Chapter 11 Developments on the U.S. Banking Scene: The S&L Crisis and FIRREA

Robert Effros
Published Date:
June 1994
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In 1989, U.S. President George Bush signed into law one of the most significant pieces of legislation enacted since this nation’s Great Depression in the 1930s. Formally entitled the Financial Institutions Reform, Recovery, and Enforcement Act, it is more often referred to by its acronym, FIRREA.1 Although the most visible portion of FIRREA is its mechanism to recapitalize the insolvent thrift deposit insurance program, the most important features of the legislation are those designed to control risk to the federal deposit insurance systems through stringent standards placed on insured depository institutions and through expanded powers given to the federal financial institution supervisory agencies.

FIRREA had four fundamental purposes. The first was to resolve the financial deficit of the Federal Savings and Loan Insurance Corporation (FSLIC), the savings and loan (S&L), or thrift, deposit insurance agency of the United States, and to resolve the outstanding insolvent S&Ls operating in the country. The second purpose was to restructure the federal regulatory framework governing S&Ls. The third was to establish uniform standards for U.S. financial institutions—both S&Ls and commercial banks. And the last was to provide the federal financial institution supervisory agencies with expanded enforcement powers.

The Problem

To understand the impact of the legislation, one needs to understand how the problem evolved. At the time of the Great Depression, there were many theories as to its cause. One popular theory was that there was too much competition in the banking industry. Mixing securities activities with banking activities was viewed as another reason. Even that banks were allowed to pay interest on their demand deposits was accepted as a possible cause.

So the legislative initiatives enacted at that time were proposed as methods to prevent the Depression from happening again. As a consequence, the U.S. banking system became very conservative, both by legislation and by practice. Federal law prohibited interest on demand deposits and administratively determined interest rate ceilings were applied to savings and time deposits. Geographic expansion, which always had been limited, continued to be limited not only in banking but in holding company operations, generally constraining banking operations to within state limits…

The powers of financial institutions also were carefully differentiated. For example, U.S. law provided that commercial banks could not engage in such activities as underwriting corporate securities. On the other hand, only commercial banks could offer demand deposit services. What was contemplated was a system of compartmentalized, highly specialized financial institutions.

Two important developments took place. Separate regulatory systems were established for each identified segment of banking and investment. The FDIC became the deposit insurance agency for banks and the federal supervisory authority for most FDIC-insured state banks.2 The Securities and Exchange Commission (SEC) was established to regulate the securities industry. The Federal Home Loan Bank Board was founded to regulate and oversee the insurance of S&Ls.

The second development was the tight restriction applied to entry into deposit-taking activities. Generally, depository institutions were allowed to be established only if they had deposit insurance, and the federal deposit insurance agencies were to apply qualifying criteria that limited entry of risky institutions. These measures were to prevent a repetition of unprotected losses to depositors and the erosion of public confidence in the banking system.

Because these various institutions were thought to be clearly segregated and protected, many people saw no need for coordination among these agencies. As a consequence, little coordination took place between the FDIC, the Home Loan Bank Board, and the SEC.

This system remained largely unchanged until the 1970s, when it began to crumble very quickly. The periods of high inflation and high interest rates in the late 1970s spurred the public into demanding a higher rate of return on deposits. The federal control of interest rates on deposits limited that, and the public promptly sought other places for their investments and deposits. The public also demanded increased services from their financial institutions. As a consequence of these pressures, the federal regulation of deposit interest rates was removed and the powers of S&Ls were substantially expanded. At the same time the communications and computer revolution permitted financial institutions a much broader geographic operation than was contemplated when the system was structured in the 1930s.

The S&L industry was particularly vulnerable and radically affected by these changes. Originally, savings and loans were conceived to be a source of funding for home financing, making long-term, fixed-rate mortgages for houses, and funding these through short-term deposit instruments. Profitability was assured by the control of interest rates. The mortgages always produced higher rates than the rates paid on deposits. As long as the federal government controlled interest rates, almost anybody could make a profit. Given stable interest rates, it was very easy to operate in the S&L industry.

When interest rates started to rise, however, depositors started leaving the S&Ls. Not enough funds were flowing into the S&Ls because depositors could get better rates of return from investments in the securities industry and the insurance industry.

The first response of Congress to the S&L deposit outflow was deregulating interest on deposits. This step reduced the immediate deposit outflows, but it did not solve the interest rate problems of the institutions. Indeed, it accentuated them because, to keep deposits, institutions paid higher returns. Yet the S&Ls were locked into the lower fixed-rate mortgages they had made earlier.

In order to avert large-scale failures, the S&L regulatory authorities permitted the institutions’ net worth to be artificially inflated through accounting changes that did not improve the real position of the institutions. Minimum capital requirements for S&Ls also were reduced. S&Ls were permitted to expand rapidly to outgrow their problems. A popular theory was that if you could grow enough, your financial troubles would never catch you. New asset powers were granted to the S&Ls by the U.S. Congress, permitting S&Ls to expand into nontraditional, high-risk lines of business—lines in which they had little knowledge or experience. Too often the customers eager to use these new services were customers who had been rejected by the experienced commercial banks as too risky. Also, in order to attract better customers, S&Ls often had to price their services out of profitability. This changed environment accentuated the problems of weak or incompetent management.

The 1980s also saw the U.S. economy slide into depression in the southwestern states; and, the state of California experienced severe problems in its real estate markets. Both conditions presented serious problems to S&Ls. In addition, the FSLIC, the deposit insurance agency for the S&Ls, was under budgetary constraints. A general objective of President Ronald Reagan’s administration at this time was deregulation. Logically, it was felt, fewer regulations and examinations are needed in a deregulated industry. But as deregulation unfolds, not fewer but more eyes are needed to watch as the deregulated industry engages in riskier activities against seasoned competitors. The lack of regulatory resources to supervise the problems that were developing made S&Ls vulnerable targets for insider abuse and fraud, both of which dramatically increased in S&Ls during this time. The FSLIC had neither the staff to spot abuse and fraud nor the resources to prevent these offenses.

By year-end 1988, there were 460 S&Ls with $217 billion in assets that had been reported as insolvent but still operating. Another 450 marginally solvent S&Ls had assets of $101 billion. The FSLIC was insolvent and was unable to close or otherwise resolve most of these institutions. A legislative solution was necessary.

The Solution

The solution was FIRREA. The new legislation revised the structure of the deposit insurance system by abolishing the FSLIC. It moved deposit insurance responsibility for S&Ls to the FDIC, so that in addition to its bank insurance fund, a new savings association insurance fund was created, under the FDIC, to insure the S&Ls. These two funds are to be separately funded and separately operated. Deposit insurance premiums for banks and S&Ls were raised significantly, and a mechanism was created for raising new funds for resolving the troubled S&Ls.

For existing problem S&Ls, a new temporary system was set up through the creation of a new corporation, the Resolution Trust Corporation (RTC). It was created to resolve existing insolvent S&Ls until August 1992. After that time, the new savings association insurance operated by the FDIC fund would take over the resolution responsibilities for insolvent S&Ls.3

The RTC is governed by an oversight board headed by the Secretary of the Treasury. Its daily activities are managed by the FDIC.4 Another corporation, the Resolution Funding Corporation, or REFCO, was created to fund the RTC through both public and private sources with assessments on S&Ls, and the issuance by REFCO of government-backed securities. The legislation authorized REFCO to issue $50 billion in securities to assist the disposition of these insolvent S&Ls.

This is a complex system of checks and balances, probably necessary given the large amount of public funds needed to resolve the S&L problem. Many agencies were affected—the U.S. Department of the Treasury, the FDIC, and the U.S. Office of Management and Budget, among others.

FIRREA also restructured the supervision of S&Ls. The Federal Home Loan Bank Board, the independent federal supervisor of S&Ls, was abolished, and the primary federal supervision of S&Ls was placed in the newly created Office of Thrift Supervision (OTS), now a part of the Department of the Treasury. The FDIC, as the new insurer of S&Ls, was given secondary, or “back up,” supervisory authority over the S&Ls. As the insurer, the FDIC has authority to curtail activities of S&Ls that it determines pose a serious threat to the insurance fund. The FDIC has a secondary administrative enforcement authority over and above the OTS. In addition, the legislation provides that state-chartered S&Ls may not exercise any powers granted by the states greater than those permitted to federal S&Ls without FDIC consent.

A third aspect of FIRREA was the establishment of uniform standards for banks and S&Ls. Before the establishment of FIRREA, there was little coordination in the development of standards for banks and S&Ls. In the case of S&Ls, the capital standards were reduced at a time when they needed to be increased. There were complaints that the Federal Home Loan Bank Board was too close to its regulated industry to be a good watchdog. The Bank Board’s charter was to encourage housing, and it viewed its primary mission to be to support the S&L industry as a means to that goal. This mission may have overshadowed its secondary role of protecting the S&L deposit insurance fund. Savings and loans and banks have now been placed under one independent deposit insurance agency, the FDIC, and are subject to a single standard for deposit insurance eligibility and for maintenance of deposit insurance.

The new Office of Thrift Supervision is required to establish capital, accounting, and regulatory standards for S&Ls no less stringent than those for national banks. A “qualified thrift lender” test has been imposed on S&Ls under which 70 percent of S&L assets must be dedicated to housing or other specifically described activities. Failure to meet this test requires an S&L to convert to a commercial bank charter. Taking advantage of their broadened authority in the 1980s, S&Ls had left their original purpose of providing housing finance to engage in other activities more appropriate to commercial banks. The legislation is attempting to return S&Ls to their original role.

A key aspect of FIRREA was expanded enforcement powers. All the federal banking agencies were given expanded powers. For example, before FIRREA, agencies could require institutions to cease unsafe or unsound practices or violations of law. FIRREA expanded agency powers not only to stop an activity, but to require affirmative action, restrict growth, rescind contracts, or require restitution by the financial institution or by their insiders. New directors or senior officers of newly chartered institutions, troubled institutions, or institutions that recently had a change of control may not be appointed or hired without notice to the institution’s federal supervisory agency, which then has an opportunity to object to the individuals. Removal orders issued by the agencies against officers or directors are given industry-wide application, and the agencies are now permitted to remove or restrict any institution-affiliated party, including controlling shareholders, attorneys, or accountants. Prior to FIRREA, it was unclear whether once someone was removed from an S&L, that person was then also prohibited from going to a bank. Now the law says that when any agency removes somebody for improper activity, that person is banned for life from any activity in any bank, S&L, or other federally insured institution.

The grounds for assessing civil money penalties and fixing their amounts were both significantly increased. Before FIRREA, the civil penalty generally imposed was $1,000 a day, and this sum was limited to violations of specified laws or regulations. As a consequence of the recent legislation, penalties may be assessed for violating a cease and desist order or any law or any regulation, and the penalties generally start at $5,000 a day and can go to $1,000,000 a day.

FIRREA greatly expanded the FDIC’s and the RTC’s powers when acting as a conservator or receiver of a financial institution. As a conservator or receiver, the FDIC and the RTC may repudiate or disaffirm most burdensome contracts, and damages for disallowed contracts are limited to compensatory damages.

Under FIRREA, if an insured depository subsidiary of a holding company fails, all other insured subsidiaries of the holding company are made guarantors to the FDIC for the losses incurred. Previously, a lead bank in a holding company system could make all the loans while the other banks in the system funneled deposits to the lead bank. Once the lead bank was in trouble, the holding company would try to keep the bad credits in that bank—if that bank failed, the FDIC bore the costs of the failure. Meanwhile, the other banks in the holding company could continue doing business as usual. The FDIC view was that if during the good times these associated enterprises were treated as a single unit, they should continue to be a unit during the bad times. Under the FIRREA legislation, if one bank in the holding company system fails, all other banks in the holding company system guarantee the FDIC against losses arising from the failure.

The Future

FIRREA is just a first step. One of the most important issues debated today is the role of deposit insurance. How can the United States protect against an unacceptable level of risk while making these financial systems stable and efficient?

The current debate on deposit insurance revolves around the moral hazard problem. So long as bank creditors are protected, there is no incentive for them to be concerned with the condition of their depository institution. The creditor’s incentive is to seek the highest return. Given the creditor pressure there is an incentive for bank management to assume a risk profile much higher than is consistent with safety and soundness.

Because of the way the insurance system is set up, once a bank gets in trouble, its management may conclude that the best course is to make large bets on risky projects. If they win, they keep the institution from failing. If they lose, they double the losses to the insurance agency.

When a bank fails, the FDIC normally seeks its lowest-cost solution, and this usually involves selling the institution to somebody else, therefore passing on the business relationships, including deposits. To date, all large bank failures have resulted in the institution being sold. In the past, at least, our resolutions have protected virtually all depositors and other general creditors. As a consequence, there is a view that this means of resolution provides no constraint on bank risk taking other than that provided by the regulatory or supervisory process at the agency.

Several possibilities for instilling discipline are being discussed. One is by forcing “depositor discipline.” For example, the present deposit insurance coverage—which has a ceiling of $100,000 per bank per depositor—could be reduced to $50,000. Another possibility for depositor discipline is to require some form of coinsurance, that is, the FDIC would take responsibility for 90 percent of the deposit and the depositor would take responsibility for the other 10 percent. For small depositors, the FDIC could provide insurance for a minimal amount of $25,000. Everything over $25,000 would be shared, with the FDIC covering 80 or 90 percent, and the depositor or creditor bearing the risk for the remaining 10 or 20 percent.

When a greater degree of risk is shifted to the depositor, this develops an incentive for the depositor to monitor the institution. The depositor creates discipline, by withdrawing deposits when the institution is on the verge of failure or by demanding a higher return for the risk that is involved. If this arrangement were mandated, all institutions, large and small, would be treated in the same way.

At the same time, the banking industry and the public would have to accept the instability that results from the chance of rapid depositor flight. If one views depositor runs as “discipline,” then depositors are probably the best ones to provide such discipline to an institution. On the other hand, depositors are generally the most skittish and the least-informed creditor in the institution. The need to determine the effect the risk of bank runs would have on the U.S. banks’ international operations will be key before any major depositor risk sharing is imposed.

Logically, the best time to make a judgment of risk is when it is too late—that is, when the institution is clearly in trouble. And then the judgment is perhaps more of a postmortem. But people are seeking a mechanism by which they can apply this discipline before the institution actually faces serious problems.

During the 1930s, when there was no deposit insurance, rumors alone tended to cause people to run up on a bank. Often these rumors, however unsubstantiated, became self-fulfilling prophesies. The experience of the 1920s and 1930s could be repeated.

The idea of “market discipline,” rather than “depositor discipline,” is another alternative. There already is some market discipline on the banks. When the FDIC steps in, it does not seek to protect shareholders and it does not seek to protect subordinated creditors of the banks or the S&Ls. The creditors of major holding companies often suffer major losses when a bank fails.

Another alternative is “management discipline.” Much more could be done to improve management discipline. Administrative enforcement tools exist for this purpose. Yet, management often seems to pursue a higher-risk profile. A consistent problem is that in many institutions, the directors are not exercising the control normally required of a board of directors.

There are a variety of reasons for this. The board of directors may be too dependent upon the bank’s management for the advice and guidance the board itself should provide, or board members may depend on the bank as a source of credit. Too often the board shows indifference. Traditionally, being a member of the board of directors conferred high prestige but was viewed as an honorary rather than active position.

Lastly, there is the possibility of fraud, particularly when the board of directors also has extensive control over the ownership of the institution. Fraud can never be legislated away, but there are ways to instill management discipline: legislating a greater separation of management and the board of directors, placing a greater responsibility on the directors, and prohibiting extension of credit to directors. Legislation could ensure separation of the chairman of the board of directors from the CEO and could prohibit management from serving on the board of directors. Furthermore, legislation could remove the institution’s proxy preparation from the institution’s management. Also, the shareholders should be briefed through proxy and shareholder information, requiring directors’ loan and audit committees so the directors are made to review the loan activities and audits of the institution independently of management.5

An alternative to the concept of discipline, which focuses on the liability side, is restricting some traditional bank activities in which the institutions can engage. At the same time, it is possible to expand the activities permitted to these institutions by allowing them to act, through affiliates or separately capitalized subsidiaries, so long as you can build some sort of fire wall.

Risks can be reduced also by permitting diversification through nationwide branching. Although some state barriers have broken down, banks are generally still severely limited by them. That means, for instance, that if a bank is operating in southwest Texas, which is economically very dependent on gas and oil, the local bank’s fortunes are highly correlated with economic swings in that one industrial sector. When banks operate nationwide, they can be more diversified. That way, they can counterbalance each other, avoiding the highs and lows that we see in the banking area today.

When discussing deposit insurance reform, the insurer must be included. The insurer should be permitted to operate as much as possible as a private sector economic agent. Costs for insurance should be based on expenses and projected losses, and the insurer should be able to limit the risk by determining the criteria and eligibility for insurance.

Until 1989, the FDIC’s premiums had been prescribed by statute. These had not changed in the almost 50 years that the FDIC had operated. The premium is still fixed by statute, with some limited ability for the FDIC to adjust premiums if certain criteria are met. Private corporations could not function that way. As a government agency, the FDIC is not intended to be profitable, but it should be structured in such a way that it can adjust to the losses it is facing.6

An insurer should be independent of its industry and of political considerations. The Federal Home Loan Bank system that controlled and operated the FSLIC was viewed as being very close to its industry, taking positions that were seen as having the support of the industry. At a time when the FSLIC was under budgetary constraints, decisions were being made based on political considerations, in a climate of deregulation and overall federal budget cutting, just when it needed to increase its expenditures in order to get more staff out to monitor what was going on in the industry. To work properly, deposit insurance must operate independently of broad social goals and cannot be used as a wide revenue source. The primary goal of an insurer must be to maintain the health of the industry it insures and, if this is accomplished, the integrity of its insurance fund also is ensured.

The problems facing the banking industry today are varied and complex. Prominent among them are the role of deposit insurance, its structure, and how to avoid repeating the problem just experienced with the S&Ls. Significant study is needed. Indeed, FIRREA does require the Department of the Treasury, in conjunction with the other banking agencies, to develop a study with recommendations on how to best restructure or reform deposit insurance. One caveat is that in seeking solutions, we must rigorously examine even the simplest ones lest they do more harm than good.



I will take a different angle on the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) than did Mr. Jones, focusing on what this statute might do to the international competitiveness of U.S. banks. I suggest that—from the viewpoint of competitiveness—the statute takes one step forward and two steps back.

The step forward is diminishing the balkanization of the U.S. banking system. Historically, the system has been fragmented along geographic lines (state boundaries), along product lines, and among service providers (savings and loans, banks, credit unions, insurance companies). In an attempt to build larger banking institutions that could be more competitive in the world marketplace, FIRREA took a deliberate step to reduce some of this fractionalization of the U.S. industry. One way of doing so was simply to eliminate a competitor—the savings and loan industry. FIRREA includes some harsh measures for savings and loans that will force many of them into the banking business.

Few of these institutions will survive in their present form. The statute made it much easier for banks and bank holding companies to acquire savings and loans. It eliminated a previous prohibition on such acquisitions. It also reduced geographic fragmentation by permitting savings and loans—including savings and loans owned by bank holding companies—to establish branches across state lines. Banks, however, cannot do so.

Another development in the United States that will have an even bigger impact is the regional banking arrangement: “regional reciprocal interstate banking.” In the southwest region, for example, each state has enacted a law permitting holding companies primarily based in another state within that region to acquire banks within the state passing the law, provided that the other state provides a reciprocal privilege. Many of these state laws have a “trigger date” for nationwide reciprocity.

Some items FIRREA did not address may be featured in the next round of legislation:

  • FIRREA did not address deposit insurance reform. Mr. Jones discussed a number of the possibilities in this area.

  • FIRREA did not address the differences between commercial banks and investment banks. The regulatory agencies, are, however, addressing that issue through a combination of rulings from Mr. Jones’s agency, the FDIC; from the Federal Reserve; and from the Comptroller of the Currency. These rulings are taking down the walls created in this country 50 years ago between investment banking and commercial banking.

  • FIRREA did not address the prohibition against industrial companies owning banks or against banks owning industrial companies. Banks in this country need capital. Industrial companies are a very likely source. So this issue also may arise in the next round of legislation.

One of the steps backward involves enforcement provisions. As Mr. Jones stated, FIRREA’s most important features are those designed to control risk through more stringent standards placed on depository institutions and through expanded powers given to the supervisory agencies. But this institutionalizes bank regulation into a game of cops and robbers.

The Comptroller of the Currency’s office decided to hold examinations in the New England states and the Mid-Atlantic states where the examiners were giving banks what has sometimes been called the Texas Haircut. The examiners were actually imported from Texas—examiners who worked for the Comptroller of the Currency’s office in Texas and who went through the banking and real estate and oil debacle in that state. Nine of the ten largest banking organizations in Texas failed. Those examiners, who witnessed the bottom dropping completely out of the real estate market and the Texas economy, conducted examinations in New England, and were scheduled to head examinations in the Mid-Atlantic states. They were assuming, probably incorrectly, that the economies in those regions would experience as bad a downturn as did the Texas economy, and they were making the banks adjust accordingly—including enormous loan loss provisions.

Not so long ago, the financial press carried reports that Moody’s was considering downgrading the debt of Citicorp. The concern was about Citicorp’s mounting levels of nonperforming loans in commercial real estate, highly leveraged transactions, and developing country loans, as well as capital adequacy. Highly leveraged loans and nonperforming loans are exactly what are being addressed by the examiners. How can a bank compete internationally if it is spending most of its time fighting the examiners?

FIRREA has made the examiners far more powerful. It has always been difficult to argue with an examiner; this statute makes it almost impossible. Consider the requirement for U.S. regulators to approve the appointment of officers by a bank that is troubled or that has changed ownership in the last two or three years. This requirement alone seems to have caused the growth of a small bureaucratic empire. FIRREA also increased a thousandfold the maximum penalty for a banker who acted illegally or unsafely (from $1,000 per day to $1,000,000 per day); made it easier for a regulator to remove an officer or director from the bank; and eliminated the confidentiality previously available for regulatory enforcement actions. So we have the field examiners and the enforcement personnel in the agencies being encouraged by this fact, and, believe me, the last thing on their minds is international competitiveness.

The other backward step from the standpoint of international competitiveness is the FDIC’s new power to disavow contracts. Mr. Jones has suggested that the FDIC can dispose of an insolvent bank by selling it and making some creditors whole, while other, similar, creditors do not receive full compensation so long as those creditors get at least as much as they would have if the FDIC had liquidated the bank. The word is creditor, and that is exactly the right word: a depositor is a creditor. The FDIC cannot distinguish among insured depositors, depositors with $100,000 or less; but among uninsured depositors, which is really what you are talking about in the international field, the FDIC now has the legal power to discriminate between who gets paid and who does not if a bank should fail.

Before the enactment of FIRREA, the National Bank Act—the organic act that governs the national banking system of commercial banks holding about two-thirds of the United States’ deposits—had a requirement for a ratable distribution of assets when a bank failed. That requirement has been around for a long time, for well over a century. It had been interpreted to mean that if one uninsured creditor received 100 cents on the dollar, then all must receive 100 cents on the dollar. There could be no discrimination among creditors. There were several similar provisions in a number of state laws. With the passage of FIRREA, ratable distributions no longer are required. When a bank—a large bank—closes with uninsured deposits, the FDIC now has the authority to say: “We will transfer all the domestic deposits to another bank, dollar for dollar. But foreign depositors will receive what they would have received had the bank been liquidated—perhaps 80 cents on the dollar.”

When the FDIC hits a situation like that, its Board of Directors faces conflicting duties. One duty is to preserve assets and preserve the money for the insurance fund; that duty pushes the FDIC toward disavowing in a particular case whatever it can. But the FDIC is at the same time a bank regulator and has an interest, even a financial interest, in the entire system. The FDIC recognizes that interest and frequently exercises its discretion to pay off, even though it might disavow legally, because of the impact on the banking system of such a disavowal.

No one can predict how this seeming anomaly will be resolved.1 What is clear, however, is that if the general objective is to make the U.S. banking system more competitive abroad, that goal is not assisted by the presence of an agency with the power, exercised or not, to disavow uninsured deposits.

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