I have been asked to address this distinguished group on current problems and proposals relating to deposit insurance. The topic is clearly timely, for there has perhaps been no other time in the 55-year period of federal deposit insurance in this country when people have begun to question more seriously the proper role and function of deposit insurance, the adequacy of the deposit-insurance funds, and their role in the proper operation of our financial system.
I have been asked to address this distinguished group on current problems and proposals relating to deposit insurance. The topic is clearly timely, for there has perhaps been no other time in the 55-year period of federal deposit insurance in this country when people have begun to question more seriously the proper role and function of deposit insurance, the adequacy of the deposit-insurance funds, and their role in the proper operation of our financial system.
In order, however, to understand the current problems and proposals, it is imperative that we gain at least a rudimentary understanding of how the current situation came about. Only then can we begin to appreciate the gravity of the problems we face and the efficacy of the various solutions that have been offered.
The history of financial institutions legislation in the United States is largely a record of governmental response to various crises. Governmental intervention in the marketplace has been and continues to be limited as long as the market has been, and is, perceived to function properly. A series of three major crises spawned the banking and thrift legislation that has shaped the regulatory structure used for all depository institutions in the United States today. These crises occurred in the 1860s, during this nation’s Civil War; in 1907; and during the Great Depression of the 1930s. The circumstances surrounding each episode were as different as the methods chosen by Congress to correct the problems presented.
The commercial banking system that existed in the United States before 1864 involved virtually no regulation by the federal government. Apart from early, unsuccessful attempts to establish national or central banks, the federal government was far removed from the operations of the financial system. The federal government did not issue a national currency. Individual commercial banks were chartered by the states and issued their own notes, which were to be redeemed by the issuing banks in gold at fixed prices. These notes constituted the only available currency, and thus there was a strong incentive for individual depositors to scrutinize the activities of the banks and bankers to which they had entrusted their funds.
The various crises surrounding the Civil War put severe pressures on the informal and ad hoc system that had developed in this country. The National Bank Act was passed in 1864 for the immediate purpose of facilitating the financing of the war by the Government. The Act instituted a system of national chartered commercial banks and altered the existing (strictly private) relationship between depositor and bank.
To administer this new system, the Office of the Comptroller of the Currency was created and empowered to regulate the note issues of the new national banks and to establish reserve requirements. One notable accomplishment of the National Bank Act was the elimination of competing notes issued by state banks, and thus for the first time a form of national currency was established. However, the Act did not create a central bank, a governmental lender of last resort, or any form of deposit insurance. The Government was not placed in the position of bearing any part of the risk involved in the relationship between depositors and commercial banks.
Despite intervening economic problems, the system of bank regulation established in 1864 remained essentially intact for almost 50 years. The pressure for modifying the system came during the Panic of 1907, one of the more severe financial panics that occurred during the latter decades of the nineteenth century and the early twentieth century. These panics, which were essentially liquidity crises, were highlighted by runs on banks, during which depositors would demand the withdrawal of their funds—that is, they sought to convert their deposits into cash. Although the National Bank Act required commercial banks to hold reserves for such contingencies, these reserves were most often held in the form of deposits with other commercial banks, which ultimately resided in the larger New York banks. In essence, the system relied upon the willingness and the ability of the New York banks to provide liquidity to smaller banks spread throughout the country. The Panic of 1907 was a reflection of a general belief that the larger commercial banks were unable to provide the necessary liquidity. In 1907, Congress called for a study of the problem, and this eventually led to passage of the Federal Reserve Act of 1913.
The Federal Reserve Act established a central bank that would serve as a lender of last resort, control the volume of reserves in the banking system, and regulate the issuance of currency. The Federal Reserve System, as an independent entity, was to determine the terms on, and the extent to, which it would lend to commercial banks; it was thus given discretion as to the policies it would pursue in times of stress. Although the Federal Reserve Act established a governmental lender of last resort, it did not establish any system of deposit insurance.
Let me digress at this point and touch briefly on the experience in this country with deposit insurance prior to the establishment of the Federal Deposit Insurance Corporation (FDIC).
There was a fairly impressive record of experiments at the state level, extending back to 1829, with deposit insurance. New York was the first of 14 states that eventually adopted some form of deposit-insurance plan to insure or guarantee bank deposits or obligations that served as currency. The purposes of the various state insurance plans were similar: to protect communities from economic disruptions caused by bank failures and to protect depositors from losses. In the majority of cases, the insurance plans eventually proved unworkable, and by 1930 the last of these plans had ceased operations.
At the federal level, deposit insurance had a legislative history reaching back to 1886. A total of 150 proposals for deposit insurance were introduced in Congress from 1886 to 1933. Many of these proposals were prompted by the various financial crises, although no crisis was as severe as the one that developed in the 1930s. The depth and gravity of that depression finally convinced the public and Congress that measures with a national scope were needed to alleviate the disruptions caused by bank failures.
Of all the financial events or circumstances that have occurred in the history of this country, perhaps none has had a greater impact or made a more lasting impression than the Great Depression of the early 1930s.
From the stock market crash in the fall of 1929 to the end of 1933, approximately 9,000 banks, or nearly half the total number of banks at that time, suspended operations. As the number of failures increased, a general sense of financial panic spread throughout the country, giving strong impetus to a movement to convert demand deposits into currency. This crisis continued in 1931 and 1932, as bank failures became more widespread. The closure of 4,000 banks in the first few months of 1933 and the financial panic that accompanied these failures led President Franklin Roosevelt to declare a bank holiday in March 1933. The financial system was on the verge of collapse, and both the manufacturing and commercial sectors were operating at only a fraction of capacity.
On March 9, 1933, President Roosevelt addressed Congress with the following words:
On March 3 banking operations in the United States ceased. To review at this time the causes of this failure of our banking system is unnecessary. Suffice it to say that the Government has been compelled to step in for the protection of depositors and the business of the Nation.
The events surrounding, and the causes of, the Great Depression have been exhaustively analyzed. Whether the lack of liquidity in the banking system was a cause or an effect has been debated. However, it is clear that the crisis of public confidence in the banks and the withdrawal of deposits compelled commercial banks to liquidate assets rapidly in a depressed market, which, in turn, resulted in additional losses and additional failures. Had additional liquidity been provided by the Federal Reserve, it is certainly arguable that the ultimate losses in the banking system and conceivably in the economy would have been significantly lower.
It is also clear that the Federal Reserve System, because of the discretionary nature of its powers, was in a position to decide the appropriate distribution of the financial risk between the private financial system and the government. Had the Federal Reserve provided more liquidity to commercial banks, the risk of ultimate loss would have been transferred, at least in part, from depositors and other commercial banks to the Federal Reserve System. It appears that the Federal Reserve System did not wish to undertake this risk.
Regardless of the cause, and regardless of where the blame belongs, the bank failures and resulting economic havoc created an irresistible demand for deposit insurance. The Banking Act of 1933, which established the FDIC, was signed by President Roosevelt on June 16, 1933, just three short months after the bank holiday.
The legislative proposal to create the deposit-insurance program was outside the mainstream of contemporary financial-reform legislation. The insurance legislation was not part of the President’s or the administration’s program, and many persons, both within and outside the administration, held out little hope for its passage. The record of state attempts to operate deposit-insurance systems was not encouraging.
The results were far different from what the pessimists had expected. The significance of deposit insurance is perhaps best illustrated by the views of two of this country’s leading economists, individuals whose views are usually thought of as being at opposite ends of the economic and political spectrum. Professor Milton Friedman has observed that:
Federal insurance of bank deposits was the most important structural change in the banking system to result from the 1933 panic, and, indeed in our view, the structural change most conducive to monetary stability since state bank note issues were taxed out of existence immediately after the Civil War [Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, New Jersey: Princeton University Press, 1963), p. 434].
Professor John Kenneth Galbraith has described the creation of the FDIC in the following terms: “The anarchy of uncontrolled banking had been brought to an end not by the Federal Reserve System but by the obscure, unprestigious, unwanted, Federal Deposit Insurance Corporation.” He also noted that “In all American monetary history, no legislative action brought such a change as this” [John Kenneth Galbraith, Money: Whence It Came, Where It Went (Boston: Houghton Mifflin, 1975), p. 197].
Why is this so? The FDIC had rather modest beginnings. It offered deposit insurance of only $2,500 per depositor, although this was quickly raised to $5,000 per depositor. This insurance, however modest, allowed consumers to remain depositors in times of economic stress by alleviating the panic that had formerly driven depositors to convert bank deposits into currency.
This comfort to depositors had an ameliorative effect on commercial banks, allowing them to rely upon a more stable source of funding, and enabling them to avoid having to maintain large cash reserves or liquidate long-term assets at inopportune times. Banks could thus convert cash deposits into longer-term investments—into the loans that allow our economy to function.
Accordingly, it was “the obscure, unprestigious, unwanted” FDIC that established an aura of confidence around our nation’s banking system. Despite all of its weaknesses and faults, the banking system provides the fuel that allows our economic system to function, and at least some measure of credit must go to the FDIC for establishing and preserving confidence in that system.
At this point in this discussion, it is useful to introduce the savings and loan industry and the events that led to the creation of the Federal Savings and Loan Insurance Corporation (FSLIC).
The crisis that affected the savings and loan industry in the early 1930s was substantially different from the one experienced by commercial banks. Unlike commercial banks, savings and loan associations did not offer transaction accounts and were not subject to regulation by either the Comptroller of the Currency or the Federal Reserve Board. Thus, they did not experience what was for commercial banks principally a liquidity problem generated by a widespread conversion of demand deposits to cash. Instead, savings and loans faced the serious problem of a large number of mortgage defaults. From 1930 to 1934, savings and loans experienced a foreclosure rate on mortgage loans of approximately 14 percent, measured as a portion of the total dollar amount of loans outstanding. Because savings and loan portfolios were almost exclusively comprised of mortgages, this constituted a severe crisis for the industry, and from 1930 to 1934, the size of the industry declined by 25 percent.
Congress reacted to this problem by assuring an adequate supply of funds for housing and by generating a federal regulatory system for savings and loans that remains largely intact. In 1932, the Federal Home Loan Bank Act established a system of specialized banks that would provide liquidity and funding to savings and loan associations. In 1933, the Home Owners Loan Act extended the powers of the Federal Home Loan Bank Board, which oversaw these specialized banks, to include the chartering and regulating of savings and loan associations. Finally, in 1934, the National Housing Act created the FSLIC to provide deposit insurance for the savings and loan industry similar to that provided by the FDIC for commercial banks.
As a result, the thrift industry operated under a regulatory structure that was roughly comparable to that surrounding commercial banks. There were, however, several important differences. The most significant difference was in the role that the savings and loan institutions played, and the way they functioned, in the economy. Savings and loans were the repository of savings accounts, not transactions accounts. These savings accounts were intended to be long-term, stable sources of funding. (Subsequent events have, however, demonstrated the fallacy of this assumption.) Further, the loans that savings and loan associations provided were virtually exclusively long-term, fixed-rate mortgages. Thrifts were perceived to be different, and in practice they were different, from commercial banks.
The perceived and actual differences led to substantial differences in the regulatory focus. Even though the regulatory structures were roughly comparable, the thrift regulatory structure was established to promote home ownership while the bank regulatory structure was established to preserve and protect the economy.
With that brief and overly simplistic presentation of the events leading to the creation of the major federal deposit insurance funds completed, let us briefly consider the role of the FDIC and how it fits within the bank regulatory structure of the United States.
If the foregoing summary of history was brief and simplistic, this summary of the bank regulatory structure in the United States will be even more so.
In its most basic form, regulation begins with the chartering of depository institutions. Both the federal government, through the Office of the Comptroller of the Currency, and each state have the power to charter commercial banks. The chartering authority is entitled to establish the powers, and regulate the operations, of the institutions it charters. This regulation is all-pervasive, encompassing not only such mundane matters as the number of members that may serve on boards of directors but also establishment of offices, the types of loans that may be made, the restrictions placed on the amounts of loans made to any one person, transactions with related parties, banking powers, which bank investments are permissible, and a wide variety of other matters.
Even though a bank may be state-chartered, there is always a federal regulatory overlay. If the state-chartered bank is a member of the Federal Reserve System (mandatory for national banks, optional for state banks), the Federal Reserve has supervisory and examination power over the institution. If the bank is not a member of the Federal Reserve System, the FDIC exercises that supervisory and examination role on behalf of the federal government in respect of insured banks.
Through its monetary-control function, the Federal Reserve System also directly regulates and affects all depository institutions. Because of the Federal Reserve’s essential role in our system, it also administers and enforces a wide variety of other statutes.
Whenever a company owns a commercial bank, it is a bank holding company and must register with, and be subject to regulation by, the Federal Reserve Board.
The federal Bank Holding Company Act establishes limitations on the types of activities a bank holding company may engage in. Generally, a bank holding company may engage only in the business of operating and owning commercial banks or other activities so closely related to managing and controlling banks as to be a proper incident thereto. As a result of the manner in which the statute has been amended, interpreted, and enforced, bank holding companies are generally precluded from engaging in full-service securities and insurance activities, and are clearly prohibited from engaging in manufacturing, industrial, and similar commercial activities.
This system of intertwining and overlapping jurisdictions and regulation has created a very complex, arcane, inefficient, and costly environment in which our commercial banks must operate. Any schematic diagram of this regulatory structure is a mass of lines, boxes, exceptions, and general confusion. While each of the various components of this regulatory structure can be justified, it is hard to justify the whole. Indeed, our system is the result of a series of rational, logical responses to various economic problems, the separate solutions to which made perfect sense at the time, yet the resulting aggregation cannot be justified on any rational basis.
Let us focus a bit more specifically on the role of the FDIC within this arcane regulatory structure.
The FDIC is the prime federal regulator of over 8,000 state-chartered banks that are not members of the Federal Reserve System. The FDIC does not charter these banks. It does not authorize new powers or new activities. It does limit the exercise of powers that might otherwise be granted by the states, primarily on safety and soundness grounds. This is a significant limitation on the authority of the states, although one that has been exercised with restraint. The goal of the FDIC is to ensure the operation of a safe and sound banking system, to ensure that powers granted to, or activities conducted by, the banks do not cause serious or fundamental damage to either the bank or, on a broader scale, the local, regional, or national economy. This role as regulator is, of course, a direct adjunct to the role of the FDIC as insurer.
To fulfill its function as regulator, the FDIC conducts direct on-site examinations of the institutions it regulates. The degree and frequency of the on-site examinations are functions of the underlying financial strength of an institution and the limitations of the FDIC’s examination staff. Because the institutions the FDIC directly regulates are also examined by the states, the FDIC attempts, where appropriate and feasible, to coordinate its examination function with the states.
The FDIC also engages in off-site monitoring of the institutions it regulates. All FDIC-insured institutions are required to submit periodic financial reports. These reports provide the FDIC with insights into capital, earnings, adequacy of reserves, non-performing assets, and other key financial parameters that provide warning signals of potential problems.
In its role as regulator, the FDIC must approve various corporate activities that might be conducted by banks. For instance, mergers, acquisitions, branch openings, and other similar transactions must be preceded by notice to, and approval from, the FDIC. Also, the FDIC directly oversees securities offerings of the banks it regulates, and through its regulatory powers the FDIC provides guidelines for other types of corporate practices.
One of the more significant approval powers exercised by the FDIC is the decision to grant insurance coverage. While institutions chartered as national banks by the Office of the Comptroller of the Currency are automatically entitled to FDIC insurance, all other institutions must apply for it. It is generally only granted when the FDIC views it as having adequate capital, strong management, and a coherent operating plan, and the FDIC is convinced that the institution has a reasonable prospect of success. This issue became extremely important when institutions insured by the FSLIC sought refuge at the FDIC.
To ensure compliance with laws, rules, and regulations, the FDIC has been granted broad enforcement powers. These include the authority to require institutions or individuals associated with institutions to cease and desist from engaging in violations of law or unsafe or unsound banking practices. The agency has the ability to impose monetary penalties against individuals or institutions and to require the suspension or removal of individuals that have engaged in unlawful or improper conduct. For institutions that repeatedly violate laws, continue to operate in unsafe or unsound conditions, or otherwise pose a severe or serious risk to the insurance fund, the agency has the power to remove federal deposit insurance. The FDIC is also charged with the enforcement of various statutes as they apply to state-chartered banks in the securities and consumer areas.
The FDIC is the insurer, but not the direct regulator, of all FDIC-insured institutions. It does, however, serve as an indirect regulator. While it does not exercise direct approval or examination powers over holding companies, Federal Reserve System member banks, or national banks, it does coordinate its activities with those of the other regulatory agencies and engages from time to time in examinations of the institutions with the other agencies. Because of its role as insurer and liquidator, its policies have far-reaching implications.
Let us consider more directly the role of the FDIC as insurer. Federal deposit insurance now provides that each depositor in an insured bank is entitled to insurance up to $100,000 for his or her accounts in that bank. This insurance limit has been raised substantially over the years from the initial level of $2,500 per depositor in 1933.
Deposit-insurance coverage has increased dramatically as the purpose and effect of the insurance function have evolved, moving far beyond merely protecting the funds of small depositors. Deposit insurance serves an important monetary and economic function. It allows banks to lend a high percentage of the funds they receive. It ensures the availability of funding. It reflects either a conscious or an unconscious judgment that having a large number of depository institutions is an important social goal.
There are over 14,000 FDIC-insured banks in this country with over $2 trillion in total deposits. Approximately 75 percent of deposits in the insured banks are covered by FDIC insurance. This leaves some $500 billion in deposits that in theory, although perhaps not in fact, are not covered by FDIC insurance.
A necessary adjunct of the role of the FDIC as insurer is its role as liquidator or receiver. Basically, the FDIC will be appointed as liquidator and receiver for any FDIC-insured institution that fails, be it a state bank or a national bank. In such capacity, the FDIC undertakes to marshal the assets of the institution in order to satisfy claims.
If you will permit me to take you on another brief excursion through history, I will describe the evolution of the liquidation function at the FDIC.
The original Federal Deposit Insurance Act gave the FDIC only the power to liquidate failed banks, paying depositors up to the limit of deposit insurance, with any excess funds resulting from the sale of assets paid to other creditors.
A relatively unnoticed amendment made TO the Federal Deposit Insurance Act in 1935 gave the FDIC the power to facilitate mergers in order to assist failed or failing institutions. In practical terms, this meant that the FDIC would not be required to liquidate a bank but would have the ability to “sell” the failed bank to another operating institution in order to minimize disruption. By the early 1940s, merger or sale became the preferred method of handling bank failures. This procedure became quite routinized, and by the 1960s it developed into the standard purchase and assumption procedure that is still used by the FDIC for the vast majority of failed institutions.
It is useful to describe this purchase and assumption procedure, and the type of analysis the FDIC undertakes in the event of a bank’s failure.
Generally, when a bank fails, the FDIC must calculate the cost of liquidating its assets and paying off its depositors. Once this is done, the FDIC can apply what it refers to as the “cost test”: if other, less disruptive methods of dealing with the failed institution are available to the FDIC, it may use them only in the event that the ultimate cost to the FDIC is less than the cost of liquidation.
In the purchase-and-assumption transaction, the FDIC allows another institution to purchase assets of the failed institution. In addition, the acquiring institution assumes the deposit liabilities of the failed bank. Because the value of these liabilities will generally exceed the value of the assets, the FDIC will, in such instances, provide cash to make up the difference.
This balanced book of assets and liabilities is offered to a number of institutions. The institutions submit bids to the FDIC advising it of how much FDIC cash they would require if they were to acquire the failed institution’s assets and assume its liabilities. Over the years, the FDIC has developed a number of variations on this standard procedure, with various options permitting banks to refuse to take bad assets, “cherry pick” good assets, take FDIC notes instead of cash, etc. Regardless of the method ultimately used, this type of transaction is designed to facilitate the orderly continuation of the failed bank’s business by a new entity.
Generally, in these purchase-and-assumption transactions, depositors and other creditors are fully protected, and there is very little disruption to the community. While the stockholders of the bank lose their equity investments, it is our belief that such transactions provide substantial benefits to the public.
Looking at our more recent history, we see the beginnings of the developments that have led to the present crises. Since the early 1970s, the United States has clearly undergone some fairly fundamental economic changes. We have experienced brief recessions, a period of high (at least in U.S. terms) inflation, and a period of expansion and relative economic stability. However, even the most recent period of economic stability has been marked by severe economic problems in the agricultural and energy sectors. While these economic problems have been geographically isolated in the Midwest and Southwest, they have had strong repercussions there, including business failures, real-estate problems, and general economic pressures.
The FDIC had a full caseload during its early years. During its first eight years, there were over 500 bank failures, or approximately 60 per year. The next forty years were marked by relative calm and stability. Banks operated in a very conservative manner; their loan-to-deposit ratios were not high; and, accordingly, there were few bank failures (fewer than six per year).
The high inflation of the late 1970s and early 1980s, and the farm and energy crises of the 1980s have resulted in a substantially higher bank failure rate. In 1982, there were 42 bank failures; in 1983, 48; in 1984, 79; in 1985, 120 (with 4 additional assistance transactions carried out to avoid failures); and in 1986, 138 (with 7 additional assistance transactions carried out). Last year (1987), there were 184 bank failures (with 9 additional assistance transactions carried out), and the failure rate this year (1988) currently equals that of 1987.
The overwhelming majority of the recent failures have been handled by the purchase-and-assumption transaction previously described or other transactions that protected all depositors and creditors, and not just insured depositors. Liquidations and insured-deposit payoffs are few. These payoffs are undertaken primarily, although not exclusively, for small banks. We are seeing an increasing number of what we refer to as open bank transactions, each of which involves private investors recapitalizing a bank that would otherwise fail.
The FDIC will provide funds to the new institution to assist in its recapitalization, and it may or may not take some form of profit participation in the ongoing entity. These practices fulfill our goal of keeping assets in the private sector and enhances certain objectives that we view as essential in maintaining the stability of the banking system.
A few actions taken by the FDIC recently have received a great deal of attention. I believe that a discussion of these should give you some reasonable insights into the philosophy and priorities of the FDIC. The ones I wish to discuss are those taken in the cases of two Texas banks, the First City Bancorporation, based in Houston, and the First RepublicBank Corporation, based in Dallas.
At one time, First City was a $15 billion institution that was generally perceived as one of the more aggressive and successful institutions in Texas. Its aggressiveness, however, eventually led to severe problems once the energy crisis hit the Southwest. The combination of energy credits, developing country loans, and real-estate credits drove the company to virtual insolvency.
Once it was determined that no private sector solution to the problem of recapitalizing First City was possible without FDIC assistance, the FDIC entered into an agreement with Mr. A. Robert Abboud and an investor group, pursuant to which they would invest $500 million in new equity and the FDIC would provide approximately $970 million in assistance. First City would restructure its debt; obtain concessions from other creditors; spin off all of its non-performing assets into a separate entity; and, under the direction of Mr. Abboud and the new management team, would, it was hoped, return to profitability. The FDIC would receive an equity interest in the ongoing institution, share in the recoveries from the non-performing assets, and receive a guaranteed payment in the future of not less than $100 million. The transaction was quite complex and ran into a number of difficulties in the process of obtaining shareholder and creditor approvals and concessions, but it was successfully consummated last month (April 1988).
The situation at First Republic is much more difficult and is not yet fully resolved. First Republic is a much larger institution than First City, with approximately $32 billion in total assets. Its non-performing assets amount to 16 percent of its total loan portfolio. It announced massive losses in 1987, and during the first quarter of 1988, it experienced a massive loss of depositor confidence. That loss of confidence was reflected in substantial outflows of funds, which on certain days exceeded $300 million, and the loss of portions of its core, fee-based business.
It became apparent both to First Republic and the FDIC that unless dramatic measures were taken, no franchise of any value would be left for the FDIC. Accordingly, about six weeks ago, the FDIC announced an interim assistance package for First Republic. The assistance was made available in the form of a $1 billion loan to First Republic’s major banks. That loan was guaranteed by the First Republic holding company, secured by the pledge of certain of its banks, and further guaranteed by each of the other banks in the First Republic system. In order to assure depositors and other sources of funding, and to ensure that the core of business of First Republic was maintained, the FDIC ensured that all depositors and creditors of the First Republic banks would be fully protected, even beyond the $100,000 deposit-insurance limit, as it resolved First Republic’s problems. The giving of such assurance is not totally unprecedented, for a similar assurance had been given by the FDIC in connection with the rescue of Continental Illinois Bank four years earlier. It was, however, unusual and was only provided because of the risk of extreme deterioration of the bank’s franchise.
The FDIC is now working toward a permanent solution with respect to First Republic. The loan and assurances have provided banks with the necessary stability, and the FDIC is now looking for an appropriate method to involve new private capital in a reconstituted entity.
One aspect of the First Republic transaction deserves special mention. The FDIC did not provide guarantees to creditors of the First Republic holding companies, nor did the FDIC provide any assurance to the share-holders of First Republic. This was intentional: It is not the FDIC’s role or function to insure holding-company creditors and shareholders. There have been, and will continue to be, repercussions from this action, however. It will be perceived, and rightly so, that holding company credits may carry more risk than credits extended to the underlying banks. We are witnessing a shift in funding from holding companies to banks, and I have perceived some increase in spreads on holding-company paper. Moving funding to the bank level does, however, require capital, and it is apparent that there is not an abundance of excess capital in the banking system.
Let me digress once again and address the FSLIC experience. This experience has been much different, for various reasons. The thrift industry enjoyed stability from the end of the Great Depression through the late 1970s. There was no disruption in the funding for thrifts during that period. The government regulated the interest rate that could be paid by the savings and loans on their deposits, and these were high enough to ensure adequate funding. The spread between the rates on long-term mortgages and the rates paid on deposits was clearly adequate, and thus through the 1970s there were few problems in the thrift industry.
The increase in inflation experienced in the late 1970s and early 1980s caused severe disintermediation at thrifts. Thrifts could no longer rely upon savings to fund their assets, and indeed they experienced a marked loss of savings as market interest rates outstripped the rates they were permitted to pay on savings accounts, thus forcing thrifts to rely upon purchased funds. Thrifts had traditionally kept their long-term assets in their loan portfolios, and the interest rates on these mortgages were generally far below the interest rates thrifts had to pay to attract new funds. The mismatch of short-term funds attracted at high market rates and long-term assets earning low interest rates created severe earnings and capital problems.
Congress reacted to this problem in stages. The first steps it took, which were initiated in 1980, included deregulation of the liability side of the balance sheet—that is, thrifts became free to pay market rates for funds. This assured them of access to funds, although at very high rates, but it did very little to alleviate the problems resulting from the low-yielding assets in their portfolios.
In 1982, Congress significantly deregulated the asset side of the balance sheet, allowing thrifts to engage in a wide variety of activities that had been generally prohibited. Thrifts obtained substantial commercial lending powers and, through a combination of federal and state laws, were able to engage in direct equity investments, real-estate-development activities, and other types of speculative ventures designed to permit thrifts to boost earnings.
Unfortunately, the experience of the late 1970s and the early 1980s had substantially eroded the capital of the savings and loan industry. The savings and loan regulators were unable to require any increase in capital in order to provide cushions against the risk posed by the new activities. Indeed, through accounting and regulatory actions, the thrift regulators allowed thrifts to operate with little or no capital. With very little capital, but with the ability to attract funds backed by the implicit guarantee of the United States provided by FSLIC insurance, the thrifts funded their new activities with federally backed funds and thus shifted the risks associated with those activities to the FSLIC.
The problems were exacerbated by the inability of the thrift regulators to supervise these new activities and were compounded by the lack of resources available to the FSLIC to enable it to handle the thrift failures that followed.
The results were predictable. We now have a large number of economically crippled institutions, many of which continue to attract funds by offering high rates of interest, and thus we are witnessing what I view as the most significant problem facing the deposit-insurance system in the United States today.
After providing all of that background, I am now prepared to address the major problems associated with deposit insurance in the United States today. These are, first, the insolvency of the FSLIC fund; second, the disparity in treating large-bank and small-bank failures; third, how to in-still greater market discipline into our commercial banking system to avoid having the government shoulder all of the risks involved; fourth, how to choose the manner and method of handling the large number of bank failures; and, finally, and most important, how to determine the optimal structure of our banking system and the role of the federal safety net provided by deposit insurance in that structure.
Let me begin with the FSLIC problem.
It is useful to compare the current status of the FDIC and that of the FSLIC. The FDIC recently received its annual audit and certification from the General Accounting Office of the United States. The FDIC insurance fund exceeds $18 billion in net value, with all assets fully marked to market and all liabilities fully reserved. Of the $18 billion in assets, over $15 billion consists of cash and other government securities. In spite of the record number of bank failures, the value of the insurance fund has increased each year, and it is generally perceived to be adequate to cover all foreseeable difficulties. This includes the transactions in Texas that I have just discussed, as well as the transactions that we believe we are likely to undertake during the next several years. While there may be some decline in the value of the insurance fund during 1988, we do not believe that its adequacy is threatened.
The FSLIC is in a much different situation. The fund is insolvent. The General Accounting Office has not issued its audit or certification because of a dispute with the FSLIC. The argument is over whether the negative net worth of the FSLIC is only $12 billion, as the FSLIC argues, or closer to $16 billion. Under either scenario, it is clear that the fund is inadequate.
The thrift industry itself is not in much better shape. As an industry, thrifts lost over $6 billion in 1987. If you separate profitable from unprofitable thrifts, the numbers are much more startling. While the profitable thrifts earned over $6 billion in 1987, the unprofitable thrifts lost over $13 billion. Many insolvent thrifts continue to operate, continue to attract funds backed by FSLIC insurance, and continue to lose money at an alarming rate. According to certain recent reports, the negative net worth of some thrifts exceeds the value of their assets.
The problems at the FSLIC are exacerbated by the strong desire of profitable thrifts to exit from the FSLIC and obtain FDIC insurance. There are at least two reasons for this desire. First, the market appears to attach a penalty, ranging from 50 to 150 basis points, to FSLIC-insured deposits. Further, the premium charged by the FSLIC for deposit insurance substantially exceeds the premium charged for equivalent coverage by the FDIC. These two factors clearly are driving many institutions away from the FSLIC and toward the FDIC, although at the behest of the FSLIC, Congress has prohibited such moves.
To summarize, the FSLIC fund is inadequate to resolve the problems in the thrift industry. These problems are getting worse, not better. Resolving these problems will cost anywhere from $20 billion to $50–60 billion, and it is apparent that a fund with a negative net worth of $12 billion does not have the resources to finance this resolution. As these facts become known, the pressure to do something about the thrift problem increases.
Deciding what to do is not so easy. There is some surface appeal in merging the FDIC fund with the FSLIC fund. In such an event, the deficit at the FSLIC would, at least, be eliminated and some amount of money would be made available to solve the thrift problem. Such a merger could theoretically avoid, but more likely would only postpone, direct taxpayer assistance. Merger of the funds, however, has at least one major political liability. The thrift industry historically has enjoyed a strong political foundation basically because thrifts, at least theoretically, promoted realization of the American dream of home ownership. The thrift industry will be adversely affected if there is no separate insurance fund and the industry’s separate regulatory structure disappears. The inevitable disappearance of thrifts into the banking system will not be well received by the thrift industry. Banks, too, will resist losing “their” fund, which has been built up over the years with assessments paid by the banks. Thus, looking only at politics, there are pros and cons associated with a pure merger of the two funds.
If one sets aside the political problems, it is perhaps easier to discuss the philosophical justifications for consolidating the insurance funds.
First, whatever the historical distinction between them might have been, the banking and thrift industries have evolved into essentially one industry. Both actively compete for transactions and savings accounts. Both engage in a wide variety of consumer and commercial lending. Thrifts no longer provide the bulk of the financing for long-term home mortgages. Indeed, earlier in this decade, we saw a number of savings and loan associations opt to be treated as savings banks under new federal and state laws. They did this not to obtain new powers or engage in new activities, but merely to be able to use and highlight the name “bank” in their corporate titles and thus avoid the adverse connotations of “savings and loan association.”
Another, more fundamental similarity between banks and thrifts is that both institutions essentially rely upon the implicit backing of a governmental guarantee in order to attract deposits. When one begins to examine closely the lack of any real distinctions between activities, powers, and funding of savings and loan associations and commercial banks at the present time, one can quickly conclude that there is no logical or rational reason for having two industries governed and regulated by two separate agencies, insured by two separate insurance funds, or operating under two sets of regulatory standards.
Notwithstanding the political difficulties involved or the philosophical reasons for combining the insurance funds, such a move poses practical problems. First and foremost, the combined insurance funds are insufficient to adequately handle the problems in the thrift industry. Second, commercial banks have no desire to engage in a bailout of the thrift industry. Indeed, there is substantial commercial bank resentment of thrifts that have been allowed to operate under much more lax regulatory standards, with substantially less capital; pay higher rates for deposits; and generally create what has been perceived to be havoc in the system of financial institutions.
Finally, apart from the reluctance of the commercial banks, there is a strong resistance on the part of the thrift industry and the thrift regulators to doing away with the separateness of the industry and the special privileges and powers enjoyed by the savings and loan industry.
My own view is that at some point during the administration of the next U.S. President, it will become obvious that the existing situation cannot continue. The funds will be consolidated in some form or fashion; banks will be “protected” with respect to their interests in the FDIC fund; and thrifts will slowly be brought up to commercial bank standards. Vestiges of the existing regulatory structure surrounding thrifts will remain, simply because it is hard to do away with any government bureaucracy.
The second problem or issue facing the insurance fund is a direct result of the volume of commercial bank failures that have been handled by the FDIC. As noted, the FDIC has operated under the premise that, wherever possible, it will act in such a way as to protect all depositors and creditors of insured banks. This has always been true for major banks, where failure would have had significant systemic repercussions. Generally, only the occasional small bank has been liquidated, and only depositors in small banks have been forced to suffer the risk of having uninsured deposits.
It is clear that there is a general discomfort with this practice. Small banks believe that they are unfairly discriminated against. While there is no evidence that funding sources of small banks have been hurt, the inherent appearance of unfairness is a difficult problem.
One possible solution would be to extend deposit insurance to all deposits regardless of amount. This would eliminate the appearance of unfairness. At first glance, it appears that providing universal deposit insurance would not entail a significant cost to the FDIC. For the more than 300 bank failures experienced over the past three years, the total amount of uninsured funds not fully paid by the FDIC has been less than $33 million. Thus, on a nominal basis, one could defend the proposition that universal deposit-insurance coverage would not entail a significant cost to the FDIC.
The concept of universal deposit-insurance coverage, however, raises other issues. It does remove a degree of depositor discipline from the system. Under present circumstances, uninsured depositors have at least some incentive to make an evaluation of the underlying financial strength of the bank. Universal insurance coverage would remove that incentive. Further, it is not clear what universal deposit insurance would do to bank funding. Would universal deposit insurance allow troubled institutions to attract even more funds in times of distress merely by increasing the offered interest rates? Is it beneficial, from a public policy standpoint, for banks to compete only on the basis of the announced interest rate? My initial reactions to these questions lead me to conclude that universal deposit insurance will not be an appropriate solution.
What is more likely to happen is that the FDIC will be forced to reevaluate its premise that certain banks are too large to fail. Some mechanism must be introduced to shift some of the burden associated with large bank insolvencies to uninsured depositors and creditors of major banks. Steps have already been taken to ensure that holding-company creditors and shareholders share in these risks. We are exploring ways of implementing this concept at the bank level in the event of insolvencies.
This brings us to the third problem of how to instill more market discipline into our banking system, and thus shift some of the burden away from the insurance fund.
From time to time, various proposals have been made to tinker with the deposit-insurance system to help instill more discipline in it. Various academics have proposed lowering deposit insurance from its current S 100,000 limit per depositor to perhaps $25,000 or $50,000. This would bring deposit insurance more closely into line with its original purpose, which was to cover the funds of consumers. The reasoning behind these proposals is that there would be more uninsured money, and thus more incentive to have third parties value underlying economic strength. The impact of such a lowering of deposit-insurance coverage limits might be to create funding instability in small banks. A more important practical problem is that it is probably politically impossible to lower deposit-insurance limits, regardless of the merits of the idea.
From time to time, the FDIC has considered using various mechanisms to reward those banks operating in a safe, prudent, and conservative manner, and punish those that are acting improperly. Proposals for imposition of risk-based deposit-insurance premiums reflect the FDIC’s desire to develop such a mechanism. Again, in theory, the proposal makes some sense. Risky banks pose more risk to the insurance fund and should appropriately be charged higher premiums. The practical aspects of implementing such a system are fairly formidable. Measuring risk is a difficult task. The banking industry will resist proposals that give the regulators unfettered discretion to determine risk, and we are not convinced of the merits of a mechanical test. Punishing those institutions that are rapidly moving toward insolvency by imposing higher rates on their deposit insurance may effectively preclude their recovery. Risk-based premiums may become self-defeating.
One proposal made a few years ago would require banks to increase their capital to a much higher level, possibly around 9 percent of their assets. Requiring banks to increase their capital to such a high level would, of necessity, require private investors to examine the strength of each institution prior to investing in it. It was believed that only those institutions that were well managed and fundamentally sound would be able to attract and retain this higher level of capital, and thus some of the risk associated with bank failure would be effectively passed to the private sector. The general difficulties of adding massive amounts of capital, however, may preclude implementation of this proposal.
One means of introducing private market judgments into the banking system is through the mechanism of disclosure. While one might argue that it would be self-defeating for the FDIC to require disclosure of problems at a troubled bank, the current attitude at the FDIC is that disclosure is appropriate, good for the banking system in both the short run and the long run, and has very healthy effects on our financial system. Accordingly, the FDIC has pushed for greater disclosure of banks’ financial condition, generally requires disclosure of various enforcement actions, and generally supports the concept of allowing depositors and other investors to have sufficient information to make an intelligent, informed decision with respect to their deposits and other investments in commercial banks.
The fourth major issue concerns an evaluation of the role played by the FDIC as insurer and liquidator.
Given the sheer volume of failures and the number of problem institutions in this country, many people are now considering whether the FDIC should modify its methods of dealing with troubled institutions. As noted earlier, the FDIC handles problem institutions by recycling them into the hands of new private investors. Old share holders are basically wiped out. If the FDIC is unable to arrange for such a transaction, it will liquidate the banks.
With the increasing number of problem banks, there is an increasing clamor for the FDIC to begin to act much as the old Reconstruction Finance Corporation (RFC) acted in the days of the Great Depression. The RFC was established to invest in companies considered important to the economy. The existing owners and managers were allowed to continue to operate their businesses, and the RFC merely injected funds in the form of preferred stock or long-term debt. If the business survived and prospered, the RFC was repaid the amount of its investment; if the business failed, the RFC lost its investment.
Invariably, when a bank is on the road to insolvency, the bank will approach the FDIC and ask for some form of assistance along the lines of that previously provided by the RFC. Thus far, the FDIC has resisted mightily taking any steps toward becoming another RFC. The FDIC believes that maintaining its policy of allowing a bank’s managers and shareholders to suffer when a bank fails is at least one important method of instilling discipline into the system and that to do otherwise would be improper and inappropriate. Further, the FDIC would have a very difficult time distinguishing among the various candidates for this type of assistance. And, frankly, the $18 billion available in the FDIC fund would not be sufficient to meet all of the requests for such funding that could reasonably be expected.
I believe that the foregoing items accurately, although briefly, summarize most of the issues currently facing the FDIC and the deposit-insurance funds. I should note that the agency is currently undertaking a major study of these issues, the results of which should be announced by the end of the year.
There is, however, one fundamental issue that must be discussed. This issue has to do with the role of the commercial bank in our financial system, particularly as it relates to activities that might be conducted by corporate owners and affiliates of that bank and the relationship of the federal safety net provided by deposit insurance to those activities.
As alluded to earlier, banks and bank holding companies basically engage in the business of banking and in certain other activities that the Federal Reserve Board has deemed to be closely related to the business of banking. Activities that are generally not permitted either in the bank or its affiliates include securities and insurance underwriting, real-estate development, and other commercial endeavors. Given the role of the FDIC and our current banking structure, it is appropriate and proper that these limitations exist. The federal safety net provided by federal deposit insurance is appropriately limited to banking activities and should not be extended to other areas.
One might properly question, however, whether this relatively restricted structure is necessarily the most desirable. Over the past 18 months, the FDIC has devoted a great deal of study and attention to the proper structure of our system of financial institutions. We have asked questions as fundamental as the following: What is a bank? What is the role of deposit insurance? Who should own a bank? What should owners of banks be permitted to do? What should banks be permitted to do? Should banks be permitted to engage in activities through subsidiaries or affiliates? If they are, what restrictions should be placed on those activities?
These are important questions that are certainly deserving of answers. And certainly any answers that you or I might propose should be, and would be, subject to a great deal of debate.
In October 1987, the FDIC issued a study entitled “Mandate for Change: Restructuring the Banking Industry.” In it, the FDIC advanced the proposition that the proper role and function of the government, insofar as banking was concerned, should be to focus on the deposit-taking bank itself. This bank should be properly constrained in its activities, properly examined and supervised, and permitted to play the essential role in our economic system of accepting funds from the public and converting them into loans and financial assets.
The study concluded, however, that there were no fundamental governmental interests, at least as far as the bank regulators were concerned, in activities that might be conducted by a bank holding company, a non-bank subsidiary of a holding company, or a non-bank subsidiary of a bank, provided that the bank was properly insulated against the effects of those activities. The FDIC study concluded that with the proper safeguards, there was no logical reason why affiliates of commercial banks could not engage in securities, insurance, real-estate development, or any other lawful activity.
While such a proposal might seem relatively modest to many of you, it represents a fundamental change in the structure of our financial-services industry. It would eliminate bank-holding-company regulations. It would allow the owners of financial institutions to engage in economic activities that made economic sense. We believe that the change is long overdue and, indeed, that implementation of this proposal is an essential step toward ensuring the long-run soundness of our financial system in the United States.
Frankly, I doubt that our proposal will ever be enacted. I believe, however, that the proposal is fundamentally sound and that the FDIC has advanced the debate on issues of extreme importance to us all.
Bank and thrift failures continue at alarmingly high levels. Bank failures exceeded 200 in both 1988 and 1989; the FSLIC handled over 200 thrift failures in 1988 and has placed over 200 thrifts into conservatorship or receivership in 1990.
On August 9, 1989, President Bush signed into law the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989. FIRREA represents a major effort to address many of the problems highlighted in this paper. Among other things, FIRREA did the following:
Provided an additional $50 billion in funding to handle insolvent thrift institutions.
Abolished the old Federal Home Loan Bank Board and shifted the insurance function formerly performed by the FSLIC to the FDIC.
Established the Resolution Trust Corporation (RTC), under the direction of the FDIC, to handle thrift failures through 1992.
Significantly strengthened the supervisory and enforcement powers of the federal bank and thrift regulators.
Much more must be done, and FIRREA recognizes this. The Department of the Treasury must report to Congress with recommendations for deposit-insurance reform. Part of that report will address failure resolution policies, risk-based insurance premiums, adjustments in deposit-insurance coverage, etc. Significantly, the study will also address broad-based reforms of our legal and regulatory framework for financial institutions.
Given the continued high failure rate, the Treasury study should prompt additional legislative action. It is widely anticipated that this next round of legislation will address many of the fundamental concerns expressed in this paper.
JOHN C. MURPHY, JR.
We believe in full disclosure in the United States, so I should say that I was Mr. Douglas’s immediate predecessor as General Counsel of the Federal Deposit Insurance Corporation (FDIC). As a result, some of the issues with which he is dealing were under consideration at the FDIC during my tenure. If you are expecting me to be critical in any way of anything he said, I will have to disappoint you, because I tend to agree with everything he said.
I would like to focus on what you, as foreign central bankers, can learn from the U.S. deposit-insurance system in structuring your own systems. In looking at these issues, there are a number of similarities in various countries’ deposit-insurance systems or mechanisms that I am aware of. I do not pretend to be familiar with all of your systems, but I would like to point out several aspects of our system in the United States that make it unique.
II. U.S. Regulatory Structure
The first unique aspect is our regulatory structure and, particularly, the separation of the central bank from the deposit insurer. That is different from what, I understand, exists in a number of countries. Indeed, we have a further separation of insurers. We have a deposit insurer for commercial banks, another for thrift institutions (savings and loan associations), and still another for entities called credit unions. (Credit unions are, to a significant extent, a local type of institution.) Thus, the United States has three overlapping types of financial institutions—banks, thrifts, and credit unions—and three separate insurance funds.
Second, it is important to understand the structure of our banking system. We have, as Mr. Douglas has said, over 14,000 banks. There are, I believe, over 1,500 banks in Texas, which probably has more banks than a number of countries do. In the U.S. banking industry, there is great ease of entry and what we call “ease of exit.” I heard that phrase for the first time when I went to the FDIC, and I asked, “What does ‘ease of exit’ mean?” It means that in the United States, banks are permitted to fail.
Another important structural element in this country is the Glass-Steagall Act. That statute is intended to separate commercial banking, whatever that is, from investment banking, whatever that is. And we also separate banking from commerce generally, which is another aspect of our system that may be very different from your own systems.
If one wishes to gain an understanding of our deposit-insurance system, it is necessary to consider how it evolved. Mr. Douglas has identified the relevant benchmarks in U.S. financial history for those seeking to understand our system. These include particularly the Banking Holiday in 1933. When one reviews this history, it will become evident that every state insurance system for depository institutions that was tried in the nineteenth century failed. Much more recently, a series of state insurance systems failed in 1985 and 1986, and there are still some unusual state insurance systems today, although they are being phased out. The United States has dealt with deposit insurance on the federal level, and it has also become a political issue for us.
III. Designing a Deposit-Insurance System
Now that you have listened to this overview of U.S. structural factors, I would like to ask you, as central bankers, the following: What do you want from a deposit-insurance system? And while that is an easy question for me to ask, those of us in the United States do not, I think, have a clear vision of what we want from our deposit insurance system. The original purpose of deposit insurance, at least in my view, was principally to protect the small depositor. Remember, many banks failed at the time of the Banking Holiday in 1933. Stories of people keeping their savings under mattresses were spread then because presumably, if a person’s money was under a mattress, he could reach underneath and get it. If his money was in a bank and all the banks were closed, he could not get it. Deposit insurance provided stability and helped attract funds to banks, so that the financial system could operate. But the small depositor was principally affected. Even today, every insured bank must have a sticker in its window that displays the FDIC symbol, a policy that underscores the Corporation’s orientation toward consumers.
What is the purpose of deposit insurance today? In my view, there is not a clear, single purpose. But I believe there has been a shift in focus and that systemic stability has become much more important. That shift is interesting because maintenance of systemic stability is a task that is usually associated, in the first instance, with a central bank. And yet in the United States it also is very much a responsibility of the deposit insurer. If systemic stability is a concern, then the principal focus of regulators in the United States is, naturally, on large banks. With more than 14,000 banks in operation, if a small bank fails, other banks will be available to provide banking services in most geographical areas. But if the regulatory focus is on large banks and large banks are not permitted to fail, deposits in any large bank are, in effect, fully protected. Because small banks are permitted to fail, depositors in those banks are protected only up to the $ 100,000 insurance limit. Not surprisingly, small banks consider that treatment both unequal and unfair. This, in turn, again raises the political issue of the purpose of deposit insurance. I believe that if you are designing a new deposit-insurance system in your country, you should try to come up with a single purpose or an agreed-upon set of purposes. In the United States, we have not done so.
The next question to be asked is what do you insure? Those of us at the FDIC knew what to insure because it was in our name—deposits. Perhaps your country would also choose to insure deposits. If there is government insurance on deposits, that makes it easier to raise deposit funds at lower cost. What is it, then, that those funds can be used for? If an institution has insurance, it has an advantage in raising funds over its uninsured competitors. In the United States, insured funds can, at least in theory, only be used in banking, for making loans and so forth, and thus all competitors in banking are on essentially the same footing. In the Federal Republic of Germany, universal banks can engage in many more activities than U.S. banks can.
In one sense, the manner in which insured funds are used should determine the level of charges for this government insurance. A private commercial insurer would examine a business and would ask what the risk was that it might have to pay an insurance claim. It would then set the premium accordingly. Premiums would depend on such factors as the nature of the business, how the funds were being used, and what the likelihood was that the bank would operate safely or fail. That is an issue you have to look at.
Another issue to consider is whether you would let a bank fail. Would your system tolerate bank failures? Our system does, but some other systems do not. This year, there will probably be more than 50 bank failures in the state of Texas alone. That is probably more failures than many countries have had in some time.
Another question to consider is what you really want the deposit insurer to do. In one sense, an insurer can take a very passive role. It can collect the insurance premium for taking the risk and then, when there is a loss, in the form of a bank failure, it can make payments on account of the loss. That serves to fulfill the role of protecting the small depositor, because the small depositor receives his or her funds. But if the primary concern is with systemic stability, then, I believe, the insurer needs other mechanisms and greater powers. What are these other powers? My own view is that, in addition to insurance powers, the deposit insurer ought to have regulatory powers and the ability to supervise. It is very interesting to note that of the failed state insurance systems that Mr. Douglas described, the systems that lasted the longest had a supervisory function.
What other powers would you give this insurance mechanism? Would you let it liquidate assets? Would you let it run banks? If a bank failed, would you let the government take over the bank and run it because that might be the quickest and the most efficient way to get control over the problem? In the United States, we have tried various alternatives. As Mr. Douglas told us when he described the First RepublicBank Corporation situation, the U.S. Government made a billion-dollar contribution to that organization and said that all deposits were protected. Suddenly, First Republic became the safest bank in the United States. There were great competitive consequences. The following morning, I received a call from a banker in Texas asking how he could compete against the government. Thus, giving the insurer the power to operate most efficiently, which could include the power to run a bank, can raise real issues regarding competition among financial institutions.
A final question to be asked is how much power should be given to the deposit insurer. Several of us discussed this question at lunch, in the context of comparing the Dutch and the U.S. systems. In fact, both systems rely upon a court at various stages in the process. And while a court provides certain protections for the system, its involvement limits the system’s flexibility. Flexibility is what lowers costs and makes operations more efficient.
Finally, I would like to touch on the Reconstruction Finance Corporation (RFC) alternative that Mr. Douglas mentioned. The RFC was established in the United States in the 1930s. Pursuing that alternative today would involve massive investments of government funds to ensure that banks did not fail. Again, one needs to ask what the purpose of deposit insurance is. If an RFC type of solution were implemented, this would indicate the Government’s intention to provide stability. But I question whether the U.S. political system would tolerate the result, because it would involve the government providing funds to some banks that would be free to compete against banks that were not receiving government assistance. While this is occurring today in specific instances, I doubt that it would be tolerated, on a political level, to any great extent.