 a 10 percent tax on note issue that made it prohibitively expensive. The Indiana, Ohio, and Iowa insurance funds closed still solvent when their members got Federal charters. The savings and loan industry began in earnest at the same time, as a product of a provision in the same law that severely restricted Federally chartered banks’ ability to make mortgages. (These restrictions lasted until the 1970s. Since then, most of the other legal barriers separating banks from savings and loans have fallen as well.)
Bank notes effectively carried a Federal guarantee from the 1860s until Federal Reserve notes replaced the last of them in 1934. Issuers had to back notes 100 percent or even 110 percent with Treasury bonds, kept in a Treasury vault. But notes were becoming decreasingly important compared to deposits as the main form in which almost everybody held money.
“Honesty Taxed to Pay for Dishonesty...”
The federal government did not insure deposits, despite many proposals in Congress from 1886 onward that it do so. William Jennings Bryan and other populist politicians favored deposit insurance as a way of protecting small depositors and small banks. Leading bankers thought differently. Near the turn of the century, the First National Bank of Chicago’s president expressed their objections to deposit insurance in these words: “Is there anything in the relations existing between banks and their customers to justify the proposition that in the banking business the good should be taxed to pay for the bad; ability taxed to pay for incompetency; honesty taxed to pay for dishonesty; experience and training taxed to pay for the errors of inexperience and lack of training; and knowledge taxed to pay for the mistakes of ignorance?"[2]
Such arguments deterred the federal government from insuring deposits, but not some states. Oklahoma established deposit insurance in 1908. Seven southern and western states followed suit within the next decade. Their systems insured from 100 to 1,000 banks apiece.
Washington’s, the last started, was the first to crack. The depression of 1921 depleted its insurance fund. Since the system was voluntary, many healthy banks deserted it rather than suffer the high fees it would have imposed, and it shut down. The same happened to the other voluntary fund, in Kansas. In the other states, where deposit insurance was compulsory for state-chartered banks, low crop prices throughout the 1920s broke many rural banks, leaving depositors clamoring for their money. By 1930, all the funds were bankrupt. Texas’s system eventually paid off depositors in full, but elsewhere depositors lost at least 15 percent of their claims. The North Dakota fund, the worst of the lot, paid only $1 of every $1,000 in claims, and even after a tax-financed bailout, depositors lost three-quarters of their money.[3]
Despite the unfavorable experience of the state deposit insurance systems, the federal government established nationwide deposit insurance in 1934. The failure of nearly 10,000 banks since the Great Depression had begun in 1929 put pressure on the federal government to do something. Many prominent economists and bankers advocated branch banking as the best cure for the American banking system’s instability. They pointed to foreign systems that allowed branch banking, where failures had been few. In particular, they saw Canada, where no banks failed during the Depression, as a model for the United States to emulate.
However, the political clout of small banks and the worse than usual public image that big business had at the time kept branch banking from getting political consideration commensurate with its economic merits. Federal deposit insurance, once established, seemed to stabilize the banking system. The banking panic of 1933 was responsible for much of the good reputation that Federal deposit insurance enjoyed. It wiped out the weak banks that would have put the greatest strain on Federal insurance funds had they begun in 1933 instead of 1934, when the panic was over.
Since 1934, 14 states have chartered deposit insurance systems for certain banks and savings and loans not covered by Federal insurance. Though nominally private, most state insurance systems have been so enmeshed in local politics as to be in reality off-budget government agencies designed to shelter members from the rigors of competition. Their history has been as blighted as that of their predecessors.
New York and Connecticut closed relatively short-lived funds intact decades ago when their members voluntarily switched to Federal insurance. Funds have failed in half of the remaining states—Hawaii, Nebraska, Ohio, Maryland, Colorado, and Utah. The 1985 Ohio and Maryland failures required millions in tax money to pay depositors in full. The aftershocks prompted most states with solvent insurance systems to require all participants to switch to Federal insurance by 1990. Only three funds still offer insurance for banks lacking Federal coverage. One, in Kansas, is winding down as its members leave it. The others, in Pennsylvania, cover just a handful of tiny banks. State deposit insurance is in effect dead.[4]
Success in Massachusetts and North Carolina
The only truly successful state funds were those of North Carolina and Massachusetts. Their good performance was the result of incentives more closely resembling those of the free market than other state systems faced. The story of North Carolina’s Financial Institutions Assurance Corporation is particularly interesting because the fund started in 1967 as “a good old boys’ hideout from Federal regulation,” as one of its officers later recalled. A new president appointed in 1977 brought in a new management philosophy. The law governing the fund was changed to require a majority of its board of directors to be unaffiliated with member institutions. (The lack of such a provision in the Ohio and Maryland deposit insurance funds encouraged self- dealing. Unlike the pre-Civil War Ohio fund, the latter-day Ohio and Maryland funds had no counterbalancing liability features to make their members keep an eye on each other’s operations.)
The North Carolina fund began basing the premiums it charged its members on the riskiness of their portfolios. It increased the minimum net worth for members to qualify for insurance from it. Furthermore, it closely monitored members’ lending practices. For instance, it induced members to reduce their investment in fixed-rate mortgages several years before the rest of the savings and loan industry began having problems with fixed-rate loans. In every respect, the North Carolina fund’s actions contrasted sharply with those of the FSLIC, which was vulnerable to political pressure from members, did not adjust insurance premiums for risk, had lower net-worth requirements, and did little to prevent members from making reckless loans.
The North Carolina fund’s record was outstanding. Its stress on preventative measures, and the incentives it gave for its members to avoid making overly risky loans, kept any of them from failing. However, the Ohio and Maryland collapses cast a pall over all state deposit insurance systems. The North Carolina fund closed voluntarily, without losses, when many of its members decided to get Federal insurance. At about the same time, the Massachusetts funds, which benefited from that state’s long tradition of conservative banking, switched roles from substitutes to supplements to Federal deposit insurance.[5]
Of all state deposit insurance systems, then, few have been really successful. The others have existed too briefly to undergo a true test of strength, have folded up at signs of trouble, or have failed. Now Federal deposit insurance is duplicating state deposit insurance’s sorry record. The cause is the same: too many insured banks, mostly small, unable to withstand bad luck and bad management.
Deposit Insurance in Other Countries
Other countries, by allowing nationwide branch banking, have gained the stability the U.S. hasn’t been able to achieve. Competitive pressures have resulted in very large banks, so solid that they have not needed deposit insurance and, in most places, have not had. It is true that West Germany’s small Bankhaus Herstatt failed in 1974 and Italy’s scandal-ridden Banco Ambrosiano failed in 1982. But there have been no other noteworthy bank failures in developed nations. Britain, which has had nationwide branch banking longer than almost any country, has not experienced a major bank failure since 1878.
Every large Western country except Italy has deposit insurance. But in all except the United States, deposit insurance is a recent innovation, dating from the 1960s or 1970s. The banking systems of those countries took their present shape, and enjoyed stability, long before they got deposit insurance. Furthermore, foreign deposit insurance systems encourage depositors to monitor the health of their banks, which the American system does not. In some countries—notably West Germany—the systems are voluntary, so banks that fear that imprudent rivals are trying to take advantage of the system can quit it. In Britain and Switzerland, insurance doesn’t pay for the full amount of depositors’ losses, but only for, say, three-quarters.
Common to all foreign deposit insurance systems is that they have much lower maximum limits than the American system—from one-half to one-tenth as much—and that foreign governments are more serious about imposing those limits in practice than the American government has been. The possibility of suffering losses en courages depositors to entrust their money only to well-managed banks. Depositors abroad rely mainly on the quality of the banks themselves rather than on government insurance for protection.[6]
The exception that proves the rule occurred in Canada, whose federal deposit insurance system is most like that of the United States. In 1985, two Canadian banks went bust in Alberta—that country’s equivalent of Texas. Previously, no bank had failed since 1923. The Alberta firms, both founded in the oil boom of the mid- 1970s, were small and undiversified, resembling U.S. banks more than the five nationwide giants that have 80 percent of Canadian deposits.
Canada instituted compulsory deposit insurance in 1967 despite the protests of its large banks, who foresaw that it would be their premiums that would pay for small rivals such as the Alberta banks. The government guarantee helped convince depositors to let