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FEDERAL RESERVE BANK
NOVEMBER 1975
OF ST. LOUIS

Oil Price Controls:
A Counterproductive Effort ..

EIGHTH
Dl

Bank Failures and Public Policy

LITTLE R O C K

'.V _

■

Vol. 57, No.

Oil Price Controls: A Counterproductive Effort
HANS H. HELBLIN G and JAMES E. TURLEY

I HE U. S. oil industry has been subjected to
varying degrees of price controls since August 1971
when general price controls were levied on the entire
U. S. economy. As controls were “phased-out” in other
industries, more stringent price regulations were im
posed on the oil industry in response to the October
1973 oil embargo and the subsequent quadrupling of
world oil prices.

U n ite d Sta te s Pe tro le u m S u p p ly a n d D e m a n d
R a tio S e a l*

R a tio Scale

The oil price control program is directed at cush
ioning the domestic impact of sharply higher external
oil prices. In this respect, the controls effort can be
regarded as successful since the effective domestic
price for petroleum remains, in fact, below world
market prices. Economic analysis, however, indicates
that the controls will (1 ) become ineffective, over
time, with respect to the above stated intention and
(2 ) will enhance the ability of external suppliers to
manipulate prices.
In support of these conclusions, this article in
cludes a discussion of the mechanics of the controls
program as it currently exists. Using economic theory
as a foundation, the eventual effects of controls on
domestic production, imports, and the domestic price
of oil are derived. In this regard, two of the more
popular questions regarding decontrol are analyzed
— will decontrol result in (1) higher domestic petro
leum prices and (2) increased domestic production
and reduced imports?

BACKGROUND
As indicated in Table I, U. S. oil refiners currently
process about 12.9 million barrels per day (M B D ). Of
this total approximately 4.7 MBD, or 36 percent, are
produced abroad.
The United States did not always rely to such an
extent on external oil supplies. In the mid-1960s oil
imports represented only 20 percent of total U. S.
consumption. In fact, as late as 1971 import quotas
on petroleum products existed in order to prevent
“cheap” foreign oil from placing domestic oil pro
ducers at a “competitive disadvantage”.
Beginning in 1966, the
tic petroleum production
1972 domestic petroleum
States actually decreased

Page 2

rate of increase in domes
began to decline, and in
production in the United
from its 1971 level. Sev-

eral factors, including price controls and environmen
tal and safety regulations, were responsible for in
creased U. S. reliance on foreign sources of supply.

OIL PRICE CONTROLS
Through a series of steps, the Federal Energy Ad
ministration (F E A ) has decreed that “old” oil — that
is, oil produced from domestic wells not exceeding
the 1972 rate of output from these wells — can sell
for no more than $5.25 per barrel. As of March 1975,
imported oil sold for $13.28 and “new” domestic
oil — that is, oil produced from both new wells and
from old wells in excess of 1972 output— sold for
$11.47 per barrel (Table I I ) .1
In March 1975 (latest available data) total crude
oil used by domestic refiners consisted of approxi
mately 41 percent “old” domestic oil, 27 percent “new”
domestic oil, and 32 percent imports. The effective
domestic price paid by domestic refiners for a barrel
of oil is simply the weighted sum of the three prices:
(0.41) X $ 5 .2 5 + (0.27) X $11.47
+ (0.32) X $13.28 = $9.49
’ As indicated in Table II, petroleum price data are available
through July 1975, but the proportions of “new” and “old”
domestic production are only available through March. For
the sake of data consistency, the analysis in this paper is
based on the prices and relative proportions that prevailed
in March 1975.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1975

1
S O U R C E S O F C R U D E O IL T O

N ovem ber

D O M E S T IC

REFINERS

D om estic Sou rces

Total C rude
O il In p ut
to Dom estic
Refiners1
(M B D )

Total
(M B D )

MBD3

1 2 .4 5 5

8 .4 5 8

5 .6 6 7

67%

2 .7 9 1

33%

3 .9 9 7

8 .4 7 1

5 .5 9 1

2 .8 8 0

3 .9 7 9

New 2

O ld 2
Percent of
Total Dom estic

MBD3

Percent o f
Total Dom estic

Im ports
(M B D )

Decem ber

1 2 .4 5 0

Jan u ary

1 2 .6 0 8

8 .6 4 4

5 .0 1 4

3 .6 3 0

3 .9 6 4

F eb ru ary

1 2 .5 4 9

8 .4 8 8

5 .1 7 8

3 .3 1 0

4 .0 6 1

M a rc h

1 2 .1 8 6

8 .3 3 3

5 .0 0 0

3 .3 3 3

3 .8 5 3

A p ril

1 1 .9 8 3

8 .5 6 7

3 .4 1 6
3 .4 9 3

May

1 1 .9 5 7

8 .4 6 4

June

1 2.2 5 1

8 .3 4 4

3 .9 0 7

Ju ly

1 2 .6 4 1

8 .3 0 4

4 .3 3 7

August

1 2 .9 0 9

8 .2 3 8

4 .6 7 1

1Total Crude Oil Input to Domestic Refiners is the sum of total domestic and imported crude oil.
2The proportions of “old” and “new” crude oil are available only through March 1975.
3The quantities of “old” and “new” crude oil were derived from published data on total domestic production and the percentage breakdown
between “old” and “new.”
NA — Not Available
MBD — Million Barrels per Day
Source: Federal Energy Administration, Monthly Energy Review (October 1975).

Controls: The Mechanics
As gauged by this effective (weighted) domestic
price equation for oil, the controls program has been
successful; the average input price of oil available to
domestic refiners is, in fact, lower than the world
market price. Achievement of this lower average
price, however, has resulted in at least two adverse
developments:
(1)
Domestic producers are discouraged from
producing “old” oil, insofar as the implicit rate of
return of keeping oil in the ground exceeds that of
investing the proceeds from the current sale of oil at
$5.25 per barrel. For example, suppose domestic oil
producers expect the price of “old” oil to eventually
(say, in 39 months, as in recent proposals) rise to the
price of uncontrolled oil. If it is assumed that the
price of uncontrolled oil at that time will be about
$12.00 per barrel, then by keeping oil in the ground
until expiration of controls a producer can realize an
annual rate of return of about 29 percent- — a return
which greatly exceeds current market yields. Under
these conditions profit-maximizing domestic oil pro
ducers would reject the option of producing now
-This compounded annual rate of return was calculated using
the following formula:

in favor of “holding back” until price controls are
completely lifted.3
(2 )
Since some refiners have access to greater
amounts of $5.25 oil than other refiners, another wave
of bureaucratic rules and regulations was deemed
necessary to prevent some firms from having a gov
ernment-mandated competitive advantage over other
firms. The nature and extent of these regulations are
discussed below.

Entitlements
With the implementation of domestic oil price
controls, the FEA recognized that some refiners de
pended heavily, in the short-run, on relatively high
cost foreign crude, while other refiners had access to
comparatively large quantities of the cheaper do
mestic “old” oil. In an attempt to equalize input costs
to all refiners, the FEA adopted the “Old Crude Oil
Entitlement Program”. This program is designed to
allocate “old” oil proportionately among all refiners
such that apparent cost differentials are reduced; that
is, equalization of the average cost per barrel is
promoted.
Each month the FEA calculates a national aver
age ratio of “old” crude to total crude usage. On the
■This assumes that changes in taxes and depletion allowances
are not expected.

Page 3

NOVEMBER 1975

FEDERAL RESERVE BANK OF ST. LOUIS

T a b le II

A V E R A G E C R U D E O IL PRICE T O D O M E S T IC
Im ports

New

O ld

Price
per
Barrel

Q u a n t it y
as a
Percent
of Total

Price
per
Barrel

4 5 .5 %

$ 1 0 .9 0

REFINERS

Q u a n tity
as a
Percent
of Total

Price
per
Barrel

2 2 .4 %

$ 1 2 .5 3

Q u a n t it y
as a
Percent
of Total

Effective
D om estic
Price
per
B a rre l1

W e ig h te d
A ve rage
Price of
N e w 8t
Im ported
O il2

3 2 .1 %

Price
of
Entitlem ent

Novem ber

$ 5 .2 5

$ 8 .8 5

$ 1 0 .2 5

$ 5 .0 0

Decem ber

5 .2 5

4 4 .9

1 1 .0 8

23.1

1 2 .8 2

3 2 .0

9 .0 2

1 0 .2 5

5 .0 0

Ja n u a ry

5 .2 5

3 9 .7

1 1 .2 8

2 8 .8

1 2 .7 7

3 1 .4

9 .2 7

1 1 .2 5

6 .0 0

Feb ru ary

5 .2 5

4 1 .3

1 1 .3 9

2 6 .4

1 3 .0 5

3 2 .4

9 .4 0

1 2 .0 0

6 .7 5

M a rc h

5 .2 5

4 1 .0

1 1 .4 7

2 7 .4

1 3 .2 8

3 1 .6

9 .4 9

1 2 .5 6

7.31

A p ril

5 .2 5

1 1 .6 4

1 3 .2 6

2 8 .5

1 2 .5 4

7 .2 9

May

5 .2 5

1 1 .6 9

1 3 .2 7

2 9 .2

1 2 .6 4

7 .3 9

Ju ne

5 .2 5

1 1 .7 3

1 4 .1 5

3 1 .9

13 .0 7

7 .8 2

Ju ly

5 .2 5

1 2 .3 0 P

1 4 .0 3 P

3 4 .3

1 3 .3 8

8 .1 3

August

5 .2 5

3 6 .2

1 3 .5 6

8.31

l The weighted average price is derived on the basis of the equation presented in this article.
2The weighted average price o f “new” and imported oil represents the sum of the price for “old” oil and the price fo r an entitlement.
P — Prelim inary
NA — Not Available
Source: Federal Energy Administration, Monthly Energy Review, and Petroleum Situation Report.

basis of this ratio, all refiners are issued entitlements
to enable them to purchase “old” crude in the same
proportion as the national average.4 For example, if
total crude usage in the nation in any particular
month consists of 41 percent “old” crude, then each
refiner is “entitled” to purchase at least 41 percent
of his input mix at the controlled price of $5.25 per
barrel, no matter where the oil actually comes from.
In principle, the refiner with access to less than the
national average of “old” crude oil can present his
entitlements to another refiner, who has more than
the national average of “old” crude, in exchange for
crude at a price of $5.25 per barrel. In practice, how
ever, the physical exchange of oil rarely takes place.
Rather, the entitlements are bought and sold among
refiners, with the price determined on the basis of
the difference between the controlled and uncon
trolled price of a barrel of oil.5 For example, in
March the average price per barrel of “new” domestic
and imported crude was $12.56. Therefore, the FEA
established an entitlement price of $7.31 for that
month. This is the price at which petroleum refiners
exchanged entitlements in March.
4For ease of illustration, it is assumed that entitlements are
physical documents which are issued by the FEA. In reality,
however, they are simply accounting fictions to which refiners
are expected to adhere.
5The FEA establishes the price per entitlement but their
choice is not arbitrary. The market price of an entitlement
would rise to the difference between the controlled and un
controlled price of a barrel of crude, even if the FEA re
mained out of the transaction.

Page 4

Refiners with access to less than the national aver
age of “old” crude can sell entitlements to those
refiners with more “old” crude than the national aver
age. The sale of entitlements represents a source of
revenue to the refiner with less than the national
average of “old” crude. The refiner who, for example,
relies mainly on imported oil can use his entitlements
revenue to reduce the effective cost of his crude oil
input.® With “old” oil representing about 41 percent
of the national input mix and the price of an entitle
ment at $7.31, the effective cost per barrel of im
ports to the refiner is reduced by $3.00 (.41 X $7.31).
That is, imports are subsidized to the tune of $3.00
per barrel. For every barrel of oil imported, the im
porter is entitled to purchase 0.41 barrel at the con
trolled price of $5.25 and is forced to pay the market
price for only 0.59 barrel.
On the other hand, a refiner who uses more than
the national average of “old” crude is required to
purchase entitlements in order to enable him to proc
ess “old” oil in excess of the national average. A
refiner who is able to meet his desired production
schedule using only “old” crude is required to pur
chase entitlements for 59 percent of his input. In
this case the effective cost per barrel to this refiner
is increased by $4.31 (.59 X $7.31). That is, “old”
domestic oil is taxed to the tune of $4.31 per barrel.
,;The analysis with imported oil is also applicable to “new”
domestic oil.

FEDERAL RESERVE BANK OF ST. LOUIS

O ld Crude O il as a Proportion of Total Crude
and Entitlement Price
M o nth ly D ata

NOVEMBER 1975

The continued maintenance of the oil price con
trols program will not prevent domestic oil prices
from rising. This would occur even without price
increases for any of the three sources of supply
(“old”, “new”, imports) to domestic refiners. As pro
duction of “old” domestic oil declines and imports
increase as a result of the controls program, the
'proportion of the higher priced oil (domestic “new”
and imports) increases, thereby raising the effective
domestic price of petroleum.
The response to the lifting of domestic price con
trols will be an immediate rise in the price of petro
leum. As long as the United States imports any oil
at all, the price of crude to domestic refiners will
be dictated by the foreign oil cartel. Accompanying
the price rise, however, will be an increase in the
quantity of oil produced domestically. Although the
increase would probably not be of a magnitude to
allow achievement of self-sufficiency in the short run,
it does imply a cutback in imports.

1974

197 5
Source: Federal E n e rg y Adm inistrati

Note: In connection with the entitlements p rogram , the FEA calculates the p ro p o rtio n s of
old, new, a n d imported oil on the b a sis o f total inputs to the refinery process. The
FEA refers to the old crud e oil p roportion a s the "o ld oil su p p ly to c a p a c ity ratio”

In essence, the price control and entitlements effort
is an income redistribution program within the oil
industry. Domestic “old” oil is taxed and the pro
ceeds are used to subsidise the purchase of imported
oil. This subsidy/tax program, through its effect on
the relative prices of imported and domestically pro
duced oil, has had a perverse impact on the national
goal of self-reliance. Domestic production is discour
aged by the imposition of price controls and there
fore has continued to decline. This, in turn, has in
creased our reliance on external suppliers.

AN EVALUATION OF SOME
DECONTROL ARGUMENTS

Will Decontrol Lead to Higher
Petroleum Prices?
Regardless of whether petroleum prices are con
trolled or decontrolled, the price of crude oil to
domestic refiners is going to increase. However, the
price increases associated with either alternative have
completely different implications for domestic produc
tion and imports.

Such a situation would create difficulties for foreign
suppliers, particularly the Organization of Petroleum
Exporting Countries (O PEC ), who have already
been forced to cut back production in order to main
tain existing prices. With reduced U.S. purchases of
imported oil as a result of decontrol, additional down
ward pressure on external oil prices would result. In
order to maintain prices, OPEC would have to volun
tarily accept a further cut in production and income
— and at a time when their domestic development
programs are in high gear.

Is the Market Solution Viable?
The free market, or decontrol, solution is rejected
by various groups of society. Proponents of continued
price controls on “old” oil suggest that although the
market price of petroleum products has already
doubled, the reduction in the quantity of petroleum
products consumed has been insignificant. In fact,
they argue that whatever reductions have been ob
served can be attributed to the reduction in business
activity, not the increase in prices. In addition, they
maintain that the current high prices have not elicited
increased petroleum production. Curiously, these
arguments lead to the conclusion that in order to
achieve both less reliance on imports and greater
domestic production, price increases substantially in
excess of those already observed would be necessary.
Opponents of continued price controls, on the other
hand, argue that economic agents are not indifferent
to the prices they pay and do indeed respond to
changes in relative prices. They point out, however,
Page 5

FEDERAL RESERVE BANK OF ST. LOUIS

that it is necessary to distinguish between a short-run
and a long-run response of both quantity supplied
and quantity demanded. With respect to the quantity
demanded, the opponents of price controls point out
that the short-run response to a hike in prices can
indeed be very weak. This has to do with the fact,
that the nation’s capital stock is energy intensive and
costs of rapid adjustment to less energy intensive
means of production are substantial. The energy re
quirement per unit of output that has been built into
production processes has been based on “cheap” oil,
and as a result of today’s prices, much of the existing
capital stock has become inefficient.
Reductions in the quantity of oil demanded depend
on the substitution of relatively less energy intensive
means of production. An example would be the re
placement of an automobile that averages 15 miles to
a gallon of gasoline with one that gets 30 miles per
gallon. The fuel costs per passenger mile as a measure
of the product produced by an automobile would then
be reduced. While this substitution process is pro
ceeding quite rapidly in the area of automobiles, the
conversion cost to many industries is very high in the
short run and therefore would be expected to take
place only over time. Although this adjustment does
take time, it must not be forgotten that the economic
incentives to make it are great and there is no reason
to believe that the adjustment will not eventually be
made. The quantity demanded is indeed responsive
to price if sufficient time is given for the affected
economic agents to respond.
Opponents of continued price controls also point out
that the response of the quantity of oil supplied to a
change in price has not been substantial because a
great deal of uncertainty surrounds the return on new
investment projects. For example, exploration for new
oil wells, more intensive utilization of existing oil
wells, as well as research into new methods of produc
tion (such as the liquification of coal and offshore
drilling) all require extensive capital investments.
Even though today’s high market prices for oil might
justify such investment expenditures, uncertainty with
respect to the future price of oil greatly lessens the
incentive to undertake such investments.7 This argu
ment implies that domestic producers expect world
market prices to decline from their present highs and
that “cheap” imports could once again be substituted
for domestic production.
7There is the additional problem of uncertainty about future
tax programs which could reduce sharply the rate of return
on these investments, even if the current price of oil prevails.

Page 6

NOVEMBER 1975

Former Secretary of the Treasury George P. Schultz
recognized this dilemma of uncertainty. He suggested
that if self-reliance is indeed a national goal, uncer
tainty which faces domestic producers should be
eliminated. To this end Schultz proposed a variable
tariff on imports designed to maintain today’s high
external price. In the event that the foreign oil cartel
would disintegrate and world market prices decline,
the proceeds from the tariff could be distributed to
consumers via the tax system.
In general, then, those opposed to decontrol are not
convinced that market forces will produce greater
self-sufficiency and lower petroleum product prices.
Those in favor of the removal of petroleum price
controls, however, contend that government restric
tions only hinder domestic oil production and provide
incentives to import, thereby supporting the collusive
actions of OPEC. Both of these effects tend to enhance
the unity of OPEC members, whose continued
strength would result in higher petroleum prices for
U. S. consumers. An additional objection is that reli
ance on controls to provide solutions to economic
problems in many cases only aggravates and intensi
fies the initial problem.

CONCLUSION
The analysis presented in this article points out
that the currently existing oil price controls program
has been successful in achieving its intended purpose
— cushioning domestic prices of petroleum products
from the higher world oil prices. But the analysis
also suggests that the controls program is in conflict
with its stated purpose over the long run. In particu
lar, controls provide both disincentives to produce oil
domestically and incentives to import oil. As imported
oil becomes an increasing proportion of total domestic
consumption, the effective domestic price of oil will
increase also. The greater U. S. reliance on foreign
sources of supply, in turn, enhances the unity of the
foreign oil cartel such that the United States becomes
increasingly vulnerable to external pricing and pro
ducing decisions. A situation has been fostered which
would perpetuate rising world oil prices in the future.
There is an alternative to this rather ominous
scenario. Even though petroleum prices would in
crease as a result of decontrol, incentives for both
increased domestic production and reduced imports
are provided. Increased domestic production and
reduced imports, in turn, would tend to strain the
unity of the oil cartel, and hence, be conducive to
lower world market prices for petroleum in the future.

Bank Failures And Public Policy
R. ALTON G ILBER T

1 I 1ANK FAILURES since the fall of last year have
caused a great deal of concern regarding both the
soundness of banks and the effectiveness of current
regulatory practices in this country.1 The largest bank
failure in U.S. history occurred last year with the col
lapse of the Franklin National Bank of New York
(total assets of $3.6 billion). One of the immediate
causes for the failure of Franklin National was large
loan losses in foreign exchange transactions. However,
Franklin National also had difficulty generating earn
ings ratios as high as banks of comparable size which
were accepting the same risks.2 Fourteen other banks
have failed or were forced into mergers since last fall,
the largest being Security National Bank of Long
Island (total assets of $1.8 billion), which had large
losses in real estate loans. Information on those fail
ures and forced mergers is presented in Table I.
The recent experience with bank failures differs
from what has occurred during most of the period
since the early 1940s, when the few banks that did
fail were primarily small banks.3 Deposits of banks
that failed during those years generally comprised
less than one-hundredth of one percent of total de
posits (see Table II). The share of total deposits in
banks that failed has tended to be higher since the
mid-1960s, rising to roughly one quarter of one per
cent in 1974. This changing pattern since the mid1960s reflects failures of larger banks.
A primary objective of bank regulation in this
country is prevention of bank failures. In addition,
1For a discussion of public concern over the soundness of
banks, see Business W eek, April 21, 1975, and Forbes, July
1, 1975. One indication of the concern of investors about the
soundness of banks is the rapid decline in bank stock prices
from spring to fall of 1974. Investors got news of the financial
difficulties of Franklin National in May of last year. An index
of stock prices of New York City Banks fell at a 63.5 percent
annual rate from April to September of 1974, compared to a
52.0 percent rate of decrease in the Standard and Poor’s
stock index during the same period. The index of bank stock
prices and the Standard and Poor’s 500 composite stock index
are presented in an accompanying chart.
-Sanford Rose, “What Really Went Wrong at Franklin Na
tional”, Fortune (October 1974), pp. 118-21, 220-27.
:iNote that the chart entitled “Bank Failures: 1934-74” and
Table II refer to only those banks that have been declared
failures by their government supervisors and do not include
those forced to merge with larger banks due to financial diffi
culties even though technically solvent. This distinction ac
counts for the differences between the observations in Table I
and those in Table II and the “Bank Failures” chart.

B a n k Stock Prices R elative to
A v e r a g e Stock M a r k e t Prices 1
January 1971-100

Janu ar y 1 9 7 1 = 1 0 0

160

1 60

ol Hew York Bank
Stock Prices

1971

1972

1973

1974

197 5

Basic d a ta sources-, fo r b a n k sto c k p rice s, the Am erican B a n k e r, fo r the S t a n d a r d
a n d P o o r In d ex, the Fe de ral R eserve Bulletin
Q _ O b s e rv a t io n s for e ach in d e x a re e x p re s s e d a s a p e rc e n t a g e of the a v e ra g e v a lu e of
the b a sic se rie s in J a n u a r y 1971.

relaxation of some banking regulations has been rec
ognized as another desirable policy goal. In recent
years some regulations have been relaxed to give
banks greater freedom to respond to changing market
conditions. As regulations are relaxed, however, banks
have a tendency to assume greater risks and, hence,
increase their vulnerability to failure. The goal of
maintaining a low rate of bank failure, in turn, is
placed in jeopardy.
These two policy goals for banking can be made
more compatible by altering the program for Federal
deposit insurance such that the premiums on deposit
insurance are based upon the risks banks assume. As
background to this proposed change, the causes of
widespread bank failures are discussed, with refer
ence to the experience of the 1930s, and the regula
tory response to dealing with the vulnerability of the
banking system to such failures is described. In addi
tion, some actual and proposed changes in bank regu
lations are presented.

EVOLVING PUBLIC POLICY
AFFECTING BANK FAILURE

What Is a Bank Failure?
Banks are officially declared failures, by the state
or Federal agencies that charter them, when the net
worth of a bank becomes zero or negative, or when a
Page 7

FEDERAL. RESERVE BANK OF ST. LOUIS

NOVEMBER 1975

situation threatens to make the
net worth of a bank zero or neg
ative. Such situations have one
of the following three outcomes:

T a b le I

Banks That Failed or W e re Forced to M e rg e W ith
Larger B an ks Since Septem ber 1974

N a m e a n d Location of B a n k

D isp o sitio n o f Ban k

Total D e p o sits
(m illio n s
of d o lla rs)

Total A sse ts
(m illio n s
o f d o lla r s)

A m e rica n B a n k a n d Trust
O r a n g e b u r g , So u th C a ro lin a

D e p o sit liab ilitie s assu m e d
b y S o u th e rn B a n k a n d Trust,
G re e n v ille , So u th C a ro lin a ,
on Sep tem b er 2 0 , 1 9 7 4 .

$ 1 2 7 .2
(Ju n e 1 9 7 4 )

$ 1 4 5 .3
(J u n e 1 9 7 4 )

T ri-C ity B an k
W a r r e n , M ic h ig a n

D e p o sit lia b ilitie s assu m e d
b y M ic h ig a n N a tio n a l Ban k,
W a rre n , M ic h ig a n , on 9 / 2 7 / 7 4 .

$ 1 6 .4
(Ju n e 1 9 7 4 )

$ 1 8 .3
(Ju n e 1 9 7 4 )

C ro m w ell State S a v in g s B a n k s
C ro m w ell, Io w a

D e p o sit lia b ilitie s assu m e d b y
Io w a State S a v in g s B an k, C reston,
Io w a in O cto b e r 1 9 7 4 .

$ 3 .3
(Ju n e 1 9 7 4 )

$ 3 .6
(Ju n e 1 9 7 4 )

F ranklin N a tio n a l B an k
N e w Y o rk C ity, N e w Y o rk

D e p o sit lia b ilitie s a ssu m e d
b y E u ro p e a n -A m e ric a n B a n k
a n d Trust C o m p a n y , N e w Y o rk City,
N e w Y o rk , o n O cto b e r 8, 1 9 7 4 .

$ 1 ,5 7 7 .7
(Ju n e 1 9 7 4 )

$ 3 ,5 9 0 .6
(Ju n e 1 9 7 4 )

S w o p e P a rk w a y N a t io n a l B a n k
K a n sa s C ity, M is s o u r i

F D IC a p p o in te d receiver of
b a n k . In su re d d e p o sit
liab ilitie s a ssu m e d b y
D e p o sit In su ra n c e N a tio n a l
B a n k o f K a n sa s C ity under
Section II o f the FDI Act,
J a n u a r y 3, 1 9 7 5 .

$ 9 .2
(Ju n e 1 9 7 4 )

$ 9 .7
(Ju n e 1 9 7 4 )

Security N a t io n a l B an k
L o n g Is la n d , N e w Y o rk

M e rg e d with C he m ical Ban k
in J a n u a r y 1 9 7 5 b ecause of
p re ssu re from su p e rv iso ry
a uthorities.

$ 1 ,4 3 2 .0
(Ju n e 1 9 7 4 )

$ 1 ,7 7 1 .3
(J u n e 1 9 7 4 )

N o rth e rn O h io B an k
C le ve la n d , O h io

D e p o sit lia b ilitie s assu m e d
b y N a tio n a l C ity B an k,
C le ve la n d , O h io , on
F e b ru a ry 1 8, 1 9 7 5 .

$ 8 5 .6
(J u n e 1 9 7 4 )

$ 1 0 4 .4
(Ju n e 1 9 7 4 )

F ra nklin B a n k
H o u sto n , T exas

C lo se d b y su p e rv iso ry
a u th oritie s o n M a rc h 2 4 , 1 9 7 5
a n d the F D IC n am e d receiver.

$ 2 4 .0
(J u n e 1 9 7 4 )

$ 2 9 .8
(J u n e 1 9 7 4 )

C h ico p e e B a n k & Trust Co.
C h ico p e e , M a ssa c h u se tts

C lo se d M a y 9 , 1 9 7 5 . D e p o sit
lia b ilitie s assu m e d b y the
H o ly o k e N a tio n a l Ban k.

$ 1 1 .7
(Ju n e 1 9 7 4 )

$ 1 3 .1
(Ju n e 1 9 7 4 )

A lg o m a B a n k
A lg o m a , W is c o n s in

C lo se d M a y 3 0 , 1 9 7 5 . D ep osit
lia b ilitie s to be a ssu m e d b y
the First State B a n k of A lg o m a ,
a new b a n k w hich w ill be
a ffiliate d with the First
N a tio n a l B a n k of S tu rg e o n Bay.

$6.1
(Ju n e 1 9 7 4 )

$ 7 .0
(Ju n e 1 9 7 4 )

B a n k o f Picayun e
P icayun e, M is s is s ip p i

C lo se d o n Ju n e 1 9, 1 9 7 5 due
to em b ezzlem ent b y a n officer.
D e p o sit lia b ilitie s assu m e d
b y H ancock B a n k , G u lfp o rt,
M is s iss ip p i.

$ 1 4 .9
(Ju n e 1 9 7 4 )

$ 1 7 .3
(Ju n e 1 9 7 4 )

B a n k o f C hid e ster
C hide ster, A r k a n s a s

C lo se d J u ly 1, 1 9 7 5 . D e p o sit
lia b ilitie s a ssu m e d b y
M e rc h a n ts a n d Planters B an k,
C a m d e n , A rk a n sa s .

$ 2.0

$ 2.2

(D ecem be r
1974)

(D ecem ber
1974)

State B a n k o f C le a rin g
C h ic a g o , Illin o is

C lo se d J u ly 12, 1 9 7 5 . D e p o sit
lia b ilitie s assu m e d b y
C le a rin g B an k, a new bank.

$ 6 2 .5
( Decem ber
1974)

$ 8 1 .3
(D ecem ber
1974)

A st ro B an k
H o u sto n , T exas

C lo se d O cto b e r 16, 1 9 7 5 .
D e p o sit lia b ilitie s assu m e d
b y C o m m o n w e a lth B a n k o f
H o u sto n , a new b ank.

$ 6 .9
(D ecem ber
1974)

$ 7 .9
(D ecem ber
1974)

A m e rica n C ity N a t io n a l B a n k
a n d Trust C o m p a n y
M ilw a u k e e , W is c o n s in

C lo se d O c to b e r 2 1 , 1 9 7 5 .
D e p o sit lia b ilitie s assu m e d
b y M a r in e N a tio n a l E x c h a n g e
B a n k o f M ilw a u k e e .

$ 1 4 6 .6
(D ecem be r
1974)

$ 1 8 8 .2
(D ecem ber
1974)

Page 8

(1 ) The chartering agency
closes a bank permanently. D e
positors receive payment from
the Federal Deposit Insurance
Corporation (F D IC ) for up to
$40,000 per deposit account.
Customers with deposits over
$40,000 lose the uninsured por
tions of their accounts, unless
there is some residual value
when the FD IC disposes of the
bank’s assets.
(2 ) The chartering agency
closes a bank, but its deposit
liabilities and assets are assumed
by another bank. In some cases,
the FD IC either purchases as
sets of a failing bank which are
of questionable value or insures
the bank that is assuming the
deposit liabilities from losses on
the assets it acquires. No cus
tomers incur losses on their de
posit accounts in this case. The
banking organization which as
sumes deposit liabilities often
begins offering banking services
at the offices of the bank that
failed.4
(3 ) Without officially declar
ing a bank to have failed, reg
ulatory authorities arrange an
emergency merger between a
bank having financial difficulties
and another bank. The merged
bank assumes all of the deposit
liabilities of the bank having
financial difficulties.
4From 1934 (the beginning of Federal
deposit insurance) through 1973, 297
insured banks were closed perma
nently for liquidation, and the de
posit liabilities of 205 failing banks
were assumed by other financial in
stitutions. Through 1973 the deposits
of insured banks that have failed less
payment to the depositors of those
banks amounted to about $25.3 mil
lion. However, some of that amount
will ultimately be recovered as the
assets of closed banks are liquidated.
Federal Deposit Insurance Corpora
tion, Annual R eport (1 9 7 3 ), p. 5.

NOVEMBER 1975

FEDERAL RESERVE BANK OF ST. LOUIS

T a b le II

Incidence o f Ban k Failure:
Deposits o f Banks That Failed

Year

D e p o sits of
C om m ercial
B a n ks
(In Billion
of $ ) 1

D e p osits of
F a ilin g B a n ks
(In T h o u sa n d s
of $)

1934
1935
1936
1937
1938
1939
1940
19 4 1
1942
1943
1944
1945
1946
1947
1948
1949
1950
195 1
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974

$ 2 9 .9 0
3 4 .4 8
3 8 .4 4
4 0 .0 5
4 0 .0 7
4 3 .4 3
4 8 .7 2
5 4 .3 7
6 0 .2 3
7 4 .4 0
8 6 .2 6
1 0 2 .0 4
1 1 2 .6 2
1 1 9 .4
1 2 2 .0
1 2 2 .0
1 2 5 .8
1 3 0 .9
1 3 8 .2
1 4 3 .5
1 4 9 .7
156.1
1 5 9 .0
1 6 3 .6
1 7 2 .8
1 8 1 .6
1 8 3 .6
1 9 5 .9
2 1 0 .7
2 2 8.1
2 4 6 .2
2 6 9 .5
2 9 1 .2
3 1 5 .6
3 4 4 .8
3 6 0 .4
3 7 6 .2
4 3 3 .7
4 8 4 .3
5 4 9 .6
6 1 1 .1

$ 37332
19987
28100
34205
60722
160211
142787
29797
19541
12525
1915
5695
494
7207
10674
9217
5555
6464
3313
45101
2948
11953
11690
12502
10413
2593
7965
10611
4231
23444
23867
45256
106171
10878
22524
40133
52826
132032
99786
971312
1571208-

D e p o sits of
F a ilin g B a n k s a s
a Perce ntage of
Total D ep osits
0 .1 2 4 9 %
0 .0 5 8 0
0 .0 7 3 1
0 .0854
0 .1515
0 .3 6 8 9
0 .2 9 3 1
0 .0 5 4 8
0 .0 3 2 4
0 .0 1 6 8
0 .0 0 2 2
0 .0056
0 .0 0 0 4
0 .0060
0 .0 0 8 7
0 .0076
0 .0044
0 .0 0 4 9
0 .0024
0 .0314
0 .0 0 2 0
0 .0 0 7 7
0 .0 0 7 4
0 .0 0 7 6
0 .0 0 6 0
0 .0014
0 .0 0 4 3
0 .0054
0 .0 0 2 0
0 .0 1 0 3
0 .0 0 9 7
0 .0 1 6 8
0 .0 3 6 5
0 .0034
0 .0065
0 .0 1 1 1
0 .0140
0 .0304
0 .0206
0 .1 7 6 7
0 .2 5 7 1

1Seaaonally Adjusted Annual Average.
2Based upon deposits as of failure date, as for other years in this
column. The deposit figures in Table I were recorded prior to fail
ure dates.
Source of Deposits of Failing B a n k s: Federal Deposit Insurance Cor
poration, Annual Report, 1973.

Widespread Bank Failures
The most recent period of widespread bank failures
in U.S. history was from 1929 to 1933 when the num
ber of banks in operation declined by over one-third.5
The sequence of events that led to this general
collapse of the banking system illustrates the process
by which widespread bank failures can be generated.
5Milton Friedman and Anna J. Schwartz, A Monetary History
of the United States, 1867-1960 (Princeton, New Jersey:
Princeton University Press, 1963), p. 299.

Although the stock market crash came in October
1929, the large rise in the rate of bank failures did not
occur until October 1930.6 The failure of several
banks in the fall of 1930 created fear that other banks
were unsound.7 Depositors began demanding con
version of their deposit balances to currency on a
large scale.
Even a conservatively managed bank has limited
ability to convert deposits to currency for a large
fraction of its depositors. A bank generally cannot use
its required reserves for such payments of currency
since bank regulatory authorities regard these re
serves as essential for a bank’s continued operation.
One source of currency for making payments to de
positors is from selling assets. When many banks
simultaneously experience large currency withdrawals,
attempts of banks to obtain currency by selling se
curities will tend to drive down the prices of securi
ties. If these runs continue long enough and the
market values of securities fall far enough, even the
most conservatively managed banks will tend to be
come insolvent as they suffer losses in liquidating
their assets.
This process of several bank failures inducing fear
of more failures, bank runs, declines in the value of
bank assets, and then additional bank failures, oc
curred in three phases in the early 1930s. The last
phase of this process came in the first three months
of 1933.8
6As one indication that the public retained its confidence in
commercial banks until the fall of 1930, the ratio of bank
deposits to currency rose during the period August 1929 to
October 1930.
Ubid, pp. 308-309.
HIbid, pp. 308-332. Widespread bank failures were not in

evitable in the early 1930s when fear of insolvency of banks
spread among bank customers. In the banking crisis of 1907
and in earlier banking crises, banks mutually agreed not to
convert deposit balances to currency for their customers.
During such periods, the public continued to use bank depos
its as money, and banks continued to offer most services, but
for a while deposits could not be converted into currency.
See Friedman and Schwartz, A Monetary History, pp.
156-68. One of the reasons for establishing the Federal
Reserve System was to make such restrictions of conversion
from deposits to currency unnecessary since the Federal
Reserve was to provide sufficient currency to banks when
ever there was a threat of large deposit withdrawals. The
existence of the Federal Reserve as lender of last resort may
have been a major reason why commercial banks did not
mutually agree to restrict payments of currency in the early
1930s. However, the Federal Reserve failed to function in its
role as lender of last resort during that period. There were
some expansionary policy actions by the Federal Reserve
immediately after the stock market crash in 1929 and again
in 1932, but these actions were not sufficient to offset the
forces tending to reduce the money stock and bank credit.
See Friedman and Schwartz, A Monetary History, pp. 305-6,
pp. 322-4.

Page 9

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1975

B a n k F ailu res
N u m b e r of B a n k s
400

So u rc e s: F o r b a n k fa ilu res, F D IC A n n u a l Report for 1 9 3 4 .F D IC A n n u a l R ep o rt fo r 1973; for p erio d s of b u s in e ss contraction, G e o ffre y H. M o o re , ed., B u sin e ss C ycle In d ic a t o rs, Vo l. I (Princeton, N J.:
Princeton U n iversity P ress, 1961)
S h a d e d a r e a s a re p e r io d s o f b u s in e s s contraction.

One important point to be emphasized from the
process that generates widespread, bank failures is
that when the public loses confidence in the banking
industry, forces which cause an individual bank to fail
are, in general, independent of its prior investment
policies. Both a bank that has invested in risky assets
and one that has assumed little risk are vulnerable to
failure in such an environment. Therefore, policies
designed to deal effectively with w idespread bank
failures must involve more than simply requiring
banks to acquire less risky assets.

Bank Regulatory Response to Widespread
Failures
The following discussion describes features of the
bank regulatory policies which have been developed
since the early 1930s that deal with the vulnerability
of the banking system to widespread failures. Indi
vidual features of the regulatory policies are evalu
ated in other studies; such an evaluation is not the

Page 10

purpose of this paper.9 Presentation of bank regula
tory policies as an interrelated system designed to
prevent bank failures facilitates the analysis below of
how proposals for financial reform would influence
bank behavior and vulnerability to failure.
The most significant innovation in bank regulation
during the 1930s was Federal deposit insurance, of
“George J. Benston, “Interest Payments on Demand Deposits
and Bank Investment Behavior,” Journal o f Political Economy
(October 1964), pp. 431-49; Benston and John T. Marlin,
‘ Bank Examiners’ Evaluation of Credit: An Analysis of the
Usefulness of Substandard Loan Data,” Journal o f Money,
Credit and Banking (February 1974), pp. 23-44; Sam Peltzman, “Entry in Commercial Banking,” Journal o f Law and
Econom ics (October 1965), pp. 11-50; Peltzman, “Capital
Investment in Commercial Banking and Its Relationship to
Portfolio Regulation,” Journal o f Political Econom y (January/
February 1970), pp. 1-26; Donald P. Jacobs, T he Im pact of
Examination Practices Upon C om m ercial Bank Lending
Policies, Staff Analysis for House Committee on Banking and
Currency, 88th Congress, 2nd Session, Washington, D.C.,
G.P.O., 1964; Lucille S. Mayne, “Supervisory Influence on
Bank Capital,” Journal of Finance (June 1972), pp. 637-51;
Hsiu-Kwang-Wu, “Bank Examiner Criticisms, Bank Loan De
faults, and Bank Loan Quality,” Journal o f Finance ( Septem
ber 1969), pp. 697-705.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1975

1 934
1136
1 938
1940
1942
1944
1 946
1948
1950
1 952
1954
1956
1 958
1960
1962
1964
1966
1968
1970
1972
Sources: For bonk failures, FDIC Annuol Report tor 1934,FDIC Annual Report for 1973; for periods of business contraction, Geoffrey H. Moore, ed., Business Cycle Indicators, Vol. I (Princeton, N.J.: Princeton University Press, 1961)
Shaded areas are periods of business contraction.

fered through the FDIC. Federal deposit insurance
reduces the incentives for bank runs when some
events occur which, in the period before deposit in
surance, would have made depositors fearful about
the safety of their deposits.
Although deposit insurance has been effective in
preventing bank runs, prevention of individual fail
ures is also a national policy objective. One important
reason for attempting to keep bank failures at a low
rate is to keep the payouts from the deposit insurance
fund low, thus promoting public confidence in the
ability of the deposit insurance fund to meet its
obligations. The risks that banks assume must be con
strained in some way in order to have a low rate of
bank failure. The Federal deposit insurance program
is not designed to constrain the incentives for banks
to assume risks since the premium rate for deposit
insurance does not vary among banks but is a given
percentage of insured deposits. Since Federal deposit
insurance provides a large degree of safety from bank
runs, it may tend to induce banks to hold portfolios
of assets with higher risks than if the banking system
was less safe from bank runs.
The risks that banks assume are constrained by
direct government regulation of bank behavior. A
limit is imposed on the maximum loan that each bank
can make to one customer which, by regulation, is a
fraction of the bank’s capital. This regulation may
cause banks to diversify their risks to a greater extent
than they otherwise would. Banks are restricted from
buying corporate stock, and there are some restric
tions on the real estate loans that banks can make.
Regulators examine banks to determine the quality of

1974

their assets and to enforce compliance with all regula
tions. As part of the examination process, examiners
rate the quality of bank management, and occa
sionally exert pressure to change management. Regu
lators put pressure on banks to keep their capital-toasset ratios above minimum levels.10 All of these
forms of regulation tend to impose the judgment of
regulators on banks, reducing the ability of banks to
respond to changing market conditions in investing
their assets.
In addition, regulation of bank liabilities involves
ceilings on interest rates that banks may pay on time
deposits and prohibition of interest on demand de
posits. An intent of these regulations is to increase
bank profits, to remove the incentives for banks to
acquire high risk assets, and to decrease the volatility
of deposits.11 One important influence of this regula
tion is that levels of interest ceilings in relation to
market rates influence the ability of banks to attract
time deposits.
'"The penalties that bank regulators have for enforcing their
capital adequacy standards include removal of bank officers
and directors, cancellation of deposit insurance, and closing
banks. These penalties are quite drastic and are seldom
imposed. There is some evidence that bank regulators
have little effect on the capital ratios of banks. See Sam
Peltzman, “Capital Investment in Commercial Banking and
Its Relationship to Portfolio Regulation,” Journal o f Political
Econom y (January/February 1970), pp. 1-26; Lucille S.
Mayne, “Supervisory Influence on Bank Capital,” Journal
o f Finance (June 1972), pp. 637-51.
"George Benston tested the hypothesis that banks which paid
higher interest rates on deposits made more risky loans.
The results of empirical tests led him to reject that hypothe
sis. See George J. Benston, “Interest Payments on Demand
Deposits and Bank Investment Behavior,” Journal o f Politi
cal Economy (October 1964), pp. 431-49.

Page 11

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1975

Effects of Bank Regulation on Failures
The bank regulatory scheme developed in the
1930s contributed to a reduction in the rate of bank
failure to relatively low levels by the early 1940s. No
more than 9 banks failed in any one year from 1943
through 1974, compared with approximately 500 fail
ures per year in the 1920s ( see accompanying
chart).12 There has been no tendency for bank fail
ures to cause loss of confidence in banks in general
and to induce additional failures. The sort of failures
that have occurred since the early 1940s have often
created public benefits since failure is one process of
removing inefficient or dishonest bankers.

Recent Developments in Bank Regulation,
Behavior, and Implications for Failures
Since the early 1940s, bank failures have been
caused primarily by embezzlement, fraud, bad man
agement, and assumption of high risks.13 This section
focuses on the risk aspect of bank failures. Several
developments in recent years have reduced regula
tory constraints on banks without changing incentives
for banks to accept risks, and many banks have re
sponded by accepting higher risks. The following
discussion includes only a few of the important
changes in regulation and bank behavior which have
been taking place.
Liability M anagement — During the 1960s, impor
tant changes took place in the sources of bank funds.
Some banks began attracting a large share of their
deposit liabilities by issuing certificates of deposit,
and the volume of transactions in Federal funds was
greatly expanded, as shown in the accompanying
chart. Banks were given greater freedom to attract
funds by issuing large CDs in 1970 when interest
ceilings were removed on short-term time deposits of
$100,000 or more and in 1973 when interest ceilings
were removed on large time deposits of all maturities.
Another source of funds that banks began to use dur
12Federal

Deposit

Insurance Corporation,

Annual

Report,

1 9 3 4 , p p . 9 3 -9 4 .

13For a discussion of the causes for individual bank failures
each year, see the Annual Reports of the Federal Deposit
Insurance Corporation. For an additional discussion of the
reasons for bank failures, see R ecent Bank Closings, Hear
ings before the Committee on Banking and Currency, House
of Representatives, March 9, 1971, pp. 33-37; Robert E.
Barnett, “Anatomy of a Bank Failure,” The M agazine of
Bank Administration (April 1972), pp. 20-23, 43; George J.
Benston, Bank Examination (New York University, The
Bulletin, No. 89-90, May 1973); and John J. Slocum, “Why
57 Insured Banks Did Not Make It — 1960 to 1972,” Jour
nal o f Com m ercial Bank Lending (August 1973), pp. 44-56.

Page 12

ing the late 1960s was that of bank related commer
cial paper, which is sold by subsidiaries of banks or
bank holding companies (see chart).
Banks which attract large shares of their funds
from sources that are not fully insured are vulnerable
to losing such funds quickly if investors discover that
those banks are having financial difficulties.14 There
fore, many banks have become more vulnerable to
liquidity crises due to their practices of attracting
large shares of their funds for investment by issuing
large CDs and by borrowing in the Federal funds
market.
Changes in Regulations Affecting Bank Assets and
C apital — Important changes have also been made in
the regulation of assets that banks may acquire and
in the capital structure of banks. Many of these
changes have been initiated by the Comptroller of the
Currency, and similar regulations have been adopted
by the other bank regulatory agencies. Several such
changes discussed in the 1963 Annual R eport of the
Comptroller are listed below.
(1) Lending limits, the largest loan banks can make
to any one customer, were increased for many banks.
(2 ) National banks were given greater freedom in
making real estate loans.
(3 ) The types of general obligation bonds of state
and local governments that national banks could
underwrite were expanded.
(4 ) National banks were allowed to count long
term debt which is subordinated to deposit liabilities
as part of their capital.15 In cases of bank liquidation,
holders of subordinated debt receive payment only if
all depositors receive full payment. Previously, bank
regulators considered only equity capital to be bank
capital.
The first three changes listed above influence the
riskiness of assets that banks may acquire. Regula
tions concerning debt as bank capital also have sev
eral important implications for the risk exposure of
banks. Suppose that for some reason a bank has a
large reduction in the value of its assets. The feasi
bility of the bank accumulating enough capital out of
retained earnings to again be considered a viable or14The CDs issued by most banks are insured by the FDIC
up to $40,000 per depositor. Federal funds borrowings are
not insured by the FDIC.
lr,The Federal Reserve and the FDIC recently proposed
changes in regulations which would specify the role of debt
as capital for banks regulated by those agencies.

FEDERAL RESERVE BANK OF ST. LOUIS

NOVEMBER 1975

Sources of Funds for B a n k s E n g a g e d in Liability M a n a g e m e n t

1959

I9 6 0

1961

1962

1963

1964

196S

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

LL A s r e p o r t e d b y l a r g e w e e k l y r e p o r t i n g c o m m e r c i a l b a n k s

ganization by regulators could depend upon how
much debt the bank has in its capital structure. In
terest payments on debt capital and its ultimate
retirement are obligations that the bank must meet in
order to remain solvent, whereas dividend payments
can be postponed, and there is no obligation to retire
equity capital. Another implication of regulators con
sidering long-term debt to be bank capital is that
banks can increase their lending limits by issuing
such debt, since lending limits are based upon the
total capital accounts of banks.
Acquisitions of Nonbanking Firms by BHCs — An
other recent development which has implications for
the risks of bank failures is the acquisition of non
banking firms by bank holding companies (BH C s).
Since 1970 the Federal Reserve Board has had the
responsibility of determining the activities in which

BHCs may engage.18 Table III lists the currently
approved activities. The expansion of BHCs into non
banking industries creates possibilities for financial
difficulties of nonbanking subsidiaries to adversely
affect bank subsidiaries. Many customers of a sub
sidiary bank may withdraw their deposits if a non
bank subsidiary of the BHC experiences financial
difficulties. One reason for depositors of a subsidiary
bank to start a run on the bank is they may assume
1''In 1956 the Federal Reserve Board received legislative
authority to regulate the acquisitions of firms that own
controlling interest in two or more banks. These holding
companies were not allowed to engage in activities other
than banking. Holding companies owning only one bank
were free to make whatever acquisitions of nonbanking
firms they wanted before 1970. The BHC Act of 1970 gives
the Federal Reserve Board authority to regulate the acquisi
tion of all BHCs with the possibility of BHCs acquiring
firms in industries other than banking which the Board rules
to be closely related to banking. BHCs must get prior
approval from the Board for each such acquisition.

Page 13

FEDERAL RESERVE BANK OF ST. LOUIS

T a b le III

N o n b a n k in g Activities in W hich Bank
H o ld in g C o m p a n ie s M a y E n g a g e 1
M o r t g a g e B a n k in g
Fin ance C o m p a n y
C re d it C a rd C o m p a n y
Factorin g C o m p a n y
In d u stria l B an k
M o rr is Plan B a n k
In d u stria l Loan C o m p a n y
Loan S e rv icin g
Trust C o m p a n y
Investm ent o r F in a n c ia l A d v ise r
L e a sin g Real o r P erson al Property
M a k in g Eq u ity a n d D ebt Investm ents in C o rp o ra tio n s o r Projects
D e sig n e d P rim arily to Prom ote C o m m u n ity W e lfa re
B o o k k e e p in g o r D a ta P roce ssin g Services
In su ra n c e A g e n t o r Broker
U nd e rw rite r of C redit In surance
C o u rie r Service s
M a n a g e m e n t C o n su ltin g A d v ic e to B a n k s not A ffiliate d with the
B a n k H o ld in g C o m p a n y

1Taken from Sec. 225.4(a) of Federal Reserve Regulation Y .

that the subsidiary bank has made the same bad in
vestment decisions as the nonbank subsidiary. An
other reason depositors may react in that way is
because they may assume that the subsidiary bank
will use its resources to help the nonbank subsidiary
in financial difficulty, even though several regulations
restrain subsidiary banks from taking such actions.
The possible risks to banks of affiliation with a BHC
are illustrated in the case of the Beverly Hills Na
tional Bank and its parent corporation. The BHC had
financed large loans to a real estate developer by
selling its own commercial paper. When the real es
tate developments became unprofitable, the BHC had
difficulty refinancing its commercial paper debt. The
bank lost deposits as the financial position of the BHC
became more widely known, although the bank itself
was solvent according to the analysis of the Comp
troller of the Currency. The holding company sold its
interest in the bank to the Wells Fargo Bank to pay
off its debts.17
O ther Causes o f R ecent Bank F a ilu r e s - It is diffi
cult to determine the role of the above changes in
regulations and bank behavior in the recent bank
failures because there have been several other forces
at work. The recent recession began in the fall of
1973, and it is during recession periods that large loan
losses make some banks insolvent. Historical evidence
in the accompanying chart indicates a tendency for
bank failures to rise when the rate of economic activ
ity declines. In addition, the risks of speculation in
foreign exchange have been greater since 1971 when
17American Banker, January 2 and 23, 1974.

Page 14

NOVEMBER 1975

the world monetary system was switched from fixed
to floating exchange rates. The failure of Franklin
National provides an example of the influence that
foreign exchange speculation can have on bank earn
ings and capital.

Some Recent Proposals for Further Relaxation
of Constraints on Bank Behavior
Proposals for financial reform which have received
much attention in the past few years may indicate
the future course of bank regulation. Proposals for
financial reform by the Hunt Commission call for re
laxation of several banking regulations which affect
various types of activities in which banks may engage
and the types of assets they may acquire.18 The
Financial Institutions Act of 1975 proposes similar re
laxation of regulations on real estate loans and com
munity development projects.
Neither group of proposals for financial reform
would alter the way in which deposit insurance pre
miums are calculated. Therefore, these proposals, like
several changes in regulation in recent years, would
move the banking system in the direction of fewer
constraints without reducing the incentives of banks
to accept high risks; the degree to which such pro
posals would affect bank safety is uncertain.

RECONCILING BANK SAFETY WITH
RELAXATION OF REGULATIONS
Bank regulation has changed in recent years to
give banks greater freedom in attracting funds and
selecting assets, and proposals currently under con
sideration indicate that there may be fewer regulatory
constraints on banks in the future. However, if a low
rate of bank failure and a solvent deposit insurance
fund also continue to be important objectives of public
policy, new forms of bank regulation must be imple
mented to restrain the risks that some banks would be
induced to assume.
18See The Report o f the President’s Commission on Financial
Structure and Regulation (Washington, D.C.: United States
Government Printing Office, 1971), pp. 41-43. The Hunt
Commission proposed, among other things, that (1 ) com
mercial banks and their subsidiaries be permitted to engage
in a variety of nonbanking activities of the type approved
for BHCs by the Federal Reserve Board; (2 ) special
statutory and regulatory restrictions on real estate loans be
abolished; (3 ) commercial banks be permitted to invest in
any assets up to 3 percent of total assets or 30 percent of
capital, surplus, and undivided profits, whichever is less;
( 4 ) authority to underwrite revenue bonds be expanded;
(5 ) commercial banks be permitted to make equity invest
ments in community rehabilitation and development corpora
tions in amounts up to 5 percent of capital, surplus, and
undivided profits.

FEDERAL RESERVE BANK OF ST. LOUIS

These objectives could be achieved through a pro
gram of charging banks deposit insurance premiums
based upon the risks they assume.10 Regulation of
bank behavior could be eliminated. Individual banks
would be free to choose the degrees of risk they
prefer. Most banks would probably not accept high
risks if deposit insurance premiums were set high
enough to compensate the deposit insurance fund for
the risks involved. Whatever would be the choices of
banks in accepting risks, the most important consid
eration is that public confidence in the capacity of
the deposit insurance fund to meet its obligations pre
vents bank runs, and under this plan the solvency of
the insurance fund would be protected by charging
banks premiums that are high enough to cover their
risks of failure.
The Hunt Commission Report presents the com
mon arguments against variable deposit insurance
premiums in the following quote:
The Commission rejected the variable rate proposal.
It recognizes that differences in risk of failure exist
and that its recommendation for liberalizing the
regulations relating to the asset, liability and capital
structures of financial institutions would probably
increase these differences. The problem is a prac
tical one. The Commission does not see how differ
ences in risks can be evaluated with sufficient
precision to be adequately reflected in insurance
assessments. Further, the Commission believes that
assessments might be used, albeit unintentionally, to
penalize innovative institutions. New and different
functions might be regarded as high risk functions.
Finally, knowledge that some institutions were pay
ing higher assessments than others could weaken
public confidence in those institutions, which would
defeat the purpose insurance was designed to
achieve.20

Sam Peltzman has answers for these arguments.21
The evaluation of assets by bank examiners could be
used as the basis for setting deposit insurance pre
miums. As to the argument that innovative institutions
1!,For other discussions of this proposal, see Thomas Mayer,
“A Graduated Deposit Insurance Plan,” Review o f Econom ics
and Statistics (February 1965), pp. 114-116; Clifton H.
Kreps, Jr. and Richard F. Wacht, “A More Constructive
Role for Deposit Insurance,” Journal o f Finance (May
1971), pp. 605-13j Sam Peltzman, “The Costs of Competi
tion: An Appraisal of the Hunt Commission Report,” Journal
o f Money, Credit and Banking (November 1972), pp. 10014; Ronald D. Watson, “Insuring Some Progress in the Bank
Capital Hassle,” Business Review, Federal Reserve Bank of
Philadelphia (July-August 1974), pp. 3-18.
2(JPresident’s Commission on Financial Structure and Regula
tion, p. 74.
21Sam Peltzman, “The Cost of Competition: An Appraisal of
the Hunt Commission Report,” Journal o f Money, Credit
and Banking (November 1972), pp. 1001-4.

NOVEMBER 1975

would be penalized with higher insurance premiums,
Peltzman maintains that such penalties would be only
temporary until the insurance agency would adjust
the premiums to actual experience. Peltzman also
argues that with information on deposit insurance pre
miums becoming public knowledge, banks would
have strong incentives to cater to the degree of risk
aversion desired by their depositors.

SUMMARY
An appropriate objective of public policy regarding
bank regulation is prevention of w idespread bank
failures. The money stock and bank credit have de
clined during past periods of widespread bank fail
ures, disrupting economic activity. In the past, large
numbers of banks have failed when some events, such
as the failure of several banks or one large bank, made
depositors fearful about the soundness of all banks,
inducing them to demand currency for their deposits.
That response tended to make even more people
fearful about the soundness of their banks, creating
runs on banks.
In this country the most recent experience with
widespread bank failures was in the period 1930-33.
Current regulatory policies were largely developed in
the 1930s in response to that experience. A central
feature of these policies is Federal deposit insurance,
which has greatly reduced the risks of bank runs.
The deposit insurance premiums of banks are calcu
lated as a given percentage of insured deposits. The
risks that insured banks assume are controlled by
direct regulation of bank behavior.
In recent years there has been some relaxation of
bank regulation, giving banks greater freedom to com
pete in attracting deposits and investing their assets.
However, there have been no changes in regulatory
policies which would induce banks to restrain the risks
they assume. If it is in the public interest to relax
direct regulation of the risks that banks may assume
and yet keep the bank failure rate low and the de
posit insurance fund solvent, one appropriate change
in policy would be to begin charging each bank a de
posit insurance premium based upon the risks that it
assumes. Such a policy would give banks greater free
dom to respond to market forces in investing their
assets while reducing their incentives to assume high
risks. The premiums would be set high enough to
compensate the insurance fund for the risks of failure
that banks assume.

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Full text of Review (Federal Reserve Bank of St. Louis) : November 1975

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