I. Introduction
In the 1980s, the United States experienced its most
serious banking crisis since the 1930s and the second most serious
crisis in its 200-plus year history. The crisis affected commercial
banks, savings banks, and savings and loan associations (S & Ls).
Between 1980 and 1991, when fundamental corrective laws were enacted,
some 1,500 commercial and savings banks (insured by the Federal Deposit
Insurance Corporation) and 1,200 savings and loan associations (insured
by the former Federal Savings and Loan Insurance Corporation) failed and
were resolved by the regulatory agencies. These resolutions represented
about 10 percent of all banks at the beginning of the period and 25
percent of all S & Ls. In addition, an even larger number of
institutions were in precarious financial condition at some time during
this period. The costs of the failures were high, not only to the
shareholders of the failed institutions, but also to the surviving
institutions, which were required to pay premiums to the deposit
insurance agencies, and to U.S. taxpayers, who were forced to make good
on the losses after the resources of the S&L insurance fund had been
exhausted. For banks, the loss to the FDIC and thus to other solvent
banks was about $40 billion. For S & Ls, the loss was near $200
billion, some $150 billion of which was beyond the resources of the
FSLIC and was therefore charged to U.S. taxpayers.
The losses accrued primarily to the federal insurance
agencies and taxpayers rather than to depositors and other creditors
because the insurance effectively guaranteed the par value of deposits
up to $ 100,000 per account de jure and, except at some small banks,
almost any amount of deposits and even borrowings de facto, regardless
of the value of the bank's assets. The FDIC and the former FSLIC were
funded by premiums imposed on banks and S & Ls, respectively, and
both had implicit access to the U.S. Treasury that legislators were
unwilling either to challenge or to make explicit until near the end of
the debacle.
The crisis ended in the early 1990s, when interest
rates declined, the yield curve turned steeply upward sloping, a series
of rolling geographic recessions in various regions of the country came
to an end, the aggregate economy slowly expanded, the real estate market
bottomed out, and newly adopted legislation increased the cost of poor
performance and failure to both the institutions and the regulators. By
1994, both the banking and thrift industries were in their best
financial condition since the early 1960s and were realizing record
profits. The number of failed and problem institutions declined sharply.
II. Background
Banking has always been a volatile industry in the
United States, but until the 1930s not an unusual one.1 The
annual failure rate for commercial banks from 1870 to 1913, before the
establishment of the Federal Reserve System, averaged 0.78 percent
compared to 1.01 percent for non-banks. The annual volatility of the
failure rate was greater for banks, however. The relatively low failure
rate existed despite a banking structure that favored failures by
restricting banks to one or at best only a few offices, thus preventing
them from reducing risk through geographical and product
diversification. As a result, the country had thousands of independent
banks; the number peaked at 30,000 in the early 1920s. The bank failures
increased sharply in the 1920s to near 600 per year, but most of the
failures were very small banks. Some 90 percent of the banks had loans
and investments of less than $1 million, which adjusted for inflation
would be equivalent to only about $10 million currently, and would rank
them among the very smallest banks. Their failure had no visible effect
on national economic activity. They were primarily located in small
agricultural towns in the mid-west. When a recession hit these towns
from the rapid fall in farm prices after the post-World War I run-up,
the local automobile dealer failed, the local drugstore failed, and the
local bank failed.
But things changed dramatically in the 1930s at the
onset of the Great Depression. Between 1929 and 1933, the number of
banks declined from 26,000 to 14,000, mostly by failure. Indeed, the
very first act of newly elected President Franklin D. Roosevelt was to
declare a "bank holiday" and close all banks in the country for at least
one week in order to prevent depositors from cashing any more of their
deposits into currency. The banks were permitted to reopen if the
government found them solvent. Thereafter, banking became a relatively
stable industry through the late 1970s. The number of bank failures
averaged only near 10 per year and the number of S&L failures was
not significantly greater. Then the picture changed again.
Before analyzing the 1980s, it should be noted that
both the 1930s and 1980s debacles occurred after the creation of
government institutions intended to correct failings in the system that
were believed to have been at the root of the problem, and in order to
reduce the likelihood of large numbers of simultaneous failures in the
future. The Federal Reserve was established in 1913 in the aftermath of
sharp jumps in the number of bank failures in 1894 and 1907 in order to
increase flexibility in the system. The Fed was to facilitate the flow
of bank reserves from capital surplus to capital deficient areas, to
provide micro-liquidity through the discount window to individual
solvent banks experiencing temporary liquidity problems, and to provide
macro-liquidity to the banking system by offsetting outflows of currency
and gold. For whatever reasons, not 20 years after it was established,
the Fed failed to achieve these objectives sufficiently to prevent the
banking crisis of the 1930s, which was far larger, longer, and costlier
than any banking crisis before the establishment of the Fed. Indeed, the
Fed appears to have introduced greater rigidities at the time of the
Great Depression, e.g., prohibiting the issuance of clearing house
certificates and making temporary bank suspensions more difficult, than
existed before its establishment. 2
In large part as a result of the Fed's failure to
prevent a recurrence of large-scale bank failures, the FDIC was
established in 1934. While the Fed's decisions to provide liquidity to
the banking system in order to offset depositor runs into currency were
discretionary, the FDIC operated by rules that effectively eliminated
the need for bank runs by unconditionally guaranteeing the par value of
insured deposits regardless of the bank's financial condition. This
objective was quickly realized and, combined with a more cautious set of
bankers and more restrictive regulations imposed by the Banking Act of
1933, the number of bank failures dropped equally quickly and remained
low for the next 50 years. However, as was true of the Federal Reserve's
structure, flaws eventually appeared in the FDIC that in time led to
increases in bank failures that matched the conditions in the 1930s
before the introduction of deposit insurance.
III. The S&L Debacle3
Savings and loan institutions are traditional
residential mortgage lenders. Before the introduction of deposit
insurance in 1934, S & Ls made primarily intermediate
three-to-five-year renewable mortgage loans. These loans were
effectively variable rate mortgages with sizeable down payments. They
were financed by time deposits (legally labeled share capital), which
were not necessarily redeemable on demand. As a result, neither the S
& Ls' interest rate nor liquidity exposures were very great.
But things changed dramatically after 1934. Public
policy encouraged S & Ls to make progressively longer-term (first
20, then 25, and finally 30-year) fixed-rate mortgages with
progressively smaller down payments. At the same time, the new deposit
insurance program effectively increased the liquidity and shortened the
maturity of their deposits. These changes increased the institutions'
exposure to interest rate and liquidity risk. Indeed, the large degree
of maturity (duration) mismatch by the mid1970s made the industry a
disaster waiting to happen.
When interest rates increased sharply in the late 1970s
as a result of inflation, the disaster occurred. Between 1976 and 1980,
interest rates on three-month Treasury bills jumped from 4 percent to 16
percent and those on long-term Treasury securities from 6 percent to 13
percent. By 1982, an estimated 85 percent of all S & Ls were losing
money and two-thirds were economically or market value insolvent so
that, ceteris paribus, they would be unable to pay their depositors in
full and on time. The negative economic net worth of the industry and
the corresponding loss to the FSLIC was generally estimated to be about
$100 billion, 4 although some estimates placed it as high as
$150 billion. This figure represents the difference between the par
value of deposit accounts (the large majority of which were less than
the maximum insured $ 100,000 per account) at insolvent institutions and
the market value of the S & Ls' assets. But the FSLIC resolved only
a very small number of the insolvencies for a number of reasons,
including: 5
* It was overwhelmed by the large number of
insolvencies, and its staff was far too small and unprepared to deal
with the crisis,
* It had insufficient reserves to cover the deficits at
insolvent institutions and pay off depositors at par, whether the
institutions were sold, merged or liquidated,
* Formal recognition of the large losses would be a
black mark on the agency's record,
* Formal recognition of the large losses and number of
insolvencies might spread fear among the public and ignite a run on all
institutions that would spill over to commercial banks and even beyond
to the macro-economy. Further,
* Many of the losses were "only" unrecognized paper
losses; and, because interest rates are cyclical and there was a high
probability that they would decline again in the not very distant
future, it was hoped that waiting would restore the associations to
economic solvency.
Therefore, regulators publicly denied the magnitude of
the problem, argued that the problem was a liquidity rather than a
solvency problem, introduced creative accounting measures to make the
industry's net worth appear higher even than the already overstated book
value levels (i.e., they covered up the evidence), delayed imposing
sanctions on insolvent and near-insolvent institutions, and encouraged
institutions to reduce their interest rate exposure by using newly
permitted variable-rate mortgages and shorter-term loans to reduce their
maturity mismatch. And the regulators and the industry lucked out.
Interest rates declined sharply from 1982 through 1986. This reversal in
rates caused the industry's net worth to rise and by 1985 its estimated
negative net worth was only about $25 billion and was expected to
improve further, ceteris paribus.
But ceteris did not remain paribus for many
institutions. A substantial number incurred increases in credit risk
that offset the decline in interest rate risk and either prevented their
net worth from increasing greatly or actually caused it to decline
further. The assumption of credit risk was either unintentional, arising
from severe local and regional economic recessions, or intentional,
arising from calculated gambles to regain solvency.
The first and most severe regional recessions started
in the mid-1980s in Texas and the neighboring energy-producing states in
the Southwest following the collapse of world oil prices. This area had
experienced a strong economic surge based on sharply rising oil prices
and expectations of continued price increases. Employment, income, and
real estate values all increased sharply and stimulated both a rapid
immigration of people in search of employment and a building boom,
particularly in commercial real estate. Much of this boom was financed
by local S & Ls. When oil prices not only failed to increase further
after 1981, but declined sharply from $30 a barrel in 1985 to near $10
in 1986, the bubble burst. 6 As incomes and real estate
values dropped, borrowers defaulted on loans, and collateral values fell
too fast for many lending S & Ls to protect the value of all their
loans. As a result, many S & Ls became insolvent.
At the same time, a number of institutions,
particularly those that had only recently converted from mutual
ownership (which was the prevailing form of ownership) to stock
ownership in order to raise additional capital more easily, became
tempted to "gamble for resurrection." Because these institutions had
little if any market value capital of their own to lose, this was a
logical strategy. If the high-risk bets paid off, the institution won
and possibly regained solvency. If the institution lost, the FSLIC bore
the loss. That is, heads the institution won, tails the FSLIC lost! Some
S & Ls placed progressively larger bets on the table by offering
above market interest rates on deposits so that their deposit size grew
rapidly. Such gambling was often accompanied by fraud, either ex-ante
deliberate or ex-ante inadvertent through excessive carelessness in
extending and monitoring loans. Particularly at the more rapidly growing
associations, loan documentation was frequently incomplete or even
nonexistent, record keeping casual at best, and loan collection was
sporadic and done with little enthusiasm. Some of the new owners were
land developers, who are gamblers almost by nature. They used greatly
over-inflated values of their personal properties as the base for their
institution's capital, and the resources of the institution as their
personal "piggy banks" to finance their ventures. Losses were often not
recognized on the institutions' books on a complete or timely basis, so
that the institutions gave false appearances of solvency.
The National Commission appointed in 1992 to identify
and examine the origins and causes of the S&L debacle concluded
that: "It is difficult to overstate the importance of accounting abuses
in aggravating and obscuring the developing debacle. It would have been
difficult for the process to continue for so long in the absence of an
information structure that obscured the extent of the mounting
losses.?7 The FSLIC economic deficit (computed as the
difference between the par value of insured deposits at economically
insolvent S & Ls and the market value of their assets), which had
declined from some $100 billion in 1982 to near $25 billion in 1985,
climbed back up to above $100 billion in 1989, almost entirely due to
losses from credit risk exposure.
Commercial banks were not as badly hit by the interest
rate increase in the late 1970s because the maturities on the two sides
of their balance sheets were not as mismatched. But, like the S &
Ls, they experienced large credit losses in the mid and late 1980s that
resulted in the largest number of bank failures since the 1930s and the
second largest number in U.S. history. These losses threatened to
bankrupt the FDIC.
IV. Structured Early Intervention and Resolution and Deposit
Insurance Reform
The S&L and bank problems were in large part caused
by deposit insurance. The structure of deposit insurance adopted in 1933
had both good and bad aspects. The good aspect effectively prevented a
system-wide run from deposits into currency by guaranteeing the par
value of most deposits. Thus, it prevented the type of reserve drain
experienced in the United States in the early 1930s.
The bad aspects were, first, that this guarantee
reduced, if it did not eliminate, the incentive for many depositors to
monitor the financial performances of their banks and thus encouraged
both a moral hazard problem for banks and a principal-agent problem for
regulators. Bank managers/owners, knowing that few if any depositors
were looking over their shoulders and that their insurance premiums were
not scaled to their risk exposure, deliberately or inadvertently assumed
greater risks either by increasing the credit and interest rate risk
exposures in their portfolios and/or by decreasing their capital-asset
ratios more than they would have in the absence of insurance. Bank
regulators, knowing that most depositors had little if any incentive to
flee financially troubled banks, were then able to delay imposing
sanctions on troubled institutions and even resolving insolvent
institutions, thereby keeping them in operation. To the extent that
these institutions increased their losses, the regulators' principals -
healthy, premium-paying institutions and taxpayers - were not well
served.8
In an attempt to solve the problem, Congress at
year-end 1991 enacted the FDIC Improvement Act (FDICIA), which focuses
on structured early intervention and resolution (SEIR). SEIR reforms
deposit insurance by attempting to impose on insured depository
institutions the same conditions that the private market imposes on
firms not covered by federal insurance whose financial condition is
deteriorating, including conditions that the banks themselves impose on
their borrowers. Moreover, it attempts to resolve troubled institutions
before their own capital turns negative. Thus, losses would accrue only
to shareholders, not to depositors, and deposit insurance would
effectively be redundant.
SEIR's objective is also to reduce the discretion of
regulators by imposing more specific rules, thus reducing the power of
regulators. As such, it resembles the partial replacement of Federal
Reserve discretion by FDIC insurance rules following the Fed's failure
to prevent the banking crisis and economic depression of the early
1930s.9 To protect their power, the regulators successfully
fought to weaken many of the provisions reducing their discretionary
authority during the legislative processing leading to the enactment of
FDICIA and continued to weaken the potential effectiveness of the Act
further by drafting weak regulations to implement it.10
V. The Lesson
An analysis of the experience of the U.S. banking
debacle of the 1980s suggests that to minimize the moral hazard problem
federally insured depository institutions should be subjected to the
same conditions imposed by the private market on noninsured firms and
that to minimize the regulators' principal-agent problem the insurer and
other bank regulatory agencies should be required to operate in a
transparent manner, be prohibited from providing forbearance, and be
held fully accountable for their actions and inactions. The major source
of both the instability in the U.S. banking system in the 1980s that
resulted in the exceptionally large number of bank and S&L failures
and the associated large losses was not the private sector but the
public or government sector. The gov- ernment first created many of the
underlying causes of the problem by forcing S & Ls to assume
excessive interest rate risk exposure and preventing both S & Ls and
banks from minimizing their credit risk exposure through optimal product
and geographic diversification and then delayed in applying solutions to
the problem by granting for- bearance to economically insolvent or near-
insolvent institutions. That is, the banking debacle was primarily an
example of government failure rather than market failure.
At the time of the original publication, Dr. Kaufman
was the John Smith Professor of Banking and Finance at Loyola
University Of Chicago, and was Co-Chair of the Shadow Financial
Regulatory Committee. This paper is a shortened version of a longer
paper presented at the International Conference on Bad Enterprise
Debts in Central and Eastern Europe in Budapest, Hungary on June 6-8,
1994. The author is indebted to Herbert Baer (World Bank) and Larry
Mote (Comptroller of the Currency) for helpful comments and
suggestions.
1. A brief history and additional references appear in
George J. Benston, Robert A, Eisenbeis, Paul M. Horvitz, Edward J. Kane
and George G. Kaufman, Perspectives of Safe and Sound Banking,
Cambridge, Mass.: MIT Press, 1986, Chapter 2.
2. Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States 1867-1960, Princeton, N.J.: Princeton
University Press, 1963, Chapter 7.
3. Although savings banks have more in common with
S&Ls than commercial banks, because they were insured by the FDIC
rather than the FSLIC, data on them is included with that for commercial
banks.
4. See Bert Ely, "Savings and Loan Crisis" in David R.
Henderson, ed., Fortune Encyclopedia of Economics, New York: Warner
Books, 1993, p. 72.
5. Edward J. Kane, The Gathering Crises in Federal
Deposit Insurance, Cambridge, Mass.: MIT Press, 1985; The S&L
Insurance Mess: How Did It Happen? Washington, D.C.: Urban Institute
Press, 1989, James R. Barth, The Great Savings and Loan Debacle,
Washington, D.C.: American Enterprise Institute, 1991; George G.
Kaufman, "The Savings and Loan Rescue of 1989: Causes and Perspective"
in George G. Kaufman, ed., Restructuring the American Financial System,
Boston: Kluwer Academic, 1990; George J. Benston and George G. Kaufman,
"Understanding the Savings and Loan Debacle," The Public Interest,
Spring, 1990, pp. 79-95; National Commission on Financial Institution
Reform, Recovery and Enforcement, Origins and Causes of the S&L
Debacle: A Blueprint for Reform-Report to the President and Congress of
the United States, Washington, D.C,, July 1993; Martin Lowy, High
Rollers: Inside the Savings and Loan Debacle, New York, Praeger, 1991;
and Martin Mayer, The Greatest Ever Bank Robbery: The Collapse of the
Savings and Loan Industry, New York: Charles Scribner, 1990.
6. Paul M. Horvitz, "The Collapse of the Texas Thrift
Industry" in George G. Kaufman, ed,, Restructuring the American
Financial System, Kluwer, 1990, pp. 95-116.
7. National Commission, p. 9.
8. Edward J. Kane, "Changing Incentives Facing
Financial-Services Regulators," Journal of Financial Services Research,
September 1989, pp. 265-274 and Edward J. Kane, " 'How Market Forces
Influence the Structure of Financial Regulation" in William S. Haraf and
Rose Marie Kushmeider, eds., Restructuring Banking and Financial
Services in America, Washington, D.C.: American Enterprise Institute,
1988, pp. 343-382.
9. The battle between rules and discretion in banking
regulation resembles the more publicized and longer-run battle between
rules and discretion in the conduct of monetary policy carried on in the
U. S. at least since the 1930s.
10. George J. Benston and George G. Kaufman, "Improving
the FDIC Improvement Act: What WasDoneand What Still Needs to be Done to
Fix the Deposit Insurance Problem" in GeorgeG. Kaufman, ed., Reforming
Financial Institutions and Markets in the United States, Boston: Kluwer
Academic, 1994, pp. 99-120; and Kenneth E. Scott and Barry R. Weingast,
"Banking Reform: Economic Propellants, Political Impediments" in George
G. Kaufman, ed., Reforming Financial Institutions and Markets in the
United States, 1994, pp. 19-36.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
April 1995, Vol. 45, No. 4.
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