The Federal Deposit Insurance Corporation - Research Paper Example

The Federal Deposit Insurance Corporation (FDIC) Takes Back the Banks Introduction The Federal Deposit Insurance Corporation (FDIC) was established in 1933, during the Great Depression, and in response to the bank failures that had followed the stock market crash on Black Tuesday, October 1929. It was established to restore confidence in banks, insure depositor savings ad prevent runs on banks, and to prevent or minimize the impact of bank failures. According to the FDICs official history, “while the agency has grown and modified its operations in response to changing economic conditions and shifts in the banking environment... [its mission] remains unchanged: to insure bank deposits and reduce the economic disruptions caused by bank failures.”(“The First Fifty Years”) The following brief discussion will focus on the FDIC and its second mission, to reduce the economic disruptions caused by bank failures. Specifically, the role of the FDIC in the recent spate of bank closures will be examined. In conclusion the FDICs intervention in the bank failures will be critically analyzed to determine its impacts, or lack thereof, on the American economy during the recent economic crisis popularly known as the Great Recession. Deregulation, Failure and Crisis Written in the 1980s the FDIC official history described American banks as “more closely regulated than in any other nation.” (“The First Fifty Years”) In the quarter century since that volume was written the situation changed significantly. American banks underwent a comprehensive process of deregulation that climaxed during the former Republican administration. In 2007 Philip E Strahan summarized the effects of more than a decade of deregulation: “Interest rate ceilings on deposits were phased out in the early 1980s; state usury laws have been weakened because banks may now lend anywhere; and limits to banks’ ability to engage in other financial activities have been almost completely eliminated, as have restrictions on the geographical scope of banking.” He also praised the positive impacts of deregulation. It “allowed banks to offer better services to their customers at lower prices. As a result, the real economy—Main Street as it were—seems to have benefited” and “Overall economic growth accelerated following deregulation.” (Strahan, 2007) Strahan was a firm proponent of the stimulative effect of banking deregulation. He also saw its benefits being distributed throughout society and including, notably, Main Street. When Strahans remarks were published in the influential, Federal Reserve Bank of St. Louis Reviews July/August issue in 2007. Moreover, his optimism was widely shared. In August 2007 the National Bureau of Economic Research published a working paper that concluded, “deregulation significantly reduced income inequality by boosting the incomes of lower income workers.” In the summer of 2007 banking deregulation was good for everyone including the factory floor and main street. Currently, this optimism seems wildly misplaced. Looming around the corner from these blithe economic pundits was the perfect financial storm. In the next two years the Big Three automakers faced an extinction that was only averted by a huge federal buyout that Ford alone was able to decline. The stock markets tumbled and institutional and individual investors found there net worth and their future plans collapsing. The housing market collapsed along with the lending industries that depended on it. Also, like the period between 1929 and 1933 banks began failing with regular, increasing and disturbing frequency. In the first seven months of 2010 U.S. regulators have already closed 108 banks compared with 140 for all of 2009, 25 in 2008 and just three in 2007, according to the Federal Deposit Insurance Corporation (FDIC). (Coyle, 2010) The figure reached 110 this year on Friday the 13th of August. The FDIC arranged for First Midwest Bank to take over the five branches of Palos Bank and Trust Co. along with its $467.8 million in deposits and $493.4 million in assets. This failure alone will cost the FDICs deposit insurance fund an estimated $72 million according to www.bailoutsleuth.com. (Carey, 2010) In 2007 there were three bank failures in the United States. Since January 1, 2008 there have been 275. At this rate, a total of at least 185 will be closed this year and a total of 325 will have been closed in 2009 and 2010. Not since the 1930s era of the Great Depression and the Dust Bowl has such a rapid succession of so many banks failed. The bank failures along with down trends in other economic indicators have earned the label the Great Recession for the last. The largest single bank failure was that of Washington Mutual (WaMu) which was seized by regulators in September 2008, almost two years ago. Fallout from this failure continues to reverberate. According to The Wall Street Journal , bankruptcy hearings and investigations of allegations of malfeasance are ongoing: A Senate panel turned up evidence WaMu helped fuel the boom in risky mortgages and engaged in questionable lending practices.... Lawyers for multiple groups of investors and lawyers for WaMus former parent company, Washington Mutual Inc., have also conducted investigations and found enough to file lawsuits claiming everything from market manipulation to mismanagement. (Bricker, 2010) Following from the evidence presented by these bank failures a set of general observations can be made. Subsequent to deregulation banks were able to expand the range of financial services and investment vehicles they offered to their clients. Over time the sub-prime mortgage market grew in importance in banks lending portfolios. Under the Bush administration lending regulations around mortgages were relaxed to encourage new home purchase and new entrants into the mortgage market. A range of extreme products such as interest-only mortgages and no (or minimal) down payment mortgages were introduced. Applicants with less than stellar credit histories, few assets and often even no regular employment found themselves approved for mortgages. They stimulated both the mortgage market and the housing construction industry. The result was a bubble that saw prices artificially inflate. When that bubble began bursting, arguably before the optimistic articles cited above were published, the entire house of cards collapsed. The recession left many new home owners without employment and unable to pay their mortgages. Other homeowners found that the amount of their mortgage exceeded the value of their house and simply walked away. Demand for new mortgages dried up at the same time that many mortgage-holders defaulted. The banks found themselves forced to foreclose on many. Overall, income from mortgages declined precipitously, the new mortgage market evaporated and the banks found themselves foreclosing on assets (houses) worth less than the debt outstanding against them. This caused hundreds of banks to fail. According to the Bank of International Settlement it was the loose mortgage lending policies that developed in the United States that triggered the global crisis in general, and American bank failures in particular: “Only in the United States was there such a rapid expansion of subprime, nodeposit, stated-income, teaser and negative-amortisation mortgage products (sometimes all of these features in the one loan). Households were therefore more likely to fall into negative equity, and if they did, to default on their mortgages.” (Ellis, 2008) In April 2010 FDIC Chairman, Sheila C. Bair outlined the FDIC procedures for taking over a bank: The FDIC resolution process for insured banks provides continuity of credit functions, while liquidating the operations of a failing firm. ….The FDIC resolution mechanism closes the institution and auctions it to the private sector, reallocating resources to stronger institutions. And it gives the government the right to repudiate executive contracts, eliminate bonuses, require derivatives counterparties to perform on their obligations, and impose losses where they belong: on shareholders and creditors. (Bair, 2010) From the current perspective the FDIC process seems to have worked. It did not prevent bank failures. However, that is not its mandate nor its responsibility. Rather, it did serve to minimize the impacts of bank failures as was its original mission and remains its mandate today. Conclusions The Great Recession of the twenty-first century did not cause the American economic system to collapse. In this minimal sense the FDIC served its purpose and fulfilled its mission. It managed the takeover and liquidation of banks that had failed. It saw their valuable assets transferred to another private-sector financial institution, facilitate elimination of bad debt, and maintained the overall integrity of he American banking system. The most important question is not how did the FDIC minimize the impacts of the housing and sub-prime lending rate crisis. Rather, the real question is how did the financial and banking system did into this crisis in the first place? The FDIC averted a crisis with emergency interventions and in so doing averted a greater crisis. However, reasonable and responsible regulation might have prevented this housing bubble and bank failure epidemic from erupting in the first place. Putting out a fire is important at any time. However, prevention, preventing fires (or bank failures) from occurring is a much more sensible policy. Bibliography Bair, Sheila C. (2010) “Beyond Bankruptcy and Bailouts: The FDIC Resolution Process is the Right Model for Failing Firms” The Wall Street Journal 5 April 2010. Web. http://www.fdic.gov/news/letters/beyond_bankruptcy.html. Beck, Thorsten, Ross Levine and Alexey Levkov (2007) “Big Bad Banks? The Impact of U.S. Branch Deregulation on Income Distribution” National Bureau of Economic Research. NBER Working Paper No. 13299. Issued in August 2007. Web. http://www.nber.org/papers/w13299. Brickley, Peg (2010)“Probe of WaMus Demise Approved”. The Wall Street Journal. 11 August 2010. Web. http://online.wsj.com/article/SB10001424052748704164904575421822599092374.html?mod=googlenews_wsj. Carey, Cris (2010). “Regulators seize Chicago-area bank in 110th closing of the year”. 14 August 2010. Web. http://bailoutsleuth.com/news/2010/08/regulators-seize-chicago-area-bank-in-110th-closing-of-the-year/. Coyle, Thomas. (2010). “Wealthy Clients Cushioned from Bank Failures” The Wall Street Journal. 3 August 2010. Web. http://blogs.wsj.com/financial-adviser/2010/08/03/wealth-clients-cushioned-from-bank-failures/. Ellis, Lucie (2008) “The Housing Meltdown: Why did it happen in the United States” Bank for International Settlement, Monetary and Economic Department. BIS Working Papers. No. 259. September 2008. http://www.bis.org/publ/work259.pdf?noframes=1. Federal Deposit Insurance Corporation (FDIC), “The First Fifty Years”.Web. http://www.fdic.gov/bank/analytical/firstfifty/chapter1.html. Strahan, Philip E. “The Real Effects of U.S. Banking Deregulation”, Federal Reserve Bank of St. Louis Reviews 85:(4) July/August 2007. Web. http://www.research.stlouisfed.org/publications/review/03/07/JulAug.pdf#page=114. Read More