In a discussion of banking, the following appeared in the April
30 issue of The Economist:
"... it is in the nature of banks that their relationship with government
is an intimate one, and often takes the form of a Faustian bargain.
In return for deposit insurance and the subsidy that goes with it,
banks agree to intense and sometimes intrusive regulation by governments."
In this analogy, the bankers represent Faust and government, the devil.
As appealing as it is to think of the government cast in the role of
the devil, I think The Economist has it backward. My reading
of recent history would make the government not the devil but the dupe,
the taxpayer the 20th century Faust, and the bankers, the devil. Surely
banks are not clamoring to break the bargain, but the taxpayers should
be willing to, or at least they should want to, renegotiate. ...
One point of clarification before I continue; when I use the
term "bank," or "banker," or "banking," I'm generally using the
term in its generic sense to apply to thrifts as well as commercial
banks. I believe it will be clear when I mean bank in the narrow
To begin, I think it's useful to recognize that banks are special.
All bankers certainly want us to believe this, most of my bank
regulator colleagues believe it, consumer groups believe it, and,
given its attention to banking, Congress must believe it. For
some purposes, even I believe it. ... In my judgment, the feature
that more than any other makes banks special is that they are
covered by the so- called federal safety net, access to the Fed's
discount window and deposit insurance. The banks receive a subsidy
from this special feature at a price well below what the market
would charge. In exchange for this valuable subsidy, in the words
of The Economist, "... banks agree to intense and
sometimes intrusive regulation by governments," and, I would add,
To explain why I believe the bankers are the winners in the
deposit insurance Faustian bargain I'm going to examine both sides
of what The Economist describes as the bargain, the
deposit insurance subsidy on the one hand, and the supervision
and regulation burden on the other.
To assess the value of the subsidy, it's instructive to first
examine the coverage provided by deposit insurance. The deposit
insurance system was enacted into law in 1933 in the aftermath
of the bank failures of the Great Depression, to protect small
depositors and provide stability to the banking system. The coverage
was set at $5,000 per account with the Banking Act of 1935 and
remained at that level until it was increased to $10,000 in 1950.
In 1966 it was increased to $15,000, in 1969 to $20,000, in 1974
to $40,000, and in 1982 it was increased to its current level
of $100,000 per account.
As it turned out, $100,000 was an exercise in congressional
restraint. In 1984, faced with the failure of Continental of Illinois,
the three federal bank regulators decided that the nation's financial
system could not tolerate the systemic risk posed by the failure
of such a large bank, and thus was born "too-big-to-fail." Almost
immediately thereafter Congress endorsed the action of the regulators.
Although "too-big" had not been defined, it didn't matter, because
hundreds of banks of all sizes failed between 1985 and the end
of the decade, and the FDIC protected over 99 percent of the uninsured
deposits in those banks. In other words, de facto, there was virtually
100 percent deposit insurance.
The subsidy the bankers receive from deposit insurance has two
components, each of which has tangible value.
First, the insurance reduces the cost of bank liabilities. Banks
have access to funds at rates lower than those paid by uninsured
financial institutions. Moreover, it is clear from the worst period
of the bank failures of the 1980s that even the most conspicuously
unsound banks have access to deposits at rates only marginally
greater than rates offered by sound banks.
The second component of the deposit insurance subsidy is lower
capital than would otherwise be required by the marketplace. A
lower capital requirement means a bank has the opportunity to
be more leveraged and take on more risk. Even those who believe
that a stable banking system requires a policy of "too-big-to-fail,"
acknowledge that bank capital has declined dramatically since
the institution of deposit insurance. ...
The market price for this subsidy would be very high, possibly
infinite. What is it about deposit insurance that generates such
a high subsidy? It is a phenomenon that any responsible insurance
company understands, called "moral hazard." Moral hazard is the
tendency of the insured to be indifferent to risks against which
it is insured. To protect themselves from the potential consequences
of moral hazard, insurers impose limitations that directly or
indirectly subject the insured to some of the risk. With virtually
100 percent deposit insurance, depositors are indifferent to the
condition of the banks that hold their deposits. Rather, their
incentive is to identify the bank paying the highest rates. With
a ready source of funds from insured deposits, bankers are willing
and able to take on much more risk than they otherwise could have.
To assess the bankers' price for this subsidy we have to examine
the supervision and regulation burden imposed upon them in this
alleged Faustian bargain. Supervision and regulation of banks
covers two broad areas.
Banks have long been subject to the first, safety and soundness
supervision and regulation. However, I believe there is no question
that since the bank failures of the 1980s the level of intensity
of supervision and regulation has increased dramatically. Both
the Financial Institutions Reform, Recovery, and Enforcement Act
of 1989 (FIRREA) and the Federal Deposit Insurance Corp. Improvement
Act of 1991 (FDICIA) were enacted in response to these bank failures.
Each added to the supervision burden, particularly FDICIA, which
few would dispute is the most Draconian piece of banking legislation
I think everyone would agree that the second area of supervision
and regulation is the most burdensome. Over the last 25 years,
banks have had to comply with a constantly growing number of consumer
laws and regulations, and their compliance is monitored by on-site
supervision. In 1968, when I started work on drafting the regulation
to implement Truth in Lending, the first of this series of laws,
I never imagined that it would be followed by as many as 20 more
consumer laws and regulations. The burden from many that have
followed pale Truth in Lending. Perhaps the most conspicuous example
is the Community Reinvestment Act (CRA). Just last month the federal
banking agencies issued a revised proposed amendment to the regulations
implementing CRA that would establish elaborate information and
data gathering requirements that would substantially increase
an already considerable burden. I think it is clear that deposit
insurance is the principal justification for subjecting banks
to these consumer laws and regulations. Even those cases where
non-banks are subject to one or more of these regulations, they
are rarely, if ever, subjected to direct supervision.
Having examined the benefit and the burden of deposit insurance,
I want to return to my claim that The Economist has
the parties to the deposit insurance Faustian bargain wrong. As
I remember the story of Faust, in The Economist's
scenario, the bankers should be losing to government. I must tell
you, if they are, it is not apparent to me. To the contrary, as
I see it the bankers are winning.
Bankers constantly remind us of the burden of supervision and
regulation and its ever increasing intensity, and the restrictions
that prevent them from meeting ever increasing competition. I
would acknowledge both complaints. Some bankers even speak of
giving up their charters. Nevertheless, I am not aware of a single
bank that has relinquished its charter to relieve itself of these
burdens and restrictions. Not even FDICIA, the most intrusive
law on banking supervision and regulation in my memory, has pushed
a bank to give up its charter. I have to ask myself, why not?
For a number of reasons, I think the answer is obvious. First,
deposit insurance continues to provide a substantial subsidy and
bankers understand its vastly understated value. Second, notwithstanding
the considerable amount of supervision and regulation imposed
upon bankers, they are clearly getting the better of the bargain.
... The Bush administration wanted FDICIA to enlarge bank powers
and eliminate interstate banking restrictions and use increased
supervision and regulation to contain the moral hazard in deposit
insurance. However, considering that the memory of what would
unquestionably be the most costly financial disaster in the nation's
history, was still fresh, no one should have been surprised that
FDICIA added harsh new regulation and supervision requirements
but was very unforgiving of bank activities.
In any case, the bankers had little to complain about. Throughout
the 1980s, despite the huge number of bank failures, the Federal
Reserve and the Office of the Comptroller of the Currency were
aggressively enlarging the securities powers of banks by narrowly
construing the restrictions imposed by Glass-Steagall. From recent
public comments by the Clinton administration, the banking regulators,
particularly the Comptroller, and even many in Congress, I would
give odds that Glass-Steagall will soon go the way of McFadden,
which was substantially repealed by the recently enacted Interstate
Banking and Branching Efficiency Act of 1994. ...
I have to wonder, if deposit insurance is a Faustian bargain,
have I either incorrectly identified Faust, the devil, or both,
or in this bargain is the devil going to lose because, I must
say, the bankers are doing just fine.
In concluding, I want to tell you why I think all of this is
bad public policy.
The cost of the thrift bailout stands as conclusive evidence
that to date the conspicuous loser is the taxpayer. The worst
of it is, the risk of additional loss sometime in the future remains
because the cause of the loss, the moral hazard in deposit insurance,
has not been contained. Congress, with the support of the regulators,
has imposed Draconian supervision and regulation measures as a
substitute for market discipline that can't be replaced and is,
more often than not, distorted by regulation.
The banks are winning. They should be reassured that the benefit
of the substantial subsidy that comes with virtual 100 percent
deposit insurance is even more entrenched because the consolidations
that are sure to follow from the Interstate Banking and Branching
Efficiency Act of 1994 will result in more banks that are too
big to fail. The Community Development and Regulatory Improvement
Act of 1994 will ease the burden of many of the harshest provisions
of FDICIA that were intended to contain moral hazard. This law
will even give the bankers a bit of the regulatory consolidation
they having been asking for. After all is said and done, the banks
are winding up much as Treasury had envisioned in its FIRREA report
on banking reform, and they are getting most of the powers that
are important to them. Finally, though I recognize the burdens
of consumer supervision and regulation, they are a small price
to pay for all these benefits.
I would add a word or two of sympathy for banks, but only for
some. The benefits of deposit insurance and burdens of supervision
and regulation are disproportionate among banks. Deposit insurance
is particularly perverse because it rewards bad banks more than
good banks. Also, small banks are disadvantaged vis-a-vis big
banks because of "too-big-to-fail." Although the Community Development
and Regulatory Improvement Act of 1994 offers some relief to small
banks, the cost of the supervision and regulation burden, particularly
consumer supervision and regulation, is inversely proportionate
to the size of the bank.
I'll leave you with one final thought. If the devil approaches
you with a bargain, tell him you want a deal like he gave the