Blame it on regulators, or on regulation?

How state and federal regulators sabotage banks

By Geoffrey Lawrence
  • Tuesday, September 16, 2008

Henderson's Silver State Bank was closed last Friday, less than two months after another Nevada bank, First National Bank of Nevada was shut down.  The Wall Street Journal highlights the tension that occurred between federal and state regulators prior to the closing of Silver State.

Silver State had been under scrutiny by the Federal Deposit Insurance Corporation, which planned to close the bank on August 29.  However, the FDIC would have overstepped its bounds in this regard.  Silver State was a state-chartered bank and fell under the jurisdiction of state regulators at the Nevada Financial Institutions Division.  The Financial Institutions Division elected to leave the bank open at that time – not agreeing to close the bank's operations until September 5.

The FDIC's investigation of Silver State and its intention of closing the bank a week earlier surely sent strong signals to the market that the bank was in trouble and likely caused large investors to withdraw deposits and dump shares – worsening the bank's financial position.  Shares in Silver State fell from $19.44 earlier in the year to $0.08 when the bank was closed on September 5.

In this regard, regulators can be blamed for exacerbating Silver State's problems.  Silver State was overly invested in a deteriorating real estate market and held $252 million in non-performing loans as of June 30.  However, the Financial Institutions Divisions had determined that the bank still maintained a high enough degree of solvency to remain open on August 29.  It appears that the visible actions of federal and state regulators prompted a late run on the bank. 

This failure places further strain on the national banking system as well as on large account holders.  The FDIC insures all accounts up to $100,000 and has estimated that this bank failure could cost the insurance fund up to $550 million – an amount that will be covered by raising the insurance rates that are charged to other banks.  There will also be a strong local effect as holders of accounts of larger than $100,000 will have difficulty retrieving their deposits.

The core issue at stake in this crisis is not whether federal or state regulators should have had jurisdiction over the bank.  When regulators make mistakes such as this, the question becomes whether the government intervention in and regulation of the banking industry is truly necessary in the first place. 

The FDIC was created to establish greater confidence in the banking industry during the Great Depression.  However, there is certainly no lack of confidence in the banking industry today and the sophistication of financial markets and access to information has improved to such an extent that regulation may no longer be necessary.  Market participants are as capable as regulators of determining the health of financial institutions.  In fact, if financial institutions were "regulated" solely by market forces, they would be constrained to maintain better financial positions.  Expectations of government regulation and bailouts encourage financial institutions to take on higher levels of risk (in order to earn higher interest rates) because that risk will be subsidized by government.

Regulators such as the FDIC are not the only government entities that distort banking markets.  The entire American financial architecture relies upon a single agency that has the power to arbitrarily decide how much the dollar should be worth – the Federal Reserve.  The effective function of the Federal Reserve is to allow government to become increasingly pervasive by perpetually expanding credit to the federal government.  Each of these arbitrary expansions in the money supply is essentially a hidden one-time tax on the wealth of all Americans; as more dollars are put in circulation the value of dollars that are currently held by individuals decreases. 

This backdoor theft by the Federal Reserve can be disastrous for the banking industry because it introduces additional risk.  Banks must not only weigh a borrower's risk of default, there is also great uncertainty over the future value of the very dollars they are lending.  Silver State Bank was likely as much a victim of the Federal Reserve as it was of regulators at the FDIC and the Nevada Financial Institutions Division.  Uncertainty over money supply and interest rates certainly contributed to the high share of its assets that Silver State had invested in the real estate market.

Silver State and its account holders were simply the latest victims of a financial architecture that suffers from far too much government control.  The appropriate regulator for Silver State should not have been the FDIC nor the Nevada Financial Institutions Division.  If Silver State had been responsible to individual investors, forced to bear the full risk of its investments, and able to work with sound money, it likely would never have found itself in the questionable position it was in on August 29 and certainly would not have crumbled the way it did in the week after regulators cast doubts about its viability.

Geoffrey Lawrence is fiscal policy analyst at the Nevada Policy Research Institute.

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