The 2000s in Retrospect

Way back in January 1997, Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, led an FDIC-sponsored panel discussion on the 1980s banking crisis with Carter  H. Golembe, the head of a banking research and consulting firm until 1989; William M. Isaac, chairman of the FDIC from 1981 to 1985; and John G. Medlin Jr., CEO of Wachovia Corporation from 1976 to 1993. 

In his introduction, Volcker complained that the title, “The 1980s in Retrospect,” instead should have read “Lessons for the Future.”  The panelists indeed offered lessons for the future — most of which have been ignored.  Many of the lessons would seem grist for a panel discussion in 2017 or thereabouts about the 2000s in retrospect.  But the first decade of the century is still not over and maybe some of the lessons can be applied to our current crisis, most notably in regards to the current debate over marked-to-market accounting.  (“Marked-to-market” accounting rules force banks to use the current market value of their mortgage-backed securities on their balance sheets, which critics complain sets values too low because it neglects long-term returns.) 

The following quotes speak for themselves:

1.  “Too-big-to-fail”

Carter Golembe.  “[T]he [FDIC] crossed its own Rubicon in 1972 with a loan to the first billion-dollar bank to face failure [the Bank of the Commonwealth in Detroit], offering as justification, among other reasons, ‘the effect its closing might have had on public confidence in the nation’s banking system.’ This was the beginning of the present ‘too-big-to-fail’ program, although the FDIC had in fact long been following a policy of attempting to treat every bank in difficulty, regardless of size, as ‘too-big-to-fail.’”

Paul Volcker. “I agree with [the decision for the FDIC to assist in keeping Continental bank open.] . . . . But, in fact, it had a big effect — that was the precursor of a lot of protection that happened afterwards. I can remember looking at television when I was out of office in 1990 and 1991 and 1992 — and it would be in the press every day — that so-and-so bank or savings and loan was close to insolvent and failing, and nobody seemed to care. Even when you had headlines about the weakness of an institution no depositors moved their money because they had been convinced that the government was going to take care of everything, so you had no market discipline. It drives the lesson that has been described here over and over again. How do you get some balance between the rescue and retaining some discipline? I don’t know whether we yet have the right answer.”

2.  The FDIC

Bill Isaac. “I don’t think [the FDIC] should be in the regulatory business. I was willing to give up the FDIC’s regulatory powers when the Bush Task Force was deliberating these issues. I don’t believe it matters to the FDIC whether a bank opens a new branch or not, and I don’t think it matters to the FDIC whether a bank is in compliance with [the Community Reinvestment Act] and other such things. I don’t believe that the FDIC ought to be dealing with anti-trust issues on mergers and the like. I believe firmly that this agency needs to be focused on the forest, not the trees.”

Carter Golembe. “[N]ot all deposit insurance systems in this country have relied on an insurance fund. The two most successful, in Indiana and Ohio — 30 or 40 years in each case — before the Civil War were the most successful insurance we ever had. They did not rely on a deposit insurance fund. They relied on cross guarantee by the banks — Indiana, for example, did not have a bank failure in 35 years.”

3. Increasing the FDIC’s deposit insurance limit

Bill Isaacs. “One of the ideas that we thought made a lot of sense was the subordinated debt idea. We wouldn’t necessarily increase capital requirements, but we would mandate that some portion of it be in subordinated debt so that you would have sophisticated creditors overseeing banks and deciding who could get subordinated debt at what price and who couldn’t. I thought it made a lot of sense at the time. The reason why we thought it was an interesting idea was because we thought that other changes to the deposit insurance system were not in the political cards. It was unlikely that Congress, having increased the deposit insurance limit to $100,000 two years earlier, would reduce the deposit insurance limit below $100,000 again. So, why not go ahead and concede defeat on depositor discipline and try to impose it through sophisticated creditor discipline. I think it made sense at the time, and I think it still could make sense today.”

4. Bundling mortgages

John Medlin.  “Also, and it is probably more popular now than back in the ‘80s, problems can arise from  syndication or selling out pieces of loans, where the syndicator takes a nice fee for putting it together, but sells it off and keeps very little risk. A ‘syndication’ is sometimes characterized as a transfer of risk from someone who lacks courage to someone who lacks knowledge. There is an enormous amount of that going on today; most smaller banks do not have the capability to assess the syndicated risks they are putting on their books.” 

[Note: “Syndicating loans” is different than “bundling subprime mortgages,” but they share very similar shortcomings: The originator of the loan generally does not own the loan, which makes Medlin’s comment quite relevant to the current crisis.]

5. Marked-to-market accounting standards

Paul Volcker.  “I think, pushed to an extreme, [marked-to-market] is nonsense for a bank. The idea that we have to be so precise about marked-to-market accounting for an institution that is supposed to take liquid funds and transform it into something longer, while we tolerate enormous uncertainties in accounting on other parts of the balance sheet and in industry generally, doesn’t make sense to me. An accounting profession that will tolerate company after company taking large accounting losses for prospective events or to account for past losses that didn’t appear on the balance sheet the day before, and doesn’t blink an eyelash, shouldn’t worry too much about marked-to-market accounting, in my opinion.”

Bill Isaacs.  “But if we had marked-to-market accounting back in that period, and if we had wanted to, we could have closed every savings bank in the country at a cost to the FDIC of tens of billions of dollars. That is what the numbers were. We had it documented in the savings bank task force. So, we could have shut them all down, marked-to-market, and spent tens of billions of dollars.  I say the social cost of that would have been inordinately high.”

Bill Isaacs.  “But I think doing everything by the numbers without discretion is a mistake. People keep on pushing for marked-to-market accounting, prompt corrective action and the like, and the next time we have an ag-bank crisis or a savings bank crisis or an LDC debt crisis, I think we are going to regret we have those laws on the books. I think it is going to tie the regulators’ hands in a way that is going to precipitate a crisis, that could otherwise be avoided.”

John Medlin.  “Market value accounting — it has its virtues, but at the same time, it is a problem in times of stress when you have to market at the worst possible condition when if you could disguise it for awhile, things would be okay.”

6. Big picture lessons

John Medlin.  “We’ve talked a lot about public policies and to boil the problem down in a [two-part] one-liner:  What we had, and to some extent what we still have, is the democratization of credit; the democratization and liberalization of credit to everyone, cheaper credit, more liberal credit. But in the final analysis, the socialization of the risks underlying that credit falls ultimately back on the people. We have some other things like that — we have Medicare and we have Social Security which are actuarially unsound and ultimately will cause problems and deposit insurance is not a problem as long as times are good. It is only when we have unusual times like the ‘80s that it becomes a problem.”

John Medlin.  “Management practices — banking can’t blame public policy, can’t blame the economy really for its problems. It can blame itself for failing to exercise proper private sector disciplines. We should have learned to expect public policies not to be very smart; in most times, very politically driven, very expediently driven.  In the management side of this equation, we had competition in laxity. Unfortunately the dumbest and weakest competitors in the marketplace set the basic standards of pricing and credit terms.”

Bill Isaac.  “When you have a massive collapse of the real estate industry like we had on the heels of the S&L crisis and the tax law changes and everything else, you’re going to have some bank failures. You can’t prevent that. All you can do is try to contain them and spot some of the trends before they get too far out. I also think it is a regulator’s job to lean against whatever wind is blowing at the time. If everybody is doing really well and they are putting on a bunch of loans in real estate, that is the time to be saying, I wonder why they are putting on all those loans in real estate — maybe we ought to be taking a much closer look at it. That is very tough to do — to go into a major bank before it has obvious problems and say, you guys are making a lot of real estate loans and we are really worried about it and we think you ought to slow down.”

John Medlin.  “I think our greatest lesson from the ‘80s would be complacency, and probably our greatest risk today is complacency. Everything is wonderful; the economy is wonderful; public policies have gotten better in many respects, but have managements learned their lessons?”

For the full text of this prescient panel discussion, see http://www.fdic.gov/bank/historical/history/vol2.html 

Peter J. Nelson is a policy fellow with Center of the American Experiment.

This commentary originally appeared in Volume 6 of “What’s a Free Marketeer to Think?”
Click here to read the entire volume.