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BANK FAILURES: Market Failure or Government Failure
by William Scott Dwyer


Introduction

It is conventional economic wisdom that mass bank failures are an insignia of market failure, of which the classic example is the era of allegedly “free banking” that existed from 1838 to the advent of the Federal Reserve in 1913. During this period, so-called “wildcat banks” are said to have ruled the day, cheating their customers and absconding with their deposits. In Paul Samuelson’s words, central banking was established because “the country was fed up once and for all with the anarchy of unstable, private banking…. Without government regulation and examination, without the Federal Reserve System, and without guaranteeing of bank deposits by the FDIC, our system of small unit banking would be intolerable.”

But there is another view, gaining currency among economists, that mass bank failures are a reflection not of market failure but of government failure. According to this view, the Great Depression was the result not of a free banking system but of an irresponsible credit expansion encouraged by the very agency empowered to protect us from financial crises and bank insolvencies. In fact, argue the revisionists, bank failures have been escalating ever since the government got involved in the banking industry.

The only way to re-establish a sound, stable banking system, free of depressions and financial crises, according to this latter view, is to adopt a policy of financial laissez-faire – of free, private banking. Under such a system, banks would function just like any other profit-making business, providing their customers with a product or service in exchange for a price. The product or service in this case would not be aggregate monetary policy, a la the Federal Reserve, but the simple extension of money and credit, which would be a commercial bank’s sole, legitimate function.

So which view is correct? In order to answer this question, one must look more closely at the historical record in order to see which system is the more stable: free, private banking or state controlled central banking. Let us begin by examining the era of so-called “free banking” which existed in the United States prior to the establishment of the Federal Reserve in 1913.


“Free Banking”

The period popularly known as the “era of free banking” in the United States extends from 1838 to 1913. Prior to this period, the United States had established government banks, but these banks did not possess anywhere near the kind of central banking powers that we have today. They did not have a monopoly on money, and during their reign, gold and silver coin circulated freely as the standard money to which all bank notes and deposits were fully convertible. The First Bank of the United States was established in 1791 and existed until 1811. The Second Bank of the United States operated from 1816 until 1836, when the Jackson Administration and Congress declined to renew its charter, thereby terminating most federal involvement in the banking industry.

A year later, in 1837, President Andrew Jackson captured the spirit of an era with the following declaration:

“Now is the time to separate the Government from all banks. Receive and disburse the revenue in nothing but gold and silver coin, and the circulation of our coin through all public disbursements will regulate the currency forever hereafter. Keep the Government free from all embarrassments, whilst it leaves the commercial community to trade upon its own capital, and the banks to accommodate it with such exchange and credit as best suits their own interests – both being money making concerns, devoid of patriotism, looking alone to their interests – regardless of all others."

Inspired by the ideals of liberty and self-interest, the Jackson administration thus proceeded to end federal involvement in the banking industry. Although replaced by state chartering and regulation, the banking system was nonetheless freed of corrupt political influences at the federal level. During this period, there was no federal bank and the standard money consisted of specie (gold and silver coin) and bank notes backed by specie.

Lending policies also differed from today’s banks. Banks lent money for productive purposes, but not to finance the purchase of consumer goods. Credit was limited by the ability of individual banks to meet their obligations. There was no lender of last resort, so banks had to be careful not to overextend themselves.

Banks failures did occur, however, including the infamous “wildcat banks”, fly-by-night financial frauds masquerading as legitimate businesses. But, instead of spreading throughout the entire banking system a la the Great Depression, these failures were confined to individual banks and their customers. Furthermore, it turns out that, contrary to popular myth, “wildcat” banks were not a consequence of free banking, but rather of the government’s intervention into the banking industry.

At that time, the law required that a potential banker purchase state bonds with his capital (which consisted of gold and silver coin) and deposit the bonds with the state auditor. The state, in turn, would often print bank notes and give them to the banker in exchange for the bonds. The banker would then put these notes into circulation by issuing them to customers in return for deposits of gold and silver coin.

As it happened, however, financially unsound states would value the bonds at par when the market value of the bonds was below par. Their reason for doing so was that by making overvalued bonds the backing for their currency, states could lower the interest charges on their debt.

So a would-be banker would buy state bonds that had depreciated, say, 50% below par, deposit them with the state auditor and receive a full 100% of their par value in bank notes. He would then put the notes into circulation in exchange for real assets (gold and silver coin) deposited by unsuspecting customers. With 100% profit in hand, the “wildcat” banker would then flee with his customers’ money before they discovered that the bank notes were exchanging at a 50% discount.

It is for this reason that these aptly named banks were located in remote areas of the country (i.e., those inhabited by wildcats). Their location made it inconvenient for noteholders to return to the bank to redeem their discounted notes in specie. And, of course, by the time they did return, the “bankers” had long since fled with their customers’ money.

Wildcat banks were thus an example not of market failure, as is commonly thought, but of precisely the opposite – government failure. They were the result of state intervention into the banking industry and of the state’s concern with lowering the interest on its debt by overvaluing its bonds.

Not all bank failures during this era were the result of wildcat banks, however. In New York, Indiana, Wisconsin and Minnesota, only seven percent of bank failures were due to wildcat banking. The majority were due to falling bond prices – which, while not a consequence of fraud, were nevertheless the result of government intervention rather than of free banking. Nor did every state value its bonds at par. For example, in New York, in which only 8% of banks failed from 1838 to 1863, bank notes were based on the market value of state bonds, not on their par value.

Despite the lurid reputation of wildcat banks and the idea that bank failures were numerous during the era of “free banking”, the total losses suffered by depositors during that period was less than one percent of total bank obligations. The reason for the relative soundness of banks was that the loans banks typically made were short term ones to merchants and dealers of commodities, whose goods often secured the loans. Banks did occasionally make unsound decisions for which they paid a price, but again these affected only individual banks, not the banking system as a whole.

Banks also exercised greater prudence in lending during this era, as there was no lender of last resort or deposit insurance to reward irresponsible management. Profitability was also higher, as was the ratio of capital to assets. (“Capital” in this context refers to a bank’s assets minus its liabilities.)


National Banking

Nevertheless, in 1863, the relative freedom of the banking industry was eroded further when the federal government passed the National Banking Act, mandating that bank notes be uniform in appearance and backed by U.S. Treasury securities. The uniformity of appearance, in which the words “U.S. Treasury” were printed on every note, removed the distinguishing characteristics of each bank’s notes, making it more difficult for noteholders to determine their legitimacy.

Banks in major cities were also required to keep reserves of 25 percent, while other banks were required to keep only 15 percent. This higher reserve requirement interfered with liquidity, as banks were prevented from depleting their reserves below the required limit in order to meet their obligations. This illiquidity, in turn, led to a series of panics, bank runs and specie suspensions in 1873, 1893, 1897 and 1907.

Despite their reputation, these panics and bank runs were due not to free banking but to government intervention in the form of the National Banking Act. What has been characterized traditionally as market failure can once more be seen as an example of government failure. Yet these panics, which were relatively short-lived in any case, did not prove especially detrimental to the banking system, as bank failures during the 50-year period from 1963 to 1913 were never more than one percent of total banks.

Also, money lost none of its purchasing power during the 75 years of relatively free banking from 1838 to 1913, in contrast to a loss in purchasing power of over 90 percent since the creation of the Federal Reserve in 1913.
It is this latter period of ballooning federal control over the banking industry to which we shall now turn. Is central banking a remedy for the alleged market failure of free banking that advocates, like Professor Samuelson, are claiming?


Central Banking

The era of central banking began with the formation of the Federal Reserve in 1913 (although the Federal Reserve Act actually went into effect in 1914). At the time, Federal Reserve notes became legal tender, and national bank notes issued by private banks were phased out. As a result, the central bank acquired a monopoly on the nation’s money supply, enabling it to reduce bank reserve requirements by more than 50%, a move which lowered liquidity and doubled the potential for inflation.

The Fed also became a “lender of last resort”, whereby it could lend money to banks in times of emergency. Because the lender of last resort is charged with stopping panics when they occur, it cannot discriminate between an illiquid bank and an insolvent one. It must lend to both in times of crises, and will therefore be placed in the position of propping up banks that are unprofitable and poorly managed.

Throughout the 1920’s bankers had come to rely on the Fed as a lender of last resort, making them increasingly less cautious and less prudent in their lending policies. Since they expected the Fed to help them liquidate their speculative loans through its discount window, they weren’t prepared when, in 1929, the Fed refused to lend them the money they needed. As a result, a huge number of banks failed, leading to the Great Depression.

The decline in capital adequacy from 1913 to 1929 confirmed a weakening in the banks’ financial status. The capital-to-assets ratio of the banks declined from 17 percent in 1913 to 13.5 percent in 1929, which contributed to the escalating rate of bank failures. From 1913 to 1922, banks failed at an average rate of 166 per year, a rate that increased sharply to 692 per year from 1923 to 1929, despite the roaring twenties’ booming economy. But that increase was nothing compared to the Great Depression. From 1929 to 1933, 9,106 banks, or 35.6 percent of those in existence in 1929, closed their doors. All told, during the first 20 years of central banking, there were more bank failures than in all of previous U.S. banking history. Depositors lost more money during that period than in the entire preceding 75 years of free banking.

Branching restrictions also contributed to bank failures, by preventing prudent diversification of assets. In Canada, with no such restrictions, bank failures in the 1930’s were rare, even though the country underwent significant supply shocks during that period.

Although bank runs were caused by the increasing liquidation of unsound credit, they were made worse by the existence of central bank management. Because individual banks could not manage their own reserves, they had no way to meet the growing demand for liquidity by their customers.

Just as bank managers had less control over their assets under central banking, so the control they did retain was exercised less prudently, because they were more willing to underwrite speculative and questionable loans. Loans, which had previously been made largely for business purposes to productive enterprises, were now increasingly made to consumers as personal loans (e.g., to finance home mortgages, etc.). It was the large number of speculative and imprudent loans that defaulted during the Great Depression, causing the widespread bank failures.

As bad as the banking system was prior to the Great Depression, it was made even worse by the government’s “corrective” action. Instead of recognizing that it was the moral hazards inherent in central banking that precipitated the Great Depression, the government drew the opposite conclusion. It expanded its monopoly control over the banking system.

In 1932, the Glass-Steagall Act prohibited banks from entering the lucrative security business, which would have helped insure them against financial failure. It also gave the Fed the power to back its own notes with government securities. In 1934, the Gold Reserve Act suspended the convertibility of Federal Reserve notes or bank deposits into gold and silver coin. With the resulting transition to pure fiat money, the Fed acquired an unlimited power to expand credit. By suspending convertibility of Reserve notes into specie, the Fed had, in effect, declared bankruptcy – a fitting culmination to a period of two decades in which its policies had caused nearly 10,000 other bankruptcies! (Of course, other central banks could still convert their notes into specie, but in 1971, the U.S. defaulted on that obligation as well.)

The Fed’s increasing use of open-market operations – the buying and selling of securities – also played a factor in undermining the health of the banking industry. Since the Fed agreed to pay for bad assets, bankers became less cautious about the assets they acquired, and accordingly were more inclined to make imprudent loans. Again, this is not a case of market failure, but a predictable consequence of government intervention in the banking system.
These perverse incentives have continued to undermine the health of the financial system, as the Fed has expanded its powers apace. In recent decades, government policy has encouraged the extension of credit to education (student loans) and to foreign countries, both of which are at a high risk of default.


The Federal Deposit Insurance Corporation

In 1934, the government instituted a system of deposit insurance by creating the Federal Deposit Insurance Corporation. Although the amount of insurance on bank deposits was initially modest at $2,500, it has expanded greatly over the years. Coverage was raised to $5,000 in 1935, to $10,000 in 1950, to $15,000 in 1966, to $20,000 in 1969, to $40,000 in 1974 and to $100,000 in 1980, where it stands today, marking its longest period without an increase. This escalation of coverage does not simply reflect an increase in the cost of living. If the coverage had been kept constant in real terms, it would not exceed $20,000 today. Thus, FDIC insurance has undergone a real five-fold increase since its inception in 1934. It is worth noting that no other industry has enjoyed the privilege of having its “accounts payable” insured by the government.

There is little excuse for the federal government to have created the FDIC, given the experience of individual states with similar financial guarantees. In response to the panic of 1907, for example, eight states established some form of deposit insurance between 1907 and 1917. The result was that all eight systems failed! In their book Banking Theory and Practice, Messrs. Harr and Harris, describe what happened when a system of deposit insurance was employed in Texas in the 1920’s.

All kinds of incapable people tried to start a bank under the protection of the fund. The system gave a false sense of security – people looked to the fund for protection and paid no attention to the soundness of the banks themselves, nor to the ability of the managers. Prosecution of bank wreckers and crooks was made impossible. The depositors got their money from the fund, so they were not particularly interested in prosecuting the unscrupulous or incompetent men who caused the banks to fail. Such an unsound system of banking weakened the financial structure of the entire state.

When asked what he thought of deposit insurance at the turn of the century, the president of the First National Bank of Chicago had this to say:

“Is there anything…to justify the proposition that the good should be taxed for the bad; ability taxed to pay for incompetency; honesty taxed to pay for dishonesty; experience and training taxed to pay for errors of inexperience and lack of training; and knowledge taxed to pay for the mistakes of ignorance?”

Even before the current financial crisis, the FDIC had increased its bailouts of insolvent banks. What is especially disturbing is that in addition to the failure of small banks, large, well-established banks, such as Continental Illinois (1984) and First City Bancorp (1987), had begun to experience insolvencies, and had to be rescued by the FDIC. Under the doctrine of “too big to fail”, deposits at large banks (over $1 billion in assets) are bailed out no matter what their amount.

Nor is this system likely to change, given the political influence and campaign contributions of big-bank and savings-and-loan political action committees. Between 1985 and 1987, the voting behavior of legislators was found to correlate directly with the contributions they received from these financial institutions. Again, we see that such corruption is a classic example of government failure – in this case, of the perverse incentives fostered in a democracy by the influence of special interest groups vying for political favors.

The worsening effects of such a system became increasingly evident during the last quarter of the 20th Century. From 1977 to 1988, the number of banks that were closed or bailed out rose from 6 to 211; the number of problem banks, from 368 to 1,400; and the amount of money disbursed by the FDIC from $27 million to $8.175 billion.

It is no surprise that the financial condition of the FDIC has been deteriorating, as it now holds record levels of defaulted loans from failed banks. The FDIC has even been forced to issue capital certificates to banks – mere promises to pay – in place of actual cash that can be used to cover deposits. In fact, banks would only have to default on less than one percent of the $2 trillion of insured deposits in order to wipe out the FDIC insurance fund, hardly a reassuring prospect for a system touted as the solution to financial risk. The FDIC is supposed to be able to "pay for itself" through assessments on insured banks. But with 95 banks having failed so far this year, the fund is in need of its own capital injection. In fact, according to a recent statement by Chairman Sheila Bair (September 18, 2009), the FDIC is now considering a bailout from the US Treasury in order to replenish its deposit insurance fund.


Conclusion

Is our system of centrally managed banks superior to the “anarchy” of free banking that economists like Paul Samuelson have derided as “intolerable”? Or does it constitute a far worse dose of the very virus of interventionism that had already infected the banking system when the Federal Reserve was instituted in 1913? Today, there is eminently good reason to believe the latter.

What started out as a grand attempt to rein in the unruliness of free banking and remedy market failure has led to the instability of statist intervention and the growing problems of government failure. The liabilities of a political system dominated by PAC's and bearing the perverse incentives of public choice can no longer be blamed on financial laissez-faire. The period of “free banking” that existed over 150 years ago was vastly superior to the increasingly wasteful, unproductive and precarious system of central banking that exists today.

If the government is truly interested in promoting a sound financial system, then it will take steps to eliminate the anarchy of fiat money as well as to deregulate the banking system and allow bankers the freedom to run their own businesses. That, more than anything else, will serve to protect the banks and their depositors from financial ruin.
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