The Crisis in American Banking 9780814784983

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The Crisis in American Banking

The Political Economy of the Austrian School General Editor: Mario J. Rizzo New York University Although lon g associate d wit h a dee p appreciatio n o f th e fre e market , th e Austrian Schoo l ha s no t bee n recognize d full y a s a uniqu e approac h i n analyzing th e rol e o f governmen t i n th e economy . A major contributio n of the Austrian Schoo l was to demonstrate, as early as 1920, the impossibilit y of economic calculation under socialism. Recent events in the former Sovie t Union and Eastern Europe have dramatically illustrate d th e cogency of this argument. In more recent time s an d i n contras t t o conventional stati c anal yses, Austrian researc h has been concerne d wit h the impact o f governmen t control o n entrepreneuria l discovery . T o wha t exten t doe s th e impac t o f such control go beyond th e firm's stati c pricing decision and reach into the very discover y o f new opportunitie s an d henc e th e transmission o f knowl edge i n society ? Austrian s ar e als o concerne d wit h th e dynamic s o f stat e intervention—the degre e t o whic h on e interventio n induce s furthe r inter ventions and, conversely, the degre e to which on e decontrol "necessitates " further step s i n the process o f deregulation . Finally , the Austrian Schoo l i s firmly committed t o the value-freedom o f economics, that is, the separatio n of the analysi s o f polic y consequence s fro m th e mora l an d politica l value s inherent in the advocacy o f particular economic policies.

The Crisis i n American Bankin g Edited by Lawrence H. White

New York University Press New York and London

NEW YORK UNIVERSITY PRES S New Yor k and Londo n Copyright © 199 3 by New Yor k Universit y All right s reserve d This boo k ha s been sponsore d i n par t by the Austria n Economics Progra m at New Yor k University . Library of Congres s Cataloging-in-Publicatio n Dat a The Crisi s i n American bankin g / edited b y Lawrence H . White, p. cm.—(Th e Politica l econom y o f the Austrian school ) Includes bibliographica l referenc e an d index . ISBN 0-8147-9260- X 1. Bank s an d banking—United States . 2 . Bank s an d banking—Unite d States—State supervision . 3 . Bank s an d banking—United States — Deregulation. 4 . Deposi t insurance—Unite d States . I . White , Lawrence H . II . Series . HG2491.C75 199 3 332.1'0973—dc20 92-4576 2 CIP New Yor k University Pres s books ar e printed o n acid-fre e paper , and thei r binding material s ar e chosen fo r strength an d durability . Manufactured i n the Unite d State s o f Americ a c1 0

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Contents

Foreword vi i Mario /. Rizzo Introduction 1 Lawrence H. White 1. Wh y Is the U.S. Banking Industry in Trouble? Busines s Cycles, Loan Losses, and Deposit Insurance 7 Lawrence H. White 2. Public-Secto r Deficits an d Private-Sector Performance 2 9 Roger W. Garrison 3. A n Empirical Analysis of Public Choice Aspects of the Savings and Loan Disaster 5 5 Thomas Havrilesky 4. Banker s as Scapegoats for Government-Created Crise s in U.S. History 8 1 Richard M. SaJsman 5. Deposi t Insurance Reform I s Not Enough 11 9 Walker Tod d an d Geral d P. O'Driscoll, Jr. v

vi Content s 6. Th e Diminishing Role of Commercial Banking in the U.S. Economy 13 9 George G. Kaufman Contributors 16 1 Index 16 3

Foreword Mario J. Rizzo

This book , The Crisis in American Banking , i s th e first i n a ne w series of books that will be published unde r the rubric of the "Polit ical Economy of the Austrian School. " The essays collected her e are the revise d version s o f paper s presente d a t a conferenc e a t Ne w York Universit y o n Apri l 29 , 1991 . The financial suppor t fo r thi s conference wa s provide d b y th e Sara h Scaif e Foundation . W e ar e indebted t o th e foundatio n an d it s president , Richar d M . Larry, fo r generous support , no t onl y o f thi s conferenc e bu t als o o f th e Aus trian Economic s Progra m a t Ne w Yor k Universit y ove r a perio d o f many years . Furthe r debt s t o Professo r Lawrenc e H . Whit e o f th e Department o f Economics , Universit y o f Georgia , fo r hi s assistanc e in organizin g th e conferenc e an d editin g th e proceedings , an d t o New York University for providing convenient conferenc e facilities , are gratefully acknowledged .

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The Crisis in American Banking

Introduction Lawrence H . White

This volum e offer s si x origina l essay s keye d t o th e continuin g crisi s in th e U.S . bankin g industry . Fiv e wer e first presente d a t a smal l conference—more lik e a serie s o f seminars—o n "Th e Crisi s i n th e Banking Industry, " sponsore d b y NYU' s Austria n Economic s Pro gram (whic h i s directe d b y Israe l Kirzner) . Th e conferenc e wa s organized b y Mari o Rizz o an d myself , an d wa s hel d a t Ne w Yor k University o n Apri l 29 , 1991 . Th e paper s generate d livel y discus sion amon g th e author s an d othe r participant s i n th e conference , and hav e bee n revise d t o reflec t (o r deflect ) constructiv e criticis m received there . A sixt h paper , b y Richar d Salsman , wa s solicite d soon afte r th e conference . Al l si x have been update d t o reflect devel opments throug h Septembe r 1991 . The U.S . banking system , it s regulatio n an d deregulation , an d it s troubles, hav e bee n muc h i n th e new s lately . Bankin g topic s hav e been discusse d b y economist s i n a numbe r o f monograph s an d conference volumes . Th e rational e fo r addin g th e presen t volum e t o the discussio n i s th e hop e tha t it s contributor s provid e fres h per spectives b y viewin g th e bankin g scen e fro m unusua l angles . I n particular, severa l author s dra w idea s fro m moder n Austria n eco nomics o r fro m publi c choic e theor y tha t hav e seldo m bee n applie d to explainin g contemporar y bankin g problems . A pervasiv e them e o f th e contribution s her e i s tha t th e U.S . banking crisi s i s fundamentall y linke d t o th e politica l regulatio n o f banking. (Popula r alternativ e explanation s poin t t o supposedl y ex cessive competitio n o r deregulatio n i n banking , o r t o a suppose d 1

2 Lawrenc e H . Whit e decline i n th e ethica l standard s o f banker s i n th e 1980s. ) Take n together, the chapters below (1) indicate that government regulatory , macroeconomic, and fiscal policies have seriously impaired the health of the banking industry ; (2 ) contribute t o explaining ho w rent-seek ing, ideology, an d th e historica l accretio n o f regulations hav e give n banking polic y it s curren t unfortunat e form ; an d (3 ) conside r th e long-term prospect s fo r refor m o f bankin g regulation , an d fo r th e banking industr y itsel f i n ligh t o f th e curren t an d foreseeabl e regu latory environment . In th e first chapte r I attempt t o provid e a n overvie w o f th e U.S . banking industry' s trouble s an d th e FDIC's insolvency, an d t o trac e them t o regulator y an d macroeconomi c policies . Th e secularl y shrinking profit s brough t t o banking by techological change , as discussed i n this volume by George Kaufman, explai n why the banking industry shoul d contract , bu t no t wh y it s contractio n shoul d b e punctuated b y a crisis involving high levels of loan losses and ban k failures. I sugges t tha t cyclica l losse s i n ban k lending , especiall y severe toda y i n th e are a o f rea l estat e lending , represen t correlate d errors induced b y unpredictable monetar y policy. Regulation (parti culary restriction s o n geographi c an d product-lin e diversification ) and deposi t insuranc e explai n wh y U.S . banks , a s th e thrift s di d earlier, hav e reacte d t o a downtur n wit h increase d ris k taking . In creased ris k takin g ha s le d t o dramati c exit s i n th e fashio n o f th e Bank o f Ne w England , rathe r tha n simpl e shrinkag e o r redeploy ment of capital. Policy reform shoul d see k to remove the distortion s that promote excessive risk taking. Roger Garriso n addresse s th e impac t o f governmen t budge t defi cits o n th e econom y i n genera l an d o n bankin g i n particular . H e argues tha t unusuall y larg e borrowing, t o cove r today's deficit , force s market participant s t o gues s abou t tomorrow' s polic y fo r servicin g or repayin g th e debt , an d t o gues s abou t ho w othe r marke t partici pants wil l vie w th e situatio n an d respond . T o wha t exten t wil l a continued deb t burde n absor b domesti c saving , causin g hig h rea l interest rate s an d crowdin g ou t domesti c investment ? T o wha t ex tent wil l i t absor b fund s fro m abroad , keepin g rea l interes t rate s a t their normal level but weakening demand for export goods? To what extent will taxes be raised, when, and o n what? To what extent wil l the deb t b e monetized , causin g inflation ? Derivin g surprisin g illu mination fro m standar d national-incom e accounting , Garriso n show s that som e combinatio n o f thes e (jointl y exhaustive ) repercussion s must follow a deficit .

Introduction 3 Empirical studie s ma y sho w n o stron g o r regular connectio n be tween deficit s an d an y on e o f thes e repercussions , bu t Garriso n points ou t that i t would b e fallacious t o conclud e tha t deficit s hav e no repercussion s o r ar e harmless . Th e lac k o f a predictable mi x of repercussions i n fac t mean s tha t marke t participant s fac e adde d uncertainty. This excess uncertainty hinders decisio n making in the banking sector—portfolio s wil l prov e t o hav e bee n misallocate d when guesse s abou t answer s t o th e abov e question s prov e t o hav e been mistaken, o r rates of return will be reduced b y greater hedgin g —and i n the rest of the economy . Thomas Havrilesky examines the role of private interests (the S&L and big-ban k lobbies ) i n shapin g bankin g legislatio n betwee n 198 5 and 1987 , a period i n whic h thrif t industr y problem s incubated . I n provocative languag e h e argue s tha t banking - an d thrift-industr y policy, like politics generally, is about "rent-seeking" or redistributing income. Critical change s i n the regulatory rule s governin g S&Ls in the 1980s (an increase in the deposit insurance ceiling, regulatory forbearance t o close insolvent thrifts, relaxe d accountin g standards ) appear to reflect th e captur e of legislators an d regulator s by the S&L lobby. Studyin g th e statistica l relationshi p betwee n a Congressper son's contribution s fro m S& L or big-ban k lobbie s (Politica l Actio n Committees, o r PACs ) an d hi s o r he r votin g o r bil l sponsorship , Havrilesky finds evidence that each lobby was influential. Congress people wh o sponsore d pro-big-ban k bill s receive d a bigger shar e of their PA C money fro m big-ban k PACs ; those wh o vote d a s the S&L lobby preferre d likewis e receive d greate r proportionat e S& L PA C contributions. Popular account s o f th e thrift-industr y fiasco, an d o f th e FDIC' s current difficulties , hav e blamed frau d an d mismanagemen t amon g bankers, citin g anecdota l evidenc e o f renegade s lik e Charle s Keat ing. Richar d Salsman' s essa y provide s a usefu l historica l perspec tive by showing that the same sort of charges were made in previou s U.S. banking crises : the "wildca t banking " episode s o f the antebel lum period ; th e mone y panic s o f th e Nationa l Bankin g era , espe cially th e Pani c o f 1907 ; the bankin g collaps e o f th e Grea t Depres sion; an d th e S& L crisi s o f th e 1980s . I n eac h cas e banker s wer e blamed fo r ill s tha t Salsman—drawin g o n importan t "revisionist " work b y monetar y theorist s an d historian s i n th e las t twent y year s —indicates shoul d i n fac t b e trace d t o governmen t interferenc e i n banking. Lega l restrictions , i n th e late r episode s combine d wit h central bankin g an d deposi t insurance , hav e create d climate s i n

4 Lawrenc e H . Whit e which unsaf e bankin g practice s ca n persist an d become institution alized. He concludes that systemic bad banking is a symptom of bad policy, rather than an independent caus e of crisis. Why the n hav e banker s bee n mad e scapegoats ? Salsma n cite s a number o f case s i n whic h federa l legislators , agenc y heads , an d commissioners hav e le d th e movemen t t o blam e bankers , rathe r than governmen t policies , fo r th e bankin g system' s failings . Self interest provide s a n obviou s motive . A question tha t remain s t o be answered i s why the popular pres s have not been more discerning . Walker Tod d an d Geral d P . O'Driscoll , Jr. , provid e furthe r evi dence o f the destabilizin g effect s o f government deposi t guarantees . They emphasiz e tha t explici t deposi t insuranc e i s onl y on e par t of the "safet y net " whos e historica l growt h the y document ; implici t guarantees ar e a n additiona l an d crucia l part . The y war n tha t gov ernment supervisor y agencie s wil l no t rei n i n excessiv e ris k takin g by bank s (bein g inherentl y pron e t o er r o n th e sid e o f wishfu l thinking) unti l i t is too late. Political pressures wil l then be brought to bear o n the supervisor s (th e FDIC and th e Fed) to bail ou t failin g institutions, a s lon g a s deposi t guarantee s o f an y amoun t ar e i n effect. The y find evidenc e o f these pressure s no t onl y i n the much discussed doctrin e tha t som e banks ar e "to o big to fail" bu t als o i n the abus e o f the Fed' s discoun t windo w fo r ban k rescues , a featur e of th e curren t syste m tha t ha s scarcel y bee n mentione d elsewhere . The centra l ban k discoun t window , unde r classica l lende r o f las t resort doctrine, is supposed t o provide onl y liquidity suppor t to the banking system , no t capita l suppor t t o individual insolven t institu tions. Walke r an d O'Driscol l not e tha t Fe d loan s t o banks declare d insolvent ar e repaid ou t of the FDIC's Bank Insurance Fund, and th e BIF is ultimatel y replenishe d wit h taxpaye r money , s o th e curren t system "convert s unsoun d bankin g polic y us e o f the discoun t win dow t o kee p insolven t bank s afloa t int o unsoun d fiscal policy. " They conclude that to achieve stability the entire safety ne t needs to be reformed, no t only deposit insurance . Todd an d O'Driscol l argu e fo r a comprehensiv e se t o f reforms that woul d eliminat e federa l deposi t guarantees . A t th e ver y least , they favor a bank closur e polic y that expose s depositor s an d share holders, bu t no t taxpayers , t o losses . Observin g tha t th e deposi t guarantee syste m wil l soo n be transferring wealt h fro m th e averag e citizen (throug h taxatio n t o recapitaliz e th e FDIC ) t o th e wealth y citizen (wh o has parke d saving s i n insure d deposits) , they reasona bly suggest that having an FDIC makes the average citizen worse off .

Introduction 5 Risk-free saving s vehicle s payin g competitiv e rate s ar e alread y available in the form o f Treasury bills and saving s bonds. Looking beyon d th e curren t crisis , Georg e Kaufma n survey s th e secular trend s tha t ar e shrinkin g th e bankin g industr y i n compari son t o othe r financial servic e providers . H e finds tha t thes e trend s stem partl y fro m technologica l change s (suc h a s advance s i n tele communications an d computerization) , an d partl y fro m ba d polic y decisions (suc h as mispriced deposi t insurance, forbearance t o close insolvent institutions , an d geographi c an d product-lin e restric tions). Shrinkage o f the banking industry du e to loss of comparativ e advantage i s efficien t an d nothin g t o mourn . Bu t shrinkag e du e t o ill-conceived publi c polic y i s no t efficient . Kaufma n call s fo r cor rectly pricin g deposi t insurance , an d fo r removin g restriction s o n the geographi c an d product-lin e power s o f banks. He warns agains t softening th e balance-sheet standard s fo r banks, which som e voices have urge d a s a wa y t o comba t a suppose d "credi t crunch/ ' Wit h broader power s bu t withou t subsidies , efficien t U.S . banks shoul d be abl e t o compet e o n a leve l playin g field. Th e succes s o f foreig n banks an d nondepositor y financial firms i n recent year s show s tha t lesser deposit guarantees (an d correspondingly higher capital ratios) do not preclude growth . As this prefac e i s written, th e stat e o f the U.S . commercial bank ing industry an d th e FDI C continues t o sugges t disturbin g parallel s to the state of the savings and loa n industry an d the FSLIC a decade earlier. With the BIF's balances dow n to $2 billion in late 1991 (less than the amount needed to close the Bank of New England earlie r in the year) , th e FDI C appeare d t o b e puttin g of f closin g bank s tha t were insolven t (o n a market-valu e accountin g basis , i.e. , whe n counting thei r asset s a t market valu e rathe r tha n boo k value). Afte r predicting earlie r i n th e yea r tha t 18 0 to 23 0 institutions woul d b e seized i n 1991 , the FDI C reduced it s estimat e i n Decembe r t o onl y 137. I n pleadin g fo r "recapitalization " o f th e BIF , FDI C chairma n William Taylo r acknowledge d i n s o many word s tha t lac k o f fund s was hindering th e agenc y fro m closin g unsound banks . Suc h a policy o f forbearanc e carrie s th e dange r o f duplicatin g i n bankin g th e second phas e o f the thrif t crisis , that is , of creatin g a new cohor t of "zombie" institution s rationall y pursuin g risk y strategie s a t the ex pense o f future taxpayer s wh o pic k up th e tab for losse s by govern ment deposi t insurance agencies . In November 199 1 the FDIC' s Bank Insurance Fun d wa s "recapi talized" b y omnibu s bankin g legislatio n grantin g th e agenc y a n ad -

6 Lawrenc e H . White ditional $7 0 billion i n borrowing authority. The FDIC Improvement Act require s th e FDI C to repa y an y borrowing s fro m it s asse t sale s or insuranc e premiums . I t remain s t o b e see n whethe r th e agenc y will b e abl e t o repay , o r whethe r taxpayer s wil l b e presente d wit h the ta b a t a later date . The legislatio n include s a number o f deposi t insurance reforms : change s i n accountin g an d examinatio n rules ; a schedule o f restriction s t o b e place d o n undercapitalize d instuti tions; a mandat e fo r th e FDI C to impos e risk-base d insuranc e pre miums b y 1994 ; and a requirement tha t th e agenc y resolv e failure s by th e metho d generatin g th e leas t cos t t o th e FDIC , eve n i f tha t means exposin g uninsure d depositor s t o losses , beginnin g 1995 . Proposals fo r structura l refor m o f banking , t o eliminat e geographi c and product-line restrictions, were excluded fro m th e legislation . With it s ne w acces s t o funds , th e FDI C i s expecte d t o begi n working of f a backlo g o f insolven t bu t not-yet-seize d institutions . The agenc y officiall y expect s t o clos e 20 0 t o 23 9 banks, wit h tota l book asset s i n th e neighborhoo d o f $10 0 billion , i n 199 2 alone . Private analyst s estimat e $5 0 billion i n losse s to the FDI C from th e closure o f som e 15 0 sic k saving s bank s i n Ne w Yor k an d Ne w England, i n additio n t o losse s fro m closur e o f ailin g commercia l banks. A s th e situatio n unfolds , observer s wh o currentl y fea r a replay o f th e $15 0 billio n FSLI C bailou t ma y find tha t the y wer e overly pessimistic—o r overl y optimistic . Eithe r way , th e polic y regime tha t allowe d bot h th e earlie r an d late r problem s t o develo p does no t see m t o b e o n th e verg e o f an y dramati c change . Th e reluctance o f Congress t o enac t rea l reform s mean s tha t th e critica l analyses an d refor m proposal s i n this volume, against the wishes of their authors, will remain relevant for some time to come.

1 Why Is the U.S . Bankin g Industr y i n Trouble? Business Cycles , Loa n Losses, an d Deposit Insuranc e Lawrence H . White

We learne d fro m th e U.S . thrift-industry debacl e tha t congresspe o ple an d regulator s hav e incentive s t o mas k an d den y th e siz e o f insolvencies among deposit-taking institutions when they first arise. Rather tha n promptl y resolv e th e widesprea d insolvencie s tha t ex isted amon g thrifts i n 1981 , the authorities chos e to revise the regulatory accountin g rules , t o practic e "forbearance, " an d t o gambl e that economicall y insolven t thrift s migh t clim b back int o th e blac k (Eisenbeis 1990 , 19-20) . A s i t turne d out , th e cos t o f resolvin g th e problem grew, to the point where taxpayers have been saddled wit h an enormous expense in covering the thrift deposi t guarantees mad e by the late FSLIC. Estimates of the expense, beginning at $10 billion in 1986 , hav e bee n revise d upwar d steadil y t o mor e tha n $15 0 billion (a s of 1991 , excluding interest). The Industry's and the FDIC's Troubles Are Large In ligh t o f thi s experience , a sens e o f dej a v u accompanie d new s reports, beginnin g i n lat e 1990 , that th e Federa l Deposi t Insuranc e Corporation, th e agenc y tha t no w guarantee s bot h thrif t an d ban k deposits, would soo n run out of money without taxpayer assistance . The FDIC' s Ban k Insuranc e Fun d shran k a s it s annua l disburse ments i n resolvin g ban k failures , whos e number s swelle d tremen 7

8 Lawrenc

e H . Whit e

Figure 1. 1 Annual U.S . Bank Failure s 1960-1990

dously th e las t decad e (se e figure 1.1) , exceede d it s incom e fro m deposit insuranc e premiums . Beginnin g 198 8 with $18. 3 billion, th e BIF los t $5. 1 billio n i n 1988-89 , an d anothe r $6. 8 billio n i n 199 0 alone, leavin g it s balanc e a t onl y $6. 4 billio n a t year-en d 1990 . Th e most recen t FDI C projections impl y ne t losse s fo r 1991-9 2 o f $1 9 t o $38 billion. 1 As the y di d wit h th e FSLIC , th e authoritie s hav e persistentl y underestimated th e FDIC' s problems . Earl y i n 199 0 FDJ C official s projected tha t th e agenc y woul d brea k eve n fo r th e year . B y midyea r they projecte d 199 0 losse s o f $ 2 billion . I n Septembe r 199 0 FDI C chairman Willia m Seidma n raise d th e estimat e t o $ 3 billion . I n retrospect th e FDI C first foun d tha t i t ha d actuall y los t $4. 8 billio n in 199 0 (th e BIF' s balance s ha d decline d t o $8. 4 billio n a t year-en d 1990 fro m $13. 2 billio n a t year-en d 1989) ; late r i t revise d th e year end 199 0 balanc e t o $6. 4 billion , implyin g 199 0 losse s o f $6. 8 bil lion. 2 The federa l Offic e o f Managemen t an d Budge t projecte d i n Sep tember 199 0 tha t th e FDI C woul d nee d infusion s o f $22. 5 billio n over th e nex t five year s t o remai n afloat . I n Octobe r 1990 , Seidma n

Why Is the U.S. Banking Industry i n Trouble ? 9 professed no t t o se e th e FDI C fun d i n dange r fo r th e foreseeabl e future, maintainin g that the fund woul d remain in the black through the en d o f 1991 . As 199 1 began Seidma n wa s asking Congres s fo r a $10 billion loa n to provide a margin o f safety , thoug h h e had previ ously indicate d tha t th e fun d coul d us e a $25 billion infusion . Th e Congressional Budge t Offic e projecte d i n January 199 1 that th e BI F would develo p a $2. 8 billio n defici t b y mid-1992 , bu t tha t (wit h increases in premiums) i t would retur n to solvency by mid-1994. In March 199 1 th e Bus h administratio n propose d tha t Congres s pro vide th e FDI C wit h $2 5 billio n i n borrowin g authority . Withi n a week Seidma n testifie d tha t unde r a "pessimisti c economi c sce nario" th e fun d migh t hav e t o borro w $3 0 t o $3 5 billion , an d th e administration's reques t fo r FDI C borrowin g authorit y wa s in creased t o $7 0 billion , jus t i n case. 3 A s o f Jun e 1991 , the FDIC' s "baseline projection' * gav e the BI F a year-end 199 1 balance o f $3. 2 billion, whil e it s "pessimisti c scenario' ' projecte d a year-en d bal ance of $1. 7 billion. B y the fall o f 199 1 it was evident that eve n th e "pessimistic scenario " was overl y optimistic. Seidma n wa s project ing that the fund woul d be insolvent at year's end, and reported tha t it had already borrowed $2. 9 billion from th e U.S. Treasury.4 As i n th e thrif t meltdown , th e projection s o f private-secto r ex perts hav e bee n mor e pessimisti c e x ant e an d hav e prove n t o b e more accurat e e x post . Ban k consultan t Davi d Cate s projecte d i n October 1990 , before th e recessio n ha d bee n officiall y declare d un derway, that in a recession banks coul d los e $86.3 billion i n equity , 41% o f th e industry' s cushion , an d taxpayer s coul d fac e a bil l a s high a s $4 0 billio n t o cove r FDI C losses . Cates' s credibilit y wa s enhanced b y his projecting that , under suc h a scenario, the Bank of New Englan d woul d fail . Th e Ban k o f Ne w England faile d i n Janu ary 1991 , amidst deposito r runs , with losse s expected t o make it (at $2.5 billion) th e thir d mos t expensiv e resolutio n i n th e FDIC' s history. Lowell Bryan, a bankwatcher a t McKinsey and Company , sim ilarly projecte d i n Decembe r 199 0 that th e FDI C would nee d injec tions o f $20-4 0 billio n ove r th e nex t fe w years . A stud y b y th e independent ban k ratin g servic e Veriban c foun d tha t th e FDI C was already insolven t a t year-end 1990 , facing resolutio n cost s for then insolvent bank s (estimate d a t $11. 6 billion ) i n exces s o f BI F bal ances. Edward Kan e estimated i n mid-1991 that the BIF was alread y $40 billion i n the hol e a s o f the en d o f 1990 , if on e recognized a s a BIF liability th e negativ e ne t wort h tha t woul d appea r unde r mark to-market accounting for insured banks' assets. 5

10 Lawrenc e H . White An authoritativ e stud y o f th e FDIC' s conditio n appeare d i n a report b y Jame s R . Barth , R . Da n Brumbaugh , an d Rober t E . Litan , dated Decembe r 1990 , commissione d b y th e Financia l Institution s Subcommittee o f th e Hous e Bankin g Committee . Barth , Brumbaugh , and Lita n (1990 , 6 ) conclude d tha t th e BI F a t th e en d o f 199 0 appeared t o b e wher e th e FSLI C wa s i n th e mid-1980s , "withou t sufficient resource s t o pa y fo r it s expecte d caseloa d o f faile d depos itories." Th e author s rehearse d a numbe r o f scenarios , varyin g i n the assume d severit y o f th e incipien t recessio n an d th e degre e o f forbearance t o be exercise d towar d large r banks . They estimate d (Barth , Brumbaugh , an d Litan , 93 , 103 ) tha t eve n under a "mil d recession " th e FDIC' s bank resolution cost s for 1 9 9 1 93 woul d ru n betwee n $3 1 an d $4 3 billion , exhaustin g it s expecte d resources o f $ 2 8 - 3 1 billio n (consistin g o f start-of-perio d reserve s o f $9 billion plu s premiu m an d interes t incom e o f $19-2 2 billion) . A majo r sourc e o f concer n i s tha t large r bank s hav e begu n t o appear o n th e FDIC' s lis t o f "proble m banks. " Th e lis t numbere d 975 bank s a t th e midpoin t o f 1991 , slightly fewe r tha n i n th e imme diately precedin g years , bu t th e aggregat e asset s o f proble m bank s had increased . Likewise , althoug h th e numbe r o f ban k failure s i n the first hal f o f 199 1 (fifty-seven ) wa s fewe r tha n i n th e first hal f o f the previou s yea r (ninety-nine) , the averag e asse t siz e o f failed bank s was muc h muc h larger : $47 5 millio n versu s onl y $6 5 millio n (FDI C 1991,2,4). In fac t som e o f th e ver y larges t U.S . bank s ar e teetering . Th e Economist commente d i n Decembe r 1990 : "Nobody know s jus t ho w much rubbis h [U.S. ] bank s hav e o n thei r books , o r ho w man y loan s might becom e rubbis h i f a recession deepens . Among th e bank s tha t fail ma y b e prominen t money-centres." 6 Barth , Brumbaugh , an d Litan (1990 , 13 ) commente d tha t a s o f the en d o f 199 0 "most " o f th e nation's larges t bank s wer e "on—o r conceivabl y over—th e edg e o f insolvency. . . . [M]an y o f thes e bank s no t onl y currentl y hav e wea k balance sheet s b y an y reasonabl e standard , bu t the y als o ar e highl y exposed t o additiona l deterioratio n i n thei r capita l position s fro m their significan t involvemen t i n high-ris k lending." 7 The y reporte d (Barth, Brumbaugh , an d Lita n 1990 , 50 ) tha t si x o f th e to p twenty five ban k holdin g companie s ha d "hig h ris k loans " (loan s fo r highl y leveraged transaction s [HLT] , mediu m an d long-ter m LD C loans , and commercia l rea l estat e loans ) i n exces s o f fou r time s thei r "ad justed tangibl e commo n equity " (tangibl e commo n equit y plu s al lowance fo r loa n losse s les s 1 % o f al l performin g loans) . Tha t is , a

Why Is the U.S . Banking Industry i n Trouble ? 1 1 25% fal l i n th e valu e o f suc h a bank' s high-ris k loa n portfolio , together with a normal 1 % loss rate on other loans , would wip e ou t its capital, leaving it insolvent . FDIC call reports show that the large banks (those with more than $10 billion in assets) as a size class have the weakest loan portfolios . Across mos t categorie s o f loans , th e larg e bank s hav e th e highes t percentages o f loan s pas t du e o r noncurrent , an d th e highes t per centage o f loa n charge-off s (FDI C 1991, 3). In recent year s the clas s of larg e banks ha s ha d th e highes t percentag e losin g money . I n th e first hal f o f 1991 , 11.2% of al l bank s (1,36 1 o f 12,150 ) los t money , while 19.6 % of large banks ( 9 of 46) did s o (FDIC 1991, 5) . Marketplace reflection s o f troubles a t the large money-center bank s are no t har d t o find. I n 198 0 Moody' s Investor s Service s rate d th e debt o f fourtee n tfiajor bank s "AAA" ; toda y i t give s onl y on e U.S . bank tha t ratin g (Salsma n 1990 , 71) . Moody' s no w rate s a fifth o f Chase Manhattan's deb t eve n below investmen t grad e (Byro n 1990 , 16). Stock traders' expectation s o f likely futur e difficultie s i n bank ing ar e reflecte d i n lo w shar e price s (relativ e t o curren t reporte d earnings) fo r al l banks, but especiall y fo r larg e banks (Barth , Brum baugh, an d Lita n 1990 , 15) . While healthie r bank s trad e a t slightl y above book value, money center banks have been trading well below (Salsman 1990 , 72). In additio n t o th e asset-qualit y problem s a t larg e banks , Barth , Brumbaugh, an d Lita n (1990 , 51 ) pointe d ou t tha t th e Ban k Insur ance Fund i s also threatened b y renewed trouble s a t savings banks. They noted that BIF-insured savings banks in the aggregate lost $670 million in 1989. The latest available figures show the situation worsening. Th e numbe r o f "problem " saving s banks , whic h stoo d a t thirty-one i n mid-1990 , had rise n t o fifty-eight a year later . Saving s banks i n th e aggregat e droppe d a staggerin g $2. 5 billio n i n 1990 , and los t anothe r $66 2 millio n i n th e first hal f o f 1991 , exceedin g losses in the first half o f 1990 . In New England, where most saving s banks are located, two-thirds o f the twenty-three larges t institution s were unprofitable i n the first half o f 1991 (FDIC 1991, 7) . With the FDIC running out of cash, there is a great danger that the agency i s neglectin g t o clos e insolven t banks , jus t a s th e FSLI C neglected insolven t thrift s fo r years . "Zombie " institution s (eco nomically "dead " bu t stil l operating ) ma y b e afoot , pilin g u p obli gations tha t wil l eventuall y b e lai d a t th e doorste p o f taxpayers . Barth, Brumbaugh , an d Lita n (1990 , 81 ) not e tha t durin g th e year s 1980-85, wit h fewe r annua l failures , th e typica l faile d ban k wa s

12 Lawrenc

e H . White

resolved abou t fifteen month s afte r i t first appeare d o n th e FDIC' s problem list . B y 1987-89 , amids t tw o hundre d failure s pe r year , th e typical faile d ban k wa s no t resolve d fo r 2 1 - 2 8 month s afte r first being listed . The Immediat e Sourc e o f Troubl e I s Ba d Loan s U.S. bank s ar e failin g o r trouble d primaril y becaus e s o man y o f th e risky loan s the y mad e i n th e 1980 s ar e i n default . I n th e fou r quar ters endin g Septembe r 30 , 1990 , th e banks ' ne t charge-off s fo r ba d loans wer e $30. 5 billion , th e larges t dolla r amoun t fo r an y four quarter perio d ever , an d a recor d hig h percentag e o f assets . Charge offs i n th e first hal f o f 199 1 continue d a t roughly th e sam e hig h rate . Despite th e charge-offs , th e proportio n o f trouble d loan s o n ban k portfolios continue d t o rise . At th e en d o f Septembe r 1990 , the tota l of noncurren t loan s an d lease s plu s "othe r rea l estat e owned " (fore closed mortgag e property ) wa s $89. 6 billion , u p b y $14. 2 billio n (19%) fro m a yea r earlie r ($75. 4 billion) , an d a t a recor d leve l a s a share (2.65% ) o f tota l asset s (FDIC 1990 , 1-3) . B y th e midpoin t o f 1991, th e tota l ($107.9 ) an d th e shar e (3.19% ) ha d bot h rise n eve n higher. Despite th e takin g o f historicall y larg e loan-los s provision s i n 1989 an d 1990 , anothe r roun d o f larg e provision s wa s neede d i n 1991, an d stil l anothe r roun d wa s expecte d t o b e neede d i n 1992 . Loan-loss reserve s wer e dow n t o 6 5 cent s pe r dolla r o f noncurren t loans a s o f 1991:2 , dow n fro m 7 3 cents a s o f 1990:3 , and dow n fro m 83 cents a year before that . Losse s from commercia l rea l estat e loans , LDC loans , an d HL T loan s wer e expecte d t o increas e i n th e reces sion, especiall y amon g th e large r northeaster n bank s (FDIC 1990, 2) . The natur e o f th e bankin g industry' s ba d loan s ha s bee n widel y reported. Southwester n banks , makin g u p th e majorit y o f faile d banks i n th e las t fe w years , suffere d bi g real-estat e an d energ y loa n losses i n th e lat e 1980s . Th e bi g money-cente r bank s too k sizabl e write-downs o f LD C loan s i n 1987 , suc h tha t al l larg e bank s poste d negative return s fo r th e year , an d anothe r milde r roun d o f write downs i n 1989 . I n bot h years , los s provision s o n oversea s loan s more tha n accounte d fo r th e tota l negativ e incom e recorded ; domes tic busines s wa s profitabl e (Duc a an d McLaughli n 1990 , 483) . I n 1989 throug h 1991 , Ne w Englan d bank s too k larg e losse s o n rea l estate loans . Depresse d rea l estat e market s ar e pushin g th e valu e o f much o f th e collatera l hel d b y bank s belo w th e valu e o f th e loan s

Why I s th e U.S . Bankin g Industr y i n Trouble ? 1

3

carried o n man y banks ' book s (Barth , Brumbaugh , an d Lita n 1990 , 47), s o tha t mor e loa n default s ar e expected . Ban k inventorie s o f foreclosed rea l estat e wer e stil l accumulatin g a s o f mid-199 1 (FDI C 1991, 2) . The Cause s o f Loa n Losse s Ar e Cyclical , Secular , an d Regulator y How ca n w e explai n th e profil e show n b y figure 1.1 , a n extraordi nary growt h i n th e annua l numbe r o f ban k failure s afte r 1981 ? Commercial ban k profitabilit y ha s trende d downwar d sinc e 197 0 (FRBNY 1986) , a tren d tha t ha s continue d i n recen t year s an d i s consistent wit h bankin g firms exitin g fro m th e market . Bu t the grad ual secula r tren d i n ban k profitabilit y canno t plausibl y explai n th e dramatic shif t i n th e tren d o f bank failures , o r why i t occurre d whe n it did . Th e onse t o f a shar p recessio n i n th e secon d hal f o f 198 1 undoubtedly helpe d swel l th e numbe r o f failure s i n 198 2 an d 1983 . But w e clearl y canno t explai n th e patter n solel y b y referenc e t o th e business cycle . Th e numbe r o f failure s wa s muc h les s i n previou s recessions, an d failure s continue d t o clim b eve n afte r th e 1982-8 3 recession gav e wa y t o a period o f sustaine d expansion . Cyclical Factors A recessio n swell s th e numbe r o f ban k failure s fo r obviou s asset quality reasons . Wit h unemploymen t up , mor e househol d loan s g o bad. A s recessio n too k hol d i n 1990 , delinquenc y rate s i n home improvement loan s an d revolvin g credi t reache d thei r highes t level s in te n year s (Farrel l 1991 , 29) . Mor e importantly , wit h corporat e bankruptcies, busines s loan s g o bad . I n th e 1982-8 3 recession , en ergy an d agricultura l busines s loan s especiall y wen t int o default . I n the mos t recen t downswing , commercia l propert y loan s hav e bee n the mos t conspicuou s sourc e o f losse s an d wer e the principa l reaso n that th e Ban k o f Ne w Englan d failed . It woul d b e myopic , however , t o trea t th e recessionar y phas e o f the cycl e a s th e ultimat e sourc e o r th e exogenou s caus e o f asset quality problems . Th e loan s tha t g o ba d wer e typicall y mad e year s earlier durin g th e expansion . Hundred s o f bank s ha d asset-qualit y problems wel l befor e th e 1990-9 1 recessio n officiall y began , an d bad asset s brough t o n th e 1988-8 9 wav e o f Texa s ban k failure s i n advance o f th e nationa l recession . Viewin g th e upsurg e i n loa n losses e x post , w e se e a "cluste r o f error " i n ban k lending : overex -

14 Lawrenc e H . Whit e pansion i n certai n loa n categorie s (LD C loans, commercia l rea l es tate, HL T loans) , o r overoptimis m regardin g thei r repaymen t pros pects.8 At the end o f 1990:3 , real estate assets (rea l estate loans plu s mortgage-backed securitie s plu s foreclose d properties ) comprise d 30.6% o f tota l commercia l ban k assets , up fro m onl y 18.8 % at en d of 198 4 (FDI C 1990 , 1-2) . Overbuildin g i n commercia l rea l estat e was eviden t fro m offic e vacanc y rates , whic h approache d 20 % i n many citie s (Mande l 1991 , 30) . Analyst s a t th e Federa l Reserv e Board (Duc a and McLaughlin 1990 , 487) noted that "concerns abou t the qualit y o f rea l estat e loan s appea r stronges t i n area s i n whic h land price s had risen sharply in previous years." This pattern—that recessio n is the sharpest wher e the expansio n had previousl y bee n mos t vigorous—i s consisten t wit h "monetar y malinvestment" theorie s o f th e busines s cycle , a clas s o f theorie s that includes the work of the Austrian school in the 1920s and 1930 s and tha t o f Rober t E . Lucas , Jr., i n th e 1970 s an d 1980s . A s Luca s (1981, 9 ) ha s commented , thi s wor k insist s o n "the'necessit y o f viewing [recurren t busines s cycles ] a s mistakes. " Th e theoretica l problem i s the n "t o rationaliz e thes e mistake s a s intelligen t re sponses t o movement s i n nomina l 'signals ' o f movement s i n th e underlying 'real ' variables we care about and want to react to." That is, a monetar y malivestmen t theor y trace s th e clustere d busines s failures an d unemploymen t o f the recession phas e to decisions (ret rospectively inappropriate ) mad e b y labo r an d capita l owner s dur ing th e expansio n phase , an d appeal s t o monetar y disturbance s t o explain why these decisions appeared sensibl e at the time they were made. Rational-expectations wor k i n monetar y busines s cycl e theor y emphasizes tha t unanticipated monetar y expansio n generate s unex pectedly hig h nomina l deman d fo r outputs . Th e Austria n theorist s emphasized tha t ne w money , injecte d int o the loanabl e fund s mar ket, reduces real interest rates in the short run. Both effects mislead ingly signa l businesse s tha t thei r rea l profitabilit y ha s increased , and s o spu r th e unsustainabl e rea l expansio n tha t constitute s th e boom period. Real interest rates (measured by the annualized nomi nal interest rate on three-month T-bill s minus the contemporaneou s annual inflatio n rate ) in the United State s fell durin g the 1970s , and were actuall y negativ e fro m 197 4 throug h 198 0 (Koh n 1991 , 729). Merely holding inventories appeare d t o be profitable. Wit h disinfla tion after 1980 , real interest rates rose sharply, and nominal deman d no longer outran expectations .

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Figure 1. 2 Growth o f Capital, Assets, and Rati o Federally Insure d Commercia l Bank s

Richard Salsma n (1990 , 25-28 ) ha s offere d th e interestin g hy pothesis tha t U.S . bank s ma y hav e bee n directl y (a s wel l a s indi rectly, vi a th e busines s cycle ) weakene d b y expansionar y monetar y policy. Th e Fe d rapidl y expande d th e monetar y base , leadin g i n textbook fashio n t o th e multipl e expansio n o f ban k deposit s an d loans. Meanwhile , Salsma n argues , bank s wer e no t abl e t o rais e o r internally generat e enoug h capita l t o keep pace , so that thei r capital / asset ratio s fell . Thi s argumen t implie s tha t movement s i n th e bank ing industry' s capital/asse t rati o shoul d b e predominantl y associ ated wit h movement s i n th e denominato r (assets) , with th e numera tor (capital ) remainin g relativel y stable . At least in the 1980s , however , industry aggregate s d o no t sho w thi s pattern . Figur e 1. 2 plot s year to-year compoun d growt h rate s (difference s i n natura l lo g levels) fo r capital, assets , an d th e capital-asse t ratio . I t show s tha t capita l growt h has bee n a t leas t a s volatile a s asse t growth . Regional Factors Various region s o f th e Unite d State s hav e take n turn s bein g wors t hit wit h ban k asset-qualit y problem s durin g recen t quarters , bu t al l

16 Lawrenc e H . White except th e Midwes t an d Centra l region s hav e bee n seriousl y hit . Southwestern banks ' portfolio s hav e no t ye t recovere d fro m prob lems tha t cam e t o a hea d i n 198 8 an d 1989 . A t midyea r 199 1 th e "troubled rea l estate asset rate" as measured b y the FDIC ("noncur rent rea l restat e loan s plu s othe r rea l estat e owne d a s a percen t o f total rea l estat e loan s plu s OREO" ) stil l exceede d 10 % in Arizona , Texas, Oklahoma , an d Louisian a an d exceede d 8 % in Ne w Mexic o and Colorado. Northeastern banks have had the biggest recent problems with real-estate loans. Troubled real estate asset rates exceede d 10% in Rhode Island, Massachusetts, Connecticut, New Hampshire, New Jersey, Ne w York , an d th e Distric t o f Columbi a an d exceede d 8% in Maryland an d Virginia. No other state in the nation had a rate exceeding 8% , an d onl y fou r (Maine , Vermont , Pennsylvania , an d Florida) ha d rate s exceedin g 6% . Nationally , 11.2 % o f bank s los t money in the first half o f 1991, but 25.7% in FDIC's Northeast region did so . Th e biggest increase s i n loa n los s provision s wer e take n during tha t perio d b y banks i n th e Northeas t an d i n th e West. Th e largest increas e i n noncurren t loan s wa s recorde d b y bank s i n th e West, where 19.2 % of banks lost money. Secularly Shrinkin g Profitability For the aggregate of federally insure d commercia l banks, the ratio of net incom e t o asset s ha s decline d fro m 0.6 8 fo r 1980-8 5 (th e aver age of annual figures) to 0.53 for 1986-90: 2 (Barth , Brumbaugh, an d Litan 1990 , 121). 9 A t th e lowe r tai l o f th e earning s distribution , where ne t incom e ca n b e negative , cumulativ e losse s ca n deplet e capital an d caus e insolvency . Som e 35 4 banks have reported losse s every year from 198 6 to 1989 (Fromson 1990 , 119). Much ha s bee n writte n i n recen t year s abou t th e erosio n o f th e profitability o f commercial banking under the impact of competitio n from nonban k intermediarie s an d fro m securitie s markets . Securiti zation i s estimate d t o have reduced th e sprea d o n residential mort gages b y fifty to on e hundre d basi s point s (Barth , Brumbaugh , an d Litan 1990 , 116 , citin g Rosentha l an d Ocamp o 1988) . Increasin g numbers o f corporations , especiall y thos e wit h bette r bon d rating s than th e money-cente r banks , find i t cheape r t o issu e commercia l paper t o investor s directl y tha n t o borrow fro m bank s a t traditiona l spreads. Wit h deposi t interes t rat e ceiling s bein g lifte d afte r 1980 , there ha s als o bee n greate r pric e competitio n fo r deposit s amon g banks and between banks and thrifts .

Why Is the U.S . Banking Industr y i n Trouble ? 1

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In ligh t o f thi s w e shoul d not e th e apparentl y contradictor y vie w that observe d spread s betwee n deposi t an d loa n interes t rate s hav e not shrunk . A Federa l Reserv e Ban k o f Ne w Yor k staf f stud y o f Becent Trend s i n Commercial Bank Profitability (1986,16 ) declare d that "despit e al l th e structura l change s relatin g t o interes t rate s an d interest rat e competitio n o f recen t years , ther e ha s bee n n o visibl e impact o n th e ne t interes t margin s o f th e banks.' ' I t i s tru e that , abstracting fro m loa n los s provisions , industry-wid e ne t incom e ha s been stabl e a s a shar e o f asset s (Duc a an d McLaughli n 1990 , 477) . Net interes t incom e actuall y show s a sligh t upwar d tren d ove r th e 1980s, from 3.03 % of asset s i n bot h 198 0 an d 1981 , to 3.40 % i n bot h 1989 an d th e first hal f o f 199 0 (Barth , Brumbaugh , an d Lita n 1990 , 121). This onl y means , however , tha t i n a n accountin g sens e i t i s loa n loss provisions , an d no t declinin g spread s a s the y ar e measure d e x ante, that accoun t fo r th e declin e i n retur n o n assets . Increasing loa n loss provision s (typicall y a belate d respons e t o increasin g defaul t rates) revea l e x pos t tha t spread s actuall y hav e decline d fo r loan s o f a give n ris k class . Loa n los s rate s hav e bee n risin g mor e o r les s steadily sinc e 196 2 (Barth , Brumbaugh , an d Lita n 1990 , 117 , 119) . Lower-quality loan s hav e bee n booke d a t e x ant e spread s tha t use d to be reserved fo r higher-qualit y loans . Barth, Brumbaugh , an d Lita n (1990, 117 ) argu e tha t th e movemen t o f blue-chi p borrower s t o th e commercial pape r market , makin g bank s unabl e t o plac e loan s o f the traditiona l sort , help s explai n wh y bank s hav e take n o n th e additional ris k tha t i s eviden t fro m risin g loa n losses . Th e los s o f traditional borrower s doe s explai n wh y commercia l an d industria l (C&I) loan s fel l fro m 2 1 % o f ban k asset s dow n t o 19 % ove r th e course o f the 1980s , to be replaced b y loan s wit h highe r defaul t risk . But i t doe s no t explai n wh y banks , a s Barth , Brumbaugh , an d Lita n (1990, 128 ) elsewher e document , chos e t o tak e o n mor e port/oli o risk ove r th e cours e o f th e 1980 s b y reducin g th e shar e o f cas h an d investment securitie s i n thei r portfolios , o r wh y the y increase d th e share o f rea l estat e loan s b y mor e percentag e point s tha n th e shar e of C& I loan s declined . I t doe s no t explai n wh y "withi n th e rea l estate loa n category , bank s shifte d towar d th e riskies t borrowers, " namely constructio n an d developmen t loan s an d commercia l mort gages. Most importantly , th e shrinkag e o f margin s o n traditiona l loan s does no t b y itsel f explai n wh y bank s hav e underprice d loan s to thei r new borrowers . Tha t is , i t doe s no t explai n wh y the y collecte d e x

18 Lawrenc e H . White ante spread s to o small t o preserve incom e net o f loa n losse s excep t in those unlikely states of the world (whic h did not obtain) in which the new loan portfolios ha d no higher a default rat e than the old. To explain thi s mistak e w e nee d eithe r t o explai n wh y bank s woul d have failed t o perceive that defaul t rate s were likely to be higher, or we nee d t o explai n wh y the y becam e mor e willin g t o take o n port folio risk . The Roles of Regulation and Deposit Insurance The root s o f th e thrif t industr y crisi s i n regulatio n an d deposi t insurance ar e no w wel l understoo d (Kan e 1985 , 1989 ; Brumbaug h 1988; Benston an d Kaufma n 1986) . A number o f long-standing lega l restrictions, particularl y restriction s agains t product-lin e diversifi cation, made (an d stil l make) thrifts weake r an d mor e vulnerable t o adverse shock s tha n the y woul d otherwis e be . Suc h restriction s alone canno t explai n wh y failure s explode d i n th e 1980s , for the y did no t suddenl y becom e mor e binding . Bu t the y hel p t o explai n why the advers e cyclica l an d secula r factor s discusse d abov e brought down as many thrifts a s they did . In the mos t genera l terms , the surg e o f thrift failure s i n 1981-8 2 can be attribute d t o interest-rate risk. 10 B y funding long-ter m fixedrate mortgages wit h short-ter m deposits , thrifts wer e implicitl y bet ting heavil y agains t a larg e ris e i n interes t rates . They los t th e bet . The averag e explici t interes t cos t o f saving s deposit s i n FSLIC insured institution s ros e from 6.6 % in 197 8 to 11.2 % in 198 2 (Kan e 1989, 12-13 , tabl e 1-2) . Althoug h interes t rate s o n ne w mortgage s also rose , the thrifts ' asset s consiste d largel y o f conventiona l fixedrate mortgage loans made in the 1960 s and 70s , paying between 6% and 9% . Borrowin g a t 11 % to fun d ol d mortgage s payin g 6 to 9% , hundreds o f thrift s soo n foun d thei r equit y consume d b y negativ e income flows . The thrift crisi s continued (o r a second thrift crisi s arose), despite the fall i n interes t rate s after 1982 , because the regulators' failure t o close literally hundreds o f insolvent thrifts create d a n army of institutional "zombies,' ' economicall y dea d bu t no t ye t buried , tha t ra tionally gamble d fo r "resurrection. " I n general terms, unclosed thrift s substituted credi t ris k fo r interest-rat e risk . Long-odd s gamblin g i n the form o f high-risk lendin g offere d th e owner s o f insolvent thrift s their bes t hop e o f gettin g bac k int o th e black , makin g thei r share s worth somethin g again . The downsid e risk fell entirel y o n the FSLIC:

Why Is the U.S . Banking Industr y i n Trouble ? 1 9 the owner s o f thrift s wit h zer o ne t wort h ha d literall y nothin g t o lose. Cole , McKenzie , an d Whit e (1990 ) provid e econometri c evi dence tha t thrif t failure s i n th e lat e 1980 s wer e swelle d b y risk taking strategies begun earlier in the decade, strategies motivated by low ne t wort h an d forbearance . Faile d thrift s ha d riskie r portfolio s than nonfailed thrifts , namely, higher concentrations o f nonresiden tial mortgages , land loans , and rea l estat e investments. "Mora l haz ard" behavio r i s indicate d b y th e lowe r failur e probabilitie s fo r institutions whos e ownershi p structure s gav e their managers les s to gain from ris k taking: mutual institutions compare d to stock institu tions, publicl y trade d stoc k institution s compare d t o closel y hel d stock institutions . Failur e probabilitie s wer e highe r fo r bank s wit h higher managerial expenses . Competition fro m zombi e thrifts , wh o bi d deposi t rate s u p an d loan rate s down , mad e surviva l mor e difficul t fo r still-solven t thrifts . By 1986 the average explicit earnings spread o n new mortgage loans was smalle r tha n i t ha d bee n sinc e 1972 , an d th e sprea d ne t o f average thrif t operatin g expense s ha d reache d a historic lo w (Kan e 1989, 12-13 , tabl e 1-2) . Th e result wa s a mushrooming numbe r of economically insolven t institution s (Kan e 1989 , 26 , table 2-1 ) an d an accumulatio n o f re d in k tha t finally exceede d th e FSLIC' s re sources by hundreds o f billions of dollars. Because commercia l bank s wer e carryin g les s o f a mismatch be tween th e repricin g frequencie s o f thei r asset s an d liabilitie s tha n were thrifts , th e bank s wer e les s victimize d b y th e run-u p i n th e level o f interes t rate s i n 1979-82 . Bu t bank s wit h larg e maturit y mismatches (borrowin g shor t t o len d long ) di d suffe r larg e losse s because o f frequentl y inverte d yiel d curve s (shor t rate s abov e lon g rates) durin g th e perio d (FRBN Y 1986 , 117-21) . Th e yiel d curv e returned t o its normal slop e in 1983 . The number o f problem bank s grew steadil y u p t o 1986 , however, wit h the rising failure rat e amon g commercial an d industria l busines s an d increasin g loa n losses. The secular trend toward declinin g spreads continued t o exert itself. The increasin g numbe r o f bank s approachin g th e brin k o f insol vency ha s meant , a s i t mean t i n th e cas e o f thrift s wh o reache d o r crossed th e brin k a fe w year s earlier , a n increase d attractio n t o financial"gambling." Bookin g high-risk loan s without premi a suffi cient t o cove r probabl e default s i s a way t o maximiz e th e expecte d value o f th e ban k t o it s owners , give n tha t th e owner s ca n pas s losses in excess of equity on to the FDIC. Deposit insurance, in other words, ha s create d i n commercia l bankin g th e sam e tw o "mora l

20 Lawrenc e H . White hazard" problem s tha t hav e bee n muc h discusse d i n connectio n with th e secon d wav e o f th e thrif t industr y crisis . 1. Insured depositor s (d e jur e o r d e facto ) d o no t disciplin e wea k institutions b y demandin g highe r deposi t rate s o r b y movin g fund s to stronge r institutions . Riskie r bank s ca n essentiall y sel l a lower quality produc t a t th e sam e pric e becaus e customer s ar e full y cov ered agains t produc t failure . Withou t risk-sensitiv e insuranc e pre miums a s a substitut e fo r deposito r discipline , deposi t insuranc e subsidizes ris k taking . A bank' s expecte d retur n o n asset s ca n b e increased b y takin g o n a riskier (higher-variance ) loa n portfolio , bu t its cos t o f fund s doe s no t ris e eve n thoug h th e ban k i s more likel y t o fail. Maximizin g expecte d ne t payof f therefor e pushe s th e ban k t o a riskier positio n o n th e risk-retur n frontie r tha n woul d b e take n b y a bank whos e uninsure d depositor s demande d compensatio n fo r a n increased ris k o f defaul t o n thei r claims , o r by a bank whos e insure r priced it s premium s t o reflec t insolvenc y risk . Bank s hav e accord ingly chose n lowe r capital/asse t ratio s a s deposi t guarantee s hav e grown i n scop e an d i n implici t value . 2. I n combinatio n wit h forbearance , deposi t guarantee s enabl e and encourag e insolven t bank s t o gambl e fo r resurrectio n fro m eco nomic insolvency . A n insolven t institutio n ca n bi d fo r fund s wit h little ris k premiu m t o tr y t o gro w bac k int o th e black . It s owner s have everythin g t o gai n and , wit h FDI C absorbin g th e downsid e risk, nothin g t o lose. With enoug h forbearanc e the y ca n eve n operat e a Ponz i scheme , usin g ne w deposit s t o pa y th e interes t o n ol d deposits (Kaufma n 1988 , 574). The U.S . syste m o f deposi t guarantee s thu s serve s a s a back ground conditio n explainin g banks ' risk-preferenc e behavior : i t en courages bank s clos e t o insolvenc y t o tak e o n greate r risks . Thi s "moral hazard " proble m likel y intensifie d i n th e 1980 s becaus e th e effective coverag e o f deposi t guarantee s wa s extended , an d becaus e the guarantee s wer e increasingl y mispriced . Th e Depositor y Institu tions Deregulatio n an d Monetar y Contro l Ac t o f 198 0 raised explici t deposit coverag e t o $100,00 0 pe r account , fro m $40,000 . Thi s mad e it cheape r fo r depositor s t o ge t ful l coverag e fo r larg e amount s b y spreading fund s amon g banks , wit h o r withou t th e hel p o f a broker , and correspondingl y mad e i t easie r fo r risk-pron e bank s t o acquir e funds (Kaufma n 1988 , 574). Perhaps mor e importantly , th e FDI C extende d d e facto ful l cov erage t o al l liabilit y holder s o f larg e banks . Th e FDI C increasingl y resolved ban k failure s b y "purchas e an d assumption, " arrangin g

Why Is the U.S . Banking Industr y i n Trouble ? 2 1 takeovers tha t full y protecte d uninsure d liabilit y holder s fro m loss , as in th e Franklin Nationa l Ban k case in 1974 . There stil l remaine d the threat that uninsure d depositor s migh t take losses i f a bank ha d to be liquidated becaus e i t was in such bad shape that no purchase r could b e found . Th e FDI C remove d eve n tha t threa t i n th e 198 4 Continental Illinois case, when the FDIC itself effectivel y purchase d (nationalized) th e insolven t ban k (O'Driscol l 1988 , 666). The FDI C enunciated th e so-calle d to o big to fail doctrine , under whic h eve n uninsured liabilit y holder s woul d b e protecte d fro m an y loss . Consistent wit h th e extensio n o f d e fact o guarantees , Shor t an d Robin son (1990 , 14-15 ) not e tha t whil e high-ris k bank s normall y ha d t o pay a premium rate to attract large uninsured CD s in the mid-1970s, studies o f more recent dat a do not consistently sho w risk premia o n CDs or subordinated debt . Finally, because banks' exposure to interest-rate ris k increase d wit h th e increase d volatilit y o f interes t rate s in the 1980s , but their deposi t insurance premiums di d not, the risk subsidy implici t i n FDI C guarantee s increase d (Bensto n an d Kauf man 1986 , 62). Evidence o f increase d ban k gamblin g ca n be found i n the chang ing compositio n o f bank portfolios . Cas h an d investmen t securitie s declined t o onl y 27 % o f asset s i n 199 0 fro m 36 % i n 1980 . Loan s rose to 61 % of asset s fro m 54% , real estat e loan s t o 23 % from 15% . Within rea l estate , a s note d above , bank s shifte d towar d riskie r borrowers, namel y constructio n an d developmen t loan s an d com mercial mortgage s (Barth , Brumbaugh , an d Lita n 1990 , 128). In 1989 , bank rea l estat e loan s exceede d C& I loan s fo r th e first tim e eve r (Fromson 1990 , 120) . Further evidenc e o f increase d ban k gamblin g can be see n i n the risin g cos t o f resolving faile d institutions : 20.3% of deposit s i n 198 9 failures , doubl e th e 10.2 % figure for 198 5 fail ures (Barth , Brumbaugh, an d Lita n 1990 , 29, table 4). Higher resolu tion cost s mea n eithe r tha t authoritie s wer e slowe r t o clos e bank s after thei r economi c ne t wort h crosse d int o th e negativ e region , o r that th e banks ' ne t wort h fel l mor e rapidly . Increase d relianc e o n high-risk "double-or-nothing " lendin g strategie s ca n hav e bot h ef fects. It can increase the discrepancy between the economic value of assets and their value according to regulatory accounting principles, so that authoritie s ar e slowe r t o recognize negativ e ne t worth . An d it ca n mak e asse t value s fal l mor e rapidly becaus e return s o n high risk assets are more sensitive to changes in the state of the world . Just as competition fro m zombi e thrifts impaire d th e profitabilit y of solven t thrifts , competitio n fro m zombi e bank s ha s weakene d

22 Lawrenc

e H . White

solvent banks . Thes e spillove r effect s ar e ironic , becaus e th e osten sible purpos e o f deposi t insuranc e wa s t o preven t spillove r effect s (namely th e sprea d o f runs ) fro m unsoun d t o soun d banks . Shor t and Robinso n (1990 , 7-8 ) find tha t insolven t (bu t stil l open ) Texa s banks bi d u p th e deposi t rate s pai d b y othe r Texa s banks , an d ma y have increase d th e numbe r an d siz e o f insolvencies . The y als o poin t out tha t th e FDI C polic y o f resolvin g institution s wit h assistance , absorbing ba d asset s t o kee p the m open , put s unassiste d institution s (who hav e t o swallo w thei r ow n ba d assets ) a t a competitiv e disad vantage. Conversely , other s hav e note d tha t th e shrinkag e o f th e thrift industry , i n par t du e t o RT C closures , ha s helpe d strengthe n commercial bank s b y givin g the m retai l deposit s tha t ar e o n averag e a cheape r sourc e o f fund s tha n brokere d deposit s (Duc a an d Mc Laughlin 1990 , 488). Policy Implication s A banke r quote d anonymousl y i n th e Ne w Yor k Fe d stud y Recen t Trends i n Commercia l Ban k Probabilit y (FRBN Y 1986 , 43 ) ex plained clearl y th e incentiv e o f a n unprofitabl e ban k t o gambl e fo r recovery: One banke r sai d tha t traditiona l corporat e bankin g face d tw o alternatives , both o f which ar e "routes to going out of business." One is just to say "no" to underprice d risk y deals . Th e othe r i s t o tak e th e risks , th e alternativ e most organization s ar e drive n t o by the nee d t o occupy a n existin g staf f o f loans officer s an d supportin g personnel . Thi s latte r alternative , h e said , simply results in going out of business "mor e dramatically," especially in a disinflationary perio d whe n th e inflatio n tha t temporaril y hi d th e risk s i s no longer there to mask them. Our curren t deposi t guarante e syste m allow s a bank t o take the risk s without a correspondingl y greate r cos t o f funds , despit e th e in creased likelihoo d tha t i t wil l exi t th e busines s "dramatically. " W e have see n al l to o man y dramati c exit s i n recen t years . Taxpayer s have discovere d tha t the y ar e the financial "angels " obliged t o cove r the cost s o f wha t threaten s t o be a very expensiv e show . A minima l goa l fo r bankin g polic y woul d b e t o giv e banker s th e proper incentiv e t o choos e th e les s dramati c rout e t o goin g ou t o f business. A bank shoul d b e le d t o retire gracefull y a s it s profitabilit y declines, rathe r tha n t o ru n u p a bil l fo r othe r banks , o r taxpayers , in th e cours e o f fighting th e inevitable . I f marke t force s dictat e tha t

Why Is the U.S . Banking Industr y i n Trouble ? 2 3 the bankin g industr y a s a whol e i s t o shrink , le t i t no t consum e others' wealth i n the process. Let it shrink quietl y and promptly , s o that financial resource s ca n b e reallocate d wit h minimu m wast e t o what promise to be more valuable uses. The absenc e o f incentives t o gamble for resurrectio n ca n be see n in historica l bankin g system s wit h unlimite d liabilit y fo r ban k shareholders. In such systems unprofitable bank s would voluntaril y wind u p thei r affair s withou t waitin g fo r insolvency . Ban k owner s had n o incentiv e t o pursue double-or-nothin g strategie s eve n a s th e bank's ne t wort h becam e negative , becaus e furthe r losse s i n ne t worth continue d t o fall entirel y o n the shareholders , rathe r than o n depositors o r o n a deposi t guarante e agency . I t ma y b e tha t unlim ited shareholder liability , or even extended liability , is not generally the optima l risk-sharin g arrangemen t betwee n shareholder s an d de positors. Tha t i s a questio n financial market s ca n resolv e i n th e absence o f subsidie s an d lega l restrictions . I t i s no t obviou s tha t extended liabilit y i s incompatibl e wit h tradabl e shares , thoug h fo r obvious reason s shareholder s whos e ow n exposur e depend s o n th e wealth o f their coshareholders migh t want shares to carry covenant s regarding ownership qualifications. 11 In the absence of government deposi t guarantees, a caveat emptor policy prevails . Wit h entr y fre e int o bot h limited-liabilit y an d ex tended-liability banking, depositors who choose limited-liability banks are choosing freely t o expose themselves to default risk , in exchang e for whateve r comparativ e benefit s limited-liabilit y bank s ca n offe r them. Th e usua l objection s t o suc h a polic y ar e (1 ) that depositor s would attemp t t o free-rid e o n on e another' s effort s t o monito r th e bank, s o tha t to o littl e monitorin g woul d tak e place ; an d (2 ) tha t depositors would ru n o n suspect banks, setting off contagiou s banking panics. The first objection i s not really specific t o banking. Quality-assur ance problem s o f thi s sor t ar e generall y handle d b y certificatio n agencies. In banking, a private clearinghouse associatio n ha s histor ically been the agency acting to certify th e solvency and liquidit y of its membe r banks , primaril y becaus e eac h membe r ban k (wh o ac cepts the liabilities o f its fellow member s daily) has a strong interes t in receiving such qualit y assurances (Timberlak e 1984 ; White 1992 , ch. 2). The secon d objectio n i s undercut b y the historica l evidenc e tha t a run o n a suspect ban k i s not generall y contagious . In the absenc e of legal restrictions that weaken banks in similar ways, bank failure s

24 Lawrenc e H . White do no t occu r i n droves , an d s o depositor s d o no t rationall y infe r from on e bank' s difficultie s tha t al l other s ar e abou t t o default . N o contagions ar e recorde d i n Canadia n o r Scottis h bankin g history , where bank s wer e fre e t o branch nationwid e an d t o capitaliz e ade quately. Eve n i n th e Unite d State s ther e i s littl e evidenc e (outsid e the exceptiona l year s o f 1929-33 ) o f runs spreadin g generall y fro m insolvent t o solven t banks (Kaufma n 1988 , 566-71; Schwart z 1988 , 591-93). Depositors fleeing suspec t bank s generall y redeposi t thei r fund s in sound banks. Such movements were occurring in the early 1930s, and one suspects that the private interest of weak banks in opposin g such a "fligh t int o quality " explain s wh y smal l bank s enthusiasti cally supporte d th e formatio n o f the FDIC , while man y larg e bank s opposed it . I f so , th e sam e sor t o f interes t toda y woul d oppos e "coinsurance" proposal s (limitin g deposi t guarantee s to , say , 90 % of deposits) . Wea k bank s ( a categor y tha t toda y include s man y o f the larges t bank s a s wel l a s th e smalles t U.S . banks) ma y fea r tha t coinsurance migh t delive r o n it s advocates ' claims : i t migh t reim pose market discipline . Proposals t o limi t deposi t guarantee s t o "narro w banks " (Lita n 1987) ar e a step towar d th e goa l o f a n undistorte d financial syste m provided that banks are free to issue explicitly and credibly unguar anteed account s o n whateve r term s informe d customer s find agree able. A number o f options ar e open to banks to make their account s run-resistant o r eve n run-proof . Deposi t contract s coul d contai n notice-of-withdrawal clauses . Checking accounts coul d be linked t o money-market mutua l funds, equit y rather than deb t claims. Capital adequacy assurances , o r even extende d shareholde r liability , coul d be offered. Som e sort of private deposit insurance might be feasible. Assuring tha t th e bes t sort s o f financial contract s wi n ou t o n a level playin g field requires eliminatin g the discriminator y practice s in the curren t operatio n o f the clearin g and settlemen t syste m (e.g. , the exclusion of money-market funds fro m direc t use of the Fed wire, and th e unprice d guarante e o f interban k payment s mad e b y wire) . Ideally the payments system would be entirely privatized . The cas e fo r governmen t deposi t guarantee s i n a deregulate d environment i s not persuasive . Any government deposi t guarantee s that remai n i n this environmen t mus t a t a minimum b e self-financ ing. I f th e guarante e syste m canno t cove r it s costs , i t i s har d t o defend it s efficiency . I f the deposit s o f banks (howeve r narrow ) ar e provided wit h government guarantees at rates subsidized by general

Why I s th e U.S . Banking Industr y i n Trouble ? 2

5

taxation, ther e ar e inadequat e incentive s fo r saver s t o see k efficien t alternative intermediar y form s (suc h a s mutua l funds) . I n th e con text o f proposal s currentl y o n th e table , thi s mean s tha t i f makin g the Ban k Insuranc e Fun d self-financin g b y raising FDI C assessment s on bank s make s th e bankin g industr y shrin k tha t muc h faster , s o

be it.

Notes 1. Bil l Atkinso n an d Rober t M . Garsson , "Ban k Fun d Los s Pu t a t $ 3 Billion," America n Banke r (2 8 Septembe r 1990) : 2 ; Catherin e Yang , 'The FDI C Keep s Diggin g a Deepe r Hole, " Business Week (1 5 Jul y 1991): 123. The net loss projections fo r 1991-9 2 ar e derived following the FDIC's method a s reported by Barbara A. Rehm, "Capital Issue: What Price the BIF Recap? " America n Banke r ( 4 April 1991) , using th e FDIC' s mid 1991 ban k failur e prediction s reporte d b y Pete r Stone , 'Th e Balanc e Sheet on Banking Reform," Atlanta Journal-Constitution (2 2 September 1991): HI. Th e FDI C predicted tha t 1991-9 2 woul d se e th e failur e o f 340-400 bank s wit h $140-20 0 billio n i n assets . Abou t 15 % of thos e assets ar e expecte d t o b e unrecoverable , an d hal f t o sel l fo r 15-20 % below book , implyin g gros s losse s o f $31. 5 t o $5 0 billion . Premiu m income, at the rate of 23 cents per $100 of insured deposits , is projecte d at $12.4 billion. Projected ne t losses are therefore $19. 1 to $37.6 billion. 2. Atkinso n and Garsson, op. cit.; Yang, op. cit. 3. Barbar a A. Rehm, "FDIC Is Said to Forecast $4 Billion Deficit by 1993, " American Banke r (2 5 Januar y 1991) : 1 ; Idem , "FDI C Defici t Wil l B e Manageable, Congressional Budge t Offic e Says, " American Banke r (3 0 January 1991) : 13; Idem, "Banker s to Discuss FDIC Fund Plan : Liquidity, Equit y Pool , Earl y Interventio n Ar e Goals, " America n Banke r ( 7 February 1991) : 2; Stephen Labaton , "U.S . Seeks Much Bigger Amount to Shor e U p Ban k Deposi t Fund, " New York Times (2 2 Marc h 1991) : Al. 4. Bil l Atkinson, "Seidman's Views on Fund: Pessimistic or Even Worse," American Banker (28 June 1991): 2; Stone, op. cit. 5. Bret t Duva l Fromson , "Wil l th e FDI C Run Ou t o f Money?" Fortune ( 8 October 1990): 119-26; "Deposit Insurance: Required, but Not Desired," Economist (2 2 December 1990) : 95; "Veribanc Stud y Finds FDIC Insolvent," Journal of Accountancy (Jul y 1991): 28-29; Yang, op. cit. 6. "Deposi t Insurance," op. cit.: 94. 7. Barth , Brumbaugh, and Litan (1990 , 34-40) compute d "implie d marke t capital whe n th e [pu t option ] valu e o f deposi t insuranc e i s strippe d away" for sixty-three of the nation's largest banks. They found th e Bank

26 L a w r e n c

e H . Whit e

of Ne w Englan d insolven t (a s o f Jun e 1990 ) b y thi s criterion . Thre e other bank s wer e o n th e edg e (insolven t whe n th e optio n valu e estimat e is higher du e t o greater assume d forbearance , barel y solven t otherwise) : Midlantic (NJ) , Southeas t Bankin g Corp . (Miami) , an d Valle y Nationa l (Phoenix). Ban k regulator s hav e force d Midlanti c t o sto p payin g ou t dividends, an d i n January 199 1 its chairma n announce d hi s resignatio n (American Banker , 2 5 January 1991,1-2) . 8. Th e phras e i n quotatio n mark s i s du e t o Rothbard (1972) . 9. I t i s appropriat e t o averag e annua l figures, rathe r tha n lookin g onl y a t the en d years , becaus e th e reporte d ne t incom e varie s greatl y yea r t o year dependin g o n whe n bank s choos e t o mak e loa n los s provisions . Reported ne t incom e wa s wa y dow n i n 198 7 becaus e th e larg e bank s chose e n mass e t o make provision s i n tha t yea r fo r losse s o n LD C loans. 10. I n th e thre e year s 1980-8 2 th e FSLI C resolve d a tota l o f 36 1 insolven cies. I n th e previou s five year s the y ha d resolve d onl y forty-on e (Kan e 1989, 26 , table 2 - 1 ; compare Brumbaug h 1988,11 , tabl e 1-2 , wher e th e 1980-82 tota l i s 368 . 11. Perhap s suc h covenant s ar e al l Woodwar d (1988 , 689 ) ha s i n min d when sh e write s tha t "publicl y trade d share s an d extende d liabilit y ar e not compatible " (emphasi s added) . Sh e i s quit e righ t t o argu e agains t legally precludin g limite d liabilit y fo r bankin g firms, whic h I a m no t suggesting. No r a m I motivated, a s ar e those sh e criticizes , by the desir e to protec t a government deposi t guarante e agency .

References Barth, Jame s R. ; Brumbaugh , R . Dan , Jr. ; an d Litan , Rober t E . The Bankin g Industry i n Turmoil : A Repor t o n the Conditio n of the U.S. Bankin g Industry an d the Bank Insuranc e Fund . Washington : U.S . Governmen t Printing Office , 1990 . Benston, Georg e J., and Kaufman , Georg e G. "Risks an d Failure s i n Banking : Overview, History , an d Evaluation. " I n Georg e G . Kaufman an d Roge r C . Kormendi, eds. , Deregulatin g Financial Services : Public Policy in Flux. Cambridge: Ballinger, 1986 . Brumbaugh, R . Dan , Jr . Thrifts under Seige: Restorin g Orde r to America n Banking. Cambridge : Ballinger , 1988 . Byron, Christopher . ' T h e Bad-New s Banks. " New York ( 8 Octobe r 1990) : 16-21. Cole, Rebe l A. ; McKenzie , Josep h A. ; an d White , Lawrenc e J . "Th e Cause s and Cost s o f Thrif t Institutio n Failures : A Structure-Behavior-Outcome s Approach." Federa l Reserv e Ban k o f Dalla s workin g pape r (Decembe r 1990). Duca, Joh n V. , an d McLaughlin , Mar y M . "Development s Affectin g th e

Why Is the U.S. Banking Industry

in

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Profitability o f Commercial Banks. " Federal Reserv e Bulletin (Jul y 1990) : 477-99. Eisenbeis, Rober t A . "Restructurin g Banking. " Challeng e (January-Februar y 1990): 1 8 - 2 1 . England, Catherine . "Judgin g th e 199 1 Reform Effort : D o U.S . Banks Hav e a Future?" Cat o Institute Policy Analysis (1 2 March 1991) . Farrell, Christopher . "Wil l Bank s Dra g th e Econom y Down ? Yes : W e Ma y Be i n fo r a 'Containe d Depression. ' " Business Week (2 1 January 1991) : 28-29. FDIC Quarterly Banking Profile (Thir d Quarter 1990) . . (Secon d Quarte r 1991) . Federal Reserv e Ban k o f Ne w York . Recen t Trend s i n Commercial Bank Profitability: A Staff Study. Ne w York : Federa l Reserv e Ban k o f Ne w York, 1986 . Fromson, Bret t Duval . "Wil l th e FDI C Ru n Ou t o f Money? " Fortun e ( 8 October 1990) : 119-26 . Kane, Edwar d J . The Gatherin g Crisis in Federal Deposit Insurance . Cam bridge: MIT Press, 1985 . . The S&L Insurance Mess: How Did It Happen? Washington , DC : Urban Institut e Press , 1989 . Kaufman, Georg e G . "Ban k Runs : Causes, Benefits , an d Costs. " Cato Journal 7 (Winte r 1988) : 559-87 . Kohn, Meir . Money , Banking, and Financial Markets. Chicago : Dryden , 1991. Litan, Rober t E . What Should Banks Do? Washington , DC : Brookings Insti tution, 1987 . Lucas, Rober t E. , Jr . Studies in Business Cycle Theory. Cambridge : MI T Press, 1981. Mandel, Michae l J . "Will Bank s Dra g the Econom y Down ? No : Banks Aren' t as Critica l t o th e Econom y Now. " Business Week (2 1 January 1991) : 2 9 30. O'Driscoll, Geral d P. , Jr. "Deposi t Insuranc e i n Theor y an d Practice. " Cato Journal 7 (Winter 1988) : 661-75. Rosenthal, Jame s A. , an d Ocampo , Jua n M . Securitizatio n of Credit: Inside the New Technology of Finance. Ne w York : Wiley, 1988 . Rothbard, Murra y N . America's Grea t Depression. Lo s Angeles: Nash, 1972 . Salsman, Richard . Breakin g the Banks: Central Banking Problems and Fre e Banking Solutions. Grea t Barrington , MA : America n Institut e fo r Eco nomic Research , 1990 . Schwartz, Ann a J . "Ban k Run s an d Deposi t Insuranc e Reform. " Cato Journal 7 (Winter 1988) : 589-94 . Short, Geni e D. , and Robinson , Kennet h J. "Deposit Insuranc e Refor m i n th e Post-FIRREA Environment : Lesson s fro m th e Texa s Deposi t Market. " Federal Reserv e Ban k o f Dalla s workin g pape r (Decembe r 1990) .

28 Lawrenc

e H . White

Timberlake, Richard H . "The Centra l Bankin g Role of Clearinghouse Associations." Journal of Money, Credit, and Banking 1 6 (February 1984) : 1 15. White, Lawrence H. The Theory of Monetary Institutions. Book manuscript in progress, 1992. Woodward, Susan . " A Transactio n Cos t Analysi s o f Bankin g Activit y an d Deposit Insurance." Cato Journal 7 (Winter 1988): 683-99.

2 Public-Sector Deficit s an d Private-Sector Performanc e Roger W. Garriso n

I. Introductio n The detrimenta l effect s o f public-secto r deficit s o n private-secto r performance ca n b e establishe d withou t referenc e t o determinat e and empiricall y demonstrabl e effect s o f budgetar y deficit s o n inter est rates , inflatio n rates , o r exchang e rates . Th e argument s i n thi s chapter, i n fact , depen d upo n th e absenc e o f reliabl e prediction s concerning suc h specifi c effects . Th e certaint y tha t deficit s mus t somehow b e accommodated , couple d wit h th e uncertaint y abou t just ho w the y wil l b e accommodated , ca n resul t i n a significan t degradation o f economi c performanc e i n th e privat e sector . Th e word "performance " i s use d her e an d throughou t th e chapte r i n place o f th e mor e narrowl y conceive d "efficiency. " Th e inten t i s t o focus attentio n o n th e economy' s performanc e a s affecte d b y th e quality an d compatibilit y o f entrepreneuria l decision s rathe r tha n on som e comparative-stati c allocationa l efficienc y a s migh t b e brough t about b y entrepreneur s wh o fac e n o uncertainty . Unforeseeabl e changes i n th e metho d o f accommodatin g th e federa l deficit , whic h can accoun t fo r extensiv e discoordinatio n amon g privat e borrowers , can, i n turn , hel p t o accoun t fo r th e declinin g rat e o f retur n (mea sured ne t o f loan-los s provisions ) o n th e loa n portfolio s o f commer cial banks . If al l deficit-induce d uncertaintie s ar e assume d away—includin g 29

30 Roger

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the uncertainties abou t how and when taxes will be raised to service and retir e th e resultin g debt—the n taxin g an d borrowin g ca n b e thought o f a s economicall y equivalen t method s o f publi c finance. Under condition s o f certainty , th e issu e o f how governmen t i s financed i s a trivia l on e i n compariso n t o th e issu e o f ho w muc h government i s financed. Th e actual uncertaintie s inheren t i n defici t finance, however , distinguis h borrowin g fro m taxin g an d establis h strict limit s t o th e applicatio n o f th e Ricardia n Equivalenc e Theo rem.1 Argument s detailin g thes e uncertaintie s tur n o n th e distinc tion betwee n a well-know n ta x code , o n whic h privat e borrower s and othe r marke t participant s ca n bas e thei r planning , an d som e unspecified an d ever-changeabl e mean s o f defici t accommodation , against which there may be no effective hedge . Heavy relianc e b y th e governmen t o n credi t markets , then , ca n impose a burden o n the private sector and especially on the banking industry far in excess of the alternative burden associated with taxes collected i n accordanc e wit h a well-know n ta x code . Th e cas e fo r taxes ove r deficit s a s a mean s o f minimizin g th e advers e effect s o f fiscal policy parallels in large measure the case for rules over discretion a s a means o f minimizin g th e advers e effect s o f monetar y pol icy. Accordingly, for a given level of government spending, a budget in balanc e o r i n near-balanc e i s strongl y preferabl e t o on e dramati cally out of balance. Establishing the basis for an d the nature o f this borrowing/taxing nonequivalenc e i s th e purpos e o f th e presen t chapter. Section 2 employ s conventiona l macroeconomi c accountin g t o identify th e possibl e effect s o f a budgetar y imbalance . Sectio n 3 considers th e relevan t polic y choice s an d identifie s th e rang e o f consequences associate d wit h eac h choice . The macroeconomic ac counting allows for a n interpretation, i n section 4, of recent empiri cal literatur e o n th e effect s o f budgetar y deficits . Sectio n 5 cata logues th e proximat e consequence s o f th e deficit-induce d uncertainties, which deriv e from th e unique features o f federal gov ernment debt . A n historica l perspectiv e i s provide d i n sectio n 6 to justify th e focu s o n deficit-induce d uncertainties . Sectio n 7 identifies th e ultimat e consequence s o f defici t spendin g i n term s o f th e economy's standar d o f living , an d sectio n 8 conclude s wit h som e implications for policy .

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II. A Macroeconomic Accountin g o f Federal Budge t Deficit s Consider the federal budge t deficit i n its relationship to both domestic an d foreig n component s o f th e privat e sector . Conventiona l in come-expenditure analysi s allow s th e interconnectednes s amon g the thre e sector s representin g government , domesti c investment , and foreig n trad e t o b e expresse d a s a simpl e summatio n o f differ ences whose net value is zero: Eq. 1: (G - T ) + ( I - S ) + ( X - M ) = 0 where G = governmen t expenditure s T = ta x revenues I = investmen t spendin g S = privat e and corporat e savin g X = revenue s from export s M = expenditure s o n import s This equatio n acknowledge s on e particula r constrain t tha t charac terizes a n econom y i n macroeconomi c equilibrium. 2 Clearly , Equa tion 1 i s satisfie d whe n G = T , I = S , an d X = M . Tha t is , th e sectoral accounts of the macroeconomy are in balance when govern ment finances it s programs wit h tax revenues, domestic investmen t is funde d b y privat e an d corporat e saving , an d revenue s fro m ex ports match expenditures o n imports. A balancing o f th e macroeconom y achieve d throug h a balancin g of eac h secto r is , of course , only a special case . In the genera l case , the macroeconomy is characterized by a balancing of sectoral imbalances. That is , while none o f the three separat e terms in Equation 1 has a value o f zero, the algebraic su m o f the terms is constrained b y the interconnectednes s o f th e thre e sector s t o be zero . And s o lon g as the governmen t secto r i s not chronicall y an d dramaticall y ou t of balance, the individual imbalance s are no cause for concern . A brief consideratio n o f the relationship betwee n th e investmen t sector ( I - S ) an d th e foreign-trad e secto r ( X - M ) suggest s tha t balance i n al l thre e sector s individuall y i s no t t o b e hel d u p a s a n ideal. A foreig n trad e defici t tha t allow s domesti c investmen t t o outpace domesti c savin g may be attributable t o favorable economi c and politica l condition s i n th e hom e country . Capita l ma y be flowing i n fro m abroa d t o tak e advantag e o f a relativel y productiv e economic environment and to be protected by a relatively stable and unthreatening politica l regime . Sectora l imbalance s roote d i n suc h

32 Roge r W. Garrison circumstances, a s actuall y existe d i n thi s countr y throughou t mos t of th e las t century , ar e a n integra l par t o f th e marke t proces s an d serve to enhance rather than degrad e the economy's performance . Sectoral imbalances that reflect a chronic and dramatic imbalanc e in the public sector, however, are a different matter . Deficit-induce d uncertainties embedde d i n th e offsettin g imbalance s i n th e invest ment an d foreign-trad e sector s ca n inhibi t marke t processe s an d degrade economi c performance . Thes e uncertaintie s an d resultin g inhibitions, in fact, ar e central to the argument for a balance or nearbalance i n th e federa l budget . An d whil e i t i s recognize d tha t th e offsetting imbalance s i n th e investmen t an d foreign-trad e sector s attributable to a budgetary defici t shoul d be measured relative to the imbalances tha t woul d exis t i n these two sector s i f the federal bud get were i n balance , the argument s t o follow assum e for th e conve nience of exposition that excep t for the consequences o f the budgetary imbalance, the other two sectors would be individually in balance. Currently, the federal governmen t i s dramatically outspendin g it s tax revenues. This budgetary imbalance implies, in accordance wit h Equation 1 , some combination o f offsetting imbalance s in the investment an d foreign-trad e sectors . Domesti c savin g ma y b e diverte d away fro m privat e credi t market s an d int o th e federa l treasury ; revenues received b y our trading partners may be lent to the federa l government rather than spent on exportable goods. The former effec t constitutes a crowding out of domestic investment; the latter constitutes a foreign-trade deficit . For a n arithmeti c example , a yea r i n whic h th e federa l budge t deficit ( G - T ) is $200 billion mus t als o be characterized b y imbalances in the other two sectors that su m to a negative $200 billion. If the foreign-trad e defici t ( M - X ) is , say , $16 0 billion , the n th e investment secto r mus t b e experiencin g a crowdin g ou t ( S — I ) i n the amount o f $40 billion. Equation 1 can be rearranged a s Equation la an d read using this conventional macroeconomi c terminology : Eq. 1(a): (G - T ) = ( S - I ) + ( M - X ) The federal budge t defici t = crowdin g ou t + th e foreign-trade deficit . The sectora l imbalance s i n th e for m o f crowdin g ou t an d th e foreign trad e defici t represen t th e proximat e consequence s o f th e budgetary imbalance . The ultimate consequenc e (t o be discussed i n section 7 ) is a lower standard o f living as measured by forced reduc -

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tions i n consume r spending . Further , i t wil l b e argue d tha t th e inherent uncertainties that characterize the proximate consequence s of a budgetar y imbalance , whic h manifes t themselve s a s greate r riskiness in the private sector and a lower rate of return (ne t of loanloss provisions ) i n th e bankin g industry , ad d substantiall y t o th e severity of the ultimate consequences . The polic y perspectiv e t o follo w i n sectio n 3 is derive d directl y from th e income-expenditur e equatio n an d macroeconomi c ac counting identities . N o particula r behaviora l equation s describin g the behavio r o f marke t participant s ar e postulated , an d henc e n o particular structura l relationship s tha t migh t giv e determinac y t o the macroeconomic magnitude s represented i n Equations 1 and 1(a ) are implied . Th e lea p fro m macroeconomi c accountin g t o polic y perspective i s intended , i n fact , t o highligh t th e structura l indeter minacies an d uncertaintie s tha t ar e implie d b y a chroni c an d dra matic budgetary imbalance. 3 III. Deficits fro m a Policy Perspectiv e Policy choic e has a direct effec t o n the left-hand sid e of Equation 1 ; it influence s th e right-han d sid e a s th e marke t respond s t o curren t policy action s an d t o anticipation s o f futur e polic y actions . I f cur rent polic y choice s hav e th e government' s outla y o f fund s runnin g dramatically ahea d o f it s intak e o f funds , the n ther e ar e furthe r choices t o b e made . Th e ac t o f borrowing , b y it s ver y nature , re quires some subsequent actio n by the fiscal—and possibl y the monetary—authorities.4 Fo r a give n leve l o f governmen t spending , th e actual men u o f polic y choic e i n th e fac e o f a budgetar y defici t consists of a short list of easily identifiable options . 1. Th e fiscal authorit y ca n continu e t o borro w i n domesti c an d foreign credi t markets. 2. Th e monetar y authorit y ca n monetiz e th e deficits , replacin g pri vately saved money with publicly printed money . 3. Th e legislature can increase the level of taxation. Historically, piecemea l fiscal an d monetar y polic y i s mor e accu rately described i n terms of a buffet rathe r than a menu: The government typically opts for some combination o f these menu items . The relationshi p betwee n polic y (bot h fiscal an d monetary ) an d its short-ru n consequence s (fo r th e investmen t an d foreign-trad e sectors o f th e economy ) i s wholl y determinat e i n aggregat e term s

34 Roge r W. Garrison but hopelessl y indeterminat e i n sectora l terms . That is , private credi t markets, bot h domesti c an d foreign , an d th e monetar y authority — in som e combination—accommodat e th e budge t deficit , whic h i s offset—again, i n som e combination—b y crowdin g ou t an d th e for eign-trade deficit. Bu t the relationships between the individual com ponents o f th e polic y mi x an d th e effect s i n th e individua l sector s are no t s o easil y stipulated . No r i s ther e an y reaso n t o believe tha t these relationships, whatever they currently are, hold ove r time and particularly from on e political regime to the next. Further, th e polic y mi x itsel f i s largel y unpredictable . W e ca n note—after th e fact—somethin g abou t th e genera l fiscal strateg y characterizing particula r periods . During the Carte r administration , for instance, debt was monetized; during the Reagan administration , debt was sold abroad. But we cannot say that federal budge t deficit s are accommodated b y the monetary authorit y i n some systematic o r predictable way . And w e canno t sa y what portio n o f the borrowin g not facilitate d b y mone y creatio n wil l dra w fund s fro m foreig n a s opposed t o domesti c sources . Th e particula r polic y mi x an d th e resulting mi x of consequence s depen d criticall y upo n uniqu e polit ical factors an d upon divers e and changin g beliefs abou t the curren t policy regime and expectations abou t subsequent regimes . IV. Empirical Studie s an d Their Collective Significanc e The empirica l literatur e o n th e effect s o f the federa l budge t deficit s is replet e wit h correlation s an d so-calle d causalit y test s tha t focu s on a single component o f the policy mix or on a single secto r o f th e economy. Does deficit spendin g lea d to an increase i n the monetar y base? Are domestic interest rates affected b y government borrowing? Do ou r tradin g partner s suppl y th e credi t demande d b y th e U.S . Treasury? I s there an y evidenc e o f crowdin g out ? Fo r eac h specifi c question asked , empirica l evidenc e o f any suc h systemati c relation ship is almost uniformly wea k and mixed. 5 The implication o f any one empirical study is commonly taken to be that worr y abou t th e defici t i s misplaced ; th e implicatio n o f th e studies considere d collectivel y i s taken to be that the worries—an d certainly the hysteria—about th e budgetary defici t ar e largely if no t wholly baseless. This reading of the empirical literatur e i s exemplified in Paul Craig Roberts's explanation o f "Why the Deficit Hysteri a Is Unjustified" (1987) . The macroeconomic accountin g of the defici t and its consequences argue against downplaying the deficit proble m

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on th e basi s o f wea k an d mixe d empirica l findings. I n a mor e en lightened—though les s comforting—interpretatio n o f thos e sam e empirical studies , the absence o f any such stron g correlations i s the very basis for worry about persistently larg e deficits . The nature o f the proble m fro m th e perspectiv e o f a typical busi ness firm can be illustrated i n terms of a simple shell game. Imagine that thre e shells , on e o f whic h conceal s a pea , hav e bee n shuffle d about by a seasoned gamester. Some player is then enticed to choose a shell . I f th e pe a i s unde r th e chose n shell , th e playe r suffer s a substantial loss . The pea will not appear in predictable fashion fro m under any given shell. The absence of such predictability, o f course, does not imply that there is no reason to worry about the pea. Quit e to th e contrary , th e uncertaint y abou t wher e th e pe a is , wher e i t might appea r next , an d ho w t o avoi d i t i s th e cru x o f th e matter . Whatever th e potentia l reward s fo r playin g this shel l gam e may be, the mor e substantia l th e losse s associate d wit h th e pea' s appear ance, the greater is the reluctance to play the game. When the federal government's deficit is in the twelve-digit range, private busines s firms ar e face d wit h highl y uncertai n marke t con ditions. Each firm must choos e a market strategy , an d an y firm that chooses the wron g strateg y wil l suffe r losse s accordingly. A firm in the busines s o f cuttin g an d exportin g timber , fo r example , ma y choose to maintain o r even increas e it s capacity i n anticipation o f a reduced willingnes s o n th e par t o f ou r tradin g partner s t o buy U.S. government deb t an d henc e o f generall y strengthene d expor t mar kets. If this anticipation fail s to become a reality, the firm will suffe r a substantia l loss . A n industria l developer , fo r anothe r example , who assume s tha t foreigner s wil l continu e t o buy U.S . governmen t debt, ma y undertak e long-ter m project s countin g o n continue d credi t at o r nea r curren t rate s o f interest . Th e assumption , though , ma y turn out to be wrong. The Treasury may have to begin competing fo r domestic savings, in which case interest rates rise and the develope r suffers a substantial loss . The economy , o f course , i s fa r mor e comple x tha n a shell game . In realit y eac h entrepreneu r (o r proprieto r o r corporat e planner ) must cop e wit h wha t migh t b e calle d multitie r uncertainty . First , there i s the uncertainty tha t characterize s an y decentralize d marke t economy. The absence of "perfect knowledge " and of "known probability distributions " pertaining to product demand , resourc e avail abilities, an d technologica l possibilitie s i s wha t make s th e real world marke t proces s differen t fro m textboo k exercises . Each entre-

36 Roge r W. Garrison preneur mus t ac t o n th e basi s o f hi s o r he r judgmen t abou t thes e things a s wel l a s hi s o r he r judgmen t abou t th e likel y action s o f other entrepreneurs . Second, ther e i s th e uncertaint y tha t i s associate d wit h eac h choice availabl e t o th e fiscal an d monetar y authoritie s fo r accom modating th e budgetar y deficit . (1 ) Continue d recours e t o privat e credit market s requires that privat e planning agents guess about th e government's particula r sourc e o f loanabl e funds . I f ou r tradin g partners continu e t o suppl y thos e funds , the n expor t market s wil l be weak ; i f ther e i s a n increase d reluctanc e o n th e par t o f foreig n savers o r o f foreig n centra l bank s t o exten d credi t t o the U.S . Treasury, then domestic interest rates will be high. (2) Debt monetization means a general pric e inflatio n durin g whic h ther e ar e transitiona l disturbances t o rea l interes t rate s an d exchang e rate s a s wel l a s increased uncertaintie s abou t th e significanc e o f an y individua l pric e change. Burdenin g th e norma l marke t proces s wit h th e additiona l task o f adjustin g t o a growin g mone y suppl y mean s tha t pric e sig nals involv e ambiguities . I n general , nominal interes t rate s an d ex change rate s a s wel l a s produc t an d facto r price s becom e les s reli able guides to entrepreneurial action . (3 ) A credible commitment b y the fiscal authorit y t o reduc e o r eliminat e th e defici t b y increasin g taxes leave s privat e plannin g agent s t o gues s abou t th e particular s of th e ne w ta x code . Possibilitie s includ e incom e taxes , corporate profit taxes , value-adde d taxes , sale s taxes , an d sumptuar y taxes . Each type o f tax has it s ow n effec t o n the plan s o f private plannin g agents.6 Third, th e uncertaintie s associate d wit h eac h polic y choic e ar e compounded b y the uncertainty abou t which choic e or which com bination o f choice s wil l actuall y b e made . Tha t is , ther e i s uncer tainty abou t th e natur e o f th e uncertaint y tha t wil l characteriz e market condition s durin g the planning period. Will there be contin ued relianc e o n credi t markets ? Wil l ther e b e deb t monetization ? Will there be new taxes? It is often take n for grante d i n the writing s of moder n politica l economist s tha t publi c deb t get s inflate d away . Arguably, i f this particula r solutio n t o the curren t proble m o f fiscal imbalance were a certainty, the high level of indebtedness would be less hauntin g tha n i t actuall y is . Statistica l studie s showin g tha t debt i s not always monetize d (o r that domesti c interes t rates d o not always ris e when th e treasury's deman d fo r credi t increases , or that the foreign-trad e defici t doe s not always mov e in lockste p wit h th e federal budge t deficit ) d o no t lesse n ou r concer n abou t governmen t

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borrowing; the y simpl y reinforc e th e notio n tha t th e uncertaint y about the particular s o f defici t accommodatio n i s the essence of th e problem. A fourth tie r of uncertainty derives from the general interconnect edness o f markets . Uncertaintie s tha t ar e inheren t i n th e marke t process consis t i n part—a s mentione d above—o f entrepreneuria l judgments abou t th e action s o f othe r entrepreneurs . I n a n er a o f deficit finance, thes e judgments ar e more difficult t o make. For each entrepreneur, then , uncertaintie s alread y identifie d ar e exacerbate d by uncertainties abou t ho w othe r entrepreneur s wil l attemp t to hedge or exploit this fiscal imbalance i n making their own plans. The deficit-induce d multitie r uncertaintie s face d b y commercia l and industria l planner s translat e directl y int o problem s fo r th e banking industry . Th e banks * borrowers mus t mak e guesse s abou t future marke t conditions a s affected b y deficit accommodation . An d under plausibl e circumstances , i f the y gues s wrong , the y los e big . Managers o f the banks ' loa n portfolio s mus t mak e judgments abou t the abilitie s o f thei r borrower s t o anticipat e deficit-relate d change s in marke t condition s a s wel l a s judgment s abou t thei r mor e nar rowly conceive d creditworthiness . I f a ban k make s loan s o n th e basis of its own guess about the future cours e of deficit accommoda tion, then it subjects itself to dramatic losses, should the guess prove wrong; i f i t makes loan s o n the basi s o f a diversity o f guesses , the n it must accept the lower net rate of return implied by such hedging . V. Market Manifestations o f Deficit-Induced Uncertaintie s Uncertainty, b y it s ver y nature , i s difficul t t o assess . An d th e fac t that ther e i s inherent uncertaint y i n the market proces s compound s the proble m o f assessing th e (additional ) uncertaint y attributabl e t o budgetary deficits . Unde r condition s o f perfec t knowledg e an d per fect foresight , deficit-finance d program s i n th e amoun t o f $20 0 bil lion would impos e cost s o n societ y o f exactly $20 0 billion i n term s of foregone alternatives . This first approximation o f the socia l cost s is base d squarel y o n th e Ricardia n Equivalenc e Theore m an d as sumes that the burden o f the deb t is borne by individuals i n societ y in som e economicall y efficien t way . Th e actua l uncertaint y tha t surrounds th e defici t an d it s possibl e effec t o n marke t condition s obscures th e socia l costs , virtually assurin g that those costs , though less clearl y perceived , ar e actuall y greater . Th e severa l considera tions below suggest that added socia l costs in the form o f discoordi -

38 Roge r W. Garrison nation, economi c crises , risk externalities, and loan-market pervers ities are substantial . 1. Deficits discoordinate. A marke t syste m facilitate s th e coor dination o f plans amon g a multitude o f market participants. A full y coordinated se t o f plan s woul d requir e eac h marke t participan t t o have the sam e perceptio n o f the relevan t marke t conditions . Differ ences i n perceptio n lea d t o arbitrag e an d speculation , which , i n turn, reduc e suc h differences . A t the ver y least , difference s i n per ceptions base d o n difference s i n guesse s abou t ho w th e budge t deficit wil l be accommodated pu t a n additional burde n o n the mar ket process. A borrower who believes that the government will soo n begin t o monetiz e it s deb t i s borrowing a t a relatively lo w real rat e of interest (a s perceived by the borrower); a lender who believes that the governmen t wil l continu e t o sel l it s deb t abroa d i s receivin g a relatively high real rate (as perceived by the lender). Such differences i n perception ca n persist for a substantial perio d of time . Whil e disparat e plan s base d o n th e differen t perception s necessarily impl y disequilibrium an d discoordination , there may be nothing i n th e natur e o f the government' s fiscal proces s tha t elimi nates i n a timely manne r th e difference s i n perception . T o the con trary, with each period i n which a high budgetary defici t i s matched by a hig h foreign-trad e deficit , bot h perception s ar e likel y t o b e strengthened. Th e lende r perceive s tha t th e fiscal patter n h e o r sh e anticipated i s materializing; the borrower perceive s that the inevita ble deb t monetizatio n i s eve n close r a t hand . S o lon g a s ther e ar e differences i n the expectation s abou t how the government wil l dea l with it s fiscal imbalance i n future periods , the corresponding differ ences i n perceive d marke t condition s wil l result i n a greater degre e of discoordination amon g market participants than would otherwis e exist. 2. Deficits destabilize. Whol e industrie s ca n functio n fo r ex tended period s o f tim e withou t an y clea r manifestatio n o f the defi cit-induced discoordinatio n tha t ma y exis t withi n o r amon g them . Plans o f individua l firms ma y b e base d o n som e broadly—thoug h not deeply—held belie f abou t the future cours e of fiscal policy. But such underlying belief, precisely because it is characterized by breadth but no t depth , i s subjec t t o dramati c chang e a s a resul t o f undra matic events. Suppose tha t marke t condition s i n a particular industr y reflec t a belief tha t massiv e deb t monetizatio n accompanie d b y double-digi t inflation wil l characteriz e th e near-to-intermediat e future . A serie s

Public-Sector Deficits and Private-Secto r Performanc e 3

9

of individuall y undramati c action s take n b y th e Federa l Reserv e may eventuall y establis h th e ne w belie f tha t monetar y polic y i s going to remai n tigh t eve n i n th e fac e o f a loose fiscal policy . Thi s shift fro m on e market-ruling belief t o another ca n account for other wise unexplainable crises , such as the crisis in agriculture in recen t years. Individua l farmers , accommodate d b y th e bankin g industry , prepared t o benefi t fro m th e expecte d deb t monetizatio n b y incur ring heavy debts of their own and then faced heav y losses in capita l and lan d values when the Federal Reserve did not turn those expectations into reality. In simila r fashion , deficit-induce d uncertaint y ca n affec t capita l markets o n an economy-wid e basis. Market condition s o n Wall Stree t near th e pea k o f th e 1980s ' bul l market , fo r instance , reflecte d a belief tha t th e Reaga n administratio n woul d g o th e distanc e o n funds borrowe d abroad . Mounting U.S. indebtedness an d increase d reluctance o n th e par t o f ou r tradin g partner s t o len d stil l mor e funds t o th e U.S . Treasury eventuall y tippe d th e balanc e towar d a new belie f tha t th e Federa l Reserv e woul d b e force d t o loose n it s monetary polic y i n order to accommodate th e Treasury. But action s taken b y th e Federa l Reserv e signalin g continuin g monetar y disci pline shattere d thi s ne w belief , leavin g n o on e particula r belie f i n its place. Conflicting hint s abou t th e cours e o f fiscal an d monetar y polic y caused th e shiftin g fro m on e broadl y bu t no t deepl y hel d belie f t o another t o b e preempte d b y a disintegratio n o f al l suc h beliefs . Uncertainty i n a more salient form began to dominate the market for equity shares, and a scramble for liquidity resulted i n a sharp fall i n stock prices . Changin g marke t condition s a s a resul t o f deficit-in duced uncertaintie s i s a ver y plausibl e basi s fo r explainin g th e volatility o f the stoc k marke t durin g th e first three quarter s o f 198 7 and the unprecedented cras h in October of that year. John Maynar d Keyne s (1964 , 153-58 ) argue d tha t suc h stock market volatilit y i s inheren t i n th e natur e o f th e market . Dramati c and unpredictabl e change s i n busines s psycholog y tur n th e securi ties marke t int o " a gam e o f Snap , Ol d Maid , o r Musica l Chairs. " Interpreters o f Keyne s wh o focu s o n thes e aspect s o f hi s Genera l Theory compar e the pattern of asset prices to the pattern of cut glass in a kaleidoscope and dwell on the inherent unknowability of futur e patterns (Shackl e 1974) . It is possible to reject this Keynesian visio n as applie d t o a decentralize d marke t econom y pe r s e but t o accep t some version o f it in the contex t o f persistently larg e federal budge t

40 Roge r W. Garrison deficits. Ther e i s som e irony , i t migh t b e noted , i n th e ide a tha t deficit spending , whic h wa s recommended b y s o many o f Keynes' s followers, can cause asset markets to behave precisely in accordanc e with Keynes's vision of them. 3. Large deficits externalize risk. The risks associated with privat e debt ar e born e primaril y b y th e individual s wh o hol d th e corre sponding privat e securities ; the risks created b y public deb t are not borne primarily by the individuals who hold government securities . The risks, of course, are not simply shunted int o the ocean or otherwise eliminate d b y th e fiscal authority . Rather , th e federa l govern ment's power s t o ta x an d t o creat e mone y provid e securit y t o th e debt holde r b y shiftin g th e associate d risk s awa y fro m hi m o r he r and ont o th e citizenr y a s a whole . Th e likelihoo d o f th e government's defaultin g o n it s deb t i n th e conventiona l sens e i s nil , bu t the likelihoo d o f it s defaultin g i n som e other wa y is all but inevita ble. I t ma y partiall y defaul t b y inflatin g awa y th e rea l valu e o f outstanding debt . It may defaul t o n its promise no t to raise taxes. It may defaul t o n it s commitment s t o pay retirement o r other benefit s to governmen t employee s an d participant s i n socia l programs . Bu t default i n an y o f thes e form s doe s no t imping e directl y o r exclu sively on the holders of government debt ; it impinges instead o n the wealth holders i n general or on the taxpayers or on the beneficiarie s of governmen t retiremen t o r socia l programs . Th e economi c ineffi ciency i n th e for m o f suc h externalitie s mean s tha t eac h dolla r o f deficit spendin g has a social cost in excess of a dollar. 4. Large deficits facilitate larger deficits. Th e dynamics of increasing indebtedness that work to curb the excesses of private borrowers and eve n o f stat e an d municipa l borrower s wor k t o magnif y th e excesses o f th e federa l fiscal authority . Mos t borrower s experienc e an increased difficult y i n acquiring additional funds a s their level of indebtedness increases . Thi s increase d difficult y i s a simple reflec tion o f a n increase d likelihoo d o f default . Thus , a borrower alread y heavily i n deb t mus t pa y a substantia l default-ris k premiu m fo r additional loans. And this high cost of borrowing provides an incentive to reduce the level of indebtedness . The correspondin g loan-marke t dynamic s tha t appl y t o borrow ing by the U.S. Treasury are, at least with respect to domestic savers, precisely opposit e to those just mentioned. Thi s perversity i s attributable to the special sens e in which loans to the federal governmen t are ris k fre e an d t o th e effect s o f governmen t borrowin g o n th e riskiness o f loan s t o the privat e sector . Here , a distinction betwee n

Public-Sector Deficits and Private-Sector Performance 4

1

domestic an d foreig n buyer s o f U.S . deb t mus t b e maintained . A deficit-induced adjustmen t i n foreign-exchang e rate s ca n impos e costs mor e directl y o n foreig n lender s tha n o n domesti c lenders . I t is this directness, in fact, that explains why foreign lender s are more concerned abou t the U.S. budget defici t tha n ar e domestic buyers of those same Treasury bills. The federal government' s abilit y t o tax distinguishe s i t from bor rowers in the private sector; its ability to create money distinguishe s it fro m stat e an d municipa l borrowers . Give n thi s uniqu e statu s o f the federal government , defaul t i n the conventional sens e is institu tionally precluded . Ther e i s n o defaul t ris k i n th e judgmen t o f th e federal government' s creditors ; there i s n o default-ris k premiu m i n the discounting o f Treasury bills. But whil e larg e deficit s d o no t increas e th e likelihoo d tha t th e government wil l defaul t (again , i n the conventiona l sense) , they d o increase th e likelihoo d o f dramati c losse s an d possibl y defaul t i n the privat e secto r b y addin g substantially , a s spelle d ou t above , t o the uncertaint y i n th e marketplace . A s the risk o f sever e losse s an d of default gro w in the judgment of private creditors, corporate stock s and bonds—an d eve n municipa l bonds—becom e les s attractiv e i n comparison t o securitie s issue d b y th e federa l government . Per versely, domestic savers buy Treasury bills in order to protect themselves fro m th e uncertaintie s tha t ar e create d b y th e government' s issuing of so many Treasury bills. 7 When th e federa l governmen t i s engage d heavil y i n defici t finance, i t enjoys , i n effect , a negative ris k premiu m o n furthe r deb t issue. Tha t is , th e mor e overextende d th e U.S . Treasury becomes , the Jes s risk y it s deb t become s relativ e t o private-secto r debt . Th e relatively lo w an d fallin g cos t o f borrowing encourage s th e govern ment t o borro w stil l more . Th e U.S . Treasury behave s a s i f i t wer e facing a n increasingl y elasti c and—i n th e extreme— a negativel y sloped long-ru n suppl y o f loanable funds . VI. A Historical Perspectiv e The macroeconomi c accountin g perspectiv e o n budgetar y deficit s and the attention to deficit-induced uncertaint y in the private sector warn agains t any historical vie w that focuses to o narrowly o n inter est rates , inflation rates , or exchang e rates—o r to o broadly, say , o n this country' s gros s nationa l produc t o r o n tota l borrowin g o f th e Western world . Publi c borrower s confront , i n th e first instance ,

42 Roge r W. Garrison private savers; the relevant focus for historical analysis is the market for loanable funds. Ho w much is the government borrowing relativ e to th e tota l amoun t o f fund s availabl e fo r lending ? I f thi s rati o o f government borrowing to private and corporate saving were so small that th e U.S . Treasury i s just on e amon g many borrower s i n lin e a t the credi t window , the n ther e woul d b e n o deficit-induce d uncer tainty o f an y grea t consequence . Bu t s o lon g a s thi s rati o i s suffi ciently large, such that the Treasury must be considered a Big Player in th e credi t market , the n uncertaint y abou t ho w th e government' s demand fo r credi t wil l b e accommodate d ca n heavil y influenc e decisions in the private sector. 8 Although i t ma y see m obviou s tha t a historical treatmen t shoul d relate the government' s deman d fo r credi t to the market's suppl y of credit, attentio n t o th e deficit-to-savin g rati o i s relativel y uncom mon. More common i s a reporting o f the ratio of deficit spendin g t o total governmen t spendin g o r th e rati o o f defici t spendin g t o th e gross national product . While these ratios may be rhetorically effec tive, if the objective i s to make a twelve-digit defici t loo k small, they are relativel y wea k proxie s fo r th e burde n o n th e privat e secto r i n the form o f deficit-induced uncertainties . Another increasingl y commo n wa y o f puttin g th e budgetar y deficit int o historica l perspectiv e i s t o redefin e th e defici t a s th e change in the real value of outstanding debt . In this accounting, th e consequences o f conventionall y define d deficit s ar e offse t b y th e debt-eroding inflatio n tha t result s fro m actua l o r anticipate d deb t monetization. I f th e governmen t ha s a n outstandin g deb t i n th e thirteen-digit range , then double-digi t inflatio n ca n wholly negat e a twelve-digit, conventionall y define d deficit . Th e budge t ca n b e de clared to be in balance or even in surplus while the Treasury contin ues to make heavy demands o n credit markets. 9 The chang e i n th e rea l valu e o f outstandin g deb t ma y b e th e relevant magnitud e i n som e contexts . It is relevant, fo r instance , i n arguments tha t lin k deficit s t o change s i n perceive d ne t wealth , which, i n turn , ar e linke d t o spendin g propensities . Bu t i n th e context o f uncertaintie s attributabl e t o defici t finance, deb t erosio n is no t a n offsettin g factor . Rather , th e heav y demand s o n credi t markets an d the—actua l o r potential—deb t monetization , whic h fuels th e inflation tha t erode s the debt , are compounding, no t coun teracting, aspects of the deficit problem . The accompanyin g tabl e an d ba r char t sho w budget deficits , pri -

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Figure 2. 1

The Federa l Budge t surplu s o r deficit a s a percentag e o f private an d corporat e saving fo r 1940 through 199 0

vate an d corporat e saving , an d th e deficit-to-savin g rati o fo r th e years 194 0 throug h 1990 . Clearly , th e ratio s fo r th e mid-1970 s an d beyond ar e i n a categorically differen t rang e o f values i n compariso n to th e earlie r postwa r years . A correspondin g differenc e i n th e na ture o f the uncertaint y face d b y the privat e secto r i s a plausible basi s for a substantia l degradatio n o f economi c performance . Argument s made i n thi s chapte r tha t th e recen t budgetar y deficit s hav e bee n substantial enoug h t o increas e th e degre e o f discoordinatio n an d decrease th e stabilit y o f asse t market s ar e consisten t wit h th e quan titative record . The curren t leve l o f budgetar y deficit s ar e sometime s down played b y comparin g the m t o th e substantiall y large r deficit s asso ciated wit h Worl d Wa r II . Whethe r th e defici t i s expresse d a s a proportion o f gros s nationa l product , o f tota l governmen t spending , or eve n o f privat e an d corporat e saving , the ostensiv e compariso n o f deficits no w t o deficit s the n suggest s tha t th e problem s pose d b y th e

44 Roge

r W . Garriso n

Table 2. 1

Year Def-(Sur+ Federal Budget deficits (and surpluses) in comparison to corporate and private savings for the years 1940 through

1990

Economic Report of the President Washington D.C. February 1991, page 318.

1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 "I960 1961 1962 1963 1964 1965 1966 1967 1868 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

-1.3 -5.1 -33.1 -46.6 -54.5 -42.1 3.5 13.4 8.3 -2.6 9.2 6.5 -3.7 -7.1 -6.0 4.4 6.1 2.3 -10.3 -1 .1 3.0 -3.9 -4.2 .3 -3.3 .5 -1.8 -13.2 -6.0 -8.4 -12.4 -22.0 -16.8 -5.6 -1 1 .7 -69.4 -53.5 -46.0 -29.3 -16.1 -61.3 -63.8 -145.9 -176.0 -169.6 -196.9 -206.9 -158.2 -141 .7 -134.3 -161.3

) Savin g Deff/Sa 14.3 22.6 42.3 50.0 54.9 45.4 30.3 28.1 42.4 39.9 44.5 52.6 56.1 58.0 58.8 65.2 72.1 76.1 77.1 82.1 81.1 86.8 95.2 97.9 1 10.8 123.0 131 .6 143.8 145.7 148.9 164.5 190.6 203.4 244.0 254.3 303.6 3 2 1 .4 354.5 409.0 445.8 478.4 550.5 557.1 592.2 673.5 665.3 669.5 662.6 7 5 1 .3 779.3 783.9

-9.1 -22.6 -78.3 -93.2 -99.3 -92.7 1 1 .6 47.7 19.6 -6.5 20.7 12.4 -6.6 -12.2 -10.2 6.7 8.5 3.0 -13.4 -1.3 3.7 -4.5 -4.4 .3 -3.0 4.0 -1 .4 -9.8 -4.1 5.6 -7.5 -1 1.5 -8.2 -2.3 -4.6 -22.9 -16.6 -13.0 -7.1 -3.6 -12.8 -1 1.6 -26.2 -29.7 -25.9 -29.6 -30.9 -23.9 -18.9 -17.2 -20-6

v

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5

current budgetar y imbalanc e ar e mino r i n compariso n t o th e prob lems pose d b y wartim e deficits . Bu t th e consideration s outline d i n this chapte r sugges t otherwise . Th e proble m i s no t deficit s pe r se , but deficit-induce d uncertainties . B y the en d o f th e war , entrepre neurs coul d mak e their plan s o n the well-founde d expectatio n tha t the level of government spending would soo n be reduced to a peacetime level and hence that the budget defici t woul d no t figure importantly i n performanc e o f th e privat e sector . Thus , ther e wa s a hig h deficit throug h 1946 , but ther e wa s littl e o r n o deficit-induce d un certainty. B y contrast , th e well-founde d expectatio n i n th e curren t period tha t th e leve l o f government spendin g wil l remain hig h int o the foreseeabl e futur e cause s th e curren t hig h deficit s t o be crystal ized int o a clou d o f uncertainty . Th e argument s i n thi s chapte r apply to the 1980 s and the 1990 s but not to the 1940s. The focus o n deficit-induced uncertaintie s ca n also be reconcile d with th e ful l histor y o f thi s country' s experienc e wit h defici t finance. Summarizing dat a for the period 178 9 to present, Barth et al. (1991, 73 ) identif y th e episode s o f larg e federa l deficit s wit h th e Great Depression, recessions, wars, and th e 1980s . The inclusion of the 1980 s i n thi s shor t lis t ha s a certai n unsettling , i f no t jarrin g effect. Deficit s pla y special role s in hard time s an d durin g wartime ; well-founded prediction s tha t recession s an d war s wil l en d carr y with the m th e predictio n tha t deficit s wil l fall . Bu t throughou t th e last decade , even the certain knowledge abou t the timing of the en d of the 1980s provided no basis for predicting an end to large deficits . Uncertainty abou t credit-marke t condition s i n th e immediat e an d extended futur e continue s to have its impact in the private sector . Barth e t al. , revie w empirica l studie s o f th e effect s o f defici t finance an d acknowledg e tha t th e collectiv e evidenc e o f systemati c harmful effect s o n interes t rates , exchang e rates , an d th e inflatio n rate i s wea k an d mixed . An d the y not e th e continuin g theoretica l disagreements among economists on the issue of deficits. The implication they dra w for policy seems to follow fro m th e inability of the empirical evidenc e to resolve the theoretical stalemate : "Faced wit h uncertain outcomes , man y (polic y advisors ) woul d argu e tha t i t i s too risk y t o adop t a view tha t deficit s d o no t matte r when , i n fact , this vie w ma y b e incorrect " (130) . Bu t surely , th e relevan t uncer tainties her e ar e no t simpl y th e uncertaintie s o n th e par t o f polic y advisors about which view of the deficit i s correct. The relevant an d more fundamental uncertaintie s are those deficit-induced uncertain ties face d b y marke t participants . Accordingly , th e polic y implica -

46 Roge r W. Garrison tion migh t wel l b e amende d t o read a s follows: Face d wit h reason able certaint y tha t larg e deficit s induc e uncertaintie s i n th e privat e sector, policy advisors should argu e against them. VII. The Ultimate Consequences of Deficit Spendin g The standar d income-expenditur e framewor k adopte d i n Sectio n 2 obscures on e significan t imbalance . Equation s 1 an d 1(a ) describ e revenues an d expenditure s ne t o f thos e associate d wit h th e con sumer-goods sector. But the effects o f excessive government borrowing are not confine d t o domestic investmen t an d foreig n trade . Ultimately, the general level of consumption enjoye d b y present incom e earners wil l als o b e reduced . Th e usua l neglec t o f thi s effec t o n consumption derive s fro m th e short-ru n focu s o f Keynesia n macro economics an d th e vie w tha t consumptio n spendin g depend s strictl y on current income—an d no t on the interest rate or on other relativ e prices. To accoun t fo r a deficit-induce d chang e i n consumptio n spend ing, le t C 0 an d S 0 represen t th e level s o f consumptio n an d savin g that woul d hav e been realize d bu t fo r th e government' s fiscal poli cies. Th e summar y ter m ( S — I ) ca n the n b e divide d int o th e tw o terms ( S - S 0) and (S 0 - I) , indicating that the total discrepanc y i s attributable i n par t t o a decreas e i n investmen t an d i n par t t o a n increase i n saving . Replacin g th e ter m ( S - S 0) with it s equivalen t (C0 - C ) provide s a n explici t accountin g o f th e consumer-good s sector. This differenc e betwee n C 0 and C can b e conceptualize d i n tw o ways. Fo r one , th e concep t o f crowdin g ou t ca n b e extende d t o include th e consumer-good s sector . Governmen t borrowin g an d spending take s resource s ou t o f the privat e sector . Crowdin g ou t i n the investmen t secto r i s brought abou t b y highe r interes t rate s tha t reflect th e government' s increase d bid s fo r credit ; crowdin g ou t i n the consumer-good s secto r i s brough t abou t b y highe r price s tha t reflect th e government's increase d bids for resources. Alternatively (C 0 - C ) can be see n a s a form o f "force d saving. " The relativel y hig h interes t rat e an d consumer-good s prices—bot h reflections o f the government' s fiscal policies—caus e incom e earn ers t o sav e mor e tha n the y otherwis e would . Th e tw o conceptuali zations ar e substantivel y equivalent ; th e latte r i s adopte d her e fo r expositional convenience . Equation s 1 and 1(a ) ar e modifie d t o al low for forced saving :

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7

Eq. 2: (G - T ) + ( C - C 0) + ( I - S 0) + ( X - M ) = 0 Eq. 2(a): (G - T ) = (C 0 - C ) + (S 0 - I ) + ( M - X ) The federal budge t defici t = force d savin g + crowdin g ou t + th e foreign-trade deficit . The concept o f forced saving s puts the relationship between government borrowin g an d privat e savin g i n a new light . Som e econo mists (notabl y Barr o 197 4 an d 1989 ) hav e argue d tha t governmen t borrowing cause s individual s t o sav e mor e i n orde r t o mee t highe r tax obligations i n the future, an d that this effect lessen s our concer n about governmen t deficits . Whil e w e ca n sa y o n th e basi s o f bot h introspection an d casua l observatio n tha t increase d borrowin g i s not fully matche d b y increased privat e saving , the presen t formula tion suggest s th e increas e i n savin g attributable t o government bor rowing, th e force d saving , i s on e o f th e effect s t o b e concerne d about. Th e actua l savin g rate , spurre d b y defici t spending , reflect s policy choic e rathe r tha n underlyin g intertempora l preference s an d resource constraints . The relativ e strength s o f th e effect s o n consumptio n an d o n in vestment depen d i n a significan t wa y upo n th e lengt h o f th e tim e period to which the macroeconomic accounting equation is applied. For accountin g period s tha t ar e lon g i n compariso n t o productio n periods, reduced investmen t earl y i n a given perio d wil l hav e tim e to manifest itsel f a s reduced consumptio n late r i n the sam e period . The longer the run, then, the more fully defici t finance get s reflecte d in th e discrepanc y ter m pertainin g t o th e consumer-good s sector . This i s onl y t o sa y that neithe r individual s no r collection s o f the m can live indefinitely beyon d their means. Maintaining a higher stan dard o f living than can be sustained indefinitel y implie s accepting a correspondingly lowe r standar d o f living sometime i n the future. I n this perspective , th e othe r tw o term s i n Equatio n 1(a ) characteriz e the transitio n fro m on e standar d o f livin g t o another . Th e deficit induced uncertaintie s an d consequen t discoordinatio n associate d with th e transitio n terms , however, ca n onl y ad d t o th e magnitud e of the inevitable reduction i n the standard o f living. VIII. A Summary Perspectiv e Attention t o deficit-induce d uncertaintie s allow s fo r a brie f sum mary o f th e defici t proble m (1 ) a s i t relate s t o th e crisi s i n th e

48 Roge r W. Garrison banking industry, (2 ) in the context o f strategic as well as analytica l considerations, an d (3 ) a s i t compare s t o th e defici t proble m mor e conventionally conceived . 1. Althoug h th e primar y focu s o f thi s chapte r ha s bee n o n th e deficit proble m itself , th e persistentl y larg e deficit s o f th e las t sev eral years and the consequent uncertainties about market condition s have undoubtedly contribute d t o the crisi s i n the banking industry . I d o no t sugges t tha t th e defici t ha s playe d th e lea d rol e i n th e current bankin g crisis , but rathe r a n importan t supportin g rol e tha t has been largely neglected. Other chapters in this volume, as well as an earlier paper of mine (Garrison, Short, and O'Driscoll 1988) , have argued tha t th e perversitie s create d b y th e mispricin g o f deposi t insurance lie at the root of the banking crisis. Because of the deposit insurance subsidy , bank s ar e le d t o tak e o n mor e ris k tha n the y otherwise woul d and , i f their capita l base suffers sufficien t erosion , to pursue shoot-the-moon strategie s in their gamble for revival. As i t turn s out , then , th e defici t proble m an d th e deposi t insur ance problem ar e not unrelated. 10 Deficit-induce d uncertaintie s cre ate prim e opportunitie s fo r bank s t o pursu e shoot-the-moo n strate gies. For instance, if a bank heavily slants its loan portfolio toward s assets tha t appreciat e wit h an d ar e sensitiv e t o inflation , the n i t stands t o win big if the federa l governmen t shift s fro m a strategy of selling deb t abroa d t o a strategy o f deb t monetization . Bu t i f heav y lending o f thi s sort , suc h a s lendin g i n th e area s o f lan d develop ment an d commercia l rea l estate , is followed b y continued relianc e on foreign sale s o f Treasury deb t and continue d monetar y restraint , the consequence s fo r th e banks pursuin g thi s shoot-the-moo n strat egy wil l b e capita l depletio n an d bankruptcy . Th e mispricin g o f deposit insurance an d the imbalance in the federal budge t may well have contribute d bot h separatel y an d interactivel y t o th e curren t banking crisis. 2. The policy perspective in section 2 as well as the discussion i n other section s ha s take n th e current , historicall y hig h leve l o f gov ernment spendin g a s given . Thi s metho d o f argumen t i s no t in tended t o impl y a belie f tha t governmen t spendin g shoul d no t b e reduced. No r does it reflect som e judgment mad e by the author tha t a reductio n i s ou t o f th e question . I t reflects, instead , th e judgmen t that suc h a reductio n constitute s n o par t o f th e expectation s o f entrepreneurs an d henc e doe s no t figure significantl y i n th e uncer tainty attributable to the budgetary deficit . A balance or near-balance in the government budget is a symptom

Public-Sector Deficit s an d Private-Secto r Performance 4 9 —but no t th e essence—o f fiscal responsibility . A balanc e a t hig h levels o f spendin g an d taxin g ma y b e mor e detrimenta l t o th e pri vate secto r tha n a n imbalanc e a t lo w levels . Bu t th e cas e agains t raising taxes, based broadly o n a comparison o f allocative efficienc y of the public secto r with that o f the private sector , shoul d no t blin d us to the specia l problem s create d b y persistently larg e budget defi cits and the uncertainties that they entail . Nor shoul d thes e specia l problem s b e downplaye d becaus e o f political factor s tha t link taxing and spending . The argument i s that for a give n Jeve J of governmen t spending , taxin g i s preferabl e t o borrowing. I f politica l consideration s al l bu t insur e tha t increase d taxes wil l b e accompanie d b y increase d spendin g rathe r reduce d deficits, the n a higher leve l o f taxatio n woul d b e ineffective , i f no t counterproductive. A blend o f economi c an d politica l understand ing ca n provid e stron g suppor t fo r balancin g th e budge t throug h reductions i n government spending . 3. The character o f deficits a s seen by three loosely define d school s of thought ha s been identifie d b y Charles Schultz e (1989 ) as that of wolves, termites, and pussycats. Wolves threaten imminent disaster ; termites ea t away at the economy's capita l base; pussycats do—an d threaten t o do—nothing . Th e uncertaint y associate d wit h deficit s together with the political lin k between taxing and spendin g allow s for a n additio n t o th e Schultz e menagerie . Th e imager y belo w i s intended t o relate borrowing to its alternative o f taxing as evaluate d by entrepreneurs—or , mor e broadly , b y tax-payin g marke t partici pants. We can conceiv e o f the government's fiscal strateg y a s a cat-and mouse gam e i n whic h th e cat s ar e federa l fiscal agent s wh o ar e looking to fund thei r spendin g programs, and the mice are entrepreneurs o r othe r marke t participant s wh o ar e lookin g ou t fo r cats . To hunt for the needed funding , th e cats are organized int o two groups. Cats in the first group, which i s charged wit h collectin g taxes, wear bells around thei r necks; cats in the second group , which i s charged with accommodating the deficit, wea r no bells. The mice are fond of neither group , bu t a t leas t the y kno w wher e member s o f th e first group are , an d the y mak e thei r ow n plan s accordingly . An d eve n though th e secon d grou p i s smaller than the first, the threat o f har m as well as actual harm don e by the unbelled cat s is relatively large. The pussyca t vie w o f th e deficit , identifie d b y Schultze , i s tha t deficits ar e harmless , o r a t leas t n o mor e harmfu l tha n taxes : Cat s are cats , bell s o r n o bells . Th e alternativ e imager y offere d her e

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suggests otherwise . Cat s ar e a threat , al l th e mor e s o i f the y ar e no t wearing bells . Som e mic e migh t wel l conceiv e o f a schem e t o bel l the unbelle d cats , t o reduc e defici t spendin g b y raisin g taxes . Bu t belling cat s i s itself a risky business an d ultimatel y a counterproduc tive on e i f wit h eac h newl y belle d ca t anothe r unbelle d ca t i s re cruited t o loo k for stil l mor e funds . The cat-and-mous e analog y offere d i n th e spiri t o f Schultze , lik e the mor e seriou s argument s i n earlie r sections , maintain s a distinc tion betwee n analytica l an d strategi c issues—betwee n economic s and politics . Shadin g economi c analysi s wit h polic y predisposition s is likel y t o resul t i n bot h ba d analysi s an d ba d policy . Mor e point edly, effort s t o restor e fiscal responsibilit y i n th e publi c secto r shoul d be base d no t o n som e fals e hop e o r o n a politicall y motivate d argu ment tha t heav y governmen t borrowin g i s inconsequentia l bu t rathe r on th e fulles t understandin g o f th e effect s o f public-secto r deficit s on private-secto r performance .

Notes The autho r thank s Ji m Barth , Dan Gropper , Geral d O'Driscoll , Part h Shah , and Lelan d Yeage r fo r thei r helpfu l comment s an d thank s th e Mise s Insti tute o f Aubur n Universit y fo r it s financial suppor t i n connectio n wit h th e presentation o f a n earlie r versio n o f thi s chapte r a t th e 199 1 Southwes t Economic Association meetings in San Antonio. 1. Th e idea that imposing a one-time tax of, say , $100 is equivalent, give n an interes t rat e o f 10% , to sellin g a $10 0 perpetua l bon d tha t i s the n serviced b y a n annua l ta x o f $1 0 i s typicall y attribute d t o Ricardo . Although Ricardo's treatment o f tax and defici t financing clearl y recognizes th e forma l stock/flo w equivalenc e betwee n $10 0 no w an d $1 0 from now on, his discussion focused o n the ways that borrowing differ s from taxing . See O'Driscoll (1977) . 2. Equatio n 1 follows straightforwardl y fro m (1 ) the propositio n tha t in come, Y, is equal t o the expenditure s tha t generate i t (expenditures o n consumer goods , investment goods , government programs , and ne t ex ports): Y = C + I + G + (X—M ) and (2 ) th e definitio n o f saving a s income ne t o f consumptio n expenditure s an d taxes : S = Y — C — T . The us e o f thi s income-expenditur e equalit y an d accountin g identity , which serve as bedrock for Keynesian macroeconomics, does not impl y the acceptanc e o f Keynesian behaviora l relationships , suc h a s the psy chological considerations that supposedly govern investment spending ,

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1

or the adoption o f the Keynesian vision o f the market process in whic h incomes—rather tha n prices , wage rates, and interes t rates—adjus t t o bring about the equality between total income and total expenditure. 3. Rober t Eisner (1991 , 90-97) criticize s thos e who discus s polic y o n th e basis o f th e accountin g identities . I n hi s ow n treatmen t o f deficits , h e bridges th e ga p between accountin g identitie s an d polic y prescriptio n by postulatin g Keynesia n behaviora l an d structura l relationships . Th e fact tha t thes e relationships—a s wel l a s th e alternativ e relationship s postulated b y Monetarists , Suppl y Siders , New Classicists , an d other s —are a matter of continuing controversy justify th e focus in the presen t chapter o n the uncertainties abou t the consequences o f large budgetary deficits. 4. Th e distinctio n her e between taxing, which has a certain finality abou t it, and borrowing, which requires som e subsequent fisca l and/o r monetary action , give s substanc e t o th e focu s o n deficit-induce d uncertain ties. When th e governmen t borrows , market participant s are , in effect , continually waitin g fo r policymaker s t o "dro p th e othe r fiscal shoe." 5. Fo r a sampling of such piecemeal studies , see Dewald and Ulan (1989), Dwyer (1982) , Evan s (1985) , Fackle r an d McMilli n (1989) , Kormend i (1983), and Niskane n (1988) . Barth e t al . (1991) , present th e wea k an d mixed findings o f forty-tw o differen t empirica l studie s i n whic h th e effects o f th e federa l deb t an d defici t o n short-ter m an d long-ter m interest rates are investigated . 6. T o the extent that the new deficit-reducin g taxe s are not fully specifie d in terms of type, rate, and timing, the uncertainties abou t the new taxes may b e a s grea t a s th e uncertaintie s abou t th e deficit . Tria l balloon s during th e Reaga n administratio n tha t hinte d a t variou s tax-refor m measures had unsettling effects o n Wall Street and drew expressions of fear an d worr y fro m th e financial community . Administratio n spokes men, wh o evidentl y di d no t recogniz e tha t th e marke t wa s reactin g t o the uncertainties create d by the tax-reform proposal , attempted t o allay those fears an d worries with repeated assurance s that the proposal wa s ''written o n a word processor"—whic h meant , o f course, that i t easil y could an d probabl y woul d b e altered . Th e relevan t distinctio n her e i s not strictl y th e taxing/borrowin g distinctio n bu t rathe r th e distinctio n between taxes collected i n accordance with a well-known tax code an d other fund s t o b e raise d i n yet-to-be-specifie d ways—whic h includ e new taxes. 7. Bowles , Ulbrich , an d Wallac e (1989 ) believ e tha t governmen t indebt edness an d defaul t ris k o n corporat e securitie s ar e relate d negatively . Their argument is straightforwardly Keynesian . Expansionary fiscal policy in th e for m o f increase d defici t spendin g stimulate s th e economy , im proving economi c condition s generall y an d thu s reducin g th e ris k o f

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default fo r busines s firms. Thei r empirica l suppor t fo r thi s negativ e relationship make s us e o f annua l dat a fro m 195 9 t o 198 5 o n (1 ) th e spread betwee n Baa corporat e securitie s an d U.S . Treasury securitie s and (2 ) the cyclicall y adjuste d deficit . A n examinatio n o f th e authors ' data suggest s that thei r result s ar e sensitive to the cyclical adjustment . For instance , th e $14 6 billio n defici t i n 1982 , a recessio n year , trans lates into a low cyclically adjusted deficit , whic h then gets paired wit h a hig h sprea d betwee n corporat e an d governmen t securities . A visua l inspection o f thei r constructe d tim e serie s o n thi s spread , however , suggests tha t i t increase d fro m th e 1960 s t o th e 1970 s an d increase d again fro m th e 1970 s t o th e 1980s . Thi s tim e patter n o f corporate government ris k differential s mirror s th e tim e patter n o f (unadjusted ) deficit-to-saving rati o presented i n the following sectio n and suggest s a positive rathe r tha n a negative relationshi p betwee n governmen t inde betedness and defaul t ris k on corporate securities. 8. Th e relevant distinctio n her e betwee n th e U.S . Treasury an d other s i n line a t th e credi t windo w i s on e identifie d b y Machlu p (1978) . Th e others i n lin e a t the credit windo w hav e a n atomistic composition ; th e law o f larg e numbers applies ; the individua l borrower s remai n "anon ymous"—to us e Machlup' s ow n characterization—whil e th e conse quences o f thei r collectiv e behavio r ca n b e predicte d o n th e basi s o f economic principles . I n contrast , prediction s abou t th e action s o f th e U.S. Treasury, as affected b y fiscal and monetary authorities, requires a more "intimate " knowledge—again, Machlup' s characterization—o f th e particular circumstances an d particular individual s involved. The term "Big Player" in this context was introduced by Roger Koppl (1991, 204). 9. A t th e tim e th e federa l governmen t ha d accumulate d a deb t o f $ 1 trillion, i t coul d borro w a n additiona l $ 1 billion whil e inflatin g a t th e rate o f 10 % an d no t increas e it s rea l indebtednes s a t all . Tha t is , th e 10% erosion o f the real value o f outstanding deb t would jus t offse t th e current, conventionally define d deficit . Th e real debt remains constant , and thus the real deficit i s taken to be zero. This nominal-to-real adjust ment, along with severa l othe r suc h adjustments, underlie s Rober t Eisner's answe r t o th e questio n How Real Is the Federal Deficit? (1986). Also, see Eisner (1989). 10. Th e possibility that th e effects o f deposit-insurance mispricin g and th e effects o f budget-induce d uncertaintie s ar e intertwine d wa s suggeste d to me by Jim Barth.

References Barro, Robert J. "Are Governmen t Bond s Ne t Wealth?" Journal of Political Economy 8 2 (November-December 1974) : 1095-1117.

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. "Th e Ricardia n Approac h t o Budge t Deficits. " Journal of Economic Perspectives 3 , no. 2 (Spring 1989) : 37-54 . Barth, James, Georg e Iden , Fran k S . Russek , an d Mar k Wohar. "Th e Effect s of Federa l Budge t Deficit s o n Interes t Rate s an d th e Compositio n o f Domestic Output. " i n Rudolp h G . Penner , ed. , The Great Fiscal Experiment. Washington , DC : Urban Institute Press, 1991 , 71-141 . Bowles, David , Holl y Ulbrich , an d Myle s Wallace . "Defaul t Risk , Interes t Differentials, an d Fisca l Policy : A Ne w Loo k a t Crowdin g Out. " Easter n Economic Journal 15 , no. 3 (July-September 1989) : 203-12 . Dewald, Willia m G. , an d Michae l Ulan . "Th e Twi n Defici t Illusion. " Cato Journal 9 , no. 3 (Winte r 1989) : 689-707 . Dwyer, Geral d P. , Jr . "Inflatio n an d Governmen t Deficits. " Economic Inquiry 20 , no. 3 (July 1982) : 315-29 . Eisner, Robert . How Real Is the Federal Deficit? Ne w York : Fre e Press , 1986. . "Budge t Deficits : Rhetori c an d Reality. " Journa l of Economic Perspectives 3 , no. 2 (Sprin g 1989) : 72-93 . . "Deficit s an d U s an d Ou r Grandchildren. " i n Jame s M . Rock , ed. , Debt and the Twin Deficits Debate. Mountai n View , CA : Mayfield, 1991 , 81-107. Evans, Paul . "D o Larg e Deficit s Produc e Hig h Interes t Rates? " America n Economic Review 75 , no. 1 (March 1985) : 68-87 . Fackler, Jame s S. , an d W . Dougla s McMillin . "Federa l Deb t an d Macroeco nomic Activity. " Souther n Economic Journal 55 , no . 4 (Apri l 1989) : 994-1003. Garrison, Roge r W. , Eugeni e D . Short , an d Geral d P . O'Driscoll , Jr . "Finan cial Stabilit y an d FDI C Insurance. " I n Catherin e Englan d an d Thoma s Huertas, eds. , The Financial Services Revolution . Boston : Kluwer 1988 , 187-207. Keynes, John M . The General Theory of Employment, Interest , an d Money . New York : Harcourt, Brac e and World, 1964[1936] . Koppl, Roger. "Anima l Spirits. " Journal of Economic Perspectives 4 , no . 3 (Summer 1991) : 203-10 . Kormendi, Roge r C. "Government Debt , Governmen t Spending , an d Privat e Sector Behavior. " American Economic Review 73 , no. 5 (Decembe r 1983) : 994-1010. Machlup, Fritz . "Wh y Bothe r abou t Methodology? " In Machlup, Methodology in Economics and Other Social Sciences. Ne w York : Academic, 197 8 [1936], 63-70 . Niskanen, William A. "Th e Uneasy Relation between the Budget Deficit an d the Trade Deficit." Cat o Journal 8 , no. 2 (Fall 1988) : 507-19 . O'Driscoll, Geral d P., Jr. "The Ricardian Nonequivalence Theorem. " Journal of Political Economy 8 5 (Februar y 1977) : 207-210 . Roberts, Paul Craig . "Why the Deficit Hysteri a is Unjustified." In Richard H.

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Fink and Jack C. High, eds., A Nation in Debt. Frederick, MD: University Publications of America, 1987 , 83-86. Schultze, Charle s L . "O f Wolves , Termite s an d Pussycats. " Brooking s Review (Summe r 1989) : 26-33. Shackle, G . L . S . Keynesian Kaleidics. Edinburgh : Edinburg h Universit y Press, 1974.

3 An Empirical Analysi s o f Public Choic e Aspects o f the Saving s an d Loa n Disaster Thomas Havrilesk y

Introduction About th e onl y thin g tha t ha s grow n faste r tha n th e ta b fo r th e savings an d loa n mes s i s th e amoun t o f literatur e devote d t o it . Unfortunately, a s thi s literatur e ha s snowballed , th e proportio n o f statistical analysi s has shrunk. Perhaps the most noticeable shortfal l lies in the interstices between the economic an d politica l aspect s of the problem . Thi s deficienc y persist s despit e growin g interes t i n politico-economic/public choic e theorie s o f bankin g regulation . Economists are increasingly aware that their earlier emphasis on the market failure theor y of regulation cause d them to regard too lightly the self-servin g behavio r o f politician s an d interes t group s tha t cre ated the present tangle o f regulations, subsidies, and taxe s and con tributed s o mightily to the debacle. 1 The Keatin g Fiv e fiasco change d al l that . Nowaday s economist s view th e saving s an d loa n mes s a s mor e tha n a proble m i n mora l hazard an d th e economic s o f bureaucracy. Moreover , they hav e no t been misle d b y th e politica l witc h hunt s an d scapegoatin g (e.g. , Pizzo, Fricker , an d Muolo , 1989 ; an d Adam s 1989 ) tha t hav e fol lowed i n th e wak e o f th e crisis . The y recogniz e tha t reciprocit y between ke y congressperson s o n th e on e han d an d Saving s an d Loan Politica l Actio n Committee s (S& L PACs ) o n th e othe r han d perpetuated th e regulator y forbearanc e tha t wa s essentia l t o th e 55

56 Thoma s HavriJesk y subsequent financial holocaust. 2 Modeling reciprocity arrangement s is th e stoc k i n trad e o f economists . However , a s indicate d a t th e outset, there is a shortage of empirical work here. The chief purpos e o f this chapter i s to provide empirical grist fo r public choice analysis. It does so by explaining the campaign contributions o f S& L PAC s a s dependen t upo n th e regulator y philoso phies, financial service s constituencies , politica l clout , campaig n financing needs , an d votin g behavio r o f congressperson s o n th e Senate and House Banking Committees. The tim e spa n selecte d i s th e critica l perio d 1985-1987 . Ther e are fou r reason s fo r thi s choice . First , th e proble m wa s properl y addressed b y politicians onl y after th e 198 8 elections. Second, ove r the 1985-198 7 interval , S& L PAC-inspired an d congressionall y di rected regulator y forbearanc e transforme d th e proble m fro m a $1 0 billion nuisanc e int o a $150 billio n disaster . Third , i n thes e years , key roll call votes and heavy S&L PAC campaign contributions hel p researchers t o identif y th e influence-peddlin g guys-with-the-black hats. Fourth, after mid-198 7 S&L PACs realized that the bailout's tab had exceede d thei r industry' s capacit y t o finance it . Wit h poorl y informed taxpayer s now footing the bill, solvent S&Ls no longer had to pressur e fo r regulator y forbearance . Thei r congressiona l friend s could then quietly switch to sombreros of a decidedly lighter hue. Another featur e o f this chapte r i s to explain , ove r th e sam e tim e span and with a similar set of variables, the campaign contribution s of bi g ban k PACs . Thi s permit s a n interestin g juxtapositio n wit h S&L PA C behavior . Bi g bank s wer e les s threatene d b y th e FSLI C fiasco, excep t a s a probabl e harbinge r o f futur e FDI C problems . Therefore, thei r PAC s financial largess e might more likely be motivated by a congressperson's regulatory philosophy than by measures of a legislator' s politica l clout . I n short , durin g thi s critica l perio d the bi g bank PAC s di d no t tr y t o be a s narrowl y self-servin g a s th e S&L PACs. In closing, this chapte r draw s parallel s betwee n th e FSLI C catastrophe o f th e 1980 s an d th e FDI C crisis o f th e 1990s . Judging fro m the behavio r o f th e actor s i n bot h tragedies , ver y littl e ha s bee n learned from th e empirical lesson s outlined i n this chapter. Given a rise i n interes t rate s i n 1993-94 , th e FDI C crisi s promise s t o b e a replay of its FSLIC harbinger.

An Empirica l Analysi s of Public Choic e 5 7 The Lack of Leadership Before w e procee d t o the empirica l analysis , it will be useful t o se t the institutiona l stage . This exercis e wil l simultaneousl y she d ligh t on th e origin s o f th e mes s an d hel p t o explai n th e lac k o f forward looking congressiona l an d administratio n leadershi p tha t allowe d the problem to mushroom . It can scarcely be claimed that politicians were not informed. Fo r example, i n 198 4 Georg e Bush heade d th e Committe e o n Financia l Deregulation. Despite the ominous silenc e on the subject durin g th e 1984 an d 198 8 presidentia l electio n campaigns , th e mountin g de posit insuranc e crisi s wa s no t exactl y a closely guarde d secret . Respected economist s ha d bee n warnin g abou t i t i n widel y rea d pub lications for years. 3 Unfortunately, economists ' earl y admonition s wer e no t heeded . There i s a painfully simpl e explanatio n fo r this . Politically, econo mists functio n primaril y a s bearers o f welcome d falsehoods . Asid e from generatin g forecast s o f economi c outcome s tha t ar e favorabl e to thei r politicia n mentors , economi c advisor s an d thei r researc h networks i n academi a devot e mos t o f thei r energ y t o legitimatin g the redistributiv e program s o f their mentors . This type o f advocac y is frequentl y accomplishe d b y cloakin g redistributiv e program s i n macroeconomic externalities . A s examples , th e Keynesia n multi plier concep t wa s repeatedl y invoke d t o hel p legitimat e th e Ne w Frontier-Great Societ y redistributiv e policie s o f th e 1960s , an d th e precepts o f nineteenth-centur y classica l economic s wer e repack aged, labele d "suppl y side" , an d invoke d t o hel p legitimat e th e status qu o ant e ta x 197 0 cu t redistribution s o f th e earl y 1980s . Despite th e obviou s ballyhoo , thi s politica l smokescreenin g i s appar ently take n s o seriousl y b y ingenuou s academic s tha t i t survive s t o contaminate their research agendas as well as their textbooks. Given their largely ceremonia l politica l roles , economists who foresaw th e deposit insuranc e crisi s i n th e 1970s , havin g n o interes t grou p t o propagate their warnings, were voices in the political wilderness . Why di d politica l leadershi p fai l t o aver t th e disaster ? I n orde r for the financial holocaus t no t to have happened, thre e centerpiece s of moder n politic s woul d hav e t o hav e been, a t leas t partially , dis mantled. Th e first wa s th e philosoph y o f systemati c redistributio n in favo r o f middle-clas s homeowners , an d thereb y i n favo r o f th e residential constructio n an d financing industries . Sinc e th e bab y boom o f th e 1950s , housin g ha d becom e somethin g o f a politica l

58 Thoma s HavriJesk y sacred cow . Until the mid-1980s, housing tax shelters were a prominent feature o f the internal revenue codes. These subsidies came to be viewed a s entitlements. Suc h a formidable cadr e of interest group s were appropriatin g th e economi c rent s associate d wit h these subsi dies tha t i t becam e politicall y costl y fo r politician s t o questio n them. Th e secon d centerpiece , on e tha t ha d bee n o n politicians ' altars fo r a somewhat shorte r period , wa s financial deregulation . I n the mid-1970s financial deregulatio n rathe r suddenl y becam e polit ical chi c amon g Republicans an d Democrat s alike . Facing competi tion fro m les s regulate d sector s an d perceivin g diminishin g ne t benefits fro m regulator y barrier s an d subsidies , powerfu l industr y interest group s prodde d politician s ont o th e financial deregulatio n bandwagon. Fo r th e nex t decad e th e financial service s secto r wa s fed megadose s o f deregulator y elixi r withou t paralle l deregulatio n of deposi t insurance . Wit h on e han d th e politician s encourage d imprudent ris k takin g b y no t reformin g deposi t insuranc e whil e with the othe r hand the y removed regulator y barriers to risk taking. As a result , i n th e 1980 s th e numbe r o f FDI C enforcemen t action s and ban k failure s skyrocketed . Th e third centerpiec e ha d a distinctively Republican burnish: the obsession with low-income tax rates. Long after thi s idea had outlive d it s usefulness, it s compulsive hol d on th e administratio n becam e somethin g o f a politica l cliche . Th e reason i s that certai n interes t group s exhibi t singleminde d devotio n to low-income tax rates while other groups have learned to live with the resultin g defici t an d th e hig h rea l interes t rate s tha t i t ha s en tailed.4 As executiv e an d legislativ e leadershi p clutche d thes e thre e icons , the greates t financial traged y i n half a century unfolded . Politician s failed t o repudiat e thes e thre e ideas-whose-time-had-gon e becaus e they ar e consummat e slo w learners . Thei r learnin g impedimen t i s totally structural . Th e polit y utilize s informatio n mechanism s tha t rely upo n infrequent , complexl y dimensione d signal s (votin g out comes, polls , demonstrations , an d th e result s o f executive , legisla tive, an d judicia l inquiries) . Correctiv e response s t o thes e signal s must b e filtered throug h semipermeabl e regulator y bureaucracie s and deepl y entrenche d politica l interes t groups . Thus , on e shoul d not b e surprise d tha t politician s consistentl y fai l t o recogniz e an d respond t o smal l shift s i n th e politica l balanc e o f power , fo r ex ample, marginal change s i n the distributio n o f voting power withi n the distributio n o f earned income , that ideall y shoul d promp t the m

An Empirical Analysis of Public Choice 5 9 swiftly t o repositio n themselve s o n ke y issue s an d thereb y avoi d losses of political support . Instead o f makin g margina l adjustment s t o subtl e change s i n th e political environment , politician s ten d t o clin g t o shopwor n shib boleths, eve n a s the y approac h th e cus p o f electora l disaster . Ho w else ca n on e explai n Jimm y Carter' s blin d obeisanc e t o inflationar y low interes t rate s an d bracke t cree p financing, eve n a s bellweathe r Californians launche d taxpaye r revolts , senio r citize n creditor s (wh o enjoy high interest rates) gathered political strength, and Republica n promises o f statu s qu o ant e tax cut s an d anti-inflationar y militanc e were like a huge moving van in front o f the White House? How els e can on e explai n Reagan-Bus h compulsivenes s ove r lo w ta x rate s and deregulation, even as the failure to reregulate deposit insurance , to provid e fo r increase d budge t appropriation s fo r beleaguere d reg ulators, an d t o reduc e th e defici t an d re val interes t rate s b y raisin g taxes were creating the biggest financial catastroph e sinc e the Grea t Depression?

Some Unpleasant Accountin g A prominen t them e o f th e publi c choic e literatur e i s tha t outrigh t redistributions o f after-ta x incom e woul d b e politicall y disastrous . In an open society institutional camouflag e i s a necessary but costl y complement t o al l redistributiv e programs . Fo r thi s reason , a t th e time that an y particula r redistributiv e progra m i s initiated, th e beneficiaries ar e easil y identified , bu t th e loser s ar e markedl y mor e remote an d diffuse . Durin g th e postwa r perio d o f th e grea t politi cally directed transfer o f resources to homeowners, to the residential development, construction , an d financing industries , to big, de facto insured depositor s a s wel l a s t o th e politicians , regulator y bureau crats, centra l bankers , an d lobbyin g group s wit h who m thes e bene ficiaries ha d t o shar e th e rents, 5 i t wa s difficul t t o pinpoin t th e ultimate losers . Now, however, a final accounting i s painfully feasi ble. The first class of losers turned ou t to be, in the late 1980s, equity holders in depository institutions . The second grou p of losers is the current generatio n o f homeowner s wh o ar e sufferin g sizabl e losse s as a result o f massiv e rea l estat e liquidation s b y depositor y institu tions an d thei r governmenta l indemnifiers . Th e final se t o f loser s will be taxpayers i n general, who will , in the 1990 s and beyond, b e

60 Thoma s Havrilesky forced t o ante up i n orde r to restore the deposi t insuranc e fund s (t o pay for insured deposit s in excess of asset values). Individual groups o f losers aside, great overall social losses befal l the natio n a s a whole. The y hav e arise n an d wil l continu e t o aris e from th e massiv e wast e o f physica l an d huma n capita l associate d with housing subsidies . Consider first th e misallocatio n o f physica l capital . Fo r severa l decades ou r natio n overinveste d i n residentia l development . Thi s resulted i n an inadequate replacement o f the stock of private as well as publi c capita l goods . A mass o f housin g wa s constructe d i n th e 1950s, 1960s , an d 1970 s a t th e expens e o f ou r industria l bas e an d public infrastructure . Instea d o f technologicall y up-to-dat e capita l goods i n America n industr y an d a n adequat e stoc k o f socia l over head capital , w e hav e superfluou s residentia l squar e footag e an d semi vacant shoppin g centers . Instead o f internationally competitiv e industries, we have underutilized vacatio n home s to blight ou r sea shores, lakesides , an d mountai n vista s an d redundan t commerica l strips to disfigure suburba n areas . Of equa l importanc e i s th e misallocatio n o f huma n capital . I n order t o sustai n program s fo r continua l subsidizatio n o f residentia l development, lobbyin g activities had to be supported. In addition, a sizable portion o f government expenditure s wa s channele d int o th e administration o f housing-oriente d programs . Furthermore, consid erable human resource s wer e absorbe d b y private an d publi c financial institutions that specialized i n housing. Also, since the housin g lobby was extremely sensitiv e to interest rates, a considerable shar e of centra l ban k huma n resource s wa s allocate d t o monitorin g an d manipulating interes t rates . Finally , a formidabl e portio n o f th e human resource s o f financial institution s wa s channele d t o deci phering th e polic y move s o f th e centra l ban k (th e Fed-watchin g industry) (se e not e 5) . Without a properly allocate d bas e o f privat e and public, physical and human capital, our growth rate, real wages, and trade deficit hav e suffered an d will continue to suffer . The Crisis Mounts: 1980-198 5 The Depository Institution s Deregulatio n an d Monetar y Control Ac t of 198 0 (DIDMCA) unfettered thrif t institution s from thei r historica l dependence o n fixed rat e mortgages . A t th e sam e tim e Congress , responding to the desires of the S&L lobby, raised the FSLIC deposit insurance ceilin g from $40,00 0 to $100,000, opposed adjustabl e rat e

An Empirica l Analysis of Public Choice 6 1 mortgages for thrifts, an d lowere d S& L net worth requirements fro m 5% t o 3 % of assets . Th e ta x cut s o f th e ensuin g yea r kep t interes t rates high , and , a s a consequence , th e profitabilit y o f depositor y institutions suffered . Losse s wer e compounde d whe n S&L s use d their new-foun d investmen t power s imprudently . I n 1981 , 85% of all S&Ls had negative earnings. In 198 1 th e regulator y respons e t o th e nascen t proble m wa s t o merge or liquidate only the most crippled institutions, leaving many insolvent thrift s open . Encourage d b y the S& L lobby, i n 198 2 Con gress exacerbated th e relaxation o f regulatory standard s by formall y codifying i t in the Garn-St. Germain Act. Suggestions that regulators might tighten standard s were battered dow n by Congress at the S&L lobby's behest . Accountin g sleight-of-hand , suc h a s carryin g asset s at book rathe r tha n marke t valu e an d countin g borrowin g fro m th e FHLBB a s ne t worth , wa s favore d b y th e lobby , endorse d b y Con gress, and quietl y accepte d b y regulators whos e caree r benefits out weighed th e benefit s o f faithfu l service . Politicians los t sigh t o f th e original purpos e o f deposi t insuranc e an d th e principa l tha t publi c monies should not subsidize private risk taking. These facts are eloquent testimony to the power and homogeneit y of th e S& L lobby during thi s crucia l period . The y revea l th e exten t of regulator y captur e (Rome r an d Weingas t 1991) . They als o sho w that politicia n principal s kep t their regulatory agent s o n shor t leashe s (McCubbins, Noll, and Weingast (1989) . Hopes tha t a crisi s migh t b e diverte d bega n dissolvin g i n 198 5 and 1986 . Th e persisten t federa l budge t defici t kep t interes t rate s high. Th e 198 6 ta x cod e revisio n virtuall y eliminate d rea l estat e shelters. Togethe r wit h fallin g oi l price s an d fallin g far m prices , these factor s depresse d rea l estat e value s an d increase d S& L losses in many part s o f the country . Th e crisi s began to come to a head i n the mid-1980s when Edwin Gray, head of the FHLBB, indicated tha t $15 billio n woul d b e neede d t o replenis h th e FSLIC' s insuranc e fund. S& L PACs a s a grou p wer e no t spli t b y th e proderegulation / antideregulation breakdow n tha t separate d bi g bank PACs from smal l bank an d nonban k PACs . Troubled S&L s wanted increase d forbear ance an d limite d recapitalizatio n o f th e fund . Health y S&Ls , wh o did no t wan t t o pa y fo r a larg e recapitalization , agreed . Depositor s from state s wit h a larg e percentag e o f trouble d thrift s migh t hav e potentially desire d a larger recapitalization, but , i n 1986 , they wer e badly informed abou t the potential losses awaiting them. As a result, in 1985-198 6 ther e wa s hardl y an y oppositio n t o S& L PACs' de -

62 Thoma s HavriJesk y mands. Congres s supporte d neithe r a get-toug h regulator y postur e nor massiv e recapitalization. T o the contrary , the legislative branc h encouraged regulator y laxity by delaying recapitalization o f the FSLIC kitty. Poorly policed deregulatio n an d forbearance wer e career serving fo r regulator y bureaucrats . A s mentione d i n th e previou s sec tion, becaus e o f it s obsessio n wit h deregulatio n an d toleranc e o f tax-cut-induced budge t problems , th e administratio n provide d n o leadership. As panicky S&L s and th e insolvenc y o f the FSLI C drove deposi t rates u p an d loa n rate s down , th e profitabilit y o f health y S&L s suffered an d th e rank s o f th e insolven t grew. 6 A s a result , withi n two years the S&L "crisis" had been transformed int o an S&L "mess." The yea r 198 7 was critical . There wa s mountin g concer n regard ing th e cos t o f recapitalizin g th e insuranc e fund . Congressperson s from region s with a high proportion of troubled thrifts wer e increasingly tor n betwee n th e desire s o f th e still-powerfu l an d homoge neous S& L PACs for modest recapitalization an d forbearance o n th e one han d an d th e emergin g anxiet y o f depositor s an d potentia l concerns o f taxpayer s o n th e othe r hand . Sinc e forbearanc e mean t that th e numbe r o f d e fact o insolven t S&L s would no t significantl y decrease an d tha t th e siz e o f the subsid y would , perforce , increase , the intensit y o f S& L PAC pressure o n politician s coul d onl y grow . At the sam e time, however, politician s kne w that depositor s woul d soon deman d massiv e recapitalizatio n an d a n en d t o forbearance . As depositors' concern s mounted , the situatio n fo r man y legislator s reached a n inflexio n poin t beyon d whic h the y coul d n o longe r b e counted upo n to support the S&L PACs. Two event s mar k thi s politica l inflexio n point. 7 Thes e wer e th e Keating Five scanda l an d a related, les s prominent bu t equall y mo mentous rol l cal l vote i n Congress . The Keating Fiv e affair i n Apri l 1987 involve d Senator s Cranston , D e Concini, Glenn , McCain , an d Riegle. They met with Charle s Keating of Lincoln Saving s and Loa n and subsequentl y pressure d regulator s t o give Lincoln a break. Ear lier, Hous e Speake r James Wrigh t an d Majorit y Whi p Ton y Coelh o had similarl y enjoine d regulator s o n behalf o f other saving s institu tions. Th e scandal(s ) precipitate d th e rol l cal l vot e tha t als o oc curred i n Apri l 1987 . I t wa s o n th e St . Germai n Amendmen t t o HR27 (as cjiscussed below , S790 was the relevant bill in the Senate). The amendmen t sough t t o rais e FSLI C recapitalizatio n t o $1 5 bil lion. I t wa s strongl y oppose d b y S& L PACs bu t openl y favore d b y Speaker Wrigh t an d othe r erstwhil e friend s o f th e S&L s wh o ha d

An Empirical Analysis of Public Choic e 6 3 been recently tainted b y the scandal(s). This vote provides a unique opportunity t o examin e directl y th e effec t o f congressiona l votin g behavior o n PA C receipt s whil e controllin g fo r les s extraordinar y influences suc h a s regulatory philosophies , constituencies, politica l clout, and campaig n needs . The Causes of Financial PA C Campaign Contribution s In recent year s controvers y ove r the powe r o f PACs has intensified . A key political issue is their effect i n deterring political competition , as th e lion' s shar e (90 % o f Hous e contribution s i n 1990 ) goe s t o incumbents. O f traditiona l concer n i s th e issu e o f whethe r PA C contributions ar e rewards fo r favors receive d (o r expected) by inter est group s o r merel y investment s i n acces s t o a congressperson . Regardless o f whic h hypothesi s i s true (an d th e distinctio n ma y b e a fuzz y one) 8 publi c choic e analyst s wan t t o kno w wha t factor s condition PA C contributions. 9 In other words, what variables lowe r the suppl y pric e o f a congressperson's service s to a n interes t grou p (Grier an d Munge r 1991) . A s lon g a s deman d i s elasti c (a s i t wil l normally be), the lower the supply price of a legislator's favors to an interest group , th e greate r th e leve l o f campaig n contribution s o f that group . "Favors " ar e conceive d a s units o f influenc e o n regula tors an d legislation . Ther e ar e five general classe s o f variable s tha t are prominently mentione d i n the literature as influencing thi s relative supply price : a legislator's regulatory philosophy, constituency , clout, campaign needs, and voting behavior (Pool e and Romer 1985; Poole, Romer, an d Rosentha l 1987) . In what follow s I discuss eac h of these categories. Regulatory Philosophy In most case s PACs represent a n industry tha t i s affected b y at leas t one regulatory body. In the financial service s sector, the overarchin g regulatory issu e o f th e pas t tw o decade s ha s bee n financial deregu lation. After th e "level playing field" compromise s o f the late 1970s, culminating i n th e Depositor y Institution s Deregulatio n an d Mone tary Contro l Ac t o f 1980 , financial service s PAC s stake d ou t fairl y clear position s o n furthe r deregulation . Bi g ban k an d S& L PAC s remained stron g advocate s o f (more ) deregulation . Bi g ban k PAC s favored deregulatio n becaus e it legitimated entr y into less regulated markets an d a (structura l arbitrage ) escap e rout e fro m assessment s

64 Thoma s Havrilesky on their banking asset s to replenish th e insuranc e funds. S& L PACs favored deregulatio n because it promised more profit for their ailin g industry. I n contrast , nonban k PACs , many o f who m wer e alread y doing a de facto banking business and whose turf wa s threatened by the incursio n o f depositor y institutions , tende d t o b e a goo d dea l more hesitan t regardin g furthe r across-the-boar d deregulation . I t threatened t o increas e th e scop e o f thei r head-to-hea d competitio n with depositor y institutions . Sinc e conservativ e congressperson s traditionally hav e th e mos t favorabl e attitud e towar d deregulation , one would expec t that legislator s with conservativ e ratings on business issues would have a lower relative supply price of deregulator y influence an d woul d attrac t relativel y mor e campaig n fund s fro m big bank an d S& L PACS than fro m nonbank , smal l bank, an d othe r financial service s PACs. Constituencies The regulatory philosophy o f a congressperson notwithstanding, th e supply pric e o f peddlin g regulator y influenc e depend s o n the pref erences o f constituent s withi n hi s o r her distric t o r state. The mor e that constituent s ar e oppose d t o a positio n favore d b y a PAC , th e more expensive will be that congressperson's influence , because the greater th e cos t t o hi m o r her i n term s o f vote s an d othe r contribu tions foregone . I n contrast , legislator s wit h sympatheti c hom e con stituencies ca n provide their services more cheaply. In the financial services sector , th e greate r th e economi c importanc e o f a particula r type o f financial institutio n i n a congressperson' s hom e stat e o r district, the lower his o r her relative suppl y pric e to and th e greate r the relative contribution o f that particular clas s of PAC. Clout Congresspersons wh o are on committees that dea l with the interest s of a certain clas s o f PAC have more power t o help them tha n thos e who ar e not . Thi s i s becaus e committee s hav e th e righ t t o hol d hearings, to recommend regulator y budgets, and t o control the con tent, timing, an d votin g on relevant legislation . Within committees , one woul d expec t th e mor e senio r member s t o have greater power , that is , t o b e abl e t o influenc e legislatio n an d regulator s a t lesse r cost. Therefore, a legislator's seniorit y o n a committee shoul d affec t the size of relevant PAC contributions. However, seniority might not

An Empirica l Analysi s of Public Choic e 6 5 affect th e relevan t PA C shar e o f tota l PA C contributions . Fo r ex ample, i f al l financial service s PAC s rewar d seniorit y proportion ately, the n i t ma y b e a scala r tha t woul d no t affec t an y clas s o f financial PAC s share of total financial PAC contributions. Nevertheless, sinc e th e 1985-198 7 perio d wa s s o critical t o S&L s relative t o other financial service s industries, an increase i n a legislator's com mittee seniorit y i s expecte d t o increas e th e S& L PACs' shar e o f hi s or her total financial service s PAC campaign contributions . Campaign Financin g Need s Legislators i n clos e race s ar e generall y i n greate r nee d o f contribu tions. The y would , ceteri s paribus , generall y b e mor e willin g t o lower thei r suppl y price s t o potentia l contributors . A s wit h clout , however, a measure of a congressperson's need s may be a scalar an d not affect th e relative contributions o f any particular clas s of PAC. Voting Behavio r Even i f regulator y philosophy , constituencies , an d clou t dispos e a legislator towar d bein g favore d b y a certai n typ e o f PAC , counter vailing influence s hav e t o b e considered . Thes e migh t includ e th e presence o f opposin g interest s i n th e legislator' s hom e stat e o r dis trict. For example, if S&Ls are an important componen t o f the financial service s secto r o f a congressperson' s district , th e existenc e o f anxious depositor s durin g th e insuranc e crisi s i n 1985-198 7 coul d have counterbalanced S& L PAC influence o n that legislator's behavior. Sinc e al l suc h countervailin g interest s canno t b e easil y mea sured, perhap s th e bes t indicato r o f th e relativ e cos t t o a PAC of a congressperson's availabilit y t o influenc e regulator s i s hi s o r he r actual votin g behavio r o n issue s t o whic h tha t clas s o f PA C i s sensitive. Empirical Specificatio n In tw o separat e OL S regression s th e dependen t variable s wer e th e dollar magnitud e o f th e campaig n contribution s o f bi g ban k an d thrift PAC s respectively durin g the 1985-198 7 period. ( A regression for nonban k financial service s PAC s i s reporte d i n Appendi x B. ) The dat a se t include d contribution s t o eac h o f sixty-eigh t congres spersons o n the House and Senat e banking committees expressed a s

66 Thoma s Havhlesky a percentag e o f tota l campaig n contribution s fro m al l financial ser vices PACs. PAC contribution s wer e obtaine d fro m th e Federa l Election s Commission an d require d considerabl e effor t t o classify . Bi g ban k PACs were define d a s organization s tha t represen t commercia l bank s with asset s ove r $1 0 billion . Asid e fro m thei r dominanc e o f tota l financial service s PAC contributions an d their obvious impact whe n joining forces, on e reason fo r th e focus o n big banks an d S&L s was that specifi c industr y an d firm-size orientation s o f othe r financial services PAC s wer e mor e difficul t t o identify . Anothe r reaso n wa s that propose d regulator y legislatio n i n thi s perio d specificall y af fected bi g commercial banks and S&L s more than other groups. 10 There were two regulatory philosophy variables. One was a political party binary measure , assigning a value of one to all Democrat s and a value o f zer o t o al l Republicans . Th e othe r wa s a legislator' s Chamber of Commerce (COC) rating.11 It was assumed that big banks and S&L s would b e mor e intereste d i n deregulation , i.e. , lowerin g geographic an d produc t lin e barriers to entr y into financial service s markets, tha n othe r financial service s groups. 12 I t wa s furthe r as sumed tha t deregulatio n tend s t o b e mor e favbre d philosophicall y by Republicans and by legislators with higer COC ratings. Therefore, the percentage of campaign contributions comin g from big bank and S&L PACs wa s expecte d t o vary directl y wit h thes e tw o regulator y philosophy variables . Constituencies wer e considere d crucia l becaus e congressperson s from area s wher e bi g bank s o r S&L s wer e relativel y unimportan t were not expected to receive sizable shares of their financial service s PAC campaig n contribution s fro m bi g ban k o r S& L PACs respec tively. Whether a congressperson ha s large commercial banks in hi s or her jurisdiction i s heavily influenced b y the bank branching law s of hi s o r he r state . A s a measur e o f th e presenc e o f a bi g ban k constituency, w e employe d a binar y variable , assignin g a valu e o f one t o congressperson s fro m state s wit h statewid e branchin g an d a value o f zero to congresspersons fro m state s with limite d branchin g or unit banking. As a measure o f an S&L constituency, we used S&L deposits a s a ratio o f tota l deposit s i n th e congressperson' s state . It was expecte d tha t the percentage s o f big bank an d S& L PAC contributions t o tota l financial service s PA C contribution s woul d var y directly with these respective variables. Political clou t wa s measure d b y the seniorit y rankin g o f the leg islator o n th e Hous e o r Senat e Bankin g Committee . Becaus e S&L s

An Empirica l Analysi s of Public Choice 6 7 needed politica l clou t mor e than othe r financial service s industrie s during the 1985-198 7 period , it was expected that the percentage of S&L PAC contributions t o total financial service s PAC contributions would var y directl y wit h seniority . Becaus e bi g banks wer e no t i n similar straits , i t wa s no t expecte d tha t th e bi g ban k PA C shar e would be affected b y seniority. Campaign financing need s wer e measure d b y th e congressper son's pluralit y i n th e lates t election . I t wa s no t expecte d tha t S& L PAC or big bank PAC shares would be affected b y this measure. While voting behavior has been linked to campaign contribution s from a number of industries in the previous literature—for example , Chappell (1981) , Silberman and Durden (1976) , and Edelman (1988 ) —it ha s neve r befor e bee n don e fo r th e financial service s sector. 13 Over the entire 198 5 to 1987 period there was only one roll call vote taken in either the House or Senate that could clearl y be considere d either favorable o r unfavorable t o large banks; this was a 1985 bill to ban credi t car d surcharges . (Large commercial banks receive signifi cant fe e revenue s fro m thes e charges. ) Unfortunately , thi s measur e did not perform wel l in the empirical tests that follow. Therefore, i n its plac e wa s use d a measure o f bil l sponsorship . Congressperson s who sponsore d legislatio n tha t wa s clearl y favorabl e t o bi g bank s were assigne d a valu e o f one ; al l other s wer e assigne d a valu e o f zero. (Th e relevan t legislatio n i s describe d i n Appendi x A. ) I t wa s expected tha t th e percentag e o f tota l financial service s PA C contri butions receive d fro m bi g ban k PAC s woul d var y positivel y wit h this measure. With regard to S&Ls the key roll call vote was on the St . Germain Amendment to HR27 in the House and a related amendment to S790 in the Senate. The House amendment propose d raising FSLIC recapitalization from $ 5 billion to $15 billion. The U.S. Savings and Loa n League oppose d th e amendment . Th e Senat e amendmen t propose d raising FSLI C capitalizatio n t o onl y $7. 5 billion . I t wa s favore d b y the league . Thes e relativel y clos e vote s (th e Hous e vot e wa s 153— 258) indicat e divide d rank s o n th e recapitalizatio n issue . A s dis cussed earlier , man y legislator s wer e becoming sensitiv e to deposi tor concerns associate d wit h advers e publicity arisin g from pressur ing regulator s fo r forbearance . Thos e votin g agains t th e Hous e amendment o r fo r th e Senat e amendmen t wer e assigne d a value of one; thos e votin g fo r th e Hous e amendment , agains t th e Senat e amendment, o r no t votin g wer e assigne d a valu e o f zero . I t wa s expected tha t th e percentag e o f tota l financial service s PA C contri-

68 Thoma

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Table 3. 1 Dependent Variable : Big Bank PAC Contributions a s a Percentage o f Tota l Financial Service s PA C Contributions, 1985-198 7 ( t statistics i n parentheses) Intercept Party -0.1506 0.039 (-1.524) (0.841 State Branchin g Status Voting 0.0574** 0.1236* (2.040) (2.495

Chambe 6 0.0025* ) (2.965 Record Seniority * 0.00456 ) (1.957

r of Commerce Rating * ) Plurality * 0.137 ) (1.455

4 )

No. of observations = 5 2 R2 = .3 0 ** Significant a t the .05 level * Significant a t the .10 level

butions receive d fro m S& L PAC s woul d var y directl y wit h thi s binary measure . As mentioned earlie r there i s a problem o f multicollinearity whe n voting behavio r an d variable s tha t ar e highl y correlate d wit h votin g behavior ar e include d a s explanator y variable s i n th e sam e regres sion. I n addition , ther e i s a revers e causalit y proble m associate d with measurin g legislator' s votin g behavio r an d thei r PA C receipt s in th e sam e period . Rationa l legislator s migh t anticipat e thei r PA C contributions an d vot e accordingly , thu s causin g confusio n o f caus e and effect . On e wa y t o reduce thes e problem s i s to choos e vote s tha t came a s authenti c behavioria l suprise s t o th e PACs. 14 T o som e ex tent HR2 7 fits thi s descriptio n sinc e man y o f thei r erstwhil e friend s abandoned th e S& L PACs o n thi s vote . Anothe r wa y t o reduc e bot h problems i s t o dro p al l votin g variable s a s explanator y variable s i n the regression . I n th e followin g sectio n th e result s wil l b e discusse d with an d withou t th e votin g behavio r variables . Results Table 3. 1 report s th e OL S results fo r bi g bank PA C contributions . O f the tw o regulator y philosoph y variables , onl y th e Chambe r o f Com merce (COC ) ratin g wa s statisticall y significan t an d ha d th e ex pected sign . Th e estimat e indicate s tha t votin g o n th e probusines s

An Empirica l Analysis of Public Choic e 6 9 side just 10 % more o f the time will increas e a congressperson's bi g bank PA C shar e o f tota l financial service s PA C contribution s b y 2%.15 I n contrast , th e estimate d coefficien t fo r th e politica l part y binary variabl e wa s no t statisticall y significan t a t a hig h leve l o f significance.16 The estimate d coefficien t fo r th e bank siz e constituency variabl e was als o statisticall y significan t an d ha d th e expecte d sign . Congresspersons fro m statewid e branchin g state s receive d ove r 5.7 % more campaign contribution s fro m bi g bank PACs as a share of total financial service s PAC contributions tha n thei r counterpart s i n lim ited branching or unit banking states. The estimate d coefficien t fo r the bill sponsorshi p binar y variabl e was statistically significan t an d ha d the expected sign . Sponsorshi p or cosponsorship o f a pro-big bank bill increased a congressperson' s big bank PAC share o f total financial service s PAC contributions b y 12%. The estimated coefficien t fo r the seniority variable was also statistically significant . A one-ste p increas e i n a legislator' s seniorit y ranking, a unit reductio n i n the explanator y variable , decreased th e dependent variabl e b y approximatel y .4%. 17 Thi s resul t wa s some what o f a surprise . Becaus e o f th e adding-u p constraint , i t likel y reflects th e effects , reporte d below , that a n increase i n seniority ha s in increasin g a congressperson' s S& L and nonban k PA C share s o f total financial service s PAC contributions. 18 As expected , th e estimate d coefficien t fo r th e pluralit y variabl e was not statistically significant . When the bill sponsorship binary is dropped because of potentia l multicollinearity an d revers e causality , th e sig n an d statistica l sig nificance o f th e estimate d coefficient s d o no t change . Whe n th e political party binary is dropped, there is a similar absence of changes. Table 3. 2 report s th e OL S result s fo r S& L PAC contributions. 19 For th e tw o regulator y philosoph y variable s th e estimate d coeffi cients wer e statisticall y significan t onl y a t th e .1 3 leve l o f signifi cance. Moreover , th e sig n o f th e coefficien t fo r th e politica l part y variable surprisingl y wa s positiv e (se e note 12) . Because the y wer e focusing thei r attentio n o n th e crucia l bread-and-butte r issu e o f recapitalization an d forbearanc e durin g this period , S& L PACs ma y not have cared about legislators' regulatory philosophy . The estimate d coefficien t fo r th e S& L constituency variabl e wa s statistically significan t an d ha d th e expecte d sign . As S& L deposits as a percentag e o f tota l deposit s ros e b y 10% , a congressperson' s

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Table 3.2 Dependent Variable : S&L PAC Contributions a s a Percentage o f Tota l Financial Service s PA C Contributions, 1985-198 7 ( t statistic i n parentheses) Intercept Party 0.0258 0.068 (-0.266) (1.514 State S&L Deposits as a Percentage of Total Deposits 0.2372* (1.860)

Chamber 2 0.001 ) (1.552

Voting Record Seniority 0.0574* -0.0035 (1.947) (-1.718

of Commerce Rating 1 )

Plurality * -0.065 ) (-0.077

6 )

R2 = .2 9 No. of observations = 5 2 * Significant a t .10 level

S&L PAC shar e o f tota l financial service s PA C contribution s ros e b y 2.4%. Apparently , i n th e 1985-8 7 period , depositor s an d taxpayer s were no t ye t sufficientl y informe d an d organize d t o caus e legislator s from state s wher e S&L s wer e importan t t o ignor e thei r PAC' s pres sures fo r continue d forbearanc e an d lo w recapitalization . The estimate d coefficien t fo r th e votin g recor d variabl e wa s als o statistically significan t an d ha d th e expecte d sign . A Hous e vot e against raisin g recapitalizatio n fro m $ 5 billio n t o $1 5 billio n o r a Senate vot e fo r raisin g recapitalizatio n t o $7. 5 billio n generate d a 5.7% increas e i n a legislator' s S& L PA C shar e o f tota l financial services PA C contributions. 2 0 The seniorit y variabl e wa s statisticall y significan t an d ha d th e expected sign . I f a legislato r move d u p on e ste p i n seniorit y o n th e Banking Committee , a uni t reductio n i n th e explanator y variable , i t generated a .3.5 % rise i n th e contribution s tha t h e o r sh e receive d from S& L PACs expresse d a s a shar e o f tota l financial service s PA C contributions. Thi s resul t support s th e conjectur e tha t durin g th e critical 1985-198 7 perio d S& L PACs ha d a greater nee d fo r politica l clout tha n othe r financial service s PAC . Finally, simila r t o the cas e of big bank PAC contributions i n Tabl e 3.1, th e pluralit y variabl e wa s agai n statisticall y insignificant . When th e vot e binar y i s droppe d becaus e o f potentia l

An Empirica l Analysi s of Publi c Choice 7

1

multicollinearity an d revers e causality , th e sig n an d significanc e o f the estimate d coefficient s d o no t chang e excep t tha t th e estimat e fo r the part y binar y become s statisticall y significan t a t th e .0 5 level . When th e part y binar y i s dropped , th e estimat e fo r th e Chambe r o f Commerce ratin g variabl e lose s statistica l significanc e an d th e esti mates fo r th e S& L constituenc y an d seniorit y variable s ar e onl y significant a t the .1 3 level . Concluding Commen t Public choic e theor y suggest s tha t politician s ar e motivate d b y ren t seeking. I n particular , th e campaig n contribution s o f politica l actio n committees ar e a n importan t benefi t tha t politician s ca n presumabl y garner b y adoptin g attitude s towar d regulatio n tha t ar e favorabl e t o certain classe s o f PACs . The presen t articl e focuse s o n S& L an d bi g ban k PAC s becaus e they hav e neve r befor e bee n studie d i n thi s context , thei r campaig n contributions ar e formidable , the y ar e fairl y easil y identified , an d there i s controversia l legislatio n o n whic h the y hav e take n a stron g stand an d fo r whic h rol l cal l vote s ar e available . I t develop s statisti cal evidenc e regardin g th e factor s tha t affec t bi g bank an d S& L PA C campaign contributions , thereb y addin g t o wha t i s know n abou t th e S&L disaster . During th e 1985-198 7 perio d th e campaig n contribution s o f bi g bank an d S& L PACs , eac h expresse d a s a shar e o f tota l financial services PA C contributions, appea r t o have been similarl y motivate d by measure s o f votin g behavior . I f a legislato r sponsore d o r cospon sored a pro-bi g ban k bill , hi s o r he r proportionat e bi g ban k PA C contributions rose , an d i f h e o r sh e vote d fo r a pro-S& L bill , hi s o r her proportionat e S& L PAC contribution s rose . Moreover, bi g ban k PA C an d S& L PA C contributions , expresse d as share s o f tota l financial service s PA C contributions , wer e als o similarly affecte d b y measure s o f th e importanc e o f bi g ban k an d S&L constituencie s i n legislators ' hom e states . Congressperson s fro m statewide branchin g state s receive d a significantl y greate r propor tion o f thei r campaig n contribution s fro m bi g ban k PACs . I n addi tion, a n increas e i n S& L deposits a s a percentag e o f tota l deposit s i n a congressperson' s stat e increase d hi s o r he r proportionat e shar e o f contributions fro m S& L PACs. Regulatory philosophy , a s measure d b y a legislator' s Chambe r o f Commerce rating , ha d a n effec t o n proportionat e bi g ban k PA C

72 Thoma s Havrilesky contributions bu t not on proportionate S& L PAC contributions. Th e more conservative the legislator's Chambe r o f Commerce rating, the larger th e bi g ban k PA C contributio n a s a shar e o f tota l financial services PA C contributions. Regulator y philosoph y a s measured b y political party affiliation di d not have a statistically significant effec t on either class of PAC contributions. Another differenc e betwee n the two classes of PAC contribution s is associate d wit h th e effec t o f politica l clou t a s measured b y com mittee seniority . Thi s variabl e ha d a significant , positiv e effec t o n S&L PA C contributions , presumabl y becaus e S&L s wer e mor e i n need o f political clout during the critical 1985-198 7 period . Finally, bot h dependen t variable s wer e no t significantl y affecte d by campaig n financing needs , a s measure d b y pluralit y i n th e pre vious election . Implications for the FDIC Crisis: The More Things Change . . . In vie w o f th e painfu l lesson s learne d fro m th e S& L disaster , th e ingenuous onlooke r woul d probabl y no t expec t an instant replay i n the bankin g industry . Unfortunately , i n comparin g th e FDI C crisi s of th e 1990 s t o th e FSLI C crisi s o f th e 1980s , on e finds tha t ver y little has changed . The FSLI C disaste r shoul d hav e reminde d politician s o f th e tra ditional principl e tha t publi c monie s shoul d no t subsidiz e privat e risk taking . Instea d i t seem s t o hav e taugh t the m tha t the y mus t subsidize private risk taking. This chapter show s that the S& L PACs prevented regulator s fro m reining i n th e risk-takin g activitie s o f larg e institution s befor e thei r depleted ne t wort h transforme d the m int o parasite s o n th e insur ance fund. Onc e the fun d ha d drie d up , implosive force s too k hol d that coul d no t b e offse t b y lowe r interes t rates , granting th e indus try's broader investmen t powers , or the infusio n o f taxpayer's mon ies. The scrip t fo r th e curren t FDI C traged y i s almos t identical . Bi g bank PAC s suppor t regulator y discretio n i n th e closin g o f faile d institutions an d refus e t o oppos e th e too-big-to-fai l doctrine . Th e FDIC has neve r allowe d th e uninsure d depositor s o f banks ove r $ 1 billion i n assets to suffer losses . (Todd and O'Driscoll , this volume). Risk taking by and consolidatio n amon g large insolvent institution s steadily increases their dependency o n the FDIC (White, this volume). The lis t o f walkin g wounde d mone y cente r bank s i s wel l known .

An Empirica l Analysis of Public Choice 7 3 The nursing of disabled banks in the early 1990 s with lowe r reserv e requirements, aberrantl y lowe r short-ter m interes t rate s (throug h discount windo w an d ope n marke t operations) , broader geographi c and produc t lin e powers , an d a prospectiv e infusio n o f taxpayers ' monies i s proceedin g i n muc h th e sam e manne r a s th e nursin g o f the insolvent thrifts i n the 1980s. Unfortunately, jus t as in the 1980s, many o f th e patient s ar e not recoverin g an d give n a significant ris e in interest rates an implosion of the banking industry and a taxpayer bailout of the fund ar e imminent (Kaufman , thi s volume). A tragic irony is that marke t forces an d public polic y ar e diamet rically opposed . Marke t forces woul d eliminat e man y o f ou r larges t banks whil e th e too-big-to-fai l doctrine , b y stimulatin g consolida tion amon g th e larges t bank s an d providin g uninsure d depositor s with glowin g incentives t o shift fund s t o them, pushes the industr y in th e opposit e direction . Taxpayers ' wealt h i s bein g use d t o kee p the larges t bank s alive . Just a s i n th e 1980s , with on e han d politi cians encourag e additiona l ris k takin g throug h d e fact o deposi t in surance coverage, while with the other hand they continue to lower regulatory barriers . Thi s ca n onl y mea n a costl y repla y o f th e S& L holocaust. The parallel persists because there are no incentives for the actors in th e traged y t o perfor m otherwise . Politician s stil l clin g t o th e same sacre d cow s and engag e in the sam e self-deception . Thei r tie s with powerfu l industr y interes t group s are , i f anything , stronger . Regulators an d centra l banker s ar e reluctant t o oppos e wholeheart edly the too-big-to-fail doctrin e because i t has not been oppose d b y the PACs . As i n th e 1980s , taxpayers an d smal l depositor s ar e dif fuse, disorganize d an d ready for their fleecing and the next round of postdisaster scapegoating . As in the 1980s , there i s moverment towar d reform : toughe r bal ance shee t standard s enacte d b y high-minde d publi c servant s an d presumably enforce d b y untouchable regulators . Unfortunately, th e public choic e perspectiv e o n refor m i s decidel y mor e pessimistic . Entrenched interes t group s continu e t o imped e enforcemen t a t th e expense o f th e industr y tha t regulation s wer e designe d t o protect . For example, the 199 1 bank reform bil l did nothing to stop totterin g banks fro m temporaril y hidin g behin d th e too-big-to-fai l doctrine , masking their insolvency , betting on rescue from permanenl y lowe r short-term interes t rates , whil e systematicall y overbiddin g fo r de posits and gambling on high-risk investments . Unless we seve r the lin k between expecte d electora l succes s an d

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manipulation o f regulator y policy , economi c well-bein g wil l con tinue t o b e sacrifice d i n th e nam e o f politica l expediency . Wit h s o many interes t group s benefitin g fro m th e politica l rentseekin g tha t permeates regulator y policy , meaningfu l refor m i s unlikely . Never theless, a s recurren t regulator y polic y crise s indicate , th e cost s i n terms of the erosion of economic health are formidable .

Appendix A Bill Sponsorshi p These were the five bills sponsored i n 1987-1988 that were assessed to be clearly favorable t o big banks (se e note 11). 1. Comprehensiv e Ban k Restructuring , Powers , an d Safet y Act . Amend banking and securitie s law s to minimize hazard to federall y insured financial institution s fro m securities , insurance , an d rea l estate activities ; develo p an d tes t structure s fo r ban k holdin g com panies t o preven t unfai r competitio n i n deliver y o f certai n securi ties, insurance , rea l estat e services ; establis h functiona l regulatio n of financial institution s by providing that bank security activities be carried o n in separat e securit y affiliate s o f bank holdin g companie s subject t o Securitie s an d Exchang e Commissio n (SEC ) oversight ; establish Financia l Intermediarie s Revie w Commissio n t o analyze , report, an d mak e recommendation s t o Congres s regardin g futur e banking institutions ' possibl e combinin g wit h financial an d com mercial firms. 2. Competitive Equalit y Bankin g Act. An origina l bil l to regulat e nonbank banks , impos e a moratorium o n certai n securitie s an d in surance activitie s b y banks , recapitaliz e th e Federa l Saving s an d Loan Insurance Corporatio n (FSLIC) , allow emergenc y interstat e ban k acquisitions, streamlin e credi t unio n operations , regulate consume r checkholds, and for other purposes . 3. A bill to perserve the authorit y o f the federal bankin g supervi sory agencie s t o arrang e interstat e acquisition s an d merger s fo r faile d or failing banks, and for other purposes . 4. Dua l Bankin g Syste m Enhancemen t an d Financia l Service s Competitiveness Act . A bill to enhance the competitiveness o f commercial banks and bank holding companies . 5. Bankin g Refor m an d Communit y Benefit s Act . A bil l t o en hance th e competitivenes s o f commercia l bank s an d ban k holdin g

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Table 3.3 Dependent Variable : Nonbank PA C Contributions a s a Percentage o f Tota l Financial Service s PAC Contributions, 1985-198 7 ( t statistics i n parentheses) Intercept Party 0.9698 -0.091 (5.893) (-1.161 State Branchin g Status Votin 0.0143 -0.1899 (0.305) (-2.301

Chambe 1 -0.0053 ) (-3.794 g Record Seniorit * -0.0160 ) (-4.109

r of Commerce Rating * ) y Plurality * -0.184 ) (-1.171

1 )

No. of observations = 5 2 R2 = .3 8 * Significant a t the .05 level

companies i n the securitie s market , to ensure that commercia l bank s and ban k holdin g companie s engage d i n securitie s activitie s wil l provide thei r communitie s wit h additona l benefits , an d fo r othe r purposes.

Appendix B The Campaig n Contribution s o f Nonban k Financia l Services PAC s The mai n purpos e o f thi s chapte r wa s t o compar e th e determinant s of S& L an d bi g ban k PA C contribution s t o legislator s o n th e Hous e and Senat e Bankin g Committees . Whe n smal l ban k PA C contribu tions wer e examine d i n simila r frameworks , th e result s wer e mildl y disappointing (se e not e 19) . However , th e result s fo r th e contribu tions o f nonban k financia l service s PAC s a s a share o f tota l financia l services PA C contribution s wer e quit e interesting . Sinc e th e inter ests o f bi g bank s an d nonban k financia l service s firms ar e ofte n a t odds i n regulator y matters , on e woul d expec t th e estimate d coeffi cients fo r th e votin g recor d an d regulator y philosoph y variable s i n an equatio n wit h th e contribution s o f nonban k financial service s PAC a s the dependen t variabl e t o be opposit e i n algebrai c sign . Table 3. 3 report s th e OL S result s fo r nonban k financial service s

76 Thomas

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PAC contributions . Th e estimate d coefficien t fo r th e bil l sponsor ship binar y wa s negativ e an d statisticall y significant . Congressper sons wh o sponsore d o r cosponsore d pro-bi g ban k legislatio n re ceived a n 18 % decreas e i n thei r contribution s fro m nonban k PAC s as a shar e o f tota l financial service s PA C contributions . Of th e tw o regulator y philosoph y variables , onl y th e Chambe r o f Commerce ratin g wa s statisticall y significant . No t surprisingly , th e sign wa s negative . Th e estimat e indicate s tha t votin g o n th e pro business/proderegulation sid e 10 % more o f th e tim e wil l decreas e a congressperson's nonban k PA C shar e o f tota l financial service s PA C contributions b y ove r 5% . The estimate d coefficient s fo r th e branchin g statu s an d pluralit y variables wer e statisticall y insignificant . Th e seniorit y variabl e wa s statistically significant . A one-ste p increas e i n committe e seniority , a uni t decreas e i n th e explanator y variable , generate d a 1.6 % in crease i n th e nonban k PA C shar e o f tota l financial service s PA C contributions. When th e bil l sponsorshi p binar y i s droppe d becaus e o f potentia l multicollinearity an d revers e causality , th e sig n an d significanc e o f the estimate d coefficient s d o no t change . Whe n th e politica l part y binary i s dropped , ther e i s a similar absenc e o f changes .

Notes Thanks g o t o Joh n Gildea , Jame s Granato , Edwar d Kane , an d th e partici pants i n th e New Yor k University Conferenc e o n the Crisis i n the Bankin g Industry fo r helpfu l suggestion s an d t o Todd Gilme r an d Scot t Jaquette fo r computational assistance . 1. A contras t an d compariso n o f marke t failur e an d publi c choic e ap proaches to banking regulation appear s i n Havrilesky (1989) . The mar ket failur e vie w envision s politician s regulatin g i n th e publi c interest , industry circumventin g thes e regulations , an d politician s continuall y reregulating again in the public interest. The public choice view is that regulations a t an y tim e reflec t th e competin g self-intereste d politica l influences o f industr y an d consume r group s wh o see k protection fro m the market whenever it is politically feasible . 2. Ther e are plenty of examples of analysts who, having keenly monitore d this problem for many years, now place heavier emphasis on the publi c choice approach. For instance, Brumbaugh (1988 ) and Barth and Brumbaugh (1990).

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3. A s a coedito r o f thre e edition s o f a boo k o f reading s i n bankin g an d financial market s an d institution s beginnin g i n th e mid-1970s , I wa s aware o f th e earl y warning s fro m respecte d economist s tha t appeare d in widel y rea d publication s throughou t th e earl y 1970s . See , fo r ex ample, the articles by Thomas Mayer, Ronald Watson, and Jack Guttentag i n Havrilesk y an d Boorma n (1976) . Th e bibliographie s o f thes e articles indicat e tha t th e literatur e o n this subjec t goe s back a t leas t a s far as the 1960s. 4. I t can als o be argue d tha t th e uncertainty regardin g which sector s wil l bear th e burde n o f defici t financing i s preferred b y politician s t o th e certainty regarding which will bear the burden o f explicit taxation. Se e Garrison (this volume). 5. Th e total cost of lobbying for maintaining and camouflaging these redistributions i s sizable . I t include s no t onl y th e expense s o f maintainin g the residentia l construction , development , an d financing lobbie s bu t also governmen t expenditure s fo r administerin g program s tha t benefi t housing. Furthermore , sinc e thes e lobbie s wer e extremel y sensitiv e t o interest rates , th e tota l cos t o f thes e redistribution s als o include s a sizable portio n o f th e expense s o f ou r monetar y polic y institutions . These include the costs of monetary policy misdirection ( a big share of the cos t o f runnin g th e Fed) , th e cost s o f maintainin g a privat e Fed watching industry, and the costs of sustaining private and public sector pressures o n monetar y policy . Finally , sinc e th e housin g lobbie s con tinually pressure d fo r lo w interes t rate s that wer e usually inflationary , the total cost of these redistributions woul d als o include a good deal of the social cost of inflation . 6. Th e Suppl y Sid e Coup o f 1985-198 6 an d th e subsequen t shif t t o eas y monetary polic y may have been directe d no t onl y toward reducin g th e value o f th e dolla r i n orde r t o reliev e export-oriente d an d import threatened industrie s but also toward lowering interest rates in order to help the troubled S&Ls. 7. Thi s labe l suggest s mor e precis e identificatio n tha n actuall y possible . There wa s considerabl e politica l jostling , shifting , an d repositionin g even after April of 1987, with some legislators returning to a proforbear ance stance. 8. Muc h o f th e earlie r literatur e model s th e reward s versu s brib e aspect s of campaig n contributions , fo r example , Welc h (1974 ) an d Zio n an d Eytan (1974) . This distinctio n disappear s whe n expected reward s an d expected politicia n responses are introduced to the model. 9. Ther e i s th e possibilit y tha t PA C contribution s ar e no t motivate d b y political consideration s a t al l bu t reflec t a retur n fo r privat e benefit s received from a congressperson's la w practice or business firm. Data on banking clients of such firms could not be obtained. 10. Expressin g contribution s a s shares was the result o f focusing o n osten -

78 Thoma

s HavriJesk y

sibly heterogeneou s subsector s o f th e financial service s secto r an d th e legislators appurtenan t thereto . Big bank PACs contributed $1,076,32 9 to thes e congressperson s i n 1985-1987 . Thrif t PAC s contribute d $878,493. Al l othe r financial service s PAC s combine d contribute d a total o f $4,006,828 . The "al l other " categor y include d PAC s represent ing smaller banks, PACS representing nonbank financial services industries, PACs representing the customers of financial services firms, and a miscellaneous category . 11. Th e potential for multicollinearity fro m havin g two regulatory philoso phy variables i n the sam e regression i s discussed below . The Chambe r of Commerce rates the percentage that each congressperson voted favor ably t o th e busines s sid e o n representativ e piece s o f busines s legisla tion. Ideally, on e would wan t to employ a similar ratin g system devel oped by the banking industry. Such a rating system does not exist. 12. Eve n thoug h bi g bank s an d S&L s hav e historicall y tende d t o oppos e nonbank entr y int o traditiona l (commercia l loa n and checkabl e depos its) markets , competitivenes s i n thes e market s ha s increase d signifi cantly i n th e pas t tw o decades . Consequently , ther e ha s bee n mor e t o gain fro m bi g banks promotin g thei r ow n entr y int o nonbankin g area s such a s investmen t bankin g rathe r tha n fro m thei r inhibitin g nonban k entry int o traditiona l bankin g markets . Similarly , S&L s ha d mor e t o gain fro m capturin g broade r investmen t power s tha n fro m impedin g nonbank encroachment int o their traditional markets. 13. Th e use o f voting variables a s explanatory variable s give s rise to problems o f multicollinearit y an d revers e causalit y i n th e statistica l analy sis. These problems are discussed below. 14. Fo r an attempt to deal with the reverse causuality proble m in this way, see Havrilesky, "Causes and Consequences" (1990b). 15. In a separat e tes t th e Chamber o f Commerc e ratin g wa s entere d i n various nonlinea r transformation s i n orde r t o captur e a conjecture d clustering o f sizabl e contribution s t o congressperson s nea r th e ratin g median. The premise was that mugwump legislator s would be easier to influence o n regulator y issues . Non e o f th e transformation s produce d statistically significant estimates . 16. Th e earlier literatur e support s th e belief tha t part y lines are not impor tant, arguin g that sinc e there i s low and decreasin g turnover o f incum bents, PA C access mus t b e maintaine d (b y PAC contributions) regard less o f part y affiliation . Becaus e o f possibl e multicollinearit y wit h th e Chamber o f Commerce ratin g variable, the part y variable was droppe d from thi s equation. When this was done there was no effect o n the sign or significance of the other estimates and a very small reduction in the R2. 17. A binary variabl e measurin g whethe r th e congressperso n wa s chai r of the Hous e o r Senat e Bankin g Committe e wa s als o trie d i n bot h equa tions but was not statistically significant .

A n Empirical Analysis

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9

18. A binar y variabl e measurin g whethe r th e congressperso n wa s a fresh man wa s als o trie d i n bot h equation s bu t wa s no t statisticall y significant . 19. A n equatio n wa s estimate d wit h th e contribution s o f smalle r ban k PACs a s a shar e o f tota l financial service s PA C contribution s a s th e dependent variable . Th e explanator y variable s wer e th e sam e a s i n Table 3.1 . Except fo r th e stat e branching statu s binary , whos e estimate d coefficient wa s negative , an d th e Chambe r o f Commerc e index , whos e estimated coefficien t wa s positive , al l estimated coefficient s wer e statis tically insignificant . The resul t was : Table 3. 4 Intercept Party 0.0111 0.0250 (0.186) (0.875 State Branchin g Votin Status Record -0.0322* 0.017 (-1.886) (0.573 R2 = .0 3

Chambe 3 0.0009 ) (1.772 g

Seniority 2 -0.000 ) (0.020

r of Commerce Ratin g * ) Plurality 1 0.025 ) (0.437

0 )

* Significant a t the .10 level

20. A binar y variabl e measurin g whethe r th e congressperso n wa s impli cated i n th e Hous e Speake r Wrigh t o r Keatin g Fiv e scandal s wa s als o tried her e bu t wa s no t statisticall y significant . Onl y Senator s Riegl e an d Cranston wer e member s o f the Keatin g Fiv e and wer e als o on the Senat e Banking Committee .

References Adams, Jame s Ring . 1989 . The Big Fix: Inside the S&L Scandal Ne w York : Wiley, 1989 . Barth, James R. , an d R . Da n Brumbaugh . "Th e Roug h Roa d fro m FIRRE A t o Deposit Insuranc e Reform. " Stanford Law & Policy Review (Sprin g 1990) : 58-67. Brumbaugh, R . Dan . Thrifts under Siege : Restoring Order to America n Banking. Cambridge , MA : Ballinger, 1988 . Chappell, Henr y W . "Campaig n Contribution s an d Votin g o n th e Carg o Preference Bill : A Compariso n o f Simultaneou s Models. " Public Choice 36 (1981) .

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Edelman, Susa n A . "Ge t 'E m Whil e They'r e Green : Corporat e PAC s an d Congressional Freshmen. " Manuscript , Apri l 1988 . Grier, Kevi n B. , and Michae l C . Munger. "Committe e Assignments , Constit uent Preferences , an d Campaig n Contributions. " Economic Inquir y 2 9 (1991): 24-44 . Havrilesky, Thomas . "Th e Influenc e o f th e Federa l Advisor y Counci l o n Monetary Policy. " Journal of Money , Credit and Bankin g 2 2 (1990a) . . "Th e Cause s an d Consequence s o f Bi g Ban k PA C Contributions. " Journal of Financial Services Research 4 (1990b) : 243-249 . . "Marke t Failur e an d Publi c Choic e Theorie s o f Bankin g Regulatio n Deregulation." Research in Financial Services 1 (1989): 129-50 . Havrilesky, Thomas , an d Joh n Boorma n (eds.) . Curren t Perspectives in Banking. Arlingto n Heights , 12 ; Harlan Davidson , 1976 . Kane, Edward J . "Th e Gatherin g Crisi s i n Federa l Deposi t Insurance. " Cam bridge: MIT Press, 1985 . . "Th e Unendin g Deposi t Insuranc e Mess. " Science 2 7 (1989) : 451-56. McCubbins, Mathe w D. , Roge r G . Noll , an d Barr y R . Weingast . "Structur e and Process , Politic s an d Policy : Administrativ e Arrangement s an d th e Political Contro l o f Agencies. " Virgini a Law Review 7 5 (1989) : 431-82 . Pizzo, Stephe n P. , Mary Fricker , an d Pau l Muolo . Inside fob: The Looting of America's Saving s an d Loans. Ne w York : McGraw-Hill, 1989 . Poole, Keith , an d Thoma s Romer . "Pattern s o f Politica l Actio n Committe e Contributions t o th e 198 0 Campaig n fo r th e Unite d State s Hous e o f Representatives." Public Choice 4 7 (1985) . Poole, Keith , Thoma s Romer , an d Howar d Rosenthal . "Th e Reveale d Pref erences o f Politica l Actio n Committees. " America n Economic Review (May 1987) . Romer, Thomas , an d Barr y Weingast . "Politica l Foundation s o f th e Thrif t Debacle." I n A . Alesina , ed. , Politics and Economics in the 1980s. Chi cago: University o f Chicag o Press , 1991. Silberman, Jonathan , an d Gare y Durden . "Determinin g Legislativ e Prefer ences o n th e Minimu m Wage : An Economi c Approach. " Journal of Political Economy 8 4 (1976) . Tullock, Gordon . The Economics of Rent-Seeking . Boston : Kluwer, 1989 . Weingast, Barr y R . "Th e Congressional-Bureaucrati c System : A Principal Agent Perspectiv e (wit h Application s t o th e SEC). " Publi c Choice 4 4 (1984): 1 4 7 - 9 1 . Weingast, Barr y R. , an d Mar k J . Moran . "Bureaucrati c Discretio n o r Congressional Control ? Regulator y Policymakin g b y th e Federa l Trad e Commission." Journa l of Political Economy 9 1 (1983) : 765-800 . Welch, Willia m P . "Th e Economic s o f Campaig n Funds. " Publi c Choic e 2 0 (1974). Zion, Uri , an d Zee v Eytan . "O n Mone y Vote s an d Polic y i n a Democrati c Society." Publi c Choice 1 7 (1974) .

4 Bankers a s Scapegoat s fo r Governmen t Created Banking Crise s in U.S. History Richard M . Salsma n

Introduction If there i s anything more tragic than ou r curren t banking crisis, it is that th e crisi s i s being blamed o n the wron g group, on the bankers, instead o f o n th e primar y culprit , governmen t intervention . Th e tragedy lies in failing t o identify th e fundamental caus e of the problem, thereb y ensurin g it s continuance . Banker s ar e no t entirel y in nocent o f wrongdoin g i n th e presen t debacle , but t o the exten t tha t bankers hav e bee n irresponsible , i t ha s bee n primaril y governmen t intervention tha t ha s encourage d the m t o b e so . More widely , i t i s irresponsible governmen t polic y tha t ha s mad e th e U.S . bankin g crises o f th e pas t centur y s o frequen t an d seemingl y s o inevitable . Government ha s create d thes e banking crises—sometime s inadver tently, a t othe r time s wit h ful l knowledge—b y makin g i t nearl y impossible t o practic e pruden t banking . Havin g don e so , govern ment ha s the n pointe d t o bad bankin g practice s a s sufficien t caus e for still further intervention s i n the industry . I. The Context of the Current Banking Crisis The view that today's banking crisis is due primarily to the misman agement an d frau d o f privat e banker s underlie s mos t popula r ac counts o f th e crisis. 1 Critic s ar e incline d t o blam e privat e banker s 81

82 Richar d M . SaJsma n for bankin g instabilit y becaus e the y wrongl y believ e tha t unregu lated banking systems are inherently unstabl e and that regulation i s required t o restrai n som e natura l tendenc y o f privat e banker s t o engage i n mismanagemen t an d fraud . Centra l bankin g i s sai d t o provide a restrainin g influenc e o n th e destabilizin g urge s o f th e private bankin g system , whil e fre e bankin g i s see n a s inherentl y prone t o instability . Th e recent, burgeoning literatur e o n free bank ing overthrows thi s conventiona l wisdo m an d defend s fre e bankin g as a n inherentl y stabl e syste m mad e unstabl e onl y b y lega l restric tions an d centra l banking-relate d interventions. 2 I n thi s view , ba d banking come s no t fro m fre e market s bu t fro m pervers e publi c pol icy. Guided b y erroneou s assumption s abou t th e natur e o f free bank ing and central banking, analysts of the current crisis typically stres s the symptom s (ba d banking practices), and overloo k the underlyin g disease (government intervention), as the cause of our problems. For example, man y commentator s an d ban k regulator s ar e satisfie d t o cite anecdota l evidenc e fro m th e curren t banking crisi s to draw th e obvious conclusio n tha t banker s lik e Charle s Keatin g ar e incompe tent an d dishonest , an d the n t o clai m tha t thes e an d simila r case s represent th e su m an d substanc e o f a n explanatio n o f th e bankin g crisis. Such figures simply are not representative of the entire industry. While ther e i s no denyin g that bankers suc h a s Charles Keatin g exist, we can only understand th e fundamental caus e of our banking crisis b y identifyin g th e institutiona l arrangement s tha t mak e suc h bankers possible. As I argue below, central banking and legal restrictions have institutionalized unsaf e banking . Today's bankin g crisi s i s onl y th e lates t i n a lon g serie s o f U.S . banking crise s blame d o n banker s bu t actuall y cause d b y government intervention. A quick review of our banking history makes the point. Th e mer e mentio n o f "wildca t banking' ' conjure s u p image s of reckles s bankin g practice s o n th e America n frontie r i n the nine teenth century , eve n thoug h i t wa s governmen t interventio n tha t promoted suc h practices. 3 "Mone y panics' ' i n th e lat e nineteent h century wer e alway s caus e fo r alarm , politica l demagoguery , an d reform movement s aime d a t checking the "power " o f bankers, even though governmen t interventio n brough t o n thos e panic s a s well. 4 The stock market crash of 1929 and the collapse of more than a third of all banks i n the Great Depression o f the early 1930 s were blame d on "excesses" in the financial system and by the bankers of the time, although i t wa s late r demonstrate d tha t irresponsibl e Federa l Re -

Bankers as Scapegoats 8

3

serve policy create d th e boom an d the bust. 5 In the past decade , the stupendous demis e o f the S&L industry, the breakdown o f commer cial banking , an d th e collaps e o f deposi t insuranc e ar e onl y th e latest example s o f crisi s i n America n banking . Bu t thes e too , ar e scandals lai d primaril y a t the fee t o f the bankers, eve n thoug h gov ernment intervention mad e them possible (Salsman 1990). In the next section I discuss the nature of banking crises and offe r a framewor k fo r understandin g wh y banker s ar e mad e scapegoat s for suc h crises . I n th e followin g section s I discuss thre e importan t banking episode s i n th e Unite d State s ove r th e pas t century , epi sodes no t onl y characterize d b y crisi s but als o followed b y reform s intended t o preclud e futur e crises : 1 ) the mone y panic s o f th e lat e nineteenth century , especiall y th e pani c o f 1907 , an d th e Federa l Reserve Syste m tha t followed , 2 ) the bankin g collaps e o f th e earl y 1930s, which brought stil l further reforms , an d 3 ) the banking problems o f th e lat e 1970 s tha t wer e agai n followe d b y reform s i n th e early 1980 s aime d a t preventin g futur e instability . Finally , I examine th e curren t bankin g crisi s i n ligh t o f th e historica l pattern . I n each of these cases I show how misguided reform s flowed naturall y from th e vie w that bankers , not government , cause d th e crises , an d that th e reforms onl y perpetuate d futur e instabilit y instea d o f fun damentally curin g it . Th e historica l patter n i s a s tragi c a s i t i s repetitive, because the recurring failure t o properly identif y govern ment interventio n a s the culprit i n these banking crises has brough t only further intervention s an d further crises . Only if we understan d the pattern and break it can we undertake truly effective reform . II. The Nature of Banking Crises and the Need for Scapegoat s Historically, bankin g crise s hav e bee n characterize d a s eithe r tem porary scramble s fo r liquidit y lastin g a fe w week s o r months , o r prolonged period s o f bankin g deterioratio n involvin g no t onl y illi quidity bu t als o fallin g asse t prices , declinin g solvency , an d ban k failure extendin g ove r a fe w years . Th e "mone y panics' ' i n th e United State s durin g th e nationa l bankin g er a ar e example s o f th e former typ e o f crisis , while th e banking collaps e o f the earl y 1930 s is a n exampl e o f th e latte r type . A s Ann a J . Schwart z (1986 ) ha s observed, th e occasiona l distres s suffere d b y overextende d debtor s is not sufficient t o warrant the label "crisis"; only major disruption s in th e payment s syste m o r widespread credi t default s closel y asso ciated wit h breakdown s i n mone y itsel f fit the bill. Moreover, ban k

84 Richar d M . Salsma n runs o f limite d scop e o r deposito r run s o n a limite d numbe r o f particular banks do not constitute a crisis. Rather, crises entail widespread failure s o r runs o n th e bankin g syste m itsel f (Calomiri s an d Gorton 1991 ; Tallman 1988). Where d o th e fundamenta l origin s o f bankin g crise s lie ? Som e have argue d tha t fractiona l reserv e bankin g i s inherentl y pron e t o panics, becaus e deposit s tha t ca n b e withdraw n o n deman d ar e primarily investe d i n longer-ter m asset s instea d o f cash . But recen t research has shown that countrie s othe r than the United State s with fractional reserv e system s hav e bee n pani c fre e an d tha t "bankin g panics ar e no t inheren t i n bankin g contracts—institutiona l struc ture matters ,, (Calomiri s an d Gorto n 1991) . Th e phras e "institu tional structure " designates the legal and economi c framework withi n which bank s operate . Som e framework s clearl y promot e stability , while others invite crises. That banker s coul d b e th e sourc e o f bankin g crise s seem s a re mote possibility , considerin g th e damag e t o th e healt h an d reputa tion o f th e industr y tha t panic s bring . Ther e i s littl e evidenc e i n economic theor y o r histor y t o sugges t tha t privat e bankers—an y more than businesspeopl e i n othe r fields—would naturall y ten d t o disrupt o r destroy their ow n industry , an d therefore thei r ow n live lihoods. Ther e i s considerabl e evidence , o n th e othe r hand , tha t governments tend to work to the detriment of the market. The "public choice " revolutio n i n economic s ha s overturne d th e long-hel d assumption tha t governmen t action s ar e conducte d i n th e "publi c interest." Instead , th e publi c choic e schoo l hold s tha t governmen t pursues it s ow n power , on e tha t i s ofte n a t odd s wit h optima l market outcomes . Public choice insights about governmental powe r seeking cal l fo r a new perspectiv e o n centra l bankin g an d bankin g regulation. I have argued elsewhere (Salsman 1990,119-24) that the primary purpos e o f central banking is to finance large r government , to provid e fund s abov e an d beyon d thos e obtaine d throug h taxin g and borrowin g powers . In th e Unite d States , such fund s hav e bee n needed t o finance wars , includin g th e Civi l Wa r an d Worl d Wa r I , but also to finance a growing welfare stat e that began in the progressive era , whe n th e Federa l Reserv e wa s created . Othe r writer s (Goodhart 1988 ; Glasne r 1989 , ch . 2 ) hav e locate d th e origin s o f foreign centra l banks , a s well , i n governments ' desir e t o secur e access t o financial resource s b y endowin g particula r bank s wit h monopoly power s ove r money . Th e basi c revenue-raisin g purpos e of centra l bankin g carrie s wit h i t a functiona l tendenc y t o under -

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mine the financial conditio n o f the private banking system (Salsma n 1990, 39-78) . Th e powerfu l intervention s o f governmen t centra l banks and the extensive lega l restrictions impose d o n the actions of private bank s ar e therefore a n obviou s startin g poin t fo r discernin g the source of banking instability . A publi c choic e perspectiv e lead s t o skepticis m abou t th e tradi tional rationale s fo r centra l bankin g an d ban k regulation . Histor y turns ou t to warrant suc h skepticism . Th e traditional "publi c inter est" perspectiv e claime d tha t centra l bank s wer e neede d t o "figh t inflation" o r "promot e economi c growth " o r "lowe r interes t rates " or "smoot h th e busines s cycle " o r "insur e ful l employment. " Prio r to the establishment o f central banking in this century, however, the United State s enjoye d muc h lowe r inflatio n an d interes t rates , greater rates o f economi c growth , narrowe r cyclica l swings , and lowe r un employment. Ban k regulation i s traditionally justifie d o n the ground s that banker s ar e reckless i n it s absence . But extensiv e researc h ha s shown tha t banker s ar e mor e reckles s whe n the y hav e acces s t o government deposi t insuranc e an d a lender o f last resort, attribute s not o f fre e market s bu t o f centra l bankin g regime s (Bensto n e t al . 1986). Public choic e theor y ca n als o infor m u s abou t th e tendenc y o f government t o mak e banker s scapegoat s fo r bankin g crises . Al though government s tak e action s tha t undermin e markets , the y d o not wis h t o b e see n a s disrupter s o f market s o r destroyer s o f th e living standards market s deliver . B y deflecting attentio n awa y fro m their ow n disruptiv e action s towar d thos e o f a scapegoat , govern ments ca n escape voter wrath and preserv e their powers for anothe r day. If banking crises were widely attribute d t o central banking an d legal restrictions—a s the y wer e i n Andre w Jackson' s day—ther e might b e genera l agitatio n fo r th e remova l o f suc h interventions . Governments that benefit fro m centra l banking and legal restrictions will naturally promote an alternative view. It is true that government official s i n the United State s have been blamed i n par t fo r today' s bankin g crisis , but seldo m i n a way tha t questions governmen t interventio n a t root. Th e U.S . government i s more ofte n blame d fo r allegedl y "deregulating " banks , fo r bein g insufficiently stric t i n its regulatory oversight , o r for being too eager to protec t unscrupulou s ban k executive s fro m regulator y scrutiny . In suc h case s governmen t i s blamed , no t fo r promotin g instabilit y through intervention, but for being insufficiently interventionist . We turn no w t o a n examinatio n o f historic bankin g crise s i n th e

86 Richar d M . Salsma n United States , showin g ho w an d wh y banker s hav e bee n mad e scapegoats for government-sponsored instability . III. Money Panics an d Banking Crises in the National Bankin g Era: Precursor to the Federal Reserve System During the "national banking era" in the United State s (1863-1913) , the bankin g syste m suffere d periodi c "mone y panics " tha t wer e significant enoug h t o provok e governmen t investigations—an d growing criticism—o f privat e bankin g practices . Throughou t thi s era, all currency-issuing U.S. banks operated under legal restrictions imposed b y th e Nationa l Currenc y Act s o f 186 3 an d 1864. 6 Sinc e the investigation s generall y faile d t o recognize tha t th e crise s wer e caused b y legal restrictions o n banks, they pave d th e way for bank ing reforms tha t extende d governmen t intervention s stil l furthe r i n money and banking. Historians hav e identifie d five episode s o f "mone y panics, " o r banking crises , i n th e fifty year s betwee n th e Civi l Wa r an d th e formation o f th e Fe d i n 1913 . Th e bankin g crise s occurre d i n th e years 1873 , 1884, 1890 , 1893, and 1907. 7 These crise s differe d con siderably fro m th e crise s experience d i n th e twentiet h century , th e era of central banking. They were briefer, milder, and involved acut e illiquidity, whereas in this century crises have involved prolongue d periods o f recessio n an d depression , widesprea d ban k failure , an d chronic insolvency . Tha t th e basi c solvenc y o f bank s wa s no t a n issue durin g th e nationa l bankin g er a i s confirme d b y th e relativ e capital strengt h o f th e bankin g system , eve n durin g th e five crises . For example , i n 1893 , th e bankin g syste m enjoye d a capita l rati o (capital a s a percen t o f tota l assets ) o f 25% , nearly fou r time s th e level maintained b y banks today (Salsma n 1990 , 107). During th e occasiona l bout s o f illiquidit y tha t aros e i n th e post Civil War banking system, depositors and banks found i t difficult, i f not impossible , t o conver t deposit s int o currency . Th e illiquidit y that di d aris e wa s seasona l i n nature , no t secular ; o n a n absolut e level, th e liquidit y rati o o f th e bankin g syste m (cas h asset s a s a percent of demand deposits ) appeared to be high during the national banking era (above 20%), again, well above the ratios maintained b y banks today . However , th e sharp , seasona l variation s i n liquidit y and occasionall y larg e difference s i n th e relativ e liquidit y level s of particular bank s prove d troublesome . I n som e case s bank s at tempted t o buil d liquidit y durin g crise s b y contractin g cal l loans ,

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instead o f preserving it by suspending the convertibility o f deposits. In this respect , depositor s wer e les s harme d b y the illiquidit y tha n were borrowers . Loa n contraction s le d t o occasiona l bankruptcie s and bank failures, whic h fo r the most part were well contained. Bu t the panics were brief an d di d not interfere wit h long-term economi c growth. They typically followed th e onset of recessions an d di d no t cause them . Moreover , th e cost s o f th e panic s i n term s o f ban k failures, deposito r losses , o r los t outpu t wer e relativel y minor. 8 I f anything, th e panic s infuse d market s wit h a renewed sens e o f cau tion an d conservatism . Overall , o f course , the nationa l bankin g er a coincided wit h a period of unprecedented growt h and prosperity fo r the country . Bank s playe d a significan t rol e i n financing th e post Civil Wa r economi c expansion , supportin g i t o n footing s o f soun d money and credit . Although banks were more liquid o n an absolute basis during the national banking era than they are today, a relatively greater portio n of thei r reserve s wer e kep t i n th e for m o f deposit s a t othe r bank s than wa s hel d directl y i n thei r ow n vaults . I n particular , i n th e spring and summer , agricultura l banks in rural areas tended t o keep reserve balances on deposit at correspondent banks located in cities, primarily i n Ne w York . Thi s arrangemen t explain s th e seasona l nature o f the liquidit y crise s that wer e occasionall y suffered . I n th e spring an d fal l months , agricultura l bank s woul d dra w o n thei r deposits a t cit y bank s t o mee t highe r currenc y deman d associate d with planting (spring ) and harvestin g (fall ) activitie s (Spragu e 1910 , 19-20; Chari 1989,11). At other times these interbank deposits were held in New York banks, which typically invested them in call loans —loans t o acquir e securities . Th e cit y bank s ofte n pai d interes t t o rural banks for these deposits, because competition compelle d the m to pas s alon g the interes t the y coul d ear n by investing th e deposit s in call loans. Although thes e cal l loans were normally considere d liqui d an d a worthy us e o f short-ter m deman d deposits , bank s foun d i t quit e difficult t o liquidate them en masse when the fall crop was a healthy one an d rura l ban k withdrawal s wer e heavy . Moreover , th e cal l loans themselve s wer e sai d t o contribut e t o speculativ e pric e rise s on stock exchanges, creating inflated value s that were not supporta ble whe n liquidit y wa s withdrawn . Loa n default s ofte n followed , disrupting business, but the process was seen as a cleansing mecha nism as well. Excesses were liquidated an d di d not accumulate int o potentially greater problems in the future .

88 Richar d M . SaJsma n The liquidit y crise s o f th e nineteenth-centur y U.S . banking sys tem wer e no t a n inevitabl e consequenc e o f unregulate d banking . Instead, the y wer e a direc t resul t o f distortiv e intervention s i n th e banking syste m impose d b y government throug h th e national bank ing acts . Thes e interventions , discusse d a t lengt h below , include d reserve requirements, branching restrictions, and bond-collateral restrictions o n currency issuance . These legal restrictions fostere d illiquidit y i n the banking syste m in tw o importan t ways . First , minimu m reserv e requirement s ac tually made it impossible for banks to use those reserves for redemption purposes . Th e inten t behin d minimu m reserv e ratio s wa s t o ensure ban k liquidity , bu t th e exac t opposit e resul t wa s achieved . Only reserve s i n exces s o f minimu m reserv e requirement s actuall y could b e use d t o mee t deposi t withdrawals . Thus , eve n i f a centra l reserve city bank met its reserve requirement, it faced a reduction of that rati o (an d a violation o f the banking laws ) with ever y margina l request fo r deposi t redemption . T o preserv e o r restor e it s reserv e ratio i n the face o f suc h withdrawals, i t had to build reserve s eithe r by acquiring additiona l reserve s o r by contractin g loans . Ironically , because th e actua l reserve s o n han d wer e jus t sufficien t t o mee t regulatory liquidity requirements, they could not be used directl y to meet demand s for liquidity. Of course, this perversity is common t o all minimum reserv e requirements. Precisely those reserves that ar e required fo r liquidit y ar e no t availabl e t o mee t deposito r request s for liquidity . Unrestricte d b y rigi d reserv e requirements , th e bank s would hav e been i n a far better positio n t o meet rising demands fo r liquidity. Durin g thi s time , th e Unite d State s wa s th e onl y majo r country i n the world tha t had lega l reserve requirements (Friedma n and Schwart z 1963 , 118 note 44). Second, by segregating the banking system into "countr y banks, " "reserve cit y banks, " an d "centra l reserv e cit y banks, " th e reserv e requirements impose d b y governmen t unde r th e nationa l bankin g system encourage d a n unstable inverte d "pyrami d o f reserves" tha t was susceptibl e t o breakdow n durin g sharp , seasona l variation s i n the demand fo r liquidity. 9 Country banks were required t o maintai n reserves equivalent to 15% of their deposits, two-fifths o f which ha d to be held a s cash in their vaults. The rest could be held a s deposit s at reserv e cit y banks , whic h typicall y earne d interest . I n turn , re serve city banks, located in fifteen designated cities, had to maintain reserves equa l t o 25 % of deposi t liabilities , hal f o f whic h coul d b e held a s deposit s i n centra l reserv e cit y banks , primaril y larg e Ne w

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York Cit y banks . Finally , th e centra l reserv e cit y bank s wer e re quired t o maintai n minimu m reserv e ratio s o f 25% . Th e centra l reserve cit y banks tende d t o inves t thei r corresponden t balance s i n call loans , normall y th e mos t liqui d investmen t available . Whe n crops wer e harveste d i n th e fal l an d th e countr y bank s demande d cash, New York banks were forced t o meet the withdrawals o f inter bank deposit s b y demandin g paymen t o n cal l loans . Ha d countr y banks no t bee n encourage d b y th e Nationa l Currenc y Act s t o hol d reserves a s deposit s i n reserv e cit y banks , the y woul d hav e bee n better equippe d t o control their ow n reserves an d to satisfy directl y seasonal change s i n deman d fo r cash . New York banks woul d hav e had little reason to invest their funds i n call loans. Branching restriction s impose d b y la w als o encourage d reserv e pyramiding b y preventin g countr y bank s fro m bein g branche s o f banks with head office s i n financial centers . Banks with widesprea d branching network s woul d hav e been abl e to shif t reserve s flexibly to branche s wher e th e deman d fo r cas h wa s greatest , instea d o f relying on the capacity o f other banks to meet requests for cas h in a pinch. Branchin g restriction s als o prevente d bank s fro m diversify ing thei r assets , a pervasiv e sourc e o f instabilit y tha t plague s ou r system eve n today . Again , th e Unite d State s wa s th e onl y majo r country in the world to impose such onerous branching restrictions. The illiquidit y inheren t i n th e nationa l bankin g syste m wa s als o a direc t consequenc e o f th e bond-collatera l provision s spelle d ou t in nationa l legislation . Bank s coul d onl y issu e ban k notes , o r cur rency, i f th e note s wer e secure d b y bond s issue d b y th e federa l government. The basic purpose o f the collateral provision, as Secretary o f th e Treasur y Samue l Chas e mad e clear , wa s t o assis t th e Union government i n financing the Civil War by fostering a demand for its debt. But the provision was also promoted as a way to provide a "uniform " currenc y an d t o protec t noteholder s agains t ultimat e loss—two "publi c interest " rationalization s tha t hav e bee n inter preted sympatheticall y by historians. Whatever th e motive s o f government , th e lega l restriction s im posed o n ban k currenc y fostere d illiquidit y b y makin g th e not e issues o f bank s "inelastic. " Bank s coul d no t freel y expan d an d contract their note circulation in accordance with the needs of trade, but instea d wer e confine d t o issuin g note s i n accordanc e wit h th e exigencies o f governmen t finance. Thi s mean t tha t bank s coul d no t easily satisfy shift s i n the public's ratio of deposits to currency. Th e restrictions becam e eve r mor e onerou s a s th e nationa l bankin g er a

90 Richar

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progressed, becaus e th e U.S . Treasur y wa s reducin g th e tota l na tional deb t availabl e t o collateraliz e ban k note s i n anticipatio n o f resuming speci e payment s i n 1879 . Even afte r resumption , th e sup ply o f require d collatera l wa s diminishing , especiall y relativ e t o trade. Th e relativ e scarcit y pu t a premiu m o n eligibl e bon d collat eral, makin g not e issu e excessivel y costl y (Smit h 1936 , 149) . Ther e were als o burdensom e administrativ e delay s impose d b y th e Trea sury whe n i t approve d an d shippe d ou t currency , delay s tha t wer e most bindin g whe n th e deman d fo r currenc y wa s greates t an d th e state o f pani c mos t acut e (Horwit z 1990 , 640-41) . The mone y panic s o f th e nineteent h centur y di d no t reflec t a lac k of confidenc e i n bank s b y depositor s bu t onl y th e fac t tha t i t wa s illegal fo r banker s t o freel y mee t shift s i n depositors ' deman d fo r currency relativ e t o checkin g deposits . A s Friedma n an d Schwart z (1963, 295 , note 77) hav e argued , th e panic s o f th e nationa l bankin g era "resulte d muc h les s fro m th e absenc e o f elasticit y o f th e tota l stock o f mone y tha n fro m th e absenc e o f interconvertibilit y o f de posits an d currency. " A syste m o f fre e bankin g woul d hav e deliv ered superio r results . As Georg e Selgi n (1988b , 626 ) ha s expained : When bank s ar e unrestricte d i n thei r abilit y t o issu e ban k notes , eac h institution ca n mee t increase s i n it s clients' demand s fo r currenc y withou t difficulty an d withou t affectin g it s liquidity o r solvency. . . . The supply of currency is flexible under unrestricted not e issue because bank note liabilities are , for a bank capabl e o f issuing them, not significantl y differen t fro m deposit liabilities . . . . The issu e o f note s i n exchang e fo r deposit s merel y involves offsettin g adjustment s o n th e liabilit y sid e o f th e th e bank' s bal ance sheet, with no change on the asset side. Unfortunately, th e nationa l bankin g law s di d no t permi t unre stricted not e issue , an d therefor e bank s wer e force d t o mee t in creased currenc y deman d b y payin g ou t reserve s an d makin g pain ful adjustment s t o thei r loa n assets . Ha d bank s bee n abl e t o issu e notes withou t inflexibl e bond-collatera l provisions , an d wit h onl y the requiremen t tha t th e note s b e redeeme d i n a mediu m mutuall y agreed t o by bank an d noteholder , ther e would hav e been n o system wide liquidit y crise s t o spea k o f i n thes e decades . Bankers wer e innovativ e i n tryin g t o offse t th e pervers e effect s o f these lega l restriction s o n currenc y issuance . Sometime s the y per mitted thei r reserv e ratio s t o fal l temporaril y belo w th e 25 % lega l minimums i n orde r t o mee t deposito r withdrawal s an d preven t suspensions. Th e bank s woul d restor e thei r ratio s onc e th e strin -

Bankers a s Scapegoat s 9 1 gency passed . I n addition , i n eac h o f th e panic s th e clearinghouse s of centra l reserv e cit y bank s create d "clearinghous e certificates " that wer e use d i n plac e o f currenc y t o settl e reserv e clearing s be tween members , thereby preservin g the more limited suppl y o f cur rency needed to meet depositor withdrawals (Timberlak e 1984; Gorton 1984) . I n othe r cases , banker s an d businesse s simpl y issue d private currency , bypassin g bankin g law s (Andre w 1908) . As a las t resort, convertibilit y wa s restricte d o r suspende d fo r brie f period s (but onl y i n th e panic s o f 1873 , 1893, and 1907 ) (Gorto n 1985) . By all these measures , banks wer e abl e t o minimiz e th e contractio n of loans tha t otherwis e woul d hav e been necessar y to meet withdraw als. Bu t despit e th e rol e playe d b y lega l restriction s i n fosterin g illiquidity an d othe r distortion s i n th e nineteenth-centur y bankin g system, an d despit e th e innovativ e attempt s b y banks t o overcom e these distortions , the banks themselves wer e largely blamed fo r th e crises. They wer e condemne d a s lawbreakers fo r going below mini mum reserv e requirements . Cit y bank s especiall y wer e blame d fo r paying interes t o n deposits , fo r lurin g countr y bank s int o openin g correspondent accounts , fo r financing speculation , an d fo r issuin g "unauthorized currency " in the form o f clearinghouse certificates . Government report s implie d tha t fraud , mismanagement , an d ban k failures wer e th e prim e cause s o f th e mone y panics . I n on e report , for example , th e comptrolle r o f th e currenc y sai d th e 187 3 crisi s was cause d b y th e paymen t o f interes t o n deposit s an d b y th e financing o f speculation by banks. The comptroller (quote d by Sprague 1910 , 81 ) furthe r blame d th e fe w bank s tha t faile d durin g th e crisis fo r havin g starte d it , an d sai d th e failure s wer e du e t o "th e criminal mismanagemen t o f their officer s o r to the neglec t o r violation o f th e nationa l ban k ac t o n th e par t o f thei r directors. " On e of the "crimina l violations " referre d t o involve d lowerin g reserv e ra tios belo w lega l minimum s t o mee t withdrawals . Th e comptroller , John Jay Knox, simply dismissed the complaint o f bankers that legal reserve requirements mad e those reserves unavailable to depositors, insisting instead that "th e provision requiring that a reserve shall be kept o n hand a t all times was intended t o protect the deposito r an d to keep the bank in funds fo r the purpose o f responding at all times to th e demand s o f it s creditors. " T o sugges t tha t th e requiremen t was harmful , h e said , "i s equivalen t t o declarin g tha t th e nationa l currency ac t was intended t o provide for the destructio n o f the very institutions i t created." 10 Th e comptrolle r recommende d increase d government interventio n int o banking: closer scrutiny o f bank lend -

92 Richar d M . SaJsma n ing practices , prohibition s o n th e paymen t o f interes t o n deposits , and swif t prosecutio n o f bank s tha t violat e minimu m reserv e re quirements. Government official s generall y di d no t criticiz e th e reserv e re quirements, th e reserv e pyramiding , o r th e not e issuanc e restric tions impose d unde r th e nationa l bankin g laws . Wher e criticism s were voiced, the y wer e not sufficientl y adopte d t o reform th e laws . In its report on the crisis of 1873, the Treasury recognized that "wit h a fixed amoun t o f circulatio n o f ban k note s an d o f Unite d State s legal-tender note s no t redeemabl e i n coi n an d wit h gol d abov e pa r with currency , ther e mus t b e eac h yea r time s o f redundanc y an d times o f scarcit y o f currency , dependin g wholl y o n demand , n o method existin g fo r increasin g th e supply . Wit h a circulatin g me dium redeemabl e i n coin , a redundancy i s correcte d b y the export , and a scarcity by the import o f specie from othe r countries." On the basis o f thi s insight , th e Treasur y recommende d " a permanen t re turn t o th e soun d basi s o f speci e payment s an d a gold standar d t o which all our paper issues shall be made of equal value." 11 A specie resumption ac t wa s passe d i n 187 5 and th e Unite d State s resume d specie payments o n legal tender notes in 1879 . The absolute ceilin g on aggregat e nationa l ban k not e circulatio n wa s lifte d an d bond collateral requirement s wer e ease d ver y slightl y i n 1900 . Bu t th e main feature s contributin g t o illiquidit y persisted , an d mone y pan ics remained a near certainty . The 189 3 pani c stemme d no t fro m banke r wrongdoin g bu t fro m uncertainty ove r the federal government' s willingness an d ability to maintain th e gold standar d i n the face o f pressure from silve r inter ests and other inflationists (Friedma n and Schwartz 1963,104-118) . Once uncertaint y se t in , th e destabilizin g feature s o f th e nationa l banking system outlined abov e made the situation worse. This time, remarkably, both the comptroller o f the currency an d the U.S. Treasury Departmen t advocate d th e repea l o f th e bond-collatera l provi sions in their 189 4 annual reports. Treasury Secretary Carlisle (quote d in Friedman an d Schwart z 1963 , 117-18, note 44) went further an d even recommended th e repeal of legal reserve requirements, arguing that every prudent bank, if left free to conduct its deposit and discount busines s in th e manne r mos t advantageou s t o it s ow n interest s an d th e interest s of its patrons, will undoubtedly keep on hand a reasonable reserve to meet not only all the ordinary demand s upon it, but to provide for such emergencie s as are liabl e t o occu r . . . bu t i t ough t no t b e prohibited b y law from usin g

Bankers as Scapegoat s 9 3 such reserve for th e onl y purpose s i t was designed t o accomplish.... T o provide for a reserve which ca n not be utilized eve n at a time of greatest stringency an d distrus t withou t incurrin g penalties o f forfeiture, afford s a most striking illustration of the impolicy of legislative interference with the natural laws of trade and finance. Unfortunately, th e insight s an d recommendation s o f th e Treasur y were ignore d b y legislatures , banker s wer e agai n blame d fo r th e panic, and the destabilizing "legislature interference'' recognize d by Secretary Carlisle remained i n place. The pani c o f 190 7 wa s th e las t o f th e mone y panic s unde r th e national banking era, but it was the most important because it was a precursor to passage of the still more interventionist Federal Reserve Act. Th e exac t origin s o f th e pani c ar e widel y debate d stil l today . Sprague's authoritativ e accoun t ha s demonstrate d th e considerabl e financial strengt h an d pruden t lendin g posture s o f th e reserv e cit y and centra l reserv e cit y bank s prio r t o th e crisis , s o ther e i s littl e reason t o suspec t speculativ e influence s playe d a major rol e (Spra gue 1910 , 216-24) . "Bu t ther e wa s anothe r influence, " remarke d Sprague (1910 , 230-31) , "poten t durin g thi s period , whic h tende d positively t o encourage unsound banking— a larg e government sur plus. " In and o f itself, a surplus reflecte d soun d publi c finance . Bu t the surplus mean t that government securities , required to back bank currency, wer e i n shor t supply . A s before , seasona l instabilit y se t in, an d th e reserv e pyrami d starte d t o topple . Thi s time , tryin g t o overcome th e illiquidit y tha t ensued , Secretar y o f the Treasur y Sha w engaged i n a serie s o f disruptiv e operations , depositin g an d the n suddenly withdrawin g governmen t deposit s fro m bank s i n nee d o f cash (Spragu e 1910 , 230-32) . Hi s effort s t o manag e th e equivalen t of a game of musical chairs were futile, i f not destabilizing . Congress furthe r undermine d confidenc e i n financial market s i n the summer of 1907 , when i t conducted hostil e investigations o f the railroad an d minin g industrie s i n keepin g wit h th e ag e o f "trust busting" an d th e wishe s o f Presiden t Theodor e Roosevel t (Grose close 1980 , 16-25) . This , i n turn , le d t o th e failur e o f som e trus t companies, notabl y Knickerbocke r Trus t Company , du e t o fallin g securities values . Unlik e th e banks , trus t companie s ha d a dispro portionate shar e o f asset s i n securitie s an d cal l loans , making the m more vulnerable; meanwhile, only six banks failed durin g the pani c (Calomiris an d Gorto n 1991 , 157). Nevertheless, afte r th e impac t of the securitie s losses , th e 190 7 pani c snowballe d fo r reason s no t terribly differen t fro m thos e in earlier panics . Legal restrictions pre -

94 Richar d M . SaJsma n vented bank s fro m satisfyin g change s i n the deposit/currenc y ratio , when fal l crop s starte d t o move. Again, bankers tried t o respond b y resorting to clearinghouse certificate s an d emergency currency . Banks ra n th e ris k o f bein g charge d wit h breakin g th e la w fo r issuing "unauthorized " currenc y (Horwit z 1990 , 641-43). But government official s coul d no t ignor e the effectivenes s o f the issue s i n ameliorating th e 190 7 Panic , an d legalize d th e procedur e vi a th e Aldrich-Vreeland Ac t of 190 8 (otherwise known a s the "Emergenc y Currency Act") . Th e ac t effectivel y "decriminalized " th e issuanc e of emergenc y currency , selectivel y permittin g group s o f bank s t o issue currency , whe n needed , o n th e basi s o f usua l bankin g assets , not governmen t bonds . Th e ac t wa s onl y intende d a s a temporar y measure, and emergenc y currency was only allowed to supplement , not replace , the bond-based currenc y alread y i n circulation . Never theless, th e concep t behin d th e Aldrich-Vreelan d Ac t prove d emi nently successfu l o n th e on e occasio n whe n i t wa s relie d upo n before the Federal Reserve was formed. The beginnings of a liquidity panic, resulting from th e outbrea k o f World Wa r I in the summer of 1914, wer e blocke d b y th e issuanc e o f $40 0 millio n i n emergenc y currency, representin g nearl y one-quarte r o f tota l currenc y i n th e hands o f th e publi c afte r issue . Whe n anxietie s diminished , th e currency wa s withdraw n an d retired . Accordin g t o Friedma n an d Schwartz (1963 , 172, 693-94), the act "provided a n effective devic e for solvin g a threatened interconvertibilit y crisi s withou t monetar y contraction o r widespread ban k failures." I n fact, the y conten d tha t the experienc e o f th e summe r o f 191 4 showe d tha t th e Aldrich Vreeland Ac t alon e wa s capabl e o f preventin g futur e panics , that a Federal Reserv e wa s unnecessary , an d tha t emergenc y currenc y powers availabl e t o th e privat e bankin g syste m woul d hav e bee n sufficient eve n to forestall th e 1929-3 3 crisis. 12 Despite distortion s impose d b y government under nationa l bank ing laws , an d th e innovativ e solution s o f privat e banker s t o over come thos e distortions , th e bankin g communit y wa s mad e a scapegoat for the 1907 crisis, and additional government intervention wa s recommended. Congres s initiate d tw o full-scal e investigation s t o achieve thes e purposes . First , actin g o n a requiremen t o f th e Ald rich-Vreeland Act , i t formed th e National Monetar y Commissio n t o study th e prospect s fo r reforming th e banking system. The commis sion publishe d ove r twenty volume s applaudin g th e alleged virtue s of foreig n centra l bankin g systems , clearly pushin g a foregone con clusion. Althoug h th e commissio n formall y recommende d a "pri -

Bankers a s Scapegoat s 9 5 vate" solution (incorporatin g a National Reserve Association amon g banks i n th e Unite d States ) t o currenc y panics , it s predominantl y favorable view s o n centra l bank s abroad , an d it s inabilit y t o full y recognize an d advis e repea l o f th e interventionis t defect s o f th e national bankin g laws , pave d th e wa y fo r th e creatio n o f wha t ha s turned ou t t o b e a powerfu l centra l bank , th e Federa l Reserve , i n 1913. A majo r impetu s t o establishin g th e Fed , however , cam e fro m another congressional committe e bent on making bankers the scapegoats. The Hous e Committe e o n Bankin g an d Currenc y convene d a subcommittee i n Apri l 191 2 "t o investigat e th e concentratio n o f money an d credit " i n privat e hand s (Clevelan d an d Huerta s 1985 , 67). Chaired b y Louisiana Representativ e Arsen e Pujo, an d i n oper ation through February 1913 , the "Pujo Committee " lambasted Wal l Street bank s fo r conductin g a n allegedl y abusive , clandestine , an d conspiratorial "mone y trust," supposedl y t o the detrimen t o f soun d banking, marke t liquidity , an d th e econom y a t large . After month s of investigation th e Pujo Committe e concluded tha t five firms—J. P. Morgan, Firs t Nationa l Bank , Nationa l Cit y Bank , Guarant y Trus t Company, an d Banker s Trust Company—ha d interlockin g director ships i n various financial an d industria l companie s wit h total capi tal of $22 billion (Clevelan d an d Huertas 1985 , 67, 359 note 53 , 360 note 54) . Th e growt h o f thes e banks , an d thei r relationships , re flected th e massiv e growth i n the country' s industria l base , and th e need t o pul l togethe r a legislativel y fragmente d bankin g structur e (Chernow 1990,153). But they were suspected of wrongdoing all the same, eve n thoug h th e committe e neve r prove d tha t suc h relation ships caused or worsened the periodic money panics or instabilities of th e pre-Fe d era . Th e committe e di d claim , incredibly , tha t cit y banks ma y hav e purposel y starve d countr y bank s o f liquidit y a t crucial times . O f course , th e committe e ignore d th e basi c illegalit y of meeting currency deman d unde r national bank laws, and it made no attemp t t o reconcil e it s charg e wit h th e opposit e conclusio n contained i n a repor t o f th e Nationa l Monetar y Commission , tha t city banks ha d cause d panic s b y overl y favorin g th e countr y bank s with attractive correspondent service s (se e Sprague 1910) . Publicity rather than objectivit y appear s to have been the major consideratio n of thes e reformer s an d othe r "trust-busters " a t th e tur n o f th e cen tury. Animosity towar d privat e banker s wa s commo n amon g politi cians. I n debat e ove r th e Federa l Reserv e Act , Senato r Hitchcoc k

96 Richar d M . Salsma n (quoted i n Timberlak e 1989 , 5 ) expressed th e prevailin g sentimen t against concentrations o f power, except in the hands of government : "We believ e i n governmen t control , rea l an d actual , al l th e time/ ' he said , "an d w e d o no t believ e tha t th e bankin g interest s i n an y community shoul d b e entrusted wit h that power.'' Presidential can didate Woodro w Wilso n (quote d i n Clevelan d an d Huerta s 1985 , 67), i n on e bi t o f torture d logic , claime d tha t "Wal l Stree t brough t on the 1907 Panic, got the people to demand currenc y reform, brought the Aldrich-Vreelan d currenc y bil l forwar d and , i f i t dares , wil l produce anothe r pani c t o pas s th e Aldric h centra l ban k plan . W e need reform, ,, h e urged , "bu t no t a t th e hand s o f Wal l Street. ,, H e also (Cleveland an d Huertas 1985 , 360 note 55; Chernow 1990 , 149) called th e Wal l Stree t bankin g communit y "th e mos t dangerou s o f all monopolies, " an d said , " a concentratio n o f the contro l o f credi t . . . may a t any time become infinitely dangerou s t o free enterprise " —a warnin g no t agains t proposal s fo r a centra l ban k bu t agains t private banks. As president tw o year s later , Wilson woul d sig n the bill formin g the Federa l Reserve , granting the government itsel f monopol y pow ers ove r mone y an d credi t i n th e Unite d States . H e di d s o eve n though Wal l Stree t di d no t produc e th e pani c h e expected ; i n fact , as mentione d above , privat e bank s positivel y suppresse d a pani c caused b y governmen t declaration s o f war . Th e momentu m fo r in creased interventio n wa s fuele d b y the tendenc y (commo n o n late r occasions a s well ) fo r leadin g banker s t o appeas e thei r critic s i n politics an d th e medi a an d eve n to assis t Congres s i n draftin g law s bringing further interventio n t o the industry. 13 While ther e wer e a fe w insightfu l contemporar y critic s o f th e national banking syste m (e.g. , Noyes 1910) , most reformers unfortu nately di d no t recognize th e benefits o f free branching , unrestricte d note issue , an d decentralize d reserv e management . The y correctl y saw panics as reflecting a n "inelasti c cuITency, ,, but somehow blamed bankers instead o f the law for their inability to manage the currenc y properly. Instea d o f freein g th e not e issue , they recommende d tha t government nationaliz e th e not e issue . Instea d o f repealin g th e in herent rigidities of the national banking laws, they condemnned th e alleged inordinat e concentratio n o f financial resource s an d manage ment i n a few, inept , privat e hands, and calle d for its concentratio n in stil l fewer , albei t government , hands , a t th e Federa l Reserve . Instead o f havin g th e contro l o f capita l i n Wal l Street , the y de manded that contro l be shifted t o Washington. They apparently ha d

Bankers as Scapegoats 9

7

no conceptio n tha t muc h greate r ineptitud e migh t follo w suc h a shift. Failin g t o locat e th e underlyin g sourc e o f nineteenth-centur y U.S. bankin g panic s i n th e distortiv e intervention s o f th e nationa l banking laws , reformers erecte d a superstructure o f centra l bankin g that would eventuall y prov e more destabilizing . IV. The Banking Crisis of the 1930s and the Expansio n of Federal Reserv e Power s The stoc k marke t cras h o f 1929 , th e bankin g crisi s o f 1931-1933 , and th e Grea t Depressio n suffere d i n th e 1930 s wer e disaster s o f unprecedented proportio n in the history of U.S. finance. Nearly onethird o f al l bank s failed . Lega l restrictions o n banks tha t prevente d branching an d th e diversificatio n o f risk s mean t tha t mos t failure s were of small, single-office bank s tied by law to undiversified pock ets o f th e economy . Lega l prohibition s o n privat e not e issu e wer e also harmful , a s neithe r bank s no r clearinghous e association s wer e permitted t o issue currency to meet depositor claims . The economi c impact o f th e bankin g collaps e wa s profoundl y damaging , a s th e money suppl y an d incom e fel l b y a third , busines s investmen t plummeted, an d unemployment reache d 25%. The basic caus e o f the banking crisi s was the Fed's monopoly o n the issuance of money and its attendant power to manipulate mone y and credit in defiance o f market preferences. Erratic inflations o f the money suppl y b y th e Fe d i n th e 1920 s encourage d th e rea l estat e and stoc k market speculatio n fo r whic h tha t decad e became know n (Rothbard 1975 , 126-52). To foster monetar y inflation , th e Fe d ha d actively countere d th e long-established , conservativ e rule s o f th e gold standard . Instea d o f tightening monetar y polic y i n response t o gold outflows (whic h signale d relativel y higher prices in the Unite d States tha n i n foreig n countries) , th e Fe d chos e t o replac e it s gol d holdings wit h governmen t deb t instruments , i n the proces s loosen ing monetary policy at precisely the wrong time. 14 The Fed deceler ated its inflating i n 1928, and the stock market crashed the followin g year. B y gross mismanagemen t o f syste m liquidit y i n th e followin g four years , th e Fe d brough t o n th e collaps e o f th e bankin g system , and the Great Depression (Friedma n and Schwart z 1963 , chapter 7). The Fe d ha d supposedl y bee n establishe d a s a better alternativ e t o the speculation s o f privat e banker s an d a s a means o f providin g a n elastic currenc y t o preven t bankin g panics , bu t o n bot h count s i t failed blatantly . I n th e 1920s , i t supplie d to o muc h mone y an d

98 Richar d M . Salsman fostered speculatio n an d unsound lending , while in the crisis of the 1930s i t supplie d to o littl e currenc y an d faile d t o satisf y a large scale shift i n depositors* demand for currency. 15 As a monopol y issue r o f currency , th e Fed' s performanc e wa s universally destructive , for without th e Fed's monopoly, the marke t would hav e ha d n o unilatera l sourc e o f speculativ e excess , an d i n troubled time s coul d hav e turned t o more reliable provider s o f cur rency. A full y free , privat e bankin g syste m woul d no t hav e bee n wholly fre e o f mistakes , bu t neithe r woul d th e entir e syste m b e exposed t o unilateral mismanagemen t o f a government agency , as it was unde r centra l banking . Th e prope r respons e t o thi s disaste r would hav e bee n t o limi t sharpl y (o r abolish ) th e Federa l Reserve , return gol d an d th e managemen t o f the gold standar d t o the privat e banking system, eliminate reserve requirements, permit the issuance of currency by banks (thi s time without bond collatera l provisions) , and repea l branchin g restrictions . Bu t becaus e th e prope r caus e of the crisis was not identified, wholl y opposit e reforms wer e enacted . As i n earlie r crises , a congressiona l commissio n wa s forme d tha t made the bankers scapegoats and laid the foundation fo r still greater grants of legislative power to the Federal Reserve and othe r bankin g regulatory agencies . Amon g othe r things , th e Pecor a Commissio n (named fo r th e lega l counse l t o th e Senat e Bankin g Committee , Ferdinand Pecora ) condemne d banker s fo r promotin g speculations , stock pric e manipulation , an d fraud . Th e commissio n charge d tha t private bankers cause d th e collapse o f their ow n industr y i n partic ular and o f economic activity in general. The Pecor a Commissio n se t th e mora l ton e fo r th e bankin g re forms o f the 1930s. The commission di d not engage in dispassionat e analysis o f th e bankin g industr y o r governmen t policies , no r di d i t explore remedies i n any scientific manner . Rather, its hearings wer e infused wit h indignatio n agains t th e banking community , chargin g that i t ha d worke d i n near-conspiratoria l manne r t o bus t th e stoc k market, brin g dow n banks , an d wrec k th e economy . It s emotion laden bia s colore d th e legislatio n tha t wa s passe d durin g an d soo n after the hearings. Although other, more dispassionate sessions were conducted aroun d th e tim e o f th e Pecor a hearings , th e damag e in flicted o n the reputation an d credibilit y o f the financial communit y by the commissio n mad e i t easie r fo r lawmaker s t o justify compre hensive interventionis t reforms. 16 Senato r Carter Glass, chairman of the Senat e Bankin g an d Currenc y Committee , conducte d hearing s that eventuall y brough t legislatio n separatin g commercia l an d in -

Bankers as Scapegoat s 9 9 vestment banking . A s on e write r (Flanner y 1985 , 69) contends , th e Pecora hearing s "becam e a watershe d i n Glass' s driv e t o divorc e investment banking from deposi t banking in the United States. " The Pecora hearings focused o n National City Bank, its chairma n Charles Mitchell, and its brokerage affiliate, Nationa l City Company, charging no t onl y tha t the y engage d i n financial malpractic e an d fraud bu t als o tha t suc h activit y wa s representativ e o f th e entir e financial communit y an d responsible for the stock market crash, the banking collapse , an d th e Depression. Thi s broad charg e was neve r substantiated, an d th e fac t tha t Nationa l Cit y an d banker s wer e scapegoats wa s clear , eve n t o Pecora . H e late r admitte d t o pickin g Mitchell a s his lea d witnes s no t because o f suspicion s o f wrongdo ing but because "Nationa l Cit y was on e of the very larges t banks i n the world , an d ha d bu t recentl y bee n surpasse d b y th e Chas e Na tional. Th e prestig e an d reputatio n o f thes e institution s wa s enor mous. The y stood , i n th e min d o f th e financially unsophisticate d public, fo r safety , strength , prudence , an d high-mindedness , an d they were supposed to be captained by men of unimpeachable integ rity, possessing almost mythical business genius and foresight" (Pe cora 1939 , 71) . Instead o f simpl y assumin g tha t th e banks ' sterlin g reputation wa s wholl y undeserved , Pecor a an d hi s fello w congres sional investigator s migh t bette r hav e considere d tha t banker s woul d not wish to throw suc h an asset away in a suicidal flourish . The Pecora Report charge d tha t National City's securities affiliat e failed t o disclose material facts, pursued high-pressur e sale s tactics, traded i n th e stoc k o f Nationa l Cit y Bank , obtaine d custome r refer rals fro m th e bank , an d too k ba d loan s of f th e book s o f th e ban k (Kelly 1985, 52). Importantly, the Pecora hearings did not show that these practice s weakene d th e ban k o r it s affiliate , o r i n an y wa y contributed t o the general crisis. 17 In fact, with a historical perspec tive devoi d o f th e emotionalis m o f the time , these practice s appea r relatively innocuous . Althoug h Pecora' s charge s referre d t o techni cal matters , th e messag e t o the publi c wa s tha t a grand immoralit y had bee n perpetrated . Th e publi c too k th e messag e t o heart . On e historian (Cherno w 1990 , 356 ) recalls tha t "a s peopl e followe d th e hearings o n thei r farm s an d i n thei r offices , o n sou p line s an d i n Hoovervilles, the y becam e convince d tha t they' d bee n conne d i n the 1920s . Yesterday's gods were no more than greed y little devils. " Another write r (Flanner y 1985 , 70-71) observe s that th e "publicit y surrounding Nationa l Cit y Ban k chairma n Charle s Mitchell' s testi mony generate d widesprea d an d intens e publi c reaction . Banker s

100 Richard

M. Salsman

came to be viewed a s venal, selfish, an d perhap s responsible for th e depression.'' A histor y o f th e Nationa l Cit y Ban k (Clevelan d an d Huertas 1985 , 172 ) recount s tha t "a s crisi s followe d crisi s an d th e depression deepened, the public mood darkened. Shock and disma y gave way t o ange r an d bitternes s an d a need t o assig n blame . Wal l Street banker s becam e th e objec t o f th e public' s mountin g wrath. " Media coverag e contribute d t o th e searc h fo r scapegoats : "a s th e depression deepened , th e pres s increasingl y picture d bank s a s vil lains rather than victims. Bankers, Charles Mitchell foremost amon g them, wer e revile d a s 'banksters ' " (Clevelan d an d Huerta s 1985 , 160). These hostil e image s o f banker s wer e reinforce d i n Congres s b y politicians lik e Senato r Wheele r o f Montana , wh o sai d (quote d i n Cleveland an d Huerta s 1985 , 356) , "Th e bes t wa y t o restor e confi dence in the banks would be to take these crooked president s ou t of the banks an d trea t the m the sam e way we treated A l Capone whe n he faile d t o pa y hi s incom e tax. " Whe n th e mos t respecte d banke r of the day , J.P. Morgan, Jr., was brought befor e th e Pecora Commis sion, h e wa s primaril y ridicule d fo r havin g pai d n o incom e ta x i n the previou s thre e year s (Clevelan d an d Huerta s 1985 , 366) . N o evidence wa s uncovere d t o sugges t tha t hi s ban k o r it s syndicate s had caused the crisis. Instead, the commission criticized the Morgan bank fo r wha t coul d a s easil y hav e been interprete d a s its busines s success, namely, it s extensiv e dealing s wit h th e country' s to p com panies, an d fo r it s prominen t rol e a s a "bankers ' bank. " Th e vilifi cation o f th e banker s extende d righ t u p t o th e Whit e House . In hi s first inaugura l addres s i n 1933 , Presiden t Roosevel t (quote d i n Cleveland and Huertas 1985,190 ) blamed the crisis on the country' s leading bankers, and referre d t o them as "the unscrupulous money changers" who "through their own stubbornness and incompetence , have admitte d thei r failure , an d hav e abdicate d . . . from thei r hig h seats i n th e temple o f civilization. " Wit h criticis m o f bankers com ing from ever y quarter—Congress, the White House, the media, an d the public—th e punitiv e syste m o f bankin g regulatio n enacte d i n the 1930 s was inevitable. The mos t respecte d academi c exper t o n bankin g a t th e time , H . Parker Willis of Columbia University (quote d in Flannery 1985 , 71), took a different view : A fair examination of the facts disclosed by the Senate investigation leaves the feeling that but few persons, relatively, have been examined, and that these, whil e ofte n "prominent " ar e no t i n themselve s representativ e o f

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either banking or business. We must, accordingly, reject entirely the notion that—so far as these inquiries show—there has been a revelation of demonstrated crookedness on the part of American finance, trade, and banking at large. There has been nothing of the sort. Willis wa s th e principa l adviso r t o Senato r Glas s o n legislativ e reforms, bu t hi s assessmen t wa s ignore d b y Glass , who wa s instru mental i n givin g greate r power s t o governmen t bankin g agencie s after th e crisis . Th e fac t tha t neithe r Willi s no r th e politician s h e advised i n the 1930s placed much blame for the crisis on the centra l bank ma y b e explaine d b y th e fac t tha t bot h Willi s an d Glas s ha d also playe d ke y role s i n th e draftin g o f th e Federa l Reserv e Ac t i n 1913.18 Other congressiona l hearing s i n th e 1930 s focuse d mor e o n th e poor lendin g experienc e o f lender s (suc h a s tha t o f Nationa l Cit y Bank i n Lati n America ) an d les s o n bankers ' mora l turpitude . Bu t the bankers were blamed nonetheless . Senator Couzens of Michigan (quoted i n Clevelan d an d Huerta s 1985 , 185 ) claime d tha t "unrea sonable salaries and bonuses lead to unsound banking and unsoun d sales o f securities. ,, Banker s wer e criticize d fo r their paychecks , fo r financing rea l estat e an d stoc k speculations , fo r supportin g securi ties affiliate s wit h commercia l loans , an d fo r bein g insufficientl y liquid t o survive deposito r runs o n their institutions. Private depos itors wer e criticize d fo r wantin g t o conver t thei r deposit s o r fo r "hoarding" gold. But there was virtually n o criticism o f the Federa l Reserve for it s inflatio n o f money an d credi t i n the 1920s , or for it s mismanagement o f th e discoun t windo w i n th e earl y 1930s . Ther e was also no criticism of the regulatory restrictions on branching that prevented diversificatio n an d kep t man y bank s smal l an d vulnera ble to failure . Some congresspeople , eage r t o pi n th e blam e fo r th e crisi s o n private bankers , claime d tha t th e smal l percentag e o f commercia l banks wit h securitie s affiliate s ha d cause d eac h o f th e importan t disasters, fro m th e stoc k marke t cras h t o th e bankin g collaps e t o the Grea t Depression . Senato r Glass , i n sponsorin g legislatio n forceably separatin g commercia l an d investmen t banking , declared , "These affiliate s wer e th e mos t unscrupulou s contributors , nex t to th e debauc h o f th e Ne w Yor k Stoc k Exchange , t o th e financial catastrophe which visited this country and were mainly responsibl e for the depressio n unde r whic h w e have been sufferin g since . They ought speedil y t o b e separate d fro m th e paren t an d i n thi s bil l w e have don e that " [77 Congressional Record, 1 9 Ma y 1933 , 3726) .

102 Richar

d M . Salsma n

The separatio n wa s finalized i n th e Bankin g Ac t passe d i n Jun e 1933. The fact s abou t th e rol e o f securitie s activitie s i n commercia l bank failure s d o no t suppor t Glass' s view . First , commercia l bank s had bee n involve d i n th e securitie s business , throug h brokerag e subsidiaries, wel l befor e th e 1920s. 19 Second , fewe r tha n 8 % o f th e national bank s wit h th e bigges t securitie s operation s faile d durin g the crisis , whil e ove r 26 % o f al l nationa l bank s failed . Mor e impor tant, mos t failure s involve d smalle r stat e banks tha t di d no t conduc t securities businesses . Finally , i n man y case s th e presenc e o f securi ties affiliate s actuall y reduce d th e probabilit y o f ban k failur e (Whit e 1986). Even i n th e fe w case s wher e bank s wer e foun d t o hav e faile d due t o a fal l i n securit y values , economis t Willia m F . Shughart , I I (1988, 605 ) ha s argue d tha t "i t i s disingenuou s t o accus e banker s o f bad managemen t afte r th e fac t whe n unanticipate d event s hav e cause d the realize d rat e o f retur n o n a particula r asse t t o b e les s tha n expected." I n short , th e securitie s activitie s o f commercia l bank s were no t responsibl e fo r th e stoc k marke t crash , th e bankin g crisis , or th e depressio n (Flanner y 1985) . Reformer s nevertheles s playe d on th e sensationalis m o f thes e event s an d pinne d blam e squarel y o n bankers. In passing th e Glass-Steagal l Act , Congres s wa s abl e to divid e an d conquer th e bankin g industry . Brokerag e firms woul d hav e a pro tected securitie s marke t al l t o themselves , an d commercia l bank s would no t fac e competitio n fro m brokerag e firms takin g deposits . Passage wa s assure d onc e banker s trie d t o appeas e th e politicians . In Marc h 1933 , after muc h criticism , Nationa l Cit y Ban k an d Chas e National Ban k agree d voluntaril y t o dives t thei r securitie s affiliates , and th e America n Banker s Association , afte r earl y opposition , als o caved i n t o pressur e an d supporte d th e act. 20 Befor e i t wa s als o targeted, J. P. Morgan's ban k ha d applaude d th e action s o f Presiden t Roosevelt, especiall y hi s demolitio n o f the gol d standard. 2 1 Th e U.S . Treasury als o benefite d b y th e ac t becaus e i t purge d commercia l bank portfolio s o f privat e securities , whic h increasingl y ha d com peted wit h governmen t securitie s fo r loanabl e fund s i n th e 1920 s (Shughart 1988 , 600, 610-11) . The mone y an d bankin g reform s tha t wer e adopte d i n th e 1930 s reflected entirel y th e misconception s abou t wha t ha d cause d th e crisis. Instea d o f reinin g i n o r abolishin g th e Fed , Congres s grante d it stil l greate r powers , includin g th e centralizatio n o f powe r a t th e

Bankers as Scapegoats 10 3 Board o f Governor s i n Washington . Instea d o f removin g politica l motives associate d wit h Fe d policymaking , th e Glass-Steagal l Ac t permitted th e Fe d t o bac k it s issue s o f currenc y wit h governmen t debt, wherea s i n th e origina l Federa l Reserv e Ac t i t ha d t o bac k them wit h commercia l pape r an d gol d (Friedma n an d Schwart z 1963, 191 , note 4) . Instead o f returnin g th e suppl y o f gol d an d th e management o f the gold standard t o the private banking system, the government criminalize d th e private ownership o f gold, confiscate d gold holding s o f bank s an d citizens , abrogate d th e gol d clause s o f Treasury bon d indentures , an d devalue d th e dollar. 22 Instea d o f giving bank s th e powe r t o issu e currenc y an d satisf y th e changin g preferences o f th e publi c fo r currenc y relativ e t o deposits , th e gov ernment gave the Fed a virtually unlimited capacit y to issue money. Instead o f permittin g banks to become safe r throug h fre e branchin g and th e diversificatio n o f loan s an d deposits , it erecte d a system of government deposi t insuranc e t o "guarantee " deposits . I n th e pro cess, flat-rate "insurance " assessment s wer e imposed o n banks tha t effectively taxe d prudent institutions for the benefit of reckless ones. Even Frankli n Roosevel t (1938 , 37) recognized a t the tim e tha t fed eral deposi t insuranc e "woul d pu t a premium o n unsound bankin g in the future." Instea d o f leaving banks free to make credit decision s on a soun d basis , th e Fe d an d othe r bankin g agencie s assume d greater influenc e ove r ban k lendin g policies , an d forceabl y sepa rated commercia l an d investmen t banking . O n th e pretex t tha t ba d lending flowe d inevitabl y fro m th e payment o f interest o n deposits , government impose d ceiling s o n th e rate s bank s offered . Finally , instead o f abolishing reserve requirements, government actually raised them i n th e mid-1930s , precipitating a second depressio n i n 1937 1938. In every respect, government interventions in money and banking were expande d an d intensifie d i n the earl y 1930s , despite the sorr y record of interventionism. Thi s result was made possible by a diversion o f attention , b y intens e muckrakin g investigation s o f privat e banking activities , an d b y th e virtua l absolutio n o f al l governmen t sins associated wit h th e crisis . The work o f the Pecora Commissio n positioned privat e banker s a s scapegoat s fo r a government-create d crisis an d provide d justification s fo r ensuin g legislation . Th e re forms tha t wer e passe d di d no t solv e th e fundamenta l problem s associated wit h centra l bankin g an d lega l restrictions, but onl y fur ther undermined soun d mone y and banking.

104 Richar d M . SaJsma n V. Institutionalized Inflatio n an d the Deterioration of Banking in the Postwar Period, 1945-198 0 Compared to the instability of today, the money and banking system appeared quit e stabl e i n th e postwa r decade s leadin g u p t o th e banking reforms o f th e earl y 1980s . But close r examinatio n reveal s that thes e decade s wer e characterize d b y prolonge d an d profoun d deterioration. Th e mone y an d bankin g reform s o f the 1930 s se t th e stage fo r a n unprecedente d wav e o f inflatio n tha t bega n buildin g after Worl d Wa r II and accelerate d i n the 1960 s and 1970s , encour aging speculative lendin g practices at thrifts an d commercial banks. These decade s wer e marre d b y chroni c defici t spendin g an d infla tion, bot h o f whic h wer e mad e possibl e b y th e fiat money-creatin g power o f th e Federa l Reserve , powe r tha t ha d bee n significantl y enhanced i n th e reforms o f th e 1930s . I n addition , durin g thes e decades interes t rate s wer e hig h an d volatile , reflectin g inflatio n expectations, an d exposin g bank s an d thrift s t o damagin g maturit y mismatches. The postwa r commercia l bankin g syste m i n th e Unite d State s suffered a secular deterioration in its financial condition that closely mirrored th e ongoin g debasemen t o f th e dollar . Fo r example , th e aggregate capita l rati o o f th e bankin g syste m decline d fro m ove r 14% a t th e en d o f th e Grea t Depressio n t o unde r 7 % i n th e earl y 1980s (Salsma n 1990 , 52-75) . Othe r measure s o f financial perfor mance i n the banking industry—suc h a s asset quality, profitability , and liquidity—showe d similarl y gri m trends . Boom-and-bus t pat terns, suc h a s th e rea l estat e debacl e o f th e mid-1970s , appeare d quite similar to those of the 1920s. As the credit ratings of banks fel l below thos e o f top customers , banks los t soun d lendin g business t o the commercia l pape r marke t an d floundered t o make up the differ ence wit h loan s agains t rea l estate , to the stoc k market , to Socialis t foreign governments , highl y leverage d companies , an d overex tended consumers . O n th e liabilit y side , bank s suffere d a massiv e outflow o f deposito r fund s t o relatively unregulate d mone y marke t mutual funds , a process o f "disintermediation " mad e possibl e by a combination o f inflatio n (causin g hig h rates ) an d lega l ceiling s o n bank deposi t interes t rate s (Regulatio n Q) . By the lat e 1970s , banks were fleeing the Federal Reserve system to escape the costs of maintaining reserves (whic h paid no interest) and losing deposits. S&Ls were eve n wors e of f tha n banks , strainin g unde r inflatio n rates an d interes t rate s tha t reache d a s hig h a s 14.5 % and 21.5% ,

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respectively, in the late 1970s. The Fed's inflationist policie s prove d destructive t o th e S&Ls , whose busines s consiste d o f makin g long term fixed rate home mortgages funded b y short-term savings deposits. Whe n interes t rate s increased , S&L s coul d no t repric e thei r assets quickl y enoug h t o reflec t ne w marke t yields . The y als o suf fered fro m disintermediation , alon g with banks . In 197 9 alone, whe n Treasury Bil l rate s wer e a s muc h a s 6 % abov e permissibl e ban k rates, savings accounts at banks and thrifts fel l by over $12 billion. This prolonge d postwa r deterioratio n i n mone y an d banking — culminating i n th e "dolla r crisis " o f th e lat e 1970s—wa s mad e possible by the government's fiat money monopoly, the widesprea d acceptance o f Keynesia n economics , an d th e chroni c defici t spend ing and inflationism tha t resulted from both. Following the inflatio n of th e 1960s , th e las t lin k o f gol d t o th e dolla r (convertibl e fo r foreign centra l banks ) wa s severe d i n 1971 , ushering i n stil l highe r rates of inflation thereafter . Fe w of the difficulties suffere d b y banks and thrift s woul d hav e arise n ha d governmen t no t sponsore d infla tion and interes t rate controls. Unfortunately, popula r explanation s fo r postwa r deterioratio n i n money an d bankin g blamed bankers , not government . Inflatio n an d high interes t rate s wer e blame d no t o n th e mone y monopolist , th e Federal Reserve , bu t o n greed y businesspeopl e an d bankers . Th e dollar crisi s wa s blame d o n "internationa l speculators, " instea d o f on the sole issuer of dollars, the Fed. 23 Disintermediation wa s blamed on "competitiv e pressures " emanatin g fro m th e relativel y unregu lated mutua l fun d industry , whos e account s pai d marke t rate s o f interest. Banks were blamed fo r leavin g the Federal Reserve Syste m and making it difficult t o conduct monetary policy. They were blamed for creatin g holding companies , eve n thoug h thes e were devise d t o overcome branching and business line restrictions, in order to diversify income sources. They were criticized when they tried to achieve efficiencies throug h mergers ; fo r example , th e merge r o f Manufac turers Trus t an d th e Hanove r Ban k face d fou r year s o f regulator y obstacles i n th e earl y 1960s . Bank s wer e blame d fo r speculativ e lending, an d S&L s were blame d fo r lendin g lon g whil e borrowin g short, even though government housing credit agencies had encour aged them to do so. By failin g agai n t o properl y identif y th e caus e o f th e postwa r deterioration i n mone y an d banking , governmen t onc e agai n en acted reforms tha t faile d t o solv e th e basi c problem s inheren t i n central bankin g an d instea d provide d th e impetu s fo r th e furthe r

106 Richar d M . SaJsma n deterioration w e ar e experiencin g today . Instea d o f permittin g a greater variety of income sources, Congress passed the Bank Holding Company Ac t i n 195 6 t o restric t banks ' well-intentione d diversifi cation strategies . Instea d o f discouragin g overcapacit y an d encour aging cos t efficiencies , th e Justic e Departmen t an d federa l court s blocked o r delaye d th e ban k merger s tha t woul d mak e the m pos sible. Instea d o f encouragin g diversification , th e 197 0 Dougla s Amendment t o th e Ban k Holdin g Compan y Ac t place d limit s o n branching. Instea d o f abandonin g Federa l Reserv e inflationis m whe n the dolla r weakene d i n th e lat e 1960s , President Nixo n abandone d the internationa l gol d standard . Instea d o f controllin g Federa l Re serve inflationis m i n th e 1970s , Nixo n an d Carte r bot h impose d controls durin g th e decad e o n th e symptom s o f tha t policy , ever rising wages , prices , an d credit . Instea d o f addressin g th e reason s why bank s wer e fleein g th e Federa l Reserv e System , legislatio n i n 1980 simpl y require d al l depositor y institution s t o b e members. 24 Instead o f addressin g th e underlyin g deterioratio n o f bank s an d thrifts an d th e diminishe d confidenc e o f depositors , th e 198 0 re forms nearl y triple d federa l insuranc e coverage , fro m $40,00 0 pe r deposit accoun t t o $100,000 . Th e 198 0 reform s establishe d a six year phaseou t o f deposi t interes t rat e ceiling s t o addres s disinter mediation, bu t th e busines s tha t flowed t o th e mutua l fund s neve r returned, an d man y institution s wer e lef t fatall y weakene d b y th e previous controls. The Garn-St. Germain Act of 1982 tried to remedy this weaknes s b y grantin g thrift s wide r lendin g powers , bu t th e combination o f greater latitude in asset choice, together with a massive expansio n o f th e federall y insure d deposit s fundin g thos e as sets, was a sure prescription for recklessness . None of the reforms o f the early 1980s would have been necessary had blam e bee n properl y place d o n defici t spending , inflationism , and lega l restriction s o n banks . Th e onl y prope r respons e t o th e deterioration woul d hav e bee n t o identif y an d eradicat e it s roo t cause, cenfra l bankin g an d lega l restrictions . Governmen t policy makers shoul d hav e rejecte d Keynesian-inspire d defici t spendin g policies. The y shoul d hav e restraine d o r abolishe d th e engin e o f inflation tha t i s the Federa l Reserve . They should hav e scale d bac k and ultimatel y abolishe d deposi t insurance , an d permitte d ful l branching, merger , an d investmen t bankin g powers . Ultimately , the y should hav e denationalize d gol d an d considere d th e adoptio n o f free banking on a gold standard .

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VI. The Present Banking Crisis If the banking reforms o f 198 0 and 198 2 had attacked th e root caus e of the banking problem , we would hav e see n some improvement i n the banking syste m i n th e rest o f the decade . Instead, th e deteriora tion o f bank s an d thrift s accelerated , despit e month s o f unbroke n economic growth . Th e exten t o f th e thrif t debacl e i n th e Unite d States is by now well known. Nearly a third o f the thirty-one hundre d S&Ls in existenc e i n 198 0 hav e sinc e faile d o r reache d insolvenc y while bein g proppe d u p b y governmen t assistance . Nearl y 20 % of the $ 1 trillion o f asset s i n the industr y becam e "nonperforming " i n the decad e o f the 1980s . The industry's deposi t insuranc e fun d wa s depleted i n less than four years after reachin g a high of $6 billion i n 1985. Estimate s o f th e tota l cos t o f th e S& L debacle hav e reache d $500 billio n (o r $13 0 billio n o n a presen t valu e basi s ove r thirt y years), and du e to legislation passed i n 1989 , the costs will be borne directly by taxpayers. 25 There ha s als o bee n massiv e deterioratio n i n th e commercia l banking industry. Sinc e 1980, U.S. banks have failed a t rates unsee n since th e Grea t Depression . Eve n i n inflation-adjuste d terms , th e largest bank failures i n our history have occurred i n the last decade . Whether lending to LDCs, to "leveraged buyouts, " or to commercia l real estat e projects , banker s hav e made lendin g mistakes o f stupen dous proportio n i n recen t decades . Sinc e a t leas t 1984 , whe n i t bailed out the failed Continenta l Illinois, the government has offere d a d e fact o bailou t promis e t o al l creditor s o f thos e bank s i t deem s "too big to fail," regardless of the detrimental effects o f such a policy on sound bankin g practice. In perhaps th e ultimate sig n of despera tion, the Federal Reserve has been using its discount window to bail out insolven t bank s (larg e an d smal l alike) , far beyon d it s origina l purpose o f providin g liquidity. 26 Th e deposi t insuranc e syste m fo r commercial bank s ha s als o collapsed . A s recently a s 198 7 the fun d of the Federal Deposit Insurance Corporation (FDIC ) reached a peak of $18 billion, but wa s expected t o be insolvent b y the en d o f 1991, and i n the red by as much a s $60 billion i n a few years. The ratio of insurance funds t o insured deposits , which was never high to begin with, fell graduall y fro m 1.16 % i n 198 0 to .60 % at the en d o f 1990 . The burden of this collapse is being shouldered by the more pruden t banks tha t hav e survive d bu t mus t no w pa y highe r insuranc e pre miums into the fund. FDI C premium rates have tripled sinc e 1988.

108 Richar d M . Salsman The cumulative burdens placed on the banking system by government inflation , deposi t insurance , an d branchin g restriction s hav e begun t o intensif y th e rat e o f deterioratio n o f th e industr y i n thi s decade. Skyrocketin g federa l budge t deficit s an d th e Fed' s ongoin g commitment t o finance the m throug h monetar y inflatio n hav e con tributed significantl y t o a nea r doublin g o f th e mone y suppl y be tween 198 2 an d 1990 . By transmitting inflatio n t o the bankin g sys tem throug h open-marke t operations , th e Fe d ha s indirectl y encouraged reckles s lending . The near tripling o f deposit insuranc e coverage ha s als o promote d ris k takin g b y depositor y institutions . Finally, the continuation o f the majority o f restrictions on branching has ensure d a relativel y undiversifie d mi x o f ban k asset s tha t ar e therefore pron e to downturns i n regional economies . The private banking system i s still reeling under the onslaught of central banking. But there i s one bank i n the Unite d State s that ha s succeeded i n resisting this deterioration , that has prospered bot h i n reputation an d financial resource s wit h ever y passin g decade , an d that ha s grow n t o becom e th e largest , mos t profitabl e ban k i n th e country. Tha t ban k i s non e othe r tha n th e Federa l Reserve , whic h earned $2 4 billion i n 199 0 alone, on an asset base of approximatel y $300 billion.27 These profits fa r surpass the earnings of all the banks in the United State s combined. Moreover, the Fed's rate of return o n assets i s nearl y eigh t time s th e leve l earne d b y privat e banks . Th e "monopolistic concentratio n o f unbridled financial power " tha t reformers had vilified nearl y a century ago has truly come to pass afte r all thes e years , an d i t i s ironi c t o conside r tha t i t woul d no t hav e been possible without their help and the help of their descendents . As migh t b e expected , popula r analysi s see s th e presen t curren t banking crisi s a s a resul t no t o f unbridle d Federa l Reserv e power , but o f banker mismanagement, fraud , an d "deregulation. " A widely publicized stud y issue d b y the comptrolle r o f the currenc y i n 198 8 concluded, o n sli m evidence , tha t mismanagemen t an d frau d wer e the mai n cause s o f modern-da y bankin g failures. 28 I n 199 0 the U.S. Justice Departmen t reporte d tha t mor e tha n fou r hundre d peopl e had bee n convicte d o f frau d a t thrift s i n 198 8 an d 1989 , creatin g losses o f $6. 4 billion ; a s troublin g a s thi s ma y appear , i t i s note worthy tha t th e los s represent s les s tha n 5 % of th e tota l estimate d loss o f th e thrif t debacle . Th e Justic e Departmen t als o reporte d re cently tha t losse s a t commercia l bank s attributabl e t o frau d ar e lower still than those at thrifts, eve n though the banking industry i s three times as large, and losses from fraud hav e increased recently. 29

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There i s littl e doub t tha t th e competenc e an d probit y o f bankers i n the Unite d State s ha s deteriorate d precipitousl y throughou t thi s century, wherea s banker s wer e rightl y see n a s conservativ e an d incorruptible i n the nineteenth century , when ou r system was freer . But the fact remain s tha t a significant portio n o f the los s associate d with today' s bankin g crisi s simpl y i s no t explaine d b y fraud . Ye t government official s hav e persisted i n suggesting otherwise . Contrary t o the claim s o f a sensationalist medi a an d self-servin g regulatory agencies , fraud ha s not been responsible fo r th e crisi s i n our banking system, and there is nothing inherent in the business of banking that would necessarily invite it. Fraud is the proximate, not the fundamental caus e of bank failure, an d failures hav e been widespread eve n i n th e absenc e o f fraud , a s i n th e 1930s . In fact, t o th e extent tha t ther e i s greate r frau d i n bankin g today , i t i s positivel y encouraged b y governmen t incentives , suc h a s deposi t insurance . Any government tha t guarantee s the liabilities o f an entire industr y invites th e incompeten t an d th e fraudulent , despit e al l th e regula tory effort s expende d t o resis t them . A liabilit y i s a promis e t o deliver som e value . I f a regime i s erecte d tha t tend s t o remov e th e responsibility fo r deliverin g o n tha t promise , thos e wh o ar e irre sponsible about meeting promises will necessarily be attracted to it. More fundamentally , centra l bankin g itsel f institutionalize s un sound an d dishones t banking , increasing the likelihood tha t incom petent, dishones t banker s wil l b e foun d amids t th e rubbl e o f ban k failures. Monetary inflation i s the most significant for m o f this institutionalized dishonesty . Wealth does not come from th e issuance of paper money . A t root , inflatio n o f th e mone y suppl y constitute s a continuous serie s o f default s o n the par t o f government, an d a highly deceptive mean s o f securin g economi c resource s a t th e expens e of unsuspecting victims . Nonetheless , ther e ar e repeate d call s fo r a n "easy" monetary polic y and a constantly booming economy i n whic h prudent banker s ar e virtually indistinguishabl e fro m thos e who ar e incompetent, dishonest , o r merel y lucky . Deposi t insuranc e goe s further still , forcin g th e pruden t t o pa y th e bill s o f th e reckless . I n free banking systems, management excellenc e is rewarded; misman agement an d frau d ar e minimized , an d whe n the y d o occur , thos e harmed by such banks can turn to government court s for justice an d remedy. But under central banking, frauds suc h as inflation ar e basic components o f governmen t policy , an d ther e i s n o plac e t o turn , certainly no t t o government , fo r restitution . Centra l bankin g doe s not insur e integrit y o r competenc e i n mone y an d banking—i t ac -

110 Richar d M . Salsma n tively undermine s the m b y supporting , protecting , an d institution alizing their opposites . Today's banker s ar e als o charge d wit h gros s mismanagement , though ther e i s little evidenc e tha t managemen t failing s alon e hav e brought o n th e crisis . A lon g histor y o f evidenc e doe s exist , how ever, tha t mismanagemen t i n bankin g tend s t o occu r i n clusters , especially unde r system s o f centra l banking . Thos e i n th e Austria n school o f economics , such a s Friedrich A . Hayek (1932) , have dem onstrated how the manipulation o f money and credit by government central bank s cause s widesprea d malinvestment s o f economi c re sources. Policies aimed at artificially lowering the market's "natural" rate of interest make s som e economic project s see m more profitabl e than they would be if the cost of capital were determined in a purely market context . Ban k credi t skill s ar e undermine d i n th e process ; when th e centra l ban k inflate s an d mone y i s easy , i t appear s tha t every loa n i s a goo d one , an d whe n th e centra l ban k tightens , i t seems none are good. When money and credit are constantly manipulated b y government , banker s find ther e i s a n ever-diminishin g connection between their lending policies and the success or failur e of those policies in practice. By the nature of their work, bankers are unavoidably ensconce d i n th e manipulatio n o f mone y an d credi t that surround s them . The y kno w i t bes t onl y whe n the y mus t pe riodically translat e "malinvestment " int o "loa n losses. " Th e long term declin e i n management competenc e i n the banking industry i s real, but i t is inherent i n central banking, not in the banking profes sion per se. Banks hav e foun d i t difficul t i n recen t decade s t o attrac t compe tent management ; but notably, i t is a difficulty share d onl y by other industries that are similarly characterized by significant governmen t intervention o r protection, such as utilities. Fortunately, most bankers toda y ar e competent , conscientious , an d honest—a s the y hav e been throughou t U.S . history. T o their credit , the y hav e develope d innovative solution s t o th e inheren t instabilit y impose d b y centra l banking. Whe n restriction s impose d o n not e issu e unde r th e Na tional Banking System caused money panics, they developed "clear inghouse certificates " an d othe r form s o f privat e currenc y tha t con sumers demanded . When restrictions impose d b y the Glass-Steagal l Act i n th e 1930 s prevente d bank s fro m underwritin g securitie s an d doing busines s wit h th e bes t U.S . companies , the y invente d ter m loans. When branchin g an d ne w produc t opportunitie s wer e blocke d by la w an d narrowl y constraine d bank s i n th e 1950s , they create d

Bankers a s Scapegoat s 11 1 holding companie s t o permi t growt h an d diversification . Whe n in terest rat e ceiling s an d restriction s o n deposi t gathering , togethe r with inflation-drive n hig h interest rates , led to an outflow o f depos its i n th e 1960 s an d 1970s , they create d certificate s o f deposi t an d "Eurodollar" accounts . Whe n centra l bankin g brough t volatilit y t o foreign exchang e markets an d interes t rates in the 1970 s and 1980s , they create d hedgin g product s t o enhanc e stability . Mor e recently , in response to central banking's double-digi t growt h rates in mone y and credi t tha t balloone d ban k balanc e sheet s an d dwarfe d capital , they invente d "securitization, " th e proces s o f preservin g liquidit y and capita l adequac y b y packagin g loan s an d sellin g the m i n th e secondary markets. To the extent that there has been any stability i n the bankin g secto r unde r centra l banking , i t ha s bee n achieve d b y the creativ e effort s o f skille d privat e bankers—i n spit e o f centra l banking, not because of it. Explanations o f today's bankin g crisi s that blame "deregulation " are probably th e most misguided . Th e fact is , the commercial bank ing an d thrif t industrie s remai n th e mos t regulate d sector s o f th e U.S. economy , an d th e historica l tren d ha s bee n fo r governmen t t o increase it s interventio n i n thes e industries—notwithstandin g oc casional superficia l change s i n th e rule s b y whic h th e industrie s must operate . In truth, th e argumen t agains t "deregulation " simpl y rests o n th e mistake n vie w tha t banke r mismanagemen t an d frau d are responsibl e fo r bankin g instability . Regulatio n i s see n a s re straining suc h impulses , whil e th e relaxatio n o f suc h restraint s i s thought t o invit e frau d an d mismanagement . Th e argumen t tha t "deregulation ha s caused the banking crisis" is simply another wa y of sayin g that , lef t t o thei r ow n device s i n a fre e o r free r environ ment, bankers will inevitably be incompetent o r fraudulent. T o blame "deregulation" fo r bankin g syste m deterioratio n i s a n unwarrante d attempt t o resurrec t th e fallac y tha t fre e bankin g i s inherentl y un stable. That this charge is leveled in today's context—when we have a banking syste m thoroughl y infuse d wit h centra l bankin g feature s and lega l restrictions—i s trul y remarkable . Tha t th e charg e i s lev eled by influential voice s and proposed i n legislative chambers is as true toda y a s ever . Lowel l Bryan , a prominen t ban k consultan t a t McKinsey an d Company , ha s advocate d recentl y tha t governmen t reimpose control s o n deposi t interes t rates , an d legislat e lendin g standards fo r banks , o n th e ground s tha t th e bankin g crisi s wa s caused by banks left free i n these areas. 30 Popular argument s tha t purpor t t o explai n th e deterioratio n o f

112 Richar d M . Salsma n today's bankin g industr y hav e th e cas e reversed. I t i s believed tha t government intervention is the solution to banking instability, whereas in fact i t is most assuredl y th e caus e of it. Government interventio n has undermined th e safety o f virtually all banks and S&Ls—an d yet critics cit e "deregulation' ' a s the problem . Governmen t ha s create d a chaoti c monetar y environmen t an d a deposi t insuranc e regim e that reward s imprudence—an d ye t blame i s directe d agains t "banke r mismanagement.'' Governmen t ha s stole n an d hoarded privat e gol d stocks, has cheated creditor s and money holders with an intentiona l policy of chronic inflation, ha s covered u p bad banking with decep tive "regulator y accounting"—an d ye t banker s ar e deeme d fraudu lent and dishonest . Wit h every mismanagement an d deceptio n con ducted b y centra l banking , an d ever y instabilit y i t promotes , it s favorable reputatio n onl y seem s t o grow , no t diminish , whil e it s power to inflict stil l further damag e is extended, not constrained . VI. Summar y Throughout U.S . history, banker s generall y hav e been mad e scape goats fo r bankin g crise s tha t wer e essentiall y governmen t created . Conventional explanation s failed t o correctly identify th e true cause of thes e crises , an d a s a result, governmen t interventio n i n mone y and bankin g gre w considerably . Becaus e th e U.S . governmen t ha s intervened i n mone y an d bankin g to enhance it s ow n power , i t ha s worked activel y t o blame the banking communit y fo r the detrimen tal effect s o f it s interventions , i n orde r t o preserv e it s monetar y privileges. Underlyin g thi s tragi c patter n i s th e mistake n vie w tha t free banking is inherently unstable , while central banking promote s safe an d soun d banking . Interpretation s o f today' s bankin g crisi s continue th e pattern . Onl y whe n thi s patter n i s broken , whe n th e damaging influenc e o f centra l bankin g i s full y recognize d an d fun damental reform s i n favo r o f fre e bankin g an d a gold standar d ar e enacted, will future crise s in the U.S. money and banking system be prevented.

Notes 1. Example s include Mayer (1990) and Pizzo, Fricker, and Muolo (1989). This theme of banker culpability has been applied equall y to the S&L crisis, the banking crisis, and of course to problems on Wall Street.

Bankers as Scapegoats 11 3 2. Se e Whit e (1989a ; 1989b) , Selgi n (1988a) , an d Salsma n (1990) . "Fre e banking" mean s a n unregulate d syste m o f mone y an d credit , includin g the competitiv e issuanc e b y privat e bank s o f currenc y convertibl e int o some widely-accepte d outsid e money , suc h a s the preciou s metals . Th e system operate s i n th e absenc e o f a centra l ban k an d o f an y lega l restrictions o n ban k operations ; bank s ar e subjec t onl y t o th e contrac t law an d genera l bankruptc y la w tha t appl y t o othe r industries . 3. Rockof f (1975 ; 1991 ) ha s demonstrate d tha t wildca t bankin g wa s pro moted b y state s tha t require d privatel y issue d ban k note s t o b e collater alized b y stat e bond s value d a t par . Thi s requiremen t wa s impose d primarily t o ensur e a sourc e o f financin g fo r states . Whe n th e marke t value o f th e bond s fel l belo w pa r value , ther e wa s a n encouragemen t for banker s t o over-issu e note s an d engag e i n fraud . 4. Whit e (1983 ) an d Smit h (1936 , 146-166 ) hav e show n tha t th e inelasti c currency o f th e post-Civi l wa r perio d wa s du e primaril y t o regulation s requiring tha t privat e banknote s b e collateralize d b y securitie s o f th e Federal government . Thes e regulation s impaire d flexibility b y makin g it difficul t fo r bank s t o accommodat e increase s i n th e deman d fo r cur rency relativ e t o checkin g deposits . Thi s proble m i s discusse d mor e fully below . 5. Rothbar d (1975 ) ha s show n tha t th e inflatio n o f th e mone y suppl y b y the Federa l Reserv e i n th e 1920 s mad e th e speculativ e boo m possibl e and th e resultin g bus t necessary . Friedma n an d Schwart z (1963 , chap ter 7 ) have show n tha t th e Federa l Reserv e prolonge d th e bankin g crisi s and th e Grea t Depressio n b y it s inep t managemen t o f th e discoun t window an d open-marke t operations . Phillips , McManus , an d Nelso n (1937) sa y th e crisi s o f th e 1930 s wa s mad e possibl e exclusivel y b y Federal Reserv e mismanagement . 6. Othe r bank s continue d t o operat e a s state-chartere d institutions . 7. Fo r a detailed discussio n o f eac h episode , se e Spragu e (1910) . 8. Tallma n (1988 ) make s thi s point . Calomiri s an d Gorto n (1991 , 114 ) show tha t th e wors t los s pe r deposi t dolla r durin g thi s er a wa s onl y 2. 1 cents, and th e wors t experienc e wit h ban k failur e rate s was onl y 1.28% , in th e Pani c o f 1893 . 9. Char i (1989 ) demonstrate s tha t thes e institutionally-impose d reserv e pyramids mad e th e U.S . banking syste m pron e t o panics , wherea s Can ada an d Britai n avoide d bot h pyramid s an d panics . 10. Excerpt s o f th e Comptroller' s repor t ar e provide d i n Spragu e (1910 , 336). 11. Excerpt s o f th e Treasury' s repor t ar e provide d i n Spragu e (1910 , 3 3 0 31). 12. Whil e thei r enthusias m fo r thi s currenc y refor m i s understandable , Aldrich-Vreeland stil l di d no t permi t bank s ful l branchin g powers , unrestricted not e issue , o r unregulate d reserves . O n th e othe r hand , t o

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the exten t tha t th e 1930 s deflationar y crisi s wa s th e inevitabl e resul t o f the Federa l Reserve' s inflationar y policie s i n th e 1920s— a positio n endorsed b y Phillips , McManus , an d Nelso n (1937 ) an d Rothbar d (1975) , but no t b y Friedma n an d Schwartz—the n i n th e Fed' s "absence " th e private bankin g syste m woul d neve r hav e face d th e crisi s o f th e earl y 1930s. 13. Clevelan d an d Huerta s (1985 , 59-61 ) describ e th e rol e o f th e Nationa l City Bank . 14. Th e procedure , referre d t o a s "sterilizing " gol d flows, wa s undertake n repeatedly i n th e 1920s , as describe d b y Friedma n an d Schwart z (1963 , 279-87), an d wa s justifie d bot h a s a mean s o f "insulating " th e U.S . from foreig n economi c influences , an d o f "assisting " Grea t Britain' s return t o th e gol d standard . Accordin g t o th e authors , "i t probabl y would hav e bee n bette r . . . t o have permitte d th e gold-standar d rule s t o operate fully. " 15. Fo r evidenc e o n th e Fe d inflatin g an d encouragin g speculatio n i n th e 1920s, se e Rothbar d (1975 , chapte r 5) ; for evidenc e o n th e Fe d fallin g to mee t th e growin g deman d fo r currency , se e Selgi n (1988a , 638 ) a s well a s Friedma n an d Schwart z (1963 , chapte r 7) . Th e shar p increas e in th e deman d fo r currency , a deman d tha t coul d no t b e me t legall y b y banks an d woul d no t b e supplie d voluntaril y b y th e Fed , i s signifie d b y the fal l i n th e deposit-currenc y rati o fro m nearl y twelv e time s i n 192 9 to les s tha n five time s i n earl y 193 3 (se e Friedma n an d Schwart z 1963 , 333). I n turn , thi s fallin g rati o precipitate d a collaps e i n th e stoc k o f money. 16. Fo r example , i n hearing s hel d o n th e mi x o f commercia l an d invest ment banking , Senato r Glas s an d other s argue d fo r a separatio n b y defending th e rea l bill s doctrine , bu t mad e frequen t reference s t o th e Pujo repor t t o strengthe n th e case . See Kelly (1985 , 48, 51-53) . 17. Durin g th e depression , th e Nationa l Cit y Bank' s capita l rati o increase d from 12 % i n 192 9 t o 15 % i n 1932 , whil e th e rati o o f it s brokerag e affiliate ros e fro m 62 % t o 70 % ove r th e sam e period . Unlik e othe r banks, Nationa l Cit y ha d als o strengthene d it s liquidit y t o fac e th e crises (Clevelan d an d Huerta s 1 9 8 5 , 1 6 0 - 6 1 , 169). 18. O n th e rol e o f Willis , se e Flanner y (1985 , 85 , not e 12) ; o n th e rol e o f Glass, se e Kell y (1985 , 45). 19. Se e Kell y (1985 , 43 ) an d Flanner y (1985 , 67-69) . Also , Friedma n an d Schwartz (1963 , 244-45 ) poin t ou t tha t loan s o n securitie s wer e 38 % of total ban k loan s i n 1929 , but ha d bee n onl y 3 % in 1914 . 20. Se e Kell y (1985 , 5 2 - 5 3 an d note s 14 8 an d 152) , wh o contend s tha t Chase an d Nationa l Cit y were als o motivated t o weaken th e competitiv e position o f th e riva l Morga n bank . Th e Chairma n o f Chas e Nationa l Bank, Winthro p Aldrich , actuall y assiste d Senato r Glas s i n draftin g th e legislation (Kell y 1985 , 3, note 157) .

Bankers as Scapegoats 11

5

21. Se e Chernow (1990 , 357-59) . Thi s wa s th e sam e Morga n Ban k that i n 1895 had defende d th e gold standard s o courageously that it bailed ou t the U.S . Treasury wit h a $65 million gol d loan , permittin g th e federa l government t o avoi d suspendin g speci e payment s (Friedma n an d Schwartz, 1963, 111, note 35). 22. Gol d coin and gold certificate confiscatio n wa s accomplished unde r th e Emergency Bankin g Ac t signe d int o la w b y Presiden t Roosevel t o n March 9 , 193 3 and include d th e powe r t o declar e th e infamou s "ban k holiday." Gol d clause s wer e abrogate d unde r a separat e ac t passe d i n 1933. 23. I n Octobe r 197 9 th e Fe d di d conced e th e nee d t o contro l th e mone y supply an d contai n inflation , bu t b y Augus t 1982 , whe n Mexic o de faulted o n it s dollar-denominate d debts , the Fe d ha d agai n abandone d concern for inflation . 24. Thi s was th e contradictor y an d ill-name d "Depositor y Institution s De regulation and Monetary Control Act" of 1980 . The "deregulation" wa s of deposit interest rates, over time. The "control" included the membership mandate, changes in reserve requirements, and extensions of FDIC coverage. 25. Th e "Financial Institutions Reform, Recovery, and Enforcement Act " of 1989 no t onl y provide d fo r a $5 0 billio n taxpaye r bailou t (onl y one tenth o f th e long-ter m expecte d cos t o f th e S& L crisis ) bu t grante d significant interventionis t power s to the Federal Deposit Insurance Corporation t o regulat e an d seiz e bank s wit h complet e discretion . Mor e recently, Congress has said it will replenish the bank deposit insuranc e fund before it grants banks "wider powers. " 26. A stud y release d i n Jun e 199 1 by th e Bankin g Committe e i n th e U.S . House o f Representative s foun d tha t 53 0 o f th e 2,99 0 bank s tha t dre w from th e Fed' s discoun t windo w betwee n Januar y 198 5 and Ma y 199 1 failed withi n three years and that the Fed routinely lends to banks with the lowest possible rating that can be given by bank regulators. According t o th e report , Fe d lendin g ha s allowe d uninsure d depositor s t o withdraw funds befor e banks are closed, shifting losse s to the FDIC. 27. Th e bul k o f th e Fed' s asset s consis t o f interest-bearin g governmen t securities, while it s liabilities primaril y consis t o f non-interest-bearin g Federal Reserv e Note s (th e country' s monopol y currency ) an d non interest-bearing deposit s tha t coun t a s reserves fo r membe r banks . The balance shee t alon e explain s th e considerabl e profi t margin s th e Fe d generates. Th e Fe d transfer s mos t o f it s annua l profi t t o th e treasury , further evidenc e that th e interest s o f government tak e precedence ove r those of the private banking system. 28. Ban k Failure: An Evaluation of the Factors Contributing to the Failure of the National Banks, Offic e o f the Comptroller of the Currency, Washington, D.C. , 1988 . Thi s repor t continue s a lon g traditio n o f simila r

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studies issue d b y th e OC C ove r th e years , al l o f whic h carefull y evad e the questio n o f whethe r frau d ha s cause d systemic instabilit y (se e Ben ston e t al., 1986 , 2-4) . 29. "Banking-Frau d Conviction s Nearl y Double, " America n Banker , 1 Au gust 1991 . 30. Se e Lowel l Bryan' s "Bank s Nee d Cap s o n Loans , Rates, " America n Banker, 1 9 June 1991 , 4. Ne w Yor k Representativ e Charle s Schumer , a member o f th e Hous e Bankin g Committee , introduce d legislatio n re flecting Bryan' s pla n durin g th e summe r o f 1991.

References Andrew, A . Piatt . "Substitute s fo r Cas h i n th e Pani c o f 1907. " Quarterl y Journal of Economics (Augus t 1908) . Benston, Georg e J. , e t al . Perspectives on Safe and Soun d Banking : Past, Present, an d Future . Cambridge : MIT Press, 1986 . Calomiris, Charle s W. , an d Gar y Gorton . "Th e Origin s o f Bankin g Panics : Models, Facts , an d Ban k Regulation. " I n Financial Market s an d Financial Crises, edite d b y R . Glen n Hubbard . Chicago : Universit y o f Chicag o Press, 1991. Chari, V . V . "Bankin g withou t Deposi t Insuranc e o r Ban k Panics : Lesson s from a Mode l o f th e U.S . Nationa l Bankin g System. " Quarterl y Review (1989). Federal Reserv e Ban k o f Minneapolis . Chernow, Ron . The House of Morgan : A n America n Dynasty an d th e Rise of Modern Finance. Ne w York : Atlantic Monthl y Press , 1990 . Cleveland, Harol d va n B. , an d Thoma s F . Huertas . Citibank, 1812-1970. Cambridge: Harvard Universit y Press , 1985 . Flannery, Mar k J . "A n Economi c Evaluatio n o f Ban k Securitie s Activitie s Before 1933. " In Deregulating Wal l Street : Commercial Ban k Penetratio n of the Corporate Securities Market , edite d b y Ing o Walter . Ne w York : Wiley, 1985 . Friedman, Milton , an d Ann a J . Schwartz. A Monetary History of the United States, 1867-1960. Princeton : Princeto n Universit y Press , 1963 . Glasner, David . Fre e Bankin g an d Monetar y Reform . Ne w York : Cambridg e University Press , 1989 . Goodhart, Charles . Th e Evolution of Centra l Banks . Cambridge : MI T Press , 1988. Gorton, Gary . "Privat e Clearinghouse s an d th e Origin s o f Centra l Banking. " Business Review (1984) . Federal Reserv e Ban k o f Philadelphia . . "Ban k Suspension s o f Convertibility. " Journa l of Monetar y Economics (Marc h 1985) : 177-93. Groseclose, Elgin . America' s Mone y Machine : Th e Story of the Federal Reserve. Westport, Conn. : Arlington House , 1980 .

Bankers as Scapegoats 11 7 Horwitz, Steven . "Competitiv e Currencies , Lega l Restrictions, an d th e Origin s of th e Fed : Som e Evidenc e fro m th e Pani c o f 1907. " Souther n Economic Journal (1990) . Kelly, Edwar d J . "Legislativ e Histor y o f th e Glasis-Steagal l Act. " I n Deregu lating Wai l Street : Commercial Bank Penetration of the Corporate Secu rities Market, edite d b y Ing o Walter. Ne w York , Wiley , 1985 . Mayer, Martin . The Greatest-Ever Bank Robbery: The Collapse of the Savings and Loan Industry . Ne w York : Macmillan, 1990 . Noyes, Alexande r Dana . Thirty Years of America n Finance : A Short Financial History of the Governmen t an d Peopl e of the United States Since the Civil War, 1865-1896. Ne w York : Putnam, 1910 . Office o f th e Comptrolle r o f th e Currency . Ban k Failure : A n Evaluation of the Factors Contributin g to the Failure of National Banks. Washington , D.C., 1988 . Pecora, Ferdinand . Wall Stree t Unde r Oath: The Story of Our Moder n Money Changers . Ne w York : Simo n an d Schuster , 1939 . Phillips, C. A., T. F. McManus, an d R . W. Nelson. Banking an d the Business Cycle: A Study of the Great Depression in the United States. Ne w York : Macmillan, 1937 . Pizzo, Stephen , Mar y Fricker , an d Pau l Muolo . Inside Job: The Looting of America's Saving s an d Loans. Ne w York : McGraw-Hill, 1989 . Rockoff, Hugh . The Free Bankin g Era : A Re-examination. Ne w York : Arno , 1975. . "Lesson s fro m th e America n Experienc e wit h Fre e Banking. " I n Unregulated Banking: Chaos or Order?, edite d b y Forres t Capi e an d Geoffrey E . Wood. Ne w York : St . Martin's, 1991. Roosevelt, Frankli n D . The Publi c Paper s of Frankli n D . Roosevelt. Ne w York: Random House , 1938 . Rothbard, Murray . America' s Grea t Depression. Kansa s City , Mo. : Shee d and Ward , 1975 . Salsman, Richar d M . Breaking the Banks: Central Bankin g Problem s an d Free Bankin g Solutions. Grea t Barrington , Mass. : America n Institut e fo r Economic Research , 1990 . Schwartz, Ann a J . "Rea l an d Pseudo-Financia l Crises. " Financial Crises and the World Banking System, edite d b y Forres t Capi e an d Geoffre y E . Wood. Ne w York : St . Martin's, 1986 . Selgin, Georg e A . The Theory of Free Banking : Money Suppl y Unde r Com petitive Note Issue. Totowa , N.J. : Rowman an d Littlefield , 1988a . . "Accomodatin g Change s i n th e Relativ e Deman d fo r Currency : Fre e Banking vs . Central Banking. " Cato Journal 7 (1988b): 6 2 1 - 4 1 . Shughart, Willia m F. , II . " A Publi c Choic e Perspectiv e o f th e Bankin g Ac t of 1933, " Cato Journal 7 (1988): 595-613. Smith, Ver a C . The Rationale of Central Banking and the Free Bankin g Alternative. Indianapolis : Libert y Press , 1990 . Orig. pub. 1936 .

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Sobel, Robert . Panic on Wall Street : A History of America' s Financia l Disasters. New York: Macmillan, 1968. Sprague, O . M. W. History of Crises Under the National Bankin g System. Washington, D.C. : Governmen t Printin g Office , 1910 . Stud y sponsore d by the National Monetary Commission . Tallman, Ellis . "Som e Unanswere d Question s abou t Ban k Panics. " Economic Review (Decembe r 1988) . Federa l Reserv e Ban k o f Atlanta . De cember 1988. Timberlake, Richard H. The Origins of Central Banking in the United States. Cambridge: Harvard University Press, 1978. . "The Central Banking Role of Clearinghouse Associations." Journal of Money, Credit, and Bankin g (February 1984). . "Seventy-Five Years of Monetary Control." Durell Journal o f Money and Banking . (November 1989) : 2-9, 30-38. White, Eugen e N . Th e Regulatio n an d Refor m of the America n Bankin g System, 1900-1929. Princeton : Princeton University Press, 1983. . "Before the Glass-Steagall Act: An Analysis of the Investment Banking Activitie s o f Nationa l Banks. " Explorations in Economic History (1986): 33-55. White, Lawrenc e H . Competitio n an d Currency : Essays on Free Bankin g and Money. New York: New York University Press, 1989a. . "Th e Growin g Scarcit y o f Banknote s i n th e Unite d States , 1865 1913." Unpublished manuscript , University of Georgia, 1989b.

5 Deposit Insuranc e Refor m I s Not Enoug h Walker Todd an d Geral d P. O'Driscoll, Jr.

Deposit insurance reform i s the cornerstone o f virtually ever y banking refor m proposal . Th e deficiencie s o f th e presen t syste m o f de posit insuranc e ar e widel y acknowledged , an d debat e ha s turne d increasingly to how, and not whether, the system should be changed. 1 In thi s chapte r w e argu e tha t deposi t insuranc e refor m alon e cannot solv e the structura l instabilitie s o f the U.S . banking system . Deposit insurance i s only one part of the federal financial safet y ne t that undergird s th e bankin g industry . Othe r element s o f th e safet y net reinforc e an d enhanc e th e pervers e incentive s generate d b y de posit insurance . Hence , policymaker s canno t expec t t o achiev e a more stable banking system by limiting themselves to even compre hensive deposi t insurance reform. 2 Further , we cite the reasons wh y any for m o f deposi t insuranc e wil l preven t th e Unite d State s fro m achieving a stable and equitable banking system . In th e sectio n tha t follows , w e trac e th e evolutio n o f th e U.S . banking syste m an d th e seemingl y innocuou s incorporatio n o f de posit guarantee s b y bot h th e stat e an d federa l governments . Th e analysis include s a n examinatio n o f earl y problem s wit h deposi t insurance, using the Kansas experience as a representative case . We then revie w th e inadequacie s o f curren t refor m proposal s an d th e prospects fo r mor e comprehensiv e reform , th e refor m o f deposi t insurance. In our conclusion, we suggest a number o f market mech anisms for achieving genuine reform o f the banking system . 119

120 WaJke r Tod d an d Geral d P . O'DriscoJJ, Jr. I. From Regulation to Ownership: The Evolution of U.S. Banking Regulation Banking, in a t least som e o f it s forms, ha s alway s been regulated i n the Unite d States . Fro m tim e t o time , however , governmen t ha s subjected aspect s o f bankin g t o greate r o r lesse r scrutiny . Fo r in stance, historians describ e bankin g fro m 183 8 to 186 3 as the er a of "free banking. ,, Th e freedo m the y refe r to , however, wa s limite d t o the acquisitio n o f bank charters : prior to the period , eac h new ban k charter require d a specia l an d specifi c legislativ e act . Th e syste m provided ampl e opportunity for bribery and subtler forms o f corruption o f legislatures. Free banking allowed thos e desirin g to incorporate a ban k t o mee t onl y certai n specifie d an d genera l lega l tests , such as minimum capita l requirements, in order to obtain a charter. The chang e diminishe d th e potentia l fo r politica l corruptio n i n th e chartering process . I t als o enhance d competition . Wha t wa s "free " in the free-banking er a was entry. Banks wer e neve r empowere d freel y t o ente r ne w activitie s or , until comparativel y recentl y an d onl y i n som e states , t o branc h freely int o ne w geographica l markets . Publi c la w an d polic y hav e always placed significan t limitation s on bank powers and branchin g rights. Banks i n the Unite d State s hav e never ha d anythin g lik e th e commercial freedom accorde d to most other enterprises. Indeed, the evolution of legal and political doctrine has denied banks even basic privileges an d immunitie s accorde d t o individual s an d othe r kind s of corporations. 3 The rationale for these restrictions has always been that banking is "clothed i n the public interest. " Regardless, th e government' s relatio n t o bankin g ha s change d dramatically i n th e shor t histor y o f ou r country . A serie s o f incre mental lega l an d polic y change s ha s wrough t a major revolutio n i n the relationship between the government, especially the federal government, an d th e bankin g industry . Pu t starkl y bu t accurately , th e outcome of this revolution was the substantial nationalization o f the U.S. banking industr y (Kan e 1985 , 23). What make s thi s nationali zation especiall y perverse , however , i s that th e governmen t under writes mos t o f th e bankin g system' s liabilitie s withou t takin g lega l title to the capital or the assets. Before th e Civi l War , th e state s tende d t o b e sovereig n i n al l matters save those specifically reserve d for the federal government. 4 Chartering corporation s wa s a power share d betwee n th e state s an d the federa l government . I n th e antebellu m period , however , onl y

Deposit Insuranc e Refor m Is Not Enoug h 12 1 two corporations , th e Firs t an d Secon d Bank s o f th e Unite d States , received federa l charters . Sav e for thes e tw o importan t episode s i n U.S. history, the federal governmen t left bank chartering exclusivel y and bank regulation largely to the states. The involvement o f the stat e governments i n banking was perva sive. The states often regulate d bank s in great detail and intervene d in ban k operation s occasionally , a s whe n the y sanctione d th e sus pension o f speci e paymen t durin g th e numerou s bankin g crise s o f the nineteent h century . I n th e antebellu m Unite d States , however , save in the aftermath o f the panic o f 1837 , state governments avoide d underwriting bankin g o r bailin g bank s ou t o f financial difficulties . In this limite d sense , banking fit a laissez fair e model . I f entr y wa s not always free, exi t through failure wa s largely unregulated . The Nationa l Ban k Ac t o f 186 3 represente d th e first significan t intrusion b y the federal governmen t int o banking regulation. I t also marked th e first instanc e i n whic h th e federa l governmen t under wrote an y aspec t o f banking. 5 Amon g othe r things , th e ac t autho rized th e charterin g o f nationa l bank s an d th e issuanc e o f a ne w currency—national ban k notes . Th e ac t require d nationa l bank s t o deposit federa l governmen t bond s wit h th e Treasury equa l i n valu e to 111 % o f th e fac e valu e o f th e notes . (Th e amoun t wa s late r reduced t o 100 % and further amended. ) A s Friedman an d Schwart z (1963, 21 ) observed , "Thoug h nationa l ban k note s wer e nominall y liabilities o f the banks that issue d them , in effect the y were indirec t liabilities o f th e federa l government. ,, Upo n failur e o f a nationa l bank, the Treasury was authorized t o redeem al l the bank's note s i n circulation, an d th e bonds securin g the note s were then forfeite d t o the U.S. government. Although literall y true , the assertio n tha t the federal governmen t stood behin d th e issuanc e o f nationa l ban k note s i s potentiall y misleading i n th e moder n contex t o f debate s o n th e wisdo m an d propriety of federal deposi t insurance. In the event of an insolvency , the governmen t use d th e bank' s ow n asset s t o redee m th e notes . National ban k failure s ordinaril y coul d no t trigge r a taxpayer bail out. Indeed , th e taxpaye r wa s insulate d fro m liabilit y severa l time s over. For instance, other provisions o f the act gave the Treasury first lien o n all assets o f a failed ban k an d upo n th e persona l liabilit y of the bank' s stockholder s t o cove r an y shortfall s betwee n th e pa r value o f th e note s an d th e fac e valu e o f th e bonds . Further , afte r 1874, there wa s a redemption fun d kep t o n deposi t wit h th e Trea sury (Friedman and Schwart z 1963 , 20-21).

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The contrast between nineteenth-century banking policy and cur rent federa l bankin g polic y coul d scarcel y b e greater . Unde r th e National Ban k Act, onl y a certain clas s o f the liabilitie s o f nationa l banks wa s guaranteed . Th e amoun t o f th e bank' s eligibl e bond s pledged strictl y limite d th e aggregat e amoun t o f ban k liabilitie s covered b y the federal government . Governmen t fiscal polic y coul d change th e theoretica l maximu m o f th e guarantee d nationa l ban k liabilities, bu t privatel y actin g banker s coul d no t (Friedma n an d Schwartz 1963 , 23). 6 Hence , taxpaye r liabilit y wa s virtuall y non existent. I f th e Nationa l Ban k Ac t wa s a foo t i n th e doo r t o late r approval o f a blanke t governmen t guarante e o f ban k liabilities , i t was a ver y tentativ e an d unintrusiv e entr y tha t n o on e involve d contemplated a t the time. Today, the federal governmen t place s few limitation s o n the siz e and typ e o f liabilitie s i t wil l guarante e fo r th e bankin g system . Contemporary taxpayer s hav e been mad e full y liabl e for nearl y th e entire amount o f the guarantees. The taxpayer's liability is potentia l and indirect only so long as the deposit insurance fund ha s adequate resources. No w tha t liabilit y i s becomin g rea l a s fun d resource s disappear. Worse , no t onl y i s th e potentia l taxpaye r liabilit y fo r bank failures immense , but the action s o f politically unaccountabl e private individual s (bankers)—no t electe d representatives—deter mine th e amoun t an d timin g o f th e dra w o n th e taxpayer . On e ca n hardly construct a less market-oriented o r more inequitable system . Experimentation wit h Deposit Insurance: The Kansas Experience The transformatio n o f nineteent h centur y bankin g polic y int o tha t of the presen t involve d a number o f steps. The common denomina tor o f the change , however, wa s the implementatio n o f governmen tally sponsore d deposi t guarantees . In response t o the financial pani c of 1907 , eigh t state s establishe d som e for m o f deposi t guarante e system betwee n 190 7 an d 1917. 7 Membershi p b y stat e bank s wa s compulsory i n som e o f thos e state s an d voluntar y i n others . Al l eight system s failed , som e mor e quickl y tha n others . Th e stat e o f Washington's syste m ended the most ignominiously: "Washington' s system wa s th e shortest-lived . I n 1921 , following th e state' s first bank failure, which happened als o to be the largest insured bank, all other banks withdrew from the system." (Wheelock and Kumbhaka r 1990, 10). This was adverse selection with a vengeance. Studies of the Kansas system by Wheelock and Kumbhakar revea l

Deposit Insuranc e Refor m I s Not Enoug h 12 3 that i n som e way s i t wa s th e mos t promisin g o f th e stat e systems . Like Washington, th e Kansa s syste m calle d fo r voluntar y participa tion b y th e state' s banks . Althoug h thi s characteristi c wa s a draw back i n th e Washingto n case , Kansa s regulator s mad e a virtu e ou t of necessity . Opponent s o f deposi t insuranc e ha d argue d tha t i t penalized conservativ e banks by compelling them to fund th e cost s of faile d institutions . T o mollif y thi s opposition , th e Kansa s la w limited coverag e t o deman d deposit s no t payin g interes t an d t o certain saving s account s wit h interes t rate s limite d t o 3% . Mor e important, th e la w establishe d stric t capita l requirement s an d re quired bank s t o b e inspecte d befor e receivin g coverag e (Wheeloc k and Kumbhakar 1990 , 6-7). It is instructive to compare these restrictions wit h today' s deposi t insuranc e system , whic h cover s hig h yielding, brokere d deposit s i n bank s wit h littl e o r n o capitaliza tion. Wheelock an d Kumbhaka r (8 ) describe the Kansas' fund's super vision o f it s insure d bank s a s "relativel y strict, " an d th e syste m i n fact achieve d a degre e o f succes s fo r severa l years . "Betwee n 190 9 and 191 9 ther e wer e jus t eigh t failure s o f stat e chartere d bank s i n Kansas, an d onl y tw o o f the m ha d bee n member s o f th e insuranc e system" (Wheeloc k and Kumbhaka r 1990 , 9). The system' s success , however, rapidl y deteriorate d onc e agricultura l distres s struc k th e state in the early 1920s. Bank losses skyrocketed and regulators were forced t o impose special assessments o n insured banks. Predictably, banks bega n t o fle e th e system , an d b y 192 6 i t wa s hopelessl y insolvent.8 One migh t suppos e tha t economi c condition s wer e responsibl e for th e wav e o f Kansa s ban k failure s i n th e 1920 s (jus t a s som e blame falling energ y prices for the recent banking debacle in Texas). If th e suppositio n wer e accurate , the n th e stat e deposi t insuranc e system woul d b e exonerate d fro m responsibility . Th e fact s ar e in consistent, however , wit h thi s view . Conside r th e followin g table , constructed fro m informatio n i n Wheelock and Kumbhakar (9) . Kansas Bank Failures, 1920-26 Period Insure 1920-22 1 1922-24 4 1924-26 3

d Uninsure d 7 (2.5%) 6 (1.4%) 2 (5.9%) 1 2 (3.0%) 5 (5.3%) 1 0 (2.6%)

124 Walke r Tod d an d Geral d P . O'Driscoll, Jr. The percentage s i n parenthese s indicat e th e proportio n o f bank s in tha t categor y tha t faile d i n th e indicate d two-yea r period . Mor e telling tha n th e eviden t differenc e betwee n failur e rate s amon g in sured an d uninsure d stat e bank s wa s th e experienc e o f nationa l banks i n th e sam e time period : "Ther e wer e n o failure s o f nationa l banks i n th e first two-yea r period , fou r fro m 1922-2 4 (1.5 % o f national banks) , an d tw o fro m 1924-2 6 (0.8 % of nationa l banks) ,, (Wheelock and Kumbhakar 1990 , 9). If economic condition s wer e no t responsibl e fo r th e rash o f Kan sas ban k failures , wha t mad e th e state' s deposi t insuranc e syste m accountable for those failures? Did insurance coverage lead banks to become riskier—th e mora l hazar d problem—o r di d risk y bank s apply fo r insuranc e i n disproportionat e numbers—th e advers e se lection dilemma ? Th e econometri c problem s inheren t i n determin ing the importance o f each factor ar e difficult t o resolve. Regardless o f whic h effec t dominated , th e Kansa s experienc e pointed (an d points ) t o th e pitfall s o f governmen t guarantee s o f deposits. Even though th e Kansas system ha d safeguard s t o preven t both mora l hazar d an d advers e selection , th e syste m di d no t avoi d an abnormall y hig h failur e rat e o f insure d banks . Th e hig h failur e rate existed despit e the state's enforcemen t o f these risk-taking con trols. Further , th e syste m wa s voluntary , a s woul d b e a privat e insurance o r reinsuranc e system . Indeed , th e Kansa s experienc e raises question s abou t th e abilit y o f insurer s t o gauge financial ris k in banking, or even to sort out good banks from bad . Moving Toward the Nationalization o f U.S. Banking During the same time that states were experimenting with guarante e systems, th e federa l governmen t wa s conductin g a n experimen t o f its own . Th e Federa l Reserv e System , create d i n 1913 , promised a degree o f securit y fo r nationa l bank s an d membe r stat e banks . Th e new bankers ' ban k wa s designe d i n par t t o provid e a mean s t o liquify previousl y illiqui d assets . Th e devic e create d t o provid e liquidity wa s the discoun t window . At the discoun t window, mem ber commercia l bank s coul d deposi t short-term , commercia l loan s to ac t a s collatera l agains t advance s o f ready cash . Th e syste m wa s not a direc t guarante e o f deposit s bu t coul d operat e indirectl y i n a similar fashion . Durin g a financial crisi s o r loca l economi c down turn (suc h a s occurre d periodicall y i n agricultura l regions) , goo d assets coul d b e converte d int o cas h temporarily . N o longe r di d

Deposit Insuranc e Refor m I s Not Enoug h 12 5 banks nee d t o dum p illiqui d asset s a t fire-sale price s t o rais e cas h with which to pay off depositors . Although no t a deposi t guarantee , th e discoun t windo w wa s a potential sourc e o f problem s i f regulator s use d th e devic e fo r mor e than transitory banking difficulties. Fo r a number of years, however, central bank doctrine, as enunciated by Walter Bagehot in the 1870s, prevented abus e of the discoun t window by recommending tha t th e central bank s len d onl y t o solven t bank s an d onl y agains t goo d collateral. Supporters o f Bagehot's lende r o f last resort concept con tended tha t th e centra l ban k wa s no t intende d o r designe d t o kee p insolvent banks open. Moreover, bank closure rules, including criminal penaltie s fo r ban k officer s an d director s wh o continue d t o re ceive deposit s whil e knowin g tha t thei r ban k wa s insolvent , oper ated t o preven t bailin g ou t insolven t bank s throug h th e discoun t window. Th e los s experienc e durin g th e onse t o f the Grea t Depression suggest s tha t ban k regulator s performe d thei r dut y remarkabl y well eve n unde r th e mos t difficul t circumstances . Fro m 193 0 t o 1933, average annua l losse s incurre d b y depositor s i n bank failure s before th e adven t o f federa l deposi t insuranc e wer e .81 % of tota l deposits (Bensto n 1986 , 64). In th e las t fe w years , classica l centra l ban k doctrin e ha s bee n honored mor e i n th e breac h tha n i n practice . Ban k regulator s rou tinely kee p insolven t bank s open , ofte n b y using discoun t windo w lending t o substitut e fo r privat e liabilities . I n s o doing , regulator s confound protectio n o f the bankin g system wit h protectio n o f indi vidual institutions. The contemporary cours e of action runs directl y contrary to classical central bank doctrine . When a n insolven t commercia l ban k i s eventuall y dispose d o f under curren t policy , th e Federa l Reserv e Banks ' loan s ar e repai d by the Bank Insurance Fun d (BIF) . This draw s dow n BIF's reserves, which deriv e fro m premiu m assessment s o n commercia l banks . A t some point—no w reache d i f no t breached—BI F itsel f become s in solvent. Taxpayers' funds wil l then be drawn upon . Thus, violating classical principle s o f centra l bankin g convert s unsoun d bankin g policy int o unsoun d fiscal policy . Th e curren t polic y i s fiscally important becaus e i t affect s th e siz e o f the federa l budge t deficit . I t is unsound i n law and in political economy because the fiscal effects are th e produc t no t o f deliberat e congressiona l action s bu t o f th e actions of private agents (bankers) and unelected decisio n makers at federal agencies . Prior t o th e Federa l Reserv e Act , nationa l bank s wer e subjec t t o

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both regulator y an d marke t disciplines . Althoug h th e comptrolle r o f the currenc y examine d th e bank s regularly , privat e clearin g house s monitored bank s o n a day-to-da y basis . Clearinghouse s coul d quickl y detect telltal e sign s o f unsaf e an d unsoun d banking . Becaus e thei r membership wa s directl y expose d t o the consequences , i t wa s ofte n the clearinghous e tha t impose d disciplin e o n shak y bank s (Whit e 1989, 230-33) . With th e creatio n o f th e Federa l Reserv e System , reserv e bank s assumed man y o f th e role s o f th e clearinghouses , eliminatin g som e of th e marke t control . Wit h th e los s o f thes e marke t controls , th e need fo r governmenta l supervisio n an d regulatio n becam e greater . In 1933 , Congress create d anothe r agency , the Federal Deposi t Insur ance Corporatio n (FDIC) , to hel p monito r banks . Th e creatio n o f th e Federal Saving s an d Loa n Insuranc e Corporatio n followe d i n 193 5 for saving s an d loa n associations . The ostensibl e purpos e o f th e FDI C wa s t o protec t th e smal l depositor. Th e ide a wa s tha t smal l depositor s wer e unabl e t o distin guish soun d fro m unsoun d banks . Massiv e ban k failures , suc h a s occurred i n th e 1930s , le d smal l depositor s t o withdra w thei r fund s from th e bankin g system . Tha t is , th e ban k failure s ha d le d t o a contagious ru n o n soun d banks , conversio n o f deposit s int o cur rency, an d th e concomitan t shrinkag e o f th e mone y suppl y an d economic disruption . A syste m o f federa l deposi t insurance , th e government surmised , woul d restor e confidenc e an d stabilit y i n th e banking system . In th e beginning , th e FDI C operate d i n a manne r broadl y consis tent wit h it s state d purpose . Insuranc e wa s initiall y establishe d a t $2,500 pe r account . Ove r th e years , however , th e ceilin g ha s bee n raised successively . Th e mos t recent , famous , an d fatefu l chang e was i n 1980 , when th e ceilin g wen t u p t o $100,000. To pu t th e issu e in perspective , i f coverag e ha d bee n kep t constan t i n rea l terms , i t should b e approximatel y $20,00 0 today . Worse , unde r th e doctrin e of "to o bi g t o fail, " deposit s a t larg e bank s ar e protecte d n o matte r their amount . Th e cumulativ e effec t o f thes e policie s ha s lef t th e FDIC facing insolvency . In les s tha n sixt y years , w e hav e com e ful l circle . W e hav e a troubled bankin g syste m an d insufficien t resource s t o resolve futur e failures. Th e legac y o f sixt y year s o f deposi t insuranc e i s twofold : subsidized lendin g t o excessivel y risk y projects , mos t visibl e toda y in commercia l rea l estate ; an d th e so-calle d credi t crunch , th e star -

Deposit Insuranc e Reform Is Not Enoug h 12 7 vation o f the productiv e elemen t o f th e econom y fo r resource s du e to the previous overcommitment t o risky projects . Because the disastrou s effect s o f federal deposi t insuranc e ar e s o conspicuous, i t i s hardl y surprisin g tha t s o muc h attentio n i s fo cused o n deposi t insuranc e reform . Unfortunately , othe r aspect s of banking hav e change d a s well . Ban k supervisio n i s mor e relaxed , and polic y allow s bank s t o tak e greate r risks . A s a result , wer e deposit insuranc e eliminate d tomorrow , these othe r change s woul d probably generat e muc h th e sam e mora l hazar d proble m tha t w e have today. Th e temptation w e must avoid , then, i s to take a piecemeal approac h t o overal l bankin g reform , concentratin g fundamen tal reform effort s o n deposit insurance alone. Sadly, as the followin g section demonstrates , th e sentimen t fo r piecemea l refor m i s perva sive. II. Avoiding Fundamenta l Reform : The Latest Banking Band-Aids As th e evidenc e suggestin g tha t th e BI F is approachin g no t merel y illiquidity bu t actua l insolvenc y continue s t o mount , th e debat e about bankin g refor m ha s begu n t o tak e som e unpredicte d and , probably, unpredictable turns. For example, in mid-March 1991 , the Treasury announce d a recapitalizatio n pla n fo r th e BIF . Th e pla n proposed tha t th e FDI C use a n undraw n $ 5 billion credi t lin e wit h the Treasur y a s th e equivalen t o f equit y o r ne t wort h t o suppor t FDIC borrowings i n th e publi c deb t market . Th e borrowin g woul d be mad e throug h th e Federa l Financin g Ban k (FFB) , which coordi nates Treasury and government agenc y borrowings i n the market. The authorizatio n fo r suc h FDI C publi c deb t borrowin g cam e from th e Financia l Institution s Reform , Recovery , an d Enforcemen t Act o f 198 9 (FIRREA) . FIRREA enable s th e FDI C to borrow o n a 9to-1 leveraging ratio against its net worth. The act also increased th e FDIC's Treasury credit line from $ 3 billion to the present $5 billion. Because th e FDIC' s ne t wort h alread y i s a t o r belo w zer o o n a market-value basis , th e FDI C wishe s t o coun t th e Treasur y credi t line as equity against which i t can borrow up to $45 billion throug h the FFB. If the FDIC does so, its available Treasury credit line would be reduced graduall y t o zero a s the full $4 5 billion wer e borrowed . The FDI C apparentl y expecte d t o us e th e $4 5 billio n fo r wha t i t terms "workin g capital " fo r BIF . "Working capital " constitute s th e funding require d to carry assets assumed from failed o r failing banks

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on th e BIF' s books pendin g th e resal e o r othe r liquidatio n o f thos e assets. Unfortunately, eve n this $45 billion would not solve the financial problems of the FDIC. One might assume, quite realistically, that the remaining $ 4 billion i n th e BI F at year-end 199 0 would cove r onl y the 15 0 to 20 0 small-ban k failure s tha t recen t histor y suggest s wil l take place through 1991 . If, however, the FDIC were to move aggressively t o resolv e som e o f th e larger , lingerin g ban k failure s an d open-but-failing ban k problems , eve n mor e fund s woul d b e re quired.9 The FDI C apparentl y ha s contemplate d th e potentia l shortfal l i t would fac e were it to recognize the additional BIF losses that acquisition o f th e asset s o f thes e othe r faile d an d failin g bank s woul d generate. Th e agenc y formall y aske d Congres s fo r permissio n t o borrow up t o $25 billion directl y from "an y Federal Reserve Bank, " in additio n t o th e $4 5 billio n o f workin g capita l borrowing s de scribed abov e (Title IV of th e Treasury' s draf t bankin g refor m bill) . Although pres s reports indicate d tha t the FDIC wanted t o repay th e Fed borrowing s ove r fifteen years , the draf t bil l specifie d n o matu rity. Further , th e FDI C proposed t o repay the Fe d by increasing th e premium rat e fo r deposi t insuranc e fro m twenty-thre e basi s point s (.23%) pe r annu m t o thirt y basi s points—a n amoun t tha t woul d begin t o approac h one-hal f o f th e tota l earning s o f a typica l Ne w York money center bank in any recent good year. As late as mid-March 1991 , the Federal Reserve Board was tacitly supporting th e FDIC' s borrowin g request . Th e boar d eve n wen t s o far a s t o circulat e interna l staf f memorand a t o th e effec t tha t th e emergency lendin g provision s o f th e Federa l Reserv e Ac t alread y authorized th e Fed to make such loans to the FDIC. About one week later, the staff o f the U.S. Senate Banking Committee was induced to arrive at a similar conclusion . Despite th e board' s suppor t fo r a n FDI C bailout loan , however , literature squarel y contradictin g th e board's positio n o n the subjec t already existe d i n th e publi c domai n (Tod d 1988 , appendi x A ; Hackley 1973 , esp . 195-201) . Towar d th e en d o f March , pres s re ports indicate d tha t th e regiona l reserv e ban k president s wer e ex pressing objection s t o the board's positio n o n a bailout loa n fo r th e FDIC. Compare thi s reactio n wit h th e reactio n o f th e sam e partie s tw o years earlier , whe n a comparabl e bailou t schem e fo r th e forme r Federal Saving s and Loan Insurance Corporation (FSLIC) , the *'Joint

Deposit insuranc e Refor m Is Not Enoug h 12 9 Lending Program," was presented t o the reserve banks. At that time, no on e objected i n the presence o f the governor s o r presidents, an d only tw o reserv e bank s delaye d thei r forma l acquiescenc e t o th e scheme b y on e additiona l busines s day . Th e Federa l Hom e Loa n Bank o f Sa n Francisc o hel d bac k it s acceptanc e o f the pla n fo r tw o weeks, but th e othe r hom e loa n bank s acquiesce d abou t a s quickl y as the reserve banks. Two year s later , th e lesson s learne d b y the Federa l Reserv e Sys tem with respect to the funding o f other agencie s of the governmen t enabled Chairma n Ala n Greenspa n t o articulat e a well-grounde d theoretical cas e agains t th e FDI C bailout loa n reques t i n hi s testi mony befor e th e Senat e Bankin g Committe e o n Apri l 23 , 1991 . Chairman Greenspa n noted , correctly , that Congres s ha s alway s se verely limite d and , mor e recently , ha s allowe d t o expir e statute s authorizing th e direc t placemen t o f Treasury deb t wit h th e Federa l Reserve. Thi s long-standin g polic y apparentl y reflect s concer n o f monetary, a s distinguished fro m fiscal, authoritie s tha t suc h a practice could compromis e the independent conduc t o f monetary polic y and woul d allo w the Treasury to escape the disciplin e o f sellin g it s debt directly to the market. Implementation o f the Treasury fundin g proposal coul d hav e create d perceptions , bot h i n th e Unite d State s and abroad, that the nature or function o f our central bank had bee n altered. I n addition , i f implementatio n o f th e proposa l create d a precedent fo r furthe r loan s t o BI F or to othe r entities , the liquidit y of th e Federa l Reserve' s portfoli o coul d hav e bee n reduce d suffi ciently ove r time to creat e concern s abou t the abilit y o f the Federa l Reserve to control the supply o f reserves and, thereby, to achieve its monetary polic y objective s (Greenspa n 1991 , 18) . Th e New Yor k Times reported tha t Chairman Greenspa n told the Banking Committee tha t th e centra l ban k di d no t se e itsel f a s a lender o f las t resor t for the bank fund (BIF) . There is "no sound economic reason" to use the Fe d instea d o f th e Treasur y fo r tha t purpose , h e sai d (Hershe y 1991). Nevertheless, the Treasury still resists learning this necessary an d useful lesson. 10 Th e rea l problem , however , ma y b e tha t th e Trea sury insufficientl y understand s th e monetar y an d fiscal conse quences o f th e distinctio n between , o n th e on e hand , centra l ban k loans t o membe r bank s o n goo d collatera l fo r liquidit y purpose s and, o n the othe r hand , fifteen-year unsecure d loan s o f capita l t o a government agenc y (Tod d 1988) . That distinctio n i s what separate s liquidity concern s fro m capita l (insolvency ) problems ; failur e t o

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observe th e distinctio n tend s t o conver t fiscal problems int o mone tary problems. III. Practical Objection s to the Current Deposit Insurance System Essentially, th e existin g federa l deposi t insuranc e system , lik e th e Kansas syste m o f the 1920 s and th e earlie r stat e safet y o r insuranc e funds, ha s cause d th e leas t well-capitalized , riskies t institution s t o rely increasingly on deposit insurance to raise funds a t costs (yields) well belo w thos e tha t depositor s woul d deman d i n th e absenc e o f federal deposi t insurance . Th e large r institution s rel y mor e heavil y on cheap, insured deposi t funds i n absolute dolla r amounts than d o similarly situated , smalle r institutions , eve n thoug h th e smalle r in stitutions rel y more heavily o n deposi t insuranc e a s a proportion of all deposi t accounts. 11 Thus, when enoug h o f the larger institution s begin to fail, the drain on the deposit insurance funds wil l be larger, in absolut e dolla r amounts , an d wil l overwhel m th e remainin g o r realistically potentia l resource s o f th e BIF . The BIF' s shortfal l wil l give rise t o call s fo r taxpayer-funde d bailouts , centra l bank-funde d bailout loans , an d th e like . Thi s problemati c scenari o i s inevitabl e and incurabl e i n a politicall y sensitiv e ban k supervisor y structur e that canno t an d wil l no t rei n i n th e risk-takin g activitie s o f th e largest insured institution s unti l it is too late. In contrast, th e classic , pre-1933 approach t o bank failure resolu tion offers th e following virtues : 1. Larg e depositor s an d othe r claimant s woul d b e force d t o shar e losses pro rata. 2. Manager s an d shareholder s woul d b e subjec t t o som e typ e o f direct, persona l liabilit y fo r shortfall s betwee n banks ' asse t an d liability values , whic h woul d mak e the m mor e pruden t i n thei r lending an d investmen t decisions . (I n th e cas e o f stockholders , there formerl y wa s supplementa l liabilit y equa l t o their origina l investment.) 3. Uninsure d depositor s typicall y woul d recove r clos e t o th e ful l value of their deposits , over time. 4. Taxpayer s an d th e centra l ban k ordinaril y woul d b e spare d th e cost o f underwritin g payoff s o f larg e depositors . I n a n environ ment i n whic h th e arithmeti c mea n insure d deposi t accoun t i s about $10,000, it is either a reverse transfer program , or a subsidy of th e fe w b y th e many , t o ta x averag e depositor s t o pa y of f

Deposit Insuranc e Reform I s Not Enoug h 13 1 $100,000 deposits . Th e averag e depositor , a t least , ordinaril y would b e better of f i f everyon e wer e lef t alon e to bear his o r he r own losses. Aside fro m th e practica l difficultie s cite d above , th e principa l problem tha t deposi t insuranc e pose s fo r economist s i s tha t i t i s inconsistent wit h a well-functionin g marke t system . Hence , an y discussion o f deposi t insuranc e refor m necessaril y descend s int o a third- and fourth-order analysi s of problems. It i s essentia l t o kee p th e derivatio n o f moder n U.S . bankin g structure in mind when reviewing deposit insurance reform propos als. I n a stat e o f nature , whe n peopl e com e t o agre e o n a conven tional standar d o f value that they cal l "money, " i t is inevitable tha t some wil l hav e mor e an d other s les s o f i t a t an y give n momen t (Aristotle 1987 , 160-63) . Thus , som e wil l len d mone y an d other s will borro w it . Th e lender s migh t b e calle d ''bankers/ ' particularl y when the y borro w fro m others—o r accep t deposit s o f money—fo r the purpose of relending. By the eighteent h centur y i n England , som e banker s sough t th e legal protection o f corporate charters . Others di d no t and continue d to engage in banking as individuals o r in partnerships. It is difficult , then, t o argu e tha t a corporat e charte r i s essentia l t o banking , al though i t i s undeniabl e tha t suc h a charte r i s convenien t t o som e bankers. Som e commercia l banker s continu e t o operat e a s partner ships, without corporat e charters . Banking in corporate form i s only a second-order concer n for market-oriented economists , yet one that (perhaps wrongly ) toda y i s almos t take n fo r granted , a s thoug h in corporated commercia l bankin g itsel f wer e par t o f th e stat e o f na ture. When we learned in the 1930s that even incorporated commercia l bankers ar e capable o f failure, th e ide a o f federal deposi t insuranc e was born. Banking reformers o f the 1930s , many of whom were fon d of central planning , recognized tha t all that deposit insuranc e coul d accomplish woul d b e to make risk taking safer fo r bad bankers. The reformers allowe d th e creatio n o f the FDI C and FSLIC , however, t o gain congressiona l vote s fo r othe r bankin g refor m measures . Thus , insured-deposit, incorporate d commercia l bankin g (mortgag e bank ing, i n th e cas e o f saving s an d loans ) wa s born . Suc h a n activit y should b e of no greate r than third-orde r concer n becaus e it s princi pal underpinnings alread y ar e quite remote from th e principles o f a market economy .

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The 1970 s an d earl y 1980 s witnesse d th e inceptio n o f a ne w doctrine, "to o bi g o r to o importan t t o fail. " Thus , th e third-orde r concern describe d abov e became a fourth-order concern , unlimite d insured-deposit, incorporate d commercia l banking. 12 Thi s concep t truly i s s o remove d fro m a market economy , bein g corporatis t an d dirigiste i n it s origins , tha t i t i s a wonde r th e existin g syste m ha s any suppor t amon g economists. Yet proposals ar e still pu t fort h fo r "market-oriented deposi t insuranc e reform, " a s though "federa l de posit insurance " logicall y belong s i n th e sam e sentenc e a s "marke t oriented." Other practica l objection s t o som e o f th e idea s currentl y bein g considered i n pursui t o f nominall y market-oriente d deposi t insur ance reform ma y be briefly stated : 1. A federall y guarantee d progra m o f deposi t insuranc e t o b e ad ministered, a t th e first level , b y private-secto r banker s probabl y is unconstitutiona l an d definitel y prove s fa r mor e costl y t o tax payers tha n an y conceivabl e benefi t tha t the y migh t deriv e fro m it. Such a program probably is unconstitutional because Congress cannot delegat e th e powe r t o creat e legall y binding , full-faith and-credit claim s o n th e U.S . Treasury t o privat e secto r banker s who ar e unaccountabl e t o th e politica l process . Also , Congres s already is aware that, without amendin g the Constitution, i t can not bin d an y futur e Congres s t o appropriat e monie s t o repa y deposit insuranc e guarantee s o f indefinit e amoun t an d duratio n that migh t b e issue d today . Thus , FIRRE A specifie s tha t onl y FDIC obligations havin g definit e principa l amount s an d definit e maturity date s hav e the full-faith-and-credit guarantee . Suc h obligations ar e constitutionall y binding , bu t indefinit e guarantee s issued b y th e FDI C are not , an d suc h concern s shoul d b e born e in min d a s we debat e market-oriente d reform s o f deposi t insur ance. 2. An y taxpayer benefit fro m federa l deposi t insurance is lost whe n the cos t o f keepin g th e progra m goin g exceed s th e payou t t o insured depositors . T o date , the presen t valu e cos t o f th e FSLI C rescue, abou t $23 0 billio n total , i s nearl y $2,00 0 pe r ta x return , while th e arithmeti c mea n FSLIC-insure d accoun t stil l i s abou t $8,000. Th e cost/benefi t tradeof f i n th e BI F migh t prov e disad vantageous t o th e averag e depositor/taxpayer , however , becaus e of th e muc h greate r proportio n o f uninsure d deposit s i n th e largest commercia l banks . The eventual BI F rescue cost also coul d

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reach $2,00 0 pe r ta x return. Wit h mea n BIF-insure d account s i n the rang e o f $12,000 , i f enoug h "to o bi g to fail " institution s ar e rescued, wit h larg e proportion s o f uninsure d deposits , then , i n those institutions , a t least, i t i s foreseeable tha t th e per-taxpaye r cost would excee d the per-mean-depositor insure d amounts . 3. Federa l deposi t insuranc e an d othe r element s o f the federa l safet y net fo r bankin g constitute a federal subsid y o f commercial bank ing. Fo r whom , exactly , i s th e subsid y intended ? Th e curren t system favor s ban k manager s an d shareholder s t o the detrimen t of depositor s i n thei r rol e a s taxpayers . Anyon e ca n purchas e highly liquid Treasur y bills paying competitive yields in maturi ties a s shor t a s thre e month s an d i n denomination s a s smal l a s $10,000. Smal l saver s ca n purchas e saving s bond s payin g com petitive yield s tha t ma y b e cashe d i n afte r onl y si x month s i n denominations as small as $100. Hence, savers already have competitive-yield, default-fre e alternative s t o insured-deposit , incor porated commercia l banking . 4. Usin g centra l ban k fund s (eithe r discoun t windo w advance s o r allocations o f governmen t securitie s purchases ) eithe r t o liquif y or guarantee the solvency of a federal deposi t insurance fund i s a dangerous us e o f monetar y reserve s o r o f th e monetar y base creating mechanism . I f no t sterilized , suc h centra l ban k activit y would be inflationary . 5. Politicall y drive n pressure s o n th e deposi t insuranc e fun d an d the centra l ban k (th e Federal Reserve ) t o bail ou t failin g institu tions wil l no t subsid e a s lon g a s an y leve l o f federa l deposi t insurance exists . Assume , fo r argument' s sake , tha t th e insure d deposit limi t wer e reduce d t o $10,00 0 (th e Treasur y bil l mini mum denomination) . I f a larg e ban k wer e i n dange r o f failin g with som e insure d bu t mostl y uninsure d deposits , however, th e existing political realities still would exert enormous pressure on central bank and insuranc e fund bureaucrat s to find a way to bail that ban k out , includin g protectio n o f the uninsure d depositors . It i s the ver y existenc e o f deposi t insuranc e a t an y level , o r o f a central ban k discoun t windo w rational e tha t contemplate s an y solvency suppor t lendin g a t al l (temporar y o r longer-term) , tha t creates the apparently irresistibl e temptation fo r policymakers t o meddle i n the market-exit proces s for failin g banks. None of thi s meddling, o f course , has anythin g whatsoeve r t o d o with a market-oriented desir e fo r competitiv e efficienc y i n commercia l banking (Maye r 1991).

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IV. Reform Proposal s It should com e as no surpris e tha t w e recommend eliminatin g gov ernmental provisio n o f deposi t insurance . Whether a system o f pri vate (competitive) deposi t insurance migh t arise in its stead is problematical (O'Driscol l 1988) . But , a s w e argue d above , practical , political, an d economi c consideration s argu e agains t continuatio n of eve n a scaled-back federa l deposi t insuranc e system . Absen t th e abolition o f federa l deposi t insurance , w e offe r som e structura l re forms tha t stil l woul d reduc e th e pervers e incentive s o f the curren t federal financial safet y net . W e d o no t hid e ou r ultimat e goa l an d hope tha t thes e reform s woul d facilitat e mor e substantia l an d far reaching policy changes . Outline of Reforms A. Deposi t Insuranc e 1. Enforc e insure d deposi t limits strictly . 2. Reduc e deposi t insuranc e ceiling s i n semiannua l stage s o f $10,000, until the upper limit is only $10,000. We choose this figure becaus e i t represent s th e minimu m denominatio n o f Treasury bills . Th e amoun t als o correspond s roughl y t o th e arithmetic mean of insured deposits . 3. Retai n liquidation operation s o f the FDIC, but merge the Resolution Trus t Corporatio n (RTC ) int o th e FDIC . Allo w th e RTC to disappea r afte r th e curren t 199 6 statutor y expiratio n date. 4. Sharpl y limit the use of conservatorships an d bridge banks to handle insolvent banks. The technique currentl y is used onl y because the FDIC has insufficient resource s to close the insolvent institutions . Wit h eac h conservatorshi p o r bridg e ban k appointment, the FDIC should be required to submit a request to Congress for the needed funds . B. Supervisor y Reform s 1. Rel y primaril y o n market-valu e accountin g statement s i n as sessing solvency and capital adequacy . 2. Publis h an d adher e t o earl y interventio n an d earl y closur e standards i n orde r t o reduce , i f no t eliminate , losse s t o th e insurance fund an d uninsured creditors .

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C. Discoun t Windo w Return t o th e classi c centra l ban k doctrin e o f lendin g onl y o n good collatera l t o solven t institutions . Allo w unsoun d bank s t o fail an d b e promptl y closed . Obviously, thes e proposal s d o no t exhaus t possibl e remedies . Bu t even thes e fe w woul d g o a lon g wa y towar d neede d reform . More over, th e proposal s ar e mutuall y supporting . Fo r instance , i f super visors use d market-valu e accountin g an d adhere d t o earl y closur e rules, the n th e FDI C fund woul d b e protecte d an d th e curren t us e o f conservatorships an d bridg e bank s woul d becom e unnecessary . Ove r time, w e predict , th e no w "politicall y impossible " refor m o f elimi nating deposi t insuranc e entirel y woul d becom e viable . Thi s woul d occur a s th e public , Congress , an d th e administratio n com e t o un derstand th e magnitud e o f th e ga p betwee n th e cost s o f maintainin g the curren t system , an d th e lowe r cost s o f th e propose d refor m system.

Notes The view s expresse d i n thi s chapte r ar e thos e o f th e author s alone , an d should no t b e attribute d t o th e Federa l Reserv e Bank s o f Dallas o r Cleve land, or to the Federal Reserve System. 1. A s w e write , th e administration' s bankin g refor m proposa l i s i n com mittee. Deposi t insuranc e refundin g i s a centra l par t o f th e proposal . Indeed, man y fee l tha t i t may b e th e onl y par t o f th e proposa l wit h a significant chanc e of passage (Knight 1991). 2. Unles s otherwis e noted , i n thi s chapte r w e us e "banking " genericall y to cover all types of deposit-taking institutions . 3. See , for instance , Articl e IV , Sections 1 and 2 of th e U.S . Constitutio n for a n importan t se t o f privilege s an d immunitie s tha t statutor y an d case law have come to deny to banks. 4. Mor e accurately, the states were sovereign in all matters governmental . This reflected thei r plac e in common la w as the inheritors o f the right s granted by the original crown grants creating each colony. Constitutionally, th e Nint h Amendmen t i s crucia l i n determinin g th e respectiv e locus o f decision-makin g powe r amon g th e people , th e states , and th e central government (Barnet t 1989) . Politically, the Civil War decisivel y shifted th e locus of power to the central government and away from th e states and the people.

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5. Th e federal governmen t di d provid e specia l treatment fo r the First an d Second Banks of the United States . For example, the banks' notes were receivable fo r taxe s an d lawfu l money ; othe r bank s di d no t hav e thi s privilege. 6. Nationa l bank s neve r issue d anythin g lik e th e theoretica l maximu m total. Onl y i n th e 1920 s di d th e not e issu e reac h 80 % of it s maximu m permissible amount . I n th e nineteent h an d earl y twentiet h centuries , the circulatio n wa s close r t o 20 % o f th e maximu m (Friedma n an d Schwartz 1963 , 23). The shortfal l remain s a theoretical an d historica l conundrum. 7. Th e eight were Oklahoma, Texas, Kansas, Washington, Nebraska, Sout h Dakota, North Dakota, and Mississippi (Whit e 1983, 210-11). 8. Wheeloc k an d Kumbhaka r (10 ) quot e th e stat e ban k commissioner' s report fo r 1926 : "In my view o f th e abov e I can se e littl e t o encourag e one t o believ e tha t th e guarant y fun d wil l eve r pa y out , an d i t i s my hope that the next legislature will repeal the law." 9. A t thi s writing , th e FDIC' s bridg e ban k fo r th e Ban k o f Ne w Englan d (about $20 billion of assets at book value) is being resolved through sale to a bidder (apparently , Fleet/Norstar an d the Kohlberg, Kravis, Roberts investment partnership ) a t a ne t cos t tha t th e FDI C estimate s a t $2. 5 billion. However, a realistic case can be made for the proposition that a net cost to the BIF closer to $3.3 billion would be more accurate. Other large ban k holdin g companie s (asset s i n exces s o f $1 0 billio n each ) whose principa l ban k subsidiarie s ma y fac e failur e i n th e nea r ter m (measured from market-to-book value ratios below 40% as of Septembe r 18, 1991 , according t o th e America n Banker ) includ e companie s wit h the followin g ratios : 7.6% , 30.4% , 33.7%, 34.1%, an d 35.0% , only on e of whic h i s i n Ne w England. Th e commo n share s o f these institution s are traded i n th e $ 2 to $ 3 price range . In addition , th e share s o f a fe w other large r institution s barel y surpasse d th e 40 % threshold , eve n a t the peak of the recent run-up in banks' share prices: 40.2%, 40.5%, and 47.1%, only one of which is in New England. Since 1982, no large bank holding company whos e share price fell below 40% of book value (an d remained ther e fo r mor e than on e calenda r quarter ) ha s survive d mor e than eightee n month s a s a n independen t entity , withou t federa l assis tance, after reachin g that level. 10. Hershe y (1991 ) writes , 'Treasur y Unde r Secretar y Rober t R . Glaube r took issu e wit h Mr . Greenspan' s assessment . Recapitalizin g th e [BIF ] . . . i s a liquidit y issue , h e said . 'Providin g liquidit y t o th e bankin g system i s on e o f th e primar y traditiona l responsibilitie s o f the Federa l Reserve.' " In a soberin g renewa l o f th e Treasury' s reques t fo r th e $2 5 billion bailou t loa n fro m th e Fe d (Ma y 29 , 1991) , Mr . Glaube r tol d a House Ways and Mean s Subcommitte e tha t he still saw no reason wh y the Fe d shoul d no t mak e th e loan . A t thi s writing , Congres s ha s no t

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incorporated thi s aspec t o f th e Treasur y reques t int o pendin g legisla tion (Tod d 1991). 11. Abou t 75 % to 80% of all commercia l banks ' U.S. deposits ar e insured , by dolla r amount . However , a t mone y cente r institutions , abou t one half o f al l deposit s ar e raise d offshor e an d ar e technicall y uninsured , although th e Federa l Reserve , the FDIC , and th e Treasury ofte n decid e to repay suc h deposit s becaus e o f som e combinatio n o f the "to o big to fail" doctrin e an d concern s regardin g th e undefine d ter m "systemi c risk," whic h usuall y mean s direc t interban k exposure . Se e Tod d an d Thomson 1990 . 12. Fo r a cal l t o exten d deposi t insuranc e universally , couple d wit h ex panded ban k power s an d close r supervisio n b y th e government , se e New York Times, 1991 .

References Aristotle. The Nichomachean Ethics. Translated by J. E. C. Weldon. Buffalo , N.Y.: Prometheus Books, 1987. Barnett, Rand y E. , ed . The Rights Retained hy the People. Fairfax , Va. : George Mason University Press, 1989. Benston, Georg e J. , e t al . Perspectives on Safe and Soun d Banking . Cam bridge, Mass.: MIT Press, 1986. Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867-1960. Princeton : Princeton Universit y Pres s for th e National Bureau of Economic Research, 1963. Greenspan, Alan . "Testimon y befor e Senat e Committe e o n Banking. " Fed eral Reserve Bulletin 77, no.6 (June 1991): 430-43. Hackley, Howard. Lending Functions of the Federal Reserve Banks: A History. Washington, D.C.: Board of Governors, 1973. Hershey, Robert D., Jr. "Greenspan Is Cautious on Easing." New York Times, April 24, 1991, CI. c5 (national edition). Kane, Edward J . The Gatherin g Crisis in Federal Deposit Insurance. Cam bridge, Mass.: MIT Press, 1985. Knight, Jerry . "Whit e Hous e Pla n t o Bolste r FDI C Deal t Ne w Setback. " Washington Post, April 24, 1991. Mayer, Martin. "Too Big Not to Fail," Forbes, April 15 , 1991, 68-71. New York Times. "Drivin g Bank s to Desperate Risks, " April 14 , 1991 (editorial). O'Driscoll, Jr., Geral d P . "Deposi t Insuranc e i n Theor y an d Practice. " Cato Journal 7 (Winter 1988): 661-75. Todd, Walker F. "Lessons of the Past and Prospects for the Future in Lender of Las t Resor t Theory. " Federa l Reserv e Ban k o f Cleveland , Workin g Paper No. 8805 (August 1988) . Also in Federal Reserve Bank of Chicago,

138 Walke

r Tod d an d Geral d P . OT)riscoll , Jr .

Proceedings o f a Conferenc e o n Ban k Structur e an d Competitio n (1988). . "Why the Fed Shoul d No t Bail Out the FDIC." Unpublished manu script, 1991. Todd, Walker F., and James B. Thomson. "An Insider's View of the Political Economy o f th e To o Bi g t o Fai l Doctrine. " Federa l Reserv e Ban k o f Cleveland, Working Paper No. 9017 (December 1990). Wheelock, Davi d C , an d Suba l Kumbhakar . "Di d Deposi t Insuranc e Con tribute t o Ban k Failure s i n th e 1920s ? Evidenc e fro m Kansas. " Austin : Center for Economi c Research , Universit y fo r Texa s Working Paper 9 102 (1990). White, Eugene Nelson. The Regulatio n an d Refor m of the America n Bank ing System, 1900-1929. Princeton : Princeton University Press, 1983. White, Lawrenc e H . Competition and Currency : Essays on Fre e Bankin g and Money . New York: New York University Press, 1989.

6 The Diminishing Rol e o f Commercia l Banking i n the U.S . Econom y George G . Kaufma n

Commercial bankin g an d depositor y institution s i n genera l wer e one o f th e grea t financial innovation s o f al l times. Indeed, i t woul d be almost impossibl e to envision the modern complex economies of highly developed countrie s without a large and strong generic banking sector . Bu t recen t an d rapi d advance s i n technolog y an d out moded publi c policies have, on the one hand, reduced the historical comparative advantag e o f bank s and , o n th e othe r hand , restricte d the competitiveness an d endangere d th e safety o f banks. As a result, the importanc e o f bankin g a s a n industr y i s bein g dramaticall y reduced. Althoug h th e longer-ru n implication s o f thi s erosio n o n the macroeconom y i s neutral , a s nonban k lender s provid e addi tional credit, shorter-run implication s may be less favorable t o some sectors of the economy and are likely to lead to the adoption of some public policie s tha t ma y trade short-ter m improvement s fo r longer term accelerated deterioration . I. Introduction Modern generi c bankin g develope d a s economie s passe d throug h the commercia l an d industria l revolution s t o encourag e aggregat e savings, improve th e collectio n o f savings , and mak e saving s avail able to a wider rang e o f potential borrowers. Before banking, saver s (lenders) an d borrower s ha d t o searc h eac h othe r ou t an d negotiat e 139

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terms satisfactory t o both parties. This process was time consuming , cumbersome, an d inefficient . I t frequently resulte d i n the failur e t o consummate agreements . In contrast, banks were able to tailor thei r securities mor e closel y t o th e need s o f almos t ever y conceivabl e potential save r and borrower i n terms of size, maturity, interest-rat e sensitivity, defaul t risk , currency o f denomination, an d prepaymen t or othe r options . The y increase d greatl y th e flow o f fund s fro m savers to borrowers. In addition , bot h becaus e bank s provid e a large number o f othe r financial service s t o their loa n customer s an d becaus e they ar e specialists in lending, they were able to acquire more complete, timely, and privat e informatio n abou t th e credi t qualit y o f thei r customer s and evaluat e thi s informatio n mor e accuratel y tha n mos t nonban k lenders. I n othe r words , they wer e the majo r beneficiarie s o f asym metrical information . But the tailoring proces s le d t o a mismatch o f the characteristic s of th e securitie s o n th e tw o side s o f th e banks ' balanc e sheets . Of particular importanc e bot h t o th e managemen t o f th e ban k an d t o public policymaker s wa s th e mismatc h i n maturit y an d liquidity . For banks, the maturities o f their deposi t liabilitie s were shorter, o n average, than thos e o f their loa n assets , and th e liquidit y wa s greater . Thus, th e bank s wer e vulnerabl e t o solvenc y problem s fro m unex pected advers e changes in interest rates and runs that led to sudde n withdrawals o f deposits . T o protec t agains t suc h problems , bank s held sufficien t capita l ancfliquic i reserve s an h manageh'tneixxrelit i and interes t rat e exposures . Althoug h throughou t mos t of , a t least , U.S. history , ban k failur e rate s wer e no t ou t o f lin e wit h nonban k failure rates , th e failure s tha t di d occu r wer e highl y visibl e an d widely perceive d t o b e mor e harmfu l t o th e communit y tha n th e failure o f a nonbanking firm o f comparabl e size , particularl y i f th e bank wer e liquidated. 1 Losse s accrue d t o noteholder s an d deposi tors that , becaus e ban k note s an d deposit s accounte d fo r th e larg e share o f th e mone y supply , a t time s resulte d i n a declin e i n th e money suppl y i n th e community , althoug h no t necessaril y nation ally i f aggregat e ban k reserve s wer e unaffected . Th e reductio n i n money i n th e communit y contribute d t o reduce d spendin g i n th e community. In addition, loan relationships were interrupted, partic ularly i n sector s such a s business lending , in which banks had ver y large share s o f th e market . Thi s als o impacte d th e communit y ad versely. Bank runs an d failure s wer e als o perceive d t o spil l ove r to othe r

The Diminishin g Role of Commercial Bankin g 14 1 banks a s th e complexitie s o f ban k balanc e sheet s wer e believe d t o make it difficult fo r most depositors to differentiate financially health y from financially sic k banks . Becaus e th e cost s o f transferrin g o r withdrawing deposit s i s small , depositor s woul d prefe r t o b e saf e than sorr y an d ru n o n othe r bank s i n sympathy . I f th e fund s wer e not redeposited a t other banks, either directly or indirectly, but held as currenc y outsid e th e bankin g system , aggregat e ban k reserve s declined an d ignite d a multipl e contractio n i n mone y an d ban k credit. Thus , th e difficultie s a t on e bank , particularl y a large bank , could infect othe r banks and adversely affect th e economy at large. The evidence suggest s that thes e fears wer e more perceive d tha n real and the costs greatly exaggerated. Nevertheless, through time as financial sector s becam e mor e important , bank s becam e target s o f progressively stronge r prudentia l regulation , culminatin g i n federa l deposit insuranc e afte r th e sever e breakdow n o f th e U.S . bankin g system in 1933. Unfortunately, th e deposit insurance was structure d perversely.2 B y reducing deposito r disciplin e an d no t chargin g banks for greate r ris k taking , deposi t insuranc e encourage d bank s t o ru n down thei r capital-asse t ratio s an d increas e th e credi t an d interes t rate ris k exposure s o f thei r portfolios . Moreover , b y guaranteein g the pa r value o f deposit s regardles s o f the solvenc y o f the bank, th e insurance discourage d depositor s fro m runnin g o n insolven t bank s and permitte d insolven t banks to continue in operation until close d by th e regulators . Bu t regulator s becam e increasingl y reluctan t t o resolve insolven t banks , particularl y large r banks, i n a timely fash ion, fo r numerou s reasons . The y feare d potentia l spillove r t o othe r banks, los s o f deposi t an d credi t service s t o th e community , an d public embarrassmen t fro m admittin g failure t o protect safety . The y faced politica l pressure s fro m th e banks ' managers , shareholders , and eve n large r loa n customers . Thus , i n mor e recen t years , th e reduction i n marke t disciplin e wa s no t offse t b y a n increas e i n regulatory disciplin e on problem banks. In earlier years, when banks had a comparative advantage in their deposit an d lendin g activities , ther e wa s widesprea d fea r o f exces sive economi c an d eve n politica l powe r b y banks . Thi s fea r wa s particularly stron g i n th e Unite d State s an d resulte d i n restriction s on thei r produc t an d geographi c powers . Wha t bette r wa y t o limi t bank power than by limiting their growth by limiting their ability to enter additional product and geographic markets! Thus, unlike firms in othe r industries , bank s wer e no t permitte d t o operat e branc h offices, excep t wher e permitte d b y stat e law , an d i n n o instance s

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across stat e lines . Thi s mad e i t difficul t fo r individua l bank s t o follow customer s wh o move d o r t o servic e customer s wit h opera tions i n distan t places . Whe n som e bank s attempte d t o circumven t these restriction s a s recentl y a s i n th e 1950 s b y crossin g stat e line s through holdin g compan y affiliates , the y wer e stoppe d i n 195 6 b y the Dougla s Amendmen t t o th e Ban k Holdin g Compan y Ac t o f tha t year. Banks ha d alway s bee n restricte d i n th e type s o f activitie s the y could conduc t withi n th e ban k o r i n subsidiarie s o f th e ban k b y provisions o f th e ban k charte r grante d b y th e federa l governmen t o r the state . For example , nationa l bank s ar e restricted t o all such incidenta l power s a s shall be necessary to carry on the business of banking; b y discountin g an d negotiatin g promissor y notes , drafts , bill s o f exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security ; and by obtaining, issuing, and circulating notes according to the provision s of this chapter . But they wer e no t restricte d i n wha t affiliate s o f their paren t holdin g companies coul d d o unti l th e enactmen t o f th e Ban k Holdin g Com pany Ac t o f 195 6 an d it s extensio n t o one-ban k holdin g companie s in 1970 . I n addition , th e Glass-Steagal l (Banking ) Ac t o f 193 3 pro hibited commercia l bank s fro m engagin g i n full-servic e investmen t banking. Thi s ac t an d th e accompanyin g separatio n o f "bankin g an d commerce , , wer e strongl y supporte d b y th e Federa l Reserve . I t i s o f interest t o not e tha t th e conventional-wisdom , "historical " separa tion o f bankin g an d commerc e i n th e Unite d State s goe s bac k onl y to 1956—indeed , onl y t o 1970 , which wa s th e dat e o f separatio n fo r all banks . Similar t o th e restriction s o n geographi c locations , th e restric tions o n produc t activitie s prevente d bank s fro m participatin g full y in th e provisio n o f th e man y financial service s tha t wer e innovate d after th e restriction s wer e imposed , i n offerin g consumer s a wid e range o f financial an d nonfinancia l service s unde r on e roof , an d i n being abl e t o generat e an y synergie s o r economie s o f scop e tha t would permi t the m t o offe r package s o f service s a t lowe r cost . Thei r competitors, includin g foreig n banks , generall y wer e no t similarl y constrained. The restriction s no t onl y limite d ban k profitabilit y bu t als o in creased ban k ris k b y limitin g th e abilit y o f bank s t o diversif y eithe r geographically o r i n produc t lines . Thus , th e financial healt h o f

The Diminishing Role of Commercial Bankin g 14 3 banks wa s closel y tie d t o tha t o f th e loca l marke t are a an d th e demand fo r th e existin g produc t lines . Befor e th e 1920 s fo r th e geographic restriction s an d th e 1960 s fo r th e produc t restrictions , the adverse impacts of the regulations o n the banking industry wer e not overl y onerous , a s th e relativel y primitiv e stag e o f technolog y did no t favo r wid e geographi c branc h network s o r wid e produc t lines. Fe w bank s too k ful l advantag e o f th e stat e branching power s that were available, the ability to acquire holding company affiliate d banks i n othe r states , o r th e abilit y t o combin e othe r financial an d even nonfinancia l activitie s withi n ban k holdin g companies . Bu t this experience changed dramaticall y i n more recent years. II. Erosion of Market Shar e Commercial bank s hav e bee n losin g marke t shar e throughou t mos t of the post-Worl d Wa r II period. I n 1950 , total asset s o f commercia l banks represente d mor e tha n one-hal f o f th e tota l asset s o f eleve n major types of financial institutions (Tabl e 6.1). By 1990, this market share had eroded to only 32%. Most of the decline occurred betwee n 1950 an d 196 0 an d ma y be attribute d t o a rundown o f th e unusua l liquidity buil t u p durin g Worl d Wa r II , whe n consume r spendin g was curtailed an d interes t rates were maintained a t very low levels. Thus, the opportunit y cos t o f holding noninteres t yieldin g deman d deposits wa s small , an d nonban k institution s ha d fe w outlet s fo r their funds . But this unusua l competitiv e advantag e disappeare d i n the post war economy . Sinc e 1960 , th e erosio n i n th e banks ' marke t shar e has bee n slower , althoug h i t accelerate d agai n i n th e 1980s . Th e rapidly gainin g financial institution s wer e primaril y privat e an d public pension fund s an d money market funds. Lif e insurance com panies hav e als o experience d a major continuin g erosio n i n marke t share. After first triplin g thei r marke t shar e through th e mid-1980s , savings and loa n associations sa w their shar e drop abruptly i n 198 9 and 199 0 to the lowest percentage since the mid-1950s. 3 The recorded los s i n ban k marke t shar e may be overstated, how ever, becaus e th e dat a d o no t includ e off-balanc e shee t activities , which ten d t o b e greate r fo r commercia l bank s tha n mos t othe r financial institutions . Moreover , marke t shar e i s no t necessaril y equivalent t o profitability , whic h i s economicall y th e mor e impor tant. Som e o r al l o f an y reduce d incom e fro m reduce d on-balanc e sheet activitie s ma y b e offse t b y highe r incom e fro m increase d off -

144 Georg e G. Kaufman Table 6.1 Asset Size, Relative Importance, and Market Share of Major Financial Institutions on the Intermediary Financial Market, From 1950-1990

Commercial Bank s Life Insurance Cos. Private Pension Fund s Savings & Loan Assns. State & Local Pensio n Funds Finance Companie s Mutual Fund s Casualty Insuranc e Cos . Money-Market Fund s Savings Bank s Credit Union s Total

1990 Asset Billions of Bank Dollars 1 3,358 2 1,381 3 1,140 4 1,106 5 7 6 8 9 10 11

Percentage ) of Total Assets 1950 1960 1970 1980 1990 52 38 37 38 32 22 20 15 12 13 2 6 9 11 12 6 12 14 15 11

756 580 641 519 499 263 213

2 1 3 4 8 -

10,457

100

3 3 5 5 7 1_ 100

5 4 5 4 6 1_ 100

5 2 5 4 2 4 2_ 100

7 6 6 5 5 3 2_ 100

Source: Boar d of Governors of the Federal Reserve System, Flow of Funds, various years.

balance shee t activities. 4 Nevertheless, the apparent los s in the bank's market shar e may be attributed primaril y to four factors : technolog ical change , regulation , reversa l o f th e federa l deposi t insuranc e subsidy, and quality deterioration . TechnoJogicaJ Change As noted earlier , commercia l banks historically hav e had a n impor tant comparativ e advantage over most other lenders. They had mor e complete an d timel y credi t informatio n abou t curren t an d potentia l borrowers a t lowe r cost . The y obtaine d thi s informatio n no t onl y from th e sam e sources a s did othe r lenders but als o from thei r ow n ongoing contact s wit h thei r customer s throug h deposit , financia l advising, safekeeping, and other relationships. This source was unique to the banks an d greatl y reduced th e cos t an d increase d th e qualit y of their credit information fo r both the initial underwriting o f a loan and the subsequent monitoring of its performance. As a result, many lenders foun d i t mor e profitabl e t o channe l credi t t o borrower s through th e commercia l bankin g syste m indirectl y tha n t o bu y th e debt of the borrowers directly .

The Diminishing Role of Commercial Bankin g 14 5 But this comparativ e advantag e ha s been erodin g i n recen t year s due t o technica l advance s i n computer s an d telecommunications . Large and complet e credi t files on major borrower s ar e now readil y available t o almos t everyone , quickl y an d a t lo w cost . A s a result , lenders ar e now finding i t increasingly mor e profitable t o buy secu rities directl y fro m large r borrowers. 5 Thi s account s i n par t fo r th e rapid increas e i n commercia l pape r issue d b y borrower s i n recen t years. I n th e te n year s betwee n year-en d 197 9 an d year-en d 1989 , commercial pape r issue d b y nonfinancia l borrower s increase d b y more than 300% . In contrast, tota l bank asset s increase d onl y 140% and bank business loan s only 100%. Commercial bank s an d othe r depositor y institution s hav e tradi tionally als o bee n abl e t o collec t fund s fro m smal l an d medium sized lender s (savers ) a t lo w cos t a t branc h office s a t whic h the y could als o provid e loa n an d othe r service s t o th e sam e customers . This ha s permitte d th e bank s t o enjo y synergie s tha t reduce d th e cost o f gatherin g th e deposits . However , th e sam e recen t advance s in compute r an d telecommunication s technolog y tha t mad e credi t information mor e readily availabl e t o a wider populatio n hav e als o reduced th e cos t o f collectin g fund s directl y fro m smal l an d me dium-sized savers . Branc h office s ma y b e bypassed , an d thes e of fices have become increasingl y mor e costly relative to funds collec tion via automatic , telephone, an d wir e transfers. A s a result, man y bank competitor s ca n operat e profitabl y o n narrowe r margins . I n response, bank s hav e increasingl y sol d loan s ou t o f their portfolio s and concentrate d mor e o n generatin g earning s fro m fee s fo r loa n originations than from loan s held as portfolio investments . Technology has also made selling existing loans easier by making it possible to creat e th e informatio n an d monitorin g system s necessar y t o se curitize packages of whole loans. Securitized loans are more marketable, mor e divisible , an d mor e diversifiabl e tha n a n equa l dolla r amount o f whole loan s and , thus, more desirabl e to nonbank inves tors. Lastly, commercia l bank s hav e traditionall y bee n grante d a monopoly ove r deman d (check-writin g transfer ) deposit s b y th e gov ernment, an d thes e deposit s hav e been thei r majo r sourc e o f fund s throughout most of banking history. But technology has now permitted almos t anyon e wit h acces s t o large-scal e computer s an d tele communications to offer demand-deposit-like an d rapid-funds transfe r services. The monopoly has been undermined. Thus , money marke t funds, owne d eithe r independentl y o r b y nonban k financial an d

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nonfinancial firms, hav e grow n rapidl y i n recen t year s an d hav e captured significan t marke t shar e fro m th e banks. Besides dampen ing their asset growth, this change has eroded the franchise valu e of banks and thus the market value of their capital . Regulation As discusse d earlier , commercia l bank s ar e hampered i n their abil ity t o compet e wit h thei r ne w nonban k competitor s b y excessiv e and outmode d governmen t regulatio n o f thei r produc t an d geo graphic powers . Unlik e mos t o f thei r competitors , bank s ma y no t offer al l type s o f financial service s o r mos t type s o f nonfinancia l services. Thus , bank s ma y no t offe r insuranc e underwriting , a ful l line of life and casualty insurance brokerage services at most offices , complete securitie s activitie s (excep t i n recen t years , relatively in efficiently, b y the ver y larges t banks through separat e subsidiaries) , retail merchandising , automobil e manufacturing , an d s o on . Also , unlike thei r competitors , commercia l bank s ma y no t operat e full service office s freel y a t an y locatio n o f thei r choosin g o r i n th e organizational for m tha t they may prefer. I n many states, banks may operate branches onl y a t limite d location s an d i n n o instance s acros s state lines an d hav e onl y recently bee n granted limite d authorit y t o operate full-servic e office s i n othe r state s i n th e for m o f holding company affiliates . Thes e restrictions hav e limited th e profit poten tial both of individual banks and o f the industry as a whole. As noted , th e reason s fo r thes e restriction s li e i n th e histor y o f U.S. publi c polic y towar d commercia l bank s an d i n th e primitiv e state o f technolog y i n earlie r periods . Bu t th e recen t advance s i n technology an d increase s i n competitors that have reduced th e market shar e o f bank s hav e als o sharpl y reduce d thei r potentia l fo r excessive concentratio n o f powe r an d abusiv e conflict s o f interest. 6 As a result, th e publi c polic y concern s fo r restrictin g ban k produc t and geographi c power s appea r t o b e les s importan t toda y tha n i n earlier year s an d justif y a careful reexaminatio n o f the benefits an d costs. Indeed , th e majo r publi c polic y concer n bein g voice d cur rently agains t expande d produc t power s center s o n th e unfai r an d potentially costl y us e of insured deposit s by banks to fund th e ne w activities t o th e taxpayers . However, th e efficien t correctio n o f thi s perceived proble m lie s i n th e appropriat e refor m o f federal deposi t insurance, rather than i n restricting bank activities. Restrictions o f ban k produc t an d geographi c power s hav e no t

The Diminishing Role of Commercial Banking 14

7

only contribute d t o reducin g th e banks ' marke t shar e b y limitin g their expansio n relativ e t o tha t o f thei r competitor s bu t als o b y reducing th e asset-to-capita l multiplie r tha t i s consisten t wit h safety . To th e exten t tha t produc t an d geographi c expansio n result s i n increased diversification , ban k ris k i s reduce d an d th e marke t wil l permit banks to operate with greater leverage. In addition, banks are prohibited fro m payin g explicit interes t o n demand deposit s an d wer e restricte d unti l te n year s ag o i n th e interest rat e the y coul d pa y o n smaller-tim e deposi t accounts . Th e latter restriction , Regulatio n Q , was directl y responsibl e fo r th e es tablishment o f mone y marke t funds , whic h hav e maintaine d a significant shar e of the market long after th e regulation was removed. Market force s d o not necessarily wai t for legislate d liberalizatio n of the restrictions, particularly at the federal level . Thus, effectively , all state s hav e no w adopte d legislatio n t o overrid e th e federa l re strictions o n interstat e holdin g compan y impose d b y th e Dougla s Amendment t o th e Ban k Holdin g Compan y Ac t o f 1956 . Simulta neously, th e regulator y agencie s an d th e court s hav e combine d t o permit bank s t o offe r a n almos t complet e men u o f securities activi ties.7 But by limiting these activities to affiliates o f the bank holdin g company an d imposin g restriction s o n th e relativ e volum e o f suc h activities t o the bank's tota l securitie s activities , the curren t regula tions effectivel y limi t mos t o f th e newl y grante d activitie s t o th e country's largest banks. Deposit Insuranc e As ha s bee n ampl y documente d i n recen t years , improperl y struc tured federal deposi t insurance substitutes public capital for privat e capital an d permit s bank s t o operat e wit h greate r privat e capita l leverage tha n otherwise . T o th e exten t tha t th e evidenc e suggest s that federal deposi t insurance has been underpriced i n recent years, it has permitted banks to maintain a larger asset base than otherwis e for th e amoun t o f capita l the y ha d an d aide d bank s i n maintainin g their marke t share . However , recen t an d propose d change s i n th e insurance structur e ar e likely to reverse this situation . Capita l rati o requirements are likely to be increased. Insurance premiums alread y have bee n increase d substantiall y an d ma y b e increase d eve n fur ther. To the extent that the premiums are now higher than necessar y for th e insuranc e fun d t o b e actuariall y soun d an d ar e impose d t o help finance pas t deficit s i n th e fund , the y ma y b e viewe d a s a

148 Georg

e G . Kaufma n

Figure 6. 1 Financial Insitutio n Capita l Levels : Median Equit y Capital-to-Total Asse t Ratios (Decembe r 31 , 1989)

Source: U.S. Treasury Department, Modernizing the Financial Syste m (Washington , D.C., 1991)

nonuser ta x impose d o n banks . Lik e an y ta x impose d o n onl y som e competitors an d no t o n others , thi s ta x increase s relativ e cost s an d reduces th e equilibriu m outpu t o f the industry. 8 At th e sam e tim e tha t insuranc e premium s ar e bein g raise d o n banks, the y ar e no t bein g impose d o n a n increasingl y significan t competitor tha t i s widely perceive d t o be also covered b y the federa l safety net . Thi s competito r i s the governmen t sponsore d enterprise s (GSEs) tha t specializ e i n housin g an d agricultura l finance, suc h a s the Federa l Nationa l Mortgag e Associatio n (FNMA) , th e Federa l Home Loa n Mortgag e Corporatio n (FHLMC) , an d th e Federa l Agri cultural Credi t Association . Althoug h the y ar e privatel y owne d an d managed, thes e agencie s hav e authorit y t o borro w fro m th e U.S . Treasury an d thei r deb t trade s a t interes t yield s highe r tha n thos e o f the U.S . Treasury bu t lowe r tha n thos e o f comparabl e privat e firms. 9 The lowe r interes t rate s indicat e tha t th e marke t perceive s tha t there i s a hig h probabilit y tha t th e federa l governmen t wil l no t

The Diminishing Role of Commercial Bankin g 14 9 permit bondholders t o suffe r losse s if the agencie s encounte r financial difficulties . Thi s publi c perceptio n i s supporte d b y th e lowe r capital ratios of these firms relative even to commercial banks. As is shown i n Figur e 6.1 , FNMA ha s a capita l rati o o f onl y 2.5% , les s than one-hal f tha t o f bank s an d les s tha n one-fift h tha t o f othe r financial industries . Moreover , i f i t wer e t o evaluat e FNM A a s a n independent entit y withou t acces s t o th e Treasury , Standar d an d Poor's woul d hav e assigne d i t a ratin g o f onl y A—i n Apri l 1991 . Indeed, S& P would hav e assigne d AA A rating s t o onl y tw o o f th e five major GSE s (Federa l Hom e Loa n Bank s an d Salli e Mae ) an d a BB to one (Farm Credit System). 10 Despite this perception, the government does not charge the agencies explici t o r implici t (regulatory ) insuranc e premiums . Thus , the y have a cost advantage an d ar e able to accept a lower return o n thei r investments tha n ar e banks . T o th e exten t tha t thes e investment s compete wit h thos e mad e by banks, they reduc e th e profitabilit y o f banks an d thei r asse t size . Indeed , i n th e fou r year s fro m 198 7 through 1990 , FNMA, FHLMC , and Salli e Ma e al l average d annua l returns on equity in excess of 25%. This was three times the average 7.6% annua l retur n fo r commercia l bank s an d doubl e th e averag e 13% return for the S&P 500.11 It is sometimes argued that the deleveraging and consequent asse t shrinkage associate d wit h th e highe r privat e capita l requirement s being imposed o n banks by regulators and legislators interferes wit h the continuatio n o f health y credi t extensio n t o businesse s an d households an d produce s a "credit crunch. ,, To the extent that bank assets an d therefor e lendin g were greater than otherwis e because of underpriced federa l deposi t insurance , a correctio n woul d reduc e bank lendin g almos t b y definition . Bu t thi s shoul d no t lea d t o a reduction i n overal l lendin g fo r economicall y soun d project s b y al l institutions beyon d a relatively brie f transitio n period . Others , pri marily th e ne w ban k competitors , shoul d b e abl e t o expan d thei r lending to offset an y cutback by banks to borrowers who are willing and abl e to pa y equilibriu m marke t rate s o f interest , an d new , ade quately capitalized commercia l banks would ente r the arena if there were excess demand fo r unique bank credit at this interest rate. This response would not differ greatl y from the entry of, say , new grocery store s o r th e additio n o f grocer y item s t o th e service s pro vided b y previousl y nongrocer y store s i f individua l grocer y store s failed o r wer e force d t o cu t bac k o n storag e spac e obtaine d tempo rarily fro m suppliers , bu t th e deman d fo r grocer y product s a t a

150 Georg e G . Kaufman market pric e remaine d unchanged . Beyon d th e tim e necessar y fo r the ne w provider s t o com e o n line , no "foo d crunch " woul d arise . In banking , th e cost s associate d wit h th e abov e transition , whil e significant fo r som e borrowers an d som e sectors, are likely to be fa r less t o th e publi c a s a whol e tha n th e cost s o f no t correctin g th e existing combination o f asset overcapacity an d lac k of market disci pline that hav e contribute d t o the large increases i n loan losses an d bank failures . Quality Deterioratio n Historically, bank s hav e ha d highe r credi t rating s an d reputation s than mos t borrowers . Thus , th e additio n o f a bank's signatur e t o a private borrower's not e would enhanc e its credit quality. Borrower s with lowe r tha n th e highes t credi t rating s coul d borro w a t banks a t no higher an d eve n lower interest cost than borrowing directly fro m lenders. But the financial difficultie s experience d by many commer cial bank s i n recen t year s hav e change d thi s scenario . I n part , th e poor curren t financial conditio n o f the banking industry reflects th e inefficient deposi t insuranc e structur e i n place , whic h ha s permit ted bank s t o operat e wit h ver y lo w capita l ratios . I n recen t years , commercial ban k capita l ratio s hav e bee n nea r 6 % i n boo k valu e and considerably lowe r in market value. In addition, particularly fo r larger banks , off-balanc e shee t activitie s ar e substantial , a t time s even larger in volume than recorded on-balanc e sheet activities. Yet, these ar e exclude d fro m th e publishe d capita l ratios . The lo w ban k capital ratio s relativ e t o othe r financial industrie s i s eviden t fro m Figure 6.1. It does not take much of an adverse shock to asset values to wip e ou t suc h smal l capita l an d driv e a ban k int o insolvency . And th e increase d volatilit y i n th e macroeconom y durin g th e pas t fifteen year s stemmin g fro m th e abrup t inflation-deflatio n cycl e o f 1978-1986 an d th e rolling regional and sectora l recessions has produced suc h shocks . U.S. banks als o appea r t o b e i n weake r financial conditio n tha n banks i n other majo r countries . As is shown i n Figure 6.2 , in recen t years the market has valued the capital of U.S. banks as a percent of assets lowe r tha n i t ha s fo r British , German , Swiss , o r Japanes e banks. A recent stud y als o reported tha t a t year en d 1990 , all thre e of th e larges t Swis s bank s ha d AA A rating s an d onl y tw o o f th e eleven largest Japanese banks and none of the largest German banks had S& P or Moody's credi t rating s o f below AA. French an d Britis h

The Diminishing Role of Commercial Banking 15

1

Figure 6.2 Market Capitalization of U.S. and Foreign Banks (percent of assets)

Source: Herbert L . Baer, "Foreign Competition i n U.S. Banking Markets," Economic Perspectives (May/June 1990) : 25.

banks wer e als o rate d highly . I n contrast , onl y tw o o f th e eigh t largest U.S . banks ha d rating s o f AA or above, and thre e were rate d below A . Man y othe r U.S . bank s ha d eve n lowe r credi t ratings. 12 The erosio n o f th e credi t qualit y o f U.S . banks ha s bee n occurrin g throughout th e 1980s . Ten year s ago , S&P rated twelv e larg e bank s AAA. In 1991 , only the Morgan Guaranty rated this rating. Over the same period, the average large bank credit rating deteriorated from a low AA to a low A-high BBB rating. Because th e credi t qualit y o f bank s hav e bee n downgraded , a n increasing numbe r o f larg e business borrower s no w find i t cheape r to borro w directl y o n financial markets , bypassin g banks . I t i s no t profitable fo r the m t o "intermediat e down, " an d th e deman d fo r bank loan services is reduced. The downgraded credi t quality of the banks, low capital ratios, and increase in failure rates may also have encouraged som e ban k loa n customer s t o loo k t o othe r type s o f institutions for a steady and dependable source of funds .

152 Georg

e G . Kaufma n

Figure 6. 3 Real Estate and C& I Loans a s a Percent o f Total Loan s Insured Commercia l Banks , 1939-198 9

Source: U.S. Treasury Department, Modernizing the Financial Syste m (Washington , D.C. 1991).

The resul t o f suc h effect s ma y b e see n fro m th e proportio n o f business loan s mad e b y banks, other financial institutions , an d lend ers directl y i n selecte d year s fro m 195 0 t o 198 9 show n i n Tabl e 6.2 . The banks ' shar e o f loan s t o nonfinancia l corporat e busines s de clined fro m nea r 90 % i n th e immediat e post-Worl d Wa r I I perio d through th e mid-1960 s t o nea r 80 % i n 1975 , 70 % in 1980 , an d onl y 60% i n 1989 . I n contrast , fund s raise d throug h commercia l pape r increased fro m 1 t o 12 % i n thi s period , loan s fro m foreig n source s from non e t o 8% , an d loan s fro m nonban k financial intermediarie s from 6 t o 16% . A s a percen t o f ban k busines s loans , commercia l paper increase d fro m onl y 10 % in 196 0 to nearl y 100 % in 1989 . Th e longer-term declin e i n business lendin g by commercia l bank s i s als o evident fro m Figur e 6.3 . Sinc e 1939 , busines s loan s hav e decline d from 4 1 % of tota l ban k loan s t o 33 % in 1989 . In contrast , rea l estat e loans hav e increase d fro m 22 % of total bank loan s t o 30% , or almos t as importan t a s business loans .

The Diminishin g Rol e of Commercial Bankin g 15

3

Table 6. 2 Composition o f Short-Ter m Credi t Marke t Debt o f Non-financial Corporat e Business 1950-198 9

Bank Loan s Nonbank Financ e Loan s Commercial Pape r Foreign Loan s Bankers' Acceptance s Total (Billion Dollars )

1950

1960

91 6 1 — 2_ 100 20

87 9 2 — 2_ 100 43

1970 (Percent) 83 9 6 — 2_ 100 125

1980

1989

71 14 9 1 5_ 100 324

60 16 12 8 4_ 100 903

Source: Board of Governors of the Federal Reserve System, Balance Sheet for the U.S. Economy, 1945-89, Octobe r 1990.

III. Publi c Polic y Implication s Why shoul d th e publi c b e concerne d wit h whethe r commercia l banks, depositor y institutions , o r an y industr y fo r tha t matte r shrink s or eve n survives ? Throug h history , man y industrie s hav e dimin ished i n siz e fro m thei r peak s an d eve n disappeare d altogether . Public polic y shoul d b e concerne d onl y i f a contributing forc e t o th e decline i s publi c polic y itsel f o r if , particularl y i n th e short-ru n o r transition period , th e reductio n i n aggregat e siz e ha s advers e effect s on th e econom y a s a whol e o r o n importan t sectors . A s wa s argue d earlier, bankin g i s rapidl y losin g it s historica l comparativ e advan tage a s a result o f technological advance s s o that it s eventua l demis e will no t impac t th e macroeconom y greatly . But it s demis e i s bein g accelerate d b y publi c policie s tha t bot h reverse th e previou s subsid y t o growt h fro m underprice d deposi t insurance an d plac e bank s a t a n artificia l competitiv e disadvantag e relative t o competitors , wh o i n th e absenc e o f th e constraint s ma y not b e mor e economicall y efficien t suppliers . I f thi s observatio n i s correct, the n extan t publi c polic y i s encouragin g a harmful misallo cation o f resources . Moreover , eve n thoug h mone y an d credi t ar e fungible, ther e ar e transitio n cost s i f th e curtailmen t o f ban k sup pliers o f credi t i s abrupt. 13 Displaced creditworth y borrower s othe r tha n th e ver y larges t hav e to searc h fo r nonban k supplier s wh o ar e compatibl e bot h geograph ically an d product-wise , an d reestablis h credi t relationships . A t th e

154 Georg e G. Kaufma n same time , potentia l nonban k supplier s hav e t o gea r u p operation ally both geographically an d product-wis e t o inaugurate credi t rela tionships. In the short term, some creditworthy borrowers are likely to be unsatisfied an d a perceived "credi t crunch " sai d to exist. Th e credit crunc h ma y b e reinforce d withi n bankin g i f increase d pru dential regulatio n i n th e for m of , say , highe r capita l requirement s are impose d an d al l bank s ar e no t abl e to attrac t additiona l capita l on equa l term s becaus e o f difference s i n thei r financial condition . Creditworthy borrower s a t capital-deficien t bank s nee d t o transfe r their relationship s t o capital-sufficien t banks , possibl y som e dis tance awa y an d specializin g i n differen t credi t types . Al l credit , even all bank credit, is not perfectly substitutabl e instantaneously. 14 Moreover, employee s lai d of f b y losin g commercia l bank s ar e un likely t o find employmen t a t gainin g bank s o r othe r institution s immediately. But publi c policie s t o increas e aggregat e o r sectora l ban k asset s by reducin g prudentia l regulation s ar e likel y t o b e counterproduc tive. The y ar e likel y t o resul t i n a temporarily large r bu t economi cally weake r bankin g secto r tha t wil l increas e it s burde n o n th e taxpayers s o tha t th e long-ru n cost s wil l greatl y excee d an y short run gains. Instead, public policy should be directed a t removing the structural restriction s t o th e exten t consisten t wit h necessar y pru dential regulatio n an d a competitive economy . The key is to refor m federal deposi t insuranc e bot h t o pric e th e insuranc e correctl y an d to restrict losse s to the private sector. 15 This should lea d to a lasting larger an d stronge r bankin g syste m consisten t wit h bot h safet y an d preserving competition. If banking continues to lose market share in such a n environment , the n it s erosio n ma y appropriatel y b e at tributed t o market force s onl y an d it s demis e n o loss to anyone bu t the industry itself an d its few remaining customers. Can commercia l banks surviv e i n a brav e ne w worl d o f efficientl y price d deposi t insurance an d broader produc t an d geographi c powers? It would b e strange i f th e industr y coul d not , eve n thoug h al l individua l bank s may not . Th e rapi d growt h o f mos t nondepositor y financial firms indicates significan t deman d fo r thei r financial services . Moreover , this growt h occurre d withou t benefi t o f acces s t o underprice d de posit insurance . A s a result , a s wa s show n i n Figur e 6.1 , thes e industries operate d wit h substantiall y highe r capital-to-asse t ratio s than banks. Moreover, bank s i n majo r countrie s als o operat e wit h substan tially highe r capita l ratios , particularl y whe n measure d i n marke t

The Diminishing Role

of Commercial Banking

15

5

Figure 6. 4 Total Assets o f Multinational Bankin g Organization s by Headquarter Countr y (197 2 = 100)

Source: George J. Benston, "U.S . Banking in an Increasingly Integrate d an d Competitiv e Worl d Economy," Journal of Financial Service s Research (December 1990) : 315.

Figure 6. 5 Total Asset s o f Multinational Bankin g Corporation s Relative to GNP (1972 = 100)

Source: George J. Benston, "U.S . Banking in an Increasingly Integrate d an d Competitiv e Worl d Economy," Journal of Financial Service s Research (Decembe r 1990) : 316.

156 Georg

e G . Kaufman

values. I n mos t o f thes e countries , bank s hav e broade r power s tha n in th e Unite d States . Indeed , th e reaso n Japanes e bank s hav e bee n able t o expan d worldwid e a s rapidl y a s the y hav e i n recen t year s i s not tha t the y hav e use d artificiall y lo w cos t Japanes e fund s o r en gaged i n long-ter m predato r pricing , a s i s commonl y claimed . (Th e asset growt h o f banks i n majo r countrie s i s shown i n Figure s 6. 4 an d 6.5.) Rather , a s i s eviden t i n Figur e 6.2 , they ha d th e highes t marke t value capita l ratios . Thi s ha s mad e the m mor e attractiv e t o bot h large loa n an d larg e deposi t customers . A market-determine d safe r bankin g industr y translate s int o a stronger, larger , an d mor e efficien t bankin g industr y tha t ca n con tribute t o th e econom y rathe r tha n bein g a dra g o n it , a s i n recen t years i n th e Unite d States . The crisi s i n th e U.S . banking industr y i n part reflect s th e failur e o f publi c policymaker s t o recogniz e tha t market-imposed, a s oppose d t o government-imposed , safet y an d ef ficient operatio n ar e compatible , no t conflicting , conditions .

Notes 1. Georg e J . Benston , e t al. , Perspectives on Safe and Soun d Bankin g (Cambridge, MA: MIT Press, 1986) ; and Georg e G. Kaufman, "Bankin g Risk in Perspective," in George G. Kaufman, ed. , Research i n Financia l Services (Greenwich , CT: JAI Press, 1989). 2. Edwar d J . Kane , The Gatherin q Crisi s i n Federa l Deposit Insuranc e (Cambridge, MA: MIT Press, 1985); and Benston, et al. 3. Georg e G. Kaufman, 'Th e Incredibl e Shrinking S&L Industry," Chicaqo Fed Letter (Federal Reserve Bank of Chicago) (December 1990). 4. Joh n H . Boyd an d Stanle y L . Graham, "Investigatin g th e Banking Consolidation Trend, " Quarterl y Review (Federa l Reserv e Ban k o f Minne apolis) (Sprin g 1991): 3-15. 5. Som e analysts den y that the private market can provide as much infor mation a s ca n banks . Se e Christophe r James , "Som e Evidenc e o n th e Uniqueness of Bank Loans," Journal of Financial Economics (Decembe r 1987): 216-35 . O n th e othe r hand , som e evidenc e suggest s tha t th e "uniqueness" o f bank loan s may also be obtained fro m othe r financial institutions o n th e intermediatio n market , suc h a s insuranc e compa nies. 6. A review of these issue s appears i n Anthony Saunders , "Bank Holdin g Companies: Structure, Performance , an d Reform, " i n Willia m S . Haraf and Rose Marie Kushmeider, Restructuring Banking and Financial Services in America (Washington , D.C. : America n Enterpris e Institute , 1988), 156-203; Franklin R. Edwards, "Concentration in Banking: Prob-

T h e D i m i n i s h i n g Role of Commercial B a n k i n

g 15

7

lem o r Solution? " i n Georg e G . Kaufman an d Roge r C . Kormendi, Dere guJatinq Financial Services (Cambridge , MA : Ballinger, 1986) , 145-68 ; and Richar d J . Herrin g an d Anthon y M . Santomero , ' T h e Corporat e Structure o f Financia l Conglomerates, " Journa l of Financial Services Research (Decembe r 1990) : 471-97 . 7. Georg e G . Kaufma n an d Larr y R . Mote , "Glass-Steagall : Repea l b y Reg ulatory an d Judicia l Reinterpretation, " Banking Law Journal (Septem ber-October 1990) : 388-421 . 8. T o th e exten t tha t ther e i s exces s capacit y i n banking , i t i s wit h respec t to tota l asset s i n th e industry , no t t o th e numbe r o f banks . Th e latte r i s a functio n o f an y economie s o f scope , intensit y o f competition , an d freedom o f entry . Thus , merger s amon g bank s wil l no t automaticall y b e profitable eithe r fo r th e participatin g bank s o r fo r societa l welfare . A recent stud y foun d tha t fe w recen t merger s amon g larg e bank s prove d successful ove r tim e fo r th e shareholder s o f th e participatin g bank s relative t o othe r banks . FMC G Capita l Strategies , Analyzin g Success and Failur e i n Bankin q Consolidation, Rollin g Meadows , IL : Ban k Administration Institute , 1990 . Se e als o Boy d an d Graham . 9. Fo r othe r lendin g activitie s covere d b y a federa l safet y net , se e Georg e G. Kaufman , ' T h e Federa l Safet y Net : No t Fo r Bank s Only, " Economic Perspectives (Federa l Reserv e Ban k o f Chicago ) (November / Decembe r 1987): 19-28 ; an d U.S . Genera l Accountin g Office , Government-Spon sored Enterprises : The Government's Exposure to Risk (Washington , D.C., August 1990) . 10. Secretar y o f th e Treasury , Repor t o n Governmen t Sponsored Enterprises (Washington , D.C. : U.S. Treasury Department , Apri l 1991) , xxi. 11. Ibid. , 1 . 12. Randal l J . Pozdena, "Recapitalizin g th e Bankin g System, " FRBSF Weekly Letter (Federa l Reserv e Ban k o f Sa n Francisco ) (Marc h 8 , 1991) : 3 . Se e also Georg e M . Salem , e t al. , Banking Industr y Outlook (Prudential Bache Securities ) (Decembe r 31 , 1990): 9-12 . 13. Th e fungibility o f credi t i s best evidence d b y the conclusions o f a recen t study b y the Federa l Reserv e Ban k o f Dalla s tha t the upheava l suffere d i n th e Texa s bankin g secto r ha d littl e effec t o n overal l economic activit y i n th e state . Whil e w e find evidenc e tha t economi c event s affected th e bankin g sector , w e ca n find littl e evidenc e tha t lendin g activit y b y Texas bank s exerte d an y influenc e o n overal l economi c activity . On e possibl e explanation fo r thes e result s i s tha t capita l apparentl y flows fairl y wel l acros s regions. If Texa s bank s wer e eithe r unabl e o r unwilling t o exten d viabl e loans , then perhaps banks and other financial institutions outside the state fulfilled thi s function. Jeffrey W . Gunther an d Kennet h J. Robinson, "Th e Texa s Credit Crunch, " Financial Industr y Studies (Federa l Reserv e Ban k o f Dallas ) (Jun e 1991) : 6.

158 Georg

e G . Kaufman

14. I t is interestin g t o not e tha t a credit crunc h ha s no t bee n perceive d i n residential mortgag e lendin g despit e th e abrup t declin e i n th e dolla r assets an d numbe r o f S& L associations . Kaufman , 'Th e Incredibl e Shrinking S&L Industry." 15. Georg e J. Benston an d Georg e G. Kaufman, Risk and Solvency Regula tion of Depository Institutions: Past Policies and Curren t Options (Ne w York: Salomon Brothers Center, New York University, 1988) ; George G. Kaufman, " A Proposa l fo r Deposi t Insuranc e Refor m Tha t Keep s th e Put Option Out-of-the-Money and the Taxpayer in-the-Money," in Charles A. Ston e an d Ann e Zissu , eds. , Risk Based Capital Regulations : Asset Management and Funding Strategies, Business One Irwin, forthcoming ; and Shado w Financia l Regulator y Committee , " A Progra m fo r Deposi t Insurance an d Regulator y Reform, " Statemen t No . 41, Chicago, Loyola University, February 13,1989 .

References Benston, George J. "U.S. Banking in an Increasingly Integrated and Compet itive World Economy." Journal of Financial Services Research. (Decem ber 1990): 311-86. Benston Georg e J., an d Georg e G. Kaufman. Risk and Solvency Regulatio n of Depository Institutions: Past Policies and Curren t Options. Ne w York: Salomon Brothers Center, New York University, 1988. Benston, Georg e J. , e t al . Perspectives on Safe and Soun d Banking . Cam bridge, MA: MIT Press, 1986. Boyd, John H., and Stanle y L. Graham. "Investigatin g the Banking Consolidation Trend. " OuarterJ y Review, Federa l Reserv e Bank o f Minneapoli s (Spring 1991): 3-15. Edwards, Franklin. "Concentration i n Banking: Problem or Solution?" In G. G. Kaufman an d R . C. Kormendi, eds. , DerequJatinq Financial Services . Cambridge, MA: Ballinger, 1986 . 145-68. FMCG Capital Strategies . Anaiyzinq Success and Failure in Bankin q Consolidation. Rollin g Meadows, IL: Bank Administration Institute , 1990. Gunther, Jeffrey W. , and Kennet h J. Robinson. "Th e Texa s Credit Crunch, " Financial Industr y Studies, Federal Reserve Bank of Dallas (June 1991). Herring, Richard J. , and Anthon y M . Santomero. "Th e Corporat e Structur e of Financia l Conglomerates. " Journa l of Financial Service s Research (December 1990) : 471-97. James, Christopher . "Som e Evidenc e o n th e Uniquenes s o f Ban k Loans. " Journal of Financial Economics. (Decembe r 1987) : 216-35. Kane, Edwar d J . The Gatherin g Crisis in Federal Deposit Insurance . Cam bridge, Mass.: MIT Press, 1985. Kaufman, Georg e G . "Th e Federa l Safet y Net : No t fo r Bank s Only. " Eco -

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nomic Perspectives, Federa l Reserve Bank of Chicago (November-Decem ber 1987): 19-28. . "Bankin g Ris k i n Historica l Perspective/ ' I n G . G . Kaufman , ed. , Research in Financial Services . Vol. 1 . Greenwich, CT : JAI Press, 1989. 151-64. . "The Incredible Shrinkin g S& L Industry." Chicago Fed Letter, Federal Reserve Bank of Chicago. (December 1990). . " A Proposa l fo r Deposi t Insuranc e Refor m Tha t Keep s th e Pu t Option Out-of-the-Mone y an d th e Taxpayer s in-the-Money. " I n Charle s A. Ston e an d Ann e Zissu , eds. , Risk Based Capital Regulations : Asset Management and Funding Strategies. Business One Irwin, forthcoming . . "Capita l i n Banking : Past, Present , an d Future. " Journal of Financial Services Research (Apri l 1992): 385-402. Kaufman, Georg e G., and Larr y R. Mote, "Glass-Steagall: Repeal by Regulatory an d Judicia l Reinterpretation. " Bankin q Law Journal (September October 1990) : 388-421. Pozdena, Randal l J. , "Recapitalizin g th e Bankin g System. " FRBS F Weekly Letter, Federal Reserve Bank of San Francisco. (March 8,1991) . Salem, Georg e M., et al . Banking Industr y Outlook. Ne w York: Prudential Bache Securities, December 31 , 1990. Saunders, Anthony . "Ban k Holdin g Companies : Structure , Performance , and Reform. " In W. S. Haraf an d R . M. Kushmeider, eds. , Restructurin g Banking and Financial Services in America. Washington , D.C. : American Enterprise Institute, 1988.156-203. Secretary o f th e Treasury . Report on Governmen t Sponsore d Enterprises . Washington, D.C.: U.S. Treasury Department, April 1991. Shadow Financial Regulatory Committee. "A Program for Deposit Insurance and Regulator y Reform. " Statemen t No . 41, Chicago, Loyola University , February 13,1989 . U.S. Genera l Accountin g Office . Government-Sponsore d Enterprises : The Government's Exposure to Risk. GAO/GGD-9097. Washington, D.C., August 1990.

Contributors

Roger W . Garrisio n i s Associat e Professo r o f Economic s a t Aubur n University. H e ha s publishe d mor e tha n a doze n article s o n capita l and busines s cycles , an d th e monograp h Austria n Macroeconomics : A Diagrammatic Exposition (1978) . H e i s currentl y workin g o n hi s first book , tentativel y entitle d Th e Macroeconomic s of Capita l Structure. Thomas Havrilesk y i s Professo r o f Economic s a t Duk e University . He i s wel l know n a s th e coautho r an d coedito r (wit h Joh n T . Boor man) o f severa l textbook s an d collection s o f reading s o n money , banking, an d macroeconomics . Muc h o f hi s recen t research , includ ing th e recen t book , Th e Pressure s o n Monetar y Policy, provide s empirical evidenc e o f th e politica l influence s o n th e Federa l Re serve. George G . Kaufma n i s th e Joh n F . Smit h Professo r o f Financ e an d Economics a t Loyol a Universit y o f Chicago . H e i s th e autho r o f numerous journa l article s an d tw o curren t money-and-bankin g text books, and i s a coauthor o f Perspectives on Safe and Soun d Bankin g (1986). He i s a n edito r o f th e Journal of Financia l Service s Besearc h and a member o f th e editoria l board s o f severa l othe r journals . Gerald P . O'Driscoll, Jr. , is Vice Presiden t an d Economi c Adviso r a t the Federa l Reserv e Ban k o f Dallas . H e i s th e autho r o f Economics as a Coordination Problem (1977 ) an d man y article s o n monetar y 161

162 Contributor s theory and the history o f economics. He is the coauthor (wit h Mario J. Rizzo) of The Economics of Time and Ignorance (1985). Richard M. Salsman is Vice President and Economist at H. C. Wainwright an d Co., Economics, Inc., in Boston and a n adjunct fello w of the America n Institut e fo r Economi c Research . H e i s th e autho r o f Breaking the Banks : Centra l Bankin g Problem s an d Fre e Bankin g Solutions (1990) . H e lecture s widel y o n money , banking , an d eco nomics. Walker Todd i s Assistan t Genera l Counse l an d Researc h Office r a t the Federa l Reserv e Ban k o f Cleveland . Hi s wor k ha s appeare d i n the annua l Researc h i n Financia l Service s an d elsewhere . His con tribution to the present volume was written while he was on a leave of absence at the Gulliver Foundation i n San Francisco. Lawrence H. White is Associate Professo r o f Economics a t the University o f Georgia . H e i s th e autho r o f Fre e Bankin g i n Britain (1984), Competition and Currency: Essays on Free Bankin g an d Money (NY U Press, 1989), and numerou s article s o n the theory an d history of unregulated mone y and banking. He is currently writing a book entitled Th e Theory of Monetary Institutions.

Index

Accounting, 3 ; macroeconomic, 30 , 3 1 33, 41 , 47 ; market-value, 134 , 135 ; national-income, 2 ; regulatory, 7 , 21 , 112; S& L disaster, 59-60 , 6 1 Adams, Jame s Ring , 5 5 Adverse selectio n dilemma , 12 4 Agricultural banks , 8 7 Agriculture, 3 9 Aldrich, Winthrop , 11 4 n . 2 0 Aldrich-Vreeland Ac t (Emergenc y Cur rency Act) , 94 , 9 6 American Banker s Association , 10 2 Andrew, A . Piatt , 9 1 Aristotle, 13 1 Asset base , 14 7 Asset diversification , 89 , 10 8 Asset quality , 13-14 , 104 ; regional fac tors in , 15-1 6 Asset size , 15 , 14 4 t. , 14 9 Asset-to-capital multiplier , 14 7 Atkinson, Bill , 2 5 nn . 1 , 2 , 4 Austrian schoo l o f economics , 1 , 14 , 110 Bagehot, Walter , 12 5 Bailout schemes , 128-2 9 Bailouts, 130 , 13 3 Balance-sheet standards , 5 Bank branchin g laws , 66 , 69 , 71 , 76 . See also Branchin g restriction s Bank charters , 120 , 121 , 14 2

Bank failur e resolution , 130-31 ; cost s of, 9 , 12 , 2 1 Bank failures , 2 , 7-8 , 8/. , 10 , 23-24 , 58 , 74, 83 , 86 , 87 , 107 , 109 , 140-41 , 150 ; and ban k runs , 126 ; deposi t insur ance and , 123-24 ; FDI C and, 128 ; i n Great Depression , 82-83 ; an d mone y panics, 91 ; 1930s, 97 , 102 ; number of , 13; i n pani c o f 1907 , 93 ; "purchas e and assumption " i n resolutio n of , 20-21; uninsure d banks , 13 5 Bank Holdin g Compan y Act , 106 ; Doug las Amendment , 142 , 147 . Se e als o Holding companie s Bank notes , 89-90 ; national , 12 1 Bank o f Ne w England , 2 , 5 , 9 , 13 , 2 5 26 n. 7 ; bridge ban k for , 13 6 n . 9 Bank runs , 23-24 , 83-84 , 126 , 140-4 1 Bank Insuranc e Fun d (BIF) , 4, 7-8 , 9 , 10, 11 , 25 , 125 , 129 ; losses/insol vency, 8 , 9 , 127-28 , 130 ; recapitaliza tion of , 5-6 , 127 ; rescue cost , 132-3 3 Bankers, 100-101 ; competenc e an d probity of , 109 ; declin e i n ethica l standards of , 2 ; as scapegoat s fo r banking crises , 4 , 81-118 ; a s sourc e of bankin g crises , 3 - 4 , 84-8 5 Bankers Trus t Company , 9 5 Banking; bad , 4 , 82 ; developmen t of , 139-40; institutionalize d inflatio n and deterioratio n of , 104—6 . Se e also Commercial banking ; Fre e bankin g

163

164 Inde

x

Banking Ac t (1933) , 10 2 Banking Ac t o f 1991 , 6 Banking collapse , 3 , 83 , 99, 101 , 10 2 Banking crises , 2 , 3 , 7 2 - 7 3 , 121 ; bank ers a s scapegoat s for , 4 , 81-119 ; con text o f current , 8 1 - 8 3 ; an d expansio n of Federa l Reserv e powers , 97-103 ; in nationa l bankin g era , 86-97 ; na ture of , 83-86 ; present , 107-1 2 Banking episodes , 8 3 Banking industry , 2 , 30 ; crisi s in , 1-2 , 156; market-determined , 156 ; reason s for problem s of , 7-28 ; secula r trend s in, 5 ; shrinkag e of , 2 , 5 , 25 ; size o f troubles of , 7-12 ; uncertaint y and , 37,48 Banking legislation , 3 , 5- 6 Banking policy , 2 , 3 , 2 2 - 2 5 , 122 ; un sound, 12 5 Banking Refor m an d Communit y Bene fits Act , 7 4 Banking system , 1 ; capita l strengt h of , 86; collaps e of , 97 , 141 ; deterioratio n of, 104-6 , 107 , 108 , 111-12 ; evolu tion of , 119-33 . Se e als o Nationa l Banking System ; Privat e bankin g sys tem Barnett, Rand y E. , 13 5 n . 4 Barro, Rober t J. , 4 7 Barth, Jame s R. , 10 , 11-12 , 13 , 16 , 17 , 21, 2 5 n. 7 , 45 , 5 1 n. 5 , 7 6 n. 2 Benston, Georg e J. , 18 , 21 , 85, 11 6 n . 28, 15 6 n . 1 , 15 8 n . 1 5 Big ban k PACs , 56 , 61 , 63-64, 65 , 67 , 68-69, 6 9 t. , 70 , 71, 72, 75; defined, 6 6 Big banks , 3 , 7 4 Bill sponsorship , 3 , 69 , 71 , 74, 75 , 7 6 Bond-collateral restrictions : currenc y is suance, 88 , 89-90 , 92 , 9 8 Boom-and-bust patterns , 10 4 Boorman, John , 77 n. 3 Borrowing, 33 , 34 ; cos t of , 40 , 41 ; government, 37 , 4 0 - 4 2 , 46 , 47 , 4 9 Borrowing/taxing nonequivalence , 30 , 51 n. 4 Bowles, David , 5 1 n. 7 Boyd, Joh n H. , 15 6 n . 4 Branches, 145 , 14 6 Branching: free , 96 , 10 2

Branching restrictions , 88 , 89 , 97 , 98 , 101, 105 , 106 , 108 , 110 , 120 , 141-43 , 146-47, 154 . Se e als o Ban k branch ing law s Bridge banks , 134 , 135 , 13 6 n . 9 Brumbaugh, R . Dan , Jr. , 10 , 11-12 , 13 , 16, 17 , 18 , 21 , 25 n. 7 , 2 6 n. 10 , 7 6 n . 2 Bryan, Lowell , 9 , 11 1 Budget: balance/imbalance , 30 , 4 8 - 4 9 ; surplus/deficit a s percentag e o f pri vate an d corporat e saving , 4 2 - 4 3 , 43/., 4 4 t . Budget deficit , 2 , 3 , 30 , 4 0 - 4 1 , 45 , 61, 108, 125 ; empirical literature , 34-37 ; historical perspective , 41-46 ; macro economic accountin g of , 3 1 - 3 3 ; pol icy perspective , 33-34 ; public-sector , 29-54. Se e als o Defici t accommoda tion Bureaucracy, 5 5 Bush, George , 57 , 5 9 Bush administration , 9 Business cycle , 13 , 14 , 15 , 8 5 Business loans , 13 , 152 , 1 5 2 / . Business psychology , 3 9 Byron, Christopher , 1 1 Call loans , 86 , 87 , 89 , 9 3 Call reports , 1 1 Calomiris, Charle s W. , 84 , 93 , 11 3 n . 8 Campaign contributions , 56 , 6 3 - 6 5 , 77 n. 8 . Se e als o Politica l Actio n Com mittees (PACs ) Campaign financing needs , 63 , 65 , 67 , 72 Canada, 2 4 Capital/asset ratios , 15 , 20 , 141 , 15 4 Capital growth : commercia l banks , 1 5 Capital levels , 14 8 /. Capital markets , 3 9 Capital problems : liquidit y concern s and,129-30 Capital rati o requirements , 14 7 Capital ratios , 5 , 86 , 104 , 149 , 150 , 151, 154-56 Carlisle, Joh n G. , 9 2 - 9 3 Carter, Jimmy , 59 , 10 6 Carter administration , 3 4

Index 16 5 Cates, David , 9 Caveat empto r policy , 2 3 Central bank(s) , 60 , 129 , 133 ; foreign , 84, 9 4 Central ban k doctrine , 125 , 13 5 Central banking , 3 , 84 , 86 , 98 , 105-6 ; and ban k stability , 82 , 97 ; an d fraud , 109-10; an d mismanagement , 1 1 0 11, 112 ; problems cause d by , 106 , 108, 109-10 , 112 ; revenue-raisin g purpose of , 84-8 5 Central reserv e cit y banks , 88-89 , 91 , 93 Certainty, 29 , 3 0 Certificates o f deposit , 11 1 Chamber o f Congres s (COC ) rating , 66 , 68-69, 71 , 72 , 7 6 Chappell, Henr y W. , 6 7 Chari, V . V. , 87 , 11 3 n. 9 Chase, Samuel , 8 9 Chase Manhattan , 1 1 Chase Nationa l Bank , 99 , 10 2 Chernow, Ron , 95 , 96 , 99 , 11 5 n . 2 1 City banks , 91 , 9 5 Civil War , 84 , 89 , 13 5 n . 4 "Clearinghouse certificates, " 91 , 94 , 11 0 Clearinghouses, 23 , 91 , 12 6 Cleveland, Harol d va n B. , 95 , 96 , 100 , 101, 11 4 nn . 13 , 1 7 Closure standards/rules , 4 , 5 , 6 , 125 , 134,135 Coelho, Tony , 6 2 Coinsurance proposals , 2 4 Cole, Rebe l A. , 1 9 Commerce: separatio n o f bankin g from , 142 Commercial an d industria l (C&I ) loans , 17, 21 , 1 5 2 / . Commercial banking , 83 , 98-99 ; dimin ishing rol e of , 139-59 ; federa l sub sidy of , 133 ; insured-deposit, incor porated, 131 , 13 2 Commercial bankin g industry , 5 , 107 ; regulation of , 11 1 Commercial banks , 6 , 19 , 66 , 67 , 74 , 101, 153 ; assets, 14 ; credit ratings , 150-52; growt h o f capital , assets , ra tio, 15/ ; income-asset ratio , 16 ; lend ing practices , 104 ; los s o f marke t

share, 143-52 ; profitability , 13 ; rate of return , 29 ; in securitie s business , 102 Commercial paper , 145 , 15 2 Commercial pape r market , 17 , 10 4 Commercial rea l estate , 12 , 13 , 14 , 48 , 107, 12 6 Committee o n Financia l Deregulation , 57 Competition, 1 , 16 , 120 , 149-50 , 154 ; non-bank, 146 ; from "zombie " insti tutions, 19 , 21-2 2 Competitive Equalit y Bankin g Act , 7 4 Comprehensive Ban k Restructuring , Powers, an d Safet y Act , 7 4 Computers, 5 , 14 5 Concentration: o f mone y an d credit , 96-97; o f power , 14 6 Conflict o f interest , 14 6 Congress, 6 , 93 , 94-95 , 96 , 100-101 , 102-3, 126 , 128 , 132 ; and S& L lobby , 60-61, 6 2 Congressional Budge t Office , 9 Congresspersons: an d PACs , 3 , 7 , 5 5 56, 62 , 63-72 , 7 5 Conservatorships, 134 , 13 5 Constituencies, 63 , 64 , 65 , 66 , 6 9 - 7 0 , 71 Constitution (U.S.) , 132 ; Ninth Amend ment, 13 5 n . 4 Consumer-goods sector , 4 6 - 4 7 Consumption: deficit s and , 4 6 - 4 7 Continental Illinois , 21 , 10 7 Convertibility, 90 , 9 1 Corporate charters , 13 1 Correspondent accounts , 87 , 91 , 9 5 Corruption, 12 0 Country banks , 88-89 , 91 , 9 5 Couzens, James , 10 1 Cranston, Alan , 6 2 Credit, 18 , 110 , 153 ; fungible, 15 3 Credit controls , 10 6 Credit crunch , 5 , 126-27 , 149-50 , 15 4 Credit information , 140 , 144-4 5 Credit markets , 30 , 35 , 36 , 42 , 4 5 Credit rating s (bank) , 104 , 150-5 2 Credit relationships , 153-5 4 "Crisis i n th e Bankin g Industry , The " (conference), 1

166 Inde

x

Crowding out , 32 , 34 , 4 6 Currency: deman d for , 89 , 90 , 98 ; ine lastic, 96 , 97 , 11 3 n. 4 ; private , 11 0 Currency issuance , 91 , 94, 103 ; bond collateral restriction s on , 88 , 89-90 , 92, 98 ; note issu e 96 ; restrictions on , 92, 97 , 11 0 Cyclical factors , 13-1 5 Debt, 2 , 30 , 34 , 42 ; rea l valu e of , 42 ; selling abroad , 34 , 38 , 4 8 Debt monetization , 34 , 36 , 38-39 , 42 , 48 De Concini , Dennis , 6 2 Default, 13 ; in publi c debt , 40 , 4 1 Default risk , 17 , 23 , 4 1, 51-52 n . 7 Default-risk premium , 40 , 4 1 Deficit accommodation , 38 ; uncertaint y regarding, 29-30 , 3 7 Deficit finance, 30 , 41 , 4 5 - 4 6 Deficit spending , 30 , 40 , 42 , 104 , 105 , 106; ultimat e consequence s of , 4 6 - 4 7 Deficit-to-saving ratio , 4 2 - 4 3 Demand deposits , 145-46 , 14 7 Deposit/currency ratio , 9 4 Deposit guarantees , 4 - 5 , 7 , 20 , 119 ; de regulation and , 24-25 ; proposal s t o limit, 24 ; an d ris k taking , 2 2 Deposit insurance , 2 , 3 , 18-22 , 103 , 108, 141 ; collapse of , 83 ; and defici t problem, 48 ; destabilizin g effec t of , 4 , 119; eliminatio n o f (proposed) , 135 ; experimentation with , 122-24 ; failur e to reregulate , 59 ; financial deregula tion and , 58 ; and fraud , 109 ; in creased coverage , 106 , 108 ; an d mar ket share , 147-50 ; mispricing , 5 , 48 , 153, 154 ; private , 24 , 134 ; an d reck lessness, 85 ; unconstitutionality of , 132 Deposit insuranc e ceilings , 3 , 16 , 106 , 126, 13 4 Deposit insuranc e crisis , 5 7 Deposit insuranc e fund , 122 . Se e aJs o Bank Insuranc e Fun d (BIF ) Deposit insuranc e premiums , 8 , 21 , 107, 128 , 147-4 8 Deposit insuranc e reform , 6 , 119-38 , 154; proposal s for , 134-3 5

Deposit insuranc e system : collaps e of , 107; practica l objection s to , 130-3 3 Deposit interes t rat e ceilings , 16 , 17 , 104, 10 6 Depositors, 23-24 , 84 , 106 ; small , 126 ; uninsured, 6 , 21 , 130, 13 1 Depository institutions , 59 , 64 , 139 , 145, 15 3 Depository Institution s Deregulatio n and Monetar y Contro l Ac t o f 198 0 (DIDMCA), 20 , 6 0 - 6 1 , 63 , 11 5 n. 2 4 Deposits: cost s o f gathering , 145 ; out flows, 111 ; payment o f interes t on , 91, 92 , 103 ; uninsured, 132 , 13 3 Depression(s), 83 , 103 . Se e als o Grea t Depression Deregulation, 1 , 59 , 85 ; as caus e o f banking crisis , 108 , 111 ; and deposi t guarantees, 2 4 - 2 5 ; financial, 58 , 6 3 64; PAC s and , 66 ; an d S& L disaster , 62 Destabilization, 38-4 0 Dewald, Willia m G. , 5 1 n. 5 Discipline (bank) , 126 ; market/regula tory, 24 , 126 , 141 , 15 0 Discoordination, 37-38 , 43 , 4 7 Discount window , 4 , 101 , 113 n. 5 , 124-25, 133 ; in bailouts , 107 ; i n re form proposals , 134-3 5 Disintermediation, 104 , 105 , 10 6 Diversification, 103 , 105 , 106 , 111 , 147; restrictions on , 2 , 97 , 101 , 142-43. See also Geographi c restrictions ; Product-line restriction s Dollar, 103 , 104 , 10 6 Dollar crisi s (1970s) , 10 5 Domestic investment , 3 1 - 3 3 Dual Bankin g Syste m Enhancemen t an d Financial Service s Competitivenes s Act, 7 4 Duca, Joh n V. , 12 , 14 , 17 , 2 2 Durden, Garey , 6 7 Dwyer, Geral d P. , Jr., 5 1 n. 5 Economic conditions : an d ban k failure , 123-24 Economic crises , 38 , 3 9 Economic growth , 85 , 8 7

Index 16 Economists: an d S& L disaster , 55-56 , 57 Economy (U.S.) : diminishing rol e o f commercial bankin g in , 139-5 9 Edelman, Susa n A. , 6 7 Edwards, Frankli n R. , 15 6 n. 6 Eisenbeis, Rober t A. , 7 Eisner, Robert , 5 1 n. 3 , 5 2 n . 9 Emergency Bankin g Act , 11 5 n. 2 2 Empirical analysis : o f publi c choic e as pects o f S& L disaster , 5 5 - 8 0 Empirical literature : budge t deficits , 34-37, 4 5 Eurodollar accounts , 11 1 Evans, Paul , 5 1 n. 5 Exchange rates , 29 , 36 ; deficit s and , 4 1 , 45 Exits, 2 , 22 ; through failure , 121 ; mar ket, 13 3 Eytan, Zeev , 77 n. 8 Fackler, Jame s S. , 5 1 n. 5 Farm Credi t System , 14 9 Farrell, Christopher , 1 3 Federal Agricultura l Credi t Association , 148 Federal Deposi t Insuranc e Corporatio n (FDIC), 4 , 16 , 19 , 2 0 - 2 1 , 24 , 72 , 131; creation of , 126 ; crisi s (1990s) , 3 , 56 , 72-74; deposi t insuranc e fund , 107 , 135; enforcemen t actions , 58 ; financial problem s of , 127-28 ; insolvency , 2; interventionis t power s of , 11 5 n . 25; liquidatio n operation s of , 134 ; ob ligations of , 132 ; an d recapitalizatio n of BIF , 5-6 ; resolutio n policy/costs , 10, 22 ; size o f trouble s of , 7-12 . Se e also Ban k Insuranc e Fun d (BIF ) Federal Financin g Ban k (FFB) , 12 7 Federal Hom e Loa n Ban k o f Sa n Fran cisco, 12 9 Federal Hom e Loa n Banks , 14 9 Federal Hom e Loa n Mortgag e Corpora tion (FHLMC) , 148 , 14 9 Federal Nationa l Mortgag e Associatio n (FNMA), 148 , 14 9 Federal Saving s an d Loa n Insuranc e Corporation (FSLIC) , 5 , 7 , 8 , 11 , 18, 19, 128-29 , 131 ; bailout, 6 ; catastro -

7

phe (1980s) , 56 ; creatio n of , 126 ; de posit insuranc e ceiling , 6 0 - 6 1 ; fun d depletion, 61 , 62, 72 ; recapitalization , 6 2 - 6 3 , 67 , 74 ; rescue cost , 13 2 Federal Reserve , 4 , 39 , 94 , 103 , 142 ; banking crisi s an d expansio n o f pow ers of , 97-103 ; creatio n of , 84 , 95 ; ex pansionary monetar y policy , 15 , 8 2 83; fiat- money-creatin g powe r of , 104; inflationis t policie s of , 105 , 106 , 113 n. 5 Federal Reserv e Act , 93 , 95-96 , 101 , 103, 125-26 , 12 8 Federal Reserv e Bank , 10 8 Federal Reserv e Ban k o f Ne w York , 17 , 22 Federal Reserv e Board , 14 , 103 , 12 8 Federal Reserv e System , 83 , 124 , 126 ; banks leaving , 105 , 106 ; liquidity , 129; precurso r to , 8 6 - 9 7 Fed wire, 2 4 Federal Hom e Loa n Ban k Boar d (FHLBB), 6 1 Financial contracts , 2 4 Financial deregulation , 58 , 6 3 - 6 4 Financial institutions : asse t size , rela tive importance , an d marke t share , 144 t . Financial Institution s Reform , Recovery , and Enforcemen t Ac t o f 198 9 (FIR REA), 11 5 n . 25 , 127 , 13 2 Financial Intermediarie s Revie w Com mission (proposed) , 7 4 Financial PA C campaig n contributions : causes of , 6 3 - 6 5 Financial safet y net , 4 , 119 , 133 , 148 ; perverse incentive s of , 13 4 Financial services , 142 , 143 , 146 , 15 4 Financial service s sector , 56 , 6 3 - 6 4 , 65 , 66; PA C contributions , 67 , 75-76 , 75 t . Financial system , 2 4 First Ban k o f th e Unite d States , 121 , 135 n. 5 First Nationa l Bank , 9 5 Fiscal policy , 30 , 33-34 , 46 , 49 , 122 ; expansionary, 5 1 n. 7 ; uncertainty in , 36, 38 , 39 ; unsound , 12 5 Fiscal responsibility , 49 , 5 0

168 Inde

x

Flannery, Mar k J. , 99 , 102 , 11 4 nn . 18 , 19 Forbearance, 5 , 7 , 19 , 20 ; i n S& L disas ter, 3 , 55-56 , 61 , 62, 67 , 69 , 7 0 Foreign banks , 5 , 142 , 154-5 6 Foreign centra l banks , 84 , 9 4 Foreign exchang e markets , 111 . Se e also Exchang e rate s Foreign-trade deficit , 36 , 3 8 Foreign trad e sector , 3 1 - 3 3 , 3 4 Fractional reserv e banking , 8 4 Franklin Nationa l Bank , 2 1 Fraud, 99 ; a s caus e o f bankin g crisis , 3 , 81-82, 9 1 , 108, 109 , 11 1 Free banking , 90 , 98 , 106 , 109 , 111 , 112, 120 ; defined , 11 3 n. 2 ; a s stabl e system, 8 2 Fricker, Mary , 55 , 11 2 n . 1 Friedman, Milton , 88 , 90 , 9 2 - 9 3 , 94 , 97, 105 , 11 3 n. 5 , 11 4 nn . 14 , 15 , 19 , 115 n. 21 , 121, 12 2 Fromson, Bret t Duval , 16 , 2 5 n. 5 Full-faith-and-credit guarantee , 13 2 "Gambling," financial, 19 , 20 , 21 , 22, 23 Garn-St. Germai n Act , 61 , 10 6 Garrison, Roge r W. , 2 - 3 , 29-54 , 77 n. 4 Garsson, Rober t M. , 2 5 nn. 1 , 2 General Theory (Keynes) , 3 9 Geographic restrictions , 2 , 5 , 6 , 66 , 14 6 Glasner, David , 8 4 Glass, Carter , 9 8 - 9 9 , 101 , 102, 11 4 n . 20 Glass-Steagal Act , 1 0 2 - 3 , 110 , 14 2 Glauber, Rober t R. , 13 6 n. 1 0 Glenn, John , 6 2 Gold, 10 5 Gold standard , 92 , 97 , 98 , 102 , 103 , 106, 11 2 Goodhart, Charles , 8 4 Gorton, Gary , 84 , 91 , 93, 11 3 n. 8 Government: fund s sources , 8 4 - 8 5 Government intervention , 91-92 ; a s cause o f bankin g crises , 2 , 3-4 , 81 , 82, 83 , 85, 86 , 88 , 9 6 - 9 7 , 98 , 103 , 112 Government sector , 3 1 - 3 3 Government securities , 93 , 10 2

Government spending , 48 , 4 9 - 5 0 Government sponsore d enterprise s (GSEs), 148-4 9 Government surplus , 9 3 Graham, Stanle y L. , 15 6 n. 4 Gray, Edwin , 6 1 Great Depression , 3 , 45, 82 , 97 , 99 , 101, 102, 11 3 n. 5 ; los s experienc e in , 12 5 Great Society , 5 7 Greenspan, Alan , 12 9 Grier, Kevi n B. , 6 3 Groseclose, Elgin , 9 3 Gross nationa l product , 41 , 42, 4 3 Guaranty Trus t Company , 9 5 Gunther, Jeffre y W. , 15 7 n. 1 3 Guttentag, Jack , 76-7 7 n . 3 Hackley, Howard , 12 8 Hanover Bank , 10 5 Havrilesky, Thomas , 3 , 55-80 , 7 6 n. 1 , 78 n. 1 4 Hayek, Friedric h A. , 11 0 Herring, Richar d J. , 15 7 n. 6 Hershey, Rober t D. , Jr., 12 9 Hitchcock, Gilber t M. , 9 5 - 9 6 HLT loans , 12 , 1 4 Holding companies , 10 , 74 , 105 , 111, 136 n . 9 , 14 3 Holding compan y affiliates , 142 , 143 , 146 Homeowners, 57 , 5 9 Horwitz, Steven , 90 , 9 4 House Bankin g Committee , 56 , 6 5 - 7 1 , 75, 11 5 n. 26 ; Financia l Institution s Subcommittee, 1 0 House Committe e o n Bankin g an d Cur rency, 9 5 Housing, 5 7 - 5 8 , 6 0 Housing lobbies , 7 7 n. 5 Housing ta x shelters , 5 8 Huertas, Thoma s F. , 95 , 96 , 100 , 101 , 114 nn. 13 , 1 7 Human capital : misallocatio n of , 6 0 Ideology: an d bankin g crisis , 2 Illiquidity, 83 , 92, 93 ; in bankin g crisis , 86, 87 ; inheren t i n nationa l bankin g system, 89 ; restrictions and , 88 , 9 1 Income-expenditure analysis , 31 , 46

Index 16 9 Income redistribution , 3 Income ta x rates , 5 8 Inflation, 2 , 36 , 38-39 , 85 ; and deficits , 42; governmen t polic y and , 108 , 112 ; institutionalized, 104-6 ; socia l cos t of, 77 n. 5 Inflation rate : deficit s and , 29 , 41 , 4 5 Inflationism, 105 , 10 6 Insolvency(ies), 7 , 19-20 , 22 , 86 , 15 0 Insolvent banks , 5 , 6 , 9 ; closing , 11-12 ; failure t o close , 125 , 14 1 Instability, 82 , 83 , 104 ; government sponsored, 86 ; imposed b y centra l banking, 110 ; seasonal , 93 ; source of , 85, 89 , 111 ; structural, 11 9 Institutional structure , 8 4 Interbank deposits , 87 , 8 9 Interest groups , 58 , 63 , 73-7 4 Interest rat e ceilings , 11 1 Interest-rate risk , 18 , 2 1 Interest rates , 19 , 35 , 85 , 148-49 ; defi cits and , 29 , 4 1 , 45; deposit/loa n spreads, 17 ; high/low, 59 , 61 , 77 n . 6 , 104-5; "natural, " 110 ; nominal , 36 . See als o Rea l interes t rat e Intermediation market , 15 6 n . 5 Investment banking , 9 8 - 9 9 , 106 , 14 2 Investment sector , 46 , 4 7 J. P . Morga n (Co.) , 9 5 Jackson, Andrew , 8 5 James, Christopher , 15 6 n . 5 "Joint Lendin g Program, " 128-2 9 Kane, Edwar d J. , 9 , 18 , 19 , 2 6 n. 10 , 120, 15 6 n . 2 Kansas, 13 6 n . 7 Kansas experience , 119 , 122-24 , 13 0 Kaufman, Georg e G. , 2 , 5 , 18 , 20 , 21, 24, 73 , 139-59 , 15 6 nn. 3 , 6 , 15 7 nn . 7, 9 , 15 8 nn. 14 , 1 5 Keating, Charles , 3 , 62 , 8 2 Keating Five , 55 , 6 2 - 6 3 Kelly, Edwar d J. , 99 , 11 4 nn . 16 , 18 , 19 , 20 Keynes, Joh n Maynard , 39-4 0 Keynesianism, 5 0 - 5 1 nn . 2 , 3 , 105 ; multiplier concept , 5 7 Knickerbocker Trus t Company , 9 3

Knox, Joh n Jay , 9 1 - 9 2 Kohlberg, Kravis , Roberts , 13 6 n . 9 Kohn, Meir , 1 4 Koppl, Roger , 5 2 n. 8 Kormendi, Roge r C , 5 1 n. 5 , 15 6 n. 6 Kumbhakar, Subal , 122-23 , 13 6 n . 8 Labaton, Stephen , 2 5 n. 3 Large banks , 1 0 - 1 1 , 12 , 24 ; deposi t guarantees, 2 0 - 2 1 Law o f larg e numbers , 5 2 n. 8 Less Develope d Countr y (LDC ) loans , 12, 14 , 10 7 Leadership: lac k of , i n S& L disaster , 57-59, 6 2 Legal restriction s o n banking . Se e Re strictions Lender o f las t resort , 85 , 12 9 Lender o f las t resor t doctrine , 4 , 12 5 Lending, 48 ; cyclica l losse s in , 2 ; error s in, 13-14 , 107 ; risky, 126-27 ; specu lative, 104 ; subsidized , 126 ; unsound , 98 Lending policies : governmen t influenc e over, 103 , 10 8 Lending strategies : high-risk , 21 , 2 3 Liability (ies), 23 ; government under writing, 109 , 120 , 122 ; managers , shareholders, 24 , 121 , 130; private , 125. Se e als o Taxpaye r liabilit y Life insuranc e companies , 14 3 Lincoln Saving s an d Loan , 6 2 Liquidity, 83 , 104 , 143 ; and capita l problems, 129-30 ; discoun t windo w and, 124-25 ; mismanagemen t of , 9 7 98; seasona l variation s in , 8 6 - 8 7 , 88 , 93. Se e als o Illiquidit y Liquidity crises , 88 , 9 0 Liquidity panic(s) , 9 4 Liquidity ratio , 8 6 Litan, Rober t E. , 10 , 11-12 , 13 , 16 , 17 , 21, 24 , 2 5 n. 7 Loan contraction , 87 , 9 1 Loan los s provisions , 12 , 16 , 1 7 Loan los s rates , 1 7 Loan losses , 2 , 19 , 150 ; cause s of , 1 3 22 Loan portfolios , 11 , 12, 18 , 37 ; rate o f return, 2 9

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Loans: bad , 1 2 - 1 3 ; high-risk , 19-20 ; selling, 145 ; underpriced, 17-1 8 Lobbies, lobbying , 3 , 77 n. 5 ; S&L , 3 , 60, 6 1 Lucas, Rober t E. , Jr., 1 4 McCain, John , 6 2 McCubbins, Mathe w D. , 6 1 Machlup, Fritz , 5 2 n . 8 McKenzie, Josep h A. , 1 9 McLaughlin, Mar y M. , 12 , 14 , 17 , 2 2 McManus, T . F. , 11 3 n. 5 , 11 4 n . 1 2 McMillin, W . Douglas , 5 1 n. 5 Macroeconomic accounting , 30 , 3 1 - 3 3 , 41, 4 7 Macroeconomy, 2 , 150 , 15 3 Mandel, Michae l J. , 1 4 Manufacturers Trust , 10 5 Market: an d deficit-induce d uncertain ties, 3 7 - 4 1 ; exi t through , 133 ; suppl y of credit , 4 2 Market capitalization , 15 1 /. Market discipline , 24 , 126 , 141 , 15 0 Market economy : uncertaint y in , 35-3 6 Market failur e theor y o f regulation , 55 , 76 n. 1 Market forces , 2 2 - 2 3 , 147 , 154 ; an d public policy , 7 3 Market-oriented deposi t insuranc e re form 132-3 3 Market share , 14 4 t. , 154 ; erosio n of , 143-52 Market system : deposi t insuranc e and , 131-32 Market-value accounting , 134 , 13 5 Markets: interconnectednes s of , 3 7 Maturity mismatches , 104 , 14 0 Mayer, Martin , 11 2 n . 1,13 3 Mayer, Thomas , 7 6 n. 3 Mergers, 105 , 106 , 15 7 n . 8 Mexico, 11 5 n . 2 3 Midlantic (N.J.) , 2 6 n. 7 Minimum reserv e ratio , 8 8 - 8 9 , 9 0 - 9 1 Minimum reserv e requirements , 91-92 . See also Reserv e requirement s Mismanagement: a s caus e o f bankin g crises, 4 , 81-82 , 91 , 108, 1 1 0 - 1 1 , 11 2 Mitchell, Charles , 99-10 0 Monetary inflation , 108 , 10 9

Monetary malinvestmen t theories , 1 4 Monetary policy , 33-34 , 97 , 105 , 12 9 adverse effect s of , 30 ; cost s o f misdi rected, 77 n. 5 ; easy , 77 n. 6 , 109 ; ex pansionary, 14 , 15 ; uncertainty in , 2 , 36, 3 9 Money: fungible , 153 ; government ma nipulation of , 110 , 11 2 Money marke t funds , 143 , 145-46 , 14 7 Money-market mutua l funds , 24 , 10 4 Money panics , 3 , 110 ; i n nationa l bank ing era , 86-97 ; nineteent h century , 82, 83 , 9 0 Money supply , 36 , 97 , 108 ; inflatio n of , 97-98, 109 , 11 3 n. 5 Money system : deterioratio n of , 104-6 , 107 Monopoly ove r mone y an d credit : o f central banks , 84 ; o f Fed , 96 , 9 7 - 9 8 , 101, 105 , 10 8 Moody's Investor s Service , 1 1 Moral hazar d behavior/problem , 19-20 , 55, 124 , 12 7 Morgan, J . P. , 10 2 Morgan, J . P. , Jr., 10 0 Morgan Guaranty , 15 1 Mortgage banking , 13 1 Mortgages: adjustabl e rate , 60 ; fixed rate, 6 0 Mote, Larr y R. , 15 7 n . 7 Muckraking investigations , 10 3 Multicollinearity, 68 , 69 , 71 , 76, 7 8 nn . 10, 13 , 1 6 Multinational bankin g corporations , 155/. Multinational bankin g organizations , 155/. Multiplier concept , 5 7 Munger, Michae l C , 6 3 Muolo, Paul , 55 , 11 2 n . 1 Mutual fun d industry , 10 5 "Narrow banks, " 2 4 National Bankin g acts/laws , 88 , 90 , 92 , 94, 95 , 121 , 122; an d panics , 9 7 National Bankin g era , 3 , 8 6 - 9 7 National Bankin g System , 110 ; critic s of, 96-97 ; destabilizin g feature s of , 9 2 - 9 3 ; illiquidit y inheren t in , 8 9

Index 17 National banks , 102 , 121-22 , 125-26 ; restrictions on , 14 2 National Cit y Bank , 95 , 99-100 , 101 , 102, 11 4 n . 1 3 National Cit y Company , 9 9 National Currenc y Acts , 86 , 8 9 National debt , 90 . Se e als o Deb t National Monetar y Commission , 94-9 5 National Reserv e Association , 9 5 Nationalization, 120-22 , 124-2 7 Nelson, R . W. , 11 3 n. 5 , 11 4 n . 1 2 New Englan d banks , 6 , 1 2 New Frontier , 5 7 Niskanen, Willia m A. , 5 1 n. 5 Nixon, Richard , 10 6 Noll, Roge r G. , 6 1 Nonbank PACs , 64 , 75-76 , 7 5 t . Nondepository financial firms, 5 , 15 4 Northeastern banks , 12 , 1 6 Noyes, Alexande r Dana , 9 6 Ocampo, Jua n M. , 1 6 O'Driscoll, Geral d P. , Jr. , 4 - 5, 21 , 48 , 50 n. 1 , 72 , 119-3 8 Office o f Managemen t an d Budget , 8 Open-market operations , 108 , 11 3 n . 5 Panic o f 1837 , 12 1 Panic o f 1873 , 9 1 Panic o f 1893 , 91 , 93 , 11 3 n . 8 Panic o f 1907 , 3 , 83 , 91 , 93-94 , 96 , 12 2 Panics, 84 . Se e als o Mone y panic s Pecora, Ferdinand , 98 , 9 9 Pecora Commission , 98-100 , 10 3 Pecora Report , 99-10 0 Pension funds , 14 3 Phillips, C . A., 11 3 n . 5 , 11 4 n . 1 2 Physical capital : misallocatio n of , 6 0 Pizzo, Stephe n P. , 55 , 11 2 n . 1 Policy perspective : deficit s in , 30 , 3 3 34, 45-46 , 4 8 - 4 9 Policy reform , 2 . Se e also Bankin g pol icy; Fisca l policy ; Monetar y polic y Political Actio n Committee s (PACs) , 3 , 7, 55-56 , 62 , 63-72 , 75 ; nonbank, 64 , 75-76, 7 5 t. Political clout , 63 , 64-65 , 66-67 , 70 , 7 2 Political regulatio n o f banking , 1- 2 Politicians: animosit y towar d bankers ,

1

95-96, 100 ; an d bankin g crisis , 73 ; and ren t seeking , 71 ; and S& L disaster, 57-59 , 61 , 6 2 Politics, 4 ; and deposi t insurance , 133 ; economics and , 50 ; and S& L crisis, 57-58 Poole, Keith , 6 3 Portfolio risk , 17 , 1 8 Portfolios, bank : changin g compositio n of, 2 1 Pozdena, Randal l J. , 15 7 n . 1 2 Private bankin g system , 85 , 94 , 10 3 Private interests , 3 . Se e also Interes t groups Private-sector performance : public-sec tor deficit s and , 2 9 - 5 4 "Problem" banks, 10 , 11 , 12 , 1 9 Product-line restrictions , 2 , 5 , 6 , 18 , 66 , 105, 110 , 141-43 , 146-4 7 Product lines , 143 , 153-5 4 Profitability, 22 , 104 , 143 , 149 ; o f depo sitory institutions , 61 ; of S&Ls , 62 ; secularly shrinking , 16-1 8 Public choice : empirica l analysi s of , 55-80 Public choic e theory , 1 , 55 , 71 , 7 6 nn . 1, 2 ; government powe r in , 84 , 85 ; reform in , 73-7 4 Public deb t borrowing , 127-2 8 Public interest , 7 6 n. 1 , 84 , 85 , 89 , 12 0 Public policy , 5 , 82 , 139 ; i n diminish ing rol e o f commercia l banking , 1 5 3 56; market force s and , 73 ; and restric tions o n banking , 14 6 Public secto r deficits : an d private-secto r performance, 29-5 4 Pujo, Arsene , 9 5 "Pujo Committee, " 9 5 Pujo report , 11 5 n . 1 6 "Pyramid o f reserves. " Se e Reserv e pyr amiding Quality deterioration , 150-5 2 Rate o f return , 29 , 33 , 3 7 Rational expectations , 1 4 Reagan, Ronald , 5 9 Reagan administration , 34 , 39 , 5 1 n. 6 Real estate , 12-13 , 14 , 61 ; loans, 2 , 16 ,

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Real estat e (Continued ) 17, 21 , 1 5 2 /. Se e also Commercia l real estat e Real estat e debacl e (1970s) , 10 4 Real interes t rates , 2 , 14 , 36 , 58 , 5 9 Recapitalization: BIF , 5-6 , 127 ; FSLIC , 6 2 - 6 3 , 67 , 74 ; S& L fund, 61 , 6 2 - 6 3 , 69, 7 0 Recent Trend s i n Commercia l Ban k Profitability (Federa l Reserv e Ban k o f New York) , 17 , 2 2 Recession(s), 9 , 10 , 12 , 13 , 14 , 45 , 86 , 87; regional/sectoral , 15 0 Reciprocity arrangements , 5 6 Redistributive programs , 5 7 - 5 8 , 59-6 0 Reform, 82 , 119 ; avoiding fundamental , 127-30; deposi t insurance , 119-38 ; public choic e perspectiv e on , 7 3 74 Reforms, 4 - 5 , 83 , 86 , 1 0 2 - 3 , 104 , 1 0 5 6, 112 ; misguided, 83 ; 1930s , 98-100 , 103; 1980s , 106 , 10 7 Regional economies , 10 8 Regional factors , 15-1 6 Regulation, 2 , 18-22 , 84 , 85 , 100 , 111 , 141, 154 ; evolutio n of , 120-22 ; justi fication of , 85 ; legislatio n regarding , 66; an d marke t share , 146-47 ; nee d for, 82 ; publi c choic e theorie s of , 5 5 Regulation Q , 104 , 14 7 Regulatory accounting , 7 , 21 , 11 2 Regulatory agencies , 9 8 Regulatory capture : b y S& L lobby , 6 1 Regulatory discipline , 14 1 Regulatory philosophies , 56 , 63-64 , 65 , 66, 69 , 71-72 , 7 6 Regulatory policy , 74 ; electora l succes s and, 73-7 4 Regulatory standards , 6 1 Rehm, Barbar a A. , 2 5 nn. 1 , 3 Rent-seeking, rents , 2 , 3 , 58 , 59 , 71 , 7 3 74 Republican party , 58 , 59 , 6 6 Reserve cit y banks , 88-89 , 9 3 Reserve pyramiding , 88 , 89 , 92 , 9 3 Reserve requirements , 88-89 , 90-92 , 98, 103 ; movement fo r repea l of , 9 2 93 Reserves, 87 , 96 , 140 , 14 1

Resolution Trus t Corporatio n (RTC) , 22 , 134 Restrictions, 3 - 4 , 85 , 93-94 , 106 , 108 , 110-11, 141-43 , 146-47 ; an d ban k failures, 97 ; a s caus e o f bankin g crises, 82 , 86 , 8 8 - 9 1 ; effort s t o avoid , 9 0 - 9 1 ; nationa l bankin g era , 89-90 ; structural, 154 ; thrifts , 1 8 Reverse causalit y problem , 68 , 69 , 71, 76, 7 8 nn. 13 , 1 4 Ricardian Equivalenc e Theorem , 30 , 3 7 Riegle, Donald , 6 2 Risk, 17 , 126-27 , 147 ; publi c debt , 40 ; thrifts, 18-1 9 Risk taking , 4 ; ba d banker s and , 131 ; deposit insuranc e and , 20 , 22 , 141; encouraged b y government , 2 , 108 ; failure t o control , 130 ; politician s and, 58 , 73 ; subsidization o f private , 61, 72 ; thrifts, 18-1 9 Rizzo, Mario , 1 Roberts, Pau l Craig , 34-3 5 Robinson, Kennet h J. , 21 , 22, 15 7 n. 1 3 Rockoff, Hugh , 11 3 n. 3 Romer, Thomas , 61 , 6 3 Roosevelt, Frankli n D. , 100 , 102 , 103 , 115 n . 2 2 Roosevelt, Theodore , 9 3 Rosenthal, Howard , 6 3 Rosenthal, Jame s A. , 1 6 Rothbard, Murra y N. , 2 6 n. 8 , 97 , 11 3 n . 5, 11 4 nn . 12 , 1 5 St. Germai n Amendmen t (HR27/S790) , 62-63, 67-6 8 Salem, Georg e M. , 15 7 n. 1 2 Sallie Ma e (Studen t Loa n Marketin g As sociation), 14 9 Salsman, Richard , 1 , 3-4 , 11 , 15, 8 1 118 Santomaro, Anthon y M. , 15 7 n . 6 Saunders, Anthony , 15 6 n . 6 Saving, forced , 4 6 - 4 7 Savings an d loa n association s (S&Ls) , 3 , 104-5, 107 ; losses , 61 ; market share , 143 Savings an d loa n crisis/disaster , 3 , 107 ; development of , 6 0 - 6 3 ; empirica l analysis o f publi c choic e aspect s of ,

Index 17 3 55-80; empirica l specification , 6 5 68; implication s fo r FDI C crisis , 7 2 74; lac k o f leadershi p in , 57-59 ; re sults o f empirica l specification , 6 8 71 Savings an d loa n industry , 5 , 8 3 Savings an d loa n lobby , 3 , 60 , 6 1 Savings an d Loa n Politica l Actio n Com mittees (S& L PACs), 61-62 ; rec iprocity betwee n congressperson s and, 55-56 , 63-72 , 7 0 t., 7 5 Savings banks , 6 , 1 1 Savings vehicles , 5 Scapegoats, 55 ; bankers as , 81-118 ; need for , 83-8 6 Schultze, Charles , 4 9 - 5 0 Schumer, Charles , 11 6 n. 3 0 Schwartz, Ann a J. , 24 , 83 , 88 , 90 , 9 2 93, 94 , 97 , 103 , 11 3 n . 5 , 11 4 nn . 14 , 15, 19 , 11 5 n . 2 1 Schwartz, Ann a Jacobson , 121 , 12 2 Second Ban k o f th e Unite d States , 121 , 135 n . 5 Secular trends , 5 , 13 , 1 9 Securities, 140 , 14 7 Securities an d Exchang e Commissio n (SEC), 7 4 Securities business , 10 2 Securitization, 16 , 111 , 14 5 Seidman, William , 8 - 9 Selgin, George , 90 , 11 3 n. 2 Senate Bankin g Committee , 56 , 6 5 - 7 1 , 75, 128 , 12 9 Seniority: an d PA C contributions , 67 , 69, 70 , 71 , 72 , 7 6 Shackle, G . L . S. , 3 9 Shaw, Lesli e M. , 9 3 Short, Eugeni e D. , 4 8 Short, Geni e D. , 21 , 2 2 Short-term credi t marke t debt , 15 3 t . Shughart, Willia m F. , II , 10 2 Silberman, Jonathan , 6 7 Small banks , 2 4 Smith, Ver a C , 90 , 11 3 n . 4 Social costs : o f deficits , 37-38 , 40 ; of inflation, 7 7 n . 5 ; of S& L disaster , 60 Solvency, 83 , 140 ; in nationa l bankin g era, 8 6

Southeast Bankin g Corp . (Miami) , 2 6 n . 7 Southwestern banks , 12 , 1 6 Specie payments , 90 , 9 2 Specie resumptio n act , 9 2 Speculation, 91 , 97 , 9 8 Sprague, O . M . W. , 87 , 91 , 93 , 95 , 113 nn . 7 , 10 , 1 1 Standard an d Poor' s (S&P) , 149 , 150-5 1 Standard o f living , 30 , 3 2 - 3 3 , 4 7 State banks , 12 2 State laws , 14 7 State regulation , 120-2 1 Sterilizing gol d flows, 11 4 n . 1 4 Stock market , 90 , 10 4 Stock marke t cras h (1929) , 82 , 97 , 99 , 101, 10 2 Stockholders: liability , 23 , 24 , 121 , 13 0 Stone, Charle s A. , 15 8 n . 1 5 Stone, Peter , 2 5 nn. 1, 4 Structural reform , 6 Supervision, 74 , 127 , 13 0 Supervisory refor m (proposed) , 13 4 Supply price , 63 , 64 , 6 5 Supply Sid e Coup , 77 n. 6 Supply sid e economics , 5 7 "Systemic risk, " 13 7 n . 1 1 Tallman, Ellis , 84 , 11 3 n . 8 Tax code , 30 , 36 , 5 1 n. 6 , 6 1 Tax reform , 5 1 n . 6 Tax shelters , 5 8 Taxes, taxation , 2 , 30 , 36 , 41 , 49 , 59 ; distinct fro m borrowing , 5 1 n . 4 ; an d spending, 4 9 - 5 0 Taxpayer liability , 122 , 125 , 130-3 1 Taxpayers, 4 , 5 , 6 , 7 , 9 , 22 , 40 , 56 , 107 , 146; cost s to , 132-33 , 154 ; and S& L disaster, 59-60 ; subsidizin g bankin g industry, 7 3 Taylor, William , 5 Technology, technologica l change , 2 , 5 , 139, 143 , 144-46 , 147 , 15 3 Telecommunications, 5 , 14 5 Term loans , 11 0 Texas, 16 , 22 , 123 , 13 6 n. 7 ; bank fail ures, 1 3 Thomson, Jame s B. , 13 7 n . 1 1 Thrift industry , 3 , 22 ; regulation an d

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Thrift industr y (Continued ) deposit insuranc e i n crisi s of , 18-19 , 20, 11 1 Thrift industr y debacle , 7 , 107 , 108 . Se e also Saving s an d loa n crisis/disaste r Thrifts, 2 , 6 0 - 6 1 , 104 , 107 ; insolvent , 18, 61 ; lending power s of , 10 6 Timberlake, Richar d H. , 23 , 91 , 9 6 Todd, Walker , 4 - 5 , 72 , 119-3 8 Too bi g t o fai l doctrine , 4 , 21 , 72 , 73 , 107, 126 , 132 , 133 , 13 7 n . 1 1 Transfer o f wealth , 4 - 5 Treasury Bil l rates , 10 5 Treasury bills , 5 , 4 1 Trust-busting, 93 , 9 5 Ulan, Michael , 5 1 n . 5 Ulbrich, Holly , 5 1 n. 7 Uncertainty(ies), 2 , 7 7 n. 4 ; deficit-in duced, 29-30 , 32 , 33 , 36-37 , 3 7 - 4 1 , 42, 43 , 45-46 , 4 7 - 4 8 , 49 ; multitier , 35-36 Unemployment, 14 , 85 , 9 7 U.S. Congress . Se e Congres s U.S. Justic e Department , 106 , 10 8 U.S. Saving s an d Loa n League , 6 7 U.S. Treasury , 9 , 4 0 - 4 1 , 42 , 90 , 9 2 - 9 3 , 102, 121 , 148 ; credit line , 127 ; an d distinction betwee n loan s o n goo d collateral an d unsecure d loans , 1 2 9 30; full-faith-and-credi t claim s on , 132 Unregulated bankin g systems , 8 2 Valley Nationa l (Phoenix) , 2 6 n . 7 Veribanc, 9

Voting behavio r (congresspersons) , 3 , 56, 63 , 65 , 67 , 68 , 70 , 7 1 Wall Street , 39 , 5 1 n. 6 Wall Stree t banks , 95 , 9 6 Wallace, Myles , 5 1 n. 7 Wartime deficits , 4 5 Watson, Ronald , 7 6 n . 3 Weingast, Barry , 6 1 Welch, Willia m P. , 77 n. 8 Welfare state , 8 4 Western banks , 1 6 Wheeler, Burto n K. , 10 0 Wheelock, Davi d C , 122-23 , 13 6 n. 8 White, Eugen e N. , 11 3 n. 4 , 13 6 n. 7 White, Lawrenc e H. , 7-28 , 72 , 11 3 n. 2 , 126 White, Lawrenc e J. , 1 9 "Why the Deficit Hysteri a Is Unjustified " (Roberts), 34-3 5 Wildcat banking , 3 , 8 2 Willis, H . Parker , 100-10 1 Wilson, Woodrow , 9 6 Woodward, Susan , 2 6 n . 1 1 World Wa r I, 84 , 9 4 World Wa r II, 14 3 Wright, James , 6 2 Young, Catherine , 2 5 nn . 1 , 2 Zion, Uri , 77 n . 8 Zissu, Anne , 15 8 n . 1 5 "Zombie" institutions , 5 , 11-12 , 18 , 19 , 21-22