Protect Savings, Prevent Bank Runs Now
With the fall of the Dow yesterday below 7000, the financial crisis passed another milestone and not a good one. Markets are now down about 50% from their peak. Only during the Depression in modern history did they drop more, in that case by 80%. However, as bad as things are they could be worse. There have been no major runs on banks so far. We shold not take this for granted.
Runs on banks, once a staple of panics, have grown less common because of the policy invention of deposit insurance. Adopted by the US in 1933 and by other countries since, deposit insurance provides assurance to depositers that their money is safe.
Runs have not disappeared, however. Iceland's collapse accelerated with a run in the UK where the Icelandic banks had gone fishing for deposits. A bank run felled Northern Rock. Indymac the largest US bank to recently fail, died from a bank run following (accurate) comments questioning its health by Senator Schumer. These banks offered some deposit insurance but not enough to prevent runs.
Bank runs occur whenever people suddenly fear they may lose their savings. Given all the loose talk of nationalization or failure of banks such as Citi, it is arguably remarkable that the public has remained as calm as it has.
While most people incorrectly think all their deposits are covered, about $2.6 trillion of deposits according to the FDIC's last quarterly report remain uninsured despite temporarily lifting the limit to $250,000. Recent examples show that all it generally takes is a few people lining up outside a branch and some media attention to provoke a full scale run.
What to do?
Many old banking hands including William Isaac who ran the FDIC during the S&L bailout and then Treasury Secretary James Baker, have called on the FDIC to gurantee all deposits as it did during the S&L crisis. They are right!
Second, the Administration needs to move forcefully on a comprehensive plan to establish financial stability once and for all as opposed to the piecemeal approach being employed as in yesterday's infusion of $30 billion to AIG.
I have proposed a plan for the Fed to take custody of troubled assets in exchange for credits to banks. This would make the banks instantly sound (for which they should reciprocate by providing warrants and changing management) and allow the assets to be sold off in an orderly fashion over time. Another approach would be to quarantine all troubled assets of salvageable banks, provide a US guaranty and, similarly, sell them off over time. The key to minimizing losses which taxpayers would inevitably have to cover is not to hold a fire sale.
Treasury's plan, announced by Secretary Geithner last month in the speech that started the market selloff would use private capital to buy up troubled assets. However, prudent private fund managers who are generally constrained by covenants with investors want to know the terms before they come in which implies setting fire sale prices. Whether the government can use some sort of guaranty to bring in private capital without taking a huge immediate loss remains unresolved and markets have responded by selling off. The other two major options, nationalization of the banks--a huge and costly undertaking--or bankruptcies, an equally disruptive option, could sow more panic.
Two things: First, fully insure deposits to prevent a run on banks before one begins. Second, carry out a comprehensive plan rather than an ad hoc series of injections to restore confidence in banks.
