In CH 10, we reviewed the regulations of the U.S. banking industry, which is a) one of
the most regulated sector of the U.S. economy and b) one of the most heavily
regulated banking industries in the world. We also discussed bank failures in the U.S.,
especially during the S&L crisis of the mid-1980s and early 1990s (1200 bank
failures). In CH 11, we look further at the economic analysis of banking regulations,
to try to understand a) bank failures, b) how regulations have contributed to bank
failures, and c) how regulations could be used to prevent bank failures.
Bank failure -
happens when a bank becomes insolvent, can't meet its obligations to
depositors and other creditors. Before FDIC, banking industry was affected adversely
by the potential problems of uninsured banks:
1. Uninsured depositors might be reluctant to deposit their money in a bank, since it
could be hard to tell how financially healthy the banks was. When uninsured banks
failed, the bank's assets were liquidated, and depositors would eventually get
something, but usually only a fraction of the value of their deposits. Without deposits,
banks can't make loans, so the banking system doesn't develop, credit markets don't
develop to the optimal level.
2. Depositors could not accurately assess the quality of the bank's loan portfolio,
leading to widespread bank panics, especially during economic contractions. Suppose
the economy goes into a recession, and historically about 5% of the banks fail during
a recession. Depositors might not be able to tell the strong banks from the weak
banks, and you could have a "run" on the bank - all depositors trying to withdraw
funds at once - even from the strong banks. Banks operated on a first-come, first-
served basis, leading to a "run" on the bank when depositors suspected trouble. The
spread of bank failures is called the
when there is a run on the
banks, and widespread bank panics.
Bank failures were very common before FDIC (1934), and major bank panics
happened on a regular basis, every twenty years or so (1819, 1837, 1857, 1873, 1884,
1893, 1907, 1930-1933). Even during the economic boom of the "Roaring 20s", there
were an average of 600 bank failures annually.
After 9000 banks failed in the early 1930s, FDIC was established in 1934 as a
government safety net to prevent future bank failures, eliminate runs and bank panics,
restore trust, etc. by providing a system of deposit insurance to protect depositors.
Deposits are now protected up to $100,000, so there are no longer runs on banks since
depositors know they are now protected even in the extreme case that the bank
actually does fail. From 1934-1981, there were fewer than 15 bank failures per year,
so FDIC did a) help stabilize the banking system for a long period, b) eliminate bank
panics and runs on the banks and c) prevent a single depositor from losing money
from a bank failure up to the limit (in some cases insurance would even cover deposits