It started with Nixon, not Obama


We've been excusing businesses and lenders from risk for 40 years, collapses are inevitable

I was reading the excellent Too Big to Fail Must Die in City Journal and I learned something new.

Fifty years of policy died in 1984. That May, the nation’s eighth-largest commercial bank, Chicago’s Continental Illinois, found itself in deep trouble. Like any enterprising company in a capitalist society, it had exercised its right to establish a competitive edge and pursue greater profits—with a corresponding risk of failure, which had now struck. Continental’s biggest error was how it paid for its investments. All banks use depositors’ money and other sources of funding to make loans and other investments. But beyond using funds from FDIC-insured small depositors and other stable, long-term lenders (such as bondholders), Continental relied more than most banks on short-term, uninsured lenders from around the globe, particularly large depositors. Global corporations and other investors often park their money overnight or for a few weeks at a time in bank accounts that offer slightly higher rates because, once they’ve exceeded the FDIC limits, they carry risk. For a lender who doesn’t mind that risk, these short-term, uninsured accounts are attractive, since he can pull his money at any time if he needs cash, finds a better rate elsewhere, or perceives a new danger. For the borrower, like Continental, however, that ease of withdrawal made the funding source perilous. A sudden panic could leave the accounts depleted and the bank without money just when it needed it most.

Looks like it was the Reagan administration that fell for the line first. But not everyone in the administration agreed. Emphasis added.

The break from normal practice divided the administration. Treasury Secretary Donald Regan found the intervention outrageous: “We believe it is bad public policy, would be seen to be unfair . . . and represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy,” he wrote to his colleagues. But the White House, by offering its quiet support to the Fed and the FDIC, plainly agreed with their compelling argument that the alternative was to risk a systemic crisis in the financial industry.

Federal Reserve chairman Paul Volcker told Congress that the decision to protect uninsured lenders of a private institution from the consequences of a freely assumed risk wasn’t meant to set a precedent. But the federal comptroller of the currency, which regulates banks, made clear that a shift in policy had taken place, telling Congress that none of the nation’s top 11 banks would be allowed to fail. Small banks were apoplectic. Jokes flourished about investors’ not wanting to put money into the nation’s 12th-largest bank. “How often and to what extent can the government, and in turn the taxpayers, prop up any institutions that are neither the nation’s best or brightest?” wondered the Independent Bankers Association of America.

Good question. So I did some checking. Continental Illinois National Bank wasn't the first. It wasn't even New York City.

It was Penn Central Railroad in 1970 with President Richard Nixon.

Nicole Gelinas was right about one thing though. It was a Republican White House that decided some companies are too big a risk.

Here's what you should remember from the City Journal article.

Gradually, lenders to big banks understood that their money was no longer at risk. And the banks realized that the bigger and more complicated they got, the safer they would be from market discipline—and so they became.

That is what our entire financial system has become based on. As long as we allow lenders and bankers to act without consequences, failures will happen more and more. The stakes will become higher and higher.

We can't afford it.

Not because of the sheer size of the sums involved.

But because we've shifted risk and higher costs to the taxpayer.

And there is no more money to use.

— NeoWayland

Posted: Mon - August 17, 2009 at 01:33 PM  Tag


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