"[M]any governments in recent years have found it necessary or desirable,
acting as a lender of last resort or otherwise, to directly intervene
in their national banking systems to provide liquidity or capital support
in the interest of preserving financial stability. As distinctions between
banks and other financial institutions become increasingly blurred and
their international character more pronounced, the proper role of governmental
safety nets and their implications for institutional behavior need
Paul Volcker, July 1997
From Global Institutions, National Supervision and Systemic
A Group of Thirty report
This warning may seem to come at an unlikely time, at least as
far as the U.S. banking industry is concerned. Banks are performing
well, along with the US economy, and the industry has been stable
in recent yearsjust six bank failures last year and just six
in 1995. But trouble may lurk below the surface. Interstate banking
restrictions have been lifted and the barriers between commercial
and investment banking are starting to fall; US banks are consolidating
in record numbers and the size and complexity of our largest banks
are growing. While this consolidation and growth may not, in and
of itself, be bad, one thing is clear: The loss of just one of these
banks will pose an even greater systemic risk than before. Therefore,
as Mr. Volcker suggests, the time is right to re-examine the safety
net that protects our banking industry.
The last time Congress re-examined this safety net was shortly
after the banking crisis of the 1980s. Recall that bank failures
in the United States reached about 1,000 between 1986 and 1990,
and the banks' deposit insurance fund teetered on the edge of insolvency.
Indeed, the Federal Deposit Insurance Corp. had to request a $30
billion line of credit from the US Treasury to remain solvent. And,
of course, the problems in the savings and loan industry were even
greater, where the virtual failure of the industry bankrupted the
Federal Savings and Loans Insurance fund and cost the American taxpayer
over $100 billion.
It took a crisis of such huge dimensions to spur a policy response,
and in 1991 Congress passed the Federal Deposit Insurance Corp.
Improvement Act (FDICIA). The intent of this law, for the most part,
was to redesign the federal safety net and the power of federal
banking regulators in the hopes of preventing another S&L-type crisis.
Here we argue that while FDICIA was a step in the right direction,
it stops short of bringing market forces to bear on our largest
banks. If the United States is to avoid another banking crisis,
uninsured depositors must in fact be uninsured.
Why is it important that uninsured depositors bear some of the
risk in a bank failure? Because having uninsured depositors bear
some of the risk is a key ingredient for mitigating a costly side
effect with deposit insurance, a costly side effect known as moral
hazard: Once a person or institution is insured, the insured
has an incentive to take on more risk than otherwise. This is why,
for example, fire and auto insurance policies have deductibles.
With deductibles, the insured have more incentive to pick up old
paint cans and drive cars more carefully.
The moral hazard problem is particularly severe in banking because
of the lack of deductibles. Governments often provide 100 percent
depositor protection, especially at large banks where a loss could
have industry wide repercussions (a practice known as too big to failTBTF).
In 1991 the US Congress created an explicit and more stringent
TBTF policy. Prior to 1991, there was an unwritten TBTF policy,
and the government was much freer to rescue large banks and protect
uninsured depositors. Under FDICIA, uninsured depositors cannot
receive protection if it raises costs to the FDIC. There is an exception,
however, if the failure of the bank poses a systemic risk. The emergency
bailout can go forward with the approval of the Secretary of the
Treasury (who must consult with the President), the Federal Reserve
Board of Governors and the FDIC's board of directors. Therein lies
the problem: FDICIA still leaves the door open for moral hazard
in the extreme. Uninsured depositors at the very largest US banks
still know they are likely to be fully protected and have little
reason to monitor how their deposits are invested. And, as a result,
large banks have an incentive to take on more risk than they would
Congress recognized the problem of moral hazard and tried to make
the protection of uninsured depositors less likely in FDICIA by
giving regulators new tools to close a troubled bank before large
losses ever develop. In theory, these tools should work. Closing
banks before they are insolvent eliminates moral hazard because
the insured cannot take advantage of the insurance fund. In practice,
however, closing banks before they are insolvent is like stopping
forest fires. Many sound precautions can be taken, but conflagrations
will always occur. For large complex banks, financial fires are
likely to be burning for some time before regulators become aware
of the fire.
Our recommendation is that when a TBTF bank is rescued, uninsured
depositors cannot be fully protected. Specifically, we recommend
that uninsured depositors can recover only 80 percent of their deposits
or the market value of their deposits, whichever is larger. Because
depositors' losses would be capped, this policy would limit the
systemic risks. At the same time, it would lift the de facto
risk-free curtain that shields large banks and would force depositors
to take a good look inside. With up to 20 percent of their deposits
over $100,000 at risk, it would behoove depositors to pay attention
to what banks are doing with their money, and, likewise, such a
plan would cause banks to more carefully conduct business. Banks
would not only have to compete on the basis of price and service,
but also on safety and soundness.
And this competition would likely spread beyond big banks. By
inducing depositors to look past a bank's size to its fundamentals,
depositors would probably begin looking at smaller banks with good
reputations, thereby spreading this incentive throughout the industry
and, in theory, making the whole industry more safe and sound than
it would be otherwise.
FDICIA did not go far enough in addressing the moral hazard problem.
The recent success of the banking industry should not lull us into a false
sense of security. Another banking crisis is possible and this timewith
ever larger and more complex banksthe costs could be even greater.
The time is right for uninsured depositors to become truly uninsured,
and thus reduce the insidious effect of moral hazard in the banking industry.