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January 19, 1990

FIRREA and the Future of Thrifts
The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA) provides the
funds to begin closing and/or reorganizing the
hundreds of insolvent savings and loan associations that contributed to the so-called thrift crisis.
In addition, it alters the legal and regulatory
environment for the remaining institutions by
changing the laws governing the deposit insurance funds, thrift powers, bank holding company
acquisition of thrifts, and capital requirements.
This Letter discusses the implications of each of
these new rules for the future operating environment and size of the thrift industry.

New insurance funds
FIRREA establishes two new deposit insurance
funds, replacing the fund administered by the
Federal Savings and Loan Insurance Corporation
with the Savings Association Insurance Fund
(SAIF) and the fund administered by the Federal
Deposit Insurance Corporation (FDIC) with the
Bank Insurance Fund (BIF). The Act places both
funds under the administration of the FDIC.
These funds offer the same protection to depositors, but differ in the level of their reserve ratios
(the ratio of insurance fund reserves to insured
deposits) and therefore, in the size of the premia
charged to their member institutions. FIRREA
requires BIF and SAIF to build and maintain a
"designated reserve ratio," which is now set at
1.25 percent of insured deposits. Because SAIF's
reserve ratio currently is considerably lower than
this target, FIRREA requires SAIF members to pay
substantially higher premia than BIF members.

However, beginning on January 1, 1995, the FDIC
is permitted to raise premia for either insurance
fund above the statutory levels set in FIRREA, if
it determ ines that reserve ratios are likely to fall
below the designated reserve ratio of 1.25 percent. Thus, the premium differential between
SAIF and BIF may persist even after 1998.

The sizeable differential between SAIF and BIF
premia may encourage institutions to convert
their memberships from SAIF to BIF. However,
depository institutions cannot convert from one
deposit insurance fund to the other until five
years after enactment of FIRREA, which will be
August 1994. Exceptions may be made for insolvent thrifts or those in danger of default and for
relatively small thrift branches.
When the moratorium is lifted, any thrift or
bank can convert from one insurance fund to
the other. To convert, a depository will have to
change its charter, merge with an institution
belonging to the other fund, or acquire a branch
or branches from an institution in the other fund.
The converting institution also will be required to
pay both an exit fee to the fund it is leaving and
an entrance fee to the fund it is joining.
FIRREA mandates that the FDIC set entrance fees
sufficiently high to prevent "dilution of the fund"
being entered. This means that an institution
seeking to convert from SAIF to BIF likely will
have to pay entrance fees approximately equal to
BIF's reserve ratio. Thus, if BIF succeeds in build-


posits, while SAIF members must pay 20.8 cents.
Over time, this differential will narrow, with
BIF and SAIF members paying 15 and 18 cents,
respectively, for each $100 of deposits between
August 1994 and January 1, 1998. After January 1,
1998, this differential is expected to disappear
altogether, and members of both funds will be
paying 15 cents for each $100 of deposits.

August 1994, institutions entering BIF will probably pay an entrance fee of at least $1.25 per $100
of insured deposits.
Given such a high entrance fee and assuming
that the premium differential in August 1994
(when the moratorium is lifted) is only three
cents per $100 per year, as FIRREA mandates,
conversions from SAIF to BIF are not likely.

Moreover, any exit fees charged for leaving
SAIF would further discourage conversions.

and, FIRREA alters the activities and investments
that are permissible for thrifts.

Persistent differentials?

Under FIRREA's Qualified Thrift Lender (QTL)
test, a thrift must have 70 percent of its tangible
assets in "qualified thrift investments:' which are
generally housing-related assets. Formerly, thrifts
were required to hold only 60 percent of their
portfolio in such investments, and the list of
assets deemed housing-related was broader than
under FIRREA. Historically, thrifts have had tax
advantages over banks that compensated them
for these portfol io restrictions. These tax advantages remain, but they have not been enhanced
in response to the new investment rules.

However, if thrifts expect premium differentials
to persist indefinitely, a substantial number of
conversions could take place, despite the hefty
entrance and exit fees. Given the large number
of thrift insolvencies, many may believe that SAIF
premia will remain permanently higher than BIF
premia in order to maintain reserves in the face
of future losses.
Faced with the expectation of permanently
higher premia, savings and loans with sufficient
cash flow to cover the exit and entrance fees
likely will convert. In fact, any thrift with a strong
net worth position could be a candidate for conversion since at the very least, it should be able
to borrow against its net worth to raise the
money to cover exit and entrance fees.

Banks, in contrast, have much broader lending
powers and are not required to hold housingrelated investments. A bank thus has more flexibility to take advantage of profitable investment
opportunities and to diversify its portfolio.

Thus, it is possible that only the 'vveaker institu-

A wall comes down

tions would be left behind in SAIF. Since weak
institutions pose the greatest risks and therefore
impose the greatest costs on the insurance funds,
SAIF premia may have to increase to cover the
higher expenses associated with a growing concentration of weak institutions. Higher premia, in
turn, may encourage even more defections from
SAl F and an even greater concentration of weak
thrifts in SAIF.

Prior to FIRREA's enactment, bank holding
companies were prohibited from acquiring all
but insolvent thrifts. FIRREA amends the Bank
Holding Company Act to authorize the Federal
Reserve to permit bank holding companies to
acquire healthy thrifts.

Switching charters

The new rule may increase the number of thrifts
purchased by bank holding companies. Many of
these acquired thrifts are likely to be converted
to bank charters because of the investment restrictions on thrifts and because a bank holding
company may find it more efficient to run a depository institution subsidiary as a bank than
as a thrift.

Although a thrift may not convert from SAIF
membership to BIF membership until August
1994, it is permitted at any time to convert to a
bank for all other purposes. It needs approval for
charter conversion from the appropriate regulaThrifts that are acquired by bank holding
tory agencies, but once it gains such approval,
a thrift can call itself a bank and exercise bank
companies also may, with certain restrictions,
... powers.!lvertst.o.a.banKcbarter have the choice of staying with SAIF or
be attractive whenever the holding company can
take advantage of economies associated with a
moving to BIF after the moratorium on insurance
fund conversion expires.
larger scale of banking operations. The merged
entity will have to pay SAIF premiums on the
Even if a thrift chooses not to convert from SAIF
portion of deposits attributable to the thrift until
to BIF, it may want to change to a bank charter
August 1994, though.
because provisions in FIRREA reduce the attractiveness of a thrift charter relative to a bank
New capital requirements
charter. First, FI RREA diverts some of the earnFIRREA introduces three new capital requirements for thrifts. First, FIRREA imposes a new
ings of the Federal Home Loan Banks in which
thrifts hold stock. This will reduce the dividends
minimum "leverage ratio!' The leverage ratio,
thrifts receive from the Home Loan Banks. Secdefined as the ratio of "core capital" to total

assets, is to be no less than three percent. Core
capital is the sum of common equity, noncumulative perpetual preferred stock, and minority
interests in consolidated subsidiaries, minus
most intangibles except purchased mortgage
servicing rights and qualifying supervisory
goodwill. (Supervisory goodwill is the premium
above tangible net worth that may be paid for
a troubled savings institution. Acquirers may
be willing to Dav such oremium to obtain the
deposit insur~nce guar~ntee.)
Second, FIRREA requires compliance with a new
mi nimum 1.5 percent tangible-capital-to-assets
ratio. Tangible capital is core capital minus
supervisory goodwill and all other intangibles
except qualifying purchased mortgage servicing
Finally, FIRREA establishes a minimum risk-ba~ed
capital requirement for thrifts. Risk weights are
applied to a thrift institution's assets according to
the assets' inherent riskiness. This yields the riskadjusted asset base against which a minimum
amount of capital must be held.
In addition to the new capital-asset ratios, new
definitions of capital are in effect since FIRREA's
enactment. Thrifts are no longer permitted to
include most types of "goodwill" in regulatory
measures of capital. Moreover, even supervisory
goodwill is to be phased out of core capital by
1995. Goodwill is the difference between the
market value of a firm's net worth and the value
based on tangible assets only. Goodwill represents the value of a franchise, including name
recognition, an established reputation, and loyal
customers. For many thrifts, goodwill was
booked as capital when they acquired other
enterprises at greater-than-tangible asset value.
For weak thrifts, the new rules pertaining to
goodwill are especially appropriate. The only
source of goodwill for these thrifts was the unpriced value of the deposit insurance guarantee
and the forbearance practicedJ})-IJheregulators.
-TheexCTusTon-of goodwill from capital will thus
be reflected in lower stock prices for these thrifts.
For healthy thrifts, however, excluding goodwill
from regulatory capital may have undesirable
effects. A healthy thrift that was operating efficiently prior to FIRREA would have chosen an

optimal capital level, including goodwill. If its
capital, excluding goodwill, is less than the
regulatory minimum, FIRREA will force the thrift
to raise additional capital. This presumably will
lead to a decrease in the wealth of the thrift's
shareholders, since the institution will be required to operate with greater-than-optimal
capital. (It is worth pointing out that any increase
in capital due to the new capital requirements
would for the same reason diminish thrift shareholder wealth. From a social standpoint, however, there is an offsetting reduction in the value
of potential claims on the insurance funds.)
Perhaps the only way for these shareholders to
recover this lost wealth would be to sell the thrift.
A purchaser should be willing to pay for the full
value of the goodwill, as long as the purchaser
does not also face the same regulatory capital
deficiency problem as the acquiree. Thus, the
new requirement concerning goodwill could
lead to increased thrift takeovers, particularly by
bank holding companies, which are not likely to
be as capital-constrained as are thrift holding
The exclusion of goodwill and the new capitalasset ratios are in sum more stringent than preFIRREA requirements. They will cause some
thrifts that are unable to raise enough capital to
close down. Many other thrifts will be able to
raise the necessary capital only by selling off
assets and/or slowing growth. These requirements, therefore, will cause the industry to shrink
considerably, at least over the next several years.
An uncertain future
It is too early to tell whether bank holding
companies will acquire healthy thrifts on a
large scale, and we will have to wait five years
to observe the extent of conversions from SAl F to
BIF. However, it is clear that the operation of a
savings and loan is a very different business from
what it was less than six months ago. Higher deposit insurance premia for thrifts, restricted thrift
activities, the prospect of bank holding company
acggisitions of thrifthand stiffer capital requirements all contribute to the likelihood that the
thrift industry will experience considerable
consolidation in the wake of the deposit
insurance crisis.
Elizabeth Laderman

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.


Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120