Deposit Insurance Deja Vu

by Kurt Schuler

The mess in the savings and loan industry is the worst thing to happen to the American banking system since the Great Depression. As an indication of how severe the problem is, government estimates of the cost of bailing out bankrupt savings and loans, which were $30 billion a few months ago, rose to $60 billion, then to $160 billion. And the cost is rising by $1 billion for every month that the federal government lets 350 bankrupt savings and loans stay open because it hasn't budgeted the money to pay off their depositors.

American taxpayers will be footing the bill for this because the federal government guarantees almost all bank deposits. The rationale of deposit insurance is that it is cheaper than the banking panics that supposedly would result without it. But the history of deposit insurance in the United States and other countries indicates that it is neither necessary nor desirable. Outside the United States, deposit insurance, even where it exists, has not been needed. Competition has forced foreign banks to develop nationwide branch networks and to diversify into lines of business forbidden to American banks. This has resulted in the creation of large banks that are very secure because they spread their risks among many regions and types of activity.

In the United States, deposit insurance has been rarely self-financing because government regulation has prevented competition from evolving the strongest banks possible. Indeed, deposit insurance crises are almost as old as deposit insurance itself. The Federal Savings and Loan Insurance Corporation's current problems have many precedents. Besides Federal deposit insurance, the United States has had about 30 state deposit insurance schemes. Nearly half operated before the Great Depression, and half since. Their experience has been dreadful. All but a few have gone broke. A brief look at their history shows what we can expect again if Congress doesn't use the current Federal bailout as an opportunity to free our financial system from the stranglehold of regulation.

New York State started the first deposit insurance system in 1829. Banks paid a tax of 3 percent of their capital into a common "safety fund." New York City banks, which were among the largest and most stable in the nation, opposed the fund. However, the more numerous rural banks influenced the state legislature to establish it. The safety fund's purpose was to instill public confidence in bank notes, although it also covered deposits. (Apparently, the legislature did not intend deposits to be covered, but they were because the law it enacted was careless on that point.) The safety fund benefited rural banks most, because their profits depended more on note circulation. Five other states imitated New York in setting up compulsory bank insurance systems before the Civil War.

The first to fail was Michigan's. It has been in operation only a year when the panic of 1837 dragged down most of the state's banks. Payments into Michigan's insurance fund barely covered supervisory costs, so creditors of failed banks got nothing. A few years later, eleven bank failures depleted the New York fund. The state government eventually issued bonds to bail it out, much as the Bush administration has proposed doing for the FSLIC. But some creditors waited as long as 21 years for payment. A single failure was enough to bankrupt Vermont's fund in 1857. Creditors there got less than two-thirds the value of their claims.

Michigan, New York, and Vermont effectively closed their insurance funds when the funds went broke. Indiana, Ohio, and Iowa had funds that stayed solvent. Oddly, the solvent funds had more potential for causing trouble than the others. Healthy banks were liable for paying failed banks' creditors if the insurance funds should be exhausted. Hence, severe losses at a few banks could have wiped out all banks in the state. However, strong industry pressure counteracted the temptation, in effect, to play fast and loose with other banks' capital.

In contrast to the systems that went broke, where bank examiners were government employees, in the solvent systems they were largely chosen by and responsible to the banks. The number of banks was small -- 41 in Ohio, 20 in Indiana, and 15 in Iowa. That made group action against imprudent banks possible. Today, when Federal deposit insurance covers thousands of banks, savings and loans, and credit unions, this element of the successful state systems would be impossible to duplicate. Ohio and Iowa also reduced the risk to their funds by guaranteeing only notes, which were being eclipsed by deposits as the chief type of bank liability.1

By 1866, changes in Federal banking law induced most banks to switch from state charters to Federal charters. Despite a Federal prohibition on branch banking, Federal charters were attractive because they allowed banks to continue issuing notes. State-chartered banks, in contrast, faced a 10 percent tax on note issue that made it prohibitively expensive. The Indiana, Ohio, and Iowa insurance funds closed still solvent when their members got Federal charters. The savings and loan industry began in earnest at the same time, as a product of a provision in the same law that severely restricted Federally chartered banks' ability to make mortgages. (These restrictions lasted until the 1970s. Since then, most of the other legal barriers separating banks from savings and loans have fallen as well.)

Bank notes effectively carried a Federal guarantee from the 1860s until Federal Reserve notes replaced the last of them in 1934. Issuers had to back notes 100 percent or even 110 percent with Treasury bonds, kept in a Treasury vault. But notes were becoming decreasingly important compared to deposits as the main form in which almost everybody held money.

The federal government did not insure deposits, despite many proposals in Congress from 1886 onward that it do so. William Jennings Bryan and other populist politicians favored deposit insurance as a way of protecting small depositors and small banks. Leading bankers thought differently. Near the turn of the century, the First National Bank of Chicago's president expressed their objections to deposit insurance in these words: "Is there anything in the relations existing between banks and their customers to justify the proposition that in the banking business the good should be taxed to pay for the bad; ability taxed to pay for incompetency; honesty taxed to pay for dishonesty; experience and training taxed to pay for the errors of inexperience and lack of training; and knowledge taxed to pay for the mistakes of ignorance?"2

Such arguments deterred the federal government from insuring deposits, but not some states. Oklahoma established deposit insurance in 1908. Seven southern and western states followed suit within the next decade. Their systems insured from 100 to 1,000 banks apiece.

Washington's, the last started, was the first to crack. The depression of 1921 depleted its insurance fund. Since the system was voluntary, many healthy banks deserted it rather than suffer the high fees it would have imposed, and it shut down. The same happened to the other voluntary fund, in Kansas. In the other states, where deposit insurance was compulsory for state-chartered banks, low crop prices throughout the 1920s broke many rural banks, leaving depositors clamoring for their money. By 1930, all the funds were broke. Texas's system eventually paid off depositors in full, but elsewhere depositors lost at least 15 percent of their claims. The North Dakota fund, the worst of the lot, paid only $1 of every $1000 in claims, and even after a taxfinanced bailout, depositors lost three-quarters of their deposits.3

Despite the unfavorable experience of the state deposit insurance systems, the federal government established nationwide deposit insurance in 1934. The failure of nearly 10,000 banks since the Great Depression began in 1929 put pressure on the federal government to do something. Many prominent economists and bankers advocated branch banking as the best cure for the American banking system's instability. They pointed to foreign systems that allowed branch banking, where failures had been few. In particular, they saw Canada, where no banks failed during the Depression, as a model for the United States to emulate.

However, the political clout of small banks and the worse than usual public image that big business had at the time kept branch banking from getting political consideration commensurate with its economic merits. Federal deposit insurance, once established, seemed to stabilize the banking system. The banking panic of 1933 was responsible for much of the good reputation that Federal deposit insurance enjoyed. It wiped out the weak banks that would have put the greatest strain on Federal insurance funds had they begun in 1933 instead of 1934, when the panic was over.

Since 1934, 14 states have chartered deposit insurance systems for certain banks and savings and loans not covered by Federal insurance. Though nominally private, most state insurance systems have been so enmeshed in local politics as to be in reality off-budget government agencies designed to shelter members from the rigors of competition. Their history has been as blighted as that of their predecessors.

New York and Connecticut closed relatively short-lived funds intact decades ago when their members voluntarily switched to Federal insurance. Funds have failed in half of the remaining states -- Hawaii, Nebraska, Ohio, Maryland, Colorado, and Utah. The 1985 Ohio and Maryland failures required millions in tax money to pay depositors in full. The aftershocks prompted most states with solvent insurance systems to require all participants to switch to Federal insurance by 1990. Only three funds still offer insurance for banks lacking Federal insurance. One, in Kansas, is winding down as its members leave it. The others, in Pennsylvania, cover just a handful of tiny banks. State deposit insurance is in effect dead.4

The only truly successful state funds were those of North Carolina and Massachusetts. Their good performance was the result of incentives more closely resembling those of the free market than other state systems faced. The story of North Carolina's Financial Institutions Assurance Corporation is particularly interesting because the fund started in 1967 as "a good old boys' hideout from Federal regulation," as one of its officers later recalled. A new president appointed in 1977 brought in a new management philosophy. The law governing the fund was changed to require a majority of its board of directors to be unaffiliated with member institutions. (The lack of such a provision in the Ohio and Maryland deposit insurance funds encouraged self-dealing. Unlike the pre-Civil War Ohio fund, the latter-day Ohio and Maryland funds had no counterbalancing liability features to make their members keep an eye on each other's operations.)

The North Carolina fund began basing the premiums it charged its members on the riskiness of their portfolios. It increased the minimum net worth for members to quality for insurance from it. Furthermore, it closely monitored members' lending practices. For instance, it induced members to reduce their fixed-rate mortgages several years before the rest of the savings and loan industry began having problems with fixed-rate loans. In every respect, the North Carolina fund's actions contrasted sharply with those of the FSLIC, which was vulnerable to political pressure from members, did not adjust insurance premiums for risk, had lower net-worth requirements, and did little to prevent members from making reckless loans.

The North Carolina fund's record was outstanding. Its stress on preventative measures, and the incentives it gave for its members to avoid making overly risky loans, kept any of them from failing. However, the Ohio and Maryland collapses cast a pall over all state deposit insurance systems. The North Carolina fund closed voluntarily, without losses, when many of its members decided to get Federal insurance. At about the same time, the Massachusetts funds, which benefitted from that state's long tradition of conservative banking, switched roles from substitutes to supplements to Federal deposit insurance.5

Of all state deposit insurance systems, then, few have been really successful. The others have existed too briefly to undergo a true test of strength, have folded up at signs of trouble, or have failed. Now Federal deposit insurance is duplicating state deposit insurance's sorry record. The cause is the same: too many insured banks, mostly small, unable to withstand bad luck and bad management.

Other countries, by allowing nationwide branch banking, have gained the stability the U.S. hasn't been able to achieve. Competitive pressures have resulted in very large banks, so solid that they do not need deposit insurance and, in most placed, do not have it. It is true that West Germany's small Bankhaus Herstatt failed in 1974 and Italy's scandal-ridden Banco Ambrosiano failed in 1982. But there have been no other noteworthy bank failures in developed nations. Britain, which has had nationwide branch banking longer than almost any country, has not experienced a major bank failure since 1878.

Every large Western country except Italy has deposit insurance. But in all except the United States, deposit insurance is a recent innovation, dating from the 1960s or 1970s. The banking systems of those countries took their present shape, and enjoyed stability, long before they got deposit insurance. Furthermore, foreign deposit insurance systems encourage depositors to monitor the health of their banks, which the American system does not. In some countries -- notably West Germany -- the systems are voluntary, so banks that fear that imprudent rivals are trying to take advantage of the system can quit it. In Britain and Switzerland, insurance doesn't pay for the full amount of depositors' losses, but only for, say, three-quarters.

Common to all foreign deposit insurance systems is that they have much lower maximum limits than the American system -- from one-half to one-tenth as much -- and that foreign governments are more serious about imposing those limits in practice than the American government has been. The possibility of suffering losses encourages depositors to entrust their money only to well-managed banks. Depositors abroad rely mainly on the quality of the banks themselves rather than on government insurance for protection.6

The exception that proves the rule occurred in Canada, whose federal deposit insurance system is most like that of the United States. In 1985, two Canadian banks went bust in Alberta -- that country's equivalent of Texas. Previously, no bank had failed since 1923. The Alberta firms, both founded in the oil boom of the mid-1970s, were small and undiversified, resembling U.S. banks more than the five nationwide giants that have 80 percent of Canadian deposits.

Canada instituted compulsory deposit insurance in 1967 despite the protests of its large banks, who foresaw that it would be their premiums that would pay for small rivals such as the Alberta banks. The government guarantee helped convince depositors to let the Alberta banks take imprudent risks with their money. The failure of the Alberta banks threatened to deplete the deposit insurance fund. To prevent a run on the two banks, the Canadian government pressured the big banks to take them over. When losses turned out to be larger than expected, the government backed out of its previous assurances to the big banks (which technically were not binding), causing them to bear the costs of the small banks' bad management.

Unrestricted nationwide branch banking, such as Canada and other countries have, is scheduled to arrive in the United States in 1991. That will be too late to save hundreds of ailing banks and thrifts. Congress should remove barriers to branching now. In particular, it should allow any bank to buy any savings and loan. (Currently, banks can buy only ailing savings and loans.) Small banks and savings and loans would oppose such a step, because it would make them takeover targets for expanding money-center and "super-regional" banks. But the alternative for many of them is to go broke, putting further strain on the Federal deposit insurance system and on taxpayers.

Deposit insurance has repeatedly proven to be not selffinancing under our artificially fragmented banking system. On the other hand, it wouldn't be necessary under a less regulated banking system. Ultimately, Congress should set a date -- say, ten years hence -- to abolish deposit insurance. At the same time, it should tear down the walls it has erected separating banking from securities, insurance, and commerce. Banks should be allowed to spread risk across lines of business just as branching enables them to spread risks across regions.

American banks are suffering at home and in world competition because the cannot engage in many profitable lines of business open to their foreign competitors. Given freedom, the U.S. banking system can become strong and flexible enough not to need deposit insurance. The alternative is to suffer another crisis when changing economic needs run up against outmoded regulations.

1. Federal Deposit Insurance Corporation, Annual Report, 1953, pp. 45-67; Federal Deposit Insurance Corporation: The First Fifty Years, a History of the FDIC, 1933-1983 (Washington: FDIC, 1984), pp. 13-24.
2. James B. Forgan, "Should National Bank Deposits Be Guaranteed by the Government...?" Address to the Illinois Bankers' Association, June 11, 1908. (Chicago: First National Bank of Chicago, n.d.), p. 3.
3. FDIC, Annual Report, 1952, pp. 59-72; Eugene Nelson White, The Regulation and Reform of the American Banking System, 1900-1929 (Princeton: Princeton University Press, 1983), pp. 188-222.
4. FDIC, Annual Report, 1950, p. 67; Victor L. Saulsbury, "The Current Status of Non-Federal Insurance Programs," Issues in Bank Regulation, Spring 1985; FDIC Regulatory Review, Sept.-Oct. 1987.
5. Catherine England, "Private Deposit Insurance That's Worked," Wall Street Journal, June 18, 1985, p. 30.
6. William M. Isaac, "International Deposit Insurance Systems," Issues in Bank Regulation, Summer 1984, p. 80.