Today in 1935: The Banking Act creates the modern day Federal Reserve System

August 23, 2013

Today in Legal HistorySince the financial crisis in 2008, almost 500 banks have failed – including Washington Mutual on September 26, 2008, which was the largest bank failure in U.S. history.

Prior to the crisis, bank failures were not a common occurrence, with only ten occurring in the five years previous.

In fact, the last time that the U.S. saw so many banks fail was during the Great Depression in the late 1920s through the mid 1930s. 

During that era, however, the fear of a bank failure caused more bank failures, as bank customers would rush to the bank to withdraw all of their deposits.  “Bank runs,” famously depicted in the film It’s a Wonderful Life, would cause banks to run out of funds and become insolvent (since banks are only required to maintain on hand only a fraction of customer-deposited funds).

The reason that we haven’t seen bank runs today, despite the massive amount of bank failures since 2008, is because of the Federal Deposit Insurance Corporation (FDIC), which guarantees bank deposits up to a certain amount.

The FDIC, which has other supervisory powers over insured financial institutions, was created by the Banking Act of 1933, but only as a temporary government corporation.

It wasn’t until two years later, when the Banking Act of 1935 was signed into law on August 23, 1935, that the FDIC became a permanent fixture in the nation’s financial world.

The 1935 Act further changed the FDIC’s operations by having it financed exclusively through assessments directly on the insured institutions.  Furthermore, the FDIC gained its supervisory powers as a result of the law.

The 1935 Act’s changes to the nation’s financial laws weren’t limited to the FDIC, though: it also greatly modified the Federal Reserve System by amending the Federal Reserve Act, originally enacted in 1913, and the 1933 Banking Act.

Through these modifications, the 1935 Act largely transformed the Federal Reserve System into what it is today.

The 1935 Act reorganized the Federal Reserve Board, renaming it the Board of Governors of the Federal Reserve System.  It further increased the board’s power over rediscount rates, the reserve requirements of member banks, and the buying and selling of government bonds.

The Act also mandated that the Chairman and Vice Chairman of the Board be two of seven members of the Board of Governors,  both of whom are appointed by the President from among the sitting Governors.

Also required by the Act was the removal of the Treasury Secretary and the Comptroller of the Currency from the Fed’s Board of Governors, and the fixing of the board members’ terms at 14 years.

The Act further reformed the Federal Open Market Committee (FOMC), a committee within the Federal Reserve System that is responsible for determining interest rates and the size of the U.S. money supply; the Act made the Board of Governors part of the FOMC (the members of the Board did not previously have voting rights within the FOMC).

In short, the Banking Act of 1935 is largely responsible for the Federal Reserve System’s current structure and powers – including its ability to buy and sell government bonds on the open market, increase or decrease the money supply, and set interest rates.

Furthermore, with the passage of 1999’s Gramm-Leach-Bliley Act which lifted the 1933 Act’s separation between commercial and investment banking, the 1935 Act’s changes to the FDIC and the Fed are the most significant legacies of the two banking acts.

Although opinions on the Federal Reserve System can widely vary, most can agree that having bank deposits insured – and thus preventing bank runs – is a necessary part of today’s financial world.