A Brief History of U.S. Banking Regulation

Alexander Hamilton once observed, "Most commercial nations have found it necessary to institute banks, and they have proved to be the happiest engines that ever were invented for advancing trade."

Since Hamilton's day, the United States has grown into the largest economy in the world. That growth has been accompanied by ever-evolving banking regulation, which has swung like a pendulum over the past three centuries between greater and lesser control. Competing forces like the desire for financial stability versus more economic freedom, or the fear that too much power is concentrated in too few hands, have kept the pendulum swinging back and forth.

Here is a brief history of banking regulation in the U.S.

The First and Second Banks of the United States

The First Bank of the United States was established in 1791. Although it helped bring a degree of economic stability to the young nation, many feared that it gave undue powers to the federal government and considered it unconstitutional. As a result, its charter was not renewed in 1811.

The U.S. government turned to state banks to finance the War of 1812, but with the significant over-expansion of credit that followed, it became apparent that financial order needed to be restored. In response, the Second Bank of the United States was chartered in 1816. It, too, would succumb to political fears over the amount of control it gave the federal government and it was dissolved in 1836.

The End of Charters, the Rise of Free Banking

Obtaining an official legislative charter was highly political at both the federal and state levels, depending more on political connections than proven competence in financial matters. The bribing of legislators was fairly common.

By the time the Second Bank dissolved, a new era of free banking was emerging, with a number of states passing laws in 1837 that abolished the requirement that banks obtain an officially legislated charter to operate. By 1860, a majority of states had passed such laws.

During this time of free banking, anyone could operate a bank on the condition that all the notes it issued were backed by proper security. While that helped reinforce the credibility of banknotes, it did not guarantee immediate redemption in specie (gold or silver), which would serve to be a crucial point.

The era of free banking suffered from financial instability, including several banking crises. It also made for a chaotic currency market, characterized by thousands of different banknotes circulating at varying discount rates. This instability and disorder led to a renewed call for more regulation and central oversight in the 1860s.

From the Civil War to the New Deal

The free banking era, characterized as it was by a complete lack of federal control and regulation, ended with the National Banking Act of 1863 (and its later revisions in 1864 and 1865), which aimed to replace the old state banks with nationally chartered ones. The Office of the Comptroller of the Currency (OCC) was created to issue these new bank charters as well as see to it that national banks maintained the requirement to back all their notes with holdings of U.S. government securities.

The new national banking system helped return the country to a more uniform and secure currency but ultimately at the expense of an elastic currency that could expand and contract according to commercial and industrial needs. The growing complexity of the U.S. economy highlighted the inadequacy of an inelastic currency, which helped fuel frequent financial panics throughout the rest of the nineteenth century.

It became apparent during the bank panic of 1907 that America's banking system was out of date. A committee gathered in 1912 to examine the situation and found that the nation's money and credit were becoming increasingly concentrated in the hands of relatively few men. The Federal Reserve Act of 1913 was approved during the presidency of Woodrow Wilson to wrest control of the nation's finances from banks while creating a mechanism to enable a more elastic currency and greater supervision over the banking infrastructure.

Although the newly established Federal Reserve improved the nation's payments system and created a more flexible currency, the country soon faced another financial crisis, exacerbated by the 1929 stock market crash and banking panics in 1930 and 1931.

The Great Depression, which began in 1929 and continued, by some measures, until 1941, led to new regulations instituted by President Franklin D. Roosevelt as part of his administration's New Deal. The Glass-Steagall Act of 1933 created the Federal Deposit Insurance Corporation (FDIC), which implemented the regulation of deposit interest rates while separating commercial banking and investment banking. The Banking Act of 1935 served to give the Federal Reserve, also called the Fed, more centralized power.

1980s Banking Deregulation

The period following the banking reforms of the New Deal up until about 1980 was marked by a relative degree of banking stability and economic expansion. Still, critics argued that regulation also made American banks less innovative and competitive than they were previously. The heavily regulated commercial banks were losing increasing market share to less-regulated and more innovative institutions. This led to a wave of deregulation throughout the last two decades of the 20th century. Those changes included:

• Congress passed the Depository Institutions Deregulation and Monetary Control Act in 1980, which served to deregulate financial institutions that accept deposits while strengthening the Fed's control over monetary policy.
• Restrictions on the opening of bank branches in different states that had been in place since the McFadden Act of 1927 were removed under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994.
• The Gramm-Leach-Bliley Act of 1999 repealed significant aspects of the Glass-Steagall Act as well as the Bank Holding Act of 1956, both of which had served to sever investment banking and insurance services from commercial banking. From 1999 onward, banks could now offer commercial banking, securities, and insurance services under one roof. 

These moves helped to accelerate a trend toward greater consolidation and conglomeration in the banking sector, with more than 4,300 bank mergers in the 1980s and more than 6,000 in the 1990s.

As banks became bigger, their financial services and products became more complex. Banks started to offer new products like derivatives. They also started packaging traditional financial assets like mortgages and selling them to investors through the process of securitization.

Banking Regulation Following the Global Financial Crisis of 2008

The subprime mortgage meltdown beginning in 2007, the ensuing global financial crisis, and the need to bail out banks deemed "too big to fail" caused the government to rethink the financial regulatory framework. In response to the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.

Some of Dodd-Frank's protections were rolled back under the Trump administration in 2018. In particular, the new rules loosened restrictions on institutions with under $250 billion in assets and eliminated the need for them to pass stress tests.

Then, in 2021, the newly arrived Biden administration signaled its intention to tighten the government's oversight of banks. A July 2021 executive order on promoting competition in the American economy called for greater scrutiny of bank mergers by the Department of Justice and federal banking regulators. "Excessive consolidation," the order explained, "raises costs for consumers, restricts credit for small businesses, and harms low-income communities."

The Bottom Line

Since the founding of the United States, there have been numerous attempts to centralize the control and regulation of the country's banking system. Prior to the Civil War of the 1860s, fears of concentrated power and political corruption served to undermine such attempts. But as the banking system grew, the need for greater regulation and federal control became more widely accepted. That led to the creation of a nationalized banking system during the Civil War, the creation of the Federal Reserve in 1913, and the New Deal reforms of the 1930s and 1940s.

While more regulation led to a long period of financial stability, banks began losing business to more innovative financial institutions, resulting in a move toward deregulation in the 1980s and 1990s. But it wasn't long before the mortgage meltdown of 2007 and the most severe economic crisis since the Great Depression led to a call for re-regulation and to the passage of the Dodd-Frank financial reforms of 2010. The Trump administration rolled back some of those rules, but much of Dodd-Frank remains in place and the Biden administration has indicated its desire to restore and tighten bank regulations, particularly with regard to mergers.

If history is any guide, the story is far from over and the regulation pendulum will continue to swing.