Bank Runs and the FDR Framework

One of the problems that FDR faced when he took office was the high frequency of bank runs across the US.  The question was how to stop these runs and the harm they caused the local economy in which they occurred.

As discussed in an earlier post, bank runs result from a change in belief about the soundness of a bank.  Since depositors cannot see how the assets that the bank invests in are performing, they have to trust that any losses will not cause the depositor to lose any of their money.  For whatever reason this trust is lost, it is in the depositor's best interest to run to the bank and withdraw all their money.

FDR addressed stopping bank runs in multiple ways.  First, he guaranteed deposits below a certain amount.  For many individual depositors, this meant that the government protected all of their deposits.  This eliminated their need to worry about the soundness of the bank.  Second, he closed a number of banks and effectively said that the remaining banks were sound.  Third, he created a regulatory infrastructure with the power to examine banks and to takeover failing banks.

How does FDR's solution for the banking system comply with the FDR framework for investments?

Rule 1:  Investors should be provided with useful, relevant information in an appropriate, timely manner.

Under FDR's solution for the banking system, the deposit guarantee puts the US into the position of an investor.  The regulatory infrastructure had the authority to access what it determines is useful, relevant information in an appropriate, timely manner.

There were two potential problems with this compliance mechanism.

First, it puts a burden on regulators to keep pace with the evolution of the banking system.  Specifically, as the banking system evolves, regulators have to understand what is useful, relevant information and when the information must be received in order for it to be timely for each financial innovation and product in the banking sector.

Second, it puts a burden on regulators to be able to use the information.  As discussed by Andrew Haldane, regulators are frequently overwhelmed by the task of using this information.

Rule 2:  Governments should not endorse specific investments

Under FDR's solution for the banking system, the government does not directly endorse an investment in a specific bank.  Given its superior access to information and its incentive to minimize losses on its deposit insurance, the government implicitly endorses investment in the entire banking system.

There is one major problem with this compliance mechanism.  It does not take into account how investors will interpret activities by the regulators.

At the start of the credit crisis, investors translated actions taken by the Bush and Obama administrations as making a broad implicit endorsement of the banking system into an explicit investment endorsement of a select few large banks.  These explicit endorsements occurred first through the government's use of investments using TARP funds and second through the government's use of bank stress tests.

How would FDR have changed his solution for the banking system if he had to implement it today?

Your humble blogger believes that he would have taken advantage of 21st century information technology.

In the 1930s, it was impractical to share with all potential depositors in a bank the current information on every asset on a bank's balance sheet.  That is why FDR's solution relied on bank examiners and regulators.  It was their role to go in, look at the assets and request asset performance information on an ongoing basis.  It was their role to protect both the deposit guarantor and the stability of the banking system.

In 2010, it is practical and very low cost using 21st century information technology to share with all potential depositors and investors current information on every asset on a bank's balance sheet.  This would be consistent with and in the spirit of providing investors with useful, relevant information in an appropriate, timely manner.

Financial institutions track all of their assets in databases.  By definition, these database track what the asset is (a loan or security) and how much of the asset there is.  These databases are updated whenever an observable event occurs involving the asset.  Examples of an observable event would be the origination or purchase of an asset, a payment on the asset, a non-payment or delinquency on the asset, a default on the asset or a sale of the asset.

Providing current information on an observable event basis on every asset on a bank's balance sheet would eliminate the problems that exist in FDR's banking solution.

It removes from regulators the burden of being the only market participants looking at the information.  It is the other market participants, like credit and equity market analysts and other bank competitors, that have an ability to look at and interpret the asset-level information.  These market participants also have an incentive to flag potential solvency problems and to exert market discipline on management to address these issues.

In addition, these other market participants can help the regulators determine what is useful, relevant information on an asset that needs to be reported.

The addition of the other market participants and the market discipline they bring removes both the implicit and explicit investment endorsement by the government.  Now it is the market that is saying which bank is a good investment, which bank is a troubled investment and which bank should be closed.