Creature From Jekyll Island by G. Edward

The first is called a payoff. It involves simply paying off the insured depositors and then letting the bank fall to the mercy of the liquidators. This is the option usually chosen for small banks with no political clout. The second possibility is called a sell o f f , and it involves making arrangements for a larger bank to assume all the real assets and liabilities of the failing bank. Banking services are uninterrupted and, aside from a change in name, most customers are unaware of the transaction. This option is generally selected for small and medium banks. In both a payoff and a sell off, the FDIC

takes over the bad loans of the failed bank and supplies the money to pay back the insured depositors.

The third option is called bailout, and this is the one which deserves our special attention. Irvine Sprague, a former director of the FDIC, explains: 'In a bailout, the bank does not close, and everyone—insured or not—is fully protected.... Such privileged treatment is accorded by FDIC only rarely to an elect few.'1

That's right, he said everyone—insured or not—is fully protected. The banks which comprise the elect few generally are the Irvine H. Sprague, Bailout: An Insider's Account of Bank Failures and Rescues (New York: Basic Books, 1986), p. 23.

50 THE CREATURE FROM JEKYLL ISLAND

large ones. It is only when the number of dollars at risk becomes mind numbing that a bailout can be camouflaged as protection of the public. Sprague says:

The FDI Act gives the FDIC board sole discretion to prevent a bank from failing, at whatever cost. The board need only make the finding that the insured bank is in danger of failing and 'is essential to provide adequate banking service in its community.'... FDIC boards have been reluctant to make an essentiality finding unless they perceive a clear and present danger to the nation's financial system.1

Favoritism toward the large banks is obvious at many levels.

One of them is the fact that, in a bailout, the FDIC covers all deposits, whether insured or not. That is significant, because the banks pay an assessment based only on their insured deposits. So, if uninsured deposits are covered also, that coverage is free—more precisely, paid by someone else. What deposits are uninsured?

Those in excess of $100,000 and those held outside the United States. Which banks hold the vast majority of such deposits? The large ones, of course, particularly those with extensive overseas operations.2 The bottom line is that the large banks get a whopping free ride when they are bailed out. Their uninsured accounts are paid by FDIC, and the cost of that benefit is passed to the smaller banks and to the taxpayer. This is not an oversight. Part of the plan at Jekyll Island was to give a competitive edge to the large banks.

UNITY BANK

The first application of the FDIC essentiality rule was, in fact, an exception. In 1971, Unity Bank and Trust Company in the Roxbury section of Boston found itself hopelessly insolvent, and the federal agency moved in. This is what was found: Unity's capital was depleted; most of its loans were bad; its loan collection practices were weak; and its personnel represented the worst of two worlds: overstaffing and inexperience. The examiners reported that there were two persons for every job, and neither one had been taught the job.

With only $11.4 million on its books, the bank was small by current standards. Normally, the depositors would have been paid back, and the stockholders—like the owners of any other failed 1. Sprague, pp. 27-29.

2. The Bank of America is the exception. Despite its size, it has not acquired foreign deposits to the same degree as its competitors.

PROTECTORS OF THE PUBLIC

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business venture—would have lost their investment. As Sprague, himself, admitted: 'If market discipline means anything, stockholders should be wiped out when a bank fails. Our assistance would have the side effect ... of keeping the stockholders alive at g o v e r n m e n t expense.'1 But Unity Bank was different. It was located in a black neighborhood and was minority owned. As is often the case when government agencies are given discretionary powers, decisions are determined more by political pressures than by logic or merit, and Unity was a perfect example. In 1971, the specter of rioting in black communities still haunted the halls of Congress. Would the FDIC allow this bank to fail and assume the awesome responsibility for new riots and bloodshed? Sprague answers:

Neither Wille [another director] nor I had any trouble viewing the problem in its broader social context. We were willing to look for a creative solution.... My vote to make the 'essentiality' finding and thus save the little bank was probably foreordained, an inevitable legacy of Watts.... The Watts riots ultimately triggered the essentiality doctrine.2

On July 22, 1971, the FDIC declared that the continued operation of Unity Bank was, indeed, essential and authorized a direct infusion of $1.5 million. Although appearing on the agency's ledger as a loan, no one really expected repayment. In 1976, in spite of the FDIC's own staff report that the bank's operations continued 'as slipshod and haphazard as ever,' the agency rolled over the 'loan'

for another five years. Operations did not improve and, on June 30, 1982, the Massachusetts Banking Commissioner finally revoked Unity's charter. There were no riots in the streets, and the FDIC

quietly wrote off the sum of $4,463,000 as the final cost of the bailout.

COMMONWEALTH BANK OF DETROIT

The bailout of the Unity Bank of Boston was the exception to the rule that small banks are dispensable while the giants must be saved at all costs. From that point forward, however, the FDIC

game plan was strictly according to Hoyle. The next bailout occurred in 1972 involving the $1.5 billion Bank of the Common-Wealth of Detroit. Commonwealth had funded most of its

Sprague, pp. 41-42.