Current Legal Issues Affecting Central Banks, Volume IV.
Chapter

Chapter 20 The Role of Deposit Insurance: Financial System Stability and Moral Hazard

Author(s):
Robert Effros
Published Date:
April 1997
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Author(s)
JAMES R. BARTH1 and R. DAN BRUMBAUGH 

The U.S. banking system has attracted substantial attention during the past 15 years. Most of the attention has focused on the large number of failed depository institutions (commercial banks, savings banks, savings and loans, and credit unions) and their unprecedented resolution costs. This attention is certainly appropriate, given the failure from 1980 through 1992 of more than 4,500 federally insured depository institutions with approximately $650 billion in assets and the subsequent resolution by federal authorities at an estimated present-value cost of nearly $165 billion.

Additional attention has been paid to the diminished role of the surviving U.S. depository institutions and the way in which they are adapting to a rapidly changing environment. U.S. depository institutions have been steadily losing market share to other, less-regulated financial service firms. From 1950 through 1993, the share of depository institutions in total U.S. financial assets held by all financial service firms fell by nearly 50 percent (Table 1).

Table 1.Distribution of U.S. Financial Assets Held by All Financial Service Firms(In percent of total assets, unless otherwise indicated)
195019601970198019901993
Depository institutions164.958.058.654.240.933.6
Commercial banks51.238.238.634.327.725.1
U.S.-chartered50.537.536.629.322.019.1
Foreign offices in United States0.40.60.72.33.03.4
Bank holding companies1.12.42.52.5
Banks in U.S. possessions0.30.10.30.30.20.2
Savings institutions13.418.718.718.311.46.7
Savings and loans5.811.812.814.49.1
Savings banks7.66.95.93.92.2
Credit unions0.31.11.31.61.81.8
Contractual intermediaries29.433.531.631.135.537.8
Life insurance companies21.319.415.010.711.411.6
Other insurance companies4.04.43.74.24.44.1
Private pension funds22.46.48.411.713.615.2
State and local government retirement funds1.73.34.54.56.16.9
Others5.88.79.614.723.528.4
Finance companies3.24.64.84.75.14.3
Mortgage companies0.40.10.2
Mutual funds31.12.93.51.45.09.3
Money market mutual funds1.84.13.6
Closed-end funds0.20.40.6
Security brokers and dealers1.41.11.21.02.23.0
REITs40.10.10.10.10.10.1
Issuers of asset-backed securities2.33.0
Bank personal trusts55.14.24.3
Total assets (in billions of U.S. dollars)2945971,3405,91012,01715,387
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts (various issues). The flow of funds accounts was restructured in the second quarter of 1993.

Commercial banks consist of U.S.-chartered commercial banks, domestic affiliates, Edge Act corporations, agencies and branches of foreign banks, and banks in U.S. possessions. Foreign banking offices in the United States include Edge Act corporations and offices of for- eign banks. International banking facilities are excluded from domestic banking and treated like branches in foreign countries. Savings and loan associations include all savings and loan associations and federal savings banks insured by the Savings Association Insurance Fund. Savings banks include all federal and mutual savings banks insured by the Bank Insurance Fund.

Private pension funds include the Federal Employees’ Retirement Thrift Savings Fund.

Mutual funds are open-end investment companies (including unit investment trusts) that report to the Investment Company Institute.

REITs are real estate investment trusts.

Bank personal trusts are assets of individuals managed by bank trust departments and non- deposit, noninsured trust companies.

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts (various issues). The flow of funds accounts was restructured in the second quarter of 1993.

Commercial banks consist of U.S.-chartered commercial banks, domestic affiliates, Edge Act corporations, agencies and branches of foreign banks, and banks in U.S. possessions. Foreign banking offices in the United States include Edge Act corporations and offices of for- eign banks. International banking facilities are excluded from domestic banking and treated like branches in foreign countries. Savings and loan associations include all savings and loan associations and federal savings banks insured by the Savings Association Insurance Fund. Savings banks include all federal and mutual savings banks insured by the Bank Insurance Fund.

Private pension funds include the Federal Employees’ Retirement Thrift Savings Fund.

Mutual funds are open-end investment companies (including unit investment trusts) that report to the Investment Company Institute.

REITs are real estate investment trusts.

Bank personal trusts are assets of individuals managed by bank trust departments and non- deposit, noninsured trust companies.

U.S. depository institutions have reacted to their diminishing role by rearranging their balance sheets. All depositories have placed a greater emphasis on real estate loans. Commercial banks, savings banks, and savings and loan institutions have emphasized both home mortgages and commercial real estate, while credit unions have emphasized only home mortgages. Larger commercial banks have increased fee and other non-interest income through off-balance-sheet activities, such as interest rate and foreign exchange swaps. Other less traditional activities, such as managing and selling securities and insurance products and services, have also been increasing. This trend is especially true for those state-chartered institutions that have been granted wider powers than federally chartered institutions, and for several of the largest bank holding companies, which have also been permitted greater leeway to engage in such activities. Depositories have also been cutting costs wherever possible, including by laying off employees.

The large number of costly depository institution failures and the changing role of depository institutions in the U.S. financial marketplace have understandably raised many questions. A number of important questions are being asked: What caused all the failures and the huge resolution costs? Why are depository institutions losing market share? Are depository institutions becoming obsolete? Should the Federal Government provide financial stability through deposit insurance, given the evolving environment of depositories? Similar questions about the evolution of financial institutions and their regulation are being asked in countries around the world, as their financial institutions, too, are adapting to changing market conditions.

These are some of the issues that this chapter attempts to address. In the next section, the turmoil that occurred in the U.S. banking system over the past 15 years is described. Then, the erosion in market share experienced by U.S. banking institutions over the same period is addressed. The third section explains why the failures were so numerous and costly, and why market shares have evolved as they have. In the fourth section, key aspects of the present U.S. regulatory system and their effect on the evolution of the U.S. banking system are described, and the diminished role of deposit insurance is addressed. Lastly, the implications of the U.S. banking experience for the evolution of financial and regulatory institutions in the United States and other countries are considered.

Numerous Failures and Huge Failure Costs

The 1980s will be remembered as the worst decade for banking institutions since the Great Depression of the late 1920s and early 1930s. The failures in the savings and loan industry were so numerous and costly that the federal insurance fund for the institutions, the Federal Savings and Loan Insurance Corporation (FSLIC), reported insolvency in 1988 in the amount of $75 billion. It was dissolved the following year, with taxpayers paying to clean up the mess. As Table 2 shows, 1,142 savings and loans with $390 billion in assets failed from 1980 through 1992; the cost to resolve these failures has an estimated present value of $127 billion. The FSLIC was replaced in 1989 by a new insurance fund, the Savings Association Insurance Fund (SAIF), for the solvent savings and loans that remained. The SAIF is administered by the Federal Deposit Insurance Corporation (FDIC).

Table 2.Failed and Insolvent U.S. Savings and Loans
YearNumber

of

Failures
Failure

Assets

(In millions

of U.S.

dollars)
Failure

Costs

(In millions

of U.S.

dollars)
Failure

Costs as

Percent of

Failure

Assets
Number of

Months

Insolvent

Before

Closure
Number of

Insolvent

Institutions
Insolvent

Institution

Assets (In

billions of

U.S. dollars)
Insurance Fund

Reserves

(In billions of

U.S. dollars)
1980111,45916611.45.4436.5
19812813,9077605.55.2112296.2
19826317,6638064.612.94152206.3
1983364,6302755.916.45152346.4
1984225,08074314.623.46953365.6
1985316,3661,02616.125.97053354.6
19864612,4503,06624.630.6672324−6.3
19874710,6643,70434.735.7672336−13.7
1988205101,24231,79031.442.0508283−75.0
19893710,8085,91454.836.0517283
199031594,24837,30239.643.056313951
199123275,94734,50645.441.0437127810.1
19926935,3386,71519.038.0200112710.3
Total1,142389,802126,77332.56,0543,180
Sources: Federal Home Loan Rank Board, Office of Thrift Supervision, Resolution Trust Corporation, and authors’ calculations.

Private sector institutions classified by the Office of Thrift Supervision as troubled, with poor earnings and low capital or expected transfers to the Resolution Trust Corporation.

Sources: Federal Home Loan Rank Board, Office of Thrift Supervision, Resolution Trust Corporation, and authors’ calculations.

Private sector institutions classified by the Office of Thrift Supervision as troubled, with poor earnings and low capital or expected transfers to the Resolution Trust Corporation.

Despite worrisome developments throughout the decade, commercial and savings banks were much more fortunate than savings and loan institutions. As Table 3 shows, although 1,503 of these institutions failed, with $259 billion in assets, they were resolved at an estimated present-value cost of only $37 billion. As a result, although the federal insurance fund for these institutions, the Bank Insurance Fund (BIF), did report insolvency in both 1991 and 1992, it returned to solvency in 1993. The BIF is also administered by the FDIC.

Table 3.Failed and Problem U.S. Commercial and Savings Banks
YearNumber of FailuresFailure Assets (In millions of U.S. dollars)Failure Costs (In millions of U.S. dollars)Failure Costs as Percent of Failure AssetsNumber of Months Rated “4” or “5” Before Closure1Number of Problem BanksProblem Bank Assets (In billions of U.S. dollars)Insurance Fund Reserves (In billions of U.S. dollars)
MeanMaximum
1980102363012.7153021210.0
1981104,85958912.1193422312.2
19824211,6321,27110.9163536913.8
1983487,2071,52121.1194564215.4
1984793,2762,29270.0153984822816.5
19851208,33785010.215581,14023818.0
19861456,8301,73225.420651,48433618.3
19872039,1982,01721.921671,57535918.3
198822152,6235,53010.524741,40625214.1
198920729,5385,99820.328881,10923613.2
199016915,3653,40222.1341091,0464094.0
199112763,3387,39311.729891,090610−7.0
199212246,1584,70010.23221262863464−0.1
Total1,503258,59737,32514.412,0073,1323
Source: Federal Deposit Insurance Corporation.

A rating of “4” or “5” is assigned by the regulatory authorities to problem banks.

Including failures only through October 1992.

Total for 1984–92 period.

Source: Federal Deposit Insurance Corporation.

A rating of “4” or “5” is assigned by the regulatory authorities to problem banks.

Including failures only through October 1992.

Total for 1984–92 period.

While credit unions also experienced difficulties in the 1980s, their condition did not deteriorate sufficiently to pose a serious risk to taxpayers. As Table 4 shows, 2,050 credit unions failed, with $2.8 billion in assets, but they were resolved at an estimated present-value cost of only $452 million. Moreover, the federal insurance fund for these institutions, the National Credit Union Share Insurance Fund (NCUSIF), never reported insolvency. As a result of losses in the early 1980s and the recognition that the premiums being collected were not adequately funding the NCUSIF, the credit unions themselves recapitalized their insurance fund in 1985 with a 1 percent levy on the insured shares or deposits of each federally insured credit union. Since then, the NCUSIF has resolved hundreds of failed institutions while simultaneously increasing its reserves.

Table 4.Failed and Problem U.S. Credit Unions
Year1Number

of

Failures
Failure

Assets

(In millions

of U.S.

dollars)
Failure

Costs

(In millions

of U.S. dollars)
Failure Costs

as

Percent of

Failure

Shares
Number of

Months Rated

“4” or “5”

Before

Closure2
Number

of

Problem

Credit

Unions
Problem

Credit Union

Assets

(In billions of

U.S. dollars)
Insurance

Fund

Reserves

(In billions of

U.S. dollars)
19801,0182.40.2
19813491,1743.00.2
19823271,1924.60.2
198325369.61,1244.70.2
198413020819.99.680.88724.10.3
1985944711.624.764.97424.11.1
19869411628.624.755.47946.61.4
19878832751.715.844.19298.11.6
19888529733.311.230.11,02210.61.9
198911428574.026.024.07948.42.0
199018948548.710.017.56789.42.1
199117329876.825.868510.42.3
1992154773107.413.96087.42.6
Total2,05032,8364452.0415.9411,63283.8
Source: National Credit Union Administration.

Fiscal year basis.

A rating of “4” or “5” is assigned by the regulatory authorities to problem credit unions.

Total for 1981–92 period.

Total for 1984–92 period.

Source: National Credit Union Administration.

Fiscal year basis.

A rating of “4” or “5” is assigned by the regulatory authorities to problem credit unions.

Total for 1981–92 period.

Total for 1984–92 period.

Steady Loss of Banking Institutions’ Market Share

In addition to the large number of failed depository institutions and their costly resolution, depository institutions have suffered from still another problem. In 1950, as Table 1 shows, depository institutions accounted for 65 percent of the total assets of all financial service firms in the United States. By 1993, however, this percentage had declined by nearly half, to 34 percent. The biggest losers in terms of market share have been the U.S.-chartered commercial banks, whose share declined to 19 percent in 1993 from 51 percent in 1950. The share for savings banks fell to 2.2 percent in 1990 from 7.6 percent in 1950. Savings and loans increased their share from 5.8 percent in 1950 to 14.4 percent in 1980, only to decline to 9.1 percent in 1990. Reflecting the savings and loans’ decline, the Federal Reserve no longer reports separate data for savings banks and savings and loan institutions; instead, it combines them into “savings institutions” for reporting purposes. Credit unions, meanwhile, have seen their share increase sixfold, from 0.3 percent to 1.8 percent during the post-World War II period.

Among nondepositories, the big gainers in market share have been private pension funds and state and local government retirement funds. The collective share of these funds increased to 22 percent in 1993 from 4 percent in 1950. They now account for a larger share of the total assets held by all financial service firms than U.S.-chartered banks. The other big gainers have been money market and other mutual funds, whose collective share increased 1,200 percent from 1950 to year-end 1993, from 1 percent to 13 percent. These funds are now more important in terms of market share than savings banks and savings and loan institutions combined, and they are rapidly approaching the importance of U.S.-chartered commercial banks.

As the provision of financial services has evolved, individuals and households (including personal trusts and nonprofit organizations) have dramatically changed the composition of their financial assets. As Table 5 shows, 57 percent of all household financial assets in 1950 were in corporate equities, U.S. government securities, and life insurance reserves. Today, households hold only 23 percent of their assets in those categories, a drop of 34 percentage points. At the same time, net household holdings in pension fund reserves, money market funds, and other mutual funds have increased by 32 percent. Households have shifted from direct holdings of stocks and bonds and holdings in depositories and life insurance companies to indirect holdings of stocks and bonds through pension funds, money market funds, and other mutual funds.

Table 5.Selected Balance Sheet Items of U.S. Households, Personal Trusts, and Nonprofit Organizations(In percent of total financial assets, unless otherwise indicated)
1950196019701980198519901993
Checkable deposits and currency4445
Small time and savings deposits18191611
Money market fund shares1233
U.S. government securities15854463
Corporate and foreign bonds1121110
Mortgages4322121
Mutual fund shares1246
Corporate equities30413817161317
Life insurance reserves12973333
Pension fund reserves591214202428
Total liabilities8232523242825
Total financial assets (in billions of U.S. dollars)4479731,9176,3919,81913,98417,230
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts (various issues).
Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts (various issues).

This pattern of shifting shares reflects, in part, an increase in competition that, in turn, largely resulted from developments in computer and telecommunications technology. Technology has been increasingly reducing the traditional need for depositories to intermediate between borrowers and lenders through its gathering, evaluation, and monitoring of information on borrowers, which was too costly an activity for lenders themselves to perform. Securitization has turned formerly illiquid assets on bank balance sheets, such as mortgages, automobile loans, credit card receivables, and, increasingly, commercial real-estate loans, into securities that can be held by individuals and by many firms (including pension funds, mutual funds, and insurance companies). For example, according to data from the Federal Reserve, although the depository institutions’ share of all home mortgages dropped from 60 percent in 1950 to 35 percent today, 41 percent of these mortgages have been securitized. Mutual funds have allowed consumers to hold indirectly a diversified portfolio of financial assets in relatively small denominations. Overall, this technological revolution and the developments in finance theory have manifested themselves in new products, new firms, lower costs of providing financial products, and lower prices for products.

The line of causation creating the profound change in the pattern of providing financial services is relatively clear. First came the technological advances that lowered the cost of gathering, processing, transmitting, and monitoring information. Then came the changes in providing financial products as a result of the technological change, such as securitization and the development of money market and other mutual funds. Finally, households have over time shifted their holdings of financial assets, fueling the growth in nonbank financial service firms.

Causes of Costly Failures and Lost Market Share

The costly depository institution failures and the decline in the depositories’ share of the total assets of all U.S. financial service firms not only reflect the market forces just described, but also other economic shocks and regulatory forces. In the late 1970s and early 1980s, inflation and interest rates became highly volatile. For a time in the early 1980s, short-term interest rates rose above long-term interest rates, particularly harming savings and loan institutions that were required by regulation to fund their long-term, fixed-rate mortgage loans with shorter-term deposits at more variable rates. In 1981, tax law changes stimulated real-estate investments. In 1986, however, the effect of the tax law changes was more than reversed, significantly harming real estate markets and depositories that had previously increased their real estate lending and investments. Fluctuations in energy prices, including the largely unexpected decline in oil prices from $28 a barrel to $10 in the first quarter of 1986, contributed to regional economic disruptions that harmed depositories that had lent or invested in those areas.

Throughout the 1980s, laws and regulations limited the ability of depositories to adapt to changing market conditions, including their ability to offer adjustable-rate mortgages, to diversify geographically, to offer market rates of interest on their deposits, and to engage in a range of securities and insurance activities. Although some of these restrictions were eliminated or relaxed over the decade, these changes were generally made in reaction to market forces that had already damaged depositories. Furthermore, restrictions still remained that impeded the ability of depositories to adapt to continued competition.

This pattern is a by-product of the access of depository institutions to federally insured deposits, which creates incentives that need to be addressed with “safety and soundness” regulations. With deposit insurance, only stockholders and unsecured creditors—not insured depositors—face the risk of loss of funds. Once stockholders have lost their equity capital, moreover, the federal insurer effectively bears any further losses. This situation gives rise to a moral hazard problem, in which a depository institution, once insured, has an incentive to engage in riskier activities. It is thus the responsibility of the insurer to contain this proclivity through safety and soundness regulations, including minimum required capital levels, risk-based capital requirements, risk-based deposit insurance premiums, restrictions on the pricing of products and services, geographical limitations on operations, constraints on involvement in various activities, and ownership restrictions.

While these regulations are designed in the last analysis to protect the insurer against losses, they can impede the ability of the depositories to compete with less-regulated financial service firms. These regulations can prevent depository institutions from altering their mix of products and services to serve their customers in a timely manner—if at all—and they raise the costs of doing business. As a result, in a changing market environment, customers of depositories can be lost to financial service firms that are able to service the demands of customers more efficiently. The outcome is predictable: more competition means increased failures of depository institutions and, more generally, excess capacity in the depository institutions.

This pattern gives rise to the problem of potentially costly exits from such industries. Tables 24 present information on the exit costs for federally insured depository institutions from 1980 through 1992. Failed commercial and savings banks cost on average about 14 percent of their assets to resolve (Table 3). These costs, however, ranged from a low of 10 percent of assets in 1985 and 1992 to a high of 70 percent in 1984. The failure resolution costs for savings and loan institutions were significantly higher as a percentage of assets. Their average cost was 33 percent, with a low of 5 percent in 1982 and a high of 55 percent in 1989 (Table 2). In the case of credit unions, the average failure resolution cost as a percentage of assets was about 16 percent, with a low of 10 percent in 1984 and a high of 26 percent in 1991 (Table 4).

In part because of forbearance on the part of the regulatory authorities, the costs of exit for many of the institutions that failed have been excessive. As can be seen in Tables 24, federally insured depository institutions for relatively lengthy periods of time were either rated by the authorities as problem institutions or reported insolvency before being resolved. For both commercial and savings banks, the average length of time between being identified as a problem institution and resolution tended to increase from 1980 through 1992. Table 3 shows that this regulatory delay lengthened while the number of problem institutions and their assets generally were also increasing. This table also shows that throughout the entire period the insurance fund reserves were steadily decreasing.

The excessive resolution costs for savings and loans are even more egregious because these institutions were reporting insolvency for lengthy periods before they were resolved. As Table 2 shows, the average delay in resolving savings and loans increased from 5 months in the early 1980s to about 40 months—more than 3 years—in the late 1980s and early 1990s. While the delay in resolution lengthened steadily, both the number and the assets of insolvent institutions reached substantial levels in the middle and later half of the 1980s. Not coincidentally, the federal insurance fund itself reported insolvency for the first time in its existence in 1986. Two years later, its insolvency amounted to $75 billion.

The regulatory authorities’ record for taking action against problem credit unions is much better than for the other depository institutions. Table 4 shows that, nonetheless, the closing of problem credit unions was clearly delayed. The length of delay, however, steadily declined once the insurance fund was recapitalized in 1985.

A major lesson to be learned from these data is that having little or no equity capital at risk provides depository institutions with a significant incentive to engage in excessively risky activities. Even projects whose expected present value may be negative are undertaken, because upside gains from such projects accrue to the benefit of the depository institution and its owners, whereas the downside losses are borne by the insurer. Regulatory forbearance gives institutions time to engage in such behavior. Even without undertaking excessively risky projects, moreover, institutions with little or no equity capital at risk may pay out excessive salaries, dividends, and directors’ fees.

The struggle to compete in a situation of excess capacity and lax regulation and supervision can produce excessive exit costs for depository institutions. Failures per se were not the most egregious problem over the past 15 years: the problem was the excessive costs required to resolve these failures, costs that were so enormous in the case of savings and loans that taxpayers have been required to assist in cleaning up the mess.

Diminished Role of Deposit Insurance

The goal of regulation is to provide a stable, efficient, and competitive financial system. The major problem that arises with banking institutions is that they offer deposits that are payable on demand at par or face value and that are used to fund longer-term assets that are illiquid and risky. The result is that depositors may become nervous about the safety of their funds and stage a run on those depositories that they perceive to be unsound, because withdrawals are honored on a first-come, first-served basis. Widespread or systemic runs can cause disruptions to the payments system and to the credit system, as otherwise healthy institutions are forced into insolvency by selling assets at “fire-sale” prices.

In the United States, the solution to this potential calamity for both the financial and real sectors of an economy has been the establishment of a lender of last resort (the Federal Reserve) and federal deposit insurance. The benefit of these two devices is stability. In particular, a source of liquidity is available at all times, and adequate funds are available to cover all failure resolution costs, which assures the maintenance of depositors’ confidence and the elimination of systemic runs. The costs are less efficiency and less competition than would otherwise exist because of the safety and soundness regulations that are imposed, including the accounting system, the restrictions on powers and activities, and the closure and resolution procedures.

The point may have been reached at which the costs are now exceeding the benefits, particularly in view of the declining importance of insured deposits in funding assets held by financial service firms. The value of insured deposits has been eroding over the years. As Table 6 shows, insured deposits fund only 55 percent of the assets of federally insured depository institutions and only 17 percent of the total assets of all financial service firms. At the same time, transaction accounts represent only 17 percent of assets, and commercial and industrial loans account for only 12 percent of the assets of BIF- and SAIF-insured depository institutions.

Table 6.Federally Insured Depository Institutions, 1993
Number of institutions13,221
Total assets (in billions of U.S. dollars)4,707
Total deposits (in billions of U.S. dollars)3,528
Insured deposits (in billions of U.S. dollars)2,582
Transaction accounts (excluding U.S. Government and depository institutions; in billions of U.S. dollars)821
Commercial and industrial loans (in billions of U.S. dollars)549
Total deposits (as share of total assets, in percent)75.0
Insured deposits (as share of total assets, in percent)54.9
Transaction accounts (as share of total assets, in percent)17.4
Commercial and industrial loans (as share of total assets, in percent)11.7
Total assets of all financial service firms
(in billions of U.S. dollars)15,387
Insured deposits (as share of financial service firm assets, in percent)16.8
Sources: Federal Deposit Insurance Corporation and Federal Reserve.
Sources: Federal Deposit Insurance Corporation and Federal Reserve.

These figures raise the following questions: Is the importance of insured deposits in providing financial stability overstated? After all, how vulnerable can the payments and credit mechanisms be if, as Table 6 shows, only 17 percent of assets at depositories are funded by transaction accounts, which, in turn, represent only 5 percent of assets of all financial service firms? If business loans represent only 12 percent of depository assets, are these loans the core business of banking? Given that 45 percent of depository assets are funded by uninsured liabilities, are insured deposits really a “low-cost” source of funds that will enable banks to compete successfully against nonbank financial service firms? Is the burden of safety and soundness regulations on depositories really necessary, given that insured deposits represent only 17 percent of all assets of financial service firms?

Responding to Contemporary Challenges: Reform of Deposit Insurance and Safety and Soundness Regulations

These questions and their answers hold many implications for the reform in the United States of deposit insurance and safety and soundness regulations. For instance, an agenda for regulatory reform must pass a two-part test. It must meet the fundamental goal of bank regulation by protecting the payments and credit mechanisms from disruption while promoting competition. Meeting both parts of this test is the only way to maximize the efficient allocation of scarce economic resources.

In the contemporary environment, there are four basic approaches to regulatory reform. The first approach would be to protect depositories from competition by granting monopoly-like powers where possible to banks and by attempting to impose regulatory restrictions on nondepository financial service firms. This reform would be an extension of the current regulatory policy of attempting to erect barriers to entry and exit in the provision of financial products and services. In an environment of rapid competitive change, this approach is increasingly counterproductive.

A second approach to reform would be to maintain the deposit insurance system while installing a mechanism to correct promptly and, if necessary, close troubled institutions. A form of this second approach was adopted in 1991 in the Federal Deposit Insurance Corporation Improvement Act.2 This Act provided for corrective action—basically, intervention by regulators that ultimately involved seizure and resolution based on declining levels of book value net worth or capital. In addition to using book value accounting rather than market value accounting, this Act allowed for significant regulatory discretion. In the recent past, using these techniques has led to a slow and costly resolution of troubled depositories. Even if these difficulties could be overcome, this approach may be seen to impede or at least not further the ability of healthy banks to adapt to competitive developments in financial markets, because the Federal Deposit Insurance Corporation Improvement Act imposes or fails to eliminate significant limitations on the activities of banking institutions.

A third approach to reform would eliminate deposit insurance and adopt a form of what is called the narrow bank. Under this proposal, deposit insurance would be eliminated without eliminating the protection that deposit insurance was designed to provide for small and unsophisticated depositors, the payments and credit mechanisms, and the taxpayer.

To understand this third approach, it is necessary to consider some theory. To prevent runs and to provide individuals with a perfectly liquid asset—one that is payable on demand at par with extremely low user cost—the third proposal would create a narrow bank at every depository. The assets of the narrow bank would be short-term treasury securities. In certain circumstances, other liquid and marketable assets could be included. The liabilities would be demand deposits or transaction accounts only. As a result, the return to the depositor would essentially be limited to the return on short-term treasury securities minus fees for servicing accounts.

Simultaneously, the third proposal would eliminate all other regulatory constraints on depositories except those that apply to other financial service firms, such as Securities and Exchange Commission disclosure requirements, consumer protection requirements, and all requirements implicit in avoiding antitrust violations. Thus, this proposal is designed to promote efficiency because the new, “non-narrow” bank, associated with but separated functionally from the narrow bank, would become a purely private financial service firm with the ability—in common with all other financial service firms—to adapt to competition.

The fourth approach involves eliminating deposit insurance and creating a federal money market mutual fund. As with the previous proposal, this approach would eliminate deposit insurance. It would also eliminate all regulatory constraints on depositories except those that apply to other financial service firms. The difference is that, instead of creating just a narrow bank at former depositories, this approach would also create a federal government money market mutual fund. There is, of course, no reason why banks should not be able to offer competing money market mutual funds or risk-free accounts in narrow banks if they so chose.

As with the narrow bank, assets of the government money market mutual fund would be short-term treasury securities, and liabilities would be demand deposits only. Access to the fund would be through check writing or debit cards issued to those wishing to purchase shares in the fund. The fund would allow all government checks, such as payroll, social security, and welfare checks, to be deposited electronically—a service that could also be provided through the narrow bank.

Under the fourth approach, all non-narrow banks would become purely private financial service firms with the ability to adapt to competition as do other financial service firms. The goals of deposit insurance would also be met. The provision of the money market mutual fund through the Government is also a function for which the Government—more so than the narrow bank—seems particularly efficient. Basically, a large-scale electronic debit and credit mechanism, requiring a sophisticated computer network and retail outlets at, for example, post offices would be required. There is, incidentally, a historical precedent for this type of mechanism: postal banks.

This approach has other advantages over the narrow bank approach alone. The proposal would create a vehicle to provide low-income individuals with certain financial services at low cost; it may represent a more efficient alternative to providing such services to low-income individuals through banks, community development banks, or narrow banks. At the moment, individuals with low incomes have difficulty cashing checks and establishing checking accounts of their own, in part because of a shortage of financial service outlets near their homes. In addition, theft of government checks is a problem. With access to the government money market mutual fund, these individuals could have checks deposited in their accounts and draw down on these accounts through the use of checks or debit cards. Electronic transfer of funds to pay bills could also be arranged easily. The government money market fund would become an efficient, low-cost provider of universal liquidity in the United States. In essence, just as the Government has provided currency over the years, it would be updating the process by providing the modern-day equivalent of such a payments vehicle.

Finally, it is frequently said that implicit federal deposit insurance exists even for the narrow bank because if difficulties arose—however remote the possibility—the Government would step in to protect depositors. This reform proposal eliminates this prospect because the Government provides a liquidity service in the first place. Individuals would never need to run to currency issued by the Government.

Conclusions

One approach to setting a regulatory agenda for banks that is applicable to almost all countries is first to examine whether the existing regulatory structure is consistent with the goals of bank regulation. The main role of bank regulation is to maintain confidence and, hence, stability in the financial system because a stable financial system facilitates the efficient allocation of scarce economic resources, which is the primary function of the financial system. The fundamental goal of bank regulation is thus to promote the efficient allocation of scarce economic resources by minimizing disruptions in the payments and credit mechanisms.

Another goal of bank regulation is to promote competitive financial markets. Regulation itself can inhibit competition and the efficient allocation of scarce economic resources. Various ways in which restrictions on the activities of banking institutions can limit competition and create excess capacity have been pointed out in this chapter. These outcomes, in turn, impede the efficient allocation of scarce economic resources.

Many of the current restrictions were adopted in the United States in legislation in the 1930s. They have evolved since then with changes in legislation and regulation that were essentially ad hoc adaptations to specific problems that appeared to need immediate attention. This pattern holds particularly true for the federal legislation since 1980. These changes, however, fundamentally ignored the development that could not have been envisioned in the 1930s but exploded dramatically in the 1980s: the revolution in computer and telecommunications technology, which, in turn, has spurred dramatic competition in the provision and distribution of financial products and services.

Market-driven forces have created and distributed new financial products and services. Federally insured and regulated depositories are finding it difficult to adapt to the competition because of the regulations under which they operate. As a result, depositories are suffering from a long-term decline in profitability, an increase in risk, and costly exits. Current attempts by banks to secure profitability by shifting on-balance-sheet assets, moving to off-balance-sheet assets, and seeking fee-based income are unlikely to overcome the long-term competitive disadvantages imposed by regulatory limitations and restrictions.

A regulatory reform proposal must pass a two-part test. It must meet the fundamental goal of bank regulation by protecting the payments and credit mechanisms from disruption while promoting competition. Meeting both parts of this test is the only way to maximize the efficient allocation of scarce economic resources.

Two reform proposals that would eliminate deposit insurance have been described. These proposals would nonetheless provide the same protection that deposit insurance was designed to provide: protection for small and unsophisticated depositors, protection of the payments and credit mechanisms, and protection of the taxpayer. One proposal would simply adopt a form of the narrow bank, while the other would create both a narrow bank and a federal government money market mutual fund.

The financial institutions in all developed countries of the world are subject to most of the competitive pressures that have contributed to the turmoil among depository institutions in the United States in the 1980s and early 1990s. Many of these countries also have explicit or implicit deposit insurance and attendant safety and soundness regulations that give rise to moral hazard, as well as the other difficulties addressed in this chapter. As a result, there are important benefits to understanding the recent U.S. experience and the reforms that have evolved and are potentially applicable elsewhere.

COMMENT

V. GERARD COMIZIO1

This comment addresses the significant causes of the savings and loan crisis that occurred in the United States in the 1980s. For the U.S. Government and, more important, for U.S. taxpayers, the total cost of protecting insured depositors from loss as a consequence of savings and loan failures is currently estimated at $150-175 billion.2 Thus, the savings and loan disaster raises significant public policy concerns in the United States. In fact, the U.S. Congress enacted legislation in 1990 establishing a national commission to examine the causes of the problems in the savings and loan industry and to make recommendations for avoiding a repetition of a similar crisis.3 The sheer financial magnitude of the savings and loan debacle makes it crucial for the financial services industry, banking regulators, policymakers, and the public to understand its root causes.

Development of the Thrift Industry

The U.S. Government’s approach to regulating savings and loan institutions was paternalistic and protective throughout most of the twentieth century. Home financing and the ability of all citizens to own homes were considered fundamental principles of American life. Because the Government viewed the savings and loan institutions as the facilitators of the goals of home lending and residential construction, the regulation of savings and loan institutions became an important aspect of public policy.

As noted in the report of the National Commission of Financial Institution Reform, Recovery, and Enforcement on the crisis (the National Commission Report), “[d]uring the 1930s, Congress transformed S&Ls into agents of national housing policy.”4 Federal deposit insurance was provided as a subsidy, allowing savings and loan institutions to raise large amounts of funds at less than market interest rates so that they could finance long-term, fixed-rate home mortgage loans. For the next 30 years, they admirably performed the role that Congress had assigned them of providing the financing for realizing the dream of home ownership. Government regulation sheltered savings and loan institutions from competition, allowing the industry to be profitable and failures to be rare. As long as interest rates did not rise substantially, savings and loan institutions faced little risk.

The National Commission Report points out that “[t]he modern savings and loan industry traces its origins to the Great Depression of the early 1930s, which brought default on 40 percent of the nation’s $20 billion in home mortgages and the failure of some 1,700 of the nation’s approximately 12,000 savings institutions.”5 At that time, Congress passed three statutes in order to stabilize the thrift industry. The Federal Home Loan Bank Act established the Federal Home Loan Bank Board (Bank Board), which was to channel funds to thrifts for loans on houses and to prevent foreclosures.6 The Home Owners’ Loan Act of 1933 gave the Bank Board authority to charter and regulate federal savings and loan associations.7 The National Housing Act “created the Federal Savings and Loan Insurance Corporation, under the Bank Board’s authority, with responsibility to insure thrift deposits and regulate all federally insured thrifts.”8

Savings and loan associations proved popular, compared to banks. From 1946 to 1965, commercial banks grew at an average annual rate of approximately 5 percent, in contrast to growth of over 14 percent for savings and loan institutions.9 The National Commission Report states:

The stronger growth of S&Ls mirrored their ability to attract large amounts of deposits from the public to engage in profitable mortgage lending. Part of the advantage that S&Ls enjoyed over banks was a consequence of strong housing demand that made mortgage lending more profitable than business loans and other kinds of lending in which banks at that time specialized. But a good deal of the advantage had been bestowed on the industry by Congress to “compensate” them for the greater powers of banks.10

In the ensuing years, the U.S. Government encouraged the existence of thrift institutions and even, on occasion, provided them with a considerable competitive edge over other financial services competitors. For example, until 1954, savings and loan institutions paid no income tax. This exemption made their loans more profitable than bank loans, which were subject to income tax. More important, federal legislation in the mid-1960s gave thrifts a competitive advantage over commercial banks by allowing them to pay higher rates of interest on passbook savings accounts than permitted by law for banks. Later federal legislation also created “bad debt reserve” tax features for savings and loan institutions that virtually eliminated the need for thrifts to pay federal tax. In addition, other tax incentives favored thrifts over commercial banks in order to encourage the thrifts’ mission of furthering home ownership.

The strategy of creating a more advantageous market for the thrift industry emerged as a notable aspect of the downfall of the savings and loan industry because, at critical points over the past 20 years, they were ill equipped to compete with emerging competitors in the mutual fund and money market industries.

Savings and loan executives sailed smoothly through the period following World War II and up to the 1970s. Their industry enjoyed a golden age, with total savings and loan assets expanding from $10 billion to $130 billion, 85 percent of which were mortgage loans.11 Moreover, during the years between 1946 and 1965, the thrift industry enjoyed significant growth at an average annual rate of more than 14 percent.12 In addition to high levels of savings, there was a great postwar demand for consumer goods and housing construction (in essence, pent-up demand), which the savings and loan industry served extraordinarily. As long as interest rates did not rise substantially, the business of savings and loan institutions faced little risk.13 Accordingly, because interest rates remained fairly stable until the mid-1960s, the thrift industry faced no profound challenges.

Adversities in the Economy Significantly Altered the Course of the Thrift Industry

Accustomed to the comfortable complacency of the golden years of the thrift industry following World War II, thrift executives were ill prepared to confront the challenges that arose in the next 15 years. In the 1960s, two of the challenges—inflation and the resulting increase in interest rates in the domestic economy—had a severe impact on the portfolios of these institutions.

During the 1960s and 1970s, the overspecialized savings and loan industry experienced increasing risk and declining profitability, as rising interest rates and increased competition turned their environment increasingly hostile. Because deposit insurance shielded depositors from loss, however, the industry continued to expand. At a time when the industry needed to shrink and increase its capital levels, it did the opposite. Proposals to grant savings and loan institutions the flexibility to cope with mounting interest rate risk by granting the industry enhanced asset and liability powers were rejected repeatedly by Congress as inconsistent with national housing policy.

By 1979, inflation in the United States had reached double digits; as a result, the Board of Governors of the Federal Reserve System implemented a relentless anti-inflationary policy from October 1979 until October 1982. The severity of this policy produced a massive interest rate shock, bringing inflation quickly under control, but at high costs and to the detriment of the savings and loan industry.14 At that time, adjustable rate mortgages, which would have helped to alleviate the interest rate burden, were generally impermissible under federal banking and consumer laws, leaving earnings on mortgage loans at fixed rates. As a result, savings and loan portfolios, comprised primarily of fixed-rate mortgage loans, sustained massive losses in market value, resulting in a combined negative net worth of approximately $150 billion.15 Therefore, concern grew that as interest rates increased, the thrifts would have to offer higher rates to attract new depositors, while the bulk of their funds were already invested in long-term mortgage loans bearing the lower rates of the past.

As skyrocketing interest rates hit the industry’s portfolios from one side, disintermediation in the American financial services community threatened the portfolios from another. Between 1966 and 1979, financial markets began to integrate, and many people came to believe that forced specialization of the various financial institutions should end; specifically, it was thought that savings and loan institutions should forsake their roles solely as home lenders so that they could diversify their assets and liabilities.16 The U.S. Congress, however, insisted that the savings and loan industry continue in its capacity as a facilitator for home construction.17 Furthermore, many in the thrift industry were reticent to relinquish the industry’s niche in the financial services sector for fear of completely losing its integral position in the home lending market. Thus, savings and loan institutions continued as mortgage lenders, offering loans at low interest rates, while market interest rates continued to fluctuate and increase sharply.

Because nondepository institution competitors were able to pay market rates of interest on investments that were much higher than rates of interest paid on passbook savings accounts, savers drew down their deposits in the thrifts and placed them with competing mutual funds and money market funds, generating billions of dollars of outflows from thrift institutions. When market interest rates rose sharply in 1966, customers began to shift their investments into other market instruments that offered higher returns. By 1980, the thrift industry was in large part insolvent, its lending portfolio “underwater.” Moreover, because of the changing facets of the financial services industry—specifically, rising interest rates and increased competition—the savings and loan industry faced an increasingly hostile environment.18

Government’s Delayed Reaction to the Impending Thrift Crisis

Despite economic strife in the savings and loan industry, the U.S. Government, including the Congress, the Administration, and the various regulatory agencies, was slow to act. Statutory changes providing savings and loans with additional asset powers and complete deregulation of deposit interest rates had been recommended for several years. However, the government implemented the changes too late to successfully avert the savings and loan crisis.19

As a result, beginning in 1980, the Government sought to address and rectify the losses that several institutions had experienced, with the hope that interest rate fluctuations and any insolvencies would be short-lived. At that time, Congress moved to increase maximum deposit insurance levels from $20,000 to $100,000, in order to allay the crisis.20 Furthermore, during 1981 and 1982, the Government introduced a policy of forbearance, under which institutions whose insolvencies were caused by unprecedented high interest rates were allowed to continue operating.21 The philosophy driving these regulatory changes was that when interest rates returned to more normal levels, the industry also would return to solvency.22

Some elements of the 1980 legislation clearly had little effect. Some 415 savings and loans with $220 billion of assets had become insolvent.23 In 1982, in addition to continuing its forbearance policies, Congress sought to resolve the crisis through the Garn-St. Germain Depository Institutions Act.24 This act sought to enable the thrift industry to recoup the losses that it had accumulated as a home lender by allowing it to diversify and expand its nonhome lending activities. A deregulatory initiative, the Garn-St. Germain Depository Institutions Act significantly increased the authority of savings institutions to engage in nontraditional lending activities and riskier investments, including direct investment, increased commercial loan authority, real estate development, and interest rate speculation. At the same time, a number of states adopted similar legislation for state-chartered institutions. These states included Texas, Florida, and California, where a significant amount of the thrift industry’s later losses would occur.25 The problem arising in this instance was that the deregulation process of the thrift industry suffered a grave imbalance. The industry obtained substantial new investment powers and was subject to less supervision; simultaneously, government-backed deposit insurance was retained and even increased.26 The disequilibrium, namely, greater risk and less supervision, which was underwritten at the expense of U.S. tax dollars, enhanced the chances of abuse in the industry and contributed significantly to the dissolution of the federal deposit insurance fund.27

The relaxation of supervision and regulation, coupled with the opportunity for higher risk endeavors and higher returns, led to a rapid expansion of the thrift industry between 1982 and 1985 that largely went unchecked by the respective regulatory agencies. In those years, industry assets ballooned 56 percent, increasing from $686 billion to over $1 trillion.28 As this occurred, owners, operators, and managers of thrift institutions paid little heed to notions of safety and soundness (otherwise fundamental concepts in the federally insured financial industry). Rather, the minds of certain individuals in the industry became focused on reaping great financial benefits, either to salvage their own institutions or, for some, simply to make a profit.

As rapid growth and large capital gains ensued, more potential thrift operators flocked to the various state and federal supervisors in order to charter their own institutions. Potential for gain in the thrift industry was immense, especially in light of the abatement of supervision and the likelihood that such supervision would not hinder efforts to gain substantial profits. At the expense of the federal deposit insurance fund, these new thrift operators were successful in their endeavors.

Effects of the Initial Governmental Response

By 1985, it was evident that the attempt at deregulation and diversification had been unsuccessful. The new thrift charter, with its significantly expanded range of activities, was an eagerly accepted invitation to responsible and irresponsible people alike to obtain thrift charters and to engage in the newly acquired and riskier activities. New regulatory actions expanded asset and liability powers of savings and loans sharply by allowing them to move into risky new areas of business in which they lacked expertise, while regulatory standards for safe and sound practices in these activities were virtually nonexistent.29

Consequently, the moral hazard became clear. An institution that was not healthy but had the opportunity to exercise the newly expanded powers had a further incentive to take risks. Specifically, because of the increase in insurance on depository accounts, owners and operators of savings and loan institutions had little of their own money to lose if the institution failed and much to gain by expanding.30 On one hand, by taking risks for high rates of return, a savings and loan institution might manage to recapitalize itself. On the other hand, if its risks did not prove successful and the thrift became insolvent, the U.S. Government stood behind the deposit insurance funds and would absorb the losses. Savings and loan institutions and the thrift industry as a whole gambled on risks at the considerable expense of U.S. taxpayers. In essence, the moral hazard of deposit insurance was a “heads I win, tails you lose” philosophy for thrifts attempting to avoid failure.

Fraud in the Thrift Industry

While it was not the primary cause of the savings and loan debacle, unprecedented fraud emerged in the savings and loan industry as dishonest operators were attracted by the new governmental policies that provided the opportunity for such fraud.31 The potential for profits was notable, while, owing to diminished levels of supervision, the chances of getting caught were minimal.32 Credit risk accumulated without the net worth to support it, and, with abusive practices proliferating, the savings and loan debacle emerged. The collapse of the real estate market that occurred in the latter half of the 1980s, especially in the southwestern part of the country, clearly compounded this crisis.

Unfortunately, new investment powers did not help thrift institutions recapitalize. Rather, new activities exacerbated losses as a result of the failure of several real estate projects throughout the Southwest. A number of large thrift institutions were intimately involved in the junk bond market, which turned out to be a disaster. When the junk bond market collapsed, portfolios evaporated.

Where Does Deposit Insurance Go From Here?

The events and circumstances that precipitated the savings and loan crisis provide a good basis upon which to evaluate new regulations and activities, or to implement an entirely new federal deposit insurance system, or both. Federal deposit insurance was a necessary condition for the debacle; in its absence, high-risk savings and loan institutions could not have developed. First, depositors would have demanded progressively higher interest rates as risks increased and ultimately would have withdrawn their funds. Second, raising the insurance limit to $100,000 exacerbated the situation, making available larger amounts of capital. These two factors “robbed the system of the market discipline needed to control risk.”33

However, even in the best of circumstances, many savings and loans would have still failed in the early 1980s when 35 percent of the industry continued to sustain losses, 9 percent of all savings and loans were insolvent based on generally accepted accounting principles, and 16 percent were insolvent based on tangible net worth.34 Clearly, in addition to the deposit insurance, other factors contributed to the profound taxpayer expense that followed. Had the Bank Board moved to close insolvent institutions in 1983, total costs to the taxpayer might not have exceeded $25 billion.35 Furthermore, had the Bank Board stepped up its supervision and regulation, especially with respect to troubled institutions, many of the institutions would not have reached hopeless states of insolvency.36

By 1985, the Federal Savings and Loan Insurance Corporation maintained only $4.6 billion, while insolvencies had risen to $26 billion of total assets. Congress attempted to recapitalize the thrift industry insurance fund through the Competitive Equality Banking Act37 in 1987. The Competitive Equality Banking Act allotted a very small amount, $10 billion, to recapitalize the Federal Savings and Loan Insurance Corporation fund. By 1988, it became apparent that this amount was insufficient and that a major financial disaster was imminent.

As a result, the landmark savings and loan bailout legislation, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA),38 attempted to forge a new resolution to the crisis. This legislation released massive amounts of taxpayer monies to fund the bailout and the resolution of up to 800 insolvent thrift institutions. FIRREA accounted for estimates by 1989 that the cost of a savings and loan bailout would exceed $100 billion. The legislation also significantly changed the regulation of savings institutions by requiring them to revert to home lending and to disengage from the direct investment and commercial lending activities granted by federal and state legislation in the 1980s.

In response to the perceived problem associated with deregulation of the thrift industry and the circumstances that arose therefrom, banking legislation since FIRREA has imposed additional operating restrictions upon both banks and thrift institutions by significantly increasing regulatory capital requirements and by significantly augmenting the regulatory oversight of the Federal Deposit Insurance Corporation. Post-FIRREA legislation also has reinforced the power of the U.S. federal banking agencies, so that those agencies can literally take over and run the business of undercapitalized banks or savings and loan institutions until capital problems are solved.

The Future

At present, the American banking community seeks to increase its securities, insurance, and other nontraditional banking activities. There are good public policy reasons, including the enhancement of the competitive position of banks, underpinning the revisiting of earlier legislation limiting these activities that was passed during the U.S. banking crisis of the 1930s. However, to some degree the savings and loan debacle continues to cast its shadow whenever Congress addresses these issues. In evaluating new activities and risks, and in determining a new course of action for any federally insured industry, the question always will arise as to how and to what extent the proposed new activities will increase the risk to the federal deposit insurance funds.

This issue becomes especially acute for legislators and banking regulators in dealing with the proliferation of other nondepository financial institution competitors. These nondepository institutions, such as mutual funds and securities firms, have been and will remain formidable bank competitors for retail funds.

Indeed, the members of the American banking industry intend to continue to demand changes that will allow for diversification of permissible activities. Thus, in the future, the primary issue on the legislative agenda will be the consideration of appropriate safeguards to protect against dangers to the deposit insurance funds. The regulatory agencies and the public policy discussions have proposed the establishment of so-called firewall safeguards between nondepository and depository activities; only the latter would be backed by the full faith and credit of the U.S. government by means of deposit insurance. If regulatory agencies start a trend toward deregulation and if diversification continues, the issue of firewalls will be a significant part of the dialogue, both within the regulatory agencies and in Congress, in light of the savings and loan crisis.

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