The Purpose and Effectiveness of Bank Examinations in

Late 19th and Early 20th Century America

Eugene N. White

Rutgers University and NBER

IAES Montreal October 5-8, 2017

The Effectiveness of Bank Supervision

Supervision & Financial Stability • December 2016 NY Fed

Conference on Supervising SIFIs---very little empirical study

• Supervisory resources – Sufficient – Allocated efficiently?

• What do exams capture? • Is there information that

can be used to take remedial actions improve stability?

• Prompt action or forbearance?

• Trade-offs: growth v. stability?

• “Supervising Large, Complex Financial Institutions. What Do Supervisors Do?

• (Federal Reserve Bank of NY February 2017)

• Historical work----produce some transparency and answer some of the tough questions

1. National Banking System, 1864-1913

National Banking Era 1864-1913

1. Entry Free Entry; Minimal Discretion

2. Capital Requirements Low Fixed Minimum; Double Liability

3. Limits on Economies of Scale Branching Virtually Prohibited

4. Limits on Economies of Scope & Diversification

Banks Narrowly Defined, limited mortgages and investment banking or insurance

5. Limits on Pricing Weak Usury Laws

6. Liability Insurance

Bond-Secured Banknotes Reserve Requirements No Deposit Insurance

7. Disclosure 3 Yrly Surprise "Calls" after 1869

8. Examination 1 then 2 Yrly Surprise Exams

9. Supervision & Enforcement Some Fines, Forbid Dividends but

Primarily threat of Closure

Dealing with Asymmetric Information: Available Information generated

to discipline banks • Banks—annual reports etc. • OCC’s balance sheets from call reports---

published in local newspapers, 3-5 times a year • Stock prices (thin markets) • Clearing house: weekly statements (public),

clearing activity (private) [No examinations by NYC Clearing House in this period, Chicago, yes]

• Bank examinations, once or twice a year & special exams----most detailed---most important?

NBS Outcome—Incentive Driven Rather than Regulation Driven

• Twice as many banks voluntarily liquidate (shareholders decision, 2/3 majority vote) than fail----close them quickly

• Over 10,000 banks chartered---540 Suspended, 39 reopened, 501 insolvent ---failing banks are rarely deeply insolvent.

• For 501 banks, depositors receive 77% proven claims, $44 million losses (< $1 billion today; tiny fraction of GDP)

• Yes, there are banking panics---1873,1884, 1893, 1907---these are LIQUIDITY events, not SOLVENCY events, driven by the fragmented system of unit banks that hold interbank reserves. Panics driven primarily by idiosyncratic incentives to take risk, not systemic incentives

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Voluntary Liquidations Insolvencies

What undermines this system? • Unmet demand for banking services, answered in

political market place and the financial markets by: • “Competition in laxity”: States respond by setting

weaker regulations for new state-chartered banks and trust companies.

• Financial Innovation: Highly restricted banknotes for lending replaced by deposit banking……but deposits are not “insured” like banknotes

• “Regulatory arbitrage”: Institutions migrate to regulatory authority with weaker regulations

What is expected of Supervision? • “It is scarcely to be expected, if a robber or a forger is placed

in control of all its assets, that a national bank can be saved from disaster by the occasional visits of an examiner.” – Comptroller Knox, Annual Report (1881)

• “Supervision by examination does not, however, carry with it control of management and can not, therefore, be held responsible for either errors of judgment or lapses of integrity. Examination is always an event after the act, having no control over a bank’s initiative, which rests exclusively with the executive officers and directors, and depends entirely on their business ability, judgment, and honest of purpose” – James Forgan, President, First National Bank of Chicago

(1910)

Project: Examination and Supervision under the NBS, 1864-1913

• Advantage: One federal regulatory agency • Advantage: all examinations and

correspondence available in the National Archives

• The NBS operated in a simpler regulatory environment

• Staffing…..

Year

Number of National

Banks Number of Examiners

Required Examinations per

Examiner 1889 3239 30 108

1896 3689 34 109

1902 4532 75 120 1903 4935 74 134 1904 5330 76 140 1905 5664 83 136 1906 6047 91 132 1907 6422 100 128 1908 6817 114 120

1911 7270 113 128

The Examination Workforce

State Date

Banks Examined/Reports

Forwarded

Banks Examined/Reports Not Yet Forwarded

Number of Banks

Examined Number of banks behind schedule

CA 9/1/1896 3 0 3 0 CO 9/1/1896 0 0 0 11 CO 9/1/1896 6 1 7 5 IL 9/1/1896 21 0 21 2 IL 9/1/1896 9 3 12 0 IL 9/1/1896 12 1 11 0 IL 9/1/1896 4 0 4 1 IN 9/1/1896 5 7 12 6 KS 9/1/1896 20 0 20 0 KY 9/1/1896 11 1 12 19 LA 9/1/1896 3 0 3 0 MA 8/31/1896 14 0 14 0 MA 9/1/1896 4 2 6 0 MD 8/31/1896 1 1 2 1 ME 9/1/1896 9 0 9 2 MO 9/1/1896 8 1 9 3 NA 9/1/1896 10 0 10 0 NB 9/1/1896 7 0 7 2 ND 9/1/1896 9 9 9 20 NY 9/3/1896 12 0 12 4

Monthly National Bank Examination Reports August 1896

Office of the Comptroller of the Currency

Bank Examinations and Correspondence • Exams and Correspondence for all national banks 1864-

1941 deposited at the national archives • 1890: 3,484 national banks; 1900: 7,135; 1920: 8,025 • Organized by charter number and split by years, 1864-1901,

1902-1906, 1907-1908 etc., sometimes combining and sometimes separating the reports from the correspondence.

• Focus of the Section 1864-1901, selecting the years 1887-1901 for all New York City banks. Exams are coded, some correspondence is examined.

• Period selected is largely due to archival organization but it captures the financial instability of the mid-1890s.

Characteristics of Exams

• Hand-written (almost all) • Forms grow in size and complexity over the years

1887-1901 • There is a regime shift from one exam per year to

two exams per year beginning in 1899, and there are some special exams

• The same examiner covers all NYC banks---Snyder, Hepburn (later Comptroller), Kimball, Raynor and Hanna. The last two rotate exams—appears to be significant differences in evaluation.

Coding the Examinations

• N.B. Basic 8 pages but there could be much more additional materials and forms

• Team of 10 research assistants (mixed undergraduate and graduate students), meet weekly to discuss progress. On-going

• Photography, on-going, perhaps 10,000 images or more

• Color Coded Spreadsheet---227 variables

The Examination

• Examiner • Time between Exams • Time lapsed for receipt in Washington D.C.

and time lapsed before Comptroller/Staff read the report

• Number of pages of the Exam • Length of the Exam in Hours (earlier exams in

days)

Balance Sheet – 56 items Some key features

• Total Assets • Capital, Surplus, Undivided Profits: capital asset

ratio, buffers against losses, tracking bank’s fragility

• Loans and Discounts—detailed structure • Bonds • Individual Deposits • Deposits due to and due from other banks • Borrowed funds

Governance and Management 71 variables

• President, VP, Cashier and other senior managers • Directors • Salaries, Bonds, Loans (including loans endorsed) • Shares owned • Potential conflicts of interest—outside activities • Concentration of Control by a individual, directors

etc.

Dividends Earnings and Losses

• Dividend Payments, Earnings carried to surplus and used for charge-offs

• Realized since charge offs • Probable Losses • Expenses • Value of Assets off balance sheet

And

• Loans in Excess of Legal 10% of Capital Limit • Real Estate—book and market value • Stocks and bonds---book and market value • Reserve requirement (25%) on day of exam and

the average ratio for past 30 days • Exposure to interbank deposits • Exposure to brokers loans v. core business loans • Interest rates • Examiner’s summary assessmentCAMELS

rating

Relevant Questions? • How to measure examiner and OCC scrutiny? • How to measure the bank’s performance, safety,

soundness? • Did a deterioration since previous exam increase

examiner scrutiny? • Did increased examiner scrutiny lead to improvement

in the bank’s condition? • How did this vary by examiner? By macroeconomic

conditions? By bank? • Two exams a year? Rotation of examiners? • How did governance affect the bank? • What did stock prices or clearing house information

contribute?

Capital to Assets (percent)

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Central Phenix Merchants Irving Third NB Commerce

Reserves (25%) Short or Good on day of exam

(number of examinations)

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NB Commerce Central Phenix Merchants Irving Third

Reserves Short Reserves Good (Minimum 25%)

Problem of calculating reserves, not usually penalized, even repeat offenders?

Past 30 Days Reserve to Deposit Ratio (percent)

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Central Phenix Merchants Irving Third NB Commerce

Excessive Loans to Capital (percent)

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1887 1888 1889 1890 1891 1892 1893 1894 1895 1896 1897 1898 1899 1899 1900 1900 1901 1901Central Phenix Merchants Irving Third NB Commerce

Never penalized?

Probable Losses to Undivided Profits (percent)---critical issue: measurement

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Central Phenix Merchants Irving Third NB Commerce

Systemic Risk? Central National Bank ($ 1000)

Examiners Unworried?!

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Deposits Due to Other Banks Brokers Loans

Examiners’ Summary Merchants National Bank 1901

• The Banks condition is excellent. It has a very well organized credit department and its credit paper is choice. The system of accounting is simple and comprehensive, with sufficient safeguards in the way of auditing to secure a reasonable degree of security from dishonest employees.

Examiner’s Summary National Bank of Commerce 1901

• This bank is doing a very large business, and is in excellent condition. The Mutual Life Insurance Company of New York owns 20,000 shares of its capital stock, and largely dominates its management. During the past six months its earnings have been largely in excess of dividend requirements, and every asset of doubtful value has been charged off. The bank also carries a contingent fund shown on the face of the statement, to meet any possible losses which may arise. The account "reserved for interest" is funds set aside to meet interest to be paid on deposits.

Examiner’s Summary Irving National Bank 1900

• This Bank is doing a safe business and making money. I can see nothing to criticize in the management excepting the tendency on the part of the directors to make themselves too large loans. The most of these are covered by collaterals and all considered reasonably good but the excessive loan to Director Totten who is President of Irving Savings Bank should be brought within the limit, and large lines of Directors Mattlage, Waters, Morse, and Kroger reduced. The President desires this done and requests a letter to this effect from the Department.

Examiner’s Summary: Central National Bank 1900 [1904, rescued by a merger]

• Management is now being left more under approval of directors than it has been before caused by accumulation of bad loans in former years when Directors did not give Bank proper attention. This bank has suffered a great deal from poor management in the past and still has a large accumulation of paper on its books that should be charged off. The Bank's business has grown considerably in the past two years. It is in the heart of the dry goods district. The late W.L. Strong during his lifetime took an active interest in the Bank's business and is said to have been the cause of its getting a considerable part of its poor paper. The most unfavorable feature of the Bank is that its stock is too widely scattered and not a sufficiently large amount in the hands of any of its strong holders to ensure an efficient attention to the bank's interests as their important demands.

Examiner’s Summary Phenix National Bank 1901

• Phenix National Bank 1901: The Bank's condition is improving but I doubt if there can be much permanent betterment without considerable change in management. It's business is of a character suitable for a small bank in the Jobbing Districts of the city but its location is in the center of the Wall Street district. The best thing for the Bank would be to consolidate with some neighborhood institution: as it is too small and weak to hold its own under present conditions. The management has recently been investing in Trust Company and other stocks, which I do not think they should do.

Examiner’s Summary Third National Bank 1890

(1897,absorbed) • Bills Receivable and Loans were well distributed of

fairly good character and fairly well secured except those to which specific attention is called later on. Cash Items were all proper... Geo L Hutchings the cashier has been with this gang all along, He is mixed up in too many outside things- His heart is not in the Third National Bank. He should be summarily gotten rid of. WM Booth is a very estimable old man nearly 85 years old, wholly under the control of Hutchings. A man of that age can lead, but one direction- downward this Bank needs strong management. It will be soured of anxiety and danger as long as its present cashier and president remain.

A useful standardized audit? Paperwork & Interrogation?

• In the wake of the Panic of 1907, the Comptroller ordered national bank examiners to ask a set of specific questions of directors to assess their knowledge of their banks. Exchange between the Philadelphia National Bank’s president, Levi L. Rue and the bank’s examiner, Frank L. Norris, was recorded in the minutes of the Board for 1908:

• Norris: How many of the Directors know the conditions of the Bank in all its details? • Rue: All so far as condition of the Bank is concerned, but not as to clerical details. • Norris: How many know nothing at all about the condition of the Bank? • Rue: All the directors have a close knowledge of the affairs of the Bank as it • is possible for men engaged in other active business. • Norris: Have the directors full knowledge of the habits and general standing • of the Bank’s employees? • Rue: It is impossible with upwards of 125 employees for the directors to possess full • knowledge of the habits of the Bank’s employees. • After this examination, the affronted board wrote to the Comptroller to protest his

right “to so interrogate its members.”

“The London Whale” New York Times (May 25, 2012)

“Bank Regulators Under Scrutiny in JPMorgan Loss” • “Scores of federal regulators are stationed inside JPMorgan

Chase’s Manhattan headquarters, but none of them were assigned to the powerful unit that recently disclosed a multibillion dollar trading loss.”

• “Roughly 40 examiners from the Federal Reserve Bank of New York and 70 staff members from the Office of the Comptroller of the Currency are embedded in the nation’s largest bank. They are typically assigned to the departments undertaking the greatest risks, like the structured products trading desk. “

• “Even as the chief investment office swelled in size and made increasingly large bets, regulators did not put any examiners in the unit’s offices in London or New York, according to current and former regulators who spoke only on condition of anonymity. “