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Is deposit insurance the bankers' Faustian bargain?

This column is based on Burstein's October address to the Minnesota Institute of Legal Education.

January 1, 1995


Melvin L. Burstein Senior Vice President and General Counsel
Is deposit insurance the bankers' Faustian bargain?

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 sense.

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, supervision.

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 in memory.

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 bankers.