A (Not So) Brief History of U.S. Banking

It is no exaggeration to say that banks, and the credit that they provide, grease the wheels of the American economy. But a look back at the last 150 years of banking reveals that the path hasn't always been smooth for the nation's leading lenders, such as JPMorgan Chase (JPM -0.10%), Bank of America (BAC -0.19%), and Citigroup (C 0.31%).

In this episode of Industry Focus: Financials, Gaby Lapera and John Maxfield trace this past back to the 1860s, when the modern American banking system was established to help the Union Army finance the Civil War.

A full transcript follows the video.

This podcast was recorded on March 28, 2016. 

Gaby Lapera: The history of banking. This is Industry Focus, financials edition.

Hello, everyone, welcome to the show! Today is Monday, March 28th, 2016. My name is Gaby Lapera and joining me on the phone is John Maxfield. Today, we have a super great show lined up on the history of banking in the United States. Shout out to William Knecht, one of our listeners. I hope I'm pronouncing your last name correctly. He wanted to hear more about Walter Wriston and you are going to get way more than you asked for. I don't know if y'all know this, but both Maxfield and I were history majors in college. Correct? That's true for you too, right?

John Maxfield: You know what, I hate to say it, but I was an econ major.

Lapera: What?!

Maxfield: As little as I learned in college, I can't tell you for sure. Maybe I was a history major.

Lapera: You seem like a history major to me. That's probably why you and I get along. Let me lay this out for you like I would one of the students that I used to tutor in college when they would really whiningly ask me why it's important to study history. History illustrates the themes of humanity and when I was growing up, when I was a kid, my father was a great believer in the classics, so all of my bedtime stories were about Roman legions and German philosophers and I don't know what. In the words of my father, because I believe most of our podcast listeners speak English and not Spanish, "Those who do not know history are doomed to repeat it." He doesn't actually sound like that, but he does have a deep voice and I have a high voice so I just... That was my best impression. That was the best I could do.

So, banking. Banking in the United States. Complicated story. Maxfield and I were having a heated, well, a spirited discussion about the founding fathers and what their vision was for banking in the United States and we both agreed that we were both Adams and Hamilton fans, so if you're a Jefferson fan... I don't know what to tell you. The real history of U.S. banking started during the Civil War in the United States. Do you want to lead off with that, Maxfield?

Maxfield: A couple things and just general points to keep in mind is that banking is... It's really easy to vilify banking and bankers. These guys just deal with other people's money is the famous saying, and they just get rich doing that. What's really important to remember is that banking is a really critical part of the growth of any economy. There's only three variables, ultimately, that dictate economic growth: labor, capital, and productivity. What banks do is provide capital. They are really, really important. If you look at... Different countries have different ways that their banking systems operate and if you look at the United States banking industry and you want to know the origins of our current banking system, like Gaby said, you have to go back to the Civil War.

That's because before the Civil War, there were no national banks because... To allude to that divide that Gaby was talking about, you had the Jeffersonians on one side that were very opposed to big banks and big concentrations of money. You have the federalists on the other side. George Washington, John Adams, Hamilton, and all these guys.

Lapera: (cheering) Just in case you're curious about what side of the line I fall on.

Maxfield: I think we know. I think Gaby made it pretty clear where we kind of stand on this. In the Civil War, all that changed. National banks came into effect. They came into effect because the North needed money. The best way for a government to get money, in particularly at the time, was to go through banks, which would not only buy the bonds of a government, but then syndicate those bonds to other banks and to other investors.

Lapera: That's true. This is something that the South really struggled with during the Civil War. They just had no really good way to raise money. People donated stuff, but that's kind... I mean, they did have all this other stuff with the bonds and the crazy money and you go to any museum in the South and they have the Confederate dollar bills and stuff like that. That was definitely a major difficulty for the South because they were so decentralized. One of the things that the federal government did, the Union side did...

Just in case, for our listeners who are not familiar with the Civil War, because this is actually a question I get a shocking amount, the Union is the north, the Confederates are the south. I'm just going to lay that out there. You'd be shocked by how many people don't know that.

Anyway. What the Union did is toward the end of the war they did these two National Banking Acts.

Maxfield: That's exactly right. In 1863, they did a National Banking Act. In 1864, they did a National Banking Act. What that allowed you to do is... It took the power to issue money away from state banks. Before the Civil War, think about this. Gaby and I could open up a bank in wherever. I know, Gaby, you trace your roots, to a certain extent, to Nebraska, and so do I, to a certain extent. We could open up just a frontier bank in Nebraska and just issue money. That all changed with these National Banking Act. One of the interesting things is that nowadays, there are three main regulators on a federal level for banks. The first of which is the office of the controller of the currency. That is the primary regulator of National Banks. You think, why don't they just call it the national bank regulator or something like that. The reason is, banks, the roll that they play in large part is to issue currency. When you think about the OCC, The Office of the Comptroller of the Currency, and its origins in the National Banking Acts of the Civil War, that's really where all those things come from.

Lapera: So we have this first component of banking in the United States set up during the Civil War. Then you get into the gilded age; this is post-Civil War. The south anyways was totally devastated. People who want to industrialize the south, the north is way ahead in that respect. This is when really industrialization takes off in the United States. You have a lot of foreign money coming in. You have the rise of the railroads. People are linking all of the country via railroads. Railroads really changed America. It's weird to get so excited about trains. It's a pursuit for guys in their basements with their little train sets, which is cool. The railroad itself was an incredible leap forward in America.

Maxfield: The railroad was so important. If you think... Not only did it connect one side of the country to the other side of the country which didn't happen until 1869, but it also was really the birth of these massive, massive industrial concerns. That is where you have... That's why banks were so important during this period. To fund those.

Lapera: Absolutely. The interesting thing about this period is that we only have The Office of the Comptroller of the Currency, so that means there still no central regulator for banks. So you're having these really frequent panics and financial crises with on average every six years. I think.

Maxfield: You had a banking panic or crisis, on average, once every six years during the gilded age.

Lapera: You ended up having to fairly big depressions, not as big as the Great Depression, obviously, but in the 1870s and 1890s, these were financially devastating events.

Maxfield: If you think about, you know, we like to think about when you look at United States history, that really the bottom point was the Great Depression of the 1930s and to a certain extent that's true, but at that point... That is very unusual to think about today because even though we went through the financial crisis, it certainly didn't turn into a Great Depression, but at the time, depressions were actually pretty common occurrences. The reason, to allude to what Gaby's getting at, is that because we only had the OCC, we didn't have the Federal Reserve, we didn't have the FDIC, banks would fail all the time and that would take all these people's savings and then they would have no money.

Lapera: Absolutely. Sorry, I just have to laugh because my mother pointed out to me the other day that I say absolutely all the time on the show and I don't say it in real life.

You are correct, John Maxfield. One of the things that was really interesting about this to me, this whole history of the banking crisis is that a lot of times people portray bankers as these fat cats, like you talked about in the beginning of the show, especially guys like J.P. Morgan. You hear J.P. Morgan, you think of this giant investment international bank, right. But the original J.P. Morgan was actually in his own way kind of a good guy, because during these financial crises, the little panics that they had, him and a few other bankers would get together and act a little bit like a central bank to help these other banks out to keep them from failing.

Maxfield: If you think about J.P. Morgan, he is maybe the greatest banker in American history and one of the reasons is during the gilded age, we had just this explosion of industrialization. That's really when the United States turned into the economic powerhouse that we are today, is during the gilded age. How did that happen? Where did the financing for that come from? That came from in large part, Europe. J.P. Morgan, what they did, this the reason they became so successful, they were the primary bank that brought money from Europe and England in particular, over to the United States to invest in railroads, to invest in steel companies and all of these different things.

Lapera: It's expensive to industrialize. A lot of people don't think about this. Say you're a farmer during the industrial revolution. You have mechanization happening. If you are going from your horse and a plow to a tractor, that's a very expensive purchase. You need these banks to finance this for you, even on just an individual level.

Maxfield: That's exactly right. The second piece to this whole thing is that because we did not have a Federal Reserve... I guess because we didn't have central bank, we call it Federal Reserve, but it really is a central bank. Because we didn't have that, when the economy got into trouble, there was nobody there to bail the banks out and to help them out to survive these things, to protect investors, to protect depositor's money and all of these different things. What came about was that J.P. Morgan headed up a group, a triumvirate, if you will, of three different bankers. Himself, at the head of his firm, J.P. Morgan; a guy by the name of James Stillman, who was heading up City Bank of New York, which is now, you go through multiple iterations, that is now Citigroup, really the oldest of our big banks that traces its roots back to 1812; and the third member of this group was a guy named George Baker. He ran a bank called the First National Bank, which was literally the first national bank to get a charter under the banking acts of 1863 and 1864.

What these guys did... They would get together and they would pool their resources of their banks and then pull other banks into this pool that could then use that pooled money to save banks that were perfectly well capitalized, but were experiencing runs by depositors. Let me just give a brief insight into how these bank runs happen. The way that bank run happens is that you're sitting at home minding your own business, you hear that the bank you have your money deposited in has maybe made some bad loans and you think it could fail, well you're going to go and get your deposits out, right? Everybody does the same thing, they take all this money away from the banks. Banks, because they're leveraged institutions, they can't convert loans into cash and then pay that back to their depositors quickly enough. What they do, nowadays, is they go to the Federal Reserve, they put those assets up for collateral, and they get cash. That's how they can satisfy their depositors.

At the time, there was no Federal Reserve, and that's what J.P. Morgan did, now it's called JPMorgan Chase, but that's what J.P. Morgan did, with George Baker of the First National Bank and with, what is today Citigroup, but at the time it was City Bank of New York.

Lapera: These guys are chugging along, just fine. Then there's a major catalyst. In 1906, there was an earthquake that devastated San Francisco. The problem is, a lot of San Francisco, the people that insured them, they were in New York. Suddenly, they get this rush of insurance claims and all this money is going out of New York and people are starting to get worried like, hey, am I going to be able to keep my money in the bank? This is kind of the catalyst that ended up creating the Federal Reserve.

Maxfield: That is exactly right. 1906 you had this horrible earthquake. Even worse than the earthquake was the fire that started afterwards. I don't know who collects these statistics and I don't know how it's possible to be accurate, but I have read that the fire that followed the San Francisco earthquake in 1906 destroyed two-thirds of that city. All those buildings, they had insurance on them. That caused this huge outflow of money from the system which then triggered another banking panic. J.P. Morgan gets together again, James Stillman, who gets together with George Baker and these guys do their normal thing. They come together, they pool all this money. They are able to stop the panic this time. The American people after... This was now 40 years where you basically have either a financial crisis...

Lapera: It was a roller coaster.

Maxfield: I'm sorry what was that?

Lapera: It was a roller coaster, economically speaking, for the United States.

Maxfield: Yes. Total nightmare right?

Lapera: Just constant. Imagine being on a roller coaster for 40 years with your money and that's what was happening in the United States.

Maxfield: Yeah. Once every six years a depression or financial crisis. What a total nightmare. Anyways, it was at that point that the bankers with some senators got together and said, look we have got to do something about this. That is really where the origins of the Federal Reserve come from. Just kind of a side not on this, on the San Francisco earthquake... Bank of America. When you look at the origins of Bank of America, it traces its roots back to 1904 when a guy by the name of A.P. Giannini founded the bank. But he didn't found it as the Bank of America, no. He founded it as the Bank of Italy. The reason the Bank of Italy was able to get so much traction so quickly, besides the fact that Giannini was a respected guy in the San Francisco business community, was the fact that after that great fire, he opened up shop. He went to his vault, took all the money out, and literally set up a table outside and started his bank, giving loans and taking deposits once again. He was really the first bank in that area to get up and going again.

Lapera: That's insane. There you go. American entrepreneurship in action. I was actually in New Orleans last weekend. There was this guy at this festival who had a vodka bottle under his arm and he was selling shots for $5. 2 shots for $5, just walking down the street. Definitely didn't have a health license or anything. I was like, there you go, that is the spirit that makes America great, I guess.

Maxfield: Yeah, probably a 60% discount from what you get in a bar. Good deal, good business model.

Lapera: Federal Reserve gets created. We're doing OK. You have the roaring 20's, right, the stock market, all that. Then the Great Depression hits.

Maxfield: Great Depression, total disaster.

Lapera: Total disaster. It didn't start out as a depression.

Maxfield: That's what's so interesting about the Great Depression. It was a normal recession, going into it. What happened was that the Federal Reserve, at the time... The Federal Reserve... We had one, right. We had a central bank. So you're thinking, well, why wasn't the Federal Reserve able to stop this? The consensus among historians is that there was infighting between the different Federal Reserve branches and the central monetary commission in Washington, D.C. There's a guy by the name of Benjamin Strong who was the first head of the central bank who had passed away before that. They weren't able to come in and stop the Great Depression. What it was, was that you had a recession that then turned into the Great Depression because of literally thousands of bank failures and people lost their savings and that just turned it into what it was.

Lapera: Part of the Great Depression everyone remembers, is this terrible day on the stock market and that combined with the bank failures, you end up with something called the Glass-Steagall Act.

Maxfield: If you think about the financial crisis, we just deal with the Dodd-Frank. Glass-Steagall was basically the Dodd-Frank of the Great Depression. You went from a relatively unregulated, to a certain extent, banking industry, to a very very strictly regulated bank industry. What Glass-Steagall did in particular is it separated a bank's investment banking activities, which is issuing bonds, underwriting stocks, trading and securities, all those types of things, from your commercial banking activities, which is just taking deposits and making loans. What's interesting about Glass-Steagall is that there is, this is an analysis I've come across in multiple books, there is reason to believe that it was really backed in large part by Chase, which is now part of J.P. Morgan and by the City Bank of New York which is Citigroup. The reason they backed it so much, is because they had large commercial banking activities, large depository activities, but J.P. Morgan, which at the time was the leading bank in the country, was really largely dependent upon investment banking. They knew that if we can separate J.P. Morgan's investment banking business from its commercial banking business, we'll be able to take the lead.

That is where, it was at that point, that Citigroup went from being the second to third largest player in the industry, to really dominating it for many decades after that.

Lapera: This is why people think bankers are sneaky. Post Glass-Steagall, not a ton really happens in banking. We're going to fast forward to the 1970s when there's an oil crisis. Do you... I don't know when you were born, Maxfield.

Maxfield: I was born in 1980.

Lapera: I was going to say, "Do you remember OPEC?" They're still around actually.

Maxfield: They are still around, doing their thing.

Lapera: Just so you guys know, I've never actually met John in person. I actually don't even really know what you look like. I've only ever talked to him on the phone. That's why I didn't really know. OPEC. There's this manufactured oil and energy crisis in the Unites States in the 1970s. This is what people think about when they think about the cars lining up at the gas stations and oil rationing. People could only go in depending on what your license plate number ended in, and stuff like that.

Maxfield: What's so funny is that people... I don't know how well-known the oil crisis of 1973, that was the first one, there was another oil shock and lit later 1970s. The oil shocks in the 70s, they fundamentally transformed the financial industry in the United States. The reason that happened was, you had these really strict regulations coming out of financial crisis that, among other things, limited... They set a cap on the interest rate that banks could pay on deposits. When you had the oil shoot up... I mean, I can't remember exactly... I mean, it went up from what, $1 a barrel... Don't quote me on exactly... I'm just saying this to illustrate the magnitude. It went up from $1 a barrel to something like $80 a barrel. It was a huge, huge increase. That triggered very rapid inflation in the United States. When you have inflation, you also have interest rates increasing and increasing and increasing. The banks were stuck in this position where they were having to pay 20% to borrow money. They were then lending out on these fixed rate 30-year mortgages that were on their books for 8%.

It created this really bad situation for banks that caused them to do multiple different things. The leader of the group that was really pushing change and transformation in the bank industry was a guy named Walter Wriston at what is now Citigroup. What he did is, he said, look, we need to unchain the interest rates that banks pay to borrow money from what was the Regulation Q which was the cap. He came up with all these innovations that unchained that. Then he also was pushing...

Lapera: Hold on, go back a second.

Maxfield: Go for it.

Lapera: What was Regulation Q for? Why did this cap exist in the first place?

Maxfield: The theory behind Regulation Q, there's a couple different things, but the main theory behind Regulation Q is that if you go back all the way to the gilded age and before that, banks that would pay at a high rate of interest for their deposits were generally more susceptible to failure. Because then, if they got into trouble, the reason that people had money there was almost as an investment. So they would pull it out very quickly, as opposed to just putting it there and forgetting about it. The other reason that Regulation Q was in effect was that the United States wanted to promote local lending by savings banks, or savings and loans. What they did is they allowed savings and loans to charge a higher interest rate to gather deposits, then they allowed commercial banks, because commercial banks would then theoretically take the money that was deposited in rural areas and bring it to money centers, which would then drain that money out of there.

Lapera: This leads us back to the energy crisis and these banks that are paying out these interest rates on the deposits that are 20%+ and then having these loans that are 8%. This is what led to the savings and loans crisis of the 1980s, which is where a ton of these small banks just collapsed. They just disappeared. They got bought up by bigger banks, because they just couldn't function anymore.

Maxfield: Literally, many, many thousands of savings and loans thrifts and banks failed during the 1980s in particular as a result of that. You can think about it like this. It would be like if you run a book store and you are buying books for $20 a book and selling them for $8 a book. Not a very good business model.

Lapera: Then you get to Walter Wriston who says "I think that we can do better than this."

Maxfield: He says look, there's two ways that we can get around these interest rate caps. The first way is that we can issue negotiable certificates of deposits, CDs. Negotiable CDs that were not capped by those interest rate requirements. They could bring in all this money from big corporations that needed to get interest on their money, but they wanted it in safe big banks. The second thing that Wriston and Citigroup did was they said, look, we can go to what's called the Euro dollar market, which after you had that explosion in the energy crisis, you have all these dollars, because oil trades in dollars, all these dollars accumulating abroad because Saudi Arabia was accumulating, Venezuela, all these other countries were accumulating these dollars. Those dollars stayed in Europe and stayed overseas but they were not susceptible to those interest rate caps, so banks could borrow those dollars for either, they could pay more to borrow those dollars, or they could pay less depending on what it was. What mattered was that they were not limited by Regulation Q.

They did one other thing at Citigroup that allowed them to finance the bank through ways other than your poor deposits. They started issuing commercial paper at the bank holding company level. Basically what this did to banks, is it transformed them from these depository institutions, to basically highly leveraged financial funds that deposits only provided some of the funding for.

Lapera: When we look at banks today, we look at how much of their income is from fees and how much of it comes from interest. That's one of the most basic things you do when you look at a bank today. Correct me if I'm wrong, did Walter Wriston come up with variable rate mortgages or loans? Was that something he did?

Maxfield: He did.

Lapera: Which is brilliant, if terrible.

Maxfield: Yeah, it's totally brilliant. What it did, at the time... First of all, the real actual term loans, for the most part before Walter Wriston and his predecessor George Moore came into effect, they really just would do very short-term loans that would roll over on a yearly, monthly basis for corporations. Moore and Wriston came in and they said look, let's do longer term loans, but as opposed to doing a fixed interest rate which would get you into that position where the thrifts were during the savings and loans crisis, where if the short-term interest rates went way up but you were locked into 8% 30-year mortgages where you could lose a lot of money, they said look, let's tie the interest rate on term loans to the prevailing interest rate in the market. That way if the interest rates in the market go up, the interest rates on the loans go up, so that protected them from so-called interest rate risk.

Lapera: We have this consolidation. We have our first national banks appearing because of other regulations that got a little bit loosened during this era. Before this, you couldn't have branches that went across state lines. Post savings and loan crisis that is something that happened. Also, the Glass-Steagall Act was loosened up a little so that investment banks and commercial banks could be housed under the same umbrella.

Maxfield: That's right. This kicked off... The oil crisis kicked off a period of very, very significant deregulation. To Gaby's point, three things in particular happened. First, banks, for the most part, across the country, were then allowed to start branching. Before this, branch bank branching, the regulations, that was dictated on the state level. Some states, like California, allowed it. That's one of the reasons Bank of America was able to get so big. It could have hundreds, thousands of branches across the state whereas banks in say, Kansas, could only have one location. Branch banking started to be allowed on the national level. The second thing is that interstate banking. Before this, banks could not have branches or other offices in other states. They are limited to the state that they are founded in. But that was opened up in a time period when the oil crisis in today. The third thing that really changed was that Glass-Steagall was really chipped away at. That's where you started to have these huge universal banks that have, again, investment banking operations and commercial banking operations and that these are your Citigroups, your J.P. Morgan Chase's, and your Bank of Americas.

Lapera: They're like technically separated inside the banks but they can operate under the same corporate structure now.

Maxfield: That's right. They're balance sheet is... Technically they do different things. They all use the bank's balance sheet. If you're taking excessive risks in your trading operation, that could hit your balance sheet, which could then impact your commercial banking operation.

Lapera: These things happen. We've had that system for a while. Until we hit the financial crisis of 2008. This happened because there wasn't quite enough regulation. People didn't quite know what was going on in CDO's or in mortgage-backed securities. You see another... History is just a giant pendulum. You see the pendulum swing the other way in terms of regulation post-financial crisis in 2008.

Maxfield: It really... History in this situation really comes full circle. Because what was one of the primary causes of the financial crisis. It was these huge, these enormous banks, that were able to get enormous because of that deregulation. They became too big too big to fail. They were doing things that your tradition commercial bank wouldn't be doing.

Lapera: It's not that they wouldn't, it's just that they could not do these things, if you were talking about your local bank.

Maxfield: Exactly. They were underwriting, they would take all of these mortgages and they pushed and they went into sub-prime mortgages. They would package them together onto these securities and then they would have derivative off these securities, and then they would sell those to investors. That decreased the incentive to really watch, to really manage your risk at the bank level. It fueled the housing bubble, and then it fueled the crash. Which, when you go back to the Great Depression, it was a very similar sequence of events that led to that speculative frenzy and led to that crash.

Lapera: You end up with Dodd-Frank which creates all these regulations to make sure that banks are sufficiently funded, so that this stuff doesn't happen again, and that banks have to know what all the laws are in the separate states, and they have to know what's in their mortgage back securities. They just put a ton of regulations on it. My mom used to work for Fannie Mae and she worked for a couple of the other big banks helping them figure out how to navigate these regulations. This is dinner table talk for me growing up in high school, which wasn't interesting then, fascinating now. Oh shoot, we are almost out of time.

Financial crisis, that's where we are...

Maxfield: Just wrap it up.

Lapera: Basel III, Dodd-Frank, this is where we are now. We're in a whole new world of banking where there's a lot more regulation. Banks are, in theory, safer. It is a complicated maze to navigate and as usual, humans are probably going to find some kind of loophole in these regulations. We'll see what happens. I'm on the edge of my seat to see what happens over the next 50 years.

Any last thoughts, Maxfield?

Maxfield: I think Gaby really wrapped it up well there. We are in that post-financial crisis period where everybody is just going to be careful, so we're probably going to see less risk and therefore less investment in the system for certainly for the foreseeable future.

Lapera: As I told my students, one of the things you always have to ask yourself when you're studying history is, so what. So what? Why do we care about all these things. I think the question was answered throughout the podcast. All of the history of banking in America is sort of the history of America. What happens with the banks is really going to dictate what happens to the United States, and now the world. This is why you should care about banking in the United States of America.

Thank you, guys, very much for joining us! As usual, people in the program may have interest in the stocks they talk about and The Motley Fool might have recommendations for or against, so don't buy or sell based solely on what you hear. Contact us at [email protected] or by tweeting us @MFindustryfocus. Let us know what you think about the length of this show. I'm pretty sure it's really long. Thank you guys for joining us and have a great week!