WHAT SHOULD BANKS REALLY DO?: REPLY

In my original article (White, 1992), I tried to sharpen the focus of the current policy debate over the proper structure and activities of depository institutions ("banks") and the concomitant safety-and-soundness regulation that would be appropriate. I suggested three core issues: "(i) Who is capable of monitoring the activities of bank managers, and under what circumstances? (ii) What are the consequences of incomplete or imperfect monitoring? (iii) What are the efficiency consequences of different banking structures or configurations?" (White, 1992, p. 104). I then specified three polar visions for the structure of a bank--(i) Litan's (1987) narrow bank; (ii) a complete absence of deposit insurance and its supporting regulation; and (iii) an extension of deposit insurance to 100 percent of all bank deposits, accompanied by appropriate and improved safety-and-soundness regulation--and offered arguments favoring and opposing each possibility. I did not in that article indicate my preference among them (although earlier |White, 1991, ch. 11~ I indicated my belief that the third possibility was the best choice). Berger (1993) focuses primarily on the question of monitoring and the stability of banks. He apparently believes that banks are inherently stable and not subject to depositor runs. I believe otherwise.(1) Diamond and Dybvig (1983) provide solid theory to support the concept of bank instability.(2) And the historical record of pre-1934 bank failures strongly suggests instability. (See the data in Benston et al., 1986, pp. 54-57.) Of course, the latter evidence is not by itself dispositive of the case for government safety-and-soundness regulation and deposit insurance. Tens of thousands of business failures occur in the U.S. economy annually.(3) The failure of some firms is an inevitable part of the competitive process and of that process's weeding out inefficient firms. Why should we care especially about the consequences of bank failures? One can rephrase this latter question: "Are banks special?" The answer to this question again depends on what one believes about bank stability, about the importance of banks in the payments mechanism of the U.S. economy, and the importance of bank deposits as a form of money and store of value for many poorly informed participants in the U.S. economy.(4) Further, even under the best circumstances, an economy without government regulation of banks would incur private monitoring and transactions costs. Pricing alone is unlikely to solve asymmetric information problems associated with any lending-borrowing relationship, of which bank deposits are an important category (Stiglitz and Weiss, 1981). These costs, as well as the costs of bank failures, could be substantial. Berger refers to the monitoring by bank clearinghouses in the 19th century as a "success." But the patterns of bank failures in the late 19th century--including 491 bank failures (5.8% of all extant banks) in 1893, as part of the "panic of '93," and 110, 141, and 139 failures, respectively, in the years 1895-1897 (Benston, et al., 1986, p. 55)--raise serious questions about the ultimate efficacy of the clearinghouses. Also, the clearinghouses sometimes simply would suspend convertibility--in essence, freeze deposit accounts and impair depositors' liquidity--when they felt that circumstances warranted such actions. What were the transactions costs of such suspensions? More recently, the evidence (Randall, 1989, 1990; Gilbert, 1990) on markets' ability or inability to monitor soon-to-fail banks raises serious questions as to how well even today's sophisticated depositors or their sophisticated agents are able to monitor and discipline banks. Clearly, some markets have serious imperfections. Externalities exist where property rights are ill-defined and/or are difficult to enforce. Information may be asymmetric. In such cases, corrective governmental action can be beneficial. …