Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : Bank Runs, Deposit Insurance, and Bank Regulation, Part I, February 1, 1988

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February 1, 1988

banks. Because such a reduction in
the money supply can be offset by
supplying additional reserves to the
banking system, justifying deposit
insurance to eliminate a bank-runinduced multiple contraction of the
money supply is not warranted.
In order to justify deposit insurance,
one must understand not only the
costs associated with its administration, but also the benefits of having
deposit insurance. The preceding discussion indicates that an analysis of
contagious bank failures is necessary
in order to understand these benefits.
Part II of this article, presented in the
upcoming February 15 Economic
Commentary, concludes with an
examination of contagious bank runs
and a discussion of how the banking
system prior to the Federal Reserve
System handled such problems.

Charles T. Carlstrom is an economist at the
Federal Reserve Bank of Cleveland. The
author wishes to thank Walker Todd,
james Thomson, john Scadding
William
Gavin, and Mark Sniderman for their helpful comments.
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

•

Footnotes

1. In 1934, the first year the FDIC operated, depositors were insured up to a maximum of $2,500 (which amounts to
approximately $22,000 today). This maximum increased slowly until 1982, when it
increased from $40,000 to its current level
0[$100,000.
2. See "1987 Bank Failures Set PostDepression Record," The Washington
January 6, 1988.

Post,

3. See George G. Kaufman, "The Truth
About Bank Runs," Staff Memoranda SM87-3, Federal Reserve Bank of Chicago,
April 1987.
4. See Daria B. Caliguire and James B.
Thomson, "FDIC Policies for Dealing with
Failed and Troubled Institutions," Economic Commentary, Federal Reserve Bank
of Cleveland, October 1, 1987.
5. See George]. Benston, Robert A.
Eisenbeis, Paul M. Horvitz, Edward]. Kane,

eCONOMIC
COMMeNTaRY

and George G. Kaufman, Perspectives on
Safe and Sound Banking: Past, Present,
and Future, Cambridge, MA: The MIT
Press, 1986, pp. 1-4.
6. See "Study Says Bad Management Had
Key Role in Bank Failures," The Washington Post,January 21,1988.

Federal Reserve Bank of Cleveland

7. See George]. Benston and George G.
Kaufman, "Risk and Solvency Regulation
of Depository Institutions: Past Policies
and Current Options," Staff Memoranda
SM-88-1, Federal Reserve Bank of Chicago,
1988. This is not meant to imply that deposit insurance is the only reason for the
decline in banks' capital-to-asset ratios.

Bank Runs, Deposit Insurance,
and Bank Regulation, Part I

8. See Edward]. Kane, The Gathering Crisis in Federal Deposit Insurance, Cambridge, MA: The MIT Press, 1985, p. 20.
9. See "Two Big Alaska Banks Unveil
Rescue Plan," The American Banker,
October 8, 1987.

by Charles T. Carlstrom

10. In fact, in the thrift industry, financial
health is usually not regained. See "Thrift
Industry: Forbearance for Troubled lnstitutions, 1982-1986," U.S. General Accounting
Office Briefing Report, May 1987.

A long as there have been banks,

there have been bank runs. Unlike
the failure of mom-and-pop grocery
stores (or Lockheed, for that matter),
bank failures are frequently viewed as
contagious-able to cause other bank
runs and lead to failures of otherwise
solvent banks.

11. See Benston, et aI., op. cit., p. 64.
Some investors did not receive their
money until years later. If capital markets
are efficient, however, depositors would
have been able to borrow against a portion of their likely settlement.

A rumor or a hunch that a bank is in
trouble can lead to its demise. Thus,
the fear that a bank "might" be in
trouble can be a self-fulfilling
prophecy.

12. This same argument has been used to
contend that deposit insurance should
cover deposits only up to a maximum of
$5,000 to $10,000.

Haunted by the contagion of bank
failures that occurred during the
Great Depression, regulators are still
wary of letting banks fail. Large banks
in particular are a cause of concern,
because the potential spillover effects
are thought to be excessive.

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Federal Reserve Bank of Cleveland
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Along with other bank regulators, the
Federal Deposit Insurance Corporation (FDIC) has an implicit mandate
to maintain confidence in, and provide stability to, the commercial
banking system. A principal method
of achieving this mandate is by insuring depositors for losses up to a current maximum of $100,000.1
The justification for FDIC insurance is
simply that insured depositors will no

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longer have an incentive to pull their
money out of a bank that is merely
rumored to be insolvent. Unfortunately, federal deposit insurance provides little incentive for insured depositors to withdraw their funds from
a bank that actually is insolvent.
For nearly 50 years after its inception
in 1934, the FDICwas considered
successful in fulfilling its mandate.
The banking system grew rapidly with
few bank failures, and none widespread enough to threaten the entire
system. Since 1981, however, the number of bank failures has increased
sharply. In 1987 there were 184 bank
closings, and an additional 19 required
FDIC assistance to stay afloat.! Bank
failures are currently at their highest
level since the Great Depression.
This Economic Commentary, presented in two parts, discusses
whether federally provided deposit
insurance is necessary to prevent
widespread bank runs by exploring
some of the myths and folklore associated with bank runs. Adam Smith
argued that the invisible hand of selfinterest leads men to effectually promote the interests of SOCiety.We
attempt to analyze whether this invisible hand extends into the banking
industry by examining both the
causes and cures of bank runs.

Widespread bank failures are often
thought to be a possible consequence
of a banking system without federal
deposit insurance. This article considers whether federal deposit insurance is necessary to prevent bank
runs. Part I describes some of the
costs of providing deposit insurance
and then introduces its justification
and benefits. Part II, presented in the
upcoming February 15 Economic
Commentary, concludes with an
examination of contagious bank runs
and a discussion of how the market
handled banking panics prior to the
Federal Reserve System and the Federal Deposit Insurance Corporation.

• The Nature of Bank Runs
A bank run can occur when some of a
bank's depositors perceive the bank
to be insolvent or expect insolvency
to occur.
If banks are like other businesses,
then a bank run would be quite
acceptable as a source of market discipline. For example, if the public

thought that a bank's manager had
embezzled a substantial portion of
the bank's capital, depositors would
have an incentive to withdraw their
money. If a substantial portion of a
bank's deposits were withdrawn, the
bank would then be forced to close.
The threat of being run on and closed
down provides the incentive for
stockholders to spend the necessary
resources to monitor their employees.
The potential for bank runs also
creates the incentive necessary to
stop banks from undertaking excessively risky investments: those in
which there is a high probabiliry of
failure as well as success.'
• The Costs of Providing
Deposit Insurance
Deposit insurance circumvents the
market discipline of insured depositors. Because their funds are guaranteed, insured depositors (those with
deposits less than or equal to
$100,000) have little incentive to
place their money in a safe, wellmanaged bank Similarly, if they discover that a bank is not financially
viable, they have no incentive to
withdraw their money from the bank
Therefore, unless regulators promptly
close insolvent institutions, it is up to
the shareholders and the uninsured
depositors to impose discipline on
troubled banks.
The role of uninsured depositors may
be quite small under the present system, however. Since a depositor can
have several accounts of $100,000, the
de facto maximum of deposit insurance is many times greater than the
stated legal limit of $100,000.And,
because of the failure-resolution policies that have been applied to some
large banks (for example, Continental
Illinois, First City,and First Republic),
the perception exists that some banks
are too big to fail and that all depositors in these banks are, in effect,
insured.' Both of these factors work
to reduce the disciplinary action of
depositors.

Deposit insurance provides banks
with a no-risk source of funding.
Without the threat of bank runs,
stockholders and senior management
in the existing regulatory environment have reduced incentive to monitor their employees to minimize
insider dealing, bank fraud, and simple incompetence.
It may not be a surprise that fraud
and embezzlement have been the primary causes of bank failures.' According to a recent study by the Office of
the Comptroller of the Currency,
since 1979 "poor management, either
by the bank officers, the board of
directors, or both, played a significant
role in 89 percent of the failures."!
Deposit insurance also reduces the
amount of capital a bank chooses to
maintain. A higher capital-to-asset
ratio enables a bank to borrow money
more easily in case of financial diffieulry. By guaranteeing insured depositors against losses, the risk of bank
runs, as well as the amount of capital
that is necessary to protect a bank
from withdrawals, is lessened.
At the turn of the century, capital-toasset ratios were 20 percent; by the
1930s, they had declined to about 15
percent. Today the capital-to-asset
ratio is approximately 7 percentsubstantially less than the capital
ratios of other industries.? Concern
about the decrease in bank profitabiliry and the increase in bank failures
during the 1970s led to increased
concern about capital adequacy and,
in 1983, to enactment of a law that
provided bank regulators with the
legal authority to enforce minimum
capital standards.
Along with limited liabiliry, deposit
insurance creates an incentive for
banks to hold more risky investment
portfolios. Bank owners reap the
rewards when a bank's investment
succeeds, but because of limited liabiliry, the FDIC-and perhaps the
taxpayers as well-shares in the
losses when an investment fails.

Deposit insurance further reduces the
incentives for banks to avoid risky
investments, because a bank does not
have to compensate its depositors (by
paying them a higher interest rate)
when it undertakes substantial risks.
This problem is aggravated by the
recent failure-resolution policies applied to some large banks. Such policies have served to erode the
market's discipline further and to
subsidize these banks just because
they are large.
• Bank Regulation and
Deposit Insurance
Bank regulators are aware of these
problems. Not only can regulators
impose minimum capital requirements on banks, but they are empowered to close down banks that are not
solvent and to assist banks that are
becoming insolvent.
Traditionally, bank regulators did not
have the power to close a bank when
its market value reached zero. Instead,
they could close a bank only after its
book value became negative.e Even
then, however, a bank was not necessarily closed down, as the recent
FDIC-assisted merger of Alaska Mutual and United Bankcorporation of
Alaska indicates." With the Competitive Equaliry Banking Act of 1987,
chartering authorities can now close a
bank when book insolvency appears
imminent.
This forbearance occurs even though
the FDIC may spend more money
later to bail out such banks. While it
is true that an insolvent bank may
later become financially viable, the
Alaskan situation illustrates that financial health may not be regained.'?
The incentive to take on more risk is
especially prevalent for a bank that is
close to being shut down. The threat
that regulators might close a bank can
lead a bank's manager to make investments that have a small chance of a
large payoff and a larger chance of

expected loss. In the outside chance
that the gamble pays off, the manager
saves the bank and hence his job; if
the gamble fails, the bank goes out
with a bang instead of a whimper.
Although this scenario is not firmly
established in banking, the precedent
has been set in the thrift industry.
The longer the FDICwaits to close a
bank, the greater the incentive for the
bank to undertake risky investments.
If an insolvent bank is not closed
promptly, then the'tosses to shareholders are postponed. Because a
dollar in the future is worth less than
a dollar today, postponing shareholders' losses provides an extra indirect subsidy.
Besides closing banks when they first
become insolvent, another way to
lessen the negative aspects of deposit
insurance is for regulators to charge
banks an insurance premium based
on the riskiness of their portfolios.
Risk-takingwould be punished by
requiring the bank to pay higher
premiums. However, Congress has
long been opposed to any plan that
would allow the FDIC to charge different premiums to different banks.
Absent these measures, the best ways
to strengthen market discipline are to
sharply reduce the legal limit of deposit insurance, to limit insurance to
one account per person, to assist only
insured depositors, and to send a signal to the market that no banks are
too large to let fail.
• The Case for Deposit Insurance
Supporters of the current deposit
insurance and regulatory system generally respond to these criticisms on
two fronts. First, while the FDIC is
interested in economic efficiency, it is
also interested in equiry considerations, that is, in protecting the interests of the small or less-informed
depositor. Second, while inefficiencies and moral hazards are the costs
of providing deposit insurance, the
benefits of deposit insurance are even

greater than the costs, because a bank
is unlike other forms of business.
Unfortunately, using deposit insurance to protect the less-informed
diminishes the incentives for them to
become informed. If the objective is
to protect the small depositors, one
might question the need to insure
depositors up to a current maximum
of $100,000, to extend coverage to
more than one account, or to protect
uninsured depositors.
Sociery should ask itself not only
whether it wants to protect certain
depositors who lose money in bank
runs, but also how much protection
to provide in the most cost-effective
way. For example, the federal government could allow an income tax credit
so that depositors could deduct their
losses, up to a legislated maximum.
Justifying deposit insurance because
depositors lost money due to bank
failures prior to the FDIC is also tenuous, because these losses were generally small. From 1930 to 1933, depositors of failed banks lost only 0.81
percent on average. During noncrisis
years, losses to depositors averaged
only 0.07 percent."
Losses have typically been small
because rational depositors run on a
bank when they first perceive it to be
insolvent. Given that depositors in
failed institutions generally receive
more than 99 cents on the dollar
even during bad times, one might
well question whether deposit insurance is necessary to protect the vast
majority of depositors.
The most important argument in
support of deposit insurance is that
banks are not like other businesses.
They are potentially special because
1) bank failures can cause undue
economic hardship in a communiry,
2) the economy depends on the
safery and security of the banking system, which could potentially be upset

if some larger banks were to fail, and
3) bank failures can be contagious
and can cause otherwise solvent
banks to fail.
The first argument, that banks are
special because bank failures could
impose a hardship in a particular
geographical area, is not unique to
banking. The closing of a mill in a
one-mill town would be at least as
devastating as the closing of the
town's only bank
In the absence of laws against branch
banking, a bank failure would rypically result in the transfer of ownership from a poorly managed banking
firm to a banking company that is
potentially better managed. It is the
presence of regulations against
branch banking and the restrictive
policies of bank chartering agencies
that can cause economic hardships
when a bank closes in a small town.
Another potential reason for protecting banks is the argument that a wellfunctioning market economy depends
on the securiry of the banking system.
Because banks facilitate savings and
investment, a large number of bank
failures can have real effects.
The potential for a series of bank runs
to threaten the banking system is limited, however, because the failure of a
few banks would tend to strengthen
the remaining banks. This is because
large depositors who have a high opportunlry cost of holding their assets
in cash would redeposit their money
in sound banks. 12 The exception to
this rule is when a bank failure causes
a run on otherwise sound banks.
A series of bank runs may also
hamper economic activity because
widespread bank failures can cause a
significant drop in the money supply.
The money supply contracted during
the Great Depression because individuals decided to hold their money
in currency instead of depositing it in