Money Banking

Problem Set 2

1. Describe the McFadden act and the implications of geographic regulation of the banking system in the United States.

The banking system in the U.S. was really fragmented. This leaded to instability (bank run, bank panic). It raised the concerns of the legislators. Legislators wanted to create more stability in the late 19th century. They applied more regulations and created also the FED to fight against the instability in the system.

In 1927 the McFadden Act was implemented. It was a geographical regulation that restricted banks to geographical area where they could operate. The idea was to try to improve the stability of the system. Banks were not allowed to open branches outside the state or acquire other banks outside the state. So they were prohibited to expand outside the state. Some states went even further and regulated banks inside the state (unit banking states), which means that they had regulations prohibiting banks from having more than one branch.

Most economists believe that this system was inefficient because it failed to take full advantage of economies of scale in banking. Economies of scale refer to the reduction in average cost that results from an increase in volume. Larger banks are able to spread their fixed costs, such as the salaries of loan officers, computer systems, and the costs of operating bank buildings, over a larger volume of transactions. Keeping banks limited to a small geographical areas was also inefficient because it exposed banks to greater credit risk by concentrating their loans in one area. Over time, restrictions on the size of geographical scope of banking were gradually removed. After the mid 1970s, most states eliminated restrictions on branching within the state. In 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which allowed the phased removal of restrictions on interstate banking. The 1998 merger of NationsBank, based in North Carolina, and Bank of America, based in California, produced the first bank with branches on both costs.

Rapid consolidation in the U.S. banking industry has resulted from these regulatory changes.

1. Describe the separation between commercial and investment banking introduces by the Glass Steagall act.

Prior to the Great Depression of the 1930s, the federal government allowed financial firms to engage in both commercial and investment banking. During the Depression, a financial panic occurred that involved a collapse in stock prices and the failure of more than 9,000 banks. As part of series of laws intended to restructure the financial system, Congress passed the Glass-Steagall Act in 1933 to legally separate investment banking from commercial banking. Congress saw investment banking as inherently more risky than commercial banking. The great stock market crash of October 1929 had resulted in heavy losses from underwriting because investment banks were forced to sell securities for lower prices than they had guaranteed to the issuing firms. The Glass-Steagall Act also contained provisions for a system of federal deposit insurance. A majority in Congress believed that if the federal government was going to insure deposits, it should not allow banks to use the deposits to engage in what it saw as risky investment banking activities.