The Revolution in Banking Theory

"The independent retail stores have given way to chain stores. ... Local industries have merged with larger corporations."

Three trends that have been developing in the banking field are now arresting public attention.

1. The failure during the past eight years of 4925 banks out of a total of 30,812 in operation on June 30, 1921, has called into question the soundness of the system. From the public standpoint the essential feature of a banking system is that the bank acts as a safe repository of the funds entrusted to it; that within limits these funds may be used by the bank for investments; but that eventually the funds must be returned to the depositors. This fundamental of a sound banking system is being called into-question by the appalling fact that within eight years almost one sixth of the United States banks have been suspended with losses to the depositors.

2. In spite of the prohibition of branch banking by national statute and by laws in most states, over six thousand banks in the United States are in no sense independent unit banks, but are grouped in chains by holding companies, corporations, partnerships, or individuals. In other words, the theory of the independent local unit bank has broken down in 25 per cent of the banks in the United States. The restriction of branch banking is bringing into existence chains of banks, some of them threatening to become systems, controlled outside of either the state or the federal system, and varying in financial resources from powerful, well-managed groups of influential city and central banks under publicly incorporated and capitalized holding companies to groups of banks precariously owned by individuals and susceptible of questionable management.

3. Finally, there is the movement toward bank mergers, presaging a new financial era. In the last eight years, the number of banks has been reduced by almost five thousand. In part this reduction is due to bank failures, and in part to the absorption of banks by mergers. Though the number declined, the total resources of all banks, and of the average bank, increased, indicating the trend to larger banking units. A recent series of mergers brought the resources of a new New York bank to two and a half billion dollars, a veritable financial empire and symptomatic of the merging movement.

Summarizing the three movements: we are faced with a banking weakness, as shown by the large number of failures; there is a tendency toward unification of the banking system by chain and group banking, thus circumventing the restrictions on branch banking; and the same tendency is working by means of mergers. These movements are related, and primarily have their inception in the integration that is taking place in business and industry and is creating a new economic era.

The theory of the national government, and of most states, on which the United States banking system is established is that each bank should be a local institution, locally financed and managed, drawing funds from local depositors and using its financial resources for the development of local business enterprises. Such lapses as have occurred in the history of the national banking development and those that have taken place in some states only serve to emphasize the tenacious adherence, in both legislative and banking circles, to the theory of the unit bank. Efforts to establish a national banking system have in the past been hampered by the fear that such banks will become dominant factors and will centralize the banking field.

The First Bank of the United States was chartered by Congress in 1791 as an outgrowth of the woeful failure of the Continental Congress to finance the War of the Revolution, but after establishing branches in some of the then larger towns Congress refused to renew the charter. In a sense, the War of 1812 repeated the banking history of the previous war; the government had no banking system through which to finance the war, and as a result of bitter experience during this period the Second Bank of the United States was chartered in 1816, the re-charter being vetoed by President Jackson fifteen years later. The years of the Civil War, and the reconstruction afterward, again emphasized the need of a national fiscal agency, and at that time a national banking system was established; but, in conformity with the principle of the unit bank, no banking head was given the system until 1913, when, after a long period of acrimonious debate, in which the sacredness of the local bank was the dominant issue, the Federal Reserve System was established. The new system, through its centralized agency, permitted certain cooperation, notably for reserves and discounts, with its member banks, but forbade branch banking—that is, ownership of one bank by another—thus maintaining the integrity of the unit-bank system.

A majority of the states have followed the lead of the Federal Government and have prohibited branch banking to the state-chartered banks, though in several instances this statement needs qualifications. Some states, like New York, permit branch banking within city limits, on the theory that branches established for the convenience of scattered customers within the city do not impeach the principle of the unit bank. Practice in other states varies. California, for example, permits branch banking to its state-chartered banks, limited only by state boundaries.

This liberality on the part of some states toward branch banking to affect the Reserve System. It became increasingly onerous in New York City for national banks to compete with state banks for deposits when the state banks had branches scattered in convenient neighborhoods, whereas the business of the national banks was confined to one headquarters, usually in the financial district. In other large cities, members of the Federal Reserve System were similarly placed disadvantages. In consequence bank after bank changed from national to state charter, and members of the Reserve System dropped out in increasing numbers in order to take advantage of the more liberal provisions of the state charters.

In 1919, the state banks’ resources comprised 55.41 per cent of the total, and in March 1929 they were 60.15 per cent. The resources of the national banks had declined from 44.59 per cent in 1919 to 39.85 in 1929. In order to enable the national banks to compete with the state banks, Congress passed the McFadden Act, permitting the establishment of branch banks to members of the Federal Reserve System in states where branch banks are permitted by state law, but in any event limiting such branch banks strictly to city limits.

The situation, then, that the banking community is facing to-day is that historically, legally, and in theory the unit bank is still entrenched in the national banking system and in that of most of the states. Branch banking is permitted under national charters only within city limits, and under most state laws there is the same restricted limit. Because of the legal adherence to this theory, there are now in the United States 25,961 supposedly local self-contained banks, which represent a decline from the peak of 30,812 banks in 1921.

It should be noted here, in passing, that neither in Canada nor in Europe has banking developed along any such theory. Thus, Canada has eleven banks with 4040 branches; the United Kingdom has seventeen banks operating through thousands of branches in England, Ireland, Scotland, and Wales, some of them being represented in the West Indies, Palestine, Egypt, India, and practically every part of Africa under the British flag, and even in parts of foreign Africa; banking in France, Germany, Denmark, Holland, and other commercial European countries is similarly centralized.

During the past ten years a business revolution has taken place. Whereas formerly each town had independent grocery, clothing, drug, and other retail stores, an ice plant, a local trolley system, an electric-light plant, a power house, coal yards, and thriving local industries, to-day the whole aspect of the town has changed. The independent retail stores have given way to chain stores; electricity, gas, water, and transportation are now supplied by public-utility corporations that are state-wide or regional in character. Local industries have been merged with larger corporations. The financing of these enterprises, once a profitable outlet for investment of the funds of the local banks, is now being done by central banking institutions, equipped to render adequate service to the larger business units.

The banks of the country have lagged behind industry in aligning themselves with the new order. The local store is only a distributing office of a vast national system of chain stores. It is in charge of a manager who receives the produce and sees that it is sold, but one who does not buy or secure credit, and who is not in any way active in the financing of the company. To be sure, he deposits his daily receipts in the local bank, but the transfer from the local bank to the central institution is of such short duration that this checking account, in common with a large number of other small checking accounts, is a loss to the bank rather than an asset. Certainly the bank has lost the opportunity it had with the independent merchant to deal with his substantial checking account, to take care of a part of his money in a savings account, and to finance him with loans. Instead of dealing with a local, independent business man, the bank is now dealing with a transient, promotion-seeking manager. The same holds true of the local gas office, now a branch of a regional utility corporation; or the local electric-light office, or scores of other local business institutions. Tires, drugs, automobiles, groceries, clothing, hardware, dry goods, shoes, candy, tobacco, household furniture, kitchen equipment, electrical equipment, radios, refrigerators, heaters, and scores of other commodities are to-day sold through chain stores, and distribution is directed from offices in central cities outside of the town.

This change in merchandising has had its effect on banks in the metropolitan cities, which have been forced to expand their capitalization in order to supply credit to these new clients whose annual business runs into the hundreds of millions of dollars. The legal loaning capacity to any one client is 10 per cent of the bank’s capital and surplus. When there were developed such businesses as Woolworth’s with $287,000,000 sales annually, or Sears, Roebuck, with $347,000,000 sales, or the Goodyear Tire Company with $233,000,000 sales, or hundreds of other organizations with annual sales running well into nine figures, even the largest bank in America, with its capital and surplus of $75,000,000 in 1927, was able to lend only $7,500,000 to any one of these clients. This seems like a good-sized loan, but it is wholly inadequate when we deal with an expanding industry running its sales up to three and four hundred million dollars annually. In consequence there was the need for expansion of the loaning capacity of banks by increased capitalization and by mergers. During the past five years, in the ten largest cities in the United States fifty-two mergers have taken place, creating three banks with over one billion dollars deposits; twelve with over five hundred million; and one hundred and eight with over fifty million. The extent to which industry has driven banks toward concentration of their resources is shown by the fact that seven banks, comprising 0.1 per cent of the total number in these ten cities, have 18.7 per cent of the total invested capital and 20.3 per cent of the total banking resources.

Mr. Paul Warburg, chairman of board of directors of the International Acceptance Bank of New York, described this new force when his bank announced the merger with the Bank of Manhattan: –

“I believe it is safe to say that the evolution in the industrial field, to a certain degree at least, is responsible for a similar development in the field of banking, because the gigantic form assumed by industrial corporations on both sides of the Atlantic renders their banking requirements so large and so all-encompassing that only banks with gigantic resources of their own are able to offer them commensurate facilities.”

But while this evolution toward industrial concentration has opened avenues for banking business in the large cities, which increasingly form centres from which industrial enterprises of the country emanate, the banks in the smaller towns have prospered. The failure of about 5000 banks in the last eight years has already been noted, but the significance to the whole banking system emerges sharply when it is noted that 88.6 cent of these banks were the smaller banks, with a capitalization of $100,000 or less, and that 87.7 per cent of the failures occurred in communities of 5000 population or less. These figures clearly centralize bank suspensions to the small bank and in the small town, the town from which individual enterprise has departed.

It seems idle to labor the point, confirmed by a wealth of evidence, that the smaller banks in the smaller towns do not pay; that the large number of failures among them, and the precarious return on capital invested in them, are making for a lack of depositor and investment confidence; that, in fact, it is the small bank in the small town that is to-day the most formidable threat to the banking system. An increase of 7000 per cent in Postal Savings deposits in one Northwestern state gives an isolated idea of the extent to which depositors are losing confidence in the small banks.

The situation has developed within it the seeds for its own remedy. As already pointed out, the centralizing tendency of industry has been proscribed for banks. The bank may not become the local office of a stronger central banking institution, by the prohibition of branch banking. However, facing the facts of an increasingly centripetal tendency in industry, a vanishing town banking business, and a transfer of the banking from small local banks to well-capitalized, growing, central institutions, the banking system has been forced, law or no law, to adjust its business to these changing economic conditions. In theory, the creation of a locally managed and financed banking unit may be ideal; in practice it has become out of step with the march of progress.

As a substitution for branch banking, there has developed the chain bank or group bank: that is, a group of banks owned by a holding company, a group of individuals, or by one person—not by a bank, as in branch banking. Bank stock is property and can be conveyed legally; hence, when a bank stockholder is approached by a holding company to sell or exchange his stock, there is no legal way of checking such transactions as may result in the concentration of several banks under the ownership of individuals, groups, or corporations. Such chain banking differs from branch banking in that the local board of directors is retained; that the bank is nominally run independently; but that savings in overhead, possible in branch banking, may be more difficult, or out of the question. In law and in theory these banks are independent. In practice, of course, the board of directors becomes virtually the creature, if not the employee, of the holding company, and the bank is controlled as thoroughly as a branch bank, though somewhat more cumbersomely.

Moreover, there are some dangers in the situation. The chain of banks may include, and in fact frequently does include, state banks distributed over several states and national banks. The holding company itself is not subject to examination by either federal or state banking commissioners. The banks themselves come under varying examination systems—some by one state, some by another, and a third group by the federal bank examiner. It becomes relatively easy to shift doubtful paper from one bank to another, until it will finally secure lodgment in the bank with the most lenient supervision. It is made increasingly easy, moreover, to shift the bank’s assets, to use the funds for non-banking purposes, or to centralize them for the development of some business of major interest to the holding company. Growth of chain banking is so rapid that figures given at any time soon become out of date. At this writing, some 240 groups, owning about 1800 banks, are known, and if to these are added the city branch banks and branch banks existing under some state laws, there are to-day some 6000 banks that are not independent units in accordance with the theory of the law.

In practice, then, about one fourth of the banks in the United States have drifted away from the theory of the unit bank. It must be recognized that the chain bank has sprung up in accordance with an economic need, that in an age of centralizing industry it is an essential substitution for branch banking. Many chain banks, under corporate control, have all the virtues inherent in sound banking business; they supplement and welcome thorough examination; they are desirous to promote and develop sound local banking practices; they supply the local management with excellent economic services, and they are able to supplement the local management by skillful shifting of deposits and credits, and by opening avenues for investments. Along these lines, many holding companies are developing sound and profitable banking business, yet there is also the opportunity for the individual, holding controlling stock in several banks, to take advantage of the weakness of the system outlined above.

A change in the United States banking system seems imminent. It is not improbable that, if the prejudices against branch banking continue to dominate legislation, a system of banking under a few large holding companies will develop, which will be to all intents and purposes outside either the state or the federal banking system, which will supply the economic need of branch banking, and which will have none of its public safeguards. In spite of the liberalizing McFadden Act, permitting restricted branch banking, there have been continued defections in the Reserve System since the passage of that act. Since February 1927, over three hundred national banks, scattered among forty-one states, with assets of nearly three billion dollars, have been superseded by state banks. The McFadden Act, therefore, has not checked the withdrawals from the Reserve System. To be sure, it would be unwise to advocate any catchpenny legislation merely to strengthen the national banking system. But when that system is out of step with the economic trend of the country; when it imposes a banking scheme made to handle modern business; when it compels by legal evasions reorganization of the banking scheme into groups that threaten to create a bootleg banking system—then the theory needs revision in the light of modern needs. Opposition comes from the local bankers, many of them successful even under present progressively disadvantageous conditions, bankers who refuse to immolate themselves on the alter of progress. It is significant, however, that at the American Bankers’ Association meeting at San Francisco last October the Comptroller of the Currency, Mr. J. W. Pole, courageously disregarded the position taken by some of his predecessors, and, with some rather sound reservations, advocated a change in the federal law in regard to branch banking. The account from the convention indicates that Mr. Pole’s views coincide with those of the Treasury Department, and possibly of the Administration. It is, therefore, to be presumed that proposed legislation along this line will find its way into Congress during the present session. If so, it will be a most significant step to change the financial and banking aspect of America. It will undoubtedly result eventually in the passing of the unique and distinctly American institution, the unit bank, and in the substituting for it of branches of powerful central institutions. Sentimentally one in regret the passing of the unit bank, entwined as it is with the history and  development of a once-virgin continent and conceived by a people loving individuality and financial independence in community affairs. The course, however, seems inevitable, and delay will retard and distort normal banking development, but cannot check the substitution of regionally widespread banking systems for the unit bank.