The crash of 1988.

THE CRASH OF 1988

JUST AS the financial community has begun to recover from last fall's nerve-wracking stock-market crash, a new danger looms: American depository institutions (banks and savings & loans) are failing at a greater rate than at any time since the Depression. If you liked Black Monday, you'll love the Great Banking Collapse of '88.

An exaggeration? Perhaps, but the current state of our banking system is anything but reassuring. In 1986 over 140 banks failed. Last year more than 180 closed their doors. In comparison, the average number of bank closings between 1940 and 1970 was less than ten per year.

Savings & loans are having even more trouble. The official statistics (229 S&L failures between 1981 and 1985) do not begin to reflect the wreckage in the thrift industry; regulators have been covering up for bankrupt thrifts on a massive scale. A more telling indicator is the fact that, at the end of 1985, some 450 thrift institutions (with combined assets of over $100 billion) had negative net worth when net worth is calculated using generally accepted accounting principles instead of regulatory accounting principles. On that basis, another 730 shaky institutions (with assets of $290 billion) had net worth between 0 and 3 per cent of assets.

What's to prevent a crisis in our banking system? Not the Federal Savings & Loan Insurance Corporation (FSLIC), whose claimed reserves totaled only $4.6 billion at the end of 1985. In contrast, the unrecognized claims against the fund totaled over $29 billion. Nor is there any sign of improvement; FSLIC reserves have since dwindled to less than $2 billion.

In short, not only is 15 to 20 per cent of the savings & loan industry at or over the brink of economic, if not legal, insolvency, but the insurance fund that supposedly safeguards depositors and thus the stability of the industry is itself economically insolvent. If a renewed burst of inflation drives up interest rates or a recession impairs the ability of borrowers to repay debts, it will not be possible to continue pretending that these zombie institutions are still viable.

The current expansion is already one of the longest on record. It would be foolish to assume that Reaganomics, however successful it has been, has permanently eliminated the business cycle. So a massive shakeout of the thrift industry is hardly an implausible scenario.

When the next recession hits, we may be left with only three choices: use general revenues to compensate depositors; nationalize defunct institutions; or allow a default by federal deposit insurance. The financial panic that the latter course would cause is too frightening to risk. Yet the first two options are scarcely more appealing. Financing FSLIC through general revenues would lead to either a major tax increase or an inflationary spiral; whereas nationalizing failed institutions would constitute one of the most breathtaking shifts of economic power from the private to the public sector in American history.

So far, politicians and regulators have simply looked the other way, hoping that the financial time bomb would somehow defuse itself, or at least wait until after they left office to explode. The legislation passed by Congress last year injecting $7.5 billion into the FSLIC kitty left FSLIC still insolvent without addressing any of its underlying structural problems. (One observer described the Administration's stronger version of the measure as "nothing more than a thirty-month punt of the FSLIC mess into the next Administration.")

There is a school of thought, represented by Wall Street economist Henry Kaufman among others, that blames the current crisis on financial deregulation. According to this view, deregulation, by forcing banks and S&Ls to pay competitive interest on deposits, encouraged them to take excessive risks. The risks produced handsome payoffs for some institutions, but they also led others to insolvency. The solution critics of competitive banking propose is simple: re-regulate banks and thrifts, prohibit payment of interest on demand deposits, and sharply limit the kinds of activities banks and thrifts may engage in.

Betting the Bank

PART OF THIS diagnosis surely is correct. Excessive risk-taking is indeed the principal threat to the banking and thrift industries. But it is not deregulation that leads depository institutions to take excessive risks: rather, deposit insurance is at fault. If their gambles pay off, managers and stockholders revel in the rewards; if not, they shift the loss to FSLIC and ultimately to the taxpayer. What is worse, the temptation to shift losses to the insurer increases rapidly as the net worth of an institution shrinks. With your equity gone, and deposit insurance there to guarantee your liabilities, why not bet the bank? So the incentive for risk-taking is greatest for the shakiest institutions.

Ironically, the system of deposit insurance that now threatens our financial system was instituted in 1933 precisely to prevent a recurrence of the banking collapse of the Great Depression. And by giving the public confidence in the safety of their deposits, FSLIC and the Federal Deposit Insurance Corporation (FDIC) certainly have prevented contagious runs on the banks and thrifts they insure. (The recent runs on S&Ls in Ohio and Maryland were on institutions insured under state-operated plans.)

However, competent students of banking have long recognized that deposit insurance has also been eroding the soundness of the banking and thrift industries. Thus there is growing support among academic observers for proposals to charge risk-adjusted premiums for deposit insurance.

Unfortunately, in practice, federal deposit-insurance agencies would never be allowed to set risk-adjusted premiums according to strictly economic criteria. Can anyone really imagine Speaker Wright standing idly by while the FDIC charged ailing Texas banks higher premiums than it charged healthy banks in other states?

Fortunately, there is another, albeit more radical-sounding, way out of the deposit-insurance trap. This new alternative has been provided by money-market mutual funds (MMMFs), the most important financial innovation of the last decade. Introduced to let small savers avoid the large minimum denominations on conventional money-market instruments, MMMFs soon began to compete with checking accounts by offering limited check-writing privileges. There is, however, a basic difference between MMMF shares and checking accounts: the MMMF shareholder owns part of the fund's asset portfolio, while the holder of a checking account has a claim on the depository institution for a fixed sum.

Each instrument has advantages and risks. A depositor always knows exactly how much he has in the bank (or thrift) but an MMMF shareholder can only find out precisely what he has by liquidating his account. On the other hand, a depositor bears a risk of default, while an MMMF shareholder, as part-owner of the fund, does not.

That is an important point because it means that MMMF shareholders have no incentive to start a run on their fund. Once depositors find out that the assets of a bank have depreciated, they may quite reasonably try to protect themselves by withdrawing their deposits. But MMMF shareholders absorb the reduction in the value of the fund's asset portfolio instantaneously so there is far less incentive to cash in MMMF shares. Even if MMMF shareholders do try to liquidate, doing so cannot threaten the solvency of the fund since all a shareholder can get is his pro-rata share of whatever is left.

Doing without Insurance

IN A competitive environment, both deposits and fund shares would be offered. But since MMMFs minimize fluctuations in the value of their portfolios by acquiring only liquid short-term asserts, banks would have to guarantee depositors against the risk of default in order to compete with funds.

Banks can provide that guarantee now only thanks to federally subsidized deposit insurance. Thus, deposit insurance gives an unsafe payments system based on debt a competitive advantage over an inherently safe and stable system based on equity. Since the Depression we have been paralyzed by the fear that, without deposit insurance, deposits would be unsafe and the financial system would be in danger of collapse. But now the competition from MMMFs would, even in the absence of insurance, force banks and thrifts to provide their own guarantee against default risk.

How could they do so? Just as any debtor does: by securing their obligations with collateral. But for the collateral to be acceptable, it would have to be readily marketable. In other words, it would consist of the same sorts of highly liquid short-term assets now held by MMMFs. By collateralizing deposits, banks would, in effect, be providing fund shares while guaranteeing depositors against any fluctuation in the nominal value of the shares. If that guarantee were worth anything to depositors, banks could pay less interest on deposits than the average return to those holding MMMF shares.

Historically, banks have performed two distinct functions. One was to provide a medium of exchange and operate a payments mechanism by appropriately crediting and debiting accounts; the other was to act as a financial intermediary pooling the money of many savers and lending it to those wishing to borrow. Unfortunately, whenever banks ran into trouble in discharging their second function, their ability to discharge the first was also impaired. The result? Instant monetary crisis.

Under the system I am suggesting, banks would, in essence, separate themselves into two independent units to perform these two distinct functions. One unit would provide payments services to depositors by managing funds of short-term marketable securities. The second would lend capital raised from stockholders and holders of long-term debt. The former unit would be completely insulated from the fortunes (or misfortunes) of the latter.

It Doesn't Have to Happen

IT WOULD be nice if there were a painless way of solving the banking problem. Unfortunately, as long as accounting devices can disguise the bankrupt state of depository institutions, our political leadership seems determined to ignore the problem. So the banking losses are likely to continue until the consequences are so great that we all feel them.

It doesn't have to be that way. A sensible approach would begin by recapitalizing and reconstituting (where possible) or liquidating institutions with negative net worth while meeting obligations to insured depositors; uninsured depositors could be left to recover whatever they could from the liquidated assets of the insolvent institutions. The next step would be to phase out federal deposit insurance by gradually reducing the maximum limits on insured deposits to zero. At the same time MMMFs should be permitted to offer a full range of payments services.

If Washington can somehow muster the courage to adopt such a strategy, we can create for ourselves and our children a safer, more stable, and more efficient financial system than America has ever had before.