Should We Have Dealt With ‘Too Big to Fail’ in the 1980s?

BY busadmin  August 5, 2009 at 2:53 PM EDT

Question: If you go back and look at the recession of 1982, you will see that the Fed bailed out large banks mainly due to bad LDC loans. I think the precedent of moral hazard was established then. I know that 1982 was a time of mass deregulation and there was no political will to change. But don’t you agree that after that recession, we should have dealt with the problem of “too big to fail”? I also might add that if you were a large depositor, would you put your money in a big bank or a little bank?

Paul Solman: Just for the record, it was the Treasury, not the Fed, that helped the banks through the then-called “Third World debt crisis” — via government guarantees of LDC (“lesser-developed country”) debts: those of Mexico, Argentina et al. And the action took place in the late ’80s, not ’82, under Secretary Nick Brady, hence the name “Brady bonds.” The crisis peaked around ’83-‘84, when major U.S. banks like Citi were said to be insolvent in that the loans, if marked down to their market price, were worth less than the bank’s total capital. The main thing the U.S. government did, for years, was to look the other way: NOT force the banks to “mark to market.”

All that said, I think the precedent of “moral hazard” was established well before and may not be as important as we think in the grand scheme of bank risk-taking.

The heavily initialed Simon Johnson (IMF, MIT and FOBD — friend of the Business Desk) points to data on U.S. bank equity as a percent of assets (basically, loans) from 1840 on. In other words, how much banks keep of their own money (original investor grubstake in the bank plus accumulated profits that haven’t been returned to shareholders as dividends), as a percentage of how much the banks lend out. In 1840, the ratio was 55:45 — banks kept a huge cushion, that is, by today’s standards of 10 percent or less, in the vault. As the century progressed and the U.S. economy grew, banks took more and more risk. By the time of the famous Panic of 1907, the ratio was down below 20 percent.

But what’s relevant to your question is that there’s been no real change from the 1940s on: the ratio has remained below 10 percent. The surprising implication? That the “moral hazard” of banks taking on more risk because of government guarantees in the 1980s was no real factor.

As to being a big depositor, I assume you mean one with larger-than-FDIC-insured deposits ($250k/person; $500k/couple). And then, sure, I’d rather have the money in a bank that’s more likely to be bailed out by the government because it’s too big to fail than in a small one that isn’t. But frankly, I’m skeptical that the government is going to let ANY deposits get lost. Not in this environment, anyway. Which is presumably one reason they merged failing banks like Washington Mutual into bigger ones rather than closing them down.

I wonder if knowledgeable readers of the BD have a different interpretation.