Notes from the Vault

Maria J. Nieto and Larry D. Wall
July 2015

Geographic limitations on the location of banks reduce banks' ability to compete with each other and to share risks across different geographic regions. Moreover, such limits may impair the relative effectiveness of monetary policy in different regions within the same currency area, especially in the wake of a financial crisis that had differential impacts across geographic regions.

However, as Charles W. Calomiris and Stephen H. Haber (2014) emphasize, the political opposition to relaxing geographic limits can be intense, especially relaxing the constraints on cross-border banking. Geographic limitations on banks convey advantages to some banks and borrowers facilitating political and banking industry capture. Limits on cross-border banking also facilitate the continued existence and importance of independent bank supervisory agencies in each state.

This Notes from the Vault reviews the history of geographic constraints on banks and the process that resulted in federalization in the United States and a nascent banking union in Europe. It then discusses how the differences in bank and safety net structures impacted the way the two areas responded to the crisis.

Pre-crisis removal of barriers in the United States
The United States took more than a century to go from a system in which banking groups and bank supervisors were fragmented along state lines to one in which where banking groups can open branches in any state and all significant banks are subject to federal supervision. The long, slow process is in large part a testament to the benefits that the state-level constraints conferred on some parties, according to Calomiris and Haber (2014). These geographic limits protected small banks from competition by larger banks by blocking expansion across state lines. The geographic limits also tied banks to the fates of their local communities, limiting the banking system's ability to reallocate resources away from local borrowers experiencing some financial distress.

The reforms in the United States proceeded piecemeal, first developing a federal supervisory system and much later relaxing the restrictions on interstate banking. The first step toward a nationwide system was taken in 1863 and 1864 with the passage of legislation creating the national banking system of federally chartered banks with a federal supervisor. The second step was the creation of the Federal Reserve in 1913, which gave the United States a lender of last resort. The last step in creating a federal supervisory structure was the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, which also provided a strong incentive for state chartered banks to submit to federal supervision. However, the creation of the FDIC likely also delayed the adoption of interstate banking as it shielded small depositors from losses, allowing small banks to better compete for deposits with larger, more diversified banks.

Yet it took another 50 years until individual states started passing laws allowing interstate banking. Calomiris and Haber attribute the relaxation of constraints on interstate banking to technological changes, which facilitated competition between geographically distant banks and which helped geographically constrained banks to better diversify their overall portfolio. However, even after states started passing laws allowing acquisition of their banks by banking groups headquartered in other states, most states banned entry via the chartering of a de novo bank. Moreover, although out-of-state groups could buy banks across state lines, they were generally prohibited from consolidating these banks into a single bank with interstate branches (see Christian Johnson and Tara Rice).

The last major step in the interstate banking process came when Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 to ratify and rationalize interstate banking. By this stage, sufficiently few interests benefited from the remaining restrictions on cross-border banking to form a blocking coalition, and many large banking groups sought greater freedom in where and how they operated (preferring branches to subsidiaries). Gillian Garcia (2009) finds that state and federal deregulation had resulted in interstate deposits accounting for 36.9 percent of all deposits in U.S. banks and thrifts by 2006.

One advantage of the piecemeal approach to deregulation is that it created almost ideal conditions for testing the impact of breaking down the barriers to competition between banks. A small literature has developed showing interstate banking offered real benefits, including Tara Rice and Philip E. Strahan's (2010) finding that small firms in states that were more open to branching paid lower interest rates and were more likely to borrow from banks. Thus the effect of less fragmentation appears to improve credit availability and the cost of capital, both of which support economic growth.

Precrisis removal of barriers in the EU
The main goal of the EU has been to create a single market for goods and services, including financial services, in order to encourage European firms to be more efficient and globally competitive.

Although some cross-border banking has existed in the EU since at least the founding in 1950 of its predecessor—the European Coal and Steel Community—cross-border banking has historically been limited primarily to wholesale banking, with national authorities retaining final responsibility for prudential supervision and the provision of a safety net. Jean Dermine (2002) breaks the period from 1957 to 2005 into five periods. The first period (1957–73) saw the adoption of the Treaty of Rome, which established the single market as a goal.

The second period (1973–83) saw the adoption of the First Banking Directive in 1977, which mandated the principle of home country control, whereby a credit institution operating across national borders via branches would be under the supervision of its home country. Prior to this time, branching across state lines was limited and the host country supervisor retained substantial prudential supervisory authority over the branch. The First Directive also took the first steps towards harmonization of regulations.

A potentially major step towards the creation of a single banking market came in the third period (1983–92) with the adoption of the Second Banking Directive. This directive created a "single passport" under which a bank authorized to operate in one EU member state was authorized to open branches and provide services in all other EU member states without further authorization. Regulation remained a national responsibility but the directive called for harmonizing some important regulations, including those related to bank capital adequacy. The Second Banking Directive could have led to an EU-wide banking system if de novo entry was an effective way of entering new markets. However, experience in Europe (and the United States) shows that entry through acquisition is far more effective than entry via new branches and is even more effective in the European case given the differences (such as languages and taxes) among member states.

Later in the third period (1992–98) a directive harmonizing minimum requirements of deposit guarantee schemes was adopted. In most member states, deposit guarantee schemes have very limited roles in bank crisis resolution.

In 1998, a subset of EU countries adopted a single currency, the euro, and a single monetary policy (the European Monetary Union, or EMU) to obtain a variety of benefits including reduced transaction costs on trades among euro area members and greater transparency in the pricing of goods and services. At present, the euro area has 19 members out of the 28 member states of the EU. The EMU gave added importance to the creation of a single financial market to enhance the effectiveness of monetary policy throughout the euro area. In turn, EMU brought along integrated money markets supported by the developments of facilities in the field of large value payment and settlement systems.

Finally, in 1999, the European Council launched the Financial Services Action Plan with the goal of fully integrating the banking system by the year 2005.

Despite all of these actions, cross-border entry into the largest EU countries remained rather limited. In 2008, Hernando and Nieto (both of the Bank of Spain) and Wall of the Atlanta Fed showed that most of the banking consolidation was taking place within member states rather than across member state boundaries. Among the reasons these authors give for the tendency to consolidate within national boundaries was the political desire to create national champions in the context of a strong home bias in national supervision. In some instances, cross-border bank mergers and acquisitions faced strong opposition in some member states. For example, Italy opposed the acquisition of Banca Nationale del Lavoro by financial firms from other EU member countries. The Netherlands's ABN Amro encountered difficulty in acquiring Italy's Antonveneta, but finally succeeded in 2005. Given the difficulties of cross-border combinations, Garcia (2009) finds that the assets of cross-border branches and subsidiaries grew from 12.2 percent in 1997 to only 18.2 percent in 2006. Given this slow progress, EU policy makers responded in 2007 with a directive aimed at establishing objective procedures and criteria for the evaluation of bank acquisitions and, in general, stock participations in the financial sector, by which all bank supervisors must abide.

Cross-border banking and the crisis
Stark differences existed between the EU and United States at the dawn of the crisis. Federal bank supervision with a single national lender of last resort and federal deposit insurance were well established in the United States. Further, interstate banking was widely practiced and fully accepted within the United States, albeit the managerial process of cross-border consolidation is a difficult, time consuming procedure so the United States likely had not yet reached its long-run equilibrium level of interstate banking.

Conversely, bank supervision and deposit insurance in the EU remained national responsibilities. Also, emergency liquidity assistance is the only responsibility of the central banks of member states. For the euro area countries, the European Central Bank (ECB) provided emergency liquidity when financial markets froze. In line with this institutional setting, bank consolidation remained rather limited in most areas in the EU with the principal exceptions being the relatively small economies in the Nordic and Eastern European regions.

These differences in structure are reflected in the way the two areas responded to the crisis. The U.S. response was a coordinated response with the Treasury, bank supervisors, the lender of last resort, and deposit insurer acting in concert together.1 The Federal Reserve took a variety of innovative steps to provide liquidity to illiquid banks to prevent their failure. The cost of resolving those banks that did fail was borne at the national level through FDIC insurance assessments and not at the state level. Moreover, the FDIC could market failed banks to other banks in the region irrespective of state boundaries and even market the largest banks to a national pool of potential buyers.

After Lehman failed, Congress approved the Troubled Asset Relief Program (TARP) to provide resources for addressing banks' problems. The existence of TARP funds managed by the Treasury gave bank supervisors the confidence that they had a mechanism for addressing the deficiencies revealed by the bank stress tests conducted in 2009. Given this confidence, the supervisors implemented a stress test that identified substantial needs for increased capital at many large banks, according to Wall. In the event, the news released by the stress tests combined with the assurance of a federal backstop allowed almost all of the banks to raise sufficient funds in private markets.

The Federal Reserve's lending programs and the TARP's equity injection programs almost surely increased the risk of moral hazard at the largest banks. However, the improved position of the banks allowed the U.S. bank supervisors to follow up the crisis with subsequent stress tests that required banks not only to meet capital requirements but also to be able to absorb the losses from a stressful scenario and remain adequately capitalized. As a result, large banks are generally better capitalized than they were prior to the crisis.

Like the Federal Reserve, the ECB aggressively addressed illiquidity problems in the euro area by providing additional reserves to the banking system. However, in most other respects the EU's fragmented supervisory and safety net structure led to fragmented responses during the crisis.

If a purely domestic bank failed, its supervisors typically looked exclusively at other domestic banks to find an acquirer. When the Belgian banking group Fortis N.V./S.A. failed in 2008, the various parts of the bank were resolved by the Benelux authorities in the country in which the most significant subsidiaries were located. In other cases—most notably, Ireland—EU authorities pressured national governments to absorb losses that would otherwise have had a significantly adverse impact on other systemically important banks in the EU. The result in the Irish case was that a country with a relatively low sovereign debt to GDP ratio prior to the crisis suddenly found itself in financial distress and needing external financial support coordinated by the EU Commission, ECB, and the International Monetary Fund.

In the EU, the recapitalization of those banks that survived the crisis was a national responsibility, one that some member states struggled to meet, resulting in a banking-sovereign "negative loop," or at least a responsibility some were unable to meet without sharing Ireland's fate.

It could be argued that policy makers' intention to avoid such a negative loop may have resulted in the limited credibility of the immediate postcrisis stress test coordination exercises by the EU. A major problem with the failure to identify capital shortfalls is that failure to recapitalize the weak banks had adverse consequences for the banking system's ability to support real growth, particularly important in the case of the EU, where banks provided four-fifths of total financing to the real economy at the time of the crisis. Moreover, a disproportionate share of the shrinkage of some banks occurred in their cross-border operations as these banks sought to shelter their home market to the extent possible (often with the encouragement of their supervisors). The focus of distressed banks on shrinking their asset base means they are far less able than strong banks to transmit expansionary changes in monetary policy through to their borrowers.

Concluding thoughts
The United States took more than a century to overcome the political obstacles to a federal supervisory and safety net system and permit nationwide interstate banking. However, the benefits of doing so were being realized prior to the crisis and became more apparent during the crisis. The gradual elimination of barriers to interstate banking enhanced both competition and risk diversification. Moreover, the placement of supervisory and safety net powers at the federal level allowed the U.S. authorities to act in a coordinated manner to mitigate the adverse consequences of the financial crisis.

At the time of the crisis, the EU had a fully decentralized safety net bound by the principles of harmonization and subsidiarity (decision making at the national level—unless by reason of the scale of the effects of the proposed action—can be better achieved at the EU level). Further, although the EU directives permitted cross-border banking, national authorities had limited the extent to which cross-border banking was a reality. As a result, the EU member states faced the crisis as a collection of individual countries rather than as a unified whole. While some countries had the financial muscle to address their banking problems, others needed credit transfers from other member states to finance public backstops. In turn, distressed banks were unable to fully pass through the ECB's simulative polices to their borrowers.

In June 2012, as the banking crisis was engulfing the sovereign credit standing of an increasing number of euro area countries, policy makers considered, as a matter of urgency, the objective of creating the Banking Union, which centralizes bank supervision and resolution and leaves two elements of the safety net in the domain of national jurisdictions: emergency liquidity assistance and deposit insurance.

Larry D. Wall is the executive director of the Center for Financial Innovation and Stability at the Atlanta Fed and Maria J. Nieto is Associate to the Director General Financial Stability and Resolution at the Bank of Spain. The authors thank Paula Tkac for helpful comments on the paper. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta, Bank of Spain, the Federal Reserve System or the Eurosystem. If you wish to comment on this post, please e-mail or email Maria J. Nieto at


Calomiris, Charles W., and Stephen H. Haber. Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton University Press, 2014.

Garcia, Gillian H. "Sovereignty versus Soundness: Cross-Border/Interstate Banking in the European Union and in the United States: Similarities, Differences and Policy Issues." Contemporary Economic Policy, 27, no. 1 (2009): 109–29.

Rice, Tara, and Philip E. Strahan. "Does Credit Competition Affect Smallā€Firm Finance?" Journal of Finance 65, no. 3 (2010): 861–89.


1 This is not to imply that the different bodies always agreed on the appropriate course of action, only that once decisions were made the bodies acted together to rebuild financial stability.