FDIC: No Savior Then or Now

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If you think the US banking system has problems now, ninety years ago this month a new President shuttered the entire banking system for a week. Knock on wood that does not happen again, as we would likely get a dangerous central bank digital currency (CBDC) out of it. But some good might still come of the current crisis if policymakers would only look to history for clues.

Every major financial crisis since the Panic of 1907 has led to some government intervention that has created yet-bigger problems down the road. The crisis in 1907, which was largely caused by the Great Quake in San Francisco the year prior, led to the creation of the Federal Reserve System (“the Fed”). That institution was supposed to implement Bagehot’s Rule (which should be called Hamilton’s Rule) during crises. In other words, it was supposed to lend freely at a penalty rate to all borrowers who could post sufficient collateral. Instead, in the 1930s, during a severe economic downturn that it helped to cause, the Fed largely watched as wave after wave of bank failures sank the US further into what we now call the Great Depression.

Come November 1932, frightened American voters ousted incumbent Republican Herbert Hoover from the Oval Office, in favor of New York governor Franklin Delano Roosevelt (FDR), a rich politico crippled by polio. Cunningly, FDR ran as a moderate, attacking Hoover for spending too much. After securing election, however, FDR and his so-called Brain Trust group of advisors started making radical noises about going off the gold standard and taxing the rich and such. As his inauguration on Saturday, March 4 approached, a wave of bank failures began, inducing many governors to declare statewide bank “holidays.” Upon taking office, FDR declared a nationwide “holiday” effective Monday, March 6. That meant no deposits or withdrawals; even the Fed district banks shut down.

What happened next was brilliant in its own way. On Sunday, March 12, FDR took to the radio for the first of his famous “fireside chats.” During the 13-minute monologue, he first thanked the American people for accepting the shutdown calmly. Then he clearly, accurately, and succinctly explained how the country’s fractional reserve banking system worked. Then he explained that he had shut down the banking system because perfectly sound institutions were being destroyed by runs on their deposits. That part of the speech established his credibility by telling Americans what they already knew in plain, frank terms.

Next came the Big Lie. During the week, FDR and Congress had worked together “patriotically” to rebuild the nation’s “economic and financial fabric.” The situation was so dire that the government had worked at unprecedented speed to differentiate sound banks from unsound ones. Only the sound ones would reopen, and with sufficient cash “to meet every legitimate call.” This newly printed money from the Bureau of Engraving was “sound” because it was “backed by actual, good assets.”

FDR then provided credible-sounding details. The next day, banks in the twelve Federal Reserve cities adjudged by the Treasury to be sound would reopen. On Tuesday, banks adjudged by the clearinghouses to be sound in some 250 US cities would reopen. Starting on Wednesday, banks in more remote areas would reopen subject to “the Government’s physical ability to complete its survey.” He made clear that all banks that passed unspecified “common sense checkups” would receive federal assistance and would reopen, even if they were chartered by states and not members of the Federal Reserve system. “I am confident,” he said in his radio-friendly voice, “that the state banking departments will be as careful as the National Government in the policy relating to the opening of banks and will follow the same broad policy.” He also claimed that it was safer to put money into a reopened bank than “under the mattress.”

As for the banks that would not be allowed to reopen, they would be reorganized, with help, if necessary, from the federal government’s Reconstruction Finance Corporation, one of the expensive boondoggles that FDR had berated Hoover for creating. FDR explicitly did not promise, however, that individuals would not suffer losses. He then thanked the American people again for taking the shutdown in stride and put the fate of the system in their hands. “Together,” he closed, “we cannot fail.”

As banks reopened over the following week, depositors, on net, returned the funds they had hastily withdrawn in previous weeks. The “chat” served its purpose well by establishing the new President’s credibility and even likability. This was, of course, before he took everyone’s gold and started jailing people for opposing him politically or not going along with his centralized economic planning scheme, the Blue Eagle. The remarks stand in stark contrast to the general banalities made by George W. Bush during the Global Financial Crisis, and the curt statement about the Silicon Valley Bank failure recently made by Joseph R. Biden. In short, FDR had the twin advantages of not yet being reviled by a large portion of the population, and of being an effective communicator.

Again, FDR explicitly did not insure deposits, he only promised the soundness of banks that reopened. It is therefore strange that, in the popular mind, the Federal Deposit Insurance Corporation (FDIC) often gets credited with the banking system turnaround. The FDIC’s official website links to FDR’s March 12 speech and claims that it was formed “at the depth of the most severe banking crisis in the nation’s history,” though the legislation creating it was not passed until mid-June and the FDIC did not have a chairman until mid-September, well after the bank holiday crisis had passed.

It is true that the US did not suffer from massive waves of bank runs again until the 21st century, but that record is hardly attributable to the FDIC. For decades after the New Deal, banking regulators engaged in financial repression by mandating the maximum interest rates that banks could pay for deposits, and imposing other rules that constrained competition and risk-taking. The United States also became the world’s dominant economy after World War II, its dollar the equivalent of gold. The FDIC’s sole job during that long period of prosperity was to close down a few small unlucky or poorly run banks.

Another federal deposit insurance scheme, the Federal Savings and Loan Corporation (FSLIC, often pronounced Fizzlick) supervised and insured the deposits of a now largely defunct type of savings bank called a Savings and Loan (S&L). Financial repression of S&Ls, combined with the Great Inflation of the 1970s, forced rapid deregulation. That saved the S&Ls temporarily but allowed them to engage in new, risky activities, like buying foreign bonds and oil-prospecting loans, which soon put many of the institutions in the red. Instead of shutting them down, though, FSLIC decided to keep them afloat, which in most instances merely led to bigger losses ultimately borne by taxpayers. The situation became so bad that the government shut down its own agency, transferring its responsibilities to the FDIC.

Deregulation of the commercial banking industry in the 1990s found the FDIC wholly unprepared, largely because it did not understand the lesson from FSLIC or its own effects on banker behavior. By rendering depositors docile and inattentive, the existence of deposit insurance, particularly with premiums not adjusted for risk, allows bankers to increase profits, but at the cost of increasing the likelihood of failure. Many economists believe that deposit insurance is actually a net negative, because US states and foreign countries with more deposit insurance have less stable financial systems, especially when regulators allow financial institutions to be competitive and innovative. Rather than a savior, then, the FDIC is unnecessary and even pernicious, and expanding insurance to previously uninsured depositors, as was recently done in the SBV case, is likely to lead to more and bigger bank failures.

Note, too, that the FDIC did not completely stop bank runs from occurring during the 2008 crisis,  nor during the present unpleasantness. True, nothing like the waves of failures that struck three times during the Great Depression have returned as of the time of writing, but then again, even the Great Recession, the COVID Recession, and whatever the US economy is experiencing now did not come close to matching the Depression’s duration. 

Moreover, a private remedy shunted aside by the New Deal might well prove superior to deposit insurance. It imposed double liability on bank stockholders, making them keen to find the right tradeoff between bank profitability and riskiness and inducing them to monitor bank behavior closely. It is true that double liability did not help to thwart the Depression’s bank-failure waves, but that was because many states did not actually enforce the liability rule strictly enough to have the intended effect on incentives.

It is not clear that some sort of enhanced stockholder liability has yet returned to the Overton Window, but it is possible that Americans will point out the hypocrisy of the Biden administration’s raising taxes on the rich with one hand while bailing them out with the other. Scaling back deposit insurance, combined with a credible policy of putting failure costs onto their rightful owners, stockholders, instead of onto taxpayers might become politically possible. It sounds progressive, yet smartly done could also be sound policy.

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