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May 15, 1989 • Conclusion The current thrift-industry debacle will • 1. See James Barth and Michael Bradley, ward Kane, The Gathering Crisis in Federal be expensive to resolve. Of the estimated $124 billion needed to resolve the crisis, at least $40 billion to $60 billion will come directly from the taxpayer. "Thrift Deregulation and Federal Deposit In- Deposit Insurance, Cambridge, MA: MIT With this commitment of taxpayer money should come a reexamination of the objective of the deposit-insurance system and far-reach ing reforms in its design so that a crisis of the current magnitude is not repeated. Any changes to the deposit-insurance mechanism should be made with a clear understanding of the associated costs and benefits. Society needs to be more aware of the size and value of govemment guarantees, like deposit insurance, and the public should make strenuous efforts to ensure that the costs of providing these guarantees do not exceed the benefits. Footnotes surance," Journal of Financial Services Re- Press, 1985, chapter 3. search, vol. 2 (1989-forthcoming). 7. The failure-resolution JUL policies of the 2. The $124 billion includes $50 billion for FDIC and FSLIC are the process through prior case resolutions and $74 billion for which implicit guarantees are issued to un- restructuring insolvent thrifts. The $ I24 bil- insured depositors, general creditors, subor- lion estimate does not include financing costs dinated creditors, and even stockholders. For of $8 I billion ($150 billion) if the spending a discussion of FDIC failure-resolution is financed over 10 (30) years at current policies, see Daria Caliguire and James market interest rates. See Barbara Pauley, 'The Thrift Reform Program: Summary and Thomson, "FDIC Policies for Dealing with Implications," New York: Salomon Brothers, Commentary, Federal Reserve Bank of April 1989. Cleveland, October I, 1987. 3. See Edward Kane, The Gathering Crisis 8. See Arthur Okun, Equality and Efficiency: The Big Tradeoff, Washington, D.C.: The in Federal Deposit Insurance, Cambridge, eCONOMIC t.tBeO~MeNTaRY 6. For a discussion of this point, see Ed- \ MA: MIT Press, 1985, chapters 5 and 6; and Brookings Institution, 1975. 9. One feature of the original Bush administration proposal is uniform capital re- Urban Institute, 1989. quirements for banks and thrifts by June 4. Some economists question whether 1991. The Bush administration has indicated federal deposit insurance is needed at all. to the Congress that it will veto any legisla- After all, the liabilities of other financial tion for resolving the thrift-industry crisis intermediaries are neither explicitly nor that waters down this provision. by James B. Thomson T he dramatic rise in interest rates during the late 1970s and early 1980s wreaked havoc on the balance sheets of savings and loan (thrift) institutions. As their cost of funds rose above what they could earn on their asset portfolios, implicitly guaranteed by the federal govern- Policymakers should consider depositinsurance reforms in the context of the overall evolution of the financial services industry and also in the context of other regulatory reforms. The result should be a deposit-insurance system with modest, well-specified objectives that are easy to understand and administer. With this in mind, federal deposit insurance should be structured in a fashion that accomplishes its goals with minimal disruption of market forces. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, Address 0" ment. Many of these institutions compete head-on with banks and thrifts for funds and provide many of the same services as insured James B. Thomson is an assistant vice presi- depository institutions. dent and economist at the Federal Reserve S. This role for deposit insurance is the motivation for the safe-bank proposals of Litan and others. See Robert Litan, What Should Banks Do? Washington, D.C.: The Brookings Institution, 1987. thrift institutions began to lose billions of dollars. By the end of 1982, 237 thrifts (with $67.8 billion in assets) in- Bank of Cleveland. The author would like to sured by the Federal Savings and Loan Insurance Corporation (FSLlC) were insolvent by generally accepted accounting principles (GAAP). I thank William Osterberg, Mark Sniderman, and EJ. Stevens for helpful comments and suggestions. The views stated herein are those of the is estimated at more than $124 billion? Furthermore, approximately 500 additional thrifts are above normal risks for failure. The expected future cost associated with these failures is not included in the FSLlC loss estimates. In contrast, the fund of the Federal Deposit Insurance Corporation (FDIC) remains solvent, despite having eroded in this decade under the pressure of record bank failures and an increase in failure-resolution costs. In 1988, the FDIC experienced its first loss in the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. BULK RATE U.S. Postage Paid The initial response of Congress and the Federal Home Loan Bank Board to post-Depression era, as the book value of its fund balance shrank from $18.3 the thrift crisis was a policy of capital forbearance. Capital requirements were billion to $14.1 billion. Academic economists and private banking relaxed for the industry as a whole, and insolvent and capital-deficient thrifts were allowed to operate because if in- analysts estimate the real value of the fund as being significantly less. In fact, terest rates declined, the institutions stood a chance of recovering. Cleveland.Dfl Permit No. 385 This policy of capital forbearance entailed a high degree of risk. By buying 44101 Correction , Economic Principles and Deposit- Insurance Reform Failed and Troubled Institutions," Economic Edward Kane, The S&L Insurance Mess: How Did It Happen? Washington, D.C.: The i I 3 2 ~e~~\al\las~;ve Bank of Cleveland Requested: Please send corrected mailing label to the above address. the private group known as the Shadow Financial Regulatory Committee estimates that the true reserve balance of the FDIC fund, net of estimated unbooked losses, is only $400 million. time to deal with the insolvency prob- On February 6, 1989, the Bush ad- lem, the ultimate cost of resolving the problem could have become smaller. Unfortunately, the outcome was disappointing, as both the number of insol- ministration announced a plan for resolving the thrift crisis that includes provisions to recapitalize the insolvent FSLlC and to close nearly 500 savings vent institutions and the cost of resolving these insolvencies rose through the end of 1987 (see table 1). and loan institutions that are currently insolvent or in danger of failing. The Bush plan also contains provisions for strengthening the FDIC's fund. By late 1988, nearly 500 thrifts were either GAAP-insolvent Material may be reprinted provided that or in danger of failing. The cost of closing, reorganizing, or recapitalizing these institutions the source is credited. Please send copies of reprinted materials to the editor. ISSN 0428-1276 Conspicuously absent from this proposal are fundamental reforms to The current system of federal deposit insurance subsidizes risk-taking by depository institutions, resulting in increased failure-resolution costs and decreased efficiency for the entire financial system. Reforms to the deposit-insurance system should consider both the policy objectives and the attendant economic consequences and costs of deposit guarantees. the federal deposit-insurance system runs. Some economists believe that an tions achieves the same result with that would help prevent another such crisis~ Numerous proposals for deposit-insurance reform have been advanced. The purpose of this Economic individual bank run can become contagious and result in a run on the entire banking system. If so, deposit insurance could remove or reduce the in- greater efficiency. Furthermore, as in the case with systemic bank runs, a properly functioning lender of last resort could immunize other banks Commentary is to examine the fundamental economic principles that should be used in evaluating these reform proposals. centives for bank runs and thus stabilize the banking system. fects of a single bank failure. A rational bank run is one that occurs because depositors have good informa- Clearly, the type of deposit-insurance system we should adopt depends criti- tion that their depository institution has (or may) become insolvent. This type of cally on our goals. For example, if the purpose of deposit insurance is to protect the savings and transactions balances of informationally disadvantaged • The Purpose of Deposit Insurance What are the policy objectives of deposit insurance? Are depository institutions special in some way that requires that they have access to federal deposit guarantees, or are they simply special because they have access to these guarantees? While often ignored, these fundamental questions are important because different objectives for deposit insurance could correspond to different methods of implementing a deposit-insurance system." One widely cited justification for federal deposit guarantees is the need to protect the savings and transactions balances of small savers. If small depositors lack the sophistication and resources to monitor the condition of their banks effectively (and the resources to absorb unpredictable losses), then perhaps their accounts should be safeguarded -,Deposit insurance is but one of many ways to achieve this. It has also been argued that federal deposit insurance is needed to improve the informational efficiency of the financial sector. If it is relatively costly for some depositors to evaluate the condition of their depository institution, then it might be more efficient to have run should not be contagious, and in fact should act as a form of market discipline on bank management. An irrational bank run is one that occurs because poorly informed depositors mistakenly believe that their depository institution has (or may) become insolvent. If the primary purpose of a deposit-insurance system is to prevent irrational bank runs, then the system bined efforts of a mass of small depositors. However, federal deposit insurance is not needed to lower information costs. These costs could be reduced simply by having an agency collect and disseminate information protect the payments system, then the type of account insured is more important than the amount of explicit coverage. For example, consumer and tificates of deposit would receive no, or only nominal, coverage. sacrificed to remove the potentially destabilizing effects of irrational bank runs. Once again, however, deposit insurance is not the only solution. A properly functioning lender of last resort can prevent irrational bank runs from becoming systemic bank runs by providing liquidity to solvent institutions experiencing runs, thus removing the destabilizing effects of irrational bank runs without precluding rational bank runs on insolvent institutions. savings and investment vehicles such as money market deposit accounts and cer- • Economic Consequences and Costs of the Current DepositInsurance System The estimated $124 billion needed to resolve the thrift crisis is just the direct monetary cost of our current system of federal deposit guarantees. Other economic consequences and costs include an overinvestment in risky assets and the subsidization of depository institutions on the basis of risk and size. In fact, perverse incentives built into these subsidies contributed significantly to the current thrift crisis. Without meaningful reforms to the deposit-insurance The need to protect the nation's payments system is the fourth reason often cited to justify federal deposit guarantees.I According to this view, a mechanism, there are strong incentives for this situation to be repeated. default on the payments system could As presently priced and administered, federal deposit insurance subsidizes be triggered by the failure of a large bank, leading other banks to become insolvent. By guaranteeing the payments- risk-taking by depository institutions in two ways. First, the FDIC and FSLIC provide a risk-related subsidy to all in- related liabilities of banks, deposit in- sured depository institutions. Second, A third motive for federal deposit in- surance immunizes the payments system from bank failures. An objection to this view is that providing direct insured institutions that are safe and well-managed subsidize the risk-taking behavior of the "high-fliers" of the in- surance is t9 prevent destabilizing bank guarantees of payments-system dustry." In both cases, the amount of without guaranteeing deposits. transac- Year Number of GAAPInsolvent Thrifts FSLlC Loss Exposure (in billions $) Assets (in billions $) 1982 237 $ 67.8 $ 3.08 1983 293 83.9 4.98 1984 445 115.5 16.89 1985 470 138.0 22.14 1986 471 137.2 33.76 1987 520 200.1 SOURCE: Edward Kane, The S&L Insurance Mess: How Did II Happen' stitute, 1989, table 3·6. 69.51 Washington. D.C.: The Urban In- the risk-related subsidies increases with the degree of risk assumed by the institution and leads to an overinvestment in risky assets in the economy. Currently, the failure-resolution policies of the FDIC and FSLIC have resulted in a system of federal deposit insurance that is biased in favor of large institutions.7 For example, the FDIC has never liquidated a bank with more than $600 million in assets, thereby providing de facto 100-percent insurance for all depositors in such institutions, On the other hand, small banks have been Some have argued for government interference into markets on equity grounds.f Equity can be used to justify federal deposit insurance if it corrects biases or favoritism existing in the absence of deposit insurance. Because equity is a relative concept, we typically judge the equity of a proposal relative to the market outcome. For a deposit-insurance system to be equitable, it must treat all financial institutions alike. As discussed earlier, the current system of federal deposit insurance is not equitable because the liquidated routinely, and some uninsured depositors in these institutions have suffered losses. This perceived as- failure-resolution policies of the FDIC and FSLIC are biased in favor of large depository institutions. A second ex- surance against liquidation has given large depository institutions a competitive advantage over small ones in issuing large, uninsured deposits. ample of the inequity of the current system is in the area of capital regulation. If capital is costly to obtain, then the equity criterion implies that all insured • Using Economic Principles to Evaluate Reform Proposals institutions should be subject to the same set of regulations as a condition for receiving federal deposit guaran- Equity and efficiency are the two basic principles economists apply when evaluating programs such as federal deposit insurance, The concepts of equity and efficiency must be considered in the context of both depositinsurance objectives and the regulatory and market structure of the insured industry. Because a trade-off can exist between equity and efficiency, the "best" deposit-insurance system may not rank as the top proposal in terms of either criterion alone, tees. For instance, if a minimum capital ratio is specified as a condition for receiving deposit guarantees, then all insured institutions should be subject to the same capital requirements. creditors, and equity-holders when those banks fail. Each class of claimants on the bank's assets should receive the same treatment irrespective of the size, location, or type of insured institution. Otherwise, the presence of deposit insurance changes the relative cost of funds and equity capital across institutions. Efficiency is the second criterion by which deposit-insurance reforms should be judged. Economists are usually concerned with allocative efficiency; that is, how close the resource allocation under each proposal is to some perceived optimal, yet usually unattainable, resource allocation. limit of $100,000. On the other hand, if the purpose of deposit insurance is to Unfortunately, deposit-insurance the monitoring performed by a centralized agency. In addition, a centralized agency is likely to have lower information costs than the total cost of the com- small savers, then the coverage necessary is less than the current explicit corporate checking accounts would be fully insured under this motive, while tems cannot differentiate between rational and irrational bank runs. Consequently, the desirable market discipline of occasional rational bank runs is ESTIMATES OF FSLIC LOSS EXPOSURE TO GAAP-INSOL VENT THRIFTS (and the payments system) from the ef- should insure only the deposits of customers who are likely to act on poor information. sys- TABLE 1 How- ever, most thrifts are currently required to hold only half as much capital as banksY Equity also implies that all depositors should be treated equally. That is, there should not be differential treatment across banks of uninsured depositors, The allocative efficiency of each reform proposal cannot be directly observed. However, judgments about the relative efficiency of alternative deposit-insurance systems can be based on the incentives built into each one. From an efficiency standpoint, the incentives built into deposit insurance, through the pricing of the guarantees and the failure-resolution policies of the FmC and FSLIC, should not subsidize risk-taking either through crosssubsidies between depository institutions or through the Treasury (to the extent that the Treasury stands behind the FDIC and FSLIC), The efficiency criterion requires that when circumstances warrant, regulators must allow banks and thrifts (regardless of size) to fail. Failure is the mechanism through which the market corrects persistent and substantial inefficiencies. Failure does not imply that the institution always must be liquidated or otherwise disappear; rather, it means that the owners and management are replaced. As we have found in the thrift industry, the lack of resolve to close institutions when they are insolvent increases the ultimate failure-resolution costs and decreases the efficiency of the financial system. the federal deposit-insurance system runs. Some economists believe that an tions achieves the same result with that would help prevent another such crisis~ Numerous proposals for deposit-insurance reform have been advanced. The purpose of this Economic individual bank run can become contagious and result in a run on the entire banking system. If so, deposit insurance could remove or reduce the in- greater efficiency. Furthermore, as in the case with systemic bank runs, a properly functioning lender of last resort could immunize other banks Commentary is to examine the fundamental economic principles that should be used in evaluating these reform proposals. centives for bank runs and thus stabilize the banking system. fects of a single bank failure. A rational bank run is one that occurs because depositors have good informa- Clearly, the type of deposit-insurance system we should adopt depends criti- tion that their depository institution has (or may) become insolvent. This type of cally on our goals. For example, if the purpose of deposit insurance is to protect the savings and transactions balances of informationally disadvantaged • The Purpose of Deposit Insurance What are the policy objectives of deposit insurance? Are depository institutions special in some way that requires that they have access to federal deposit guarantees, or are they simply special because they have access to these guarantees? While often ignored, these fundamental questions are important because different objectives for deposit insurance could correspond to different methods of implementing a deposit-insurance system." One widely cited justification for federal deposit guarantees is the need to protect the savings and transactions balances of small savers. If small depositors lack the sophistication and resources to monitor the condition of their banks effectively (and the resources to absorb unpredictable losses), then perhaps their accounts should be safeguarded -,Deposit insurance is but one of many ways to achieve this. It has also been argued that federal deposit insurance is needed to improve the informational efficiency of the financial sector. If it is relatively costly for some depositors to evaluate the condition of their depository institution, then it might be more efficient to have run should not be contagious, and in fact should act as a form of market discipline on bank management. An irrational bank run is one that occurs because poorly informed depositors mistakenly believe that their depository institution has (or may) become insolvent. If the primary purpose of a deposit-insurance system is to prevent irrational bank runs, then the system bined efforts of a mass of small depositors. However, federal deposit insurance is not needed to lower information costs. These costs could be reduced simply by having an agency collect and disseminate information protect the payments system, then the type of account insured is more important than the amount of explicit coverage. For example, consumer and tificates of deposit would receive no, or only nominal, coverage. sacrificed to remove the potentially destabilizing effects of irrational bank runs. Once again, however, deposit insurance is not the only solution. A properly functioning lender of last resort can prevent irrational bank runs from becoming systemic bank runs by providing liquidity to solvent institutions experiencing runs, thus removing the destabilizing effects of irrational bank runs without precluding rational bank runs on insolvent institutions. savings and investment vehicles such as money market deposit accounts and cer- • Economic Consequences and Costs of the Current DepositInsurance System The estimated $124 billion needed to resolve the thrift crisis is just the direct monetary cost of our current system of federal deposit guarantees. Other economic consequences and costs include an overinvestment in risky assets and the subsidization of depository institutions on the basis of risk and size. In fact, perverse incentives built into these subsidies contributed significantly to the current thrift crisis. Without meaningful reforms to the deposit-insurance The need to protect the nation's payments system is the fourth reason often cited to justify federal deposit guarantees.I According to this view, a mechanism, there are strong incentives for this situation to be repeated. default on the payments system could As presently priced and administered, federal deposit insurance subsidizes be triggered by the failure of a large bank, leading other banks to become insolvent. By guaranteeing the payments- risk-taking by depository institutions in two ways. First, the FDIC and FSLIC provide a risk-related subsidy to all in- related liabilities of banks, deposit in- sured depository institutions. Second, A third motive for federal deposit in- surance immunizes the payments system from bank failures. An objection to this view is that providing direct insured institutions that are safe and well-managed subsidize the risk-taking behavior of the "high-fliers" of the in- surance is t9 prevent destabilizing bank guarantees of payments-system dustry." In both cases, the amount of without guaranteeing deposits. transac- Year Number of GAAPInsolvent Thrifts FSLlC Loss Exposure (in billions $) Assets (in billions $) 1982 237 $ 67.8 $ 3.08 1983 293 83.9 4.98 1984 445 115.5 16.89 1985 470 138.0 22.14 1986 471 137.2 33.76 1987 520 200.1 SOURCE: Edward Kane, The S&L Insurance Mess: How Did II Happen' stitute, 1989, table 3·6. 69.51 Washington. D.C.: The Urban In- the risk-related subsidies increases with the degree of risk assumed by the institution and leads to an overinvestment in risky assets in the economy. Currently, the failure-resolution policies of the FDIC and FSLIC have resulted in a system of federal deposit insurance that is biased in favor of large institutions.7 For example, the FDIC has never liquidated a bank with more than $600 million in assets, thereby providing de facto 100-percent insurance for all depositors in such institutions, On the other hand, small banks have been Some have argued for government interference into markets on equity grounds.f Equity can be used to justify federal deposit insurance if it corrects biases or favoritism existing in the absence of deposit insurance. Because equity is a relative concept, we typically judge the equity of a proposal relative to the market outcome. For a deposit-insurance system to be equitable, it must treat all financial institutions alike. As discussed earlier, the current system of federal deposit insurance is not equitable because the liquidated routinely, and some uninsured depositors in these institutions have suffered losses. This perceived as- failure-resolution policies of the FDIC and FSLIC are biased in favor of large depository institutions. A second ex- surance against liquidation has given large depository institutions a competitive advantage over small ones in issuing large, uninsured deposits. ample of the inequity of the current system is in the area of capital regulation. If capital is costly to obtain, then the equity criterion implies that all insured • Using Economic Principles to Evaluate Reform Proposals institutions should be subject to the same set of regulations as a condition for receiving federal deposit guaran- Equity and efficiency are the two basic principles economists apply when evaluating programs such as federal deposit insurance, The concepts of equity and efficiency must be considered in the context of both depositinsurance objectives and the regulatory and market structure of the insured industry. Because a trade-off can exist between equity and efficiency, the "best" deposit-insurance system may not rank as the top proposal in terms of either criterion alone, tees. For instance, if a minimum capital ratio is specified as a condition for receiving deposit guarantees, then all insured institutions should be subject to the same capital requirements. creditors, and equity-holders when those banks fail. Each class of claimants on the bank's assets should receive the same treatment irrespective of the size, location, or type of insured institution. Otherwise, the presence of deposit insurance changes the relative cost of funds and equity capital across institutions. Efficiency is the second criterion by which deposit-insurance reforms should be judged. Economists are usually concerned with allocative efficiency; that is, how close the resource allocation under each proposal is to some perceived optimal, yet usually unattainable, resource allocation. limit of $100,000. On the other hand, if the purpose of deposit insurance is to Unfortunately, deposit-insurance the monitoring performed by a centralized agency. In addition, a centralized agency is likely to have lower information costs than the total cost of the com- small savers, then the coverage necessary is less than the current explicit corporate checking accounts would be fully insured under this motive, while tems cannot differentiate between rational and irrational bank runs. Consequently, the desirable market discipline of occasional rational bank runs is ESTIMATES OF FSLIC LOSS EXPOSURE TO GAAP-INSOL VENT THRIFTS (and the payments system) from the ef- should insure only the deposits of customers who are likely to act on poor information. sys- TABLE 1 How- ever, most thrifts are currently required to hold only half as much capital as banksY Equity also implies that all depositors should be treated equally. That is, there should not be differential treatment across banks of uninsured depositors, The allocative efficiency of each reform proposal cannot be directly observed. However, judgments about the relative efficiency of alternative deposit-insurance systems can be based on the incentives built into each one. From an efficiency standpoint, the incentives built into deposit insurance, through the pricing of the guarantees and the failure-resolution policies of the FmC and FSLIC, should not subsidize risk-taking either through crosssubsidies between depository institutions or through the Treasury (to the extent that the Treasury stands behind the FDIC and FSLIC), The efficiency criterion requires that when circumstances warrant, regulators must allow banks and thrifts (regardless of size) to fail. Failure is the mechanism through which the market corrects persistent and substantial inefficiencies. Failure does not imply that the institution always must be liquidated or otherwise disappear; rather, it means that the owners and management are replaced. As we have found in the thrift industry, the lack of resolve to close institutions when they are insolvent increases the ultimate failure-resolution costs and decreases the efficiency of the financial system. May 15, 1989 • Conclusion The current thrift-industry debacle will • 1. See James Barth and Michael Bradley, ward Kane, The Gathering Crisis in Federal be expensive to resolve. Of the estimated $124 billion needed to resolve the crisis, at least $40 billion to $60 billion will come directly from the taxpayer. "Thrift Deregulation and Federal Deposit In- Deposit Insurance, Cambridge, MA: MIT With this commitment of taxpayer money should come a reexamination of the objective of the deposit-insurance system and far-reach ing reforms in its design so that a crisis of the current magnitude is not repeated. Any changes to the deposit-insurance mechanism should be made with a clear understanding of the associated costs and benefits. Society needs to be more aware of the size and value of govemment guarantees, like deposit insurance, and the public should make strenuous efforts to ensure that the costs of providing these guarantees do not exceed the benefits. Footnotes surance," Journal of Financial Services Re- Press, 1985, chapter 3. search, vol. 2 (1989-forthcoming). 7. The failure-resolution JUL policies of the 2. The $124 billion includes $50 billion for FDIC and FSLIC are the process through prior case resolutions and $74 billion for which implicit guarantees are issued to un- restructuring insolvent thrifts. The $ I24 bil- insured depositors, general creditors, subor- lion estimate does not include financing costs dinated creditors, and even stockholders. For of $8 I billion ($150 billion) if the spending a discussion of FDIC failure-resolution is financed over 10 (30) years at current policies, see Daria Caliguire and James market interest rates. See Barbara Pauley, 'The Thrift Reform Program: Summary and Thomson, "FDIC Policies for Dealing with Implications," New York: Salomon Brothers, Commentary, Federal Reserve Bank of April 1989. Cleveland, October I, 1987. 3. See Edward Kane, The Gathering Crisis 8. See Arthur Okun, Equality and Efficiency: The Big Tradeoff, Washington, D.C.: The in Federal Deposit Insurance, Cambridge, eCONOMIC t.tBeO~MeNTaRY 6. For a discussion of this point, see Ed- \ MA: MIT Press, 1985, chapters 5 and 6; and Brookings Institution, 1975. 9. One feature of the original Bush administration proposal is uniform capital re- Urban Institute, 1989. quirements for banks and thrifts by June 4. Some economists question whether 1991. The Bush administration has indicated federal deposit insurance is needed at all. to the Congress that it will veto any legisla- After all, the liabilities of other financial tion for resolving the thrift-industry crisis intermediaries are neither explicitly nor that waters down this provision. by James B. Thomson T he dramatic rise in interest rates during the late 1970s and early 1980s wreaked havoc on the balance sheets of savings and loan (thrift) institutions. As their cost of funds rose above what they could earn on their asset portfolios, implicitly guaranteed by the federal govern- Policymakers should consider depositinsurance reforms in the context of the overall evolution of the financial services industry and also in the context of other regulatory reforms. The result should be a deposit-insurance system with modest, well-specified objectives that are easy to understand and administer. With this in mind, federal deposit insurance should be structured in a fashion that accomplishes its goals with minimal disruption of market forces. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland, Address 0" ment. Many of these institutions compete head-on with banks and thrifts for funds and provide many of the same services as insured James B. Thomson is an assistant vice presi- depository institutions. dent and economist at the Federal Reserve S. This role for deposit insurance is the motivation for the safe-bank proposals of Litan and others. See Robert Litan, What Should Banks Do? Washington, D.C.: The Brookings Institution, 1987. thrift institutions began to lose billions of dollars. By the end of 1982, 237 thrifts (with $67.8 billion in assets) in- Bank of Cleveland. The author would like to sured by the Federal Savings and Loan Insurance Corporation (FSLlC) were insolvent by generally accepted accounting principles (GAAP). I thank William Osterberg, Mark Sniderman, and EJ. Stevens for helpful comments and suggestions. The views stated herein are those of the is estimated at more than $124 billion? Furthermore, approximately 500 additional thrifts are above normal risks for failure. The expected future cost associated with these failures is not included in the FSLlC loss estimates. In contrast, the fund of the Federal Deposit Insurance Corporation (FDIC) remains solvent, despite having eroded in this decade under the pressure of record bank failures and an increase in failure-resolution costs. In 1988, the FDIC experienced its first loss in the author and not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. BULK RATE U.S. Postage Paid The initial response of Congress and the Federal Home Loan Bank Board to post-Depression era, as the book value of its fund balance shrank from $18.3 the thrift crisis was a policy of capital forbearance. Capital requirements were billion to $14.1 billion. Academic economists and private banking relaxed for the industry as a whole, and insolvent and capital-deficient thrifts were allowed to operate because if in- analysts estimate the real value of the fund as being significantly less. In fact, terest rates declined, the institutions stood a chance of recovering. Cleveland.Dfl Permit No. 385 This policy of capital forbearance entailed a high degree of risk. By buying 44101 Correction , Economic Principles and Deposit- Insurance Reform Failed and Troubled Institutions," Economic Edward Kane, The S&L Insurance Mess: How Did It Happen? Washington, D.C.: The i I 3 2 ~e~~\al\las~;ve Bank of Cleveland Requested: Please send corrected mailing label to the above address. the private group known as the Shadow Financial Regulatory Committee estimates that the true reserve balance of the FDIC fund, net of estimated unbooked losses, is only $400 million. time to deal with the insolvency prob- On February 6, 1989, the Bush ad- lem, the ultimate cost of resolving the problem could have become smaller. Unfortunately, the outcome was disappointing, as both the number of insol- ministration announced a plan for resolving the thrift crisis that includes provisions to recapitalize the insolvent FSLlC and to close nearly 500 savings vent institutions and the cost of resolving these insolvencies rose through the end of 1987 (see table 1). and loan institutions that are currently insolvent or in danger of failing. The Bush plan also contains provisions for strengthening the FDIC's fund. By late 1988, nearly 500 thrifts were either GAAP-insolvent Material may be reprinted provided that or in danger of failing. The cost of closing, reorganizing, or recapitalizing these institutions the source is credited. Please send copies of reprinted materials to the editor. ISSN 0428-1276 Conspicuously absent from this proposal are fundamental reforms to The current system of federal deposit insurance subsidizes risk-taking by depository institutions, resulting in increased failure-resolution costs and decreased efficiency for the entire financial system. Reforms to the deposit-insurance system should consider both the policy objectives and the attendant economic consequences and costs of deposit guarantees.
@FedFRASER