Death of a Middleman: The Banking Crisis and the Role of the Securities Markets in

Comparative Historical Perspective

Oren Litwin1
15 July 2009

Introduction

As the financial crisis unfolds, interested parties from all sides of the political spectrum have
been quick to assign blame. To some (for example Krugman [2009]), the banking crisis was
caused by deregulation and the fruits of unrestrained capitalism. To others, the crisis was set off
by government incentives for risky behavior by mortgage lenders, particularly through asset
securitization by Fannie Mae and Freddie Mac. While each of these explanations is partly true,
both miss the larger structural reasons that led to the conditions the two sides decry. This paper
hopes to remedy this lack by employing a comparative approach. The history of the American
banking system, which at present is tightly intertwined with the securities markets, will be
compared to that of Germany, which has a reputation for excessive control by banks and weak
securities markets. Surprisingly, neither of these two characterizations used to be true—and the
history of how each system changed over time illuminates the roots of the modern crisis, and
where to go from here. Briefly, the American banking sector has been slowly dying for the last
few decades, unable to compete with the strengthening capital markets—and this paper argues
that we should stop propping up the corpse and let it finally molder away.
This paper argues that the financial systems of the United States and Germany diverged in
their logic because of the effect of bank regulations on the availability of capital to industry. In
Germany, a banking environment with relatively few legal restrictions allowed for rapid
industrial growth by granting easy access to capital—not least through the Berlin securities
exchange, among the best in the world—despite Germany’s status as a late developer. The
United States, despite having built an advanced banking system fifty years earlier than
Germany’s, ran up to limits on growth in the second half of the 1800s due to the unit banking
system, which made the banking system more fragile and limited banks’ ability to provide
capital, stifling the development of large-scale industry. United States securities markets also
developed more slowly as a result. Perversely, this resulted in powerful banks gaining more
control over the American economy than would have happened otherwise.
The trajectories of both systems were radically altered in the 1930s. In Germany, the Nazis
deliberately throttled the securities markets as part of their campaign against finance capitalism;
after the war, the German economy was dominated by direct lending relationships with powerful
banks as a result, while the securities markets languished. In the United States, a federal
government hostile to the great power of the banks passed a series of laws to curb their power,
starting with the 1933 Glass-Steagall Act which divorced investment banking from commercial

1 This article is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 United
States License, described here: http://creativecommons.org/licenses/by-nc-nd/3.0/us/

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banking. After an initial period of capital scarcity and accompanying economic stagnation, this
had the effect of supercharging the development of the securities markets, as specialized
investment banks had strong incentives to foster financial innovation in securities. Interest-rate
controls enacted in 1966 accelerated this process and caused the banks to lose business to
money-market mutual funds and other direct investments. The competitive pressure caused large
commercial banks to take greater and greater risks to maintain profits and to circumvent Glass-
Steagall restrictions, culminating in the passage of the Gramm-Leach-Bliley Act of 1999
(GLBA), which repealed the provisions of Glass-Steagall preventing commercial banks from
participating in investment banking. Ultimately, however, banks are becoming increasingly
obsolete, and the damage caused to the financial system by their behavior is only made worse by
protective subsidies and preferential regulation by the government and the Federal Reserve.

Background

This paper takes inspiration from Hall and Soskice’s (2001) theory of institutional
complementarities. The authors argue that specific types of economic institutions will become
mutually reinforcing and lead to very different patterns of behavior. Liberal market economies
will tend to encourage interaction between firms based on supply and demand, and arm’s-length
transactions. Coordinated market economies, on the other hand, encourage interaction based on
strategic bargaining and large-scale coordination between actors. While these are ideal types and
both styles of behavior can be found in any economy, the tone will be predominantly set by one
of these logics. “In any national economy, firms will gravitate toward the mode of coordination
for which there is institutional support” (Hall/Soskice 2001:9; cf. Baliga/Polak 2004, Monnet/
Quintin 2007). In particular, access to capital in a liberal market economy is granted most often
through the capital markets; in coordinated market economies, capital is accessed via long-term
relationships with powerful banks (Hall/Soskice 2001:28). The United States is considered the ne
plus ultra of liberal economies, while Germany is a good example of a coordinated economy.
A given pattern of institutions constrains future development of the system, by making some
changes more attractive than others in the short-term—even when other changes might have
better effects in the long-term (North 1990:7). Institutions will also guide the behavior of actors
operating within them, by encouraging particular kinds of behavior, skills, and learning over
other kinds (North 1990:74). Consequently, the constellation of actors and institutions will
constrain each other’s development over time, causing the system as a whole to move according
to an inherent logic guided by past history (North 1990:99). This is often called path
dependency. Path-dependency effects are immensely powerful in the financial industry, in
particular when considering the interaction between two components: the banking sector and the
securities markets.
Firms trying to raise capital from investors 2 need two related things: information and control.
Investors must be able to tell whether a given firm is a good investment; additionally, they must

2 Firms have two means of raising capital: debt and equity. Borrowing money, either in a straight loan from a bank
or by issuing bonds, imposes a fixed payment obligation on the firm. Issuing equity, i.e. stock, carries no fixed
obligations, but rather a proportional claim on the profits of the firm. Equity is thus riskier but potentially more
lucrative for investors.

2
have some assurances that the firm will stay a good investment, and that managers will not
suddenly adopt risky practices once they can use other people’s money. Banks solve both
problems by extracting information from firms and exerting control over behavior through the
threat of withholding future credit. The public capital markets, on the other hand, are less able to
monitor firms and exert control than are banks. Thus, the markets will tend to only fund
companies that they trust (Calomiris 1995).
In general, high-quality borrowers will raise capital in the financial markets, while lower-
quality borrowers will turn to bank lending (Macey/Miller 1995). Whether a given firm will be
considered high- or low-quality depends heavily on the relative sophistication of the banking
sector and the financial markets. The better the markets, the easier for firms to get funding
through them (Boot/Thakor 2004). This means that the banking sector tends to lose monopoly
power as the markets reduce transaction costs, becomes more transparent, and develops
institutional responses that allow it to exert control over firms.
The foregoing stylized discussion assumed a dichotomy between the stock market and banks.
In fact, there are different kinds of banks and different banking systems. A bank that engages in
lending is called a commercial bank. An investment bank, on the other hand, provides services to
firms seeking capital on the securities markets; investment bank fortunes are tied to the markets,
and not to lending.
A bank that does both is called a universal bank. A bank might want to help a firm issue
securities, instead of lending money directly, in order to expand its client base and not to tie up
its own capital in a limited number of firms. Additionally, the fees for underwriting (facilitating
and marketing) a securities issue can be quite high, partly compensating for lost lending
business.
In environments of low information and high transaction costs, universal banks can fill an
invaluable role. A universal bank can establish long-term lending relationships with new firms,
giving them access to capital in exchange for a large degree of control over their activities.
Ideally, as a firm become more seasoned, the bank can help shepherd it up the “financial
pecking-order” of funding sources, moving from bank loans, to venture capital, to bonds, to
stock (each requiring more trust from investors), taking advantage of its lengthening track
record, visibility to investors, and the credibility of the sponsoring bank. Ultimately, the firm will
graduate to relying heavily on the capital markets, using banks for short-term credit and as expert
advisors in navigating the financial world (Calomiris 1995; cf. Fama 1985). This sequence
depends on the quality of the financial markets—if the markets are sluggish, firms will be forced
to rely more on banks for capital.
Universal banks will be less likely to foster the development of the capital markets and the
innovation of new financial products, all else equal, because the additional profit they receive is
offset by cannibalized lending business. Furthermore, such innovations are soon adopted by
competitors, reducing the potential gains if the banking system features heavy competition.
Specialized investment banks, on the other hand, are far more likely to innovate because they
have no lending business to sacrifice. And as the markets grow more sophisticated, they allow
the creation of new products that are even more sophisticated. The reciprocal development of the
markets and financial products conditions future innovation, in a classic example of a form of
path dependency called increasing returns (Boot/Thakor 2004).

3
 The German banking system allowed universal banks throughout its history. In such systems,
universal banks tend to overpower their specialized competitors because of sheer size and their
consequent influence over regulators. The United States, in contrast, enforced a segregated
banking system after 1933 where commercial and investment banks were rigidly divided. In such
systems, investment banks are given free rein. Due to the accelerated financial innovation in
segregated banking systems, commercial banks will end up losing much more market share than
they would in universal-banking systems (Boot/Thakor 2004).
As we shall see, the regulatory structure can have a large effect on the functioning of a
financial system. Regulations can improve the functioning of public markets by improving
transparency and lowering transaction costs (cf. Zingales 2009), and can improve the banking
system by reducing incentives for excessive risk-taking (cf. Lorenzoni 2008). Regulation can
also be harmful, especially when it impedes activity that is natural to the financial industry and
the prevailing state of technology. Transaction costs especially are a crucial driver of behavior
and institutional change. Activities that are prohibitively expensive within a particular
institutional framework can be extremely profitable in a different one (North 1990:95). In
particular, “The costliness of information is the key to the costs of transacting” (North 1990:27).
Therefore, the effectiveness of a particular regulation is directly related to the costs of
sidestepping it through some other means (Kane 1977).
Ultimately, as long as market participants are able to work around regulations, such
regulations will fail in their intended purpose: “Prototypically, bureaucratic controls and market
adaptation chase each other round and round, generating additional problems, confrontations,
and costs for society at large” (Kane 1977:56). Indeed, while the typical large firm is seen to be
hidebound and set in its ways, large firms facing burdensome regulation will be driven to seek
new and innovative methods of corporate organization or product design that allow them to
escape regulatory burdens, while performing much the same functions as before. This leads to
what Kane (1981) calls the Law of One Tax-Adjusted Price. For example, early Australian
banking law forbade banks from making advances on real estate.3 But by the 1850s, these
restrictions had become a dead letter due to legal and financial “ingenuity,” and Victoria repealed
them in 1888 (Hickson/Turner 2002).
In the discussion to follow, the following arguments will be made. Germany’s system of
large, branching universal banks featured very low transaction costs, allowing firms to easily
raise credit both from banks and then later from the securities markets. In contrast, the early
American banking system had very high transaction costs due to the unit-banking system, which
impeded the pooling of capital. Industrial development was stifled, and those banks that did
accumulate large amounts of capital developed tremendous power. Ironically, it was this power
that ultimately led to Glass-Steagall.

German Banking, 1830-1918

3 While a full discussion is outside the scope of this paper, banking-industry behavior is a primary contributor to
speculative bubbles in real estate. See Herring and Wachter (1999, 2002) for a theoretical and empirical analysis,
and policy proposals.

4
 Nineteenth-century Germany is a classic case for understanding the effects of a strong
banking system. Germany is considered to be a late industrializer, having developed heavy
industry considerably after Britain and other international competitors. Nevertheless, in short
order the German economy developed into the powerhouse of Europe. Gerschenkron (1962)
attributed Germany’s rapid industrialization to its powerful banks, who used their power over
industrial firms to organize them for large-scale, efficient production. While later research has
added some caveats to this story, the period remains a good demonstration of the interaction
between banks and the financial markets, and how banks benefit from large branching networks.
In Germany, private banking evolved in two flavors (Guinnane 2002). The first group of
private banks, many centered around the port of Hamburg and the trading hub of Cologne,
expanded into the lending and bill-discounting business from their core activities as merchants.
The second group, centered around Berlin, emerged only in the 19th century and was chiefly
involved in lending to the Prussian state and marketing its debt. German banks were generally
forbidden to issue private notes (not least because such notes competed with state debt), and
therefore initially relied on investors for their capital (Calomiris 1995, Guinnane 2002). This is in
contrast to the British experience, in which goldsmiths pioneered deposit banking and note issue
very early on, shaping the development of British banking practices (and later those of the
United States).
Private banks tended to be small, made up of individuals or family groups or partnerships
between investors (Guinnane 2002). (The Rothschild banking network is the archetypical
example, unusual only in its eventual size.) By about 1830, private bankers were providing
limited lending and investment banking services to new firms. Over time and as restrictions on
incorporation loosened, private bankers organized larger Kreditbanken (credit-banks), which
made it easier to raise money and finance large industrial projects like railroads.
Between 1848 and 1870, forty credit-banks were founded by private bankers; the credit-
banks operated in much the same way as private banks, but they tended to have much higher
levels of capitalization (Da Rin 1996). The Grossbanken tended to favor dealing with large firms,
creating what Gerschenkron called a “sectoral bias” (1962:10). “As early as 1853, the stated
policy of the Bank of Darmstadt was to concentrate on firms with a turnover of 50,000
Guilders” (Baliga/Polak 2004).
Another form of banking institution, which pioneered the use of mass deposits, was the
Sparkassen, or savings banks. These were meant to provide a place for the poor and middle class
to keep their savings; they were government-supported, sometimes government-owned, and
initially were required to invest their reserves in government debt, providing the provincial
governments with a cheap source of funds. (Competing banks often complained that the savings
banks were shown favoritism for that reason.) The savings banks developed the “banking habit”
among a wide strata of society, making it easier for the universal banks to begin accepting
deposits themselves in the 1890s (Guinnane 2002, Da Rin 1996). Additionally, credit
cooperatives formed in many places beyond the reach of the larger banks, allowing small, riskier
borrowers some access to finance (Guinnane 2002).
Private banks and credit banks were soon playing a key role in helping client firms issue
securities. Until the 1870s, almost all German bonds were issued by governments and railroads;
stock (much less common than bonds) was issued by railroads, banks, and industrial firms. To a

5
degree not found elsewhere, German private banks were heavily involved in helping the railroads
secure funding during the early part of the century. The banks typically purchased a large part of
the securities issues themselves for later resale (aside from what they took as their fee), as the
trading markets of the day were underdeveloped and could not handle high-volume issues
(Guinnane 2002). As a result, private banks were able to place their own representatives on the
boards of the companies they financed, giving them considerable control. Da Rin (2002) argues
that the banks’ equity holdings and control over industry gave them the incentives necessary to
actively organize the German economy for better growth.
In 1870, Germany liberalized the rules for forming joint-stock companies. This stimulated a
rush of corporate reorganizations and subsequent equity offerings; at the same time, many
private bankers cooperated to form new joint-stock banks (Burhop 2006). The 1870 law required
that new issues of securities be fully subscribed. Therefore, underwriters tended to be large banks
who could purchase the whole issue, and then resell it into the market over time (Fohlin 2002).
Banks marketing shares often chose to retain small equity stakes in their firms, or were forced to
retain equity if they could not market the whole issue. This gave them voting rights and
membership on the corporate board, much as the private banks had done previously (Fohlin
1999). Banks also held a great deal of stock in trust for clients, who typically signed over their
proxy votes to the bank. In this way, even once a bank had completely marketed a stock issue, it
could retain a great deal of power over the firm’s board (Guinanne 2002).
Germany saw a rapid boom in equity issues as banks helped the new firms raise capital; this
soon produced a glut of offerings, leading to a market crash in what was called the Panic of 1873
(Da Rin 1996).4 The Panic tended to increase firms’ reliance on the large banks. Investors were
much more cautious with their money, and banks became more important as a facilitator of
capital investment. Firms that lacked close ties with a major bank appear to have had much less
access to capital than those with such ties (Becht/Ramirez 2003). Additionally, Germany
instituted a series of shareholder protection laws, most notably the Corporate Law of 1884. This
included a mandatory one-year waiting period between incorporation and equity offerings, and
strengthened the power of the Aufsichtsrat (supervisory board) over management. As bank
directors often sat on these boards, the Corporate Law and others like it (such as the closing of
the futures markets) may have had the effect of strengthening the position of the banks over
management (Becht/Ramirez 2003).5
One law that had a significant impact was a new tax on market trades introduced in 1881.
This gave an advantage to banks, which could hold investors’ shares in trust and execute
transactions internally, only incurring taxes on net purchases and sales across the whole bank. As
a result, banks quickly gained custody over investors’ securities and trading shifted away from
the open exchanges—at least until the tax was extended to internal trades in 1900 (Fohlin 2002).
The banks took advantage of their new power to enforce exclusive relations with their firms,

4 The similarities between this sequence and the one leading up to the 1929 crash, described below, are instructive.
While a full discussion is outside the scope of this paper, it seems plausible that any sudden increase in liquidity or
investment capital leads to speculative bubbles and subsequent oversupply, as the market adjusts to the new
conditions. Cf. Fisher (2007:248-251).
5 However, Fohlin (2002) finds little quantitative evidence to support this point.

6
allowing the banks to gain more information about their borrowers and monitor them more
effectively (Da Rin 1996).
However, by the 1890s, the great banks had lost their power over industry; given the easy
entry of new banks into the business, the banking sector had become fully competitive
(Calomiris 1995). Additionally, firms were growing large enough to regain some control from the
banks and play them off against each other. While the early process of cartelization was often
bank-led, by the 1890s it was being run by the firms themselves, driven by technological
concerns (Da Rin 1996). In response, the banks went through a period of consolidation, trying to
regain their competitive edge by buying competing banks, incorporating more activities, more
size, and more geographic scale—becoming true “universal” banks, capable of accumulating the
savings of many depositors and providing financing and investment banking services to even the
largest cartels (Burhop 2006). Even then, however, the old era of exclusive relationships could
not last; large industrial groups often had relationships with several banks at once, and relied
more on self-financing through retained earnings and their increasing access to the financial
markets (Da Rin 1996; cf. Becht/Ramirez 2003). As part of this, industrial firms started placing
their own directors on the boards of their associated banks, especially banks that facilitated
securities offerings, in a pattern of interlocking directorates (Fohlin 1999).
Ultimately, the prewar German banking system consolidated into six Konzerns, affiliated
networks of local and regional banks tied closely to universal banks. The smaller banks allowed
universal banks to extend their reach across Germany and continue serving smaller borrowers
and local communities, which made the banking system as a whole much more stable due to
diversification; the networks also gave the large banks a ready market for securities issues
(Guinanne 2002, Da Rin 1996). Finally, the local banks could more easily monitor the sprawling
operations of German cartel groups, centralizing information and allowing the universal banks to
focus on relationships with the top management. The universal banks gave the smaller local
banks access to the financial markets and much greater capitalization. While both sides
benefited, there was no doubt that the universal banks ran the show (Da Rin 1996).
At the turn of the century, German firms relied considerably less that American firms on
long-dated debt issuance; with more advanced financial markets, they were able to raise money
with more advantageous terms, such as through equity (Calomiris 1995). The underwriting
spread (fee) for new issues was between 3 and 5 percent of an issue, much less than in the
United States in the same period. “German bankers’ spreads on equity were less than one-fourth
those in the United States. Small German firms were able to issue equity for less than the cost
large American corporations paid for issuing bonds” (Calomiris 1995:297). The German
universal banks were able to efficiently market new issues to their base of clients. This had the
effect, however, of cutting into their traditional lending business (Da Rin 1996).
The largest banks continued to grow, aided by a strong stock market that richly benefited
their investment banking business (Fohlin 2002, 2007). At the eve of World War I, 17 of the
largest 25 German firms were banks; the Konzernen also controlled access to the Berlin financial
markets, which were second only to the London markets on overall size and liquidity (Baliga/
Polak 2004, Fohlin 2007). WWI greatly accelerated the concentration of the banking sector, as
the state employed the largest banks to help raise funds for the war effort (Fohlin 2002). The
savings banks in particular played a key role; by the end of the war, German war loans made up

7
more than 35% of the Sparkassen’s assets (Guinanne 2002). This gave them crucial experience
that they later used in marketing general securities to the public.

American Banking, 1780-1932

In the 1780s, there were only three, brand-new banks in the United States—one each in
Boston, Philadelphia, and New York. Additionally, the country was awash in devalued paper
currency issued by the separate states. In 1791, Alexander Hamilton proposed that the federal
government charter the Bank of the United States (a public-private bank) as a means to sell
federal debt, retire the debt of the states, introduce a more uniform currency backed by gold and
silver, and develop the banking system. In the next year, the new bank issued 6%-yield securities
that were fully subscribed, trading at or above par in newly established securities markets in
Philadelphia, New York, Boston, and Baltimore. These new securities markets soon traded in
other, more local securities as well, growing more formalized and sophisticated in the process
(Rousseau/Sylla 2005; cf. Baliga/Polak 2004).
Had the BUS remained a monopoly bank comparable to the Bank of England, American
history would have been very different. Instead, entrepreneurs across the country applied for
bank charters of their own from the states; the states, seeking to defend their financial systems
against the encroaching BUS, were cooperative (Rousseau/Sylla 2005). In the 1790s, 28 new
banks were chartered, and 73 more in the next decade. By 1860, there were some 1600 state
banks across the United States. “From the 1790s to the middle of the 19th century nowhere else
in the world was the banking corporation developed as a competitive business enterprise to the
extent that it was in the United States” (Rousseau/Sylla 2005:5). This includes Britain; as early
as 1825, America had more than twice as much bank capital as Britain, despite having a smaller
population. Nonbanking firms, in turn, were able to secure charters of incorporation from the
states which facilitated investment; many of these new corporations were in and around the cities
with active securities markets, which let them market shares (Rousseau/Sylla 2005).6
The apogee of early American banking was reached during the so-called free banking period,
which lasted from the demise of the Second Bank of the United States in 1832 to the beginning
of the Civil War. In this period, there was no central bank, states regulated their own banking
industries, banks could issue private notes backed by state bonds, and in most states, anyone with
sufficient collateral could gain a bank charter (Briones/Rockoff 2005; cf. Sechrest 1993,
Shambaugh 2006).
While entry into the banking field was free, states often imposed restrictions on bank
practices. The most significant of these for our purposes was called unit banking. Banks in most
states were allowed to operate only a single location. Branching was forbidden, including
branches from out-of-state banks (Briones/Rockoff 2005). This limited banks’ size, available
capital, and ability to diversify their lending portfolio. Later American regulation limited the size

6 Early stock exchanges had very low liquidity. Stock par values were quite high, typically $1000 per share at a time
when per-capita annual incomes were typically between $100 and $300. Rousseau (2009) finds that equities trading
in the Boston stock exchange were predominantly bank stocks until par values came down into the low hundreds in
the mid-1800s, stimulating liquidity and allowing large numbers of industrial firms to issue shares.

8
of a bank loan to 10% of its surplus plus capital; therefore, a firm’s access to credit was directly
proportional to the size of the bank or banks from which it borrowed (Giedeman 2005).
Until the second half of the 19th century, unit banking did not cause shortages of credit in
practice. In antebellum America, as in Britain, most manufacturing took place in small-scale
artisan shops or relatively modest factories, which the banks were able to finance adequately
(Bodenhorn 1999). Early American banking, particularly in New England, was quite similar to
the German model of close integration with industry (Calomiris 1995).
The Civil War period saw several changes to the operation of the banking system. First, the
governments of both sides turned to the banks to help them market war bonds. This gave the
banking system valuable experience in forming underwriting syndicates and finding buyers. The
banking networks formed during the war persisted and deepened afterward, forming the basis for
the later emergence of the great underwriting empires of the 1880s and 1890s. Nevertheless, the
process was made costly by prohibitions against branching and interstate consolidation, which
prevented the economies of scale and of information-processing that were emerging in Germany
at the same time (Calomiris 1995).
Second, the federal government instituted the National Banking Act of 1864 and began to
charter its own banks. National banks had the privilege of issuing national bank notes, which
were fully backed by U.S. Treasury bonds. At the same time, the federal government imposed a
new tax on note issues by state banks, with the result that state bank notes were soon replaced by
national bank notes (Calomiris/Mason 2008).
After the Civil War, large differences in the cost of capital developed across regions. These
differences were starkest in the industrial sector, which had returns on capital far exceeding those
of other sectors of the economy. This indicated the difficulty of raising money for large industrial
projects (Calomiris 1995). 7 Giedeman (2005) finds that large American firms had insufficient
access to capital even during the comparatively late period of 1911-1922.
By this time, industrial technology was beginning to favor modern, large-scale manufacturing
instead of the old pattern of small artisan shops. Large firms, which needed more capital than
most banks could handle, instead relied on the short-term commercial-paper and long-term bond
market when they could. Debt issues allowed firms to access larger pools of capital than local
banks could provide. Commercial paper, in particular, was for a long time a unique feature of
American finance (Calomiris 1995). By syndicating debt offerings on behalf of their client firms,
banks could provide the capital that they themselves did not have. Moreover, banks also issued
their own debt on the markets, increasing their capital reserves and allowing them to tackle
larger-scale deals (Calomiris 1995). However, debt issues were not a costless alternative to bank
loans. Early American securities exchanges still tended to be thinly-traded by modern standards,
and limited by region. Additionally, only high-quality firms could market their debt or equity on
the exchanges, leaving many firms cut off from access to capital (cf. Rousseau 2009).
Unit banking also restricted the ability of banks to market securities offerings. They lacked a
ready market for shares and the economies of scale that a large branch network would provide.

7 One consequence is the fragmented American electrical grid. While in Germany the utilities were financed by large
banks and could afford to install a bigger and better-integrated electrical system, American utilities were financed by
electrical-equipment manufacturers for lack of bank capital, limiting the size of their installations (Calomiris 1995).

9
While they could and did organize networks of banks into underwriting syndicates, the process
involved considerable transaction costs and friction (Calomiris 1995).
As a consequence, bank underwriting fees for bringing new issues to market were extremely
large, and varied with the risk of the issue and the consequent difficulty of finding buyers. Even
when the great investment banking firms such as J.P. Morgan emerged in the late 1800s, the
typical underwriting spread for equities was 20% of the entire issue.8

It is worth emphasizing how large these spreads are. A 20 percent spread indicates that a firm only
receives 80 cents for every dollar of claims it issues. This places a substantial cost on investments,
especially by young, unseasoned firms. An investment opportunity must be able to generate
enough income to pay interest or dividends to claimants and compensate existing shareholders by
an amount (in present value) in excess of 20 percent of the project’s cost (Calomiris 1995:296).

The shortage of capital had costs. American industry depended more heavily on labor and
was more natural-resource-intensive than did German industry, as a substitute for more efficient
methods of production which needed more capital. Additionally, much more of the economy was
devoted to consumer goods than capital equipment; as investment capital was scarce, it made
more sense to make what you could sell to consumers (Calomiris 1995). 9
As noted, those banks with expertise in securities issues reaped huge fees from issuing firms.
Additional fees were generated through restructuring and mergers, particularly in the troubled
railroad industry; for some firms, fees could go as high as 10% of the value of the company (De
Long 1991). As in Germany, American investment banks often took an equity stake for their fee
in lieu of cash. The difference was in the consequent degree of bank control: because the
underwriting fees were so high, banks controlled much larger fractions of their firms. This would
soon have political consequences.
Even in the heyday of American universal banking, only a handful of investment banks had
the capital, the connections with investors, and the expertise to market security issues of more
than $10 million; the largest of these were J.P. Morgan and Co. and Kuhn, Loeb, and Co. (De
Long 1991).10 J.P. Morgan in particular benefited from strong connections to the London capital
markets, allowing the firm to raise tremendous amounts of capital from European investors.11
Other investment banks simply did not have access to enough capital. As a result, not banks in
general but particular bankers such as J.P. Morgan himself gained concentrated control over large
swaths of American industry, seating his allies on the boards of dozens of industrial firms and
railroads. “Morgan’s Men” did not (only) exploit the firms they oversaw, however; analysis of
the firms indicates that “Morganized” firms were more profitable, and their stock traded at a

8 That this fee accurately reflected the cost of bringing issues to market, and was not simply an expression of bank
power over industrial firms, is indicated by the decline in spreads in the 1920s even as banks grew more powerful.
The most likely explanation for the decline is the emergence of large institutional buyers such as life-insurance firms
that made bulk placement feasible (Calomiris 1995).
9 Could the much-maligned American consumer culture have gotten its start due to government restrictions on
banking?
10
Later, with the development of bank-retailed investments, they would be joined by the First National Bank and the
National City Bank (eventually renamed Citibank).
11 Nor was J.P. Morgan the last bank to do so, as we shall see.

10
premium to the market estimated between 7% (Simon 1998) and 30% (De Long 1991). Morgan
was able to gain his power by providing good value for investors, in part by constructing
industry cartels. “Morgan made companies, effectively warranted them against failure, and stood
behind the warranty; and the securities industry evidently knew it” (Sabel in De Long 1991:246).
Starting at about 1890, the New York Stock Exchange (which had listed few industrial
securities previously) saw a sudden growth in equity issues and a consequent deepening of the
financial markets, partly from the ongoing restructuring of industry. The growth in trading
volume increased during the depression of 1893-1897, as equities were viewed by banks as less
risky to hold than loan portfolios (Smiley 1981). When the economy recovered in 1897, the stage
was set for a sustained growth in the equities markets—the stock exchanges had become more
advanced and major institutional buyers such as banks were more willing to hold equities than
ever before.
Meanwhile, the growing power of the investment banks started to alarm the political
establishment:

Banks became victims of their own success; by 1912, 18 financial institutions sat on the boards of
134 corporations with $25.325 billion in combined assets. Of these 18 institutions, five banks held
the lion's share: J. P. Morgan & Co., First National Bank, National City Bank, Guaranty Trust Co.,
and Bankers' Trust sat on the boards of 68 nonfinancial corporations with $17.273 billion in assets.
To put this number in perspective, U.S. GNP in 1912 was $39.4 billion; hence, these five banks
controlled industrial assets (on behalf of others) representing 56 percent of the country's GNP
(Simon 1998:1081).

As a result of their growing power, the “money trust” drew the enmity of Progressives.
Presidents Theodore Roosevelt, Taft, and Wilson all fought vigorously to curtail the banks; their
cause was given intellectual heft by the writings of Louis Brandeis, who believed that the social
effects of monopoly and cartels were so harmful that interlocking directorates should be
outlawed, even if they were in some sense the “best” way to organize industrial production
(Simon 1998).
Congress ultimately passed the Clayton Act of 1914, which outlawed interlocking
directorates and placed limits on the amount of stock banks could own in nonfinancial firms. J.P.
Morgan, hoping to derail the legislation, had announced just beforehand that his representatives
would resign from the boards of thirty firms (but not all of them). The move was partly
successful: the Clayton Act did not forbid bankers from sitting on industrial boards entirely, as
had been initially proposed (Simon 1998). Nevertheless, the restrictions were enough to preclude
the emergence of German-style universal-bank control over industry (Calomiris 1995).12
The anti-banking campaign was abruptly halted by World War I. Bankers were heavily
involved in financing the Allied war effort, and in return the Wilson administration gave tacit
approval to continued bank influence over the industrial sector (Ramírez 1999).

12 It is noteworthy that while bank control over management was weakened, there was nothing with which to replace
it. Shareholders remained dispersed and unable to monitor or discipline companies on their own, and it would be
decades before the rise of powerful institutional investors. In the meanwhile, the manager class had unchecked
power over firms they did not own (De Long 1991; cf. Mises 1996:306). Even now, institutional shareholders in the
United States are still not powerful enough to truly control management (Macey/Miller 1995, Zingales 2009).

11
 Yet again, the needs of wartime finance stimulated new developments in the financial system.
This time, the key change came when the government enlisted banks to sell Liberty Bonds
directly to the public (De Long 1991). Banks developed sales teams to sell the new issues,
gaining expertise in selling securities to unsophisticated homeowners. The experience made a
deep impression on one man in particular—Charles Mitchell, eventual president of National City
Bank. “[He] came to recognize that a financial empire does not have to be built by slowly
creating a reputation as a shrewd judge of investments but can be built through direct
salesmanship by uninformed representatives” (De Long 1991:231).
Over time, national banks began engaging in securities dealing and underwriting, which took
them outside of the bounds of the National Banking Act of 1864. Regardless, it became the
common practice, and when the McFadden Act of 1927 authorized banks to operate internal
securities departments, it was only ratifying and formalizing an existing practice (Kroszner/Rajan
1997).
Banks benefited from new forms of corporate organization such as the bank holding
company, which allowed formally distinct banks to be consolidated within the same corporate
structure. This allowed banks to partly overcome the restrictions of unit banking and develop
larger distribution networks for securities (cf. Kane 1981). Securities affiliates of large,
universal-style commercial banks had a distinct advantage over investment banks in that their
large branch networks let them more easily market securities issues (Calomiris 1995).
A prime example was National City Bank. Charles Mitchell became president of NCB in
1921, and with great fervor set about building a massive sales organization to mobilize the
“large, new army of investors” that had purchased their first bonds during the war (Wilmarth
2005). National City Bank, as well as Chase Bank, were among the most aggressive of the new
breed of securities marketers, and securities they sold ended up having especially poor
performance. Bonds underwritten by both Chase and National City sold at discounts to their
peers, indicating that the market recognized the banks’ risky practices—even if the true
magnitude of the problem was still larger than thought (Kroszner/Rajan 1997).
Commercial banks underwrote 22% of new securities in 1927, and 45% in 1929 (Kroszner/
Rajan 1997). Over a hundred banks opened up new securities affiliates or developed internal
securities departments in the decade ending in 1931. The increasing access to the capital markets
spurred many firms to issue securities instead of relying on loans. “Beginning in the latter half of
1928 and continuing through October of 1929, equity issuance grew rapidly in popularity, and
firms switched from issuing bonds to issuing stocks” (Kroszner/Rajan 1997:509; cf. Wilmarth
2005). The quality of bond issues was also deteriorating, as underwriting standards loosened.
Easy access to investment capital led to a glut of manufacturing capacity. Large industrial
projects were begun based on overly optimistic projections of future demand, which also
discounted that competing projects were doing the same thing. Soon, matters came to a head and
deflation resulted (Schweikart 1991, Wilmarth 2005). Large firms suddenly faced huge deficits,
making their heavy debt loads unsustainable. As a result, many firms defaulted.
A similar process was playing out on the stock exchanges. The rush of new stock offerings
had saturated the market; stock returns were being kept artificially high by the aftereffects of
wartime inflation and easy access to margin, where banks let traders finance as much as 90% of

12
their stock purchases on credit (Wilmarth 2005). This could not last; the market ultimately
reverted to the mean in the Crash of 1929.
Banks, who were especially exposed to macroeconomic risk due to their changing business
practices, soon faced a crisis of bank runs and failures. A crucial element in the mass failures of
the banks was the declining value of their asset portfolios (Schweikart 1991, Wilmarth 2005).
First, many borrowers defaulted. Second, banks often held large amounts of securities,
particularly international bonds, which plummeted in value as the market crisis unfolded. Often,
big-bank securities affiliates had retailed the riskiest securities to unsophisticated local banks,
which consequently went bankrupt at a high rate (Wilmarth 2005).13
The carnage was exacerbated by the unit-banking system. In Canada, which had strong
branching banks, not a single bank failed during the Depression (Bordo/Rockoff/Redish 1996).
Similarly in California (which allowed branching), even singleton banks tended to last longer
during the crisis if they faced competition from a branch bank like Bank of America, in part
because they had already become more efficient to survive (Carlson/Michener 2009).14

German Banking, 1920-Postwar

The Weimar hyperinflation of the 1920s was devastating to the banking sector. Worst hit
were the Kreditbanken, whose clients in the industrial sector were taking huge losses. Several
banks failed in the banking crisis of 1931, and the survivors became even more concentrated than
before—the “Big Six” became the “Big Three” (Guinanne 2002, Kopper 1998). The large
universal banks had depleted capital reserves and an uncertain future when the Nazis rose to
power. Being dependent on state funds to survive, they were forced to sell large stakes to the
government, the Reichsbank, or its subsidiaries: 91% in the Dresdner Bank, 70% in the
Commerzbank, and a minority stake in Deutsche Bank (Kopper 1998). Ultimately, banking
policy became totally dependent on state goals.
The Nazis believed that the power of the banking sector had grown too great, and that the
industrial sector had been weakened by overborrowing and dispersion of control. They put in
place policies designed to encourage self-financing of new development by industrial firms
(Kopper 1998). The maximum allowable level of dividend payments was sharply restricted,
discouraging new stock issues; at the same time, banks were discouraged from making long-term
loans to industry by capital controls that mandated a low interest rate.15 Industrial firms instead
ran up large debts to suppliers of raw inputs, and as the German economy recovered they also

13This is in contrast to the behavior of the German Konzernen; because universal banks marketed their securities to
local banks affiliated with the same Konzern, they had a strong interest in ensuring the securities’ quality.
14 In part, however, their performance was dumb luck. As competition increased, Californian banks tended to shift
their portfolios away from securities (which were seen as safe investments) into loans (which were more lucrative,
but seen to be riskier). As a result, they were insulated from the capital-market crash (Carlson/Michener 2009).
15The capital controls were also meant to facilitate borrowing by the state. As before, the chief role here was played
by the savings banks, who held nearly half of Reich debt by 1939 (Kopper 1998). Nazi capital policy also favored
particular sectors key to economic autarky, particularly synthetic fuel, mining, and metals production. Banks were
pressured to invest large sums in these industries, despite low projected profits.

13
reinvested more of their profits instead of acquiring equities, as the Nazis had hoped. “Despite
economic recovery, the issue of new shares and industrial debt fell to levels below those that had
prevailed at the nadir of the economic crisis in 1932” (Kopper 1998:54).
In short, the Nazi regime deliberately starved off what had been one of the best capital
markets in the world, and tied the banks closely to government policy:

National Socialist credit policy prevented the provision of credit from resuming its traditional
routine by directing the banks into a rather riskless, uninnovative and boring business with limited,
but guaranteed profit margins. Allocating credits and loans became less and less a matter of skilful
banking through being more and more determined by government interests (Kopper 1998:62).

In the turmoil after World War II, the new West German political order ultimately settled on a
form of cooperative corporatism in which government and universal-bank ownership played a
key role in the ownership and management of the large corporations. The new economic system
in West Germany was carefully designed to produce stability first and foremost, in a political
climate in which labor needed to be incorporated into economic governance and instability
would have been fatal. Growth, on the other hand, was sacrificed. This tended to make equity
investing relatively less attractive than lending, reducing the incentives to turn to the capital
markets for financing and strengthening the position of the banks (Macey/Miller 1995).16 In
particular, banks have continued to benefit from their control of clients’ equity proxies, and bank
representation on the advisory boards of firms is among the highest in the world (Santos/Rumble
2006).
The securities markets never recovered their former glory (Fohlin 2007). “German firms
borrow $4.20 from banks for every dollar they obtain from capital markets, whereas American
firms borrow $0.85 for every dollar they raise in the capital markets” (Macey/Miller 1995). As of
2002, there were only about 700 firms on the German stock exchange, while in the United States
there were over 7000 (Guinnane 2002).
In modern Germany, most large-scale investing is done via personal connections with
executives in the banks and other firms, instead of relying on the public capital markets (Hall/
Soskice 2001:23). Of the European countries, Germany has the highest percentage of firms
controlled by other firms; around 80% of direct equity stakes in public firms are owned by firms
instead of individuals (Goergen/Manjon/Renneboog 2008). This system makes it difficult for
new firms to start up and attract financing; at least as late as 1990, Germany had no dedicated
venture-capital sector (Hart 1992:188).
More recently, there has been some reform of the capital markets to encourage liberal-style
investing. In large part, this was due to competition from aggressive American investment banks
that were able to penetrate the German market. German universal banks, relying on their
dominance of the economy, had become sluggish and uncompetitive (Boot/Thakor 2004).
Advances in the European securities markets since the 1970s have transfered some power to
borrowing firms and away from the incumbent universal banks, who now face a more
challenging environment. In particular, competing banks now tend to assume much more of the
risk when bringing new issues to market (Battilossi 2000).

16“As a generalization, the more easily others can affect the income flow from someone’s assets without bearing the
full costs of their action, the lower is the value of that asset” (North 1990:31).

14
 American Banking, 1933-Present

In response to the Crash of 1929, the Senate began an investigation of Wall Street practices.
The investigation became known as the Pecora Commission, after Ferdinand Pecora—who was
not a senator, but the chief counsel of the investigation. Pecora and his assistants exposed
widespread malfeasance by investment and commercial banks, especially National City Bank
and Chase. For example, banks had often knowingly marketed securities on behalf of failing
companies to enable those firms to repay bank loans (Wilmarth 2005).17
The Roosevelt Administration used the Pecora hearings as a springboard for its vast program
of banking and securities regulation. Chief among the new laws was Glass-Steagall, which
forced commercial banks to give up their investment banking business.
Krugman (2009:157) argues that the division between commercial and investment banking
was enforced in order to allow tight regulation of the commercial banks’ deposit-taking practices,
to prevent bank runs in the future. However, the main focus of Senator Carter Glass and his allies
was not on bank runs, but on the banks’ role in creating the speculative boom in stocks
(Wilmarth 2005). He and his allies argued that aggressive marketing of new issues, excessive
credit given to firms and to stock traders, and conflicts of interest between underwriters and
brokers, led to the glut of shares and the eventual crash.
The Glass-Steagall Act outlawed the underwriting of securities by commercial banks or any
of their subsidiaries. “From a governance perspective, the importance of Glass-Steagall was that
it no longer allowed private bankers to exist” (Simon 1998:1091). The Act also forbade national
banks from owning any corporate stock (Santos/Rumble 2006).
The industrial sector was suddenly cut off from its former access to capital. Firms responded
in different ways. Many firms replaced their former relationships with banks by allying with
insurance firms, which controlled large amounts of assets; over the next several decades,
representatives of insurance companies began showing up on corporate boards and playing much
the same role as bank representatives once had (Ramírez 1999). American firms also responded
by entering into subsidiary relationships with large, well-capitalized holding companies, which
could then operate internal capital markets and allocate resources among subsidiaries, acting as a
universal bank would (Baliga/Polak 2004).
In general, however, firms’ access to capital was sharply constrained—particularly those
firms without ties to insurance companies (Ramírez 1999). Indeed, Senator Glass himself was
soon dismayed by the shortage of capital. He had expected that investment banks would be able
to adequately finance the industrial economy on their own; when it became clear that they were
not up to the job, Glass proposed an amendment to the Banking Act of 1935 that would have
given commercial banks limited authority to issue bonds (but not stock). But the Roosevelt
Administration opposed the amendment and it was soon dropped (Wilmarth 2005).
The new banking regulations had the additional effect of disrupting both bank and market
control of firm managers, contributing to managers’ growing power in the American economic

17For a more critical view of the Pecora Commission, particularly for its ignorant characterization of stock pools
(which has sadly become conventional wisdom), see Mahoney (1999) and Jiang/Mahoney/Mai (2005).

15
system (Calomiris 1995). Furthermore, the position of unit banks (reeling from crisis-related
losses at the time) was buttressed by the new legislation, delaying reform of the unit-banking
system for decades. “Once the Great Depression legislation was passed, it resuscitated unit banks
as a powerful special interest resisting reform or repeal of Great Depression
protections” (Calomiris 1995:307).
Of all the effects of the new legislation, two are crucial for our argument. First, commercial
banks were barred from investment banking, and investment banks were barred from commercial
banking. Thus, investment banks had strong incentives to build up the financial markets, and
develop new types of securities products to poach business from the commercial banks (cf.
Baliga/Polak 2004). This was sharply different from the normal pattern followed by universal
banks, in which securities innovation was limited by the need to retain lending business. While it
took some decades for the capital market to recover, in time financial innovation by investment
banks became a direct threat to the commercial banks.
Second, the new legislation outlawed paying interest on demand accounts, and directed the
Federal Reserve to impose capital controls on the interest rates banks could pay their depositors.
This the Fed did on November 1, 1933 with Regulation Q, which limited deposit rates to 3%.
This rate was actually above the prevailing market rate at first; the Fed did not see it as its job to
restrict the industry as a whole, as Congress had wished, but instead to control the most
aggressive banks who might attract deposits with excessively high interest rates (Gilbert 1986).
Regulation Q policy therefore did not distort the credit market.
As late as the 1960s, banking was a safe and lucrative profession. Banks had a simple,
effective business model: attract interest-free demand deposits and low-interest savings deposits,
invest in safe government debt, and engage in judicious lending to high-quality businesses
(Wilmarth 2002).18 When prevailing interest rates started creeping up, the Fed raised the
Regulation Q limits to accommodate them (Gilbert 1986).
Then, in 1966, Congress passed legislation radically changing Regulation Q policy (Gilbert
1986). Concerned that mortgage rates were increasing, Congress felt that rising interest rates
were the fault of competition between banks and thrifts to attract deposits. The new interest-rate
caps were set below the yield on Treasury bonds, in an attempt to halt the rise in rates. This
attempt was doomed from the start, as rates were rising due to growing borrower demand, rather
than increasing bank costs (Gilbert 1986).
A key goal of the new deposit-rate ceilings was to favor particular interests such as the
thrifts, savings-and-loan banks, mutual savings banks, the housing industry, and construction
unions at the expense of commercial banks, credit unions, and small savers (Kane 1981, Gilbert
1986). Favored institutions linked to the mortgage industry were given higher interest-rate
ceilings, allowing them to attract more deposits and hence offer more mortgages. To sustain the
implicit subsidy, Federal regulators were forced to extend regulation over more and more
activities as households tried to find new places for their money; not least, minimum
denominations for Treasury bills were raised to take them out of reach of small households. On
the other hand, regulations were relaxed for large depositors. For example, repurchase
agreements transformed large-dollar deposits into contractually guaranteed securities

18 This business model is summarized by the 3-6-3 Rule: borrow at 3%, lend at 6%, play golf at 3:00.

16
transactions, allowing banks to compensate depositors without falling afoul of interest-rate
restrictions (Kane 1977). In June 1970, deposits of more than $100,000 were exempted from
Regulation Q entirely (Gilbert 1986). All in all, banks and thrifts benefited at the expense of the
poor and middle class, while the rich were largely spared.19 20
The inability for small households to protect their savings from inflation fundamentally
changed their spending patterns. Consumers stocked up on tangible goods like food,
commodities, and real estate. Purchases on credit increased, as lending rates were kept artificially
low as well. The result was increased consumption, increased inflation, reduced savings, a
shortage of business investment, and a government-subsidized boom in real estate (Kane 1981,
Herring/Wachter 1999).
Capital controls in all of the industrialized Western countries also had the entirely predictable
effect of stimulating the development of international credit markets. The Euromarkets, as they
were called, allowed banks in one country to evade domestic regulations by borrowing money in
another country, especially through the London exchange (Battilossi 2000). As capital controls
tightened, the Euromarkets became larger and more sophisticated—not least because of
innovations from aggressive American investment banks. For example, Citibank created the first
negotiable CDs (which banks could trade in the money market) in 1961, increasing the liquidity
of American bank assets. Soon, world markets adopted Euro-CDs, which traded on a London
secondary market run by specialized dealers (Battilossi 2000).
Tight regulation once again ended up favoring those banks with branches overseas. They
were able to bypass capital controls by financing the foreign operations of American
multinationals, and could raise money in the European markets to lend back in the United States,
weakening the impact of American monetary policy. Finally, American commercial banks could
expand into investment banking in foreign markets, circumventing Glass-Steagall and preparing
the ground for later regulatory erosion (Battilossi 2000; cf. Schweikart 1991). 21 In this manner,
the regulatory system favored securitization of credit, and the increasing power of large banks
over small ones.22
When interest rates spiked in the 1970s, interest-rate caps provided a golden opportunity for
new competitors to emerge. While American banks were subject to interest-rate controls, foreign

19 “Controls on prices and quantities challenge the market’s solution [to conflict between social groups] without
themselves resolving conflict. Controls perpetuate the conflict of economic interests and divert this into
noneconomic channels” (Kane 1977).
20In partial response to this blatant discrimination, “[P]ublic-interest lobbyists… called down upon banks a veritable
plague of what we may call financial fair-play regulation” (Kane 1981:364). Rather than ending the distortion
caused by interest-rate controls, Congress first imposed new mandates on banks based around social objectives.
These included several Fair Credit laws, the Community Reinvestment Act, and laws regulating the provision of
mortgages. Kane (1981) accurately predicted that these laws would remain in effect “long after deposit-rate ceilings
have gone to regulation heaven,” introducing new distortions into the economy.
21These investment banking activities were in fact carried out under the authority of Federal Reserve Regulation K
(Wilmarth 2002; cf. Kane 1983).
22 “The dynamic of banking multinationalisation during the 1960s and 1970s can be conceptualised as a self-
reinforcing interaction between derived demand and regulation arbitrage. Relationship banking provided a
particularly strong incentive to expand multinational branch networks in order to supply services to corporate
customers with large international and multinational activities” (Battilossi 2000:169).

17
banks operating on American soil were not—nor did they have to contend with “relationship
banking” patterns of customer loyalty. As a consequence, domestic banks lost a tremendous
amount of deposits to the invaders (Battilossi 2000, Kane 1981, Hackethal 2000). Additionally,
the interest-rate caps fueled the rise of money-market mutual funds (MMFs). Money-market
funds were able to pay the true prevailing interest rate to savers, causing a dramatic erosion of
bank deposit accounts as large savers switched over in search of better returns (Kane 1977,
Gilbert 1986, Edwards/Mishkin 1995). Demand deposits fell from 60% of bank liabilities in
1960 to less than 20% in the 1990s (Edwards/Mishkin 1995).
Nonbank finance companies were also coming into their own (Calomiris 1995; cf. Glaeser/
Scheinkman 1998). In 1975, business lending by finance companies exceeded their consumer
lending for the first time (Marquis 2001). Nonbank finance companies, such as credit-card
companies or GE Credit, engage in several types of commercial lending not by taking deposits,
but by raising money on the capital markets by issuing debt and equity (aside from retained
earnings). This allows them considerable freedom to structure their obligations optimally.
Without demand deposits, finance companies do not face the risk of a run on the bank. Debt
issues can be made for any length of time desired. And equity imposes no hard financial
constraints at all, unlike debt (Cowen/Kroszner 1990, Marquis 2001).
Additionally, specialized finance companies can often better understand their borrowers than
can banks. Many finance firms are subsidiaries of businesses such as auto manufacturers,
existing to finance big-ticket purchases and allowing the firms to internalize the profits once
earned by bank financing. Similarly, a great deal of finance is concentrated in the equipment-
leasing industry; firms such as Caterpillar have expertise in evaluating large capital-equipment
deals and in repossessing and reselling equipment if borrowers default. They thus have
significant competitive advantages over banks, eroding the traditional role of banks as
informational monitors (Marquis 2001).
The fortunes of finance companies have been closely linked to the commercial-paper
market,23 which was being quickly expanded by investment banks eager to seize lending
business from the commercial banks. When transaction costs are low enough, commercial paper
makes an excellent substitute for bank loans, since the short maturities allow the markets to
discipline firm behavior much as banks would (Macey/Miller 1995). From 1960 to 1985, the
commercial paper market grew four times as quickly as bank loans; large corporations financed
over half of short-term borrowing with commercial paper, and only a quarter with bank loans
(Cowen/Korszner 1990).24
The growth in commercial paper was driven in large part by the increasing popularity of
money-market funds, which invest in paper. In turn, the deepening money markets have allowed
nonbank financial firms to raise more money and expand their own lending, cutting further into
bank business (Edwards/Mishkin 1995).

23And more recently, to the growth in asset-backed securitization; finance companies have been able to securitize
many of their loans and transfer the risk onto the open market (Marquis 2001, Wilmarth 2002).
24 To make things worse, banks began losing their lower-quality borrowers to the new market in junk bonds
(Schweikart 1991, Edwards/Mishkin 1995). By 2000, there was almost $600 billion in junk bonds outstanding, over
twice the outstanding business loans by banks (Wilmarth 2002).

18
 In response, banks scrambled to exploit regulatory loopholes in order to evade capital
controls, and to encroach on the securities, underwriting, and insurance industries.25 In this, they
were helped by several new technologies, particularly the EFT (electronic funds transfer) system.
By dramatically reducing the cost of processing customer transactions, EFT made several new
products feasible and increased the profits for providing multiple services to existing customers
(Kane 1981).
EFT also made long-distance banking possible, obliterating the regulatory logic behind unit
banking and several other regulations. Banks responded with creative new corporate structures to
allow them to expand operations; regulators struggled to keep up. What was often discussed as a
period of deregulation was in truth one of “re-regulation,” as authorities tried desperately to
reassert control over a rapidly changing industry (Kane 1983). One factor conditioning
regulatory change was the competition between several regulatory agencies, such as the Federal
Reserve, the FDIC, the SEC, and state-level authorities. If one agency’s regulations grew too
onerous, banks could adjust their corporate structure so as to exit that agency’s control and move
to another, more hospitable, regulator. This encouraged empire-building regulators like the
Federal Reserve to loosen their guidelines over time, while tightening them in particular areas to
extend their power (cf. Kane 1999, Calomiris 2006).
As banks continued hemorrhaging their deposit base to money market funds, Congress
finally abolished interest-rate controls between 1980 and 1986 (Gilbert 1986). Banks were able
to slow the loss of funds, at the cost of a permanent erosion in their profit margins—they were
now obliged to pay market rates for most of their capital. Banks were thus exposed to a new
source of risk: the spread between long-term and short-term interest rates. Recall that banks
borrow short and lend long; if the spread narrows, bank profits evaporate. If short-term rates rise
above long-term rates, banks are in great peril (Wilmarth 2002).
The increasing depth and liquidity of capital markets brought about a new concept of what
banking liquidity meant. Banks increasingly relied less on equity investors and depositors, or
assets kept in cash or readily marketable bonds, than on their ability to arbitrage between
different markets for capital, borrowing cheaply on the open market and lending out at higher
rates. The largest banks become spinning-plate artists: their solvency depends on borrowing
enough money to meet ongoing obligations, while their long-term loans and investments yield
rich returns in the long run. “[I]t appears that the principal business of large banks is no longer
the intermediation of credit but has instead become the management, transfer, and trading of
various types of risk in the financial markets” (Wilmarth 2002). Unsurprisingly, the pioneers of
this strategy were American banks facing competitive pressure in the 1960s (Battilossi 2000).
When all goes well, this creates a flexible, profitable banking system able to meet nearly any
client’s needs. But should this great river of capital suddenly turn against the banks—either if
short-term rates rise too much relative to long-term rates, or if the markets lock up so that banks
cannot borrow at all—then banks will be in trouble. Either they must quickly sell their illiquid
assets (at bad prices, most likely), or they will implode (Iori/Jafarey/Padilla 2006).

25 “In the 1970s, loophole mining and fabrication became the main business of modern depository institutions…. It
was the main avenue left along which bankers could exercise old-time yankee ingenuity. Their innovative behavior
stands as a convincing contemporary manifestation of the can-do spirit that made our country great” (Kane
1981:359).

19
 This transformation of the banking industry into one of risk arbitrage was exacerbated by
government-subsidized sources of credit, which banks used to replace their eroding deposit base.
Over time, the federal government has provided banks with several subsidized (or “non-risk
priced”) sources of capital. Among these are brokered deposits, which are insured by the FDIC,
and long-term advances from the Federal Home Loan Bank, which must be fully collateralized
by real estate (King/Nuxoll/Yeager 2006).26 FHLB advances had historically been restricted to
thrifts, but in 1989 they were extended to commercial banks as well.
The attractiveness of FDIC deposit insurance and subsidized sources of cheap capital led to
“structural arbitrage” in which banks increased their dependence on government failsafes over
time, dramatically increasing the government’s risk exposure and the general fragility of the
system.27 28 Moreover, these subsidies encouraged nonbank financial firms such as insurance
companies and brokerage firms to open up their own subsidiary deposit institutions, so that they
could extend the benefits of government protections across all of their operations (Kane 1983,
Billet/Garfinkel/O’Neal 1998, King/Nuxoll/Yeager 2006, Wilmarth 2002).29
With Congress dithering over how to respond to the new crop of nonbank banks, the Fed
took action. In 1983, it unilaterally broadened its interpretation of what activities fell under the
Bank Holding Company Act, and therefore under its regulatory control. At the same time, the
Fed created new privileges for BHC subsidiaries, making it more attractive for financial firms to
recharter themselves as BHCs. One result was to open the door for deposit-taking banks to ease
their way into the securities and insurance businesses, while at the same time raising new barriers
to securities and insurance firms who wanted to enter banking (Kane 1983).
In the 1980s, banks faced a difficult environment of interest-rate instability, coupled with
increasing competition from finance companies and foreign banks. As a result, some banks
(especially those with “entrenched” bank managers benefiting from the disproportionate power
that the managerial class has gained over investors and the board) began taking more risks to
maintain their profit margins (Gorton/Rosen 1995, Edwards/Mishkin 1995). In particular, banks
sought to replace their shrinking corporate lending with commercial real-estate loans, fueling a
speculative boom during the 1980s. Troubled thrifts turned to subsidized FHLB advances to plug

26 Note first that FHLB advances therefore privilege real-estate lending, adding permanent inflationary pressure to
the market; and second, that if real-estate prices decline sharply, FHLB loans will suddenly lack collateral.
27 The FDIC Improvement Act of 1991 replaced the flat rate for deposit insurance, which was unresponsive to credit
risk, with a series of graduated rates ranging first from 0.23% to 0.31% (Hovakimian/Kane 2000), then from zero to
0.27% after 1994 (Billet/Garfinkel/O’Neal 1998), depending on banks’ capital levels and supervisory ratings. The
higher-rate tiers were intended to penalize banks for excessive risk. However, in 1996, a full 95% of banks were
paying zero percent. Regulators apparently had become more permissive, not less (Billet/Garfinkel/O’Neal 1998).
And in any event, the rate tiers were still too cheap relative to actual credit risks (Hovakimian/Kane 2000).
28 This is an example of how subsidized programs tend to create their own constituencies, who adjust their behavior
to rely on the programs and become more dependent on them over time, even if such dependencies create perverse
behavior (Pierson 1994:42).
29 Such subsidized access to capital interferes with the disciplining effects of the market. This has been demonstrated
in the interbank market, where banks provide short-term loans to each other. Lending banks charge interest rates that
are sensitive to the riskiness of the borrowing bank; however, because of the presence of subsidized capital, banks
that have become too risky simply stop borrowing on the interbank market instead of changing their behavior. Thus
the market “may exhibit monitoring but not influence” (King 2008:313; cf. Furfine 2001).

20
the holes in their balance sheet, allowing them to pursue even riskier lending in hopes of making
back their losses (Stojanovic/Vaughan/Yeager 2008). This ended in disaster; while banks had
failed at a rate of 6 per year between 1946 and 1980, in the next decade failures skyrocketed to
104 per year (Gorton/Rosen 1995).
Federal regulators, responding to the rising instability of the banking system, set the first
general balance-sheet rules in 1981-83. In response, banks shifted away from traditional lending
and expanded their use of off-balance-sheet activities such as asset-backed securitization and
standby lines of credit, which were often riskier than traditional practices (Wilmarth 2002).
Starting in 1975, regulators had also put in place rules limiting financial firms’ ability to buy
junk bonds; in short order, the credit-rating agencies became “captured” by their clients, taking
large fees in exchange for the investment-grade bond ratings so crucial to expanding the market
for an issue (Wilmarth 2002).
In 1987, Federal Reserve regulators took advantage of imprecise language in Section 20 of
the Glass-Steagall Act to allow BHCs to operate “Section 20” subsidiaries making up to 5% of
their revenue from investment banking. This limit was soon raised to 10% in 1989, and then to
25% in 1996 (Wilmarth 2002). These Section 20 subsidiaries proved quite profitable for their
parent organizations; at the same time, entry by the commercial banks into the debt-underwriting
field ended up lowering underwriting spreads, making the commercial-debt market more
efficient and adding to the competitive pressure (Mamun/Hassan/Maroney 2005). Thus, well
before Congress passed GLBA, commercial banks had already reentered the investment banking
field in the United States.
By 1994, off-balance-sheet income (mostly from advisory and underwriting fees and active
market trading) had grown to 35% of total bank income (Edwards/Mishkin 1995). Such business
is riskier and more heavily exposed to macroeconomic factors than traditional lending (Wilmarth
2002). Banks that failed between 1995 and 2003 depended much more heavily on fee income
than other banks. Moreover, general industry trends showed increased competitive pressure and a
worrying accumulation of risk. Bank deposits are steadily shrinking, banks have engaged in
more commercial real-estate lending, banks depend more on Federal Reserve funds, and cash
reserves are at historic lows (King/Nuxoll/Yeager 2006).
The push toward securitization was accelerated by the 1998 Basel Accord, which set risk-
based standards for banking soundness. To evade these standards, banks increased their use of
securitization to transfer assets off of their balance sheets, reaping immediate underwriting fees
instead of sustained growth over time (Wilmarth 2002). Increasingly, banks only retain those
assets they cannot securitize—meaning those that are opaque, highly uncertain, and difficult to
understand (Macey/Miller 1995).
After the banking crises of the 1980s, policymakers began to realize that the many federal
subsidies for banking, and the general policy to protect banks that were “Too Big To
Fail” (TBTF), had created malign incentives that were contributing to the weakening of the
banking system. In response, several new laws were passed, including the FDIC Improvement
Act of 1991, and National Depositor Preference legislation that went into effect in 1994 (King
2008). These new laws were meant to restrict the ability for risky banks to abuse the federal
safety nets, and included several provisions meant to discourage regulators from favoring
troubled banks. The 1994 implosion of Long-Term Capital Management, a large hedge-fund,

21
demonstrated that regulators had no intention of listening. The Federal Reserve orchestrated a
massive capital infusion to LTCM’s largest creditor-banks, though as it turned out the banks were
never in danger of collapse, and the market perceived the Fed’s action as a reinforcement of the
TBTF doctrine (Furfine 2006).
In part responding to the legislative attack on their TBTF subsidies, banking firms initiated a
wave of massive mergers in 1998, starting with Citicorp-Travelers (Kane 1999). The idea was to
make the resulting firm such an integral component of the system that the government would be
forced to protect it from failure, whatever the law said (cf. Hovakimian/Kane 2000, Wilmarth
2002). Additionally, many of these mergers were between traditional competitors such as banks
and insurance companies, straining the limits of Glass-Steagall (Wilmarth 2002). These
megafinancials increased the systemic risk of the financial system, by concentrating asset and
counterparty risks onto a very few actors who turned out to be unable to handle the late crisis (cf.
Wilmarth 2002). 30
The Citigroup merger is remarkable because it explicitly violated the core prohibitions of
Glass-Steagall: Citibank was a commercial bank, while Travelers was a financial services and
insurance conglomerate. The merger, and the regulatory-financial alliance that fostered it, was
the crowning moment in the long campaign to defeat Glass-Steagall once and for all.

An extraordinary feature of the Citigroup transaction was that Citicorp's and Travelers' chairmen
consulted with, and received positive signals from FRB chairman Alan Greenspan, Treasury
Secretary Robert Rubin, and President Clinton before the merger was publicly announced.
Eighteen months later, during intense negotiations between the Clinton administration and
congressional leaders over the final terms of the GLB Act, Citigroup appointed Mr. Rubin—a
close confidant of President Clinton and a prominent supporter of the legislation—as its new co-
chairman (Wilmarth 2002).

The Federal Reserve’s approval of the Citicorp-Travelers merger was a direct challenge to
Congress. While technically the merger was granted only a 5-year temporary approval, this in
fact added to the pressure—no one seriously imagined that in five years the two companies
would split apart again. Glass-Steagall’s restrictions had just been set aside by regulatory fiat.
Unsurprisingly, Congress passed the GLBA within the year, having been successfully
“dragooned” by the banking industry (Kane 1999, Wilmarth 2002).
That said, Congress was also responding to the undeniable changes in the financial industry.
“Congress adopted the GLB Act because it recognized that advances in information technology
and the development of innovative financial instruments had subverted the prior legal barriers
between banks and other financial firms” (Wilmarth 2002). Electronic funds transfers and the
sharp competitive pressure from the capital markets had made the banks’ position untenable
under the old restrictions. Additionally, there was wide consensus among economists and finance
academics that Glass-Steagall had harmed the American banking system and needed to be
repealed (see for example Wilmarth 2002 and 2005, Calomiris 1995, Macey/Miller 1995).

30 Large banks also contribute to the instability of the system through the interbank market, where banks lend each
other short-term funds. While such lending tends to make the system more stable in general, when crises occur they
can quickly cause “avalanche” effects by transmitting losses from bank to bank. This is particularly so when some
banks are heavy borrowers and others are heavy lenders (Iori/Jafarey/Padilla 2006). In fact, the largest banks tend to
be net borrowers, and small banks are net lenders (Furfine 2001). Thus, if a large bank fails, it could bring down
several smaller banks with it.

22
 As the largest banks were consolidating, they were also engaging in riskier activities to keep
profit margins up. A small group of giant banks accounted for almost all foreign lending,
particularly in emerging markets, and in 2000 controlled 8 of the top 10 subprime mortgage-
lending companies (Wilmarth 2002). Banks reduced their capital reserves to “dangerously low
levels” in the 1990s to meet earnings targets, in part because of pressure from the SEC for banks
to be more aggressive (Wilmarth 2002, footnote 113). Large banks were also using equity
investments to generate a large portion of their income. Ten major banks had over $30 billion in
venture-capital stakes in technology start-ups right at the top of the bubble (Wilmarth 2002).
Notably, many studies have concluded that banks stop becoming more efficient when they
grow larger than $10-25 billion, and efficiency in fact declines. The megamerger trend had more
to do with preempting hostile takeovers, becoming an irreplaceable part of the banking system so
as to extort regulatory lenience and TBTF status, and managerial hubris (Wilmarth 2002).
At the beginning of 1998, the spread between short and long interest rates shrank to nearly
zero. This hurt banks tremendously, as their profit margins from lending practically vanished. In
early 2000, the spread actually turned negative and remained so for over a year. In response, the
Fed cut interest rates from 6.5% all the way down to 1.75% over the course of 2001, eventually
reversing the negative spread.31 This came at a substantial cost—cheap credit provided the
impetus to the real-estate speculative boom (Wilmarth 2002). Additionally, falling interest rates
made mortgage refinancing attractive, placing mortgage-servicing companies under more
competitive pressure. Profit margins in home mortgages fell steadily, leading to reckless lending
standards (Wilmarth 2002).
We know how that turned out, of course.

Policy Recommendations

Hall and Soskice argue (2001:49) that a liberal economy, because of its pattern of
institutional development, can usually be reformed most effectively through deregulation.
Broadly speaking, this article concurs. Our economy has been moving toward a financial system
built around public capital markets, and we should see that as a good thing. The great power of
financial intermediaries like banks is corrosive to systemic stability, free enterprise, and
democratic society itself, while direct unmediated access to the capital markets benefits lenders,
borrowers, investors, and innovators alike. Intermediaries can still exist in such a financial world,
but they must prove their value over direct access, instead of relying on political power to
enforce their position.
Krugman (2009:163) argues for more stringent regulation of “shadow banking,” i.e. illiquid
structured debt and the over-the-counter derivatives market: “Influential figures should have
proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in
crises the way banks are, should be regulated like a bank.” This pronouncement neglects the
history driving the development of these products—it was precisely the heavy regulation of

31 Another reason for the cuts was to arrest the stock-market crash of 2000. Chairman Greenspan made explicit
reference to the danger of “a sharp deflation in asset prices.” While the stock market was now tied to the pension
wealth of most working Americans, generating heavy political pressure to intervene (Zingales 2009), the fall in asset
prices also harmed the banks specifically (Wilmarth 2002).

23
banks and the resulting advantages for securities that made them popular. Merrily extending the
regulatory net to each new thing that comes along will only make the next new thing come along
that much faster (cf. Kane 1977, 1981, 1983).
The more that governments try to constrain banks through regulations alone, the more strain
is put on the regulators until keeping up is beyond their ability. Additionally, regulatory oversight
is notorious for focusing on the old threats and missing new ones, or being most lenient precisely
when greater scrutiny is needed (Herring/Wachter 1999, Zingales 2009). Increasing the banks’
exposure to market discipline, paradoxically, makes it easier for regulators to do their jobs.
Therefore, the general policy must be to cut back on government-subsidized benefits for the
banks. In particular, the price for deposit insurance or free-flowing credit must be responsive to
the actual risks, or else banks will have fewer incentives to moderate themselves (Billet/
Garfinkel/O’Neal 1998, Herring/Wachter 1999).
Furthermore, while the concern over bank-run-style collapse is real, it is the regulatory
morass in the financial sector that has impeded the growth of alternatives such as mutual-fund
banking (Cowen/Kroszner 1990), which would be relatively safe from bank runs. Banks are
currently the beneficiaries of privileged access to the Federal Reserve System’s wire-transfer and
check-clearing networks, the Fed discount window, and myriads of special subsidies and
regulatory “moats” with which to deter competitors (Cowen/Kroszner 1990, Kahn/Roberds
2009).32 Yet even so, these moats have been insufficient to totally prevent the rise of credit-card
companies, money-market mutual funds, Paypal, Prosper.com, and a host of nonbank
alternatives. Banking system regulations need to be dramatically cut down to enable the financial
sector to rationalize itself and move away from the antiquated yoking of long-term assets to
short-term liabilities. Traditional banking is a vestige of coordination problems that no longer
exist. To keep defending banking from nonbank competitors would be like outlawing email to
save the Post Office.
This analysis suggests that the health of the public capital markets is of great importance to
the economy. It is therefore alarming to see that increasingly heavy regulation of publicly traded
securities, such as the Sarbanes-Oxley Act of 2004, has driven many firms to go private, or else
issue “unregistered” securities that trade on new private-equity exchanges, controlled by the
megabanks and unavailable to small investors (Zingales 2009; cf. Calomiris 1995, Boot/
Gopalan/Thakor 2006).33 Since SarbOx was passed, over half of all new equities issues have
been private placements—a sharp change from 2002, in which only 22% were. If left unchecked,

32 One reason for government favoritism toward banks that this paper has not addressed is that the Federal Reserve
employs the banking sector to carry out monetary policy. This would be much harder to do with nonbank financial
firms, and the government will likely fight hard to prolong the death-throes of the banks for that reason. While it is
outside the scope of this paper to discuss the ills of macroeconomic policy, Sechrest (1993) has a good treatment.
33Two examples of such exchanges are the Goldman Sachs Tradable Unregistered Equity (GSTrUE) exchange, and
the Open Platform for Unregistered Securites (OPUS), initially run by Citigroup, Lehman Brothers, Merril-Lynch,
Morgan Stanley, and Bank of New York Mellon (Zingales 2009). The much-reviled collateralized debt obligations
(CDOs) that facilitated securitization of risky mortgages were private placements, and were not traded on the open
markets.

24
this trend will radically shift the balance of power away from small investors34 and toward the
banks and other “Qualified Institutional Buyers.” This should be anathema to a free society, and
government regulations should certainly not be fostering such a plutocracy. We should strive to
make the public markets as attractive to issuers as possible.
It should also be a general policy goal to improve the capital markets’ ability to control firm
management. At present, the managerial class has tremendous influence with state and federal
governments that prevents effective shareholder discipline. Additionally, shareholders have no
control over which directors stand for election to the board—the slate is chosen by the incumbent
board (Zingales 2009). If the capital markets are to effectively control American companies,
these privileges must be sharply reduced. Zingales (2009) proposes that investors be able to
propose their own slate of board candidates, which would be a good start. Additionally, I propose
that board members no longer be paid stipends by the companies they ostensibly oversee, but
should be paid instead by shareholders, on whose behalf they are supposed to act.
Ultimately, the overriding policy goal must be to remove the protections and subsidies
enjoyed by the banking system, to allow free competition with new alternatives so that the
system as a whole can adjust to modern technologies. There is no inherent reason—none—why
bank instability should be a danger to the modern financial system. Existing regulations that
maintain the banks as favored gatekeepers to the capital markets have kept us under threat of
economic collapse, merely to benefit those financial powers that have bought government
cooperation. America needs to open the gates and let us all through.

34 Or, more realistically, the large investment intermediaries like mutual funds that work on small investors’ behalf
(cf. Macey/Miller 1995, Zingales 2009).

25
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