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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO JULY 1990 NUMBER 35 Chicago Fed Letter W hat we know about the deposit insurance problem When the final bill is in for the 1980s, the difference between assets and liabilities at insolvent banks and thrifts may well turn out to have been as great a $200 billion—over $2,000 per household. The magni tude of the losses has propelled the debate over deposit insurance re form to the top of the political and regulatory agenda. Economists have argued about de posit insurance reform for many years. For most of that time, their arguments—both pro and con— were based more on theory than on empirical evidence. But events in the financial services industry, espe cially in savings and loans (S&Ls), have now provided the needed em pirical underpinning. Recent re search has further amplified our knowledge of the effects of deposit insurance and the importance of market forces in the regulation of banking. Based on the accumulated evidence, this Chicago Fed Letter asserts several propositions that should form the basis of future debates on deposit insurance. 1. Deposit insurance is different What has become abundantly clear is that deposit insurance is very differ ent from other forms of insurance. With other forms—life, auto, etc.— the insurer has only limited control of risk once the decision to insure and the terms of the contract are set. With deposit insurance, the insurer can control risk. Indeed, losses are only incurred when the insurer has failed to act promptly with the regula tory tools it has at its disposal— par ticularly its power to close an institu tion before, or as soon as, it becomes insolvent. Thus, the costs of deposit insurance can be made arbitrarily small by forcing recapitalization, liquidation, or merger before losses begin accruing to the insurer.1 vent today were also the most insol vent in 1982. This fact suggests, and several studies confirm, that these institutions were engaged in end-ofgame play—going, as it were, for broke. This kind of behavior was made much easier by deposit insur ance and the failure of the regula tory agencies to enforce meaningful capital guidelines. 2. Moral hazard is real The failure—for whatever reasons— of the regulatory bodies to use their preventive tools to avert deposit in surance losses represents, in effect, a subsidy to insolvent and poorly capi talized financial institutions. The availability of this subsidized deposit insurance gives beneficiaries an in centive to increase their expected profits by taking additional risks. This is known as moral hazard. The evidence that moral hazard is an im portant part of the deposit insur ance problem takes several forms. For example, Charles Calomiris found that during the 1920s failure rates for banks participating in staterun deposit insurance schemes were more volatile than failure rates for uninsured national banks. This sug gests that insured banks were taking greater risks than uninsured banks. O ther evidence comes from the thrift industry during the 1980s. Capitaldeficient and insolvent thrifts were the ones most heavily involved in nontraditional activities at that time. What is less well known is that most of these thrifts were already insolvent when they began their expansion into nontraditional activities follow ing the passage of the Garn-St Ger main Act in 1982. Indeed, those institutions that are the most insol <2 2-4 4-6 years insolvent >6 S O U R C E : James Barth. Based on generally accepted accounting principals. Several recent studies suggest that poorly capitalized institutions have actively sought to take additional risk. George Benston and Michael Koehn found that increased empha sis on riskier nontraditional activities by these thrifts resulted in greater stock price volatility. In contrast, shifts toward nontraditional activities by healthy thrifts reduced stock price volatility. This suggests that dis tressed thrifts were acting to maxi mize the value of deposit insurance. Elijah Brewer tested the hypothesis that shareholders of distressed thrifts rewarded additional risk-taking by h h h b h HHHHHHNI |||::||||lillll||||||®|■ I :||||11|||||||||| ■ |i' I: ||||||111|||'|||.§ |§ I11||||I||.|||||§|||I|||||| i I ® | §1 |fgs _ management. He found that the announcem ent of shifts in asset com position toward nontraditional activi ties resulted in a one-time increase in the market value of equity for dis tressed institutions but had no effect on healthy institutions. This suggests that the shareholders encourage moral hazard by rewarding actions that raise the value of the insurance subsidy. The evidence of moral hazard in banking is weaker than it is in S&Ls, perhaps because only a small portion of the industry has been insolvent at any one time. However, there is evi dence that the same factors are at work. Gregory Gajewski used a fail ure prediction model to identify 600 small banks that were “ persistently vulnerable” to failure. A third of these 600 banks displayed the same rapid growth of assets that has been associated with end-of-game play in the thrift industry. ...................................................................................... : oped countries (LDCs). Also during the 1980s, Congress gave preferential treatm ent to small agricultural banks facing capital problems. The final piece of evidence is that the banking system is incurring more losses today, when it is shielded from the market by deposit insurance and forbearance, than it did prior to the creation of federal deposit insurance. Losses per dollar of deposits are higher today than in the 1930s. This is particularly striking because GNP fell 30% in the early 1930s while it rose during the 1980s by 28%. (See Figure 2.) One could argue that the 1920s pro vide a more relevant comparison. And here the contrast is even more striking. Loss rates during the 1920s were about 0.1% of all deposits while in the last half of the 1980s they were about 0.7% of all deposits. 4. Market forces are valuable 3. Forbearance is costly Allowing an insolvent financial insti tution to remain open is known as forbearance. Deposit insurance cre ates a climate that fosters forbear ance. Those who stand to lose from closures—stockholders—can apply great political pressure to regulators. Regulators themselves may be reluc tant to admit that banks under their supervision need to be closed. Dur ing the 1920s, for example, Nebraska regulators perm itted some insolvent banks to operate for 10 years before they were closed. Forbearance was endemic in the thrift industry during the 1980s. James Barth, former research direc tor for the Federal Home Loan Bank Board, reports that 45% of the thrifts that were insolvent in 1988 had been insolvent for four or more years. (See Figure 1.) During the 1980s, forbearance has also occurred in commercial bank ing. Bank regulators did not force commercial banks to reflect fully their losses on loans to less devel Market participants do not necessar ily have better information. How ever, they have different incentives to make use of the information they do have. Depositors at uninsured banks have an incentive to run as soon as they have doubts about the condition of the bank. In this environment, forbearance is more difficult to achieve. With deposit insurance in force, however, the closure decision becomes entirely a regulatory event. The elimination of uninsured credi tors also has political implications. When uninsured creditors are pres ent, effective forbearance merely redistributes money from these credi tors to shareholders. For every shareholder who benefits from for bearance, there will be an uninsured creditor who loses. Thus, forbear ance generates few benefits for poli ticians or regulators. With the elimi nation of creditor discipline, the only market influence left is from share holders. The goal of the sharehold ers of an insolvent bank is simple—to keep the bank open as long as pos sible. To do so, shareholders will lobby anyone and everyone in sight. The result is greater forbearance and a more costly deposit insurance sys tem. Deposit insurance reforms that restore creditor discipline will be doubly effective because they will also restore political discipline. 5. Banks— and regulators— need sensible, explicit directives One of the reasons the current sys tem has broken down is that regula tors have, rightly or wrongly, been so concerned about deposit runs that they have been unwilling to perm it uninsured depositors to suffer losses. But, lowering insurance limits will not be sufficient to restore creditor discipline. Congress must either explicitly tell regulators that it wants these losses imposed, or Congress and regulators must find a way to restore creditor discipline without relying on deposit runs. Indeed, the experience of the 1980s has shown that at least some creditors of large institutions can be penalized without creating spillover to the rest of the system. The best support for this proposition comes from our experience in Texas. Creditors at several large Texas holding compa nies suffered significant losses during the 1980s. The systemic effects of this have been minimal. Clearly, if the notion that some banks are too-bigto-fail has any implications, they are about who in the private sector should bear losses, not whether or not the losses should be borne by the private sector. This suggests that proposals to place the primary bur den of creditor discipline on subordi nated creditors,2 on private insurers, or on mutual guarantee systems may be more compatible with regulator’s incentives, and hence more useful, than a proposal to simply adhere to dejure insurance limits. How can the regulatory system pro mote rapid closure? The SEC’s regu lation of broker dealers provides an example. Minimum capital require ments, market-value accounting, uninsured debt, “ haircuts,” and a turing insolvent institutions. Second, there ceased to be a political con stituency interested in seeking the rapid closure of insolvent institu tions. This led to delays in closing insolvent institutions and in turn cre ated a serious moral hazard problem. _________: ----------------------------------losses as a percent of all deposits A /\ / \ a.O 1Q / 4O 1 J 06 S ^ ------------------------ --------------------------0.0 , 1922 1978 ‘23 79 ’24 ’80 *25 ’81 f J 1 2 -3 92 3 \ 11978-89 ____1 ________1 ________1 ________ 1 ________1 ________ 1 ________ 1 ________1 ________ ’33 ’28 ’29 ’30 ’31 ’32 ’26 *27 '89 ’84 ’85 ’86 '87 '88 ’83 82 S O U R C E : Bert Ely, Ely and Company., Inc. closure rule that shuts firms down while they still have positive capital work together to control losses aris ing from asset portfolios that are much more volatile than those held by banks. Similar systems are em ployed by futures clearinghouses to regulate clearing members. It is interesting to note that, despite the risky nature of the business they con duct, no clearing member of the Chicago Board of Trade or the Chi cago Mercantile Exchange has ever failed. Bank regulators would do well to study these sorts of systems more closely than they have. Why the difference between the two industries? As noted earlier, BHC creditors have sustained substantial losses. Because creditors will be at risk, BHCs’ subsidiaries will not be able to fund themselves unless they make prudent investments. In this case, firewalls perform the vital func tion of keeping nontraditional activi ties from being funded with insured deposits. The lesson is clear: With creditor discipline, expanded powers are beneficial. Without creditor dis cipline they are a disaster. 6. Reform should precede new powers The heavy losses suffered by insol vent banks and thrifts during the 1980s make clear the im portant role that the closure decision plays in con trolling the cost of deposit insurance. Had creditors or regulators closed down these institutions as soon as their condition had become imper iled, the losses to the deposit insur ance funds would have been much smaller. However, the governm ent’s dejure and de facto guarantees elimi nated depositor incentives to with draw funds from capital deficient and insolvent institutions. When high-risk activities can be funded with artificially cheap insured deposits, expanding banks’ powers only serves to broaden the opportu nities for bank risk-taking. However, with proper restrictions in place, expanded powers can be beneficial. In another study, Brewer examines the impact of expanded powers on bank holding companies. The find ings are instructive. In contrast to the thrift experience, Brewer finds that nontraditional activities were risk-reducing for all holding compa nies and were most beneficial for holding companies that initially had the greatest risk of failure. These developments underline the crucial role that creditor discipline plays in controlling risk-taking. They also suggest that deposit insurance reforms that fail to create a private sector constituency for prom pt clo sure begin their operations with a possibly fatal flaw. If legislators and regulators wish to avoid failure of future deposit insurance systems, it is im portant that creditor discipline be reintroduced and that regulators have an incentive to permit that disci pline to work. —H erbert L. Baer ^ e n s t o n , G e o rg e J., R o b e rt A. E isenbeis, P aul M. H orvitz, E dw ard J. K ane, a n d G e o rg e G. K aufm an, Perspectives on Safe and Sound Banking: Past, Present, and Fu ture, C a m b rid g e , Mass.: M IT Press, 1986. 2See, fo r in sta n c e , Silas K eehn, B anking on the Balance: Powers and the Safety net, F e d e ra l R eserve B an k o f C hicago, 1989. Conclusion This loss of creditor discipline had two consequences. First, the govern m ent regulators were forced to bear the entire responsibility for restruc Karl A. S cheld, S en io r Vice P re sid e n t a n d D irecto r o f R esearch; David R. A llardice, Vice P re sid e n t a n d A ssistant D irecto r o f R esearch; E dw ard G. N ash, E ditor. Chicago Fed Letter is p u b lish e d m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o r s ’ a n d are n o t necessarily th o se o f th e F ed eral Reserve B ank o f C hicago o r th e F ed eral R eserve System. A rticles m ay be re p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is p ro v id ed w ith copies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t ch arg e fro m th e Public In fo rm a tio n C e n te r, F ed eral Reserve B ank o f C hicago, P.O. Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 After rebounding in February and March from January’s depressed auto production levels, manufacturing activity in the Midwest dropped sharply (down 1.8%) in April. Most industries experienced the decline, led by trans portation equipm ent and primary metals. Only industries in the chemical sector continued to expand in April. Nationally, manufacturing activity de clined 0.3%. The pattern in manufacturing activity is being heavily influenced by auto production. Auto production dropped to a 4 million unit annual rate in January, from over a 7 million rate at the end of 1989. After rebounding to a 7 million unit rate in March, production dropped again to a 6 million rate. Chicago Fed Letter FEDERAL RESERVE BANK OF CHICAGO Public Information Center P.O. Box 834 Chicago, Illinois 60690 (312) 322-5111 11 3S10 NANCY AHLSTROM RESEARCH CHI N O T E: T h e MMI a n d th e USMI are co m p o site in d ex es o f 17 m a n u fa c tu rin g in d u stries a n d are deriv ed fro m e c o n o m e tric m o d els th a t estim ate o u tp u t from m o n th ly h o u rs w o rk ed a n d kilow att h o u rs data. F or a discussion o f th e m eth o d o lo g y , see “R eco n sid erin g th e R egional M an u fac tu rin g In d e x e s,” Economic Perspectives, F ed eral Reserve B ank o f C hicago, Vol. X III, N o. 4, Ju ly /A u g u s t 1989.
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