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ARTICLE

The Banking Crisis

NOVEMBER 01, 1988 by HANS SENNHOLZ

Dr. Sennholz heads the Department of Economics at Grove City College in Pennsylvania. He is a noted writer and lecturer on monetary affairs.

The Federal Savings and Loan Insurance Corporation (FSLIC), which insures deposits in savings institutions, is in dire straits. Its liabilities exceed its assets by more than $13 billion, up from $6.3 billion a year ago. Currently 505 of the country’s 3,120 Savings and Loan Associations are insolvent, and another 435 institutions are barely solvent. FSLIC funds are not adequate to resolve the financial dilemma. Once again, Congressional action may be needed to keep the system afloat. The U.S. government may have to come to the rescue, although just last year Congress authorized the sale of $10.8 billion in bonds over three years to save the ailing industry.

In testimony prepared for the Senate Banking Committee, the General Accounting Office, which is the auditing arm of Congress, estimated the costs of saving more than 200 “hopelessly insolvent” associations at $17.4 billion and of saving another 300 units at $26.4 billion to $36.4 billion.[1] Private analysts estimate total costs to be as high as $60 billion. All such calculations rest on the precarious assumption that interest rates will not rise significantly and that no new problems will arise in the next ten years.

Such a view is extremely optimistic. After all, interest rates are likely to rise again during the 1990s as a result of two Federal policies. The budget deficits are likely to continue to consume business capital en masse, crowding out private demand and frightening creditors who finance the deficits. Moreover, the rate of price inflation is likely to rise during the 1990s because the extenuating circumstances of the 1980s are drawing to a close, such as the agricultural depression in the U.S. and falling energy prices.

A more realistic appraisal of the financial situation would consider additional factors. Since 1982, the U.S. has experienced one of the longest booms in recent history. And yet, the U.S. government had to rescue the deposits of millions of savers from 620 commercial bank failures and forced mergers. Some 100 Savings and Loan Associations failed and were liquidated; another 505 are officially insolvent. Federal agencies had to make good some $200 billion of depositors’ savings lost in failures involving 7 per cent of some $3 trillion deposits in U.S. savings institutions. If this is peacetime prosperity, what is to become of the financial institutions during the 1990s when the great boom is likely to give way to a recession? After all, recessions follow booms as night follows day.

Persistent economic instability is aggravating the financial situation. The federal government is suffering huge budget deficits that are draining the capital markets, boosting interest rates, and causing large trade imbalances, which in turn are threatening free-trade relationships. Similarly, third-world debt, which has more than quintupled during the 1970s and 1980s, is casting a shadow on the banking system. The funds have been wasted on government enterprises and political largesse, lost in a fruitless effort to export American know-how and prosperity. The policy has cost Americans hundreds of billions of dollars and now is jeopardizing the solvency of the financial institutions that extended the credits.

The American financial structure is teetering on the edge of disaster.[2] A time bomb is ticking away under both domestic banking and international finance. Ticking loudly, it makes us wonder when it will go off. It may explode suddenly in the form of a classic “bank-ran” or an international panic. Depositors fried with fear and in doubt about deposit insurance and government guaranties, may suddenly rush to withdraw their funds from all savings and loan associations. They may lose faith in the central pillar of the American financial structure, the Federal guaranty, which is bending and cracking under the heavy load of bank losses and Congressional reluctance to cover those losses. The run would be like a bolt from the blue, spreading from the thrifts to all banking, and from the U.S. to all comers of world finance.

Private foreign investors may suddenly bail out, frightened by a sudden outbreak of U.S. inflation, by poor trade figures or harmful government policies, or merely by some unfortunate pronouncement by foolish officials. Sudden foreign withdrawals of large funds would strain the American system and test the solvency of many institutions. Without immediate support by the U.S. Congress, many undoubtedly would fail.

The bomb may explode when foreign central banks abandon their dollar-support operations. Stephen N. Morris, an economist at Washington’s Institute for International Economics, estimates that major foreign central banks bought $130 billion last year to support the U.S. dollar and that, by the end of 1987, the 20 largest foreign banks were sitting on a stockpile of more than $454 billion.[3] If these holders of dollar reserves should lose confidence in our financial structure or in the resolve of our financial authorities to correct its lingering defects, a crisis may erupt. When the financial wheels grind to a halt, the system that was born of government thus will return to government for repair and restructure.

We must not allow it to perish suddenly, which would not only spell ruin to many sound institutions alongside the failures, but alsoravage the capital market and depress economic activity. It would turn today’s creeping nationalization into galloping regimentation. Indeed, a financial crash would have ominous consequences for our economic, social, and political lives.

An Artifact of Government

The American financial edifice was built by legislation and is maintained by regulation. It is as rigid and inert as politics, and as complex as the tangled web of bank regulation. Designed by the New Deal politicians of the 1930s and embellished by their successors in the ‘40s and ‘50s, it is clearly incapable of coping with the market forces of the 1980s and ‘90s. It is destined to give way to a new order.

The edifice that was built during the 1930s replaced the regulatory structure of earlier years, which was the product of a myriad of Federal and state banking regulations. It practically collapsed in 1931 and 1932. By scores and by hundreds the banks closed their doors. Banks that remained open were forced to curtail their operations sharply. Indeed, banking weakness was a prime factor that added impetus to the Great Depression.

The new system was organized as a cartel-like order, complete with all the characteristics of a monopoly.[4] Rigid entry barriers protected its members from “destructive” competition, as did government regulation of production, pricing, and marketing. The Banking Act of 1933, which also created the Federal Deposit Insurance Corporation (FDIC), separated commercial banking from certain investment banking activities. The portion of the law that effected the separation is commonly called “the Glass-Steagall Act.” It was to give stability to the system and guarantee the safety of every bank. Toward that end, the law sought to discourage competition and to set narrow limits on branching. It imposed a “needs test” for the issue of new charters, and fixed interest-rate ceilings to prevent the competition of banks for funds. Deposit insurance by the FDIC, finally, was to make all banks equally safe.

New Deal legislation effectively segmented the financial industry. It created the Securities and Exchange Commission to oversee the securities industry. To facilitate more credit expansion, it granted additional powers to the Federal Reserve System, such as the powers to mandate reserve requirements and to extend credit on government obligations, not just on “real bills.” In 1956 Congress passed the Bank Holding Company Act, extending the Glass-Steagall Act’s restrictions to corporate owners of banks. Amendments to the Act, passed in 1966 and 1970, further tightened the restrictions. They limited the expansion of multibank holding companies by requiring Federal Reserve Board approval for new acquisitions, and ordered the companies to divest themselves of ownership in businesses deemed “unrelated” by the Federal Reserve Board. All interstate banking was prohibited.

Throughout the years Federal regulators and special-interest banks lobbied Congress to pass more restrictive legislation. After lengthy hearings, Congress usually complied by removing exemptions and broadening regulatory authority. The 1970 amendments sought to bring one-bank holding companies under Federal regulation and impose additional criteria to the “needs test” for permissible activity. Charter applications henceforth had to prove not only that the planned activity was “closely related” to banking, but also of “positive benefit to the public.” It also instructed the Federal Reserve Board to determine which activities were permissible for bank holding companies. The Garn-St. Germain Depository Institutions Act of 1982 permitted bank holding companies to engage in some limited “nonbanking activity” provided it was “closely related” to banking.

It is amazing that, after nearly 200 years of banking legislation and regulation, the U.S. government continues to wrestle with the definition of “banking.” The 1970 legislation modified the definition of a bank to include all institutions that both accept demand deposits and extend commercial loans. Thereafter, many new institutions sprang up that either accept deposits or extend commercial loans, but not both. Commonly known as “nonbank banks,” they could pursue most financial activities without coming under the restrictions and regulations of financial authorities. As “non-bank banks” became increasingly popularduring the 1980s, competing most effectively with banking institutions, Congress proceeded to close the regulatory loophole by passing the Competitive Equality Banking Act of 1987. The Act extended the definition of a bank to all FDIC-insured institutions and subjected them all to Federal regulation.[5]

Winds of Change

The financial cartel system worked for a while. But, like all other cartels, the financial cartel was destined to degenerate as soon as its members were no longer prepared to live by the “stabilization” arrangements and found ever new ways of competing with each other. Even a thick blanket of cartel regulation cannot suppress competition for long. It springs to life in countless forms because man is ever eager to improve his lot. In an economic order based on private property in the means of production, he can do so best by rendering better services to his fellowmen; that is, he competes with other producers in serving consumers. He does so even within a cartel.

When newcomers are permitted to join the organization, they are likely to add competitive fervor. Foreign bankers are very anxious to enter the U.S. market for obvious reasons: to join the cartel and enjoy its advantages, to oat-strip the older members through greater effort and efficiency, and to place their funds at exceptionally high interest rates.

The spirit of competition is gnawing at the foundation of the financial cartel. It is weakening the structure from within and from the outside. Throughout the world, massive capital formation in private- property economies has given rise to new financial centers that compete vigorously with New York. Tokyo, Hong Kong, Singapore, London, and Frankfurt are financial centers that “globalize” the capital market and erode competitive barriers. Shackled and handicapped at home, many U.S. banks have chosen to go offshore and compete in foreign financial centers. Similarly, foreign banks have come to compete vigorously in American markets through branches, agencies, subsidiaries, Edge corporations (which cannot accept deposits from U.S. residents unless the deposits are linked to international trade), and representative offices. In short, the new world of international competition is seriously threatening the old world of protection and insulation.

The spirit of internal competition is clearly visible in the frantic search for new ways to diversify. It is visible in the rise of “nonbank banks” that render financial services formerly reserved to commercial banks. Brokerage houses, money market mutual funds, finance and insurance companies, and retail establishments compete effectively, offering cash management accounts, other liquid accounts, credit card services, and loan services. Merrill Lynch, American Express, and Sears are pointing the way. Financial competition is alive although the regulatory apparatus is fighting it every step of the way.

Technological innovations are forcing their way through the thicket of regulations. Thecomputerization of many financial operations has greatly reduced transaction costs, which is enabling nondepository institutions to offer many bank-like services. The use of automated teller machines (ATMs) has grown dramatically since the late 1970s. Individual ATM systems may soon link up with national and international networks. Thousands of point-of-sale terminals may serve millions of customers using a great variety of credit cards. On the financial horizon, in-home banking promises to offer all the essential banking services, including bill payment, electronic purchases and sales of securities, and so on. Telephone or cable hookups, satellite linkages, and home computers are destined to play important roles in the financial system of the future.

Keen competition is bound to separate the successful enterprises from the failures. The former succeed by best serving consumers; the latter fail because they fail to serve consumers satisfactorily. They may misjudge or ignore consumer choices and preferences, or mismanage their resources, or allow themselves to be misled by political machinations. To rely on cartel regulation and insulation is to invite financial disappointment in the end.

Regulatory Restructuring

Financial observers of all persuasions and ideologies are in full agreement that the American edifice is in urgent need of restructuring. A healthy and viable banking industry needs to generate returns that not only cover its costs but also attract new capital to support modernization and expansion. It must be able to compete with other financial institutions and other business enterprises.

Most legislators and regulators readily admit that a safe and sound system should not be unduly hampered by regulation and supervision. They may even favor some measure of “decontrol” and “banking freedom to operate in the marketplace.” They may advocate “product liberalization” by eliminating some restrictions imposed by the Glass-Steagall Act and certain provisions of the Bank Holding Company Act. Yet, they all envision a restructuring that would strengthen the supervisory and regulatory restrictions on banks. They emphasize “prudent supervision,” “careful monitoring,” and “limiting the risks” posed by new bank services. In short, the old regulators would like to replace the crumbling cartel wall with a new supervisory safety and soundness wall.[6]

The world is a scene of changes. We change and our policies change. But we should always ascertain the direction of the change. To replace one wall with another is to reinforce the old direction. To substitute prudent regulation for imprudent regulation is to continue the regulation; it does not reverse the direction. We may wonder about our destination, but it is rather obvious that legislators and regulators will always be in the driver’s seat.

Most writers about financial matters accept it as a self-evident truth that legislators and regulators need to manage the people’s finances. They are convinced that no one ought to be free because no one is fit to use his financial freedom responsibly and beneficially. This is why they favor a mandatory deposit insurance system with Federal guarantees. They advocate the separation of banking and securities activi ties, the separation of banking from commerce, and careful supervision of them all. They prefer a financial structure with thousands of small banks to one characterized by large financial institutions. In short, they thoroughly distrust men of finance, but place their trust in legislators and regulators.

To embark upon financial reform and revival is to discard many false beliefs about finance and the role of government intervention. In finance as in all other pursuits, man is free tochoose between two basic systems of economic organization: the individual enterprise system and the command system. Throughout their short history Americans generally opted for the former, the system of private property and individual enterprise. In all matters of finance, unfortunately, they frequently succumbed to the lures and temptations of political command. In money and banking they generally preferred politicians and government officials over bankers and entrepreneurs.

After 200 years of countless banking scandals and unending financial crises it is appropriate to reconsider the direction of the road we are travelling. After thousands of bank failures and billion-dollar losses we may want to reverse our financial direction, turn away from the command system, and seek individual freedom. It is eminently effective and beneficial in all other pursuits; it is likely to be the same in financial matters.

No man is free who is not master of his finances. The American command system is an abomination to all friends of freedom. They will not rest until financial commands finally give way to individual freedom. []


1.   The New York Times, May 20, 1988, pp. D1, D3.

2.   Edward J. Kane, The Gathering Crisis in Federal Deposit Insurance (Cambridge, Mass.: MIT Press, 1985).

3.   Business Week. May 23, 1988, p. 27.

4.   Franklin R. Edwards, “Can Regulatory Reform Prevent the Impending Disaster in Financial Markets?” in Restructuring the Financial System, The Federal Reserve Bank of Kansas City, 1987, pp. 1- 17.

5.   Federal Deposit Insurance Corporation, Mandate for Change (Washington, D.C.), October 1987. pp. 29-33.

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November 1988

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