Mutual deposit insurance: other lessons from the record.

AuthorHartley, James E.

In the wake of the savings and loan crisis, many proposals to reform the deposit insurance system have been made. Bert Ely (1999) has advocated one of the more sweeping proposals: move to a system of private insurance in which banks would guarantee each other's deposits. In introducing this proposal, Ely notes, "[T]hree successful state deposit insurance plans operated in Ohio, Indiana, and Iowa prior to the Civil War (Calomiris 1989, 15-19). Those three plans are the historical precursors to the cross-guarantee concept" (242).

Ely's proposal is very similar to one made by Charles Calomiris (1989), who came to the proposal after a look back at the liability insurance plans adopted in fourteen states before the Great Depression. Six of those plans were implemented in the antebellum era, the other eight between 1907 and the Great Depression. Examining the record of these plans, Calomiris argues that only three of them can be considered successful: the antebellum plans in Indiana, Ohio, and Iowa.

The plans adopted in those three states closely resembled one another and differed from the plans used in all of the other states. Calomiris argues that the successful plans succeeded because they were mutual insurance plans: the banks were insured not by a state-run agency or insurance fund, but rather by one another; each bank in the insured system was responsible for meeting the obligations of any one of the other banks in the system should it fail. Moreover, in this mutual insurance plan, the banks exercised regulatory power over one another.

In light of this historical experience, Calomiris concludes that, in considering reform proposals for contemporary deposit insurance, legislators should profit from the lessons of the successful plans. In particular, he argues for a system in which the banks would be tied together in some sort of regulatory arrangement, each having the responsibility and the power to regulate the others and each liable, either directly or indirectly via required insurance premiums, for the activities of other banks in the system.

As noted, Ely's proposal is broadly similar and explicitly relies on Calomiris's account as a historical justification of the proposal. Calomiris's proposal has also garnered wider attention. It has made its way into both undergraduate (Mayer, Duesenberry, and Aliber 1996, 181) and graduate (Freixas and Rochet 1997, 262) money and banking textbooks, as well as into a Congressional Budget Office (1990) study. Calomiris's work has also been more widely cited with approval in works that range from proposals for reform after the savings and loan crisis (for example, see Wallison 1990) to a study of the Japanese deposit insurance program (Fries, Mason, and Perraudin 1993) and a Harvard Law Review article on bank holding companies (Jackson 1994).

The proposal has not gone unnoticed by legislators. Congressman Tom Petri (R-Wisc.) has introduced a bill that would abolish the current deposit insurance system and replace it with a "cross-guarantee' system. Ely helped write Petri's bill and describes the legislative proposal in his work (see Ely 1999; Petri and Ely 1994, 1995).

Notwithstanding the impact of Calomiris's work on this subject, important questions remain unanswered in his account of the successful deposit insurance plans. Of the eight states that adopted insurance plans after 1907, none adopted the sort of system used earlier in Indiana, Ohio, and Iowa. If those antebellum schemes were so successful, why did no state adopt such a system in later years? Why did they all adopt plans much closer to that used in antebellum New York, which Calomiris argues was a comparative failure? Moreover, none of the three states that Calomiris argues had successful insurance plans before the Civil War adopted any sort of insurance plan after 1907. Why would states with historically successful insurance plans fail to adopt any insurance plan at all in the later period? It seems remarkable to assume that legislators failed to notice a successful government plan that existed a mere half-century earlier. Indeed, early in the Great Depression, Indiana commissioned a study of its financial institutions (Study Commission for Indiana Financial Institutions 1932). In its review of the history of the state, the resulting report provides a glowing discussion of the antebellum Indiana State Bank. Nevertheless, when later in the report the commission discusses potential solutions for the problem of bank failures, including a discussion of "guaranty of bank deposits," it does not even mention the antebellum Indiana deposit insurance system.

In view of the foregoing questions, a look back at the complete record of the banking systems in Indiana, Ohio, and Iowa seems warranted. Such an examination reveals a number of details about those systems that are not included in Calomiris's account. It is not surprising that Ely and others, having read Calomiris's discussion of the banking systems in these states, would be led to believe that the mutual deposit insurance plan of those systems accounts for their stability. Moreover, it is not surprising that some lawmakers, after reading Calomiris's and Ely's proposals, would believe that the historical record provides ample evidence of the benefits of mutual deposit insurance and would therefore propose legislation to reform deposit insurance along the lines of the similar systems Calomiris describes as having existed in antebellum Indiana, Ohio, and Iowa.

However, a more complete account of the banking systems in antebellum Indiana, Ohio, and Iowa might lead one to conclusions different from Calomiris's. We shall see that the banking systems in those states were unique in more ways than just the mutual insurance plan Calomiris mentions. If we consider the systems as a whole, it is not clear that their mutual insurance accounts for their success, nor is it clear that the positive aspects of these systems gave rise to greater benefits than costs, because even though the systems did provide soundness, they did so at significant cost. Similarly, it is not clear that these plans provide any reliable lessons for designing a deposit insurance plan for the modern economy; instead, the main lesson may actually be that this sort of system restrains competition, fosters political corruption, and severely limits economic and financial development and growth.

The problems of the antebellum banking systems in Indiana, Ohio, and Iowa do not prove, of course, that proposals such as Calomiris's mutual deposit insurance or Ely's cross-guarantee system would be failures in practice. However, as Ely's remarks show, one of the principle arguments in favor of those proposals is that similar plans were previously "successful" in history. My wider-ranging discussion of these plans raises questions about reliance on the historical record as support for the present-day proposals. Instead, the lesson may simply be that government attempts to create banking cartels give rise to undesirable outcomes.

The Legend of Mutual Deposit Insurance

Before we examine the historical record, it is worth recalling the tale of the mutual deposit insurance plans as told by Calomiris (1989), who relied primarily on unpublished work by Carter H. Golembe and Clark Warburton (1958) at the Federal Deposit Insurance Corporation. (1)

In 1834, Indiana became the first state to adopt such a plan. In it, separately owned and operated banks were called "branches" of the State Bank of Indiana. The banks were regulated by a board of directors, most of whom the banks themselves appointed. The board had the authority to investigate, regulate, and even close the banks in the system. The mutual insurance provision obligated each bank to cover the liabilities of other banks. Because of this mutual responsibility, the state board imposed regulations, such as rules about dividend payments and loan provisions, intended to limit excessive risk taking. The coupling of mutual liability with the strong regulatory power of the board, Calomiris argues, made for a successful institution.

Calomiris counts the system a success because during its thirty years of operation no insured bank failed, although one was briefly suspended because of irregularities of its loan portfolio. In each banking crisis during the life of the insurance plan, the State Bank retained its soundness. It performed "admirably" during the crisis that began in 1837, although it did suspend convertibility of its paper into specie from May 1837 to August 1838 and again from November 1839 to June 1842. It survived both the regional crisis of 1854-55 and the national crisis of 1857 without suspending convertibility. This performance compares favorably with that of the free banks of Indiana that cropped up in the wake of a free-banking law passed in 1851: fifty-five of the ninety-four free banks failed in the 1854-55 crisis; fourteen of the thirty-two free banks failed in the 1857 crisis.

Ohio adopted a system similar to Indiana's in 1845. The Ohio and Indiana plans differed primarily in that the former provided for a "safety fund" into which banks deposited money to be used to pay off' the liabilities incurred by the system. The Board of Control in Ohio had "virtually unlimited authority over individual banks" (Calomiris 1989, 16). It imposed assorted regulations designed to ensure the safety of the system, including a limit on the amount of notes that could circulate relative to capital and a 30 percent reserve requirement on notes.

The Ohio system was put to a serious test in 1857, when a nationwide financial panic began with the failure of the Ohio Life Insurance and Trust Company. Although many Ohio banks had substantial deposits in that institution, only one Ohio bank (not a branch of the State Bank) failed in the crisis, and no general specie suspension occurred. The relative success in weathering the crisis sprang from the "wise and timely"...

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