President Franklin D. Roosevelt could teach today’s regulators and politicians a lot about how to deal with a banking crisis.
Two aspects of his leadership from his first year in office stand out.
First, FDR understood the danger of excessive government protection of banks and would be dismayed by the extent of it today. He solved the 1933 bank meltdown with smart regulatory policy and real government oversight, not a bailout as is currently being done. He agreed to the use of deposit insurance reluctantly and kept it limited. It was not the reason for his success.
Second, he knew what it took to deal with a banking crisis, and, specifically, how to restore public confidence in the banking system. At the worst moment of the Great Depression, he faced a much more daunting challenge than the problems of the present — and he succeeded in turning things around almost immediately. In contrast, policymakers and regulators today dither, hoping that empty words and weak measures can restore confidence. The FDR mirror is very revealing of the inadequacies of the current policy response.
Many people are surprised when I tell them that FDR explicitly opposed federal deposit insurance during the 1932 presidential campaign. In the heart of the banking upheaval, with many bank failures producing depositor losses in 1931-1932, his 1932 letter to the New York Sun stated that federal deposit insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor. I believe that it would be an impossible drain on the Federal Treasury.”
FDR here makes an important, and empirically correct, point: Good bank risk management depends on depositors’ discipline, which depends on their having skin in the game.
Later, Roosevelt reluctantly agreed to create FDIC insurance, at the insistence of Rep. Henry Steagall, as part of a larger political deal, but he kept the agency’s coverage limited to small deposit balances. Furthermore, he had closed all banks in March 1933, and they were permitted to reopen and have access to insurance coverage only after they had undergone a thorough examination to establish that they were in sound financial condition.
FDR did not handle the banking panic by throwing deposit insurance at the problem, or by waiting for more banks to be shut down by worried depositors. He first put an end to runs by closing banks and established a credible process for them to reopen upon demonstrating their strength. Because regulators’ examinations were demonstrably credible to independent observers, and often accompanied by increased capital, confidence in the system was restored and many banks were able to reopen quickly. Runs did not return — not because of the small coverage of the new deposit insurance system, but because FDR had actually addressed the problem of bank weakness that was driving the runs.
What would a similarly effective policy response for the current crisis look like? The problem today is much less severe, making the solution easier.
There are only about 200 U.S. banks that are clearly vulnerable because of securities losses similar to those of Silicon Valley Bank. Regulators should have met with those banks individually last weekend, required them either to immediately come up with credible recapitalization commitments, or put them into conservatorship (beginning Monday morning). In conservatorship, they would have had limits placed on their activities until it was determined whether they could offer adequate recapitalization, or, if not, be placed in receivership. In the meantime, they could have been allowed to pay out all insured deposits, but only to pay out a fraction of uninsured deposits (based on the potential losses of uninsured depositors at each bank). This would have put pressure on those banks to resolve the problem quickly, and would have limited the illiquidity problem to a portion of the uninsured deposits at a small number of banks.
If that had been done, industry and academic experts would have been able to immediately reassure relatively uninformed depositors that the government policy response had been effective and that there was no cause for further alarm. I believe some uninsured depositors would still have wanted to move their funds, as a long-term precaution, but the short-term urgency of these disruptions would have been substantially reduced.
Instead, the Biden administration has done nothing about the 200 vulnerable banks, thereby encouraging continuing panic. The two measures they did undertake last Sunday have clearly failed to calm the market. First, the bailout of uninsured depositors at Signature and SVB has no clear implication for the risk of loss to uninsured depositors at other banks, especially given how much criticism those bailouts have received for being politically motivated and unfair. No uninsured depositor worried about their own potential losses will think that their money is necessarily safe now.
The second policy announcement was also ineffectual. The Federal Reserve created a new special lending facility for banks, allowing them to borrow for up to one year against qualifying Treasury and Agency securities. Banks can borrow an amount equal to the face value of those securities, which exceeds their market value. This implies a partially noncollateralized loan (the opposite of the typical “haircut” applied to collateral in central bank lending).
These loans provide no reason for worried uninsured depositors to rest easy. The decline in the value of securities at vulnerable banks is not temporary but is fundamentally the result of the Fed’s interest rate hikes, which are not only going to persist but will be increased going forward. Securities used as collateral are not going to increase in value as the result of the Fed stepping in here. Second, the loan is only for a year, so after the end of that year, a bank that is insolvent today because its securities have fallen in value will still be insolvent. For these reasons, the Fed lending program will not cause uninsured depositors at an insolvent or deeply weakened bank to decide not to withdraw their funds immediately, if they were already predisposed to do so.
It is time to take FDR’s example to heart, address the banking problem immediately and directly, and give U.S. depositors a real reason to believe that “there is nothing to fear but fear itself.”
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