Banking Without the "Too Big to Fail" Doctrine; R. Salsman

has given government wide latitude to bail out failed or failing banks for whatever reasons it deems necessary. Of course, deposit insurance legislation itself arose out of the bank failures of the early 1930s. These failures in turn were largely the result of Federal Reserve monetary mismanagement,3 In short, today's "too-big-to-fail" doctrine can trace its roots to the very establishment of central bankMr. Salsman is a banker in New York City and an adjunct fellow of the American Institute for Economic Research in Great Barrington, Massachusetts. This article is adapted from a speech delivered at a conference spon sored by The Federal Reserve Bank ofDallas, May 12-13, 1992. ing in this country in 1913.Before we examine the merits of the manner in which government has decided to handle bank failures, it is helpful to understand why banks are failing today in such large numbers to begin with.

The main theme of my own research on U.S. banking history has been that central banking is detrimental both to sound money and safe bank ing. In particular I have found that the U.S. com mercial banking industry has suffered a secular decline in financial strength in the 80 years since the Federal Reserve System was established in 1913. For example, capital ratios have fallen from 20 percent at the turn of the century to around 6 percent today. Banks are also far less liquid today than they were in earlier decades. The loan quality of banks has declined steadily over our central banking era. Profitability has been weak and irreg ular compared to the period before central bank ing. Finally,bank failures have been more a prob lem under central banking than under previous banking eras in U.S. history.4 To be sure, these measures of banking system strength have ebbed and flowed cyclicallyover the past eight decades-for example, the dissolution of the 1930s, the seeming calm of the 1950s, and the renewed turbulence of the past two decades.

But in my own work, I've identified an undeniably pronounced secular decline in the financial condi tion of banks, in good times and bad. This leads me to question the legitimacy of central banking as such. I'm encouraged to find that other scholars are also questioning the conventional wisdom about central banking.5 I attribute the secular decline of banks to central 426 banking not only because that has been the pre dominant structure governing our money and banking system for most of this century, but because the main features of central banking bear directly on the worsening finances of the banks. For example, central banking involves a legal tender monopoly on the production of paper cur rency' and to the extent this money is produced in excessive supply and forms the base of banking system deposit expansion, it inflates bank balance sheets and invites malinvestment of resources.

Central banking is characterized by a lender of last resort function that can be seriously mismanaged, as it was in the 1930s, causing widespread bank failures. Central banking is usually accompanied by a system of flat-rate federal deposit insurance, a system known by all to promote excessive risk taking and imprudence among banks. It should not have taken decades to see this would happen. Back in 1908,when earlier versions of government deposit insurance were advanced, the president of the First National Bank of Chica go, James Forgan, asked the following: "Is there anything in the relations between banks and their customers to justify the proposition that in the banking business the good should be taxed for the bad; ability taxed to pay for incompetency; hon esty taxed to pay for dishonesty; experience and training taxed to pay for the errors of inexperience and lack of training; and knowledge taxed to pay for the mistakes of ignorance?"6 As I have argued elsewhere, "deposit insurance is a scheme put in place because the Federal Reserve mismanaged the discount window in the 1930s,and it is a scheme that has been expanded ever since in concert with the Fed's inflation of the money supply (which consists predominantly of bank demand deposits)."7 Finally, systems of central banking involve ex tensive regulation of bank branching, lending, and product offerings-regulations that prohibit sound diversification and invite still greater insta bility.

Unsafeand Unsound If the purpose of central banking is to ensure sound money and safe banking, then central bank ing has been an unmitigated failure. I have already summarized the relative decline of banking's strength as captured in financial ratios. But the 427 purchasing power of money has also declined, so that a 1913 dollar is worth ten times more than a 1992dollar. We enjoyed much sounder money and safer banking in the eight decades before central banking was established here in 1913than we have in the eight decades since. I conclude that this is so because central banking represents a special case of the general failure of central economic plan ning, a failure that most of the world is only now beginning to recognize.8 The fact that central banking flies in the face of free-market alternatives is recognized by some of its most prominent practitioners. In a symposium sponsored by the Federal Reserve Bank of Kansas City in August 1990, Paul Volcker noted that, "Central banks were not at the cutting edge of a market economy .... Central banking is almost entirely a phenomenon of the 20th centu ry.... Central banks were looked upon and cre ated as a means of financing the government.

... If you say central banking is essential to a free market economy, I have to ask you about Hong Kong, which has no central bank at all in the absolute epitome of a free market economy. Yet it does quite well in terms of economic growth and stability."9 My research confirms Mr. Volcker'sassessment. The primary purpose of central banking is to finance the government,10That's what it does con sistently and what it does best-and does so, unfortunately, at the expense of sound money and safe banking. Mr. Volcker would find results in the U.S. similar to those of Hong Kong, as I did, by examining the decades before the Federal Reserve was established. In the eight decades before 1913 we had a sys tem which can very loosely be called "free bank ing and the gold standard." There was no central bank, no lender of last resort, no federal deposit insurance. Banks issued currency as well as checking deposits, convertible into the precious metals. Bank note redemptions and the gold stan dard anchored the money supply. Excessive cur rency issuance was prevented. Money expanded and contracted with the needs of trade, not with the needs of government. Banks formed clearing houses to settle balances and they lent on an interbank basis to temporarily illiquid but sol vent institutions. The few banks that failed were absorbed into stronger ones or simply liquidated at a discount to noteholders. 11 428 THE FREEMAN • NOVEMBER 1992 The free banking era was not totally free, of course. Bank note issues were restricted by laws requiring currency to be backed by state or federal bonds-an indirect means of financing govern ment. Branching was restricted as well,preventing full diversification. But the U.S. free banking era was more in line with a free market system of mon ey and banking than our present era. As such, it should not be surprising that it produced relatively higher quality money and much safer banking. I document these facts in my book. For more back ground on the favorable history of the free bank ing era, I recommend the work of Arthur Rolnick and Warren Weber at the Federal Reserve Bank of Minneapolis.12 Only with this wider historical and theoretical context can we grasp the full implications of today's "too-big-to-fail" doctrine. In my view, banking without the "too-big-to-fail" doctrine is not simply banking prior to 1984, the year when Todd Conover, Comptroller of the Currency, said the top 11 banks in the country would not be per mitted to fail. For me, banking without "too-big to-fail" is banking before 1913,the year when the Federal Reserve was established. For as I have indicated, the doctrine is inextricably linked with central banking. No free market system of money and banking would aim to sustain insolventinsti tutions, and there would be no institutional bias in favor of generating insolvent institutions, as cen tral banking engenders. Free banking minimizes the spread of problem banks from the very start.

No central bank monetary inflation or taxpayer deposit guarantees are employed to force-feed a free banking system. Undenniningthe Financial Integrityof Banks In two important respects, the "too-big-to-fail" doctrine represents an unhealthy extension of two central banking features that have already been shown to undermine the financial integrity of banks. First, the "too-big-to-fail" doctrine has trans formed the lender of last resort from one provid ing cash to temporarily illiquid banks to one pro viding extended credit to permanently insolvent banks. One of the first theorists of the lender of last resort function, Walter Bagehot, warned us that there would be times when a central bank couldn't effectively distinguish between illiquidi ty and insolvency,!3But in recent years the dis count window has been thrown wide open to banks widely admitted to be insolvent. For exam ple, a 1991 House Banking Committee report concluded that the central bank provided subsi dized credit to hundreds of banks that ultimately failed. In six years ending May 1991, 530 of the 3000 banks that drew on the discount window failed within three years. Many more, if not out right failures, had the lowest financial perfor mance ratings assigned by regulators.

Even as a provider of short-term liquidity, the lender of last resort offers a safety valve for banks that do not properly manage their liquidity posi tions. This subsidy for liquidity mismanagement has been in place for years. We were always assured that the Fed would manage access to the window with prudence and discretion. But now this mal-incentive has been extended still further to cover up the insolvency of banks. Perhaps even worse, access to the discount window was widened in the 1991 banking law to include the securities industry. More recently, there was talk among U.S., British, and Canadian central bankers of assisting real estate developer Olympia and York, on the grounds that its bad loans would harm big banks. There appears to be no end to the degeneration of the lender of last resort function. Second, the "too-big-to-fail" doctrine has unwisely extended deposit insurance coverage from insured depositors to uninsured depositors and creditors. Government guarantees of insured deposits are bad enough in the way they promote reckless banking. The more than doubling of deposit coverage in 1980institutionalized the reck lessness.The extension of coverage to all creditors of banks, as under the "too-big-to-fail" doctrine, is the height of irresponsibility.

Nothing in the 1991 banking law rempves the discretion of the Fed or the Treasury in employing "too-big-to-fail" at any time for any purpose,14To the extent the doctrine has not been employed as extensively in recent failures, it seems only because of the insolvency of the deposit insurance funds themselves. "Too-big-to-fail" is not a doc trine which can be effectivelyscaled back in isola tion or in increments. Unless there is an outright rule against it, exceptions will always be made to expand it.

BANKING WITHOUT THE "TOO-BIG-TO-FAIL" DOCTRINE 429 "As the late Nobel Prize-winningeconomist FriedrichHayek argued, we need'a denationalization of money,'and the kind of choicein cu"encies that broughtus stable moneyand banking in the 19th century." Bad as they already were, discount window activity and deposit insurance coverage have degenerated further in recent decades, in the name of the "too-big-to-fail" doctrine. We need to repeal the structural central banking features that generate failed banks, not simply patch on some extended version of these features, a patch job supposedly justified by pointing to all the fail ures. Accompanying the unconditional repeal of "too-big-to-fail" must be a scaling back and even tual abolition of federal deposit insurance and discount window lending as well. The sooner this occurs, the sooner banking will be restored to the health it enjoyed before these features were in place.IS The Fearof Contagious BankRuns Opponents of the repeal of the "too-big-to-fail"

doctrine often cite the so-called "contagion" effect of bank failures, the domino effect of large bank failures precipitating other failures, allegedly cas cading into a system-wide collapse. In my estimation, no factor contributes more to this risk than government restrictions on branching. U.S. banking historians know all too well that widespread correspondent banking and extensive reliance on interbank deposits in this country stem directly from branching prohibi tions.16 In nationwide banking systems, such as in Canada, interbank exposures are minimal.l7 But in the V.S., the government has promoted an interlocking banking system, in effect requiring banks to line up like dominos, preventing them from holding their own direct deposits in their own chosen areas of the country. Having created such unstable links, government has then advanced a "too-big-to-fail" doctrine to prevent smaller banks from being harmed by losses on deposits at bigger banks.

Here is an obvious case of government interven tions that have bred further intervention, allegedly to remedy the distortions brought about by still earlier interventions. Eugene White and others have shown t.hat V.S. banking history is replete with evidence of this viciouscircle.18 There is only one solution to this madness, and that is to repeal the interventions across the board. Let's start by permitting what every advanced country permits of its own banks-the ability to branch freely and diversifytheir operations. I will not repeat here in detail other important refutations of the so-called "contagion" argument, especially those made by economist George Kauffman.19Sufficeit to say,he argues that ifsome banks are weak, depositors willtransfer their mon ey to stronger ones. If they don't find stronger ones they will make a flight to quality and acquire gov ernment securities, the sellers of which must be confident of finding stronger banks, because in sellingthey expect to deposit the cash proceeds. In either of these cases, there is a redistribution of reserves, but no destruction of them. There is no deflation of the aggregate money supply and hence no contagion effect.

What if the strength of all banks is doubted by all parties? Then there will be a flight out of deposits into currency, a precipitous drop in the deposit/currency ratio so common to deflations. A loss of reserves could kick off a multiple con traction process that affects healthy banks as well as insolvent ones. But observe that such defla tions are exacerbated by fractional reserve bank ing, and especially by very low fractions. Economists who recognize this potential problem tend to argue for some form of deposit insurance to contain it. I believe, to the contrary, that all 430 THE FREEMAN • NOVEMBER 1992 government deposit insurance is de-stabilizing. I oppose it on principle, mindful of the fact that even limited forms of it soon grow into uncontrol lable excess. Furthermore, my own research indicates that bank liquidity is far lower-that is, reserve frac tions are far lower-under central banking than under free banking. Hence a deposit contraction is potentially more severe when a central bank is in charge. More important, free banking offers a direct solution to the problem. A system of free banking permits private bank currency issuance, so banks can easily meet shifts in customer demand for currency relative to checking deposits.

Such shifts are far less easily accommodated by a monopoly currency issuer which can misjudge and mismanage the shift, as did the Federal Reserve in the early 1930s. On these grounds alone, I believe there is good reason to secure some end as well to the legal ten der laws which grant a monopoly on currency issuance to the Federal Reserve. I have offered other reasons for the repeal of the legal tender laws in my book. As the late Nobel Prize-winning economist Friedrich Hayek argued, we need "a denationalization of money," and the kind of choice in currencies that brought us stable money and banking in the 19th century.20Parting some.:. what from Hayek, I believe this free issuance of bank notes must also involve gold-convertibility, as note issue did during our better banking era. A proper legal structure upholding property rights is also important. Free banking does not entail anarchy. Contracts must be enforced. The repeal of the "too-big-to-fail" doctrine will not be truly sustainable unless banks are fully subject to the general bankruptcy laws. No other industry is exempt from such laws, nor so harmed by the exemption.

Until and unless banks are subject to bankrupt cy'we willcontinue to see failures handled accord ing to politics and bureaucratic motives-such as agency "image"-not according to simple justice and sound economics. We willcontinue to witness swings from a regulatory policy of "forbearance" to a policy of "early intervention," to forbearance, and back again. Both policies are detrimental to the banking system, and not only because of their unpredictable application from one case to the next or one year to the next. Forbearance, as is known to all, promotes laxity in accounting and financial control, condon ing, if not encouraging, recklessness, hiding insol vency, and ballooning ultimate losses. "Early intervention," on the other hand, has its own dan gers. While posing as a remedy for the ills of for bearance' a policy of early intervention actually holds out the very definite prospect of de facto nationalizations of the banks. After all, if banks with 2percent capital ratios are to be closed down or taken over, as provided in the 1991 banking law, what else can such a policy be called but a nationalization, indeed a "taking," under the Fifth Amendment? The recent nationalization of Crossland Savings Bank offers a chilling prece dent for this disturbing new extension of the "too-big-to-fail" doctrine.21 If, instead, banks are subject to the bankruptcy laws, the competing interests of management and creditors, including the creditors who are depos itors, will prevail. Closures of failed institutions will not be sudden but orderly. They'll be drawn out in a rational manner, but not forever, as in the case of the thrifts or the Rhode Island credit unions. Neither will closures under bankruptcy take place prematurely, while there remains value in the franchise. For a more detailed look at this approach, I commend to you the work of Robert Hetzel at the Federal Reserve Bank of Richmond.22 In conclusion, I want to stress that the "too big-to-fail" doctrine is part and parcel of a wider system of central banking that undermines the financial condition of the banking system. The sooner we phase out this system in favor of free banking and the rule of law, the better off we will be. In other words, repealing the "too-big-to-fail"

doctrine will be a good start, but it won't go far enough in curing what really ails the banks. D 1. Irvine H. Sprague, Bailout: An Insider's Account of Bank Fail ures and Rescues (New York: Basic Books, 1986). 2. Paul A. Samuelson and Herman E. Krooss, Documentary History of Banking and Currency in the United States, Volume W (New York: Chelsea House Publishers, 1983), p. 354. 3. Milton Friedman and Anna J. Schwartz, A Monetary History ofthe United States,1867-1960(Princeton, N.J.: Princeton University Press, 1963), Chapter 7. 4. Richard M. Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions (Great Barrington, Mass.: American Institute for Economic Research, 1990). 5. See especially Lawrence H. White's works, Free Banking In Britain: Theory, Experience and Debate, 1800-45 (Cambridge: Cam bridge University Press, 1984) and Competition and Currency: Essays on Free Banking and Money (New York: New York Univer sity Press, 1989).

6. James B. Forgan, "Should National Bank Deposits Be Guar anteed by the Government?" Address to the Illinois Bankers' AssoBANKING WITHOUT THE "TOO-BIG-TO-FAIL" DOCTRINE 431 dation, June 11, 1908 (Chicago: First National Bank of Chicago). 7. Richard M. Salsman, The Credit Crunch: Myth or Reality? American Institute for Economic Research, October 1991. 8. Economists of the Austrian School of economics, especially Ludwig von Mises and Friedrich Hayek, have been identifying this failure for most of this century. 9. Paul Volcker, "The Role of Central Banks" in Central Banking Issues in Emerging Market-Oriented Economics (a symposium spon sored by the Federal Reserve Bank of Kansas City, August 23-25, 1990). Definitive historical evidence for Volcker's summary assess ment can be found in Charles Goodhart's The Evolution of Central Banks (Cambridge: The MIT Press, 1988). 10. Salsman, Breaking the Banks, chapter 8.

11. Salsman, ibid., chapter 6. 12. See especially Arthur J. Rolnick and Warren E. Weber, "Free Banking, Wildcat Banking, and Shinplasters." Quarterly Re vieHl, Federal Reserve Bank of Minneapolis, Fall 1982,pp.1O-19. 13. Walter Bagehot, Lombard Street:A Description ofthe Money Market (London: Kegan, Paul & Co., 1873). 14. See the misnamed Federal Deposit Insurance Corporation ImproveJ1lent Act of 1991 (FIDICIA). 15. I have explained in detail how this might be accomplished in Chapter 9 of Breaking the Banks. 16. Walker Todd and James Thompson, "An Insider's View of the Political Economy of the 'Too-Big-To-Fail' Doctrine," Federal Reserve Bank of Cleveland, Working Paper #9017,December 1990, p.16. 17. Lawrence Kryzanowski and Gordon Roberts, "The Perfor mance of the Canadian Banking System, 1920-1940," Proceedings from a Conference on Bank Structure and Competition (Chicago: Federal Reserve Bank of Chicago, May 1989), pp. 221-232.

18. Eugene Nelson White, The Regulation and Reform of the American Banking System, 1900-1929 (Princeton, N.J.: Princeton University Press, 1983). 19. George Kauffman, "Are Some Banks Too Large to Fail?" Federal Reserve Bank of Chicago Working Paper, June 1989. 20. Friedrich A. Hayek, Denationalization of Money (London: The Institute for Economic Affairs, 2nd Edition, 1978). 21. Jonathan R. Macey, "Needless Nationalization at the FDIC," The WallStreet Journal, February 14, 1992.According to Macey, "By nationalizing Crossland, the FDIC is signaling that it can take over any bank or thrift it wants, no matter how large or small, or how remote the threat to the banking system." 22. Robert Hetzel, "Too Big To Fail: Origins, Consequences, and Outlook," Economic Review, Federal Reserve Bank of Richmond, November/December 1991,pp. 3-15. THE ACION INSTITUTE FOR THE STUDY OF REUGION AND LIBERTI Promoting a society that combines religious pluralism, civil liberties, and a free market within a tradition that places a high value on scholarship, religion, and religious institu tions. To that end, the Institute seeks to familiarize the religious community, particu larly students and seminarians, as well as business leaders, with the ethical basis for liberty and the free market.To receive a free sample issue of our journal, Religion & Liberty,call or write to: THE ACTON INSTITUTE 161 Ottawa Ave. NW, Suite 405K Grand Rapids, MI 49503 (616) 454-3080 We, the People, and Our Deficit by T. Franklin Harris, Jr.