Current Legal Issues Affecting Central Banks, Volume III.

Chapter 10 Developments in the U.S. Banking Scene: The S&L Crisis and Bank Failures

Robert Effros
Published Date:
August 1995
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The Federal Deposit Insurance Corporation (FDIC) insures the deposits in all federally insured depository institutions, both commercial banks and savings institutions, but not credit unions, in the United States. For the purpose of insuring bank deposits, it manages the Bank Insurance Fund (BIF). The FDIC is also the primary bank supervisor and regulator, at the federal level, of banks chartered by the various states that are not members of the Federal Reserve System.

The regulation of nationally chartered banks is the primary responsibility of the Office of the Comptroller of the Currency (OCC). Bank holding companies and state-chartered commercial banks that are members of the Federal Reserve System are regulated by the Board of Governors of the Federal Reserve System. The Federal Reserve also serves as the U.S. central bank.

The primary supervision of savings institutions in the United States falls to the Office of Thrift Supervision (OTS). Like the OCC, the OTS is, in effect, a bureau within the Department of Treasury. The deposits of savings institutions, however, also are insured by the FDIC through a separate fund, called the Savings Association Insurance Fund (SAIF).

To complicate matters further, the savings and loan crisis for the most part has been addressed by the Resolution Trust Corporation (RTC). The RTC, a temporary agency scheduled to terminate December 31, 1995, is responsible for the resolution of all savings institutions that have failed since January 1, 1989.1 A separate fund, called the FSLIC Resolution Fund, absorbs the resolution costs of savings institutions that failed before 1989. (FSLIC refers to the former Federal Savings and Loan Insurance Corporation.) The FSLIC was the insurer of savings deposits before August 1989, when the U.S. Congress abolished it and transferred responsibility for insuring the deposits of savings institutions to the FDIC.2

The FDIC provides a common linkage. Subject to prescribed limits, it insures the deposits of virtually all banks and savings institutions.3 By statute, it is appointed receiver of all commercial banks and all federally insured banks and savings institutions that fail.4 The FDIC, therefore, has important and abiding interests in the savings and loan (S&L) crisis and bank failures.

This paper outlines some of the principal challenges confronting the U.S. banking industry and the best current assessments of the resulting challenges likely to face the FDIC and the BIF. Then, it summarizes the current status of the savings industry and the efforts of the OTS and the RTC to deal with failing and failed participants in that industry. Finally, it addresses significant legislative developments and important case precedents that have affected U.S. banking.

FDIC Legal Division

The Legal Division of the FDIC is one of the largest legal organizations in the world. There are approximately 830 staff attorneys located at its Washington headquarters and its 36 regional and field offices throughout the country. They are supported by a paraprofessional, administrative, and clerical staff numbering another 1,200. The efforts of the Legal Division are supplemented by assistance from 1,650 outside private law firms that handle many of the 41,000 pending lawsuits, claims, bankruptcy proceedings, and collection matters. The FDIC is among the largest consumers of legal services in the nation.

The Legal Division is organized into three principal departments, or branches. The first branch is responsible for supporting the core client, the Division of Supervision, in its efforts to supervise insured banks and to enforce compliance with applicable legal and regulatory requirements. That branch also assists with important rule-making initiatives needed to implement existing requirements of law, and it is responsible for the legal work involved in resolving failing banks. The second branch shoulders responsibility for litigation involving the FDIC. It handles the cases on appeal to the U.S. Courts of Appeal involving the FDIC in its corporate capacity and in its role as receiver of failed institutions. The branch is also responsible for claims against former directors and officers of failed banks and their professional advisors, such as law firms or accounting firms, whose actions contributed to those failures. The third branch provides all legal services required by the Division of Liquidation to dispose of the assets of failed banks that are retained. In 1992, those assets had an aggregate value of about $47 billion.

Although outside lawyers must be relied upon because of the case load, fully 56 percent of the cases and claims are handled by staff lawyers. In addition, more than 75 percent of the legal efforts required to resolve failing banks is undertaken by internal staff lawyers. All compliance and enforcement efforts, as well as all rule-making initiatives, are handled exclusively by internal Legal Division attorneys.

Industry Challenges

Past U.S. banking performance has displayed positive elements. In the first quarter of 1992, the industry’s net income reached an all-time quarterly record of $7.6 billion. More than 93 percent of insured commercial banks were profitable, compared with 89 percent in 1991. Almost three quarters of the banks reported improved earnings, compared with 1991 results. And, in 1991, insured commercial banks reported $18.6 billion in net income, an increase of $2.4 billion over 1990 earnings. Annualized first-quarter results for 1992 indicated that commercial banks averaged a 0.88 percent return on assets, the highest quarterly average since the second quarter of 1989. The average return on assets for 1991 was 0.56 percent. By comparison, the average return on assets for commercial banks for the 1980s was 0.59 percent: the high being 0.82 percent, reached in 1988, and the low 0.12 percent, in 1987.

During 1991 and 1992, the banking industry benefited from low interest rates, allowing banks to earn more positive interest spreads. Lower rates also provided borrowers with increased opportunities to refinance in the private debt and equity markets. The favorable rate conditions also made possible large profits from sales of investment securities. In addition to low interest rates, another important factor contributed to the earnings improvement in 1991 and the first quarter of 1992: unlike the two preceding years, there was no significant increase in the inventory of troubled loans. There also were improvements in certain regions of the country’s economy. Commercial banks’ capital positions also improved. Total equity capital increased by $13.5 billion in 1991. This helped increase the average equity-to-assets ratio to the highest level in 20 years. By the end of the first quarter of 1992, the average ratio was almost 7 percent. All of these were positive signs.

At the same time, however, certain underlying difficulties persisted. There was concern that low interest rates might extend the lives of some institutions but not save them. In addition, asset growth in commercial banks was weak, increasing only 1.2 percent in 1991, the smallest increase since 1948. The assets of banks that failed during 1991, $63 billion, were greater than any previous year in history. Furthermore, at year-end, $600 billion in assets were held by problem banks, a 50 percent increase over the preceding year. Bank exposure to weakened real estate markets was also of great concern in 1992. Commercial banks held almost $400 billion in loans secured by commercial real estate at a time when concern about the continuing oversupply in the property markets extended to projects elsewhere in the world.

Condition of the Bank Insurance Fund

The Bank Insurance Fund of the FDIC serves to underwrite these concerns and to protect the nation’s depositors. The BIF ended 1991 with a deficit of approximately $7 billion, reflecting allowances for insurance losses and operating expenses of $16.9 billion.

Banks that failed in 1991 were expected to cost the BIF $7.4 billion. Provisions for this expected loss were taken in 1990, and an additional provision of $15.4 billion for unresolved insurance losses was charged against income in 1991. This brought the reserve to $16.3 billion at year-end 1991.

Attempts to make informed judgments about the condition of the BIF require that a number of uncertain factors that influence costs and revenues be addressed. Forecasts about the likely state of national, regional, and local economies must be made, and future assessments of real estate markets are required. The likely impact of these conditions on bank losses, the number of bank insolvencies, and the probable cost of the failures must be quantified. In short, the condition of the BIF is dependent upon a complex series of events that are difficult to predict with confidence.

However, there is a positive side. For example, in 1992 the dividend payout rate on bank stock was down. Furthermore, a number of large banking companies were successful in raising new equity. Additionally, banks’ capital ratios continued to improve, and first-quarter earnings were substantial. Yet, notwithstanding these improvements, difficulties in commercial real estate lending, the high level of nonperforming assets, and the total assets of banks on the problem list warranted attention and concern.

In 1992, it was believed that improved conditions could postpone the need to close some institutions. However, it was unclear whether those “problem” institutions were fully out of danger. Accordingly, the FDIC acted cautiously. The 1991 reserve for future losses reflected this caution.


In a longer-term perspective, the U.S. banking industry has experienced a trend toward consolidation. This trend is expected to continue. If consolidation occurs by merging healthy organizations, or through acquisitions of weaker institutions by stronger ones, and cost savings and market synergies are realized, the trend should prove positive.

There are also downside risks of consolidation. When consolidation results in increased competition, bankers may take on greater risk to remain competitive, which carries with it the potential for mistakes. Accordingly, the FDIC watches, with keen and cautious interest, the positive developments on the U.S. banking scene. It monitors developments, both beneficial and worrisome, as it manages the BIF.

Status of the S&L Crisis

The state of savings institutions, in the light of the recent events affecting that industry, presents another story. Nonetheless, there is some cause for optimism.

The magnitude of the problem is reflected in statistical data from the Resolution Trust Corporation. From the inception of the RTC to 1992, 704 savings institutions were assigned to it for resolution. It sold or paid off 651 of those institutions. The RTC accomplished asset sales and collections during that period involving $258 billion. The book value of unsold assets totaled $116 billion. All the while, almost 22 million depositor accounts, which totaled $212 billion, were protected. The average account size was about $10,000.

This massive cleanup effort was taken at an enormous cost to the American taxpayer. Up to 1992, including adjustments through the fourth quarter of 1991, the taxpayers shouldered a cost of $84 billion to address the S&L crisis and the activities by the RTC. However, notwithstanding the costs to the taxpayer, the OTS concluded that nationwide the savings industry had “turned the corner” of recovery. There were, for example, at the end of 1991, 2,100 privately owned savings institutions with nearly $900 billion in assets. They earned $1.8 billion that year, the first time the industry made a profit in all four quarters since 1985. Furthermore, nine out of ten private sector savings institutions in the United States were profitable in the fourth quarter of 1991. This contrasts with the results one year earlier, when the industry lost nearly $3 billion, or two years earlier, when it lost more than $6 billion.

As is the case with the banks, the clearest indicator of the savings industry’s safety and soundness is its capital. The industry’s average tangible capital in 1992 climbed to nearly 5 percent from less than 1 percent in 1986.5 Almost 90 percent of the savings institutions could meet a core-capital requirement of 4 percent. By contrast, in the mid-1980s, capital as a ratio of assets was less than 0.5 percent.

By 1992, the savings industry, therefore, consisted of strong institutions that were able to maintain their strength over some time. A core group of nearly nine out of ten of the healthiest savings institutions, for example, was consistently well capitalized and profitable over a nine-quarter period.

Three factors tend to explain the industry’s recovery. First, as indicated earlier, the OTS closed 704 failed savings institutions between 1989 and 1992. Second, it took a reasonably aggressive enforcement posture to make certain that those who caused or contributed to the S&L failures no longer participated in the savings industry. Third, the surviving institutions, like the banks, subsequently enjoyed a very low cost of funds.

Legislative Initiatives

When the S&L concerns began to surface in the United States in the early 1980s, Congress responded. It began by deregulating rates and phasing out rate controls. Then, it broadened savings institutions’ powers to acquire and invest in different types of assets, including direct real estate investments. Next, it recapitalized the insurance fund-backing deposits in savings institutions. These initiatives, however, did not work. An ever-increasing number of savings institutions continued to fail, absorbing the deposit insurance funds.

In 1988, more than 200 savings institutions failed, which depleted the savings insurance fund, as recapitalized. In consequence, in August 1989, Congress enacted, and then President Bush signed into law, one of the most significant pieces of banking legislation since the Great Depression. That statute, entitled the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA),6 was intended to allow more aggressive supervision of all insured depository institutions and greater powers for the resolution or liquidation of failed banks and savings institutions. In 1991, apparently unsatisfied with its earlier efforts and interested in still more aggressive supervision and regulation of the banking industry, Congress enacted a statute called the Federal Deposit Insurance Corporation Improvement Act (FDICIA).7 These two statutes have directly affected the U.S. banking industry and will affect significantly the conduct of business by commercial banks and savings institutions for years to come.


The most visible part of FIRREA is a mechanism that was created to recapitalize, still again, the insolvent insurance program for savings institutions8 and to dispose of the large number of insolvent savings institutions.9 The more important provisions of FIRREA are designed to control risks through stringent standards placed on all depository institutions and through the expanded powers given to the supervisory agencies.10

FIRREA was enacted to achieve four fundamental purposes. The first purpose was to resolve the financial deficit of the FSLIC,11 which, as earlier indicated, was the deposit insurance agency for savings institutions. Second, the statute restructured the federal regulatory framework governing savings institutions. It created a new agency within the Treasury Department, the Office of Thrift Supervision.12 Third, FIRREA established uniform standards for U.S. financial institutions, both commercial banks and savings institutions.13 Fourth, it provided the federal bank regulatory agencies expanded enforcement powers. Some of the more notable and expanded powers included (i) the power to restrict growth,14 (ii) the power to require prior approval of new directors or senior executive officers at “troubled” institutions,15 (iii) expanded authority to remove parties “affiliated” with insured institutions from their positions,16 and (iv) significantly increased monetary penalties to be assessed for violations of law.17


The two-stroke engine driving further bank “reform” or “improvement” in 1991 was, first, the need to provide the FDIC with more resolution funds and, second, the decision to recapitalize the BIF. FDICIA increased sixfold the amount that the FDIC can borrow from the Treasury, from $5 billion to $30 billion.18 Loans must be repaid on an established schedule from assessments the FDIC charges for deposit insurance.19 FDICIA also permits the FDIC for the first time to calculate the premiums of member institutions according to the risks that they pose to the Bank Insurance Fund.20 In addition to increasing the FDIC’s line of credit with the U.S. Treasury to $30 billion, FDICIA also authorizes the FDIC to borrow working capital for BIF or Savings Association Insurance Fund.21 Generally, the FDIC can borrow the sum of (i) cash and cash equivalents carried by BIF or SAIF and (ii) 90 percent of the fair market value of the assets of BIF or SAIF.22

The statute requires the FDIC to rebuild the BIF to a 1.5 percent designated reserve ratio within 15 years.23 With total insured deposits at U.S. banks of $2 trillion at year-end 1991, the BIF balance would have to reach $25 billion before that required ratio is met. FDICIA also limits the Federal Reserve’s traditional role as “lender of last resort” for undercapitalized institutions.24 The idea is to avoid keeping dying institutions alive with transfusions from the Fed’s discount window while they incur additional losses that ultimately must be borne by the FDIC.

Perhaps most important, the FDICIA imposes capital “trip-wires” for regulatory intervention. Since December 1992, capital-based supervision has been conducted through a system that the statute identifies as “prompt corrective action.”25 The purpose is to resolve problems of insured depository institutions at the least possible long-term loss to deposit insurance funds.26

The FDIC and other federal banking agencies are required to act promptly to impose sanctions on institutions when capital falls below specified thresholds.27 The statute establishes and defines, in general terms, five capital categories.28 The determination of the category of each institution governs corrective measures to be taken and activities that are permitted. As a bank’s capital falls to lower levels, regulators are required to begin a variety of enforcement proceedings.29 The definition of capital, therefore, is of paramount importance.

FDICIA also requires the banking agencies to establish, by regulation, safety and soundness standards for nearly every aspect of a bank’s day-today operations.30 These include standards for internal controls and auditing, loan documentation, interest rate risk, credit underwriting, asset quality, stock valuation, earnings, and excessive director, officer, and employee compensation.31

FDICIA also substantially affects the resolution of failed or failing banks. Previously, the FDIC could provide assistance to failing banks if the FDIC Board of Directors determined that assistance would be “less” costly than liquidation of the bank. The law now requires that the Board of Directors first determine whether assistance is “necessary” to protect insured depositors and whether it represents the “least costly” of all possible alternatives.32 The second test reflects an important change: the Board must elect the “cheapest” among the alternatives; not just one that is “cheaper” than the cost of liquidation.33

Although the FDIC can still offer emergency assistance to avoid “systemic risks,” the law imposes more stringent procedures if it is necessary to avoid the least cost-resolution test and a test intended to limit the losses to the insurance fund by restricting the FDIC’s actions with respect to depositors and other creditors. The ultimate systemic determination now must be made by the Secretary of the Treasury, upon the recommendation of a two-thirds majority of the Boards of the FDIC and the Federal Reserve, and in consultation with the President of the United States.34 Finally, FDICIA permits, but does not require, the FDIC to provide open bank assistance subject to the least-cost test.35 It expresses the “sense of Congress” that the federal banking agencies should facilitate early resolutions to minimize costs to the insurance fund.36 It sets forth a number of “general principles” to be followed that are similar to the policies of the FDIC applicable to “open bank assistance.”37

Case Precedents

In 1991, the U.S. Supreme Court protected the exercise of informal oversight or discretion by a banking supervisor (the Federal Home Loan Bank Board and a Federal Home Loan Bank) over failing institutions. In the case, it was alleged by the plaintiff, a former chairman of a savings and loan, that the federal regulators were negligent in taking certain actions, such as urging the institution to convert from a state to a federal charter and giving advice as to whether and how the institution’s subsidiaries should be placed in bankruptcy. In effect, the Court concluded that the federal banking agencies are immune from tort liability for their discretionary decisions and actions pursuant to the discretionary-function exception to the federal government’s liability under the Federal Tort Claims Act.38

The Court of Appeals for the Fifth Circuit upheld the discretion of the FDIC to resolve a systemic bank failure by providing assistance in a way that can assure unaffiliated creditors that their claims will be protected but that leaves affiliated creditors (specifically, affiliated banks) only the pro rata amounts that they would have received in a liquidation of the insolvent lead bank. Essentially, this means that no creditor of a failed bank, except insured depositors, is entitled to receive more than it would have received if the institution had been liquidated.39

In 1990, the Court of Appeals for the Tenth Circuit held that the FDIC could transfer assets from itself in its capacity as receiver of a failed bank to the FDIC in its corporate capacity even if the relevant state law would prohibit the transfer.40 In the case, the assets were letters of credit that were not normally assignable under the applicable state law. If one may generalize on the significance of the case, it would seem that the FDIC can override restrictions embodied in state law that adversely affect the federal statutory obligation to maximize recoveries on the assets of failed insured institutions.

A case posing the question whether Eurodollar deposits, placed in a foreign branch of a federally insured U.S. bank, are payable only at the foreign branch, unless the parties otherwise agree, was before the Supreme Court for the second time in 1992. At the Court’s invitation, the FDIC joined the OCC and the Department of Treasury in an amicus brief. They urged the Court to review the case again and to decide that, under U.S. federal common law and Philippine law, when a foreign government seizes payment of deposits from the assets of the foreign branch, the risk of foreign sovereign action falls upon the depositor whose deposits are not payable from the assets of the U.S. home office, unless the parties have otherwise specifically provided. Notwithstanding these arguments, the Supreme Court denied certiorari. 41

Finally, the FDIC has aggressively pursued claims against those who caused or contributed to bank or savings institution failures. A notable example occurred with the settlement of claims against Michael Milken and other former employees of Drexel Burnham Lambert for manipulation of the junk bond market.42


The recession, the lingering effects of weakened commercial real estate markets, the savings industry crisis, and the unprecedented charges to the BIF have all placed enormous and continuing challenges before the FDIC. This combination of circumstances prompted legislative solutions of “reform” and “improvement.” There is no doubt that many of the legislative measures were needed and are prudent. However, it also should be observed that banking regulators in the United States and elsewhere in the world probably perform best when they have a clear charter of their responsibilities and a clear understanding of the expectations held of them. They also perform best when they have sufficient authority and discretion to discharge those responsibilities.

Banking regulators must be held accountable for their actions as a matter of course. That is where the system of “checks and balances,” inherent in the U.S. form of government, offers the most value. This system affords to the legislative branch the appropriate role of oversight. At the same time, the system necessarily implies a notion of balance, so that legislative oversight does not lead to legislative overkill. A critical challenge for the FDIC, therefore, is to implement the new legislative directives in a fashion that does not repeat the challenges of the past or further exacerbate those challenges that continue to confront the depository institutions and the economy.

The U.S. economy works best when it is permitted to function free of unnecessary or unduly burdensome restriction or regulation. It works best when all industries, including the banking industry, have the benefits of unfettered access to open markets. This means that it works best when the promise and perils of competition are allowed to run their course. The government and the banking industry must recognize that an appropriately regulated environment, open markets, and free competition are the hallmarks of an efficient economy. That is the real challenge today.

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