Current Legal Issues Affecting Central Banks, Volume IV.
Chapter

11B. Report from the Federal Deposit Insurance Corporation: National Deposit Insurance Has Worked to Promote Banking Stability

Author(s):
Robert Effros
Published Date:
April 1997
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Author(s)
THOMAS A. ROSE1, CHRISTINE M. BRADLEY and LINDA L. STAJWP 

Overview

During the 1980s, bank failures soared to levels not seen since the Great Depression of the 1930s. During those years, the Federal Deposit Insurance Corporation (FDIC) was able to cushion the collapse of about one-tenth of the U.S. banking system, contain the damage, and proceed to clean up the wreckage while maintaining public confidence in the U.S. financial system. For over 60 years, the FDIC has been successful in maintaining public confidence in the banking system.

Prior to the establishment of the FDIC, large-scale cash demands of fearful depositors were often the fatal blow to banks that otherwise might have survived. Widespread bank runs have become a thing of the past and no longer constitute a threat to the industry. Even during the 1980s, with bank failures at record levels, bank runs were rarely experienced and readily contained. Money supply on both a local and national level has ceased to be subject to the radical contractions caused by bank failures in the past.

To meet these challenges, the FDIC relied on the mechanisms put in place in response to the Great Depression, underwent fundamental changes, and shouldered once-unimaginable responsibilities,2

Structure of the U.S. Banking Regulatory System

The U.S. banking regulatory system has been formed over the past 130 years. It is a complex system, owing in part to the overlapping responsibilities of the various regulatory agencies. Today, at the federal level, the Office of the Comptroller of the Currency (OCC) directly charters and regulates national banks.3 The Office of Thrift Supervision directly regulates federally chartered savings and loan associations and has some oversight over state-chartered institutions.4 The Board of Governors of the Federal Reserve System, which is the central bank of the United States, directly regulates bank holding companies and those state-chartered banks that are members of the Federal Reserve System.5 The FDIC directly regulates state-chartered banks that are not members of the Federal Reserve System and insures the deposits of all of the insured depository institutions, including savings and loan associations.6 This complex system has evolved out of a long-standing public distrust of a strong central bank, dating back to the abolition of the Bank of the United States in 1832. Although several bank consolidation schemes have been proposed in the U.S. Congress,7 these proposals are often criticized for placing too much power in the hands of a few regulators and thus risking greater politicization of the regulatory framework, and possibly eliminating healthy competition among regulators to develop open-minded approaches to new ideas and products.

History of the FDIC and Bank Failures

Early Years

About 9,000 banks suspended operations between the stock market crash in the fall of 1929 and the end of 1933; 4,000 banks closed during the first few months of 1933, and the panic that accompanied these suspensions led President Roosevelt to declare a bank holiday on March 6, 1933. At that point, the financial system was on the verge of collapse, and both the manufacturing and agricultural sectors were operating at a fraction of capacity.8 Although experiments with deposit insurance at the state level date back to 1829, it took this crisis environment for the public to demand national deposit insurance. The FDIC, originally created as a part of the Federal Reserve Act, was signed into law by President Roosevelt on June 16, 1933.9

The history of the FDIC cannot be considered apart from concurrent changes in economic and banking conditions. The early years of the FDIC’s existence were marked by caution: banks did not take much risk, and regulators kept banks and banking practices within narrow bounds of competition. Congress and the public had been chastened by the experiences of the Depression and viewed unfettered competition as having led to excesses and abuses.

From 1934 through 1941, the FDIC handled 370 bank failures, most of which involved small banks. Without the presence of federal deposit insurance, the number and size of bank failures would undoubtedly have been greater. Indirectly, the presence of deposit insurance may have encouraged the retention of restrictive state branching laws and maintained a number of independent unit banks that otherwise would have been compelled to merge.

World War II

During World War II, government financial policies and private sector restrictions produced an expanding banking system. Total bank assets at the end of 1945 were nearly double the $91 billion total at the end of 1941. Large-scale war financing, including lending to bond buyers, contributed to this growth. Loan losses during this period were practically nonexistent, and only 28 banks failed from 1942 to 1945.

Post-World War II

Conservative banking practices and favorable economic conditions resulted in few bank failures during the late 1940s and 1950s. Some viewed the low incidence of bank failures as a sign that the bank regulators were overly strict and had gone too far in the direction of ensuring bank safety. Until about 1960, banks continued to operate in an insulated, highly regulated environment. Gradually banks began to change their operations to strive for more growth in assets, deposits, and income. Large banks led the aggressive trend to greater risk taking by pressing the boundaries of allowable activities. In addition, some states began to liberalize branch banking laws, and the holding company model was developed as a vehicle to allow banks in other states to achieve similar accumulations of capital and establish multioffice facilities.

1970s

Until the mid-1970s, U.S. banks were not noticeably harmed by the movement toward increased risk taking. Generally favorable economic conditions allowed many borrowers who might have been marginal credit risks to repay their obligations, and bank failures remained at low levels. The recession of 1973–75 led to real estate loan problems, which ultimately caused the bank failure rate to increase to a peak of 16 percent in 1976. In 1978, interest earned on securities began to outstrip yields on time accounts payable by depository institutions, and deposit growth slowed as these alternative investments became more attractive.

1980s

As the 1980s began, several factors undermined the banking industry’s traditional approaches to profitability. High and volatile interest rates caused an outflow of funds from banks and thrifts because they were subject to interest rate caps on deposits. Banks, however, were not burdened with the same high proportion of long-term fixed-rate assets as the thrifts. As banks’ assets were generally of much shorter duration, yields were more closely tied to the prime rate, and banks could more readily adjust the price of loans and other assets upward as the cost of funds increased.

Beginning in the late 1970s and continuing into the 1980s, both banks and thrifts experienced increased competition from nonbanks. By issuing commercial paper, nonfinancial corporations eroded the banks’ traditional, safe, and profitable intermediary role in commercial lending on the asset side of the balance sheet. On the liability side of the balance sheet, money market mutual funds attracted substantial amounts of liquid funds that would formerly have been placed in low-cost deposits in banks and thrifts.

As a result of the geographic and product limitations on U.S. banks and thrifts, the industry was unconcentrated and segmented, compared with the depository industry in other countries. Thousands of institutions existed in insulated markets, effectively limiting competition. Lack of competition and existing regulatory restrictions hampered innovation in products and services, while nonbank institutions unconstrained by this regulatory environment intruded on the banks’ traditional markets. Technology and the increased access to information that it provided accelerated the process of eliminating the dependence on local banks to deliver financial services. Overcapacity in U.S. bank and thrift sectors also contributed to the consolidation that the industry experienced in the 1980s, although capacity in banking is difficult to measure as the ultimate product is intangible.

In addition, banks and thrifts had other difficulties, involving loans to less-developed countries and to the energy, agriculture, and real estate sectors of the U.S. economy. In the real estate market, the distress began in the Midwest with the weakness in the agricultural economy, moved into Texas and the West with railing energy prices, and then spread to the Northeast, the Southeast, and finally the West Coast, as the rolling recessionary factors caught up with the industries concentrated in those geographic areas. With respect to the real estate sector, Congress may have contributed to the upswing in speculative prices through its tax cuts in 1981, which contained accelerated depreciation provisions and investment tax credits that made real estate investments artificially attractive.10 When Congress subsequently enacted the Tax Reform Act of 1986, which reduced depreciation benefits, restricted passive loss deductions, and eliminated favorable tax treatment of capital gains, it may have also accelerated the downturn in the real estate market.11 Because the benefits of real estate ownership were so substantially and abruptly reduced, real estate values plummeted, resulting in tremendous banking losses.

In an attempt to curtail the deficiencies present in the financial system, Congress enacted in 1980 the most sweeping banking deregulation legislation since 1933.12 This legislation required interest rate ceilings to be lifted by 1986, liberalized the lending powers of federally licensed thrifts, and raised the federal deposit insurance limit for both banks and thrifts to $100,000. In 1982, further bank deregulation legislation gave regulators more flexibility in dealing with failing institutions,13 A severe recession in 1981–82, additional risk taking by banks to maintain interest margins in the face of rising liability costs, excessive loan concentrations in fragile industries, and an oil surplus resulting in declining prices in that industry all caused loan charge-offs to increase by more than 50 percent in 1982 alone. In 1982, the number of bank failures hit 42, which was a new post-World War II high, and, in 1983, 27 banks failed.

During the 1980s, the rate of thrift failures increased dramatically, and the Federal Savings and Loan Insurance Corporation, which insured the deposits of savings and loan associations, became insolvent. For the first time, taxpayer money was required to pay for deposit insurance obligations when resolving failed savings and loan associations.14

Many critics anticipated that a similar insolvency could hit the FDIC as it honored its deposit insurance obligations with U.S. banks, which also began to fail at record levels. Between 1984 and 1993, 1,381 banks failed, with total assets valued at $217.5 billion.15 Although the FDIC has succeeded to date in surviving this banking crisis without infusions of U.S. taxpayer money, observers urged Congress to enact deposit insurance reforms.

1990s

Since 1989, Congress has enacted several additional pieces of major banking legislation. First, it enacted in 1989 legislation that, among other things, defined and expanded the powers of the FDIC as the conservator or receiver of failed insured depository institutions.16 This legislation has been important to the FDIC and the deposit insurance funds primarily for the way that it dealt with the administration of receiverships and conservatorships of these failed institutions. However, except to the extent that it assessed liability for any loss incurred by the FDIC on institutions that are commonly controlled,17 the legislation did not generally address the overall risk-taking behavior of financial institutions.

In contrast, when Congress passed additional banking legislation in 1991,18 the risk-taking behavior of financial institutions became its main focus. This legislation contained provisions that, among other things, adopted a system of risk-based capital, provided for prompt corrective action, mandated early intervention when critical capital levels reached the 2 percent level, modified the FDIC’s cost test in closed-bank transactions (giving the FDIC less discretion to pay uninsured depositors and other creditors), modified the systemic risk test for the “too-big-to-fail” doctrine in major bank failures, limited the FDIC’s discretion to pay foreign depositors, and gave the FDIC authority to impose assessments on banks based on risk,19 Again, in 1993, when Congress adopted a national depositor preference20 as a budgetary relief measure, it made a further public policy decision concerning the risk-taking behavior of depository institutions and determined to place the risk of market discipline on the nondeposit creditors of such institutions.

Therefore, in enacting risk-based enforced capital standards, together with national depositor preference, Congress seems to have accepted the argument that public policy should discard depositor discipline and rely on other factors to restrain bank risk. Market discipline and supervision work in tandem to control risk. Therefore, Congress has chosen to increase the regulators’ ability to close insolvent institutions in a more timely fashion, relying on risk-based equity as the appropriate measure for determining solvency and requiring that all federally insured banks protect the FDIC against losses in any banks owned by a common parent.

Conclusion

The deposit insurance system and the FDIC did not face a severe test within the first 50 years of their creation. During the 1980s, however, when the rate of bank failures increased dramatically without a major disruption in the financial markets, the effectiveness of the deposit insurance system was tested, and the FDIC’s ability to contain the crisis was proven.

The deposit insurance fund established for commercial banks ended 1992 with a negative balance of $7 billion, but the fund had a positive balance of $13.1 billion by the end of 1993.21 In the first five months of 1994, there were only two bank failures, involving total assets of $186.3 million. Although no one can predict what specific role the FDIC will play in the years to come, the FDIC will continue to adapt to the changing economic conditions and shifts in the banking environment in order to protect insured deposits with minimal disruption to the U.S. economy and financial markets.

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