Bank Deregulation and the S&L Crisis

American Banking: Crisis, Reform, and Evolution

Banking, an integral component of the American economic system, has experienced numerous highs and lows throughout the nation’s history. These financial institutions, which serve as the backbone for economic transactions, savings, and investments, profoundly influence both individual financial health and national economic stability. While the U.S. banking system has enjoyed long periods of prosperity and growth, it has also encountered significant crises that shook public confidence and necessitated comprehensive reforms. Understanding the cyclical nature of financial crises and the subsequent regulatory responses offers insights into the ever-evolving relationship between the banking industry, government oversight, and the broader economy. This guide delves into the major banking crises in American history and the reforms designed to prevent their recurrence.

Historical Perspective: Major Banking Crises in America

The Panic of 1907:

Often referred to as the “Knickerbocker Crisis,” this panic was triggered by a liquidity crisis in New York City. The failure of the Knickerbocker Trust Company led to a severe panic in the financial sector, with numerous bank runs and failures. This crisis underscored the need for a centralized banking system to act as a lender of last resort, eventually leading to the creation of the Federal Reserve System in 1913.

The Great Depression (1929-1939):

The stock market crash of 1929 was just the beginning of a decade-long economic downturn. Bank runs became common as depositors scrambled to retrieve their money, fearing bank insolvencies. By 1933, one-fifth of the nation’s banks had failed, leading to significant losses for depositors and businesses. The government’s response included the Banking Act of 1933, introducing the Glass-Steagall Act that separated commercial and investment banking. Additionally, the Federal Deposit Insurance Corporation (FDIC) was established to insure depositor funds, aiming to restore public confidence in the banking system.

The Savings and Loan Crisis (1980s):

Savings and Loan associations, primarily involved in home mortgages, faced challenges in the 1980s due to a combination of deregulation, bad lending practices, and unfavorable economic conditions. These institutions found themselves unable to cope with rising interest rates, leading to widespread failures costing taxpayers an estimated $132 billion. In response, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 to address the regulatory shortcomings that contributed to the crisis.

The Financial Crisis of 2007-2008:

Complex financial products, lax lending standards, and a housing market bubble set the stage for the most severe financial crisis since the Great Depression. When the bubble burst, the values of securities tied to U.S. real estate plummeted, critically damaging financial institutions globally. As banks faced insolvency, global economic activity contracted, leading to significant job losses and a worldwide recession. In response to the crisis, the Emergency Economic Stabilization Act was passed in 2008, which included the Troubled Assets Relief Program (TARP). This allowed the U.S. Treasury to purchase distressed assets and inject capital into banks. Later, the Dodd-Frank Wall Street Reform and Consumer Protection Act was established in 2010 to prevent future crises by enhancing regulation and oversight of the financial sector.

By examining these pivotal moments in the nation’s banking history, we can glean essential lessons about the fragility of financial systems and the necessity of robust regulatory frameworks to maintain stability and public trust.

Regulatory Responses and Reforms

Banking crises, while traumatic, have consistently provoked introspection and regulatory action aimed at averting future catastrophes. The U.S. regulatory landscape, intricately woven over a century of trials and tribulations, encapsulates a dynamic balance between free-market operations and government oversight. Here’s a comprehensive look at pivotal regulatory responses and reforms that emerged in the wake of past banking crises:

The Federal Reserve Act (1913):

The Panic of 1907 exposed a critical weakness in the U.S. banking system: the absence of a central banking institution to stabilize the financial sector during disruptions. Recognizing the necessity for an elastic currency and a lender of last resort, the U.S. Congress passed the Federal Reserve Act in 1913. This legislation established the Federal Reserve System, comprising twelve regional Reserve Banks overseen by the Federal Reserve Board. Entrusted with the power to regulate monetary policy and supervise member banks, the Federal Reserve has played a pivotal role in ensuring economic stability, especially during times of financial distress.

The Glass-Steagall Act (1933):

The turbulence of the Great Depression illuminated the perils of risky investment ventures by commercial banks, using depositor funds. To segregate everyday banking activities from speculative investment actions, the Banking Act of 1933, commonly known as the Glass-Steagall Act, was passed. It mandated a strict separation between commercial and investment banking. Further, it gave birth to the Federal Deposit Insurance Corporation (FDIC), offering deposit insurance to instill confidence among depositors and prevent bank runs. Although critical components of Glass-Steagall were repealed by the Gramm-Leach-Bliley Act in 1999, its legacy in advocating for a demarcation between different banking activities remains influential.

The Riegle-Neal Act (1994):

Banking in the U.S. had historically been constrained by state borders, with many states prohibiting banks from opening branches outside their home states. However, as financial markets became more interconnected and competitive, these barriers began to seem outdated. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 revolutionized the landscape. It permitted bank holding companies to acquire banks in any state, and from 1997 onward, allowed banks to establish branches across state lines without acquiring another institution. This legislation propelled the banking sector toward a more national model, promoting efficiency but also fueling concerns about the size and influence of mega-banks.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010):

The Financial Crisis of 2007-2008 revealed systemic vulnerabilities and the cascading effects of the failure of large, interconnected financial institutions. In response, the Dodd-Frank Act was signed into law in 2010, aiming to reduce the risks posed by these “too big to fail” entities. Some of its notable provisions included:

Volcker Rule:

Restricting banks from engaging in proprietary trading and limiting their affiliations with hedge funds and private equity funds to minimize high-risk activities.

Consumer Financial Protection Bureau (CFPB):

An agency designed to protect consumers from deceptive financial practices, ensuring clearer standards for financial products.

Financial Stability Oversight Council (FSOC):

Tasked with identifying risks to financial stability and promoting market discipline.

Enhanced Prudential Standards:

Large banks were required to undergo regular stress tests and maintain certain capital and liquidity levels to ensure they could withstand economic downturns.

Orderly Liquidation Authority:

In the event of a major financial company’s impending collapse, the government can step in to oversee an organized dismantling to minimize risks to the broader economy.

The Dodd-Frank Act, while comprehensive, has been the subject of debate. Advocates argue it has made the financial system safer and more accountable. Detractors, however, believe it might have added undue regulatory burdens that stifle financial innovation and growth.

Across a century of change, regulatory responses and reforms have aimed to safeguard the U.S. financial system, with the overarching goal of promoting a stable, efficient, and inclusive banking sector. Each crisis, while painful, offered valuable lessons that shaped policy actions and established guardrails for the industry’s future.

The Role and Evolution of the Federal Reserve

Founded amid a clamor for financial stability post the Panic of 1907, the Federal Reserve System has undergone transformative changes, shaping and being shaped by the tumultuous waves of the American economic landscape.

Origins and Establishment:

The absence of a central authority to manage monetary policy and prevent widespread banking panics was keenly felt in the early 20th century. The Federal Reserve Act of 1913 answered this call, establishing the Federal Reserve System—a decentralized central bank composed of twelve regional Reserve Banks with a central governing board.

Dual Mandate:

As its functions evolved, the Federal Reserve emerged with a dual mandate: ensuring price stability and achieving maximum sustainable employment. Through tools like open market operations, the discount rate, and reserve requirements, the Fed orchestrates monetary policy, influencing interest rates and overall economic activity.

Crisis Interventions:

The Fed’s role as the “lender of last resort” has been crucial during times of economic distress. Whether during the Great Depression, when it was criticized for not doing enough, or during the 2007-2008 Financial Crisis, when it implemented unconventional monetary policies like quantitative easing, the Federal Reserve’s actions have been pivotal. By providing liquidity, stabilizing financial institutions, and ensuring the smooth functioning of the financial system, the Fed has often been at the forefront during crises.

While the Federal Reserve’s primary functions have remained consistent, its tools, strategies, and communication practices have evolved. Its role in the 21st century is not just that of a monetary authority but also as a regulatory and supervisory entity, ensuring the safety and soundness of financial institutions.

History of the Federal Reserve – Chairman’s from 1951 – 2023:

William McChesney Martin Jr. (1951-1970)

  • Martin was the longest-serving Chairman of the Federal Reserve, serving under five presidents.
  • He is credited with helping to create a new kind of monetary regime that promoted low inflation and economic growth.
  • Martin was a strong advocate for the independence of the Federal Reserve from the political process.

Arthur F. Burns (1970-1978)

  • Burns was a former economist and academic who served as Chairman of the Council of Economic Advisers under President Nixon before being appointed to the Fed.
  • During his tenure, the Fed faced the challenges of high inflation and unemployment.
  • Burns was criticized by some for his close ties to the Nixon administration.

G. William Miller (1978-1979)

  • Miller was a former businessman and Secretary of the Treasury who was appointed to the Fed by President Carter.
  • He served for a brief period before being appointed Chairman of the Board of Governors of the Federal Reserve System.
  • Miller is credited with helping to bring down inflation, but he was also criticized for raising interest rates too aggressively.

Paul A. Volcker (1979-1987)

  • Volcker was a former economist and Treasury official who was appointed to the Fed by President Carter.
  • He is best known for his aggressive interest rate hikes in the early 1980s, which brought down inflation but also caused a recession.
  • Volcker is widely considered to be one of the most successful Fed Chairs in history.

Alan Greenspan (1987-2006)

  • Greenspan was an economist and businessman who served as Chairman of the Fed under four presidents.
  • He is credited with presiding over a period of economic prosperity and low inflation.
  • However, Greenspan was also criticized for his role in the financial crisis of 2008.

Ben S. Bernanke (2006-2014)

  • Bernanke was an economist and academic who served as Chairman of the Fed during the financial crisis of 2008.
  • He is credited with taking aggressive action to prevent the crisis from becoming a depression.
  • Bernanke is also known for his quantitative easing programs, which were designed to boost the economy during the Great Recession.

Janet L. Yellen (2014-2018)

  • Yellen was an economist and academic who served as the first female Chairman of the Fed.
  • She continued Bernanke’s policies of low interest rates and quantitative easing.
  • Yellen is credited with helping to guide the economy out of the Great Recession.

Jerome H. Powell (2018-present)

  • Powell is a lawyer and investment banker who is the current Chairman of the Fed.
  • He has raised interest rates in an effort to combat inflation, which has reached a 40-year high.
  • Powell is also facing the challenge of a slowing economy and the ongoing war in Ukraine.


Contemporary Issues in Banking and Reforms

As the global financial landscape grows increasingly complex, contemporary challenges in banking transcend traditional boundaries, prompting continuous evolution in reforms and approaches.

Too Big to Fail:

The consolidation and growth of financial institutions have given rise to entities so large and interconnected that their failure could imperil the entire financial system. The moral hazard of these institutions expecting government bailouts presents significant risks. Reforms, like those in the Dodd-Frank Act, aim to address these issues through rigorous oversight, capital requirements, and the Orderly Liquidation Authority.

Stress Testing and Bank Resilience:

Post the 2007-2008 crisis, regulators recognized the need for banks, especially significant ones, to be resilient against potential economic downturns. Stress tests, like those conducted by the Federal Reserve, simulate adverse economic scenarios to assess if banks can sustain themselves, ensuring they have sufficient capital buffers.

Technological Innovations:

The digital era heralds significant changes for banking. From mobile banking, AI-driven financial advice, to blockchain and cryptocurrencies, technology is revolutionizing how banking is done. However, these advancements also bring risks—cybersecurity threats, tech glitches, and concerns over data privacy. Regulations must evolve continuously to address these challenges, ensuring that technological advances don’t undermine financial stability.

Globalization and Financial Systems Interconnectedness:

The 21st-century economy is deeply interconnected. A ripple in one part of the world can create waves elsewhere, as seen during the European sovereign debt crisis. Cross-border banking, global trade, and international financial markets demand that reforms aren’t just national but coordinated on an international scale.

Navigating the myriad challenges of the modern financial world requires a proactive, agile, and coordinated regulatory approach. While the essence of banking—safeguarding and lending money—remains unchanged, the environment in which banks operate today is vastly different from a century ago. Adaptation, vigilance, and innovation are the cornerstones of ensuring that the banking sector remains robust, reliable, and responsive to contemporary needs.

Banking Crisis and Reform

There are many people that feel that the government should remove much of the regulations placed on banks and allow them to compete on the open market. Regulations, they feel, destroy the ability of banks to make money, raises costs, lowers interest rates paid to depositors and is not generally not good for the bank or the consumer. This was the belief of the Carter and Reagan Administration’s in the late 70’s and early 80’s. The result of this rather laissez faire approach was a period of deregulation. What is meant by deregulation is the removal of, or lessening of government regulations restricting an industry. Deregulation has effected many industries in recent years, including banking.

The Reagan Deregulation Program

  • Federal requirements that set maximum interest rates on savings accounts were phased out. This eliminated the advantage previously held by savings banks.
  • Checking accounts could now be offered by any type of bank.
  • All depository institution could now borrow from the fed in time of need, a privilege that had been reserved for commercial banks. In return all banks had to place a certain % of their deposits in the fed. This gave the FED more control and stabilized state banks.
  • Garn – St. Germain Act of 1982 allowed savings banks to now issue credit cards, make non residential real estate loans and commercial loans; actions previously only allowed to commercial banks.

The Effect of Deregulation – The S&L Crisis

  • Deregulation practically eliminated the distinction between commercial and savings banks.
  • Deregulation caused a rapid growth of savings banks and S&L’s that now made all types of non homeowner related loans. Now that S%L’s could tap into the huge profit centers of commercial real estate investments and credit card issuing many entrepreneurs looked to the loosely regulated S&L’s as a profit making center.
  • As the eighties wore on the economy appeared to grow. Interest rates continued to go up as well as real estate speculation. The real estate market was in what is known as a “boom” mode. Many S&L’s took advantage of the lack of supervision and regulations to make highly speculative investments, in many cases loaning more money then they really should.
  • When the real estate market crashed, and it did so in dramatic fashion, the S&L’s were crushed. They now owned properties that they had paid enormous amounts of money for but weren’t worth a fraction of what they paid. Many went bankrupt, losing their depositors money. This was known as the S&L Crisis.
  • In 1980 the US had 4,600 thrifts, by 1988 mergers and bankruptcies left 3000. By the mid 1990’s less than 2000 survived.
  • The S&L crisis cost about 600 Billion dollars in “bailouts.” This is 1500 dollars from every man woman and child in the US.
  • In summary, the S&L crisis was caused by deregulation which led to high interest rates that then collapsed. Other causes included inadequate capital and defrauding shorthanded government regulatory agencies (less regulators and inspectors).

Steps Taken to Solve the S&L Crisis

  • Passed the Financial Reform, Recovery and Enforcement Act (FIRREA)
  • Abolished the independence of the S&L industry.
  • Abolished the Federal Home Loan Bank Board which gad been in charge of supervising S&L’s
  • New agency Office of Thrift Supervision (OTS) created as part of the executive branch.
  • Changed Federal Insurance.
    • FSLIC eliminated and responsibilities transferred to FDIC.
    • Two separate funds were created within the FDIC:
      • SAIF – Savings and Loan Insurance Fund – for all savings type banks.
      • BIF – Bank Insurance Fund – for commercial banks.
  • Resolution Trust Company (RTF) created to dispose of failed thrifts.

Frequently Asked Questions about American Economics: Banking Crisis and Reform

The economic crises in U.S. history have had profound impacts on the nation’s banks. The immediate aftermath of major crises often saw bank failures, decreased lending, and eroded consumer confidence. For instance, during the Great Depression of the 1930s, numerous banks faced insolvency due to bad loans and a run on deposits. Similarly, the 2007-2008 financial crisis resulted in significant liquidity problems, necessitating unprecedented federal interventions to prevent a total banking collapse. Beyond immediate fiscal concerns, crises have typically brought about more stringent regulatory environments, reshaping the banking landscape in their wake.

The term “American banking crisis” can refer to several episodes in U.S. history when the banking system faced systemic threats, often resulting in bank failures, reduced credit availability, and economic downturns. Notable crises include the Panic of 1907, bank collapses during the Great Depression, the Savings and Loan Crisis of the 1980s, and the 2007-2008 financial crisis. Each of these events had unique causes and repercussions but shared a common thread of significant distress within the banking sector, requiring intervention and prompting reform.

Following the 2007-2008 financial crisis, one of the most significant reforms enacted was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The legislation aimed to reduce systemic risk, enhance transparency, and protect consumers. Key provisions included the creation of the Consumer Financial Protection Bureau (CFPB), the Financial Stability Oversight Council (FSOC) to identify threats to financial stability, the Volcker Rule which restricted proprietary trading by banks, and mandatory stress tests for large financial institutions. The goal was to prevent a recurrence of the events leading up to the crisis and to ensure that banks were better equipped to handle future economic downturns.

Different banking crises had distinct causes:

  • Panic of 1907: Triggered by a failed attempt to corner the stock of a mining company, leading to trust issues among banks and a cascade of bank runs.

  • Great Depression: Factors include stock market crash, severe droughts affecting agriculture, reduced consumer spending, and a widespread loss of confidence leading to bank runs.

  • Savings and Loan Crisis: Deregulation, poor lending practices, and economic volatility caused many savings and loan associations to fail in the 1980s.

  • 2007-2008 Financial Crisis: Complex interplay of factors including a housing market bubble burst, risky mortgage lending practices, complex financial products like mortgage-backed securities, excessive leverage by financial institutions, and global financial interdependencies.

Each crisis offered unique lessons, prompting reactive reforms and reshaping the U.S. banking sector.