Dismantling the economy’s legal infrastructure V-5-c: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 3: First Pennsylvania bailout

The Bailout of First Pennsylvania Bank

In the last months of 1978 the Iranian Revolution triggered a second dramatic rise in oil prices, and by 1979 US inflation was beginning to spiral out of control. As the Federal Reserve struggled with the problem of monetary control, regulators were very aware that non-bank liabilities and the Eurodollar market with its 20% per annum growth rate were part of the problem (Hawley 1984: 148). As the nature of the money supply was transformed, the Fed began to have control over only a portion of the de facto money supply: the Fed had traction over local domestic markets, but not the Eurodollar market; it had traction over bank-reliant SMEs, but not large firms that could raise funds on the commercial paper market (which was of course also bank-reliant, but off-balance-sheet and subject to little or no monetary control). The changing nature of the money supply meant that by the end of the 1970s the tools of monetary policy mostly affected local domestic markets and SMEs, that is those with no or limited access to Eurocurrency and commercial paper markets (Hawley 1984: 149, 153).

As a result, in early 1979 Fed Chairman Miller, New York Fed President Paul Volcker, and Treasury Undersecretary Anthony Solomon (who would succeed Volcker as New York Fed President) sought (i) to bring non-banks within the purview of the Fed’s control and (ii) to control and regulate the Eurodollar market (Hawley 1984: 151).[1] The Depository Institutions Deregulation and Monetary Control Act of 1980, which is discussed in a previous post, was (mistakenly) expected to address the first agenda item.[2] The second item required coordination with foreign regulators. This type of coordination had been initiated in 1974 with the formation of the Basel Committee of Bank Supervisors (“BCBS”). The US policymakers in 1979 had two policy objectives: the systematic collection of data on Eurocurrency markets and the imposition of minimum reserve requirements on Eurocurrency deposits (Hawley 1984: 152-55). The BCBS was, however, composed of regulators with very different interests and thus was unable to frame a common approach to the problem, much less a common solution. Neither of the regulators’ goals was achieved (Kapstein 1994: 52; Hawley 1984: 158-59). Acknowledging defeat, US regulators ultimately stopped advocating for controls on the Eurodollar market and settled instead in 1981 for a policy that attempted to draw the offshore accounts onshore by permitting international banking facilities (IBFs) – with their minimal level of regulation – to be located in the United States (Hawley 1984: 156; 46 FR 32426). This was a solution the biggest banks had been lobbying for since 1978 as a step towards deregulation of the domestic market (FRBNY 1978).

The bank regulators imposed the first mandatory capital requirements on banks between 1980 and 1981 without Congressional prompting, presumably due to concern over the deterioration of bank balance sheets during Volcker’s interest rate hike (FDIC 1997b: 89. Prior to this policy, regulators were described as “attempting to persuade” banks to improve their capital ratios, Gilbert et al. 1985: 15.)[3] Notably the distinction between primary (now called Tier I) and secondary (now called Tier II) capital, that is the treatment of subordinated debt of more than seven years as secondary capital, was incorporated into these early requirements.[4]

By mid-summer 1979 there was a sense that the economic situation was spiraling out of control and that President Carter might not have what it takes to deal with the situation (Greider 1987). Carter reconfigured his cabinet and, after moving the Chairman of the Federal Reserve to Treasury, appointed Paul Volcker to the Federal Reserve. There is no question that Volcker’s job was to restore economic confidence – or that Volcker was going to take aggressive measures to stem the rise in prices. Note that Volcker was aware that one of the reasons interest rates would have to be raised to unprecedented levels was because the Fed’s monetary control had been eroded by the growth of thrift transaction accounts, money market funds, and Eurodollars (Volcker 1979: 54-56).[5] This also meant that when monetary policy was used to slow the economy, local domestic markets and SMEs bore the brunt of the burden, while firms with access to international markets bore less of it. Volcker viewed the oil price hike as a stimulus to inflation that was forcing him “to push harder against inflation than ever before and risk damage to economic activity here and abroad” (Volcker 1980: 33).

In order to force inflation back under control, Volcker initiated a policy of raising short-term interest rates as high as was necessary to complete the task.[6] Early 1980 was a moment in Fed history when the path set by the Fed was designed to shift the future performance of the economy onto a better path. As a result, the last thing the Fed needed was to set off a banking collapse. And Paul Volcker knew that the Fed had the capacity to keep a troubled bank alive indefinitely. Thus, a little recognized aspect of Volcker’s monetary policy was a commitment to support banks through the tight money period – in order to ensure that the seeds of confidence that Volcker was sowing could take root.

Just eight months into Volcker’s chairmanship, the sharp rise in interest rates triggered the failure of an incompetently managed bank.[7] (This discussion is based on Sprague 1986: Ch 5.) In 1968 First Pennsylvania Bank, one of the nation’s oldest banks, had appointed a CEO who sought to join the ranks of the largest banks by embracing a policy of aggressive growth based on volatile funding sources such as brokered certificates of deposits and Eurodollars, together with not-so-careful loan origination. Increasingly intrusive Fed supervision starting in 1969, had led the bank to convert in 1974 to a national charter and OCC supervision. Finally, in 1976 the bank had tried to gamble its way out of its difficulties by investing heavily in long-term Treasuries that were paying unprecedentedly high yields, funding the purchases with short-term borrowings.

By the start of 1980 the OCC, whose Comptroller was a member of the three-man FDIC board, was sure that when First Pennsylvania reported another quarter of massive losses, a run on its market-based funding would ensue. The FDIC had spent the previous year preparing for the failures of mutual savings banks that were doomed in the contemporary high interest rate environment through no fault of their own. Thus, the remaining two FDIC directors were acculturated to imposing market discipline on banks, and had to be convinced that there was a good reason to make an exception for First Pennsylvania. Their resistance was worn down in no small part because the Fed was lending ever increasing amounts to the bank and Fed Chairman Paul Volcker told the FDIC board that he was committed to continue doing so. At the same time, the Fed alongside the Comptroller (and FDIC Board member) pressured the remaining two members of the FDIC board that “there was no alternative” to an FDIC bailout as a crisis of confidence would follow. The FDIC, of course, knew that the Fed could keep the bank alive indefinitely – at increasing cost to the insurance fund as more and more uninsured depositors withdrew their funds.

The FDIC finally settled on a bailout via a below market-rate loan together with warrants that would provide a controlling interest in the bank. In this case, the bailout was successful: within five years First Pennsylvania had paid off the FDIC loan and bought back the warrants.[8]

Observe what had taken place. In market-based lending’s first decade, it had been used to hold financial regulators hostage, not once, but twice. At least in response to the Franklin National failure the Fed Board had recognized that the bailout was a very dubious way to socialize private losses and therefore sought to dramatically expand control over the banks. The First Pennsylvania bailout, although it took place only six years later, did not generate a similar reaction. Bailouts of poorly managed banks – at least those that were financed on the Eurodollar market – had become the usual course of business for the Fed.

One can only speculate as to what had happened within the culture at the Fed that made possible this shift in policy in favor of bailouts. Two factors, however, stand out. It seems very likely that the turnover that was taking place at both the Fed Board and the Fed’s General Counsel’s office played a role in the normalization of the use of the Fed to socialize private losses. And it is noteworthy that banks were using the language of the new portfolio theory to frame their activities: in federal testimony they presented the “competitive advantages” provided by Eurodollar markets as promoting “efficient” allocation of resources; they described the Eurodollar market as “simply an efficient intermediary between national markets,” denying the evident capacity of the Eurodollar markets to create money; they portrayed the offshore interbank market as something that should be ignored when calculating monetary aggregates – despite the fact that Eurodollar markets were funding banks that could not get domestic funding; at the same time they argued that the central banks as lenders of last resort were “responsible not only for the banking systems, but … for the totality of financial markets” (Weatherstone 1979a, 1979b; Ogden 1979).[9] In this environment where the instability being generated by Eurodollars and other forms of so-called market-based funding was not being acknowledged as a problem, the coming bailout of Continental Illinois National Bank had been made inevitable.

Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois

[1] Eventually Governor Wallich got on board, worried that Fed could lose control of monetary aggregates (Hawley 1984: 153).

[2] DIDMCA made the thrifts subject to the Federal Reserve’s reserve requirements, eliminated Regulation Q interest rates caps, and increased the level of deposit insurance in hopes of giving deposits a competitive advantage over money market funds. As was noted in a previous post, regulators at this time apparently underestimated the importance of structural separation and simply assumed that deposit insurance was the key stabilizing innovation of the 1930s.

[3] The International Lending Supervision Act of 1983 also mandated the imposition of capital regulations (Pub. L. 98-181 §908; FDIC 1997b). Wallich (1981) indicates that the early capital requirements that were being implemented by examiners were still not very effective and served mostly to put a bank’s management and board on notice that a problem was brewing.

[4] The treatment of subordinated debt as capital dates backed to Kennedy’s enterprising Comptroller of the Currency, James Saxon, who was the first regulator to approve the issue of subordinated debt by banks. At the same time he ordered its treatment as capital (Mayer 1974: 397-400). By 1970 all the federal regulators permitted the issue of subordinated debt (Mayer 1974: 237). On Saxon, see also Kettering 2008: 1667.

[5] Note also that Volcker had a more sanguine view of the severity of the effects of Eurodollars and nonbanks on monetary control than, for example, Anthony Solomon, but also deferred to Treasury on international monetary matters (Volcker 1979: 33).

[6] Technically, there was a “monetarist experiment” first, but it is still being debated whether this was only a front to make Volcker’s aggressive policy more palatable (see e.g. Stigum & Crescenzi 2008: 377).

[7] The FDIC was able to force out the CEO, but not to undo the “golden parachute” he had negotiated prior to the collapse.

[8] In 1998 First Pennsylvania merged into First Union National Bank, which later changed its name to Wachovia. Wachovia failed in 2008 and was taken over by Wells Fargo.

[9] Hawley (1984: 132-34) describes the contradictory positions taken by the money center banks with respect to the Federal Reserve and the banking system as “policy schizophrenia.”

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