|Too Big to Fail' Is Too Important To Throw Away

The "too big to fail" concept is essential to a healthy financial system and a thriving economy. The U.S. government should promote the idea visibly and clearly state that federal deposit insurance will not be tampered with -- now nor ever.

Without such assurances, our nation's banking system will remain at a competitive disadvantage with respect to those whose safety is assured. Moreover, U.S. banks will continue to avoid risk-taking; their balance sheets will wind up looking like those of the 1930s.

"Too big to fail" promotes a healthy banking system - one that stimulates economic growth. Any stepping back from the doctrine creates liquidity crises, bank failures, and no-growth economics.

In the 1920s, banking companies were lending 54% of their assets, or 71% of their deposits. The economy was healthy, and the system was not stressed.

As the 1930s began, the Federal Reserve panicked, creating a severe liquidity crisis during what had promised to be a moderate recession.

The monetary crisis was compounded by the lack of any safety doctrine to protect the banks. The implicit doctrine, therefore, was: "Protect thyself - at all costs."

A Terrible Lesson

By 1934 the country had experienced a bank holiday, was well entrenched in the Great Depression, and had seen half its 10,000 banks fail.

The surviving banks had learned a terrible lesson; they were united behind the concept that the risk associated with lending money was far greater than any conceivable potential reward from this activity.

By 1940, as World War II began, an incredible 73% of bank holdings were in cash or securities. The country could not have asked for a safer banking system - or a worse economy.

Even when the war had ended and national incomes had risen, banks were not lending money. In 1946, 78% of their assets were in cash and other investments.

For every $1 the banks had in loans, they had $2 in government bonds. One form of investment was protected; the other was a "wild card" gamble. The safe, assured return of 2% on a long-term government bond was far preferable to the uncertain return from making a loan.

How different is the situation today?

In the past 12 months, according to the Federal Reserve's Weekly Consolidated Condition Report of Large Commercial Banks in the United States, American banks actually sold $10 billion dollars of their loans and bought $15 billion of U.S. government securities. Clearly, the 8% return on a long-term government instrument is superior to the "wild card" gamble of making a loan.

Our banking system is getting safer. And our economy is weakening.

Guaranteed Solution

The government's problem in the 1930s was how to persuade lenders to put funds into the private sector. The answer was simple: "Guarantee their funds."

Laws were pass to provide the requisite guarantees. Bank and thrift deposits were insured, so depositors took their money out from under the mattress and put it back into depository institutions. Loans were also guaranteed in certain sectors so that financial intermediaries would put the newly obtained deposits into the private sector. (Mortgage guarantees were the most enduring.)

The process was slow and agonizing, but it ultimately worked. Unlike the aftermath of World War I, the post-World War II era was one of great prosperity.

Regulatory Panic

It is clear that in the past few years the regulators have panicked, as the Fed did in the early 1930s. This time, however, the well-crafted system put in place in the 1930s held together to prevent the type of liquidity crisis experienced at that time.

The problem today is that the people who make banking policy are trying to repudiate the foundation of that system, which has worked superbly for half a century. They are casting doubt on the network of guarantees that made the system work.

The regulators argue publicly that no bank in the United States is too big to fail. Legislators try to water down the basic insurance guarantees that enticed depositors back to the banks. And regulators and legislators alike regularly tell the American public that the banks are suspect, and that hundreds are likely to fail.

Foreign Banks Move In

The competitors of the American banking system are not unmindful of what is being done through such gross ineptness. They are selling the safety of their banking systems to our country's big-ticket depositors.

According to reports I have received and believe, some large corporations are being approached by foreign banks that say their governments' belief in "too big to fail" is a reason for the depositor to switch funds. Who among the readers of this article believes that the Swiss, British, Japanese, or German government would let its large banks fail and depositors lose money?

The Federal Reserve report I have cited here illustrates the enormous instability of American bank balance sheets.

In the past 12 months, $43 billion of short-term borrowings have left the system, and demand deposits have dropped by well over $8 billion.

Nervous big-ticket depositors have pulled $23 billion out of CDs larger than $100,000. Bankers have scrambled to replace this money by offering a variety of savings or nontransaction deposits and increasing other liabilities, including various types of long-term debt.

Who Gets Hurt?

This instability is occurring largely because the United States government has lost faith in its banking system. This is apparent in the legislation offered by the Treasury Department, which places its faith outside the system to reestablish credibility.

The administration wants nonbanking companies to sweep in as white knights to rescue the system. Little is being done to rebuild confidence in the existing system.

In essence, the United States government is betting that non-banks can handle the financial needs of the U.S. economy while the traditional banks contract.

For some - notably, the investment banking types who run the U.S. Treasury - this is not such a bad bet. Their constituents, the large corporations, would do quite well.

A Disaster for the Economy

But for others the result would be disaster.

Our favorite government report shows that loans to commercial and industrial corporations fell by $13 billion dollars in the past 12 months. Which companies? The midsize ones, which employ the largest number of American workers.

Let me restate, in the starkest terms, what this Federal Reserve report is saying:

* While large U.S. companies tap international markets for necessary funds, American banks are taking money away from midsize companies to invest in Treasury bills.

* The banks are opting for liquidity because don't know whether they can hold onto their deposits. The doubts come from Washington's repeatedly raising the issue of whether it should continue to protect deposits.

This process is not ending, it is just beginning. Why? Because it is the policy of the U.S. Treasury Department.

Safety Doctrine Isn't Expensive

Our government must change course. It must stimulate risk taking within the banking system and assure depositors that money in the system will protected.

This is not a costly policy. It promotes economic growth, which in turn stimulates tax payments, which in turn cut Treasury debt.

It is regrettable that the taxpayers must come up with so much money to bail out the savings and loans. Failings in the private sector and in government led to this necessity.

However, these tax dollars come from the interest payments that those failing S&Ls made to those same taxpayers. Thus to some extent it is a zero-sum game, and one that kept the economy healthy. The alternative would have been a depression.

Furthermore, all the learned pronouncements that banks and thrifts take unusual risks because they have little to lose if their investments fail are pompous hogwash. Ask the former chairmen, presidents, and loan officers of failed banks and thrifts in the Southwest and New England how much they benefited when their institutions went under. Ask current bank managers whose institutions are benefiting from FDIC insurance if they believe they can take risks with impunity.

I can see little disadvantage from having a "too big to fail" doctrine. There is even less risk in maintaining FDIC insurance at current levels. It is financial lunacy to even suggest a step backward from these concepts.

Mr. Bove is a banking consultant with the Bove Group in Chatham, N.J.

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