Waves of red ink wash banks away before regulators can intervene

I've previously lauded the Federal Deposit Insurance Corporation for having perhaps the most robust procedures in the world for dealing with failed banks.  The extraordinary competence of the FDIC is probably one of the reasons that we didn't start talking about nationalization a lot sooner:  after seventy years, they are extremely expert at the ordinary wind-down of failed institutions.

That competence counts for a lot.  As any student of the banking system will tell you, one of the major causes of a bank run is . . . fears of a bank run.  The fact that the FDIC is so good at taking care of bank failures makes depositors and creditors a lot less likely to summarily demand the return of their capital in the first place.  Libertarians are right to bemoan the survival of creaky old FDR-era institutions on sheer inertia.  (TVA, I'm looking at you!)  But the existence of the FDIC goes a long way towards vindicating the New Deal.

But while the FDIC does a great job at handling individual bank failures, the Wall Street Journal points out that the agency, along with other bank regulators, is simply being overwhelmed by the speed at which bank failures operate these days:

Banking regulators across the country are struggling with a new phenomenon: Banks are failing with accelerating speed, exposing holes in the regulatory infrastructure designed to catch collapsing institutions.

The two small banks that failed a week ago, National Bank of Commerce in Berkeley, Ill., and Bank of Clark County, in Vancouver, Wash., both fell before regulators hit either one with public enforcement actions that would have alerted the public to their condition and allowed regulators to demand changes. National Bank of Commerce, for one, was reeling from losses related to its investments in mortgage giants Fannie Mae and Freddie Mac.

Of the 25 banks that failed in 2008, nine toppled before regulators publicly cracked down, including IndyMac Bank and the banking operations of Washington Mutual Inc., two of the biggest seizures in U.S. history. Two banks failed after being under an enforcement action for only two or three days.

Regulators also agreed to prop up Bank of America Corp., Citigroup Inc., and Wachovia Corp., even though none of them faced any type of formal enforcement action related to their safety and soundness.

The problem illustrates a fundamental weakness in the country's regulatory infrastructure. The government is positioned to help banks if there is erosion in their capital levels, referring to the cushion banks hold against unexpected losses.

But that isn't what happened last year. Instead, many banks faced a liquidity crisis as customers and business partners lost faith, shutting off the banks' access to short-term cash.

This is nothing that we haven't heard before:  the debate about whether banks are facing a liquidity crisis or a solvency crisis has been raging since August.  But it's worth pointing out, as the Wall Street Journal does, that America's regulators simply have no institutional capacity to deal with a liquidity crisis.  They are set up to handle individual risk, not systemic failures. 

Part of it is, as Democrats complain, that they don't have adequate staff.  But the staff would go a lot further if things were business as usual.  Instead, they have to make it up as they go along.  That means wasted time, energy--and inevitable mistakes.

In that respect, they are like the banks they regulate, which calculated their own risk exposure without adequate regard to the possibility of positive feedback.  But in a way, the FDIC has less excuse--after all, it was born in the wake of our last big banking panic.  Why have we shed the one institutional legacy we could really use?