History of Banking Crises Holds a Warning for Jay Powell
Responding to bank failures in 1972 and 1984, the Federal Reserve pursued two very different paths, with very different consequences for inflation.
To brake? Or to break?
For central banks throughout history, there has been a recurrent tension between price stability and financial stability. Raising short-term interest rates acts as a brake on economic activity by increasing the cost of credit throughout the financial system. But raising rates can also break financial intermediaries such as banks. It’s close to impossible to apply brakes to the economy without breaking something — even if investors and policymakers never tire of fantasies about soft landings, immaculate deleveragings or Goldilocks scenarios.
Last week, the failure of Silicon Valley Bank (SVB) — not forgetting Silvergate and Signature — led to emergency measures by the US financial and monetary authorities, who feared a wider bank run affecting at least half a dozen regional banks. How far these measures will succeed remains to be seen. At the time of writing, the risks of a wider bank run in the United States appeared to have subsided, but there were troubling signs of reduced liquidity in the US Treasury market and the first evidence of a European banking crisis with the news that Credit Suisse Group AG needed a $54 billion lifeline from the Swiss National Bank. By Friday it seemed possible that the bank would be acquired by arch-rival UBS Group AG. Stock indexes ended the week by sliding. In the case of US bank stocks, they are now down 30% to 40% compared with a year ago.
Here in the US, the key question in the short run is how much this effort to avert a banking crisis is going to undercut the effort to bring down inflation from 6% — where consumer price inflation landed in February — toward the Federal Reserve’s target of 2%. History offers some clues as to the answer. I suspect this history is very much on Fed Chair Jerome Powell’s mind as Wednesday’s meeting of the Federal Open Market Committee approaches.
First, let’s briefly recap what happened last week. Last Sunday night, regulators released their three-part plan to avert a banking crisis. The measures were extraordinary. First, with the help of the Treasury Department and the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) invoked the “systemic risk exception” to protect uninsured deposits at SVB and Signature. Second, the Fed and the Treasury used the Federal Reserve Act’s 13(3) emergency authority to create a Bank Term Funding Program (BTFP) to lend against Treasuries and Agencies, at par — in other words at face value with no haircuts — for a year. Access will be anonymous, with the identities of the banks who apply kept secret for a year.
Speaking at the White House on Monday morning before markets opened, President Joe Biden declared: “Americans can have confidence that the banking system is safe.” And he went on to echo former European Central Bank President Mario Draghi’s famous 2012 speech at the height of the euro zone crisis: “We will not stop at this,” Biden said. “We’ll do whatever is needed on top of all [this].”
But the Fed and the FDIC have already done a whole lot, as Biden well knew. They have implicitly extended deposit insurance to all deposits, and not just those in excess of $250,000. That is not a trivial commitment of taxpayers’ money. At the same time, they have created yet another device to expand the Fed’s balance sheet at a time when that is supposed to be shrinking. JPMorgan estimates that the Fed might end up lending as much as $2 trillion to banks. That would spell the end of Quantitative Tightening (QT). Indeed, the BTFP might turn out to be just the latest iteration of Quantitative Easing, unless there is minimal take-up by banks. Thus far, it’s been minimal: $11.9 billion by Wednesday. But the Fed balance sheet overall expanded by nearly $303 billion, in the forms of borrowing through the discount window and for banks seized by the FDIC, erasing all the QT the Fed has done since mid-November
More broadly, the authorities have redefined the meaning of the word “systemic.” If losses on SVB’s uninsured deposits posed a systemic risk, then every medium-sized bank that screws up is a systemic risk. As my Hoover colleague John Cochrane has pointed out, the hundreds of pages of regulation produced in the wake of the 2008/2009 financial crisis defined quite clearly which institutions were systemically significant and regulated them differently. My own 2018 prediction that the Dodd-Frank regime would disintegrate on contact with the next financial crisis has proved right. Of course, it can be argued that the Trump administration weakened the Dodd-Frank rules. But does anyone really think SVB would have failed a stress test under the original Dodd-Frank? In any case, not even in my wildest imaginings did I foresee that Barney Frank himself would sit on the board of one of the banks (Signature) blown up by the next financial crisis.
Is there a parallel for the authorities’ intervention? Several commentators cast their minds back to the rescue of Continental Illinois in 1984, the largest bank failure in US history until the 2008/2009 financial crisis. Paul Volcker, then Fed chairman, was persuaded to protect the bank’s uninsured deposits for the sake of financial stability. As Volcker later recalled, he had intended “a rescue where, as a formality, some of the private banks put some money in with us so it looked like a private rescue.” This is what had been done in the case of First Pennsylvania in 1980. However, no banks could be induced to participate in a rescue of Continental Illinois:
Volcker: The FDIC put in a little capital and we asked the banks to put some more capital, and we would provide all the liquidity it needed. Well, the banks weren’t in the mood to put any more capital in.
So, we had to go ahead anyway. … So, we left it to [William] Isaac [then head of the FDIC] to arrange it all. And … it was basically all arranged with one difference, he was going to guarantee all the deposits.
Interviewer: Even the uninsured ones.
Volcker: Yeah, which, as a matter of policy I didn’t want to do. I thought if the FDIC put in some more capital, the Federal Reserve would pledge to provide all of the liquidity and so forth, and things would straighten out without formally guaranteeing the deposits. But Isaac wanted to be sure, and he may have been right. He thought he was protecting the FDIC by going all the way.
I don’t remember any debate about this, but the way he put in the capital included protection for the subordinated debt of the holding company as well. We didn’t want to do that, but that was Issac’s decision.
If one goes back to the FOMC transcript of May 21-22, 1984, Volcker would also have preferred to continue with monetary tightening at that juncture:
But, unfortunately, I don’t think that course of action is open to us. I look at this financial market as being on a knife’s edge. I don’t believe all this business about policy at this point working at the margin with a nice little rise in interest rates slowing things down here and there. … If you want to see a group of ashen-faced bankers, sit down in a group and talk to them about the Continental situation and possible repercussions for the funding of their own banks against the background of this LDC [less developed countries] situation and what that might mean in terms of their own behavior and policies. I don’t think it is occurring at the moment, unfortunately — I don’t know, maybe some of this is going on — but what it could mean is a sudden change in attitudes. I hope it’s working gradually at the margin, to some extent, and maybe it is. I don’t see any evidence yet but this is very recent.
My bottom line is that we’ve run out of room for the time being for any tightening, given this situation.
As the transcript makes clear, Volcker was concerned that the troubles of Continental Illinois would spread to other institutions — including those with exposures to the then-intensifying Latin American debt crisis — if it was not rescued.
Yet there is a key difference between Volcker’s action in 1984 and what happened last week. Unlike Powell in March 2023, Volcker had already conquered inflation two years before. Moreover, although Volcker said he had “run out of room for the time being for any tightening,” in fact the Fed continued to raise rates after the Continental Illinois rescue. And this was at a time when 12-month average CPI inflation was around 3.5%. The authoritative historian of the Fed, the late Allan Meltzer, summed up the 1984 story:
Between March and August the funds rate increased from an average 9.9 to an 11.6% rate. The operating target for adjustment plus seasonal borrowing remained at $1 billion during this period, but in order to avoid the appearance of internal problems, fewer banks were borrowing. Growth of the monetary base and money slowed. The unemployment rate remained above 7%; the market could see that policy had tightened. Although Volcker had expressed political concern about an 11% funds rate, and this was an election year, the average remained above 11% between June and September. This action was strikingly different from the actions in the 1970s, so it contributed to the credibility of the Federal Reserve’s commitment to low inflation.
As Meltzer rightly noted, the 1970s had been different. So let’s go all the way back there. Because a better historical analogy for our purposes today may well be the rescue of the Detroit-based Bank of the Commonwealth in January 1972. Like SVB, Commonwealth grew too rapidly before a hiking cycle. Between 1964 and 1970 the bank’s assets tripled in size to $1.2 billion. On the assets side, its strategy, much like SVB’s, was to put assets in high-yielding, long-term fixed-income instruments. Commonwealth’s holdings of municipal bonds rose from 7% of its assets in 1964 to 22% in 1969.
However, interest rates also began rising in 1969—the effective federal funds rate rose from 6.3% to above 9% — as the Fed responded to inflationary pressures, and the value of munis plummeted. Commonwealth sought to tap the international Eurodollar markets by opening a branch in the Bahamas. After word got out that the Fed had refused its application to do so, a bank run ensued. Michigan state law did not allow interstate acquirers and the existing banks in the state were already too concentrated. The choice was between bailing Commonwealth out or letting it go under.
Much as happened on Sunday, regulators said they were “concerned with public confidence in the nation’s banking system if a billion‐dollar bank were to close,” even although Commonwealth was only the 50th-largest bank in the country and the fourth largest in Detroit. Bending the rules of that time, the FDIC ruled that Commonwealth was “essential” (the 1970s word for “systemic”) because of its “service to the black community in Detroit, its contribution to commercial bank competition in Detroit and the upper Great Lakes region, and the effect its closing might have had on public confidence in the nation’s banking system.”
Fed Chair Arthur Burns agreed to assist Commonwealth “with all the money it needed to stay open.” 2 The bailout was not a free lunch for stockholders, to be sure. Commonwealth had to reduce the par value of all outstanding stock from $45.5 million to $7.9 million to absorb the losses from the sale of its municipal bonds. The FDIC also lent the bank up to $60 million to replenish its capital. Senior management was replaced. (The FDIC extended the loan in 1977, but Commonwealth never recovered fully and was eventually acquired by Comerica Bank in 1983.)
This episode occurred between the 1969-70 and the 1973-75 recessions, at a time when inflationary pressures appeared to be abating. Consumer price inflation (seasonally adjusted) had come down from a high of 6.4% in February 1970 to below 3.3% at the end of 1971. Although inflation rose back to nearly 3.8% in February 1972, however, the Burns Fed held the discount rate steady at 4.5%, down from 5% in October 1971. The rate remained there throughout 1972, even as inflation began to pick up in the second half of the year. Measured by the federal funds effective rate, monetary policy eased significantly in January and February 1972. By the end of 1973 inflation was at 9%.
There is a warning from history here for the Powell Fed. In the face of the first sign of financial distress, the Fed and the FDIC have intervened to give implicit coverage to all uninsured depositors and to establish a new and potentially large line of credit for banks carrying losses on their bond portfolios. But what about inflation?
The argument will certainly be made by some at the next FOMC meeting that, under these circumstances of financial fragility, there should also be a pause in rate hikes. On Monday the Wall Street Journal quoted the former president of the Boston Fed, Eric Rosengren, as saying it would be a “disconnect” to raise interest rates next week. “Why raise rates,” he asked, “if you are worried about a systemic problem to the US economy?” Market participants — who just a few weeks ago were speculating about a 50-basis-point rate hike — now think there is close to a one in three chance the Fed will stand pat and a one in four chance of a rate cut in June.
Jay Powell must be torn between his impulse to vanquish inflation and his fears for financial stability. On the one hand, he reveres Paul Volcker. On the other, he recalls his time as a young official at the Treasury in January 1991, when it was the Bank of New England that was about to go under. Then, as last weekend, there was a debate about whether to make the uninsured depositors whole. Powell’s boss, Robert Glauber, was for administering a haircut to them. He lost the argument to Fed governor John LaWare, who warned that, if uninsured depositors got burned, “There will be a run on every American bank when they open Monday.” Powell will also recall that the Fed cut rates right the way through 1991.
Yet this is not 1991, when a recession was well underway, any more than it is 1984. With inflationary pressures still discernible, as even the economists of “Team Transitory” admit, the situation seems closer to that of 1972. If, like Arthur Burns more than 50 years ago, Powell combines the alleviation of financial distress with a premature pause in monetary tightening, he risks repeating one of the key mistakes of the Fed in the Seventies.
My guess is that next week’s FOMC meeting produces a 25-basis-point hike precisely because Powell does not want to be remembered as the heir of Burns. The European Central Bank’s decision to go ahead with a 50-basis-point hike on Thursday, despite the alarms and excursions in neighboring Switzerland, adds to the pressure on Powell not to go wobbly. If, however, he chooses instead to pause — signaling to markets that this tightening cycle is over — I may have to reiterate an earlier observation. I knew Paul Volcker. Is Jay Powell Paul Volcker? Give me a break.