Current Legal Issues Affecting Central Banks, Volume III.


Robert Effros
Published Date:
August 1995
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This comment addresses some of the significant factors that led to the savings and loan crisis in the United States. On first blush, from an international perspective, the problems of a few U.S. domestic lenders may not appear to be significant. However, there are certain instructive lessons that can be learned from the situation.

Four important concepts in examining these historical factors are important: (i) legislative and regulatory approaches to the regulation of depository institutions; (ii) government regulations of the thrift industry designed to foster home ownership; (iii) the moral hazard of deposit insurance; and (iv) a principle of life, known as Murphy’s Law, that at any given point in time, anything that can go wrong will.

History of the S&L Crisis

The first fundamental principle of the thrift industry was the growth in its importance after World War II as a home financing conduit. After World War II, there was a domestic housing boom in the United States. Thrifts expanded their operations and engaged extensively in home lending. In the 1950s and early 1960s, there was the “3–6-3” era of savings and loan operation. This was a stable interest rate era and, as such, was not particularly challenging for thrift executives in terms of their overall financial plans. The “3–6-3” stood for (i) taking in short-term deposits at a low rate of interest (3 percent, for example); (ii) lending out long-term home loans at a higher rate (6 percent, for example); and (iii) the time that the thrift executive could get out to the golf course in the afternoon (3 p.m.). The challenges that were presented by the thrift business at that time from an investment perspective were not great. Market demand was heavy and the ability to make a steady profit was assured by the spread between the rates on deposits and loans.

The importance of home ownership in American life was reflected in Public Law 89–597 of September 21, 1966, which authorized the appropriate federal regulators to set maximum rates of interest that could be paid on deposits. Pursuant to this authority, the regulators fixed the interest rate that could be paid on deposits at a higher rate for thrifts than for their commercial banking counterparts. This reflected the philosophy that thrift institutions should be the primary home lenders and accordingly should be able to draw on a reliable fund of deposits for this purpose.

Things started to change dramatically for thrift institutions in the 1970s through a process of disintermediation. Inflation heated up in the U.S. domestic economy. This affected the “3–6-3” rule. Interest rates skyrocketed. The ability of thrifts to maintain low interest rates on short-term deposits was impaired. Billions of U.S. dollars flowed from savings institutions into other forms of investment. During this period, there was increased competition from nondepository investment institutions, mainly money market and mutual funds. The advantage for a potential investor was that they paid market rates of interest at that time, which were substantially higher than those that could be generated from the investment portfolios of the thrift institutions.

The result was dramatic. Fixed-rate long-term loans and low-paying short-term deposits crippled large segments of the thrift industry. By 1980, legislation began to address this problem. The Monetary Control Act of 19801 increased for all depository institutions the extent of deposit insurance. While the Senate and House versions of the bill proposed two different amounts, $40,000 and $50,000, for deposit insurance coverage, in the end the amount was raised to $100,000.2 In addition, and perhaps more significantly for thrifts’ deposit-paying rates, this legislation also phased out the Regulation-Q interest rate caps for both banks and thrifts.3 Furthermore, the federal banking agency responsible for the oversight and regulation of thrift institutions at the time, the Federal Home Loan Bank Board, prohibited thrift institutions from lending on other than fixed-rate mortgages, with the consequence that a fixed portfolio was unable to adjust to changes in market rates. In 1981, the Federal Home Loan Bank Board permitted the thrift industry to utilize adjustable-rate mortgages so as to hedge risk from interest rate changes.

In 1982, there was a legislative and executive initiative in the United States to deal with the continuing failure of large segments of the thrift industry. There was a prevalent belief in many quarters that diversification of portfolio was the key to survival for the thrift industry. The result of this belief was the Garn-St. Germain Depository Institutions Act of 1982.4 It allowed thrifts to diversify their direct investment activities. They were authorized to increase their real estate investment loan capabilities as well as to invest in consumer loans and unsecured commercial loans to a great extent. Meanwhile, there was a correlative phenomenon on the state level. Many U.S. states enacted legislation to expand the powers of state-chartered savings and loan associations.

By the mid-1980s, the effects of the Garn-St. Germain Act, as well as other events, raised issues as to whether deregulation had backfired. In Florida and the Southwest, thrifts had expanded in the early 1980s by utilizing new powers under Garn-St. Germain, specifically in the real estate lending areas. However, by the mid-1980s, oil prices fell and land values plummeted dramatically, especially in Texas and the Southwest. Thrifts that had invested in the Southwest were affected adversely.

There was a related phenomenon: a perception of the moral hazard of deposit insurance. A savings and loan charter was seen as desirable for a depository institution’s investment activities. Everybody wanted to acquire a thrift charter because thrifts now had broad powers that were not available to commercial banking institutions. Concomitantly with the increase in these powers and the perceived opportunity for profit came the S&L crooks and incompetents. Reckless investments were made that were beyond the ability of thrift executives to evaluate and monitor. There were investments in wind farms, fast-food franchises, horse stables, and other types of businesses that were not within the traditional investment expertise of thrift executives. Also, there was outright fraud and abuse of the thrift charter. With the safety net of deposit insurance, thrift institution investments became a “heads you win, tails the U.S. Government deposit insurance fund loses” proposition. So the risks did not have a significant downside, at least as perceived personally by some players in that game. This gave rise to the notion that deposit insurance carries in its wake a moral hazard.

By 1986, the U.S. Government and the thrift industry itself realized that the Federal Savings and Loan Insurance Corporation, the insurance fund for the thrift industry, was insolvent. In 1987, the Competitive Equality Banking Act legislation recapitalized the FSLIC fund.5 It was a controversial piece of legislation. The power of the thrift industry to lobby against a bailout of the industry with the industry’s own funds was a significant issue. Events proved, subsequent to 1987, that the approximately $10 billion allotted to the FSLIC recapitalization in 1987 was woefully inadequate to the task of recapitalizing the fund and resolving the insolvent thrifts.

From 1987 to 1989, failures in the Southwest significantly increased the original round of failures. By 1988, as the government sought to sell off as many of the sick institutions as it could, it was clear that the FSLIC fund would require an infusion of funds. Consequently, in 1989, the landmark Financial Institutions Reform Recovery and Enforcement Act was adopted.6 The task of administering the thrift deposit insurance fund was transferred to the FDIC, and the fund was renamed the Savings Association Insurance Fund.7 As a result, there are now two subfunds of the Federal Deposit Insurance Corporation, the Bank Insurance Fund for banks and the Savings Association Insurance Fund for thrift institutions.

Another important issue addressed by FIRREA was the danger of having the charterer and regulator also be the insurer. This raised an inherent conflict of interest since the insurer had an interest in giving an institution more time to work out its problems instead of placing it into conservatorship. The solution of FIRREA was to restructure the regulatory framework for savings and loans by separating the insurance function from that of chartering and regulatory oversight.

In part as a result of the S&L crisis, the United States arrived at a new level of bank and thrift regulation. Depository institutions in the United States today function in a highly regulated environment. The concerns that were raised by the S&L crisis spawned a number of legislative and regulatory developments that should put U.S. regulation of depository institutions in good stead into the end of the twentieth century.


First, in the future the regulation of all types of depository institutions will be consolidated and homogenized. Legislation is seeking to make such regulation more generic, so that similar types of regulatory activities will have similar types of regulation. That is an important development in having good, tough, and fair regulation of deposit insurance that is consistent with the activities of well-capitalized institutions.

Second, the S&L crisis teaches the advantage of having differential regulation. It is important to regulate healthy institutions in a manner different from that employed for sick institutions. A higher degree of scrutiny and intervention is more appropriate for the latter.

Finally, an important concept with respect to national and international developments concerns diversification of activities. The financial services holding company has been a vehicle for such diversification in the United States. It may be expected to develop further by engaging in various types of regulated activities, including banking business, insurance activities, broker, dealer, and underwriter activities. Separate regulation of the subsidiaries may be indicated with firewalls between these activities.

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