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Federal Reserve Bank of Cleveland

October 1, 1987
ISSN 0428·1276

ECONOMIC
COMMENTARY
Bank failures reached a post- Depression
high in 1986. One hundred thirty-eight
banks, including one mutual savings
bank, were closed by their primary
regulator; an additional seven banks
needed assistance from the Federal
Deposit Insurance Corporation (FDIC)
to prevent them from failing.
In the first half of 1987, 100 banks
failed or required assistance from the
FDIC. Failures and assistance cases for
1987 are projected to reach the 200
mark by year-end. Moreover, the number of banks on the FDIC's problem
bank list is at an all-time high (see figure 1), indicating that the rate of bank
failures might continue at or exceed the
1986-1987 pace in the near future.
For the banking industry, the increasing incidence of troubled and failing banks reflects the changed economic
environment in which they operate.
Technological innovations, combined
with a trend toward deregulation, have
increased the competitiveness of banking markets and, consequently, have
increased the degree of exposure of
banks to changes in market conditions.
These factors, coupled with regulations restricting geographic and activity diversification in bank portfolios,
have limited the ability of banks to protect themselves against national and regional economic shocks. In recent years,
for example, depressed agricultural and
energy markets have contributed to the
solvency problems of an increasing
number of banks in the southwest.
The FDIC has a mandate to maintain
confidence in and provide stability to
the commercial banking system through
its regulatory and insurance functions.
In addition, it is empowered to preserve

Daria B. Caliguire was a Research Department
intern and James B. Thomson is an economist at
the Federal Reserve Bank of Cleveland. The
authors would like to thank William Osterberg,
Gary Whalen, E.]. Stevens, Charles T. Carlstrom,
and William D. Fosnight for their helpful comments, and offer special thanks to Walker Todd
and Lynn Downey for their valuable assistance.

that confidence and stability through
the quick and efficient resolution of
bank failures. The recent wave of failures has challenged the FDIC's ability
to achieve these objectives. The FDIC
insurance fund increasingly is threatened with illiquidity. Secondly, FDIC
failure-resolution policies followed
since 1984 have eroded market discipline
by expanding de facto deposit insurance
coverage far beyond the coverage originally intended for insured depositors.
This Economic Commentary examines
the FDIC's policies for handling bank
failures and discusses both the intended
and the unintended outcomes of those
policies. We conclude that the evolution
of FDIC policies can be linked importantly to FDIC actions that have undermined market discipline on banks.
Background
At the lowest point in the Depression,
the Banking Act of 1933 was enacted as
a comprehensive reform package aimed
at restoring public confidence in the
stability of the banking system. Congress was concerned with eliminating
the destabilizing contagion of bank
runs. The banking industry was perceived as being unable to withstand
"failures" in the same sense that other
industries could withstand bankruptcies. Consequently, safety and soundness were placed before the "survival
of the fittest" principle of market efficiency in the order of governing principles of banking. The Banking Act
attempted, among other objectives, to
insulate banks from some market forces
by separating commercial banking from

The views stated herein are those of the authors
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

FDIC Policies for
Dealing with Failed
and Troubled
Institutions
By Daria B. Caliguire
and James B. Thomson

Figure 1 FDIC Problem Banks
1982-1986
Problem banks
1,500
~Total

D Net change

1,000

500

SOURCE: 1986 FDIC Annual Report,
Washington D.C.

investment banking. One component of
the total reform package, federal deposit insurance, was put in place to
enhance the long-run stability of the
banking system.
Federal deposit insurance was instituted to prevent the contagion of bank
runs by protecting the small depositor.
Originally, the FDIC was authorized to
cover insured deposits up to a $2,500
limit.' In this way, stability and public
confidence in the banking system were
to be restored at the grass-roots level.
By offering insurance only to small depositors, it was intended that large depositors, general creditors, subordinated
debtors, and shareholders still would be
subject to the risk of financial loss that
1. Even in 1934, the first year the FDIC operated,
$2500 was not much money, equivalent to about
$22,000 today, as measured by the consumer
price index. Currently, the deposit insurance ceiling is $100,000.

is a normal part of market discipline.
Even at such low levels, however,
deposit insurance was controversial because it was well understood that any
insulation against risk impedes the
effective restraint on a bank's risktaking ventures that is imposed by its
depositors.s Uninsured depositors monitor a bank's risk-profile. As banks
pursue riskier investment strategies,
these depositors demand higher interest rates as compensation for bearing
the additional risk. When deposits are
insured, however, the deposit guarantor (the FDIC, for example) bears the
risk of the deposits, and the depositor's
incentive to monitor conduct of the
bank's affairs is reduced.

the liquidation of the failed bank. Subordinated debtors and shareholders
normally are subject to partial or complete losses if the proceeds of the liquidation are insufficient.
A purchase and assumption (P&A)
transaction is a sale of the banking
franchise, rather than a liquidation.
The FDIC solicits bids for the failed
institution, with the successful bidder
purchasing the assets and assuming
the liabilities, and with the FDIC
absorbing any negative difference
between the two.'
An attempt is made to make the bidding process as competitive as possible
by attracting the maximum number of
potential acquirers in order to attain
the highest premium+ However, the
pool of potential bidders can be limited
severely by state branching laws, by
the absence of state interstate banking
laws, by federal antitrust laws, by the
quality of the failed bank's assets, and
by the size and 'fit' of the failed bank in
relation to its potential acquirer."

Traditional Methods of Resolving
Bank Failures
Deposit insurance was instituted to
eliminate the contagion of bank runs,
not to eliminate bank failures altogether. Given that bank failures are
part of a normal functioning of the
financial market, the FDIC was empowered under the Banking Act with two
initial means of resolving them: payout,
and purchase and assumption.
Here is how the process works. Once
a bank is declared legally insolvent, and
is unable to meet the demands of its depositors, the FDIC is appointed receiver
by the bank's chartering agent."
The FDIC operates in two capacities,
as a corporation and as receiver. In its
corporate capacity, the FDIC pays off
insured depositors and provides necessary funding and guarantees to the receiver. As receiver, the FDIC's primary
obligation is to distribute the failed
bank's assets equitably, to both depositors and general creditors. Under either
resolution option, the FDIC assumes a
fiduciary obligation to maximize the
amounts recovered from the assets and
liabilities sold.
In a payout, the FDIC (in its corporate
capacity) first advances funds to the
receiver to payoff the insured deposit
claims. The receiver, with respect to
that advance, then joins the pool of
uninsured depositors and general creditors as a claimant on the proceeds of

P&A vs. Payout
The Banking Act of 1933 did not specify
exact guidelines for the FDIC to use in
choosing between payout and P&A.
Instead, it gave the FDIC an implicit
mandate to balance two goals: to preserve market discipline and to minimize
disruptions to local banking services. In
view of the debate surrounding deposit
insurance, market discipline concerns
were given priority over service disruption considerations throughout most of
the history of the FDIC.7
The payout better accomplishes the
market discipline objective because it
more closely approximates the consequences of a bank failure in an unregulated market. In a payout, only the insured depositors are guaranteed full
reimbursement if the bank fails; in a
P&A, both insured and uninsured depositors receive protection, as well as most
general creditors. On the other hand, the
P&A is less disruptive to the community
because entire blocs of banking relationships are sold intact and, therefore, are
preserved. By contrast, these banking
services are dismantled under a payout.

2. See Guy Emerson, "Guaranty of Deposits

4. Traditionally,

Under The Banking Act of 1933," Quarterly [ournal of Economics, vol. 48, 1934, pp. 229·44.
3. For state-chartered banks, the FDIC does not
have to be, but almost always is, appointed
receiver, and it always is receiver of national
banks.

the FDIC extracts all the bad
assets and sells the bank on a "clean- bank basis"
in order to make the offer more attractive to the
bidders. As a result of placing all the bad assets
on the FDIC's books, however, the liquidity of the
fund increasingly is threatened. These assets
now account for two- thirds of the assets in the
FDIC's $18 billion fund. Operating under the philosophy that loan collection is best accomplished

The difficulty of measuring the costs
of decreased market discipline, versus
the community impact of a loss of
banking services, initially led the FDIC
to adopt a cost test for choosing
between a payout or a P&A: a payout
was to be performed unless a P&A was
less costly to the FDIC. In practice,
however, the FDIC preferred the P&A
to the payout.
During the 1930s and 1940s, the
P&A was employed more often because
it frequently proved more cost effective.
Over time, however, the political attractiveness of the P&A led to its exclusive
use in resolving failures, whether or
not it was the most cost-effective policy. By 1950, de facto, previous FDIC
policy was reversed; a purchase and
assumption was to be transacted unless
it was impossible to find a buyer due to
prohibitive branching or holding company laws, or if contingent liabilities or
fraud were extensive enough to render
the cost-test inaccurate.
The almost exclusive use of P&As in
failure resolution, irrespective of cost
or market discipline considerations,
prompted a revision of policy in the
1950 Federal Deposit Insurance (FDI)
Act. The cost test was named explicitly
as the primary criterion for determining
FDIC action in individual bank failures.
Congress felt that such a restatement
of purpose was a necessary reminder to
the FDIC that its mission was not to
eliminate bank failures, but to dispose
of failed banks in the least costly and
most efficient manner."
Problems in Application
The extensive use of P&As instead of
payouts, and the ensuing debate over
the use of the cost test in 1950-1951,
and again in recent years, highlights a
fundamental flaw in the FDIC program
for bank failure resolution: the assumption that the long-run impact of payouts
and P&As are the same. They are not,
because the payout preserves the operation of market forces while the P&A
reduces market discipline by extending
de facto insurance coverage to uninsured depositors and general creditors.

locally, the FDIC has begun experimenting with
leaving the delinquent loans in the failed-bank
package. Rescues of BancTexas Corp. and First
City Bancorp in 1987 illustrate this principle.
5. Potential acquirers are willing to offer a premium for the entire bank because the value of the
bank charter is preserved. See Steven A. Buser,
Andrew C. Chen, and Edward]. Kane, "Federal
Deposit Insurance, Regulatory Policy, and

A fundamental defect in using the
cost test as the primary determinant
for choosing between payouts and
P&As is that the cost test considers
only the short-run fiduciary costs to
the FDIC fund. While the costs associated with the loss of banking services
and the out-of-pocket costs of resolving
failures tend to be short-run in nature,
the costs associated with the erosion of
market discipline occur in the future.
Thus the choice of a resolution policy
based on short-term cost considerations
alone has a natural bias towards the
use of P&As over payouts.
The second defect in the cost test is
that it does not include the value of
FDIC guarantees and indemnifications
against unforeseen liabilities routinely
given to the acquiring banks in a P&A.
The seriousness of this defect is magnified by the ease at which out-of-pocket
costs (counted in the cost test) can be
translated into off-balance-sheet contingent claims on the FDIC (which are
either not explicitly counted, or can be
seriously understated in the cost test).
Thus, discretion in the application of
the cost test can result in actions either
not consistent with the intent of the
law or not consistent with sound economic practice.
By itself, the ability to redefine the
costs associated with resolving bank
failures would not necessarily lead to
FDIC actions that systematically would
favor P&As over payouts. However, it
does make the resolution policy choice
sensitive to political pressures and to
other noneconomic considerations.
These factors may be expected to operate in favor of P&As instead of payouts
also because P&As create no large class
of disgruntled claimants, while payouts
usually leave large classes of unhappy
uninsured depositors, shareholders,
subordinated debtors, and general creditors who are not paid quickly, if at all.
Given the difficulty of defining failure resolution policy costs, coupled
with the pressures favoring P&As, the
cost test is an inherently flawed criterion for choosing between different
failure resolution policies. Therefore,
using the cost test to choose between
payouts and P&As has had some serious
unintended effects on the equity and

Optimal Bank Capital," Journal of Finance, vol.
36, no. 1, March 1981, pp. 51-60.
6. When a billion-dollar

bank nears failure, such
as the Bank of the Commonwealth in Detroit, the
pool of eligible bidding banks is often very
limited. See Irvine H. Sprague, Bailout: An Insider's Account of Bank Failures and Rescues. New
York, Basic Books, Inc., 1986, pp. 53-76.

Table 1

Insured Deposits for the 10 Largest United States Banks

Bank

Citibank
Bank of America'
Chase Manhattan Bank
Morgan Guaranty Trust
Manufacturers Hanover
Chemical Bank
Bankers Trust
Security Pacific
Wells Fargo Bank
First National Bank of Chicago
10 Largest Banks
20 Largest Banks
All Insured Banks"

Insured deposits
(billions of dollars)

21,687
38,967
15,389
1,467
8,293
11,518
2,738
16,677
25,577
4,858
147,172
189,014
1,634,302

Insured as a percent of
Domestic
Total
deposits"
deposits

58.09
68.63
56.27
12.32
34.82
48.77
25.88
63.56
81.10
43.18
56.52
54.26
75.40

22.53
43.96
26.11
3.48
18.2.8
32.73
9.55
51.37
78.50
19.57
53.68
56.36
N/A

a. Total deposits equals the sum of domestic deposits and deposits in foreign offices.
b. Based on December 31, 1986 numbers. Source: The 1986 FDIC Annual Report, Washington,
DC.
SOURCE: Federal Financial Institutions Examination Council's Consolidated Reports of Condition and Income.

efficiency of the banking system, which
include a 'large-bank bias' and a
decrease in market discipline on banks.
A large-bank bias, in the administrative sense, has emerged from the established pattern of FDIC bank failure
resolutions. Large banks may be difficult to liquidate due to their size and to
the complexity of their banking relationships. Consequently, the perception
of bank regulators generally has been
that large-bank failures pose a greater
threat to both depositors' confidence
and the safety and soundness of the
financial system than do small-bank
failures. In addition, the political pressures to bailout some or all parties in a
bank failure are directly related to the
size of the failing bank.
As a result, large-bank failures are
rarely paid out. In fact, no bank over
$600 million in assets has been liquidated. This is all the more striking
because, at large banks, insured deposits typically constitute only a small
percentage of all deposits (see table 1).
The 100 percen t de facto coverage of all
large-bank depositors tends to produce

a fundamental inequality, a large-bank
bias in the banking system.
The implicit insurance protection provided by nonpayout failure-resolution
policies has led to a public perception
that the FDIC provides de facto coverage of all depositors and most creditors.
Over the extended period (1934-1970)
when the P&A was used almost exclusively to resolve bank failures, the
claims of creditors and uninsured depositors were preserved continually.
Such an unintended yet pervasive public expectation of insurance coverage
becomes a corrosive agent on the forces
of market discipline.
.
The greatest danger inherent in deposit insurance coverage is its tendency
to make the uninsured depositors less
cautious." Even when coverage is
limited, insurance insulates depositors
against risk and inadvertently encourages management's risk-taking behavior. Whether a bank follows a cautious
or a speculative path in an insured system, the payment to insured depositors
is the same in either scenario; however,
the rewards are much greater for the
risk-taker in management.

7. Id., pp. 24-25.

9. See George G. Kaufman, "The Truth About
Bank Runs," paper presented to Cato Institute
Conference on the Financial Services Revolution.
Washington, D.C., February 27, 1987.

8. See FDIC: The First Fifty Years. Washington,
D.C.: Federal Deposit Insurance Corporation,
1984, p. 86.

2. See Guy Emerson, "Guaranty of Deposits

4. Traditionally,

Optimal Bank Capital," Journal of Finance, vol.
36, no. 1, March 1981, pp. 51-60.
6. When a billion-dollar

Table 1

Insured Deposits for the 10 Largest United States Banks

Bank

Insured deposits
(billions of dollars)

21,687
38,967
15,389
1,467
8,293
11,518
2,738
16,677
25,577
4,858
147,172
189,014
1,634,302

Insured as a percent of
Domestic
Total
deposits"
deposits

58.09
68.63
56.27
12.32
34.82
48.77
25.88
63.56
81.10
43.18
56.52
54.26
75.40

22.53
43.96
26.11
3.48
18.2.8
32.73
9.55
51.37
78.50
19.57
53.68
56.36
N/A

7. Id., pp. 24-25.

9. See George G. Kaufman, "The Truth About
Bank Runs," paper presented to Cato Institute
Conference on the Financial Services Revolution.
Washington, D.C., February 27, 1987.

8. See FDIC: The First Fifty Years. Washington,
D.C.: Federal Deposit Insurance Corporation,
1984, p. 86.

The erosion of market discipline, via
100 percent de facto insurance coverage, poses a long-term threat to the
FDIC's ability to close banks and
slowly undermines the solvency of the
FDIC's insurance fund.
New Resolution Policies
The need for reform of previous FDIC
policies resulted from a changed economic environment. Interest-rate volatility and the collapse of the commodities prices in the 1980s destabilized a
large number of banks. When the wave
of failures began (see figure 2), there
was an urgent need for new ways to
cope with them. Unlike failures in previous years, the 1980s failures were
concentrated geographically (see figure
3). Moreover, large banks now populate
the ranks of troubled and failed banks.
The development of new resolution policies, for example, began in the early
1970s as a response to the first megabank failures.
The 1980s bank failure experience
has led to an accelerated series of FDIC
policy initiatives producing new
options that are adaptations of the earlier payouts and P&As, corrected for
their more obvious shortcomings. One
set of policies is designed for failed
banks, another set for troubled and failing banks. Although FDIC failureresolution policies are still in the mainstream of the FDIC's explicit statutory
authority, the new assistance programs
for troubled and failing banks stretch
the limits of that authority. These programs include modified payout, open
bank assistance, capital forbearance,
and bridge banks.
Modified Payout
The FDIC devised the modified payout
plan in 1983 in reaction to the 100 percent de facto coverage previously associated with widespread use of P&As.
As in a straight payout, the modified
payout created a receivership and liquidated the failed bank's assets. However, rather than waiting until assets
were sold to begin payments, the FDIC
estimated the current value of the
remaining assets as the basis for an

Figure 2 Bank Failures
1982-1986
Number of failures
150,--------------,
DOBA's

Payouts

Ip&As
100

• Total

1983

1984

1985

1986

SOURCE: 1986 FDIC Annual Report,
VVashingtonD.C.

immediate advance to the receiver for
payments to the uninsured depositors
and other claimants. In this way, the
market discipline of potential losses to
uninsured depositors was joined with
the disruption-free timeliness of the
ordinary P&A. As a result, the modified
payout showed promise as a policy that
could be applied equally to both large
and small banks.
The modified payout first was used
in 1984 as an experimental procedure
with small failed banks. In the two
months prior to the collapse of the Continental Illinois National Bank and
Trust Company of Chicago in May
1984, nine of 17 failures involved a
modified payout. Given that this procedure had been tried only on small
banks, the FDIC argued that the policy
was too early in its development to be
applied with the requisite degree of
assurance to the $33.6 billion Continental Illinois,"? Based on its prior successful application before Continental Illinois, however, the modified payout still
could be used as a possible nondiscriminatory failed-bank policy option.

10. See Hearings before the House Committee on
Banking, Finance and Urban Affairs, Subcornmittee on Financial Institutions, Supervision,
Regulation and Insurance, Inquiry into Continental Illinois Corp. and Continental Illinois National
Bank, October 4, 1984 (98th Congress, 2nd session). Washington, D.C.: Government Printing
Office, 1985, pp. 466·467.

Open Bank Assistance
The most significant developments in
FDIC policy initiatives have come
under the umbrella of the open-bank
assistance program (OBA). Under the
FDI Act of 1950, the FDIC obtained
authority to intervene prior to a bank's
failure in order to 1) facilitate the
merger of a failing bank or 2) prevent
failure of a bank that is deemed 'essential.' Up to this time, capital assistance
to open banks to prevent failure, had
been the job of the Reconstruction
Finance Corporation (RFC).ll
The first provision, section 13(e) of
the FDI Act, is an extension of the
P&A powers to enable conversion of a
closed-bank merger into an open-bank
merger when failure is imminent. The
FDIC's financial assistance is predicated upon the condition that the failing bank be absorbed by another bank.
The open-bank merger was an innovation intended to expedite the arrangement of a P&A and, thus, to minimize
further disruption of banking services.
It was not intended to save the troubled
institution from failure.
The second provision, section 13(c) of
the FDI Act, allows the FDIC to prevent
the failure of a bank " ...when in the
opinion of the Board of Directors [of the
FDIC] the continued operation of such
bank is essential to provide adequate
banking service in the community."12
This interventionary power was intended to be restricted by the condition of
essentiality attached to it. In this way,
the status of such OBA as an exception
rather than a rule was to be preserved.
Although authorized by statute in
1950, this essentiality doctrine was not
actually used until 1971 with the "bailout" of Unity Bank of Boston. Within
the span of the subsequent 10 years, however, a finding of essentiality was made,
and OBA was provided four more times
(the Bank of the Commonwealth in
Detroit [1972], American Bank & Trust
in South Carolina [1974], Farmers
Bank of the State of Delaware [1976],
and First Pennsylvania National Bank
in Philadelphia [1980]).
The greatest logical criticism of OBA
has been made on the grounds that it

11. See Jesse H. Jones, Fifty Billion Dollars: My
Thirteen Years with the RFC, 1932·1945, MacMillan, New York, 1951.
12. See Section 13(c}of the Federal Deposit Insurance Act, 12 U.S.C. Section 1823(c}.

Figure 3

extreme condition that needed to be
met in order to override the FDIC's
noninterventionary role.
By 1987, however, OBA had lost its
status as an exceptional measure and
has become a mainstream policy. The
September 10, 1987 bailout of First
City Bancorp of Texas became the 41st
case of OBA by the FDIC. Of the 41
OBAs, 37 have occurred in the 1980s.
Although the OBA policy affords
greater flexibility for the FDIC to
resolve failures, such assistance packages usually have some benefit for
shareholders and move the FDIC closer
to 100 percent de facto coverage of all
parties in a failed bank, which further
insulates banks from market discipline.

Bank Failures by State 1982-1986

SOURCE: 1986 FDIC Annual Report, Washington, D.C.

expands implicit insurance coverage to
stockholders and creditors of parent
bank holding companies who are not
protected under a P&A or a payout."
A second source of criticism surrounds the broad interpretations given
to the essentiality test that arise from
the vague definition of "community"
and the role of opinion in assessing
OBA.14
Third, the case-by-case basis on
which the FDIC has bailed out large
banks has propagated the general belief
that certain banks are "too large to let
fail." If depositors act on this belief, it
can lead to an undesirable concentration of assets in large banks. Furthermore, such a belief has dangerous
repercussions for the effectiveness of
market discipline on the risk-taking of
big banks. Overall, the-criticisms of
OBA highlight the danger that it poses
to the continued efficient operation of
market discipline in the long run.
As the number and complexity of
bank failures has risen in recent years
under deregulation, so has the adoption
of new OBA programs. Within the last
five years, the FDIC has revised the

OBA guidelines twice to afford greater
flexibility in preventing the closure of a
failing bank." The 1982 Garn-St Germain Act removed essentiality as the
prime consideration for OBA and
replaced it with cost-efficiency: only if
the cost of assistance exceeds the cost
of closing and liquidating does a finding
of essentiality have to be made. The
underlying design is " ...to lessen the
(financial) risk to the Corporation posed
by such insured bank under such
threat of instability."16 Since OBA
enables the FDIC to accrue losses as
off-balance-sheet contingent claims,
there is a strong incentive for the FDIC
to infuse capital into a failing institution rather than to arrange a payout or
P&A, which would require immediate
recognition of losses.
The replacement of essentiality with
cost-efficiency as the main determinant
reflects the changed role of OBA as a
policy tool of the FDIC for resolving
bank failures. In 1950, the OBA provision was issued as a last-resort measure, intended to save a failing bank in
a rural, unit-banking area in which
that bank actually did provide essential
banking services. Essentiality was an

13. See James B. Thomson, "The Use of Market
Information in Pricing Deposit Insurance," Journal of Money, Credit, and Banking, vol. 19, no. 4
pp. 528·537 (November 1987).

15. See FDIC Policy Announcements
25, 1983 and December 8, 1986.

14. See Sprague, supra note 6, p. 28.

of August

16. See Section 13(c), Federal Deposit Insurance
Act, supra note 12.

Capital Forbearance
The most recent FDIC policy initiatives
have been in the area of capital augmentation. Initially, a number of techniques, such as warrants and net
worth certificates (before 1982, called
income capital certificates) were
employed to "create" capital through
alterations in regulatory reporting
methods. Since 1985, the FDIC has
moved toward a relaxation of capital
standards for troubled institutions.
Regardless of which technique is used,
the policy allows a troubled bank, operating with substandard capital, to
remain open in the hope that the bank
will eventually recover.
In March 1986, the FDIC and the
Comptroller of the Currency
announced a joint effort to forbear
regarding the enforcement of minimum
capital-asset ratios below 7 percent, but
above 4 percent, for sound banks with
concentrations in agriculture or energy
lending." A sizable proportion of
recent bank failures have occurred in
agriculture and energy-belt states (see
figure 3). Accordingly, the capital forbearance plan is aimed at troubled
banks within these regions that are
seen to have been destabilized more by
depressed markets than by mismanagement. The plan is designed" ... to
provide greater operational flexibility to
well-managed banks" in the hope that
they will recover and thus spare the
FDIC considerable liquidation costs."

Within seven months of the beginning of the forbearance plan, fewer
than 20 banks had been accepted, and
17 banks had been denied acceptance
into the program.'? The FDIC and the
Comptroller of the Currency then
announced a revision of their guidelines, making more banks eligible for
capital forbearance. According to the
Comptroller of the Currency, capital
forbearance is a worthwhile program,
although it has not" ... covered as
many banks as it should have."2o
Consequently, the program has been
broadened in two significant ways:
first, capital forbearance has been
made available to all insured banks
whose problems are seen to be the
result of economic conditions, not just
energy and agriculture banks; second,
the minimum capital-asset ratio of 4
percent has been abolished (that is, any
positive capital ratio conceivably may
be enough to satisfy minimum regulatory requirements).
By broadening its availability, the
FDIC made capital forbearance a more
mainstream policy instrument, which
is the same pattern previously noted in
the development of the OBA programs.
An early criticism of capital forbearance in its currently revised form is
that it poses the same moral hazard
problem that surfaces when troubled
banks are insulated from market forces.
Counter to the plan's intent, it encourages even greater risk-taking on the
part of the failing institution as a last
chance to gamble its way out of a weakened capital condition."
19. See A. Bennett, "Regulators Report Slow
Beginning For Capital Forbearance Program,"
American Banker, December 5,1986, p. 3.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Bridge Banks
The latest policy response to the
increasing bank failure rate came with
the August 1987 banking bill, the Competitive Equality Banking Act, which
affords the FDIC more time and greater
influence in the decision-making processes of troubled institutions. The
FDIC is empowered to construct "bridge
banks," which can run ailing institutions for up to three years. Under such
a provision, the FDIC can charter a
national bank with new management
to guide troubled institutions to recovery. Rather than being subject to
urgent time constraints, the bridge
bank solution allows the FDIC expanded
flexibility in pursuing many options.
Conclusion
Over the last two decades, the FDIC
has assumed a more active role in the
resolution of bank failures and particularly in the regulation of problem
banks. Each expansion of FDIC powers
has occurred in response to needs that
have arisen out of a changed economic
or regulatory environment. Due to the
recent rise of bank failures, most of the
new initiatives attempt to address the
problems of troubled banks before they
actually fail. Many of the programs
under OBA, for example, were developed to prevent banks from failing,
albeit with generous infusions of FDIC
financial assistance.
In addition, capital forbearance pro-

20. See B. Rehm, "FDIC Will Expand Forbearance Plan For Ailing Banks," American Banker,
June 9, 1987, p. 1.

vides banks with time to recover from
problems created by depressed market
conditions. Bridge banks have been
created to combat the increased incentive for the management of troubled
banks to "gamble" out of their problems. In this way, bridge bank arrangements could provide sufficient time for
the other programs to take effect.
The greater flexibility afforded by an
increased number of options allows the
FDIC to meet the challenges of problem
banks innovatively. However, there is a
cost to the more active failure intervention by the FDIC: the erosion of market
discipline in the banking system. The
trend in bank failure resolution policies
has reached a point of 100 percent de
facto insurance for all depositors and
most creditors, and at least some protection for stockholders. Some of the
new FDIC policies, such as the modified
payout, have tried to correct for such
misallocations and inefficiencies while
maintaining the economies associated
with preserving ongoing banking
franchises.
However, the areas in which the
FDIC's failure-resolution policy is being
expanded the most, such as OBAs or
capital forbearance, tend to insulate
problem banks even further from market forces and arguably encourage risktaking. This could have a perverse effect
on the banking system and on the ability of the FDIC to do its job. Thus, a
better balance between market regulation and FDIC intervention needs to be
more clearly addressed in future FDIC
failure resolution policy initiatives.
21. See "Thrift Industry: Forbearance for
Troubled Institutions, 1982-1986," May 1987,
U. S. General Accounting Office Briefing Report.

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17. An agriculture or energy bank is customarily
defined as one in which 25 percent of its assets is
in farm or energy lending.
18. See FDIC Announcement of Capital Forbearance, March 27, 1986.

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