LA midst all the groping and furor over the savings and
loan crisis, no public official has pointed a finger at the ultimate
culprit. The Bush Administration admits that the nation's ailing S &
L industry will cost the government at least $90 billion. That would be
the most expensive bailout in U.S. history - bigger than those for
Lockheed, Chrysler, New York City, and Western Europe (through the
Marshall Plan) combined, even after adjusting for inflation. But
contrary to popular perceptions, the crisis stems not from too little
regulation, but too much. It all can be traced to the perverse influence
of government deposit insurance.
The federal government first insured deposits in
reaction to the Great Depression. A scramble for currency among
depositors had led to runs on nearly 10,000 banks. This liquidity crunch
forced otherwise solvent institutions into emergency sales of their
assets. Unnecessary bank failures, a one-third collapse in the money
supply, and deflation were the result. To protect the economy from
future panics, the newly established Federal Deposit Insurance
Corporation (FDIC) guaranteed small depositors against any tosses.
Comparisons with other countries now suggest that the
regulations already existing in the 1920s were responsible for the
precariousness of the American banking system. Canada, for example,
permitted its commercial banks to open branches nationwide and had yet
to set up a central bank. Not one Canadian bank failed during the Great
Depression.
However plausible the justification of deposit
insurance for U.S. commercial banks, it certainly did not apply to
savings and loan associations. Unlike banks, S & Us at that time
didn't offer checking accounts or any other deposit that served as a
medium of exchange, nor were they plagued by runs. Yet S & L's got
similar guarantees with the establishment of the Federal Savings and
Loan Insurance Corporation (FSLIC) in 1934.
Government deposit insurance may have dampened the
danger of bank runs, but only at the cost of incurring another danger.
Private insurance companies have long been aware of what is called
"moral hazard." If you protect someone from the painful consequences of
risk, he will have less incentive to avoid risky actions. Insurance
against fire or automobile accidents thus can be so complete that it
fosters carelessness and leads to more fires and accidents.
One way insurance companies get around the moral-hazard
problem is with a deductible, which makes the insured bear some of the
cost of risky actions. Private insurance companies also vary premiums
according to actual risks; otherwise they lose money. Government deposit
insurance, in contrast, ignores these sound principles. It therefore
subsidizes risk-taking by depository institutions. They pay the same
premium regardless, and their depositors have no financial reason to
impose market discipline by doing business elsewhere.
Not until the 1980s, however, did this moral-hazard
time bomb explode. Pervasive government regulation protected banks and S
& L's from competition while simultaneously restricting their
portfolios to safe assets. Only after the inflation and climbing
interest rates of the 1970s required these institutions to bid actively
for deposits did the government initiate financial deregulation.
Unfortunately, deregulation did not go far enough. By leaving deposit
insurance untouched (except to raise coverage), it rewarded the managers
of banks and S & L's who gambled with their depositors' money. All
the colorful headlines about cowboy bankers and corporate swindlers
overlook the way that the regulatory environment distorts the normal
market curbs against such behavior.
Government favoritism for insolvent banks and S &
L's aggravates the crisis. If the FDIC and FSLIC were truly interested
in protecting the small depositor, they would close insolvent
institutions and pay off the depositors directly. Instead, they usually
arrange purchase and assumption agreements that merge failed
institutions with healthy ones. Big depositors are protected as well as
small in a short-term solution that merely compounds long-term
difficulties.
The crisis has reached such epic proportions among S
& L's that the FSLIC no longer has enough resources even to arrange
bailout mergers. Growing numbers of bankrupt institutions continue to
compete with sound S & L's, driving the interest paid to depositors
still higher. Genie Short and Jeffrey Gunther of the Federal Reserve
Bank of Dallas point out in a recent study that "such policies penalize
the more conservatively managed institutions over the more aggressive
ones."
Indeed, no regulatory sleight of hand can magically
transform bad loans into good. Without enough income from these loans,
the failed but still operating "zombie" institutions can pay interest to
their current depositors only with money from new depositors. The
regulators thereby sanction an escalating chain letter that makes the
final accounting ever more expensive. When they take over an S & L
themselves, the regulators still are powerless to do anything else
without outside funds.
None of the Administration's proposals address the root
cause. Attempting to re-regulate the S & L industry by imposing, for
instance, higher capital requirements, will simply destroy it. Market
forces already are unleashed. The competitive survival of banks and S
& L's compelled financial deregulation. The regulatory haven that
gave banks and S & L's a tidy marketsharing arrangement cannot be
reconstructed.
If Congress increases insurance premiums, the sound
institutions will be the ones to pay. This will further punish the very
kind of management that should be encouraged. Nor can government ever
adequately administer variable premiums. "A rational system of
risk-based insurance premiums offered monopotistically by a public
agency is simply impossible," argues Gerald O'Driscoll of the Federal
Reserve Bank of Dallas. Without the feedback of profit and loss,
bureaucrats have neither the information nor the incentive for matching
premiums to risk.
And foisting the cleanup bill on the taxpayer is not
merely unjust but also tempts politicians and bureaucrats to try the
same scam again. How much longer will the taxpayer be expected to cough
up the cash for the government's self-serving and disingenuous pledges?
How much higher will the price tag have to soar? Unfortunately, some
undeserving group must take the hit for the irretrievable S & L
losses, but the depositors at least voluntarily assumed a risk when they
accepted fabulous political promises at face value. If the depositors
want compensation, let them turn not to the much-abused and
long-suffering taxpayer but to the managers of the failed S & L's,
perhaps to the sale of government assets, and ultimately to the personal
liability of the politicians and bureaucrats who perpetrated this
outrage.
Only one solution can overcome moral hazards in the
banking and thrift industries: private deposit insurance. The government
must dissolve the FDIC and FSLIC and remove all remaining regulations
upon depository institutions. The first step would permit the
competitive forces of the market to arrange actuarially sound insurance
that protects depositors without subsidizing insolvency. The second step
would help depository institutions gain the geographical and asset
diversity necessary to shore up liquidity during runs.
The S & L crisis is just the tip of the
moral-hazard iceberg. Although not yet visible, deposit insurance
creates the same perverse incentives for commercial banks. The FDIC
already rates 10 percent of these institutions in the problem bank
category, within an industry with $2 trillion worth of deposits. Unless
deregulation proceeds to the privatization of deposit insurance, the
nation soon faces a larger crisis throughout the banking industry.
At the original publication date, Jeffrey Rogers
Hummel was Publications Director for the Independent Institute in San
Francisco.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
July 1989, Vol. 39, No. 7.
Yourname@libertyhaven.com
