Interstate Banking: The Reform That Won’t Go Away

Of the policies that have actually weakened the U.S. banking system, among the most important are long-standing restrictions against interstate branching. Its long history of unit banking places the United States in a unique position among nations with developed banking systems.

  Current law, based on the McFadden Act of 1927, the Banking Act of 1933, and the Bank Holding Company Act of 1956, with their amendments, allows each state to establish its own policies concerning the ability of out-of-state banks to enter the state’s market. Some 30 states and the District of Columbia have reached reciprocal interstate banking agreements with states or other groups of states. Four other states permit banks from any state to operate within their boundaries. Over three-fourths of these 34 states limit such interstate banking to purchases of in-state banks by out-of-state bank holding companies as opposed to allowing out-of-state banks to set up completely new branches. The other one-fourth permit de novo branching. The remaining 16 states allow no interstate banking at all.

 After the panic of 1907, branch banking was considered as a means of avoiding future crises, but it lost out in the political battle to the formation of a central bank.

When the banking industry collapsed in the early 1930s, nationwide branch banking wasproposed again but was rejected in favor of federal deposit insurance.

 The National Banking Act of 1863 created the national banking system, andwhile it did liberalize many banking laws, it did not form a branch banking system. The states retained control overbranching, and most of them prohibited it. Although branching regulations were subsequently relaxed in many states,they were never made liberal enough to contribute to the national system's stability.

With limited country-bank support, the law approved in 1913 to deal with the recurring panics called for 12 FederalReserve banks, with partial federal government control but with control really based on the New York Fed.

In brief, central banking was a compromise erected in response to theNew York banks' desire for continued hegemony, plus the country bankers' opposition to branch banking.

The establishment of the Federal Deposit Insurance Corporation (FDIC) "weakened theprevious sense of urgency to modify federal statutes regulating branching."

deposit insurance was not new. It had been tried in several states after the panic of 1907, and in each casewhere it was introduced, problems quickly arose. First, by making banks pay into a fund out of their own assets, thestates faced an incentive problem. Because they bore only a fraction of the added risk of failure, banks began to holdmore risky portfolios. Second, deposit insurance could do little to save banks when the economy turned bad. Asagricultural prices fell in the late 1920s, banks in states with insurance plans began to collapse, and the insurancefunds dried up. By early 1930 all eight state funds had gone bankrupt.

The McFadden Act of 1927 and the Banking Act of 1933, which are still in effect, prohibit banks headquartered in onestate from operating additional deposit-taking offices in any other state.

Douglas Amendment to the Bank Holding Company Act of 1956,which prevented holding companies from owning a bank in another state without that state's permission. Until around1980, this legislation effectively checked interstate operation of full-service banks or branches.

Taken together, diverse portfolios and easier funds movement help explain the superiority ofbranch banking in preventing and handling crises and panics. Restrictions on branching kept the bank small and prevented them from adequately diversifying, thereby increasing their risk of failure. In the absence of these restrictions, bank failures in the 1920s and1930s would have been significantly reduced.

 thatmonopolization of the banking industry is not a likely outcome of nationwide branching.

 Branch banking encourages a higher quality ofmanagement, thereby reducing the risk of crises and failure. In Canada, it should be noted, the Canadian BankersAssociation has historically been ahead of its U.S. counterpart in providing the educational and training programsneeded to develop the qualified bankers necessary for branch banking.

 loan decisionsare usually left up to local branch managers and loan officers; only in cases of very risky or large loans do suchdecisions go to the head office

 Econometric evidence on market shares in states that permit unrestricted branching indicates that branches do not increase market shares to any potentially troublesome degree. Although the number of firms shrinks, the number of offices increases, and any possible adverse effect on prices is compensated for by increases in services and office hours.

 only at market shares and concentration ratios, many of the previously cited studiesunderstate the degree of competition in a branched banking industry.