The proposal now before Congress to give a preference to the Federal Deposit Insurance Corp. in bank liquidations is extremely misguided for a number of reasons.
Most important, the proposal is wrong from a systemic point of view. Few people seem to realize that recent changes in the banking laws have made the banking system rather brittle. That's because these changes have taken away the sources of liquidity that weaker banks have used to fund outflows.
Currently, a run on a bank by uninsured depositors is distinctly possible if the bank reports a few adverse events.
The major changes that have taken place can be catalogued as follows:
* The brokered deposits rule now prevents less-than-well-capitalized banks from paying up to attract insured deposits in an emergency.
* The new deposit insurance pass-through rules make pension funds and similar pooled funds vulnerable once a bank is not well capitalized.
* The new requirements that force the FDIC not to pay off uninsured deposits in many cases already threaten uninsured depositors.
* The prompt corrective action rules threaten uninsured depositors much earlier in a bank's trouble cycle, making it likely that sophisticated depositors will withdraw their money much earlier.
* The new restrictions on the Federal Reserve banks' ability to lend to troubled institutions make depositors more worried still. In practice, these new rules may make it more difficult for the Federal Reserve Board and the FDIC to deal with runs.
The new laws have made it more certain that the Continental Illinois experience will be repeated. Banks will fail because of liquidity problems before they are close to balance sheet insolvency.
This phenomenon is intended by the theorists of the 1991 banking law. It puts depositor discipline into the system and thereby discourages the taking of risk by banks.
It also results in early closure and thereby, it is said, reduces the risk to the deposit insurance fund.
Cost of Bank Failures
The first problem with this approach is that it fails to take account of the natural cost of bank failures. That is, based on experience, it appears that a failure depreciates all but the most liquid assets on a bank's balance sheet by something like 20%.
A failure, therefore, should be avoided where possible not just to preserve an institution that may have been valuable to its community, but also because failure is inherently wasteful.
Some observers would advocate that the elimination of excess capacity is beneficial. There are, however, better ways.
The second problem with the depositor discipline approach is that it threatens to change the nature of banking by banks overly risk-averse.
This phenomenon has contributed to the credit crunch and may continue to cause credit to be unavailable to some types of borrowers who relied on bank credit in the past.
The new volatility also may place U.S. banks at a competitive disadvantage in competition with foreign banks.
Invitation to Runs
Foreign banks do not live under such such rules and they do not have to disclose as much about their operations. They therefore may appear to be stronger than similarly, situated U.S. banks.
Adding a preference for the FDIC to the already substantial tendency of the new rules to create runs would not be a good idea.
Today a large depositor knows that if it's gets caught when the music stops, it will suffer a loss of some percentage of its deposit.
If the large depositor knows that it will lose its entire deposit, the flight to safety will take place at a very early stop indeed, and the system will become both more concentrated and more prone to general runs when cataclysmic events occur.
And make no mistake about it, such cataclysmic events, while infrequent, will occur. Neither law nor technology has repealed the basic cyclicality of capitalist economies.