The Crisis in American Banking in the Early Twentieth Century

The creation of the Federal Reserve system in 1913 marked the beginning of the modern era of American banking. From 1864 until 1913, American banking was dominated by a federally regulated system of national banks. They alone were allowed to issue currency, and the currency notes they issued were printed by the federal government with uniform size and design. How much currency a national bank could issue depended on its capital. Although this system was an improvement on the earlier period in which banks issued their own notes with no uniformity and virtually no regulation, the national banking regime still suffered numerous bank failures and major financial crises—at least one and often two per decade.

The main problem afflicting the system was that the money supply was not sufficiently responsive: it was difficult to shift currency around the country to respond quickly to local economic changes. (In particular, there was often a tug-of-war between New York City banks and rural banks for adequate amounts of currency.) Rumors that a bank had insufficient currency to satisfy demands for withdrawals would quickly lead to a bank run. A bank run would then spark a contagion, setting off runs at other nearby banks, sowing widespread panic and devastation in the local economy. In response, bankers in some locations pooled their resources to create local clearinghouses that would jointly guarantee a member’s liabilities in the event of a panic, and some state governments began offering deposit insurance on their banks’ deposits.

However, the cause of the Panic of 1907 was different from those of previous crises; in fact, its cause was eerily similar to the roots of the 2008 crisis. Ground zero of the 1907 panic was New York City, but the consequences devastated the entire country, leading to a deep four-year recession.

The crisis originated in institutions in New York known as trusts, bank-like institutions that accepted deposits but that were originally intended to manage only inheritances and estates for wealthy clients. Because these trusts were supposed to engage only in low-risk activities, they were less regulated, had lower reserve requirements, and had lower cash reserves than national banks.

In both the Panic of 1907 and the financial crisis of 2008, large losses from risky speculation destabilized the banking system.

However, as the American economy boomed during the first decade of the twentieth century, trusts began speculating in real estate and the stock market, areas of speculation forbidden to national banks. Less regulated than national banks, trusts were able to pay their depositors higher returns. Yet trusts took a free ride on national banks’ reputation for soundness, with depositors considering them equally safe. As a result, trusts grew rapidly: by 1907, the total assets of trusts in New York City were as large as those of national banks. Meanwhile, the trusts declined to join the New York Clearinghouse, a consortium of New York City national banks that guaranteed one anothers’ soundness; that would have required the trusts to hold higher cash reserves, reducing their profits.

The Panic of 1907 began with the failure of the Knickerbocker Trust, a large New York City trust that failed when it suffered massive losses in unsuccessful stock market speculation. Quickly, other New York trusts came under pressure, and frightened depositors began queuing in long lines to withdraw their funds. The New York Clearinghouse declined to step in and lend to the trusts, and even healthy trusts came under serious assault. Within two days, a dozen major trusts had gone under. Credit markets froze, and the stock market fell dramatically as stock traders were unable to get credit to finance their trades and business confidence evaporated.

Fortunately, New York City’s wealthiest man, the banker J. P. Morgan, quickly stepped in to stop the panic. Understanding that the crisis was spreading and would soon engulf healthy institutions, trusts and banks alike, he worked with other bankers, wealthy men such as John D. Rockefeller, and the U.S. Secretary of the Treasury to shore up the reserves of banks and trusts so they could withstand the onslaught of withdrawals. Once people were assured that they could withdraw their money, the panic ceased. Although the panic itself lasted little more than a week, it and the stock market collapse decimated the economy. A four-year recession ensued, with production falling 11% and unemployment rising from 3% to 8%.

Responding to Banking Crises: The Creation of the Federal Reserve

Concerns over the frequency of banking crises and the unprecedented role of J. P. Morgan in saving the financial system prompted the federal government to initiate banking reform. In 1913 the national banking system was eliminated and the Federal Reserve system was created as a way to compel all deposit-taking institutions to hold adequate reserves and to open their accounts to inspection by regulators. The Panic of 1907 convinced many that the time for centralized control of bank reserves had come. In addition, the Federal Reserve was given the sole right to issue currency in order to make the money supply sufficiently responsive to satisfy economic conditions around the country.

Although the new regime standardized and centralized the holding of bank reserves, it did not eliminate the potential for bank runs because banks’ reserves were still less than the total value of their deposits. The potential for more bank runs became a reality during the Great Depression. Plunging commodity prices hit American farmers particularly hard, precipitating a series of bank runs in 1930, 1931, and 1933, each of which started at midwestern banks and then spread throughout the country.

After the failure of a particularly large bank in 1930, federal officials realized that the economy-wide effects compelled them to take a less hands-off approach and to intervene more vigorously. In 1932, the Reconstruction Finance Corporation (RFC) was established and given the authority to make loans to banks in order to stabilize the banking sector. Also, the Glass-Steagall Act of 1933, which created federal deposit insurance and increased the ability of banks to borrow from the Federal Reserve system, was passed. However, the beast had not yet been tamed. Banks became fearful of borrowing from the RFC because doing so signaled weakness to the public.

As we noted earlier, during the catastrophic bank run of 1933, the new president, Franklin Delano Roosevelt, was inaugurated. He immediately declared a “bank holiday,” closing all banks until regulators could get a handle on the problem.

Like FDR, President Obama, shown here meeting with economic advisers, was faced with a major financial crisis upon taking office.

In March 1933, emergency measures were adopted that gave the RFC extraordinary powers to stabilize and restructure the banking industry by providing capital to banks through either loans or outright purchases of bank shares. With the new rules, regulators closed nonviable banks and recapitalized viable ones by allowing the RFC to buy preferred shares in banks (shares that gave the U.S. government more rights than regular shareholders) and by greatly expanding banks’ ability to borrow from the Federal Reserve. By 1933, the RFC had invested over $16.2 billion (2010 dollars) in bank capital—one-third of the total capital of all banks in the United States at that time—and purchased shares in almost one-half of all banks. The RFC loaned more than $32.4 billion (2010 dollars) to banks during this period.

A commercial bank accepts deposits and is covered by deposit insurance.

An investment bank trades in financial assets and is not covered by deposit insurance.

Economic historians uniformly agree that the banking crises of the early 1930s greatly exacerbated the severity of the Great Depression, rendering monetary policy ineffective as the banking sector broke down and currency, withdrawn from banks and stashed under beds, reduced the money supply.

Although the powerful actions of the RFC stabilized the banking industry, new legislation was needed to prevent future banking crises. The Glass-Steagall Act of 1933 separated banks into two categories, commercial banks, depository banks that accepted deposits and were covered by deposit insurance, and investment banks, which engaged in creating and trading financial assets such as stocks and corporate bonds but were not covered by deposit insurance because their activities were considered more risky.

Regulation Q prevented commercial banks from paying interest on checking accounts in the belief that this would promote unhealthy competition between banks. In addition, investment banks were much more lightly regulated than commercial banks. The most important measure for the prevention of bank runs, however, was the adoption of federal deposit insurance (with an original limit of $2,500 per deposit).

These measures were clearly successful, and the United States enjoyed a long period of financial and banking stability. As memories of the bad old days dimmed, Depression-era bank regulations were lifted. In 1980, Regulation Q was eliminated; by 1999, the Glass-Steagall Act had been so weakened that offering services like trading financial assets was no longer off-limits to commercial banks.

The Savings and Loan Crisis of the 1980s

A savings and loan (thrift) is another type of deposit-taking bank, usually specialized in issuing home loans.

Along with banks, the banking industry also included savings and loans (also called S&Ls or thrifts), institutions designed to accept savings and turn them into long-term mortgages for home-buyers. S&Ls were covered by federal deposit insurance and were tightly regulated for safety. However, trouble hit in the 1970s, as high inflation led savers to withdraw their funds from low-interest-paying S&L accounts and put them into higher-interest-paying money market accounts. In addition, the high inflation rate severely eroded the value of the S&Ls’ assets, the long-term mortgages they held on their books.

In order to improve S&Ls’ competitive position vis-à-vis banks, Congress eased regulations to allow S&Ls to undertake much more risky investments in addition to long-term home mortgages. However, the new freedom did not bring with it increased oversight, leaving S&Ls with less oversight than banks. Not surprisingly, during the real estate boom of the 1970s and 1980s, S&Ls engaged in overly risky real estate lending. Also, corruption occurred as some S&L executives used their institutions as private piggy banks.

Unfortunately, during the late 1970s and early 1980s, political interference from Congress kept insolvent S&Ls open when a bank in a comparable situation would have been quickly shut down by bank regulators. By the early 1980s, a large number of S&Ls had failed. Because accounts were covered by federal deposit insurance, the liabilities of a failed S&L were now liabilities of the federal government, and depositors had to be paid from taxpayer funds. From 1986 through 1995, the federal government closed over 1,000 failed S&Ls, costing U.S. taxpayers over $124 billion.

In a classic case of shutting the barn door after the horse has escaped, in 1989 Congress put in place comprehensive oversight of S&L activities. It also empowered Fannie Mae and Freddie Mac to take over much of the home mortgage lending previously done by S&Ls. Fannie Mae and Freddie Mac are quasi-governmental agencies created during the Great Depression to make homeownership more affordable for low- and moderate-income households. It has been calculated that the S&L crisis helped cause a steep slowdown in the finance and real estate industries, leading to the recession of the early 1990s.

Back to the Future: The Financial Crisis of 2008

The financial crisis of 2008 shared features of previous crises. Like the Panic of 1907 and the S&L crisis, it involved institutions that were not as strictly regulated as deposit-taking banks, as well as excessive speculation. Like the crises of the early 1930s, it involved a U.S. government that was reluctant to take aggressive action until the scale of the devastation became clear.

In addition, by the late 1990s, advances in technology and financial innovation had created yet another systemic weakness that played a central role in 2008. The story of Long-Term Capital Management, or LTCM, highlights these problems.

A financial institution engages in leverage when it finances its investments with borrowed funds.

Long-Term Capital (Mis)Management Created in 1994, LTCM was a hedge fund, a private investment partnership open only to wealthy individuals and institutions. Hedge funds are virtually unregulated, allowing them to make much riskier investments than mutual funds, which are open to the average investor. Using vast amounts of leverage—that is, borrowed money—in order to increase its returns, LTCM used sophisticated computer models to make money by taking advantage of small differences in asset prices in global financial markets to buy at a lower price and sell at a higher price. In one year, LTCM made a return as high as 40%.

LTCM was also heavily involved in derivatives, complex financial instruments that are constructed—derived—from the obligations of more basic financial assets. Derivatives are popular investment tools because they are cheaper to trade than basic financial assets and can be constructed to suit a buyer’s or seller’s particular needs. Yet their complexity can make it extremely hard to measure their value. LTCM believed that its computer models allowed it to accurately gauge the risk in the huge bets that it was undertaking in derivatives using borrowed money.

However, LTCM’s computer models hadn’t factored in a series of financial crises in Asia and in Russia during 1997 and 1998. Through its large borrowing, LTCM had become such a big player in global financial markets that attempts to sell its assets depressed the prices of what it was trying to sell. As the markets fell around the world and LTCM’s panic-stricken investors demanded the return of their funds, LTCM’s losses mounted as it tried to sell assets to satisfy those demands. Quickly, its operations collapsed because it could no longer borrow money and other parties refused to trade with it. Financial markets around the world froze in panic.

The balance sheet effect is the reduction in a firm’s net worth due to falling asset prices.

The Federal Reserve realized that allowing LTCM’s remaining assets to be sold at panic-stricken prices presented a grave risk to the entire financial system through the balance sheet effect: as sales of assets by LTCM depressed asset prices all over the world, other firms would see the value of their balance sheets fall as assets held on these balance sheets declined in value. Moreover, falling asset prices meant the value of assets held by borrowers on their balance sheets would fall below a critical threshold, leading to a default on the terms of their credit contracts and forcing creditors to call in their loans. This in turn would lead to more sales of assets as borrowers tried to raise cash to repay their loans, more credit defaults, and more loans called in, creating a vicious cycle of deleveraging.

A vicious cycle of deleveraging takes place when asset sales to cover losses produce negative balance sheet effects on other firms and force creditors to call in their loans, forcing sales of more assets and causing further declines in asset prices.

The Federal Reserve Bank of New York arranged a $3.625 billion bailout of LTCM in 1998, in which other private institutions took on shares of LTCM’s assets and obligations, liquidated them in an orderly manner, and eventually turned a small profit. Quick action by the Federal Reserve Bank of New York prevented LTCM from sparking a contagion, yet virtually all of LTCM’s investors were wiped out.

Subprime Lending and the Housing Bubble After the LTCM crisis, U.S. financial markets stabilized. They remained more or less stable even as stock prices fell sharply from 2000 to 2002 and the U.S. economy went into recession. During the recovery from the 2001 recession, however, the seeds for another financial crisis were planted.

The story begins with low interest rates: by 2003, U.S. interest rates were at historically low levels, partly because of Federal Reserve policy and partly because of large inflows of capital from other countries, especially China. These low interest rates helped cause a boom in housing, which in turn led the U.S. economy out of recession. As housing boomed, however, financial institutions began taking on growing risks—risks that were not well understood.

Subprime lending is lending to home-buyers who don’t meet the usual criteria for being able to afford their payments.

Traditionally, people were only able to borrow money to buy homes if they could show that they had sufficient income to meet the mortgage payments. Home loans to people who don’t meet the usual criteria for borrowing, called subprime lending, were only a minor part of overall lending. But in the booming housing market of 2003–2006, subprime lending started to seem like a safe bet. Since housing prices kept rising, borrowers who couldn’t make their mortgage payments could always pay off their mortgages, if necessary, by selling their homes. As a result, subprime lending exploded.

In securitization, a pool of loans is assembled and shares of that pool are sold to investors.

Who was making these subprime loans? For the most part, it wasn’t traditional banks lending out depositors’ money. Instead, most of the loans were made by “loan originators,” who quickly sold mortgages to other investors. These sales were made possible by a process known as securitization: financial institutions assembled pools of loans and sold shares in the income from these pools. These shares were considered relatively safe investments, since it was considered unlikely that large numbers of home-buyers would default on their payments at the same time.

But that’s exactly what happened. The housing boom turned out to be a bubble, and when home prices started falling in late 2006, many subprime borrowers were unable either to meet their mortgage payments or sell their houses for enough to pay off their mortgages. As a result, investors in securities backed by subprime mortgages started taking heavy losses. Many of the mortgage-backed assets were held by financial institutions, including banks and other institutions playing bank-like roles. Like the trusts that played a key role in the Panic of 1907, these “nonbank banks” were less regulated than commercial banks, which allowed them to offer higher returns to investors but left them extremely vulnerable in a crisis. Mortgage-related losses, in turn, led to a collapse of trust in the financial system.

Figure 29-10 shows one measure of this loss of trust: the TED spread, which is the difference between the interest rate on three-month loans that banks make to each other and the interest rate the federal government pays on three-month bonds. Since government bonds are considered extremely safe, the TED spread shows how much risk banks think they’re taking on when lending to each other. Normally the spread is around a quarter of a percentage point, but it shot up in August 2007 and surged to an unprecedented 4.58 percentage points in October 2008, before returning to more normal levels in mid-2009.

The TED Spread The TED spread is the difference between the interest rate at which banks lend to each other and the interest rate on U.S. government debt. It’s widely used as a measure of financial stress. The TED spread soared as a result of the financial crisis of 2007–2008.Sources: British Bankers’ Association; Federal Reserve Bank of St. Louis.

Crisis and Response The collapse of trust in the financial system, combined with the large losses suffered by financial firms, led to a severe cycle of deleveraging and a credit crunch for the economy as a whole. Firms found it difficult to borrow, even for short-term operations; individuals found home loans unavailable and credit card limits reduced.

Overall, the negative economic effect of the financial crisis bore a distinct and troubling resemblance to the effects of the banking crisis of the early 1930s, which helped cause the Great Depression. Policy makers noticed the resemblance and tried to prevent a repeat performance. Beginning in August 2007, the Federal Reserve engaged in a series of efforts to provide cash to the financial system, lending funds to a widening range of institutions and buying private-sector debt. The Fed and the Treasury Department also stepped in to rescue individual firms that were deemed too crucial to be allowed to fail, such as the investment bank Bear Stearns and the insurance company AIG.

In September 2008, however, policy makers decided that one major investment bank, Lehman Brothers, could be allowed to fail. They quickly regretted the decision. Within days of Lehman’s failure, widespread panic gripped the financial markets, as illustrated by the surge in the TED spread shown in Figure 29-10. In response to the intensified crisis, the U.S. government intervened further to support the financial system, as the U.S. Treasury began “injecting” capital into banks. Injecting capital, in practice, meant that the U.S. government would supply cash to banks in return for shares—in effect, partially nationalizing the financial system.

By the fall of 2010, the financial system appeared to be stabilized, and major institutions had repaid much of the money the federal government had injected during the crisis. It was generally expected that taxpayers would end up losing little if any money. However, the recovery of the banks was not matched by a successful turnaround for the overall economy: although the recession that began in December 2007 officially ended in June 2009, unemployment remained stubbornly high.

The Federal Reserve responded to this troubled situation with novel forms of open-market operations. Conventional open-market operations are limited to short-term government debt, but the Fed believed that this was no longer enough. It provided massive liquidity through discount window lending, as well as buying large quantities of other assets, mainly long-term government debt and debt of Fannie Mae and Freddie Mac, government-sponsored agencies that support home lending. This explains the surge in Fed assets after September 2008 visible in Figure 29-9.

Like earlier crises, the crisis of 2008 led to changes in banking regulation, most notably the Dodd-Frank financial regulatory reform bill enacted in 2010. We discuss that bill in the following Economics in Action.

!worldview! ECONOMICS in Action: Regulation After the 2008 Crisis

Regulation After the 2008 Crisis

In July 2010, President Obama signed the Wall Street Reform and Consumer Protection Act—generally known as Dodd-Frank, after its sponsors in the Senate and House, respectively—into law. It was the biggest financial reform enacted since the 1930s—not surprising given that the nation had just gone through the worst financial crisis since the 1930s. How did it change regulation?

The Wall Street Reform and Consumer Protection Act of 2010 was an attempt to extend the spirit of old-fashioned bank regulation to today’s more complex financial system.

For the most part, it left regulation of traditional deposit-taking banks more or less as it was. The main change these banks would face was the creation of a new agency, the Bureau of Consumer Financial Protection, whose mission was to protect borrowers from being exploited through seemingly attractive financial deals they didn’t understand.

The major changes came in the regulation of financial institutions other than banks—institutions that, as the fall of Lehman Brothers showed, could trigger banking crises. The new law gave a special government committee, the Financial Stability Oversight Council, the right to designate certain institutions as “systemically important” even if they weren’t ordinary deposit-taking banks.

These systemically important institutions would be subjected to bank-style regulation, including relatively high capital requirements and limits on the kinds of risks they could take. In addition, the federal government would acquire “resolution authority,” meaning the right to seize troubled financial institutions in much the same way that it routinely takes over troubled banks.

Beyond this, the law established new rules on the trading of derivatives, those complex financial instruments that sank LTCM and played an important role in the 2008 crisis as well: most derivatives would henceforth have to be bought and sold on exchanges, where everyone could observe their prices and the volume of transactions. The idea was to make the risks taken by financial institutions more transparent.

Overall, Dodd-Frank is probably best seen as an attempt to extend the spirit of old-fashioned bank regulation to the more complex financial system of the twenty-first century. Will it succeed in heading off future banking crises? Stay tuned.

Quick Review

  • The Federal Reserve system was created in response to the Panic of 1907.

  • Widespread bank runs in the early 1930s resulted in greater bank regulation and the creation of federal deposit insurance. Banks were separated into two categories: commercial (covered by deposit insurance) and investment (not covered).

  • In the savings and loan (thrift) crisis of the 1970s and 1980s, insufficiently regulated S&Ls incurred huge losses from risky speculation.

  • During the mid-1990s, the hedge fund LTCM used huge amounts of leverage to speculate in global markets, incurred massive losses, and collapsed. In selling assets to cover its losses, LTCM caused balance sheet effects for firms around the world. To prevent a vicious cycle of deleveraging, the New York Fed coordinated a private bailout.

  • In the mid-2000s, loans from subprime lending spread through the financial system via securitization, leading to a financial crisis. The Fed responded by injecting cash into financial institutions and buying private debt.

  • In 2010, the Dodd-Frank bill revised financial regulation in an attempt to prevent repeats of the 2008 crisis.

29-5

  1. Question 14.9

    What are the similarities between the Panic of 1907, the S&L crisis, and the crisis of 2008?

  2. Question 14.10

    Why did the creation of the Federal Reserve fail to prevent the bank runs of the Great Depression? What measures stopped the bank runs?

  3. Question 14.11

    Describe the balance sheet effect. Describe the vicious cycle of deleveraging. Why is it necessary for the government to step in to halt a vicious cycle of deleveraging?

Solutions appear at back of book.

The Perfect Gift: Cash or a Gift Card?

It’s always nice when someone shows his or her appreciation by giving you a gift. Over the past few years, more and more people have been showing their appreciation by giving gift cards, prepaid plastic cards issued by a retailer that can be redeemed for merchandise. The best-selling single item for more than 80% of the top 100 American retailers, says GiftCardUSA.com, is their gift cards.

What could be more simple and useful than allowing the recipient to choose what he or she wants? And isn’t a gift card more personal than cash or a check?

Yet several websites are now making a profit from the fact that gift card recipients are often willing to sell their cards at a discount—sometimes at a fairly sizable discount—to turn them into cold, impersonal dollars and cents.

Cardpool.com is one such site. At the time of writing, it offers to pay cash to a seller of a Whole Foods gift card equivalent to 88% of the card’s face value. For example, the seller of a card with a value of $100 would receive $88 in cash. But it offers cash equal to only 70% of a Gap card’s face value. Cardpool.com profits by reselling the card at a premium over what it paid; for example, it buys a Whole Foods card for 88% of its face value and then resells it for 97% of its face value.

Many consumers will sell at a sizable discount to turn gift cards into cash. But retailers promote the use of gift cards over cash because much of the value of gift cards issued never gets used, a phenomenon known as breakage.

How does breakage occur? People lose cards. Or they spend only $47 of a $50 gift card, and never return to the store to spend that last $3. Also, retailers impose fees on the use of cards or make them subject to expiration dates, which customers forget about. And if a retailer goes out of business, the value of outstanding gift cards disappears with it.

In addition to breakage, retailers benefit when customers intent on using up the value of their gift card find that it is too difficult to spend exactly the amount of the card. Instead, they end up spending more than the card’s face value, sometimes even more than they would have without the gift card.

Gift cards are so beneficial to retailers that instead of rewarding customer loyalty with rebate checks (once a common practice), they have switched to dispensing gift cards. As one commentator noted in explaining why retailers prefer gift cards to rebate checks, “Nobody neglects to spend cash.”

However, the future may not be quite so profitable for gift card issuers. Hard economic times have made consumers more careful about spending down their cards. And legislation enacted in 2009 requires that cards remain valid for at least five years. As a result, breakage has fallen sharply, although it still amounts to more than $1 billion a year.

QUESTIONS FOR THOUGHT

  1. Question 14.12

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    Why are gift card owners willing to sell their cards for a cash amount less than their face value?
  2. Question 14.13

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    Why do gift cards for retailers like Walmart, Home Depot, and Whole Foods sell for a smaller discount than those for retailers like the Gap and Aeropostale?
  3. Question 14.14

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    Use your answer from Question 2 to explain why cash never “sells” at a discount.
  4. Question 14.15

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    Explain why retailers prefer to reward loyal customers with gift cards instead of rebate checks.
  5. Question 14.16

    PVFpade6TcVEAKYCe6g58XpkZiFOdSsizPYm7TG4tgNL5q39WigqCv7CbllqVQ1Hfst8eRK3r1iDR2B+FHNn/nmyrUmJ8QDrjlwEwf5i+1IbQ6irct09MCb1UTl13LYsWOG+fmK/VCpUeuLKPewwrkbJyvwHjdLUFD/7E8KRucdmyXwQI1OovOKFgoCYSNI2tSjhAIChc3gXbHwu8CDwuel76VLpd/SpR78S6KEXL+oQNcDht6JoYAgwBaCEd76d6J+rMWrIvxWt+tliEauvfciEnJU=
    Recent legislation restricted retailers’ ability to impose fees and expiration dates on their gift cards and mandated greater disclosure of their terms. Why do you think Congress enacted this legislation?