The U.S. Banking Debacle Of The 1980s: A Lesson In Government Mismanagement
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 nearinsolvent 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 eeping 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 overinflated 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 systemwide 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' principalshealthy, 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 focusses 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 government 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.
End Notes1 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 Inustry. New York: Charles Scribner, 1990.
6 Paul M. Horvitz, "The Collapse of the Texas Thrift Industry" in George 0. 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 Was Done and What Still Needs to be Done to Fix the Deposit Insurance Problem" in George G. 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.
George G. Kaufman is the John Smith Professor of Banking and Finance at Loyola University of Chicago, and is 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. The Foundation for Economic Education (FEE), one of the oldest free-market organizations in the United States, was founded in 1946 by Leonard E. Read to study and advance the freedom philosophy. FEE's mission is to offer the most consistent case for the "first principles" of freedom: the sanctity of private property, individual liberty, the rule of law, the free market, and the moral superiority of individual choice and responsibility over coercion.
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