Stopping Bank Runs Forever

    

Large numbers of ill-informed bank depositors panicked in 2008 and caused a problem that should have been snuffed out in the 1930s: Bank Runs.  Bad information circulating at the speed of light greatly contributed to the sudden collapse of multiple very large U.S. banks; among them, Countrywide, IndyMac, and Washington Mutual (WAMU).

Bank runs, in disastrous concert with other financial debacles in 2007-2008, brought commercial banking to a financial precipice in the fall of 2008.  Misinformed individuals greatly exacerbated a banking crisis that already presented the single greatest financial challenge to the United States since the early 1930s.  Bank runs have potentially dire implications, as the U.S. banking system plays a vital and indispensable role in the U.S. and world economies.  

Congress should amend the National Bank Act to prohibit any FDIC member bank from accepting customer deposits that are neither directly insured by the FDIC nor indirectly insured through an affliliate bank mechansim, such as the Certificate of Deposit Account Registry Service (CDARS)¹. In short, the idea of FDIC member banks accepting and holding any un-insured deposits must be outlawed.  If un-insured national bank deposits were to perish, panicky-depositor bank runs would most likely follow suit. 

Objective Situation

Approximately 99% of all deposit accounts held by FDIC member banks are fully insured.²  Further, FDIC insured deposits are backed by the full faith and credit of the United States; this phraseology is exceptionally important. The "full faith and credit" guarantee is not limited to funds held within the purview of the FDIC insurance premium system; that system helps ensure that FDIC member banks cough up the overwhelming majority of money that backs the guarantee. However, even though member banks pay insurance premiums to fund the FDIC reserves, the U.S. Government is the ultimate bank deposit guarantor. The "full faith and credit" guarantee given to bank depositors is the same unqualified guarantee that the U.S. Government provides to international investors with respect to U.S. Treasury obligations. No credit guarantee is considered stronger in global finance; that is, U.S. Treasury debt obligations are treated by global investors as risk-free investments.  All other credit risks contemplated in global financial circles are weighed against the U.S. guarantee.

Unfortunately, too many people mistakenly assumed that the FDIC was in a similar position as the mortgage giants, the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddy Mac). Congress, by statute, explicity repudiated guarantees for those organizations (prior to the 2008 financial crisis). If bank depositors were both fully informed and fully rational, (taking account of the U.S. "full faith and credit guarantee"), bank runs should have been impossible in 2008.  Since bank runs did occur, we must recognize that flaws remain within the deposit insurance system.

Bank Runs

A classic and well-represented example of a 1930s bank run is in Frank Capras holiday classic, Its a Wonderful Life.³  If the Bailey Building and Loan customers insisted on withdrawing all of their money at once, the bank would collapse into bankruptcy for failing to meet its financial obligations. Bank failures in the early 1930s had a cascading effect: some failed because of bad loans, while many others succumbed to waves of stampeding depositors panicked by the thought of completely losing all of their savings (there was no insurance). It is not difficult to understand why those depositors panicked. 

The U.S. Government established the Federal Deposit Insurance Corporation (FDIC) to act as its primary conduit for guaranteeing bank deposits in national and participating state banks. The FDIC created a depositor safety net: no prospect of losses, no panicky runs on banks.  With comparatively minor exception, the FDIC system worked well for 75 years. 

What Went Wrong?

The panics of 2007-2008 included bank runs on Washington Mutual (WAMU)⁴, Indy Mac, and Countrywide Bank, among others. Depositor panic appears to have flowed from two inter-related causes: lack of depositor knowledge concerning the implications of a "full faith and credit" guarantee (comprehension of this would have rendered any discussion of FDIC insolvency moot); and secondly, the presence of any un-insured deposits in FDIC member banks allowed panics among the extremely rare un-insured depositors to spill over into panics among the fully insured. 

The first problem is illustrated in a 2007 L.A. Times story.  The story concerned a bank run on Countrywide bank; however, the true disservice of the media was that no one pointed out that the featured customer in the article chose to put five times more money on deposit at one bank ($500,000 under the conditions at the time) than FDIC limits allowed . . . and that the overwhelming majority of deposits were fully insured by the U.S. Government at Countrywide Bank. 

Discussions of a bank probably getting ready to fail because of a horrible gamble on toxic securities devolved into allowing people to believe that their money (deposits) were at risk. This thinking was perpetuated by internet sites that failed to highlight the fundamentally different positions of the mortgage GSEs, Fannie Mae and Freddy Mac, companies that have no federal statutory guarantee, and the bank deposits that carry the explicit federal statutory guarantee. 

The real genesis of the bank run problem lay in the fact that discussion of un-insured bank deposits was even possible in the first place. As a result of there being any un-insured depositors, and the natural consequence of discussions that would ensue over that issue, the ubiquity of partially-informed internet discussions propagating an ill-informed message concerning bank deposits (failing to know about both the existence and implications of a "full faith and credit" guarantee) to untold numbers of individuals ultimately contributed to the greater problem. The bank runs that ensued brought several commercial behemoths to the brink of collapse and greatly contributed to the recent misguided collapse of confidence in depositor banking generally.

What Must Go Right?

Going forward, the Government must take into account the fact that the internet can spread misinformation just as rapidly as good information.  As such, allowing there to be any un-insured bank deposits puts the entire system at risk because of the ubiquity of communications outlets that have widely varying knowledge bases. Two key issues must be addressed: first, institute a more explicit bank education program that informs the public about the presence and meaning of a "full faith and credit guarantee"; and second, amend the National Bank Act to prohibit FDIC member banks from accepting any deposits that would not be fully FDIC backed, directly or through such indirect methods as the CDARS. Certain rare individuals may be inconvienced who are unwilling or unable to get protection at greater rates than $100,000 (after the temporary regulations expire) from CDARS or similar organizations; however, that inconvience pales in comparison to the damage that has been done because there were un-insured deposits in FDIC member banks during the Financial Crisis of 2008.

¹http://www.cdars.com/index.php

²According to the U.S. Federal Reserve Bank of Cleveland, as recently as 2001, [c]lose to 99 percent (pg 1, column 3)of all domestic deposit accounts in commercial banks are under the $100,000 deposit-insurance limit [my emphasis]. Additionally, the Federal Reserve has also calculated that the median values of checking accounts and certificates of deposit of the households with the highest income in the United States both averaged less than $25,000 in 2001.

³Wonderful Life (YouTube clip from the movie)

⁴Article reporting that WAMU suffered more than $16 billion loss of depositor money, as a bank run went into full swing.

 

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Sam's Comments:
Sounds like an easy fix to me!

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