Two aspects of his leadership from his first year in office stand out.
First, FDR understood the danger of excessive government protection of banks and would be appalled today by the magnitude of it. He solved the banking collapse of 1933 with smart regulatory policies and real government oversight, not a bailout as is currently being done. He reluctantly agreed to use the deposit insurance and kept it limited. It was not the reason for his success.
Second, he knew what it took to deal with a banking crisis, and in particular how to restore public confidence in the banking system. At the worst of the Great Depression, he faced a far greater challenge than the problems of the present – and he managed to turn things around almost immediately. In contrast, policymakers and regulators today waver, hoping that empty words and feeble measures can restore confidence. The FDR mirror is very revealing of the shortcomings of the current policy response.
Many people are surprised when I tell them that FDR was explicitly against federal deposit insurance during the 1932 presidential campaign. At the heart of the banking turmoil, with many bank failures leading to losses for depositors in 1931-1932, his 1932 letter to the New York sun stated that federal deposit insurance “would lead to lax bank management and carelessness on the part of both banker and depositor. I believe it would be an impossible drain on the federal treasury.”
FDR makes an important, and empirically correct, point here: good banking risk management depends on the discipline of depositors, which depends on their role in the game.
Later, Roosevelt reluctantly agreed to set up FDIC insurance, at the urging of Rep. Henry Steagall, as part of a larger political deal, but he kept the agency’s coverage limited to small deposits. In addition, by March 1933, he had closed all banks and only permitted them to reopen and access insurance coverage after they had undergone a thorough investigation to determine that they were in sound financial condition.
FDR didn’t solve the banking panic by throwing deposit insurance on the problem or waiting for more banks to close by worried depositors. He first ended the runs by closing banks and set up a credible process for them to reopen after showing their strength. Because regulators’ investigations were demonstrably credible to independent observers, and often accompanied by increased capital, confidence in the system was restored and many banks were able to reopen quickly. Runs did not return – not because of the scant coverage of the new deposit insurance system, but because FDR had addressed the problem of banking weakness that caused the runs.
What would a similarly effective policy response to the current crisis look like? The problem is much less serious today, making the solution easier.
There are only about 200 U.S. banks that are clearly vulnerable to securities losses comparable to Silicon Valley Bank. Regulators should have talked to those banks individually last weekend, requiring them to either come up with credible recapitalization commitments immediately or place them in receivership (starting Monday morning). Under receivership, their activities would be restricted until it was determined whether they could provide sufficient recapitalization or, if not, would be placed in receivership. In the meantime, they should have been allowed to pay out all insured deposits, but only a fraction of the uninsured deposits (based on the potential losses of uninsured depositors at each bank). This would have put pressure on those banks to solve the problem quickly and would have limited the illiquidity problem to a portion of uninsured deposits in a small number of banks.
Had that happened, experts from industry and academia could have immediately reassured relatively uninformed depositors that the government policy response had been effective and that there was no cause for further concern. I think some uninsured savers would still have wanted to move their money, as a long-term precaution, but the urgency of these short-term disruptions would have been greatly reduced.
Instead, the Biden administration did nothing about the 200 vulnerable banks, encouraging continued panic. The two measures they did take last Sunday clearly did not calm the market. First, the bailouts of uninsured depositors at Signature and SVB have no clear implications for the risk of loss for uninsured depositors at other banks, especially given the criticism of those bailouts for being politically motivated and unfair. No uninsured depositor worried about their own potential losses will think their money is necessarily safe now.
The second policy announcement was also ineffective. The Federal Reserve has created a new special lending facility for banks, allowing them to borrow against eligible Treasury and government securities for up to one year. Banks can borrow an amount equal to the face value of those securities, which is higher than their market value. This implies a partially unsecured loan (the opposite of the typical “haircut” applied to collateral in central bank loans).
These loans are no reason for worried uninsured savers to keep calm. The fall in the value of securities held by vulnerable banks is not temporary, but is essentially the result of the Fed’s interest rate hikes, which will not only continue, but will be increased in the future. Securities used as collateral will not appreciate in value if the Fed intervenes. Second, the loan is only for one year, so after the end of that year, a bank that is insolvent today because its securities have fallen in value will still be insolvent. For these reasons, the Fed’s lending program will not cause uninsured depositors at an insolvent or severely weakened bank to decide not to withdraw their money immediately, if they were inclined to do so at all.
It is time to take FDR’s example to heart, address the banking problem immediately and head-on, and give American savers real reason to believe that “there is nothing to fear but fear itself.”