Perhaps the most important reform in the banking system was the introduction of deposit insurance. The Federal Deposit Insurance Corporation (for commercial banks) and the Federal Savings and Loan Insurance Corporation (for savings banks) were established in 1934. Roosevelt was somewhat skeptical about deposit insurance, fearing that it would encourage lax banking practices, but he bowed to strong congressional support for deposit insurance (Calomiris and White 1994).
For many years deposit insurance was viewed as an unalloyed success. In A Monetary History of the United States, Milton Friedman and Anna J. Schwartz argued that “Federal insurance of bank deposits was the most important structural change in the banking system to result from the 1933 panic, and, indeed, in our view, the structural change most conducive to monetary stability since state bank note issues were taxed out of existence immediately after the Civil War” (1963, 434). A major part of their evidence (see Economic Reasoning Proposition 5, evidence matters) was the tremendous fall in the annual number of bank failures and losses borne by depositors after deposit insurance was introduced. Most economic historians have agreed with Friedman and Schwartz. During the savings and loan crisis of the 1970s, however, several economists pointed out that deposit insurance had come with a long-run cost: Depositors no longer had an incentive to regulate the banking system by withdrawing funds from risky banks.
There were a number of other important reforms of the banking system. Under the Glass-Steagall Act, commercial banking (taking deposits from the public and making short-term loans) was separated from investment banking (buying and selling securities). Banks could do one or the other, but not both. This reform reflected the belief that combining the two activities had undermined the banking system in the late 1920s: Banks had taken the hard-earned savings of their depositors and used them to finance loans to stock market speculators. Research by White (1986), Kroszner and Rajan (1994), and Ramirez (2002), however, shows that these charges were largely baseless. (Recall again Economic Reasoning Proposition 5, claims must be tested; evidence matters.) Another reform prohibited the payment of interest on bank deposits. The argument here was that in the 1920s competition to pay high interest rates on deposits had led banks into reckless lending. Both of these restrictions, separation of commercial banking from investment banking and the prohibition of interest on deposits, have since been removed on the grounds that they inhibited competition and punished bank customers.
World History
