The banking crisis isn't over

There was those in the 1930s who did not think Federal deposit insurance was a desirable reform. When temporary deposits. insurance was enacted beginning in 1934, there was one banker who refused to join. John M. Nichols advocated 100% reserve banking, and practiced what he preached. Nichols was president of the First National Bank of Englewood, Ill., established in 1891 on the south side of Chicago. He earned his nickname "100%" as a result of his move early in the Depression to liquidate his non-U.S. government securities and loans and hold almost exclusively cash and government securities. Nichols' was the only one of the 6,000 banks required to subscribe to Federal deposit insurance to refuse to join the FDIC.

Nichols was not alone in his view that banks primarily were responsible to their depositors and stockholders. Because many loans were risky during the early 1930s, he advocated the holding of only safe assets. At the same time, proposals came from a number of prominent economists who began to question whether it was desirable for banks to provide both depository and lending functions. In March, 1933, economists at the University of Chicago--including Henry Simons, Frank Knight, Lloyd Mints, and Paul Douglas (later a U.S. senator)--circulated a proposal that also called for the abolition of fractional reserve banking. The plan would separate the deposit and lending functions of banks. A Federal Monetary Authority would be in charge of conducting the monetary policy under definite rules established by Congress. These views were based fundamentally on Article 8 of the Constitution, which gives Congress the sole right to coin money and protect the value thereof. Private banks have usurped this power, and the proposals to abolish fractional reserve banking sought to return control to Congress as the Constitution had intended.

The views expressed by these economists thus can be summarized: Since bankers could be presumed to put their own self-interests above those of society and politicians had a penchant for abusing the lending powers of government, it would be in society's best interests to separate the respective banking functions and have Congress make definitive provisions for each. The supporters of this proposal believed that it would reconcile the divergence of private and public interests in a manner consistent with the problems of centralization of economic and political power. The worst possible combination would be to have the government insure commercial lenders' deposits and then leave lending discretion to the banks. The over-all vision was of a financial system with deposit banks serving essentially a warehouse function as trustees, small mutual savings associations for lending, and a centralized monetary authority.

The financial system's role today

The 1930s alternative banking reform proposals concluded that Americans do not need banks to serve both a depository and lending function. This mixture of deposit and credit functions has continued to provide an unstable and risky banking structure, which is supported through deposit insurance and an extensive Federal safety net. The recent taxpayer bailout of the thrift system and the losses experienced by the bank insurance fund indicate some of the weaknesses in this safety net. Also, the use of deposit insurance has given the poorest bank lenders the same access to funds as the most discerning ones--a result that is unlikely to have led to an optimal allocation of credit. This misallocation, although it has received little attention, probably has had a cost to the economy far in excess of the taxpayer bailout of the thrift industry.