debate revealed much concern about adverse selection, which meant the worst risks tended to be the ones who wanted insurance the most. If policies were sold only to those who wanted insurance, a portfolio would become loaded with bad risks, requiring very high premiums to be financially sound. Moreover, insurance had to be priced according to the risks of individual policyholders. Undercharging bad risks meant subsidizing the very practices that increased risks. Overcharging less risky banks (to subsidize more risky banks) would give less risky banks an incentive to drop the insurance, jeopardizing funds available to pay insurance claims.

The Banking Act of 1933, which became known as the Glass-Steagall Act, was signed into law on June 16. The provisions that Henry Steagall supported set up the Federal Deposit Insurance Corporation on a temporary basis to guarantee the first $2,500 of deposits in Federal Reserve System member banks ($5,000 after July 1, 1934). The FDIC was established on a permanent basis by the Banking Act of 1935. Ironically, as economist Carter Colembe observed, “Deposit insurance was not a novel idea. It was not untried. Protection of the small depositor, while important, was not its primary purpose. And finally, it was the only important piece of legislation during the New Deal’s famous 100 Days, which was neither requested nor supported by the administration.”¹¹

Federal deposit insurance, it should be noted, didn’t stop bank failures. Banks continued to fail. Since depositors no longer worried about losing their money, though, there weren’t any more serious bank panics. A major effect of deposit insurance was to transfer the cost of bank failures from depositors to taxpayers.¹² The full consequences of federal deposit insurance didn’t become apparent until the 1980s, when bailing out savings and loan associations cost $519 billion.

BESIDES DEPOSIT INSURANCE, the Banking Act of 1933 had provisions that made it illegal for commercial (deposit-taking) banks to engage in investment banking (securities underwriting) and for investment banks to engage in commercial banking. These provisions had been drafted by Carter Glass while Hoover was still president, but his bill had repeatedly stalled in Congress. Glass, age seventy-five, had helped draft the Federal Reserve Act two decades earlier when he was a congressman, and he served as President Woodrow Wilson’s secretary of the Treasury. “In appearance, Glass was a cartoonist’s delight,” observed historian James T. Patterson. “No more than 100 pounds, he was but five feet, four inches tall. His white hair stood stiffly and wildly like a porcupine roach; his nose was beaked and crooked. His narrow mouth grimly dropped down at one corner and twisted up at the other.” ¹³ Biographer Lester V. Chandler remarked that Glass was “surpassed by few in the sharpness of tongue and capacity for righteous indignation.” ¹⁴

Only the biggest money center banks engaged in both commercial banking and investment banking, which meant Glass-Steagall was aimed at these, the strongest banks in the United States. The best-known example was J.P. Morgan & Company, which subsequently split into the deposit-taking J.P. Morgan & Company and the investment bank Morgan Stanley. Neither was as strong or influential as J.P. Morgan & Company had been before.

The forced separation of commercial banking and investment banking emerged from the “progressive” era campaign against big business, under way for more than two decades. Anything big was considered suspect, if not bad—capable of monopoly and exploitation. The most famous “progressive” attack on big bankers was Other People’s Money and How the Bankers Use It (1914) by Louis D. Brandeis. He had made his name as a skilled Boston lawyer who took on cases challenging big municipal transit companies, railroads, and insurance companies. He encouraged President Woodrow Wilson to approve the Federal Reserve Act (1913), which gave the federal government control of banking, and he supported the Clayton Antitrust Act (1914) and the Federal Trade Commission Act (1914), which expanded federal government power over big business. In Other People’s Money, Brandeis denounced “consolidation of banks and trust companies.” He cited J.P. Morgan & Company, which “encroached upon the functions” of other companies. He declared that “these banker-barons levy, through their excessive exactions, a heavy toll upon the whole community.” He accused big bankers of “despotism” and held them responsible for “the suppression of industrial liberty, indeed of manhood itself.” Brandeis liked small things, and he commended developments in Germany—“the 13,000 little cooperative credit associations, with an average membership of about 90 persons, are truly banks of the people, by the people, and for the people.”¹⁵

This “progressive” passion for small banks defied the reality of the Great Depression. As already noted, small-town banks accounted for about 90 percent of the bank failures. These were mostly rural banks that had a single office—they were in states with unit banking laws, limiting a bank to just one branch. Deposits from farmers and loans to farmers dominated the balance sheet of a small bank in a rural area, and it was almost impossible for such a bank to survive when farmers went through hard times. If the primary concern in 1933 was preserving the assets of small depositors—and not the wishes of the country banking lobby, which didn’t want competition from big-city bankers—surely breaking up big banks, as the Glass-Steagall Act did, was about the worst imaginable policy. FDR would have done far better to have used the enormous goodwill he had coming into office, together with his formidable skills as a campaigner and a radio speaker, to get rid of unit banking laws and let strong banks establish branches throughout the country, so people everywhere could have had greater peace of mind.

The idea of separating commercial banking from investment banking gained momentum during the “Hearings on Stock Exchange Practices” that had been going on since January 1933 before the Senate Committee on Banking and Currency. These hearings continued until July 1934, generating some 12,000 pages of evidence. Lawyer Ferdinand Pecora was the major interrogator, and the proceedings were usually referred to as the Pecora hearings. He further publicized the findings in his 1939 book Wall Street Under Oath. Two principal allegations seemed to support the view that commercial banking should be separated from investment banking. First, commercial banks supposedly faced an inherent conflict of interest when they both served depositors and engaged in securities underwriting. Since underwriting involves buying securities from an issuing company at a wholesale price, reformers thought banks had an overwhelming temptation to move some of this securities inventory by retailing it to the bank’s depositors, whether or not the securities were appropriate investments. Second, legislators believed that the securities business exposed commercial banks to excessive risks and contributed to the epidemic of bank failures. Further, reformers suggested that banks made unsound loans to companies issuing the securities they underwrote, in an effort to maintain the prices of those securities. Glass and many others believed that depositors’ savings would be safer if commercial bankers stayed out of the securities business.¹⁶

The most famous witness was Albert H. Wiggin, president of Chase Bank, who admitted that between September and December 1929 he borrowed money from Chase and used it to short Chase stock while maintaining that the bank was perfectly sound. Like every other short-seller, Wiggin expected the price to go down and hoped to profit from it. Wiggin’s testimony was considered so damaging that he had to resign. The other major witness was National City Bank president Charles Mitchell, who acknowledged that he sold stock to his wife and bought it back later, to avoid taxes.

Until recently, historians have repeated the allegations as reasons for separating commercial banking from investment banking. Then during the 1980s, economist George J. Benston examined the original sources, namely, (1) allegations made by senators and representatives, published in the Congressional Record before the passage of the Glass-Steagall Act, (2) the Pecora hearings, 1933 and 1934, (3) the Stock Exchange Practices Report (SEP), 1934, and (4) the Securities and Exchange Commission’s Investment Trusts and Investment Companies Study, 1940. Benston reported that the endlessly repeated allegations couldn’t be documented in the original sources. In addition, he explained why these sources, particularly the hearings, should be viewed with some skepticism: “The congressmen and their staffs structured the hearings, decided which witnesses to call, and conducted the questioning. Witnesses could not confront their accusers. Nor could people with contrary views call rebuttal witnesses. Thus, there is reason to believe that congressional hearings, then as now do not provide a complete or unbiased record of events.”¹⁷

First of all, the sensational cases were notable for being very few in number. The Pecora hearings, by far the most voluminous of the sources, failed to establish that banking abuses were widespread. Second, Pecora didn’t show any pattern of banks promoting the securities they had underwritten to the bank’s unsophisticated depositors. Third, Pecora didn’t provide any evidence that securities underwriting imperiled the soundness of depositor savings.

As for the sensational cases, Benston wrote, “The charges against Wiggin and Chase related mostly to Wiggin’s intermingling of his personal affairs with those of the bank and company. His tax avoidance does not appear to be reprehensible in the light of analysis [Pecora ignored Wiggin’s losses, which legally reduced his tax liability]. Nor was his receipt of fees (probably as a director) from corporations that were customers of the Chase National Bank contrary to ordinary banking practice then or now.” As for Mitchell, Benston wrote that “his principal personal ‘crime’ was in attempting to avoid personal income taxes, which was then and remains now legal.” And the allegedly unsophisticated investor, a Mr. Brown who testified that he was bankrupt and sick after National City Bank foisted some bad securities on him, had been a successful businessman with over $100,000 to invest (equivalent to over $700,000 today), so he was hardly a novice. The only example cited of a big bank that got in financial trouble because of affiliates was the Bank of the United States, but its failure in 1930 had nothing to do with securities underwriting. Its affiliates engaged mainly in real estate speculation— assets that could never be sold quickly to raise cash. Benston noted that the allegation of widespread abuses “rests on the dubious activities of three banks and their affiliated investment companies.” 18

None of the witnesses testifying on behalf of the Glass-Steagall Act—and these included the chairman of the Federal Reserve Bank of New York and the controller of the currency—mentioned securities business as a factor in any bank failures.¹⁹ For instance, when Senator Glass asked Comptroller of the Currency J. W. Pole about the causes of recent bank failures, he replied: “Well, 90 per cent of the banks are in the small rural communities. Economic changes have put these small communities within easy distances of the larger commercial centers where the banks are stronger and more efficient in every respect, and as a consequence . . . [the small country] bank is not able to maintain itself.”²⁰

Discussing the 1934 Stock Exchange Practices Report, Benston observed that it “does not show the banks transferred or sold the securities of their troubled borrowers to the investment companies they sponsored.” According to his study, “There is no evidence that the investment companies took their sponsor-banks’ illiquid (in the sense of worth less than face value) loans, made loans to bank customers at less than market rates, or purchased slow-moving or less-than-good (or, for that matter, any) securities from the bank or its securities affiliate, whether underwritten by them or not. . . . I cannot determine from this record how many or what proportion of commercial banks engaged in abusive practices.” ²¹

Other studies have failed to implicate securities underwriting in bank failures. Benston cited a 1931 Federal Reserve study of 105 member banks that failed in 1931. “The principal cause of the failures was poor and dishonest lending practices, particularly ‘lax lending methods,’ ‘slack collection methods,’ ‘unwise loans to directors and officers,’ and ‘lack of credit data,’” Benston wrote. “These four criticisms accounted for 68 percent of the examiners’ criticisms of lending policies. . . . Finally, the 50 bond issues contributing to the greatest depreciation to the portfolios of the 105 banks were analyzed. . . . 85.1 per cent of the total depreciation was due to bonds in three groups of industries: public utilities (37.6 per cent), industrials (33.0 per cent), and railroads (14.5 per cent). Both public utilities and railroads were regulated by government agencies.”²²

SINCE THE CASE for breaking up the strongest banks turns out to have been much weaker than historians have reported, Benston became suspicious about what was actually going on. He observed that two of the biggest lobbyists for Glass-Steagall were the Investment Company Institute and the Securities Industry Association, representing securities dealers and investment firms that would benefit by eliminating commercial banks as competitors. Indeed, since the late 1920s, commercial banks had achieved an increasing presence in the securities business, and they posed a competitive threat to securities dealers and investment firms.²³

The securities business contracted with just about every other business during the Great Depression, and Benston suggested that Glass-Steagall reflected “a willingness by both investment and commercial bankers to eliminate competition for a shrinking market and to secure other benefits and avoid more restrictive legislation.”²⁴

Other recent investigations have found that investors fared better with securities issued by big banks that both served depositors and engaged in securities underwriting. Randall Kroszner and Raghurm Rajan reported in American Economic Review that they gathered data on securities issues during the 1920s and compared the performance of issues underwritten by universal banks (which engaged in both deposit taking and securities underwriting) versus those issued by investment banks (which engaged only in securities underwriting). Universal banks underwrote very few stocks during the 1920s, so the data involved bonds. Kroszner and Rajan found that 40 percent more of the bonds issued by investment banks—the kind of banks approved by Senator Glass—went into default.

How could this be? Kroszner and Rajan explained a likely answer: “Investors realize that some [universal bank] affiliates may be less forthcoming than independent investment banks in communicating information about issue quality, due to possible conflicts of interest. They will be most wary when there is little public information about an issue, as in the case of small issues by little-known firms.” Consequently, suspicious investors were reluctant to bid for bonds they knew little about and had less confidence in, and when they did bid, they offered less money for such bonds than for well-established, less risky issues. In an effort to avoid the investor discount, due to suspected conflict of interest, universal banks might have avoided new issues by little-known firms and favored issues by “blue chips” that were beyond suspicion. Indeed, Kroszner and Rajan found that universal banks underwrote securities by older, larger firms than investment banks.²⁵

Why was it that universal banks underwrote very few highly speculative stock issues? Companies that could borrow money from a universal bank, Kroszner and Rajan suggested, might have had less need to raise money through a stock issue than companies that didn’t have good banking relationships. Conversely, companies with good banking relationships were more likely to get capital needed to survive difficult times—contributing to lower default rates for the bonds of these companies.²⁶

In a related study, Eugene White reported that during the 1920s, before the passage of the Glass-Steagall Act, banks that both served depositors and engaged in securities business were less likely to fail than banks that didn’t engage in securities business. White went on to say that “while 26.3 percent of all national banks failed in this period [1930–1933], only 6.5 percent of the 62 banks which had [investment] affiliates in 1929 and 7.6 percent of the 145 banks which conducted large operations through their bond departments closed their doors.” The reason for the greater safety of universal banks, White suggested, was diversification.” ²⁷

While breaking up big universal banks, the Glass-Steagall Act had no impact on the small unit banks that failed by the thousands. These banks typically didn’t engage in corporate underwriting. Incredibly, as Benston noted, the Glass-Steagall Act “did not change the most important weakness of the American banking system—unit banking within states and the prohibition of nationwide banking.” In fact, he says, “This structure is considered the principal reason for the failure of so many U.S. banks, some 90 percent of which were unit banks with under $2 million of assets.” ²⁸