Twenty years ago it was commonly believed that deposit insurance had put an end to banking instability. But now quite the opposite seems to be the case, particularly as the idea of insuring bank debt has spread from the United States to other countries and to international protection through International Monetary Fund largesse.
The history of banking crises worldwide during the last 20 years reveals how damaging safety nets can be. Though some see the recent experience as proof of banks' inherent instability, the last 20 years, when contrasted to earlier eras, stands out as a uniquely unstable and costly era, with events that have shown the flaws in bank safety nets.
Losses to U.S. depositors during the Depression (the negative net worth of banks) were 4% of domestic gross domestic product. Though enormous by historical standards, such losses are now commonplace. Since 1982 there have been some 90 banking crises worldwide that have produced losses comparable to, or in excess of, the U.S. experience during the Great Depression. In about 20 of those cases, losses have exceeded 10% of GDP, and in half of those 20 cases, losses have reached more than 20% of GDP.
At the same time, the recent volatility of aggregate demand and supply shocks has been small in comparison with those of other eras (including the 1830s, 1850s, 1890s, and 1930s). The last 15 years have seen positive and relatively stable growth in demand worldwide and an absence of oil price shocks or other supply-side disturbances. What, then, has produced the unprecedented wave of banking loss?
A mountain of academic research links the expansion of government bank safety nets to the new banking "mega-crises" worldwide. The details of crises vary, but the essential pattern (which fits the U.S. S&L debacle of the 1980s, the Mexican collapse of 1994, the recent banking crises of Thailand, Korea, and Indonesia, and the demise of Japanese banks in the 1990s) is the same: When banks know they can count on government bailouts, they and their creditors have strong incentives to assume higher asset risk and leverage, especially in response to adverse shocks that reduce bank capital.
The upside profits from taking such risk belong to protected banks' stockholders. The increased downside risk of bank debt is absorbed by taxpayers, not bank stockholders or debtholders. That protection explains why bank debtholders are willing accomplices in excessive risk taking. And government supervisors of banks throughout the world repeatedly have turned a blind eye to bank losses and risks, because they lack the skills and the incentives to discipline banks.
Policymakers refer to the need to modernize the "architecture" of the financial system to deal with new banking system risks, but they often mistake the sources of those new risks. Rather than expand the scope of safety nets, they should consider a "back-to-the future" approach.
From the perspective of the 1980s and 1990s, late 19th century capital markets and banking systems offer an enviable blueprint-one based on credible market discipline, not ever-expanding safety nets. Banks knew that excessive risk taking would be penalized by the marketplace, just as productive investment opportunities would be rewarded by inflows of funds. That system was not perfect, but from the perspective of the 1990s it looks better every year.
Of course, deposit insurance, for better or worse, is here to stay.
What is needed is a way to introduce market discipline into the deposit insurance system. The key ingredient here is a mandatory requirement that banks raise a minimum portion of their funding in the form of credibly uninsured debt, subordinated to insured bank debt.
Doing so would force banks to satisfy market perceptions that their risk is sufficiently low, or suffer market-induced contraction of their risky assets. Such an approach would stabilize banking systems' responses to adverse shocks, and protect taxpayers. Plans to impose such a requirement have been proposed by the Federal Reserve banks of Chicago and Atlanta since 1988.
Now the Senate Banking Committee is considering the possibility of adding a subordinated debt requirement to existing bank capital requirements.
Not only would such a requirement strengthen the banking system and protect American taxpayers, it would open the way to significant deregulation of banking services, by removing the potential for abuse of deposit insurance.
The recent consolidation wave and expansion of powers in American banking has redressed structural inefficiencies, but concerns about the abuse of deposit insurance remains an important impediment to further deregulation.
Concerns that expanding bank powers might unwittingly increase the safety net "subsidy"-a recurrent theme of Fed Chairman Alan Greenspan's congressional testimony-must be addressed, and market discipline is the way to do it.
Today, the path forward in banking deregulation requires that we borrow a page from the past by restoring credible market discipline as a core principle of sound banking.