Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Reconstruction Finance Corporation: Would It Work Today?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Reconstruction Finance Corporation: Would It Work Today?

Article excerpt

With the deposit insurance fund continuing to shrink, some banking experts argue that the government should invest in weak banks to nurse them back to health. According to this view, government investment can avoid the unnecessary closure of viable banks, benefiting both the taxpayer and the economy as a whole. Other experts argue that weak banks should be promptly shut down or that government investment has no advantage over forbearance.

Advocates of government investment in weak banks often point to the success of the Reconstruction Finance Corporation (RFC) in the Great Depression as evidence the approach would also work today. By purchasing preferred stock in thousands of banks, the RFC is claimed to have spurred a strong recovery in banking. But no one has examined the evidence in detail. Was the RFC really that successful in revitalizing the banking industry? And even if government investment did work in the 1930s, does such an approach make sense in the very different circumstances faced by banks today?

This article argues that the RFC did help many viable banks survive in the 1930s but that government investment should be used with caution today. The first section of the article reviews the current debate over government investment, describing recent proposals and summarizing arguments for and against the approach. The second section reexamines the record of the RFC in the 1930s. The section explains how the preferred stock program came into existence and presents evidence that the program worked better than prompt corrective action or forbearance. The last section considers the implications of the RFC experience for the current debate in light of key differences between the 1930s and today.

THE CURRENT DEBATE

The high rate of bank failures and the sharp decline in the bank insurance fund over the last several years have intensified debate over the best way to deal with poorly capitalized banks. One option is prompt corrective action. Under this approach, regulators would allow the bank to remain open only if it could raise enough capital to satisfy minimum capital requirements within a short period of time. While raising the additional capital, the bank would also be subject to tighter regulation. A second option is forbearance. In this case, regulators would allow the bank to continue operating with low capital and few additional restrictions on its behavior on the condition that it gradually rebuild its capital. The final option is government investment. Under this approach, the government would supply part or all of the capital the bank needed to comply with minimum capital requirements.

Some banking experts and government officials have argued that government investment is the best of the three alternatives because it minimizes the costs of bank failures to the FDIC and society as a whole. This section describes recent proposals for government investment in weak banks, explains the rationale for government investment, and summarizes the major criticisms of the approach.

RECENT PROPOSALS FOR GOVERNMENT INVESTMENT

Interest in government investment in weak banks increased in late 1990 in response to two closely related developments. First, bank failures seemed likely to remain high for several years due to the large number of troubled banks and the weak economy. And second, the Bank Insurance Fund (BIF) appeared in much worse shape than previously believed, suggesting the FDIC would soon run out of money to resolve failures. Some banking experts argued that government investment could alleviate these problems by helping temporarily troubled banks get back on their feet.

One way the government can invest in weak banks is through "open-bank assistance" by the FDIC. Current law permits such assistance if it would cost the FDIC more to close the bank and pay off insured depositors or if the continued operation of the bank is essential to the community.(1) Open-bank assistance usually consists of subordinated debt or preferred stock, both of which count toward bank capital requirements. …

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