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.
