A Book Review of Senseless Panic by The Economist.
The S&L crisis – It’s all happened before…Week by week America’s toll of failing banks continues to rise. The Federal Deposit Insurance Corporation (FDIC) reckons this year’s tally will exceed the 2009 total of 140 banks. But even this will fall well short of the record 534 failures in 1989 during the savings-and-loans crisis. Small banks were not the only ones that got into trouble back in the 1980s: the problems of Continental Illinois, then the country’s seventh-largest bank, confronted regulators with the same “too big to fail” issue that bedevils finance today.
William Isaac, the chairman of the FDIC at the time of Continental’s collapse in 1984, reckons that the lessons of this earlier wave of bank failures were not properly learned. Previously in his tenure, he had resisted heavy pressure to bail out a smaller bank called Penn Square: he judged the system could cope with its failure. Letting a bank the size of Continental go under was an entirely different matter, because of its links with other banks and because of the panic that would ensue. Under Mr Isaac’s watch, the FDIC bought a bundle of Continental’s bad loans and also injected money into the bank; shareholders and managers suffered, but Continental’s creditors did not.
In a financial crisis, he says, diluting market discipline is a lesser evil than trying to maintain public confidence. Judged by this overriding priority, Mr Isaac finds plenty to criticise in the recent past. He slams not just the decision to let Lehman Brothers fail in September 2008 but others, as well—the imposition of losses on uninsured depositors at IndyMac, a big Californian thrift, in July of that year, and the hit to preferred shareholders in Freddie Mac and Fannie Mae when the government took over America’s two housing-finance giants. Policymakers eventually got to the right destination—by offering greater security to depositors in banks and money-market funds, for instance, and guaranteeing banks’ debt issuance—but the journey was horribly chaotic.
Mr Isaac takes aim at other targets, too. The secret of good bank regulation is to “lean against the prevailing wind”; force banks to build up capital and reserves in good times so they can get through bad times. But the lessons that policymakers drew from the crisis of the 1980s ended up having precisely the opposite effect. They felt that banks got into trouble because the penalties for bad lending decisions had not been severe enough. Mr Isaac reckons that many of the measures that were introduced to instil discipline—notably fair-value accounting, which forces banks to mark assets to the prevailing market price—actually exacerbated the latest crisis. In a similar vein he also attacks capital regimes and deposit-insurance schemes that require banks to raise equity and pay premiums when losses are high.
Mr Isaac’s account is selective. He says, for example, that the volume of subprime loans was too small to have caused Armageddon, but he skates over the huge amount of leverage that built up. That makes his book unsatisfying as a guide to how the crisis unfolded. But as a warning that big banks are always likely to be too big to fail, whatever the claims made of America’s new financial-reform bill, it has the wisdom of experience.