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What Do Bank Runs and Health Reform Have in Common?
April 24, 2012 Health Care

The query in the title suggests an epic post, but we’ll keep it simple today. Let me ask folks what they think of a policy proposal that does the following:

  1. Examines the entrepreneurial ability, dynamism, job creating tendencies, etc. of companies and puts companies into two groups: dynamic/productive and stagnant/destructive.
  2. Takes the dynamic companies and asks them to “voluntarily” support their non-dynamic brethren.
  3. The worse their non-dynamic brethren behave, the more the dynamic ones are asked to “contribute”

Well, this is precisely what Federal Deposit Insurance does. The FDIC was established during the banking panics of 1933 as a way to improve confidence in the bank system and to stem runs, and because the reformers in government refused to otherwise deregulate the banking system by allowing nationwide branch banking (for example) as our brethren in Canada had always allowed. All members of the Fed system are required to carry this insurance, which means they pay a (risk adjusted?) premium on their deposits to the FDIC so that in the event of bank failure and insolvency, depositors will be made whole from the FDIC fund. In effect, what FDIC insurance does is that it has safe banks underwrite the risks of unsafe banks. In other words, prudent and health institutions are legally required to help their imprudent brethren. Not only does this create moral hazard, but it also institutionalizes sclerosis in the financial system by preventing the evolutionary forces of creative destruction to work their magic (please spare me the charge of social Darwinism).

I suggest that many folks find this set-up problematic. Why should well capitalized, plain-vanilla banks subsidize the activities of greedy leveraged banks? And when the FDIC is underfunded, as it inevitably has been and may still be, why should taxpayers be on the hook ¬†for this? Indeed, I’ve seen OWS protests pretty much making these arguments.

So pardon me for getting a headache when I see the very same folks who understand this make the argument that “health insurance mandates are necessary” because the healthy ought to pay for those who got the short straw in the sickness lottery. The point of insurance is not to have healthy folks subsidize sick folks. Sorry. If that is what you WANT it to be, that does not mean that this is what it actually IS. The point of insurance is for folks of similar risk profiles to pool themselves together so that what becomes an uncertain event for any one agent becomes a “certain” event for the pool as a whole. That is a far cry from having the “healthy” subsidize the sick. If you want an analogy, it is closer to the “lucky” being asked to unsubsidize the “unlucky.”

Is the force of moral hazard as strong in medicine as in banking? I cannot say. But if you cling to the idea that the healthy ought to subsidize the unhealthy as a matter of justice, irrespective of behavior and how we got there, then I don’t see how you can be all up in arms when Goldman Sachs, AIG, etc. eats at the trough of taxpayer guarantees.

"2" Comments
  1. Does your average depositor even know what a well-capitalized bank is? I used to follow a number of local and regional banks that were in our clients’ portfolios, and all of them had conservative loan loss reserves and earned over one percent on average assets. What I really wanted to know was what was in the bank’s loan portfolio, but the banks all kept that to themselves, as they had a right to do. Instead, I relied on the bank’s long-term record of cautious and conservative practices and their ability to earn ten percent or more than the year before for many years in a row. Now, that was all from a shareholder’s point of view, but if deposits were not FDIC insured (for example, some of our clients had “Jumbo” CD’s that were uninsured), I’d want to know as much as a shareholder would want to know.

    Also, depositors earned significantly less on insured deposits than the holders of Jumbo CD’s. In the case of Hill Financial, a thrift headquartered in my home town, Red Hill, back in the late 1970’s they were paying 15 percent or more on uninsured CD’s. They also lent money to very risky enterprises: a theme park in Florida’s panhandle and a huge real estate development in Denver that had not yet attained approval for public water (these were facts revealed to depositors after Hill Financial failed). The interest rate for those two projects was 20 percent, giving Hill a net interest margin of over 4 percent. Of course, after the theme park and the big real estate venture went broke, they earned zero percent on their two big loans. Hill then became the most insolvent thrift in Pennsylvania and number 17 in the country. They even made it to Sixty Minutes as a sad story of the savings and loan business. The video clips included the kids in daycare at St. Paul’s Lutheran Church playing in the leaves near “Thou Shalt Not Park Here” signs.

  2. I should add that while some of our clients bought Jumbo CD’s back in the Jimmy Carter years, we told them to unload them and buy AAA bonds instead.

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