2002 MARKED THE THIRD CONSECUTIVE YEAR OF FINANCIAL TURBULENCE IN THE UNITED STATES. In early 2000, investors lost faith in technology stocks and later in other stocks, ushering in what has turned out to be a long bear market in equities. In March 2001, the economy entered its first recession in a decade. Then, in September 2001, terrorists attacked New York City and Washington, D.C. After these shocks, one might have expected a calmer 2002. Instead, last year brought new challenges in the form of sensational accounting and investment-banking scandals, large corporate bankruptcies, and historically high levels of stock- and bond-market volatility.

Yet, three consecutive years of turbulence have not damaged the roots of the U.S. financial system—the banking sector. Commercial banks and thrifts have proven financially robust—indeed, quite profitable—during this period. Creditworthy households and businesses continue to enjoy uninterrupted access to credit, while the payments system functions as smoothly as ever. Steady performance is important because access to credit and to a functioning payments system are the twin hallmarks of financial stability.

Although financial market turbulence did spread to the banking system in the 19th and early 20th centuries in the United States and sometimes still does in other economies around the globe, our financial system has stood immune and stable for decades.

Why?

The Seeds of Stability

Financial stability rarely comes up in daily conversation precisely because the U.S. financial system has proven so stable since the 1930s. Stability implies widespread reliance on the financial system and its parts to function smoothly—as, for example, when we expect a 24-hour ATM machine to dispense cash on demand, when we assume a gas pump will accept a debit card without fail, when we anticipate that online lenders will refinance mortgages without a hassle or when we trust our money to an unfamiliar bank without a second thought.

To the Federal Reserve, the term has a more precise meaning: Financial stability refers to the smooth, uninterrupted operation of both credit and payment mechanisms. In practice, financial stability means that all credit-worthy borrowers can obtain funds at reasonable rates and that all monetary payments and securities transactions will settle accurately and promptly. Because extending credit and executing payments are two core commercial banking functions, it should come as no surprise that the Fed’s mandate to promote financial stability is carried out largely through policies designed to preserve the health of individual banks and the integrity of interbank networks. (See sidebar)

The Fed plays an important role in maintaining both economic and financial stability. Using monetary policy, the Fed exerts a stabilizing influence on the economy as a whole, working primarily through interest-rate channels that influence borrowing and lending decisions. The Fed also relies on lender-of-last-resort (discount window) and payments-systems policies to calm financial markets after a shock. Finally, the Fed monitors many U.S. financial institutions to make sure that they are run in a safe-and-sound manner. All of these responsibilities interact to stabilize the banking system, thereby preserving its ability to extend credit and to serve as the backbone of the payments system.1

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Uprooting Stability

Historically, financial instability—a temporary but potentially severe disruption of credit and payment mechanisms—has occurred from time to time despite the best efforts of market participants and policy-makers. (See timeline) To be sure, the U.S. financial system was perhaps most notable among advanced economies for its instability as late as the 1930s. Caveat emptor was the operative rule because banks failed as frequently as any other kind of business. System-wide collapses, albeit temporary, were not unknown.

Business and financial cycles did not originate in the United States, of course. Adam Smith, the Scotsman who is now known as the father of modern economics, long ago distilled the essential dynamics of a modern economy as an inevitable, recurring sequence of “overtrading,” followed by “negligence and profusion,” culminating in “revulsion and discredit.”2 What was unusual about the U.S. financial system is how long it took to temper the “overtrading-negligence-revulsion” cycle. England experienced only one banking crisis after 1866—when the Bank of England first intervened successfully as a lender of last resort. Meanwhile, serious banking disruptions struck the United States in 1873, 1884, 1890, 1893, 1907, 1914, and most tragically, 1930-33.3 Crashes of the stock market and collapses of major financial institutions were even more frequent. These episodes contributed to a widespread belief that the U.S. financial system—and particularly the banking system—was inherently unstable.

The remarkable 19th- and early 20th-century instability of the U.S. banking system was, in many ways, homegrown. Because the U.S. Constitution prohibited states from taxing interstate commerce or printing money, they turned in large part to taxes on state-chartered banks to cover their expenditures.4 Many of the restrictions on geographical and product expansion in banking date from this period. To maximize tax revenues from banks, states restricted competition. (See chart)

As a result, the United States ended up with a very large number of small, undiversified institutions that were vulnerable to local economic as well as national financial shocks. Depositors, aware of this vulnerability, rationally responded to such shocks by “running” their banks. Bank panics, in turn, depressed the real economy by reducing the available supply of credit to business firms and preventing businesses and households from making payments.

Financial instability amplified economic instability to create a self-reinforcing downward spiral. Before 1914, no central bank existed in the United States to help break the vicious cycle. A demand for the government to provide deposit insurance arose as a means to keep small banks competitive with larger banks that could offer greater safety. Many states responded with programs for local banks. Typically, the insurance was voluntary, and its price did not rise much with bank risk. These design flaws ultimately bankrupted the states’ reserve funds and, more importantly, kept the state-run programs from exerting a stabilizing influence on the financial system.5

What forced fundamental change on the U.S. financial system, of course, was the Great Depression. Between 1930 and 1933, roughly 9,000 U.S. banks failed—some 30 percent of the nation’s total. Today, many economists believe that the collapse of the banking system transformed a garden-variety recession into an economic calamity. Bank failures destroyed deposits in droves (or froze them as the failed banks were resolved), causing the available money supply to drop by one-third. Bank failures also destroyed valuable lending relationships, further contributing to the depth and length of the Depression. Between 1929 and 1933, the unemployment rate soared to 25 percent from 3 percent, not falling back into the single digits until the 1940s. Sadly, the Federal Reserve—created in 1914 in part to ensure that financial shocks would not spark financial instability—made things worse in the early 1930s by tightening monetary policy to defend the gold standard rather than injecting liquidity to contain the banking panic. This financial, economic and social catastrophe convinced a sufficient majority of business and political leaders of the day that the hitherto lightly regulated financial system was inherently and intolerably unstable.

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Root-and-Branch Reform

The New Deal was a massive policy response to the economic calamity. In the financial sector, the response took the form of strict bank chartering requirements, narrowly drawn activity restrictions across all types of financial institutions, price controls (such as interest-rate ceilings), federal deposit insurance, new government financial institutions (such as the Reconstruction Finance Corp. and the Federal National Mortgage Association, or “Fannie Mae”) and a restructured Federal Reserve System. Although many warned of the inhibiting effects of government intervention, the risk of not attempting root-and-branch reform of the financial system appeared even greater. And while a revisionist school of thought today questions the wisdom of many New Deal financial reforms, the circumstantial evidence suggests that these reforms have contributed to our success in avoiding bouts of financial instability during the past seven decades.

The United States has suffered no instances of generalized financial instability since the 1930s despite the fact that shocks to financial markets have been no less frequent than in earlier eras. A partial list of shocks since the Depression includes World War II and the Korean War, the Cuban missile crisis, the Penn Central commercial-paper crisis, two OPEC oil shocks, the 1974 and 1987 stock market crashes, and the regionally devastating energy and real estate lending cycles of the 1980s, culminating in the failure of thousands of bank and thrift institutions. Most recently, corporate accounting scandals, large corporate bankruptcies and stock market volatility have shaken investor and consumer confidence. Yet, none of these events produced economy-wide financial instability. Why?

Federal deposit insurance—the keystone of the New Deal reforms—largely explains the disappearance of financial instability. When designing the program, Congress sought to avoid the problems that brought down the state systems. For example, Congress insisted that all national banks and members of the Federal Reserve System accept coverage—thereby preventing larger, and typically stronger, banks from opting out. The nationwide scope of the program reduced the likelihood that a geographic or industry shock would bankrupt the reserve fund. In the worst case, the federal treasury could be called upon to bolster the fund. These improvements over the state-run programs kept financial turbulence from provoking banking panics. No longer did a financial shock—such as the failure of a major financial institution—spell trouble for a small depositor. Nationwide bank panics became the stuff of newsreels, not CNN.

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Other Weaknesses Surface

Although federal deposit insurance did much to stabilize the U.S. banking system, it contained structural flaws that would later come back to haunt policy-makers and, ironically, test the robustness of the post-Depression financial system. Specifically, the flat-rate premium structure—a design flaw in the state-run systems as well—promoted imprudent risk-taking, thereby contributing to the savings and loan debacle of the 1980s. With flat-rate premiums, troubled thrifts could take on risky activities, knowing that deposit insurance would cost no more than before and that the government would bear most of any resulting losses. These perverse incentives resulted in billions of dollars of loans to support projects of dubious value and, ultimately, in thousands of failures with enormous cost to taxpayers. (See sidebar)

To be sure, flat-rate premiums were not the only cause of the thrift debacle. Policy-induced incentives to take on interest-rate risk, inadequate supervision of risk-taking and poorly designed legislative responses contributed as well.8 New Deal programs that were aimed at stabilizing the mortgage market encouraged thrifts to lengthen the maturity of their assets, while deposit insurance allowed thrifts to shorten their liabilities. The resulting mismatch increased the interest rate risk exposure of the industry and ate away capital during the period of higher and more volatile interest rates in the late 1960s, 1970s and early 1980s.

Congress responded to the developing crisis by deregulating thrift asset portfolios—a sensible move for a strongly capitalized industry, but an ill-advised policy for a weakly capitalized one. With little of their own wealth to lose, some undercapitalized thrift owners gladly took on risky investments. Congress also raised the deposit insurance ceiling, thereby shielding thrifts from market discipline because a greater portion of their funding became insensitive to risk. Underfunded thrift supervisors, who operated under intense political and lobbying pressure, sanctioned the use of accounting gimmicks to give thrifts more leeway to avoid recognizing losses, presumably so that they could grow out of their problems. In many cases, however, these gimmicks simply gave thrift managers more time to experiment with new, even riskier investments, thereby compounding the cost of the eventual cleanup. Despite an ultimate loss to taxpayers of roughly $150 billion, the federal deposit insurance system—and what is more important, the banking system—did not break. Through it all, the public never lost confidence in depository institutions because the insurance was fully backed by the federal government. Because the credit and payment mechanisms remained intact, the thrift crisis did not degenerate into a vicious cycle of financial and economic instability. The role of federal insurance cannot be overemphasized: In the mid-1980s and early 1990s, state-insured depository institutions in Maryland, Ohio and Rhode Island were destroyed by panicked deposit withdrawals. Such panics could have become national rather than localized phenomena if no federal deposit insurance system had existed.

No doubt, other factors help account for the financial stability of the 1980s and 1990s. Unlike the early 1930s, monetary policy during and after the S&L crisis took explicit account of the condition of the banking system. Government-sponsored enterprises—Fannie Mae, Freddie Mac and the Federal Home Loan Banks—stepped in with commercial banks to replace thrift institutions as the primary conduits for channeling funds to households desiring mortgages.

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A New Season

Even though the New Deal reforms helped us survive the thrift debacle, the high price paid to protect the financial system, in terms of taxpayer funds and resource misallocation, dictated a re-evaluation. This re-evaluation pointed to five important lessons. First, it became clear that mechanisms should be in place to encourage faithful and timely disclosure of financial condition. Second, a new method was needed for pricing deposit insurance, whereby the explicit price of deposit insurance plus the implicit price imposed by bank supervisors would mimic the private sector’s risk-sensitive approach to pricing. Third, wherever possible, market discipline must reinforce pressure from deposit-insurance premiums and bank supervisors to contain risk. Fourth, financial firms must maintain adequate capital to promote market discipline and to provide a cushion against mistakes and unforeseen portfolio losses. Finally, bank supervisors must receive adequate funding and remain shielded from political pressures.

The Federal Deposit Insurance Corp. Improvement Act of 1991 (FDICIA) constituted a significant step in the right direction. The act beefed up supervision by mandating safety-and-soundness exams at least every 18 months, prompt corrective action, risk-based deposit insurance premiums and least-cost failure resolution. Frequent exams improved the flow of information between bankers and supervisors so that emerging problems could be addressed quickly and decisively. Prompt corrective action, which mandates specific supervisory responses to deteriorating bank capital, guaranteed that emerging problems would be addressed quickly and decisively—thereby keeping supervision insulated from politically motivated tampering. Risk-based premiums, which currently range from 0 to 27 cents annually per $100 of deposits, increased the cost of deposit insurance coverage as bank risk rises, thereby making deposit insurance more like private insurance. Finally, least-cost resolution, which forces the FDIC to clean up failures in the least costly way for the deposit insurance fund, shifted more of the losses to uninsured depositors. Greater loss exposure increases investors’ incentive to demand higher interest rates from riskier institutions—an illustration of market discipline. The consensus view so far seems to be that FDICIA has reduced the chances of another thrift-type deposit-insurance meltdown.

FDICIA brought one more important change—it scaled back the so-called “too big to fail” protection for large banks. In May 1984, concerns about “systemic risk” (another term for financial instability) led regulators to shield all creditors of Continental Illinois from losses when the bank became insolvent. That September, the Comptroller of the Currency formalized the policy in congressional testimony by announcing that the 11 largest national banks were too big to fail. The equity markets immediately priced a reduction in risk into the publicly traded securities of all large banking organizations. That is, market participants came to believe that the failure of a large bank was unlikely; so, the potential damage one bank’s failure might cause for other banks also diminished. As a consequence of implied federal protection, of course, market pressure on all large banks to contain risk was reduced.

FDICIA curbed too-big-to-fail protection by requiring the consent of the Secretary of the Treasury, along with two-thirds majorities of the Board of Governors of the Federal Reserve and the directors of the FDIC, before an institution could be given an exemption from normal procedures for resolution. To be sure, regulatory resolve has yet to be tested in a crisis; so, we do not know if the claim by regulators that no bank is too big to fail is, indeed, true. The consensus view among market participants appears to be that uninsured creditors of large banks now face greater default risk than before FDICIA, which is the intent of the law. Genuine risk exposure ensures that market discipline will reinforce supervisory efforts to maintain the safety and soundness of large banks.

Why the banking sector has fared so well during the recent economic slowdown can be explained in part by the retooling of policy following the thrift crisis, along with:
• other changes in regulation that permitted greater bank diversification across product lines and geographic markets,
• the strengthening of capital requirements under the Basel Capital Accord,
• technological advances in risk management, such as asset securitization, and
• better risk management by banks.

For the banking sector as a whole, return on assets remains comfortably above the traditional 1 percent benchmark for strong earnings. Bank failures numbered more than 100 every year between 1985 and 1991, but since 1995, they have not exceeded 11 in any year. The average commercial bank’s equity capital ratio stood at 6.4 percent of assets at the end of 1990, but had risen to 9.2 percent of assets by the end of 2002.

One other stabilizing aspect of the supervisory framework is worth mentioning. The Federal Reserve’s role as supervisor of all financial holding companies, bank holding companies and some state-chartered banks contributes to financial stability in two ways. First and foremost, the Fed’s supervisory role yields critical feedback about ongoing developments in the financial sector and in the non-financial economy. This feedback puts the Fed in a better position to carry out its function as lender of last resort. Second, and somewhat under-appreciated, the Fed’s status as being “independent inside the government” puts some distance between the political process and bank supervision. The Fed shares supervisory responsibility at the federal level with the Office of the Comptroller and the FDIC; each state also has a supervision department.

The Fed’s independence helps guarantee that competition among state and federal regulators, which can do much to improve efficiency and reduce regulatory burden, does not compromise the integrity of the supervisory process.

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Threats on the Horizon

We have learned from long and painful experience that the best safeguard against financial instability is a carefully designed private-public partnership. Yet, as a result of rapid financial innovation as well as profit-driven incentives to avoid regulation, a thriving set of non-bank financial entities has emerged in the United States and many other nations. These lightly regulated entities are not allowed to offer deposits, but compete with banks on other fronts. Prominent non-bank financial entities today include investment banks, mutual funds, finance companies, the “financial conglomerates” permitted by the Gramm-Leach-Bliley Act of 1999 and financially oriented government sponsored enterprises (GSEs). Because these institutions have grown rapidly, they have become important players in the financial system. Yet, because we do not have many centuries of experience with non-bank financial institutions as we do for banks, we do not really know what risks they potentially pose to the financial system. As important, they are not federally insured and do not have access to the Federal Reserve discount window.

Two of these entities—Fannie Mae and Freddie Mac—merit special attention because of their size and dominance in the housing finance market in the United States. These two housing GSEs are so massive in size and are growing so fast that any significant disruption at one or both of the enterprises necessarily would impact a large number of other financial institutions and non-financial entities.9 The securities issued and guaranteed by the housing GSEs are widely held in the United States and abroad, notably by commercial banks.10 U.S. households depend on Fannie and Freddie to obtain capital-market rates for home mortgage borrowing. A large number of players in the interest-rate derivatives market (including commercial banks) count one or both enterprises among their most important counterparties. Illiquidity caused by concerns about enterprise viability, not to mention outright default, could disrupt commercial banks’ liquidity management and other financial institutions and markets in unpredictable ways. The collapse of the hedge fund Long-Term Capital Management (LTCM) in 1998 illustrates how disruptive a single large player’s demise can be, especially in the global derivatives markets. Federal Reserve intervention, which encouraged a capital infusion and an orderly winding-up of LTCM’s business, prevented much greater financial turbulence. (See sidebar)

Housing GSEs also operate with an ambiguous status in the market. Participants in capital markets clearly perceive a significant credit-quality benefit attached to GSE status, as reflected in the very tight interest-rate spreads that GSE obligations enjoy over Treasury securities. Yet, the housing GSEs have no legal right to call upon the federal government to provide financial support beyond a trivial line of credit. If market participants were to abruptly downgrade the credit quality of GSE-issued or GSE-guaranteed securities, the resulting repricing and loss of wealth by securities holders could unleash substantial portfolio reallocations and widespread market volatility.

The potential threat to financial stability posed by the housing GSEs has not gone unnoticed. The housing GSEs’ federal regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), recently published an extensive study analyzing the systemic-risk implications posed by Fannie Mae and Freddie Mac.13 The report concluded that the immediate risks of financial-solvency issues at either Fannie or Freddie—and hence, the risk they pose for financial stability—were quite small because these enterprises are very strong financially and are well-regulated by OFHEO. The agency also believes it likely that other financial institutions, such as large banks, could quickly fill any void created by the pullback of Fannie or Freddie from the mortgage market due to financial problems they might encounter.

Nevertheless, OFHEO concluded that the chance of such a systemic disruption could not be ruled out and that further research is warranted. For, though a Fannie or Freddie insolvency is unlikely, the ramifications for financial markets and some financial institutions should insolvency occur—particularly if it occurred abruptly, say, as a result of uncovering an accounting fraud—would be profound, to say the least. A more likely event is not outright insolvency of one or both of the enterprises, but some disruption to the liquidity of the markets in which their fixed-income securities trade—the agency market or the mortgage-backed security (MBS) market. Such a “liquidity event” could stress the banking system because banks are relying more and more on agency securities and MBS as secondary liquidity reserves.

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As Unpredictable as the Weather

Sudden shocks—including dramatic revaluations of currencies, stock market corrections or terrorist events—are facts of life in modern economies. Economic disturbances such as recessions and lending cycles appear to be unavoidable as well. Without prudent policy, these shocks and disturbances, if severe or concentrated enough in time, could translate into a financial crisis that critically damages the banking sector. This, in turn, could severely disrupt credit and payment mechanisms—that is, create financial instability. (See chart)

Extensive government intervention into the financial sector of the U.S. economy—federal deposit insurance, the Federal Reserve System’s multifaceted role as promoter of macroeconomic and financial stability, and other financial regulations—has short-circuited this damaging feedback loop since the 1930s. To be sure, private-sector risk management practices have improved, but it is no accident that the New Deal financial reforms described in this essay have coincided with the longest uninterrupted stretch of financial stability in U.S. history.

Even though no bouts of financial instability have occurred in the United States since the 1930s, we know its reappearance is not outside the realm of possibility. The bursting of Japan’s “bubble economy” of the 1980s has crippled its banking sector. Indeed, Japan has avoided profound financial instability only by massive ad hoc government interventions that well may bring long-lasting negative consequences, such as an unsustainable amount of government debt issued to support the banks. Moreover, many less-developed economies have succumbed to macroeconomic and financial instability of the type that bedeviled the U.S. economy during the 19th and early 20th centuries.

As we move into the 21st century, we must build on our successes and learn from our own and other countries’ mistakes. In practice, this means paying careful attention to the incentives created by our banking policies. The fact that we have avoided financial instability for 70 years is, unfortunately, no guarantee that we will be as lucky during the next seven decades. In addition to continuous updating of financial supervisory practice and regulation, constant vigilance by government regulators—the public’s watchdogs—will be required.

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