Following a decade of neglect, the Bush administration and Congress moved

Transcription

1 Journal of Economic Perspectives Volume 3, Number 4 Fall 1989 Pages 3 9 Symposium on Federal Deposit Insurance for S&L Institutions Dwight M. Jaffee Following a decade of neglect, the Bush administration and Congress moved early in 1989 to resolve the most serious problems yet to confront federal insurance of U.S. bank deposits. Federal deposit insurance was introduced to eliminate the bank runs of the Great Depression: the FDIC (Federal Deposit Insurance Corporation) was created in 1933 to insure commercial bank deposits and the FSLIC (Federal Savings and Loan Insurance Corporation) was created in 1934 to insure savings and loan association (S&L) deposits. 1 Success was immediate; the bank runs stopped as soon as deposits were federally insured. Federal deposit insurance then continued to operate successfully for almost the next 50 years, until about During this period, few institutions failed and bank runs did not develop. The situation changed dramatically during the 1980s. The FDIC suffered major losses as a result of bank failures due to bad energy and agricultural loans, while failing loans to foreign borrowers (mainly in Latin America) threatened even greater losses. For the FSLIC, rapidly rising interest rates during the late 1970s and early 1980s initiated serious problems. Because the S&Ls held mainly long-term and fixed-rate mortgages, the rising rates created capital losses that were large enough to wipe out the net worth of the S&L industry. Even after interest rate levels fell in the mid-1980s, FSLIC losses continued to escalate. 1 More specifically, there are four categories of U.S. depository institutions: commercial banks, savings and loan associations, savings banks, and credit unions (with the last three often referred to as "thrift" institutions). Savings banks can be insured by either the FSLIC or the FDIC. Credit unions now have their own federal insurance agency. Dwight M. Jaffee is Professor of Economics, Princeton University, Princeton, New Jersey.

2 4 Journal of Economic Perspectives Table 1 Commercial Banks Closed Due to Financial Difficulties Data that reflect the initial success and later failure of federal deposit insurance are shown in Tables 1 and 2. Table 1 shows the number of commercial banks closed over time due to financial difficulties. The annual average number of banks closed rose during the early part of the century, with a dramatic peak between 1930 and Then, following the introduction of FDIC insurance in 1933, the number of bank failures declined rapidly, and the number remained low for most of the next 50 years. Banks sometimes even received FDIC insurance premium rebates as a result of the low level of losses. The few failures that did occur, moreover, were mainly the result of theft and petty fraud: managers stealing money from their banks, and the like. The number of bank failures has been higher since 1980, but it still remains well below the level of the early 1930s (in part reflecting the positive contribution of federal deposit insurance). Table 2 shows the comparable available data for savings and loan associations that were closed due to financial difficulties. The same pattern is evident: the number of S&Ls closed is high during both the Great Depression and the 1980s. In fact, the number of S&Ls closed in the 1980s is much closer to the corresponding number for the 1930s than is the case for commercial banks. This is true even though the number of S&Ls in the late 1980s is only about one-quarter the number that existed in the early 1930s. In this symposium, Lawrence J. White and Edward J. Kane investigate the sources and solutions for the federal deposit insurance problems of the 1980s, using the FSLIC and the S&L industry as a case study. The FSLIC provides a more interesting

3 Dwight M. Jaffee 5 Table 2 Saving and Loan Associations Closed Due to Financial Difficulties case study than the FDIC because its problems are more severe and immediate. Indeed, as a result of the S&L failures, the FSLIC is insolvent; its liabilities exceed its assets by an amount estimated to be on the order of $100 billion. In contrast, although commercial bank problems have weakened the FDIC, it remains financially solvent and continues to function normally. Still, the points that are developed here with respect to the FSLIC generally also apply to the FDIC. In examining the sources and solutions of the FSLIC crisis, four questions stand out: How did S&L losses expand so rapidly and unexpectedly? How should the FSLIC be redesigned to avoid a reoccurrence? Who is going to pay for the existing FSLIC losses? What are the future prospects for the S&L industry? Financial Institutions Reform, Recovery and Enforcement Act of 1989 Just as this symposium was going to press, President Bush signed into law the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) on August 9, 1989, the most important legislation in 55 years to affect savings institutions. Most of its main parts are anticipated and discussed in the papers of this symposium. The following summarizes this legislation. The Federal Home Loan Bank Board (FHLBB) is abolished, with a new Office of Thrift Supervision, within the Treasury Department, taking over the FHLBB's regulatory role. The Federal Savings and Loan Insurance Corporation (FSLIC) is

4 6 Journal of Economic Perspectives abolished, with the Federal Deposit Insurance Corporation (FDIC) taking over the FSLIC's insurance role. A new Resolution Trust Corporation (RTC) is given responsibility for dealing with savings institutions placed in conservatorship or receivership after January 1, 1989 (including the sale of $300 billion in real estate owned by failed institutions), and will continue to accept insolvent institutions for three years. The Oversight Board for the RTC includes the Housing and Urban Development Secretary, the Treasury Secretary, and the Federal Reserve Board Chairman. The total cost is estimated at $166 billion through 1999, including $40 billion for last year's rescues, $50 billion to close currently insolvent institutions, $33 billion for future costs, and $43 billion of interest costs. Of the total $50 billion for currently insolvent institutions, $20 billion is treated as on-budget funding, assuming that it is spent before September 30, 1989, to resolve current cases and to reduce the high cost of funds for insolvent institutions. Higher risk-based capital requirements were placed on savings institutions to discourage risky investments. Institutions must meet a 1.5 percent capital-to-loan ratio shortly, and a 3 percent ratio by Both commercial banks and thrift institutions will face higher insurance premiums to offset the program's cost. Bank premiums rise to 15 cents per $100 of deposits from 8 cents, while savings institution premiums rise to 23 cents per $100 from 20.8 cents. Nevertheless, U.S. taxpayers are expected to pay about 75 percent of the total costs of the program. How Did S&L Losses Expand So Rapidly and Unexpectedly? As already explained, most S&Ls faced a negative net worth and net operating losses during 1981 and 1982 as a result of escalating interest rates in the late 1970s and early 1980s. But when interest rates fell in the following years, the industry split into basically two parts. In one part of the industry, the net worth and profit margins recovered as the interest rates fell. These S&Ls are generally still healthy in In the other part, net worth and profits deteriorated further, and these are the institutions that today account for the $100 billion deficit of the FSLIC. The symposium paper by Edward Kane focuses on the activities that created this second group of S&Ls and their $100 billion of losses; he calls them the "zombie" institutions. Kane analyzes their behavior and the FSLIC disaster in terms of a moral hazard problem that was combined with a principal-agent problem. The moral hazard problem concerned the incentive for increased risk-taking by S&Ls with low or negative net worth, a condition that applied to many institutions during the early 1980s. In this setting, if an S&L's high-rate/high-risk loans worked out well, then there was a chance that it could recover its profitability and solvency; whereas if these loans ended in default, then the S&L failed and the FSLIC had to pay the resulting costs. Note in this regard that deregulation legislation provided S&Ls

5 Symposium on Federal Deposit Insurance 7 with substantially expanded lending powers after Some S&Ls used their expanded powers wisely, but others took the high risk strategy. The principal-agent problem concerned the failure of the FSLIC regulators to monitor and control these risk-taking activities of weak S&Ls. Kane argues that Congressmen and FSLIC regulators (the agents) were acting on their own behalf, rather than on behalf of U.S. taxpayers (the principals). The result was that each wave of regulators deferred action, left office, and passed the problem to the next group, which then repeated the process. To offset these moral hazard and principal-agent problems, Kane proposes changes that would force regulators to act promptly in closing insolvent S&Ls; he would also reduce the overall amount of discretion regulators are allowed in such matters. Most importantly, Kane objects to the policy of forbearance allowing insolvent institutions to continue to operate in the hope that they will recover. In Kane's view, forbearance reduces the immediate political costs of dealing with the problems, but it ultimately leads to much higher economic costs. How Should FSLIC Be Redesigned To Avoid a Reoccurrence? The symposium paper by Lawrence J. White focuses on the question of how federal deposit insurance should be redesigned in order to avoid similar crises in the future. White adopts the useful approach of evaluating federal deposit insurance in terms of a list of eight instruments and devices that are generally used by insurance firms. White argues that the FSLIC has depended on only two of these instruments: regulations that attempt to control risk (called "rules of applicability") and fixed net worth requirements (which reduce the FSLIC costs by introducing insurance "deductibles"). He proposes that the FSLIC use its existing instruments more flexibly (such as adding risk-based net worth standards) and that it use a wider set of these instruments (such as relying on subordinated debt to increase private sector monitoring of S&L risk). Most economists are likely to agree with these conclusions. White also considers a set of radical reforms, such as replacing government insurance with private insurance, or providing government insurance only to "narrow banks" that invest in only U.S. Treasury securities. But he believes the radical reforms are neither feasible nor desirable for a number of reasons. For one thing, what institution other than the government could provide complete deposit insurance? For another thing, if S&Ls were required to hold only Treasury securities, who would hold mortgage loans? As a result of such concerns, White prefers to use only insurance reforms, not radical reforms, to avoid future problems. There may be disagreement regarding White's negative conclusions concerning radical reforms. In particular, the mutual fund industry suggests a counterexample in which financial intermediaries operate quite successfully without federal insurance. Specifically, money market mutual funds are generally able to issue fixed-price shares, with the same features as bank deposits except federal insurance, by investing in a

6 8 Journal of Economic Perspectives portfolio of low-risk and liquid securities (such as Treasury bills). 2 Stock and bond mutual funds illustrate an alternative solution, in which the mutual fund's share price varies directly with the value of its portfolio. Investors seem willing to accept this price risk, given that the shares can be readily liquidated at the net asset value. It is also possible to combine White's insurance reforms with the radical reforms. One idea is that S&Ls could offer classes of deposits with different levels of government insurance. The safest class would provide complete federal deposit insurance, with the S&Ls required to maintain perhaps 100 percent Treasury bill reserve backing for these deposits. The yield on these deposits, of course, would be relatively low. Other classes of deposits would then offer more limited amounts of federal insurance (based on deductible limits and coinsurance), but their yields would be higher since the S&Ls could invest these funds in higher return assets. Who is Going to Pay for the Existing FSLIC Losses? Even if federal deposit insurance is redesigned to operate effectively in the future, there remains the practical problem of who is to pay $100 billion to resolve the FSLIC's existing losses. In principle, as one extreme measure, the FSLIC could be declared bankrupt, in which case depositors and other claimants on the FSLIC would suffer an unexpected loss. Perhaps surprisingly, the only legally binding requirement for the federal government to aid the FSLIC is a small line of credit ($750 million) which the Department of the Treasury must provide to the FSLIC. In practice, however, both Congress and the Bush administration have assured depositors that the government will stand behind the FSLIC, and it seems unlikely that this promise will be broken. Given that the FSLIC is to be bailed out, three main groups are available to provide the money: healthy S&Ls, the FDIC (the insurance agency for commercial banks), and U.S. taxpayers. U.S. taxpayers, of course, are ultimately the insurers of last resort. So the question really concerns the extent to which the FDIC or healthy S&Ls should be, or could be, prevailed upon to bail out the FSLIC. This raises issues of both equity and efficiency. In terms of equity, the blame for the FSLIC disaster clearly rests with neither the FDIC nor the healthy S&Ls, but with the FSLIC itself, the failing S&Ls, and exogenous market conditions. There are few precedents, moreover, for asking one group of insured parties (commercial banks or healthy S&Ls) to bail out a failing insurance company because another group of insured parties suffered massive losses. 3 In particular, requiring commercial banks through the FDIC to bail out the FSLIC is tantamount to forcing the banks to bail out their main competitors. Requiring healthy 2 Supplementary private insurance against fraud and related events is sometimes purchased by the mutual funds. 3 The reinsurance facility of Lloyds of London does function in this manner, with the separate insurers providing joint guarantees. It is interesting, however, that Lloyds has recently faced internal battles over these joint obligations.

7 Dwight M. Jaffee 9 S&Ls to bail out the FSLIC creates an incentive for these institutions to operate without insurance (although their charters may not allow them to do so currently). Efficiency arguments also appear to run counter to taxing either the FDIC or healthy S&Ls. For one thing, additional taxes on healthy institutions gives these institutions an incentive to shift to riskier investments in the future whenever a major segment of the industry is weakened. For another thing, many healthy institutions still have inadequate capital, so imposing additional charges on them could have the counterproductive effect of raising the number of failing institutions. What are the Future Prospects of the S&L Industry? Even after the immediate FSLIC crisis is dealt with, there will remain the question of the future status of the S&L industry. In fact, the FSLIC crisis is likely to be a catalyst of change for the S&L industry, speeding up the effects of several fundamental forces that are already in motion. One fundamental force was created by the removal of Regulation Q ceilings on deposit interest rates between 1980 and 1986, which reduced access to low cost deposits and thereby reduced the value of S&L (and commercial bank) charters. Another force is the wave of competitive entry into the mortgage market, which includes the financial subsidiaries of major corporations (such as the General Motors Acceptance Corporation) and commercial banks (such as CitiBank). As a related matter, S&Ls have also replaced their mortgage assets with mortgage-backed securities by using the rapidly expanding secondary market for mortgages. Finally, deregulation has expanded S&L lending powers, so that S&L charters are now actually more liberal than commercial bank charters in terms of allowed activities. The overall effect of these forces is to reduce the need for specialized mortgage lending intermediaries, which has been the traditional role of S&Ls. This does not mean that the unique features of the S&L industry will disappear abruptly: the industry retains a large store of mortgage lending expertise, and this is not likely to be thrown away. But it does mean that the distinctions between S&Ls and commercial banks are already becoming blurred, and that the FSLIC crisis is likely to accelerate this process. References Barth, Feid, Riedel and Tunis, "Alternative Federal Deposit Insurance Regimes," Research Paper #152, Office of Policy and Economic Research, Federal Home Loan Bank Board, January, Brumbaugh, R. Dan, Jr., Thrifts Under Siege. Cambridge: Ballinger Publishing Company, Brumbaugh, R. Dan, Jr., Andrew S. Carron, and Robert E. Litan, "Cleaning up the Depository Institutions Mess," Brookings Papers on Economic Activity, forthcoming. U.S. Department of Commerce, Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Part 2, Washington D.C., U.S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United States 1987, Washington D.C., 1986.

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