Greenspan, interventionist

by Russ Roberts on November 19, 2011

in Uncategorized

In 1991, Alan Greenspan testified before Congress on three bills related to banking:

I am pleased to appear before this Committee to
discuss three important banking reform bills: H.R. 6, the
Deposit Insurance and Regulatory Reform Act of 1991,
introduced by Chairman Gonzalez; H.R. 15, the Depositor
Protection Act of 1991, introduced by Congressman Wylie; and
H.R. 1505, the Treasury's proposed Financial Institutions
Safety and Consumer Choice Act of 1991. These three bills
all would modify our deposit insurance system in order to
place limits on an expansive safety net that has created
incentives for our banks to take excessive risk with
insufficient capital.

It was a very good idea to get rid of that “expansive safety net” that encouraged “banks to take excessive risks with insufficient capital.” But did Greenspan really think it was a good idea?

The standard narrative is that Greenspan was the free-market ideologue who opposed all regulation of the financial sector. But did he favor intervention of other kinds? He did orchestrate the rescue of LTCM (though without government money). He testified in favor of the government rescue of Mexico, which made sure that all of Mexico’s creditors, many of which were American financial institutions. And he often lowered interest rates to protect asset values. Not exactly a free-marketer (unless it benefits American banks and their bottom line. And later in the testimony Greenspan testified that it was a good idea to keep in place the power to bail out creditors. His bottom line is in the last paragraph below.

Greenspan was not a free-marketer. A simpler explanation is that he and the rest of the Fed and the rest of the policymakers responded to incentives and those incentives were to protect large American banks.

The Wylie bill is silent on the failure resolution
procedure of the FDIC, while the Treasury and the Gonzalez
bills would require the FDIC to resolve failed banks in the
least costly manner, which generally means that uninsured
depositors would receive only pro rata shares of residual-12-
value, if any. The Gonzalez bill, however, has no provision
permitting conaideration of systemic risks, and, after 1994,
prohibits outright any financial assistance by the FDIC to
an insured bank that would have the effect of preventing
loss to uninsured depositors or creditors. The Gonzales
bill also contains a provision intended to limit Federal
Reserve discount window lending to undercapitalized
institutions, where lending to such institutions is not just
for very short-term liquidity purposes. The Federal Reserve
is sympathetic to concerns about failing bank use of the
discount window to fund the flight of uninsured creditors,
potentially raising the cost of resolution to the FDIC. The
Federal Reserve would prefer not to lend to insolvent
institutions unless the failure to do so might have systemic
implications. However, we are concerned that the Gonzales
bill would seriously handicap the Board's ability to ensure
the stability of the banking system and might prematurely
close off liquidity support to viable institutions.
The Treasury bill calls for an exception to the
least costly resolution of failed banks when the Treasury
and the Federal Reserve Board, on a case-by-case basis,
jointly determine that there would be bona fide systemic
risk. No one — including the Federal Reserve Board — is
comfortable with the exception procedures for addressing
systemic risk, even though the Treasury proposal would
tighten up the way such cases are handled. While, in-13-
principle, systemic risk could develop if a number of
smaller or regional banks were to fail, systemic risks are
more likely to derive from the failure of one or more large
institutions. Thus, the need to handle systemic risk has
come to be associated with the too-big-to-fail doctrine.
The disproportionate degree of systemic risk at larger banks
highlights the tension between one of the main purposes of
deposit insurance — protecting smaller-balance depositors
-- and the concern that the rapid withdrawals by uninsured
depositors and other short-term creditors from larger banks
perceived to be in a weakened condition could cause and
spread significant disruptions that could, in turn, affect
credit availability and macroeconomic stability. Whatever
its macro benefits might be, too-big-to-fail has
increasingly offended observers and policymakers alike
because of its inequitable treatment of depositors, other
short-term creditors, and borrowers at banks of different
sizes, and its tendency both to broaden the safety net and
to undermine depositor and creditor discipline on bank risk-taking.
Despite the substantial concerns, the Board, like
the Treasury, has reluctantly concluded that there may be
circumstances in which all of the depositors and short-term
creditors of failing institutions will have to be protected
in the interests of macroeconomic stability. In evaluating
our conclusion, it is important to underline that we
anticipate that there will also be circumstances in which
large banks can fail with losses to uninsured depositors and
creditors but without undue disruption to financial markets.


31 comments    Share Share    Print    Email

Previous post:

Next post: