I'm reading John Allison's "
The Financial Crisis," a free-market take on the collapse that precipitated the Great Recession. He's been discussing the moral hazard of deposit insurance, a difficult topic for me. I've known since the S&L crisis in the mid-1980's, which created the wave of bankruptcies on which I cut my teeth as a young lawyer, that deposit insurance threatens a dangerous spiral in interest paid on consumer deposits, followed by riskier bank investments needed to generate the higher interest. Without deposit insurance, a bank that pays too high an interest rate on consumer deposits will face a corrective mechanism: the difficulty of finding safe borrowers who can pay high interest on loans. If the bank takes too many wild flyers on its borrowers, it goes broke, and its depositors lose their money. Depositors who don't want to lose their money won't deposit it in a bank with a reputation for wild-eyed lending.
No one likes this disciplinary mechanism, because it tends to lead to panics and bank runs, especially on the part of small mom-and-pop depositors with all their liquid eggs in one basket. Politically and practically, we're going to have deposit insurance one way or another. Allison points out, however, that even with deposit insurance, people with deposits over the insured limit can exert useful pressure on banks to moderate their appetite for making risky loans. But in the run-up to the 2008/2009 financial crisis, the uninsured-depositor disciplinary mechanism broke down.
In July 2008, regulators shut down IndyMac, with loans (assets) of $32 billion and deposits (liabilities) of $19 billion, without opting to cover any of the $1 billion (5%) of its deposits that were uninsured, (that is, deposits exceeding $100,000 per customer). It was the largest collapse of an FDIC-insured institution since Continental Illinois in 1984, and it hit the public hard. Five percent of deposits being uninsured may not seem like a lot, but the public was nervous, and it didn't help that newscasts showed unhappy depositors lined up at windows.
So the stage was set for real jumpiness over the summer. Regulators had known for most of the year that failure was inevitable at Washington Mutual, the country's largest savings & loan, with assets in mid-2008 of $308 billion and deposits of $188 billion. Whether because of the IndyMac experience, general jumpiness in the real estate market, or machinations by regulators and their cronies (the last possibility is the subject of litigation that hasn't yet quit, six years later), WaMu suffered a $16 billion bank run in September 2008 just before regulators shut it down and sold its assets to J.P. Morgan for a pittance. Regulators, in no mood to spark an even more widespread bank run, made a fateful decision to cover all uninsured deposits.
Here is where Allison argues the biggest mistake was made. It would have been possible to cover the uninsured deposits with taxpayer money. That would have been politically poisonous, of course, but infuriated taxpayers could have done little about it in the short run. Instead, however, regulators dumped the entire hit on WaMu's bondholders: that is, the capital markets that had provided liquidity to the bank via traditional loans rather than through insured deposits. Unlike taxpayers, the capital markets could and did retaliate instantly. Allison, who ran BB&T (a real-estate-oriented Atlanta bank), reports that the capital markets had been tight during that troubled summer, but BB&T had just succeeded in floating a bond issue before WaMu failed. The day after the feds stiffed the WaMu bondholders, the capital market for banks dried up without a trace. Allison argues that this event was far more damaging to the liquidity of the financial markets than the failure of Lehman Brothers that same month. He also argues that it was D.C.'s panic over the dried-up capital markets resulting from the WaMu decision that drove the TARP bank-bailout bill later in the year.
