How Federal Deposit Insurance Was Won

While Congress rejected a bailout of depositors, a battle ensued over whether deposit insurance would be included in a reform bill. Flood’s (1991) survey of the contemporary deposit insurance debate reveals that it was extremely well-informed and considered all the issues that are today believed to be pertinent to deposit insurance.

This is not surprising in light of the collapses of state deposit insurance systems in the 1920s, which had been observed and commented upon frequently. Indeed, the American Bankers Association (1933) provided a detailed quantitative analysis of the state insurance system failures as part of its campaign against federal deposit insurance.

Opponents of deposit insurance used this evidence as an example of the moral-hazard costs of providing government guarantees to depositors. Proponents of deposit insurance did not try to dismiss the potential importance of such costs.

Rather, they argued that deposit insurance could avoid moral-hazard costs if properly designed. Furthermore, they argued that deposit insurance was necessary and fair.

Supporters of deposit insurance argued it was a matter of simple justice that depositors not be forced to bear the losses from bankers’ mistakes or folly. On the other side, bankers argued that it was unjust for well-managed banks to subsidize poorly run banks.

The president of the American Bankers Association pointed out that deposit insurance would mean a net transfer from big banks, where most deposits were, to smaller statechartered banks, where most of the losses were.

The money center banks all emphasized that it was not an actuarially sound insurance plan, as premiums were not set by exposure to risk. The character of the bank failures of the 1930s and the widespread losses suffered by depositors throughout the country were a new and important ingredient in the political debate after 1932.

Figure 5.1 reports data on the number of failing national banks, and figure 5.2 shows the percentage of proven claims paid one, two, and three years after national banks were placed in receivership.

From I929 to 1933, as the number of banks failing increased, the percentage of deposit claims recovered fell dramatically.

In prior decades, bank failures had sometimes been numerous, but never had there been so many bank failures at such high cost, and never had this cost been spread throughout the country. In the recession of 1920-21, there were large losses for the relatively few banks that failed.

In the 192Os, the number of failures rose, but recoveries were fairly high, and losses were concentrated in a few states. But in the 1930s, failures rose and recoveries fell; few people in the country did not know someone who had lost substantial wealth as the result of the banking collapse.

Thus the expected value of a dollar deposit fell precipitously. The severity of these costs, however, by itself was not enough to produce success for the proponents of deposit insurance. Even after the banking crisis of 1933, there still was formidable opposition to deposit insurance.

President Roosevelt, Secretary of the Treasury Woodin, Senator Carter Glass, the American Bankers Association, and the Association of Reserve City Bankers all remained opposed to deposit insurance.

While not offering any formal position, the leading officials of the Federal Reserve did not favor insurance. On the other side, Vice President John Nance Garner, Jesse Jones of the RFC, and Chairman Steagall favored deposit insurance.

Perhaps most important, the severity of losses during the early 1930s changed the location of the debate over deposit insurance. For decades, deposit insurance.had been one of the hundreds of issues coming before Congress repeatedly.

Like most others, it received relatively little attention from the general public, and its fate was determined by the relative weights of special interests measured on hidden scales in smoke-filled rooms.

The banking crisis had the attention of the public, and the costs of the crisis were one of the major public concerns of the time. The debate over banking reform thus moved from the smoke-filled room to the theater of public debate.

Once it became a focal issue of relevance for the election of 1934, the contest between proponents and opponents became a struggle for the hearts and minds of the public. Public support would be courted, and public support-not just special interestswould govern congressional voting.

Public attitudes were shaped in part by events and debates of the 1930s other than those that pertained directly to deposit insurance. People’s perceptions of banks had been changed by the events of the Great Depression, and the way those events were interpreted at the time.

In particular, many influential contemporaries were arguing that banks were the perpetrators rather than the victims of the Great Depression. Bankers were sometimes referred to as gambling “banksters” in the popular press.

Some critics of banks argued simply that bankers were to blame because depositors placed funds with bankers for safekeeping, and such funds should not have been risked at the depositors’ expense.

By 1933, it had become commonplace to blame the stock market crash and the Depression on the recklessness and greed of large, reserve-center banks.

The press and the Pecora hearings blamed the speculative excesses of the 1920s on the big-city bankers, depicting the depositor-and to some extent the bank shareholder-as a victim of bankers’ greed.

The Pecora hearings, which were widely covered in the press, involved little evidence or systematic discussion, and their conclusions have been questioned by subsequent scholarship (White 1986; Benston 1989; Kroszner and Rajan 1993).

The hearings provided scapegoats for the financial collapse of 1929-33 and a springboard for new regulation.

The challenge for Steagall and his allies was to break the deadlock with Glass by wooing the public, and by offering Glass something he wantednamely, the separation of commercial and investment banking.

Steagall’s strategy for winning the public debate was to respond to the actuarial and fairness concerns of critics of deposit insurance, while stressing the evils of large-scale banking and the unfairness of making depositors pay for bankers’ errors.

Steagall responded to critics by emphasizing that his system would only cover the small depositor because of the ceilings on deposits insured.

The actual ceiling set in 1933 for insured deposits of $2,500 covered 97 percent of depositors and 24 percent of deposits (Board of Governors 1933,414). Moreover, his bill provided for less than 100 percent coverage even of small deposits, which he argued would reduce problems of moral hazard.

Finally, in comparison to the state systems, a federal system with its broader geographic coverage (including industrial areas) would diversify and strengthen the plan.

Steagall also wanted to allow membership in the insured system for state banks who were not members of the Federal Reserve System. As Keeton (1990, 31) points out, this may have been a crucial ingredient for receiving support from small rural banks who were not members of the Fed.

Many of these banks earlier had joined forces with big-city banks to oppose deposit insurance legislation.

Apparently, for many small, rural banks, the value of the cross-bank subsidy from flat-rate federal deposit insurance was not as great as the costs of complying with Fed regulations, and so their support for insurance hinged on allowing state nonmember banks to join.

On 1 I March, Glass introduced a bill that was very similar to his previous bank reform bill-once again, without deposit insurance. The president called a White House conference attended by Treasury officials, representatives of the Federal Reserve Board, and Senator Glass.

Working on the basis of the Glass bill, there were further conferences and consultations for the next six weeks, with Glass a frequent visitor. Senator Duncan Fletcher, chairman of the Banking and Currency Committee, and Steagall were also polled (Burns 1974, 80).

The most hotly contested issue was deposit insurance, which neither the president nor Glass wanted included in the bill. But congressional pressure was building. Twenty-five Democratic house members signed a petition in support of a guarantee in early March (Burns 1974, 89-90).

Key congressmen, like Senator Arthur Vandenberg (R-MI), became outspoken insurance advocates after local bank failures generated enormous constituent pressure.” Patrick (1993, 176) argues that mounting public pressure in support of deposit insurance at this juncture partly reflected anti-big-bank sentiment due to the coincident resumption of the Pecora hearings, with testimony from J. P. Morgan and George Whitney that made front-page news.

Glass reportedly told the White House that, if insurance was not put into the administration bill, Congress would include it anyway.

Glass reportedly yielded to public opinion because ‘‘Washington does not remember any issue on which the sentiment of the country has been so undivided or so emphatically expressed as upon this.

In mid-May, Glass and Steagall each introduced their own bills with changes in the structure of the Federal Reserve, separation of commercial and investment banking, equal branching rights for national banks (which had more limited rights than state banks), and a plan for the creation of the FDIC (Bums 1974, 8 1).

Both bills included specifications made by the Roosevelt administration that deposit coverage be based on a sliding scale and that there be a one-year delay in the start of the insurance corporation.

Accounts were to be 100 percent insured up to $10,000, 75 percent for deposits between $10,000 and $50,000, and 50 percent for funds in excess of $50,000. Deposit insurance was to be financed by assessments levied on banks, the Federal Reserve Banks, and $150 million from the Treasury.

It would begin on 1 July 1934 (Burns 1974,90). Glass’s original bill required all FDIC member banks to join the Federal Reserve, but he was blocked by a coalition led by Steagall in the House and Huey Long in the Senate, joined by Senator Vandenberg, who feared this would end state-chartered banking.

Long, who had blocked Glass’s bill in the previous Congress with a ten-day filibuster, virulently opposed Glass’s branching provisions. Long and Steagall extolled deposit insurance as a means of survival for the small banks and the dual banking system (Flood 1991, 5 1- 52).

Eager for a bill to separate commercial and investment banking, Glass finally agreed to support deposit guarantee and the coverage of nonmember banks in exchange for more Federal Reserve authority.

The prohibition of interest payments on deposits appears to have been another part of this elaborately crafted compromise. Glass argued that the prohibition of interest was necessary to reduce the flow of interbank deposits to reserve centers, where funds were often invested in securities.

Consistent with his desire to break the link between commercial and investment banking, Glass viewed the investment of interbank deposits in the securities market as a destabilizing influence on banks.

This carefully crafted compromise bill reflected the tenuous balance of power between the dominant factions in the House and Senate.

However, in a maneuver reflecting the ability of individuals to use congressional rules to alter the balance of power, the bill was radically amended by a proposal of Senator Vandenberg. His amendment proposed to create a temporary deposit insurance fund, thereby offering deposit insurance more quickly.

The amendment of the bill was engineered by Vice President Garner, who was presiding over the Senate, while it sat as a court of impeachment in the trial of a district judge.

In a surprise move that enabled him to seize control of the agenda, Gamer temporarily suspended the court proceedings and ordered the Senate into regular session to consider the amendment presented by Vandenberg.

The amendment-establishing a temporary fund effective 1 January 1934 to provide 100 percent coverage up to $2,500 for each depositor until a permanent corporation began operation on 1 July 1934-was overwhelmingly adopted (Federal Deposit Insurance Corporation 1984, 41-43).

The bill was almost derailed in a joint conference committee on 12 June, but survived to pass both houses of Congress the next day. Glass was forced to make another concession and permit nonmember banks to join under the amendment’s terms.

The American Bankers Association urged its members to telegraph the president to veto the bill. Although the president was opposed to the Vandenberg amendment, Glass warned him not to delay, and Roosevelt signed the Banking Act of 1933 on 16 June 1933.

Under the provisions of the Banking Act, the Temporary Deposit Insurance Fund would begin operations on 1 January 1934. Only those banks certified as sound could qualify for insurance (Burns 1974, 120).

The capital required to establish the FDIC was contributed by the Treasury and the twelve Federal Reserve banks. Banks joining the FDIC were assessed 0.5 percent of insurable deposits, of which one-half was payable immediately and the remainder on call.

All Federal Reserve member banks were required to join the FDIC; other licensed banks could receive FDIC protection upon approval of the FDIC so long as they became Fed members within two years. Throughout 1933, many banks still were adamant in their opposition to insurance.

The American Bankers Association at its annual meeting adopted a resolution to recommend that the administration postpone initiation of deposit insurance (Burns 1974, 125). They hoped that Congress would reconvene and make some adjustment, but they were sorely disappointed.

When the Temporary Deposit Insurance Fund was given a one-year extension in 1934 and permanent deposit insurance was postponed, Steagall pushed his agenda further. Steagall wanted to increase the deposit coverage from $2,500 to $10,000.

Although Roosevelt opposed this change and pointed out that 97 percent of depositors already were protected, Congress followed Steagall’s lead and set the account limit at $5,000 (Burns 1974, 127-28). In addition, compulsory membership in the Fed was postponed from 1 July 1936 until I July 1937.

Bankers gradually gave up their opposition and accepted that deposit insurance would remain in place (Bums 1974, 129). The temporary system was extended to 1 July 1935 by an amendment in 1934, and to 31 August 1935 by a congressional resolution signed by the president.

On 23 August, 1935, the permanent system finally became effective under Title I of the Banking Act of 1935, which created the FDIC and superseded the original permanent plan, liberalizing many of its provisions.

All members of the Federal Reserve System were required to insure their deposits with the FDIC. Nonmember banks with less than $1 million in deposits could obtain insurance upon approval of the FDIC, but were required to submit to examination by the FDIC.

The insurance limit was set at $5,000 for each depositor. Insured banks were charged a premium of one-twelfth of 1 percent of their deposits payable semiannually. This was a substantial reduction from 0.5 percent, half of which was paid to the temporary fund, which was returned to banks upon its closure.

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