Business School as a professor of financial crises in 2013. She lives in Washington, DC.Day applied the “Page 99 Test” to her new book, Broken Bargain: Bankers, Bailouts, and the Struggle to Tame Wall Street, and reported the following:
Page 99:Learn more about Broken Bargain at the Yale University Press website.states-rights advocates in the Jeffersonian tradition, who feared that branching would create just the sort of large urban money centers they had long mistrusted. These advocates favored deposit insurance as a way of preserving small rural banks. The fight over branching and, by extension, deposit insurance was a much more visceral issue than the question of whether to separate commercial and investment banking, which had almost unanimous support. Arguments over insurance and branching, by contrast, threatened to torpedo all of Glass-Steagall.Ford Madox Ford's statement "Open the book to page ninety-nine and read, and the quality of the whole will be revealed to you," is accurate for my book.
As bank runs and closings accelerated in the winter of 1933, proposals to use deposit insurance to protect savings and thus avert runs gathered more support than motions to expand branching. The national and state bank holidays, coupled with snags in the Fed’s role as lender of last resort, accelerated calls for some kind of permanent guarantee for depositors. Deposit insurance addressed a central paradox of banking: when people think they can get their money, they don’t want to. If they think they can’t, they do. Branching would help with this, but a federal guarantee was more concrete, and in many cases it would make a lender of last resort unnecessary. Deposit insurance had many opponents, but its star ascended when the Fed failed to act as lender of last resort from 1930 to 1933.
The idea of insurance wasn’t new. New York State had experimented with deposit insurance in 1829, and between 1886 and 1933, Congress considered 150 deposit insurance proposals. None went anywhere. After the panic of 1907, seven states—Oklahoma, Kansas, Nebraska, Texas, Mississippi, South Dakota, and North Dakota—guaranteed deposits at state-chartered banks, but these plans were overwhelmed by the massive number of bank failures in the 1920s. The state funds failed not just because so many banks went under at once, but also because too many had been given coverage without sufficient screening to weed out weaker, poorly run firms.
Beyond these failed efforts, deposit insurance proved controversial for another good reason. Although insurance calmed depositors, it also made them indifferent to how their bank was run. Depositors’ indifference is an instance of what economists call “moral hazard,” a situation where someone receives the benefits of a financial action or decision but is shielded from any downside. Insured depositors, for example, would get their money if a bank prospered or failed. People in this or similar financial situation, opponents of insurance argued, might be not only indifferent to risks, but encouraged to take bigger and
This page captures the essence of the nation’s debate in the 1930s over federal deposit insurance: Republican President Herbert Hoover and smaller banks favored it as a way to calm depositors and thus stop the thousands of bank runs and subsequent failures that were plaguing the country, contracting credit and making the depression longer and deeper. Democratic President Franklin Delano Roosevelt opposed it. He argued that while deposit insurance might end runs, it would do so by making depositors’ indifferent to whether the banks into which they put their money were prudently run or not. That in turn could saddle taxpayers with enormous liability.
FDR finally relented, agreeing to federal deposit insurance in exchange for legislation he wanted to encourage home ownership and for tighter oversight of banks to mitigate risks to taxpayers.
FDR proved to be correct: Deposit insurance bred moral hazard—defined on page 99--among depositors, who were willing during the banking crisis of the 1980s to deposit money in increasingly risky “zombie” banks—insolvent institutions that should have been closed. Depositors knew they would get their money whether or not a bank fell into ruin. Instead of closing these dead banks, Presidents Ronald Reagan and George G.W. Bush used bogus accounting to keep them open to hide—until after the elections—a growing liability taxpayers eventually would have to pay. Reagan and Bush could only do this because deposit insurance calmed depositors—so much so they happily put their savings in zombie banks, which in their desperation for cash offered higher-than-market interest rates. Retail depositors knew they wouldn’t lose money, even on these irresponsibly high rates, because their fellow taxpayers would pick up the tab. Knowing this made members of the public, including many policymakers, indifferent to what was going on. That allowed the situation to continue and worsen.
The ensuing $500 billion bailout was 10 times more expensive than if the banks had been closed years earlier, when they first became insolvent. It remains the costliest in U.S. history. The bailouts of the Great Depression 10 years ago were far bigger—$24 trillion by some estimates—but because that money was either repaid or never spent, the 1980s bailout remains the costliest.
This page outlines a key aspect of a debate Americans have had going back to Jefferson and Hamilton over how to prevent the dangers posed by banks and corporations from outweighing their benefits. It sets the stage for one of the grand bargains Congress struck with Wall Street, that of providing a taxpayer-subsidized safety net of deposit insurance in exchange for more oversight. It’s a bargain regulators break when they fall down on the job—which they do repeatedly—and that we as a nation have wrestled with ever since.
--Marshal Zeringue
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