Jeffrey M. Lacker

English

Research Papers in Economics

O
ne of the Federal Reserve’s
most important duties is
to make sure that the na-
tion’s financial system is stable.
But how should we and other
bank regulators go about achiev-
ing this goal? That’s a large and
complicated question.
In  many ways, the banking
industry in the United States was
shaped by the events of the 1930s.
The collapse of a number of
financial institutions led to regulations that limited the activi-
ties of banks. This was meant to shelter them from risk and to
prevent additional collapses. At the same time, efforts were
made to protect the consumer from another wave of bank fail-
ures. In particular, the federal government began insuring
deposits through the Federal Deposit Insurance Corporation.
A quick glance at the post-Depression history of the
banking industry would seem to vindicate these decisions.
Until recently, many of the regulations that went on the
books in the 1930s were still in operation — and overall, the
industry has been quite stable, with relatively few failures.
But does this necessarily mean that such regulations were
the best — or only — course of action? I don’t think so.
In fact, research suggests that the collapse of the 1930s
could have been averted — or at least would have been 
considerably less severe — had the regulation of the banking
industry been less restrictive prior to the Depression. As the
cover story in this issue of Region Focus discusses, branch 
banking has grown dramatically in the United States in 
the past decade. Freed from regulations that confined their 
business activities to specific states or geographic regions,
some banks are now operating on a nearly national scale,
with branches throughout the country.
At first blush, such expansion might seem like a poten-
tially risky phenomenon. After all, the bigger an institution 
gets, the more it has to lose, right? At one level this is correct:
The collapse of a large bank with branches in numerous 
areas would pose a significant problem to the nation’s finan-
cial system. 
But the data pose an interesting problem for proponents 
of regulation. Prior to the Depression, some states pro-
hibited branch banking while others allowed it. In addition,
some states already had deposit insurance programs of their
own. How did the different states fare? On balance, banks
in states that permitted branch banking and did not adopt
deposit insurance programs performed better than banks in
states with tighter regulatory environments. 
Deposit insurance programs presented a moral hazard
problem: Some banks got too big too fast, secure in the 
knowledge that there was a safety net to protect them from
bad business decisions. The problem was particularly acute in
heavily agricultural states, where banks loaned freely during
the agricultural boom of 1914 to 1920, but faced hard times
when farm goods prices began to fall. In fact, all the state
deposit insurance fund systems collapsed during the 1920s.  
Meanwhile, branch banking proved quite successful. As
Columbia University economist Charles Calomiris has writ-
ten, “States that allowed branch banking saw much lower
failure rates — reflecting the unusually high survivability of
branching banks — and responded well to the agricultural
crisis by consolidating banks and expanding branching sys-
tems, where this was allowed.”
Consider an example from the Fifth District: South
Carolina. Its economy, like those of other primarily agricul-
tural states, was hurt by the drop in farm prices during the
1920s. But its banking system stood up relatively well — as
did the banking systems in most other states that 
permitted branch banking. 
The success of branch banking may seem counterintu-
itive. It might appear that a bank with branches spread
throughout a region is especially risky since that bank often
has more to lose than a bank with just one office. But the
very fact that a bank has a large and diversified portfolio
actually enhances its stability. Its risk is spread over a wider
pool, meaning that if business is ailing in one area, others
may remain healthy. 
In  contrast, the more geographically concentrated a 
bank’s depositor base and lending clientele, the more risk it
faces. In such a world, if one segment of its customers is 
facing problems, it’s likely that other parts are as well. This 
can put a bank under severe, and perhaps fatal, pressure — and
is arguably what happened to many banks during the 1930s.
So, overall, I think that we should look at the deregula-
tion of the banking industry and the resulting rise of inter-
state branch banking as a welcome occurrence. The U.S.
financial system, I believe, will become more efficient over
time. And for the reasons I have discussed, I think it also will
become more stable. Both are healthy trends for consumers.
NOTEW ORTHY
Does Deregulation Undermine Stability?
Winter 2005 • Region Focus 1
JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND
RF Winter 04 FINAL.ps - 1/10/2005 13:56 PM

Noteworthy : Does deregulation undermine stability?

http://www.richmondfed.org/publications/research/region_focus/2005/winter/pdf/noteworthy.pdf

Noteworthy : Does deregulation undermine stability?

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