Wayne O'Leary

Zombie Banks and Rogue Bankers

Since March, the economy has been plagued by a problem most observers thought was behind us: the return of rogue banking, which played such a large role in the financial crash of 2008. It’s a development that not only threatens the financial structure overall, but illustrates in distressing detail how the American economic system really works.

The problem concerns the failure, or pending failure, of several medium-sized, mostly West Coast banks engaged in risky activity Federal Reserve officials characterized as mismanagement — basically, overextending lending operations while maintaining insufficient capital on the optimistic assumption that upward-trending interest rates would stabilize or fall, replenishing liquidity. As economist James K. Galbraith pointed out in The Nation (4/17/23), the Fed itself applied the coup de grâce when its high interest rates encouraged big depositors at those banks to withdraw their money and invest it more profitably elsewhere, leaving the banks in question cash-poor, vulnerable to “runs,” and in need of rescue.

The rescue came in due course, with the announcement by the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corporation (FDIC) that they would act in concert to ensure all depositors at three failed institutions, San Francisco’s First Republic Bank and Silicon Valley Bank (SVB), and New York City’s Signature Bank, would have their account losses covered (or “made whole”), even if they exceeded $250,000, the established ceiling for FDIC deposit insurance.

This would be done by declaring the failed banks (the 14th, 16th ad 29th largest in the country, respectively) to be “systemic risk exceptions,” thereby qualifying their underinsured depositors for bailouts paid for by special assessments on Fed member banks; the collapsed banks themselves would be taken over and run in the meantime by the FDIC in hopes of eventually finding buyers — a status rendering them walking-dead “zombie” banks. (One of the three, First Republic, was acquired in May by JP Morgan Chase.)

The rapidly evolving situation has led to plaintive calls for a substantial upward revision in the FDIC’s statutory coverage of deposit insurance, so that those the system wants most to protect, business and the wealthy, will not be at risk. Moves are under way in Washington to remove the current $250,000 FDIC reimbursement limit on bank accounts, allowing all deposits, no matter how large, to be covered either temporarily while the present uncertainty lasts, or, preferably, on a permanent basis.

Those who will decide the issue have in many cases a vested interest. The nation’s political officeholders are heavily invested in the stock market (see: New York Times report on congressional securities trading, 9/14/22), and since bank stocks are trending down, that fact appears to be a contributing factor in the push towards deposit-insurance “reform.” One failed bank, former Wall Street favorite First Republic, whose deposits had dropped by half in recent months, lost 85% of its share price by the time of its rescue sale; shares once worth $150 were then bringing $5.69.

Several congressional investors in First Republic unloaded personal or family holdings in the troubled institution as it imploded. One was Rep. Ro Khanna (D-Calif.), a rising progressive star, who’s been prominent in bipartisan discussions about raising deposit insurance; according to Times investigators, he made more stock trades involving more companies over the three-year period 2019-21 than any other congressperson.

The three failed zombies that precipitated the current crisis through their fast-buck banking operations (SVB, Signature and First Republic) had certain characteristics in common. All catered to wealthy customers and business firms, not average savers. All had a majority of their deposits in large uninsured accounts. All were involved with chancy technology start-ups, real-estate speculation, or venture capitalism. Their clients were concentrated in affluent locales like Greenwich, Connecticut, and Palm Beach, Florida, and tended to be entrepreneurs and executives in need of risk capital, money-management services, or what were termed “jumbo” mortgages for multimillion-dollar mansions.

Bank managers reflected the gambling spirit of their customer base; they were growth-obsessed, willing to take extreme risks, and profit-oriented. Their annual salaries, which were in the $10 million range, rewarded them accordingly, as the market dictated.

Clearly, these high-flying institutions, which flew too close to the sun, were not classically staid, mid-level banks of the sort that predominated when the FDIC was created a century ago; they were, in some ways, betting palaces as aggressively entrepreneurial as the high rollers that borrowed from or deposited with them. The financially conservative, small-town banker of the Frank Capra film “It’s a Wonderful Life” (1946) would not recognize their business model.

Their potential savior, the FDIC, a New Deal agency formed in 1933 as part of the Glass-Steagall Banking Act, was originally intended to insure small depositors against the ravages of the Great Depression and prevent runs of the sort that caused over 5,000 banks (a third of the national total) to fail between 1930 and 1932. The law worked, ending bank runs, but the ceiling for FDIC coverage, initially $2,500, was gradually raised to increasingly protect large depositors rather than everyday savers, what William Greider (“Secrets of the Temple,” 1987) called “the creditor class.” Maximum coverage, $10,000 in 1950, expanded sixfold (from $40,000 to $250,000) between 1980 and 2008.

Now, some want the ceiling totally removed, providing open-ended coverage for the 43% of US deposits over $250,000. This produces at least two dangers. In the first place, there’s an increased likelihood of generating “moral hazard”: creation of a speculative environment where reckless bankers and their clients take large risks, knowing their greed or bad judgment will go unpunished — will, in fact, be rewarded.

An unlimited deposit-insurance system also means any broad-based collapse of the banking industry beyond the Federal Reserve’s ability to control could lead to a massive government bailout, with the US Treasury acting as ultimate backstop. A handful of bank failures perpetrated by bad actors is one thing, but in 2018, Congress, with the acquiescence of current Trump-appointed Fed Chairman Jerome Powell, seriously weakened the 2010 Dodd-Frank law. Stress tests for most banks were eliminated, along with strong liquidity requirements and restrictions on proprietary trading by regional banks under the Volcker Rule.

We’re partway back to the days of the global financial crisis, when hundreds of banks failed. By all means, guarantee all bank deposits into infinity. What could possibly go wrong?

Wayne O’Leary is a writer in Orono, Maine, specializing in political economy. He holds a doctorate in American history and is the author of two prizewinning books.

From The Progressive Populist, July 1-15, 2023

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