McFadden Act: What It is, How It Works, Criticism

Elizabeth Blessing is a financial writer and editor specializing in growth investing, high-yield stocks, small caps, and gold investing.

Michael Logan is an experienced writer, producer, and editorial leader. As a journalist, he has extensively covered business and tech news in the U.S. and Asia. He has produced multimedia content that has garnered billions of views worldwide.

What Is the McFadden Act?

The McFadden Act of 1927 is a piece of federal legislation that gave individual states the authority to govern bank branches located within the state. This includes branches of national banks located within state lines. The McFadden Act was intended to allow national banks to compete with state banks by permitting them to open branches within state limitations.  

The McFadden Act included several other significant provisions. The charters for the 12 Federal Reserve Banks were scheduled to expire in 1934. The act rechartered the Federal Reserve District Banks into perpetuity, eliminating the previous 20-year charter limitations. It also revised a wide range of banking laws in order to expand the services that Federal Reserve member banks could offer customers.  

Key Takeaways

• The McFadden Act of 1927 is a U.S. federal law that gave individual states the authority to govern bank branches located within state borders.
• While the McFadden Act permitted national banks to operate multiple branches within a state's limitations, it prohibited interstate banking or the expansion of banks across state lines.
• The act also extended the Federal Reserve's charter into perpetuity and reduced regulations governing commercial banks that were members of the Federal Reserve.  
• The Riegle-Neal Act of 1994 repealed the provision within the McFadden Act prohibiting interstate banking, thus enabling national banks to open branches across state lines.  

Understanding the McFadden Act

On Feb. 25, 1927, President Calvin Coolidge signed the McFadden Act into law. The act came amid the boom years of the 1920s when the sky seemed the limit for stocks, banks, and the economy. The Federal Reserve, established in 1914, had been a huge success. Bankers and politicians alike credited the Fed for its role in strengthening the economy.  

Prior to the creation of the Federal Reserve, the United States was viewed as financially unstable. Panics, seasonal cash crunches, and a high rate of bank failures made the U.S. economy a riskier place for international and domestic investors to place their capital. This lack of dependable credit stunted growth in many sectors, including agriculture and industry.

The McFadden Act sought to bolster the economic success of the 1920s by addressing three key issues that impacted the Federal Reserve and the nation's banking system.

The Federal Reserve Charter

The first issue was the length of the Federal Reserve's charter. Set to expire in 1934, the original charter establishing the Federal Reserve District Banks required Congress to recharter the banks after 20 years.   Should Congress fail to pass the recharter, the Federal Reserve would effectively be dissolved.

Such a decision would not be without precedent. Congress opposed the recharter of the First Bank of the United States in 1811 and the Second Bank of the United States in 1836.   Rather than risk this threat to the Fed's existence, the McFadden Act rechartered the Federal Reserve Banks into perpetuity.

National Bank Branches

Another issue the McFadden Act addressed was branch banking. At the time, national banks operating under federal government corporate charters were restricted from operating in multiple buildings. On the other hand, corporate charters granted by state governments varied on this issue. Some states allowed banks to operate out of multiple locations or branches. The McFadden Act permitted a national bank to operate multiple branches to whatever extent the state governments allowed within each state. However, the act prohibited interstate banking, forbidding banks from being owned and operated across state lines.  

Competition Between Banks

Prior to the McFadden Act, commercial banks that were members of the Federal Reserve operated under stricter regulations than commercial banks that were not Federal Reserve members. In many cases, member banks had to maintain larger reserves and were prohibited from offering their customers certain types of loans that were considered too risky. The McFadden Act loosened these restrictions on member banks, enabling them to more effectively compete with non-member commercial banks.  

Criticism of the McFadden Act

The McFadden Act is credited for leveling the playing field between Federal Reserve member banks and non-member banks. However, its relaxed regulations would have repercussions in the crash of 1929, contributing to the bank failures that occurred during the Great Depression that followed.

The McFadden Act's prohibition of interstate banking received criticism from legislators and banking authorities that said the restriction left regional banks unprotected against local economic downturns. Small, regional banks did not have enough of a diversified loan portfolio to withstand economic events that impacted a given area or state. By sanctioning interstate banking, banks would be less vulnerable to any given economic event that in turn could lead to a bank's failure.

In 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act repealed the provision within the McFadden Act prohibiting interstate banking. It allowed well-capitalized banks to open limited service bank branches across state lines by merging with other banks. This resulted in the rise of nationwide banks in the United States.