The Obama administration has just sent Congress its proposals for improved regulation of financial institutions. In future columns we can examine just how proposals from the administration and Congress might work out.
First, however, let’s take a moment to reflect on how we developed the regulatory institutions and policies we currently have and why they were found lacking.
Just as the layout of computer keyboards stems from a response to problems in early typewriters, U.S. regulation of banking, insurance and investment companies has its roots in problems that occurred decades or centuries ago. The current structure is not one you would rationally choose if you started to design an effective one from scratch. But once institutions are in place, it is extremely difficult to start anew. This is what economists call “path dependency.”
The hodgepodge nature of U.S. regulation of depository institutions goes back to the founding of the republic. (The fact that we have to say “depository institutions” rather than simply “banks” illustrates the problems. Over the years we developed institutions like trust companies, savings and loans and credit unions that function like banks, but are not legally banks.)
The few banks that existed in 1789, when George Washington became president, were regulated, if at all, by the states in which they were located. That pattern of state regulation of many banks continues to the present.
Alexander Hamilton, the first Treasury Secretary, wanted a national bank, patterned on the Bank of England as a private corporation granted special duties and privileges by Congress. It would perform some functions of what we now call a central bank, such as the Federal Reserve.
We had two such banks between 1791 and 1836, until Andrew Jackson’s veto of a bill to re-charter the second bank extinguished anything like a central bank until the Federal Reserve began operating in 1914. But state banks thrived, with most even issuing their own paper money.
The exigencies of financing the Civil War led to the establishment of nationally chartered banks and the introduction of federal paper money — “greenbacks” — partly as a move to drive private banknotes out of circulation. A new Office of the Comptroller of the Currency took on the responsibility of chartering and then auditing national banks.
This started our dual banking system, in which banks can have either state or federal charters. The largest banks are all national banks and hold a large majority of all assets, but most banks still are state-chartered.
The contemporary “shadow banking system” of unregulated independent mortgage originators, finance companies and private-equity firms that in recent years issued 70 percent of home mortgages (among other things) has historical precedents. In the 1890s a similar shadow system of “trust companies” grew to be significant. These were not legally banks, but performed many of the functions of banks. It was the falling-domino failure of these trust companies that touched off the Panic of 1907 and an ensuing severe recession.
Six years later, the Democratic administration of Woodrow Wilson responded with the Federal Reserve Act. Since the primary function of the 12 new district banks was to lend money to cash-short commercial banks, the Fed was given power to periodically examine banks to be sure they were creditworthy.
The Fed failed at its mandate of stabilizing the banking system, so we created yet another institution, the Federal Deposit Insurance Corporation. If a government agency was to guarantee deposits, the thinking was, it should audit banks to ensure they were operating prudently.
That is how we ended up with four different primary bank regulators, state bank commissions, the Comptroller of the Currency, the Fed and the FDIC, all responsible for examining banks.
Oh yes, we also have separate regulators for savings and loans and credit unions. And we let some financial companies choose their own legal structure. This resulted in the parent company of AIG, one of the largest financial corporations in the world, legally being a savings-and-loan regulated by an Office of Thrift Supervision that was simultaneously allowing IndyMac, also technically a savings and loan, to cook its books to meet regulatory standards.
About the time we added the FDIC, we also decided that investors needed protection from unscrupulous financial firms. So we created the Securities and Exchange Commission.
Farmers needed protection from fraudulent manipulation in commodities trading, so we created what became the Commodity Futures Trading Commission. Since it involved farm products, we gave the House and Senate Agriculture Committees broad responsibility for its oversight. Nowadays, most of the futures and options traded under its supervision are financial ones, but the ag committees jealously guard their turf.
That is part of how we got where we are. Structures are outdated and overlapping, but there is some entrenched interest against virtually any change one might propose. Congress now has the ball and it is interesting to see what it will do with it.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.