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The Origins of Federal Deposit Insurance

The Origins of Federal Deposit Insurance

The insurance of bank deposits has become a common feature of banking regulation in many countries, but until recently it was strictly an American phenomenon. 

Many countries adopted deposit insurance in imitation of the United States, where-with the exception of many economists-it is regarded as an institution necessary for the stability of the banking system and the protection of depositors. 

In the current debate about how to reform the U.S. banking system, most argue on economic or political grounds that deposit insurance must be retained in some form, despite the enonnous costs it has imposed. Federal deposit insurance may thus be the only enduring legacy of the New Deal’s banking legislation. 

The widespread support for deposit insurance in the United State represented a remarkable change of public opinion. Until the early 193Os, there was no general interest in deposit insurance. Even after the 1933 banking crisis, a bitter struggle was waged over deposit insurance legislation. 

As Carter Golembe (1960, 181-82) pointed out over thirty years ago, “Deposit insurance was not a novel idea; it was not untried; protection of the small depositor, while important, was not its primary purpose; and finally it was the only important piece of legislation during the New Deal’s famous ‘one hundred days’ which was neither requested nor supported by the new administration.” 

On the one hand, the answer to the question why the United States passed Charles W. Calomiris is associate professor of finance at the University of Illinois at UrbanaChampaign and a faculty research fellow of the National Bureau of Economic Research. 

Eugene N. White is professor of economics at Rutgers University and a research associate of the National Bureau of Economic Research. The authors are grateful to the conference organizers, Claudia Goldin and Gary Libecap, and to other participants in the preconference and conference for helpful comments, and to Greg Chaudoin and Ronald Drennan for research assistance.

long-dormant deposit insurance legislation is simple. In 1933, the United States had just suffered the worst economic contraction in its history, and proponents of deposit insurance offered it as a prophylactic against a repetition of the disruption and depositor loss that plagued America in the early 1930s. 

Had there been no Great Depression, it seems unlikely that the United States would have adopted deposit insurance. On the other hand, although the Great Depression may have constituted a necessary condition for deposit insurance’s success, it is not clear why it was sufficient. 

There were many formidable obstacles to its passage, and there were alternative means to stabilize the banking system. The obstacles included the Roosevelt administration and the bank regulatory agencies, all of which opposed deposit insurance. 

Bankers were divided on the issue, but the banks who traditionally favored deposit insurance-small, rural, single-office (unit) banks in states that prohibited bank branching-had been in retreat economically since 1921 and had lost ground politically. 

Agricultural distress in the post-World War I years hastened the movement toward larger, more diversified banks, which had less need of protection. Experiences with deposit insurance at the state level had proved disastrous. 

Eight state-level deposit insurance systems had been created since 1908 at the behest of small unit banks in those states. In the 1920s, all collapsed under the weight of excessive risk taking and fraud, encouraged by the protection of deposit insurance. 

The experiences of these states were widely discussed at the time (American Bankers Association 1933; White 1983; Calomiris 1992a). Deposit insurance cannot be explained as an emergency measure conceived in haste to resolve an ongoing crisis. 

The legislation had been debated for years, the banking crisis of 1933 had been over for months prior to the implementation of the new insurance plan, and prior losses of banks and depositors were unaffected by the plan. 

Finally, there was an alternative long-run solution to the instability of the American banking system-nationwide branch banking-and it had been gaining ground politically in the 192Os, partly in response to widespread failures of agricultural unit banks and the failures of state deposit insurance schemes. 

The purpose of our paper is to explain how and why federal deposit insurance-special-interest legislation that had failed in Congress for nearly fifty year-was adopted with near unanimity in 1933. 

We consider the forces in favor of, and against, federal deposit insurance from the nineteenth century to 1933. 

We argue that, even though the traditional supporters of federal deposit insurance had suffered repeated defeats and their power was at the nadir in 1933, the nature of the political struggle over deposit insurance changed in the 1930s from a battle waged in Congress among special interests to one that engaged the general public. 

The banking collapse focused the attention of the public on the otherwise esoteric political issue of banking reform and offered the supporters of deposit insurance the opportunity to wage a campaign to convince the public that federal deposit insurance was the best solution to banking instability. 

Throughout the history of the debate over federal deposit insurance, advocates and opponents agreed that an alternative solution to bank instability would be to reduce the number of banks and increase their geographic scope by repealing limits on bank branching and consolidation.' 

Advocates of insurance-including small banks-opposed allowing greater bank concentration, while opponents of deposit insurance saw concentration as the best means to promote stability. A key factor in the passage of federal deposit insurance was the discrediting of large-scale banking by the advocates of deposit insurance.

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