Paul Peretz

California State University

Jean Reith Schroedel
Claremont Graduate University

Financial Regulation in the United States: Lessons from History PAR Symposium
on the Financial
Crisis

History is institutional memory writ large. One looks at
economic history to see what problems recur, what causes
them to recur, what solutions have worked best in the
past, and which interventions have made the problems
worse. The authors argue that a moderately complex
interaction between the workings of the financial sector,
the way in which the political system is organized, and
the administration of regulation makes perfect regulation
of the financial sector extremely unlikely. Many of these
problems arise as a result of conflicting incentives for those
participating in and regulating the financial field. The
The History of Financial Regulation
Because of vast differences over time in the ways in
which banking and finance have been organized and
regulated, it might appear there is little to be learned
from an examination of financial history. However,
history is institutional memory writ large. One ignores
it at one’s peril. We begin with a brief history of
financial regulation and then examine the major recur-
ring problems in the financial sector and the ongoing
structural problems of the regulatory process. The
absence of effective regulation, particularly in the early
Paul Peretz is a professor in the Division
of Politics, Administration and Justice at
California State University, Fullerton, and
coordinator for the public administra-
tion program. He is the author of The
Political Economy of Inflation in the United
States, The Politics of American Economic
Policy Making, and numerous articles
primarily on economic policy making. He
holds a doctorate from the University of
Chicago and has taught at the University
of Washington, Brown University, Cornell
University, and Columbia University.
E-mail: pperetz@exchange.fullerton.edu

authors find that some proposed solutions have improved
matters but have costs, and that some proposed solutions
have actually worsened problems in the financial sector.
Peoples and governments never have learned anything
from history, or acted on principles deduced from it.
—Georg Wilhelm Friedrich Hegel, 1837
nineteenth century, can provide a fix on the underly-
ing patterns that financial regulation seeks to control.
The Antebellum Period, 1791–1863
During the antebellum period, all banks were small by
today’s standards, but there was a mix of small, family-
run operations in rural areas and much of New Eng-
land and somewhat larger, more hierarchical banks
in cities elsewhere. The largest banks were located in
Jean Reith Schroedel is a professor
in the Department of Politics and Policy
and Applied Women’s Studies Program in
the School of Politics and Economics at
Claremont Graduate University. She is the
author of Congress, the President, and
Policymaking: A Historical Analysis
(M. E. Sharpe, 1994) and Is the Fetus a Per-
son? A Comparison of Policies Across the
Fifty States (Cornell University Press, 2000);
the latter was awarded the American

I
nitially, the current financial morass appears to be Philadelphia, Boston, and New York, with the last Political Science Association’s 2001 Victoria
Schuck Award. She is currently editing a
caused by a series of recent financial innovations: growing in importance. Capital generally came from two-volume study for the Russell Sage
collateralized debt obligations, credit default subscribers (investors promising to purchase securi- Foundation on the impact of Christianity
swaps, subprime mortgages, Alt-A mortgages, and ties) rather than depositors and was lent out for short on democracy in the United States.
E-mail: jean.schroedel@cgu.edu
others (Morris 2008). It is the argument of this paper, periods to farmers for seeds and harvesting. A smaller
however, that these innovations, important as they number of longer-term loans were largely for agricul-
are, are not the real cause of the financial problem tural land in the South and West and for commerce in
but manifestations of a more serious underlying the East (Bodenhorn 2003; Schroedel 1994, 29).
problem—a series of conflicting incentives for those
participating in and regulating the financial field. Treasury Secretary Alexander Hamilton put the
United States on a bimetallic gold and silver (specie)
It is unfortunate that this is the case. Financial in- standard in 1791 as a reaction to colonial inflation,
novations can be undone, de-leveraged, or reworked. making the country vulnerable to international
But the conflicting incentives that we shall discuss flows of specie. The notes issued by banks to lend-
are built into the fabric of the ers based on reserves of specie
nation and are much more To take a medical analogy, one also became a form of currency.
difficult to solve. To take a
medical analogy, one would like
would like a problem that could During the 1791–1811 and
1816–36 periods, some of the
a problem that could be solved be solved with a pill, but instead functions of a central bank were
with a pill, but instead we have we have a problem that requires performed by the First and
a problem that requires con- continuous monitoring and Second Banks of the United
tinuous monitoring and daily daily treatment. States. The Bank of the United
treatment. States, which acted as a general
Financial Regulation in the United States 603
 creditor to other banks, worried about inflation and 1982, 49). By 1890, there was more money in state
often restricted the funds available for lending. But banks than in national banks (U.S. Census Bureau
national regulation was generally weak and erratic. 1975), and by 1910, there were four times as many
state-chartered and private banks as national banks,
Regulation was primarily performed by the states, and greatly reducing the regulatory power of the Comp-
the degree of regulation was uneven. Some states with troller of the Currency (Sylla 1975, 26). These banks
strong economies, such as Louisiana and New York, and the unincorporated banks had a much higher
had firm regulation and did reasonably well during failure rate (U.S. Census Bureau 1975, 1038). Finally,
downturns. Other states with weaker economic bases, the failure of the New York banks—the default lend-
such as Michigan, had very weak regulation and banks ers of last resort—to provide credit to country banks
that regularly failed during downturns. Indeed, during was a factor in the liquidity crises of 1873, 1893, and
the depression of 1837, the number of banks dropped 1907 (Schroedel 1994, 32).
from 28 to 2 (Poulson 1981, 348–49).
The postbellum years are generally seen as America’s
In 1798, 1811, 1821, 1825, 1837, 1839, 1845, takeoff period, with gross domestic product growth
and 1855, bank runs and international currency rates around 4.0 percent. The country reduced its
movements triggered economic downturns in the reliance on agriculture, and manufacturing grew
United States. Most of these were more severe than rapidly. In 1869, agriculture accounted for 53 percent
current ones, and the 1837–43 downturn, which of output and manufacturing for 33 percent. By
followed a long run-up in asset values, was almost 1899, the percentages were reversed (Lee and Passel
as harsh as the Great Depression. This made bank- 1979, 267, 273). Banks grew in size and loans became
ing regulation a major political issue. The issue was longer, both of which increased the amount of risk in
generally framed as elite Eastern banks exploiting the system. It was also in this period that savings and
poor farmers in the South and West. The major effect loans (then called building societies or thrifts) became
of this movement was the abolition of the Bank of serious rivals to banks in the area of home finance.
the United States under President Andrew Jackson.
Rather than making matters better, this made them This was also an era of heavy deflation and continual
worse, by removing the nearest thing America had to economic crises. The slow growth in the money sup-
a lender of last resort. ply relative to real gross national product, the Republi-
cans’ desire to deflate the economy to enable America
The Postbellum Period, 1863–1913 to return to the gold standard, experiments with
During the Civil War, the country temporarily aban- bimetallism, periodic bank runs, and the transmission
doned the gold standard, but deflationary policies af- of foreign crises through currency movements were ex-
ter the war led to the resumption of the gold standard acerbated by the lack of a reliable lender of last resort.
in 1879 (Poulson 1981, 363–64). Of more long-term Twenty-four of the 47 years between 1867 and 1913
consequence was the passage of were spent in downturns (Fried-
the National Bank Act of 1863, man and Schwartz 1963, 55,
which established three im- During the Civil War … 94–95). Part of the problem was
portant precedents in banking [a legislative action of ] long- the lack of communication with
regulation: national supervision term consequence was the branch banks, and with boards
by the newly created Comptrol- passage of the National Bank of directors in the ever-larger
ler of the Currency, minimum Act of 1863, which established financial institutions. Dur-
capital requirements, and the ing the 1893 depression, the
maintenance of specified reserve
three important precedents in first national savings and loan
requirements. Individual bank- banking regulation: national proved unable to keep track of
notes were replaced by govern- supervision by the newly created what its far-flung branches were
ment banknotes backed with Comptroller of the Currency, doing and declared bankruptcy
U.S. bonds, which the banks minimum capital requirements, (Mason 2004). In 1909, the im-
purchased from the Comptrol- and the maintenance of mediate cause of crisis was the
ler. The Comptroller was also insolvency of the Knickerbocker
given some power to charter
specified reserve requirements. Trust Company. J. P. Morgan’s
and regulate national banks, nephew, Herbert Satterlee,
and it was (incorrectly) anticipated that all banks remarked about its president,
would get national charters. Comptrollers were fairly
successful in preventing bank suspensions for the Mr. Barney had a very fine Board of Directors
national banks under their control, but because they but they knew little of a large part of the busi-
interpreted the National Bank Act as prohibiting na- ness of the Trust Company which Mr. Barney
tional banks from establishing branches, state banks kept “under his hat.” He ran his company with
expanded more rapidly than national banks (Eccles but few board meetings and with scant reports
604 Public Administration Review • July | August 2009
 of operations to his subordinates or executive
committee. (Bruner and Carr 2007, 68–69)
After the 1907 panic, Congress established the
National Monetary Commission with a mandate to
recommend reforms in banking regulation. Many
of its recommendations became part of the Federal
Reserve System.
The 1913–45 Period
The Federal Reserve Act of 1913 was a compro-
mise among financial interests, Congress, and the
Woodrow Wilson administration. Banking interests
and Republicans supported the creation of 12 Federal
Reserve Banks owned by regional banks, with boards
of directors representing banks and local businesses.
These were to be represented on a Federal Open
Market Committee that bought and sold government
bonds, thereby increasing or decreasing the money
supply. The Federal Reserve Bank of New York was
preeminent because bond sales occurred in New
York. President Wilson and congressional Democrats
supported a seven-person advisory Board of Gover-
nors appointed by the president with the advice and
consent of the Senate. The resulting divided control
and uncertain lines of authority violated Gulick’s
(1933, 1937) call for unity of command and for uni-
fied authority and responsibility. This was to lead to
problems when the Federal Reserve tried to deal with
the Great Depression.
The relatively short period between 1913 and 1929
had three short recessions, of which the most serious
was a fairly brief downturn during 1920 and 1921,
when the share of the civilian workforce that was
unemployed reached 11.7 percent (U.S. Department
of Commerce 1975, 126). But this was followed by
a prolonged boom, and the newly formed Federal
Reserve was not really tested until the late 1920s.
One of the primary jobs of a central bank is to
maintain liquidity and an adequate money supply
during a crisis. In the period after the stock crash in
October 1929, the New York Fed drove down inter-
est rates from 6 percent to 2.5 percent in order to
encourage loans and maintain liquidity, and would
have driven them down further but for opposition
from the Federal Reserve Board. But in late 1930,
the Board of Governors, backed by Treasury Secre-
tary Andrew Mellon and President Herbert Hoover,
decided that the market should be allowed to drive
down prices and that, eventually, the low prices
would bring people back into the market. They also
thought it imperative to remain on the gold stand-
ard, even as other nations improved their economies
by pulling out from it. These policies resulted in a
stable real money supply (and a declining nominal
money supply) from 1929 to 1932, when mon-
etary expansion was needed (Lee and Passell 1979,
362–92).
As we now know, this free market response was a
mistake (Christiano, Motto, and Rostagno 2003;
Friedman and Schwartz 1963). The unemployment
rate rose from 3.2 percent in 1929 to 25.2 percent by
1933 and did not drop below 15 percent until 1941.
Loans dropped from $14.8 billion in 1930 to $7.4
billion in 1935 and did not reach $14 billion again
until 1946. The number of banks fell from 25,568 in
1929 to 14,771 four years later (U.S. Census Bureau
1975, 1019). Between 1930 and 1933, 2,310 Federal
Reserve System banks and 6,796 other banks were
suspended (U.S. Census Bureau 1975: 1038).
President Franklin D. Roosevelt’s initial response to the
Great Depression was a mixed bag. After worsening the
downturn by refusing to cooperate with the Hoover
administration, Roosevelt proceeded to follow even
more conservative policies, passing a balanced budget
act as his second initiative and slowing the real supply
of money in his first two years. He also threatened
to veto the Glass-Steagall Act if it contained a provi-
sion for deposit insurance. But he imposed the bank
holiday called for earlier by the Federal Reserve and ac-
cepted the 1933 Emergency Bank Act, authored largely
by the Federal Reserve, which reopened sound banks
and closed or reorganized weak ones (Temin 1989, 96;
Worsham 1997, 34–44). More importantly, Roosevelt
surprised many at the time by taking the United States
off the gold standard (Schlesinger 1958, 199–203).
The Democratic Congress worked with the Roosevelt
administration to pass major reforms. The Glass-Stea-
gall Act of 1933, the Bank Act of 1935, and other
less important acts improved financial regulation
by strengthening the Federal Reserve, establishing
deposit insurance, and creating regulatory agencies to
police the financial sector. Links between commercial
banking and investment banking were severed. The
Federal Reserve, which had been formed as a system
of 12 regional bank–owned entities with an advisory
board appointed by the president and the Senate, was
changed into a somewhat more centralized organiza-
tion, with the Board of Governors given more author-
ity and its seven members placed on the 12-member
Federal Open Market Committee. Deposit insurance
was instituted for deposits under $2,500 to protect
small depositors and to limit runs on banks. Regula-
tion in all financial areas was strengthened to prevent
criminal acts and exploitation of the less informed.
But like all activity undertaken in crisis, there were
errors of omission and commission. While the 1860s
had seen a serious, if badly executed, attempt to move
banking regulation to the national level, in the 1930s,
state regulation was largely untouched, and banks
remained free to choose their regulators. Opposition
from the banking sector left in place state and federal
prohibitions against branch banking, inhibiting the
stabilization that comes from geographic dispersion.
Financial Regulation in the United States 605
 Partly as a payoff to different financial intermediaries, than $20,000 from holders who were unable to carry
the government created a regulatory structure that them, paid for taxes and repairs, and issued new longer-
split the financial sector into separate entities, each term mortgages at lower interest rates. According to
with its own agency. At the national level, regulation Harriss (1951), it received requests for refinancing from
was provided by the Comptroller of the Currency about 40 percent of qualified mortgage holders and
and by the Federal Reserve, with the Federal Deposit made loans to a little over 20 percent. Both the HOLC
Insurance Corporation (FDIC) underwriting deposit and the RFC eventually made small official profits, but
insurance for both of these, as well as many state- these calculations leave out some relevant costs.
regulated banks. Savings and loans were regulated
by Federal Home Loan Bank Board (FHLBB) and If this all sounds confusing, it was. The most benefi-
received deposit insurance from the Federal Savings cial financial reforms of the era were abandoning the
and Loan Insurance Corporation (FSLIC) until the gold standard, strengthening the Federal Reserve, and
responsibilities of the latter were taken over by the instituting deposit insurance on small deposits. But
FDIC and the former was reconstituted as the Office the New Deal also put in place Regulation Q (impos-
of Thrift Supervision in 1989 in the aftermath of the ing interest rate ceilings on deposits), reinforced divi-
savings and loan crisis. Credit unions were regulated sions between financial sectors, made it more difficult
and insured by the Bureau of Federal Credit Unions, to form geographically diversified banks, and ensured
which in 1970 became the National Credit Union Ad- that the newly formed regulatory agencies would find
ministration, with a subsidiary Federal Credit Union it hard to avoid capture by the interests they regulated.
Share Insurance Fund. Investment banks and brokers
were loosely regulated by the Securities and Exchange The Post–World War II Era, 1945–2008
Commission (SEC). After the U.S. Supreme Court’s The New Deal financial reforms were, on balance,
1944 ruling in U.S. v. Southeastern Underwriters As- positive for the postwar economy. The eight recessions
sociation (322 U.S. 533) that insurance was part of were much shorter than the downturns in earlier
interstate commerce, the insurance industry persuaded periods and did less damage to gross domestic product
Congress to pass the 1945 McCarran-Fergusson Act, growth and employment. The removal from the gold
which ensured that insurance regulation remained in standard, the willingness of the Federal Reserve to
state hands. lend during downturns, and the fact that small de-
positors were protected from loss were important fac-
Two other agencies of particular interest today were tors in preventing a recurrence of the bank crisis–led
the Reconstruction Finance Corporation (RFC), depressions of earlier eras.
formed by President Hoover in 1932, and the Home
Owners’ Loan Corporation (HOLC), formed by Good things rarely come without accompanying
President Roosevelt in 1933. By 1938, the RFC, problems, however. The absence of lengthy depres-
which was originally intended as an agency to make sions, during which prices deflated, led to much
loans to banks, had lent $4 mil- higher inflation rates. Though
lion to financial institutions and one must be cautious with early
another $6 million for railroads, Two … agencies of particular statistics, the Bureau of Labor
public works, agriculture, and interest today were the Statistics shows that in the 140
business. Under President Roo- Reconstruction Finance years between 1800 and 1940,
sevelt, the RFC switched from the Consumer Price Index for
Corporation (RFC), formed
making loans based on collateral all items actually decreased
to making loans in return for by President Hoover in 1932, slightly from 51 to 47, using an
preferred stock in the banks. and the Home Owners’ Loan index where 1961 = 100. In the
When banks proved unwilling Corporation (HOLC), formed 65 years from 1940 to 2007,
to borrow on these terms, the by President Roosevelt in 1933. it increased from 47 to 696
Roosevelt administration forced (Council of Economic Advisers
them to borrow by insisting that 2008, B60; U.S. Census Bureau
banks applying for the newly enacted deposit insur- 1975, 210–11). Throughout the period, monetary
ance issue a certificate of solvency. As half the banks and fiscal authorities saw themselves as steering be-
were actually insolvent, this could only happen if the tween the perils of high inflation and high unemploy-
banks agreed to accept the RFC’s conditions for the ment, although, with the possible exception of the
loans, which they did. late 1970s, inflation never actually reached levels that
imposed serious harm (Peretz 1983).
The HOLC was a product of the Roosevelt adminis-
tration, instituted after the failure of Hoover’s Federal Inflation led to the second major financial problem of
Home Loan Bank Act, which was intended to encour- the modern era, the savings and loans crisis. Savings
age banks to lend voluntarily. Between 1933 and 1935, and loans essentially borrowed money from depositors
the HOLC bought short-term mortgages worth less in the short term and used the money for long-term
606 Public Administration Review • July | August 2009
loans to home buyers, generally at fixed interest rates.
Most of the lower-cost loans were then sold to Fannie
Mae, Freddie Mac, and Ginnie Mae. Fannie Mae,
founded in 1938, was a Roosevelt-era government
agency formed to buy home loans from the private
sector at low interest rates. In 1968, it became an un-
dercapitalized quasi-government agency in an attempt
to make it more like a private firm. Freddie Mac and
Ginnie Mae (also undercapitalized) were later added
to provide competition. Together, they lowered loan
rates on middle- and working-class housing.
This system worked well when inflation was low. But
as inflation rose, the savings and loans had to pay
higher rates to depositors than they were receiving
from borrowers. This, together with deregulatory
decisions made by political actors and the FHLBB
and FSLIC, resulted in the collapse of the industry.
Between 1945 and 1979, not a single savings and
loan became insolvent, but between 1980 and 1992,
1,806 were closed by the FSLIC and the FDIC
(FDIC 2008). The federal government lost $130 bil-
lion (Eichler 1989; Kane 1989; Mason 2004; White
1991).
Inflation, and competition from the newly deregu-
lated savings and loans, also negatively affected less
nimble banks. In the 1960s, only 44 FDIC-insured
banks failed. In the 1970s, this figure rose to 80
banks, and in the 1980s, to 1,564 (FDIC 2008).
Large banks, eager to expand, pushed for regulatory
changes that would allow branch banking in states
and would permit them to pay interest on depos-
its. Small banks, which had opposed both changes,
were unable to stop them (Strahan 2003, 111–14).
While these moves undid two of the mistakes of the
New Deal, the added competition also worsened
the savings and loan crisis of the 1980s. In a similar
vein, the Gramm-Leach-Bliley Act of 1999 removed
long-standing prohibitions against mixing banking
with insurance and investment banking. While this
initially had little effect, it prepared the way for a
move toward a European model of combined com-
mercial and investment banks. The recent takeovers
of Bear Stearns by JPMorgan Chase and Merrill
Lynch by Bank of America show this model coming
to fruition. While the diversification should provide
greater stability, the increased lack of transparency
permits abuses, and there may be losses in innovation
(Brown 1995).
Less obvious, but more important in explaining the
current financial crisis, was the general regulatory
laxness springing from Chicago School beliefs about
perfect markets and a push for deregulation by a
newly resurgent Republican Party. In this climate,
devious methods of evading Depression-era rules lim-
iting leverage, such as collateralized debt obligations
and credit default swaps, were celebrated as American
financial innovations, instead of being tightly regu-
lated. Increased leverage is very profitable when asset
prices are increasing. But when prices fall, leverage
magnifies the loss and forces banks to cut lending to
build their suddenly inadequate reserves.
The world also has become more interdependent.
Successive tariff reductions and the integration of
financial markets have reduced nations’ economic
independence. Events such as the financial panic in
Thailand in 1987 and the Russian meltdown in 1998
affected American markets (Kindleberger and Aliber
2005), but the main effect is now in the other direc-
tion. We are currently seeing a wave of European bank
failures springing from the integration of European
and American financial markets, and the falling
American stock market has sparked even larger share
declines in most foreign countries.
Lessons Learned and Remaining Problems
As this history shows, there have been substantial im-
provements in financial regulation since the founding
of the republic. The growth-oriented structure of the
economy has transformed the United States into the
world’s leading economy. This means that we have be-
come less vulnerable to other countries’ problems. For
example, the American economy experienced robust
growth during the 1990s, while Japan, the world’s
second-largest economy, had a prolonged downturn.
We have abandoned the idea of basing our currency
on specie. By the end of the nineteenth century, we
had learned that Alexander Hamilton was wrong to
base currency on gold and silver. The Great Depres-
sion subsequently taught us that the gold standard’s
utility in combating inflation and preventing currency
debasement were not worth the cost of artificially
limiting the money supply and rapidly transmitting
one country’s problems to others. We also have partly
accepted that without a gold standard, it is necessary
to regulate the financial system more closely. For most
of the post–World War II period, we have had much
more regulation of financial intermediaries than in
any other period of our history.
In a similar vein, by 1913, we had come to under-
stand that the country needed a lender of last resort,
and after looking closely at the lessons of the Great
Depression, we have come to accept that it is the job
of the lender of last resort to actually lend during eco-
nomic crises (Bernanke 1983; Friedman and Schwartz
1963; Temin 1989). We have also come to accept
that some level of deposit insurance is necessary to
prevent runs on banks during financial crises. The
abrupt cessation of bank runs after deposit insurance
was introduced during the Great Depression made a
lasting impression.
Finally, we have made some advances in international
cooperation. The last-minute frantic negotiations of
Financial Regulation in the United States 607
 the nineteenth and early twentieth centuries have
been replaced by regular meetings of the world’s lead-
ing economies, and we have developed international
bodies such as the World Bank, the International
Monetary Fund, and the GATT (General Agreement
of Tariffs and Trade) structure to stabilize the world
economy and prevent foolish mercantilist responses to
major financial crises.
Asymmetric information can also enable people with
the information to exploit others, as happened with
the Knickerbocker Trust in 1907 and Bernie Madoff
in the recent period. In recent years, we have tried to
guard against this by regulation, auditing of financial
statements, and more transparent accounting meth-
ods. But, as the recent downturn illustrates, these
measures have not solved the problem.

Unfortunately, there are a number of problems that Leverage. A generally bigger risk problem has been
remain, most of which are not easy to solve. One set the combination of excessive leverage and increas-
of problems revolves around the risky practices of ing loan longevity. If a home borrower puts down
the private sector. The other set deals with problems 20 percent of the value of a house and the loan is for
within the regulatory structure. five years, a 10 percent drop in price will not alter the
incentive to pay the loan back. But in recent years,
Private Sector Risk borrowers have been allowed to put down as little as 1
The private sector is organized to encourage risk percent of the home value. Given the same 10 percent
taking. This is necessary because most people are drop, the borrower now owes much more on the
risk averse and are normally unwilling to embrace house than it is worth, giving him or her an incentive
innovations that maximize economic growth. From to default.
its inception, the United States has adopted policies
to encourage the private sector to adopt innovations, In the early days of the republic, the average loan
which encourages growth. The most significant in- was made for a short period of time, typically to
novation was the development cover the costs of planting or
of the corporate form, which harvesting. But as time went
enables people who are not In the early days of the republic, on, the length of loans and the
involved in a firm to invest in the average loan was made for leverage increased. As early as
it and earn a return on their a short period of time, typically the 1837–43 depression, bank
money. This encourages saving. to cover the costs of planting failures resulting from exces-
In order to encourage people to sive loans made on insufficient
or harvesting. But as time went
invest, they must be at risk only capital bases worsened the de-
for the money invested in the on, the length of loans and the pression in many Western states
corporation. This reduces inves- leverage increased. (McGrane 1965). In most of the
tors’ incentives to acquire infor- later downturns, the pattern of
mation on their investments, increasing leverage and longev-
while enabling large corporations that are likely to be ity during upturns and problems de-leveraging during
more difficult to control. downturns lengthened the recession or depression.
In the upturn in 2001–7, the amount of leverage got
Much of the financial services industry mediates out of hand. By the end of the upturn, U.S. banks
this process. Banks offer a fixed, riskless return to were leveraged at 35 to 1 (a small amount of share-
depositors and then use their superior information to holder equity to invest in a large amount of assets),
reinvest these deposits for a profit. Brokers take fees and hedge funds and investment bank subsidiaries
for advising people which firms to invest in. Invest- had even higher leverage. Many European banks are
ment bankers and hedge funds take fees for directly in worse shape than ours, despite the lack of subprime
investing the money given to them. The major mortgages in Europe, because their banks were lever-
problem is that the financial system, which was set aged at an even higher 61 to 1 (Zakaria 2009, 31).
up to encourage risk taking, often overencourages
risk taking. In the financial sector, three forms of risk Financial innovation. While financial innovations
taking have been particularly important in deepening usually do bring the promised benefits, most also in-
recessions. crease risk. In the nineteenth century, the moves from
family banking to financial trusts and from building
Poor information. The increasing size of financial societies to savings and loans to national savings and
firms and their increasing propensity to outsource loans reduced transparency and led to the collapse of
decisions can easily leave depositors, investors, national savings and loans during the 1893 depression
counterparties—and even the firms themselves—with and to the opaque trusts that failed in 1907. Buy-
insufficient information to make sound decisions. ing on margin is often seen as one cause of the 1929
The recent reliance on mortgage companies to initiate crash. In the current era, hedge funds, collateralized
subprime loans illustrates the problem, as does the debt obligations, and credit default swaps, largely
complex tranching in instruments such as the CDO. designed to get around regulatory limits on leverage,
608 Public Administration Review • July | August 2009
were all hailed as examples of the genius of American
financial engineering.
Risk cycles. Finally, it should be emphasized that risk
taking is cyclical. When times are good, financial
institutions increase risk, lured by the siren song of
higher profits. When times are bad, financial institu-
tions cut back on leverage and increase reserves. The
nearer the previous downturn and the greater the
harm it caused, the more financial risk is restrained.
Much of the restraint of the postwar era was caused
not by regulatory brilliance but by memories of the
Great Depression. Likewise, one can make the case
that the excessive risk taking in the current period,
with its successive bubbles, is attributable to the fact
that the period from 1991 to 2007 was distant from
any major downturn and was only briefly interrupted
by the mild 2001 recession.
Structural Problems
The regulatory structure established to deal with these
problems is itself beset by a number of structural
problems that inhibit effective regulation. There are
problems with goals, regulatory coverage, incentives,
and political interference.
Conflicting goals. Perhaps the most basic structural
problem is the inherent conflict between growth and
stability. The United States is a capitalist country with
a laissez-faire ideology. Most Americans believe that
the private sector is more efficient than the public
sector, and businesspeople generally view regulation
as a burden that inhibits growth and makes them
less competitive. This view is not a fantasy. Excessive
regulation can indeed make industry less efficient
and weaken a firm’s competitive position (Demirgüç-
Kunt, Laeven, and Levine 2004). This is particularly
true for the financial sector, where most firms are not
just competing with other local firms but also with
firms in other states and countries.
It is one of the clichés of regulation that problems
are most likely to arise when the agency has both
a promotional and a regulatory function. But for
many financial regulatory agencies, the dual role is
a necessary one. Neither the Federal Reserve nor the
SEC wants America’s financial sector to lose business
to firms in other countries. But both agencies want
to restrain the sector from taking excessive risks. This
means that they are continually walking a tightrope,
and, when one is doing this, it is easy to fall off. This
problem is worst for the SEC, which regulates the
sector of the financial market most in competition
with other countries. Looked at in this light, the
SEC’s generally condemned 2004 decision to increase
allowable leverage to up to 40 to 1 from 12 to 1 is
more understandable (Labaton 2008). It is clear from
the accounts of the meeting that the agency under-
stood the possible risks, but it placed more emphasis
on enhancing the international competitiveness of the
American financial industry (SEC 2004).
Unregulated entities. One of the largest problems is
unregulated or weakly regulated parts of the financial
structure. As we have seen, throughout the nineteenth
century, there was little effective national regulation of
the financial sector, and state-level efforts were mixed
at best. The federal government did not seriously
attempt to regulate the financial sector until the early
part of the twentieth century. However, by the end of
World War II, there was little unregulated activity.
The past quarter century has seen an upsurge in
deregulatory activity, which again has left us with im-
portant parts of the financial sector unregulated. This
has led to four types of problems. The most obvious is
that the depositors, investors, or shareholders in such
firms may suddenly lose all the wealth they have com-
mitted to these firms. As the lack of regulation is likely
to increase leverage, this should happen frequently
during downturns. In and of itself, however, this is not
a reason for regulation. Regulation of these entities is
needed because of the risk to those not directly con-
nected with the unregulated firm. The most immedi-
ate risk is to the unregulated firm’s counterparties—
those at the other end of their transactions. These
may lose when the firm fails to deliver the insurance
it promised, defaults on a promise to pay depositors
back, or demands early repayment of its loans. If the
unregulated sector is large, there may also be spiral
risk, when small downturns lead to large losses and
cause unregulated firms to dump securities or other as-
sets on the market. This drives down the value of more
conservative firms’ financial assets, increases defaults
by those to whom they have lent money, sets off a
run by depositors in these institutions, and puts them
in danger of bankruptcy. Finally, the presence of an
unregulated sector is likely to weaken the regulation
of the regulated sector, as firms in the sector complain
that their regulation puts them at a competitive disad-
vantage, and regulators weaken regulation to prevent
flight from their base of regulated firms.
Too many regulators. Even when all firms are
regulated, regulation can be weakened by too many
regulatory entities. In the period between 1836 and
1863, when there was no federal regulation of bank-
ing, the states had wildly uneven regulatory regimes.
States with strong regulation, such as Louisiana, had
fewer banking problems, while states such as Michi-
gan, which oscillated between too little and too much
regulation, had more.
After 1863, the Comptroller of the Currency was
unable to gather all the banks under its aegis because
banks preferred to be subject to state regulators, which
allowed the branch banking that the Comptroller
thought imprudent.
Financial Regulation in the United States 609
 Decisions made during the Great Depression exacer- bank holidays of the 1830s, the J. P. Morgan rescue in
bated the problem of multiple regulators. President 1907, the inflation of the currency during the Great
Roosevelt established separate regulatory commissions Depression, and the FDIC’s recent decisions to extend
for every financial sector, but he did not dismantle deposit insurance on banking deposits to $250,000
state supervision over parts of the financial sector. and to extend coverage to money markets. This leads
Over time, each of these commissions came to view people to expect this kind of behavior in downturns
their turf as something to be defended against other and makes them more inclined to take risk during
areas rather than as part of an integrated financial upturns. To prevent this risk, it is necessary to increase
system. As the terms of trade moved against an area, the level of regulation during upturns, which, as we
regulators were tempted to lighten regulation to help have seen, government has little incentive to do.
“their” sector survive. This was a major factor in the
savings and loan crisis of the 1980s, and has contin- On the other end, when the lack of such regulation
ued to be important, as is shown by the Thrift Com- leads to another crisis, it is necessary to take firm
mission’s overly lenient treatment of IndyMac Bank action to rescue financial intermediaries, depositors,
(Heisel 2008). and borrowers from their own foolish actions and the
foolish actions of others. But because giving things to
Political incentives. The primary incentive of politi- people who have been foolish and making those who
cians is to get elected, either for their own sake or as a have not pay for it is politically risky, both regulatory
means of changing policy (Mayhew 1975). Financial agencies and governments take half steps in the early
regulation is an important and complex subject about part of financial crises and only take the necessary
which voters know almost nothing and politicians steps when the public panics and is willing to support
only a little more (Schroedel 1986). In normal times, almost any action.
when the economy is doing well, elected officials
have little reason to incur the costs of imposing more Recommendations
regulation and can gain needed financial support by Because most of these problems arise from fundamen-
weakening regulation. As we shall see when we look at tal factors that are unlikely to change, we think there
moral hazard, this is precisely is only a limited amount that can
the wrong thing to do. be done, and most solutions will
Because most … problems arise come with trade-offs against new
Regulatory agencies. Regula- from fundamental factors that problems. That said, here are a
tory agencies are basically risk are unlikely to change, we think few suggestions:
averse. They gain from doing a there is only a limited amount
good job, as seen by politicians Enhance transparency. The poor
and the industry. But strong
that can be done, and most information problems could be
regulation that inhibits finan- solutions will come with trade- helped by further transparency. It
cial intermediaries from mak- offs against new problems. is in the interest of all to insist on
ing profits is likely to result in standardized accounting reports
pressure from the industry and with asset values in noncrisis peri-
Congress. Seeking to prevent new financial techniques ods marked to market, in order to strengthen internal
such as derivatives that enable financial intermediar- controls within firms and provide accurate informa-
ies to evade regulation or increase risky behavior will tion on bank activities to shareholders and deposi-
meet opposition from the trade associations and from tors. Confining auditing firms to auditing and rating
their captive politicians. Therefore, it is more political- agencies to rating and rewarding them for long-term
ly expedient for regulators to concentrate on prevent- accuracy would help. Reducing the number of layers
ing embezzlement and other criminal behavior than in financial transactions is also desirable.
to ensure that financial innovations are prudent, even
though the latter are likely to do more harm in the Limit leverage. Leverage problems would be reduced
long term. Political pressure is less influential when by the application of firm caps on leverage that apply
applied to the Federal Reserve, which has considerable to all of the players, something that would probably
formal independence and an independent source of require international agreement. In a similar vein,
finance, and is more important in the smaller financial there should be close scrutiny of complex and highly
regulatory agencies. leveraged investment options. We would also give
regulatory agencies the power to ban new financial in-
Moral hazard. Governments tend to underestimate novations and have them test such innovations to see
moral hazard during upturns and overestimate it dur- whether they reduce transparency and increase risk.
ing downturns. When the banking system gets into
trouble, it is typically rescued by policies that stop Expand regulatory coverage and consolidate
those who have made risky decisions from bearing regulatory authority. Solving many of the regulatory
the full consequence of their errors. Examples are the structure problems would require massive and
610 Public Administration Review • July | August 2009
unlikely changes in our governmental structure. But
bringing all financial entities under regulation, mov-
ing regulation of all financial players to the federal
level, and greatly reducing the alphabet soup of regu-
latory agencies—possibly to just the Federal Reserve
and the FDIC—would, in our opinion, be helpful
moves, even given their possible downsides. We also
think the structure of regulatory agencies that have
to weigh growth and stability should look more like
that of the independent Federal Reserve and less
like that of the SEC. While the Fed’s independence
sometimes has led it astray, we have been impressed
by what has been achieved by an independent Fed
during the current crisis. It would also be nice if
the media and politicians focused more on impend-
ing risk than on juicy stories of Ponzi schemes and
malpractice, but we have no expectation that this
will happen.
Swift and coordinated regulatory action in times of
crisis. We feel it is worth pointing out that the major
government actions during the current crisis have
been far better than those of the government during
the Great Depression. The postcrisis actions of the
George W. Bush and Barack Obama administrations
have been generally in the right direction. There was
some cooperation during the transition between the
two administrations, and both coordinated their ac-
tions with those of the Federal Reserve. They also have
tried to address the issues by using both fiscal and
monetary solutions.
Finally, it is worth noting that most proposed reforms,
our own included, have downsides as well as upsides.
History tells us to look before we leap.
References
Bernanke, Ben S. 1983. Nonmonetary Effects of the
Financial Crisis in the Propagation of the Great De-
pression. American Economic Review 73(3): 257–76.
Bodenhorn, Howard. 2003. State Banking in
Early America: A New Economic History. New York:
Oxford University Press.
Brown, J. Robert, Jr. 1995. “The Great Fall”: The
Consequences of Repealing the Glass-Steagall Act.
Stanford Journal of Law, Business, and Finance 2(1):
129–45.
Bruner, Robert F., and Sean D. Carr. 2007. 1907:
Lessons Learned from the Market’s Perfect Storm.
Hoboken, NJ: Wiley.
Christiano, Lawrence, Roberto Motto, and Massimo
Rostagno. 2003. The Great Depression and the Fried-
man-Schwartz Hypothesis. Working Paper no. 03-18,
Federal Reserve Bank of Cleveland. http://www.
clevelandfed.org/research/workpaper/2003/
wp03-18.pdf [accessed March 30, 2009].
Council of Economic Advisers. 2008. Economic
Report of the President 2008. Washington, DC:
Government Printing Office. http://www.gpoaccess.
gov/eop/ [accessed March 30, 2009].
Demirgüç-Kunt, Asli, Luc Laeven, and Ross Levine.
2004. Regulations, Market Structure, Institutions,
and the Cost of Financial Intermediation. Journal of
Money, Credit and Banking 36(3): 593–622.
Eccles, George S. 1982. The Politics of Banking. Provo:
University of Utah Press.
Eichler, Ned. 1989. The Thrift Debacle. Berkeley:
University of California Press.
Federal Deposit Insurance Corporation (FDIC). 2008.
Failures and Assistance Transactions. http//www2.
fdic.gov/hsob/selectRpt.asp?EntryTyp=30 [accessed
March 30, 2009].
Friedman, Milton, and Anna Jacobson Schwartz. 1963.
A Monetary History of the United States, 1867–1960.
Princeton, NJ: Princeton University Press.
Gulick, Luther. 1933. Politics, Administration, and
the “New Deal.” Annals of the American Academy of
Political and Social Science 169: 55–66.
———. 1937. Notes on the Theory of Organizations.
In Papers on the Science of Public Administration, ed-
ited by Luther Gulick and Lyndall Urwick, 79–87.
New York: Institute of Public Administration.
Harriss, C. Lowell. 1951. History and Policies of the
Home Owners’ Loan Corporation. New York:
National Bureau of Economic Research.
Hegel, Georg Wilhelm Friedrich. 1837. The Philosophy
of History. Translated by James Sibree. New York:
Colonial Press, 1899.
Heisel, William. 2008. Mortgage Woes Hit Downey
Savings and Loan. Los Angeles Times, July 24.
Kane, Edward J. 1989. The S&L Insurance Mess: How
Did It Happen? Washington, DC: Urban Institute
Press.
Kindleberger, Charles P., and Robert Z. Aliber. 2005.
Manias, Panics, and Crashes: A History of Financial
Crises. 5th ed. Hoboken, NJ: Wiley.
Labaton, Stephen. 2008. Agency’s ’04 Rule Let Banks
Pile Up New Debt. New York Times, October 2.
Lee, Susan Previant, and Peter Passell. 1979. A New
Economic View of American History. New York:
W. W. Norton.
Mason, David L. 2004. From Buildings and Loans to
Bail-Outs: A History of the American Savings and
Loan Industry, 1831–1995. New York: Cambridge
University Press.
Mayhew, David R. 1975. Congress: The Electoral
Connection. New Haven, CT: Yale University
Press.
McGrane, Reginald Charles. 1965. The Panic of 1837:
Some Financial Problems of the Jacksonian Era. New
York: Russell & Russell.
Morris, Charles R. 2008. The Trillion Dollar Meltdown:
Easy Money, High Rollers, and the Great Credit Crash.
New York: Public Affairs.
Peretz, Paul. 1983. The Political Economy of Inflation in
the United States. Chicago: University of Chicago
Press.
Financial Regulation in the United States 611
 Poulson, Barry W. 1981. Economic History of the United
States. New York: Macmillan.
Schlesinger, Arthur M., Jr. 1958. The Coming of the
New Deal, 1933–1935. Boston: Houghton Mifflin.
Schroedel, Jean Reith. 1986. Campaign Contributions
and Legislative Outcomes. Western Political Quar-
terly 39(3): 371–89.
———. 1994. Congress, the President, and Policymak-
ing: A Historical Analysis. Armonk, NY: M. E.
Sharpe.
Securities and Exchange Commission (SEC). 2004.
SEC Open Meeting, Wednesday, April 28, 2004,
2:30 pm, Agenda Item 3: Alternative Net Capital
Requirements for Broker-Dealers That Are Part of
Consolidated Supervised Facilities and Supervised
Investment Bank Holding Companies [audio
recording]. http://www.sec.gov/news/openmeetings.
shtml [accessed March 30, 2009].
Strahan, Philip E. 2003. The Real Effects of U.S. Bank-
ing Deregulation. Federal Reserve Bank of St. Louis
Review, July/August, 111–28.
Sylla, Richard Eugene. 1975. The American Capital
Market, 1846–1914: A Study of the Effects of Public
Policy on Economic Development. New York: Arno
Press.
Temin, Peter. 1989. Lessons from the Great Depression.
Cambridge, MA: MIT Press.
U.S. Census Bureau. 1975. Historical Statistics of the
United States. Vols. 1–2. Washington, DC: Govern-
ment Printing Office.
U.S. Department of Commerce. 1975. Historical
Statistics of the United States: Colonial Times to 1970,
Parts 1 and 2. Washington, DC: Government Print-
ing Office.
White, Lawrence J. 1991. The S&L Debacle: Public
Policy Lessons for Bank and Thrift Supervision. New
York: Oxford University Press.
Worsham, Jeffrey. 1997. Other People’s Money: Policy
Change, Congress, and Bank Regulation. Boulder,
CO: Westview Press.
Zakaria, Fareed. 2009. Worthwhile Canadian Initiative.
Newsweek, February 16, 31.

FOUNDATIONS OF PUBLIC ADMINISTRATION

Let PAR be your Guide to discovering the Treasures in the

ongoing and historical work of Public Administration….

The Foundations of Public Administration Series is a collection of articles

written by experts in 20 content areas, providing introductory essays and
recommending top articles in those subjects. Introducing:

Administrative History as a Core Dimension of

Public Administration
By: Jos C.N. Raadschelders
University of Oklahoma

The Foundations Series for Human Resources also includes a sample

Syllabus and Select Readings from PAR on Administrative History.

Login at http://www.aspanet.org and click on “Public Administration Review”,

and ‘Foundations of Public Administration’. Select ‘Administrative History’

612 Public Administration Review • July | August 2009