Although banking may be more fragile than other industries, this does not imply a higher breakage or failure rate. Rather, greater fragility implies "handle with greater care," much as it does with glass and porcelain objects. And apparently that is what the private market did in the United States when the proper incentives to encourage such behavior were in place. Before the introduction of government safety nets, banks held considerably higher capital ratios and assumed considerably less credit and interest rate risks in their portfolios. The average annual failure rate for U.S. banks from the end of the Civil War in 1865 to before the establishment of the Federal Reserve System in 1914 was somewhat lower than for nonbank firms, although the annual variance was greater (Kaufman 1996). In addition, losses to depositors as a percent of deposits at failed banks were lower than losses to creditors at failed nonbanks (Kaufman 1994). Jack Carr, Frank Mathewson, and Neil Quigley (1995) describe the stability of the Canadian banking system before the introduction of deposit insurance in 1967. Anna Schwartz (1988) argues that until the recent worldwide rash of bank failures--which are described in Herbert Baer and Daniela Klingebiel (1995), Gerald Caprio and Daniela Klingebiel (1995), Gillian Garcia (1995), Charles Goodhart (1995, particularly chapter 16), and Zenta Nakajima and Hiroo Taguchi (1995)--while banks failed, bank panics and contagion had almost disappeared in developed countries, other than the United States, by the late 1920s.
Ironically, the introduction of government regulations and institutions in the United States intended to provide protection against the fragility of banks appears to have unintentionally increased both the fragility of the banks and their breakage rate. By providing a poorly designed and mispriced safety net under banks for depositors, first through the Federal Reserve's discount window lender of last resort facilities in 1914, and then reinforced by the FDIC's deposit guarantees in 1934, market discipline on banks was reduced substantially. As a result, the banks were permitted, if not encouraged, to increase their risk exposures both in their asset and liability portfolios and by reducing their capital ratios. As noted by Edward Kane (1985, 1989, and 1992), George Benston and Kaufman (1995), Kaufman (1995a), George Selgin (1989), and others, this represents a classic and predictable moral hazard behavior response. Public (taxpayer) capital has largely replaced private (shareholder) capital as the ultimate protector of depositors. For example, in its 1994 Annual Report, the FDIC (1995: 35) declared that "the FDIC remains today the symbol of banking confidence."
Moreover, it could also be argued that the introduction of the safety net encouraged the federal government to impose greater risk on the banks. For example, national banks were not permitted to make mortgage loans before the Federal Reserve Act in 1913 and then only one-year loans until 1927. Likewise, the government did not encourage banks and thrifts to make long-term fixed-rate mortgages until after the introduction of deposit insurance. It is interesting to speculate whether the government would have introduced such risk increasing policies in the absence of a safety net.
But, in addition, as repeatedly emphasized by Kane (1989, 1995a and b), the establishment of the Federal Reserve and FDIC in the U.S. introduced severe principal-agent problems. The Federal Reserve was charged with acting as the lender of last resort to the macroeconomy by, among other things, offsetting the impact of losses of reserves from the banking system for reasons such as a run to currency by depositors or gold outflows that threatened to reduce the money supply below appropriate levels. But the Federal Reserve was given discretion with respect to when and to what extent to do so. Unfortunately, as Milton Friedman and Anna Schwartz (1963) document, when the banking system experienced a run into currency during the Great Depression from 1929 to 1933, which dramatically reduced aggregate bank reserves, money supply, and bank credit, the Federal Reserve failed to inject sufficient offsetting reserves. As a result, the simultaneous attempt by nearly all banks to contract by selling assets led to large fire-sale losses and the largest number of bank failures in U.S. history.
The rest of it: Bank Failures, Systemic Risk, and Public Policy by George G. Kaufman
