No. 9004
BANKING
REFORM
by
Gerald P. O'Driscoll, Jr.*
February 1990
Research Paper
Federal Reserve Bank of Dallas
N o . 9 0 0 4 BANKING REFORI.'
by
G e r a l d P . O ' D r i s c o l l , J r . *
February L9 90
*Vice Presldent and Associate Director of Research, Federal Reserve Bank of
Dallas. Prepared for Kewin Dowd and Mervyn Lewis, Current Issues in Monetarv
Analysis and Policy. The views expressed in this article are solely those of
the author and should not be attributed to the Federal Reserve Bank of Dal1as
or to the Federal Reserve System. I rrould like to especially thank George
If the U.S. econonry has performed so rernarkably for sewen years, its banking system has surely been an enbarrassment. How can an econouy that has
grown consistently for more chan seven years have a banking system in such disarray? In 1988, the slxth year of an expanslon, the economy generated 3.5 m i l l i o n n e w j o b s - - o v e f 3 0 0 , 0 0 0 e a c h r n o n t h . l In the same period, 200
commercial banks failed -- a post war record. Concomitantly, 12 percent of the nation's savlngs and loans were Lnsolvent according to generally accepted accounting principles. The nation,s thrift industry ls being all but
n a t i o n a l l z e d i n t h e p r o c e s s .
I n t h i s p a p e r , I o f f e r a d i a g n o s i s o f w h a t w e n t w r o n g w l t h the U.S. banking system and examlne some proposed remedies. Only by understanding the Plesent situation one can appreciate why so many banking reform proposals have recently been offered. Many deal only with syrnptoms and not causes,
attempting to stop a financial hemorrhage r,rith a policy Band-Aid. In the first half of the paper, I focus on proposals that identify and address the causes of the banklng crisis. Nonetheless, these take for granted most institutional features of the monetary and banking systems. In the second half, I examine some even more fundarnental reforms that have been recently put forth. I begln with an examination of the thrift crisis that curlently grips the Unlted States, The crisis encompasses all of the problems plaguing
banklng. It is noteworthy only because the problens afe preselt to such a heightened degree axnong savings and loan associations.
The Thrift Cris is
It is difficult to exaggerate the magnitude of rhe problens in the U.S. thrlft industry. President Bush proposed and Congress irnplernented a $157 billion bailout of insolwent thrifts, prevlous efforts hawing conspicuously
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failed. Uost recent anong these was the late but not lamented ,,southwest Plan, " which enwlsioned merging insolwent savings and loan associations wltll solvent ones to form a larger and more viable institution. The Federal Home Loan Banking System, the supervtsory agency overseelng the nation,s savings and loans, lras so constrained by political conslderatlons that the plan was dooned from the beginning, First and forenost, Congress newer provided the Federal Horne Loan Banking System wlth enough money to resolve the problern.2 The System had $10.8 blllion with which to iraplemenr rhe Sourhwesr plan which was not enough even to resolve the insolvent savlngs and loans in Texas.s Second, opposltion prevented the Systen from merging institutions into viable interstate or even statevrlde lnstitutions. The lack of
geographical diversification had contrLbuted greatly to the economic losses incurred by thrifts. Localisrn was to be preserved as a natter of public p o l i c y .
Finally, when all else is said, the Southwest Plan was flawed in a wery basic way: The plan had been trled once before and failed. The Southwest Plan reincarnated the nphoenix" progran of the early 1980s, which merged two or more failing thrifts into one larger entity. The Federal Savings and Loan Insurance Corporation (FSLIC) injected new funds into the instituti.ons and replaced nanagement. The policy was predicated on the belief that one larger insolwent instltution is better than two snaller ones. Whatever the
attraction rnight have been originally, the plan failed in its irnplementat ion. FSLIC found it difflcult to extricate itself frorn the mesa- ins t i tutions it had c r e a t e d ( K a n e , 1 9 8 5 , p p . 5 - 6 ) .
The Southwest Plan was supposed to be dlfferent because it would attract p r i v a t e c a p i t a l a n d p e r m l t a rapid withdrawal of FSLIC,s equity position. N o t
nuch private capital was attracted, however, and FSLIC retains a substantial iropllclt investment positlon. The new o!,rrers wefe largely irnmunized frorn losses. Any posttive present walue these new phoenlx flrms possess reflects the FSLIC guarantee. A balance sheet accurately reflecting market values of assets and liabtllties would enter the guarantee as an funplicit equlty
investnent. Llkewise, an accurate representation of the goverfiIlent's own balance sheet would show the guarantee as a uasslwe taxpayer liability.
If not conpletely natlonalized, the new phoenix instltutlons still have a large FSLTC lnvolvenent. If the past is any guide, these undercapitaliz ed institutions will hawe a difficult tine surviving. Some will probably end up back in the care of the deposit insurer. The rnain point here, however, is that the Southwest Plan as implenented repeated many of the mistakes of the phoenix program. once the Federal Home Loan Bank Board saw thaL sufficient prlvate capital nould not be forthcoming, it should have withdrawn the p]-an. To go ahead in disregard of its onn previous policy failure makes the Bank Board culpable no matter r,rhat the constralnts were under which it was o p e r a t i n g .
P r e s i d e n t B u s h ' s p r o p o s a l m a k e s e x p l i c i t w h a t h a s l o n g b e e n i m p l i c i c : the necessity for the taxpayer to undervrrite the losses accruing frorn
successLve public policy fallures in the thrift industry. The proposal also signals the end of the Southwest Plan. Finally, the proposal renoves the thrift crisis frorn the status of a reglonal problern to a national one. For these and other reasons, the plan is laudable. It does have the potential, however, for mlsdirecting polic1'rnakers' attentlon and, possibly, sowing the seeds of an even larger financlal crisis in the future.
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As constituted, the plan suggests thac money !s the gg!34[4 to the thrlft crisis. Certalnly, an injection of funds nust be an eleDent in any plan. But lack of rnoney, specifically capital, is not the primary cause of the current crlsis. The savings and loan industry dlsslpated billions of dollars of capital that it onee had. Understanding how indtwldual
instltuttons could not only perrnit thetr capital to dissipate, but also rnove deeply into the red ls fundanental to any pernanent solution. Ttlat
understanding has yet to take hold anong policymakers. It requlres insight into how federal deposit insurance operates.
Before discussing the role of deposit insurance, I offer a perspective to non-American readers. Focusing on deposit insurance may strike you as parochial, But deposit insurance is only the peculiarly American forrn that blanket financial quarantees of the banking systen have taken. Any policy
that effectively undenrfites banking losses produces moral hazard and invites Amefican style banklng problems. As Europeans look to 1992, they need to consider the incentives generated by thelr public policy toward banking. Among other things, they need
public policy towards banking n o t i m i t a t e d .
DeDosit Insurance
l e a r n t o a l l o w i n s o l v e n t b a n k s t o f a i l . U . S . one American idea that should be discarded.
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In the simplest terms, insurance constltutes an lntertemporal exchange between the insured and the insuref. Ttle insured trades a flxed loss or ourqo each period (the premium) for a promise that he will be indernnifled against Iosses of a stated kind, but an uncertain amount, for the life of the insurance contract, The insured gains because he forgoes a srnall sum in r e t u r n f o r p r o t e c t i o n a g a i n s t a p o t e n t i a l l y g r e a t e r l o s s . T h e i n s u r e r g a i n s
5 b e c a u s e , b y p o o l l n g r i s k s o f n a n y i n s u r e s , b a s i c p r i n c i p l e i s q u l t e s i r n p l e , p r o w i s i o n
can earn a Profit. Though the
insurance is a cornplex natter.
Many of the provlsions of an insurance contract are designed to specify the exact rlsks covered and the amounts of the coverage. other provisions are designed to constraln the insured's behavior in the future, because possession of insurance establlshes perverse incentives, Havlng insurance reduces the lncentives for the insured to avoid the rlsk against which he has been
insured. Such behawlotal change, by increasing the frequency of occurrence of the risk, would alter the probability calculus underlying the insurance
contract: What would have been a profitable transactLon for the insurance company might becorne unprofitable (Arrow, L97I, p. L42).
Fire insrfance provides a readily understandable example. A homeowner cowered by flre insuxance will, on the margln, Eake fewer precautions than he r,Tould were he exposed to the entire rlsk of loss due to fire. Notice that 1 am not assuming that he will deliberately lncrease the risk of fire. (Such behavior might occur if the house were insured for more than its value.) Risk
is sornething that individuals x0ust incur costs to avoid. Being insured against a particular risk reduces the return to rlsk awoldance. Insured individuals will, therefore, reduce their effort at the margin to avold the r l s k , C o n s e q u e n t l y , f i s k y o u t c o m e s i n c r e a s e .
A situatlon in which opportunlstlc behavlor wlll result in greater risk is called moral hazard, Sound insurance is structured to awoid moral tr'azaxd, or offset its effects with countervailing incentives. In the case of flre insurance, underwriters r"rill both prescribe and proscribe certain
behavior so as to reduce the probability of loss. The insurance contract will norrnally lnclude a deductible anount, so the insured bears sorne of the cost of
he o f
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opportunistic behavior. The presenee of such features ls essential to the vlability of insurance as a commercial product.
Since 1-933, the U.S. government has provided for lnsurance of bank d e p o s i t s . e I n i t l a l l y s e t a t $2,500 per deposit, the insured amount has risen over the years. In 1980, Congress raised the coverage frorn $40,000 to
$ 1 0 0 , 0 0 0 . I n d i w l d u a l s a r e c o v e f e d f o r u p t o $100,000 at each depository lnstitution. Since there are approxlmately 1,4,000 separate conmerclal banks i n t h e U n i t e d S t a t e s , o n e i n d i v i d u a l c o u l d t h e o r e t i c a l l y h o l d $ 1 . 4 b i l l i o n l n insured deposits at cornmercial banks. Additionally, there are the nation's thrift lnstitutions, savings and loans, plus credit unions. Furthernore, by holding Jolnt accounts and accounts in trust for others, an lndlwidual can multiply several fold the tnsured deposits in each bank.5
Federal deposit insurance has always been provided in an unsound
fashion. Speclfically, the premir.rms charged are unrelated to the riskiness of the bank's portfol-lo. Thus provided, deposlt lnsurance skews the choice in favor of lncurring additional losses. An investor can generally l-ncrease the probability of earning higher returns if he is wilting to incur additional-r i s k o f l o s s ( S h o additional-r t a n d 0 ' D additional-r i s c o l f , 1 9 8 3 , p p . 1 4 - 1 - 5 ) , A r a r i o n a l i n v e s t o r weighs uhe expected returns agalnst the risk of loss, and decldes whether an investment's expected returns conpensates for the probability of loss.
Normally, various rnarket signals are sent to an investor undertaking a risky actlvity. If he has purchased lnsurance protection for the activity, he will face rising premiurns as the risk increases. The higher prerniurns will
tend to restrain risk taking by increasing its cost. In the case of banking, this channel is blocked. It turns out, however, that blocking this channel also interferes with the transnisslon of other potential rnarket signals.
I
Crediuors of rny hypotheticaL lnvestor wlll ordinarily make the same risk-return declsion as the investor. As the tl.sk of hls investment
increases, creditors will demand higher returns. Accordlngly, the investor will pay higher interest rates on borrowings the riskler is the proposed investment project. We observe the phenonenon in a wide variety of contexts. Well established firrns in predictable lines of business pay less to borrow than staru-up flturs in netr and untested business ventures. B-rated bond i s s u e s p a y a h i g h e r r e t u r n t h a n A - r a t e d i s s u e s .
We hawe not historically observed the relationship in banking
--certainly not to the sarne degree. While riskier banks hawe had a higher cost of funds, the differentlal has tended to emerge not when the risk was taken, but only after problerns developed. To be an effective price signal,
any premium must affect risk taklng ex ante. Moreovef, the roagnitude of the differentials ln banks's funding costs have historically not approached those f o r n o n f i n a n c i a l c o r p o r a t i o n s ( S h o r t , 1 9 8 7 ) .
Because of misprlced deposit insurance, the deposit market does not adequately constrain risk taking by banks. The narket for deposits is the most inportant one for pricing rlsk in banking because banks enter it daily. By contrast, banks issue new equity shares or subordinated debt infrequently. In the United States, nost banks are small and will never issue either debt or new equlty once establlshed. If the deposit narket does not work, then banks will- not teceive timely narket signals as they alter their risk exposure. Consequently, they w111 tend to incur too much risk (giwen the expected r e t u r n ) .
Depositors are not irrational. The sarne indiwiduals who tgnore a bank's tisk of fallure carefully investigate the risk of their nonbank investnents.6
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The incentives generated by deposit insurance explaln the apparently
inconsistent behavlor. DeDositors behave as if thev are not at risk because thev normall]r are not. Deposits at insured banks have no rlsk of loss so long as their account balances are within the insured linits. At large banks, d a p o s l t s o f a n y s i z e c a n b e h e l d r i s k f r e e . T h i s l s b e c a u s e o f t h e ' , t o o b i g to fail" doctrlne that protects large banks from failure, In an ornlnous development, regulators have in one lnstance -- Continental lllinois National Bank -- indernnified all creditors, depository and nondepos itory, of a failed bank.7 Blanket guarantees of safety anesthetize credit markecs, dulling the s e n s e s t o r i s k .
Many factors can generate losses on bank portfolios, The relevant Policy question, howewer, is why so many bank managers have permitted losses to nount, erodlng capital and threatening their viability of their
institution. And, if managers have allowed this to happen, why have
depositors funded the losses? In other words, what is the SJSlCgtg cause of the current banking problerns in the United States? llisprlced deposit
insurance has played a criuical role in the emergence of these problems. Insolwent banks ate currently open for business and attracting deposits, And attract funds they must, because they are using insured deposits to cover dal1y operating losses. Institutions known to be insolvent can attract funds only because deposit insurance imrnunizes the depositor from loss. The
deposltor is effectlvely depositing his uroney with the governnent, not the bank
-Not only do insolvent lnstitutions garner funds in conpetitive deposit markets, thelr stock trades at a positive price. This makes no sense in ordinary accounting terms, unless one realizes that the stock trades with a
Y
put option on the deposit insurance fund. For a firm to be lnsolwent means t h a t i t s l l a b i l i t i e s e x c e e d i t s a s s e t s , A c c o r d i n g l y , i t s e q u i t y v a l u e o u g h t to be negative. A positlve share price, however, irnplies posltive equity value. What gives? What gives, or who gives, is the taxpayer. The equlty rnarkets clarify lrhat accounting practices obfuscate -- deposlt lnsurance guarantees ate an unbooked asset on the balance sheets of deposltory i n s t l t u t i o n s . I n d e e d , K a n e ( 1 9 8 5 , p , 2 3 ) h a s e s t l m a t e d r h a r r h e U . S .
government is 'rthe leading supplier of equity funds to deposlt lnstitutions. " Put ln the most straightforward way, deposit insurance constltutes a blanket guarantee against losses to depositors. By protecting deposltors, however, deposlt insurance also Lnsulates stockholders and managers agains! near-tern effects of excessiwe fisk taking. Managers are free to engage in strategies that 'rbet the bank" on particular outcomes. If they wln, managers book the profits. If they lose, the deposit insurance picks up the tab for
a n y l o s s e s i n e x c e s s o f b a n k c a p i t a l
Critics point to the lo!, level of capital, particularly equity capital, in U.S. depository institutions. Sone see this as the cause of current difficulties. Consequently, many have called for tougher capital standards. There ls no questlon that bank capltal has eroded ln recent years and that a healthy dose of capital tould screngthen depository institutlons. But actions
to lrnprove the capital positions of banks will not address the fundamental problern of lncentives. With deposit insurance, who needs capital? It is a wonder that banks have any at all. Mlsprlced deposit Lnsurance
encourages the substitution of public for private capital.
Uncovered creditors (for example, holders of subordinated debt) will inslst that the bank have sorne equity capital . In recent years, the demands
l-0
hawe becorne more lnsistent as these cfedltors have watched the rising bank failure rate. Most banks do not issue any subordinated debt, honever. To a significant extent, banks are holding as much capital as they do only because of regulatory pfessure. Where that pressure has been relaxed and supervision lax -- as ln the savings and loan lndustry -- capital levels are lower than in the rest of the banking systen.
If lncentives are not changed, coupelllng banks to hold nore capital nay Just be increasing the anount to be dissipated by risk taklng. True, nore capital lengthens the period in which regulators can identify problero institutions. But the ragulatory record does not nake one sanguine that regulators will avail thenselves of the opportunity, Seweral factors contrlbute to the problem.
Fifst and foremost, the incentive structure rlilitates against the abllity of regulators to sufficiently constrain bankers' behawlor. Bankers stand to capture the gains from financial innovations. For every form of risk taking constrained, bankers have found two new ways to take on roore risk in the search for higher returns. The lure of higher profits w111 always make it feasible for banks to pay inventive employees more than regulatory ageneies can compensate methodical examlners. If an exarniner happens along who
outmaneuvers the best and brightest products of the nation's business schools, a depository instltution will likely lure hirn away.
Second, regulators Judge bank solvency according to accounting
principles that value assets at cost or book walue, The economic solvency of a bank depends on market values, however. The discrepancy between hlstorical or accounting walue, and economic or r0arket walue, can be quite large. It is certainly large enough to permit a bank to stay withln regulatory standards,
t 1
but be utterly insolvent if lts assets and liablllttes were marked to market, If taxpayers are to be protected against future losses, a market-valued
accounting system uust be introduced.
Third, it is practically lnpossible to supervlse adequately all the number of depository instl-tutions in the United States. Conmercial banks alone nuqber approxinately 14,000. The ktnd of close supervl-slon necessary to prevent loss to the insurance fund is beyond the resources concelwably
available to the superwisory agencies.
Finally, supervisory respons lb il- ities are diwided be reen federal and state goverrments. (This dlvision is raThat is neant by "dual banking" in the Unlted States. ) It would be naive to expect the federal and state
bureauctacies to keep at all times in as close contact as rpould be necessary to adequately supervlse banks. Additionally, the interests of federal and state banking regulators do not always coincide. State regulators generally take a Posltlon as nore of an advocate for the interests of the banks they supervise than do their federal counterparts. More inportantly, the deposit insurance agencies are more attentive to the effects of public policy on their funds than are the other regulators, be they state or federal.
All thlngs considered, lt is too rnuch to expect any system of supervision and regulatlon to offset perverse incentives established by financial safety nets like the present deposit insurance systen. To stralghten out the mess, policy makers need uo get the incentives right.
G e t t l n 8 i n c e n t L v e s r i g h t , h o w e v e r , s e e m s t o b e j u s t w h a t t h e p o l l t i c a l s y s t e n s e e r n s le a s t c a p a b l e o f d o i n g . I f t h e p e s s i m i s t i c a s s e s s r n e n t i s a c c u r a t e , t h e n the present crisis has the potential to be repeated -- probably within the next decade. And each repetlcion brings greater federal goverrunent
involveuent and further moves to de facto nationalization of banking in the U n i t e d S t a t e s ( K a n e , 1 9 8 5 , p . 1 3 ) .
other factors have contributed significantly to the current Lhrift
crisis. Previous regulation of savings and loans can only be described as lax -- at both the state and federal levels (Kane 1989). When sawings and loans experienced losses, the Federal Hone Loan Bank Board engaged in "capital forbearance.'r The policy further relaxed capital standards. To put lt straight forwardly, regulators allowed the industry's actual capital posltlon to affect the capital regulations, rather than the other way around.s Now the taxpe.yer will be payi.ng the piper.
One nust be wery careful not to confuse cause and effect. The existence of deposit Lnsurance leads banks to lower capital below what it ra'ould
o t h e r w t s e b e . A d d i t i o n a l l y , r n i s p r i c e d d e p o s i t i n s u r a n c e r e s u l t s i n e x c e s s i v e risk taking that often erodes what capltal there is. Increasing capital
requlrements, howewer, is not a substitute for altering the lncentives set up by deposit insurance.
. Deoosit Insutance Reforn
Virtually every tnaj or public policy problen in banking derives fron the existence of mlspriced deposit lnsurance. If deposit insurance is not
actually the cause of the problem, it is the chief obstacle to reforrn. 0n1y recently, however, has the deposit insurance system become the focus of
banking teform proposals. That it has done so is testimony to the suddenness with which the consensus on the deposit insurance systern has changed.
In their monumental work on banking history, Friedrnan.and Schwartz ( 1 9 6 3 , p . 4 3 4 ) c o n c l u d e d that "federal deposit insurance of bank deposlts was the most inportant structural change in the banking systen to result from the
I J
1933 panic, and, i.ndeed ln our view, the structural change most conducive to nonetary stability since state bank noEes wefe taxed out of exlstence
irnmediately after the Civil War." In other words, deposit insurance was a goverrunent program that worked -- even from a classical liberal,s perspective. Friednan and Schwartz,s statenent at once summarized economists, view at the time and shaped it for years to come.
Besides deregulatlng deposit liabilttles and broadenlng asset powets for thrifts, the Carn-St Gernain Act nandated that the deposit insurance agencies reexanlne the Lnsurance protection afforded commercial banks, savings and loans, and credit unions. This produced a flurry of studies at the various federal bank regulatory agencies. The studies, though well done, languished. The moral hazard inherent in the deposit insurance system was evident to many, but it was not the tlne to act polltically.
It is now apparent to nearly al] that the deposic insurance system is broke in nore ways than one (Garcia 1988). Through rhe end of 1988, there have been 878 cornrnercial bank failures in the 1980s for an annual average of 98. In 1989, 207 banks insured by the Federal Deposit Insurance Corporation (FDIC) falled. Meanwhile, 262 savings and loans have been intervened and are being operated under FDIC supervision.s These figures compare with an annual average of 6 cornmercial bank failures in the period L946-79, Recorded
failures undoubtedly understate banking ptoblerns. If assets and liabilities were valued at market rather than historical prices, additional banks ruould surely be rewealed to be insolvent. FSLIC is broke and the FDIC'S fund is s t r a i n e d .
Suddenly, substantive reforrn of deposit insurance is a serious
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And the topic appears on aluost every banking progriun, Yet all the proposals take as given the political lmpossibility of conpletely aboltshlng federal deposit insurance,10 Consequently, ln one way or another, each proposal involwes conDromises.
B e n s t o n , e t a l ( 1 9 8 6 , p p . 3 0 4 - 1 4 ) a d v o c a t e a f a l r l y t y p i c a l r e f o m package for FDIC lnsurance, Fifst, the authors recornmend establishing risk-elated premiums for deposit insurance. They prefer joining this with a systen of risk-adjusted capital standards. Next, they suggest several alternatlves for reducing coverage. These include a selectLve rollback of the de jure c o v e r a g e f r o m $100,000 ro 50,000 or $25,000. Finally, they argue rhau
Ptemlums should be coll-ected based on the riskiness of the entire portfolio of the hol-ding company. Th"y rejec! the idea that the rlsks of nonbank
actlvities can be functlonally isolated from them.11
l n a n e a r l l e r a r t l c l e , S h o r t a n d O ' D r i s c o l l ( 1 9 8 3 ) p r o p o s e d a p l a n designed to facilitate a transltl"on to conpetitive provLslon of deposit insurance. They proposed that de facto coverage above statutory llnits be eliruinated; coverage lirnits be introduced, and some form of coinsurance developed. These proposals were each intended to address the moral hazard inherent ln the current systen, Additionally, they recommended a number of other actions to open the door to private suppliers of deposit insurance. They did so on the views that, wiLhout competitlve markets, it would be
imposstble to systenatically price the risk. The FDIC could renaLn as a supplier of deposit lnsurance, but its rnonopoly needed to be eliminated.
F l a n n e r y a n d P r o t o p a p a d a k i s ( 1 9 8 5 , p . 8 ) a d v a n c e d t h e c r i t i q u e o f a governmental agency's attempting to prlce rlsk.
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P u b l i c i n s t i t u t i o n s ' d e c i s i o n s a r e s u b j e c t to publlc scrutiny. Such scrutiny can involve lengthy debates, appeal
pfocedures, and conprouises between e c o n o m i c e f f l c l e n c y a n d p o l i t i c a l n e e d s . Even the rnost well-neanlng and efficient publlc institutions move wlth glaclal speed compared to the rapid assessment of information and the continuous
reassessment of risk that takes place in the financial markets.
Aslde from the public choice critique, there afe addltlonal difficulties with reform proposals llke those offered by Benston, et al. Analysis suggests that narket forces are likely to effectively undermine many of the suggested reforrns that are lnstituEed. For lnstance, there does not appear to be
coverage 1ow enough to prevent most depositors from securing as rnuch insurance prolectj.on as they desire. Money-market brokers routinely place funds in lots as small as $L,000. With cornmercial banks and thrifts nurnbering in the
thousands, financial markets could reallocate even large sums into many smaller lnsured accounts. Any successful proposal surely must incorporate sone form of deductible or coinsurance. Yet any such proposal would run afoul of the political conrnLtrnent to protecting srnaller depositors.
Deposlt insurance was crafted to protect not the snall depositor, but a s y s t e m o f u n e c o n o m i c a l l y s m a l l and undiversified b a n k s ( O , D r i s c o l l , 1 9 8 8 b , p p . 2 - 5 ) . E c o n o m i c f a c t , h o w e v e r , c a n n o t s u r m o u n t t h e o b s t a c l e o f t h e p o l l t i c a l nytholo8y surrounding the snall depositot. Unless the rnythology is
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successfully countered, deposit insurance reform will be unsuccessful. Even the $150 billlon cost of the thrift crisis has not shaken the faith of the s y s t e m t s s u p p o r t e r s . P e r h a p s o n l y a s e c o n d b i l l o f s i m i l a r s i z e w i l l a w a k e n Anerican taxpayers to the system's cos!.
Other banking reform proposals attenpt to offset the effects of deposlt lnsurance by perforrning more radical surBery on the banking system. Robert L l t a n ( 1 9 8 6 , 1 9 8 7 a n d 1 9 8 8 ) h a s p r o p o s e d i n p l e m e n t i n g a u o d l f i e d v e r s i o n o f 100 per cent banking -- the old "Chicago Plan" for banking. Hls plan
envlsions highly dlversified flnanclal holdlng companles (akin to universal banks), which would conprise both tradltional corunercial banking services as well as a broad range of additlonal financial services. His plan enwislons carving out a narrow subset of banking services; only these services could be f u n d e d b y i n s u r e d d e p o s i t s . " , . . T h e , b a n k , . . . w o u l d e s s e n t i a l l y b e a n o n e y -n a r k e l f u -n d , p e r u i t t e d t o i n v e s t i n h i g h l y l i q u i d r s a f e ' securities, s u c h a s obllgatlons of the United States Treasury and high-quality cornmerclal paper"
( L i t a n , 1 9 8 6 , p , 1 0 ) . T h e f i n a n c i a l h o l d i n g c o m p a n y , s o t h e r a c t i v i t i e s c o u l d be funded by anything except insured deposits.
L i t a n ' s i n g e n i o u s , i f s o m e w h a t c o r n p l e x , p l a n t e s t i f i e s t o t h e l e n g t h s reformers must go to offset the effects of deposit insurance. Viewed in isolation, Lhe plan makes little sense. I{hy institute a legally separate lnstitution for lnwesting in very safe and liquid assets? Tlte answer, the only answer, is the existence of a blanket guarantee for deposits. To render that systern safe and sound, the assets purchased rrith the deposits x0ust themselves be immunized from risk -- Litan,s plan would largely accomplish this task at the cost of potentlal inefficlencies in the financial systen.
L I
The inefficiencies rnay be preferable, however, to the losses being generated under the current sys tem.
One telli-ng crllicism of the Litan proposal can be made. The proposal suggests that deposit lnsurance only be offerbd on transaction accounts backed 100 per cent by highly liquid and safe assers. Yer rhe financial system has already developed a similar system: noney-market rnutual funds. Notabty, however, these accounts are not insured, In the United States, they have groum phenomenally, and now contaln rrrell over 9300 billion in assets.
O ' D r i s c o l l ( 1 9 8 8 a , p p . 673-14) questioned whether a broad systern of lnsurlng deposlts of a safe and sound banking system would meet a market test. The experience of money-market mutual funds suggests that deposlt insurance would not be required 1n such a system. Further, if banks were coEpelled to provtde such insurance on transaction accounts, they would likely lose even more market share to noney-market mutual funds, The latter have been consistently lower cost providers of funds. It appears, then, that Litan,s proposaL uright be a case of overkill. If we could get banks to hold the appropriately safe asset portfolios, then deposit insurance would be unnecessary.12
Market forces and leglslative changes at the state level are evolving a systen of rnore diverslfied regional, if not natlonal banks. These
developmenus are to applauded, as they nay partlally offset the effects of d e p o s i t i n s u r a n c e ( 0 ' D r i s c o l l 1 9 8 8 a ) . B r o a d e n i n g b a n k p o w e r s t o p e r m i t
greater asset diversification nould further strengthen the U.S. banking system ( B e n s t o n , e t a I . , 1 9 8 6 , p p . IZ7-59). I t i s u n l i k e l y , h o w e v e r , t h a r t h e U . S . banking system will be safe and sound until deposit insurance is e1lmlnated or signif icantly changed.
1 8
Sorne banklng reform proposals now go significantly beyond addressing deposit insurance. These proposals question basic features of the exlsttng banking systern. In the next section, I examine some of thern and analyze the
l s s u e s t h e y r a i s e . Banking Reform
Robert Lltan's plan constltutes a transition betrueen reform ptoposals designed sirnply to deal with the moral hazard generated by the current deposlt insurance system, and those proposals envisaging nore far-reaching changes in the commercial banking system. A move to 100 per cent banking would be a signiflcant change in commercial banking. In the context of Litan,s proposal, the move is probably not a rnaj or one. Yet he ftopllcltly raises the question of whether substantial changes ln the structure of the banking system are needed. l^lhat the proposals I now consider have in conmon is that they each provide an affirmative answer to the question.
A11 of the proposals examined here advocate a highly deregulated
financial systen in which there is no role for central banks, Since Europeans are now debating ra'hether to have a European central bank, the questions raised by the ltterature are particularly relevanr roday. i{htte (1984) is rhe nosr influential recent r,/ork on the historical perforrnance of free banking. He e x a n i n e d t h e S c o t t i s h c a s e . In a series of articles, R o l n i c k a n d W e b e r ( 1 9 8 2 , L983, L984, and 1986) reexamined the American free banking experience.13
I d h i t e ( 1 9 8 4 ) a r g u e d t h a t , ludged by accepted criteria, t h e S c o t t i s h system of competltive and unregulated free banking performed weII historically ( 1 7 1 6 - 1 8 4 4 ) . 1 4 The banking system was safe and relatively s t a b l e . W h i l e there were bank failures, these did not generate uncontai4ed runs or sysEemic failure. The Scottlsh banks compared particularly well to the unstable
Engllsh banking system, whose source of strength was the Bank of England. I,Ihite found the Scottish system to be stable despite the absence of a central b a n k .
In her important but neglected book on central banking, Lutz (1936) aptly described the American banking system as one of ', decentralization
without freedou.'r To this day, the American banking system reflects a public policy of an uneconomically large number of sroal1 banking unlts. In conrrasr, l l h l t e ( L 9 8 4 , p p . 3 3 - 3 4 a n d 8 2 - 8 4 ) idenrified t h e s y s t e m o f n a t i o n r , ' i d e b r a n c h banking as playing a crucial role in stabilizing Scorrish banks by imnunizing them from local do\^mturns. Additionally, ln ttre U,S., regulators have
traditlonally prescrlbed and proscribed assets for bank portfollos.
Particularly important in nany states was the requlrement that lnstltutlons chartered under the free-banking staEutes hold state bonds as collateral for notes issued. Purportedly designed to ensure that notes were backed by safe assets, the requirenents look rnore like a scheme designed to stimulate denand for the sometines dubious paper of antebellum state goverrunents. In sone cases, new banks could acquire depreciated state bonds and deposit thern with the state banklng cornmissioner, who valued them at par. The banks then issued liabiliuies ln the forn of bank notes against the lnflated value of the bonds. This policy effectively made rhe banks insolvent from their inception. In periods of rislng interest rates, the gap betrreen accounting and Darket values of the bonds increased. If a bank experienced a run, Lt would be unable to redeem all its notes. This made for a system of unsound banking and gave free b a n k i n g i t s b a d n a m e a n o n g h i s t o r i a n s .
Rolnick and lJeber thus dealt with a system of free banklng more alike in name than akln in substance Inrith the Scottish systen. yet they found that the
2 0
system was not lnherently unstable. That is, problems "were caused by economic shocks that caused nany banks lead to bank runs or panics" (Rolnick and l,Ieber, 1986, I.Ieber (1984) found that the role played by state bonds the state bond prograrns represented bad public policy, t o f r e e b a n k s ( W h l t e , 1 9 8 5 , p p . 8 9 1 - 9 5 ) .
The recent work on free banking has generated a litefature that reassess free banking historlcally and
faced by free banks to falL but did not p . 8 7 8 ) . R o l n l c k a n d w a s s i g n i f i c a n t , Y e E not an elenent inherent
large and growing t h e o r e t i c a l l y . Lacking, however, are prograns for applying the inslghts to contenporary monetary insEitutions. Advocates face the classic problem of getting frorn here to there. So Lt becomes a question of creating or ewolving parallel
i n s t i t u t i o n s , 1 5
In a separate strand of literalure, a numbar of authors offer proposals for fundamental institutlonal change. Less grounded in hlstory, the
literature is more dlrected to the financial future. The critlques of the cufrent banking system also focus sornewhat more on Dacroeconomlc issues than o n n l c r o e c o n o r o i c p r o b l e r n s ( e . g . , p r i c e s t a b i l i t y c o r n p a r e d t o b a n k f a i l u r e s ) .
Intellectual and hlstorical priority in the literature is surely held by Black (1970). He imagined the future evolution of banking. It would be world in whtch banks were free to offer any variety of depository liabilities and price them as they choose. In Black's world, banks cease to be lnstitutions whose distinctlveness lies in their producing money. In this world, "money"
is an abstract unit of account and banks the place in which exchanges of goods are registered. The unit of account is no longer a means of payrnent, and there is no Longer any cifculating nediun. The unit of account is a kind of rnnemonic for reglstering exchanges and entering loans and repa)menls in units
of equLvalent value, There ls no reason to fear of restflct the creation of bank deposits -- their supply is conpletely endogenous to real transactions. Reserve requirenents would be absent, so there would be no reason for open market operations by a central bank. rln such a lrorld, lt would not be posslble to give any reasonable definitlon of the quantity of money, The pa)nnents uechanlsm in such a world would be very efficient, but noney ln the u s u a l s e n s e w o u l d n o t e x l s t , , ( B l a c k , L 9 7 0 , p . 9 ) .
O ' D r i s c o l l ( 1 9 8 5 ) a r g u e d that, both historically a n d t h e o r e t i c a l l y , circulating money would not disappear. Largely unregulated banking systens haVd produced no observable tendency for circulating money to disappear. Moreover, Black's banking system is theoretically incomplete. Any banking systern requires somethlng conslituting final settlement between banks. By tts nature, the good constltuting final palrnent cannot itself be a liability
of one of the banks. I,Ihat the good is has varied over time, but it ls base noney in all its instantiations. We can perhaps contrive a world without circulating currency, in which deblt cafds substitute for currency and coin. B u t w e c a n n o t c o n c e i v e a b a n k i n g s y s t e m w i t h o u t a m e a n s o f s e t t l e m e n t , i . e . , banks reserves or base money. Thus, the llrnltaElon on bank deposits is not a contrivance but a natural phenomenon,16
D e s p i t e t h e f a u l t s i n B l a c k , s a r r i c l e , i t s m e r i t s h a d a s i g n i f i c a n t influence on subsequent authors. Though clearly derivative, Farna (l-980) further developed Black's vislon of an unregulated pa1nrents systen.
G r e e n f i e l d a n d Y e a g e r ( 1 9 8 3 ) c o n s t i t u t e a g e n u i n e e x t e n s i o n . T h e y p r e s e n t a blueprlnt for implenentlng a Black-Fama payments system. They advocate the system because of what they vievr as the poor nacroecononic performance of fiat money, whose supply is unresponsive in uhe shor! run to changes in money
dexnand. There is no stability of value in our current xnonetary system, because purchasing power is only what the demand and supply for money fleetingly accord to a dollar, pound or franc.
Conpllcating the problems is the fact that noney has no market of its own. Consequently, monetary disequilibrium must be worked out in 4!! rnarkets. Further, prices are inflexible in the shor! run. ',Under these realistic
clrcunstances, failure to keep the quantity of money correctly and steadily managed can have momentous consequences" (Greenfleld and Yeager, 1983, p. 309). They conclude that nonetary authorltles are not up to the task of so precisely nanaging a fiat noney supply. They view Black,s vision as
inplementable and desirable.
Key to their proposal is the government, s defining a unit of value, just as lt does unlts of weight and measurenent. They suggest a unit of value encompassing a broadly representatiwe bundle of tradable corunodities. The cornmodities chosen, however, need not be either stored nor slorable, as there would be no conwertibility. Tn fact, the authors point to the lack of
c o n v e r t i b i l i t y a s o n e o f t h e s y s t e r n , s c h i e f b e n e f i t s . " . . . T h e v a l u e u n i t remains stable in terms of the deslBnated cornrnodity bundle because its value never did depend on direcu convertibility into the bundle or any speclflc conrnodity. Instead. its walue is fixed bv definition. It is free of any link to issues of uroney that xnight becorne inflated" (Yeager and Greenfleld, 1983, p . 3 0 6 ; e r n p h a s i s a d d e d ) .
No one other than the authors seens to understand how value can be effectively fixed by definition. A great deal of rhe literarure that has developed around the orlginal article (lncludlng responses and additional contributions by Greenfield and Yeager) deals with this issue. Ttre crltlcs
L J
have not been able to understand the point, and the authors hawe supplled no satisfactory explanation. To be rnore precise, Greenfield and Yeager have speclfied no market mechanism naintaining the equivalence of defined values and actual prices. Under certain circunstances, convertlbillty could
accornplish this, but they hawe ruled out chis mechanl-srn. It would be fai.r to say that the reader is being asked to take their proposal on faith.
One can approach the lssue from another perspective. yeager and G r e e n f i e l d ( 1 - 9 8 3 , p p . 3 0 7 - 0 8 ) allow for the development of debr lnstnu0ents denorninated in units of account. I{hat is to keep these lnstfunents frorn trading? In the laissez faire systen they propose, there could be no basis for a prohlbition. Experience telLs us, howewer, that tradable debt
instruments easily becorne circulatlnt rnedia, like bills of exchange once were. The final stage in the evolution of circulating currency comes when issuers teaLi-ze that market dlmamics will allow them to issue non- interes t -bearing n o t e s ( O ' D r i s c o l 1 , 1 9 8 5 , p . 2 8 ) . N o w w e h a v e t h e m a r k e t d y n a r n i c s f o r a classic case of overl-ssuance of circulating xnedi.a. An issuer can trade non-interest -bearing currency for lnteres t -bearing debt. He will want to do so 45! libitum. In Greenfield and Yeager's systen, we not only hawe the potential f o r m o n e y ' s r e e n e r g e n c e but for instabtllty o f p r i c e s i n t h e e x t r e n e .
One rnus t conclude that Greenfield and yeager contains a basic error, Price stabillLy cannot be attained simply by definition. Further, though they beliewe that they hawe ridded their system of circulating noney, the syslem contains the lncentives to reinttoduce it. Moreover, in their system there would be no central bank or narket constraint on overissuance of fiat
2 4
Such systems require some anchor for nominal val-ues, whether provlded by a central bank or otherwise.
C o n c l u s i o n
Itrs been said that bad monetary practice produces good nonetary theory. Theorles are not developed ln a vacuum, and pressing economlc problerns often stlrnulate sound economic analysis. Recent banking difficulties in the U.S. have stimulated a host of policy proposals. These naturally focus on the crttical role played by deposiu lnsurance in the recent wave of bank fallures. While perhaps seeming to be a peculiarly American problem, the bank failures reveal the po\.rerful effects that bad public policy can generate. As Europe dewelops a comprehensive banking policy, the coulrlunity surely wants to avoid the policy traps thar have lead to the banking problens in the U.S. Mosr importantly, policyrnakers must avoid actions that hide risk and lnsulate risk-takers frorn the consequences of their actlons.
The cumulative uonetary aad banking problerns of the '50s, ,70s, and ,80s hawe also generated broader and more far-reaching reconmendations for changing the banking system. Because they are more lemoved from immediate public
policy problems, these plans tend to be more abstract than deposit
insufance reforrn. Nonetheless, they ralse inportant and interesting questions that rnerit further development and debate.
2 5
REFERENCES
Arrow, Kenneth J. Essays in the Theory of Risk-Bearing (Chl-cago: M a r k h a r n , 1 9 7 1 ) .
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B e n s t o n , G . J . , e t a l , , P e r s p e c t i v e s o n S a f e & S o u n d B a n k i n e : P a s t .
P r e s e n t a n d F u t u r e ( C a n b r i d g e , M a s s . : M I T p r e s s , 1986).
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Black, Flscher, "Banklng and Interest Rates in a i./orld Without Money: The Effects of Uncontrolled Banking, " Journal of Bank Research, 1 (Aurumn r 9 7 0 ) , 8 - 2 0 .
Dowd, Kevin, Private Mone,'r: The Path to Monetarv Stability, Hobart Paper N o . 1 1 2 , ( L o n d o n : T h e I n s t l t u t e o f E c o n o m i c A f f a i r s , 1 9 8 8 ) .
Fama, Eugene F., "Banking in the Theory of Flnance, " Journal of MonetarJ E c o n o n i c s , 6 ( J a n u a r y 1 9 8 0 ) 3 9 - 5 7 .
Flannery, Mark J. and Arls A. Protopapadakis, ,'Risk- Sens itive
Deposit Insurance: The Pricing of Federal Deposlt Insurance, " Federal Reserve B a n k o f P h i l a d e l p h i a B u s i n e s s R e v i e w ( September/Ocrober 1985) 45-57.
GareLa, Cillian, "The FSLIC is ,Broke, ln More Ways Than One, " ggEg J o u r n a l , 7 (Winter 1988) 727-4L.
Greenfield, Robert L. and Leland B, Yeager, "A Laissey-Falre Approach to Monetary Stability,n Journal of Monel/. Credit and Banking, 15 (August 1983) 3 0 2 - 1 5 .
2 6
Jordan, Jerry, "The Future of Price Stability in a Fi.at Money Wor1d," forthcorning in the Cato Journal (photocopy).
Kane, Edward J., The Catherinq Crisis in Federal Deoosit Insurance ( C a n b r i d g e , M a s s . : M I T P r e s s , 1 9 8 5 ) .
The S&L Insurance Mess: Hor,r Dld lt Happen? (Washington, D . C . : T h e U r b a n I n s t i t u r e , 1 9 8 9 ) .
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( S p r i n g / S u n m e r 1 9 8 1 ) .
Litan, Robert 8., "Taktng the Dangers Out of Bank Deregulation, " f!9 B r o o k i n g s R e v i e w , ( F a l l 1 9 8 6 ) 3 - L 2 .
W h a t S h o u l d B a n k s D o ? ( W a s h i n g t o n , D . C . : B r o o k i n g s I n s t l t u t i o n , 1 9 8 7 ) .
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7 ( W i n t e r 1 9 8 8 ) 8 0 3 - 2 1 .
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r 9 3 6 ) .
O ' D r i s c o l l , G . P . , J r . , " M o n e y in a D e r e g u l a t e d F i n a n c i a l S y s t e r n , " F e d e r a l R e s e r v e B a n k o f D a l l a s E c o n o m i c R e v i e w , ( M a y 1 9 8 5 ) , ' ) - - t - 2 .
"Deregulation and Monetary Reforrn, " Federal Reserve Bank of D a I I a s E c o n o m l c R e w i e w , ( J u l y 1 9 8 5 ) , 1,9-31.
G . P . , J r . , " D e p o s i t l n s u r a n c e i n T h e o r y a n d P r a c t i c e , " C a t o J o u r n a l , 7 ( W i n t e r 1 9 8 8 a ) 5 6 1 - 7 5 .
"Bank Failures: The Deposit Insurance Connection " C o n t e m o o r a r v P o l l c - v l s s u e s , 6 ( A p r i l 1988b) 1-12.
Rockoff, Hugh, "The Free Banking Era" A Re - exarnination, " Journal of Monel/. Credit and Banking, 6 (May L974, L4'L-67.
Rolnick, Arthur J. and Warren E. Weber, "Free Banklng, Wildcat Banking and Shinplasters,r' Federal Reserve Bank of Minneapoli-s Ouarterl:r' Review, (Fall 1 9 8 2 ) , r 0 - 1 9 .
"New Ewldence on the Free Banking Era," American Economic
R e w i e w , 7 3 ( D e c e m b e r 1 9 8 3 ) , 1 0 8 0 - 9 1 .
"The Causes of Free Bank Failures: A detalled Examination. " J o u r n a l o f M o n e t a r v E c o n o m i e s , L 4 ( 0 c t o b e r L 9 8 4 ) , 2 6 7 - 9 L .
"Inherent Instabillty in Banking: The Free Banking Experience, " Cato Journal, 5 (Winter T986) 871 -9O.
Short, Eugenie D., "Bank Problems and Financial Safety Nets, " Federal R e s e r v e B a n k o f D a l l a s E c o n o r n i c R e v i e w ( M a r c h 1987) 17-28.
Short, Eugenie D. and Jeffery W. cunther, The Texas Thrift situation: lnplications for the Texas Financial lndustry (DaIIas: Federal Reserve Bank o f D a l l a s , 1 9 8 8 ) .
S h o r t , E u g e n i e D . a n d c e r a l d P . O ' D r l s c o l l , J r . , " D e r e g u l a t i o n a n d Deposit Insurance,' Federal Reserve Bank of Dallas !99494!g_fo14!g (Septenber 1 9 8 3 ) .
2 8
NOTES
L. In terns of job creatlon, the U.S. economy is surely the env1/ of the world. No other major country -- not even Japan -- connes close in this
r e g a r d . F r o m t h e e n d o f 1 9 8 2 t h r o u g h t h e c l o s e o f 1 9 8 8 , U . S . c i v i l i . a n enployment expanded 15 percent while Japanese emplolment grew only 6.6 percent. This growch translates lnto an average annual galn of over 2.1
nillion jobs in the U.S. conpared to approxiuately 515 thousand jobs in Japan. (The figures represent the !g! gains ln enployment. See the Handbook of Labor S t a t i s t i c s , U . S . D e p a r t r o e n t o f L a b o r , B u r e a u o f L a b o r S t a t l s t i c s , A u g u s t
r 9 8 9 . )
2, It is true that the Chairman of the Federal Home Loan Banking System, M. Danny l^Ial1, got the amount of money that he requested. trIhether intenttonal or not, Mr. Wall conslstently underestimated the amount needed -- at least
i n i t i a l l y - - by a factor of roughly ten times. It ls fairly clear, however, that until recently, Congress as a whole had refused to face up to the
r e a l i t i e s o f t h e t h r i f t p r o b l e m s . I n a r e a L s e n s e , M r . W a l l g o t t h e j o b
because he prouised to contain the situation. The political crisis carne when Mr. WaIl, realizlng that containment was impossible, came clean publlcly and admltted the dimensions of the problern were rnuch greater than he had
heretofore acknowledged.
3, The "South\dest Plan" was a misnomer. Many of the more notorlous insolvent thrifts were domiciled ln Texas. The problero of insolvent
deposltory institutions is national, however, not regional, in scope. Short a n d c u n t h e r ( 1 9 8 8 ) .
4. Fron this polnt on, when I use the tern "bank" (with no nodifier) I will mean any depository instltution. In the Anefican context, this covers commercial banks, savings and loan associacions, sawings banks and credit unions. Each type of banking organization is covered by a legally separate deposit insurance agency. A1l the ageneies are effectively backed by the fu11 faith and credit of the U. S. sovefrnnent.
5. Most deweloped countries now hawe some system of deposit insurance, Most are of recent vintage compared to that in the United States. Further, in no other country has the deposit insurance system played the same role as it h a s l n t h e U n i t e d S t a t e s
6. "Casual observation lndicates that [households and companies] ate very rnuch aware of what money narket fund balance sheets are, much more aware than of what bank balance sheets are. Nor is it accidental that funds and
2 9
b a n k s d i f f e r s o l n t h e i r b a l a n c e s h e e t s " ( K a r e k e n , 1 9 8 f , p . 4 ) . M o n e y n a r k e t funds are uutual funds holding a portfolio of sholt-tern liquld assets.
Note that the argument does not assume that investors never make errors or even that their analysls ls cornplete or even adequate. It merely asserts that depository credltors of banks are less knowledgeable about their bank deposits than about other lnvestments. Ihis is a conundrum that must be explai.ned.
7. Banking regulators do not specify exactly which banks are too large to fail. At the tine the doctrine was publicly announced by the Conptroller of the Currency, 'rat least" the top 11- banks were lncluded. Banking analysts generally believe that at least the top 20 banks are presently included,
8. For an exceLl-ent sunnary of the regulatory actions in the early 1 9 8 0 s , s e e B a r t h , e t a I . T h e a u t h o r s a l r e a d y s a w t h e c o s t o f p o l i c y
p r o c r a s t i n a t i o n : " . . . N o t c l o s i n g t h e s e Iinsolvent] institutions m o s t l i k e l y increases the eventual cost to the FSLIC, as the institutions tfy to overcoxne t h e i r p r o b l e m s t h r o u g h r i s k i e r a c t i v i t i e s . T h e r e f o r e , d e l a y i s c o s t l y . " T o put things Ln perspectlve, if thrift problerns had been resolved ln 1985 -- the year this article was r,Tritten -- the cost would probably have been on the order of one- tenth what it will be now.
9. A polltlcal decision was made to hand ovef
the thrift problera to the FDIC, even rhough FSLIC is
1 0 . A s w i l l b e s e e n i n l r h a t f o l l o w s , t h e r e l s private deposit insurance is not a viable product. premiuls would have to be risk sensitive.
the problero of roanaging the insurer of record.
no presumption that T o b e v i a b l e , h o w e v e r ,
1 1 . I n t h e U n i t e d S t a t e s , S o n e a c t i v i t l e s n o t p e r n i s s l b l e parent company, The concept is viewed as inherently rnore risky
itself. The bank would rhen be nonbanking actlvlties. Indeed,
should be na source of strensth,, comPauy,
rnany banks are part of a holding company. for cornmetcial banks are permissible for the that the nonbank actlvities, some of which are than banking, be conducted outside the bank isolated frorn deleterious effects of the the Federal Reserve Systen believes these
for the banklng actlvitles of the holding
L2. It should be noted that Litan has backed away from his original
p r o p o s a l . H e l s a c o a u l h o r o f B e n s t o n , e c a l . ( 1 9 8 9 ) , w h l c h r e p r e s e n t s a m o r e c e n t r i s t p o s i t i o n i n t h e p u b l i c p o l i c y d e b a t e .
13. White, and Rolnlck and l^leber followed in the intellectual footsteps of Rockoff (L974). This serninal vrork was largely neglected, however, excepc
3 0
by econonic historians. The debate over free banking has now gained broad attention l-n lhe economics orofession.
L4. White (1984, p. l) defines free banklng as "the system under l.rhlch there are no political restrictions on the business of issuing currency
c o n v e r t i b l e l n t o f u l l - b o d l e d c o i n . "
1 5 . J o r d a n ( 1 9 8 9 ) d o e s o f f e r a r a t h e r e x p l i c i t t r a n s i t i o n p r o p o s a l t o a free banking systen that builds on the existing structure of Federal Reserve Banks. On the face of it, the proposal appears econonically feasible but p o l i t i c a l l y l n p r o b a b l e .
L 6 , A l s o v a l i d a t e d i s t h e c l a s s l c a l c o n c l u s i o n t h a t , w i t h o u t a
linitatlon on the quantity of bank liabilities, there is no anchor for nominal v a l u e s i n t h e e c o n o r n y ( O ' D r i s c o l l , 1 9 8 5 , p p . 5 - 7 ) .
RESEARCH PAPERS OF THE RESEARCH DEPARTMENT FEDERAL RESERVE BANK OF DALI.AS
Awailable, at no charge, ftom the Research Department Federal Reserve Bank of Dallas, Station K
D a l l a s , T e x a s 1 5 2 2 2
8901 An Econometric Analysls of U.S, Oil Denand (Stephen P.A. Brown and K e i t h R . P h l l l i p s )
8902 Further Evldence on the Liquidlty Effect Uslng an Efficient -Markets Apptoach (Kenneth J. Roblnson and Eugenle D. Short)
8903 As)nruretrlc Information and the Role of Fed l.tatching (Nathan Balke and J o s e p h H . H a s l a g )
8 9 0 4 F e d e r a l R e s e r v e S y s t e m R e s e r v e R e q u i r e r n e n t s : 1 9 5 9 - 8 8 - - A N o t e ( J o s e p h H . H a s l a g a n d S c o t t E . H e t n )
8905 Stock Returns and Inflatlon: Furthef Tests of the Proxy and Debt-Monetization Hypothesis (David Ely and Kenneth J. Robinson)
8905 Real Money Balances and the Timing of Consumption: An Enpifical Investigation ( Evan F. Koenig)
8907 The Effects of Flnancial Deregulatlon on Inflation, Velocity crowth, and Monetary Targeting (W. Michael Cox and Joseph H. Haslag)
8 9 0 8 D a y l i g h t O v e r d r a f t s : W h o R e a l l y B e a r s t h e R i s k ? ( R o b e r t T . C l a t r ) 8909 Macroeconomic Policy and Incorne Inequality: An Error - Correc tlon
R e p r e s e n t a t i o n ( J o s e p h H . H a s l a g a n d D a n i e l J . S l - o t c j e )
8910 The Clearing House Interbank Payments Systen: A Descriptlon of lts Operations and Risk Management (Robert T. Clair)
8911 Are Reserve Requlrement Changes Really Exogenous? An Example of Regulatory Acconmodation of ludustry Goals (Cara S. Lor{rn and John H. W o o d )
89L2 A Dynanic Comparison of an Oil Tariff, a Producef Subsidy, and a Gasoline Tax (Mine Yucel and Carol Dahl)
8913 Do Maquiladoras Take American Jobs? Some Tentative Econometric R e s u l r s ( W i l l i a n C . G r u b e n )
8914 Nominal GNP Growth and AdjusEed Reserve crowth: Nonnested Tests of t h e S t . L o u i s a n d B o a r d M e a s u r e s ( J o s e p h H . H a s l a g a n d S c o t t E . H e i n ) 8915 Are the Permanent- Incorne Model of Consumption and the Accelerator
2
8916 The Location Quotient and Central Place Theory (R. W. Gilrner, S. R. K e i l , a n d R . S . M a c k )
89L7 Dynax0lc Modeling and Testing of OPEC Behavlor (Carol Dahl and l'line YuceI )
9001 Another Look at the Credit-Output Llnk (Cara S. Lown and Donald W, Hayes )
9002 Dernographics and the Forelgn Indebtedness of the United States (John K . H i l t )
9003 Inflation, Real lnterest Rates, and the Fisher Equation Since 1983 (Kenneth M. Emery)
