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Should Large Banks Be Allowed to Fail?

Published online by Cambridge University Press:  19 October 2009

Thomas Mayer
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Extract

The question of whether large banks should be allowed to fail brings us face to face with a conflict between two social goals. On the one hand, the goal of optimal resource allocation suggests that even very large banks, like other firms, should be allowed to fail. On the other hand, the stabilization goal suggests that, given the present institutional structure, failures of large banks should be prevented lest they lead to runs on other banks and to a significant reduction in the money stock. The solution suggested here for this conflict is small changes in the institutional structure.

Type
V. Implications of Recent Developments for Financial Stability
Information
Journal of Financial and Quantitative Analysis , Volume 10 , Issue 4 , November 1975 , pp. 603 - 610
Copyright
Copyright © School of Business Administration, University of Washington 1975

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References

1 Portfolio regulation of banks should be thought of as a way of protecting the FDIC's fund rather than as needed for ony other reason such as the “strategic” nature of banks.

2 Bank examinations are not audits. However, the FDIC could, in principle, conduct bank audits as well as examinations. Moreover, the FDIC's ability to control risk taking by banks could be increased by imposing very rigid and inflexible regulations on banks, e.g., a minimum capital/deposit ratio which every bank regardless of its special circumstances would have to meet. But such inflexibility would make for inefficiencies.

3 For small banks supervision by large depositors might be ineffective. Substantial depositors in a bank that does not issue large CD's are likely to be either local business firms that are borrowing from the bank, and hence reluctant to remove their deposits from it, or the proverbial “little old lady” who keeps a very large bank deposit because she thinks that only banks are safe.

4 Peltzman, Sam, “Capital Investment in Commercial Banking and its Relationship to Portfolio Regulation,” Journal of Political Economy, Vol. 78 (January/February 1970), pp. 1–26.CrossRefGoogle Scholar

5 Such a deposit run off is, however, limited by the fact that aside from FDIC protection many large depositors who are also borrowers have the protection of being able to offset their deposits against their outstanding loans.

6 Unfortunately, information on the number of accounts above $40,000 by size of bank is not presently available. However, we do have data on the number of accounts over $20,000 and on the number of accounts of over $100,000. These data show that banks with assets of over $1 billion do have a larger proportion of their accounts in these two categories than is true for banks in general. (See FDIC, Summary of Accounts and Deposits in all Commercial Banks—June 30, 1972, p. 20.)

7 It is worth noting that the danger is a run on just a few large banks. A run on all large banks simultaneously need not be dangerous. Large depositors are hardly likely to withdraw currency from a risky bank; they have little choice except to move their funds into another bank. Thus, if all large banks are run at the same time, their deposit inflow might suffice to pay off those depositors who want to withdraw their accounts.

8 If this is done “large banks” should be defined unequivocally. Unfortunately, as pointed out above, the government is likely to be reluctant to do this. Admittedly, if two or more large banks approach failure at the same time, there is a problem because the government controls the timing of failure. Perhaps in such cases an independent commission could be charged with declaring the “victor” in the race to fail.

9 These calculations relate to “large commercial banks” defined as those banks that are included in the Federal Reserve's tabulation of “weekly reporting banks, assets and liabilities of large commercial banks,” Federal Reserve Bulletin, vol. 60 (August 1974), p. A.24.

10 If the insurance ceiling is eliminated for banks it would probably be eliminated for Savings and Loan Associations and mutual savings banks too. This would help the competitive positions of these institutions vis-a-vis banks.

11 For a further discussion of this proposal see Scott, Kenneth and Mayer, Thomas, “Risk and Regulation in Banking: Some Proposals for Federal Deposit Insurance Reform,” Stanford Law Review, vol. 23 (May 1971), pp. 806–894 and the literature cited therein.CrossRefGoogle Scholar

12 The private insurance companies should then be required to reinsure with the FDIC in case its resources might not be sufficient.

13 There is, however, the danger that pressures would be brought to bear on Congress to provide mandatory insurance for small banks that could not obtain private insurance and whose demise would leave a town without a single bank.

14 The discussant has raised the question of what I mean by saying that a bank should be allowed to fail. I do not object to the FDIC arranging a merger as long as this does not involve the FDIC in substantially greater costs than paying off deposits would or in the Federal Reserve's making loans to the bank at below free-market rates.

15 To be sure, one could argue that the damage is already done, that the Lockheed case has already started us out down the road, but I believe that there is still time to call a halt.