Something is obviously wrong with the U.S. financial system. Witness
the $200 billion bailout of the S&L industry and the recently reported
large number of troubled and failed banks. Most people recognize
that these problems stem from the government's policy of insuring
virtually all deposits at financial institutions. With fully insured
deposits, S&Ls and banks can effectively gamble with taxpayers'
money, enjoying the benefits if the gambles pay off, suffering little
if they do not.
A simple way to correct this costly flaw in our financial system
is to limit insurance coverage, a technique commonly used in most
insurance contracts to limit risk-taking. Yet, bank regulators have
rejected this proposal because they are concerned about putting
depositors at risk. Doing that would mean incurring the risk of
bank runs, which they see as putting the whole economic system at
risk. This is why the Treasury, in its recently released report
on "modernizing" our financial system, is reluctant to change current
policy. But while this general reluctance is understandable, not
to change policy now would be a costly mistake.
A panicky policy...
The fear of bank runs is not unfounded. U.S. banking history includes
well-known examples of bank runs leading to a collapse of confidence
in the entire financial system. Banking panics occurred in every
decade after the Civil War and they continued even after the Federal
Reserve System was established in 1913. By far the worst panics
occurred between 1930 and 1933 when over one-third of the nation's
banks failed. This led in 1933 to the official banking holiday,
during which all U.S. banks were closed for over a week.
This turmoil convinced Congress and a reluctant president that
some federal deposit insurance was necessary to protect the small,
unsophisticated depositor. In 1934, deposits in banks became federally
insured up to $5,000 (and deposits in S&Ls received comparable coverage).
Since then the ceiling has been raised several times, usually to
keep up with inflation. At today's $100,000, though, the ceiling
is well beyond the small-saver range, especially since the number
of institutions at which a depositor may have an insured account
is not limited. Today more than three-quarters of all bank deposits
are officially insured.
Ironically, what was designed to be limited coverage has become
unlimited. Unofficially, even the uninsured depositors are protected
today. Bank regulators are now unwilling to allow uninsured depositors
at large failed banks to lose any money; they fear that a bank run
at such an institution might easily become contagious and spread
to sound as well as other unsound institutions.
This policy formally began in 1984 when bank regulators protected
all depositors at one of the largest banks in the nation, the Continental
Bank of Illinois, and thereby announced that some banks in this
country were "too big to fail." Once depositors at large banks became
fully protected, other banks naturally began pressuring regulators
for equal treatment—and they seem to have succeeded. Between 1985
and 1990, over 99 percent of the uninsured deposits at failed institutions
were fully protected.
...with alarming costs
As a result, the government has eliminated even the possibility
of a bank run—a very expensive policy. Regulators were aware that
fully insuring bank deposits could have a serious side effect, but
they did not know how serious. Banks and S&Ls with fully insured
deposits have an incentive to take on risky portfolios, while their
depositors have no reason to care.
And these institutions have done just that, despite all the regulations
designed to stop them. During the eight-year economic expansion
of the 1980s, a majority of S&Ls either failed or are now in serious
trouble. While banks over this period fared better, more than 1,000
failed, and roughly that many are on the regulators' problem list,
including some of our nation's largest institutions. Again, the
cost of the S&L bailout is now estimated at $200 billion. The financial
losses in the banking industry are just surfacing, but we now know
that the insurance fund may need as much as a $30 billion capital
infusion to survive.
A better way...
The objective of current policy is not so much to prevent a bank
run but rather to prevent a bank run from spreading systemwide.
The concern is that any single bank run might become contagious
and cause a banking panic. Eliminating even the possibility of a
bank run in order to prevent panics, however, is overkill. Bank
runs have an important role to play in promoting bank safety. And
there is a better way to prevent banking panics than eliminating
Under current policy we lose the disciplining benefits of bank
runs. Without full deposit insurance, just the potential of a bank
run would limit a bank's willingness to take on risk. And runs on
troubled banks are the market's way of ensuring prompt closure.
It is unlikely that bank regulators can do better. Proposals to
have tougher capital standards and prompter closure of troubled
institutions won't help much. Owners of banks are the beneficiaries
of high-risk strategies; they gain at the expense of the federal
deposit insurance fund. As long as owners can diversify their risk
to some extent, capital standards will have limited effects on a
bank's strategy toward risk- taking. This, then, leaves much of
the burden of managing bank risk on the threat of prompt closure,
a policy that is difficult for regulators to enforce. Regulators,
in fact, have always had this option and typically have chosen not
to use it. Without bank runs, I doubt closure will ever be prompt.
Moreover, we do not need to lose the disciplining benefits of
bank runs in order to prevent banking panics. The Federal Reserve
was established to act as the lender of last resort in order to
stem systemwide bank runs, and today it is well-equipped to do that.
The Fed can provide virtually unlimited funds to solvent banks to
convince uninsured depositors of their bank's safety. And through
the purchase of government securities, the Fed can provide virtually
unlimited liquidity to the market on very short notice as it did
after the 1987 stock market crash. The Fed, therefore, can prevent
systemwide bank runs, or at least limit their impact.
How serious would that impact be, even if it weren't limited?
Not as great as some claim. During the banking panics that occurred
before the Fed was established, systemwide bank runs appear to have
been more like a symptom of a declining economy rather than its
cause. They tended to start soon after the economy began to decline
and not last long. During the Great Depression years, systemwide
bank runs had a much greater impact. Yet even for this period the
influence of banking panics on the economic decline is debatable.
Canada, for example, experienced roughly the same decline in economic
activity as did the United States, but had no bank runs or bank
...with less insurance
The type of reform needed to solve the current U.S. financial industry
problem seems clear. We still need to protect the small saver, but
we must return to some degree of market discipline.
Two years ago the Federal Reserve Bank of Minneapolis proposed
a way to do that, and I still believe it is the best option. We
recommended an insurance system under which each depositor is allowed
one fully insured account up to some reasonable amount and that
all other deposits be COINSURED: only a fraction of all other deposits
be insured, we suggested 90 percent of them. By putting depositors
at risk this way, banks would be less likely to choose risky strategies.
Systemwide bank runs, of course, would be possible; but with coinsurance,
they would be less of a threat than they were historically.
After the Great Depression, the U.S. government was still willing
to rely on depositors to help discipline banks and on the Federal
Reserve to deal with banking panics. That partnership worked well
for many years. Nevertheless, fearful of even the possibility of
a bank run, regulators now fully protect deposits. The costs of
this policy, though, have become alarming, and regulators should
be questioning whether they have relied too much on deposit protection
and not enough on depositor discipline.