The mess in the savings and loan industry is the worst
thing to happen to the American banking system since the Great
Depression. As an indication of how severe the problem is, government
estimates of the cost of bailing out bankrupt savings and loans, which
were $30 billion a few months ago, rose to $60 billion, then to $160
billion. And the cost is rising by $1 billion for every month that the
federal government lets 350 bankrupt savings and loans stay open because
it hasn't budgeted the money to pay off their depositors.
American taxpayers will be footing the bill for this
because the federal government guarantees almost all bank deposits. The
rationale of deposit insurance is that it is cheaper than the banking
panics that supposedly would result without it. But the history of
deposit insurance in the United States and other countries indicates
that it is neither necessary nor desirable. Outside the United States,
deposit insurance, even where it exists, has not been needed.
Competition has forced foreign banks to develop nationwide branch
networks and to diversify into lines of business forbidden to American
banks. This has resulted in the creation of large banks that are very
secure because they spread their risks among many regions and types of
activity.
In the United States, deposit insurance has been rarely
self-financing because government regulation has prevented competition
from evolving the strongest banks possible. Indeed, deposit insurance
crises are almost as old as deposit insurance itself. The Federal
Savings and Loan Insurance Corporation's current problems have many
precedents. Besides Federal deposit insurance, the United States has had
about 30 state deposit insurance schemes. Nearly half operated before
the Great Depression, and half since. Their experience has been
dreadful. All but a few have gone broke. A brief look at their history
shows what we can expect again if Congress doesn't use the current
Federal bailout as an opportunity to free our financial system from the
stranglehold of regulation.
New York State started the first deposit insurance
system in 1829. Banks paid a tax of 3 percent of their capital into a
common "safety fund." New York City banks, which were among the largest
and most stable in the nation, opposed the fund. However, the more
numerous rural banks influenced the state legislature to establish it.
The safety fund's purpose was to instill public confidence in bank
notes, although it also covered deposits. (Apparently, the legislature
did not intend deposits to be covered, but they were because the law it
enacted was careless on that point.) The safety fund benefited rural
banks most, because their profits depended more on note circulation.
Five other states imitated New York in setting up compulsory bank
insurance systems before the Civil War.
The first to fail was Michigan's. It had been in
operation only a year when the panic of 1837 dragged down most of the
state's banks. Payments into Michigan's insurance fund barely covered
supervisory costs, so creditors of failed banks got nothing. A few years
later, 11 bank failures depleted the New York fund. The state government
eventually issued bonds to bail it out, much as the Bush administration
has proposed doing for the FSLIC. But some creditors waited as long as
21 years for payment. A single failure was enough to bankrupt Vermont's
fund in 1857. Creditors there got less than two-thirds the value of
their claims.
Michigan, New York, and Vermont effectively closed
their insurance funds when the funds went broke. Indiana, Ohio, and Iowa
had funds that stayed solvent. Oddly, the solvent funds had more
potential for causing trouble than the others. Healthy banks were liable
for paying failed banks' creditors if the insurance funds should be
exhausted. Hence, severe losses at a few banks could have wiped out all
banks in the state. However, strong industry pressure counteracted the
temptation, in effect, to play fast and loose with other banks' capital.
In contrast to the systems that went broke, where bank
examiners were government employees, in the solvent systems examiners
were largely chosen by and responsible to the banks. The number of banks
was small - 41 in Ohio, 20 in Indiana, and 15 in Iowa. That made group
action against imprudent banks possible. Today, when Federal deposit
insurance covers thousands of banks, savings and loans, and credit
unions, this element of the successful state systems would be impossible
to duplicate. Ohio and Iowa also reduced the risk to their funds by
guaranteeing only notes, which were being eclipsed by deposits as the
chief type of bank liability. 1
By 1866, changes in Federal banking law induced most
banks to switch from state charters to Federal charters. Despite a
Federal prohibition on branch banking, Federal charters were attractive
because they allowed banks to continue issuing notes. State-chartered
banks, in contrast, faced a 10 percent tax on note issue that made it
prohibitively expensive. The Indiana, Ohio, and Iowa insurance funds
closed still solvent when their members got Federal charters. The
savings and loan industry began in earnest at the same time, as a
product of a provision in the same law that severely restricted
Federally chartered banks' ability to make mortgages. (These
restrictions lasted until the 1970s. Since then, most of the other legal
barriers separating banks from savings and loans have fallen as well.)
Bank notes effectively carried a Federal guarantee from
the 1860s until Federal Reserve notes replaced the last of them in 1934.
Issuers had to back notes 100 percent or even 110 percent with Treasury
bonds, kept in a Treasury vault. But notes were becoming decreasingly
important compared to deposits as the main form in which almost
everybody held money.
"Honesty Taxed to Pay for Dishonesty.
The federal government did not insure deposits, despite
many proposals in Congress from 1886 onward that it do so. William
Jennings Bryan and other populist politicians favored deposit insurance
as a way of protecting small depositors and small banks. Leading bankers
thought differently. Near the turn of the century, the First National
Bank of Chicago's president expressed their objections to deposit
insurance in these words: "Is there anything in the relations existing
between banks and their customers to justify the proposition that in the
banking business the good should be taxed to pay 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?" 2
Such arguments deterred the federal government from
insuring deposits, but not some states. Oklahoma established deposit
insurance in 1908. Seven southern and western states followed suit
within the next decade. Their systems insured from 100 to 1,000 banks
apiece.
Washington's, the last started, was the first to crack.
The depression of 1921 depleted its insurance fund. Since the system was
voluntary, many healthy banks deserted it rather than suffer the high
fees it would have imposed, and it shut down. The same happened to the
other voluntary fund, in Kansas. In the other states, where deposit
insurance was compulsory for state-chartered banks, low crop prices
throughout the 1920s broke many rural banks, leaving depositors
clamoring for their money. By 1930, all the funds were bankrupt. Texas's
system eventually paid off depositors in full, but elsewhere depositors
lost at least 15 percent of their claims. The North Dakota fund, the
worst of the lot, paid only $1 of every $1,000 in claims, and even after
a tax-financed bailout, depositors lost three-quarters of their money.
3
Despite the unfavorable experience of the state deposit
insurance systems, the federal government established nationwide deposit
insurance in 1934. The failure of nearly 10,000 banks since the Great
Depression had begun in 1929 put pressure on the federal government to
do something. Many prominent economists and bankers advocated branch
banking as the best cure for the American banking system's instability.
They pointed to foreign systems that allowed branch banking, where
failures had been few. In particular, they saw Canada, where no banks
failed during the Depression, as a model for the United States to
emulate.
However, the political clout of small banks and the
worse than usual public image that big business had at the time kept
branch banking from getting political consideration commensurate with
its economic merits. Federal deposit insurance, once established, seemed
to stabilize the banking system. The banking panic of 1933 was
responsible for much of the good reputation that Federal deposit
insurance enjoyed. It wiped out the weak banks that would have put the
greatest strain on Federal insurance funds had they begun in 1933
instead of 1934, when the panic was over.
Since 1934, 14 states have chartered deposit insurance
systems for certain banks and savings and loans not covered by Federal
insurance. Though nominally private, most state insurance systems have
been so enmeshed in local politics as to be in reality off-budget
government agencies designed to shelter members from the rigors of
competition. Their history has been as blighted as that of their
predecessors.
New York and Connecticut closed relatively short-lived
funds intact decades ago when their members voluntarily switched to
Federal insurance. Funds have failed in half of the remaining states -
Hawaii, Nebraska, Ohio, Maryland, Colorado, and Utah. The 1985 Ohio and
Maryland failures required millions in tax money to pay depositors in
full. The aftershocks prompted most states with solvent insurance
systems to require all participants to switch to Federal insurance by
1990. Only three funds still offer insurance for banks lacking Federal
coverage. One, in Kansas, is winding down as its members leave it. The
others, in Pennsylvania, cover just a handful of tiny banks. State
deposit insurance is in effect dead. 4
Success in Massachusetts and North Carolina
The only truly successful state funds were those of
North Carolina and Massachusetts. Their good performance was the result
of incentives more closely resembling those of the free market than
other state systems faced. The story of North Carolina's Financial
Institutions Assurance Corporation is particularly interesting because
the fund started in 1967 as "a good old boys' hideout from Federal
regulation," as one of its officers later recalled. A new president
appointed in 1977 brought in a new management philosophy. The law
governing the fund was changed to require a majority of its board of
directors to be unaffiliated with member institutions. (The lack of such
a provision in the Ohio and Maryland deposit insurance funds encouraged
self-dealing. Unlike the pre-Civil War Ohio fund, the latter-day Ohio
and Maryland funds had no counterbalancing liability features to make
their members keep an eye on each other's operations.)
The North Carolina fund began basing the premiums it
charged its members on the riskiness of their portfolios. It increased
the minimum net worth for members to qualify for insurance from it.
Furthermore, it closely monitored members' lending practices. For
instance, it induced members to reduce their investment in fixed-rate
mortgages several years before the rest of the savings and loan industry
began having problems with fixed-rate loans. In every respect, the North
Carolina fund's actions contrasted sharply with those of the FSLIC,
which was vulnerable to political pressure from members, did not adjust
insurance premiums for risk, had lower net-worth requirements, and did
little to prevent members from making reckless loans.
The North Carolina fund's record was outstanding. Its
stress on preventative measures, and the incentives it gave for its
members to avoid making overly risky loans, kept any of them from
failing. However, the Ohio and Maryland collapses cast a pall over all
state deposit insurance systems. The North Carolina fund closed
voluntarily, without losses, when many of its members decided to get
Federal insurance. At about the same time, the Massachusetts funds,
which benefited from that state's long tradition of conservative
banking, switched roles from substitutes to supplements to Federal
deposit insurance. 5
Of all state deposit insurance systems, then, few have
been really successful. The others have existed too briefly to undergo a
true test of strength, have folded up at signs of trouble, or have
failed. Now Federal deposit insurance is duplicating state deposit
insurance's sorry record. The cause is the same: too many insured banks,
mostly small, unable to withstand bad luck and bad management.
Deposit Insurance in Other Countries
Other countries, by allowing nationwide branch banking,
have gained the stability the U.S. hasn't been able to achieve.
Competitive pressures have resulted in very large banks, so solid that
they have not needed deposit insurance and, in most places, have not
had. It is true that West Germany's small Bankhaus Herstatt failed in
1974 and Italy's scandal-ridden Banco Ambrosiano failed in 1982. But
there have been no other noteworthy bank failures in developed nations.
Britain, which has had nationwide branch banking longer than almost any
country, has not experienced a major bank failure since 1878.
Every large Western country except Italy has deposit
insurance. But in all except the United tates, deposit insurance is a
recent innovation, dating from the 1960s or 1970s. The banking systems
of those countries took their present shape, and enjoyed stability, long
before they got deposit insurance. Furthermore, foreign deposit
insurance systems encourage depositors to monitor the health of their
banks, which the American system does not. In some countries - notably
West Germany - the systems are voluntary, so banks that fear that
imprudent rivals are trying to take advantage of the system can quit it.
In Britain and Switzerland, insurance doesn't pay for the full amount of
depositors' losses, but only for, say, three-quarters.
Common to all foreign deposit insurance systems is that
they have much lower maximum limits than the American system - from
one-half to one-tenth as much - and that foreign governments are more
serious about imposing those limits in practice than the American
government has been. The possibility of suffering losses encourages
depositors to entrust their money only to well-managed banks. Depositors
abroad rely mainly on the quality of the banks themselves rather than on
government insurance for protection. 6
The exception that proves the rule occurred in Canada,
whose federal deposit insurance system is most like that of the United
States. In 1985, two Canadian banks went bust in Alberta - that
country's equivalent of Texas. Previously, no bank had failed since
1923. The Alberta firms, both founded in the oil boom of the mid-1970s,
were small and undiversified, resembling U.S. banks more than the five
nationwide giants that have 80 percent of Canadian deposits.
Canada instituted compulsory deposit insurance in 1967
despite the protests of its large banks, who foresaw that it would be
their premiums that would pay for small rivals such as the Alberta
banks. The government guarantee helped convince depositors to let the
Alberta banks take imprudent risks with their money. The failure of the
Alberta banks threatened to deplete the deposit insurance fund. To
prevent a run on the two banks, the Canadian government pressured the
big banks to take them over. When losses turned out to be larger than
expected, the government backed out of its previous assurances to the
big banks (which technically were not binding), causing them to bear the
costs of the small banks bad management.
Unrestricted nationwide branch banking, such as Canada
and other countries have, is scheduled to arrive in the United States in
1991. That will be too late to save hundreds of ailing banks and
thrifts. Congress should remove barriers to branching now. In
particular, it should allow any bank to buy any savings and loan.
(Currently, banks can buy only ailing savings and loans.) Small banks
and savings and loans would oppose such a step, because it would make
them takeover targets for expanding money-center and "super-regional"
banks. But the alternative for many of them is to go broke, putting
further strain on the Federal deposit insurance system and on taxpayers.
Deposit insurance has repeatedly proven not to be
self-financing under our artificially fragmented banking system. On the
other hand, it wouldn't be necessary under a less regulated banking
system. Ultimately, Congress should set a date - say, ten years hence -
to abolish deposit insurance. At the same time, it should tear down the
walls it has erected separating banking from securities, insurance, and
commerce. Banks should be allowed to spread risk across lines of
business just as branching enables them to spread risks across regions.
American banks are suffering at home and in world
competition because they cannot engage in many profitable lines of
business open to their foreign competitors. Given freedom, the U.S.
banking system can become strong and flexible enough not to need deposit
insurance. The alternative is to suffer another crisis when changing
economic needs run up against outmoded regulations.
At the original publication date, Kurt Schuler was a
graduate student in economics at the University of Georgia.
1. Federal Deposit Insurance Corporation, Annual
Report.1953, pp. 45-67; Federal Deposit Insurance Corporation: The First
Fifty Years, a History of the FDIC, 1933-1983 (Washington: FDIC, 1984) ,
pp. 13-24.
2. James B. Forgan, "Should National Bank Deposits Be
Guaranteed by the Government. . . ?" Address to the Illinois Bankers'
Association, June 11, 1908. (Chicago: First National Bank of Chicago,
n.d.), p. 3.
3. FDIC, Annual Report, 1952, pp. 59-72; Eugene Nelson
White, The Regulation and Reform of the American Banking System,
1900-1929 (Princeton: Princeton University Press, 1983), pp. 188-222.
4. FDIC, Annual Report, 1950, p. 67; Victor L.
Saulsbury, "The Current Status of Non-Federal Insurance Programs,"
Issues in Bank Regulation, Spring 1985; FDIC Regulatory Review,
Sept.-Oct. 1987.
5. Catherine England, "Private Deposit Insurance That's
Worked," Wall Street Journal, June 18, 1985, p. 30.
6. William M. Isaac, "International Deposit Insurance
Systems," Issues in Bank Regulation, Summer 1984, p. 80.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
July 1989, Vol. 39, No. 7.
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