Economics and The Public Welfare

Chapter 46

The Banking Act of 1938—Extreme Reform Bill, Not New Deal Measure

The Glass Banking Bill, adopted June 16, 1933, was a reform measure designed to prevent the abuses that had developed, particularly in the relation of the banks to the securities market, in the wild period, 1924-1929. One sympathized with some of the provisions of the bill. But it went a great deal too far in dealing with symptoms, and it failed entirely to strike at the basic evil, which was the unsound Federal Reserve policy for the period 1924-1928, which blew up the appalling bubble of stock market speculation and reckless security issues. It was not, however, in essence a New Deal measure. It was a measure directed toward conservative finance rather than toward monetary manipulation and inflation.

Separation of Commercial and Investment Banking—Investment Affiliates. One important provision of the Act was that designed to effect a complete separation of commercial and investment banking. The first draft of the Act undertook to accomplish this in a one-sided way, by requiring the commercial banks to divorce themselves from their investment affiliates within one year. Steps had already been taken in this direction by the National City Bank and by the Chase National Bank. The Chairman of the Chase National Bank proposed that the separation of commercial and investment banking be made complete, by forbidding investment bankers to receive deposits, and by forbidding partners or officers of investment banks to sit on the boards of commercial banks. This suggestion was welcomed by Senator Glass, and adopted in the Banking Act of 1933.

The conspicuous abuses of the period 1927-1929 had made legislation of this sort politically necessary. From the economic point of view, the abolition of the investment affiliates of the great banks was unfortunate, and legislation regulating their activities would have been better. The investment affiliates of the great banks had had, in general, good records down to 1927. In one conspicuous case the rule had been that the investment affiliate, whose capital was entirely separate from the capital of the bank, would risk its money, but would not risk its reputation or the bank’s reputation. It did engage in underwriting. It did deal in securities with wholesalers and retailers of securities. But it did not put its name or the bank’s name upon an issue, and it did not sell securities to the public. These investment affiliates brought a needed element of competition, and a very substantial additional amount of capital, into the investment banking field.

Great Harm Came in Retailing by Investment Affiliates. The great harm came when they began to put their names upon issues and, above all, when they established retail selling organizations with enterprising, high-pressure salesmen selling securities to individuals in the name of a great bank. This changed their character in many respects. One change was this: as long as the investment affiliate had no retail sales organization, it could have an inexpensive organization. It could afford to wait until satisfactory underwriting opportunities appeared. When, however, it had a large body of salesmen out in the field, they had to be supplied with securities to sell. The pressure on the head office to provide securities was immense. If first-rate securities were not available, the temptation was great to provide them with something to sell anyway. This was a factor of real importance in the deterioration of the quality of new securities offered to the public in the period of 1924-1929. I think that if the investment affiliates had had no retail organizations they would be in existence and doing useful work today. The Glass Act forced upon the investment banking field a great liquidation at a time when investment banking, chastened by the bitter experiences of the preceding years, would otherwise have been doing a great deal of useful and constructive work.

Bank Underwriting of Bonds. The Glass Bill also limited very strictly the underwriting of bonds by commercial banks. It went much too far in this. There are times when participation by the banks in bond issues is highly important, highly necessary. A case in point is the refunding issue of $230,000,000 of the Great Northern and Northern Pacific railroads in 1921, which would have been a failure with disastrous consequences to the country if the great banks had not participated in the underwriting syndicate. The Glass Bill forbade the participation by commercial banks in underwriting bonds of any kind except Federal, State, and municipal bonds, and the bonds of Government corporations. This went too far. Commercial banks should be allowed to underwrite any bonds which they are allowed to buy, and when bond issues meet the specifications of the Comptroller of the Currency for bonds appropriate for purchase by a bank, they may very well be underwritten by a bank. Commercial banks, of course, ought not to underwrite stock issues, but this they were not doing in any case, and were not allowed to do under legislation previously existing.

Loans to Bank Officers. The Glass Banking Act forbade loans by banks to their own officers. In this it went too far. Banks should not make loans to their senior officers, but it is very well that the junior officer of a bank should borrow from his own bank and borrow only from his own bank, or at all events, borrow from another bank only with the knowledge and approval of his own bank, so that the bank may be fully informed as to what he is doing. It is very important that a bank should be free to help its younger men in emergencies.

It is unnecessary to give here a detailed account of the many provisions of this Act. It included a provision for deposit insurance. It dealt with branch banking and group banking. It gave the Federal Reserve Board carefully limited power to remove officers of member banks, after a hearing. It abolished interest on demand deposits, and gave the Federal Reserve Board power to regulate interest on time and savings deposits.

Interest on Deposits. With respect to the provisions of the Act forbidding the payment of interest on demand deposits, the present writer had the opportunity of an interchange of views with Senators McAdoo and Glass two years later in the Senate Committee Hearings on the Banking Act1 of 1935:

Senator Glass’s point regarding country banks sending their money to the great centers to get 2% instead of lending it out at home is one which he had in mind at the time when he was drafting the Federal Reserve Act. He wanted to stop the practice of country banks’ sending their money to New York City, which New York City banks would often lend on call to the stock market. He wanted the money left in the local communities. But the Senator did not adequately reckon with the seasonal needs of the country banks in his evaluation of this phenomenon. The typical country bank has an excess of cash after crops have been moved and sold in the late autumn or early winter, but it is going to need all that cash in lending to the farmers as crops are being made in the following spring and summer, and it is going to need a great deal more, borrowed from city correspondents or from the Federal Reserve banks, at the peak of the crop-moving season. If it lends it out at home in January, February, and March, it will not be able to take care of its customers’ needs in the later months of the year. The best thing it can do from a standpoint of taking good care of the community needs is to keep the funds liquid by sending them to the financial centers as deposits with correspondent banks, or for the purchase of commercial paper or acceptances, or for call loans to the stock market. One especially important reason for making deposits with correspondent banks is that the country bank thereby acquires a “borrowing equity” from the city correspondent and thereby earns the right to have the city correspondent serve it in selecting sound commercial paper, sound acceptances, or in making and supervising stock market loans instantly available on need, and in performing a multitude of other services.

It is significant that both of Senator Glass’s efforts to stop the practice of country banks’ sending their surplus funds to the great cities failed. The Federal Reserve System and the requirement that banks keep their legal reserves with the Federal Reserve banks did not stop the practice on the part of country banks (even though members of the Federal Reserve System) of keeping large deposit balances with city correspondents during the season when they have surplus cash. Nor has the abolition of interest on demand deposits stopped the practice. The country bank needs the city correspondent. The sound country bank does not lend out all its funds at home all the year round.

Securities Act of 1933. Another piece of legislation adopted in the spring of 1933 was the Securities Act (signed May 27), designed to compel truth in securities. The purpose was admirable. There had been altogether too many recklessly drawn and irresponsible security prospectuses, concluding usually with the statement that “the information herein contained is obtained from sources believed to be reliable but not guaranteed by us.” It was right to require full disclosure of all relevant facts and to impose full responsibility for the truth of the prospectus upon those who issued it, including both the underwriting bankers and the issuing corporation. But the terms of the legislation were so drastic, and the responsibilities imposed were so great, that they paralyzed the issue of new securities. We shall discuss this matter more fully in connection with the stock market episode of 1937.

Senator McAdoo: Do you think we did a wise thing in prohibiting the payment of interest on demand deposits?

Mr. Anderson: I am glad you raised that point, Senator. I believe we are going to have to change that law just as soon as we approach a normal money market. I think at all events interbank interest—interest on deposits of one bank with another—ought to be allowed. Here is a great lot of excess reserves in one Federal Reserve district which can be used in another section if it is needed. They ought to be able to get it by paying for it.

Senator McAdoo: I was speaking more, of course, of demand deposits. Do you think we did a wise thing in prohibiting the payment of interest on demand deposits?

Mr. Anderson: I think the only place where a definite abuse existed that needed public regulation was time deposits in smaller places. I think they paid rates much too high, and there should have been public regulation of that; but I think that the practice in New York as to interest on demand deposits and interest on time deposits under clearing-house regulations was quite wholesome. Some bankers did not like it. Some of them welcomed your abolition of interest. But I am looking at it as an economist. I want a good flow of funds, and interest is the way to move them.

Senator McAdoo: Suppose, for instance, we had said that we would permit the payment of interest on demand deposits on interbank transactions; would you still say that we should also permit the payment of interest on customers’ demand deposits?

Mr. Anderson: My view would be “yes”. . . .

Senator McAdoo: In the city of Los Angeles, a city of 1,250,000 people, with quite a large number of banks, the abuse got to be very great, so bankers have informed me. One bank would offer a large depositor a very much higher rate of interest than was justified, and at the first sign of trouble this large depositor got uneasy and withdrew his whole deposit at once, which was a very bad thing for the bank, or it might have been, whereas, in the ordinary course of business, where interest was not paid on demand deposits, and deposits might be more widely distributed, less injury might follow from a large number of small withdrawals.

Mr. Anderson: You could have a rule that the rate in each city should be the same so that the banks in a particular city are not competing, by varying the rate, against one another. The main thing that I have in mind to be accomplished is that if Los Angeles is needing money which Chicago has, it should be possible to bring that money to Los Angeles at a higher rate.

Senator McAdoo: It was experimental, of course, to prohibit the payment of interest on customers’ demand deposits. If it has not worked well or if it is inadvisable, the question in my mind is whether or not it might not be restored with provision for the regulation of the rate of interest by the Federal Reserve Bank of the district or by Government authority, just as we permit the regulation of the rate of interest now on time deposits.

Mr. Anderson: I would so recommend, Senator.

Senator Glass: As a matter of fact, there were various reasons why we did that. In the first place, country banks had what they call standard rates of discount. It is almost impossible ever to get them to depart from that standard rate of discount. They would rather bundle up their surplus funds and send them to the money centers at a nominal rate of 2 per cent than to give the merchants of the town or the industries of the town, or the locality the benefit of an abundance of money and an abundance of credit. . . .

Senator McAdoo: And also for another reason, that where we were requiring the banks to pay a premium to insure any part of their deposits, to relieve them of this payment of interest on demand deposits we gave them an additional means by which they could pay premiums upon insurance.

Mr. Anderson: With these very low interest rates now prevailing the banks are moving very rapidly to protect themselves anyhow. We have abolished interest on time deposits in New York because we cannot afford to pay it. We don’t want money that we have to pay for.

• 1This point will be discussed at length in Chap. 34.