The Strength of a Weak Institution : Clearing House , Federal Reserve , and the Survival of Commercial Banks in Manhattan , 1840 - 1980

This paper compares the function of public vs. private institutions and studies conditions that influence their effectiveness. We use the population of commercial banks in Manhattan from 1840 to 1980 and investigate the impact of banks‟ participation in the New York Clearing House Association, an industry-level cooperative arrangement, and the New York Federal Reserve Bank, the governmental regulatory institution, on their failure rates. We find that banks‟ participation in the private institution reduced their failure rates more than did participation in the public institution. The effectiveness of the private institution hinges on its nature as a local organization that includes a relatively small number of homogeneous and densely-connected banks. Localism enables strong monitoring and enforcement mechanisms that are critical to solve the problem of collective action. In contrast, the governmental regulation enlarges the geographical scope of participation, adopts standardized procedures, and introduces regulatory agencies, which in fact loosen monitoring and create an opportunity for banks to be more risktaking. But the upside of the public institution is its „public‟ nature, and we find banks that were excluded from the private institutions were better off under the regime of government regulation.