Full text of Financial Industry Studies : December 1991

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FINANCIAL INDUSTRY
December 1 9 9 1

STUDIES
Federal Reserve Bank of Dallas

Banking in the Southwest
and the Rest of the Nation:
Where We Are and Where We Are Going
Genie D. Short
Vice President

Brokered Deposits:
Determinants and Implications
for Thrift
Institutions
Robert R. Moore
Senior Economist

1988

1989
1990
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
1991

Financial Industry Studies
Federal Reserve B a n k o f Dallas
D e c e m b e r 1991

President and Chief Executive Officer
Robert D. McTeer, Jr.
First Vice President and Chief Operating Officer
Tony J. Salvaggio
Senior Vice President
George C. Cochran, III
Vice President
Genie D. Short
Senior Economists
Jeffery W. Gunther
Robert R. Moore
Kenneth J. Robinson
Economist
Linda M. Hooks
Financial Analyst
Kelly Klemme

Industry Studies is published by the Federal Reserve Bank
of Dallas. The views expressed are those of the authors and
do not necessarily reflect the position of the Federal Reserve Bank
of Dallas or the Federal Reserve System.

Financial

Subscriptions are available free of charge.
Please send requests for single-copy and multiple-copy subscriptions,
back issues, and address changes to the Public Affairs Department,
Federal Reserve Bank of Dallas, Station K, Dallas, Texas 75222, (214) 651-6289.
Articles may be reprinted on the condition that the source
is credited and the Financial Industry Studies Department is provided
a copy of the publication containing the reprinted material.

Banking in the
Southwest and the
Rest of the Nation:
Where We Are and Where We Are Going
Genie D. Short
Vice President
Financial Industry Studies Department
Federal Reserve Bank of Dallas

uring the past decade, the question of
how to refonn the U.S. banking industry
has been widely debated among industry
practitioners, policymakers, politicians, the
academic community, and the general public.
In an attempt to address declines in bank and
thrift profitability, four major congressional
bills were introduced in the 1980s—the
Monetary Control Act of 1980, the Garn-St
Germain Depository Institutions Act of 1982,
the Competitive Equality Banking Act of
1987, and the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
(FIRREA). This year, Congress is considering
another comprehensive refomi package.
The debate currently surrounding banking
refonn has centered on several key issues,
including expansion of geographic and product markets, regulatory restmcturing, and
deposit insurance reform. Given the significance
of the changes being considered in the
banking reform bill, the intense interest the
legislation has generated is not surprising. As
in the early 1980s, the discussion centers on
how to deregulate the U.S. financial system
while controlling for the moral-hazard
problem inherent with mispriced deposit
insurance guarantees. Unlike the early 1980s,
however, much of the attention today has
shifted from examining whether we need to
change the current financial safety net
system to determining how to proceed with
needed changes when the profitability of
many financial intennediaries is seriously

strained by asset quality problems.
In this article, I review the major factors
that have contributed to the changing trends
in bank profitability and examine some
lessons learned from the banking difficulties
that emerged in the Eleventh District, which
is composed of Texas, northern Louisiana,
and southern New Mexico. I then offer a
perspective on the impact that the refonn
legislation may have on the banking
industry. Finally, I address the question
of why substantive reforms in banking
have been difficult to implement despite
persistent problems in the industry.

What Caused the Decline
in U.S. Bank Profitability?
Throughout most of the post—World War
II period, U.S. banks generally prospered.
Separations in geographic and product
markets protected banks from competitive
pressures, and deposit insurance increased
the value of the banking franchise. Since
the mid-1970s, however, U.S. bank profitability has been declining. As shown in
Chart 1, the return on bank assets declined
to slightly less than 0.7 percent during the
Chart 1
Profitability of Insured U.S. Commercial Banks
Return on assets (percent)

S O U R C E S : U.S. Treasury Department, Modernizing

the
Financial System: Recommendations
for Safer,
More Competitive Banks (Washington, D.C.:
Government Printing Office, 1991); Federal
Deposit Insurance Corporation, Quarterly
Banking Profile, various issues.

early 1980s and fell further to 0.55 percent
later in the decade. Moreover, during 1989
and 1990, U.S. bank profitability as measured by the return on assets was about
0.5 percent, which is just above the return
reported between 1934 and 1939, following
the Great Depression.
The recent decline in bank profitability
is not a new phenomenon. This trend has
been evident for a number of years, and
debates about the factors that contributed
to declining bank profits have persisted for
an equally long time. Much of the discussion has centered on the dramatic changes
that have occurred in the banking environment since the 1930s as technological
innovations and new competitors emerged.1
On the funding side, banks lost their
competitive advantage in the early 1980s
when Regulation Q interest-rate restrictions
were phased out by the Monetary Control
Act of 1980 and the Garn-St Germain
Depository Institutions Act of 1982. Chart 2
shows that the interest-rate advantage that
banks had maintained relative to short-term
Treasury securities disappeared quickly
after passage of the 1982 Garn-St Germain
legislation, which accelerated the phase-out
of Regulation Q interest-rate restrictions.
The primary impeais for these legislative
changes came from competitive pressures,
particularly from money market mutual funds
that offered comparable deposit products
at higher yields than banks and thrifts.
Nonbank competitors also made considerable inroads into banking asset markets.
The traditional role of banks has been to
intermediate between depositors and borrowers by channeling short-term liabilities,
including demand deposits, into longerterm loans. Because banks specialize in
lending, they historically have been able to
reduce the cost of acquiring timely information on the credit quality of individual

Kaufman (1991).

Bernanke (1983), among others, discusses this role
of banks.
2

Chart 2
The Disappearance of Banks' Funding
Advantage in the 1980s
Interest rate (Percent)

borrowers, thereby lowering the cost of
credit.2 However, recent technological
advances in the processing and transmitting of information have enabled other
financial intermediaries to compete more
effectively with banks.
Chart 3 highlights the 20-percent decline
in commercial banks' share of U.S. financial
assets that has occurred during the past
forty years. In 1950, banks controlled about
50 percent of the financial assets in this
country. By 1990, the market share of
banks had fallen to 30 percent, while
pension funds and mutual funds made the
most significant gains. In addition, within
this smaller U.S. banking market, foreignowned banks have steadily increased their
share, as shown in Chart 4. Data for 1990
show that foreign-owned banks held more
than 20 percent of the U.S. domestic
banking market and about 25 percent of
the market for commercial business loans.
Growth in commercial paper issued by
nonfinancial borrowers also has far exceeded growth in bank commercial and
industrial loans, as Chart 5 shows. Improved information technologies and the
associated increase in the availability of
credit information about large borrowers

Chart 3

Chart 6. These real estate loans became the
primary source of recent bank losses.
Many analysts argue that banks accepted
increased risk through real estate lending
to compensate for reduced profit margins
in their traditional business loan markets.3
Chart 7 shows that by mid-1991 U.S. banks
had nearly $115 billion in troubled assets,
including nonperfolining and renegotiated
loans and foreclosed real estate properties.
And troubled real estate assets reached $67
billion, accounting for close to 60 percent
of the troubled assets at U.S. banks. This
high concentration of problem credits was
a key factor in the decline in bank profitability after the mid-1980s. A review of the
factors that contributed to the Eleventh
District banking difficulties may enable us
to better understand and evaluate the
banking trends that have emerged elsewhere in the country.

Share of Financial Assets Held
by Major Intermediaries
Percent
• • • Commercial Banks
—
Insurance
• - • Pension Funds
— Savings and Loans
• • • Finance Companies
- — •Mutual Funds

•

'50

'60

'70

'80

'85

'90

S O U R C E S : Board of Governors of the Federal Reserve
System, Annual Statistical Digest, various
issues.

helped spur the high growth in the commercial paper market relative to bank
lending. As business borrowers increasingly turned to alternative sources of
financing, banks attempted to reconfigure
their lending activities, which resulted in
increased real estate lending, as shown in

Chart 4
Foreign Banks' Increasing Share
of the U.S. Banking Market
Percent

S O U R C E : Statistical

Abstract

of the United States, 1990.

Eleventh District Banking:
Lessons from the Southwest
To understand the financial-sector
difficulties that emerged in the Southwest,
it is important to examine the factors that
contributed to lending decisions made
during the strong economic growth from the
late 1970s to the early 1980s, those made
during the mid-1980s when the Southwest
economy experienced two separate energyrelated recessions, and those made in the
region's most recent slow economic recovery,
which began in mid-1987.
The oil-price shock of the mid-1980s
pushed the Eleventh District's economy
into a steep recession. Nonagricultural employment in the three District states—Texas,
Louisiana, and New Mexico—dropped by
390,000 from the fourth quarter of 1985
through the first quarter of 1987. This
regional recession followed an earlier
downturn that lasted from the second
quarter of 1982 through the first quarter of
1983, with a decrease in employment of

See, for example, Litan (1991).

Chart 5
Commercial Paper Issued
by Nonfinancial Borrowers versus
Bank Commercial and Industrial Loans
Index, 1975 = 100
1,150 •
1,050 •
950 •
850 750 -

Commercial Paper

650 •
550 450
350
250
150

Commercial and Industrial Loans

S O U R C E : CITIBASE, Citibank Economic Database.

290,000. The asset-quality problems that
severely impaired Eleventh District banks
during the 1980s initially were concentrated in nonperfonning business loans that
surfaced in 1982, following the weakening
of oil prices. But bank loan growth remained strong in the region through 1984,
even though the energy sector had turned
down earlier. Chart 8 shows the composition
of lending activity at Eleventh District banks
from 1980 through 1990. From 1980 through
1984, loans at Eleventh District banks
increased by $45 billion, on an inflationadjusted basis. This increase represented
average annual inflation-adjusted increases
of 13 percent, compared with 5 percent for
the rest of the nation. Bank loan growth in
the Eleventh District slowed to 0.8 percent in
1985, primarily from a reduction in business
loan growth. But real estate lending remained
strong through 1986, increasing by nearly 10
percent in 1985 and an additional 4 percent
in 1986.

With hindsight, it is apparent that problem real estate loans ultimately proved to
be the biggest challenge to the financial
institutions in the Southwest, just as they
have for financial institutions elsewhere in
the country. And the decisions of many
managers of Eleventh District financial
institutions to maintain a high growth
strategy despite the regional recession and
the troubled energy-related credits that
had already surfaced suggest that the
propensity to become overexposed to risk
at Eleventh District banks was greater than
in past economic cycles. Rather than
contributing to a sustained economic
recovery in the region, the high growth
strategies that the most aggressive institutions pursued ultimately exacerbated the
difficulties that developed in the region's
financial sector. And these difficulties
affected virtually all the banks and thrifts
in the Southwest, including the more
conservatively managed firms.'1

Bank Profitability Improves in the
Southwest but Deteriorates Elsewhere
The severe difficulties of the late 1980s
continue to affect the performance of
financial institutions in the region, but signs

Chart 6
U.S. Bank Lending
Billions of dollars, adjusted for inflation
1,800 •
1,600
1,400

I Other Loans
C&l Loans*
I Real Estate Loans

1,200 1,000
800
600
400
200

0
See Short and Gunther (1988) regarding the effect of
the most troubled financial institutions on the operations of solvent competitors.
1

•Commercial and Industrial Loans.
S O U R C E : CITIBASE, Citibank Economic Database.

Chart 7

a bank is considered to have extremely
serious earnings and asset quality problems.
Chart 11 shows the concentration of bank
failures at both Eleventh District banks and
at banks elsewhere in the countiy. From
1985 through 1990, 485 banks in the Eleventh
District were closed because of failure, and
those banks accounted for 46 percent of all
U.S. bank failures and 69 percent of failedbank assets. This year, the concentration of
failures in terms of both size and number
has shifted from the Southwest to the East
Coast. Through September, twenty-nine
banks had been closed in the Eleventh
District, which compares favorably with the
ninety-one closures that had occurred a
year earlier. The 1991 bank failures in the
Eleventh District accounted for about 30
percent of all U.S. bank failures, but these
failed banks were small and accounted for
only 3 percent of all 1991 failed-bank assets.
In contrast, through September, twenty-

Troubled Assets,
U.S. Insured Commercial Banks
Billions of dollars
120
I Other Real Estate O w n e d
Consumer Loans
I Real Estate Loans
I Business Loans

1984

1 985

1 986

1 987

1 988

1 989

1990 1991

S O U R C E : Report of Condition and Income.

of recovery have emerged. Since the beginning of 1990, Eleventh District banks have
reported six consecutive quarters of positive
net income, as shown in Chart 9. Return on
assets increased to 0.44 percent in 1990 and
strengthened further to approximately 0.7
percent during the first half of 1991.
The turnaround at the region's banks is
primarily attributable to improvement of
their troubled asset ratios. Chart 10 shows
that, by the second quarter of 1991, the
ratio of past-due loans and foreclosed real
estate to total assets had fallen to 2.4
percent, slightly lower than the year-earlier
level. But banking performance elsewhere
in the country continues to slide, underscoring the greater volatility in U.S. bank
earnings that has emerged across regions.
Serious asset quality problems similar in
magnitude to those that emerged in the
Southwest have now surfaced in other
regions of the country, particularly in New
England.5 The troubled asset ratio at banks
outside the Eleventh District has trended
upward since the beginning of 1990 and
was at 3.3 percent in June 1991. This ratio
serves as a valuable indicator of a bank's
financial strength. When the ratio of
troubled assets reaches 5 percent or higher,

Chart 8
Composition of Lending
at Eleventh District Banks
Billions of dollars, adjusted for inflation
140 •

•

'80

'81

'82

'83

'84

'85

Other Loans
C&l Loans*
eal Estate Loans

'88

'89

'90

' C o m m e r c i a l and Industrial Loans.
S O U R C E S : Report of Condition and Income; CITIBASE,
Citibank Economic Database.

For information about regional bank performance,
see FD1C Quarterly Banking Profile, fourth-quarter
1990 and first-quarter 1991.
5

Chart 9
Return on Assets* for the Eleventh District
versus the Rest of the Nation
Percent, annualized

2 -i

1988

1989

1990

1991

* Ratio of quarterly net income to average assets.
S O U R C E : Report of Condition and Income.

eight banks failed in New England, and
these failed banks accounted for nearly 55
percent of all 1991 U.S. failed-bank assets.6

Financial-Sector Weakness
and the Credit Crunch
The financial-sector distress that emerged
in the Southwest has been associated with a
subsequent decline in lending. From the
1985 peak through the end of 1990, the
volume of total loans at Eleventh District
banks declined by $59 billion in inflationadjusted dollars. Some of this decline represents the impact of loan writedowns and the
reclassification of troubled real estate loans
to "other real estate owned" (meaning foreclosed real estate) on bank balance sheets.
Paralleling the concerns expressed in
the Southwest during the 1980s, troubled
real estate credits are now cited as an

important source of recent weakness in
U.S. bank lending. The heightened attention given to this issue reflects widespread
concerns that tight credit conditions are
restraining the U.S. economy's ability to
recover from the recent recession. Banks
are alleged to be unwilling or unable to
extend loans to viable borrowers. At the
same time, it is also likely that demand-side
factors are playing a role, because bankers
maintain that they are facing lower loan
demand from creditworthy borrowers.
These alternative explanations frame the
current debate about whether insufficient
bank credit is constraining economic activity,
both in this region and elsewhere in the
country.7 Observers widely acknowledge that
bank credit practices have been reexamined
in response to the massive loan losses that
have occurred. But a more difficult question
is whether changes in lending practices—
either at the initiative of the banks or the
bank examiners—are preventing creditworthy borrowers from obtaining loans.
These issues are being addressed at the
nation's highest policy levels, and several
measures aimed at increasing bank lending
have been initiated.8 Among the most recent
Chart 10
Troubled Asset Ratio* for the Eleventh District
versus the Rest of the Nation

Eleventh District
Rest of the Nation

New England includes Connecticut, Maine, Massachusetts, New Hampshire. Rhode Island, and Vermont.

For a discussion of die impact of credit availability
on economic activity in Texas, see Gunther and
Robinson (1991).

" See American Banker (1991a) and (1991b).

* Ratio of loans p a s t d u e ninety days or more, nonaccrual loans,
and other real estate owned to end-of-period gross assets.
S O U R C E : Report of Condition and Income.

Chart 11
Bank Failures in the Eleventh District
and the Rest of the Nation
Number of failures
250
Eleventh District

200
150

100

'80 '81

'82 '83 '84 '85 '86 '87 '88 '89 '90 '91*

* 1991 data include failures through September 30.
S O U R C E : Federal Deposit Insurance Corporation.

suggestions are a temporary relaxation of
capital requirements, new accounting
procedures designed to enhance the book
value of real estate assets, more flexible
procedures for bankers who wish to appeal
an examiner's evaluation, and efforts to
establish more uniform application of bank
credit standards by the different regulatory
agencies. 9 In addition, policymakers
continue to emphasize the need to move
forward with comprehensive banking reform
legislation. The recent changes to regulatory
practices may help banks manage current
asset quality problems, but the Bush administration is also stressing that fundamental
reform measures are needed to reestablish a
well-functioning banking industry.10

Treasury's Reform Proposal
and the 1991 Banking Legislation
As the 1980s came to a close, a consensus had developed on the need to change
both the financial structure and the incentive system under which U.S. depositories
currently operate. Efforts to address the
troubles facing the thrift industry, particularly from the inadequate funding available
to close insolvent institutions, intensified
after the passage of the FIRREA legislation

in 1989. But part of the FIRREA legislation
also directed the U.S. Treasury Department
to conduct a comprehensive study of banking reform, including an assessment of the
U.S. system of deposit insurance and other
issues of relevance to the competitiveness
and structure of the U.S. banking system.
The Treasury's report, Modernizing the
Financial System: Recom mendations
for
Safer, More Competitive Banks, was released in February. The report provided
the framework for the 1991 banking reform
legislation." In completing its study, the
Treasury was requested to consult the
Federal Reserve System, the Office of the
Comptroller of the Currency, the Federal
Deposit Insurance Corporation (FDIC), and
several other government agencies. Congress
also requested that the Treasury solicit input
from individuals in the private sector.12
The reform proposals recommended in
the Treasury study focus on four interrelated
problems that have been identified as significant factors in the financial-sector distress
that emerged in the United States during the
1980s. These problem areas are the decline
in the competitive position and financial
strength of U.S. banks in both domestic and
international markets, the fragmented
regulatory structure, the overextension of
the federal safety net for deposits,13 and the
undercapitalized deposit insurance fund.
The changes recommended by the
Treasury to solve these problems concentrated on three key issues: expanding the
geographic and product markets in which

U.S. Treasury Department (1991a). See also American Banker (1991b).

See American Banker (1991b).

U.S. Treasury Department (1991b).

See FIRREA, section 1001.

13 The federal safety net includes the current system
of federal deposit guarantees for insured depository
institutions and the discount window function of the
Federal Reserve System.

U.S. banks can compete, streamlining the
bank regulatory framework to avoid
overlapping responsibilities across bank
regulatory agencies, and reducing the
scope of deposit insurance coverage to
minimize taxpayer exposure to losses and
to reintroduce greater market discipline
against excessive risk-taking. The Treasury
made no specific recommendations for
recapitalizing the bank insurance fund but
supported efforts by the FDIC to work
closely with the banking industry in developing a recapitalization plan for the fund.
The Treasury's report provided the
framework for the legislation that was
introduced in Congress this year. The
legislative debates have centered on four
key issues: product powers, geographic
expansion, deposit insurance reform and
recapitalization, and regulatory restructuring. Based on the marked-up versions of
the bill that have progressed through the
House and Senate Banking Committees,
the legislation was expected to include
greater emphasis on capital adequacy,
minimal changes to the scope of deposit
insurance coverage, restrictions on the use
of brokered certificates of deposit,14 some
new asset powers, and continued progress
toward interstate branching. 15
The decline in U.S. bank profitability
was a key motivating factor behind the

14 Moore, in this issue of Financial
Industry Studies,
examines the use of brokered deposits at thrift institutions before and after the passage of the FIRREA
legislation.
15 Recent amendments to the House version of the
banking bill introduced by Representatives Dingell
and Gonzalez placed restrictions on insurance and
underwriting powers that are currendy available to
banks through bank holding company arrangements.
The House rejected this version of the banking bill. As
of this writing, it is now projected that only a narrow
bill—including provisions to recapitalize the Bank
Insurance Fund and greater emphasis on bank capital
and regulatory oversight—will be enacted by Congress
this year.

16 Samolyk (1991) examines the link between regional
downturns and regional banking conditions.

Bush administration's reform proposal.
Concern shifted from the fear that, if left
unrestricted, banks might gain excessive
economic power to the idea that binding
legal restrictions on product powers and
geographic expansion have prevented U.S.
banks from competing effectively in both
domestic and global financial markets.
Product restrictions, for example, have
prevented banks from diversifying across
product lines and from reducing costs
through the efficient production of a full
line of financial services. Branching
restrictions have hindered banks' ability to
benefit from geographic diversification,
thereby reducing their efficiency and
increasing their susceptibility to regional
economic downturns.16
Analysts generally acknowledge that
greater diversification likely would have
helped reduce the concentration of bank
failures in the Southwest and, more
recently, in New England. The reductions
in bank product and geographic restrictions that are expected from the pending
legislation will help banks regain at least
part of their lost competitiveness. But
concerns persist that relaxation of product
and geographic restrictions, while beneficial, will not be sufficient to establish a
stronger, more efficient banking industry.
Lessons from the thrift industry suggest that
efforts to deregulate financial markets can
be counterproductive if the remaining
incentive structure does not complement
the reforms. The 1980s demonstrated the
unintended consequences of partial
reforms that gave depository institutions
expanded powers without reforming the
system of federal deposit guarantees.
The proposed 1991 legislation attempts
to deal with the moral-hazard problem of
deposit insurance by placing greater
emphasis on capital guidelines. Only wellcapitalized banks will be granted increased
powers and expanded opportunities to
diversify geographically. The pending
legislation also calls for prompt corrective
action when dealing with problem banks.
Providing authorization to regulators to

intervene earlier in the resolution process
should reduce the cost of bank failures to
the insurance fund and to the taxpayer.
Questions remain, however, as to whether
or not these changes, if enacted, will be
sufficient to address the problem of
mispriced deposit guarantees.17

Banking Reforms of the 1990s
Compared with Those of the 1930s
Much of the current financial structure in
the United States originated in the aftermath
of the Great Depression. The Banking Act of
1933, also known as the Glass-Steagall Act,
defined commercial banks as separate and
distinct from other types of financial finns
and separate from other commercial firms.
The legislation also authorized federal
deposit insurance to restore public confidence in the U.S. banking system.
Deposit insurance was introduced in the
United States ostensibly to accomplish two
objectives. The first, most publicized
objective was the protection of small
depositors. The second goal was a monetaiy
policy objective—the protection of the
circulating medium of exchange. However,
a third, much less publicized role for federal
deposit insurance was the protection of
small, independent banks.18 The problem of
deposit confidence that erupted during the
banking crisis in the early 1930s was not
unique to that period, and the solution of
providing federal deposit guarantees was not
a novel idea at the time. Branching restrictions had perpeaiated a banking system that
consisted of a large number of banks, many
of them quite small. This situation gave rise
to a unique banking structure with a unique
set of problems—namely, that branching
restrictions made U.S. banks unusually
prone to deposit runs and suspensions.
The introduction of deposit insurance
to address the problem of depositor confidence was only one component of the
1930s financial legislation. A number of
other changes, most of which imposed
restrictions on bank activity, were also
introduced. Among other things, banks
were prohibited from underwriting corpo-

rate securities, paying interest on demand
deposits, and paying interest on savings and
time deposits in excess of allowed limits.
Asset and liability constraints, restrictive
chartering policies, and limits to geographic
expansion were intended to ensure safe
banking by reducing competition. Incentives
provided by deposit insurance to undertake
excessive risk were thus partially offset.
The banking legislation of the 1930s
reflected the prevailing view that excessive
competition fostered imprudent risk-taking
on the part of banks. The emphasis of the
legislation was to limit the concentration
of power at major financial institutions by
carving out different markets for different
types of financial intermediaries. By offering federal deposit guarantees to small
depositors, the legislation also attempted
to reduce the potential for destabilizing
deposit runs on commercial banks. And
the legislation established or maintained
different responsibilities for the major bank
regulatory agencies.
The thrust of the reform measures being
discussed today is quite different. Most now
tend to agree that the financial structure introduced in the aftermath of the Great Depression is no longer well-suited to promoting
the effectiveness and competitiveness of U.S.
banks in the marketplace. The emphasis of
the Treasury's proposal was to remove
barriers to competition in the private sector,
reduce the scope of federal deposit guarantees, and streamline the regulatory stmcture.
These divergent interests have offset each
other in the legislative process, making the
adoption of a comprehensive reform bill
more difficult today than it was in the 1930s.
Moreover, considerable disagreement still
exists among policymakers regarding the
extent to which we should roll back federal
deposit guarantees to allow deposit-market
discipline to have a greater impact on risktaking at insured financial institutions.

Corrigan (1991) and Hoskins (1989).

Golembe (I960).

Deposit Insurance Reform:
Has the Time Come?
The current system of federal deposit
insurance represents an attempt to protect
depository institutions and the public from
the potentially damaging effects of banking
panics, in which depositors indiscriminately
withdraw funds from the banking system by
converting bank deposits into currency.
Since its beginning in 1934, federal deposit
insurance coverage has been expanded
repeatedly, so that now it is not uncommon
for all deposits, regardless of size, to be
protected from loss when a bank fails.
By guaranteeing the full value of deposits,
federal deposit insurance greatly reduces the
potential for banking panics, but the extension
of federal deposit guarantees has created its
own problems. Without deposit guarantees,
the threat of withdrawal by uninsured depositors concerned about the safety of their
deposits provides a disciplinary role in guiding
banks to maintain sufficient capital and to
limit risk-taking. While the current system of
deposit insurance reduces the likelihood of
banking panics, it also effectively removes
the incentive for depositors to monitor banks.
This lack of deposit-market discipline encourages banks to reduce their capital-to-asset
ratios and to pursue high-risk investments.19
Because increased competition has reduced
the value of bank charters in recent years,
banks have had less to lose in the event of
failure and, consequently, have become
more prone to respond to the risk-taking
incentives provided by deposit insurance.20
The system of regulatory constraints designed to substitute for the monitoring and
disciplining role of depositors has not been
fully effective, as evidenced by the unprecedented financial losses from recent bank and
thrift failures. Since 1980, more than 1,300
banks have failed throughout the United
States, with the bulk of these difficulties con-

See Short (1987) and Short and O'Driscoll (1983).

Keeley (1990) discusses the decline in the value of
bank charters and its effect on deposit insurance abuse.

centrated between 1985 and the present.
Since 1985, the annual rate of U.S. bank failures has averaged nearly 2 percent. As shown
in Chart 12, this rate is comparable to the
bank failure rate in the 1920s. And with the
exception of the Great Depression (when
the rate of bank failures reached 20 percent),
the concentration of banking problems
during the past several years exceeds that
which occuned during any other banking
crisis in this country. In fact, the rate of bank
failures during the banking panic of 1907
was 0.42 percent, less than half the current
rate. The banking crisis of 1907 has important historical significance, because it is cited
as a strong motivating force behind the
establishment of the Federal Reserve System.
To an increasing number of depository
institutions, the price of deposit insurance
has become prohibitively high. Losses at the
nation's insolvent thrifts crippled the Federal
Savings and Loan Insurance Corporation
fund, and banks now face the growing
expense of recapitalizing the Bank Insurance
Fund when low profitability already has
strained the industry's competitiveness in the
financial-services market. Reform measures
currently under consideration link regulatory
discipline to bank capital levels, culminating
in bank closure before insolvency to minimize future losses to the Bank Insurance
Fund. But concerns persist. Will such changes
be sufficient, given the difficulty of measuring the present value of regulatory capital?
Evidence suggests that the appropriate
policy response to current banking difficulties
would be to relax the geographic and product restrictions under which banks currently
operate. Disagreement persists, however, over
the degree to which reintroducing deposit
market discipline will result in severe banking panics. These concerns are centered on
the potentially severe economic consequences
that could result if less than 100-percent
deposit insurance coverage is provided
when settling failed banks, particularly those
deemed "too big to fail." But the too-big-tofail doctrine itself is now being questioned
because of concerns that it adds to the cost
of resolving large failed banks. Analysts also

Chart 12
U.S. Commercial Bank Failure Rate*
Percent of all banks

* Vertical axis scale is logarithmic.
S O U R C E S : U.S. Department of Commerce, Bureau of the
Census, Historical Statistics of the United States
Colonial Times to 1970; Federal Deposit
Insurance Corporation, Annual Report, various
issues; Report of Condition and Income.

have serious concerns about issues of competitive equity vis-a-vis smaller banks.21
Recent evidence about the impact of
banking failures suggests that the potential
adverse effects of banking panics on the
health of solvent banks and macroeconomic
activity have been exaggerated. Throughout
most of U.S. banking history, losses on bank
deposits have been very small and similar
in magnitude to losses from failures of
nonbank businesses. Moreover, evidence
suggests that a spillover effect from the
failure of a large bank to other banks would
not have a severe adverse effect on general
economic activity. Finally, even if a potentially damaging panic developed, the central
bank could offset and reverse a generalized
outflow of deposits from the banking system
by extending credit to solvent banks through
the discount window or by injecting reserves
through open market operations.22

Concluding Remarks
The difficulties that financial institutions
in the Eleventh District experienced during
the 1980s involved a number of complicated
and interrelated factors—some economic,

some managerial, and others regulatory in
nature.23 The depth and duration of the
economic downturn in Texas had a dramatic
impact on the condition of the financial
institutions in the region. And the impact of
changing economic conditions in the
Southwest was certainly an important
detemiinant of the lending decisions made
by the region's financial institutions. But
the managerial decisions that were made
at the banks and thrifts in the region also
contributed to the financial difficulties that
emerged. And these managerial decisions
were influenced by the major legislative and
regulatory changes introduced in the 1980s
to deregulate the financial industry.24
In evaluating the broad-based financialsector difficulties that emerged in the
Southwest in the 1980s, a number of
questions have surfaced about the decision
to deregulate depository institutions without
adequately addressing the moral-hazard
problem inherent in the U.S. financial safety
net. The events that emerged in the Southwest and that have now surfaced elsewhere
in the country suggest that the legislative
changes in the early 1980s that deregulated
depository institutions while expanding the
scope of federal deposit insurance coverage
contributed to the portfolio choices and the
subsequent financial-sector difficulties that
have affected both borrowers and lenders in
this country.23

Proposed legislation would place some restrictions
on the too-big-to-fail closure policy, although it is still
uncertain what the final version of the legislation will
include. For additional discussion of too-big-to-fail
policies, see Short (1985).
21

22 For more on these issues, see Kaufman (1989),
Benston et al. (1986), Goodfriend and King (1988),
Wall and Peterson (1990), and Gunther and Robinson
(1991).
23

For more about these factors, see Robinson (1990).

See Robinson (1990).

For an empirical investigation of the impact of
moral hazard on bank risk-taking during the 1980s,
see Gunther and Robinson (1990).
25

Efforts to reintroduce a greater role for
deposit-market discipline in controlling
bank risk-taking would, over time, improve
the overall performance of the banking
industry. Such changes, however, are
unlikely to be introduced in the current
legislative environment. Our concern is
that, if market forces continue to be
discouraged from monitoring and shaping
bank risk-taking because of implicit 100percent deposit guarantees, expanded

powers for banks and a capital-based
system of regulatory oversight will not be
sufficient to ensure a sound banking
system. In addition to measures that
emphasize capital standards and regulatory
oversight, successful banking reforms need
to increase reliance on the incentives and
self-correcting processes provided by the
market to produce a safer, stronger, and
more efficient banking industry.

References
American Banker (1991a), "Treasury Unveils
Steps to Stimulate Lending," October 9, p. 1.
(1991b), "Loan Evaluation Guidelines Issued," March 4, p. 1.

Hoskins, W. Lee (1989), Reforming the
Banking and Thrift Industries: Assessing
Regulation and Risk, The American College/
Bryn Mawr Frank M. Engle Lecture, May.

Benston, George J., Robert J. Eisenbeis, Paul
M. Horvitz, Edward J. Kane, and George G.
Kaufman (1986), Perspectives on Safe and
Sound Banking (Cambridge, Mass.: MIT Press).

Kaufman, George C. (1991), "The Diminishing Roles of Commercial Banking in the U.S.
Economy," Issues in Financial
Regulation,
Federal Reserve Bank of Chicago Working
Paper Series, No. 1991/11, 6-7.

Bernanke, Ben S. (1983), "Nonmonetary
Effects of the Financial Crisis in the Propagation of the Great Depression," American
Economic Review 73(3): 257-76.

(1989), "Banking Risk in Perspective," in Research in Financial Services, ed.
George C. Kaufman (Greenwich, Conn.:
JAI Press).

Commerce Clearing House (1989), Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (Chicago: Commerce Clearing House, Inc.).

Keeley, Michael C. (1990), "Deposit Insurance,
Risk, and Market Power in Banking," American Economic Review 80(5): 1183-1200.

Corrigan, Gerald E. (1991), "The Risk of a
Financial Crisis," in The Risk of Economic
Crisis, ed. Martin Feldstein (Chicago: The
LJniversity of Chicago Press): 44—53.

Litan, Robert E. (1991), "The Present Crisis
in Banking: A Harbinger of the Future?"
The Future of Money and Banking in
America (Phoenix, Ariz.: The George
Edward Durell Foundation Conference, May).

Golembe, Carter H. (I960), "The Deposit Insurance Legislation of 1933: An Examination
of Its Antecedents and Its Purposes," Political
Science Quarterly 76(June): 181-200.

Moore, Robert R. (1991), "Brokered Deposits:
Determinants and Implications for Thrift
Institutions," Federal Reserve Bank of
Dallas Financial Industry Studies, December.

Goodfriend, Marvin, and Robert G. King
(1988), "Financial Deregulation, Monetary
Policy, and Central Banking," Federal
Reserve Bank of Richmond Economic
Review 74(May/June): 3-22.

Robinson, Kenneth J. (1990), "The Performance of Eleventh District Financial
Institutions in the 1980s: A Broader Perspective," Federal Reserve Bank of Dallas
Financial Industry Studies, May.

Gunther, Jeffery W., and Kenneth J. Robinson (1991), "The Texas Credit Crunch: Fact
of Fiction?" Federal Reserve Bank of Dallas
Financial Industry Studies, June.

Samolyk, Katherine A. (1991), "A Regional
Perspective on the Credit View," Federal
Reserve Bank of Cleveland Economic
Review 27(2): 27-38.

, and
(1990), "Empirically
Assessing the Role of Moral Hazard in
Increasing the Risk Exposure of Texas
Banks," Financial Industry Studies Working
Paper, Federal Reserve Bank of Dallas, No.
4-90 (October).

Short, Genie D. (1987), "Bank Problems and
Financial Safety Nets," Federal Reserve Bank
of Dallas Economic Review, March, 17-28.
(1985), "FDIC Settlement Practices
and the Size of Failed Banks," Federal

Reserve Bank of Dallas Economic
March, 12-20.

Review,

, and Jeffery W. Gunther (1988),
"The Texas Thrift Situation: Implications
for the Texas Financial Industry," Federal
Reserve Bank of Dallas Financial
Industry
Studies, September.
, and Gerald P. O'Driscoll, Jr. (1983),
"Deregulation and Deposit Insurance,"
Federal Reserve Bank of Dallas Economic
Review, September, 11-23.
U. S. Treasury Department (1991a), "Easing
the Credit Crunch to Promote Economic

Growth," Treasury News (Washington, D.C.:
Government Printing Office), October 8.
(1991b), Modernizing the Financial
System: Recommendations
for Safer, More
Competitive Banks (Washington, D.C.:
Government Printing Office), February 5.
Wall, Larry D., and David R. Peterson (1990),
"The Effect of Continental Illinois' Failure
on the Financial Performance of Other
Banks," Journal of Monetary
Economics
26(1): 77-99.

Brokered Deposits:
Determinants and Implications
for Thrift Institutions
Robert R. Moore
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

ome analysts view the use of brokered
deposits as a method to exploit the
shortcomings of the deposit insurance
system. Although brokered deposits can be
used to exploit those shortcomings, they can
also help improve the economy's ability
to allocate capital. The adverse effects of
brokered deposits emerge as a result of their
100 percent coverage by deposit insurance.
In this article, I examine the determinants
and implications of brokered deposits. I find
that a low capital-to-asset ratio, high asset
risk, and large thrift size are associated with
a high probability that a thrift uses brokered
deposits. In addition, evidence suggests that
thrifts are less likely to use brokered deposits
once they have been placed in conservatorship. These findings support concerns about
brokered deposits being used to exploit the
shortcomings of the deposit insurance system.
In the remainder of the article, I discuss
recent conditions in the thrift industry, provide a brief overview of brokered deposits,
examine the treatment of brokered deposits
under the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
(FIRREA), present summary statistics regarding
brokered deposits, develop and test a simple
model of brokered deposit use, and discuss
empirical results and policy implications.

Thrift Industry Conditions
The troubled thrift industry has received
widespread attention for several years. The
combination of short-term deposit liabilities
and long-term mortgage assets led to large
losses in the thrift industiy as interest rates

rose in the early 1980s. While declining
interest rates later reduced these losses, this
effect was offset by losses on problem loans
beginning in 1986, as Cacy (1989) reports.
By the end of 1988, 320 privately held thrifts,
or 10.8 percent of all federally insured thrifts,
were both unprofitable and insolvent, as
Table 1 shows. These thrifts had an average
return on assets of —11.3 percent and an
average capital-to-asset ratio of-21.4 percent.1
Because of the failure and subsequent
resolution of many insolvent thrifts since
the enactment of FIRREA in August 1989,
however, these figures improved somewhat
by the first quarter of 1991. Table 2 shows
that seventy privately held thrifts, or 3.1
percent of all federally insured thrifts, were
both unprofitable and insolvent, and these
thrifts had an average return on assets of
-4.1 percent and an average net-worth-toasset ratio of - 6 . 8 percent. At the same
time, 180 thrifts, with an average return
on assets of —13-5 percent and an average
net-worth-to-asset ratio of - 3 0 percent,
remained in the Resolution Trust Corporation's (RTC) conservatorship program.2
According to aggregate thrift data
released by the Office of Thrift Supervision
(OTS) for the second quarter of 1991, the
thrift industry's troubles are far from over.
While 85 percent of the nation's privately
held thrifts were profitable and earned net
income of $1.42 billion, the industry's overall second-quarter earnings were lower than

1 The economically relevant value of net worth is not
identical to the accounting value of net worth. Regula tors have allowed thrifts to carry large amounts of
goodwill on their balance sheets, and throughout this
study net worth refers to net worth excluding goodwill. Also, the accounting value of net worth is flawed
when assets are not marked to market; no attempt
was made to adjust asset values to market value in
this study.

The first quarter of 1991 was die most recent date
for which financial data on individual thrifts were
available for this study. Progress has been made since
then in resolving thrifts in conservatorship. As of
September 30, 1991, there were 104 thrifts in conservatorship nationwide, eight of which were in Texas.
2

Table 1
Thrift Profitability and Net Worth at Federally Insured Thrifts, 1988:4
Profitable

Unprofitable
Insolvent

320 Thrifts (10.8 percent of total)
Mean ROA:-11.3 percent
Mean C/A: - 2 1 . 4 percent
Mean BD/L:
5.9 percent

54 Thrifts (1.8 percent of total)
Mean ROA: 1.5 percent
Mean C/A: - 4 . 6 percent
Mean BD/L: 1.11 percent

Solvent

580 Thrifts (19.5 percent of total)
Mean ROA: - 1 . 4 percent
Mean C/A:
5.0 percent
Mean BD/L:
1.9 percent

2,016
Mean
Mean
Mean

Thrifts (67.9 percent of total)
ROA:
.8 percent
C/A:
6.9 percent
BD/L: 1.0 percent

NOTE: ROA = annualized fourth-quarter return on assets
C/A = ratio of equity capital less goodwill to assets
BD/L = ratio of brokered deposits to liabilities
S O U R C E : Author's calculations using thrift call report data.

those in the first quarter. The OTS attributed
the drop in earnings to the unprofitable
thrifts, which as a group lost $1.03 billion.3
The expense of resolving failed thrifts has
reached $160 billion, and an additional $80
billion of funding is proposed in new
legislation.4 One factor that may have
contributed to the expense of resolving
thrift failures was brokered deposits.

Overview of Brokered Deposits
Brokered deposits are deposits that are
channeled to thrift institutions through
investment bankers. A thrift may obtain
deposits directly or through a broker. For
example, if a thrift needs $1 million in new
deposits, it may obtain these deposits
through a broker, who for a fee would
divide the $1 million among ten or more
clients so that each depositor is fully insured.
There are several potential benefits of
brokered deposits. One benefit is the
improved flow of credit across regional

Cope (1991).

Thomas (1991).

boundaries. A thrift may be able to obtain
funds nationwide at a lower cost by using
brokered deposits than it could by obtaining deposits directly. In addition, the
brokered deposit market could improve
competition by exposing geographically
isolated thrifts to competition for deposits
from thrifts nationwide.
Although potential benefits of brokered
deposits exist, these deposits may exacerbate the problems inherent in the current
system of deposit insurance. The insurance
component of brokered deposits raises
concerns because it allows thrifts to
circumvent the $100,000 per account
ceiling on deposit insurance to obtain 100
percent explicit coverage of deposits.
Under the current structure of deposit
insurance, thrifts with low capitalization or
risky portfolios are able to attract deposits
without compensating insured depositors
for the risk in the thrift's portfolio. This
occurs because insured depositors are
relatively unconcerned about the soundness of the thrift in which their deposit is
located, given that they would be protected
from losses if the thrift were to fail. The
deposits in these high-risk thrifts represent

Table 2
Thrift Profitability and Net Worth at Federally Insured Thrifts, 1991:1
Unprofitable

Profitable

Insolvent

70 Thrifts (3.1 percent of total)
Mean ROA: -4.1 percent
Mean C/A: - 6 . 8 percent
Mean BD/L: 3.4 percent

36 Thrifts (1.6 percent of total)
Mean ROA: .5 percent
Mean C/A: - 2 . 0 percent
Mean BD/L: .89 percent

Solvent

284 Thrifts (12.4 percent of total)
Mean ROA: - 2 . 1 percent
Mean C/A:
5.0 percent
Mean BD/L: 1.5 percent

1,893
Mean
Mean
Mean

Thrifts (82.9 percent of total)
ROA: .7 percent
C/A: 7.1 percent
BD/L: .5 percent

NOTE: ROA = annualized first-quarter return on assets
C/A = ratio of equity capital less goodwill to assets
BD/L = ratio of brokered deposits to liabilities
Thrifts in conservatorship (180 thrifts) are excluded from the sample.
SOURCE: Author's calculations using thrift call report data.

potential losses for the thrift insurance
fund. Brokered deposits expose the
insurance fund to the risk of greater losses,
because a high-risk thrift generally can
attract more funds using brokered deposits
than by using only locally generated
deposits.
The use of brokered deposits by unhealthy thrifts may also have an adverse
effect on healthy thrifts. Brokered deposits
make it easier for unhealthy thrifts to
siphon deposits away from healthy thrifts
by offering higher interest rates on deposits
that are fully insured.5 This, in turn,
weakens thrifts that would otherwise be
profitable, thereby further increasing the
insurance fund's exposure to losses.

Brokered Deposits and FIRREA
In light of the adverse effects that may
arise when weak institutions use brokered
deposits, FIRREA contains provisions that
restrict the use of brokered deposits by
troubled institutions. In particular, paragraph 2224, section 224 states, "A troubled
institution may not accept funds obtained,
directly or indirectly, by or through any
deposit broker for deposit into 1 or more

deposit accounts." This restriction may be
waived on a case by case basis, however.
Furthermore, thrifts in conservatorship are
granted additional exemptions from the
restriction on brokered deposits.

Summary Statistics on Brokered Deposits
Evidence presented below shows that
brokered deposits have been an important
source of funds for thrifts.6 As of year-end
1988, thrifts outside of Texas had an
average of $23-3 million in outstanding
brokered deposits, and the average ratio of
brokered deposits to liabilities was 1.4
percent; the ratio ranged from a low of
zero to a high of 88.6 percent. In Texas,
the average thrift had $44.8 million in outstanding brokered deposits, and the average

5 Short and Gundier (1988) and Short and Robinson
(1991) discuss interest rate premiums at unhealthy
thrift institutions and the resulting adverse effects on
healthy institutions.

All of the data for this article were obtained from
thrift call reports from the fourth quarter of 1988 and
the first quarter of 1991. The sample was limited to
thrifts with federally insured deposits.
6

ratio of brokered deposits to liabilities was
6.2 percent; the ratio ranged from a low of
zero to a high of 54 percent. Also, 21.8
percent of thrifts outside of Texas used
brokered deposits, while 48.5 percent of
Texas thrifts used them. Chart 1 shows the
brokered-deposit-to-liability ratio by decile
for thrifts both within and outside Texas.
Thrifts in the highest decile had an average
brokered-deposit-to-liability ratio of 12.2
percent outside Texas and 35.8 percent
within Texas. Nationwide, thrifts that were
both unprofitable and insolvent had an
average brokered-deposit-to-liability ratio
of 5.9 percent, as Table 1 shows.
As of first quarter 1991, thrifts outside
of Texas had an average of $12.1 million
in outstanding brokered deposits, and the
average ratio of brokered deposits to liabilities was 0.9 percent; the ratio ranged from
a low of zero to a high of 81.2 percent. In
Texas, the average thrift had $23-3 million in
outstanding brokered deposits, and the
average ratio of brokered deposits to liabilities was 4.6 percent; the ratio ranged from
a low of zero to a high of 75.3 percent.
Chart 1
Brokered Deposit Use at
Thrift Institutions, 1988:4
Brokered deposits (percent of liabilities)

N O T E : B r o k e r e d d e p o s i t s w e r e 0 p e r c e n t of liabilities for all
thrifts in d e c i l e s 1 - 5 a n d for n o n - T e x a s thrifts in
deciles 1 - 7 .
S O U R C E : Author's calculations using thrift call report data.

Chart 2
Brokered Deposit Use at
Thrift Institutions, 1991:1
Brokered deposits (percent of liabilities)

•

36.3

•

Texas

•

Rest of the Nation

1
9.2

0.1

—m

H O . 2

Decile by brokered deposits

N O T E : B r o k e r e d d e p o s i t s w e r e 0 p e r c e n t of liabilities for all
thrifts in deciles 1 - 6 a n d for n o n - T e x a s thrifts in
deciles 1 - 8 .
S O U R C E : Author's calculations using thrift call report data.

Also, 16.3 percent of thrifts outside of Texas
used brokered deposits, while within Texas
36.4 percent of thrifts used them. Chart 2
shows the brokered-deposit-to-liability ratio
by decile for thrifts both within and outside
Texas. Thrifts in the highest decile had an
average brokered-deposit-to-liability ratio of
9.2 percent outside Texas and 36.3 percent
within Texas. Nationwide, privately held
thrifts that were both unprofitable and
insolvent had an average brokered-depositto-liability ratio of 3.4 percent, as Table 2
shows.
This preliminary look at the data reveals
that brokered deposits were used more
intensively among Texas thrifts than among
thrifts in the rest of the United States, both
in absolute dollar value and as a percentage of liabilities. Furthermore, the data
reveal that the use of brokered deposits at
the average thrift declined between 1988
and 1991, both in absolute dollar value and
as a percentage of liabilities. Within the
highest decile of thrifts, however, brokered
deposits increased as a fraction of liabilities
within Texas and declined modestly out-

side of Texas. Hence, in the post-FIRREA
environment, brokered deposit use has
declined on average, but brokered deposits
continue to be used intensively by a small
proportion of thrifts.

A Simple Model of Brokered Deposit Use
A simple model of brokered deposit use
can be built on the following principle:
Brokered deposits become more attractive
relative to alternative sources of funds
when the cost of obtaining funds through
uninsured deposits rises relative to the cost
of obtaining funds through insured deposits.
As insured deposits become more attractive
relative to uninsured deposits, a thrift will
be more likely to seek insured deposits
aggressively, using the brokered deposit
market. Using this principle, the net-worthto-asset ratio and measures of the risk in
the thrift's portfolio will help determine the
probability that a thrift will use brokered
deposits. Also, I will examine the influence
of the ratio of dividends to assets, net
income after taxes, conservatorship status,
and thrift size on the probability that a
thrift will use brokered deposits.
The probability of using brokered deposits
should be negatively related to the networth-to-asset ratio. When the net-worth-toasset ratio rises, the riskiness of uninsured
deposits falls, because there is a larger
cushion of capital protecting uninsured
depositors from declines in asset values.
The reduction in the riskiness of uninsured
deposits will reduce the competitive interest
rate that the thrift must offer to attract uninsured deposits. This reduces the attractiveness of brokered deposits relative to
uninsured deposits, therefore causing a
decrease in the probability of using brokered
deposits. In other words, the stronger the
financial institution, the lower the need for
brokered deposits.
The risk in a thrift's portfolio should
have a positive influence on the probability
of using brokered deposits.7 An increase
in the risk of the thrift's portfolio makes
uninsured deposits riskier as well, which
increases the competitive interest rate that

the thrift must offer on uninsured deposits.
This increases the attractiveness of brokered
deposits relative to uninsured deposits,
therefore causing an increase in the probability of using brokered deposits. In this
study, junk bonds, land loans, real estate
held for investment, repossessed assets,
and past-due loans are considered risky,
while government securities and one-tofour family mortgages are considered safe.
The risky assets can be divided into two
groups: junk bonds, land loans, and real
estate held for investment are considered
ex ante risk measures, because these areas
represent exposure to risks of loss in the
future; repossessed assets and past-due
loans represent ex post risk measures,
because they indicate that risky loans were
extended in the past. If patterns of risktaking persist, then ex post measures of risk
can be indicators of exposure to future
losses. To examine the effect of risk in
the thrift's portfolio on the probability of
brokered deposit use, I divide all the aforementioned risk measures by total assets to
control for the size of the thrift.
The theoretical effect of dividends paid
by a thrift on the probability of using
brokered deposits is ambiguous; paying
dividends reduces the amount of internal
funds available, leading to an increase in
the probability of brokered deposit use, but
paying dividends indicates financial strength,
implying a decrease in the probability of
brokered deposit use. Although the theoretical effect of dividends is ambiguous, the
empirical effect has interesting policy
implications; if an increase in dividends is
accompanied by an increase in the probability of brokered deposit use, then thrifts
may be replacing inside funds with outside
funds, thereby increasing the probability of
failure and the expected losses of the thrift

Risk, however, is difficult to measure, because the
amount of risk an asset contributes to the overall risk
in the portfolio depends on the covariance of the
asset's return with the other assets' returns.

insurance fund. To examine the effect of
dividends on the probability of brokered
deposit use, I divide dividends by total
assets to control for the size of the thrift.
I include the thrift's net income after
taxes as a determinant of brokered deposit
use. A firm operating with a net loss
indicates riskiness; if the losses persist,
then the thrift will eventually become
insolvent, leading to possible losses for
uninsured depositors. Also, firms with
negative net income will not have internally generated funds available for their
operations, and hence they will need a
larger quantity of outside funds, some of
which may come from brokered deposits.8
To control for the effect of thrift size when
examining the effect of net income after
taxes on the use of brokered deposits, I
divide net income after taxes by total assets.
Placing a thrift in conseivatorship has an
ambiguous theoretical effect on the probability of brokered deposit use. If reducing
reliance on brokered deposits were a goal
of the RTC, then the longer a thrift is in
conservatorship, the lower its probability of
brokered deposit use should become. 9 If,
however, funding constraints were limiting
the RTC's ability to resolve thrifts in
conservatorship, then the probability of

Alternatively, unprofitable thrifts might obtain funds
needed for operation by selling assets. Because of
information problems, the thrift would be likely to
sell its best assets, which provides an additional link
between net income after taxes and the riskiness of
a thrift.
8

Cole (1990) reports that the RTC used much of its
initial allocation of funds to replace brokered deposits
at thrifts in conservatorship.

10 Kane (1990) points out that the limited resources of
the RTC under FIRREA make it impossible to eliminate
all the high-cost brokered deposits in thrifts in conservatorship.
11 For example, if brokered deposit use is associated
with risky assets, but thrifts with risky assets tend to
have low capital, then brokered deposit use could be
mistakenly attributed to low capital.

brokered deposit use may increase as time
in conservatorship increases.10
The size of the thrift should have a positive
effect on the probability of brokered deposit
use. Thrifts that are large relative to their
local deposit base will be more likely to need
to obtain deposits from outside their local
market, leading to an increase in the use of
brokered deposits by large thrifts. Additionally, size may be correlated with aspects of
risk not captured in the other risk measures.

Empirical Evidence Regarding
Brokered Deposit Use
In this section, I assess the empirical
validity of the simple model of brokered
deposit use.
Sorting approach. One way of examining
the data to see whether a thrift characteristic has an influence on brokered deposit
use is to use a sorting approach. For
example, to see whether the net-worth-toasset ratio has an effect on brokered
deposit use, the sample of thrifts can be
sorted into four groups by their net-worthto-asset ratio; the average use of brokered
deposits can then be examined within each
of the four groups. This sorting approach
has the desirable feature of being simple,
but it does not control for other factors.11
The results obtained using the sorting
approach to examine the effect of the ratio
of net worth to assets on the brokereddeposits-to-liabilities ratio are presented in
Chart 3. In both 1988 and 1991, thrifts in
the lowest quartile of net worth to assets
had the highest ratio of brokered deposits
to liabilities, suggesting that net worth has
a negative effect on brokered deposit use.
This result is consistent with the predictions of the simple model.
Chart 4 presents evidence regarding the
effect of the size of the thrift (as measured
by total assets) on brokered deposit use
obtained using the sorting approach. The
results show that thrifts in the top quartile
by size have the highest ratio of brokered
deposits to liabilities in both 1988 and
1991, suggesting that there may be a

Chart 4

Chart 3
Brokered Deposit Use and Net Worth

Brokered Deposit Use and Thrift Size

Brokered deposits (percent of liabilities)

4•

5
• 1988:4
• 1991:1

3
Quartile by total assets

Quartile by net worth
SOURCE: Author's calculations using thrift call report data.

S O U R C E : Author's calculations using thrift call report data.

positive effect of thrift size on brokered
deposit use. This finding is also consistent
with the predictions of the simple model.
Evidence regarding the effect of time
spent in conservatorship on brokered
deposit use obtained using the sorting
approach is presented in Charts 5 and 6.
When thrifts in conservatorship are sorted by
the length of time spent in conservatorship,
the ratio of brokered deposits to liabilities
increases monotonically when moving from
the lowest quartile to the highest, as Chart 5
shows, and the percentage of thrifts using
brokered deposits increases monotonically
when moving from the lowest quartile to the
highest, as Chan 6 shows. These results
suggest a positive relationship between the
amount of time spent in conservatorship and
reliance on brokered deposits. Furthermore,
the average ratio of brokered deposits to
liabilities was 6.3 percent for thrifts in conservatorship, compared with 0.7 percent for
privately held thrifts.

bility that a thrift uses brokered deposits.12
Tables 3 and 4 present the numerical
results, and the box titled "Determinants of
Brokered Deposits" presents the qualitative
results. The qualitative effect of net worth
on the probability of brokered deposit use
is the same in both samples. In each
sample, an increase in net worth is associated with a reduction in the probability of
brokered deposit use, as predicted by the
theory discussed above. The effect of net
worth on the probability of brokered
deposit use is statistically significant at the
1-percent level in both samples.13 The
probit results are thus consistent with the
sorting approach results presented in Chart
3. As a thrift becomes more poorly capitalized, it is more likely to rely on brokered
deposits, which can increase the exposure
of the thrift insurance fund to losses.

Probit model. A probit model is used to
measure the partial effect of each of the
explanatory variables on brokered deposits,
holding all the other variables constant. The
probit model measures the effect of each
of the explanatory variables on the proba-

See Judge and others (1982) for a discussion of
probit models.
12

13 Statistical significance at the 1-percent level implies
that there is only a 1-percent chance of rejecting the
hypothesis that the coefficient on the variable in question equals zero when the coefficient is in fact zero.

Furthermore, the use of brokered deposits
by poorly capitalized thrifts contributes to
the lack of market discipline on thrift
activities. If poorly capitalized thrifts were
denied access to the nationwide pool of
insured deposits, then they would find it
more difficult to obtain funds needed for
operation. This would help limit the size
of undercapitalized thrifts.
The probit results show that an increase
in the fraction of a thrift's portfolio composed of risky assets is associated with an
increase in the probability of brokered
deposit use in both samples; the estimated
coefficients on all the risk measures are
positive, but the significance levels vary
widely. Both the effect of the fraction of
the portfolio composed of junk bonds and
the effect of the fraction of the portfolio
composed of real estate held for investment
are significant at the 1-percent level in the
1988 sample and the 10-percent level in the
1991 sample. The effect of both the fraction
of the portfolio composed of repossessed
assets and the fraction of the portfolio composed of land loans are insignificant in the
1988 sample at the 10-percent level but are
significant in the 1991 sample at the 1-percent

Chart 5

Brokered Deposit Use for
Thrifts in Conservatorship, 1991:1
Brokered deposits (percent of liabilities)

Quartile by time in conservatorship
S O U R C E : Author's calculations using thrift call report data.

Chart 6
Percentage of Conservatorship Thrifts
Using Brokered Deposits, 1991:1
Percent

Quartile by time in conservatorship
S O U R C E : Author's calculations using thrift call report data.

and 10-percent levels, respectively. The
effect of the fraction of the portfolio composed of past-due loans is not statistically
significant in either sample. The overall
results obtained for the effect of holding
risky assets are consistent with the theoretical
prediction regarding the effect of risk on
brokered deposit use; thrifts that hold a
large fraction of their portfolio in risky
assets are likely to use brokered deposits.
An increase in the fraction of a thrift's
portfolio composed of government securities
leads to a decrease in the probability that the
thrift uses brokered deposits in both samples;
the effect is significant at the 1-percent level
in both samples. Also, an increase in the
fraction of the thrift's portfolio composed
of one-to-four family mortgages leads to a
decrease in the probability that the thrift
uses brokered deposits in both samples,
with significance at the 1-percent level.
These results are consistent with the previous prediction regarding the effect of risk
on brokered deposit use; thrifts that hold
a large fraction of their portfolios in safe
assets are unlikely to use brokered deposits.
The dividends paid as a fraction of
assets have a positive effect on the prob-

Table 3
Probit Estimates for Brokered Deposit Use, 1988:4
Variable
INTERCEPT
ANWA**
JUNKA**
GOVTA**
MTG14A**
REOA**
DIVA*
PD60A
REPODA
LANDA
NIA**
A**
TEXAS

Estimated Coefficient
.156
-1.15
10.2
-3.85
-1.98
5.90
36.7
.504
.836
1.02
-5.48
.141
.00681

Standard Error
.101
.374
3.54
.578
.172
2.13
21.4
.822
.821
.771
2.31
.019
.121

n=2979
- 2 x log likelihood ratio = 612.41
"denotes significance at the 10-percent level
"denotes significance at the 1-percent level
Dependent Variable:
BD = 1 if brokered deposits > 0 (702 observations)
BD = 0 if brokered deposits = 0 (2,277 observations)
Independent Variables:
ANWA = assets minus liabilities minus goodwill divided by total assets
JUNKA = securities rated below investment grade divided by total assets
GOVTA = government securities divided by total assets
MTG14A = mortgage loans on one-to-four family structures divided by total assets
REOA = real estate held for investment divided by total assets
DIVA = cash dividends paid divided by total assets
PD60A = loans sixty or more days past due divided by total assets
REPODA = repossessed assets divided by total assets
LANDA = land loans divided by total assets
NIA = net income after taxes divided by total assets
A = total assets (in billions of dollars)
TEXAS = 1 if the thrift is in Texas, 0 if not in Texas
SOURCE: Author's calculations using thrift call report data.

ability of brokered deposit use in the 1988
sample, with significance at the 10-percent
level, but the effect is not statistically significant in the 1991 sample. Hence, the concern
regarding dividend payments causing inside
funds to be replaced by insured outside
funds may be less warranted in 1991 than
it was in 1988.
An increase in the thrift's net income after
taxes relative to assets causes a decrease in

the probability of brokered deposit use in
the 1988 sample, with significance at the
1-percent level, while the effect was not
statistically significant in the 1991 sample.
This suggests that the market relied on net
income as an indicator of risk to a greater
extent in 1988 than in 1991.
An increase in the size of the thrift (as
measured by total assets) leads to an
increase in the probability of brokered
23

Table 4
Probit Estimates for Brokered Deposit Use, 1991:1
Variable

Estimated Coefficient

INTERCEPT**
ANWA**
JUNKA*
GOVTA**
MTG14A**
REOA*
DIVA
PD90A
REPODA**
LANDA*
NIA
A**
TIMECON*
TEXAS
n=2467
-2 x
"denotes significance
'denotes significance
**denotes significance
Dependent Variable:

-.488
-3.10
20.0
-3.55
-.915
7.22
24.7
.211
5.41
2.30
1.56
.120
-.00114
-.224

Standard Error
.113
.564
10.5
.739
.197
4.14
26.8
2.15
.999
1.29
2.01
.0171
.000575
.159

log likelihood ratio = 367.95
at the 10-percent level
at the 5-percent level
at the 1-percent level

BD = 1 if brokered deposits > 0 (429 observations)
BD = 0 if brokered deposits = 0 (2,038 observations)
Independent Variables:
All independent variable definitions are the same as those in Table 3, with the following
exceptions:
PD90A = loans ninety or more days past due and still accruing divided by total assets
TIMECON = number of days in conservatorship, 0 if not in conservatorship
SOURCE: Author's calculations using thrift call report data.

deposit use; this effect was significant at the
1-percent level in both samples. This is consistent with the theoretical prediction regarding the effect of thrift size on brokered deposit
use. The results are also consistent with the
findings obtained using the sorting approach
presented in Chart 4. Size may have a positive influence on the brokered deposit ratio
because as a thrift becomes larger, it is more
likely to exhaust the supply of locally available deposits, causing it to seek deposits
nationwide through brokered deposits.
I estimated the effect of the amount of
time spent in conservatorship on the probability of brokered deposit use only for the
1991 sample, and the effect was negative and
24

significant at the 5-percent level. This implies
that the longer a thrift is in conservatorship,
the less likely it is to rely on brokered
deposits. This result contradicts the findings
obtained using the sorting approach presented in Chart 6, which showed that the
percentage of thrifts using brokered deposits
increased as the time spent in conservatorship increased. This inconsistency arises
because the sorting approach did not control
for the other determinants of brokered
deposit use. For example, the thrifts in
conservatorship had much lower capital-toasset ratios, on average, than the privately
held thrifts. After controlling for the positive
effect of low capital and other factors on

Determinants of Brokered Deposits
Determinant

Expected Sign

Estimated Sign
1988:4

1991:1

Significance
1988:4

1991:1

Net Worth

< 1%

Junk Bonds

< 1%

< 10%

Government Securities

< 1%

•

< 1%

< 10%

Dividends

< 10%

> 20%

Repossessed Assets

> 20%

< 1%

Past-Due Loans

> 40%

> 80%

Land Loans

> 10%

< 10%

Net Income

< 1%

> 40%

Size

< 1%

Days In Conservatorship

<5%

Texas Location

—

Residential Mortgages
Real Estate Holdings

> 80%

> 10%

NOTE: See Tables 3 and 4 for numerical values of the estimates and definitions of the
variables.
SOURCE: Author's calculations using thrift call report data.

brokered deposit use, the probit analysis
reveals that conservatorship actually reduced
the probability that a thrift would use
brokered deposits.
Finally, the effect of a Texas location does
not have a statistically significant effect on
the probability of brokered deposit use in
either sample, after controlling for the
effects of the other explanatory variables.
Texas thrifts are no more likely to use
brokered deposits than other thrifts in
similar financial condition.

Policy Implications
Brokered deposits, as the theory predicted, are more likely to be used when
underlying factors cause the cost of
obtaining funds through uninsured sources

to rise relative to the cost of obtaining
funds through insured sources. Decreases
in the capital-to-asset ratio, increases in the
risk in the portfolio, and increases in thrift
size are associated with increases in the
probability of brokered deposit use. The
results support concerns regarding the use
of brokered deposits to exploit the current
shortcomings of the deposit insurance
system. Hence, some may view FIRREA's
restriction on brokered deposit use by
troubled thrifts as a desirable first step in
curbing the abuses of deposit insurance,
although the evidence suggests that deposit
insurance may continue to be exploited
through brokered deposits. It is, however,
only the insurance aspect of brokered
deposits that has proven troublesome, and
25

current policy proposals may not go far
enough in reforming deposit insurance.
Because deposit insurance is not priced
in a way that reflects the risk in the thrift's
portfolio, thrifts with risky portfolios are in
effect receiving subsidized deposit insurance. These thrifts are able to maximize the
value of the subsidy by increasing their
holding of risky assets and financing the
risky assets through insured deposits,
including brokered deposits. This behavior
increases the thrift insurance fund's expo-

sure to losses if these risky activities cause
the thrift to fail. While there is nothing
fundamentally wrong with engaging in
risky activities, there will be an excessive
amount of lending to risky activities when
the cost of funds does not fully reflect the
risk, as is the case under deposit insurance
The best policy may be to address the
problems inherent in the current system of
deposit insurance, which are at the root of
the recent difficulties associated with
brokered deposits.

References
Barth, James R., Carl D. Hudson, and Daniel
E. Page (199D, "The Need to Reform the
Federal Deposit Insurance System," Contemporary Policy Issues 9 (1, January): 24—35.
Cacy, J. A. (1989), "Thrifts in the Troubled
1980s: In the Nation and the District,"
Federal Reserve Bank of Kansas City
Economic Review (December): 3-23.
Cole, Rebel A. (1990), "Thrift Resolution
Activity: Historical Overview and Implications," Federal Reserve Bank of Dallas
Financial Industry Studies (May): 1-12.

Chao Lee (1982), Introduction to the Theory
and Practice of Econometrics (New York:
John Wiley and Sons).
Kane, Edward J. (1990), "Principal-Agent
Problems in S&L Salvage," The Journal of
Finance 45 (3, July): 755-64.
Short, Genie D., andjeffery W. Gunther
(1988), "The Texas Thrift Situation: Implications for the Texas Financial Industry,"
Federal Reserve Bank of Dallas Financial
Industry Studies (September): 1—11.

Commerce Clearing House (1989), Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 (Chicago: Commerce
Clearing House, Inc.).

, and Kenneth J. Robinson (1991),
"Deposit Insurance Reform in the PostFIRREA Environment: Lessons From the
Texas Deposit Market," Consumer
Finance
Review Quarterly Report (Spring): 128-34.

Cope, Debra (1991), "Sick Thrifts Hold
Back S&L Profits in 2d Quarter," American
Banker, September 6.

Thomas, Paulette (1991), "House Panel
Votes Changes in S&L Bailout," The Wall
Street Journal, October 3-

Judge, George G„ R. Carter Hill, William E.
Griffiths, Helmut Lutkepohl, and Tsoung-

Full text of Financial Industry Studies : December 1991

FRASER