Since the failure of Continental Illinois in 1984, the
U.S. government has pursued a deliberate policy of bailing out large
commercial banks deemed "too-big-to-fail." l
The "too-big-to-fail" doctrine has arisen not simply
because of the growing number of bank failures in the past decade,
though indeed failures have increased. In fact, the doctrine's
historical origins go back much further than a decade. More than 40
years ago, a 1950 amendment to the Federal Deposit Insurance Act of 1934
introduced the "essentiality doctrine." As codified, that doctrine
states that in its sole discretion the government can rescue any failed
bank when "continued operation of such bank is essential to provide
adequate banking service in the community." 2 None of the key
terms in that provision-such as "essential," "adequate," or
"community"-has ever been defined, permitting arbitrary discretion to
rule. Coupled with the diminishing financial condition of banks in
subsequent decades, the "essentiality doctrine" has given government
wide latitude to bail out failed or failing banks for whatever reasons
it deems necessary.
Of course, deposit insurance legislation itself arose
out of the bank failures of the early 1930s. These failures in turn were
largely the result of Federal Reserve monetary mismanagement.
3 In short, today's "too-big-to-fail" doctrine can trace its
roots to the very establishment of central banking in this country in
1913. Before we examine the merits of the manner in which government has
decided to handle bank failures, it is helpful to understand why banks
are failing today in such large numbers to begin with.
The main theme of my own research on U.S. banking
history has been that central banking is detrimental both to sound money
and safe banking. In particular I have found that the U.S. commercial
banking industry has suffered a secular decline in financial strength in
the 80 years since the Federal Reserve System was established in 1913.
For example, capital ratios have fallen from 20 percent at the turn of
the century to around 6 percent today. Banks are also far less liquid
today than they were in earlier decades. The loan quality of banks has
declined steadily over our central banking era. Profitability has been
weak and irregular compared to the period before central banking.
Finally, bank failures have been more a problem under central banking
than under previous banking eras in U.S. history. 4
To be sure, these measures of banking system strength
have ebbed and flowed cyclically over the past eight decades-for
example, the dissolution of the 1930s, the seeming calm of the 1950s,
and the renewed turbulence of the past two decades. But in my own work,
I've identified an undeniably pronounced secular decline in the
financial condition of banks, in good times and bad. This leads me to
question the legitimacy of central banking as such. I'm encouraged to
find that other scholars are also questioning the conventional wisdom
about central banking 5
I attribute the secular decline of banks to central
banking not only because that has been the predominant structure
governing our money and banking system for most of this century, but
because the main features of central banking bear directly on the
worsening finances of the banks.
For example, central banking involves a legal tender
monopoly on the production of paper currency, and to the extent this
money is produced in excessive supply and forms the base of banking
system deposit expansion, it inflates bank balance sheets and invites
malinvestment of resources. Central banking is characterized by a lender
of last resort function that can be seriously mismanaged, as it was in
the 1930s, causing widespread bank failures. Central banking is usually
accompanied by a system of flat-rate federal deposit insurance, a system
known by all to promote excessive risktaking and imprudence among banks.
It should not have taken decades to see this would
happen. Back in 1908, when earlier versions of government deposit
insurance were advanced, the president of the First National Bank of
Chicago, James Forgan, asked the following: "Is there anything in the
relations between banks and their customers to justify the proposition
that in the banking business the good should be taxed for the bad;
ability taxed to pay for incompetency; honesty taxed to pay for
dishonesty; experience and training taxed to pay for the errors of
inexperience and lack of training; and knowledge taxed to pay for the
mistakes of ignorance?" 6
As I have argued elsewhere, "deposit insurance is a
scheme put in place because the Federal Reserve mismanaged the discount
window in the 1930s, and it is a scheme that has been expanded ever
since in concert with the Fed's inflation of the money supply (which
consists predominantly of bank demand deposits)." 7
Finally, systems of central banking involve extensive
regulation of bank branching, lending, and product offerings-regulations
that prohibit sound diversification and invite still greater
instability.
Usafe and Unsound
If the purpose of central banking is to ensure sound
money and safe banking, then central banking has been an unmitigated
failure. I have already summarized the relative decline of banking's
strength as captured in financial ratios. But the purchasing power of
money has also declined, so that a 1913 dollar is worth ten times more
than a 1992 dollar. We enjoyed much sounder money and safer banking in
the eight decades before central banking was established here in 1913
than we have in the eight decades since. I conclude that this is so
because central banking represents a special case of the general failure
of central economic planning, a failure that most of the world is only
now beginning to recognize. 8
The fact that central banking flies in the face of
free-market alternatives is recognized by some of its most prominent
practitioners. In a symposium sponsored by the Federal Reserve Bank of
Kansas City in August 1990, Paul Volcker noted that, "Central banks were
not at the cutting edge of a market economy.... Central banking is
almost entirely a phenomenon of the 20th century... Central banks were
looked upon and created as a means of financing the government. ... If
you say central banking is essential to a free market economy, I have to
ask you about Hong Kong, which has no central bank at all in the
absolute epitome of a free market economy. Yet it does quite well in
terms of economic growth and stability." 9
My research confirms Mr. Volcker's assessment. The
primary purpose of central banking is to finance the government.
l0 That's what it does consistently and what it does best-and
does so, unfortunately, at the expense of sound money and safe banking.
Mr. Volcker would find results in the U.S. similar to those of Hong
Kong, as I did, by examining the decades before the Federal Reserve was
established.
In the eight decades before 1913 we had a system which
can very loosely be called "free banking and the gold standard." There
was no central bank, no lender of last resort, no federal deposit
insurance. Banks issued currency as well as checking deposits,
convertible into the precious metals. Bank note redemptions and the gold
standard anchored the money supply. Excessive currency issuance was
prevented. Money expanded and contracted with the needs of trade, not
with the needs of government. Banks formed clearinghouses to settle
balances and they lent on an inter-bank basis to temporarily illiquid
but solvent institutions. The few banks that failed were absorbed into
stronger ones or simply liquidated at a discount to noteholders.
11
The free banking era was not totally free, of course.
Bank note issues were restricted by laws requiring currency to be backed
by state or federal bonds-an indirect means of financing government.
Branching was restricted as well, preventing full diversification. But
the U.S. free banking era was more in line with a free market system of
money and banking than our present era. As such, it should not be
surprising that it produced relatively higher quality money and much
safer banking. I document these facts in my book. For more background on
the favorable history of the free banking era, I recommend the work of
Arthur Rolnick and Warren Weber at the Federal Reserve Bank of
Minneapolis. 12
Only with this wider historical and theoretical context
can we grasp the full implications of today's "too-big-to-fail"
doctrine. In my view, banking without the "too-big-to-fail" doctrine is
not simply banking prior to 1984, the year when Todd Conover,
Comptroller of the Currency, said the top 11 banks in the country would
not be permitted to fail. For me, banking without "too-big-to-fail" is
banking before 1913, the year when the Federal Reserve was established.
For as I have indicated, the doctrine is inextricably linked with
central banking. No free market system of money and banking would aim to
sustain insolvent institutions, and there would be no institutional bias
in favor of generating insolvent institutions, as central banking
engenders. Free banking minimizes the spread of problem banks from the
very start. No central bank monetary inflation or taxpayer deposit
guarantees are employed to force-feed a free banking system.
Undermining the Financial Integrity of Banks
In two important respects, the "too-big-to-fail"
doctrine represents an unhealthy extension of two central banking
features that have already been shown to undermine the financial
integrity of banks.
First, the "too-big-to-fail" doctrine has transformed
the lender of last resort from one providing cash to temporarily
illiquid banks to one providing extended credit to permanently insolvent
banks. One of the first theorists of the lender of last resort function,
Walter Bagehot, warned us that there would be times when a central bank
couldn't effectively distinguish between illiquidity and insolvency.
13 But in recent years the discount window has been thrown
wide open to banks widely admitted to be insolvent. For example, a 1991
House Banking Committee report concluded that the central bank provided
subsidized credit to hundreds of banks that ultimately failed. In six
years ending May 1991, 530 of the 3000 banks that drew on the discount
window failed within three years. Many more, if not outright failures,
had the lowest financial performance ratings assigned by regulators.
Even as a provider of short-term liquidity, the lender
of last resort offers a safety valve for banks that do not properly
manage their liquidity positions. This subsidy for liquidity
mismanagement has been in place for years. We were always assured that
the Fed would manage access to the window with prudence and discretion.
But now this mal-incentive has been extended still further to cover up
the insolvency of banks. Perhaps even worse, access to the discount
window was widened in the 1991 banking law to include the securities
industry. More recently, there was talk among U.S., British, and
Canadian central bankers of assisting real estate developer Olympia and
York, on the grounds that its bad loans would harm big banks. There
appears to be no end to the degeneration of the lender of last resort
function.
Second, the " too-big-to -fail" doctrine has unwisely
extended deposit insurance coverage from insured depositors to uninsured
depositors and creditors. Government guarantees of insured deposits are
bad enough in the way they promote reckless banking. The more than
doubling of deposit coverage in 1980 institutionalized the recklessness.
The extension of coverage to all creditors of banks, as under the
"too-big-to-fail" doctrine, is the height of irresponsibility.
Nothing in the 1991 banking law removes the discretion
of the Fed or the Treasury in employing "too-big-to-fail" at any time
for any purpose. 14 To the extent the doctrine has not been
employed as extensively in recent failures, it seems only because of the
insolvency of the deposit insurance funds themselves. "Too-big-to-fail"
is not a doctrine which can be effectively scaled back in isolation or
in increments. Unless there is an outright rule against it, exceptions
will always be made to expand it.
"As the late Nobel Prize-winning economist
Friedrich
Hayek argued, we need 'a denationalization
of money,' and the kind
of choice in currencies
that brought us stable money and
banking
in the 19th century."
Bad as they already were, discount window activity and
deposit insurance coverage have degenerated further in recent decades,
in the name of the "too-big-to-fail" doctrine. We need to repeal the
structural central banking features that generate failed banks, not
simply patch on some extended version of these features, a patch job
supposedly justified by pointing to all the failures. Accompanying the
unconditional repeal of "too-big-to-fail" must be a scaling back and
eventual abolition of federal deposit insurance and discount window
lending as well. The sooner this occurs, the sooner banking will be
restored to the health it enjoyed before these features were in place.
15
The Fear of Contagious Bank Runs
Opponents of the repeal of the "too-big-to-fail"
doctrine often cite the so-called "contagion" effect of bank failures,
the domino effect of large bank failures precipitating other failures,
allegedly cascading into a system-wide collapse.
In my estimation, no factor contributes more to this
risk than government restrictions on branching. U.S. banking historians
know all too well that widespread correspondent banking and extensive
reliance on inter-bank deposits in this country stem directly from
branching prohibitions. 16 In nationwide banking systems,
such as in Canada, inter-bank exposures are minimal. 17 But
in the U.S., the government has promoted an interlocking banking system,
in effect requiring banks to line up like dominos, preventing them from
holding their own direct deposits in their own chosen areas of the
country. Having created such unstable links, government has then
advanced a "too-big-to-fail" doctrine to prevent smaller banks from
being harmed by losses on deposits at bigger banks.
Here is an obvious case of government interventions
that have bred further intervention, allegedly to remedy the distortions
brought about by still earlier interventions. Eugene White and others
have shown that U.S. banking history is replete with evidence of this
vicious circle. 18 There is only one solution to this
madness, and that is to repeal the interventions across the board. Let's
start by permitting what every advanced country permits of its own
banks-the ability to branch freely and diversify their operations.
I will not repeat here in detail other important
refutations of the so-called "contagion" argument, especially those made
by economist George Kauffman. 19 Suffice it to say, he argues
that if some banks are weak, depositors will transfer their money to
stronger ones. If they don't find stronger ones they will make a flight
to quality and acquire government securities, the sellers of which must
be confident of finding stronger banks, because in selling they expect
to deposit the cash proceeds. In either of these cases, there is a
redistribution of reserves, but no destruction of them. There is no
deflation of the aggregate money supply and hence no contagion effect.
What if the strength of all banks is doubted by all
parties? Then there will be a flight out of deposits into currency, a
precipitous drop in the deposit/currency ratio so common to deflations.
A loss of reserves could kick off a multiple contraction process that
affects healthy banks as well as insolvent ones. But observe that such
deflations are exacerbated by fractional reserve banking, and especially
by very low fractions. Economists who recognize this potential problem
tend to argue for some form of deposit insurance to contain it. I
believe, to the contrary, that all government deposit insurance is
de-stabilizing. I oppose it on principle, mindful of the fact that even
limited forms of it soon grow into uncontrollable excess.
Furthermore, my own research indicates that bank
liquidity is far lower-that is, reserve fractions are far lower-under
central banking than under free banking. Hence a deposit contraction is
potentially more severe when a central bank is in charge. More
important, free banking offers a direct solution to the problem. A
system of free banking permits private bank currency issuance, so banks
can easily meet shifts in customer demand for currency relative to
checking deposits. Such shifts are far less easily accommodated by a
monopoly currency issuer which can misjudge and mismanage the shift, as
did the Federal Reserve in the early 1930s.
On these grounds alone, I believe there is good reason
to secure some end as well to the legal tender laws which grant a
monopoly on currency issuance to the Federal Reserve. I have offered
other reasons for the repeal of the legal tender laws in my book. As the
late Nobel Prize-winning economist Friedrich Hayek argued, we need "a
denationalization of money," and the kind of choice in currencies that
brought us stable money and banking in the 19th century. 20
Parting somewhat from Hayek, I believe this free issuance of bank notes
must also involve gold-convertibility, as note issue did during our
better banking era.
A proper legal structure upholding property rights is
also important. Free banking does not entail anarchy. Contracts must be
enforced. The repeal of the "too-big-to-fail" doctrine will not be truly
sustainable unless banks are fully subject to the general bankruptcy
laws. No other industry is exempt from such laws, nor so harmed by the
exemption.
Until and unless banks are subject to bankruptcy, we
will continue to see failures handled according to politics and
bureaucratic motives-such as agency "image"-not according to simple
justice and sound economics. We will continue to witness swings from a
regulatory policy of "forbearance" to a policy of "early intervention,"
to forbearance, and back again. Both policies are detrimental to the
banking system, and not only because of their unpredictable application
from one case to the next or one year to the next. Forbearance, as is
known to all, promotes laxity in accounting and financial control,
condoning, if not encouraging, recklessness, hiding insolvency, and
ballooning ultimate losses. "Early intervention," on the other hand, has
its own dangers. While posing as a remedy for the ills of forbearance, a
policy of early intervention actually holds out the very definite
prospect of de facto nationalizations of the banks. After all, if banks
with 2 percent capital ratios are to be closed down or taken over, as
provided in the 1991 banking law, what else can such a policy be called
but a nationalization, indeed a "taking," under the Fifth Amendment? The
recent nationalization of Crossland Savings Bank offers a chilling
precedent for this disturbing new extension of the "too-big-to-fail"
doctrine. 21
If, instead, banks are subject to the bankruptcy laws,
the competing interests of management and creditors, including the
creditors who are depositors, will prevail. Closures of failed
institutions will not be sudden but orderly. They'll be drawn out in a
rational manner, but not forever, as in the case of the thrifts or the
Rhode Island credit unions. Neither will closures under bankruptcy take
place prematurely, while there remains value in the franchise. For a
more detailed look at this approach, I commend to you the work of Robert
Hetzel at the Federal Reserve Bank of Richmond. 22 In
conclusion, I want to stress that the "too-big-to-fad" doctrine is part
and parcel of a wider system of central banking that undermines the
financial condition of the banking system. The sooner we phase out this
system in favor of free banking and the rule of law, the better off we
will be. In other words, repealing the "too-big-to-fail" doctrine will
be a good start, but it won't go far enough in curing what really ails
the banks.
At the time of the original publication, Mr. Salsman
was a banker in New York City and an adjunct fellow of the American
Institute for Economic Research in Great Barrington, Massachusetts.
This article is adapted from a speech delivered at a conference
sponsored by The Federal Reserve Bank of Dallas, May 12-13, 1992.
1. Irvine H. Sprague, Bailout: An Insider's Account of
Bank Failures and Rescues (New York: Basic Books, 1986).
2. Paul A. Samuelson and Herman E. Krooss, Documentary
History of Banking and Currency in the United States, Volume IV (New
York: Chelsea House Publishers, 1983), p. 354.
3. Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States, 1867-1960 (Princeton, N.J.: Princeton
University Press, 1963), Chapter 7.
4. Richard M. Saisman, Breaking the Banks: Central
Banking Problems and Free Banking Solutions (Great Barrington, Mass.:
American Institute for Economic Research, 1990).
5. See especially Lawrence H. White's works, Free
Banking In Britain: Theory, Experience and Debate, 1800-45 (Cambridge:
Cambridge University Press, 1984) and Competition and Currency: Essays
on Free Banking and Money (New York: New York University Press, 1989).
6. James B. Forgan, "Should National Bank Deposits Be
Guaranteed by the Government?" Address to the Illinois Bankers'Asso
ciation, June 11, 1908 (Chicago: First National Bank of Chicago).
7. Richard M. Salsman, The Credit Crunch: Myth or
Reality? American Institute for Economic Research, October 1991.
8. Economists of the Austrian School of economics,
especially Ludwig von Mises and Friedrich Hayek, have been identifying
this failure for most of this century.
9. Paul Volcker, "The Role of Central Banks" in Central
Banking Issues in Emerging Market-Oriented Economics (a symposium
sponsored by the Federal Reserve Bank of Kansas City, August 23-25,
1990). Definitive historical evidence for Volcker's summary assessment
can be found in Charles Goodhart's The Evolution of Central Banks
(Cambridge: The MIT Press, 1988).
10. Salsman, Breaking the Banks, chapter 8.
11. Salsman, ibid., chapter 6.
12. See especially Arthur J. Rolnick and Warren E.
Weber, "Free Banking, Wildcat Banking, and Shinplasters." Quarterly
Review, Federal Reserve Bank of Minneapolis, Fall 1982, pp. 10-19.
13. Walter Bagehot, Lombard Street: A Description ofthe
Money Market (London: Kegan, Paul & Co., 1873).
14. See the misnamed Federal Deposit Insurance
Corporation Improvernent Act of 1991 (FlDICIA).
15. 1 have explained in detail how this might be
accomplished in Chapter 9 of Breaking the Banks.
16. Walker Todd and James Thompson, "An Insider's View
of the Political Economy of the 'Too-Big-To-Fail' Doctrine," Federal
Reserve Bank of Cleveland, Working Paper #9017, December 1990, p. 16.
17. Lawrence Kryzanowski and Gordon Roberts, "The
Performance of the Canadian Banking System, 1920-1940," Proceedings from
a Conference on Bank Structure and Competition (Chicago: Federal Reserve
Bank of Chicago, May 1989), pp. 221-232.
18. Eugene Nelson White, The Regulation and Reform of
the American Banking System, 1900-1929 (Princeton, N.J.: Princeton
University Press, 1983).
19. George Kauffman, "Are Some Banks Too Large to
Fail?" Federal Reserve Bank of Chicago Working Paper, June 1989.
20. Friedrich A. Hayek, Denationalization of Money
(London: The Institute for Economic Affairs, 2nd Edition, 1978).
21. Jonathan R. Macey, "Needless Nationalization at the
FDIC," The Wall Street Journal, February 14,1992. According to Macey,
"By nationalizing Crossland, the FDIC is signaling that it can take over
any bank or thrift it wants, no matter how large or small, or how remote
the threat to the banking system."
22. Robert Hetzel, "Too Big To Fail: Origins,
Consequences, and Outlook," Economic Review, Federal Reserve Bank of
Richmond, November/December 1991, pp. 3-15.
Reprinted with permission from the
Freeman a publication of the Foundation for Economic Education, Inc.,
November 1992, Vol. 42, No. 11
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