A crisis not wasted

June 10, 2010

White House Chief of Staff Rahm Emanuel famously said crises shouldn’t be wasted. Lucky for U.S. financial markets, the 80s savings and loan debacle wasn’t. Reforms passed in response meant U.S. regulators were better prepared than their European rivals to process the current crop of bank failures.

For months Spain has struggled to resolve troubled savings banks, resorting to a haphazard merger process. It’s not clear such combinations will bring stability, even if they can be completed. The collapse/bailout of CajaSur caused markets much consternation. Even now, Spain’s other savings banks are racing to merge before the June 30 expiration of the country’s temporary bailout law.

Meanwhile America’s FDIC closes a handful of institutions every Friday night without incident. The difference is strong rules to resolve collapsing banks, rules we got thanks to the S&L crisis.

During that episode the Federal Reserve routinely lent to insolvent institutions, funds that often ended up in the pockets of insiders and bank creditors, compounding taxpayer losses.

Such walking dead banks were christened “zombies” by Boston College Professor Edward Kane. Kane, along with other academics George Kaufman and George Bentson, helped lead reform efforts to stop Fed lending to insolvents and to empower bank regulators to seize them proactively, reducing costs. As a result, FDIC was well-prepared for the latest wave of bank failures. Over two hundred have been quickly and quietly closed since 2008.

Not having suffered similarly instructive bank crises in their own past, European nations were caught flat-footed coming into this one. Besides Spain’s troubles with savings banks, the UK was unprepared for Northern Rock’s collapse in 2007. Only afterward did the British adopt a special resolution regime modeled on the American one.

True, the European banking system is more concentrated than the American one. Most of FDIC’s takedowns are of small, systemically meaningless banks. But its regulatory toolkit proved adequate to shutter WaMu, a giant bank with $307 billion of assets, at no cost to anyone besides the bank’s shareholders and creditors. And since 2008, it has closed 53 banks with more than $1 billion of assets, 10 of which had assets over $10 billion.

The U.S. system is far from perfect. The original sin of the post-S&L rules was a “systemic risk exemption” granted regulators to lend to zombies determined too big to fail. That exemption was trotted out multiple times during the crisis, most infamously for FDIC’s debt guarantee program, which gave financials like Citi, Goldman, GE and many others explicit government backing.

The real problem, facing Americans and Europeans alike, is that the very biggest banks remain too large and complex to resolve. American regulators hope this problem will be solved with new “resolution authority” contained in legislation.

Still, most bank failures are, thankfully, remarkably boring affairs as insured depositor accounts are seamlessly transferred to healthy institutions or paid out. It goes to show that good regulation can indeed come out of crisis.

2 comments

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I agree that giving the FDIC resolution authority has been helpful. That aside, it still begs the question of whether deposit insurance is effective at preventing bank failures to begin with. If you take for granted that some number of banking institutions will fail no matter what, I suppose deposit insurance makes sense. But what if deposit insurance is largely responsible for the existence of those weak savings banks in the first place? Would consumers willingly deposit their funds, thereby allowing the bank to function, in the absence of deposit insurance? I’m not sure of the answer, but we have to think about the FDIC’s resolution authority as seperate and distinct from FDIC insurance. The former is necessary and effective, while the latter is problematic.

Posted by RickGomez | Report as abusive

Those weak banks might not ever get large enough to cause a financial stir if the FDIC made some of their ratings public. After all we have to bare our financial souls to borrow a dime, why shouldn’t banks have to prove their solvency to their customers? Then consumers would shun weak banks before they got too big.

Posted by cuddyent | Report as abusive