By England, Catherine
National Forum , Vol. 70, No. 2
The savings and loan industry fiasco of the past decade will cost United States taxpayers a minimum of $150 billion. Some reliable estimates place the ultimate cost at closer to $300 billion. Given roughly 110 million taxpayers, each individual taxpayer will contribute an average of $1,360 to $2,700 over the next several years. And it is impossible to guess the final cost. Many insolvent savings and loans remain open and continue losing money. In addition, many S&Ls carry assets on their books at inflated values. We cannot know how inflated those values are until the assets are sold. No single program in United States history has ever come close to matching the size of this bailout.
At the root of this fiasco is the federal deposit insurance system. Federal deposit insurance encourages risk-taking among depositors, bank managers and stockholders, and politicians. And though the problems created by federal guarantees have been most apparent in the unfolding savings and loan industry debacle, the same flaws also affect banks. Ultimately, correcting the current problems and returning the financial industry to a more stable course will require turning from federal guarantees to the private sector.
The Case Against Federal Deposit Insurance. Federal deposit insurance undermines the strength and stability of the United States financial system by affecting the decisions of three groups: depositors, bank owners and managers, and political overseers. (In this article, "banks" will refer to savings and loan associations and credit unions as well as commercial banks.)
Depositors. Federal deposit insurance creates what is known in the insurance industry as a "moral hazard." Depositors whose accounts are fully protected by the government do not choose their banks on the basis of financial strength, conservative investment practices, or the managers' gilt-edged reputations. Convenience and rates paid on deposits or charged on loans take precedence. While such behavior is understandable, the indifference exhibited by depositors about the financial strength of competing institutions relieves bank owners and managers of the need to compete on the basis of safety and financial stability.
Bank owners and managers. Recognition of this problem is not new. During the 1930s, President Franklin Roosevelt, his Comptroller of the Currency, the American Bankers Association, and most major state banking groups opposed the introduction of federal deposit insurance for precisely these reasons. Depression-era critics understood that as safety and stability were deemphasized by depositors, bank managers and owners would be freed to seek higher profits from their investments through increased speculation and risktaking.
Because observers in the 1930s understood these dangers, the legislative package that introduced federal deposit insurance also included extensive regulation of the activities of banks. Legislators sought to minimize the moral hazard problem by limiting banks' abilities to compete with other banks, thus protecting each institution's profitability. The 1933 and 1934 banking bills that established the FDIC and FSLIC respectively, placed ceilings on the interest rates banks could pay on deposits and limited the types of activities banks and S&Ls (and other types of financial institutions) could pursue. S&Ls did not face interest rate ceilings until 1966.) In addition, Congress limited the scope of federal deposit insurance. In 1935, federal guarantees protected only about forty-five percent of deposits in United States banks and S&Ls. (By contrast, more than seventy-five percent of bank deposits are explicitly protected today.) Many depositors remained exposed to some loss in a failure, and these individuals continued to monitor the risk-taking behavior of bankers.
On the other hand, there has never been an effort to encourage more conservative, prudent bank management decisions through the way deposit insurance is priced. …