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/ There are ten CHAPTERS and the original press release. Link to them here -- I • II • III • IV • V • VI • VII • VIII • IX • X • press release
CHAPTER VII of "A Primer On Money" / continue to Chapter VIII
WHY WAS THE FEDERAL DEPOSIT INSURANCE ACT PASSED?
For 18 years after the Federal Reserve Act was passed, no basic changes were made in our banking laws. This was not because the banking system had no problems. On the contrary, the problems it had were ignored until the holocaust of the great depression faced the Nation with the brutal cost of years of neglect. The seemingly trouble- free system described a few chapters ago simply broke down in 1932-33. Widespread runs on the banks during this period became commonplace. When President Roosevelt took office in 1933, one of his first acts was to declare a bank holiday, closing the banks in an attempt to halt the runs and shore up, if at all possible, the collapsing structure.
The fatal flaw in the system developed in the late 1920’s. During this period the banking system unwittingly transformed itself into a huge credit plant directly supplying the essential ingredient sustaining a crazily inflating stock market. The banks created money by making loans to brokers. And the brokers loans were so important that they became a prime source of the money supply.
These brokers’ loans were based on collateral in the form of the stocks acquired by the loans. But since millions of people were wildly speculating in stocks and raising their prices skyward, the value of the collateral was highly volatile and unsound. Nevertheless, brokers loans grew from $2 billion to over $8 billion during the boom. As someone put it, the market discounted not only the future, but the hereafter. When the inevitable crash came, and many sensible people, including some Federal Reserve officials, had foreseen it, brokers’ loans were called; $4 billion in only 4 months, and within the next 3 years an additional $4 billion had been called. Largely because of this, the Nation’s total money supply decreased by about $8 billion, or one-third, between 1929 and 1933. Such a reduction in the money supply could not help but magnify if not initiate any crash in prices and output and it did.
The unprecedented reductions in output and prices, in turn, weakened the banks to the point of bankruptcy. Many banks, sound before the crash, were in bankruptcy in the following years. The number of commercial banks in the United States declined drastically, falling from 26,401 in 1928 to 14,771 in 1933.
The bank holiday was seized on by President Roosevelt as an opportunity for action. The Emergency Banking Act of 1933, pushed through the entire legislative process in a single day, marked the start of efforts to solve the problems of the banking system. It provided that all banks would be checked; sound banks would reopen, unsound banks would remain closed. This in itself restored a degree of confidence in the banking system, and the runs on banks were largely stopped. But, it was felt, major steps to correct the situation were still required. The result was the establishment of the Federal Deposit Insurance Corporation.
But many changes of importance, other than creation of the Federal Deposit Insurance Corporation, were made in 1933, 1934, and 1935. Some, like the Emergency Banking Act mentioned above, were of a temporary, stopgap nature, but others were permanent, with lasting effects on the banking system of the country.
What changes were made by the Banking Act of 1933?
Most important was the establishment of a temporary deposit insurance plan which went into effect on January 1, 1934. This plan was made permanent and took its present form in the Banking Act of 1935. Other major changes were made by the 1933 act:
(1) To prevent cutthroat competition for demand deposits, the act provided that commercial banks should no longer pay interest on their demand deposits. This was desirable from the standpoint of the banks because it reduced their costs. Although it was designed merely as a temporary measure, this provision still remains in the law books.
(2) The Federal Reserve Board was given power to change the reserve requirements required of member banks, subject to approval by the President. This, too, was changed by the 1935 act, which provided that the Board of Governors alone, by majority vote, could change reserve requirements, within limits set by the law.
(3) The 1933 act also prohibited commercial banks from making stock market loans, and investment banks from accepting public deposits. This was an effort to prevent a wave of stock market speculation like that of the twenties by keeping commercial banking and investment banking separate and distinct.
What did the Securities and Exchange Act of 1934 do?
This act put various restrictions on stocks offered for sale, and established the Securities and Exchange Commission to police them. From the standpoint of monetary controls, however, perhaps the act’s most important aspect was the provision giving the Federal Reserve Board power to set the cash down payment required on stock market purchases.
What changes were made by the Banking Act of 1935?
Some have been already discussed: the Federal Deposit Insurance Corporation was made permanent, and the Board of Governors was given power to change reserve requirements. The act of 1935 had other important provisions:
(1) The Board of Governors of the Federal Reserve System was changed. Membership no longer included the Secretary of the Treasury and the Comptroller of the Currency, and the number of members was cut from nine to seven. The name, the Federal Reserve Board, was changed to the Board of Governors of the Federal Reserve System. The reorganized Board, with its ill creased powers really gave us a central bank for the first time, in place of a system of individual Federal Reserve banks which were largely on their own.
(2) Also of primary importance in creating a true central bank was the establishment of the Federal Open Market Committee to determine purchases and sales of Government securities for the entire system.
(3) Another change made by the 1935 act related to loans of the Federal Reserve banks. This act allowed the Federal Reserve banks to extend reserve bank credit on any type of credit which the commercial bank possessed.
(4) The 1935 act also contained provisions concerning regulation of bank holding companies.
What is the Federal Deposit Insurance Corporation?
The Federal Deposit Insurance Corporation -- the FDIC-- is a Government corporation set up to provide depositors of funds in commercial banks insurance against loss of such deposits in the event of failure of the bank, to the extent of $10,000 for each depositor. Deposit insurance was set up on a temporary basis by the Banking Act of 1933 and was made permanent by the Banking Act of 1935. Such insurance, it was hoped, would prevent the recurrence of serious runs on banks.
What is an insured bank?
A bank is insured when it complies with the rules and regulations laid down by FDIC and becomes a member of FDIC. In selecting members, the law requires FDIC to consider the adequacy of the bank’s capital structure, its earnings prospects, and the general character of its management. At the end of 1962, 13,455 banks were members while only a few hundred small banks had not joined the FDIC.
What is an insured deposit?
When a bank becomes a member of the FDIC each individual deposit in that bank is insured up to $10,000. This insurance is much like your life insurance policy, or the fire insurance that guarantees to pay you if certain events occur. Here the “event” is a bank failure. On December 31, 1962, $179 billion of deposits were insured.
What happens if an insured bank fails?
The depositors receive the full amount of their deposits, up to the maximum of $10,000, usually within 10 days to 2 weeks. If the FDIC desires, it may set up a new bank in the community. Then depositors in the bank ‘which has gone broke are given the option of taking their money as deposits in this new bank.
How many insured banks have failed since 1933?
Since 1933, 445 insured banks have failed, as of December 31, 1962. Total deposits of these banks were about $600 million. Slightly more than 5,000 depositors with accounts over $10,000 lost any money, and these losses were small.
Where does FDIC get its money?
The FDIC has two main sources of money: assessments on insured banks and interest on U.S. Government securities it holds. Each accounts for roughly half of the corporation’s income.
How did the FDIC get the money to start business?
The Treasury purchased $150 million of stock and the Federal Reserve, on the instructions of Congress bought $139 million of stock. This stock was repaid by the FDIC in 1947 and 1948 -- but only at 2 percent simple interest. It should have paid compound interest.
How much do the insured banks pay the FDIC?
Insured banks are required to pay FDIC a gross assessment of one twelfth of 1 percent of their total deposits. This assessment is similar to the premium paid on a life insurance or fire insurance policy.
Has the rate of assessment been the same since 1933?
The gross rate has remained the same, but since 1950 the FDIC has been allowed to give back more than half of the total assessment. The FDIC has actually returned approximately $1.2 billion -- over 57 percent of the gross assessments -- to the banks since 1950. The law giving the money back to the banks was steered through the 80th “do nothing” Congress by Congressman Jesse P . Wolcott. The Eisenhower administration rewarded him by making him Chairman of the Board of Directors of the FDIC.
Is the FDIC subsidized by the Federal Government?
Yes. Although it paid back the original $289 million of stock, several subsidies still remain. The fact that the FDIC gets almost half of its total income from Government securities represents a sizable subsidy and means that the taxpayers are footing almost half the bill for this insurance.
What direct commitment does the Treasury have to the FDIC?
The 1947 amendments to the FDIC Act provide that the FDIC can borrow up to $3 billion from the U.S. Treasury, at its discretion. The law directs the Secretary of the Treasury to put up this $3 billion anytime the FDIC requests it.
Does the FDIC pay for this commitment?
No. But if normal banking practices were followed, the FDIC would be required to pay the Treasury 1 percent a year. If the FDIC were standing on its own feet, it would have to pay $30 million a year for this commitment -- a total of $510 million for the past 17 years. This subsidy is over $200 million greater than the original capital stock subsidy.
Does the Treasury have any other commitments to the FDIC?
Yes. It is generally agreed that if there were a wave of bank failures, the Treasury would be morally bound to stand behind the FDIC although there is no legal obligation.
Should an organization operating on Government funds be allowed to build an $8.5 million office building without permission of Congress?
No. But this is precisely what the FDIC has recently done. It should be allowed to do so no more than should the local postmaster.
Does the FDIC maintain a sufficient reserve fund?
Proper management of any insurance company requires that a sizable reserve fund be maintained to provide payment in times of need. No one knows exactly how much the FDIC should keep, but it probably should keep more than the present $2.5 billion.
How much reserve does the FDIC maintain per $100 of deposits?
If we compute the reserves for each $100 of insured deposits, the FDIC now has $1.40 for every $100 of insured deposits compared with $1.84 for each $100 of insured deposits in 1934. Because the FDIC has given back over half of its assessments during the past, decade, its reserve per $100 of insured deposits is now less than in 1934.
How much reserve do life insurance companies maintain?
Whereas the FDIC keeps only $1.40 in reserve for each $100 of potential liabilities, private life insurance companies keep over $20 for each $100 of potential liabilities. Private life insurance companies find it desirable to keep a reserve ratio which is more than 13 times the reserve ratio kept by the FDIC. No one knows just how much the FDIC should keep, but these comparative figures indicate that it probably does not now keep enough.
Does FDIC regulate and control insured banks?
Yes. Under the provision of the act which allows the FDIC to see to it that banks do not engage in “unsafe and unsound practices in conducting business” and which allows it to lay down basic requirements for membership, the FDIC has come to regulate the banks rather completely, because banks need deposit insurance to hold deposits and remain in business. If banks are to perform their duty of financing business, they must take risks; the amount of risks which banks may take is greatly reduced by FDIC regulations.
Does this mean that the FDIC is running the banks?
To a large extent it is. By regulation and examination, the FDIC can prevent banks from investing in any investment the examiners deem undesirable. And FDIC conservatism is making it more and more difficult for small businessmen and farmers to get the financial assistance they need.
Do the bank examiners consider public welfare in deciding whether or not loans are satisfactory?
No. This point is made clearly by Prof. Raymond P. Kent in his textbook on “:Money and Banking”:
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The regulatory authorities and examiners, so to say, are not especially interested in the justification given loans from the standpoint of public welfare and economic stability, but rather in the probabilities of their being repaid at maturity so that depositors may not be endangered by losses. The loan to Bill Smith may be adjudged “good” because he has put up adequate collateral and even though he is using the money to put out a useless patent medicine, while that granted to Jack Brown may be condemned as “unsound” because he is not a very good risk and even though he is using the money to pay his son’s tuition in college.
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How else does FDIC control banks?
In addition to regulating insured banks through bank examinations, the FDIC controls the banking industry by refusing to let it expand. This it does by refusing to insure banks. A national bank must be insured to come into existence as must a State bank which is a member of the Federal Reserve System. For success in banking, membership in the FDIC and the Federal Reserve are highly desirable. By controlling membership, the FDIC controls the number of banks in existence.