Danger From Deposit Insurance: A Lesson of the 1980s Bank Crisis
The sudden collapse of two banks last week has worried depositors across the country, even as regulators took quick action to reassure them that deposits would be repaid in full. Treasury Secretary Janet Yellen said that regulators decided to step in at Silicon Valley Bank because of concerns that depositors' fears could result in runs on other banks.
Many economists and analysts agreed that the government’s response should not be considered a “bailout” because the banks’ shareholders will lose their money, and the banks have been closed, The New York Times reported. But investors in the banks will not be protected, President Biden said this week. “They knowingly took a risk, and when the risk didn’t pay off, investors lose their money. That’s how capitalism works.”
Bank bailouts during the 2008 recession totaled trillions of dollars, but because most of the money was repaid or not used, the bailout during the bank crisis of the 1980s retains the title as the most expensive for taxpayers. At the heart of the 1980s crisis was federal deposit insurance, which the U.S. Congress had enacted 50 years earlier during the Great Depression despite initial objections from President Franklin D. Roosevelt. It works like this: Banks pay an insurance premium into a federal fund that guarantees that if a bank fails, depositors will receive their deposits up to a specified amount. When adopted in 1933, the amount was $2,500; today it is $250,000. If the premiums banks pay into the fund prove insufficient during a time of economic crisis, taxpayers must fill the gap.
President Roosevelt agreed that deposit insurance would stop the bank runs plaguing the country, but he argued that it also would create moral hazard in depositors, who, knowing their money was safe no matter what, would become indifferent to whether bank executives ran institutions safely or not. He proved to be correct. During the 1980s bank crisis, President Ronald Reagan allowed hundreds of insolvent banks to remain open. The sicker these institutions became, the more incentive they had to find cash that they could invest in high-risk but potentially high-return ventures, and possibly grow out of their troubles. To raise this cash, the banks paid higher-than-market interest rates. Depositors, knowing they would be paid no matter how risky the banks’ behavior was, flocked to put money into them. The high-risk gambling failed, and banks became ever more insolvent. . . .
The ultimate strategy was to postpone, until after Reagan and George Bush won their collective three terms in office, any mention to the public of the need for tens of billions — and as time wore on, hundreds of billions — in taxpayer dollars. In 1981, Reagan and Bush reasoned that leveling with the public that a $50 billion bailout was needed would be political suicide. They feared voters would see it as a tax increase and thus a breaking of their campaign promises. Postponing the inevitable, however, turned a crisis that had not been the fault of either Reagan or Bush into one squarely of their own making. . . . Years later, the Government Accountability Office, the watchdog arm of Congress, tabulated the final cost to be $500 billion, almost all borne by taxpayers.
Adapted from "Rewarding Risk: Federal Deposit Insurance and the 1980s Bank Crisis" by Kathleen Day, Perspectives on History magazine, April 3, 2019.
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