Why Regulation Will Never Prevent a Meltdown (Part 2)

All the legislation hastily passed following economic disasters in the 1980s, 1990s, and the last few years revolve around a key assumption:  bank failures are caused by crooked bankers.

Not free market competition.  Not honest errors.  Not economic cycles.  Greedy, irresponsible, negligent fat cats who don't care what happens to everyone else are villains who must be punished.  Congress has sung the same song each time a crisis comes along, and they always end up causing more harm than good:

"The legislature's haste to get the 'savings and loan crooks,' which is particularly evident in provisions granting regulators extraordinary powers to freeze or attach assets, has caused substantial social and economic costs.'*

But if failures are due to fraud, why would we have a such a rash of greedy bankers all at once?  Even if the abuse rode on the back of a bubble, surely a competent FDIC examiner would uncover these fraudsters one by one.  The only logical explanation is that the economic downturn took its toll.  For those who question whether history really does repeat itself, note that the same problems (economic, not fraudulent) leading up to the Great Recession are almost exactly mirrored by those before the 1873-1878 depression:

"The causes of the failure of the national banks were mainly injudicious banking and depreciation of securities.  In only one case was failure due to fraudulent management.  The state bank failures arose from excessive competition among the too numerous banks.  New banks were chartered freely by the state legislature during the preceding years of prosperity.  Public supervision was entirely absent....  When seven of the largest savings banks failed between August 29 and December 31, 1877, it was found that over 45 per cent of their combined assets was invested in real estate or real estate loans.  In addition the banks had lent large amounts at high rates of interest on worthless collateral to individuals speculating in land and construction enterprises."**

By the way, this was written in 1935 as a comparison to the Great Depression.  A second parallel between the Great Recession and historical depressions is the question of whether bigger is better.  Should we encourage Bank of America or Bank of the Ozarks, with their better capital and efficiency, to take over community banks to create greater stability?

"It is commonly held that small banks are much more susceptible to failure than the large and, therefore, large banking units are to be encouraged.  This study, however, shows that the failure rate of large banks is quite as great as that of small banks during the last few years.  An attempt to prevent failures by encouraging development of banks of larger size cannot in itself be expected to be particularly beneficial."**

As we've written previously in this blog, the vast majority of community banks do not fit the profile of greedy fat cats taking advantage of the rest of us.  There are crooks in any industry, but they are not as pervasive as Congress would like us to believe. 

When Congress tars all banks with the same brush, the public turns against the bankers who are "widely regarded as major culprits in the crisis because of press reports detailing reckless, and sometimes outright fraudulent, management practices."***

Being legislators, Congress responds by creating acts such as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) as well as a host of bureaucratic regulators and regulations.  Try this one on for size:

"Until 1989, deposits in S&Ls were insured by the Federal Savings and Loan Insurance Corporation (FSLIC), and the S&Ls themselves were under the chartering, regulatory, and supervisory authority of the Federal Home Loan Bank Board (FHLBB).  In August of 1989, FIRREA, the major piece of legislation aimed at resolving the failed S&Ls and recapitalizing the S&L deposit insurance fund, became law.  FIRREA abolished the FHLBB and the then-insolvent FSLIC, transferred FHLBB's regulator powers to the Office of Thrift Supervision (OTS), established the Resolution Trust Corporation (RTC), whose function is to manage and resolve the failed S&Ls, and transferred FSLIC insurance functions to the Federal Deposit Insurance Corporation (FDIC)."***

We don't know about you, but FDIC Exposer thinks that's overkill to the nth degree and has no idea how bankers can comply with all these regulators at once.  Did any of this really contribute to the recovery?  The industry was recovering long before any of this took effect, and community banks suffered from the economic downturn and not abuse of regulations.  Not to mention that the problem arose again in the 1990s.  And again in 2007.  So is regulation the solution?  FDIC Exposer thinks not. 

And that is yet another example of why regulation will never prevent a meltdown.


*  Crawford, P. (1993). Inefficiency and abuse of process in banking regulation: Asset seizures, law firms, and the RICOization of banking law.  Virginia Law Review, 79, 205-242.
**  Thomas, R. G. (1935). Bank failures - Causes and remedies. The Journal of Business of the University of Chicago, 8, 297-318.
***  Anbari, M. M. (1992). Banking on a bailout: Directors' and officers' liability insurance policy exclusions in the context of the Savings and Loan crisis. University of Pennsylvania Law Review, 141, 547-589.