David R. Henderson  

Too Small to Succeed?

How I Would Have Sold Obamacar... Increasing Liability of Bank E...
Indeed, one of the major contributors to bank failures during the Great Depression was the National Banking Act of 1864. That law, according to monetary historian Jeff Hummel, an economist at San Jose State University, banned any branching (interstate or intrastate) by nationally chartered banks, except for a few grandfathered banks. Because banks during the Great Depression were so small, they were undiversified. So when the agriculture sector went under, in part because of the Smoot-Hawley Act that attacked free trade, many rural banks failed. Call it "too small, so we failed."

This is from my article, "Making Banks Too Small to Succeed," published yesterday on AOL-Sphere.

The following paragraph was cut:

Obama's plan amounts to regulatory whack-a-mole: Take wild swipes at the problem and hope that it won't rear its ugly head again. His plans, in this area and others, would involve the federal government even more in our lives. But the federal government is simply too far removed, has no incentive to do it well, and is too big to plan for us. Let's hope Obama changes.

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CATEGORIES: Finance , Regulation

COMMENTS (5 to date)
Milton Recht writes:

Actually, the failure of rural banks was ironic. In addition to Federal law, most State banking laws also prohibited intra-state and interstate banking. The common belief was that the rural banks would just send the deposits to the cities and there would be insufficient funds for farmers, etc. Laws intended to help rural areas actually hurt them during the Depression.

The decline of the agricultural workforce allowed banks to expand nationally without negative political ramifications.

Eliminating deposit insurance now is politically very difficult and the insurance is often cited as the sole cause of the moral hazard problem. Unfortunately, when federal deposit insurance was passed, private bank notes were also banned.

These private bank notes traded as currency at par or discounts based on the healthiness of the bank issuing them. Their exchange values were probably the foremost indicators of a bank's safety and soundness. The bank notes also stopped moral hazard.

As far as I know, the reintroduction of private bank notes as currency has not be studied or promoted (but my knowledge of this area of research is limited).

Could allowing banks to issue private bank notes remove moral hazard issues? Are private bank notes viable in today's economy? Could the Fed still control the money supply? SEC issuance problems?

Gift and prepaid merchant cards are like private money in many ways since insolvency and bankruptcy leave the cardholder as a general creditor of the firm. I do not know of markets that trade these cards and reflect the viability of the issuing merchant. It may be one reason bank prepaid cards, such as Visa, MasterCard and American Express have gained in popularity over private merchant cards.

Greego writes:
These private bank notes traded as currency at par or discounts based on the healthiness of the bank issuing them. Their exchange values were probably the foremost indicators of a bank's safety and soundness. The bank notes also stopped moral hazard.

Just thinking out loud - do you think that the increased use of electronic money in various forms (EFTPOS, Visa, Paypal, et al) has a similar effect to privately issued bank notes? That is, they are also private proxies for money, and can trade at a discount at times (such as Amex usually having a bigger fee attached than say Visa) and create an profit opportunity through float (or whatever it's called).

Loof writes:

When any whole system is economically geared for fewer and fewer to get every bigger for evermore greed, then anything smaller, for sure, won’t succeed. Quantifying bank size in a basketcase without qualifying the system worldwide is folly. Speculatively, all self-interested citizens and every selfish encorporation would invest in bigger banks abroad wanton to get ever bigger on paper.

Patrice Peyret writes:

The references to interstate branching as a measure of size is obsolete in the Internet days.
Same issue as with the MoveYourMoney.info initiative:
this is not only about small community banks versus large nationwide concerns; it is also about creative and caring versus top-heavy and disconnected from consumers.

Small banks by their geographical footprint can be big by their online reach and their creativity.
Take MetaBank and its MetaPay subsidiary: they are the second largest prepaid card issuer in the US.
Who is first? H&R Block's Bank.

I hope that several "small" players with limited or no corner offices and few VPs to distribute big bonuses to, will kick some major butts in the coming few years.

mulp writes:

If the reason for bank failures was the prohibition on branch banking, then Citi, BofA, and the other interstate banks that needed government infusions of capital, and the dozens of interstate banks that failed and were taken over by the FDIC resolution trust, should not have failed or been at risk of failure but for government bailouts.

Would you care to explain why interstate banking didn't make the interstate banks immune to failure, but instead seems to have made them far more prone to failure.

Do you have statistics that show interstate banks failed or should have failed by not being bailed out by the government at a lower rate than the non-interstate banks which did not have branches.

As to the issue of FDIC, are you arguing that the economy would be healthier today if the money market funds breaking the buck created widespread runs on the money market funds with the funds freezing withdrawals, creating credit crises for business and industry who use money market funds instead of banks for their cash reserves, not to mention the personal losses to individual investors sitting in broker sweeps accounts that are in fact money market funds?

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