This "U.S. Banking Panic of 1933 and Federal Deposit Insurance" case study discusses the Banking Panic of 1933 and how it was extraordinary, requiring significant action on the part of the U.S. government. It looks into the difference of the banking system in the U.S. from that of other countries and how the U.S. government reacts during the same credit crisis.
Julio J. Rotemberg; Sabina Ciminero
Harvard Business Review (799077-PDF-ENG)
January 11, 1999
Case questions answered:
- In 1929, there were more than 25,000 commercial banks in the U.S. Today there are still approximately 7000 banks. In most other countries there are just a handful of major banks – often 4 to 8 institutions dominate the market place. What explains the vastly different character of the banking system in the U.S. from that of other countries? Similarly, most other countries have not in the past provided government-sponsored deposit insurance, though some have put it in place as part of their response to the credit crisis. Does the unique structure of the U.S. banking system indicate a greater need for such insurance?
- As the case study notes, the U.S. Banking Panic of 1933 was not unique. There had been many previous banking waves of panic periodically over the previous century. What made the banking panic of 1933 so extraordinary that it required significant action on the part of the U.S. government?
- Similarly, what was so extraordinary about the credit crisis of 2007-2010 that it has become the centerpiece of economic policy and required such unusual actions as bailouts, government injections of equity into financial institutions, emergency lending facilities, etc.?
- Perhaps the best-known quotation of Roosevelt’s was “The only thing we have to fear is fear itself”. How does the thought behind that quotation fit into the provision of Federal deposit insurance? How does it relate to the response by governments around the world to the current credit crisis?
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Case answers for U.S. Banking Panic of 1933 and Federal Deposit Insurance
The U.S. Banking Panic of 1933
The different character of the banking system
The U.S. banking system has historically been different from that of other countries. As of 1929, America had over 25,000 banks which comprised of over 1,100 state banks, 7,000 national banks, and over 16,000 nonmember state banks (Rotemberg & Ciminero, 1999). The state laws insisted that the banks could not have more than one bank office; thus the introduction of unit banks.
Unlike in other countries where banks have branches in various states, the US banking system did not allow branches in most states and the states that permitted subsidiaries contributed to only 13% of the total banks at the time (Rotemberg & Ciminero, 1999). Another contributing factor to the existence of different banking systems in the U.S. traces back to the historical nature of the states as they believed that it was the state’s responsibility to regulate the banks thus opposed the creation of the central bank. Many states had allowed the banks to open unit banks and the state government could closely monitor the activities of the banks.
Therefore, America’s political and legal structure had an impact on the real difference between the U.S. banking system and the rest of the nation. The state government developed a centralized federal power thus promoted protest on the creation of the central bank but supported the legal rights of different states to license their banks (Rotemberg & Ciminero, 1999).
Besides, the Federal Reserve Act lacked the central bank and a primary currency since the states had different bank rules and regulations. There was also an introduction of the Glass-Steagall Bill which separated commercial and investment banking to create the need for the establishment of several financial institutions. The bill imposed restrictions on the bank’s assets, activities as well as their capital and their liabilities.
The argument was that commercial banks had security affiliates that were a threat to the U.S. banking system (Rotemberg & Ciminero, 1999). The commercial banks could have possibly put much pressure on small banks to buy weak securities, and upon trading they make losses. This deal was beneficial to the bank managers but at the expense of the depositors.
The U.S. banking system is also different since there was a new capital requirement for the chartered national banks to double as the banks had to operate under the national and not the State charters. It was the impacts of the Great Depression that contributed to the proposed capital requirement thus resulting in the existing differences in America’s banking system and the rest of the countries.
It was evident that many banks could not operate efficiently after the Great Depression as they have capital which was below $50,000 (Rotemberg & Ciminero, 1999). Therefore, there was the need to double the capital requirements for the national banks to $50,000 to enhance the effectiveness of investment in the chartered banks.
The unique banking structures of the U.S. call for the need for deposit insurance as a strategic approach of responding to the credit crisis. The existence of many unit banks in the U.S. facilitated the creation of government-sponsored deposit insurance to eliminate the possibility of inflicted fear on the banks due to the threat of bank failure (Rotemberg & Ciminero, 1999).
One of the significant benefits of FDIC is it offers insurance to the depositor’s fund which became exposed to the risk of loss of securities (Rotemberg & Ciminero, 1999). Also, large banks diversify their operations in several states to reduce the risks that may affect the performance of the bank. They can as well operate in different industries and reduce the impact of the threat that affects the banks. However, the U.S. banking system has many small banks that are more exposed to risks than the large banks thus the significant value of the insurance to boost the confidence level of the depositors and encourage them to invest in available small banks.
Banking panic of 1933 was extraordinary
It is essential to note that there had been other banking panics that occurred before 1933. For example, many banks became interconnected to maintain the bank reserves and lend loans to firms and individuals after the Federal Reserve Act of 1913.
The central bank had the power to loan other banks to help them come out of the financial problems. The federal government could impose limitations and create changes in the total volume of currency for buying and selling the bank assets (Rotemberg & Ciminero, 1999).
The Reserve Banks also provided…