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inancial Industry

STUDIES
Federal Reserve Bank of Dallas

M a y 1990

Thrift Resolution Activity:
Historical Overview and
Implications
Rebel A. Cole
Economist

The Performance of Eleventh District
Financial Institutions In the 1980s:
A Broader Perspective
Kenneth J. Robinson
Senior Economist

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

Financial Industry Studies
Federal Reserve Bank of Dallas
May 1990

President and Chief Executive Officer
Robert H. Boy kin
First Vice President and Chief Operating Officer
William H. Wallace
Senior Vice President
George C. Cochran, III
Vice President
Genie D. Short
Economists
Rebel A. Cole
Jeffery W. Gunther
Kenneth J. Robinson
Kevin J. Yeats
Financial 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.
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.

Thrift
Resolution
Activity:
Historical Overview and
Implications
Rebel A. Cole
Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

etween 1980 and 1988, the Federal
Home Loan Bank Board (FHLBB)
resolved more than 900 troubled thrift institutions using a variety of techniques,
including supervisory merger, assisted
merger, liquidation, and stabilization.1 Of
the 115 Texas resolutions, 81 were involved
in transactions arranged as part of the
Southwest Plan introduced by the FHLBB in
1988 to address the concentration of
troubled thrifts in Texas. 2
This article examines thrift resolutions
completed during the 1980s and their
implications for public policy. Evidence
from the returns to the acquirers of failed
thrifts during the 1980s indicates that the
complex transactions negotiated by the
FHLBB may have led to wealth transfers
from both the Federal Savings and Loan
Insurance Corporation (FSLIC) and the
taxpayer to these acquirers.3 This evidence
suggests that greater reliance on simple
clean-bank and whole-bank, transactions for
resolving troubled institutions is preferable
to the more complex transactions implemented by the FHLBB during the 1980s.4

During 1989, the Federal Deposit Insurance Corporation (FDIC) placed an additional 317 thrifts into conservatorship or
receivership. These institutions held more
than $138 billion in assets. By the end of
1989, the Resolution Trust Corporation
(RTC) had liquidated only thirty-seven of
these thrifts. Inadequate resources slowed

the RTC's pace in resolving the remaining
280 institutions, forcing the RTC to raise additional working capital to expedite the
resolution process.5
The large number of thrifts that are
awaiting resolution pose a major challenge
to the regulatory agencies responsible for
implementing resolution activities. Beyond
the intervened thrifts that have already been
placed into conservatorship or receivership,
the FDIC has targeted more than 200 thrifts
with more than $160 billion in assets for
intervention during 1990. As many as 600

1 Cole (1990a) summarizes each of these resolution
techniques.
2 For a more complete assessment of the FHLBB's
Southwest Plan, see Short and Gunther (1988).
5 See Cole and Eisenbeis (1989), Cole, Eisenbeis, and
McKenzie (1989), and Balbier, Judd, and Lindahl
(1989).
1 In a clean-bank,
deal, the insurer removes nonperforming assets from a failed depository's portfolio,
replacing them with cash. This results in an essentially
healthy institution that is then marketed. In a ivholebank deal, the failed depository is marketed as is, with
potential acquirers bidding on the lump-sum cash
payment that they will receive from the insurer. In the
1980s, the FDIC has used clean- and whole-bank
transactions extensively to settle failed banks. The
strategic plan for the Resolution Trust Corporation also
favors this approach. Clean- and whole-bank deals
contrast with the typical FHLBB deals, as exemplified
by its Southwest Plan transactions, which involved the
acquisition of one or more institutions marketed as is,
but with complex and open-ended FSLIC assistance.
This assistance typically provided an intermediate- to
long-term note to cover the institutions' negative net
worth. It also provided guarantees against capital losses
and guaranteed yields on nonperforming assets. In
some cases, the capital-loss provisions called for loss
sharing or other incentives for the acquirer to minimize
actual losses and/or for the yield maintenance to taper
down over time. While such assistance packages
allowed both for the FSLIC to economize on cash and
for asset disposition to be regionally dispersed and
conducted by the private sector, they also were most
difficult to accurately value.

To resolve troubled thrifts, the RTC initially needs
more funds than it will ultimately spend. For example,
in a liquidation the RTC must pay off all insured
liabilities of a failed thrift upfront, but it can recover
some percentage of this payout as it disposes of the
thrift's assets. Much of the RTC's initial $20 billion
allocation was used to replace high-cost brokered
,

additional thrifts may not meet the minimum capital standards mandated by the
Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA).6 These
thrifts would face immediate restrictions on
growth and dividend payments and could
eventually face intervention.
To facilitate a better understanding of the
pending thrift resolutions that will be
implemented during the 1990s, it is important first to examine the thrift resolutions
that were completed in the 1980s.

A Historical Overview of Thrift Resolution
Activities in the 1980s

The thrift experience during the 1980s
had two distinct phases. In the first phase,
interest-rate spread problems caused by
rising interest rates and the deregulation of
deposit rates plagued the thrift industry.
This combination left thrifts holding portfolios of mortgage assets that were earning
substantially less than the interest cost of the
deposit liabilities with which they were
funded. In the second phase, asset quality
problems caused by the FHLBB's policy of
capital forbearance, deregulation, and asset

deposits at conservatorship institutions to decrease the
industry's cost of funds. FDIC Chairman William
Seidman testified before the U.S. House Banking
Committee that the RTC needed more than $50 billion
in working capital to resolve thrifts during 1990 and
that the shortage of working capital had seriously
delayed resolution efforts. In February 1990. the U.S.
Justice Department approved a plan by which the RTC
would borrow short-term working capital from the
Federal Financing Bank, an arm of the U.S. Treasury.
Initially, $11 billion would be raised through the
issuance of 90-day bonds at 12.5 basis points above the
Treasury bill rate.
In addition to authorizing $50 billion to close
insolvent thrifts, FIRRFA established a three-tiered
capital adequacy test for all remaining institutions. As
of December 7, 1989, thrifts must hold 1.5 percent
tangible capital, 3 percent core capital, and 6.4 percent
risk-based capital. Supervisory goodwill and purchased
mortgage servicing rights may be counted toward as
much as half of the core capital requirement. The riskbased capital requirement rises to 7.2 percent on
December 31, 1990, and to 8 percent on December 31.
1992.
6

See Flannery (1982) for a discussion of this issue.

growth as solutions to the earlier spread
problems plagued the thrift industry. In the
absence of deposit insurance reform, this
combination created strong incentives for
thrifts to adopt go-for-broke strategies
because the owners of a depository institution with near-zero or negative net worth
who are subject only to limited liability—
meaning that they can lose only the amount
of their investment—have incentive to
undertake high-risk, high-return investments
in an attempt to return their institution to
solvency. For a variety of reasons, including
the declines in oil and real estate prices,
problems in this second phase were concentrated in the Southwest, especially in
Texas.
Thrift resolution activities reflect the two
phases of the thrift experience during the
1980s. Chart 1 presents thrift case resolutions by year and by type. In this chart, two
waves of resolutions are visible. The first
wave peaks in 1982 with 247 resolutions,
while the second wave peaks in 1988 with
229 resolutions. During the intervening
trough years of 1983-87, less than 100
resolutions occurred in any one year.
The First Wave: Interest-Rate Spread
Problems. In the first wave of resolutions,
from 1980 to 1982, the FHLBB dealt with
troubled institutions primarily by arranging
supervisory mergers that entailed no explicit
cost to the insurance fund. Supervisory
mergers accounted for 181 of the 247
resolutions in 1982. In contrast, only one
liquidation occurred in that year. Reliance
on supervisory mergers allowed the FHLBB
to conserve the dwindling liquidity of the
FSLIC. The total cost of the 247 resolutions
completed in 1982 was less than $1 billion.
During this first wave, the FHLBB looked
to regulatory forbearance and asset growth
as substitutes for explicit assistance in
attracting potential merger candidates. In
effect, the FHLBB was anticipating that
declining interest rates would eliminate the
need for further action as institutions outgrew their spread problems. A fall in interest
rates would appear on thrift balance sheets
as an upward revaluation of underwater

Chart 1
Thrift Case Resolutions, 1980-88
(Number of Resolutions)

1980
•

1981
Stabilization

1982

1983

1984

" : Supervisory Merger

1985
Assisted Merger

1986

1987

1988

"P Liquidation

Source: Federal Home Loan Bank Board

Table 1
Case Resolutions by Type and Year*

Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
TOTAL

Stabilization
0
0
0
0
0
23
29
25
18
95

Supervisory
Merger
21
54
184
34
14
10
5
5
6
333

Assisted
Merger
11
27
62
31
13
22
36
30
179
411

Liquidation

Total
Closed

Total
Insolvent

0
1
1
5
9
9
10
17
26
78

32
82
247
70
36
64*
80*
77*
229*
917*

48
85
237
293
445
470
471
515
364
—

* These figures overstate the true total number of resolutions because many institutions were stabilized before final
resolution. Virtually all stabilizations have appeared or will appear again as mergers or liquidations. In addition,
several resolutions from the early 1980s reappeared in the latter years.
Sources: Analysis and Evaluation Division, Management Consignment Program Division, and Financial Assistance
Division of the FSLIC

mortgage portfolios.8 Asset growth would
allow a thrift to make new investments
earning returns greater than deposit costs.
Newer assets earning positive spreads
would offset the effect of older assets
earning negative spreads. Together, the
revaluations and growth effects would pull
formerly insolvent thrifts into the black.
Although interest rates did indeed
decline, regulators had not foreseen the
unintended side effect of regulatory forbearance on incentives for risk-taking. In an
attempt to outgrow their spread problems,
hundreds of thrifts moved into high-risk,
high-return investments in which they
lacked the expertise of their competitors.9
In so doing, they incurred huge credit risks
that ultimately would swamp the beneficial
effects of falling interest rates.
The Second Wave: Asset Quality
Problems. The second wave of resolution
activity came in the late 1980s. As Table 1
and Chart 1 show, resolutions rose from 64
thrifts in 1985 to 229 thrifts in 1988, and this
second wave was characterized by the
FHLBB's continuing policy of capital
forbearance and increasing reliance upon
assisted mergers. During 1988, the FHLBB
engaged in 179 assisted mergers. Despite
these efforts, 364 insolvent thrifts remained
in operation at year-end.
Problems in this second wave were
concentrated in the Southwest, and Table 2
and Charts 2-5 show how Texas resolutions
compare to those in the rest of the nation.
Chart 2 plots the number of case resolutions
in Texas and the United States from 1980 to
1988. In 1983-87, only 13 of 327 resolutions

H Underwater

mortgages refer to mortgages whose
market value is less than their face value because of a
rise in interest rates since the time the mortgage was
issued. Such discounts are not recognized on the books
of thrifts.
Many spread cases rode out the interest-rate peaks of
the early 1980s and returned to solvency and profitability in the falling-interest-rate environment of the mid1980s. These thrifts primarily made traditional housingrelated investments rather than moving into more
speculative commercial lending and direct investment
activities. See Rudolph (1989).
9

Chart 2
Thrift Case Resolutions, 1980-88
(Number of Resolutions)

•

Texas

•

Rest of U.S.

Source: Federal Home Loan Bank Board

—less than 4 percent of the total—occurred
in Texas. But, in 1988, 81 of the 229
resolutions—more than 35 percent of the
total—occurred in Texas.
Chart 3 plots the cost of resolutions
during 1980-88. From 1985 to 1988, Texas
resolutions accounted for a growing fraction
of the total U.S. cost. In 1988, Texas closures cost more than $19 billion, nearly
two-thirds of the $32 billion national total.
Nationally, resolution costs in 1988 were
more than three times the spending for the
entire 1980-87 period, which is strong
evidence that forbearance was the FHLBB's
preferred remedy during the 1980s.
Charts 4 and 5 identify thrift insolvencies
by year for both Texas and the United
States. Chart 4 shows the percentages of
insolvent thrifts, while Chart 5 shows the
actual number of insolvencies. The number
of insolvencies, excluding resolutions,
increased in each of these years, both in
Texas and in the nation. In 1983, 7 percent
of the 268 Texas thrifts were insolvent,
while nationally 9 percent of the 3,146
thrifts were insolvent. Texas thrift insolvencies peaked at 56 percent in 1988.
Nationally, insolvencies peaked in 1987 at
16 percent, declining in 1988 to 12 percent
as a record 229 thrifts were resolved.

Chart 3
Thrift Case Resolution Costs, 1980-88
(Billions of Dollars)

1980

1981

1982

1983
•

Texas

1984

1985

1986

1987

1988

Ht Rest of U.S.

Source: Federal Home Loan Bank Board

Table 2
Assisted Case Resolutions in Texas and the United States"
Year

Texas
Closed

Total
Closed

Texas
Cost

Total
Cost

Texas
Total
Insolvent Insolvent

(Billions of dollars)

1980
1981
1982
1983
1984
1985
1986
1987
1988
TOTAL

0
4
17
3
3
1
2
4
81
115

32
82
247
70
36
64*
80*
77*
229*
917*

0.000

0.001
0.078
0.000

0.164
0.155
0.493
1.504
19.491
21.886

0.167
0.759
0.803
0.275
0.743
0.979
3.065
3.704
31.792
42.286

7
8
23
19
36
48
85
128
114
—

48
85
237
293
445
470
471
515
364
—

Chart 4
Percentage of Insolvent Thrifts, 1980-88

Chart 5
Number of Insolvent Thrifts, 1980-88
500 _

400 300 200 .

100

1980

1982
•

Texas

1984
•

1986

1988

Rest of U.S.

1980

1982
•

Texas

1984
•

1986

1988

Rest of U.S.

Source: Federal Home Loan Bank Board

In this second wave of thrift resolutions,
supervisory mergers all but disappeared as
healthy thrifts were increasingly unwilling to
assume the burden of working out problem
assets of an insolvent institution as a means
of growth. As an alternative to supervisory
mergers, the FHLBB began a strategy
designed to stabilize insolvent thrifts by instituting its Management Consignment
Program (MCP) in 1985. In an MCP action,
the FHLBB placed an institution into
conseivatorship or receivership and usually
replaced the thrift managers responsible for
insolvency with managers of its own
choosing. The FHLBB aimed this program at
extinguishing shareholders' claims while
conserving the institution's franchise value
until a suitable merger partner could be
found. This was the FHLBB's way of dealing
with a shortage of reserves in the thrift
deposit insurance fund. By placing institutions into the MCP, the FHLBB made
progress in dealing with problem insolvencies while conserving the liquidity
that remained in the FSLIC.

national average and represented nearly
one-third of the national total. The Southwest Plan sought economies of scale by
merging many small insolvent thrifts into
larger entities that were then marketed to
potential buyers. Consolidations were
intended to lead to economies in operating
costs through the elimination of redundant
branches, making the packages more
attractive to potential bidders. Overall,
eighty-one Texas thrifts wrere closed in 1988
under the Southwest Plan at a cost of more
than $19 billion. But these actions were not
sufficient to completely restore the thrift
industry to financial health. As fast as the
FHLBB completed transactions, new
insolvencies occurred, and existing insolvencies grew more costly to resolve.

To deal with the regional concentration
of troubled thrifts in Texas, the FHLBB
instituted its Southwest Plan in 1988. As
Charts 4 and 5 show, insolvencies in Texas
in 1988 were more than five times the
6

The FHLBB's Resolution Strategies.
Through both waves of resolutions, the
FHLBB sought to merge insolvent thrifts
with healthy institutions, either with or
without FSLIC assistance. If a troubled thrift
retained franchise value in excess of its
negative net worth, then a merger was often
accomplished at no explicit cost to the
FSLIC in a supervisory merger.10 While
supervisory mergers involved no explicit
costs to the FSLIC, they always entailed
implicit costs of regulatory forbearance,

including reduced capital requirements,
waived interstate branching restrictions, and
the potential for reemergence as a problem
institution. A major point of contention over
the recent implementation of stricter capital
requirements for thrifts, some of which
exclude supervisory goodwill, was the loss
of forbearance.11 Acquiring institutions
booked large amounts of goodwill in
supervisory mergers and were allowed to
count this goodwill toward regulatory
capital. This type of forbearance saved the
FSLIC the considerable cash outlays necessary to resolve these institutions by other
methods.
When no supervisory merger partners
could be found, the FHLBB was forced to
grant assistance to the acquirer at a positive
explicit cost to the thrift insurance fund in
an assisted merger. In addition to implicit
costs associated with supervisory mergers,
assisted mergers also carried explicit costs,
usually incurred in the form of cash or notes
in the amount of the institution's negative
net woith, indemnification for capital losses
incurred on the sale of covered nonperforming assets, and yield subsidies on
nonperforming assets to compensate
acquirers for accepting a below-market
return on these assets.
The open-ended nature of assisted
mergers made them the most difficult type
of resolution for the FSLIC to value. Many of
the costs attributable to explicit assistance
depended on future events. Lower-thanexpected returns and disposition prices on
covered assets have significantly increased
the costs of the majority of FSLIC-assisted
transactions. The resulting increase in assistance increased the acquirers' tax shelter.12

Evidence on Abnormal Returns and Sources of
Value in Thrift Resolutions
Congressional hearings on the thrift crisis
focused new attention on how the FHLBB
conducted case resolutions and how it
structured FSLIC assistance packages. In a
properly structured assistance agreement,
the value of assistance provided would be
sufficient to compensate the acquiring

institution for assumed risks, and thus
would yield no wealth transfer from the
deposit insurance fund to the acquirer. If,
on the other hand, the assistance package
overcompensated the acquirer, then wealth
transfers from the deposit insurance fund to
shareholders of the acquiring institution
would occur. These transfers should be
observable through abnormally large returns
on the acquirers' publicly traded equities.
Evidence from several studies confirms
the existence of such returns.13 When FSLICassisted thrift mergers were publicly announced, they led to positive abnormal
returns on the acquirers' stocks. When
voluntary thrift mergers were announced,
no such positive abnormal returns were
observed. These findings suggest that the
FHLBB overcompensated acquirers of
failing thrifts.
While the abnormal returns were statistically significant, their economic significance
is less certain. Abnormal returns observed in
assisted mergers averaged about 2 percent
of the acquiring firm's market value, which
is small relative to the amounts of assistance
granted. While wealth transfers appear to
have occurred, they were not a very large

"' Franchise value refers to intangibles such as longterm customer relationships that are of value to
financial institutions.
11 Several thrifts have filed suit for breach of contract
over this issue.
All FSLIC assistance was exempt from federal taxation
until 1989, when tax benefits were cut in half. Losses
on the sale of nonperforming assets were deductible,
even as FSLIC indemnification for such capital losses
was tax-exempt. Hence, the tax shelter increased with
the amount of assistance. For thrift acquirers only,
accumulated net operating losses from the failing thrift
could also be used for tax shelter. Both Kormendi,
Pirrong, and Snyder (1989) and Cole, Eisenbeis, and
McKenzie (1989) find evidence that the FSLIC did not
adequately value these tax benefits as part of its
assistance packages. This oversight may have biased
case resolutions away from liquidations toward mergers
by understating the full costs of these mergers.
" Cole and Eisenbeis (1989), Cole, Eisenbeis, and
McKenzie (1989), and Balbier, Judd, and Lindahl (1989)
report such results.

pait of the total resolution costs incurred in
these transactions.14
More interesting than the existence of
positive abnormal returns are the potential
sources of these returns. If abnormal returns
can be attributed to the ways in which the
FHLBB conducted case resolutions, then it
may be possible to eliminate these sources
of value in future resolutions by altering the
methods used by the FHLBB. Hence,
identification of the sources of value in past
assisted acquisitions may lead to significant
economies in the hundreds of resolutions
that the RTC has yet to conduct.
Analysis of potential sources of abnormal
returns in FSLIC-assisted mergers provides
evidence that three factors—capital forbearance granted by regulators, underestimation
of assistance costs by regulators, and superior information held by acquirers relative to
regulators—led to positive abnormal returns
and wealth transfers from the FSLIC and the
Treasury to the thrift acquirers.15 Other
potential sources of value, including core
deposits, relative size, and geographic
diversification through interstate acquisitions, were also examined but were not
found to be significant in explaining
abnormal returns. Table 3 summarizes these
findings.
In each assisted merger, the FHLBB
granted regulatory capital forbearance to the
acquiring thrift. Forbearance is most valuable to acquirers with low or negative net
worth because it protects them from being
seized by regulators for deficient capital.
Evidence suggests that shareholders of
acquirers with low or negative tangible net
worth realized an increase in value from the
regulatory capital forbearance that accompanied their firm's initial assisted acquisition.
In all of its deals, the FHLBB has been
criticized for underestimating the true costs
of the open-ended assistance granted to
acquirers. If shareholders perceived that the

14 Abnormal returns also averaged about 2 percent of
resolution costs, but with considerable variation.
15 See Cole, Eisenbeis, and McKenzie (1989).

FHLBB was undervaluing the assistance
packages, then abnormal returns should be
positively related to the estimated value of
FSLIC assistance.
To test two variants of this criticism,
researchers examined both the ratio of
assistance to acquired assets and the
absolute amount of assistance as potential
sources of value. If systematic underestimation of the assistance cost was a source of
excess returns, then the assistance-to-assets
ratio should be positively related to abnormal returns. As this ratio increased, so did
the potential for measurement error. Hence,
the larger this ratio is, the larger the potential abnormal returns become.
However, if measurement errors were
small, but tax benefits to acquirers were not
included in the assistance cost estimates,
then abnormal returns should be positively
related to the absolute amount of assistance.
Abnormal returns would depend only on
the tax benefits, which are proportional to
the dollar value of assistance granted. Abnormal returns would not depend upon the
size of the acquired firm. In this latter case,
the acquirer would receive wealth transfers
from the taxpayer rather than from the
FSLIC insurance fund. Evidence supports
only the latter criticism that the FHLBB did
not adequately value the tax benefits
granted to acquirers. This finding suggests
that acquirers received wealth transfers from
the taxpayer rather than from the FSLIC
insurance fund.
Concerns were expressed that cash and
personnel constraints placed the FHLBB at a
disadvantage to acquirers in assessing the
market value of assets held by troubled
thrifts. Such asymmetric information could
lead acquirers to ask for more assistance
than necessary to compensate them for the
risk involved in the acquisition. If successful, the acquirer would reap a wealth
transfer from both the FSLIC insurance fund
and the taxpayer. Results of the analysis
strongly support this informational asymmetry hypothesis. Specifically, acquirers appear
to have more accurately assessed the market
value of the mortgage-backed securities

Table 3
Sources of Value in FSLIC-Assisted Acquisitions
Source of Value

Expected Sign

Actual Sign

+
+
+
+
+

Capital Forbearance
Underestimation of Costs
Informational Asymetries
Interstate Merger
Core Deposits
Relative Size of Frims
1988 Deals

Significance*
< 10
< 5
<.01
> 10
> 10
> 10
> 10

*Probability (in percent) of rejecting the hypothesis that the variable in not a source of value when, in fact, it is not.
Source: Cole, Eisenbeis, and McKenzie (1989).

held by the thrifts upon which they were
bidding, and this superior information
appears to have enabled them to reap
windfall gains in these transactions.
In summary, analysis of voluntary and
FSLIC-assisted thrift mergers reveals that
acquirers earned positive abnormal returns
from assisted transactions that were not
present in voluntary mergers. Further
analysis of potential sources of value in
these assisted mergers shows that three
factors—regulatory capital forbearance,
underestimation of assistance costs, and
superior information held by acquirers
relative to the FSLIC—were significant in
explaining the positive abnormal returns.
These results have important policy implications for the FDIC, the RTC, and the Office
of Thrift Supervision (OTS) as they continue
to deal with the thrift crisis. FIRREA has
appropriated funds for the RTC to begin
case resolutions and has granted regulators
important new tools in an attempt to
prevent a recurrence of the systemic
failures. Still, it is the FDIC, RTC, and OTS
that must implement the actual cleanup. In
the next section, the public policy implications of these findings are examined.

Policy Implications from FSLIC-Assisted
Case Resolutions
To assess the policy implications from
the evidence on FSLIC-assisted resolutions,
one must remember the political and financial constraints under which they were con-

ducted. The FHLBB had to regulate an
industry whose market value was negative
throughout the 1980s. It simply lacked the
personnel resources to adequately monitor
the troubled segment of the industry, and it
lacked the monetary resources to close the
insolvent segment of the industry. In this
second-best world, the evidence that
acquirers earned positive abnormal returns
averaging 2 percent of their market value is
not surprising. Under the circumstances, this
is not an unduly large margin of error.
However, the evidence on sources of the
abnormal returns offers some guidance on
how to make margins of error even narrower in future case resolutions.
Regulatory forbearance provides positive
abnormal returns to acquirers, which is
consistent with other work on forbearance
demonstrating that resolution costs increased if a thrift continued to operate while
insolvent.16 To stanch the financial hemorrhaging of insolvent depository institutions,
regulators should follow a policy of prompt
closure for undercapitalized institutions. Unfortunately, as both the FHLBB and the RTC
have found, liquidity constraints may force
regulators to delay resolution actions until
Congress can provide adequate funding.

16 Cole (1990b) reports that the 769 failed thrifts he
examined were insolvent, on average, for more than
three years, and that the length of insolvency was
statistically significant in explaining resolution costs.

The positive influence of the dollar value
of FSLIC assistance provides evidence that
the FSLIC underestimated the true value of
the tax breaks it was granting to acquirers.
This finding suggests that the use of tax
breaks to augment assistance packages is
inefficient; therefore, future resolutions
should be explicitly funded from deposit
insurance reserves.
Strong evidence exists of informational
asymmetries between regulators and acquirers. Regulators should explore ways to
improve their informational endowment.
Performance of due diligence reviews on all
failed institutions before marketing is one
avenue by which to remedy this informational problem. Assistance cost savings from
information thus acquired should easily
offset the costs of the reviews.
Taken as a whole, the evidence suggests
that future case resolutions should follow
the FDIC's lead in moving away from
complex deals involving open-ended assistance and moving toward simpler cleanbank and whole-bank deals, where bidders
ask for a one-time lump sum payment from
the insurance fund in exchange for taking
over a troubled thrift. Once the regulator
has performed a due diligence review and
marked assets to market value, there is
much less chance for underestimating the
ultimate costs of cash assistance. By reducing the potential for underestimation of the
cost of assistance, regulators can ultimately
reduce the actual assistance costs.
The advantages of clean- and wholebank transactions derive from the simplicity
in estimating the costs to the deposit
insurance fund. Bidders calculate how large
of a single payment they would require to
take over the troubled thrift. Hence, regulators can readily compare the impact of
alternative bids on the deposit insurance
fund.

FIRREA explicitly requires regulators to reexamine all
1988 FSLIC-assisted transactions to identify if cost
savings could be achieved by renegotiating the deals.
17

In contrast, estimation of the costs of a
transaction involving open-ended assistance
are subject to large errors because of the
long-term nature of the assistance and the
uncertain value of the covered assets and
the tax shelter granted to the acquirer. If
interest rates or asset market conditions
change from those assumed in the costing
scenarios, the ultimate costs to the insurance fund can vary greatly from the
assumed costs.
These results also suggest that the RTC
should investigate the possibility of exercising call options on covered assets included
in past deals.1" The FHLBB wrote into many
deals options that allow the government to
buy back covered assets at book value.
Such buybacks hold the promise of considerable cost savings for deals where guaranteed yields on nonperforming assets are
above the RTC's cost of funds.

Conclusions
This historical overview of thrift resolutions in the 1980s may show how to reduce
the costs of resolutions in the 1990s. As an
unprecedented number of institutions are to
be dealt with in a short time, evidence from
FSLIC case resolutions offers the following
insights.
Costs may be reduced by striving to
eliminate potential informational asymmetries between regulators and potential
acquirers through the collection of assetspecific information on the market values of
thrifts that are to be resolved. To accomplish
this, more resources may need to be
directed at current thrift resolution efforts to
ensure that cash and personnel constraints
do not hinder these efforts.
Furthermore, the structure of assistance
agreements has a major effect on resolution
costs. The use of implicit assistance such as
capital forbearance and tax benefits as
substitutes for explicit assistance payments
appears to be less efficient than direct cash
assistance because implicit assistance is
more difficult to value.
Based on the experience in the 1980s,
the resolution policies of the FDIC and RTC

appear preferable to those of the FSLIC.
Simple whole-bank and clean-bank transactions decrease resolution costs relative to
the more complex mergers involving openended assistance by reducing the potential
for underestimating the final dollar cost of
the assistance. Despite this advantage, even
these simply structured assisted resolutions
may not adequately account for the com-

petitive impact that the newly created
institutions have on their nonintervened
competitors, banks and thrifts alike. Because
of the large number of thrift institutions that
will require resolution during the next few
years, the unassisted competitors of the
resolved institutions will grow more concerned with this issue, meriting additional
study of this subject.

References
Balbier, Sheldon, G. Donald Judd, and
Frederick W. Lindahl (1989), "Wealth Effects
and the Acquisitions of Failed Thrifts,"
Mimeo, Duke University, February.

Flannery, Mark J. (1982), "Deposit Insurance
Creates a Need for Bank Regulation,"
Federal Reserve Bank of Philadelphia
Business Review, January/February.

Cole, Rebel A. (1990a), "Insolvency versus
Closure: Why the Regulatory Delay in
Closing Troubled Thrifts?" Mimeo, Federal
Reserve Bank of Dallas, February.

Kane, Edward J. (1989), The S&L Insurance
Mess: How Did it Happen? ( Washington,
D.C.: The Urban Institute Press).

(1990b), "Agency Conflicts and
Thrift Resolution Costs," Mimeo, Federal
Reserve Bank of Dallas, February.
, and Robert A. Eisenbeis (1989),
"Excess Returns in FSLIC-Assisted Acquisitions of Thrift Institutions," Proceedings of
the Conference on Bank. Structure and Competition, Federal Reserve Bank of Chicago,
May.
,
, and Joseph A. McKenzie
(1989), "Excess Returns and Sources of
Value in FSLIC-Assisted and Voluntary Acquisitions of Thrift Institutions," Financial
Industry Studies Department Working Paper
no. 189, Federal Reserve Bank of Dallas,
December.
Eisenbeis, Robert A., and Myron Kwast
(1989), "Are Real Estate Specializing Depositories Viable?" Board of Governors of the
Federal Reserve System, Finance and
Economics Discussion Series, No. 88,
August.

Kormendi, Roger, Victor Bernard, Craig
Pirrong, and Edward Snyder (1989), "Crisis
Resolution in the Thrift Industry: Beyond
the December Deals," Report of the MidAmerica Institute Task Force on the Thrift
Crisis, March.
Rudolph, Patricia (1989), "The Insolvent
Thrifts of 1982: Where are They Now?"
AREUEA Journal (Winter).
Short, Genie D., 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
(1989), "The New Financial Landscape in Texas," The Bankers'
Magazine (March/April).

The Performance of
Eleventh District
Financial Institutions
In the 1980s:
A Broader Perspective
Kenneth J. Robinson
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

n the three decades preceding the 1980s,
a bank failure was a relatively rare event.
The number of banking institutions that
failed averaged about six per year from
1950 through 1979. This tranquil period
came to an abrupt end in the 1980s. Bank
failures in the United States increased from
10 in 1980 to more than 200 in 1989. An
even bleaker picture emerged in the
Eleventh District of the Federal Reserve
System, where District bank failures rose
from zero in 1980 to 144 in 1989. More
important, as a percentage of total U.S.
failures, Eleventh District bank failures
climbed steadily from zero percent at the
beginning of the decade to 70 percent in
1989- The increase in failures in the savings
and loan industry reflects an even more
dramatic pattern.
The unprecedented number of financial
institution failures, both in the nation and in
the District, necessitated increasingly costly
outlays by the various federal agencies
responsible for insuring deposits. As the
burden on insurance funds grew, innovative
ways to deal with financial-sector distress
emerged. Innovations ranged from new
settlement practices implemented by the
Federal Deposit Insurance Corporation
(FDIC), to the Federal Home Loan Bank
Board's Southwest Plan, to the Financial
Institutions Reform, Recoveiy and Enforcement Act of 1989. The 1989 legislation

resulted in a major restructuring of the
regulatory framework for thrifts, eliminated
the Federal Savings and Loan Insurance
Corporation (FSLIC), and placed responsibility for insuring the deposits of both banks
and thrifts under the FDIC.
To help prevent future difficulties, the
causes of current financial distress need to
be identified. Those factors that led to the
problems plaguing financial institutions in
the Eleventh District can be viewed as a
microcosm of those factors that have
afflicted intermediaries throughout the
nation. A confluence of elements—economic, regulatory, and managerial—lies
behind the deterioration of financial institutions both in the District and across the
nation. Because the same factors, albeit in
more concentrated dimensions, lie behind
both national and Eleventh District financial
troubles, the District's experience can shed
light on how best to achieve a smooth
transition to the new financial environment
that is evolving nationwide.

Background
Financial intermediaries are middlemen
in financial markets. Banks, savings and
loan associations, credit unions, and other
types of intermediaries channel the surplus
funds of savers to the most productive use
by investors. These financial intermediaries,
in effect, transform their demand deposits—
or short-term liabilities received from depositors—into longer-term, less liquid and
higher-yielding assets, mainly in the form of
loans. This transformation encourages
saving, stimulates investment, and promotes
economic growth by reducing the cost of
credit.
Traditionally, banks provided most
financial intermediation services, and they
did so within a prescribed set of regulations. Much of the current banking regulatory framework originated in the aftemiath
of the Great Depression. Particularly, the
Banking Act of 1933 shaped much of the
regulatory structure of banking for the next
fifty years. The Banking Act of 1933, also
known as the Glass-Steagall Act, separated
13

commercial and investment banking,
prohibited payment of interest on demand
deposits, and regulated the amount of
interest payable on time and savings deposits. In addition, the Glass-Steagall Act
established the FDIC. One year later,
Congress created the FSLIC under the
jurisdiction of the Federal Home Loan Bank
Board.
Federal deposit insurance helped restore
confidence in U.S. depository institutions.
Congress created both the FDIC and the
FSLIC as part of an overall legislative
package designed to regulate bank risktaking and ensure the safety and soundness
of the financial system. Banks were limited
primarily to accepting deposits and making
loans, while thrifts dealt mainly with the
provision of home mortgage credit. In short,
intermediaries generally conducted business
in their home states or counties and paid
interest on deposits no higher than allowed
by federally authorized ceilings.
This institutional framework performed
fairly well throughout most of the period
following the Great Depression. Except for
episodes of severe economic distress,
misuse of banking resources by inept or
corrupt managers caused most postDepression bank failures. By the mid-1970s,
however, the financial sector was in the
early stages of a major restructuring.
Traditional financial intermediaries faced
increasing competition from new providers
of financial services. In addition, with the
emergence of the Euromarkets, capital markets worldwide became increasingly
integrated.

(1984). Moreover, thrift institutions, which
primarily hold large amounts of long-term,
fixed-rate mortgages, suffered large declines
in net worth. The sharp run-up in interest
rates that began in the late 1970s hit thrifts
particularly hard.1 By the early 1980s, the financial environment clearly was in a state of
flux as the number of bank failures began to
rise steadily (Chart 1). A sign of further
instability is revealed in Chart 2, which
shows the percentage of banks that the
FDIC labeled as problems.

Chart 1
U.S. Bank Failures

1980

1982

1984

1986

1988

Source: FDIC Annual Reports

Chart 2
FDIC Problem Banks as a Percentage
of Total Insured Banks
(Percent)

Along with these changes in the financial
framework, several large banks failed or
required special assistance to continue
operations. Troubled banks included U.S.
National Bank of San Diego (1973), Franklin
National Bank (1974), Penn Square Bank
(1982), Seattle-First National Bank (1983),
and Continental Illinois National Bank
1980
For a discussion of the problems in the thrift
industry, see Cole (1990).

1982

1984

Source: FDIC Annual Reports

1986

1988

District Financial Distress
Recent attention has focused on the
severe problems of Eleventh District
financial institutions, banks and thrifts alike.
Return on average assets of District commercial banks turned negative in 1986 and
stood at -0.28 percent at the end of 1989.
For banks in the rest of the United States,
average return on assets was 0.5 percent in
1989- The District thrift industry suffered
even more severe losses. More than onehalf of all Texas thrifts were insolvent at the
end of 1988. As of the third quarter of 1989,
only one-fourth of the thrifts in the Eleventh
District of the Federal Reserve System were
both profitable and solvent.
No single cause can be identified for the
troubles experienced by Eleventh District
financial institutions in the last few years.
Rather, events seem to have resulted from a
combination of forces that precipitated an
adverse financial climate. Economic,
regulatory, and managerial factors played a
role, although the specific impact of each
factor is difficult to distinguish and may vary
across regions and institutions. But a
growing consensus of opinion maintains
that the same interrelated forces that created
difficulties in the Eleventh District are
emerging at financial intermediaries nationwide.
Economic Factors. Several volatile economic factors had a negative impact on
financial intermediaries both in the region
and nationally during the past decade. As
inflation accelerated in the 1970s, binding
interest-rate ceilings on deposits made
banks and thrifts nationwide increasingly
vulnerable to deposit outflows. Inflationinduced increases in market interest rates
spawned substitutes for regulated deposit
accounts, principally in the form of mutual
funds. As a result, traditional intermediaries
began to face increased competition in the
provision of financial services. In addition,
financial institutions holding a significant
amount of long-term mortgages suffered a
sharp deterioration in the market value of
their asset portfolios. Finally, adverse

economic conditions in a number of
developing countries appear to have had a
negative impact on the performance of
banks with a significant amount of outstanding debt from lesser developed countries, while depressed commodity prices led
to a record number of bank failures in the
Farm Belt.2
Locally, the oil-price shock of the
mid-1980s plunged the Eleventh District
economies into a prolonged slump. The deterioration in economic activity precipitated
asset-quality problems at a number of
District financial institutions. Chart 3 tracks
the increase in average nonperforming loan
rates for selected loan categories of Eleventh
District banks. Real estate loans presented
the most difficulties for banks, but they
were preceded by problems with business
loans. Chart 4 shows the upward trend of
nonperforming loans recorded since the
mid-1980s for Texas thrifts.
As asset-quality problems increased,
financial institutions in the Eleventh District
began to experience a depletion in their
Chart 3
Nonperforming Loan Rates for
Eleventh District Banks
(Percent)

1982

1983

"Total

1984

1985

1986

Real Estate

1987

1988

1989

Business

Source: Report of Condition and Income

See Kane (1985), Sachs and Huizinga (1987), and

Carron (1988).

Chart 4
Nonperforming Loan Rates for Texas Thrifts
(Percent)

~~ Mortgages

*"" Nonmortgages

Source: Thrift Financial Report, Federal Home Loan
Bank Board

equity capital. Chart 5 indicates that equity
capital of banks, measured as a percent of
assets, declined from about 7 percent at the
beginning of the decade to less than 5
percent at the end of 1989. Texas thrift
institutions suffered a much larger decline in
their net worth position, as shown in Chart
6. Encouragingly, many difficulties in the
Eleventh District appear to have abated.
Problems at the largest institutions have
been identified and steps toward solutions
have begun. Some improvement in the
nonperforming loan rate at Eleventh District
banks is evident in data for the past two
years. However, the current rate of total
nonperforming loans is still above that
recorded in 1985, the last year in which
Texas banks overall reported positive
net income.
Regulatory Factors. The changing
economic climate provided the impetus for
both de facto and de jure deregulation of
the financial services industry that characterized the 1980s. A diverse group of parties
pushed for changes in the regulation of the
financial system, including the federal
government, regulatory agencies, financial
institutions themselves, and consumer
groups.
16

Interest rate ceilings on deposits were
gradually eliminated beginning in the late
1970s in response to the disintermediation
brought about by these ceilings. This
deregulatory process reached its peak in the
early 1980s with the passage of the Depository Institutions Deregulation and Monetary
Control Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982.
One consequence of these regulatory
changes is that financial intermediaries
nationwide are becoming more and more
alike in their provision of financial services.
Deregulation in the 1980s freed both banks
and thrifts to engage in new activities and
to enter ventures that previously were off
limits to them.
Deregulation also phased out interest
rate ceilings on most deposit accounts and
broadened the asset and liability powers of
a number of financial institutions. New
legislation also authorized savings and loans
to expand their consumer loan business and
to issue credit cards, eliminated the effects
of state usury laws on certain types of
loans, and empowered all depository
institutions to pay interest on checkable
deposits. Entry restrictions were relaxed,
which contributed to increased competition
among various types of depository institutions. At the same time, the scope of federal
guarantees of deposits was increased
substantially. In contrast to the movement
toward a more deregulated environment,
federal deposit insurance coverage was
extended to accounts of up to $100,000,
from a maximum of $40,000. 3 In the
Eleventh District, a deteriorating economy
in a more deregulated financial environment, coupled with an increase in federal
deposit insurance, set the stage for managerial decision-making that followed.
Managerial Factors. The managerial
factors that contributed to financial-sector
problems of the 1980s resulted from a
regulatory-incentive structure that motivates
managers of insured institutions to assume
added risk. A recent analysis of the difficulties troubling Texas banks indicated that the
sharp decline in oil prices initiated the

Chart 5
Equity to Assets Ratio for
Eleventh District Banks
(Percent)

Source: Report of Condition and Income

Texas banking problems, but risk-taking
also contributed substantially to the severity
of the financial losses. Banks that adopted
relatively risky management strategies in the
form of both high reliance on commercial
and industrial loans and constmction loans,
and greater use of large certificates of
deposit for funding, suffered much greater
difficulties than did their more conservative
counterparts. Aggressively managed banks
experienced sharper increases in their
average troubled asset ratios and suffered a
much sharper decline in their equity positions than did their more conservative
counterparts.4
Economic theory predicts that it is not
coincidental for a structural change in the
regulatory framework, coupled with a
deteriorating economic environment, to be
followed by a decade of the worst banking
and thrift performance since the 1930s. The
existing regulatory-incentive structure
encourages excessive risk-taking on the part
of managers of financial institutions. When
this structure is combined with a deteriorating economic climate, financial distress is
likely to follow.
The risk-taking incentives inherent in the
current regulatory framework stem from the
moral hazard problem associated with
deposit insurance. Moral hazard, present in

Chart 6
Equity to Assets Ratio for Texas Thrifts
(Percent)

Note: Net worth measured under Generally Accepted
Accounting Principles
Source: Thrift Financial Report, Federal Home Loan
Bank Board

any insurance scheme, refers to the likelihood that insurance coverage leads insured
parties deliberately to pursue risks that, in
an uninsured state, they would not undertake. The flat-rate premiums assessed for
deposit insurance make intermediaries' cost
of this insurance independent of their risk
profile. Given the moral hazard problem,
insurance coverage tends to increase
institution risk-taking unless deposit insurance is properly priced. Therefore, deposit
insurance has not eliminated the risk of
deposit institution insolvency, but merely
transferred this burden from deposit institutions and their creditors to the deposit
insurance funds.
Regulators impose capital standards on
insured institutions to offset the moral
hazard problem. Private capital acts as a

See Benston (1986), Cooper and Fraser (1986), Litan
(1987), and Kane (1989) for a more complete
description of the various changes in the regulatory
environment. For a thorough analysis of the consequences of regulation in the financial services industry,
see Haraf and Kushmeider (1988).
1 See Gunther (1989).
3

buffer to shield the deposit insurance funds
from any potential losses these intemiediaries might incur.5 When deposit insurance
guarantees remain both credible and
underpriced, too few managers find the
benefits of strengthening their capital
accounts to be worth the cost of raising
additional equity. Unclerpricing of deposit
insurance results in a substitution of equity
in the form of insurance guarantees for
private capital. Moreover, as the market
value of deposit institutions' charters
declines due to increased competition and
adverse economic conditions, the insured
institutions have increased incentives to
gamble on more risky investments.6 With
lower amounts of private capital at risk,
managers are even more willing to undertake risky projects because they will benefit
from any potential returns, no matter how
remote the possibility. On the other hand,
losses in excess of the capital cushion are
absorbed by the deposit insurance fund.
With little of their own capital at stake,
deposit institutions are encouraged to adopt
a higher-risk profile than they might in the
absence of deposit insurance.

Proposed Solutions
The lessons of the recent past help
identify both the direct and indirect effects
that arise from asset-quality problems at
financial intermediaries. The direct effects
spring from the operation of impaired or
thinly capitalized institutions and the
resulting decline in financial-intermediation

See Buser, Chen, and Kane (1981), who argue that
there exists both an explicit and an implicit premium
associated with federal deposit insurance. The explicit
premium is the flat-rate assessment. The implicit
premium appears in the form of regulatory standards
for capital adequacy. These authors argue that capital
adequacy rules are the critical element in the FDIC's
pricing strategy.
s

See Kane (1985) and Keeley (1988).
As was true before the 1980s, managerial factors in
the form of fraud and abuse have also contributed to
current financial difficulties.
s For an analysis of thrift resolution activities in the
1980s, see Cole (1990).
6
7

services. The healthy segment of the
industry feels the indirect effects as adverse
consequences arise from the continued
operation of troubled intermediaries.
Financial-institution distress, both in the
Eleventh District and in the nation, has
prompted a variety of innovative measures
to resolve current difficulties and to enhance
the safety and soundness of the financial
system.
Bank Resolution Activities. In its resolution activities, the FDIC attempts to accomplish two goals: to minimize the cost of
failure resolution to the deposit insurance
fund and to maintain discipline in the
banking industry. Traditionally, the FDIC
has used two methods in resolving individual bank failures: the standard purchase and
assumption (P&A) and the payoff (P/O).
The P&A is the most common settlement
practice. Under a purchase and assumption,
a healthy bank purchases a failed bank, including the assumption of its sound assets,
often with FDIC assistance. The P/O
involves a payment by the FDIC to insured
depositors. Then, the FDIC liquidates the
assets of the failed institution and distributes
the proceeds on a pro-rata basis to the
failed institution's secondary creditors.
As the size and complexity of banking
industry problems increased, the FDIC
began to implement new procedures for
resolving failed banks. Some of these new
resolution activities represent variations on
the two traditional methods. Other procedures involve various degrees of financial
infusions to the ailing institutions. A more
complete description of these innovations
appears in the box on page 19-8
Financial Institutions Reform Recovery
and Enforcement Act. In response to the
continuing deterioration of the thrift industry, and in recognition of its potential
impact on banks, President George Bush
unveiled a comprehensive reform package
on February 6, 1989- The legislation was
signed into law on August 9, 1989, and is
formally known as the Financial Institutions
Reform, Recovery, and Enforcement Act of
1989 (FIRREA). This legislation created the

FDIC Resolution Activities
The increasing frequency of bank failures
led the FDIC to introduce several modifications to and innovations on its traditional
resolution activities—the purchase and assumption (P&A) and the payoff (P/O). The
modified payoff (MODPO) operates much
like a P/O, but immediate fractional payments are made on the claims of secondary
creditors rather than after liquidation.
The total asset purchase and assumption
(TAPA) is an innovation classified as a
whole-bank deal. All assets of a failed bank
are passed to the acquiring institution, which
then pays a negative bid premium for the
failed institution. The insured deposit transfer
(IDT) functions much like a P&A—after
soliciting bids, the FDIC transfers all federally
insured deposits, less a premium, to the winning bank. The deposit transfer and asset
purchase agreement (DITAPA), introduced in
1986, is a combination of the insured deposit
transfer and a P&A. Insured deposits are
transferred to the acquiring institution, which
may then purchase only those assets it

Resolution Trust Corporation (RTC) to
merge or liquidate all existing insolvent
savings and loan associations and any that
fail in the next three years. The act placed
the regulatory and supervisory functions of
the Federal Home Loan Bank Board under
the Treasury Department in the Office of
Thrift Supervision. All twelve regional
Federal Home Loan Banks are now under
the newly established Federal Housing
Finance Board, an independent agency of
the Executive Branch. Thrift deposit insurance is brought under the FDIC, with
separate thrift and bank reserve funds to be
maintained.
FIRREA contains many measures ostensibly designed to prevent a recurrence of the
events of the past few years. Thrifts must
abandon some of their riskier activities, including equity investments and junk bonds.

deems desirable. Setbacks in many FDICinsured mutual savings banks in the late
1970s led to the development of the financially assisted merger (FAM). Under a FAM,
the institution remains open with FDIC
assistance until a merger can be arranged.
Under open bank assistance (OBA), the
FDIC can assist a troubled bank before and
in lieu of closure. A bridge bank (BB) is a full
service national bank operated for up to
three years by a board of directors appointed
by the FDIC. Finally, the small loan asset
purchase, or SLAP, is the most recent FDIC
creation. The acquiring institution assumes
all insured deposits and purchases all loans
with balances below an established amount. 1
Tablel and Table 2 provide a summary of
the distribution of these resolution activities
both nationwide and in the District during the
1980s.

For a more complete description of these resolution

methods, see FDIC (1984, 1987), and Kane (1985).

They must also have 70 percent of their
assets in mortgage-related investments.
Thrifts will be required to meet more
stringent capital requirements and will
ultimately be held to the same capital
standards as banks. Many observers expect
that problems plaguing the thrift industry
today will be resolved through provisions in
FIRREA. Sufficient funding may enable the
RTC to close insolvent thrifts or merge them
with healthy institutions. Satisfactory
resolution of problem institutions would
eliminate any adverse effects that these
institutions can inflict on their healthy
competitors.9

See Short and Gunther (1988). For more on the

competitive impacts of financial-sector distress and
resolution, see Short (1990).

Table 1
Distribution of U.S. Failed Bank Resolutions (1980-89).
Year

P/O

1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
Total

3
2
7
7
1
18
12
10
6
9
75

P&A

7
5
25
35
62
87
98
133
95
89
636

TAPA

IDT

FAM

OBA

MODPO

69
42
111

2
12
7
19
40
30
22
132

3
10
4
1
2
5
5

2
2
14
20
1
40

3
4
9
1

Total

11
10
42
48
79
120
145
203
220
207
1,085

Resolution Methods:
P / O = D e p o s i t P a y o f f or L i q u i d a t i o n
P&A = Purchase and Assumption
T A P A = Total Asset Purchase and Assumption
IDT = I n s u r e d D e p o s i t T r a n s f e r
F A M = Financially A s s i s t e d M e r g e r
O B A = O p e n B a n k or 13(c) A s s i s t a n c e
M O D P O = M o d i f i e d Payoff
DITAPA = Insured Deposit Transfer and Assets Purchase Agreement
Notes: Open Bank Assistance (OBA) was granted to First Pennsylvania Bank in 1980. OBA granted to First City
counted in 1988 as assistance to one bank. OBA granted to United Bank Alaska and Alaska Mutual Bank
in 1988 counted as assistance to one bank. Both banks sold to Alliance Bank. OBA granted to Texas
Bancorp Shares counted as assistance to one bank in 1988. Texas Bank and Texas Bank North were
merged. Forty FirstRepublic Bank Bridge Banks counted under P&A in 1988. Assistance granted to
FirstRepublic on March 17, 1988, was not counted separately. One MBank was transferred to the Deposit
Insurance Bridge Bank (BB) via a DITAPA transaction and is counted here under BB. A total of twenty
banks from MCorp were under the Bridge Bank and were sold to BancOne Corp. Twenty-four banks of
Texas American-Bancshares transferred to Texas American Bridge Bank on July 20, 1989, and later to
Team Bank.
Source: Federal Deposit Insurance Corporation

Table 2
Distribution of Eleventh District Failed Bank Resolutions (1980-89).
Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
Total

P/O

2
3
1
1
4
4
3
15

P&A TAPA

IDT

FAM

4
2

OBA

MODPO

DITAPA

SLAP

Total

40
44
84

0
0
7
3
6
15
33
67
121
144
396

1
1
3

12
25
38
11
22
117

4
34
24
62

1
1
1
2
8

1
3
1

12
4
1
17

2
7
14
13
36

14
35
49

Financial Reform. FIRREA represents an
important step toward improving the safety
and soundness of the financial system.
However, additional reform measures could
further enhance the effects of FIRREA.
Congress recognized this by requiring in
FIRREA that the Treasury Secretary and the
General Accounting Office deliver, within
eighteen months of the bill's enactment,
separate studies of the deposit insurance
system. These studies will investigate,
review, and evaluate the current system in
an effort to "reduce the probability of future
problems in the financial sector that would
necessitate Federal outlays."10
The debate on further reform measures
has not centered exclusively on the current
structure of deposit insurance. Instead, to
help ensure against a replay of recent
events, a combination of reform measures

has been proposed. Market-value accounting, more stringent capital requirements,
and reform of the deposit insurance system,
taken together, aim to restrain excessive
risk-taking on the part of managers of
financial intermediaries. Greater prudential
supervision and examination would complement these market-oriented reforms and
would also help temper the possibility for
fraud and abuse in the financial sector.
A move toward a more accurate assessment of financial intermediaries' balance
sheets would enhance regulators' goals of
maintaining a safe and sound financial system. Market-value accounting, by providing

See Title X of FIRREA and paragraph 5001 of the

Conference Report of FIRREA.

reliable information on the value of unrealized losses and gains, would also provide
valuable information to investors and
depositors. Valuing assets that do not trade
in an open market is more difficult, but as
long as unbiased appraisal techniques are
used, errors in valuing individual assets
would tend to cancel out one another.
Market-value accounting would also
facilitate the introduction of more stringent
capital requirements. Sufficient capital,
measured at market value, helps ensure that
owners of depository institutions, rather
than the deposit insurance funds, absorb
any losses that might occur. As Congress
recognized in FIRREA, higher capital cushions enhance the condition of individual
institutions and promote the stability of the
banking system. Implementation of riskbased capital requirements, scheduled for
1992, represents a movement in this direction. These requirements provide a definition of capital, a scheme for risk-weighting
bank assets and off-balance-sheet items, and
target capital ratios.11
Observers have noticed that banking and
thrift industry troubles, both in the District
and nationwide, could not have occurred
without the current system of federal
deposit insurance.12 A flat-rate deposit
premium encourages insured institutions to
hold riskier portfolios than they otherwise
would and at the same time penalizes more
conservatively managed institutions. To
address this issue, reformers have proposed
measures to reduce or eliminate the moral
hazard problem associated with deposit
insurance.
Replacing the current flat-rate premium
with a risk-based assessment, consistent
with risk-based capital requirements, would

eliminate some of the incentives the current
system offers to engage in excessively risky
activities. Administration of these proposals
would require an accurate assessment of
risk, however, which is not easy to accomplish. Implementing a system of coinsurance
is another technique for ameliorating the
defects in the current system of deposit
insurance. Coinsurance introduces discipline
on risk-taking by forcing depositors to
participate in any realized losses. This could
result in some loss of depositor confidence,
though, as the unavoidable side effect of the
introduction of coinsurance.13
The three interrelated proposals outlined—market-value accounting, more stringent capital requirements, and deposit
insurance reform—are attempts to complement FIRREA by introducing greater discipline on the risky activities undertaken by
depository institutions. This would be
accomplished by offering depositors both
more reliable information about the underlying soundness of financial institutions and
incentives to monitor and respond to
changes in an institution's risk exposure.
These reforms would reduce the completeness of deposit insurance coverage for those
depositors large enough and sophisticated
enough to protect their exposure at a lower
cost than regulators are able to achieve. As
a result, the goal of these additional proposals for reform is to supplement the regulatory activities of those agencies responsible
for the smooth functioning of the financial
system. Coupled with more prudential
monitoring and examination, these measures would provide flexibility for depository
institutions to respond to a changing
financial environment without imposing
undue risks on the system of federal safety
nets.

Conclusions
See Wall (1989) for a description of these proposed
capital standards.
12 See Carron (1988), and Kane (1985, 1989).
L A coinsurance system was a part of the original
<
deposit insurance plan. See FDIC (1984). Title X of
FIRREA directs the Secretary of the Treasury to consider
these (and other) reform measures in its report to
Congress.
11

Financial distress has been evident in the
Eleventh District. A sharp regional recession
brought about by the decline in oil prices in
the early 1980s precipitated a host of bank
and thrift difficulties. Economic factors
alone, however, cannot account for the

condition of financial institutions in the
Eleventh District. A regulatory framework
that encouraged risk-taking, along with
managerial decision-making that responded
to these incentives, also played a role in the
current plight of District banks and thrifts.
The condition of depository institutions
nationwide has also deteriorated. On a
national scale, financial-sector difficulties
can be traced to a melding of the same
three interrelated factors—economic, regulatory, and managerial—that affected District
financial institutions. Analysts expect recent

legislation to help resolve financial intermediaries' current distress. Additional measures that have been debated would complement regulatory efforts at achieving safety
and soundness and would also help to
prevent a replay of the current situation. A
move toward more meaningful accounting
measures, enhanced capital requirements,
and diminution of the moral hazard associated with deposit insurance, would
strengthen market discipline and serve as a
safeguard against excessive risk-taking by
depository institutions.

References
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Full text of Financial Industry Studies : May 1990

FRASER