"Too big to fail" and the FDIC are connected

The President today ended a national address calling for financial reform with a humorous counterattack against any potential criticism. He cited a quotation from Time magazine, saying:

"I read a report recently that I think fairly illustrates this point. It's from Time Magazine. And I quote:

Through the great banking houses of Manhattan last week ran wild-eyed alarm. Big bankers stared at one another in anger and astonishment. A bill just passed … would rivet upon their institutions what they considered a monstrous system… Such a system, they felt, would not only rob them of their pride of profession but would reduce all U.S. banking to its lowest level.

That appeared in Time Magazine – in June of 1933 [laughter from audience]. The system that caused so much concern and consternation? The Federal Deposit Insurance Corporation – the FDIC – an institution that has successfully secured the deposits of generations of Americans [more laughter from audience]."

The President's reference to that article from 1933 -- which can be found in its entirety here -- was meant to defuse any alarm caused by new government regulation proposals, by saying that the excessive alarm bankers voiced in 1933 over the creation of the FDIC is laughable from our enlightened perspective 37 years later.

However, we would argue that the selection of that quotation by the President actually cuts both ways. It could very well be argued that the bankers in 1933 were right on target with their concern -- and that misguided government regulations such as the creation of the FDIC lead directly to financial disasters such as the one we just experienced, the one the President is using as an argument for more regulation.

Reading a little further in that Time article from June, 1933 we find that opponents of the FDIC envisioned "deposits which they had spent a lifetime to build up and protect with their good names confiscated by the Government to pay for the mistakes and dishonesty of every smalltown bankster." Funny that the speechwriters decided to end their quotation before reaching that sentence!

In fact, scholars of banking point out that radical new changes in banking regulations in the US in the 1930s -- including the FDIC -- are directly connected with the phenomenon of government using taxpayer dollars to bail out institutions deemed "too big to fail."

Back in 1992 (and in essays he had written before that as well), banker and banking scholar Richard M. Salsman wrote "Banking without the Too-Big-to-Fail Doctrine" in which he demonstrates the essential connection between the FDIC (and other essential aspects of centralized banking) and the "too-big-to-fail" concept.

There, and in other publications, he argues that the creation of deposit insurance led inevitably to implicit backing by the Treasury and the Fed -- first to insured depositors, later to uninsured depositors and creditors, and finally to the securities industry (Wall Street brokerage firms). While Mr. Salsman was writing in 1992, it is clear that this is exactly what has happened in the past two years.

The logical connection between the FDIC and reckless behavior is fairly clear if you think about what it means -- suddenly, solid and conservative banks are no riskier to the customer than reckless, profligate, and/or unproven ones, and so customers become free to chase the highest interest rate on deposits without worrying about whether that bank is a solid business or not.

This changes the incentives for banks from competing based on solidity and solvency, to competing based on highest yield. The same types of changes take place throughout the financial system wherever bad loans and bad business practices are given a safety net of taxpayer dollars (think Fannie and Freddie, the Wall Street affair with synthetic products such as CDOs, and the entire mark-to-market episode we have detailed at length in previous posts).

This is a broad topic worthy of greater discussion and careful consideration beyond the scope of this particular post. The important point for today is the fact that increasing government intrusion into business activity is no laughing matter. The example of the creation of the FDIC in 1933 should be a warning against ill-considered government "solutions," not an argument for more of the same.