The nation´s banks have overextended themselves with questionable loans in a time of easy credit, and their balance sheets are a mess. The federal government has been slow to react to the problem, and its first solution of a voluntary pool to loan money to troubled banks has not worked. Manufacturers´ woes in Detroit threaten to spread and undermine confidence in the banking system. Some policymakers are advocating for a temporary nationalization of the banking system while others argue that no matter how bad it may seem at present, market solutions will provide better and more stable long-term solutions. It's probably not what you think--this is a historical snapshot from 1933.
This is hardly the first time someone has noticed the parallels between the 2008-2009 crisis and the banking crisis of 1932-1933. My colleague at the Credit Slips blog, Adam Levitin, wrote a summary of the earlier crisis and its parallels with the current time. Still, the lessons of history are often ignored because they are forgotten, and the story of the 1932-1933 crisis is worth repeating. As I prepared this past weekend for my seminar in "Bailouts," I devoted a good deal of thought to this earlier time period. We have been going through some of the history lessons for the current time. Having spent previous classes on the British government loan to the East India Company in 1773 and J.P. Morgan's intervention during the Panic of 1907, our topic this week was the U.S. government's response to the 1930s banking crisis.
In 1932, the Reconstruction Finance Corporation (RFC) had been created to try to loan money to troubled banks with the same debates that are occurring now over the Treasury Department's Troubled Asset Relief Program funds. Should the RFC try to recapitalize banks or just purchase their troubled assets? Should the RFC finance only the relatively healthiest banks, or should it have a broader mandate to try to save banks in deep trouble? Should the RFC work only through financial institutions, or should it make loans directly to manufacturers and merchants? In 1932, the RFC helped to stem the immediate tide of risking bank closures. The RFC policies, however, were largely influenced by the laissez-faire tendencies of the Hoover Administration, and it tended to adopt more conservative measures in dealing with failing banks.
The RFC's limitations meant it was unable to contain a widespread banking panic that began in January and February 1933 in Detroit and eventually spread across the country. These were days before federal deposit insurance, meaning a loss of confidence by bank depositors could result in massive bank closures and losses. By March 4, 1933--the day of President Franklin Roosevelt's inauguration--most every state governor had closed the banks in his state by declaring a banking holiday. Immediately upon taking office, Roosevelt declared a bank holiday until March 9, 1933.
Before the bank holiday had expired, Congress had enacted the Emergency Bank Act of 1933 which validated Roosevelt's actions, extended the bank holiday for another 5-7 days, and set forth the general outlines of a procedure to reopen the banks. Roosevelt's first fireside chat assured citizens that only the soundest banks would reopen and tried to assuage fears that massive amounts of depositor money would be lost. Roosevelt's famous line, "The only thing we have to fear is fear itself," came from his inaugural address of this time and was in part a reference to the banking problems that had ordinary Americans on edge. By the end of March, many banks had reopened and American confidence in the banking system was restored. Later that summer, Congress passed the Banking Act of 1933, which is more commonly known as the Glass-Steagall Act. In this law, Congress created the Federal Deposit Insurance Corporation and separated the investment and commercial banking businesses (a rule which would stand until 1999).
One thing that struck me about the RFC's actions in 1933 was that it took preferred stock in the banks, much as the Treasury has done today. The terms of the RFC's preferred stock were very different than today. The RFC preferred stock had voting power, and if the bank missed two consecutive dividend payments, the RFC had the power to take control of the bank. Because the RFC had the power to takeover a bank, the RFC's investment had a disciplining effect on bank management and caused management to shift away from riskier assets to assets with a safer return. The safer return gave a more reliable income stream which in turn made it more likely the bank would make its dividend payment to the RFC. Thus, the RFC did more to shore up banks' balance sheets and less to stimulate the economy.
The Treasury's current investments are far less powerful than the rights the RFC had. Under the Treasury's current investments in preferred stock, the dividends are cumulative. If six missed dividend payments accumulate, the Treasury then has the power to elect two new directors to the bank's board. (See, for example, the terms of Citigroup's preferred stock here.) Two new directors does not amount to effective control of a bank. There are many who think--and I include myself in this number--that the current Treasury leadership should have taken investments in the banks that gave them stronger powers to interfere in bank management decisions, similar to what the RFC did in the 1930s. These stronger investment powers come with a price, however, because they encourage banks to make safer investments and discourage commercial lending. If we expect Treasury to use the Tarp money to jump-start the economy, then discouraging commercial lending is the last thing we should want. The stimulus package currently before Congress should provide that jump-start. If it passes, it will relieve pressure to use Tarp for economic stimulus In that case, I would like to see more Treasury interference with banking decisions, not to force lending as so many have advocated but to create pressure to again put our nation's banking assets on a sound footing.
Bob Lawless is a professor of law and the Galowich-Huizenga Faculty Scholar at the University of Illinois College of Law.