Bank Architecture, Financial Architecture

For the past 25 years one of commuting’s little pleasures has been waiting at the traffic light in Watertown Square and admiring the architecture of the local bank (built in 1921.)  Unfortunately the links here and here don’t even come close to doing it justice, as it has the sort of deeply recessed arches associated with Alberti’s church in Rimini.  By the 1950s and 1960s, bank architecture had begun to reflect the aesthetics of the strip mall.  How did that happen?

One explanation would point to the general decline in architectural standards during the overly ideological “less is more” era.  (On the other hand I wish my own college had adhered to that aesthetic in the 1960s when they decided to build seven story dorms with neo-Georgian hats on top.)  But I don’t think that fully explains the problem.  Even by the standards of 1920s commercial architecture, the Watertown Savings Bank would have been very impressive.  It obviously isn’t a drug store or restaurant.  There is a sort of temple-like quality to many of these edifices, as if they were trying to awe the public.  And why not, they were asking the public to trust them with their life savings, as no deposit insurance existed in 1921.

I have recently been thinking about bank architecture as I read all the various articles about reconfiguring the “financial architecture” of the world economy (a metaphor that refers to regulatory structure, not bricks and mortar.)  What can 1920s bank architecture teach us about where to go in the future?  I’d like to throw out an offbeat suggestion; maybe we should try to get banks to behave like the sober, conservative institutions of the 1920s; not by deregulating them completely, but rather by regulating them in such a way that they will mimic the behavior of those earlier institutions.  But first we need to clear up a few historical misconceptions.

There is a widespread view that the 1920s banks behaved in all sorts of devious and irresponsible ways, and that the Great Depression (and Congressional hearings) exposed those shenanigans.  Nothing could be further from the truth.  There was a basic flaw in the U.S. banking system during the 1920s, but it was almost entirely due to misguided regulation.  The flaw was state regulations limiting branch banking, which resulted in an absurdly large number of independent banks, each very poorly diversified.  Most relied on a local and mostly rural deposit base.  The following numbers are from memory, and may be slightly off, but capture the spirit of what happened.

Even during the prosperous 1920s the U.S experienced about 600 bank failures per year, as small rural banks often failed.  During the Great Contraction (1929-33) about 4000 banks failed, and many more merged, reducing the total from about 25,000 to about 15,000.  In Canada (a country one tenth our size), there were 11 banks, each having nationwide branching.  None failed and one merged during a Depression comparable to that experienced by the U.S.  So we might want to reconsider the view that smaller banks are a foolproof remedy for our current problems.

You might be wondering why 4000 bank failures doesn’t suggest that we had a poorly managed banking system.  Context is everything.  The U.S banking system was hit by hurricane force winds after October 1929.  Nominal GDP plunged at more than 15% per year. Yet the first (very small) banking panic didn’t occur until more than a year later.  Even by 1933, when nominal income had nearly fallen in half, the vast majority of banks didn’t fail.  I have no idea how people who lost half their nominal income were able to repay their loans, but they did.  In contrast, in late 2007 our banking system was hit by a little puff of wind, and collapsed like a $3 suit.

There is a common misconception that without the FDIC, bank runs would develop any time a rumor began to circulate that a bank was in trouble.  Obviously that was not the case, as most banks survived the Depression, and banks runs were localized in terms of time and place (until rumors of dollar devaluation in early 1933 led to a fairly widespread bank run.)  And as noted earlier, the prosperous 1920s saw many bank failures but no systemic bank runs.

Without branch banking laws, our banking system might have looked more like the Canadian system, and might well have come through the Depression in reasonably good shape.  Our modern system could not survive a Depression even half as bad, even if not a single subprime or adjustable rate mortgage had ever been made.  We have a very fragile banking system, and so do many other developed countries.

Many free market economists have put too much faith in market forces to provide bankers with the right set of incentives.  The entire deposit base of the banking system is essentially loans from the Federal government, at near risk-free rates of interest.  It doesn’t seem that way because we are so used to deposit insurance that people tend to forget just how important is its impact.  When we deposit $100 into our checking account, the action is no different from us loaning the $100 to the Federal government, and then having them re-loan the money to the banks.  With this almost unlimited source of funds at near risk free rates, it’s no surprise that the U.S. (and European) banking system became too highly leveraged.

Non-free market economists make the opposite mistake; they put far too much faith in regulation.  Each time there is a scandal, they propose regulatory fixes for that specific issue, without considering the deeper systemic problems.  Just think about the regulations after the S&L crisis, after Enron, and now what is being discussed today.  The last thing we need to worry about is another orgy of sub-prime loans; the next fiasco will almost certainly be in some other area.

So what do we do?  If the root cause of the problem is moral hazard, then we could try to repeal FDIC, and other policies like “too big to fail,” in order to get back to the system of the 1920s.  But that is not politically feasible.  Some might also argue that it would lead to banking crises, but I don’t think that is the case.  We have the worst banking crisis in American history today, and we have deposit insurance.  In addition, the banking crises of the 1930s reduced the money supply only because we were on a gold standard; under a fiat money regime the Fed would offset cash hoarding with an increase in reserves.  (Of course if they continue to pay interest on reserves, even that may not be enough—but any regulatory fix has to assume the Fed will come to its senses, and not continue this sort of recklessly deflationary policy.)

A few bank runs are actually desirable, they don’t impact the broader economy under a fiat money regime, and they encourage banks to behave more conservatively.  How do we get bank runs without giving up deposit insurance?  By limiting the insurance to 90% of deposits, starting at the very first dollar.  Depositors will then have an incentive to pull money out of banks making lots of sub-prime loans, but people will not lose their entire life savings in a bank failure.  In addition, regulators should look at the way banks behaved in the 1920s, and impose similar capital ratios as was the norm during that period.  (I’m under no illusion that this will be easy.)

To free market economists I say don’t assume all the changes since the 1920s are “financial innovation.”  In my view there is zero evidence that the higher leverage ratios represent true financial innovation, and lots of evidence that they represent the distortionary effect of deposit insurance and multiple bailouts of big banks.

I started this post by describing the pleasure of driving by the handsome bank in Watertown Square.  Just imagine how fortunate the residents of Owatonna, Minnesota are, as they get to walk by this pre-FDIC bank building everyday (also see here.)  I’m not saying that modestly reducing the FDIC coverage will revive the architectural fashions of the early 1900s, but if it produces buildings even 1/10th as beautiful as Sullivan’s masterpiece, then it will have been worthwhile.

Postscript: I should thank my architectural history prof at Wisconsin, Narciso Menocal, who was my favorite professor in college.  And also my brother and sister, for asking me a lot of probing questions about what’s wrong with the banking system.  Questions that forced me to rethink this issue.



20 Responses to “Bank Architecture, Financial Architecture”

  1. Gravatar of Larry Larry
    5. April 2009 at 13:05

    Let’s assume that FDIC insurance is 100% responsible for this crisis, but also give it credit for the lack of banking disasters since the Depression. On balance I’d say we did the right thing.

    I think there are other regulatory things we can do to protect the financial system. The most important is to control leverage. Both homeowners and investment banks went to 30:1 leverage. I don’t know what the number is, but might that change alone be sufficient?

  2. Gravatar of ssumner ssumner
    5. April 2009 at 15:03

    Larry, Perhaps we did the right thing if the only two choices are the current deposit insurance system (and importantly the even worse too big to fail system) and nothing. But I proposed an FDIC that would cover 90% of deposits–why wouldn’t that be better? The current banking crisis is far worse than anything that occurred in the Great Depression. The Depression panics did reduce AD more sharply than this one, but only because we were on the gold standard. If we had been on a fiat money standard (like today) the Depression panics–even without FDIC—would have been of trivial importance compared to the current fiasco.
    Perhaps you are right about leverage (and I tend to agree with you), but didn’t we try something similar after the S&L fiasco? Why should we expect better results this time from a purely regulatory approach?

    We talk about failures of “the market”, but for 75 years we have had no real market for most of bank liabilities. Maybe it’s time to inject some market incentives back into that side of the balance sheet.

  3. Gravatar of Kaleberg Kaleberg
    5. April 2009 at 18:12

    You are basically correct about the quality of the 1920s US banking system. I gathered from an old article in Fortune that the bank failure rate roughly doubled in the 1930s, but it had been pretty high in the 1920s as well. I’m not sure how the power law for bank destroying “turbulence” works, but I’d guess that conditions had to be more than twice as bad to simply double the failure rate. There were an awful lot of small banks, many too small to research investment opportunities outside the community. Worse, there was an entire unregulated business dedicated to selling basically bogus securities to isolated rural banks.

    If you look at the recent crisis, the big issue isn’t so much the FDIC. To be honest, I actually considered moving my IRA into cash. It could easily have fit into a shoebox in hundreds, but there was really no mechanism for declaring a shoebox of cash in my safe deposit box a properly tax sheltered IRA. I didn’t want to get hit by the withdrawal penalties, and then hit again by losing tax exemption during the anticipated recovery. Luckily, the FDIC was there, so I simply moved everything into CDs.

    Since many individuals, unlike most economic pundits, expected the recent downturn, I could imagine the shoebox solution writ large. I’m sure that my IRA holding company would have given me a large check to cover my liquidation, but I could imagine the trouble I would have had cashing the check. I doubt that any of the local branch banks has that much cash on hand, or would be willing to hand that much over to an individual, even if they were just going to stuff it into a safe deposit box in the same building. If you can imagine a few hundred of us trying to pull this stunt, you can imagine a modern day bank run. It wouldn’t look quite like one from the 1930s. Bankers aren’t expected to provide payment in cash, let alone gold, just because an instrument says “pay to the order”.

    The real problem is that incomes haven’t kept up with economic growth. That means that there aren’t a lot of good investment opportunities. That means there is a lot of money out there mainly looking for bubbles. That’s all that’s left when producing goods and services doesn’t pay very well. If incomes were rising, as they were before Reagan, it might pay to invest, but one has to face reality.

    As for the crash, yes, the bulk of the losses involved gambling contracts placed on other people’s risks by third parties. Yes, the creation of a mortgage origination industry led to the production of low quality mortgages, just as Soviet taxi drivers produced all the miles the politburo wanted by jacking up the rear wheels and jamming down the accelerator. Everyone knew that the FDIC and the federal government would be stuck holding the bag, though most people find it a mystery as to why the government is using the most roundabout means possible for restoring credit.

    As for bank architecture, you are on the money. In the 1920s, the banks wanted to look reliable. That meant looking expensive. In the 1950s and 1960s banking was aimed at becoming more convenient, more friendly and more computerized. They didn’t need to waste their time looking trustworthy. If you want, compare the gingerbread houses with more modern houses, and consider the tradeoff between more gingerbread and central heating, modern plumbing and plenty of hot water.

  4. Gravatar of Larry Larry
    5. April 2009 at 22:17

    I agree that injecting some risk would be a better approach. But if we look back at when the S&Ls failed, we see that the FDIC wasn’t strong enough to stick to the then 100k coverage limit. In for 90 cents, in for a buck, I’m thinking.

    I agree that regulation is a poor alternative to a well-functioning market, if one can be constructed. But the market did not until too late recoil from AIG, Countryside, Merrill, etc. These are not banks, so banking regulations did not apply. Regulating by behavior instead of by institution type may help.

  5. Gravatar of septizoniom2 septizoniom2
    6. April 2009 at 00:48

    the references to architecture are wonderful and evocotive. some of the most impressive exteriors and interiors are classic bank buildings. there are many such examples in downtown nyc and i often enjoy viewing the lobbies for their quiet solidity. true expressions of the building crafts and classic forms.

    on the substance, i find it somewhat inconsistent that you agree in any regard with larry or anyone who in the main stresses regulation as a cure. your main point in this blog seems to be to me that the correlation in the decline in all asset values/markets is at bottom caused by a decline in ngdp, which can be further traced to overly tight fed policy. i would stick to that theme in all regards.

  6. Gravatar of Andy Ormsby Andy Ormsby
    6. April 2009 at 03:03

    I rather like this idea.

    Here in the UK, it is interesting that local government institutions and charities, organisations with qualified professionals who should have known better, continued to maintain large deposits in Icelandic banks even after knowledge of their poor stability became obvious. If the possibility of a _real_ bank failure had been part of current thinking, rather than a dimly remembered story from history books, perhaps they would have thought twice.

  7. Gravatar of Alex Golubev Alex Golubev
    6. April 2009 at 09:03

    i prefer the 90% FDIC suggestion (compared to the current alternative). Makes all the sense in the world. Leverage and moral hazard are some of the biggest issues, whether they’re politically adressable or not. unfortunately, if they’re not, then countries that took the less levered road to begin with will win in the long run… if of course they can recreate the highly important freedoms and military might of the US. It’s important to remind us theoreticians sometimes that we don’t live in a vacuum and that RELATIVE success is actually more important for survival (outrunning a bear vs outrunning the other guy).

  8. Gravatar of ssumner ssumner
    6. April 2009 at 17:08

    Kaleberg, I agree with some of your points, but I think people should be careful with the “everyone knew” stuff (i.e. the FDIC would have to pay up.) This crisis was not foreseen by stock investors (including me) so not quite everyone knew (you may have.)

    Larry, You are right that markets failed big time, but as I pointed out in my efficient markets hypothesis piece, regulators failed even worse.

    Septizoniom2, I mostly agree. I think the initial problem was partly mistakes by bankers, but the much bigger more recent problem is the Fed. There is some argument for a few regulations (capital ratios?) to offset other distortionary government policies such as deposit insurance. But I am skeptical of regulation like you are. (BTW, are there so many Septizonioms that you had to add a “2”?)

    Andy, Thanks, the Iceland banks are an excellent example.

    Alex, Yes, I agree. BTW, I should do a “featherbed” post. We have two models, those impressed by the rugged pioneers going out West who had no protection, or the people who say the Americans should just be able to lay back on featherbeds and let someone else make all the hard choices. Don’t make people actually think about which bank to put their money into, which school to send their kid to, whether a health test is worth spending their own money (from health saving account), where to invest their Social Security money. Just lie back on a nice featherbed and let Uncle Sam take care of everything. We can do that, but people should know that there will be a cost.

  9. Gravatar of septizoniom2 septizoniom2
    7. April 2009 at 03:22

    thank you. i am both septizoniom and septizoniom2. a digression on why or how i am both is not worthy of this insightful blog.

  10. Gravatar of Alex Golubev Alex Golubev
    7. April 2009 at 06:45

    Wild West vs Featherbeds. I think i would lean “right” on this one. I lived in the USSR until ’93 and moved here when i was 13. The featherbeds were not what was ordered in 1917! It’s a tough choice though. Republicans are in bed with religious nuts and liberals are in bed with socialist nuts. Pick your poison. Both parties take turns furthering the agenda of the powerful and the elite. I’m not talking politics, i’m talking anti-politicians. I think we have a wonderfull oportunity for a revolution via the internet. Although the wisdom of crowds might be even more dangerous. But that’s a bit of a tangent. On a more relevant topic, i think you will find this short paper/essay interesting: “The Unfortunate Complexity of the Economy” . It’s a dicussion of possible applications of physics to help us overcome/look into the assumption of the rational agent.

  11. Gravatar of Thruth Thruth
    7. April 2009 at 06:59

    >But I proposed an FDIC that would cover 90% of deposits-why
    >wouldn’t that be better?

    As an empirical matter, domestically insured deposits are a small fraction of the liabilities of the big banks after you take the entire holding company into account. The deposits that are insured are 100% insured, but forcing all depositors to take a haircut by lowering the fraction insured to 90% would be almost impossible to sell politically. Such a haircut flies in the face of the bailout de jour taking place right now that’s protecting unsecured creditors to the same degree as insured depositors.

    I think the rationale for insuring “small” deposits has always been to (1) PROTECT the “little people” from losses when the more savvy creditors run and (2) PREVENT the same “little people” from panicked herding to the exits at the first sign of trouble.

    Uninsured creditors should provide some measure of discipline. Isn’t that what we’re seeing? The banks screwed up and so their short-term credit dried up. Of course, this is ex post discipline and not ex ante, and even then, it is being countered in good measure by current Federal policy. Do we have any good reason to think banks would have thought twice about the off balance sheet shenanigans knowing their deposit base was also at risk?

    The FDIC is just a small part of a broken regulatory system that helped foster moral hazard. Fannie and Freddie also subsidize bank lending and are now just another bailout tool. The FHLBs have extended enormous advances to banks on easy terms since the onset of the crisis. The regulatory framework and incentive structures seem to encourage herding into the same risks. Risk assessors such as the ratings agencies were captured by their clients long ago. Bank balance sheets are opaque and rife with exposures to untold maximal losses. The federal government’s failure to address any of these problems sent a clear signal that it would stand behind the financial system at all costs.

  12. Gravatar of ssumner ssumner
    7. April 2009 at 17:20

    Alex, I see no reason at all to give up on the rational agent model. See my efficient markets post. If that paper has any useful investment advice, let me know (I just skimmed it.) I think you and I have similar politics.

    Thruth, I actually agree with most of what you say. I agree my plan is not politically feasible right now. I agree that there already are strong incentives for banks not to do reckless lending, and I agree that there are other bigger problems like Fannie mae and Freddie mac. I should have mentioned them, and would favor abolishing both, along with all the other Federal agencies that promote home ownership. And of course get rid of the tax deductibility of mortgage interest and property taxes. BTW, if I am not mistaken it was the government that encouraged the 30 year mortgages. Weren’t bank loans pretty short term back in the 1920s? I seem to recall that mortgages were 3 years. If so, that may explain why so few banks failed in the Depression. I should have done more research before doing this post.

  13. Gravatar of septizoniom2 septizoniom2
    8. April 2009 at 01:22

    i think it is a fool’s errand to attempt to regulate away the effects of a severe decline in asset prices that is correlated accross all assets and accross all countries. leverage/risk measures are only important in an examination of the idiosyncratic nature of any particular financial institution’s profile (and thus in the main left best to the market). in a severe, correlated asset price crash accross countries and assets, almost any leverage/risk is too much, not forseeable and mostly divorced from credit risk (vis-a-vis any particular debtor) measures. i suspect such a turn of events erupts in an unforseeable way from an alteration in perceptions on a mass scale and a resulting insatiatle craving for pure liquidity (money). thus, i think this blog has it the most right of all blogs—fix this crisis through the most direct way possible: satiate the demand for money.

  14. Gravatar of Alex Golubev Alex Golubev
    8. April 2009 at 06:59

    I saw the EMH post and commented a few times. 1 – I dont’ think it’s the economist’s job to predict. 2- I also don’t think lack of predictability is an argument for rationality. Just cause the future is unpredictable, doesnt’ mean that the allocation of resources is rational or efficient. So as far as i am concerned the EMH should substitute unpredictable for rational. Modeling the irrational human behavior more correctly will allow us to create incentive structures to allocate resources more efficiently and limit the factors that exagerate the deviations. THAT is the goal of econ. Here are some excerpts from the article that i found interesting and tend to agree with:
    “If all agents made their mind in isolation (zero herding tendency) then the aggregate opinion would faithfully track the external influences and, by assumption, evolve smoothly. But surprisingly, if the herding tendency exceeds some finite threshold, the evolution of the aggregate opinion jumps discontinuously from optimistic to pessimistic as global factors only deteriorate slowly and smoothly.Furthermore, some hysteresis appears. Much as supersaturated vapor refusing to turn into liquid, optimism is self-consistently maintained. In order to trigger the crach, global factors have to degrade far beyond the point where pessimism should prevail. On the way back, these factors must improve much beyond the crash tipping point for global optimism to be reinstalled, again somewhat abruptly. Although the model is highly simplified, it is hard not to see some resemblance
    with all bubbles in financial history. The progressive reckoning of the amount of leverage used by banks to pile up bad debt should have led to a self-correcting, soft landing of global markets – as the efficient market theory would predict. Instead, collective euphoria screens out all bad omens until it becomes totally unsustainable. Any small, anecdotal event or insignificant news is then enough to spark the meltdown.”
    “even if an equilibrium state exists in theory it may be totally irrelevant in practice, because the equilibration time is far too long. As Keynes noted, in the long run we are all dead. The convergence to the Eden Garden of economic systems might not be hobbled by regulations but by their tug-induced complexity. One can in fact imagine situations where regulation could nudge free, competitive markets closer to an
    efficient state, which they would never reach otherwise.”
    I guess if one calls herding and hot potato activities rational, simply because i can’t beat the market set up in that environment, then i don’t really have a good argument, but then why bother with anythign if the unpredictability of the future can be used to justify any current policy. I gues the Fed must have been acting rationally this fall. 😉

  15. Gravatar of ssumner ssumner
    8. April 2009 at 16:26

    septizoniom2: It is very gratifying to find others who understand how a big part of what looks like bad investment decisions is actually a systemic failure produced by deflationary monetary policy.

    Alex, It all sounds fine until the last sentence “One can in fact imagine situations where regulation could . . .” when in fact the passage you quoted predicts the very opposite. He says at the beginning that herd behavior, or what I call “groupthink” is the problem, I entirely agree. Now where are you likely to get more of that occurring, in a stock market which aggregates the opinions of surfers in Hawaii, farmers in Iowa, and old ladies in Miami, or in a room in Washington DC where a half dozen middle aged white guys from similar schools who talk mostly to each other decide where the market went wrong and how to regulate it. “One can in fact imagine?” Yes, until you actually study the real world record of regulators. I still don’t buy the anti-EMH position. BTW, you said I made an argument for rationality. I did not, nor do I believe people are “rational”, whatever that means. I made an argument for models that assumed rationality, until we can come up with a better assumption. I still think its the best assumption (unrealistic as it is) out there.

  16. Gravatar of Alex Golubev Alex Golubev
    10. April 2009 at 07:03

    1. I don’t fully buy in on the efficiency of regulation in tugging us toward the efficient state myself. i just couldn’t leave out the author’s conclusion. One of the areas where regulation COULD benefit from this is by actually making the system less complex with more flexibility and thus easier to repair in the off chance that herding becomes extreme as it regularly does. 2. The issue of groupthink is also a reflectin of inefficient incentive systems. This is where i think the anonymity and google-popularity-algorithms will create much more efficient democracy-hybrids that will benefit a lot of aspects of our life including politics. However we’ll then be subject to a new phenomenon “groupthink not”, where we’ll do LESS thinking and more relying on the opinion of crowds. The positives will outweight the negatives but herding increases and thus we’re subject to harsher turndowns. 3. What i think we oughta do, is MODEL the human behavior as accurately as we can, instead of assuming that we’re completely rational agents. The herding (self-reinforcing) tendency is a very important aspect of human behavior and most social sciences ignore it. It’s definitely not realistic. I’d rather stay away from labels like “rationality” and aim to model more realistic behavior. 4. I’m gonna speculate that if economics embraced herding, then the idea that confidence and economic activity can go through drastic phase transitions even if actual economic variables change slightly would be more likely to be accepted. Groupthink is a static variable. Politicians always follow CYA, so what they would do is a completely different issue, but at the very least the interpretation of events and consequences by those who study the events and inform the public would be less wrong.

  17. Gravatar of ssumner ssumner
    10. April 2009 at 15:20

    Alex, I agree that the internet will make for better, less “herding” decisions. Indeed I think it will make the human race in some sense smarter. (As did writing, and then books).
    There is one problem with modeling irrationality, or whatever you call it. It may be possible, but even if we do it won’t help us model markets. That was something I should have emphasized in my EMH post. Even if we can show exactly how people are irrational, it won’t help us predict markets. Rather that irrationality will already be incorporated into market prices–i.e. speculators will discover the irrationality before academics.

  18. Gravatar of willmcbride willmcbride
    15. April 2009 at 14:04

    Scott, why be modest? Let’s get rid of the FDIC already.

    Also, do you know which bank that is in the movie Catch Me If You Can? It is stunning, like a cathedral. Can’t say that about the Bank of America up the street.

  19. Gravatar of ssumner ssumner
    16. April 2009 at 17:53

    willmcbride, Now that I have spent 20 years studying the Great Depression, I have come to believe that FDIC might have been a big mistake. But I just don’t see it as being politically acceptable to get rid of it. Hence the “modesty”.
    I saw the film but don’t recall that bank right now. There was some great bank architecture back then.

  20. Gravatar of TheMoneyIllusion » Reply to McArdle TheMoneyIllusion » Reply to McArdle
    19. December 2009 at 16:56

    […] to instill a sense of trust in the public.  They had to behave responsibly.  This is mirrored in bank architecture, which used to be very strong and impressive looking, like Greek temples.  By the 1960s a bank […]

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