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Foreword
Shortly after her confirmation, then-Chairman Ricki R. Helfer directed the FDIC’s
staff to undertake this study. She strongly believed that a careful examination and analysis
of the banking crises of the 1980s and early 1990s would provide information that would
allow the FDIC to better fulfill its mission.
The banking problems of the period were of a magnitude not seen since the Great
Depression and the advent of federal deposit insurance and therefore provide a unique window through which we can study the causes of, and the regulatory and supervisory response
to, sharply increased numbers of bank failures in a modern economic and banking environment. There have, of course, been significant changes since the early 1990s in the performance and structure of the banking industry. Moreover, in the wake of the banking crises
and subsequent legislative reforms, changes in the supervisory process have attempted to
ensure improved monitoring of bank risk and more timely intervention in, and closure of,
troubled banks. But not all the issues raised by the problems of the 1980–1994 period have
been laid to rest. Moreover, the current improved condition of the industry and the supervisory changes of the late 1980s and early 1990s do not mean that banking problems cannot
return sometime in the future. Although it is clear that the problems of the past are unlikely
to be precisely repeated in the future, the study of these recent crises is nevertheless instructive. At the very least, the history of the turbulent time in banking should teach us that
we cannot afford to be complacent, and the FDIC hopes this study that glances backward
will be helpful as we look forward.
This study was prepared by the FDIC’s Division of Research and Statistics. Every effort was made to ensure the accuracy of the information it contains and to provide an impartial assessment of what occurred. As is the case with any history, however, the
interpretations made by those who have written it are important to its structure and conclusions, and these interpretations are not necessarily those of the Federal Deposit Insurance
Corporation.

Andrew C. Hove, Jr.
Chairman
December 1997

Acknowledgments
As Chairman Hove has indicated in his foreword, in 1995 the Division of Research
and Statistics was directed by then-Chairman Helfer to undertake an examination of the history of the banking crises of the 1980s and early 1990s. The study was initiated in the belief that with the banking industry recovering, it was important to look back at the crises that
had just passed and to assess what had taken place. The study would serve to identify areas
where the agency’s mission could be better accomplished in the future, and to learn from
the unique experience that the 1980s and early 1990s provided to the regulators and bankers
alike.
This study was conducted under the direction of George Hanc, Associate Director,
Division of Research and Statistics. Lee Davison was responsible for day-to-day management of the study and provided expertise on historical research methods. Jack Reidhill was
integral to the process of planning and executing the study. John O’Keefe made many
important contributions concerning analytical methodology in all areas of the study.
The primary authors of the study were:
Chapter 1. The Banking Crises of the 1980s and Early 1990s:
Summary and Implications

George Hanc

Chapter 2. Banking Legislation and Regulation

Lee Davison

Chapter 3. Commercial Real Estate and the Banking
Crises of the 1980s and Early 1990s

James Freund,
Timothy Curry,
Peter Hirsch,
and Theodore Kelley

Chapter 4. The Savings and Loan Crisis and Its
Relationship to Banking

Alane Moysich

Chapter 5. The LDC Debt Crisis

Timothy Curry

Chapter 6. The Mutual Savings Bank Crisis

Alane Moysich

Chapter 7. Continental Illinois and “Too Big to Fail”

Lee Davison

Chapter 8. Banking and the Agricultural Problems of the 1980s

Brian Lamm

Chapter 9. Banking Problems in the Southwest

Brian Lamm
and John O’Keefe

Chapter 10. Banking Problems in the Northeast

Brian Lamm
and John O’Keefe

Chapter 11. Banking Problems in California
Chapter 12. Bank Examination and Enforcement

Chapter 13. Off-Site Surveillance Systems

Victor Saulsbury
and Timothy Curry
Timothy Curry,
with contributions by George Hanc,
John O’Keefe,
Lee Davison,
and Jack Reidhill
Jack Reidhill
and John O’Keefe

Many others on the staff of the Division of Research and Statistics provided extremely
valuable research assistance, analyzed large quantities of complex data, and helped in other
ways, both with production of the study and with the organization of the FDIC symposium
on the study held in January 1997. Especially important research and analytical support
were provided by Cynthia Angell, Jane Coburn, Joseph Colantuoni, Steven Guggenmos,
James Heath, Robin Heider, Matthew Klena, Sandra Meyer, Lynne Montgomery, Lynn
Shibut, Tara Sorensen, and Kenneth Walsh. Additional work was done by Joseph Bauer,
Daniel Bean, Richard Brown, Timothy Critchfield, James Curtis, Jay Golter, Ronnie Kidd,
Laura Kittleman, Rose Kushmeider, James McFadyen, Erin Robbins, Martha Solt, Mark
Taylor, Ross Waldrop, Katie Wehner, Thomas Yeatts, and Jennifer Zanini.
In addition, I want to thank Detta Voesar, Jane Lewin, and Christine Blair for their
work in editing and reviewing the many drafts of each chapter, Geri Bonebrake for her work
on graphics and layout, and Cathy Wright and Donna Schull for secretarial assistance in
preparing the final manuscript. I also want to thank the reference staff of the FDIC Library,
all of whom were unfailingly helpful in locating research materials for the study.
The FDIC’s Division of Supervision was extremely helpful during the course of the
study, and provided us with invaluable support. In particular, Joseph Ketchmark and Eric
Dahlstrom provided both knowledge about the supervisory process and important research
assistance, and Sidney Carroll, Michael Jaworski, and Robert Walsh took part in the interviewing of regulators and bankers for the study.
I want to acknowledge the contribution of George French, now Deputy Director of the
FDIC’s Division of Insurance, who directed the project in its initial stages.
vi

History of the Eighties—Lessons for the Future

Several individuals, both inside and outside the FDIC, provided extremely helpful
reviews of drafts of various chapters, and I would like here to thank Peter Elmer, Donald
Inscoe, Barry Kolatch, Daniel Nuxoll, and Steven Seelig (from the Division of Research
and Statistics), Frederick Carns and Gary Zimmerman (Division of Insurance), Lynn
Nejezchleb (Office of the Vice Chairman), and Jesse Snyder (Division of Supervision) for
their thoughtful readings. Other staff in both the Division of Supervision and the Division
of Insurance read drafts of all the chapters and provided many helpful suggestions. In
addition, I want to express my appreciation to David Boughton from the International
Monetary Fund, Jennifer Eccles from the Office of the Comptroller of the Currency,
Leonard Lapidus from the Department of the Treasury, and Kevin Kleisen from the Federal
Reserve Bank of St. Louis for their reviews of specific chapters. Finally, I want to recognize
the contribution made by participants at the FDIC’s symposium on the History of the
Eighties, whose comments led to improvements in this, the published study.
I would also like to thank our colleagues at the Office of the Comptroller of the
Currency, the Federal Reserve System, and the Office of Thrift Supervision for their
assistance in providing information without which the study could not have been
completed. In particular, I would like to acknowledge Fred Finke, Robin Stefan and Sally
Curran from the OCC and Stephen Schemering, AnnMarie Kohlligian, Carolyn Drach, and
Susan Fleshman from the Board of Governors of the Federal Reserve for their help in
assembling examination and/or enforcement data for the study. The FDIC would also like
to thank those bankers in various regions across the country who generously took time to
answer questions and give their views on the banking crises of the 1980s and early 1990s.
William R. Watson, Director

Division of Research and Statistics

History of the Eighties—Lessons for the Future

vii

List of Tables and Figures
Table 1.1
Table 1.2
Table 1.3
Table 1.4
Table 1.5
Table 1.6
Table 1.7
Table 1.8
Table 1.9
Table 1.10
Table 1.11
Table 1.12
Table 1.13
Table 1.14
Table 3.1
Table 3.2
Table 3.3
Table 3–A.1
Table 3–A.2
Table 4.1
Table 4.2
Table 4.3
Table 5.1a
x

Bank Failures by State, 1980–1994
Assets of Failed Banks at the Quarter before Failure, by State,
1980–1994
Bank Failures and Growth Rates of Real Personal Income, by State,
1980–1994
Bank Failures and Growth Rates of Real Personal Income, by State
Recession Quartile
Selected Financial Ratios
Failure Rates, Newly Chartered and Existing Banks
Failure Rates of Converted Mutual Savings Banks and Other Banks,
Northeastern States
Results of Bank Forbearance Programs
Number of Bank Examiners, Federal and State Banking Agencies,
1979–1994
Mean Examination Interval, by Initial Composite CAMEL Rating
Failing Banks with CAMEL Ratings of 1 or 2, Two Years before
Failure, 1980–1994
Asset Growth Rates, Dividend Payments, and Capital Injections,
All Banks with CAMEL Ratings of 4 and 5, 1980–1994
Probability of Failure, Banks in the Highest Loans-to-Assets Quintile
Probability of Failure for “Low-Risk” Banks (Banks Not in the
Highest Loans-to-Assets Quintile)
Production of New Office Space, 31 Major Markets, 1975–1994
Major Loan Categories of U.S. Commercial Banks as a Percentage
of Total Assets, 1980 and 1990
Real Estate Loan Portfolio Quality, U.S., 1984–1994
Major Tax Law Provisions Affecting Returns on Commercial
Real Estate Investment
Hypothetical Investment Illustrating the Economic Effects of Major
Tax Legislation on Commercial Real Estate Investment
Selected Statistics, FSLIC-Insured Savings and Loans, 1980–1989
S&L Failures, 1980–1988
Number of Newly Chartered FSLIC-Insured S&Ls, 1980–1986
Average Financial Ratios for Eight Money-Center Banks, 1974–1989

Page
14
17
20
21
30
32
33
48
57
58
60
63
73
73
145
152
153
163
164
168
169
178
196

History of the Eighties—Lessons for the Future

List of Tables and Figures

Table 5.1b
Table 5.2
Table 6.1
Table 6.2
Table 6.3
Table 6.4
Table 6.5
Table 6–A.1
Table 7.1
Table 7.2
Table 7–A.1
Table 7–A.2
Table 7–A.3
Table 8.1
Table 8.2
Table 8.3
Table 8.4a
Table 8.4b
Table 8.5
Table 8.6a
Table 8.6b
Table 9.1
Table 9.2

Aggregate Financial Data for Eight Money-Center Banks, 1974–1989
Long-Term Debt Ratings of U.S. Money-Center Banks, 1977–1989
Number, Total Assets, and Average Assets of Selected Types of
Financial Institutions, Selected Years, 1900–1975
Composition of Assets of Mutual Savings Banks, Selected Years,
1900–1980
Percentage Distribution of Assets and Liabilities of Mutual Savings
Banks, by State, Year-end 1975
Failed and Assisted Savings Banks, 1981–1985
FDIC Net Worth Certificate Program
BIF-Insured Savings Banks That Failed, 1986–1994
Growth in Assets and Domestic C&I Lending at the Ten Largest U.S.
Banks, 1976–1981
Average Returns and Equity Ratios at the Ten Largest U.S. Banks,
1977–1981
Continental Illinois National Bank and Trust: Consolidated
Statement of Condition, 1977–1983
Continental Illinois National Bank and Trust: Consolidated
Statement of Income, 1977–1983
Continental Illinois National Bank and Trust:
Financial Ratios, 1977–1983
Gross Income per Acre and Return on Farmland Investment,
U.S. and Iowa, 1970–1990
Farm Loans and Bank Assets, Agricultural Banks versus All
Banks, 1979–1990
Total Deposit Insurance Fund Losses and Average Loss per
Bank, 1980–1990
CAMEL Ratings for All Agricultural Banks, 1981–1990
CAMEL 4- and 5-Rated Institutions, Agricultural Banks versus
Small Non-Agricultural Banks, 1981–1990
Median ROA, ROE, and Equity Ratios, Agricultural Banks versus
Small Non-Agricultural Banks, 1979–1990
Equity and Reserves to Assets of Agricultural Banks, 1979–1990
Equity and Reserves to Assets of Small Non-Agricultural Banks,
1979–1990
Construction Permits in the Southwest, 1980–1994
Large Southwestern Bank Failures, 1980–1994

History of the Eighties—Lessons for the Future

197
202
214
215
216
226
229
234
237
239
255
256
257
268
279
280
283
284
286
288
289
302
323
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An Examination of the Banking Crises of the 1980s and Early 1990s

Table 9.3a
Table 9.3b
Table 9.4
Table 9.5
Table 9.6a
Table 9.6b
Table 10.1
Table 10.2
Table 10.3
Table 10.4
Table 10.5
Table 10.6
Table 10.7
Table 10.8
Table 10.9
Table 11.1
Table 11.2
Table 11.3
Table 11.4
Table 11.5
Table 11.6
Table 11.7a
Table 11.7b
Table 11.8a
Table 11.8b
xii

Volume I

CAMEL Ratings for All Southwestern Banks, 1981–1990
CAMEL 4- and 5-Rated Institutions, Southwestern Banks versus
Banks in Rest of U.S., 1981–1990
CAMEL Ratings for All U.S. Banks, 1981–1990
Median ROA, ROE, and Equity Ratios, Southwestern Banks
versus Banks in Rest of U.S., 1979–1990
Equity and Reserves to Assets of Southwestern Banks, 1978–1990
Equity and Reserves to Assets of Nonsouthwestern Banks, 1978–1990
Nonresidential and Residential Construction, Northeast Region,
1980–1994
CAMEL Ratings for All Northeastern Banks, 1981–1994
CAMEL 4- and 5-Rated Institutions, Northeastern Banks versus
Banks in Rest of U.S., 1981–1994
Median ROA, ROE, and Equity Ratios, Northeastern Banks
versus Banks in Rest of U.S., 1980–1994
Equity and Reserves to Assets, Northeastern Banks, 1980–1990
Equity and Reserves to Assets, Nonnortheastern Banks, 1980–1990
Bank Failures, 1980–1994
FDIC Bank-Failure Resolution Costs, 1990–1994
Large Northeastern Bank Failures in the 1990s
Three Economic Growth Measures, California and U.S., 1980–1994
Office Real Estate Market Trends, Los Angeles County and
San Francisco, 1980–1994
Recession-Related Employment Losses in California and
Los Angeles County
Median Return on Assets for U.S. and California Banking Industries,
1980–1994
Ten Largest Depository Institutions in California,
December 31, 1979
Market Share of Total Domestic Deposits, by Type of Depository
Institution in California, 1984–1992
CAMEL Ratings for All California Banks, 1981–1994
CAMEL 4- and 5-Rated Institutions, California Banks versus
Banks in Rest of U.S., 1981–1994
Equity and Reserves to Assets, California Banks, 1980–1994
Equity and Reserves to Assets, U.S. Banks, 1980–1994

327
328
329
330
331
332
340
363
364
365
366
367
369
369
373
381
389
394
398
400
400
403
404
405
406

History of the Eighties—Lessons for the Future

List of Tables and Figures

Table 11.9
Table 11.10
Table 12.1
Table 12.2
Table 12.3
Table 12.4
Table 12.5
Table 12.6
Table 12.7
Table 12.8
Table 12.9
Table 12.10
Table 12.11
Table 12.12
Table 12.13
Table 12.14

Table 12.15
Table 12.16

Table 12.17

Median Return on Assets for California Banking Groups and U.S.,
1990–1994
Bank Failures in California by Region, 1990–1994
Mean Examination Interval for Commercial Banks, by CAMEL
Rating, 1979–1994
Mean Examination Interval for Commercial Banks, by
Regulatory Agency, 1980–1994
Failing Banks with CAMEL Ratings of 1 or 2 Two Years
before Failure, 1980–1994
Asset Growth Rates, Dividend Payments, and Capital Injections,
All Banks with CAMEL Ratings of 4 or 5, 1980–1994
FDIC Formal Enforcement Actions by Examination
Rating, 1980–1995
FDIC Formal Enforcement Actions by Type, 1980–1995
FDIC-Supervised Problem Banks, 1980–1994
FDIC Problem Banks That Received Formal Enforcement Actions,
1980–1994
Percentage of FDIC Problem Banks That Received Formal
Enforcement Actions, by CAMEL Rating, 1980–1994
Federal Reserve Formal Enforcement Actions by Examination
Rating, 1980–1995
Federal Reserve Formal Enforcement Actions by Type, 1980–1995
Federal Reserve-Supervised Problem Banks, 1980–1994
Federal Reserve-Supervised Problem Banks That Received Formal
Enforcement Actions, 1980–1994
Percentage of Federal Reserve-Supervised Problem Banks
That Received Formal Enforcement Actions, by CAMEL
Rating, 1980–1994
Estimated Number of Failed Banks That Would Have Been
Closed Earlier under FDICIA Rules, 1980–1992
Estimated Number of Failed Banks That Would Have Been
Closed Earlier under FDICIA Rules, by Bank
Charter Class, 1980–1992
Estimated Number of Failed Banks That Would Have Been
Closed Earlier under FDICIA Rules in the Six States
with the Greatest Number of Closings, 1980–1992

History of the Eighties—Lessons for the Future

408
411
429
430
434
440
443
444
445
446
446
447
447
448
449

449
455

456

457

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An Examination of the Banking Crises of the 1980s and Early 1990s

Table 12.18

Table 12.19
Table 12.20

Table 12.21

Table 13.1
Table 13.2
Table 13.3
Table 13.4
Table 13.5
Table 13.6
Table 13.7
Table 13.8
Table 13.9
Table 13.10
Table 13.11
Table 13.12
Table 13.13
Table 13–A.1
Table 13–A.2
Table 13–A.3
Table 13–A.4

xiv

Volume I

Changes in Total Equity Capital for Failed Banks That
Would Have Been Closed Earlier under FDICIA
Rules, 1980–1992
Estimated Number of Problem Banks That Survived but
Might Have Been Closed under FDICIA Rules, 1980–1992
Timing of FDIC Enforcement Actions against FDIC Problem
Banks That Failed and Would Have Been Closed Earlier
under FDICIA Rules, 1980–1992
Timing of FDIC Enforcement Actions against FDIC Problem
Banks That Survived but Might Have Been Closed
under FDICIA Rules, 1980–1992
Ratio Measures of Bank Performance
Probability of Failure When a Bank Appears in the
Highest-Risk Category
Probability of Failure When a Bank Appears in the Highestand Second-Highest Risk Categories
Probability of Failure in “Low-Risk” Banks
Hypothetical GMS Score Computation Example
Bank Failures by GMS Score Ranking and Failure Year
Comparisons of Exam Ratings as Assigned in 1985 and 1987
Relationship between GMS Weightings and Logit Estimations of
CAMEL Downgrades
Hypothetical Loan Portfolios for Bank A: Loan Shares Not Weighted
Hypothetical Loan Portfolios for Bank A: Loan Shares Weighted
Loan Portfolios Concentration Index
12/1988 CAMEL Logit
Comparisons of Exam Ratings as Assigned in 1985 and 1987
Portfolio Concentration Model
Comparison of Different Factors in Predicting Bank Failures
Four and Five Years Forward, 1980
Comparison of Different Factors in Predicting Bank Failures
Four and Five Years Forward, 1982
Comparison of Different Factors in Predicting Bank Failures
Four and Five Years Forward, 1984
Comparison of Different Factors in Predicting Bank Failures
Four and Five Years Forward, 1986

458
460

462

462
490
493
494
495
497
499
500
503
505
505
506
507
508
515
516
517
518

History of the Eighties—Lessons for the Future

List of Tables and Figures

Table 13–A.5
Table 13–A.6

Figure 1.1
Figure 1.2
Figure 1.3
Figure 1.4
Figure 1.5
Figure 1.6
Figure 1.7
Figure 1.8
Figure 1.9
Figure 1.10
Figure 1.11
Figure 1.12
Figure 1.13
Figure 2.1
Figure 3.1
Figure 3.2
Figure 3.3
Figure 3.4
Figure 3.5
Figure 3.6
Figure 3.7
Figure 3.8

Comparison of Different Factors in Predicting Bank Failures
Four and Five Years Forward, 1988
Table of Peer–Group Characteristics

Number of Bank Failures, 1934–1995
Bank Performance Ratios, 1973–1994
Bank Price-Earnings Ratios as a Percentage of S&P 500
Price-Earnings Ratios, 1964–1995
Price-to-Book Value per Share, 1982–1995
Farm Prices, Exports, Income, Debt, and Real Estate Value, 1975–1994
Changes in Gross State Product and Gross Domestic Product, 1980–1994
Ratio of Gross Loans to Total Assets, Failed and Nonfailed Banks,
1980–1994
Ratio of Commercial Real Estate Loans to Total Assets, Failed and
Nonfailed Banks, 1980–1994
Composite CAMEL Ratings Two Years before Failure for
Banks Failing between 1980 and 1994
Median Asset Growth Rates of CAMEL 4-Rated Banks
before and after Regulatory Intervention
Dividend Rates and Capital Infusions of CAMEL 4-Rated
Banks before and after Regulatory Intervention
Bank Condition Ratios for Failed and Nonfailed Banks, 1982–1986
Bank Risk Ratios for Failed and Nonfailed Banks, 1982–1986
Newly Chartered Banks: United States, Texas, California, and
Florida, 1980–1994
Total Nonresidential Construction Put in Place, 1970–1994
Office Vacancy Rates in Major Texas Cities, 1980–1994
Commercial Real Estate Cycles in Selected States, 1980–1994
Nonresidential Construction Put in Place, 1975–1994
Office and Total Employment Growth, 1976–1994
Office Market Conditions, 1980–1994
Retail Market Conditions, 1980–1994
Industrial Market Conditions, 1977–1994

History of the Eighties—Lessons for the Future

519
520

3
6
7
9
22
23
28
29
59
65
67
70
71
108
142
143
144
145
146
147
147
149

xv

An Examination of the Banking Crises of the 1980s and Early 1990s

Figure 3.9
Figure 3.10
Figure 3.11
Figure 3.12
Figure 3.13
Figure 4.1
Figure 5.1
Figure 5.2
Figure 5.3
Figure 5.4
Figure 5.5
Figure 5.6
Figure 5.7
Figure 5.8
Figure 5.9
Figure 6.1
Figure 7.1
Figure 8.1
Figure 8.2
Figure 8.3
Figure 8.4
Figure 8.5
Figure 8.6
Figure 8.7
Figure 8.8
Figure 8.9

xvi

Volume I

Real Estate Portfolio of U.S. Banks as a Percentage of Total
Assets, 1980 and 1990
Commercial Real Estate Loans as a Percentage of Total Assets,
Failed and Nonfailed Banks, 1980–1990
Commercial Real Estate Loans as a Percentage of Total Real
Estate Loans, Failed and Nonfailed Banks, 1980–1994
Nonperforming Real Estate Assets as a Percentage of Total
Nonperforming Assets, Failed and Nonfailed Banks, 1980–1994
Real Estate Charge-Offs as a Percentage of Total Charge-Offs,
Failed and Nonfailed Banks, 1984–1994
Percentage of S&L Assets in Mortgage Loans, 1978–1986
U.S. Crude-Oil Refiner Acquisition Cost, 1970–1988
Monthly Commodity and Consumer Prices, 1970–1994
Total Latin American Debt Outstanding, 1970–1989
Total Outstanding LDC Loans by the Largest U.S. Banks, 1977–1989
U.S. Commercial Paper Outstanding, 1973–1989
German Mark and Japanese Yen U.S. Dollar Exchange Rates, 1971–1994
Share Price of Money-Center Banks and Regional Banks
versus S&P 500, 1970–1995
Monthly Treasury Bill Rate (3-Month), 1970–1994
Return on Assets, U.S. Banking Industry, 1970–1994
Monthly Treasury Bill Rate (3-Month), 1977–1983
Continental Illinois Corporation: Average Weekly
Share Price, 1981–1984
Index of Prices Received by Farmers for All Crops, 1970–1989
Farmland Value per Acre, U.S. and Iowa, 1970–1990
Farm Debt, 1970–1990
Lender Shares of Farm Real Estate Debt, 1975–1988
Lender Shares of Farm Non-Real Estate Debt, 1975–1988
Agricultural Bank Failures versus All Bank Failures, 1980–1990
Number of Agricultural Bank Failures and Percentage of Failed
Agricultural Bank Assets in U.S., 1977–1993
Comparison of Selected Factors in Predicting Agricultural Bank
Failures Four and Five Years Forward, 1980
Comparison of Selected Factors in Predicting Agricultural Bank
Failures Four and Five Years Forward, 1982

152
159
160
161
162
179
193
194
194
195
198
200
201
205
209
221
238
261
266
267
275
276
277
278
281
282

History of the Eighties—Lessons for the Future

List of Tables and Figures

Figure 8.10
Figure 8.11
Figure 9.1
Figure 9.2
Figure 9.3
Figure 9.4
Figure 9.5
Figure 9.6
Figure 9.7
Figure 9.8
Figure 9.9
Figure 9.10
Figure 9.11
Figure 9.12
Figure 9.13
Figure 9.14
Figure 9.15
Figure 9.16
Figure 9.17
Figure 9.18
Figure 9.19
Figure 9.20
Figure 10.1

Agricultural Banks versus Small Non-Agricultural Banks:
Nonperforming Loans As a Percentage of All Loans, 1982–1990
Agricultural Banks versus Small Non-Agricultural Banks:
Percentage of Institutions with Negative Net Income, 1980–1990
Domestic Crude-Oil Refiner Acquisition Cost versus
Average Number of Rotary Rigs, 1972–1988
Changes in Southwest Gross Product versus Changes in U.S. Gross
Domestic Product, 1980–1994
Domestic Crude-Oil Refiner Acquisition Cost versus Gross
Domestic Product, 1970–1988
Office Vacancy Rates, Southwestern Cities versus U.S., 1980–1994
Median Home Resale Prices, Houston versus U.S., 1980–1990
Newly Issued Building Permits (Residential), Houston versus
U.S., 1980–1990
Housing Starts, Houston versus U.S., 1976–1995
Newly Chartered Banks, Southwest versus U.S., 1974–1994
Asset Growth Rates, Southwest versus U.S., 1975–1994
Median Commercial and Industrial Loans, Southwest
versus U.S., 1974–1994
Median Total Real Estate Loans, Southwest versus U.S., 1974–1994
Median Commercial Real Estate Loans, Southwest versus U.S., 1980–1994
Median Gross Loans and Leases, Southwest versus U.S., 1976–1994
Median Total Nonperforming Assets, Southwest versus U.S.,
1982–1994
Median Net Charge-Offs on Loans and Leases, Southwest versus
U.S., 1976–1994
Bank Failures, Southwest versus U.S., 1980–1994
Commercial Real Estate Lending in Houston, Dallas, and
Oklahoma City, Failed versus Nonfailed Banks, 1974–1994
Nonperforming Loans as a Percentage of All Loans, Southwest
versus Rest of U.S., 1982–1990
Percentage of Banks with Negative Net Incomes, Southwest versus
Rest of U.S., 1978–1990
Comparison of Selected Factors in Predicting Southwest Bank
Failures Four and Five Years Forward, 1982, 1984 and 1986
Changes in Northeast Gross Product versus Changes in U.S.
Gross Domestic Product, 1980–1994

History of the Eighties—Lessons for the Future

285
287
293
294
301
303
307
308
309
313
316
316
317
318
318
319
319
320
322
333
333
334
339
xvii

An Examination of the Banking Crises of the 1980s and Early 1990s

Figure 10.2
Figure 10.3
Figure 10.4
Figure 10.5
Figure 10.6
Figure 10.7
Figure 10.8
Figure 10.9
Figure 10.10
Figure 10.11
Figure 10.12
Figure 10.13
Figure 10.14
Figure 10.15
Figure 10.16
Figure 10.17
Figure 10.18
Figure 10.19
Figure 11.1
Figure 11.2
Figure 11.3
Figure 11.4
Figure 11.5
Figure 11.6

xviii

Volume I

Office Vacancy Rates in Boston, 1980–1994
Rent Indices, Boston and Hartford versus U.S., 1980–1995
Median Home Resale Prices, Boston versus U.S., 1982–1995
Office Vacancy Rates in New York City, 1980–1994
Rent Indices, New York City and Long Island versus U.S.,
1980–1995
Asset Growth Rates, Northeast versus U.S., 1975–1994
Median Gross Loans and Leases, Northeast versus U.S., 1976–1994
Median Total Real Estate Loans, Northeast versus U.S., 1974–1994
Median Commercial and Industrial Loans, Northeast versus U.S.,
1974–1994
Median Residential Real Estate Loans, Northeast versus U.S., 1974–1994
Median Commercial Real Estate Loans, Northeast versus U.S., 1980–1994
Median Total Nonperforming Assets, Northeast versus U.S.,
1982–1994
Median Net Charge-Offs on Loans and Leases, Northeast versus
U.S., 1976–1994
Northeast Bank Failures, 1980–1994
Nonperforming Loans as a Percentage of All Loans, Northeast
versus Rest of U.S., 1982–1990
Percentage of Banks with Negative Net Income, Northeast versus
Rest of U.S., 1980–1994
Comparison of Selected Factors in Predicting Northeastern Bank
Failures Four and Five Years Forward, 1986
Comparison of Selected Factors in Predicting Northeastern
Bank Failures Four and Five Years Forward, 1988
Changes in California Gross State Product versus Changes in U.S.
Gross Domestic Product, 1980–1994
Defense-Related Manufacturing Sector, FY 1980–1994
The California Construction Sector, 1980–1994
New Housing Permits, Multifamily versus Single Family,
California, 1978–1994
Median Home Prices, California (Selected Markets) and
U.S., 1980–1994
Commercial Office Vacancy Rates, California (Selected Markets)
and U.S., 1980–1994

341
342
344
346
347
349
350
350
351
352
353
353
354
362
368
368
371
372
380
383
384
386
386
388

History of the Eighties—Lessons for the Future

List of Tables and Figures

Figure 11.7
Figure 11.8
Figure 11.9
Figure 11.10
Figure 11.11
Figure 11.12
Figure 11.13
Figure 11.14
Figure 11.15
Figure 11.16
Figure 12.1
Figure 12.2
Figure 12.3
Figure 12.4
Figure 12.5
Figure 12.6
Figure 12.7
Figure 12.8
Figure 13.1
Figure 13.2
Figure 13.3

Japanese Investment in U.S. Real Estate, 1985–1994
Newly Chartered Banks in California, 1980–1994
California Bank Failures, 1980–1995
Median Total Loans and Leases, Southern California versus
the Rest of California and U.S., 1980–1994
Median Total Real Estate Loans, Southern California versus
the Rest of California and U.S., 1980–1994
Median Total Commercial Real Estate Loans, Southern California
versus the Rest of California and U.S., 1980–1994
Median Total Commercial and Industrial Loans, Southern California
versus the Rest of California and U.S., 1980–1994
Median Nonperforming Assets, Southern California versus the
Rest of California and U.S., 1982–1994
Median Net Charge-Offs on Loans and Leases, Southern
California versus the Rest of California and U.S., 1980–1994
Median Commercial Real Estate Loans, California Banking
Groups versus the U.S., 1980–1994
Field Examination Staffs of the Federal and State Banking
Agencies, and Total Number of Problem Banks, 1979–1994
Total Number of Examinations per Year and Total Number of
Problem Banks, 1980–1994
Average Number of Examinations per Year for Texas
Commercial Banks, 1980–1994
Median Examination Period (Days) for Failed Banks, 1980–1994
Composite CAMEL Ratings Two Years before Failure for Banks
Failing between 1980 and 1994
CAMEL Ratings of Failed Banks Two Years before Failure,
1980–1994
Median Asset Growth Rates of CAMEL 4-Rated Banks
before and after Regulatory Intervention
Dividend Rates and Capital Infusions of CAMEL 4-Rated
Banks before and after Regulatory Intervention
Bank Condition Ratios for Failed and Nonfailed Banks, 1982–1986
Bank Risk Ratios for Failed and Nonfailed Banks, 1982–1986
Procedure Used in Contingency Table Analysis

History of the Eighties—Lessons for the Future

390
402
410
414
414
415
415
416
416
417
427
428
431
431
433
437
451
453
482
484
492

xix

A Note on the Study’s Organization and Data
The study is divided into three main sections. Part 1 contains four chapters, the first
of which presents a detailed summary of the study’s findings as well as an exploration of
the implications of those findings. The other three chapters deal with what might be viewed
as issues that were “national” in scope: developments in banking legislation and regulation,
the role of commercial real estate, and the relationship of the savings and loan crisis to the
problems in banking. The seven chapters in Part 2 look at the sectoral and regional banking crises of the 1980s and early 1990s. These are presented chronologically (although
since the discrete problems in banking often overlapped one another, the periods covered
within chapters frequently coincide). In turn, the chapters in this section examine the LDC
debt crisis and mutual savings bank problems of the early 1980s, the crisis surrounding
Continental Illinois in 1982–84, banking and the agricultural problems of the mid-1980s,
and then the rolling regional recessions from the mid-1980s to the early 1990s in the
Southwest, Northeast, and California. Finally, the two chapters in Part 3 present an analysis of the supervisory tools used by the banking agencies during the period, dealing first
with bank examination and enforcement, and then with off-site surveillance systems.
******
Readers should note that if no source is given for data, the source for that data is the
FDIC. Unless otherwise defined, “banks” in this study should be assumed to include commercial banks (national, state member and state nonmember institutions) and FDIC-insured
mutual savings banks. Unless otherwise indicated, this study treats open-bank assistance
transactions as bank failures.

xx

History of the Eighties—Lessons for the Future

Chapter 1

The Banking Crises of the
1980s and Early 1990s:
Summar y and Implications
Introduction
The distinguishing feature of the history of banking in the 1980s was the extraordinary upsurge in the number of bank failures. Between 1980 and 1994 more than 1,600
banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance—far more than in any other period since the advent of
federal deposit insurance in the 1930s (see figure 1.1). The magnitude of bank failures durFigure 1.1

Number
300

Number of Bank Failures, 1934–1995

250
200
150
100
50
0

1935

1945

1955

1965

1975

1985

Note: Data refer to FDIC-insured commercial and savings banks that were
closed or received FDIC assistance.

1995

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

ing the 1980s put severe, though temporary, strains on the FDIC insurance fund; raised basic questions about the effectiveness of the bank regulatory and deposit insurance systems;
and led to far-reaching legislative and regulatory actions.1
This chapter summarizes the findings and implications of History of the Eighties—
Lessons for the Future: An Examination of the Banking Crises of the 1980s and Early
1990s, a study conducted by the FDIC’s Division of Research and Statistics to analyze various aspects of the 1980–94 experience. The four sections of this summary deal with (1) the
factors underlying the rapid rise in the number of bank failures; (2) the regulatory issues
raised by this experience; (3) questions that remain open despite the legislative and regulatory remedies adopted between 1980 and 1994; and (4) concluding comments.

The Rise in the Number of Bank Failures in the 1980s:
The Economic, Legislative, and Regulatory Background
The rise in the number of bank failures in the 1980s had no single cause or short list
of causes. Rather, it resulted from a concurrence of various forces working together to produce a decade of banking crises. First, broad national forces—economic, financial, legislative, and regulatory—established the preconditions for the increased number of bank
failures. Second, a series of severe regional and sectoral recessions hit banks in a number of
banking markets and led to a majority of the failures. Third, some of the banks in these markets assumed excessive risks and were insufficiently restrained by supervisory authorities,
with the result that they failed in disproportionate numbers.
Economic and Financial Market Environment
During most of the 1980s, the performance of the national economy, as measured by
broad economic aggregates, seemed favorable for banking. After the 1980–82 recession the
national economy continued to grow, the rate of inflation slowed, and unemployment and
interest rates declined. However, in the 1970s a number of factors, both national and international, had injected greater instability into the environment for banking, and these earlier
developments were directly or indirectly generating challenges to which not all banks
would be able to adapt successfully. In the 1970s, exchange rates among the world’s major
currencies became volatile after they were allowed to float; price levels underwent major
increases in response to oil embargoes and other external shocks; and interest rates varied
widely in response to inflation, inflationary expectations, and anti-inflationary Federal Reserve monetary policy actions.
1

4

Although this study is devoted to banking, it is appropriate to recall that the thrift industry suffered an even greater catastrophe. In 1980 there were 4,039 savings institutions; approximately 1,300 savings institutions failed during the 1980–94
period. This high proportion of failures led to the demise of the fund that insured savings institution deposits, and imposed
heavy costs on surviving institutions and on taxpayers.

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Developments in the financial markets in the late 1970s and 1980s also tested the
banking industry. Intrastate banking restrictions were lifted, allowing new players to enter
once-sheltered markets; regional banking compacts were established; and direct credit markets expanded.2 In an environment of high market rates, the development of money market
funds and the deregulation of deposit interest rates exerted upward pressures on interest expenses—particularly for smaller institutions that were heavily dependent on deposit funding. Competition increased from several directions: within the U.S. banking industry itself
and from thrift institutions, foreign banks, and the commercial paper and junk bond markets. The banking industry’s share of the market for loans to large business borrowers declined, partly because of technological innovations and innovations in financial products.3
As a result, many banks shifted funds to commercial real estate lending—an area involving
greater risk. Some large banks also shifted funds to less-developed countries and leveraged
buyouts, and increased their off-balance-sheet activities.
Condition of Banking on the Eve of the 1980s
Yet on the eve of the 1980s most banks gave few obvious signs that the competitive
environment was becoming more demanding or that serious troubles lay ahead. At banks
with less than $100 million in assets (the vast majority of banks), net returns on assets
(ROA) rose during the late 1970s and averaged approximately 1.1 percent in 1980—a level
that would not be reached again until 1993, after the wave of bank failures had receded (see
figure 1.2).4 For this group of banks, net returns on equity (ROE) in 1980 were also high by
historical standards, equity/asset ratios were moving gradually upward, and charge-offs on
loans averaged approximately what they would again in the early 1990s. The fact that key
performance ratios in 1980 compared favorably with those in 1993–94—a period of extraordinary health and profitability in banking that has continued to the present (mid-1997)—
emphasizes the absence of obvious problems at most banks at the beginning of the eighties.
Large banks, however, showed clearer signs of weakness. In 1980 ROA and equity/assets ratios were much lower for banks with more than $1 billion in assets than for small
2
3
4

Many of these developments are discussed in Allen N. Berger, Anil K. Kashyap, and Joseph M. Scalise, “The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It’s Been,” Brookings Papers on Economic Activity 2 (1995).
Between 1980 and 1990, commercial paper outstanding increased from 7 percent of bank commercial and industrial loans
(C&I) to 19 percent.
Data in figure 1.2 are unweighted averages of individual bank ratios. Use of median values or averages weighted by assets
reveals broadly similar trends, except that medians are less affected by extreme values and tend to be less volatile than unweighted averages, while weighted averages are dominated by larger banks in each size group. The data in figure 1.2 are for
banks with assets greater than $1 billion (large banks) or less than $100 million (small banks) in each year; thus, the number of banks included in the two size groups varies from year to year. In 1980, there were 192 banks with assets greater than
$1 billion and 12,735 banks with assets less than $100 million. In 1994, the comparable figures were 392 banks and 7,259
banks. Asset data are not adjusted for inflation.

History of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

Figure 1.2

Bank Performance Ratios, 1973–1994
ROA

Percent
1.4

ROE

Percent
20
15

1.0

10
5

0.6

0
0.2

1974

1978

1982

1986

1990

1994

Equity/Assets

Percent
12

-5

1974

Percent

1978

1982

1986

1990

1994

Net Loan Charge-Offs/Loans

1.6

10

1.2
8

0.8

6
4

0.4
1974

1978

1982

1986

1990

1994

0

1974

1978

1982

1986

1990

1994

Loans and Leases/Assets

Percent
70
65
60
55
50
45

1974

1978

All Banks

1982

1986

Large Banks

1990

1994
Small Banks

Note: Data are unweighted averages of individual FDIC-insured commercial and savings bank ratios. Large banks are those
with assets greater than $1 billion in any given year. Small banks are those with assets less than $100 million in any given year.

6

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

banks and were also well below the large-bank levels they would reach in the early 1990s.
Market data for large, publicly traded banking organizations suggest that investors were
valuing these institutions with reduced favor. During the 1960s and 1970s price-earnings
ratios for money-center banks trended generally downward relative to S&P 500 price-earnings ratios, although for regional banks the decline was much less pronounced (see figure
1.3). For the 25 largest bank holding companies in the late 1970s and early 1980s, the market value of capital decreased relative to—and fell below—its book value, suggesting that
to investors, the franchise value of large banks was declining.5
Differences in performance between large and small banks in 1980 are not surprising.
At that time, because of branching restrictions and deposit interest-rate controls, many
small institutions operated in still-protected markets. Accordingly, they were affected more
slowly by external forces such as increased competition and increased market volatility.
Figure 1.3

Bank Price-Earnings Ratios as a Percentage
of S&P 500 Price-Earnings Ratios,
1964–1995
Percent
100
90
80
70
60
50
40

1964

1970

1975

Money-Center

1980
Banks

Regional

1985

1990

1995

Superregional

Source: Salomon Brothers, Bank Annual, 1992 and 1996 editions.
Note: Data for superregional bank price-earnings ratios begin in 1982.

5

Michael C. Keeley, “Deposit Insurance, Risk, and Market Power in Banking,” American Economic Review (December
1990): 1185. Data are for the 25 largest bank holding companies as of 1985.

History of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

During the 1980s, of course, performance ratios of banks of all sizes weakened and exhibited increased risk. Profitability declined and became more volatile, while loan charge-offs
rose dramatically.6 Large banks assumed greater risk in order to boost profits, as is indicated
by the sharp rise in the ratio of loans and leases to total assets for these banks. In contrast,
equity ratios increased over the period, particularly for large banks, in line with increased
regulatory capital requirements and perhaps also in response to market concerns about distress in the banking system.
Then in the 1990s the performance of banking improved markedly. This is apparent
not only from the accounting data presented in figure 1.2 but also from the market data presented in figures 1.3 and 1.4, which suggest that to investors, the value of publicly traded
banks improved greatly in the 1990s. From 1993 to 1995, bank price-earnings ratios rose
relative to S&P 500 price-earnings ratios, although the movements in this measure were extremely volatile. After the early 1980s market prices per share of money-center and regional
banks increased from below book value per share to well above book value, except for a
sharp and temporary drop in 1990 (figure 1.4). The major improvement in the performance
and investor perceptions of banking in the 1990s, albeit of limited duration so far, does not
support earlier concerns that banking was a declining industry or the view that banking was
characterized by widespread and persistent overcapacity that would lead to increased failures.7
Although the overall performance of the banking industry varied greatly during the
1980–94 period, in its structure the industry showed a strong trend in one direction—toward
consolidation into fewer banking organizations. This trend was partly due to the relaxation
of branching restrictions.8 From the end of 1983 through the end of 1994, the number of insured commercial banks declined by 28 percent, from 14,461 to 10,451. The number of
separate corporate units—bank holding companies plus independent commercial banks—

6
7

8

8

The 1986 peak in net loan charge-offs for small banks was associated with the agricultural, energy, and real estate problems
of the Southwest; the 1991 peak for large banks was associated with the real estate problems in the Northeast.
The issue of whether banking is a declining industry and the related question of overcapacity in banking are explored in Federal Reserve Bank of Chicago, The (Declining?) Role of Banking, Proceedings of the 30th Annual Conference on Bank
Structure and Competition (May 1994). In the Proceedings, see particularly Alan Greenspan, “Optimal Bank Supervision
in a Changing World,” 1–8; John H. Boyd and Mark Gertler, “Are Banks Dead? Or, Are the Reports Greatly Exaggerated?”
85–117; and Sherrill Shaffer, “Inferring Viability of the U.S. Banking Industry from Shifts in Conduct and Excess Capacity,” 130–144. Shaffer concludes that a small amount of excess capacity in bank loans was eliminated in the mid-1980s.
Some observers have argued that bank failures in the 1980s were partly due to restrictions on bank ownership (geographic
restrictions within the banking industry, and prohibition of acquisitions by nonbank organizations), which prevented weak
or inefficient banks from being taken over before they failed. Although such restrictions on ownership probably contributed
to the rise in the number of bank failures, particularly in the early 1980s, the large number of voluntary mergers and consolidations within the industry may have averted some other failures by eliminating weaker institutions while they still had
some value.

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Figure 1.4

Percent

Price-to-Book Value per Share,
1982–1995

175
150
125
100
75
50

1982

1984

1986

Money-Center

1988
Banks

1990

Regional

1992

1995

Superregional

Source: Salomon Brothers, Bank Annual, 1992 and 1996 editions.
Note: Values are industry composite medians. Data for superregional bank
price-to-book ratios begin in 1987.

decreased somewhat more, by 31 percent. The 4,010 reduction in the number of insured
commercial banks was due primarily to the consolidation of bank affiliates of multibank
holding companies and to unassisted mergers of unaffiliated banks (4,803). The net effect
of failures, new charters, conversions, and other changes was an addition of 793 banks.
Legislative Developments
Banking legislation also played a large role in the bank-failure experience of the 1980s
and early 1990s.9 This legislation was largely shaped by two broad factors: widespread
recognition that banking statutes should be modernized and adapted to new marketplace realities, and the need to respond to the outbreak of bank and thrift failures. In the early 1980s
the focus was on the attempt to modernize, and congressional activity was dominated by actions to deregulate the product and service powers of thrifts and to a lesser extent of banks.
9

See Chapter 2, “Banking Legislation and Regulation.” Tax legislation was also a significant influence. After-tax yields on
real estate investment were enhanced by the Economic Recovery Act of 1981 and then reduced by the Tax Reform Act of
1986 (see the appendix to Chapter 3).

History of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

These deregulatory actions were generally unaccompanied by actions to restrict the increased risk taking they made possible, and so they contributed to bank and thrift failures.
As the number of failures mounted, the legislative emphasis then shifted to recapitalizing
the depleted deposit insurance funds and providing regulators with stronger tools, while at
the same time restricting their discretion. As a group, the various legislative actions addressed a variety of issues, but only the provisions most relevant to the increased number of
bank failures are discussed here.
The Depository Institutions Deregulation and Monetary Control Act of 1980
(DIDMCA) phased out deposit interest-rate ceilings, broadened the powers of thrift institutions, and raised the deposit insurance limit from $40,000 to $100,000. Two years later
the most pressing problem was the crisis of thrift institutions in an environment of high interest rates. Accordingly, the Garn–St Germain Depository Institutions Act of 1982 (1)
authorized money market deposit accounts for banks and thrifts to stem disintermediation,
(2) authorized net worth certificates to implement capital forbearance for thrifts facing insolvency in the short term, and (3) increased the authority of thrifts to invest in commercial
loans to strengthen the institutions’ viability over the long term. In the case of national
banks, Garn–St Germain removed statutory restrictions on real estate lending, and relaxed
loans-to-one-borrower limits. With respect to commercial mortgage markets, this legislation set the stage for a rapid expansion of lending, an increase in competition between
thrifts and banks, overbuilding, and the subsequent commercial real estate market collapse
in many regions.
As the thrift crisis deepened and commercial bank problems were developing, Congress passed the Competitive Equality Banking Act of 1987 (CEBA). It provided for recapitalizing the fund of the Federal Savings and Loan Insurance Corporation (FSLIC)
through the Financing Corporation (FICO), authorized a forbearance program for farm
banks, extended the full-faith-and-credit protection of the U.S. government to federally insured deposits, and authorized bridge banks. Two years later, again grappling with the thrift
debacle, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), which authorized the use of taxpayer funds to resolve failed
thrifts. Other provisions reflected congressional dissatisfaction with the regulation of
thrifts: the act abolished the existing thrift regulatory structure, moved thrift deposit insurance to the FDIC, and mandated that bank and thrift insurance fund reserves be increased
to 1.25 percent of insured deposits.
The belief that regulators had not acted promptly to head off problems was again
evident in the Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA). This act was aimed largely at limiting regulatory discretion in monitoring and
resolving industry problems. It prescribed a series of specific “prompt corrective actions”
to be taken as capital ratios of banks and thrifts declined to certain levels; mandated annual
10

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

examinations and audits; prohibited the use of brokered deposits by undercapitalized institutions; restricted state bank activities; tightened least-cost standards for failure resolutions;
and mandated a risk-based deposit insurance assessment system.
Two years after the enactment of FDICIA, the Omnibus Budget Reconciliation Act
of 1993 included a national depositor preference provision, which provided that a failed
bank’s depositors (and the FDIC standing in the place of insured depositors it has already
paid) have priority over nondepositors’ claims. It was believed that national depositor preference would make failure transactions simpler and less expensive to the insurance fund
and would encourage nondeposit creditors to monitor bank risk more closely.
The final chapter of the savings and loan emergency legislation was completed in October 1996 with the enactment of the Deposit Insurance Funds Act, which provided for the
capitalization of the Savings Association Insurance Fund, phased in pro rata bank and thrift
payments of interest on FICO bonds, and required merger of the bank and thrift insurance
funds in 1999 if no savings associations are in existence at that time. Given Congress’s past
reluctance to address promptly the need to fund thrift deposit insurance, enactment of this
legislation at a time when no major thrift failure was on the horizon suggests the extent to
which safety-and-soundness considerations had come to dominate banking legislation.10
Legislation addressed not only the thrift and banking crises of the 1980s but also, after those crises had ended, the question of interstate banking. By the end of the 1980s the
risks posed by geographic lending concentrations were well understood, so attempts were
made to eliminate the remaining legal impediments to full interstate banking. Already state
action had enabled many banking firms to use bank holding company affiliations to circumvent geographic restrictions. Interstate banking was enacted in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which enables banks to diversify
loan portfolios more effectively. (As noted below, it also requires existing regulatory riskmonitoring systems to adapt to the changing nature of individual bank loan portfolios.)
Regulation
The tension between the two objectives of deregulating depository institutions and
preventing or containing failures was manifest not only in legislative activity but also in
policy differences among the federal bank regulators.11 Of course, all three agencies were
sensitive to issues of safety and soundness as well as to the importance of modernizing bank
powers. On specific issues, however, the Office of the Comptroller of the Currency (OCC)
10

11

Passage of the Deposit Insurance Funds Act was helped along by (1) the possibility of a FICO default if deposits were to
shift from the Savings Association Insurance Fund, with higher assessment rates, to the Bank Insurance Fund, with lower
assessment rates, and (2) the budgetary treatment of deposit insurance assessments, $3 billion of which was to be counted
as revenue to “pay” for nonbanking spending programs.
See Chapter 2, “Banking Legislation and Regulation.”

History of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

tended to emphasize the need to allow banks more freedom to compete and seek profit opportunities, the FDIC leaned toward protecting the deposit insurance fund, and the Federal
Reserve often took a middle-of-the-road position.
Differences between the FDIC and the OCC reflected the different responsibilities of
an insurer and a chartering agency. They also reflected a problem that may potentially arise
in bank regulation regardless of the agency involved: how to strike the correct balance between encouraging increased competition and preserving stability and safety. To be sure, no
such conflict is likely to exist in the long run: depository institutions must be able to compete and to participate in market innovations if they are to be viable in the long term. At any
particular time, however, a short-term conflict may arise. The classic case is that of the savings and loan industry. Broadened nonmortgage powers were deemed essential to the longterm viability of thrift institutions, but the very act of providing these powers (without
appropriate safeguards and at a time when thrifts were undercapitalized) contributed to the
collapse of many thrift institutions and the weakening of many banks in the 1980s.12
In varying degree, differences among regulators were evident in the development of
policies relating to chartering new banks, the use of brokered funds, and capital requirements. With respect to the entry of new banks, both the OCC and the states sharply increased chartering in the 1980s. (Texas—where branching was restricted—accounted for
particularly large shares of total new state and national bank charters.) In 1980, when the
OCC sought to foster increased competition by allowing new entrants into banking markets, the agency revised its requirements for approving new charters. But when a disproportionate number of new banks became troubled and failed, the FDIC expressed its
concern about the OCC’s policy. A basic issue was the FDIC’s ability to deny insurance
coverage to newly chartered institutions. FDIC approval of insurance was, for all practical
purposes, necessary before a state would grant a new charter, but national banks and Federal Reserve member banks received insurance upon being chartered as a matter of law.
Congress settled this issue in FDICIA by requiring that all institutions seeking insurance
formally apply to the FDIC, thereby assuring the deposit insurer a role in new bank chartering. Meanwhile, the number of new commercial bank charters reached a peak in 1984,
then gradually declined until 1994.13
12

13

With respect to the potential short-term conflict between pro-competitive and safety-and-soundness objectives, the following statement on S&L deregulation, made by the National Commission on Financial Institution Reform, Recovery and
Enforcement, is instructive: “[C]ommon sense and prudence should have dictated that the industry be required to wait out
the high interest rates, regain net worth, and then gradually shift into new activities. This is what well-managed and responsible S&Ls did on their own, and they were largely successful” (Origins and Causes of the S&L Debacle: A Blueprint
for Reform [1993], 32).
In 1984, 356 new commercial banks were chartered. By 1994 the number had declined to 47, but it then increased to 97 in
1995 and 140 in 1996.

12

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

The regulators also differed on the appropriate treatment of brokered deposits. (Brokered deposits had a largely indirect influence on bank failures in that many weak savings
institutions used them to fund rapid loan expansion in competition with healthier banks and
thrift institutions.) In 1984, the FDIC and the Federal Home Loan Bank Board proposed
that brokered deposits be insured only up to $100,000 per broker per bank, whereas the
OCC favored a less-stringent approach. Safety-and-soundness considerations seemed to be
pitted against the objective of permitting evolution to proceed in the financial markets. In
the end Congress stepped in, and both FIRREA and FDICIA limited the use of brokered deposits by troubled institutions.
A third instance of regulatory disagreement concerned the adoption of formal capital
requirements with uniform standards for minimum capital levels. In view of the relatively
low capital ratios at many large banks and the rise in the number of failures, all of the agencies favored the objective of explicit capital standards, but initially they differed on the
specifics; the FDIC generally favored higher capital requirements than the OCC, and the
Federal Reserve offered a compromise in at least one instance. In 1985, with congressional
encouragement, the regulators agreed on a uniform system covering all banks. In 1990 a
further, major change came with the adoption of interim risk-based capital requirements,
supplemented by leverage requirements. Capital standards became part of the triggering
mechanism for the Prompt Corrective Action (PCA) prescribed by FDICIA in 1991. Final
risk-based requirements took effect in 1992.
Geographic Pattern of Bank Failures
The national economic, legislative, and regulatory factors discussed above affected
potentially all banks. A variety of other factors affected banks differently in particular
regions of the country, as indicated by the geographic pattern of bank failures. During
the 1980–94 period, 1,617 FDIC-insured commercial and savings banks were closed or
received FDIC financial assistance (see table 1.1). This number was 9.14 percent of the sum
of all banks existing at the end of 1979 plus all banks chartered during the subsequent
15 years. The comparable figure for the preceding 15-year period (1965–79) was 0.3
percent.
The geographic pattern of bank failures can be expressed in a number of ways—by
number of failed banks, amount of failed-bank assets, proportion of failed banks and failedbank assets relative to all banks in individual states, or particular states’ shares in national
totals for bank failures and failed-bank assets. But by any of these measures, it is evident
that bank failures during the 1980–94 period were highly concentrated in relatively few regions—which, however, included some of the country’s largest banking markets in terms of
number of institutions and dollar resources. Thus, geographically confined crises were
translated into a national problem. At one end of the scale, in 7 states the number of bank
History of the Eighties—Lessons for the Future

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Volume I

Table 1.1

Bank Failures by State, 1980–1994

Alabama
Alaska
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
District of Columbia
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Puerto Rico

14

Number of Bank
Failures

Percent of Total
Number of Banks

9
8
17
11
87
59
32
1
5
39
3
2
1
33
10
40
69
7
70
2
2
44
3
38
3
41
10
33
1
16
14
11
34
2
9
5
122
17
5
5

2.47
44.44
26.15
4.03
15.26
12.39
18.39
1.61
17.86
4.56
0.53
20.00
3.13
2.52
2.40
6.07
10.71
1.91
22.44
2.63
1.45
10.63
0.75
4.87
1.63
5.24
5.75
6.88
4.17
12.60
5.71
11.00
8.79
1.59
5.00
1.14
22.02
17.00
1.19
33.33

Assets of Failed Banks
($Thousands)
$ 215,589
1,083,417
331,059
160,797
4,222,302
1,035,553
6,818,223
582,350
1,135,066
4,524,461
60,922
13,941
42,931
35,031,196
241,463
652,681
1,233,874
97,742
4,105,621
875,303
43,827
10,240,719
159,917
1,491,250
338,680
1,043,379
172,739
323,646
18,036
3,320,916
4,695,156
568,326
31,701,442
74,553
77,565
171,765
5,838,273
599,703
17,454,150
527,375

Percent of Total
Bank Assets
1.18
41.58
1.66
1.47
1.69
5.24
22.17
0.74
13.39
4.30
0.17
0.29
0.84
25.75
0.76
3.25
7.26
0.48
17.39
13.51
0.06
12.90
0.29
4.95
3.18
2.25
3.32
2.91
0.10
31.98
9.49
9.47
6.22
0.27
1.76
0.29
23.85
4.34
16.99
8.94

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Table 1.1 (continued )

Bank Failures by State, 1980–1994
Number of Bank
Failures
Rhode Island
South Carolina
South Dakota
Tennessee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
U.S.

2
1
8
36
599
11
2
7
4
5
2
20
1,617

Percent of Total
Number of Banks
8.33
0.87
4.73
9.05
29.41
11.58
5.41
2.45
2.63
1.98
0.30
16.67
9.14%

Assets of Failed Banks
($Thousands)
323,861
64,629
711,345
1,730,076
60,192,424
339,237
93,802
133,529
713,803
123,829
50,882
375,332
$206,178,657

Percent of Total
Bank Assets
3.29
0.67
4.04
6.34
43.84
4.04
2.94
0.47
2.42
1.25
0.19
10.30
8.98%

Note: Data refer to FDIC-insured commercial and savings banks that were closed or received FDIC assistance. Total number of banks is the number of banks on December 31, 1979, plus banks newly chartered in 1980–94. Asset data are assets of
banks existing on December 31, 1979, plus assets of newly chartered banks as of date of failure, merger, or December 31,
1994, whichever is applicable, and first available assets for Massachusetts banks that became FDIC-insured in the mid-1980s.
Data exclude 13 newly chartered banks that reported no asset figures and 4 banks in U.S. territories.

failures constituted at least 20 percent of the total number of existing and new banks
(Alaska, Arizona, Hawaii, Louisiana, Oklahoma, Puerto Rico, and Texas). At the other end
of the scale, in 24 states bank failures represented less than 5 percent of the total number of
existing and new banks. Of the total 1,617 failures during the entire 1980–94 period, nearly
60 percent were in only 5 states: California, Kansas, Louisiana, Oklahoma, and Texas.
Included in these numbers are failures of bank holding company subsidiaries; in Texas and
other states with branching restrictions, these were more like branches than independent
institutions.
An alternative measure of the severity of bank failures is based on assets. Assets of
banks failing in 1980–94 constituted 8.98 percent of the sum of total bank assets at the end
of 1979 plus the assets of banks chartered during the 1980–94 period.14 In 6 states (Alaska,
Connecticut, Illinois, New Hampshire, Oklahoma, and Texas), failed-bank assets consti14

The 8.98 percent figure refers to the failed-bank portion of the following: assets of all banks existing as of December 31,
1979, plus assets of banks chartered in 1980–94 as of the date of merger, failure, or December 31, 1994, whichever is applicable, and first available assets for Massachusetts banks that became FDIC-insured in the mid-1980s. Data are not adjusted for inflation.

History of the Eighties—Lessons for the Future

15

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

tuted at least 20 percent of total assets at year-end 1979 plus new-bank assets. On the other
hand, in 33 states the failed-bank share was less than 5 percent. Of all banks that failed during the 1980–94 period, 59 percent of assets at the quarter before failure were accounted for
by 3 states: Illinois, New York, and Texas. (See table 1.2.)15
Although widespread bank failures were limited to a few areas of the country, even a
relatively “small” number of failures could cause serious strains on the deposit insurance
fund. In 1988, for example, the number of failures and the amount of failed-bank assets
reached post-Depression records of 279 and $54 billion (nominal dollars), respectively, but
still represented in each case less than 2 percent of the total number of banks and total bank
assets at the beginning of the year. Nevertheless, in that year the FDIC sustained the first
operating loss in its history, and operating losses continued through 1991, after which, provisions for insurance losses were sharply reduced. And even the smaller number of failures
before 1988 had an evident effect on the FDIC’s income and expense position. Beginning
in 1984, provisions for insurance losses exceeded annual deposit insurance assessments,
and this shortfall continued through 1990.16
The figures by state illustrate some of the factors associated with bank failures. The
incidence of failure was particularly high in states characterized by
• severe economic downturns related to the collapse in energy prices (Alaska, Louisiana,
Oklahoma, Texas, and Wyoming);
• real estate–related downturns (California, the Northeast, and the Southwest);
• the agricultural recession of the early 1980s (Iowa, Kansas, Nebraska, Oklahoma, and
Texas);
• an influx of banks chartered in the 1980s (California and Texas) and the parallel phenomenon of mutual-to-stock conversions (Massachusetts);
• prohibitions against branching that limited banks’ ability to diversify their loan portfolios geographically and to fund growth through core deposits (Colorado, Illinois,
Kansas, Texas, and Wyoming);17
• the failure of a single large bank (Illinois) or of a small number of relatively large banks
(New York and Pennsylvania).
15
16
17

Comparisons based on assets of failed banks are subject to distortion because of the effect of inflation, differences in the
timing of failures among the states, and differences in asset dates between new banks and banks existing at year-end 1979.
Beginning in 1989, data refer to the Bank Insurance Fund (FDIC, Annual Report, various years).
Information on state branching provisions is as of September 30, 1985, as compiled by the Conference of State Bank Supervisors. CSBS listed 7 states as having unit banking as of September 30, 1985, 6 as a result of legal prohibitions (Colorado, Illinois, Kansas, Montana, North Dakota, and Texas). One (Wyoming) had no statute, but unit banking was
prevalent.

16

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Table 1.2

Assets of Failed Banks at the Quarter before Failure, by State, 1980–1994
State
Alabama
Alaska
Arizona
Arkansas
California
Colorado
Connecticut
Delaware
District of Columbia
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisiana
Maine
Maryland
Massachusetts
Michigan
Minnesota
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania

History of the Eighties—Lessons for the Future

Assets of Failed Banks
($Thousands)
$

266,443
3,049,573
453,522
229,700
6,018,036
1,072,556
17,717,959
582,350
2,189,658
15,471,515
104,607
11,486
55,867
40,765,430
311,825
809,089
1,697,588
114,931
4,616,370
2,228,177
57,000
26,632,401
160,300
1,669,974
288,949
3,096,719
212,896
402,185
18,036
5,393,842
6,919,198
723,576
51,577,291
74,553
120,109
152,254
6,712,651
622,091
14,265,742

Percent Distribution
0.08
0.96
0.14
0.07
1.90
0.34
5.59
0.18
0.69
4.88
0.03
0.00
0.02
12.87
0.10
0.26
0.54
0.04
1.46
0.70
0.02
8.41
0.05
0.53
0.09
0.98
0.07
0.13
0.01
1.70
2.18
0.23
16.28
0.02
0.04
0.05
2.12
0.20
4.50
(continued)

17

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

Table 1.2 (continued)

Assets of Failed Banks at the Quarter before Failure, by State, 1980–1994
State
Puerto Rico
Rhode Island
South Carolina
South Dakota
Tennessee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
U.S.

Assets of Failed Banks
($Thousands)

Percent Distribution

543,748
600,706
64,629
743,698
2,446,083
93,061,510
469,637
329,478
296,368
769,109
123,139
70,757
428,606
$316,813,917

0.17
0.19
0.02
0.23
0.77
29.37
0.15
0.10
0.09
0.24
0.04
0.02
0.14
100.00%

Note: Failed-bank assets are assets as of the quarter before failure or assistance, or assets as of the last available Call Report
before failure or assistance.

In some states bank failures were affected by more than one of these factors. For example, the particularly high incidence of failures in Texas reflected the rapid rise and subsequent collapse in oil prices, the commercial real estate boom and bust, the effects of the
agricultural recession, the large number of new banks chartered in the state during the
1980s, and state prohibitions against branching. (The high proportion of bank failures in
Texas also reflected supervisory developments. As noted below, declines in the number and
frequency of on-site examinations in the 1983–86 period were particularly pronounced in
Texas; earlier identification of troubled banks might have prevented some failures.)18 By
the same token, some states that exhibited only one or two of the factors associated with
bank failures had relatively few failures. Montana and North Dakota, for example, had prohibitions against branching, but their failure rates were below the national average, whether
measured by number of institutions or by assets. Differences among the states in failure
rates and in the presence or absence of factors associated with failures illustrate the conclusion that the rise in the number of bank failures cannot be ascribed to any single cause.

18

Texas was also a leading state for S&L failures. Texas S&Ls accounted for 18 percent of all of the failures resolved by the
Resolution Trust Corporation (RTC), 14 percent of S&L assets at time of takeover, and 29 percent of total estimated RTC
resolution costs. See RTC, Statistical Abstract (August 1989/September 1995).

18

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Regional and Sectoral Recessions
Although the interplay of broad economic, legislative, and regulatory forces helped
make the environment for banking increasingly demanding, the more immediate cause of
bank failures was a series of regional and sectoral recessions. Because most U.S. banks
served relatively narrow geographic markets, these regional and sectoral recessions had a
severe impact on local banks. It should be noted, however, that not all regional recessions
of the magnitude experienced during the 1980–94 period resulted in a major increase in the
number of bank failures. Rather, bank failures were generally associated with regional recessions that had been preceded by rapid regional expansions—that is, they were associated
with “boom-and-bust” patterns of economic activity. Bank loans helped to fuel the boom
phase of the cycle, and when economic activity turned down, some of these loans went sour,
with the result that banks holding these loans were weakened. By contrast, recessions that
were preceded by relatively slow economic activity, such as those in the Rust Belt, generally did not lead to widespread bank failures.
This relationship between the number of bank failures and regional boom-and-bust
patterns of economic activity is illustrated by the data in tables 1.3 and 1.4, which show that
bank failure rates were generally high in states where, in the five years preceding state recessions, real personal income grew faster than it did for the nation as a whole. Conversely,
bank failure rates were relatively low in states where, in the five years preceding state recessions, real personal income grew more slowly than it did for the nation as a whole.19
There were four major regional and sectoral economic recessions that were associated
with widespread bank failures during the 1980–94 period. The first accompanied the downturn in farm prices in the early and middle 1980s after years of rapid increases during the
late 1970s (see figure 1.5). The downturn in prices led to reductions in net farm income and
farm real estate values and a rise in the number of failures of banks with heavy concentrations of agricultural loans. The second recession occurred in Texas and other energyproducing southwestern states, where gross state product dropped after oil prices turned
down in 1981 and again in 1985 (see figure 1.6). The 1981 oil price reduction was followed
by a regional boom and bust in commercial real estate activity. The third recession was in
the northeastern states, which experienced negative growth in gross state product in
1990–91. The final episode was a recession in California, as growth in gross state product
turned negative in 1991–92.
Of the 1,617 bank failure and assistance cases from 1980 to 1994, 78 percent were located in the regions suffering these economic downturns—the Southwest, the Northeast,
19

In some high-growth states the number of bank failures rose sharply after the states’ recessions, but the increase fell outside the three-year periods shown in table 1.3. For example, Arizona experienced especially rapid growth before the state’s
1982 recession and also saw a high rate of bank failures (tables 1.1 and 1.2), but most of them occurred in 1989–90.

History of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

Table 1.3

Bank Failures and Growth Rates of Real Personal Income, by State,
1980–1994 (Percent)
Growth Rates of Real Personal Income
Five Years before Recession
State*
Wyoming
Nevada
Oklahoma
Alaska
Arizona
New Hampshire
Louisiana
Washington
Maryland
Texas
Maine
Vermont
Connecticut
California
Oregon
New Jersey
Rhode Island
Massachusetts
New York
Mississippi
Arkansas
Kentucky
Tennessee
West Virginia
Illinois
Missouri
Wisconsin
North Dakota
Kansas
Idaho
Michigan
Alabama
Michigan
Hawaii
Indiana
Iowa
Iowa

20

Recession
Years†

State Growth Rate,
Recession Years

State Growth
Rate

State Minus
U.S. Growth
Rate

1982–87
1982
1983–87
1986–87
1982
1990–91
1983–87
1982
1991
1986–87
1991
1991
1991
1991
1981–82
1991
1991
1991
1991
1980
1980–82
1980–83
1982
1981–83
1991
1980–82
1981–82
1985–88
1980
1982
1991
1982
1980–82
1981
1980–82
1979–85
1991

−3.03
−0.17
−1.42
−5.46
−0.18
−0.43
−0.75
−0.24
−0.33
−0.98
−2.15
−1.45
−1.94
−1.04
−2.40
−1.13
−1.82
−1.87
−0.88
−1.09
0.27
0.17
−0.05
−0.73
−0.09
0.55
−0.22
−3.54
−0.30
−1.91
−0.58
−0.24
−2.73
−0.63
−1.39
−0.31
−0.39

8.26
7.83
6.05
6.63
6.69
5.69
4.69
4.97
4.49
4.43
4.42
4.32
4.30
4.20
5.03
3.89
3.79
3.79
3.71
4.15
4.14
4.08
3.12
3.63
2.64
3.41
3.49
2.28
3.32
2.79
2.41
2.72
3.12
3.20
3.03
1.83
2.04

5.05
4.62
3.78
3.75
3.49
2.50
2.41
1.76
1.61
1.55
1.54
1.44
1.42
1.32
1.21
1.01
0.91
0.91
0.83
0.42
0.42
0.36
−0.09
−0.19
−0.24
−0.32
−0.33
−0.38
−0.41
−0.41
−0.47
−0.48
−0.60
−0.62
−0.69
−0.79
−0.84

Percent of Banks Failing
in Recession and Next 2
Years‡
18.52
8.33
20.83
50.00
0.00
19.51
21.22
0.93
1.92
20.45
5.13
6.25
22.05
7.26
14.63
6.00
13.33
9.77
3.86
0.00
2.33
0.58
7.41
0.84
0.55
0.69
0.00
4.52
0.49
0.00
0.00
0.97
0.54
0.00
0.49
4.92
0.18

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Table 1.3 (continued)

Bank Failures and Growth Rates of Real Personal Income, by State,
1980–1994 (Percent)
Growth Rates of Real Personal Income
Five Years before Recession
State*
Montana
Nebraska
Montana
Ohio
Illinois
South Dakota
West Virginia
North Dakota
Iowa
District of Columbia
North Dakota

Recession
Years†

State Growth Rate,
Recession Years

1980–82
1979–83
1985–88
1980–82
1980–82
1980–82
1987
1991
1988
1980
1979–80

1.21
0.24
−0.17
−0.73
−0.28
−1.38
−1.33
−2.50
−1.11
−2.94
−3.54

State Growth
Rate
2.87
1.67
1.39
2.41
2.34
2.09
0.51
0.08
1.01
−0.08
−1.59

State Minus
U.S. Growth
Rate

Percent of Banks Failing
in Recession and Next 2
Years‡

−0.86
−0.96
−1.28
−1.31
−1.38
−1.63
−2.65
−2.80
−3.09
−3.80
−4.21

0.62
4.20
4.79
0.00
1.60
1.30
0.47
0.00
1.17
0.00
0.58

Note: Data refer to all states that experienced a decrease in real personal income in any year from 1980 to 1992.
*States are ranked according to the magnitude of the difference between state growth rates and the U.S. growth rate in real
personal income during the five years before state recessions.
†Recessions are defined as years in which personal income deflated by GDP deflator decreased. Recoveries are counted as
having at least two consecutive years of growth in real personal income. In some states, therefore, personal income increased
during a single year sufficiently to produce positive growth for the recession as a whole.
‡Percent of banks failing is based on the number of banks existing as of December of the year preceding the recession.

Table 1.4

Bank Failures and Growth Rates of Real Personal Income,
by State Recession Quartile
(Percent)
State Recession
Quartile*

Average Difference between State
Growth Rate and U.S. Growth Rate,
5 Years before Recession†

Average State Bank Failure
Rate in Recession
and Next 2 Years

1

2.79

14.42

2

0.71

7.34

3

−0.48

1.06

4

−2.07

1.28

*State recessions are grouped in quartiles according to the magnitude of the difference between state growth rate and U.S.
growth rate in real personal income from table 1.3.
†Data are unweighted averages of individual state data.

History of the Eighties—Lessons for the Future

21

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

Figure 1.5

Farm Prices, Exports, Income, Debt, and Real Estate Value, 1975–1994
Index

Prices Received by Farmers
1990–1992 = 100

Farm Exports

$Billions
45

100

35

90
80

25
1975

$Billions

1980

1985

1990

1994

Net Farm Income

1975

1980

1985

1990

1994

1990

1994

Farm Debt

$Billions
180

40

150
30

120

20

90
1975

1980

1985

1990

1994

1975

1980

1985

Average Farm Real Estate Value per Acre

Dollars
800

600

400
1975

1980

1985

1990

1994

Source: Economic Report of the President, 1986, 1996.

22

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

and California—or were agricultural banks outside of these three regions.20 These failures
accounted for 71 percent of the assets of failed banks over the period. Although all four of
Figure 1.6

Changes in Gross State Product and Gross Domestic Product, 1980–1994
Southwest

Percent
9

Percent
9

Southwest
6

Northeast

6

U.S.

3

3

0

0

-3

Northeast

1980 1982 1984 1986 1988 1990 1992 1994

-3

U.S.

1980 1982 1984 1986 1988 1990 1992 1994
Peak Number
of Failures

Peak Number
of Failures

Percent
9

California
California

6
3

U.S.
0
-3

1980 1982 1984 1986 1988 1990 1992 1994
Peak Number
of Failures

Source: U.S. Department of Commerce, Bureau of Economic Analysis.
20

Agricultural banks are defined as banks with 25 percent or more of total loans in agricultural loans. Data on assets of failed
banks are as of the quarter before the date of failure. The Southwest includes Arkansas, Louisiana, New Mexico, Oklahoma, and Texas. The Northeast includes New Jersey, New York, and the six New England states (Connecticut, Maine,
Massachusetts, New Hampshire, Rhode Island, and Vermont). The bulk of the agricultural bank failures, other than those
in the two southwestern states of Oklahoma and Texas, were in Iowa, Kansas, Minnesota, Missouri, and Nebraska.

History of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

the recessions associated with bank failures were partly shaped by their own distinct circumstances, certain common elements were present:
1. Each followed a period of rapid expansion; in most cases, cyclical forces were accentuated by external factors.
2. In all four recessions, speculative activity was evident. “Expert” opinion often
gave support to overly optimistic expectations.
3. In all four cases there were wide swings in real estate activity, and these contributed to the severity of the regional recessions.
4. Commercial real estate markets in particular deserve attention because boom and
bust activity in these markets was one of the main causes of losses at both failed
and surviving banks.

Rapid expansion. In the agricultural belt, increased farm production and purchases of
farmland were stimulated by rapid inflation during the 1970s in the prices of farm products,
a sharp run-up in farm exports, and widespread expectations of strong worldwide demand
in the 1980s. But as farm exports declined and higher interest rates increased farm costs, the
expansion gave way to a downturn.21 Similarly, in the Southwest (as well as other oil-producing areas around the world) strong worldwide demand for oil plus OPEC restrictions on
supply led to a major rise in oil prices and strong economic expansion—but the weakening
in oil prices after 1981 and their rapid drop in 1985 (brought on partly by the collapse of discipline in the international oil cartel) resulted in two economic downturns during the 1980s
in the Southwest.22 California enjoyed a rate of economic growth above the national average during the 1980s but was hit particularly hard during the 1991–92 national recession,
partly because of cutbacks in defense spending.23 In the Northeast, growth rates in overall
production were above the national average during 1982–88; the subsequent decline came
about mainly because a local economic slowdown was followed—and aggravated—by the
1991–92 national economic recession and by a boom and bust in northeastern residential
and commercial real estate activity.24
Speculative activity with “expert” support. Speculative activity was reflected in a
number of developments. Farm real estate values showed an uninterrupted rise in the late
1970s and early 1980s, even though gross returns per acre for major crops were tracing a

21
22
23
24

See Chapter 8, “Banking and the Agricultural Problems of the 1980s.”
See John O’Keefe, “The Texas Banking Crisis: Causes and Consequences, 1980–1989,” FDIC Banking Review 3, no. 2
(1990); and Chapter 9, “Banking Problems in the Southwest.”
See Chapter 11, “Banking Problems in California.”
See Chapter 10, “Banking Problems in the Northeast.”

24

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

highly variable and generally downward trend.25 In the Southwest, commercial construction and lending activity continued in major markets after vacancy rates began to soar. In
many commercial real estate mortgage markets, underwriting standards were relaxed.26 The
presence of speculative activity was frequently mentioned in interviews conducted in 1995
by staff of the FDIC’s Division of Research and Statistics as part of the research for this
study.27 (In all, approximately 150 bankers and regulators were interviewed in Atlanta,
Boston, Dallas, Kansas City, New York, San Francisco, and Washington). Numerous interviewees cited a belief common in the 1980s that the boom economies of this period had unlimited viability. They also noted that in many cases bankers were engaged in asset-based
lending, relying on collateral values supported by inflationary expectations rather than by
cash flows.
Examples of “expert” opinion that supported optimism included statements attributed
to two secretaries of agriculture28 and comments by many observers in the Northeast that
the area’s economy was diversified, mature, and largely immune to Texas-style real estate
problems.29 Another example is provided by economists and other analysts, who as late as
1990 and 1991 were discounting the prospect of a bust in California home prices.30
Wide swings in real estate activity. In the agricultural belt, prices of farmland were bid
up during the 1970s by farmers and investors, who were responding to increases in the
prices of farm products as well as expectations of continued strong foreign demand. Farmland values continued to rise until 1982, remained at high levels until 1984, and then collapsed (figure 1.5). In the Southwest, both residential and nonresidential construction rose
sharply during the early 1980s before falling precipitously later in the decade; these wide
real estate swings followed the earlier oil-generated cycle and contributed to the second
Southwest recession in the 1980s. In both the northeastern states and California, boom-andbust real estate activity aggravated general state recessions in the early 1990s.

25

26
27

28

29
30

In 1982, when land values reached their zenith, gross rates of return for corn and soybeans were less than two-thirds their
1970 levels and approximately one-third their 1973 levels. See Chapter 8, “Banking and the Agricultural Problems of the
1980s.”
See Chapter 3, “Commercial Real Estate and the Banking Crises”; and O’Keefe, “The Texas Banking Crisis.”
“Speculative activity” in this context is synonymous with economic “bubbles” defined as follows: “if the reason that the
price is high today is only because investors believe that the selling price will be high tomorrow—when “fundamental” factors do not seem to justify such a price—then a bubble exists.” See Joseph E. Stiglitz, “Symposium on Bubbles,” Journal
of Economic Perspectives 4, no. 2 (spring 1990): 13.
Robert Bergland, secretary of agriculture in 1980, said, “The era of chronic overproduction...is over.” In 1972, then-Secretary of Agriculture Earl Butz is said to have advised farmers to plant “from fencerow to fencerow.” (Both quotations are
from Gregg Easterbrook, “Making Sense of Agriculture: A Revisionist Look at Farm Policy,” The Atlantic 256 (July 1985):
63. See Chapter 8, “Banking and the Agricultural Problems of the 1980s.”
Interviews with regulators and bankers. See Chapter 10, “Banking Problems in the Northeast.”
See citations in Chapter 11, “Banking Problems in California.”

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Commercial real estate markets and bank losses. Commercial real estate development
is inherently risky, partly because of the long gestation period of many commercial construction projects. When completed projects finally come to market, demand conditions
may have changed considerably from what they were at the time of conception. Another
cause of risk is that many firms seeking commercial floor space are geographically mobile,
so developers are affected by economic events not only in the project’s proximity but in fardistant areas as well. In addition, commercial real estate projects tend to be highly leveraged, a condition that increases the volatility of returns. Relevant data on commercial real
estate are often difficult to obtain because these markets are not highly organized and because transactions are often “private deals” whose crucial elements may not be publicly
available. Finally, commercial loan contracts usually have nonrecourse provisions prohibiting lenders from satisfying losses from other borrower assets.
In the early 1980s, booming activity in commercial construction was supported by
rapidly increased bank and thrift commercial mortgage lending. A major stimulus for this
activity was provided by public policy actions: tax breaks enacted as part of the Economic
Recovery Act of 1981 greatly enhanced the after-tax returns on real estate investment, and
the Garn–St Germain Act expanded the nonresidential lending powers of savings associations. Competitive pressures, including those reflected in the reduced bank share of the
market for business loans to large companies, also provided an important stimulus.
Many banks and thrifts moved aggressively into commercial real estate lending. During the 1980s, when total real estate loans of banks more than tripled, commercial real estate loans nearly quadrupled. As a percentage of total bank assets, total real estate loans rose
from 18 to 27 percent between 1980 and 1990, while the ratio for nonresidential and construction loans nearly doubled, from 6 to 11 percent. A pervasive relaxation of underwriting
standards took place, unchecked either by the real estate appraisal system or by supervisory
restraints. Overly optimistic appraisals, together with the relaxation of debt coverage, of
maximum loan-to-value ratios, and of other underwriting constraints, meant that borrowers
frequently had no equity at stake, and lenders bore all of the risk. 31
Overbuilding occurred in many markets, and when the bubble burst, real estate values
collapsed. (The downturn was aggravated by the Tax Reform Act of 1986, which removed
tax breaks for real estate investment and caused a reduction in after-tax returns on such investment.) At many financial institutions loan quality deteriorated significantly, and the deterioration caused serious problems. As discussed in detail below, banks that failed in the
1980s had higher ratios of commercial real estate loans to total assets than surviving banks.
31

These observations on underwriting practices, taken from Chapter 3, reflect the comments of, and have been reviewed by,
a number of FDIC examiners and supervisory personnel who were actively engaged in bank examination and supervision
during the 1980s.

26

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Failing banks also had higher ratios of commercial real estate loans to total real estate loans,
of real estate charge-offs to total charge-offs, and of nonperforming real estate assets to total nonperforming assets.
Bank Performance in Regional and Sectoral Recessions
The behavior of banks in the regions and sectors that suffered recessions during the
1980s also exhibited some common elements:
1. In the economic expansions that preceded these recessions, banks generally responded
aggressively to rising credit demands.
2. Banks that failed during the regional recessions generally had assumed greater risks, on
average, than those that survived, as measured by ratios of total loans and commercial
real estate loans to total assets. Banks that failed had generally not been in a seriously
weak condition (as measured by equity-to-assets ratios) in the years preceding the regional recessions.
3. Banks chartered in the 1980s and mutual institutions converting to the stock form of
ownership failed with greater frequency than comparable banks.

Aggressive response. In the case of agricultural banks, aggressive response is evident
in the growth of farm loans, which increased rapidly and reached a peak in 1984, after the
1981 highs in prices received by farmers and net farm income and the 1982 high in farmland values. In Texas, banks responded to the rise in oil prices by rapidly increasing not only
their commercial and industrial loans (including loans to oil and gas producers) but also the
share of commercial and industrial loans in total bank assets. In most of the regions that underwent recessions, the aggressiveness of bank lending is evident as well in the rapid expansion in nonresidential mortgage lending and in the increased share of commercial
mortgages in total bank assets.
Risk taking and failure. Banks that would fail during the 1980–94 period generally had
higher ratios of total loans to assets and commercial real estate loans to assets throughout
most of the period (see figures 1.7 and 1.8). (In this context, commercial real estate loans include construction loans, nonfarm nonresidential loans, and multifamily mortgages.) This
was true for banks in the agricultural belt, the Southwest, the Northeast, California, and the
total United States. In the agricultural belt, the Southwest, and the Northeast, banks that
would fail during the regional recessions had significantly higher loans-to-assets ratios in
the year before the recessions began (see table 1.5).32 In the Northeast and Southwest, com32

Regional recessions are considered to have begun in the agricultural belt in 1982 (following the 1981 high in prices received by farmers), in the Southwest in 1982 (after oil prices reached a peak in 1981), and in the Northeast and California
in the first year of negative gross state product (figure 1.6).

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Figure 1.7

Ratio of Gross Loans to Total Assets, Failed and Nonfailed Banks, 1980–1994
Agricultural Banks*

Percent

Southwest

Percent
65

60
55

55

50
45
1980

45
1982

1984

1986

1988

1990

1992

1980

1994

1982

1984

1986

1988

1990

1992

1994

1990

1992

1994

*Agricultural banks are banks where agricultural loans are at least

25% of total loans.

Northeast

Percent

California

Percent
75

75
65

65

55

55
1980 1982

1984

1986 1988 1990

1992 1994

1980

1982

1984

1986

1990

1992 1994

1988

Total U.S.

Percent
70

60

50
1980

1982

1984

1986

Banks That Subsequently Failed

1988

Banks That Did Not Fail

Note: Data are unweighted averages of individual bank ratios. Data for banks that subsequently failed are not shown for years when
there were fewer than ten banks that would fail in subsequent years. Open-bank assistance cases are not counted as failures.

28

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Figure 1.8

Ratio of Commercial Real Estate Loans to Total Assets, Failed
and Nonfailed Banks, 1980–1994
Percent

Agricultural Banks*

Southwest

Percent
14

5
4

10

3

6

1980

1982

1984

1986

1988

1990

1992

1994

1980

1982

1984

1986

1988

1990

1992

1994

1990

1992

1994

*Agricultural banks are banks where agricultural loans are at least

25% of total loans.

Percent

Northeast

25

30

20

20

15

10

10
1980 1982

California

Percent

1984

1986 1988 1990
Percent

1992 1994

1980

1982

1984

1986

1988

Total U.S.

30
20
10
0

1980 1982 1984 1986 1988 1990 1992 1994

Banks That Subsequently Failed

Banks That Did Not Fail

Note: Commercial real estate loans = construction loans + multifamily loans + nonfarm, nonresidential loans. Data are
unweighted averages of individual bank ratios of commercial real estate loans to total assets. Data for banks that subsequently
failed are not shown for years when there were fewer than ten banks that would fail in subsequent years. Open-bank assistance
cases are not counted as failures.

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mercial mortgages were higher relative to total assets for failed banks. Banks that would fail
also had lower equity-to-assets ratios than survivors in the year before the recession.33

Table 1.5

Selected Financial Ratios
A. Failed and Nonfailed Banks 1 Year before Regional Recession
1981
Agricultural Banks
Ratio

Failed

Equity/Assets
Eq.+Loss Res./Assets
Nonprfm Lns/Tot Lns
ROA
ROE
Loans/Assets
Comm. Mtgs/Assets

7.91%
9.11
NA
1.26
16.90
56.30
2.08

Nonfailed
8.30%*
9.77*
NA
1.33
16.44
48.48*
2.19

1989
Southwest Banks

Failed
7.00%
8.64
NA
1.22
18.98
53.94
3.92

Nonfailed
7.63%*
9.25*
NA
1.38*
18.99
47.72*
3.42*

Northeast Banks
Failed

Nonfailed

6.67%
8.34
8.60
-1.68
-23.65
75.16
13.91

1990
California Banks
Failed

9.21%*
9.93
2.95*
0.67*
6.73*
68.05*
9.44*

Nonfailed

5.71%
7.20
6.23
-0.63
-7.78
73.12
10.79

10.47%*
11.46*
2.39*
0.36
9.88*
69.63
11.91

B. Failed and Nonfailed Banks 3 Years before Regional Recession
1979
Agricultural Banks
Ratio

Failed

Equity/Assets
Eq.+Loss Res./Assets
Nonprfm Lns/Tot Lns
ROA
ROE
Loans/Assets
Comm. Mtgs/Assets

7.39%
8.85
NA
1.15
16.10
58.40
2.13

Nonfailed
7.87%*
9.45*
NA
1.28*
16.64
55.56*
2.42*

Southwest Banks
Failed
6.94%
8.45
NA
1.00
15.55
53.42
3.99

Nonfailed
7.45%*
9.08*
NA
1.28*
17.80*
50.02*
3.71

1987

1988

Northeast Banks

California Banks

Failed
7.96%
8.53
1.70
0.62
11.66
74.31
13.08

Nonfailed
8.86%*
9.37
1.14*
1.04*
14.32
66.33*
8.25*

Failed
6.95%
8.02
4.86
0.08
2.29
68.72
7.78

Nonfailed
9.58%
10.52
2.28*
0.78*
10.85
63.01*
8.76

Note: Data are unweighted averages of individual bank ratios. Asset and loan figures are year-end values of the given year,
and equity figures are year-end of the previous year. Excluded were banks chartered within the specified year, banks that
failed before the recession, and banks participating in the Net Worth Certificate Program. Nonperforming loans were not reported before 1982.
*Significant at 95 percent level

33

The comparison in California is between failing and surviving banks with assets below $300 million. All but one of the
state’s bank failures were in that asset-size group, while the total state data are dominated by California’s four megabanks
(see Chapter 11).

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History of the Eighties—Lessons for the Future

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Summary and Implications

Three years before the onset of the regional recessions, banks that would fail likewise had
significantly higher ratios of loans to assets, but these banks’ equity-to-assets ratios—although somewhat lower than those of banks that would survive—were in the generally
healthy range of nearly 7 percent to nearly 8 percent (table 1.5).
These results are generally consistent with the findings on measures of risk and condition summarized below in the section on off-site surveillance. As noted in that section,
five years before their failure, banks that would subsequently fail differed little from banks
that would survive in terms of equity-to-assets ratios and other measures of current condition. On the other hand, banks that would fail had higher loans-to-assets ratios than survivors, and high loans-to-assets ratios were the risk factor with the strongest statistical
relationship to incidence of failure five years later.
Although high loan volumes were a prominent feature of failing banks from 1980 to
1994, they obviously were not an automatic route to failure. Banks earn income by managing risk, including risk of loan defaults. The averages of individual bank ratios discussed
above obscure the fact that some banks that survived also had high concentrations of assets
in total loans and/or commercial mortgages. Similarly, as noted below in the section on offsite surveillance, only a fraction of the banks with high loans-to-assets ratios would fail five
years later. The conditions enabling many banks with high-risk financial characteristics to
survive the recessions and avoid failure may include the following, among others: strong
equity and reserve positions to absorb losses, more-favorable risk/return trade-offs, superior
lending and risk-management skills, changes in policies before high risk was translated into
severe losses, improvements in local economic conditions, and timely supervisory actions.
High lending volumes may lead to trouble if a bank achieves them by relaxing credit standards, entering markets where management lacks expertise, or making large loans to single
borrowers, or if loan growth strains the bank’s internal control systems or back-office operations. That such factors were present at many banks that failed from 1980 to 1994 has been
suggested by numerous observers, including those interviewed during the research for this
study.
New and converted banks. Approximately 2,800 new banks were chartered in the period covered by this study, 39 percent of them in the Southwest (notably Texas) and California. Of all the institutions chartered in 1980–90,34 16.2 percent failed through 1994,
compared with a 7.6 percent failure rate for banks that were already in existence on De-

34

The 1980–90 period was selected in this comparison to compensate roughly for the fact that banks chartered between 1991
and 1994 did not have as much chance to fail during the period through 1994.

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cember 31, 1979 (see table 1.6).35 Although the data are dominated by the Texas experience,
in most areas banks chartered in the 1980s generally had a higher failure rate than banks existing at the beginning of the 1980s.36
In the Northeast, mutual savings banks that converted to the stock form of ownership
represented a somewhat comparable phenomenon.37 Of the mutuals that converted in the
middle and late 1980s after state legislation permitted such action, 21 percent of the institutions existing at the end of 1989 failed in 1990–94. This compared with 8 percent of the
Table 1.6

Failure Rates, Newly Chartered and Existing Banks
Banks Chartered, 1980–1990
Number Failed

Percent Failed

1980–1994

1980–1994

Southwest

248

33.3

Southeast

26

4.3

Northeast

38

19.3

41

13.1

420

16.2

Region

California
U.S.

Banks Existing on December 31, 1979
Number Failed

Percent Failed

1980–1994

1980–1994

Southwest

538

21.4

Southeast

77

3.1

Northeast

89

8.5

California

31

12.8

1,114

7.6

Region

U.S.

35

36

37

A study of the Texas experience concluded that “the relatively high failure rate for newly established Texas banks can be
explained by high-risk financial policies” (Jeffery W. Gunther, “Financial Strategies and Performance of Newly Established Texas Banks,” Federal Reserve Bank of Dallas Financial Industry Studies [December 1990]: 13).
In the Southwest and Northeast, newly chartered banks failed with greater frequency than preexisting banks, whether
“newly chartered” includes all banks chartered during the 1980–90 period or only those that were in existence for five years
or less. In Southern California, however, failure rates for banks in existence for five years or less were lower than those for
preexisting banks, whereas failure rates for all banks chartered in the entire 1980–90 period were higher.
Jennifer L. Eccles and John P. O’Keefe, “Understanding the Experience of Converted New England Savings Banks,” FDIC
Banking Review 8, no. 1 (1995): 1–18.

32

History of the Eighties—Lessons for the Future

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Summary and Implications

mutuals that existed as of the end of 1989 and had not converted, and 11 percent of the region’s commercial banks (see table 1.7). New banks and converted mutuals highlighted in
extreme fashion the problems confronting many other banks in the 1980s. These institutions had strong incentives to expand loan portfolios rapidly in order to leverage high initial capital positions, increase earnings per share, and meet stockholder expectations.38 In so
doing, these institutions rapidly increased their lending in markets already experiencing
vigorous competition and deteriorating credit standards. They combined powerful competitive pressures to assume greater risk with relative inexperience in a demanding new environment. Newly chartered banks began operations at a time when inexperience was a
distinct liability, while many converted mutuals responded to internal and external pressures by entering unfamiliar markets or geographic areas. As a result, a disproportionate
number of new and converted banks failed.
Table 1.7

Failure Rates of Converted Mutual Savings Banks and Other Banks,
Northeastern States

Number Existing 12/31/89

Savings Banks

Commercial
Banks

Stock

Mutual

Cooperative
Banks*

Total

588

149

211

101

1,049

Number of Failures, 1990–94

65

32

16

5

118

Percent Failed

11

21

8

5

11

Note: Data are for Connecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont.
* “Cooperative banks” is the term used for state-chartered savings and loan associations in Massachusetts.

Fraud and Financial Misconduct
The precise role of fraud and financial misconduct as a cause of bank failures is difficult to assess. The consensus of a number of studies is that fraud and financial misconduct
(1) were present in a large proportion of bank and thrift failures in the 1980–94 period, (2)
contributed significantly to some of these failures, and (3) were able to take root because of
the same managerial deficiencies and inadequate internal controls that contributed to the financial problems of many failed and problem institutions (apparently internal weaknesses
left some institutions vulnerable not only to adverse economic developments but also to

38

Managers of savings banks that converted may also have been willing to take greater risks with their personal compensation than managers of banks that retained the mutual form.

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abuse and fraud). The studies also agree that the dollar impact of such activity is extremely
difficult to estimate.
A 1988 OCC study of 162 national bank failures between 1979 and 1987 concluded
that insider abuse was a significant contributing factor in 35 percent of the failures, and
fraud in 11 percent.39 As for problem banks that recovered and survived, the OCC found
that 24 percent of these banks had suffered from significant insider abuse, while none had
significant problems with fraud. Another study, which drew on a number of analyses and reports prepared by Congress and the regulators, concluded that fraud and insider abuse contributed to between 33 and 50 percent of commercial bank failures and from 25 to 75
percent of thrift failures in 1980–88.40 A 1993 U.S. General Accounting Office (GAO) report pointed to the difficulties of quantifying the effects of fraud and to the wide variations
in estimates of its impact.41 Whereas the OCC study found that fraud played a significant
role in 11 percent of national bank failures, the FDIC found that fraud and insider abuse
were present in 25 percent of 1989 bank failures; and the Resolution Trust Corporation
(RTC) reported in 1992 that potential criminal abuses by insiders contributed to 33 percent
of RTC failed thrift cases. Finally, a 1994 GAO report indicated that FDIC investigators had
found insider fraud to be a major cause of failure in 26 percent of a sample of 286 banks that
failed in 1990–91 and insider “problems” (fraud, noncriminal abuses, and loan losses on insider loans) to be present in 61 percent.42
A number of factors make it difficult to measure the effect of fraud and abuse. First,
some cases of fraud go undetected. Second, sometimes the line between poor business
judgment and fraud is difficult to draw, as is the line between criminal and noncriminal activities. Third, the regulators and the Federal Bureau of Investigation do not maintain complete or consistent records on fraud convictions, reported incidents of fraud, and financial
misconduct. Fourth, new legislation had effects that make comparisons over time difficult
to draw: FIRREA and the Crime Control Act of 1990 increased the resources for detecting
and reporting fraud and broadened the agencies’ powers to deal with bank and thrift fraud.
For all of these reasons, any attempt at precision would be unwarranted. However, it seems
reasonable to infer that fraud and abuse not only were present in a large number of bank and
thrift failures in the 1980–94 period but also contributed to some of them.

39
40
41
42

Office of the Comptroller of the Currency, Bank Failure: An Evaluation of the Factors Contributing to the Failure of National Banks (1988).
Benton E. Gup, Bank Fraud: Exposing the Hidden Threat to Financial Institutions (1990).
U.S. General Accounting Office, Bank and Thrift Criminal Fraud: The Federal Commitment Could Be Broadened
(GAO/GGD-93-48, January 1993).
U.S. General Accounting Office, Bank Insider Activities: Insider Problems and Violations Indicate Broader Management
Deficiencies (GAO/GGD-94-88, March 1994).

34

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Factors Associated with Bank Failures: Conclusion
The preceding discussion points to a variety of factors—economic, financial, legislative, regulatory, supervisory, managerial—that contributed to bank failures during the
1980s. Not all observers subscribe to a multiple-cause interpretation of bank-failure history
or to the particular set of multiple causes described in this study. Some place particular emphasis on one or two specific causes that they believe were especially influential. For example, bank regulators tend to place heavy weight on deficiencies in bank management.43
Bankers tend to blame government policy and adverse changes in the economy. Journalists
point to cases of malfeasance. Academic writers have placed special emphasis on the financial incentives facing bank owners and managers.
With respect to these last, a considerable body of academic literature has stressed the
effect that flat-rate deposit insurance (whose cost is unrelated to the level of risk assumed
by individual institutions) had in encouraging moral-hazard risk taking and leading to
depository-institution failures.44 There seems little question that excessive risk taking by
then-solvent banks contributed to bank failures and that flat-rate deposit insurance contributed to risk taking. However, singling out deposit insurance pricing as the principal explanation of bank failures seems unwarranted. Deposit insurance was available at fixed rates
throughout most of the FDIC’s history, but before the 1980s bank failures were few in number and were often caused by fraud rather than by financial risk taking. It was changes in the
marketplace (increased competition, downward pressure on profits, lifting of legal restraints, and so forth) that created the environment in which increased risk taking (including
exploitation of flat-rate deposit insurance) became advantageous or necessary for many
banks.
Furthermore, as mentioned above, although banks that failed had generally assumed
greater risk before their failure, many other banks with similar risk profiles did not fail. In
the case of these surviving banks, the effects of risk taking, including risk taking stimulated
by underpriced deposit insurance, were apparently offset by other factors, including superior risk-management skills. The absence of these offsetting factors should therefore be
considered more important causes of bank failures. Moral-hazard risks appear to have had
greater significance in the savings and loan industry than in the banking industry; this was
mainly because thrift regulators permitted (or were forced by a depleted insurance fund to
permit) a large number of thrifts to operate for lengthy periods with little or no equity, a situation that produced extraordinary incentives for risk taking.
43

44

See OCC, Bank Failure, 5, 10: “The study showed that deficiencies within boards of directors and management were the
primary internal problems of problem and failed banks . . . The evidence from healthy and rehabilitated banks also supports
our hypothesis that economic conditions are rarely the primary factor in determining a bank’s condition.” See also Richard
Duwe and James Harvey, “Problem Banks: Their Characteristics and Possible Causes of Deterioration,” Federal Reserve
Bank of Kansas City Banking Studies (1988): 3–11.
See discussion below of moral hazard (“Role of Deposit Insurance”).

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The academic literature has also produced a second, alternative explanation of the incentives facing solvent banks, focusing on issues related to the control of banks exercised
by owners and managers.45 According to this view, managers rather than owners make lending decisions. If managers are entrenched (imperfectly controlled by owners), they may
make decisions that are at odds with the interests of stockholders. According to this view, in
periods (such as the 1980s) when the lending opportunities for banks were reduced as a result of the loss of market share in financing large businesses, some managers sought to preserve their perquisites by shifting lending to risky loans—a shift that led to loan losses and
reductions in capital. Focusing on the sometimes different incentives of managers and owners is useful for understanding variations in the behavior of different institutions. However,
it is not clear that such differences played a leading role in the increased number of bank
failures. Many managers may have believed that maintaining their reputations and future
employment prospects would best be served by risk-averse policies that avoided the failure
of their institution. Furthermore, some “entrenched” managers of solvent institutions (for
example, managers of savings banks that retained the mutual form) seem to have operated
their institutions relatively conservatively in the late 1980s. 46
A third view of the role of incentives in explaining risk taking by banks draws an analogy between federal deposit insurance and a trilateral performance bond in which the insurance agency provides a bond that protects depositors against poor performance by the
bank.47 This view emphasizes incentive conflicts between various parties: for example,
bank owners and managers, stakeholders in insured institutions and managers of the insurance agency, insurance agency managers and elected government officials, elected
government officials and taxpayers. In this setting, regulators lack the incentives to enforce
effective loss-control measures (capital requirements, monitoring, etc.) that are opposed by
the regulated industry or “threaten a regulator’s ability to mask poor performance.”48
45

46

47
48

Gary Gorton and Richard Rosen, “Corporate Control, Portfolio Choice, and the Decline of Banking,” Journal of Finance
(December 1995): 1377–410. Gorton and Rosen conclude that issues of corporate control are more important than moral
hazard in determining the behavior of solvent institutions. In the case of insolvent institutions, managers and owners have
identical interests and behave in the manner suggested by the moral-hazard principle. Another study, based on experience
in the 1990s, concluded that the relationship between corporate structure and risk is significant only at low-franchise-value
banks where moral hazard problems are most severe and conflicts between owner and manager risk preferences are therefore the strongest. See Rebecca S. Demsetz, Marc R. Saidenberg, and Philip E. Strahan, “Agency Problems and Risk Taking at Banks,” Staff Report, Federal Reserve Bank of New York, September 1997.
As noted before, mutual savings banks that converted to the stock form failed with greater frequency in the late 1980s and
early 1990s than mutuals that retained the mutual form. Mutual savings banks had no stockholders and were governed by
self-perpetuating boards of trustees or directors, which in some cases were dominated by their chief executive officers;
managers of such institutions might reasonably be considered entrenched in the sense of being imperfectly controlled.
Edward J. Kane, “Three Paradigms for the Role of Capitalization Requirements in Insured Financial Institutions,” Journal
of Banking and Finance 19 (1995): 431–59.
Ibid., 447.

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History of the Eighties—Lessons for the Future

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Summary and Implications

These academic views share an emphasis on the sometimes conflicting incentives of
bank owners, managers, regulators, and others as the principal explanation of insufficiently
restrained bank risk taking. They also share the view that bank risk is essentially endogenous, arising from factors internal to the banking and regulatory systems, including mispriced deposit insurance, inadequate owner-control of bank managers, or more general
principal-agent problems among various parties involved in or affected by deposit insurance and bank regulation. The importance of exogenous factors (the economy, financial
markets, etc.) is correspondingly diminished in explaining bank risk taking and failures.
Ultimately, the role of financial incentives in bank failures is inseparable from the role
of broader economic, financial, legislative, and regulatory factors; the extent to which flatrate deposit insurance pricing, for example, led to excessive risk taking and widespread failures apparently depended on the circumstances. The multiple-cause explanation appears to
be a more plausible reading of the history of the 1980s. According to this view, the rise in
the number of bank failures was caused by a variety of factors internal and external to the
industry.49 This is not to say that failures were due merely to “bad luck,” with everything
going wrong at the same time. More realistically, the preconditions for a rise in the number
of bank failures were present well before the 1980s. These preconditions included, among
others, a structure of banking laws that inhibited competition, geographic diversification of
risks, and consolidation of units. They also included managerial attitudes and regulatory
provisions that reflected the relatively benign pre-1980 environment for banking when failures were rare, and a system of flat-rate deposit insurance premiums that was tenable when
other incentives and opportunities for risk taking were weak. The localized nature of many
banks and a lack of experience with hard times left them vulnerable to external shocks and
regional and sectoral recessions. Under the pressure of increased competition, many banks
assumed greater risks, and as long as they remained solvent and profitable they were insufficiently restrained by the supervisory authorities. When the economic, financial-market,
and competitive environment turned markedly less favorable for banks and some government policy actions (principally ill-timed deregulation and tax changes) exacerbated the situation, the preconditions were translated into increased numbers of bank failures. Which
banks failed and which banks survived in an increasingly demanding environment was
largely determined by an individual bank’s circumstances, particularly variations in the levels of risk it assumed, its success (or lack thereof) in operating with high risk levels, the

49

A study by the FDIC Office of Inspector General (OIG) of the 13 bank failures in 1994, when conditions for banking were
much different from in the 1980s, concluded that in a majority of cases problems were evident in loan underwriting, credit
concentrations, high overhead, imprudent management, and external economic factors. Less common or critical factors
were financial derivatives, volatile deposits, cross-guarantee assessments, and newly chartered banks. See FDIC Office of
Inspector General, 1994 Failed Banks Trend Analysis (1995), 2. Similar results were found for 6 failures in the OIG’s 1995
Failed Banks Trend Analysis (1996).

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overall strength of its management, good or bad fortune, and (in some cases) the presence
or absence of fraud and misconduct.

Regulatory and Supervisory Issues Raised
by the Experience of the 1980s
The principal regulatory and supervisory issues arising from the experience of the
1980s include the role of deposit insurance, the treatment of large-bank failures, the use of
forbearance, the impact of Prompt Corrective Action, and the effectiveness of supervisory
tools—examination, enforcement, and off-site surveillance.
Role of Deposit Insurance
Deposit insurance has often been described as involving a trade-off between stability
and moral hazard.50 On the one hand, by protecting depositors against loss, deposit insurance virtually eliminates the risk of bank runs and disruptive breakdowns in bank lending.
On the other hand, by assuming the risk of losses that would otherwise be borne by depositors, deposit insurance eliminates any incentive for insured depositors to monitor bank risk
and permits bank managements to take increased risks. Because of deposit insurance, banks
are able to raise funds for risky projects at costs that are not commensurate with the risk of
the projects, a situation that may lead to the misallocation of resources and to failures.51
Moral hazard is a particularly serious concern if the bank is insolvent or close to insolvency,
in which case the owners have strong incentives to make risky investments because profits
accrue to the owners, whereas losses fall on the insurer. (On the other hand, risk taking may
be restricted if the bank has sufficient franchise value, defined as the present value of future
income expected to be earned by the bank as a going concern.) In principle, the insuring
agency can protect itself by requiring deductibles (equity positions) so that owners have
their own funds at risk and by charging premiums commensurate with the risk assumed by
the various banks. However, because it is difficult to identify indicators that give accurate
advance warning of future distress, moral-hazard problems are inherent in deposit insurance, as in other types of insurance.52 Deposit insurance suffers from the additional prob-

50

51
52

Arthur J. Murton, “Bank Intermediation, Bank Runs, and Deposit Insurance,” FDIC Banking Review 2, no. 1 (1989): 1–10.
The term “moral hazard” has been defined as “a description of the incentive created by insurance that induces those insured
to undertake greater risk than if they were uninsured because the negative consequences are passed through to the insurer”
(Congressional Budget Office, Reforming Federal Deposit Insurance [September 1990], 163).
In principle, owners of marginally solvent nonbank firms may also have incentives to take greater risk, but they are generally constrained by uninsured creditors.
The unreliability of ex ante risk measures has been attributed to information asymmetries between the insured and the insurer, whereby the former is seen to be better informed about his or her risky behavior.

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Summary and Implications

lem that it insures against losses that are not independent but are interrelated through the effects of cyclical economic activity and the possibility of contagious bank runs.
During the 1980s, the balance in this trade-off was generally tipped in favor of stability. In this respect, regulatory policy was eminently successful; despite an unprecedented
number of bank and thrift failures, there was no evidence of serious runs or credit-flow
disruption at federally insured institutions. Stability was achieved, it should be noted, at
substantial cost to surviving institutions and to their customers (assuming the institutions passed on at least part of the burden of increased assessments). In the case of thriftinstitution failures, some of the costs were borne by taxpayers as well. The estimated total
cost of FDIC failed-bank resolutions in 1980–94 is $36.3 billion. The estimated cost of the
savings and loan debacle is $160.1 billion, of which an estimated $132.1 billion was borne
by taxpayers.53
In contrast, the record of regulators with respect to controlling risk taking was
mixed—and in the case of still-profitable and solvent banks, often unfavorable. Here a distinction must be made between controlling the risky behavior of profitable, solvent banks
and controlling risk taking by problem banks that already face the near-term prospect of insolvency and failure. The record of the 1980s seems clear on this point. The regulators were
reasonably successful in modifying the behavior of officially designated problem banks so
as to reduce the prospects of their failure or the cost to the insurance fund if failure occurred. The regulators were less successful in constraining risk taking by still-profitable and
healthy banks, partly because there were no reliable, generally accepted, forward-looking
measures of risk.
There are three traditional means of controlling moral hazard: (1) examination and supervision; (2) regulatory capital requirements and risk-based deposit insurance premiums;
and (3) uninsured depositor and creditor discipline.54 In varying degrees and at various
times, all three of these means were operating imperfectly in the 1980s. As discussed below,
examination of many banks was infrequent in the early and middle 1980s, with the result
that the consequences of risky behavior and other problems were not always identified on a
53

54

The savings and loan cost figure includes the costs of the FSLIC and the RTC plus tax benefits under FSLIC assistance
agreements, but excludes potential costs from supervisory goodwill claims. See U.S. General Accounting Office, Resolution Trust Corporation’s 1995 and 1994 Financial Statements (July 1996), 13.
See Murton, “Bank Intermediation.” A study of Texas banks concluded that “the propensity to engage in risky activities depends on more than just changes in capital. A bank’s current risk influences the response of bank lending to changes in capital. As long as banks possessed the ability to expand their lending, lower growth rates of capital were associated with larger
increases in lending, as moral hazard would suggest. However, once banks were more exposed to risk, those institutions
with lower capital growth recorded statistically insignificant differences in lending compared to those banks with greater
increases in capital. While this latter finding is inconsistent with moral hazard, it points out the potential importance of both
regulatory and liquidity constraints at work” (Jeffery W. Gunther and Kenneth J. Robinson, “Moral Hazard and Texas
Banking in the 1980s,” Federal Reserve Bank of Dallas Financial Industry Studies [December 1990]: 6).

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timely basis. Although for some time regulators had been using capital standards to assess
the condition of banks, uniform minimum capital requirements covering all banks were not
adopted until 1985, and risk-based capital requirements not until 1990. Most bank failures
were resolved through purchase-and-assumption transactions or open-bank assistance
agreements that protected uninsured depositors and nondeposit creditors and therefore fostered the belief that all deposits of large banks were 100 percent insured. This belief severely limited the discipline that depositors might otherwise have exerted on the behavior
of banks.
More specifically, supervisory restraints did not prevent the speculative binge of commercial real estate and other risky lending by solvent banks in many regions of the country
in the 1980s. Regulators apparently believed that as long as risky behavior was profitable,
they had limited leverage to restrain such behavior. Examiners interviewed for this study
stated that as long as the banks were profitable, it was difficult to persuade bank managements or their own superiors in the regulatory agencies that problems could lie ahead. When
risky behavior resulted in actual losses, regulators were more effective, but often by that
time the damage had been done.
Part of the problem was the absence of explicit penalties or costs to make risky behavior less attractive—penalties and costs such as risk-based premiums and capital requirements that, as stated, were not adopted until late in the period. Earlier adoption of
uniform capital requirements and risk-based premiums would have improved the position
of the bank regulators but might still have been insufficient to curb the excessive risk taking in the 1980s. As noted, capital regulation is a principal means of restraining risky behavior, but equity-to-assets positions are lagging indicators of a bank’s risk profile and
therefore poor indicators of the risk of failure several years before the fact. Current riskbased capital standards, which differentiate among broad asset categories, permit considerable shifting toward riskier lending within categories without requiring additional capital,
while higher risk-based premiums are charged to banks whose condition has already deteriorated.55 In short, regulators’ ability to restrain the risky behavior of currently profitable
banks was limited by the absence of penalties or costs based on reliable and generally accepted early-warning signals.56
55

56

The shift in bank lending from business loans to commercial mortgages during the 1980s would not have required increased capital under present risk-based capital standards. Risk-based premiums vary according to capital positions and supervisory ratings.
Some would argue that problems of controlling risky behavior would be solved by the adoption of market value accounting. This argument assumes that market participants, utilizing publicly available data, would be better able than regulators
to correctly recognize advance warning signs of risk, even though regulators have access to information developed through
on-site examinations. This assumption remains unproven. See section below on “Treatment of Big Banks: Systemic Risk
and Market Discipline.”

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The problems faced by regulators in controlling the risky behavior of profitable banks
as compared with troubled banks illustrate differences between ex ante and ex post measures of risk. Common measures of ex ante risk (for example, loans-to-assets and other asset-composition ratios) measure risk taking independent of the current condition of the
bank. They tend to be limited in their reliability—for example, many banks with high-risk
profiles were able to avoid failure in the 1980s. Thus, regulators may be reluctant to apply
stringent restraints and penalties on the basis of ex ante risk measures. On the other hand,
ex post measures of risk (for example, capital-to-assets ratios) are the most proximate measures of risk to the insurance fund and measure the consequences of risk taking after it has
materially weakened the condition of the bank. Supervisory restraints and penalties can be
more confidently applied on the basis of ex post risk measures, but they may be less effective than those based on reliable ex ante measures in curbing risk taking before it weakens
the condition of the bank. Moreover, the weakened condition of banks identified on the basis of ex post risk limits the magnitude of penalties that can actually be applied.57
Whereas bank regulators may have lacked the tools to restrain solvent banks from excessive risk taking, thrift regulators were in a far different position. The Federal Home Loan
Bank Board was not confronted by the problem of limiting risk taking by healthy institutions but by a large number of savings and loan associations that were insolvent or barely
solvent in the early 1980s. The course that thrift regulators followed may in retrospect be
termed high risk, featuring reduced capital standards, liberalized ownership restrictions for
stockholder-owned thrifts, and capital and accounting forbearance that allowed savings and
loan associations to operate with minimal or no equity while their true condition was obscured.58 This course was followed partly because the financial resources of the FSLIC fund
were inadequate. It was apparently motivated by the belief (or hope) that thrifts could grow
out of their problems by acquiring new assets, that external capital could be attracted to
shore up the industry, and that thrift institutions should be permitted to operate with minimal capital until they were able to improve earnings by using new asset powers. In contrast
to banks, in the first half of the 1980s undercapitalized thrifts were allowed and even encouraged to grow.59 Apart from differences in regulatory philosophy, FHLBB policies reflected the depleted state of the FSLIC insurance fund. The closure of all thrifts as they
reached or approached insolvency was not a viable option. One obvious conclusion from
the experience of the 1980s is that an adequate insurance fund is a prerequisite for any
attempt to control moral hazard.

57
58
59

For discussions of this topic, see two FDIC studies: Deposit Insurance for the Nineties: Meeting the Challenge (1989) and
A Study of the Desirability and Feasibility of a Risk-Based Deposit Insurance System (1990).
See Chapter 4, “The Savings and Loan Crisis and Its Relationship to Banking.”
See “Use of Forbearance” below.

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Treatment of Large Banks
Regulators’ preference for solutions that promoted stability rather than market discipline is apparent in the treatment of large banks (mutual savings banks, money-center
banks, and Continental Illinois). At various times and for various reasons, regulators generally concluded that good public policy required that big banks in trouble be shielded from
the full impact of market forces and that their uninsured depositors be protected. This policy contributed to the overall record of stability achieved by the deposit insurance system in
the 1980s. At the same time, however, it weakened any incentive for uninsured depositors
to monitor and restrain risk taking by the banks. The first big bank to fail in the 1980s was
First Pennsylvania Bank, N.A., of Philadelphia, with $8 billion in assets in early 1980.60 In
this case the FDIC provided open-bank assistance, and the agency’s determination of the
bank’s “essentiality” was based mainly on First Pennsylvania’s size as the city’s largest
bank and on the possibility that its failure would have local and national repercussions.
Large mutual savings banks. The issue of systemic risk was raised more explicitly by
the threatened insolvency of mutual savings banks. Located mainly in New York and other
northeastern states, these institutions suffered a severe earnings squeeze because of the
rapid rise in interest rates in the late 1970s and early 1980s, pushing interest costs on shortterm deposits above interest rates on the institutions’ long-term, fixed-rate mortgage loans
and bond holdings. Earnings were also held down by usury ceilings applicable to residential mortgage loans in New York. Although asset quality was not generally a problem at this
time, the net worth shortfall at market values was so large, according to one estimate, that
if the banks had failed, the liability facing the FDIC would have exceeded the size of the insurance fund.61
The first savings bank to fail was the Greenwich Savings Bank with $2.5 billion in assets—at the time, the third-largest bank failure in the FDIC’s history. The initial estimated
cost of the Greenwich failure was more than the recorded total cost of all previous failures
of insured banks. Federal action was precipitated by the bank’s inability to roll over foreign
borrowings. Among the FDIC’s first acts was to announce that no depositors, insured or
uninsured, would lose any principal or interest, a move designed to preserve confidence in
other savings banks that were also suffering severe interest-rate pressures. The bank was resolved through an FDIC-assisted merger transaction with another savings bank, a transaction assisted through an Income Maintenance Agreement, and this became the prototype for

60
61

FDIC, The First Fifty Years: A History of the FDIC, 1933–1983 (1984), 95.
See Chapter 6, “The Mutual Savings Bank Crisis.”

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Summary and Implications

other savings bank transactions. In all, 17 mutual savings banks with $24 billion in assets
were resolved through assisted mergers during 1981–85.62
Money-center banks with LDC (less-developed-country) loans. The case of moneycenter banks with large concentrations of loans to developing countries also illustrates the
regulators’ preference for stability (as well as other public policy objectives) over market
discipline.63 Between year-end 1978 and year-end 1982, total LDC debt held by the eight
largest money-center banks expanded from $36 billion to $55 billion. Total LDC portfolios
held by these banks averaged more than double the banks’ aggregate capital and reserves at
the end of 1982, a ratio that put some of the largest banks at risk. Bank regulators made
some attempt to curtail LDC lending activity and ensure diversification of foreign lending
risk, doing this partly through the Interagency Country Exposure Review Committee, composed of officials of the OCC, the FDIC, and the Federal Reserve. These efforts apparently
had little effect on the growth of LDC loans. Conversely, LDC lending may have been encouraged by the OCC’s 1979 interpretation of the loans-to-one-borrower rule, an interpretation according to which public sector borrowers that met certain conditions did not have
to be counted as parts of a single entity. On balance, it may be said that government policy
supported LDC lending activity by the banks.
In August 1982, the government of Mexico announced it could no longer meet interest payments, and by the end of the year 40 nations were in arrears. By the end of 1983, 27
countries were in negotiations to restructure their existing loans. Following the Mexican default, U.S. banking officials did not require that large reserves be immediately set aside for
the restructured LDC loans, apparently believing that some large banks might have been
deemed insolvent and that an economic and political crisis might have been precipitated.64
Although loss reserves did increase, at the end of 1986 they still averaged only approximately 13 percent of the total LDC exposure of the money-center banks. Starting in 1987,
however, the money-center banks began to recognize massive losses on LDC loans that in
some instances had been carried on the banks’ books at par for more than a decade. By the

62

63
64

The assisted merger transaction was chosen over a purchase and assumption or a deposit payoff so that the FDIC could
avoid the immediate outlays necessary to offset the full amount of asset depreciation and because these institutions had no
stockholders to benefit from the transactions (and, in most cases, few uninsured depositors to share the cost with the FDIC).
Most of the transactions were accomplished before the Net Worth Certificate Program was adopted as part of the Garn–St
Germain Act (see the section below on forbearance).
See Chapter 5, “The LDC Debt Crisis.”
L. William Seidman, Full Faith and Credit: The Great S&L Debacle and Other Washington Sagas (1993), 127. According
to former FDIC Chairman Seidman, “U.S. bank regulators, given the choice between creating panic in the banking system
or going easy on requiring our banks to set aside reserves for Latin American debt, had chosen the latter course. It would
appear that the regulators made the right choice.”

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end of 1989, total reserves at the money-center banks were nearly 50 percent of total LDC
loans.
The LDC experience illustrates the high priority given to maintaining financial market stability in the treatment of large banks. It also represents a case of regulatory forbearance. The OCC’s 1979 interpretation of the loans-to-one-borrower rule permitted banks to
continue lending in the face of signs that Latin American nations were having increasing
difficulty meeting their obligations. Regulatory forbearance also enabled money-center
banks to delay recognizing the losses and thereby avoid repercussions that might have
threatened their solvency. In time, loss reserves and charge-offs were greatly increased, and
no money-center bank failed because of LDC loans.65 The creation of the Brady Plan in
1989 reflected recognition that banks would not recover the full principal value of existing
loans and turned international efforts from debt rescheduling to debt relief. As part of the
process, substantial funds were raised from the International Monetary Fund and the World
Bank to facilitate debt reduction. Ultimately, the shareholders of the world’s largest banks
assumed the losses under the Brady Plan, which brought the crisis to an end.
Continental Illinois. The failure of Continental Illinois—a bank with $45 billion in assets in 1981 and one of the ten largest in the nation—was the large-bank transaction that set
the terms for the ensuing “too-big-to-fail” debate.66 The $4.5 billion rescue package devised
by the regulators in May 1984 was prompted by a high-speed electronic bank run that followed a period of deteriorating performance. Problems in Continental’s loan portfolio had
been highlighted in July 1982, when Penn Square Bank failed; Continental Illinois had had
a heavy concentration of loan participations with Penn Square. The rescue package included the promise to protect uninsured depositors fully, and it brought to an end the
FDIC’s modified payoff program, in which only a portion of the amount owed to uninsured
depositors was paid; that portion was based on the estimated recovery value of the failed institution’s assets. The reversal in FDIC policy reflected concerns that other large banks
might be subject to bank runs and that Continental’s correspondent banks would suffer
losses if the FDIC resolved the bank through a deposit payoff or otherwise failed to protect
uninsured deposits.
The justification for the Continental Illinois transaction has been debated at length.
For example, a 1993 article criticizing the transaction and its rationale concluded that in
65

66

One analysis concluded that “had these institutions been required to mark their sometimes substantial holdings of underwater debt to market or to increase loan-loss reserves to levels close to the expected losses on this debt (as measured by
secondary market prices), then institutions such as Manufacturers Hanover, Bank of America, and perhaps Citicorp would
have been insolvent” (Robert A. Eisenbeis and Paul M. Horvitz, “The Role of Forbearance and Its Costs in Handling Troubled and Failed Depository Institutions,” in Reforming Financial Institutions in the United States, ed. George G. Kaufman
[1993], 60).
See Chapter 7, “Continental Illinois and ‘Too Big to Fail.’ ”

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Summary and Implications

most cases losses on deposits held by correspondent banks at Continental would have been
relatively small and that these banks probably would have been able to meet any liquidity
strains through the Federal Reserve’s discount window.67 As for the possibility that problems at Continental Illinois might have caused contagious runs on otherwise viable banks,
the essential question is whether the market would have been able to distinguish between
viable and nonviable banks (so that it would be able to end quickly any run on the former).
Uncertainties on this point have made decisions on the resolution of large-bank failures difficult and will continue to make them difficult in the future. (See “Open Questions” below.)
*
*
*
These transactions in the early 1980s involving mutual savings banks, money-center
banks, and Continental Illinois generally set the pattern for the treatment of large banks
throughout the rest of the decade. In large-bank resolutions in the Southwest and Northeast
as well as in other regions, the FDIC used purchase-and-assumption transactions, bridge
banks, and open-bank assistance agreements that provided full protection for uninsured depositors. These methods eliminated the need for uninsured depositors to monitor the performance of large banks and raised questions of fairness, since numerous small-bank
failures were resolved through deposit payoffs, in which uninsured depositors suffered
losses.68
The treatment of some large-bank failures has also been criticized on the ground that
regulators were not assertive or prompt enough in curbing the risky behavior that led to the
failures. It is clear that some years before its failure in May 1984, Continental Illinois had
embarked on a rapid-growth strategy built on decentralized loan management that was unconstrained by an adequate system of internal controls and was heavily reliant on volatile
funds. It is also clear that supervisory restraints were insufficient to modify the bank’s behavior. A House subcommittee report in 1985 criticized a lack of “decisive action” on the
part of the OCC and also found fault with the Federal Reserve’s supervision of the parent
holding company. Some of the regulators who participated in the Continental Illinois transaction have indicated that while the bank was profitable, regulators were reluctant to take
early action in opposition to the bank’s board of directors.

67
68

Larry D. Wall, “Too-Big-to-Fail after FDICIA,” Federal Reserve Bank of Atlanta Economic Review (January/February
1993): 1–14.
It is likely that even without the too-big-to-fail policy, large banks would have been resolved less frequently through deposit payoffs because they tended to have greater franchise value and marketability. The greater marketability of large
banks may have been due to their greater flexibility in seeking new markets and offering new product lines, their location
in states where the absence of restrictions on geographic expansion meant a greater number of qualified bidders, and the
earlier resolution action (to the extent that disclosure requirements applicable to publicly traded companies alerted regulators to problems at an earlier stage).

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Criticism has also been leveled against the supervisory treatment of the Bank of New
England in the years before its failure in January 1991. 69 According to the General Accounting Office, problems in the bank’s operations were identified through the examination
process several years before its failure. The firm grew rapidly from 1985 to 1989, primarily
through acquisitions and aggressive real estate lending. During this high-growth period,
OCC examiners repeatedly identified and reported problems with the bank’s controls over
lending operations and strategies. However, not until 1989 were any enforcement actions
taken against the bank to compel corrective measures. The GAO concluded that the OCC
relied on management’s assurances that it would address the problems; it also concluded
that more vigilant supervision could have reduced losses.
Use of Forbearance
Forbearance has taken on such pejorative connotations that various uses of the term
need to be distinguished.70 At one extreme, forbearance may be said to occur when supervisory authorities permit an insured depository institution to operate without meeting established safety-and-soundness standards for a limited period of time while taking remedial
actions to reduce risk exposure and correct other weaknesses. Forbearance in this sense has
often been applied by bank regulators on a case-by-case basis. As an example, problem
banks that face near-term insolvency and closure frequently attempt, under pressure from
regulators, to acquire additional capital. The success or failure of such efforts often determines whether the bank survives or is closed. Decisions as to whether, and for how long, to
allow these efforts to continue are in fact decisions as to whether, and for how long, forbearance of this limited type should be granted. Whether regulators make the correct decisions in these situations cannot be tested with any precision. However, such limited,
case-by-case forbearance seems to be an integral part of the overall supervision of problem
banks, and its usefulness is best judged by the degree of success of such supervisory efforts.71
At the other extreme is the type of forbearance practiced by the FSLIC, as a result of
which a large number of insolvent or marginally solvent savings and loan associations were
permitted to operate as open institutions for lengthy periods.72 The difference between the
extremes is more than a difference of degree. Limited, case-by-case forbearance is designed
to provide an opportunity to reduce risk exposure and correct weaknesses. Longer-term,
69
70
71
72

See Chapter 10, “Banking Problems in the Northeast.”
Bank forbearance programs are discussed by Dean Forrester Cobos, “Forbearance: Practices and Proposed Standards,”
FDIC Banking Review 2, no. 1 (1989): 20–28.
See “Effectiveness of Supervisory Tools: Examination and Enforcement” below.
In 1984, 687 FSLIC-insured thrifts with $358 billion in assets, constituting 22 percent of the number of thrifts and 37 percent of total industry assets, were insolvent on the basis of tangible net worth. See Lawrence J. White, The S&L Debacle:
Public Policy Lessons for Bank and Thrift Regulation (1991), 114.

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wholesale forbearance as practiced by the FSLIC was a high-risk regulatory policy whose
main chances of success were that the economic environment for thrifts would improve before their condition deteriorated beyond repair or that the new, riskier investment powers
they had been granted would pay off. The latter type of forbearance, which the FSLIC
adopted against the background of a depleted insurance fund, is widely judged to have increased the cost of thrift failures.73 Because of the state of the FSLIC fund, forbearance became a necessity for the thrift regulators rather than a matter of choice74 and continued to
be widely granted after interest-rate reductions in the early and middle 1980s had alleviated
maturity mismatches in thrift portfolios, and poor-quality assets had become the chief problem of S&Ls. Generally, the bank regulators did not practice such wholesale, protracted,
and risky forbearance.
The bank regulators did, however, allow several large banks that subsequently failed
to operate for long periods with minimal capital (see “Impact of Prompt Corrective Action”
below). As noted above, bank regulators also eased the problems of money-center banks
with large holdings of LDC loans by not requiring prompt establishment of reserves against
such loans. This was a form of temporary forbearance; eventually money-center banks substantially increased their reserves.75 Finally, bank regulators administered three forbearance
programs that were applied to classes of banks rather than to individual institutions (see
table 1.8). These programs were initiated or inspired by Congress rather than by the bank
regulators.
The first such program was the Net Worth Certificate Program for thrifts that was
adopted, despite FDIC reservations, as part of the Garn–St Germain Act.76 This program
was applied mainly to FDIC-insured mutual savings banks in New York and other northeastern states that were suffering extreme earnings pressures in a period of high and rising
73

74
75

76

See, for example, Edward J. Kane, The S&L Insurance Mess: How Did It Happen? (1989); Eisenbeis and Horvitz, “Forbearance and Its Costs,” 49–68; Edward J. Kane and Min-Teh Yu, “Opportunity Cost of Capital Forbearance during the Final Years of the FSLIC Mess,” Quarterly Review of Economics and Finance 36, no. 3 (fall 1996): 271–90; and Ramon P.
DeGennaro and James B. Thompson, “Capital Forbearance and Thrifts: An Ex Post Examination of Regulatory Gambling,” in Proceedings of the 29th Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago, May
1993, 406–20. However, one analysis concluded that “[F]orbearance was not a major culprit in the taxpayer bill for the
thrift crisis.” See George J. Benston and Mike Carhill, “FSLIC Forbearance and the Thrift Debacle” in Credit Markets in
Transition, Proceedings of the 28th Annual Conference on Bank Structure and Competition, Federal Reserve Bank of
Chicago, 1992: 131.
One analysis concluded that the FSLIC’s ability to dispose of insolvent thrifts was constrained by S&L industry pressures,
by the extent of past cover-ups of thrift insolvencies, and by the actions of elected officials (Kane, The S&L Mess, 97, 98).
According to some authors, the case for forbearance rests on the existence of market imperfections (such as legal impediments to diversification), deadweight bankruptcy costs, inefficient markets for bank assets, information asymmetries
whereby assets have greater value when managed by the banks that originated them than when managed by FDIC liquidators, and macroeconomic considerations (Eisenbeis and Horvitz, “Forbearance and Its Costs,” 52, 64, 65).
FDIC, The First Fifty Years, 102.

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Table 1.8

Results of Bank Forbearance Programs
Mutual Savings Banks,
Net Worth Certificates

Agricultural and
Energy Sector Banks

29
40
22
7

301
13
236
65

Number of banks in program
Assets of banks in program ($billions)
Number of banks that survived
Number of banks that failed
Losses as percent of assets at failure
Banks in forbearance program
Comparable banks not in program

4

21*

12

22*

* Data refer to banks with less than $100 million in assets.

interest rates. Between 1982 and 1986, 29 mutual savings banks with approximately $40
billion in assets participated. Of these, 22 banks were restored to profitability as falling interest rates in the early and middle 1980s enabled these institutions to improve equity positions and retire their net worth certificates. Seven savings banks that participated in the
program failed as a result of interest-rate pressures and were resolved at a cost of $420 million, or approximately 4 percent of total assets at the time they entered the program.77 This
loss rate was substantially less than the average loss rate of 12 percent for savings banks resolved before the Net Worth Certificate Program was adopted.78
The effectiveness of the Net Worth Certificate Program was due largely to the drop in
interest rates after 1981. In effect, Congress required that action against insolvent savings
banks be deferred until after interest rates had come down, by which time, it was thought,
profitability and equity positions would be restored, and in fact in most cases they were.79
Also important was the fact that the FDIC was generally able to contain moral-hazard risks
associated with the continued operation of banks having little or no equity. Most of the sav77

78

79

See Chapter 6, “The Mutual Savings Bank Crisis.” Two of the 22 savings banks failed subsequently, four to six years after
having retired their net worth certificates. These failures were probably the result of actions taken after the two banks left
the program.
The lower loss rate of banks that failed while in the Net Worth Certificate Program was probably due in part to the fact that
after the program was introduced, interest rates were generally declining. In addition, the first savings banks to fail might
have been in a more serious condition than those that failed later.
By comparison, many insolvent savings and loan associations did not recover as a result of the drop in interest rates. At the
end of 1982, there were 222 GAAP-insolvent FSLIC-insured thrifts. In September 1986, despite a nearly 500 basis-point
drop in 90-day Treasury bill rates from 1982 to 1986, only 29 percent of these institutions were now GAAP-solvent,
whereas 36 percent were still GAAP-insolvent and 35 percent had ceased to exist. See U.S. General Accounting Office,
Thrift Industry: Forbearance for Troubled Institutions, 1982–1986 (GAO/GGD-87-78BR, May 1987), appendix 1.

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Summary and Implications

ings banks were free of serious credit-quality problems (as mutual institutions, they might
have had less incentive than stockholder-owned institutions to make risky investments),
and the relatively small number of savings banks in the program simplified supervision and
facilitated control of risky behavior.
The second instance of class-of-bank forbearance was the 1986 temporary capital forbearance program for banks that were weakened as a result of lending to the troubled agricultural and energy sectors; this program was later extended to all banks that were
experiencing difficulties because of economic factors beyond their control. Bank regulators
developed the program at a time when support for forbearance was building in Congress.
By developing their own program, bank regulators sought to include a strong safety-andsoundness focus and to avoid being required to use measures like the Net Worth Certificate
Program or those the thrift regulators employed.80 Of the 301 banks in the capital forbearance program, 201 were operating as independent institutions one year after leaving the
program, another 35 had been merged without FDIC assistance, while 65 had failed. As
these results indicate, after a period of forbearance a large majority of the institutions in the
program either were able to recover as independent institutions or had sufficient value to be
acquired by merger partners without FDIC assistance. Losses of the 65 banks that failed
were similar to those of comparable failed banks, a fact suggesting that the period of forbearance did not result in serious deterioration. Of the 65 failed banks in the program, 59
were under $100 million in assets and had losses of 21 percent of assets. In comparison, 965
banks with assets less than $100 million that were not in the forbearance program and failed
during 1986–94 had a 22 percent loss rate. As in the case of the Net Worth Certificate Program, the effectiveness of the 1986 regulators’ program was largely due to its temporary nature and to cyclical economic forces, in this case, a recovery in the agricultural sector.
A third instance of class-of-bank forbearance was the Agricultural Loan-Loss Amortization Program adopted by Congress in 1987 as part of CEBA, apparently because Congress concluded that the regulators’ program was inadequate. Of 33 banks in the program,
27 survived as independent institutions one year after leaving it, another 2 had merged,
while 4 had failed.81 Essentially the same conclusions apply to this program as to the 1986
regulators’ agricultural and energy forbearance program.
In assessing the effectiveness of class-of-bank forbearance programs, one needs to
consider how banks are chosen to participate when the regulators are allowed to exercise
discretion. Ideally, the regulators must be able to distinguish between institutions that will
recover after a period of forbearance and those that will not recover and should therefore
80
81

See Chapter 2, “Banking Legislation and Regulation”; and Cobos, “Forbearance: Practices and Proposed Standards,” 23.
Data exclude banks that were in both the CEBA and the 1986 regulators’ programs. These banks are included only in data
for the latter program.

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not be granted forbearance. The ability to make such distinctions accurately is important for
reasons of fairness and because of moral hazard. In making such distinctions, the regulators
have the benefit of information derived from examination reports—information that is not
available in financial reports or other public records. Nevertheless, picking winners and
losers is difficult, and some writers have concluded that regulators were unsuccessful in
their attempts.82
Furthermore, applying forbearance to a group of banks may have adverse competitive
effects on institutions outside the program. Unless restrained by the supervisory authorities,
insolvent banks may offer above-market deposit rates and submarket loan rates, thereby
weakening healthy competitors. Such behavior by many thrift institutions during the 1980s
generated frequent complaints, but it was apparently less of a problem in the bank forbearance programs because a smaller number of institutions were involved and the participants
were closely monitored and supervised. In other words, while forbearance may provide an
opportunity to correct weaknesses, without effective oversight it may also permit further
deterioration. As noted below (“The Impact of Prompt Corrective Action”), allowing unprofitable banks to continue operating can increase resolution costs as operating losses accumulate. Even if it is successfully applied to some banks, forbearance may have
undesirable effects if it encourages other banks to expect similar treatment. Moreover, if
forbearance is granted to a large number of institutions, it may have adverse effects on the
economy.83
Thus, forbearance programs may have a number of disadvantages—and, when practiced on the scale and with the purposes of the FSLIC program, they can be a disaster. While
survival of the institution is not the only criterion for the success of forbearance programs,
it remains significant that most of the banks in class-of-bank forbearance programs survived,84 and the minority that failed had losses comparable to, or lower than, those of failed
banks not included in the programs. The more favorable results of bank forbearance programs as compared with the FSLIC strategy reflect the smaller number of banks involved,
the closer monitoring of banks, the fact that the problems addressed by bank forbearance
programs were temporary and cyclical in nature,85 and (most important) the fact that bank
82
83
84

85

See, for example, Emile J. Brinkmann, Paul M. Horvitz, and Ying-Lin Huang, “Forbearance: An Empirical Analysis,”
Journal of Financial Services Research (1996): 39–40.
See the discussion in Congressional Budget Office, The Economic Effects of the Savings and Loan Crisis (1992).
One analysis states that “the cost to taxpayers of FDIC gambling lies in offering the equivalent of dividend-free equity capital to undercapitalized banks. The success of these gambles must not be measured by whether assisted banks recovered,
but by whether societal returns on taxpayer funding proved high enough to justify the waiver of dividends.” See Kane,
“Three Paradigms,” 444.
One view of S&L forbearance programs is that as a result of deregulation, these institutions were undergoing a permanent
change that could not be addressed by an essentially temporary measure. See Congressional Budget Office, Reforming
Federal Deposit Insurance, xiv.

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Summary and Implications

regulators sought to control risk taking by participating institutions rather than encourage
it.86 In the absence of the class-of-bank forbearance programs, more of the banks that actually survived might have been closed: for example, as shown in the next section, if the provisions of Prompt Corrective Action had been in effect throughout the 1980s, 12 of the 22
mutual savings banks that participated in the Net Worth Certificate Program and recovered
would have faced the prospect of closure, while 50 of the 236 surviving farm and energy
banks in the regulators’ 1986 temporary program might also have been closed.
Impact of Prompt Corrective Action
The Prompt Corrective Action (PCA) provisions of FDICIA were designed to limit
regulatory forbearance by requiring more-timely and less-discretionary intervention, with
the objective of reducing failure costs. FDICIA mandated that the regulatory authorities
adopt five capitalization categories, ranging from “well capitalized” to “critically undercapitalized,” to serve as the basis for Prompt Corrective Action. As an institution’s capital
position declines, the appropriate regulator is required to increase the severity of its actions.
These actions range from restricting asset growth (for undercapitalized institutions) to closing banks (those that are critically undercapitalized for a prescribed period). The top four
capital categories are defined in terms of risk-based capital and leverage ratios. Critically
undercapitalized institutions are those with tangible capital ratios of 2 percent or less. In
general, a receiver must be appointed for any institution that is critically undercapitalized
for up to 270 days.87
It is difficult to judge what would have happened if PCA had been in effect during the
1980s, for the behavior of both banks and bank regulators would have been altered. However, it appears that some banks that failed might have been closed earlier than they actually were, whereas some banks that survived might have faced the prospect of being
86

87

The difference between the FDIC forbearance program for mutual savings banks and the FSLIC program for savings and
loan associations has been described as follows: “[A]ccounting gimmicks were limited—and the mutual savings banks
were not allowed to grow. With a conservative policy of temporary forbearance in place, many mutual savings banks recovered, and those ultimately shut down or merged did not put an intolerable burden on the FDIC . . . the S&Ls that followed the incentives and implicit advice of government policy to enter new areas rapidly and grow their way out of the
problems became part of the S&L debacle” (National Commission on Financial Institution Reform, Recovery and Enforcement, Origins and Causes, 32–33).
Under FDICIA, when an institution is critically undercapitalized for 90 days a receiver or conservator must be appointed
or some other action must be taken to achieve the purpose of the provision. The 90-day delay may be extended, provided
that the regulator and the FDIC concur and document why extension would better serve the purposes of the provision. After the institution has been critically undercapitalized for 270 days, a receiver or conservator must be appointed unless the
regulator and the FDIC certify that the institution is viable and not expected to fail. Under the conditions existing in the
1980s when failures were bunched and the market for failed institutions was often saturated, it seems reasonable to suppose that taking more than 90 days to spread out marketing efforts for failed banks would have been an acceptable reason
for delay up to the 270-day limit.

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unnecessarily or erroneously closed. Alternatively, banks in the latter group might have
been compelled to try either to recapitalize earlier than they actually did or to merge with
healthier banks. A large majority of banks that failed were closed within the time frame
specified by FDICIA for critically undercapitalized banks. However, 343 banks that failed
(21 percent of all failures from 1980 to 1992) with $88 billion in assets would have faced
earlier closure because they were critically undercapitalized for more than 270 days.88 For
the same reason, 143 problem banks (those with CAMEL ratings of 4 or 5) with $11 billion
in assets that did not fail would have faced the possibility of unnecessary closure because
of the 2 percent rule.
Of the 343 failed banks that would have been closed earlier under the PCA rule, 201
(59 percent) were national banks, 131 (38 percent) were state nonmember banks, and 11 (3
percent) were state member banks. In the case of national banks, closure is the responsibility of the OCC; in the case of state-chartered institutions, of state banking departments. In
the states that had the most closings and the most late closings, the state authorities closed
problem banks more quickly than the OCC did.89 The difference was especially apparent in
Texas and Oklahoma, which accounted for a disproportionate number of bank failures. Part
of the difference was due to the fact that state banking authorities had greater flexibility under applicable law. The OCC had statutory authority to close a national bank “whenever the
Comptroller shall become satisfied of the insolvency of the bank” (12 U.S.C. 191). Thus,
the OCC had to wait until the bank was insolvent before being able to close it. On the other
hand, the six states had the authority to close banks when capital was “impaired,” when the
bank faced “imminent insolvency” or was in an “unsafe” or “unsound” condition. These
more flexible standards made it possible for the states to close banks earlier.90 However, although the OCC’s closing policy was constrained by the statutory-insolvency rule, the
agency had wide latitude to define insolvency and presumably could have adopted a more
flexible standard than was actually in effect during most of the 1980s. Until December
1989, the OCC’s definition of insolvency was the exhaustion of primary capital (equity plus
loan-loss reserves). In December 1989, after approximately a year of study, the OCC shifted
to equity capital alone, without loss reserves, and the new definition permitted more expeditious closing of national banks.91 This change was made after most of the failures of the
1980s had already been resolved.

88

Excluded from this analysis are banks that participated in forbearance programs mandated or inspired by Congress.
In six states (California, Colorado, Louisiana, New York, Oklahoma, and Texas) the OCC closed 473 banks during the
1980–92 period, 38 percent of which were closed later than would have been required under PCA. The state authorities
closed 459 banks, 17 percent of which were closed later than would have been required under PCA.
90 Information on the statutory authority of the six state banking departments is based on conversations with representatives
of each of the six departments.
91 OCC, Bulletin BB-89-39 (December 13, 1989).
89

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Summary and Implications

Estimates of the cost savings that would have resulted from the earlier closure of
failed institutions are necessarily very rough.92 For most of the 343 banks that would have
faced earlier closure if PCA had been in effect, the interval between the date that closure
would have been required by PCA and the actual closure date was approximately two quarters.93 During this interval, these banks experienced a reduction in equity from $220 million
to a negative $1.6 billion. But a large part of this reduction was due to the recognition of
losses that were already embedded in loan portfolios and would not have been affected by
more-timely closure. Another portion—chiefly operating losses associated with higher private-sector funding costs and the cost of operating retail bank branch systems—could have
been avoided by earlier closure. This avoidable cost for the 343 banks is estimated to be on
the order of $825 million and constituted 8 percent of the actual estimated resolution costs
of the 343 banks and approximately 2 percent of the cost of all bank failures during the
1980–92 period.94 Approximately 60 percent of the $825 million estimated cost savings is
attributable to six large banks.
An alternative estimate of the avoidable cost, based on net operating losses, produced
essentially the same aggregate result. For the 343 banks, net operating losses before loanloss provisions, gains/losses on asset transactions, taxes, and extraordinary items totaled
$815 million for the intervals between closure dates required by PCA and actual closure
dates. As with the previous estimate, these losses were concentrated in a few large banks.
A number of caveats are in order when one considers these estimates. Regulators’
bank closure policies would have been different if PCA had been in effect in the 1980s, and
such policy changes might have reduced projected cost savings. For example, for the large
number of banks that were allowed to operate with tangible capital below the 2 percent
level for only a few months beyond the interval allowed by PCA, earlier closure might have
92

93
94

The calculations are described in note 94. R. Alton Gilbert concluded, contrary to the implications of this study, that FDIC
resolution costs were not positively related to the length of time that banks operated with relatively low capital ratios before their failure. See “The Effects of Legislating Prompt Corrective Action on the Bank Insurance Fund,” Federal Reserve
Bank of St. Louis Review 74, no. 4 (July/August 1992): 3–22.
The unweighted average interval was two quarters. Weighted by assets, the average interval was three quarters, reflecting
the especially long intervals for a few large banks.
The avoidable cost is estimated as the sum of (1) the actual funding costs of these banks minus the one-year Treasury rate
and (2) the operating expenses of transactions and nontransactions deposit accounts as estimated by the 1990 Functional
Cost Analysis of the Federal Reserve Board. The avoidable cost was computed for the period of time beyond 270 days that
the bank’s tangible capital ratio was below 2 percent. In cases where the tangible capital ratio fluctuated below and above
2 percent, the bank was considered to be critically undercapitalized for the entire period after the ratio first fell below 2 percent, except when the ratio subsequently rose above 3 percent. In the latter case, that bank was counted as critically undercapitalized only for the period it was below 2 percent subsequent to having reached the 3 percent level. Two large savings
banks that had entered into Income Maintenance Agreements with the FDIC in connection with the acquisition of other
failed institutions were counted as critically undercapitalized from the time the bank’s agreement was terminated (in one
case) and (in the other case) from the date the FDIC formally permitted the bank to miss capital targets prescribed in its
agreement.

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meant that, because of insufficient time to market the institutions among potential acquirers, more institutions would have been resolved through insured-deposit payoffs.95 This
likelihood would have been greatest in periods when failures were bunched, temporarily
saturating the market for failed bank and thrift deposit franchises and assets. Spreading
closings over a longer period of time might have attracted better bids and offset some of the
additional costs resulting from delayed closings. Thus for many of the 343 banks, the cost
savings resulting from earlier implementation of PCA might have been smaller than the estimates set forth above suggest. For the six large banks that operated for extended periods
of time with minimal capital, earlier closure would probably have achieved cost savings.
For some of these banks, fairly lengthy marketing periods might have been needed and, because of PCA, regulators might have had to start the marketing process while the banks had
capital above the 2 percent tangible level. In any event, whatever savings might have been
achieved through earlier closure would apparently have been concentrated largely in a few
large banks that were permitted to operate with little or no equity for relatively long periods
of time.
During the interval between the actual and the PCA-required closure dates, problem
institutions were generally under close supervision and many of them were subjects of enforcement actions aimed at reducing losses to the insurance fund. Of the 343 failed banks
that would have faced earlier closure under PCA, 127 were FDIC-supervised state nonmember banks for which enforcement data are available. Of the 127 banks, 101 (approximately 80 percent) had been issued formal enforcement actions before the closure date
required by PCA—in fact, an average of 14 months before—and the remaining 26 banks
might have had informal enforcement actions.96
The consequences of unnecessarily closing some of the 143 problem banks that were
below the 2 percent level but did not fail must be weighed against the cost savings of closing failed banks earlier. As noted above, some of these banks would have recapitalized or
would have merged sooner to avoid closure.97 However, any unnecessary or erroneous closure of these institutions would be difficult to justify and might have involved unnecessary
95
96

97

This possibility was pointed out by R. Alton Gilbert. See his comments in volume 2 of this study.
Data on formal enforcement actions (such as cease-and-desist orders and terminations of insurance) are presented here only
for FDIC-supervised state nonmember banks. Comparable data are not available for OCC-supervised banks; relatively few
banks were supervised by the Federal Reserve. Systematic data on informal enforcement actions are unavailable for the
FDIC and the OCC.
The cost of unnecessary or erroneous closure of banks that would otherwise have survived is likely to be large if bankruptcy costs are high and if investors undervalue the assets of the banks. As noted by Stanley C. Silverberg in volume 2 of
this study, “Early resolution works very well when the market places reasonable or high valuations on bank franchises.
However, in, say, 1990, the stock prices of several of the most conservatively run banks were well below book value. Investors and other banks were reluctant to pay positive prices for troubled banks without FDIC assistance. That has changed
considerably during the past several years.”

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History of the Eighties—Lessons for the Future

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deadweight bankruptcy costs. In any future period of widespread failures, balancing the
benefits of earlier closure against the consequences of closing some banks that otherwise
would have survived may be difficult. Presumably banks will strive to avoid becoming subject to the 2 percent rule, or to any other similarly binding rule, by maintaining capital levels higher than they otherwise would or by seeking merger partners while they still have
value. However, the history of the 1980s shows that capital levels may decline quickly in
the face of external shocks or other unforeseen events. Or at times the market may temporarily undervalue a bank franchise, making it difficult for some banks to secure external
capital when they are in danger of failing the 2 percent rule. Thus, in some future period of
widespread depository-institution failures, the issue of erroneously closing salvageable institutions may be unavoidable and critical in implementing statutory closure rules.
The computations that produced the estimates that 343 failing banks would have been
closed earlier and 143 banks might have been unnecessarily closed as a result of the application of PCA in the 1980s did not include banks in the class-of-bank forbearance programs, because the assumptions underlying these programs were obviously at variance with
the later views of Congress as expressed by the PCA provision of FDICIA. However, for
the sake of completeness, separate calculations using the same methodology were made for
the banks that participated in these forbearance programs. The results show that (1) 48
banks with $11 billion in assets that actually failed would have been closed earlier as a result of PCA, and (2) 66 banks with $16 billion in assets that actually survived would have
been closed.
In addition to the closure of critically undercapitalized banks, FDICIA requires specific regulatory intervention geared to capital positions of open banks. For example, in the
case of undercapitalized banks, FDICIA requires regulators to have the bank submit a capital restoration plan, restrict asset growth, and get prior approval for expansion. For significantly undercapitalized banks, more-stringent actions are prescribed. In this regard, a study
of the New England banking crisis, which occurred before the adoption of FDICIA in 1991,
found that regulators were already imposing formal actions on banks before they became
undercapitalized as defined by PCA. Moreover, according to the study, the regulators imposed restrictions more comprehensive than those prescribed in the PCA legislation.98 The
reason given for this result is that capital ratios prescribed in PCA are lagging indicators of
the health of the institution and will trigger enforcement action well after problems are identified in examinations. Examiners analyze considerably more information than capital ratios to determine a bank’s likelihood of failure. Therefore, more-timely intervention would
98

Joe Peek and Eric S. Rosengren, “The Use of Capital Ratios to Trigger Intervention in Problem Banks: Too Little, Too
Late,” Federal Reserve Bank of Boston New England Economic Review (September/October 1996). See also Peek and
Rosengren, “Will Legislated Early Intervention Prevent the Next Banking Crisis?” working paper series no. 96-5, Federal
Reserve Bank of Boston, September 1996.

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result from triggers that mimic the timing of problem-bank identification by examiners.
This view of the lagging nature of capital ratios is consistent with the findings summarized
below in the section on off-site monitoring.
Effectiveness of Supervisory Tools: Examination and Enforcement
The increased number of bank failures in the 1980s raised questions about the effectiveness of bank regulators’ systems of identifying problem banks and then influencing
their behavior in order to prevent failures and reduce insurance losses. The evidence suggests that bank examination ratings provided a reasonably accurate indication of the
prospect of failure if the ratings were based on recent examinations. But in the early and
middle 1980s many banks were not examined frequently, and the ratings available for them
at any point tended to be obsolete. Troubled banks that were properly identified, however,
were generally subject to enforcement actions that appear to have been effective in reducing insurance losses. The critical issues, therefore, are the frequency and use of examinations, the effectiveness and limitations of CAMEL ratings, and the effectiveness of
follow-up enforcement actions.99
Evolution in the frequency and use of examinations. In the late 1970s and early 1980s,
the bank examination process was affected by two key policy changes embraced particularly by the OCC and the FDIC: (1) relatively more reliance was placed on off-site monitoring and relatively less on on-site examination, and (2) examination resources were
concentrated on those institutions that posed the greatest threat to the insurance fund and to
the stability of the financial system. These changes were made partly because it was believed that comprehensive Call Report data and the use of computer technology would enhance off-site surveillance and enable the agencies to reduce the examination burdens on
banks and on their own staffs. Further, the decision to concentrate resources on the larger
and the more-troubled banks was seen as an efficient allocation of resources. (Both the
FDIC and the Federal Reserve also made increasing use of state bank examinations for nonproblem institutions.) Another important change took place at the OCC, where the traditional emphasis on a detailed audit and verification system was replaced by a focus on the
quality of management and internal policies. The OCC also placed increased weight on targeted examinations, which focused on a particular aspect of a bank’s operations, rather than
full-scope examinations.
These policy changes implied that fewer examiners would be needed. In addition,
both the Carter and Reagan administrations restricted federal hiring in an attempt to reduce
the size of the federal government. In this climate, the FDIC and the OCC froze examiner
staffing levels in 1981. As a result, between 1979 and 1984 the total number of examiners
99

This section is based on Chapter 12, “Bank Examination and Enforcement.”

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Summary and Implications

in federal and state banking agencies declined by 14 percent (see table 1.9). Among the
agencies, the reductions varied in size: examiner staffing at the FDIC declined by 19 percent, at the OCC by 20 percent, and at state agencies by 12 percent. At the Federal Reserve,
examiner staffing was largely unchanged. While examination forces were being reduced,
the total number of troubled banks was increasing from 217 in 1980 to 1,140 in 1985. In the
mid-1980s, therefore, the FDIC and the OCC began to rebuild examiner staffs—but several
years of training are required to produce qualified examiners, so it was not until the late
1980s that the examiner forces at those two agencies were restored to 1980 levels in number and experience.100
Table 1.9

Number of Bank Examiners, Federal and State Banking Agencies, 1979–1994
Year

FDIC

FRS

OCC

States

Total

1979

1,713

805

2,151

2,496

7,165

1984*

1,389

820

1,722

2,201

6,132

1990

2,645

1,025

1,907

2,470

8,047

1994

2,547

1,529

2,376

2,564

9,016

Source: Compiled by FDIC on the basis of information from FRS, OCC, and Conference of State Bank Supervisors.
*Trough in total number of examiners.

These trends in examiner staffing contributed to marked changes in the number and
frequency of examinations. Between 1981 and the low point of 1985, the number of examinations declined from approximately 12,300 to 8,300. The decline was particularly sharp
for state nonmember banks; for national banks and state member banks it was less severe.
In 1979, the average length of time between examinations was 379 days, or 13 months (see
table 1.10). By 1986, the average interval had increased to 609 days, or 20 months. The
greatest change was for CAMEL 1-rated banks, whose average interval increased from 392
days to 845, or from 13 to 28 months. The increase in examination intervals was greatest at
the OCC and the FDIC and smallest at the Federal Reserve. As the agencies built up their
examination staffs in the late 1980s, intervals between examinations shortened once again,
and by 1990, the average interval was 411 days (14 months) for all banks; for all banks with
CAMEL ratings below 2, it was one year or less. In 1991 FDICIA reinforced the return to
greater frequency of examinations by requiring annual full-scope examinations for all

100

The demands on the shrunken examiner staffs extended to training new hires and taking on duties related to settlement and
asset liquidation for failed banks.

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Table 1.10

Mean Examination Interval, by Initial Composite CAMEL Rating (in days)
Year

1

2

3

4

5

All Banks

1979

392

396

338

285

257

379

1986*

845

656

407

363

313

609

1990

463

436

331

303

270

411

1994

380

357

296

279

245

354

Source: FDIC, FRS, and OCC.
*Peak of mean intervals.

banks, except that for small banks with satisfactory ratings an 18-month interval could be
substituted.101
For some banks during the mid-1980s, these changes meant that CAMEL ratings and
other information derived from examinations were sometimes obsolete and unrepresentative. CAMEL ratings are a measure of the condition of a bank essentially at the time it is examined; as a bank’s condition changes, old ratings become increasingly inaccurate as
indicators of its current health.102 Problems developing at some banks in the 1980s were not
identified on a timely basis; this view is supported by examiners interviewed for this study,
who indicated that extended examination intervals and increased demands on staff resources meant that some banks received insufficient attention. For example, banks that
were well rated but deteriorating might not receive attention until it was too late to prevent
serious losses. In Texas, which had the largest concentration of bank failures and losses to
the insurance fund, the problem of extended examination intervals was particularly acute.
The severe problems of some Texas banks might have been recognized sooner if examinations had been more frequent.103
The reduced frequency of examinations limited the usefulness not only of information
derived from the examinations but also of the financial reports used in off-site monitoring.
On-site examiners are able to evaluate the quality of the loan portfolio and verify the data

101
102

103

58

John O’Keefe and Drew Dahl, “The Scheduling and Reliability of Bank Examinations: The Effects of FDICIA” (unpublished paper presented at the Financial Management Association conference, October 1995).
Rebel A. Cole and Jeffery W. Gunther, “A CAMEL Rating’s Shelf Life,” Federal Reserve Bank of Dallas Financial Industry Studies (December 1995). Cole and Gunther concluded that the information content of CAMEL ratings decays
rapidly; examination ratings indicate bank survivability more accurately than off-site monitoring does for two quarters after examinations; for periods longer than two quarters, examinations are less accurate than off-site monitoring.
O’Keefe, “The Texas Banking Crisis.”

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on nonperforming loans and loan charge-offs that banks report in Call Reports.104 In other
words, on-site examinations are needed to ensure the accuracy of bank financial reports. If
examinations are less frequent, the accuracy of off-site monitoring systems using Call Report data suffers.
Effectiveness of CAMEL ratings. When examination ratings were up-to-date, they
generally identified most of the banks that required increased supervisory attention well before the banks actually failed. As shown in figure 1.9, of the more than 1,600 banks that
failed in 1980–94, 36 percent had CAMEL 1 and 2 ratings two years before failure; 25 percent had ratings of 3, 31 percent had ratings of 4, and 8 percent had ratings of 5. But these
Figure 1.9

Composite CAMEL Ratings Two Years before
Failure for Banks Failing between 1980 and 1994
CAMEL Rating
36%

1 and 2

26%
25%
28%

3

31%

4

36%
8%
10%

5
0

10
20
30
As a Percentage of Failing Banks
All Available Ratings

40

Ratings Less Than One Year Old*

* Ratings that were less than one year old as of the two-years-before-failure date;

that is, ratings based on examinations dated between two and three years
before failure.

104

R. Alton Gilbert, “Implications of Annual Examinations for the Bank Insurance Fund,” Federal Reserve Bank of St. Louis
Review 75, no. 1 (January/February 1993); and Drew Dahl, Gerald A. Hanweck, and John O’Keefe, “The Influence of Auditors and Examiners on Accounting Discretion in the Banking Industry,” unpublished paper presented at Academy of
Financial Services conference (October 1995).

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data refer to examination ratings available two years before failure, whereas some of the
examinations had actually been conducted considerably more than two years before failure.
Also included in these data are banks that failed for types of reasons that cannot be anticipated well in advance by safety-and-soundness examinations: cross-guarantee failures; failures due to fraud; and failures of affiliates of certain Texas holding companies that were
essentially operating as branches of the parent institution, were tracked outside the CAMEL
system, and were resolved through procedures that had much the same effect as cross-guarantees.105 If we exclude examinations for these banks as well as examinations that are more
than one year old,106 the percentage of failed banks that had CAMEL 1 and 2 ratings two
years before failure drops to 16 percent of the total number of failures (see table 1.11).107 In
other words, the proportion of failed banks that were not identified as requiring increased
scrutiny two years before their failure was 16 percent. 108
Table 1.11

Failing Banks with CAMEL Ratings of 1 or 2 Two Years before Failure,
1980–1994
Number
Total 1- and 2-rated future failures
Specific types:
Cross-guarantee cases
Failures associated with fraud
First City Bancorporation affiliates
First RepublicBank Corporation affiliates
CAMEL ratings more than one year old*
Total of above
Remaining 1- and 2-rated future failures

565
25
24
36
26
194
305

Percent of Total Failures
35%

19
260

16

* Failures of banks with ratings more than one year old (two years before failure) do not include cross-guarantee cases, failures associated with fraud, First City Bancorporation affiliates, or First RepublicBank Corporation affiliates.

105

106
107

108

60

In the case of First RepublicBank Corporation, the FDIC’s demand that affiliate banks honor their pledge to back the
agency’s assistance to the lead bank caused the affiliates to fail. In the case of First City Bancorporation, the FDIC provided
assistance to the holding company and required that it be downstreamed to the affiliates. One may argue that examiners
should consider what the condition of the lead bank implies for the condition of affiliated banks in the holding company.
However, examiners could not have known two years in advance the nature of the resolution arrangements that would be
adopted in these two cases and in post-FIRREA cross-guarantee cases and their effects on other banks in the company.
Exclusion of banks with ratings that were more than one year old two years before failure means, in effect, that the data
refer to examinations conducted between two and three years before failure.
Banks with CAMEL 1 and 2 ratings are treated here as a separate category from banks with worse ratings. CAMEL 1- and
2-rated banks are defined as “basically sound in every respect” or “fundamentally sound, but may reflect modest weaknesses correctable in the normal course of business.” Banks with a CAMEL 3 rating “give cause for supervisory concern
and require more than normal supervision,” while CAMEL 4 and 5 ratings are reserved for progressively weaker banks.
For banks with assets of more than $250 million, the proportion was 15 percent. This suggests that the effectiveness of
CAMEL ratings in anticipating failures was about the same for large and small banks.

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Over the course of the 1980–94 period, the record of CAMEL ratings in anticipating
failures improved as the frequency of examinations increased and problems were apparently better identified. From the period 1980–86 to the period 1987–94, the proportion of
failed banks that had CAMEL 1 and 2 ratings two years before failure declined from 28 to
12 percent. Similarly, the proportion of failed banks that had CAMEL 4 and 5 ratings two
years before failure rose from 25 to 46 percent.109
Limitations of examination ratings. Although CAMEL ratings were reasonably successful in identifying banks that required greater supervisory attention, they also had limitations. First, they did not necessarily capture the severity of the situation of the banks that
subsequently failed. Second, they are based on the internal operations of the bank and therefore do not take into account local economic developments that may pose future problems
and are not yet reflected in the bank’s condition. Third, as noted above, they are generally a
measure of the condition of the bank at the time it is examined. They do not systematically
track risk factors that may produce future losses.110 Fourth, frequent use of on-site examinations imposes a burden on depository institutions. Examinations may seem particularly
burdensome during good economic times, when the condition of most banks is healthy and
examination ratings change relatively little. An average of 85 percent of all banks examined
each year during the 1980–94 period experienced either no change or an improvement in
ratings; only 15 percent, on average, experienced ratings downgrades. However, examination ratings changed considerably more often in particular regions of the country and during periods of regional recessions.
Most banks that are designated as troubled banks (rated CAMEL 4 and 5) do not fail.
This may be regarded as a deficiency of CAMEL ratings. On the other hand, examination
ratings trigger the supervisory responses that may prevent troubled banks from failing or
may reduce failure costs when the banks have to be closed. From this perspective, when supervisory efforts to cure bank problems as revealed by examinations have been successful,
the failure forecasts based on these examinations will necessarily prove to have been inaccurate. Either way, the large number of troubled banks that do not fail and the large number
of banks whose ratings do not change through repeated examinations are unavoidable consequences of frequent use of on-site examinations. However, on-site examinations provide
109

110

Data are the numbers of failed banks that had the indicated CAMEL ratings two years before failure in each year, weighted
by the total number of failures in that year. The data are based on 260 banks after exclusion of examinations more than one
year old, failures due to fraud, cross-guarantees, and the subsidiaries of two Texas bank holding companies (table 1.11).
A possible exception is the management rating, which encompasses technical competence, leadership qualities, adequacy
of internal controls, and other factors that may determine the bank’s ability to weather future adversity. However, examiners appear to be reluctant to rate management much below capital, asset quality, and other CAMEL components. In this
regard, in only 6 percent of failed banks were the management ratings of two years before failure one full number worse
than the average of other components.

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information to the regulators that is otherwise unavailable,111 and they also help ensure the
accuracy of financial reports issued by the banks.112 As a result, the burdens of frequent examinations must be borne if the condition of insured banks is to be monitored effectively.
Recognizing these burdens, the FDIC has sought to reduce the time examiners spend in
banks and is developing a program designed to allow individual loan files to be examined
off-site.
Number, kinds, and effectiveness of enforcement actions. After troubled institutions
were identified during the 1980–94 period, they were subject to supervisory and enforcement actions that appear to have been effective in reducing failures and losses to the insurance fund. This conclusion is based on evidence concerning the behavior of banks with
respect to asset growth rates, dividend payouts, and equity infusions when the banks had
been designated as problem institutions and been made subject to informal and formal enforcement actions.113
The FDIC used formal enforcement actions (for example, cease-and-desist orders)
sparingly in the 1970s but more frequently in the early 1980s, as the number of troubled
banks increased. Formal enforcement actions are legally enforceable in court, and noncompliance with such actions may lead to heavy fines. Most FDIC formal enforcement actions
in the 1980s were issued against 4-rated banks, which are troubled but salvageable; most of
the remainder were issued against 5-rated banks, which face a high probability of imminent
or near-term failure. About one-half of all banks rated 4 and 5 by the FDIC in the 1980s
were the subject of formal enforcement actions; many of the remaining banks received informal enforcement actions (for example, memoranda of understanding).114 Enforcement
actions require banks to take corrective actions in various areas: compliance with regulations, improvement in operating procedures, the raising of new capital, the cutting of dividend payments, replacement of managers, and so forth.
That supervisory and enforcement actions were effective in reducing failures and
losses to the insurance fund is suggested by the following:
• Of all banks that were rated 4 and 5 sometime during the 1980–94 period, 73 percent
recovered, while 27 percent failed. As noted above, one-half of the FDIC-supervised problem

111

112
113
114

62

The view that examinations yield unique information is largely based on the belief that banks specialize in evaluating and
monitoring idiosyncratic borrowers who do not have practical access to the capital markets. This view suggests that the
best way to secure the private information banks have gathered about borrowers is by examining individual loan files.
See Drew Dahl, Gerald A. Hanweck, and John O’Keefe, “The Influence of Auditors and Examiners on Accounting Discretion in the Banking Industry,” and Gilbert, “Implications of Annual Examinations.”
Data on enforcement actions are available for FDIC- and Federal Reserve–supervised banks only.
In a sample of 307 FDIC-supervised problem banks there were 209 with formal actions, 83 with informal actions only, and
merely 15 with neither formal nor informal actions.

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

banks were the subject of formal enforcement actions, and many others received informal
actions.
• For all insured banks rated 4 and 5, in the three years before failure or recovery their asset growth and dividend payout rates declined (see table 1.12).115 (Recovery was defined as either a CAMEL rating upgrade to 1, 2, or 3 or merger without FDIC financial assistance.) Capital
injections generally increased over the three years before recovery for the banks that recovered,
and from the third to the second year before failure for the banks that failed.

Table 1.12

Asset Growth Rates, Dividend Payments, and Capital Injections,
All Banks with CAMEL Ratings of 4 and 5, 1980–1994

Years before
Failure, Recovery,
or Merger
1980–85

Failed Banks

Surviving Banks

Total Banks
(Failed and Surviving)

Years
of Failure
1986–91

Years of Recovery*
or Merger
1980–85 1986–91 1992–94

Years of Failure, Recovery,*
or Merger
1980–85 1986–91 1992–94

1992–94

Asset Growth Rate (Percent)
3

14.60

15.65

18.77

10.39

13.38

4.42

11.91

14.09

5.93

2

10.72

1.71

−3.53

3.67

1.25

−0.61

6.21

1.40

−0.92

1

0.91

−10.17

−13.39

1.96

0.96

−0.64

1.58

−2.51

−1.98

Dividends to Average Assets (Percent)
3

0.34

0.42

0.09

0.20

0.21

0.13

0.25

0.21

0.13

2

0.32

0.52

0.06

0.16

0.14

0.09

0.22

0.15

0.09

1

0.16

0.39

0.02

0.13

0.13

0.08

0.14

0.11

0.07

Capital Injections to Average Assets (Percent)
3

0.18

0.42

0.45

0.19

0.46

0.42

0.19

0.45

0.42

2

0.22

0.52

0.54

0.39

0.56

0.42

0.33

0.55

0.43

1

0.65

0.39

0.40

0.44

0.45

0.49

0.51

0.43

0.48

Note: Data are unweighted averages of individual bank percentages.
*Recovery is either the date of a bank’s unassisted merger, or if the bank survived as an independent institution, the date it received a CAMEL rating of 1, 2, or 3.

115

For dividends, similar results are produced whether dividends are expressed as a percentage of net income or as a percentage of assets. Capital injections include stock transactions, capital contributed through merger, and capital transactions
with parent holding companies.

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• The data in table 1.12 suggest that in the later years of the banking crisis, supervisory
efforts to reduce risk taking and insurance losses became increasingly aggressive. During
1992–94, for both failed banks and survivors, the levels to which asset growth rates and dividend payouts dropped in the final year before failure or recovery were considerably lower than
had been the case during the 1980–85 period.116

Table 1.12 and the preceding pages summarize an analysis of the behavior of problem
banks in relation to the dates of their failure or recovery. Problem-bank behavior was also
analyzed in relation to the dates of regulatory intervention. For purposes of this second
analysis, the dates of regulatory intervention were taken to be the dates of on-site examinations that led to either formal enforcement actions or downgrades in CAMEL ratings without such actions.117 The purpose was to test more directly the effects of formal and informal
enforcement actions on problem-bank behavior. (As noted before, most problem banks that
did not receive formal enforcement actions received informal ones.) As shown in figure
1.10, at FDIC- and Federal Reserve–supervised banks with CAMEL ratings of 4, median
quarterly asset growth rates declined before the date of regulatory intervention and generally remained negative in the four quarters immediately following the intervention.118 This
was true both for banks that were downgraded to a CAMEL 4 rating and had no formal enforcement action taken against them and for 4-rated banks that eventually did receive formal actions. Growth rates of banks with formal enforcement actions showed greater
changes, on average, from before intervention to after intervention than growth rates of
banks without such actions.119 Similar results were produced by other measures of bank be-

116

117

118

119

64

R. Alton Gilbert found that undercapitalized banks during the 1985–89 period generally did not grow rapidly, pay dividends, or make loans to insiders. See his “Supervision of Under-Capitalized Banks: Is There a Case for Change,” Federal
Reserve Bank of St. Louis Review 74, no. 4 (1992): 3–20.
Enforcement data in this analysis are based on 2,398 formal actions issued by the FDIC and 362 by the Federal Reserve.
Comparable data are not available for the OCC. Intervention dates are (1) the date of the examination that resulted in a
downgrading of the bank to a CAMEL 3, 4, or 5 rating for the first time without a formal enforcement action or (2) the
date of the last examination before the issuance of a formal enforcement action for banks receiving such actions. At the
end of the examination the bank would normally be informed of conditions that were likely to result in such downgrades
or of the likelihood of formal enforcement actions. Actual issuance of the formal enforcement actions would not take place
until six to nine months after the examination. For FDIC-supervised banks, the median interval between the date of formal enforcement actions and the last examination before such actions was 261 days for 4-rated banks and 176 days for 5rated banks.
It is not clear that the remedial actions taken by management before regulatory intervention were purely voluntary and
would have been undertaken even if such intervention had not been expected. See also George E. French, “Early Action
for Troubled Banks,” FDIC Banking Review 4, no. 2 (1991): 1–12.
Similar patterns in growth rates were found for banks with CAMEL 5 ratings. For banks with CAMEL ratings of 3 that
were subject to formal enforcement actions, however, growth rates were highly variable, perhaps because for these banks
the number of such actions was relatively small.

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Figure 1.10

Median Asset Growth Rates of CAMEL 4-Rated Banks before and
after Regulatory Intervention
(Annualized)

1979–1985

Percent

1985–1990

Percent

8

12

8

4

4

0

0
-4

-4
-8

-4

-3

-2

-1

0

1

2

Quarter Relative to Intervention

3

-8

4

-4

-3

-2

-1

3

4

0

1

2

Quarter Relative to Intervention

3

4

1990–1995

Percent

8

4
0
-4
-8
-12

-4

-3

-2

-1

0

1

2

Quarter Relative to Intervention

Banks Downgraded to CAMEL 4 Rating That Received No Formal Action
4-Rated Banks That Did Receive Formal Action
Note: Data are median asset growth rates of FDIC- and Federal Reserve–supervised banks before and after regulatory
intervention. For this analysis, the intervention dates were dates of:
(1) examinations that resulted in the downgrading of the bank's CAMEL rating to 4 but did not result in a formal
enforcement action, or
(2) the last examination before the issuance of a formal enforcement action against a bank with a CAMEL 4 rating.
Normally, a bank is informed at the time of the examination of the prospect of a CAMEL rating downgrade or a formal
enforcement action. Data were run on a constant population sample for each period. The number of observations ranged from
200 to almost 500 for the different periods for banks downgraded to CAMEL 4 rating that did not receive formal enforcement
actions, and from 200 to 300 for 4-rated banks that did receive formal enforcement actions.

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havior (see figure 1.11). Dividend rate reductions and increases in external capital injections began before regulatory intervention and generally continued in the first year after intervention, and banks that became the subject of formal enforcement actions showed the
greatest dividend cuts and capital injections.120 Comparable behavior was also exhibited by
loan-loss provisions (not shown in figure 1.11).
The foregoing analysis indicates that bank managements took remedial actions even
before the examinations that triggered reductions in CAMEL ratings or led to formal enforcement actions. Whether these remedial actions were driven by market forces, by management’s own objectives, or by expectations of future regulatory action cannot be readily
ascertained. In any event, regulatory intervention apparently had the effect of reinforcing
and accelerating these remedial actions. Changes in the behavior of problem banks were
greater for banks that later received formal enforcement actions as compared with banks
subject only to informal actions. However, it is not clear whether these differences in behavioral change were due primarily to the more demanding nature of formal actions or to
the condition and behavior of the banks that received them. Formal actions are frequently
taken when banks fail to comply with informal ones. Such failure may be due to the existence of more severe problems at the banks receiving formal actions or to less willingness
on the part of their management to cure them.121
In general, the reduction in asset growth was an indication that moral hazard was being contained—that troubled banks were not attempting, or were not being allowed, to
“grow out of their problems”; indeed, in many cases their assets were shrinking. In the case
of the surviving banks, reduced dividend payouts and increased capital injections helped restore equity positions and were instrumental in facilitating recovery. In the case of the failing banks, dividend cuts and new capital had the direct effect of reducing failure costs.122
These favorable results, no matter what the immediate stimulus, were consistent with the
regulators’ objectives of preventing the failure of troubled banks and reducing the insurance
costs of banks that did fail.
The policy of encouraging or forcing problem banks to retrench and shrink has been
criticized by some observers for inhibiting the banks’ recovery and, in the context of the
1990s, for contributing to the “credit crunch.” For example, it is sometimes argued that restrictions on asset growth may have deprived problem banks of attractive investment op120
121

122

66

Data for capital injections are annual in figure 1.11 because small banks do not report capital injections quarterly. The
analysis was confined to 4-rated banks in order to have large samples of banks with similar conditions.
As noted in Chapter 12, 71 percent of problem banks that failed had received formal enforcement actions, compared with
41 percent of problem banks that survived. This is consistent with the view that formal actions were taken against the most
unhealthy banks.
Although dividend payout ratios declined for troubled banks, a significant number of undercapitalized banks did pay dividends. See David K. Horne, “Bank Dividend Patterns,” FDIC Banking Review 4, no. 2 (1991): 13–24.

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Figure 1.11

Dividend Rates and Capital Infusions of CAMEL 4-Rated Banks
before and after Regulatory Intervention
Percent of Assets
0.25

Dividends
1979–1985

Capital Infusions
1979–1985
Percent of Assets

2.0

0.20

1.6

0.15

1.2

0.10

0.8

0.05

0.4

0

0

1985–1990

1985–1990

0.8

0.3
0.6
0.2
0.4
0.1
0.2
0

1990–1995

2.0

0.8

1.5

0.6

1.0

0.4

0.5
0

1990–1995

1.0

0.2

-1

0

1

2

Year Relative to Intervention

3

0

-1

0

1

2

Year Relative to Intervention

3

Banks Downgraded to CAMEL 4 Rating That Received No Formal Action
4-Rated Banks That Did Receive Formal Action
Note: Data are averages of individual bank ratios. See note to figure 1.10.

History of the Eighties—Lessons for the Future

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portunities and required them to sell high-quality assets they already owned.123 Similarly, it
is sometimes argued that cuts in dividends may have retarded the growth of external capital
infusions. It should be remembered, however, that the range of choices available to regulators in dealing with problem banks was limited and permeated by uncertainty. Many problem banks had exhibited a tendency toward excessive risk taking and/or managerial and
other weaknesses. A more relaxed supervisory posture might have resulted in the resumption of risk taking and an increase in losses when an institution failed. Continued dividend
payments would also have increased insurance losses if failure occurred. It is not surprising
that bank regulators generally chose the surer course of reducing risk-taking opportunities
and insurance losses by seeking the retrenchment and shrinkage of problem banks.
Effectiveness of Supervisory Tools: Off-Site Surveillance
Off-site monitoring based on financial reports submitted by banks evolved during the
1980s in response to earlier developments in computer technology and to fundamental
changes in the OCC’s examination policies after two large national banks failed in the
1970s.124 The evolution of off-site monitoring appeared to justify reductions in examination
staffing and frequency. As the number of failures mounted during the 1980s, however, it became clear that off-site monitoring was not a substitute for, but potentially a useful complement to, on-site examinations. Compared with on-site examinations, off-site monitoring
systems have a number of advantages: they are less intrusive and costly, they can be updated frequently when new information is received through quarterly Call Reports, they can
provide the basis for a financial evaluation of the bank between examinations, and they are
potentially able to isolate risk factors that may lead to future problems, whereas examinations are essentially a measure of the bank’s current condition. Furthermore, Call Report
data on which off-site monitoring systems are based are largely available to the public and
can be used by investors and others as the basis for imposing market discipline on the
banks. By identifying those banks that appear to have deteriorated since their last examinations, the systems can help regulators allocate examiner resources.
The disadvantages of off-site monitoring systems are that they provide no direct evaluation of management, of individual loan characteristics, of underwriting practices, or of
internal controls and procedures. Moreover, the accuracy of the financial reports on which
they are based, particularly the quality of loan portfolios, is dependent on periodic on-site
examinations.
Off-site surveillance systems, despite their distinct advantages, did not play a very
helpful role in the 1980s. On the contrary, belief in their usefulness and their potential
123
124

68

See comments by Joe Peek in volume 2 of this study.
This section is based on Chapter 13, “Off-Site Surveillance Systems.” See also Jesse Stiller, OCC Bank Examination: A
Historical Overview, (1995).

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

helped reinforce the idea that fewer on-site examinations were necessary. In addition, with
the large number of failed and troubled banks already straining supervisory resources, targeting banks for additional examinations was not a high priority (staff limitations meant
that resources were unavailable to examine any additional banks targeted by off-site systems). Off-site systems appear to have worked best when the number of problem institutions and failures was not large and when examination resources were sufficient for
identified banks to be examined.
Condition and risk factors. Call Report data can be used to provide an indication of
the condition of a bank and the level of risk it has undertaken. In this context, condition
variables are indicators of the current strength or weakness of a bank. A bank in a weak condition would typically have low capital and net-income ratios and high nonperforming-loan
ratios. Such a bank would face insolvency and failure in the near term. Risk factors, on the
other hand, are indicators of a longer-term problem. A bank may be pursuing risky policies
but still be in a currently healthy condition, with strong earnings and capital. In time, however, the risky policies could result in loan losses, reduced income, deterioration in capital,
and eventual failure. (The distinction between condition and risk in this context is essentially the same as the distinction between ex post and ex ante risk measures discussed
above.)
The possibilities of isolating condition and risk factors by analyzing banks’ financial
data are illustrated in figures 1.12 and 1.13. Figure 1.12 shows various measures of the current condition of banks—ratios to assets of equity, of equity plus reserves minus nonperforming loans (coverage), of net income, and of nonperforming loans—as of l982 for banks
that failed four to five years later (in 1986–87) and for banks that existed throughout the period and never failed. On the basis solely of these condition variables, there was little as of
1982 to distinguish banks that subsequently failed from those that did not.125 Although the
condition ratios for the future failures were slightly below those for the future survivors,
they were nonetheless at levels that would normally be considered healthy; for example, in
1982 the average equity/assets ratio of banks that failed in 1986–87 was over 8 percent. As
the banks that failed approached their dates of failure, their condition ratios deteriorated
markedly compared with those of the nonfailures.
Comparisons of long-run risk factors show a considerably different picture (figure
1.13). In 1982 and throughout the subsequent four to five years, the risk profile of banks
125

The data in figures 1.12 and 1.13 include, for 1982, all banks that existed in 1982 and failed in 1986–87 and all banks that
existed throughout the 1982–87 period and did not fail after 1987. Certain failures are excluded: those due primarily to
fraud, cross-guarantee failures subsequent to FIRREA, and bank affiliates of two Texas bank holding companies with
CAMEL ratings of 1 and 2 that were essentially branches of the lead bank and were resolved through transactions whose
effects were similar to cross-guarantees.

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Figure 1.12

Bank Condition Ratios for Failed and Nonfailed Banks
1982–1986
A. Equity Ratio*

Percent
10

Percent
10

8

B. Coverage Ratio*

5

6
0
4
-5

2
0

1982

1983

1984

1985

1986

-10

*Equity/assets

Percent
2

1982

1983

1984

1985

1986

*(Equity + reserves – nonperforming loans) /assets

C. Return on Assets*

Percent

D. Nonperforming Loans*

12
0
8

-2

4

-4

-6

1982

1983

*Net income/assets

1984

1985

1986

Banks That Subsequently Failed

0

1982

1983

*As a percentage of assets

1984

1985

1986

Banks That Did Not Fail

Note: “Failed” means banks that existed in 1982 and failed in 1986 or 1987; “nonfailed” means banks that existed during
the entire period and never failed.

70

History of the Eighties—Lessons for the Future

Chapter 1

Summary and Implications

Figure 1.13

Bank Risk Ratios for Failed and Nonfailed Banks
1982–1986

Percent

A. Loans to Assets

B. Asset Growth Rate

Percent

60

10

40
0
20

0

1982

1983

1984

1985

1986

-10

C. Interest Income and Fees Ratio*

1982

1983

$Thousands

8

20

4

10

1982

1983

1984

1985

1986

1985

1986

D. Average Employee Salary

Percent

0

1984

0

1982

1983

1984

1985

1986

*Total interest and fees on loans and leases/total loans and leases

Banks That Subsequently Failed

Banks That Did Not Fail

Note: “Failed” means banks that existed in 1982 and failed in 1986 or 1987; “nonfailed” means banks that existed during
the entire period and never failed.

History of the Eighties—Lessons for the Future

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that failed in 1986–87 was distinctly higher than that of banks that did not fail. Banks that
would fail had substantially higher loans-to-assets ratios than survivors did. They also had
substantially higher ratios of interest and fee income on their loan and lease portfolios,
which suggests that their loans were riskier. Finally, banks that subsequently failed had
higher growth rates in 1982 than the banks that did not fail, but as the banks approached
failure these growth rates were sharply cut back in a manner consistent with the findings
cited above on FDIC enforcement actions.
Many prediction models constructed for the purpose of predicting bank failures use
measures of current condition (or ex post risk) as independent variables. Thus, the accuracy
of failure predictions falls off considerably for predictions of failures more than one year
ahead. As part of the research for this book, an attempt was made to use ex ante risk measurements to identify groups of banks that had a high long-term risk of failure. For this purpose, nine risk ratios were tested: loans to assets, deposits over $100,000 to liabilities,
ROA, asset growth rate, loan growth rate, operating expenses to total expenses, salary expenses per employee, interest yield on loans and leases, interest and fee income on loans
and leases. The banks were divided into quintiles according to these ratios. The periods of
analysis were four and five years from 1980, 1982, 1984, 1986, and l988. In each period the
risk ratio with the strongest statistical relationship to failures turned out to be the ratio of
loans to assets.126 For example, 8.20 percent of the banks that were in the highest loans-toassets ratio quintile in 1984 failed in 1988–89, compared with 2.89 percent of all banks in
the sample, for an increase of 184 percent in the incidence of failure (see table 1.13).127
The same statistical procedure was applied to the “low-risk” group (the lowest four
quintiles) as measured by the loans-to-assets ratio, and different risk factors proved to be
the best predictors of failure in four to five years (see table 1.14). ROA was the best predictor of failure for the “low-risk” group in 1984; of the “low-risk” loans-to-assets group in
1984, 3.96 percent of the banks in the highest-risk ROA quintile failed in 1988–89.
A number of observations are in order. First, the risk factors do not predict which individual banks will fail; rather, they identify a group of banks with the highest incidence of
failure. Second, the risk group encompassing the highest loans-to-assets ratio quintile plus
126

127

72

Logit regressions were performed on each of the risk variables where the dependent variable was whether the bank failed
or not. The risk variable with the highest predictive power for failure was determined by a Chi-Square test score for each
regression. The coefficients for each quintile of the variable were then compared, and a Chi-Square test was performed to
determine which quintile or group of quintiles was the best predictor of failure. The analysis was then repeated on the
high- and low-risk quintiles to determine which was the next-best predictor of failure in both groups. See Chapter 13,
“Off-Site Surveillance Systems.”
In an initial inquiry, the ratio of large deposits to total liabilities was found to be the best predictor of failures in 1984 and
1986. However, this ratio was found to be essentially a proxy for location in Texas, where large-scale use of large deposits
occurred in part because of restrictions on branching. Once the large-deposit ratio was excluded, the loans-to-assets ratio
was the best predictor of failure in all years.

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the high-risk ROA group in the remainder of the banks in 1984 accounted for 76 percent of
all failures in the entire sample.128 Third, to capture 76 percent of the total number of failures in 1988–89, the two risk groups “flagged” a large proportion (34 percent) of the total

Table 1.13

Probability of Failure
Banks in the Highest Loans-to-Assets Quintile
All Sample Banks
Beginning
Year

Probability of
of Failure

Number of
Failures

Highest Loans-to-Assets Quintile
Probability
of Failure

Number of
Failures
88

Percent of
Total Failures

Increase in
Probability
of Failure

1980

1.51%

184

3.62%

47.8%

140%

1982

2.45

291

6.75

160

55.0

175

1984

2.89

332

8.20

188

56.6

184

1986

2.25

253

6.46

145

57.3

187

1988

1.24

133

3.36

72

54.1

171

Table 1.14

Probability of Failure for “Low-Risk” Banks
(Banks Not in the Highest Loans-to-Assets Quintile)
Failures in Highest-Risk Group of “Low-Risk” Banks
Beginning
Year

Highest-Risk Indicator for
“Low-Risk” Group

Probability of
Failure*

Number of
Failures

Percent of Total Failures in
“Low-Risk” Group†

1980

Loan Growth

2.32%

40

41.7%

1982

Interest Yield

3.76

53

40.4

1984

ROA

3.96

65

45.1

1986

ROA

3.74

62

57.4

1988

ROA

2.12

35

57.4

* This is the probability of failure in the 80 percent of banks that are not in the high-risk loans-to-assets quintile.
† Excludes failures in the high-risk loans-to-assets quintile.

128

The 76 percent was derived as follows: 188 failures in the high-risk loans-to-assets ratio quintile plus 65 failures in the
high-risk ROA group in the four “low-risk” loans-to-assets quintiles, for a total of 253, or 76 percent of all the 332 failures in the sample. See Chapter 13, table 13-A.3.

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number of banks in the sample.129 Fourth, most banks in the high-risk groups did not fail.
For example, nearly 92 percent of the banks in the high-risk loans-to-assets ratio quintile in
1984 did not fail four to five years later, in 1988–89.
These findings suggest that failing banks shared a common characteristic: they followed a relatively high-risk strategy, as indicated particularly by the ratio of loans to assets,
and could be identified well in advance of their failure dates. The findings also indicate that
many other banks had similar risk characteristics but were able to avoid failure. As indicated above, the success or failure of banks depends on many factors, so predicting failures
far in advance on the basis of the institutions’ risk characteristics is difficult.
Specific off-site surveillance systems. The original off-site surveillance systems used
in the 1970s were a collection of commonly used financial ratios. The OCC’s system eventually evolved into the Uniform Bank Surveillance System, whose best-known product is
the Uniform Bank Performance Report (UBPR). The UBPR is a bank-specific report that
allows an analyst to compare the financial characteristics of an individual bank with the
characteristics of comparable (peer) banks. The Federal Reserve and the FDIC developed
similar systems. In 1985 the FDIC developed the CAEL system (Capital, Assets, Earnings,
Liquidity—Management is not modeled). This was designed to replicate the examination
rating that an “expert examiner” would give an institution solely on the basis of Call Report
data. Banks were flagged for attention if their CAMEL rating was 2 or worse and their
CAEL rating was more than one rating worse than their current CAMEL rating.130
The CAEL system was adopted in the mid-1980s and has been used to help achieve
and maintain efficient allocation of supervisory resources, primarily by detecting at an early
date banks that appear to have a high probability of receiving a CAMEL downgrade at their
next on-site examination. CAEL uses 19 financial ratios by which a bank is matched against
its peer group. From 1987 to 1994, the CAEL system was reasonably correct in its predictions; approximately one-half of all CAMEL downgrades predicted by the system actually
occurred within six months. The CAEL system identified approximately 25 percent of total
rating downgrades in the relevant group (banks downgraded from CAMEL 2 or worse). By
design, CAEL misses a large number of actual downgrades in order to avoid targeting many
banks that are in fact in a stable condition. This appears to be appropriate in a regime of frequent on-site examinations, for banks whose conditions have deteriorated since their last
examinations but that were not identified by the CAEL system will in any event be examined without too much delay.
129

130

74

The 34 percent figure refers to the highest loans-to-assets quintile plus the highest ROA group of the “low-risk” loans-toassets quintiles, or 3,935 (2,292 + 1,643) banks. This was 34 percent of the 11,479 banks in the sample. See Chapter 13,
table 13-A.3.
The various systems of off-site surveillance are treated in detail in Chapter 13.

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Summary and Implications

In the mid-1980s the FDIC also developed the Growth Monitoring System (GMS).
Banks flagged by GMS as rapid-growth institutions are identified for off-site review and
may receive increased supervisory attention. The system is based on the levels and quarterly
trends of five summary measures: asset growth rate, growth rate of loans and leases, and ratios to assets of equity capital, volatile liabilities, and loans and leases plus securities with
maturities of five years or more. The system’s premise is that rapid growth in total assets or
loans represents a risky activity. Through the 1980s banks that generated high growth scores
in the model had a higher-than-average incidence of failure up to four years later.
In the years since the CAEL and GMS systems were developed, there has been a substantial body of economic research related to modeling bank failures and financial distress.
The Federal Reserve has based its off-site surveillance methods on statistical modeling
techniques, beginning with the Financial Institutions Monitoring System (FIMS), which
was adopted in 1993 and predicted CAEL-like ratings and bank failures. As of mid-1997
the FDIC was considering substantial modifications in GMS and adoption of a statistical
model for predicting CAMEL rating downgrades for banks and thrifts.

Open Questions
Many of the weaknesses revealed in bank statutes, regulations, and supervisory practices in the 1980s were subsequently addressed and corrected. However, some issues remain
open—two in particular: the potential impact of resolving large-bank failures in accordance
with FDICIA, and the adequacy of present systems of identifying and pricing risk.
Treatment of Large Banks: Systemic Risk and Market Discipline
FDICIA shifted the balance between stability and market discipline toward market
discipline. It accomplished this by requiring that the methods used to resolve bank failures
produce the least cost to the FDIC and by prohibiting the protection of uninsured deposits
when such action would increase the cost to the insurance fund. Under the pre-FDICIA cost
test, either the FDIC could choose to sell the failed bank if the estimated resolution cost was
less than that of a deposit payoff or the FDIC could provide open-bank assistance, regardless of cost considerations, if the bank’s services were determined to be “essential” to the
community. Failures of big banks were generally resolved in ways that protected all deposits against loss because of fears of depositor runs on other banks, systemwide crises
through correspondent accounts, or disruption of the payments system.
FDICIA also limits the ability of the Federal Reserve to provide liquidity to problem
banks (defined in terms of capital position) through its discount window. For critically undercapitalized banks, repayment must be demanded within no more than 5 days, and if that
limit is violated, the Federal Reserve is liable to the FDIC for any additional cost. In the
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case of undercapitalized banks, Federal Reserve advances can remain outstanding for no
more than 60 days in any 120-day period.131
FDICIA increases the likelihood that large banks will be resolved with losses to uninsured depositors and reduces the likelihood that open-bank assistance will be used to deal
with large troubled banks. An exception to the least-cost test is allowed in cases of systemic
risk: two-thirds of the FDIC Board and two-thirds of the Federal Reserve Board would have
to recommend that an exception be made, with the final decision in the hands of the secretary of the treasury in consultation with the president. Any loss incurred by the FDIC as a
result of using the systemic-risk exception would have to be made up by a special assessment on all institutions insured by the same fund. These provisions were designed to discourage use of the exception and to increase accountability.
The 1980–94 experience provides only limited guidance as to how the rules prescribed by FDICIA will affect future large-bank resolutions. On the one hand, there are the
well-known troubles of Continental Illinois, which in 1984 sustained enormous withdrawals of foreign deposits through high-speed electronic transfers. At the time there was
concern that if uninsured deposits were not protected, Continental’s correspondent banks
would sustain serious losses, possibly with “ripple” effects on other major banks that were
perceived to be vulnerable. Action by the regulators in assisting Continental Illinois forestalled the possibility of such effects on other major banks.
On the other hand, in numerous cases the FDIC resolved banks through methods that
left uninsured depositors unprotected yet had no serious repercussions.132 These were generally smaller banks that did not pose problems of systemic risk.133 Another instance was
the modified payoff method used to resolve 13 banks in 1983–84, a method that caused
uninsured depositors to suffer losses: at closure uninsured depositors were paid a portion of
their money based on the value of the bank’s assets that it was estimated would be recovered in liquidation. At the time of these resolutions there were no flights of deposits from
other institutions. Similarly, in the period since FDICIA, resolutions with losses to uninsured depositors have not produced large-scale withdrawals at other institutions. From 1992
131

132

133

76

A decision by the FDIC to act in the Federal Reserve’s stead by providing open-bank assistance might have rendered this
provision less substantial. However, this avenue was essentially closed by the Resolution Trust Corporation Completion
Act of 1993, which effectively prohibited—unless the systemic-risk exception had been invoked—the use of BIF or SAIF
funds to benefit the shareholders of insured depository institutions, a likely outcome of FDIC open-bank assistance.
From 1986 through 1991, 199 banks (representing 19 percent of all bank failures) were resolved through means that did
not protect uninsured depositors. Average assets of these banks amounted to $57 million. See FDIC, Failed Bank Cost
Analysis, 1986–1995.
A possible exception was Penn Square Bank, which was closed through a deposit payoff in 1982. Because of Penn Square,
“Some banks had difficulty rolling over large CDs. The business of brokers, who divide up large deposits and participate
them to several banks, was significantly boosted. Depositors generally became more selective in their choice of banks”
(FDIC, The First Fifty Years, 98).

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Summary and Implications

to 1995, uninsured depositors were unprotected in 63 percent of all failures, compared with
19 percent in 1986–91. The experience since the adoption of FDICIA is, of course, hardly
a rigorous test. In this period bank profits have increased to record levels, failures have
slowed to a trickle, and no major bank has been threatened.
Some studies, published mostly in the post-FDICIA period, present evidence suggesting that investors recognize the risk of loss on uninsured deposits and that the market responds appropriately to new information about risk in banking firms. For example, one
study found that when banks’ subordinated debt claims were downgraded by Moody’s rating service, the stock prices of banks with larger proportions of insured deposits declined
less, and downgraded banks then increased their reliance on insured deposits.134 Another
study found that stock prices reacted negatively after a downgrade in a bank’s CAMEL rating, and suggested that such information may be transmitted to the market through the
bank’s Call Reports.135 A study of subordinated debt concluded that yields on such instruments rationally reflected changes in the government’s policy toward protecting large bank
holding company creditors.136 Still another concluded that bond rating agencies convey
new information to the market and thereby enhance market discipline, since banks that experience downgrades suffer negative stock returns.137
Studies have also been done to compare the accuracy of “inside” information developed through on-site examinations with that of “outside” information available to market
participants. For example, one study of problem banks concluded that stock returns had
failed to anticipate downgrades in CAMEL ratings; neither the market nor the banks’ managements seemed to have been aware of the banks’ problems before the examinations took
place.138 Another study concluded that both regulators and market participants price credit
risk, but only regulators price capital strength; the results seem to reflect, on the one hand,
the supervisors’ concern with preventing bank failures and protecting the deposit insurance
fund and, on the other hand, the market’s emphasis on risk/return trade-offs.139 But a third
study concluded that CAMEL ratings are primarily proxies for available market informa134
135
136
137
138
139

Matthew T. Billet, Jon A. Garfinkel, and Edward S. O’Neill, “Insured Deposits, Market Discipline, and the Price of Risk
in Banking,” unpublished paper (November 28, 1995).
Allen N. Berger and Sally M. Davies, “The Information Content of Bank Examinations,” working paper 94-24, Wharton
Financial Institutions Center, 1994.
Mark J. Flannery and Sorin M. Sorescu, “Evidence of Bank Market Discipline in Subordinated Debenture Yields:
1983–1991,” Journal of Finance 51, no. 4 (September 1996): 1347–77.
Robert Schweitzer, Samuel H. Szewczyk, and Raj Varma, “Bond Rating Agencies and Their Role in Bank Market Discipline,” Journal of Financial Services Research 6 (1992): 249–63.
Katerina Simons and Stephen Cross, “Do Capital Markets Predict Problems in Large Commercial Banks?” Federal Reserve Bank of Boston New England Economic Review (May/June 1991): 51–56.
John R. Hall, Andrew P. Meyer, and Mark D. Vaughan, “Do Markets and Regulators View Bank Risk Similarly?” Federal
Reserve Bank of St. Louis, supervisory policy analysis working paper no. 1-97, February 1997.

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tion about the condition of banks; the additional informational content of CAMEL ratings
did not appear large.140
These studies often address the issue of whether, in monitoring large, publicly traded
banks, market discipline and supervision are interchangeable. However, their results also
have a bearing on the issue of the future treatment of large problem banks. If it appears that
the market exercises appropriate discipline and readily obtains relevant information, then
there are grounds for optimism that, in the future, major surprises at large banks may be
avoided because weaknesses will become public knowledge at an early stage, the market
will have sufficient information to make realistic assessments of bank risk, and investors
will be able to distinguish accurately between viable and nonviable banks. Under these conditions, the likelihood that contagious runs will cause systemic problems would be reduced.
There would be fewer grounds for optimism if it appeared that the market had inadequate
or obsolete information (as compared, for example, with information produced by examinations) about a bank’s condition.
With respect to contagious runs, the evidence is not clear; some failures apparently
have not affected other banks, whereas others seemingly have.141 Testing for contagious
runs on large banks is obviously problematic: federal deposit insurance and the practice of
protecting uninsured depositors of large banks eliminated the possibility of such runs during the 1980s, and an environment highly favorable to banking has minimized their likelihood in the 1990s. Experience from the pre-FDIC era or from countries that have no formal
deposit insurance system is not always consistent or clearly applicable to present-day U.S.
conditions.142
The most likely scenario in the event of a future large-bank problem is that the FDIC,
the Federal Reserve, and the administration will have to make difficult judgment calls on
whether use of the systemic-risk exception is justified. Such decisions will probably have
140
141

142

78

Thomas F. Cargill, “CAMEL Ratings and the CD Market,” Journal of Financial Services Research 3, no. 4 (September
1989): 347–58.
However, one study concluded that “analysis suggests that bank contagion is largely firm-specific and rational, as it appears to be in other industries, and that the costs are not as great as they are perceived to be” (George G. Kaufman, “Bank
Contagion: A Review of the Theory and Evidence,” Journal of Financial Services Research 8, no. 2 [April 1994]:
123–50).
Among the studies of this issue are Charles W. Calomiris and Joseph R. Mason, “Contagion and Bank Failures during the
Great Depression: The June 1932 Chicago Banking Panic,” 110–22; and Fred R. Kaen and Dag Michalsen, “The Effects
of the Norwegian Banking Crisis on Norwegian Bank and Nonbank Stocks,” both in Proceedings of the 31st Conference
on Bank Structure and Competition, Federal Reserve Bank of Chicago, May 1995, 123–61; Gerald D. Gay, Stephen G.
Timme, and Kenneth Yung, “Bank Failure and Contagion Effects: Evidence from Hong Kong,” Journal of Financial Research (summer 1991): 153–65; George G. Kaufman, “Bank Contagion: A Review of the Theory and the Evidence,” Journal of Financial Services Research 8, no. 2 (April 1994): 123–50; Charles W. Calomiris and Gary Gorton, “The Origin of
Banking Panics: Models, Facts and Bank Regulation,” in Financial Markets and Financial Crises, ed. R. Glenn Hubbard
(1991), 109–74; and Wall, “Too-Big-to-Fail after FDICIA,” 7–9.

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Summary and Implications

to be made more quickly than were decisions relating to large-bank failures in the 1980s. In
any event, the combination of least-cost resolutions, PCA, and limitations on Federal Reserve advances will no doubt increase market discipline and reduce regulatory discretion.
These, of course, are what the supporters of these measures sought to achieve. Additional
and unintended effects of the new requirements may be that some regulatory decisions will
have to be made in haste and that the range of potential solutions to large-bank problems
will be narrowed.
Adequacy of Present Systems for Identifying and Pricing Risk
Banking operations became more complex during the 1980s and deviated increasingly from the traditional loan and deposit-taking model (the increase in various types of
off-balance-sheet activity is one example). These developments pose new risks and have required adaptations in capital standards and reporting requirements to ensure that major
types of risk are addressed.143
Another development that has important implications for assessing risk is the continued geographic diversification of the banking industry through consolidation. As more
banks spread their activities across state boundaries, they will have increased opportunities
to diversify their loan portfolios. But as a result of consolidation of multibank holding companies into out-of-state branch systems, financial reports under current reporting procedures will provide increasingly uncertain indications of the geographic concentrations of
credit risk.144 For example, if multibank holding companies were to consolidate all their
bank and thrift affiliates into a single lead bank, 38 states would show an apparent decline
in bank loans outstanding, whereas a few states would show substantial gains.145 Currently
(as of mid-1997) a number of efforts are being made to ensure that meaningful data on geographic concentrations of lending risk are available.
As these remarks suggest, bank regulators are attempting to adapt systems for identifying and pricing risk in order to keep up with developments in the banking industry, and
one of the principal tools for restraining risk is capital requirements that also serve to trigger
increasingly severe regulatory action under PCA. As emphasized repeatedly in this chapter,

143
144
145

The revisions in risk-based capital rules are discussed and evaluated in U.S. General Accounting Office, Financial Derivatives: Actions Taken or Proposed since May 1994 (November 1996).
“Minimum Data Needs in an Interstate Banking Environment,” FDIC staff analysis, September 16, 1996.
To the extent that out-of-state affiliates were consolidated into a local lead bank, a particular state would show an increase
in loans. To the extent that locally based affiliates were consolidated into an out-of-state lead bank, a particular state would
show a decrease in loans.

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however, bank capital positions are poor predictors of failure several years before the fact.
If regulatory action were based solely on capital positions, in many cases such action might
come too late to do much good. Yet a policy of basing costs or penalties on more-forwardlooking measures would have its own problems. Although ex ante measures of risk—such
as the ratio of loans to assets—correctly flagged a large majority of the institutions that
failed several years later, they also flagged a much larger number of banks that did not fail.
The latter group of banks was presumably being compensated—by earning higher returns,
at least for a time—for the greater risk it was assuming. Imposing restrictions on this group
of banks might unnecessarily restrain potentially profitable activities. Basing penalties on ex
ante measures of long-term risk might also expose the regulators to charges of credit allocation, since they might be restraining banks’ efforts to meet rising credit demands in particular regions or sectors of the economy. And basing regulatory restraints on unreliable ex ante
risk measures might increase the prospect of a regulator-induced “credit crunch.” All these
difficulties may make regulators loath to base supervisory restraints on, or levy penalties on
the basis of, ex ante risk measures, a situation raising the possibility that some future episode
of high-risk activity will go unrestrained until the risky behavior is translated into actual
losses and erosion of capital positions. In other words, identifying and restraining risky bank
behavior on a timely basis will continue to be a difficult task for bank regulators.
Some observers would address the issue by placing greater reliance on bank owners
and the marketplace, and less on regulators, to monitor and restrain risky behavior. Thus,
raising regulatory capital requirements considerably above present standards would increase stockholders’ stake in the banks, increase their incentive to enforce conservative
policies, and provide greater protection for the deposit insurance fund, taxpayers, and the
economy against the risk of bank failures. However, if capital requirements are set too high,
entry into the industry will be discouraged, competition within the industry will be weakened, and credit flows through bank and thrift intermediation will be reduced. A trade-off
exists between the objective of restraining risk through regulatory capital requirements and
the consequences of reduced competition among, and credit flows through, depository institutions.
Market value accounting has been proposed as a means of substituting the judgment
of the marketplace for that of regulators in assessing bank risk. This assumes that market
participants are better able (or willing) to evaluate the risk characteristics of depository institutions on the basis of publicly available data than regulators who have access to internal
information gained through examination of loan files. As has been frequently pointed out,
there are serious problems in assigning market values to bank loans that have no secondary
markets and have little or no inherent marketability because of the difficulty of assessing information developed by the banks on the characteristics and behavior of their borrowers.
Aside from implementation problems, market value accounting may reduce longer-term
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Summary and Implications

bank lending, restrict credit flows during periods of falling asset prices, and inject greater
instability in the banking system as a result of fluctuations in net worth positions of depository institutions. In short, whether risky behavior is monitored by regulators, bank owners,
or the market, the objective of greater ex ante restraints on risky behavior may conflict with
other public policy objectives.146

Concluding Comment
An eminent philosopher once offered this discouraging view of the lessons policymakers learn from history: “[P]eople and governments never have learned anything from
history, or acted on principles deduced from it.”147 The present study is based on the view
that history can be used constructively by policy makers. The lessons to be learned from this
history concern the effectiveness of the federal bank regulatory and deposit insurance systems during a period of extraordinary stress. How well did they perform in the 1980s, and
how can a study of their performance benefit future policymakers?
Despite bank and thrift failures in numbers not seen since the Great Depression, the
government’s promise to protect insured depositors was fully honored: no depositor lost a
penny on federally insured deposits, there was no significant disruption of the financial intermediation process, and a high degree of financial market stability was maintained. These
results did not come cheap, but the financial cost for the banking industry was borne by the
banks themselves and by their customers rather than by taxpayers, who ended up bearing
most of the much greater cost of the S&L debacle. There were also other, less-quantifiable
costs, particularly those associated with the moral-hazard risk taking inherent in deposit insurance. A chief example was the misallocation of resources when banks and thrifts poured
funds into high-risk commercial real estate lending, although other factors besides moral
hazard contributed to this outcome, including poorly conceived deregulation and disruptive
tax-law changes. In view of these overall results, several lessons can be drawn about the
performance of bank regulators in the 1980s.
1. Problems in the operations of depository institutions must be identified at an
early stage if serious deterioration in the institutions’ condition is to be prevented, and
early identification requires continuous and sometimes burdensome monitoring of the
institutions’ activities. Partly to support the objective of reducing the federal work force
and partly because of presumed efficacy of off-site monitoring, the number of bank exam-

146

147

See Allen N. Berger, Kathleen Kuester King, and James M. O’Brien, “The Limitations of Market Value Accounting and a
More Realistic Alternative,” Journal of Banking and Finance 15 (1991): 753–83; and Allen N. Berger, Richard J. Herring,
and Giorgio P. Szego, “The Role of Capital in Financial Institutions,” Journal of Banking and Finance 19 (1995): 393430.
Georg Wilhelm Friedrich Hegel, Philosophy of History (1832), quoted in John Bartlett, Familiar Quotations, 14th edition.

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iners and the frequency of on-site examinations were reduced in the first half of the 1980s,
at the very time when the number of troubled banks and bank failures began to rise rapidly.
As a result, emerging problems were not always identified on a timely basis, some failures
occurred that might have been averted, and losses to the insurance fund were probably increased. Examination forces were rebuilt and the frequency of examinations was increased
in the second half of the 1980s, even before legislation requiring such action was passed by
Congress in 1991. Up-to-date, on-site examination results appear to yield information on
banks not available through other means, and they help maintain the integrity of Call Report
and other publicly available bank data. In the 1980s, they provided reasonably accurate advance warning of future banking problems, and their accuracy increased during the period.
2. Adequate funding of the deposit insurance agency is essential to effective regulatory control of risk taking by insured institutions. The FSLIC suffered from a number of defects, but among the most serious was the lack of funding (and the reluctance of the
S&L industry and Congress to provide it). As a result, the FSLIC was unable to close large
numbers of insolvent S&Ls, which were allowed to continue operating in the hope that
higher-risk investments would pay off. FDIC resources, although strained during the late
1980s, were sufficient to close failed banks. Bank regulators generally forced or encouraged problem banks to cut asset growth, reduce dividend payments, and attract external
capital. Problem banks were generally not permitted to “throw the long bomb,” and most of
them survived as independent institutions or were merged without FDIC financial assistance. With some significant exceptions, most problem banks that failed were closed within
the time frame later prescribed by the PCA provisions of FDICIA for critically undercapitalized banks. Forbearance programs mandated or inspired by Congress were administered
in a generally effective manner by the bank regulators, in contrast to the unfavorable S&L
experience with forbearance. Although other factors obviously affected the quality of regulation, the availability of the financial resources needed to close insolvent institutions was
central to the bank regulators’ ability to control bank risk and moral-hazard problems and
reduce losses to the insurance fund when failure occurred.
3. The treatment of large-bank failures had undesirable side effects, but it is unclear whether alternative resolution methods would have been successful in the environment of the 1980s. Protecting uninsured depositors of large failed banks weakened
market discipline and exposed regulators to charges of treating small banks unfairly. Imposing losses on uninsured depositors and liquidating a few large banks might have had
salutary effects on market discipline, and some observers suggest that the regulators should
have been more willing to take the risk involved in such actions. However, no such experi-

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ment was undertaken, and therefore the experience of the 1980s provides little guidance on
whether these actions would have led to runs on other large banks and to more-general financial market instability.
In other respects, it is clear that the treatment of large banks could have been improved. While still profitable and solvent, some large banks that eventually failed were engaging in risky behavior that was not sufficiently restrained by bank regulators. In addition,
a few large banks continued to operate with little equity for extended periods before being
closed; these banks generated avoidable losses that increased total resolution costs. In these
instances, more-effective regulatory action was feasible and could have reduced losses to
the insurance fund.
4. Statutory rules limiting regulatory discretion may help prevent a repetition of
the regulatory lapses that occurred in the 1980s, but it remains to be seen whether
such rules will be maintained in a future period of widespread banking distress. Limits on the discretionary authority of bank regulators were adopted as part of FDICIA after
the banking crisis had largely passed, and they have raised few problems in the benign
banking climate that has since prevailed. However, the tension between rules and discretion
in bank regulation may reappear in some future period of widespread banking problems. In
the early 1980s, Congress responded to the concerns of the banking and thrift industries and
limited the ability of regulators to close weakened institutions. In that instance, Congress
mandated forbearance for thrifts and some banks, delayed recapitalization of the FSLIC’s
insurance fund, and then declined to provide the amount requested by the Reagan administration.148 Given this experience, it is difficult to predict the effect of current statutory rules
in some future banking crisis, or the willingness of legislators to retain them. In such a crisis, numerous banks might be suffering substantial operating losses and capital reductions
resulting from external shocks and other unforeseen developments. Will it then be politically feasible, for example, to liquidate a significant number of large banks in accordance
with least-cost resolution requirements or to close many small and large banks because they
fail a statutory solvency test? If so, will such actions be compatible with the objective of
maintaining financial market stability? Experience in the 1980s provides little basis for confident answers to these questions.
5. Bank regulation can limit the scope and cost of bank failures but is unlikely to
prevent failures that have systemic causes. The rise in the number of bank failures in the
148

National Commission on Financial Institution Reform, Recovery and Enforcement, Origins and Causes, 73.

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1980s had many causes that were beyond the regulators’ power to influence or offset. These
included broad economic and financial market changes, ill-considered government policy
actions, and structural weaknesses that inhibited geographic diversification and made many
banks vulnerable to regional and sectoral recessions. Earlier implementation of uniform
capital standards and other improvements in regulation might have reduced the number of
failures in the 1980s, but it could not have prevented a great many of them. Legislation permitting geographic consolidation was a major step toward correcting existing structural
weaknesses in the banking system. However, if significant new structural weaknesses or serious economic problems are allowed to develop in the future, bank regulation alone will
not be able to prevent a major increase in the number of bank failures.
6. The ability of regulators to curb excessive risk taking on the part of currently
healthy banks was (and continues to be) limited by the problem of identifying risky activities before they produce serious losses and by competing public policy objectives.
As noted, bank regulators were reasonably successful in curbing risk taking on the part of
officially designated problem banks whose condition had already deteriorated. However, in
dealing with ostensibly healthy banks, regulators had difficulty restricting risky behavior
before the fact, while the banks were still solvent and the risky behavior was widely practiced and currently profitable. It was (and remains) hard to distinguish such behavior from
acceptable risk/return trade-offs, innovation, and other appropriate activity, or to modify the
behavior of banks while they were (and are) still apparently healthy. Current risk-based capital requirements are forward-looking in the sense that they apply different weights to different asset categories, but the categories are so broad that they permit major increases in
high-risk loans without requiring more capital. On the other hand, current risk-based premium schedules penalize banks after the fact, when losses have already weakened their
condition. In addition to problems of identification, conflicting public policy objectives are
also a limiting factor; this was evident during the “credit crunch” of the early 1990s, when
bank regulators were criticized by legislators and administration officials for retarding economic recovery through their excessive zeal in applying the very supervisory restraints they
had previously been urged to implement.
An alternative approach, proposed mainly by academic writers, would be to rely more
heavily on bank owners and investors, rather than on regulators, to restrain risky behavior
on the part of profitable banks; this would be done by raising overall capital standards to
considerably higher levels than at present in order to increase shareholders’ stake or by
adopting market value accounting. Aside from problems of implementation, the potential
efficacy of this alternative is also limited by conflicts with other public policy objectives,
such as maintaining financial stability and meeting private sector credit demands.

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Summary and Implications

7. Differences in perspective among federal bank regulators may have delayed
recognition of the nature of the problems of the 1980s. Differences among the regulators
are to be expected, given their various primary responsibilities, and the resulting checks and
balances are frequently cited as one of the main advantages of the present regulatory structure. However, conflicts among regulators on the issue of brokered funds persisted until
1985, and on new bank charters until 1989. Arguably, it should have been clear before then
that bank failures were the most pressing problem, outweighing such considerations as encouraging innovations in deposit gathering and easing the entry of new institutions into
banking markets. While the present system of divided regulatory responsibilities is believed
to have important advantages, in the early 1980s it may have delayed recognition of the seriousness of a new crisis.
*
*
*
Finally, it is appropriate to emphasize that the lessons of the 1980s need to be applied
to future problems judiciously. As noted by one of the participants in the FDIC’s symposium at which an earlier version of this chapter was presented, the problems of the past may
bear little or no resemblance to those of the future.149 Therefore, it is important to keep in
mind those lessons of the 1980s that appear to be relevant while remaining alert to emerging problems that have few or no precedents in the past.

149

See comments by Carter H. Golembe in volume 2 of this study.

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Chapter 2

Banking
and

Legislation
Regulation

Introduction
The period between 1980 and 1994 saw more legislative and regulatory change affecting the financial services industry than any other since the 1930s. This is hardly surprising, for the legislative and regulatory landscape was inextricably bound up with the
profound transformation that took place within the industry. The structure of banking legislation and regulation might be compared to a stratified but active geologic formation:
clearly identifiable separate levels are present, but these come into contact at various points,
and sometimes collide. At the legislative level, Congress passed five major laws between
1980 and 1991, and significant bills were considered, if not passed, in nearly every session.1
Regulatory change during the period was equally extensive, much of it stemming from
these new laws. But because the federal banking agencies have authority to protect the
safety and soundness of the banking system,2 they often proposed and implemented new
regulations under authority granted by earlier statutes. In addition, the existence of the dual
banking system gave state legislatures and state banking authorities a significant role in the
regulation of state-chartered institutions—and they played this role frequently. The constant
interaction among all of these legislative and regulatory bodies was made even more complex by their occasional differences in viewpoint—and by the often-fragmented voice of a
banking industry in which competing needs shaped conflicting responses to regulatory proposals.

1

2

These five laws were the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA); the Garn–St
Germain Depository Institutions Act of 1982 (Garn–St Germain); the Competitive Equality Banking Act of 1987 (CEBA);
the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA); and the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA).
The Office of the Comptroller of the Currency is the primary federal regulator of national banks, as well as their chartering
authority; the Federal Reserve Board is the primary federal regulator of (a) state-chartered banks that are members of the
Federal Reserve System and (b) bank holding companies. The FDIC is the primary regulator of state-chartered banks that
are not members of the Federal Reserve System.

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With such a multiplicity of actors, it would be overly simplistic to identify the period
1980–94 with a single trend in policy. The early 1980s, after at least a decade of debate
about restructuring the financial services industry, was dominated by movement toward
deregulation: both DIDMCA and Garn–St Germain readily fall under that heading. Moreover, proponents of continued deregulation did not see 1982 as the end of that process, and
continued to press for congressional action; their main objectives were to repeal GlassSteagall and expand the powers of banks. Nevertheless, in Congress the momentum of
deregulation slowed markedly, and certainly by 1989–91 the environment had become far
more favorable to stringent bank regulation. By 1994, however, with the thrift and banking
crises in the past, the climate in Congress and the industry was again conducive to at least
some deregulation.
After 1982, none of the bills introduced in the 1980s to extend deregulation became
law, and the main objectives of CEBA, passed in 1987, were to clean up various problems
in the banking and thrift industries. As originally written, CEBA would have granted banks
additional powers in securities, insurance, and real estate, but in its final form it created a
comprehensive—albeit temporary—moratorium on federal regulators’ ability to grant
those powers. The attempt to legislate expanded bank powers continued, but FIRREA,
passed in 1989 and described as “supervisory reregulation,” concentrated on reforming the
thrift industry and providing regulators with greater enforcement powers.3 In 1991 FDICIA, like CEBA four years before, began as an ambitious attempt to repeal Glass-Steagall,
expand bank powers, and restructure the banking industry but, again, ended much more
narrowly, recapitalizing the Bank Insurance Fund and providing for banks what FIRREA
had provided for thrifts: more supervisory regulation and oversight. So in Congress, although deregulation remained an undercurrent, the laws actually passed during the latter
part of the period were aimed at recapitalizing the depleted deposit insurance funds and
equipping regulators with a stronger—and, indeed, less flexible—hand in supervising depository institutions.
National legislative developments, however, form only part of the story. A great deal
of regulatory activity took place within the federal banking agencies, although often congressional and agency strands would meet. For example, frequently the agencies asked
Congress for legislative action, particularly with regard to supervision, enforcement, and
dealing with failed and failing institutions. At the same time, the agencies were responsible
for drafting regulations to implement statutory changes, and the agencies’ interpretations of
3

Daniel Gail and Joseph Norton, “A Decade’s Journey from ‘Deregulation’ to ‘Supervisory Reregulation’: The Financial Institutions Reform, Recovery, and Enforcement Act of 1989,” Business Lawyer 45, no. 3 (1990): 1103–228. It should be
noted that only two years before passing DIDMCA, Congress had passed the Financial Institutions Regulatory and Interest
Rate Control Act (FIRIRCA), which gave regulators a wide range of authority to enforce penalties in supervising depository institutions—thus, significant increases in supervisory regulation occurred nearly simultaneously with deregulation.

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congressional intent were significant. The agencies also had the authority under previous
laws to make new regulations that required no additional action from legislators. An important example of such authority, and one that had implications for the banking crises of
the 1980s, was the Office of the Comptroller of the Currency’s (OCC) procompetitive policy for chartering new banks, inaugurated in 1980 partly at congressional urging.
As was the case in Congress, deregulation and the reaction against it were crucial
components of the regulators’ policies. In general, all of the federal banking agencies endorsed deregulation, although they often differed as to its extent and the manner of accomplishing it. Of the three federal agencies, the OCC was generally the first to push for
deregulation and did so most actively; both the Federal Reserve Board (FRB) and the FDIC
were less sanguine about some proposals. Still, by the mid-1980s, regulators at all three
agencies were increasingly allowing banks to enter new product areas.4 At the same time,
however, deregulation hardly meant an end to new regulation. Instead, it became one of the
most important forces behind stricter regulatory developments in the 1980s and early
1990s. One of the most significant and comprehensive of these was the imposition of morestringent capital requirements for banks: the regulators imposed mandatory capital-toassets ratios in 1980–81, refined and made them more uniform in 1984–85, and then moved
to a combination of risk-based and leverage capital ratios by 1988–92.5 After the implementation of prompt corrective action (PCA) under FDICIA, capital ratios became key regulatory measures of bank soundness. The definition and redefinition of capital standards
was one of the most pervasive regulatory stories of the 1980s and early 1990s.
The federal banking agencies also were active in responding to downturns in specific
sections of the financial services industry. For example, when thrifts, including savings
banks, were struggling with the interest-rate conditions of the early 1980s, the agencies
adopted forbearance policies that would allow institutions to continue to operate even when
failing to meet regulatory standards. The first formal use of forbearance in banking during
the period was the Net Worth Certificate Program implemented under Garn–St Germain.
The second was several years later, in 1986, when all three agencies responded to sectoral
problems in agriculture and then energy by inaugurating capital forbearance programs for
banks in the affected sectors.6 By the end of the 1980s the broad use of regulatory forbear4

5

6

See Wolfgang H. Reinicke, Banking, Politics and Global Finance: American Commercial Banks and Regulatory Change,
1980–1990 (1994); and George Kaufman and Larry Mote, “Glass-Steagall: Repeal by Regulatory and Judicial Reinterpretation,” Banking Law Journal 107, no. 5 (1990): 388–421.
Most of this was accomplished without congressional action, though it is important to note that in response to the less-developed-country crisis, the International Lending Supervision Act in 1983 mandated that the regulators impose capital regulations on banks. Capital ratios would also form the heart of FDICIA’s PCA provisions. For an explanation of PCA, see
section on FDICIA below; and for an analysis of PCA, see Chapter 12.
Agricultural interests, especially, believed the regulators applied the capital forbearance program too restrictively, and this
belief resulted in CEBA’s mandating the agricultural loan-loss amortization program.

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ance had been roundly condemned for contributing to the S&L crisis; its role in banking,
however, had been much more limited. Nevertheless, by 1991 and the passage of FDICIA,
lawmakers—having previously urged such programs—were now unwilling to allow the
agencies to exercise discretion in keeping banks afloat.
Another regulatory issue involved the use of brokered deposits. Again, even as deregulation was the watchword in the industry and in Congress, some of the regulators—in the
wake first of Penn Square’s failure and then of the failures of other banks and thrifts—
moved in 1983–85 to restrict the perceived risk that such deposits created for the deposit insurance funds.7 Although the initial regulatory attempts were invalidated by the courts, this
so-called hot money became one of the bêtes noires of those seeking causes for the thrift
crisis. Eventually, both FIRREA and FDICIA placed limits on the use of brokered deposits
by troubled institutions.
Although after 1982 Congress failed to grant banks new powers, from the early 1980s
state legislatures and state banking authorities were increasingly allowing their statechartered banks to enter securities, insurance, and real estate activities not permitted by federal statutes.8 As has already been noted, regulatory decisions were also allowing banks into
new areas. But although many of the new powers granted by the states were not thought to
add significant dangers to the banking system, others—notably in real estate investment
and development—were perceived as risky by the FDIC and the FRB, both of which proposed regulations in the middle to late 1980s to control them. The result was conflict not
only among the agencies but also between the agencies, the states, and the industry. Neither
of the proposed regulations was adopted, but this episode illustrates how the question of
banking regulation could be played out beyond Congress.
FDICIA and its requirements mark the legislative boundary to the banking crisis, although in 1993 Congress did pass legislation that at least partly was a residual reaction to the
crisis: a national depositor preference law. This law established a uniform order for distributing the assets of failed insured depository institutions. Although designed as part of a deficit
reduction plan, the law was also intended to reduce the FDIC’s losses from bank failures.
By 1994 the banking crisis was clearly over, and Congress sought to pull back from
what it now perceived as the imposition of overly onerous regulatory requirements on
banks. The beginning of this trend was embodied in the Riegle Community Development
and Regulatory Improvement Act of 1994. Also in 1994, Congress returned to the more
7
8

On this issue, the regulators disagreed considerably among themselves (see below).
Victor Saulsbury’s article (“State Banking Powers: Where Are We Now?” FDIC Regulatory Review [April/March 1987]:
1–17) reviews state banking powers as of 1987; see also the annual publication of the Conference of State Bank Supervisors, The State of State Banking (1988–92); and Advisory Commission on Intergovernmental Relations, State Regulation of
Banks in an Era of Deregulation (1988).

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structural industry issues that had become less critical during the immediate crisis. The
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 addressed the longstanding question of geographic expansion within the banking industry, but other structural
issues, such as the separation between banking and commerce, have not been resolved even
yet (though at this writing, a financial modernization bill is again under consideration). If
FDICIA can be viewed as the end of the immediate legislative response to the banking crisis, a law passed five years later, the Deposit Insurance Funds Act of 1996, provided for the
capitalization of the Savings Association Insurance Fund (SAIF) and thereby effectively
closed the chapter on the troubled period of the 1980s and early 1990s.

Legislation, 1980–1991
After 1980, Congress was particularly active, attempting to legislate numerous reforms to the financial services industry and its regulatory structure. DIDMCA in 1980 was
hailed as the first sweeping change in industry structure in half a century, and it was followed by significant legislation in 1982, 1987, 1989, and 1991. Moreover, few years passed
without the presence of substantial banking bills on the legislative calendar.
In the past, major changes in banking legislation (notably the Federal Reserve Act of
1913 and the Banking Act of 1933) were direct responses to financial crises. Legislation is
generally a reactive process, and banking legislation is no exception. In the case of banking,
however, Congress has had difficulty not only anticipating problems but also addressing issues that legislators and others have recognized as requiring legislative action. Changes had
been occurring in the financial services industry since the 1960s, for example, and had
greatly accelerated starting in the 1970s, but these changes had not been addressed in legislation. The often-complex laws enacted in and after 1980 were therefore not only a reaction
to crises in both the thrift and then the banking industry but also a response to the changes
of the previous 20 years.
Deregulation: The Depository Institutions Deregulation and Monetary
Control Act of 1980 and the Garn–St Germain Depository Institutions
Act of 1982
In 1980 the problems in the thrift industry were already becoming apparent, and some
provisions of DIDMCA were certainly an attempt to alleviate them. Nevertheless, this
wide-ranging law can best be described as a response both to a high-interest-rate climate
and to evolutionary change in the financial services industry. Many of the law’s provisions
had in fact been anticipated during the 1970s by the Hunt Commission and the FINE Study.
The Hunt Commission (1971) had argued for the removal of regulatory restraints and the
provision of additional powers under an umbrella of competitive equality among financial
institutions. Its recommendations included the gradual removal of interest-rate ceilings on
time and savings accounts, the addition of new lending and investment powers for financial
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institutions, removal of restrictions on statewide branching, and elimination of differential
reserve requirements for different types of financial institutions.9 The FINE Study (1975)
echoed many of these recommendations.10
DIDMCA established phased-in uniform reserve requirements for all depository institutions to ensure the Federal Reserve’s ability to conduct monetary policy, to stem the spate
of industry withdrawals of member banks from the Federal Reserve System, and to equalize the positions of commercial banks and thrifts.11 In addition, DIDMCA required the Federal Reserve to provide services (including access to the discount window) to all depository
institutions for set fees. In response to the disintermediation caused since 1979 by the combination of deposit interest-rate ceilings and the sharp rise in interest rates, the law also provided for the gradual removal by 1986 of Regulation Q ceilings on maximum allowable
rates on deposit accounts.12 The removal of the ceilings was meant particularly to increase
depository institutions’ ability to compete against money market mutual funds, but the ceilings were also attacked for penalizing small savers who did not have access to instruments
through which they could obtain market rates. The bill was therefore also proclaimed proconsumer. The phaseout of the ceilings was to be achieved by March 31, 1986, and was to
be overseen by the Depository Institutions Deregulation Committee (DIDC), which was
created by the law.13 In keeping with the general aim of increasing competition and remov9

U.S. President, The Report of the President’s Commission on Financial Structure and Regulation (1971). See pt. 2, pp.
23–112, for recommendations. The commission also advocated uniform federal income tax requirements for depository institutions, and consolidation of the regulatory and insurance agencies.
10 See U.S. House Committee on Banking, Currency and Housing, Subcommittee on Financial Institutions Supervision, Regulation and Insurance, Financial Institutions in the Nation’s Economy (FINE), “Discussion Principles”: Hearings, 94th
Cong., 1st sess., 1975. See also “Symposium on the FINE Study,” Journal of Money, Credit and Banking 9, no. 4 (1977):
605–61.
11 Public Law 96-221. This discussion is based on the detailed description in Kerry Cooper and Donald Fraser, Banking
Deregulation and the New Competition in Financial Services (1986), 105–25. See also Charles McNeill, “The Depository
Institutions Deregulation and Monetary Control Act of 1980,” Federal Reserve Bulletin 66, no. 6 (June 1980): 444–53; and
Thomas McCord, “The Depository Institutions Deregulation and Monetary Control Act of 1980,” Issues in Bank Regulation 3, no. 4 (1980): 3–7. The costs of the reserves required by Federal Reserve System membership were driving institutions to leave the System. One article noted that 60 banks withdrew during the first nine months of 1979; and in January
1980, Equibank ($1.9 billion in assets) announced its intention to leave the System—it would have been the largest such defection ever (John Yoch, “Fed Pullouts Seen Spur to Member Bill,” American Banker [January 28, 1980], 14; also American Banker [January 20, 1980], 7). Legislative action to stem the withdrawals was endorsed both by the Carter
administration and by Federal Reserve Board Chairman Paul Volcker.
12 Disintermediation is “an excess of withdrawals from a depository institution’s interest-bearing accounts over its deposits in
such accounts” (Encyclopedia of Banking and Finance, ed. Charles J. Woelfel, 10th ed. [1994], 306). This occurs when
rates on competing investments, such as Treasury bills or money market mutual funds, offer the investor a higher return.
13 The DIDC consisted of the secretary of the treasury, and the chairmen of the FRB, FDIC, FHLBB, and National Credit
Union Association (NCUA) as voting members, and the Comptroller of the Currency as a nonvoting member. For a discussion of Regulation Q and a detailed survey of DIDC actions, see R. Alton Gilbert, “Requiem for Regulation Q: What It
Did and Why It Passed Away,” Federal Reserve Bank of St. Louis Review 68, no. 2 (February 1986): 22–37.

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ing regulatory differences among depository institutions, all such institutions were authorized to provide checking account services and NOW accounts or their equivalent. Moreover, thrifts were granted many powers that had been available only to commercial banks.
For example, S&Ls could enter consumer loan and credit card businesses, and mutual savings banks could make business loans and accept demand deposits. Finally, the act preempted state usury laws concerning several kinds of loans, and made changes to the Truth
in Lending Act.
One aspect of the law that received little attention during the debate over passage but
would come to be viewed as crucial to the S&L crisis and to the brokered-deposits issue was
the raising of the deposit insurance limit from $40,000 to $100,000. In the Senate, the first
proposal was to increase the limit to $50,000 as an adjustment for inflation. But there was
clear sentiment in Congress for a greater increase that would help draw deposits into the
thrifts.14 It has been argued that the S&Ls were the driving force behind the increase in insurance, and after the provision passed, the U.S. League of Savings Associations did state
that it was “particularly helpful.” Some of the bill’s sponsors also believed that the increase
would strengthen depository institutions’ ability to compete with money market funds.15
FDIC Chairman Irvine Sprague noted in testimony before Congress that an accurate adjustment for inflation would mean an insurance level of approximately $60,000, but he said
nothing about a higher increase.16 The Federal Reserve supported the proposed increase to
$50,000 but was “inclined to favor an increase to $100,000.”17 The lower figure remained
in the bill, however, until it was replaced by the $100,000 limit at a late-night House-Senate conference. The decision, scarcely remarked at the time, would come to be viewed by
many as having weighty consequences.
14

Congressional Record, S. 15278 (October 29, 1979). Senator Alan Cranston proposed the increase to $50,000; Senators
William Proxmire and Jake Garn both supported the proposal but suggested a further increase was needed.
15 Joseph Hutnyan and Jay Rosenstein, “Conferees Forge Financial Modernization,” American Banker (March 7, 1980), 1;
Washington Financial Reports (March 10, 1980), A-29; and Joseph D. Hutnyan, The S&L Lobby: An Exercise in Customer
Service, consultant study no. 3, National Commission on Financial Institution Reform, Recovery and Enforcement, 1992,
22–23. See also L. William Seidman, Full Faith and Credit: The Great S&L Debacle and Other Washington Sagas (1993),
178–79.
16 Testifying before Congress four years later, Chairman William Isaac (who succeeded Irvine Sprague in 1981) noted that he
believed Congress had passed the $100,000 limit over the objections of the FDIC. House Banking Committee Chairman
Fernand St Germain replied that he had agreed with the FDIC at the time but that “it was one of the things we had to compromise on . . . I thought it was a mistake” (U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee
on Financial Institutions Supervision, Regulation and Insurance, Inquiry into Continental Illinois Corp. and Continental Illinois National Bank: Hearings, 98th Cong., 2d sess., 1984, 559). See also U.S. Senate Committee on Banking, Housing, and
Urban Affairs, Deposit Insurance Reform and Related Supervisory Issues: Hearings, 99th Cong., 1st sess., 1984, pt. 1, 7.
17 U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on Financial Institutions Supervision, Regulation and Insurance, Regulation Q and Related Matters: Hearings, 96th Cong., 2d sess., 1980, 783, 836. The $100,000
limit had been written into H.R. 6216. Sprague noted that any increase in the insurance limit should be accompanied by a
decrease in assessment refunds to maintain the ratio of the insurance fund to insured deposits.

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Two years later, Garn–St Germain was largely an attempt to rescue the thrift industry,
which by this time, due to earnings problems, was generally perceived to be in crisis.18 The
thrift lobby was strongly in favor of the provisions in the bill. Sources of funds were broadened: the act mandated creation of money market deposit accounts that could compete directly with money market mutual funds. The act also allowed federal, state, and local
governments to hold NOW accounts; allowed federally chartered S&Ls to offer demand deposits; and required the DIDC to abolish by 1984 any remaining Regulation Q differentials
(on maximum allowable rates on deposit accounts) between banks and thrifts. Federally
chartered S&Ls and savings banks were given additional powers—most significantly, the
power to invest up to 5 percent of their assets in commercial loans. S&Ls were also permitted to invest up to 30 percent of their assets in consumer loans, and were allowed to invest in state and local government revenue bonds.
Another significant element of the legislation, one promoted by the OCC, was revision of the rules on lending and borrowing by national banks.19 With respect to regulations
on loans to one borrower, national banks perceived themselves to be at a competitive disadvantage, for almost all state banking regulations provided more liberal rules than did national bank regulations.20 (Smaller rural banks claimed that the existing 10 percent limit had
forced them to turn down many loan applications, and in general an increase in the limit was
seen as a necessary tool in the increasingly competitive banking environment.)21 Garn–St
Germain increased the limit on loans to one borrower from 10 percent of a bank’s capital to
15 percent (for unsecured loans). The limit could be extended another 10 percent if the additional loans were secured by readily marketable capital.22

18

Public Law 97-320. For discussions of Garn–St Germain, see Cooper and Fraser, Banking Deregulation, 127–43; and
Gillian Garcia et al., “The Garn–St Germain Depository Institutions Act of 1982,” Federal Reserve Bank of Chicago Economic Perspectives 7, no. 2 (1983): 1–31.
19 See the statement of Comptroller of the Currency John Heimann before the Senate Committee on Banking, Housing and
Urban Affairs, April 28, 1981, reprinted in OCC Quarterly Journal, Special Anniversary Issue 1981–1991 (September
1992): 59. Heimann noted that the rigid loan-to-value ratios, the 30-year amortization requirement, and aggregate limitations on total real estate lending, construction lending, and second-lien real estate lending were at variance with evolving
market realities, and deterred national banks from engaging in prudent and profitable loans.
20 See Conference of State Bank Supervisors, A Profile of State-Chartered Banking (1981), 128–31.
21 Charles Lord before Senate Banking Committee, October 30, 1981, reprinted in OCC Quarterly Journal 1, no. 1 (1981):
58.
22 There was some concern among bankers that the OCC’s regulation interpreting the law would be overly restrictive in its definitions of loan aggregation, but when the final rules were issued, banks were not forced to automatically aggregate loans
to individuals with loans to corporations and affiliated subsidiaries in which the individual owned a majority interest, unless a “common-enterprise” test was met. For discussion of these issues, see Jay Rosenstein, “Banks Say Easing of Loan
Limits Being Frustrated,” American Banker (January 26, 1983), 2; Jay Rosenstein, “Comptroller Expected to Ease Proposed Loan Limit Formula,” American Banker (March 15, 1983), 1; and Lisa J. Mc Cue, “Comptroller Eases Rules on Loan
Limits,” American Banker (April 13, 1983), 1.

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Garn–St Germain also removed statutory restrictions on real estate lending by national banks, and gave the OCC the authority to set such rules in the future. The more significant of these restrictions had imposed maximum loan-to-value ratios for real estate
loans under certain conditions, had required that certain kinds of real estate loans provide
for amortization of the entire principal within 30 years, and had set aggregate limits on real
estate loans.23 In response to the removal of statutory restrictions, the OCC proposed a regulation that imposed no limitations on real estate loans. The agency believed the regulations
had hampered national banks’ ability to respond to changes in real estate markets, and believed also that decisions concerning national-bank lending were the responsibility of bank
management. National banks responded very positively to the proposed removal of the regulations, and the new rules became effective in September 1983.24 Many state laws continued to impose limits on commercial bank real estate loans; for national banks the new
regulation preempted such limits, which still applied to state-chartered banks.
At the strong urging of the regulatory agencies, the law also enhanced the powers of
the FDIC and the Federal Savings and Loan Insurance Corporation (FSLIC) to provide aid
to troubled institutions. The legislation gave regulators the authority to make a loan to a failing institution, make a deposit in such an institution, purchase its assets, purchase securities
it had issued, and assume its liabilities. One aspect of this authority provided for the purchase of net worth certificates from troubled institutions; these certificates would be
counted as capital by the regulators and would therefore allow the institutions to continue
operating until they could return to a sound condition. This authority was to last for three
years. In addition, the law sought to address problems (stemming from geographic barriers
to mergers and acquisitions) associated with locating acquirers for failing institutions. The
FDIC could now authorize emergency interstate acquisitions of closed commercial banks
or savings banks with assets over $500 million, as well as interstate mergers or takeovers of
mutual savings banks of that same size which were in danger of closing. The asset size restrictions, which did not apply to the FSLIC, stemmed from a desire to placate those who
saw the provision as an attack on the McFadden Act and Douglas Amendment, an attack designed (in their view) to lead to nationwide interstate banking.25

23

The regulations had also placed restrictions on loans secured by leaseholds and had set limitations on forest tract loans. See
12 CFR 7.2000–7.2700 (1983).
24 See Federal Register 48 (March 10, 1983), 10068, and Federal Register 48 (September 9, 1983), 40698. See also Laura L.
Mulcahy, “Key Restrictions Dropped on Real Estate Lending,” American Banker (September 12, 1983), 3; and Comptroller C. T. Conover’s statement on liberalization of real estate lending rules (OCC Quarterly Journal 1, no. 3 [1982]: 23).
25 Regulators also had to adhere to a set of priorities that, while keeping the insurance funds’ losses to a minimum, sought to
guarantee precedence in bidding to in-state institutions and same-type institutions. See Cooper and Fraser, Banking Deregulation, 132–33.

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Legislative Stalemate, 1982–1986
One element that had had to be dropped from Garn–St Germain as too controversial
was a provision to grant banks new powers to underwrite securities and deal in mutual
funds. The battle over new bank powers would dominate the legislative agenda for the next
five years. The contest over expanded powers involved all the varied interests attached to
the industry: individual institutions, industry associations, state banking agencies, and federal banking agencies. Fernand St Germain, chairman of the House Banking Committee—
perhaps forgetting that congressional opinion was hardly united—compared the debate
surrounding these issues to a “Tower of Babel–like cacophony of voices.”26 A recent analyst of the politics of the period succinctly described the process as gridlock.27
The Reagan administration strongly believed that product deregulation was necessary
if the banking industry was to be reformed, and Senator Jake Garn, who had become head
of the Senate Banking Committee by virtue of Republican control of the Senate, made expanded powers a priority during (and beyond) his tenure as chairman. Even so, congressional supporters of expanded powers and the administration did not always speak with one
voice.28 Moreover, there were powerful forces militating against such change. The securities, insurance, and real estate industries all objected to bank entry into their businesses and
mounted a considerable effort to thwart legislation that would permit it.29 In addition, the
banking industry itself was not united on these issues—the large money-center banks
tended to be more interested in acquiring new powers than smaller institutions were, a state
of affairs that made lobbying by bank trade associations rather complicated. Within Congress, some influential voices, arguing that new powers would inject too much risk into the
system, resisted tampering with Glass-Steagall’s separation between banking and com-

26

William S. Moorhead, “Issues in Coming Revolution in Banking Legislation,” American Banker (July 29, 1983), 4.
Reinicke, Banking, Politics and Global Finance, 57–90. Reinicke provides a detailed discussion of legislative attempts to
reform Glass-Steagall and argues that the period from 1980 to 1986 was one of mobilization but little effective action.
28 In 1982–84, for example, the Treasury wanted to insulate banks from risk by requiring that expanded powers be conducted
in subsidiaries of bank holding companies. See Banking Expansion Reporter 1, no. 8 (May 3, 1982): 2. Senator Garn, at
least initially, did not. This debate fed into one between the regulators: the FDIC thought that new powers ought to be conducted in bona fide subsidiaries of the banks, whereas the Federal Reserve was happier with the administration’s proposal—
except that that proposal initially called for the Securities and Exchange Commission to regulate securities subsidiaries of
the holding companies, a plan the Federal Reserve resisted.
29 The associations representing these industries also frequently pursued judicial remedies against regulatory decisions that
went against their interests. The Securities Industry Association, for example, attempted to overturn the FDIC ruling (see
note 31) that state nonmember banks were not bound by Glass-Steagall restrictions, but the attempt was ultimately unsuccessful.
27

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merce.30 Finally, the banking agencies, too, had differing ideas about how new powers
ought to be regulated, and this was all bound up with discussions about major reform of the
financial regulatory structure.31 Perhaps the best chance to legislate expanded powers occurred in 1984, when Garn piloted a somewhat less-ambitious bill through the Senate. The
collapse of Continental Illinois in that year, however, furnished ample ammunition to opponents of the legislation and ensured that the bill did not move through the House Banking Committee.32 All told, the situation was hardly conducive to decisive action, and a
comprehensive solution was never reached during the period through 1994.
The Competitive Equality Banking Act of 1987
Legislative inaction ended in 1987 with the passage of CEBA.33 The primary motive
behind passage was to aid the deteriorating FSLIC. CEBA provided $10.875 billion toward
recapitalization of the fund and created a forbearance program for certain “well-managed”
thrifts, as well as providing for stricter accounting, appraisal, reserve, and capital standards
for the thrift industry. Originally the bill was another piece of omnibus legislation that included expanded powers for commercial banks as a key provision. However, the continuing inability to find consensus on that issue resulted not only in the dropping of expanded
powers from the bill but also in the adoption of a six-month moratorium on the granting of
new powers in securities, insurance, and real estate by any of the federal banking agencies.
The short time limit was ostensibly to allow Congress to reconsider the issue and come to a
speedy decision. After the moratorium ended, both the Federal Reserve and the OCC would
increasingly grant banks entry into new areas. At the legislative level, however, the thrift
and bank crises would combine to make expanded powers a secondary matter for the remainder of the period.

30

The most notable defenders of Glass-Steagall were Senators John Heinz and William Proxmire and Representatives St Germain and John Dingell. Heinz tried to push for a moratorium on new powers in 1983; Proxmire was also against repeal of
Glass-Steagall for much of the period, although he had a change of heart and promoted such legislation in 1988. St Germain frequently tried to tie consumer provisions to new bank powers, and Dingell, chairman of the committee responsible
for the securities industry (the Energy and Commerce Committee), strongly opposed allowing banks to enter that business.
31 The FDIC, for example, ruled that state nonmember banks were not included within Glass-Steagall’s prohibitions, and allowed such banks to establish securities subsidiaries in 1982; it expanded those powers in subsequent rulings in May 1983
to allow banks to underwrite corporate securities. This ruling produced tensions between the FDIC and the Federal Reserve. Consolidation of the federal agencies had been discussed for many years and returned to the fore in 1984 with the
Bush Task Force. See Blueprint for Reform: The Report of the Task Group on Regulation of Financial Services (1984).
32 David S. Holland, “A Broad Banking Bill This Year? A Prediction,” Banking Expansion Reporter 3, no. 17 (September 3,
1984): 1.
33 Public Law 100-86. For a discussion of the law, see Stephen K. Huber, “The Competitive Equality Banking Act of 1987:
An Analysis and Critical Commentary,” Banking Law Journal 105, no. 4 (1988): 284–324.

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CEBA did resolve one of the main points of contention that had dogged the debate
over expanded powers, the “nonbank-bank” loophole. In 1970, under amendments made to
the Bank Holding Company Act, banks had been defined as entities that both accepted demand deposits and engaged in commercial lending.34 If the “bank” did only one or the other,
it was not a bank and so not subject to the applicable Federal Reserve regulation. The OCC
chartered the first nonbank bank in 1982 and was soon flooded with applications. Contemporary observers widely held that the loophole should be closed, although this view was not
shared by firms attempting to use nonbank banks as a vehicle for entering banking. The
nonbank banks were perfectly legal, however, and the Comptroller of the Currency, C. T.
Conover, sought to use the issue to push for wider deregulation of the industry.35 After a
self-imposed moratorium from April 1983 to November 1984, the OCC resumed chartering
nonbank banks and received more than 250 new applications within a few months.36 However, as we have seen, Congress was unable to come to a consensus on further deregulation.
The nonbank-bank issue might have languished in 1987 as well, but the needs of the FSLIC,
which had already been frustrated in 1986, helped carry CEBA through Congress. The law
created a new definition closing the loophole and placing restrictions on the activities of the
55 “grandfathered” nonbank banks.37
Most of the other provisions of CEBA can be summed up as efforts to encourage the
revival or acquisition of failed or failing institutions, whose numbers were by then reaching
truly alarming levels: 145 banks had failed in 1986, and in 1987 there promised to be many
more. The new law made permanent, and expanded, the emergency interstate acquisition
provisions originally adopted in Garn–St Germain.38 Significantly, not only failed banks but
also those in danger of failing became eligible for interstate acquisition. CEBA originated a
new category of troubled institution: a bank “in danger of closing.” When an insured bank’s
chartering agent made this determination, the bank became eligible for interstate acquisi34

Public Law 91-607.
Ross M. Robertson, The Comptroller and Bank Supervision (1995), 221.
36 David S. Holland, “Nonbank Banks: An Update,” Banking Expansion Reporter 5, no. 11 (June 2, 1986): 9.
37 Firms that owned nonbank banks that had been chartered before March 5, 1987, were allowed to continue operating them
without becoming bank holding companies, though they were not allowed to engage in expanded activities, offer products
or services of an affiliate not permitted under the Bank Holding Company Act, or increase their assets at an annual rate
greater than 7 percent. The new definition of bank included any institution insured by the FDIC, as well as any institution
that both accepted transaction accounts and made commercial loans. The definition excluded federally insured thrifts,
credit unions, certain trust companies, credit card banks under certain circumstances, and certain industrial banks. See Title I of CEBA. The Federal Reserve proposed regulations in 1988 under CEBA that were very harsh; in response to protests
from the firms involved, changes were made easing the way in which asset growth would be calculated and removing required divestiture as a penalty for regulatory violations. Strict limits on cross-marketing and product expansion remained.
See Barbara A. Rehm, “Fed Relaxes Restrictions on Nonbanks,” American Banker (September 7, 1988), 1; and Banking
Expansion Reporter 7, no. 21 (November 7, 1988): 15–17.
38 These had been scheduled to end in 1985, but Congress had renewed them several times until July 15, 1986, when they expired. The FDIC had pushed for further liberalization, notably the halving of the $500 million asset figure.
35

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tion. The FDIC’s authority to permit and assist large emergency interstate acquisitions was
expanded—either an entire bank holding company or a portion of it could be part of an interstate acquisition if a large bank subsidiary was in danger of closing. To facilitate such acquisitions, some state restrictions on subsequent branching by an out-of-state acquirer of a
failing bank were eliminated. The law also allowed the FDIC to create “bridge banks,” or
temporary national banks, for up to three years in order to deal with situations in which an
immediate acquisition could not be arranged but liquidation was problematic.39 The Net
Worth Certificate Program of Garn–St Germain was extended for five years.40
CEBA also provided a loan-loss amortization program for agricultural banks that had
assets of $100 million or less, that adopted a capital restoration plan, and that maintained
their percentage of agricultural lending. Such banks could amortize agricultural loan losses
incurred after December 31, 1983. As early as 1985, the Independent Bankers Association
of America had called for loan-loss deferrals for agricultural banks. Legislation proposed
during that year failed in the Senate and was superseded in 1986 by the regulatory capital
forbearance plans, but both bankers and some members of Congress questioned whether
regulators were genuinely seeking to grant that forbearance. All three federal banking agencies opposed loan-loss deferrals in 1987, likening them to “cooking the books” and legislating “water to run up hill,” but the program received enough support to pass.41
CEBA also contained consumer provisions dealing with expedited funds availability,
changed the laws governing the operation and regulation of credit unions, exempted the
federal banking agencies from certain provisions of the Anti-Deficiency and Gramm-Rudman-Hollings laws, and mandated a number of studies by the General Accounting Office
and the banking agencies. CEBA also stated that insured deposits were backed by the full
faith and credit of the United States. This had previously been articulated but never as part
of a statute, and therefore it had never been made binding on the United States.42

39

The notion of creating such entities was not new; it was included in FDIC-suggested legislation in 1983 (FDIC, Annual Report [1983], xi). The bridge-bank provisions were broadened under FIRREA in 1989. Under CEBA the FDIC could not
establish a bridge bank until an insured bank was closed, but under FIRREA, a bridge bank could also be established in anticipation of a failure. In 1989 there were other revisions to the bridge-bank provisions as well (see Gail and Norton, “A
Decade’s Journey,” 1148–49, and FIRREA §214).
40 Huber, “CEBA,” 303–8.
41 See Bartlett Naylor, “Senators Pledge Farm Bank Aid Hearings in ’86,” American Banker (December 5, 1985), 1; Jay
Rosenstein, “Banking Groups Appeal for Farm Lending Relief,” American Banker (February 7, 1986), 3; Paul Tosto, “Bills
Seek to Help Plight of Agricultural Banks,” American Banker, (February 4, 1987), 6; and Jay Rosenstein, “Federal Regulators Oppose Allowing Stretchout of Bad Farm Loans,” American Banker (April 3, 1987), 14. Relatively few banks were
enrolled in the program—never more than 50 at any one time. All of these banks were small, with average assets of approximately $25 million.
42 Huber, “CEBA,” 318.

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Although CEBA’s moratorium on new bank powers had been intended to provide time
to construct a legislative solution to that issue, Congress failed to act on new powers before
the moratorium ended. Not surprisingly, Glass-Steagall quickly returned to the fore in 1988
when a dramatic shift occurred in Congress: Senator Proxmire, who had long been reluctant
even to discuss repeal, now supported it. His bill to provide additional securities powers to
banks swiftly passed the Senate. In the House, St Germain eventually responded with a
more limited bill, but Dingell proposed an even more restrictive bill, and the combined
squabbles over provisions and turf meant that no legislation emerged from the House.
These developments pushed the decision-making process on Glass-Steagall issues from the
legislative to the regulatory and judicial arenas.43
The Financial Institutions Reform, Recovery, and Enforcement
Act of 1989
The S&L crisis absorbed congressional energies throughout 1989 and resulted in passage of a law—FIRREA—that significantly restructured the regulation of thrifts.44 The
statute abolished the FSLIC and replaced it with the Savings Association Insurance Fund
(SAIF), under separate FDIC management from the Bank Insurance Fund (BIF), also created by the law. Financial institutions’ ability to transfer from one insurance fund to the
other was restricted for five years, and was made subject to FDIC approval. The law also
created the FSLIC Resolution Fund and the Resolution Trust Corporation (RTC), under the
sole management of the FDIC, to handle former FSLIC institutions that were insolvent. (An
organizational restructuring in 1991 removed the RTC from FDIC management.)45 The
Federal Home Loan Bank Board (FHLBB) was abolished and a new thrift regulator, the Office of Thrift Supervision (OTS), was created within the Department of the Treasury to
oversee the industry.
FIRREA also imposed stricter accounting and other standards on thrifts: thrift capital
standards were required to be at least as stringent as those for national banks; thrifts were
required to adhere to national-bank limits on loans to one borrower and on transactions with

43

For a summary of S. 1886, the Proxmire Financial Modernization Act of 1988, see Banking Expansion Reporter 7, no. 8
(April 18, 1988): 8–10. Reinicke argues that beginning in 1987, even though Congress had failed to act, legislators increasingly believed that U.S. banks required new powers in order to compete in the globalized financial industry. Banking
regulators came to hold the same view, with Alan Greenspan replacing Paul Volcker as chairman of the Federal Reserve
Board. See Reinicke, Banking, Politics and Global Finance, 91–133.
44 Public Law 101-73. For a full discussion of the S&L crisis, see Chapter 4.
45 A provision in the Resolution Trust Corporation Refinancing, Restructuring and Improvement Act of 1991 displaced the
FDIC as sole manager of the RTC, abolished the RTC Board of Directors, and created the office of CEO of the RTC as well
as an executive committee made up of four senior vice presidents. See RTC, Annual Report (1991), 2.

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affiliates; limits were imposed on the activities of state-chartered thrifts; the use of brokered
deposits was restricted; and investments in junk bonds were prohibited. 46
In addition, some significant aspects of FIRREA applied to commercial banks. The
Deposit Insurance Fund was dissolved and its assets and liabilities transferred to the Bank
Insurance Fund under FDIC management. The law mandated that BIF levels had to be increased until the ratio of the fund to total insured deposits reached 1.25 percent. The reserve
ratio was to be maintained at that level thereafter unless the FDIC Board of Directors determined that potential risks required a higher level, to a maximum of 1.5 percent. FIRREA
enacted a schedule of rising BIF assessment rates that would move assessments from 8.3
basis points to 15 basis points by January 1, 1991. The FDIC Board of Directors could not
raise the assessment rate above 15 basis points before 1995 unless either the reserve ratio
failed to rise during any given year or the agency projected that the BIF would first reach
the designated reserve ratio at some time before 1995. After that time, the Board could raise
assessment rates above the statutory rate if the reserve ratio was expected to drop below
1.25 percent.47
An important element of FIRREA was its cross-guarantee provisions. These were intended to protect the deposit insurance funds by establishing that insured financial institutions were liable for losses incurred by the FDIC (and for losses that the FDIC reasonably
anticipates incurring) in connection with either (1) the default of a commonly controlled insured depository institution or (2) any assistance provided by the FDIC to any commonly
controlled depository institution in danger of default. For example, healthy affiliates of a
bank holding company (BHC) that controlled a failed institution could be required to pay
a share of the loss incurred by the FDIC in resolving the failed institution. The crossguarantee provisions applied to institutions controlled by the same BHC, or to one depository institution controlled by another. The FDIC could waive this liability if it determined
that waiver was in the best interest of the BIF or the SAIF.48
FIRREA significantly expanded the enforcement authority of banking regulators. The
FDIC was given authority to terminate insured banks’ insurance coverage more quickly,
and to suspend temporarily the deposit insurance of a bank with no tangible capital. Regulators’ cease-and-desist (C&D) authority was extended to cover specific bank activities.
Temporary C&Ds could be issued to restrict an insured bank’s growth. Temporary C&Ds
could also be issued if regulators concluded an activity would result in “significant” damage
46

Boston University School of Law, Annual Review of Banking Law 9 (1990): 2–31. FIRREA, of course, had many other elements. For a guide to monographs and articles discussing the law, see Office of Thrift Supervision, Financial Institutions
Reform, Recovery, and Enforcement Act of 1989: Bibliography (1993).
47 See FIRREA, §208.
48 See FIRREA, §206.

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to bank assets or earnings, or if bank records were too incomplete to allow determination of
its financial condition. The law also greatly increased the civil money penalties that could
be imposed on federally insured banks. The statute also required banks that could not meet
capital adequacy requirements to obtain FDIC approval before accepting brokered deposits.
Finally, FIRREA required each federal banking agency and the RTC to establish real estate
appraisal standards and created an Appraisal Subcommittee (under the Federal Financial Institutions Examination Council) to set those standards.49
The Federal Deposit Insurance Corporation Improvement Act of 1991
As Congress dealt with the thrift crisis, the number of bank failures remained at a high
level and put increasing strain on the BIF. By 1990 it was clear that the fund needed to be
replenished. In the aftermath of the S&L disaster, the political climate was such that Congress was intent on finding ways to make the U.S. financial system more stable. In 1991 the
Bush administration put forward a wide-ranging plan that would reform the deposit insurance system, provide for increased supervision of and intervention in undercapitalized
banks, limit states’ ability to authorize banking powers, consolidate the regulatory structure,
allow nationwide interstate banking, give new powers to commercial banks, and permit
cross-ownership in the financial industry.50 Many of these supervisory and regulatory issues
were endorsed in bills sponsored by the House and Senate Banking Committee chairmen,
Henry Gonzalez and Donald Riegle.51 However, the idea of giving banks new powers was
not met with great enthusiasm. Gonzalez said that given the problems with the BIF, he did
not believe new powers had the same priority as reform of deposit insurance. The S&L
bailout was embedded in political memory. Gonzalez noted, “People would say, ‘That’s
what you did with the S&Ls.’ ” In the midst of the debate, one lobbyist remarked that members of Congress were concerned that any banking legislation with the word “deregulation”
attached to it would “come back . . . to bite them.”52
The combination of the specter of the S&L debacle plus the usual disputes that accompanied banking legislation doomed much of the administration’s plan as well as the alternatives offered by Congress. None of the more drastic proposals for limits on deposit
49

KPMG Peat Marwick, Financial Institutions Reform, Recovery, and Enforcement Act of 1989: Implications for the Industry (1989), 1-7ff, 21-3. Many of these provisions also applied to savings banks (see chapter 3 in same).
50 Robert M. Garsson, “Treasury Treads Easy on ‘Too Big to Fail,’ ” American Banker (February 6, 1991), 1.
51 Robert M. Garsson, “Gonzalez Unveils Insurance Plan,” American Banker, (January 4, 1991), 2; and Robert Trigaux,
“Early Rescues Gaining Favor But Banks Wary,” American Banker (January 25, 1991), 1. The Gonzalez bill called for a
new independent bank regulator, early intervention into troubled banks, limits on deposit insurance to $100,000 in all accounts, the end of the regulators’ “too-big-to-fail” policy, limits on state powers, and risk-based deposit insurance premiums. Riegle’s bill had similar components and advocated strong and early regulatory intervention into institutions that fell
below minimum capital requirements.
52 Robert M. Garsson, “Bush Bill Passes Test, But Margin Only 3 to 2,” American Banker (July 1, 1991), 1.

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insurance for individuals proved politically viable.53 It remained difficult to get agreement
on the creation of a new regulatory structure. And many of the other provisions in the Treasury plan (including expanded powers and removal of the separation between banking and
commerce) were opposed by one interest group or another. After several months of legislative bargaining, the banking lobby began to fear passage of a law that would repeal GlassSteagall but simultaneously take away securities and insurance powers that banks already
had. After the administration plan was rejected, the lack of consensus coupled with the need
to recapitalize the BIF led Congress to abandon attempts to achieve structural reform of the
industry. Nevertheless, FDICIA54 resulted in significant regulatory change.
FDICIA increased sixfold the FDIC’s authority to borrow from the Treasury to cover
insurance losses, raising it from $5 billion to $30 billion. Any borrowing was to be repaid
through deposit insurance assessments. The FDIC was also authorized to borrow funds on
a short-term basis for working capital, the borrowing to be repaid by sales of assets acquired
from failing institutions. In addition, the law provided that the BIF was to achieve its designated reserve ratio of $1.25 per $100 of insured deposits within 15 years, and that the
SAIF’s capitalization was to occur within a “reasonable” period of time.
Aside from providing for the necessary recapitalization, FDICIA was above all a supervisory law, created in a climate shaped by the S&L bailout, the ongoing crisis in commercial banking, and a belief that both had occurred because the supervisory system had
failed to act swiftly enough to head off problems. The provision of FDICIA that most reflected this belief was prompt corrective action. The law required the federal banking agencies to develop five categories of capitalization for institutions, with a ladder extending from
“well capitalized” to “critically undercapitalized.” As an institution’s capital ratio dropped
down the ladder, the regulator was required to take increasingly severe action, ranging from
restricting certain activities to closing institutions that remained critically undercapitalized.
In response to the belief that on-site examinations were an integral part of ensuring
safe operation, federal regulators were required to conduct annual safety-and-soundness examinations of all insured institutions.55 In addition, FDICIA required each institution with
more than $150 million in assets to provide its regulator with an annual financial statement
audited by an independent public accountant. The federal bank and thrift agencies were required to create safety-and-soundness standards in three areas: operations and management;
53

Measures that would have limited insurance to $100,000 per individual per institution, and that would have limited insurance to $100,000 per individual per institution with another $100,000 coverage on an Individual Retirement Account, were
both defeated. A move to end pass-through insurance coverage for large accounts opened by pension funds also failed. See
Garsson, “Bush Bill Passes Test,” 1.
54 Public Law 102-242.
55 Healthy institutions with less than $100 million in assets could be examined every 18 months. Federal regulators were permitted to alternate their examinations with those of state regulators.

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asset quality, earnings, and stock valuation; and employee compensation. The agencies were
also required to revise their risk-based capital standards to account for interest-rate risk.
In a reaction to the obvious fact that real estate had been causing banks problems since
the mid-1980s, the law mandated the adoption of uniform standards for real estate lending
by insured depository institutions. The law also addressed the issue of states granting powers to banks: insured state-chartered banks could no longer engage in activities not permitted to national banks unless the bank met regulatory capital standards and the FDIC
determined that the activity would not pose a risk to the insurance fund. FDICIA also placed
new restrictions on the use of brokered deposits. These restrictions built on the ones in FIRREA but now were based on the capital position of institutions. Undercapitalized institutions were no longer allowed to accept brokered deposits and were subject to interest-rate
limits on deposits solicited directly from the public. Adequately capitalized institutions
could accept brokered deposits but only with FDIC permission; they, too, were subject to
interest-rate limits. Well-capitalized institutions could operate without restriction.
Deposit insurance reform was enacted as well. Most significantly, the long-discussed
system of risk-based premiums was required to be in place by 1994.56 Although the more
draconian attempts to roll back deposit insurance for individuals were removed before the
bill was passed, the law did require the FDIC to aggregate an individual’s interests in all
IRAs, Keogh Plans, and some other pension accounts and insure only the total up to
$100,000. FDICIA therefore contained some reduction in deposit insurance coverage.
FDICIA had many other provisions, and one of the most important of these sought to
limit the “too-big-to-fail” policy. The FDIC was now made to use the least-cost alternative
in resolutions unless it was decided—with the agreement of a two-thirds majority each of
the FDIC Board of Directors and the Board of Governors of the Federal Reserve, and the
agreement of the secretary of the treasury (in consultation with the president)—that the failure of an institution constituted systemic risk. In addition, FDICIA established a relationship between a bank’s capitalization and the Federal Reserve’s ability to provide assistance
through the discount window: for critically undercapitalized banks, the Federal Reserve
would have to demand repayment within no more than five days, and if that limit were vio-

56

The use of risk-based premiums had been discussed for many years, but regulators were faced with finding a system that
accurately assessed risk (see FDIC, Deposit Insurance in a Changing Environment [1983], appendix A). In 1984 the Bush
Task Force endorsed their use provided this could be done, and in 1984–85 the FDIC supported their use, but they were not
adopted. See Blueprint for Reform (1984), 83; FDIC, Annual Report (1984), xvi, and Annual Report (1985), xvi; and
Bartlett Naylor, “Risk-Based Deposit Insurance Idea Comes under Fire at Senate Hearing,” American Banker (July 24,
1985), 1. As an alternative, the FDIC (in a 1984 bill sent to Congress) suggested that assessment rebates be related to risk.
See the Federal Deposit Insurance Improvements Act of 1984, reproduced in Washington Financial Reports 42, no. 22
(May 28, 1984): 932.

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lated the Federal Reserve would be liable for increased costs to the FDIC.57 A decision by
the FDIC to act in the Federal Reserve’s stead by providing open-bank assistance might
have rendered this provision less substantial. However, this avenue was essentially closed
by the Resolution Trust Corporation Completion Act of 1993, which effectively prohibited—unless the systemic-risk exception had been invoked—the use of BIF or SAIF funds
to benefit the shareholders of insured depository institutions, a likely outcome of FDIC
open-bank assistance.58
Banking legislation traveled a long road between 1980 and 1991. Deregulation
marked the beginning of that road and was perceived as a way to create a more stable and
profitable banking system. Deregulation continued to stretch across the entire period. In
1991, the Bush administration’s plan sought to address issues the legislative process had
left unanswered since the early 1980s. But the climate in 1991, instead of leading to another
stalemate over new powers, compelled Congress to mandate a less-discretionary system of
supervision. Deregulation was by no means dead, but many feared that the banking crisis
would continue. Thus, the notion that deregulation did not mean “de-supervision” was—at
least at that time—very powerful.

Regulation
Regulatory policies set by the federal banking agencies, often but not always in conjunction with legislative changes, were also important to the banking environment from
1980 to 1994. Five of the most significant issues were entry, capital adequacy, regulatory
forbearance, brokered deposits, and expanded powers.59 Although very different in nature,
the regulations and proposed regulations in these areas for the most part reflected the need
to support the safety and soundness of both individual institutions and the industry as a
whole in the changing financial environment. (Regulatory forbearance does not readily fit
this description but was an important corollary to the imposition of capital adequacy standards—and it illustrates how regulatory policy could pursue conflicting strategies at the
same time.) Most of the regulations issued or proposed in all these areas can be viewed as
a regulatory response to deregulation. The fact that the restrictions on brokered deposits and
on expanded powers were ultimately not adopted by the agencies but were later incorpo-

57

Larry D. Wall, “Too-Big-to-Fail after FDICIA,” Federal Reserve Bank of Atlanta Economic Review 78, no. 1 (January/
February 1993): 1–2. See also Chapters 1 and 7.
58 Public Law 103-204, §11.
59 This discussion surveys only some of the most important regulatory issues and is not meant to provide a comprehensive history of the large volume of regulation from 1980 through 1994.

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rated in FIRREA and FDICIA illustrates the changing times: deregulation remained strong
in the mid-1980s but by the end of the decade that strength was considerably diminished.
Regulators, of course, acted on many other fronts, such as insider transactions and
management interlocks. They responded to innovations in banking practice; for example,
they created a regulatory definition of highly leveraged transactions and implemented
guidelines for examiners in their evaluations of leveraged-buyout loan portfolios.60 As Congress intended when it created the Federal Financial Institutions Examination Council
(FFIEC) in 1978, regulators used this organization as a vehicle for developing uniform regulatory changes across the various agencies.61 The FFIEC, whose membership includes all
the banking regulators, facilitated major revisions to Call Reports (the information banks
were asked to provide grew steadily in both volume and complexity). Moreover, the regulators often responded to industry concerns about regulatory burden by abolishing and simplifying many regulatory requirements and streamlining the various application processes.
Entry
Regulation begins at an institution’s point of entry into commercial banking. Among
the federal regulators, only the OCC serves as a chartering agent, setting entry policy for all
national banks. All other commercial banks, whether they become members of the Federal
Reserve System or not, are chartered by the individual state banking authorities. Chartering
authorities at both national and state levels seek to determine a proposed bank’s potential
for successful operation. Making this assessment generally involves examining the bank’s
capital adequacy, the character and experience of its proposed management, its ability to attain a certain level of profitability, and the role of the bank in its community. There were,
however, variations among state requirements, and there were also differences between
states and the OCC.
The most striking policy shift in chartering occurred at the very beginning of the period under consideration. In 1980 the OCC, partly in response to congressional criticism,
significantly changed its chartering policy, focusing more on the organizing group and its
operating plan and less on the ability of a community to support another bank. The new policy stated that a competitive marketplace would promote a more sound banking system that
better served the consumer. The OCC would therefore “foster competition through the chartering of national banks.”62 This led to an immediate and substantial increase in new na-

60

FDIC, Annual Report (1990), 22
The FFIEC was created by Title X of FIRIRCA and came into existence on March 10, 1979. See Robert J. Lawrence, Origin and Development of the Examination Council (1992), 15.
62 12 CFR 5.20(c).
61

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tional bank charters, an increase that lasted into the mid-1980s (see figure 2.1).63 During the
1970s the OCC had approved an average of 58 percent of new bank applications each year.
In the 1980s this rose to 89 percent.64 In addition, the previous policy on applications had
provided for much of the application material to be available to the public, for public comment and, potentially, for a hearing on the application; after 1980 this no longer obtained.65
National bank chartering decreased in 1985 as economic decline and bank failures began to plague the Southwest, and rolling regional banking problems continued for the remainder of the period. Chartering at the state level showed no real trend during most of the
1980s but fluctuated within a fairly narrow range. State bank charters did decline steadily
after 1988 and were especially low from 1992 through 1994 (figure 2.1).
The boom in Texas in the early 1980s had led to a situation in which, as one Houston
banker noted, “Everyone who has two nickels to rub together is opening a bank or trying
to.”66 Most of the new banks in Texas were national banks chartered under the new policy,
and this aroused some concern. A national-bank president remarked in 1983 that the OCC
policy “needs to be looked at . . . with the changes brought about by deregulation, I don’t
think everybody’s going to survive. There are going to be fatalities.”67 Later that year it was
reported in the press that the OCC, after finding that many newly chartered banks had
quickly become problem institutions, was planning to tighten its chartering policy. Michael
Mancusi, senior deputy comptroller for national operations, noted that more than a third of
the national banks chartered in California in the previous two years were “receiving a high
degree of attention” from the agency.68
In 1985 the OCC began to require of most groups applying to form a new bank that
they designate their CEO before charter approval; in the following year, the agency required
statements on formal lending policies and funds-management strategies. Even so, the OCC
chartering policy continued to generate criticism, with some observers suggesting that the
agency would approve applications regardless of ability, capital, or the community’s eco63

Eugene N. White, The Comptroller and the Transformation of American Banking, 1960–1990 (1992), 53–54. For congressional criticism of the previous policy, see U.S. Senate Committee on Banking, Housing, and Urban Affairs, Majority
Staff Study on Chartering of National Banks: 1970–1977, 96th Cong., 2d sess., 1980, 4. Even before the Senate document
was released, however, the agency was considering a new policy to provide greater freedom of entry (Majority Staff Study,
73). In 1978–79, before the formal policy change, the proportion of approvals of new bank applications rose significantly
(White, 88). For a discussion of chartering policy at the OCC, see OCC, Major Issues Affecting the Financial Services Industry (1988), 157–60. See also Bernard Shull, “Interstate Banking and Antitrust Laws: History of Public Policies to Promote Banking Competition,” Contemporary Policy Issues 6, no. 2 (1988): 34–37.
64 White, Comptroller, 88.
65 See 12 CFR 5.3 (1979).
66 Phillip L. Zweig, “37 Bank Openings in Texas This Month to Set Record,” American Banker (January 4, 1983), 1.
67 Ibid., 6.
68 Jay Rosenstein, “Comptroller May Tighten Chartering Process,” American Banker (October 12, 1983), 3.

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nomic need. In 1988 FDIC Chairman L. William Seidman called the policy “shortsighted”
because many of the new banks were failing at significant cost. The OCC defended its policy, saying it required the agency to “strike a proper balance between procompetitive entry
Figure 2.1

Newly Chartered Banks:
United States, Texas, California, and Florida, 1980–1994
Number

A. United States

B. Texas

Number

375
125
300

100

225

75

150

50

75

25
0

0

1980 1982 1984 1986 1988 1990 1992 1994

1980 1982 1984 1986 1988 1990 1992 1994
Number

C. California

Number

60

40

45

30

30

20

15

10

D. Florida

0

0
1980 1982 1984 1986 1988 1990 1992 1994

OCC-Chartered Banks

108

1980 1982 1984 1986 1988 1990 1992 1994

State-Chartered Banks

Total

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and ‘a reasonable likelihood of a proposed bank’s success.’ ” The agency did note in 1989
that a disproportionate number of new national banks had come under special supervision,
but it attributed this largely to the economic downturn in the Southwest, where more than
51 percent of national banks chartered between 1980 and 1987 were located. Comptroller
Robert Clarke argued that any attempt to revise chartering standards to make them less
“procompetitive” would be harmful.69
The criteria by which state banking authorities evaluated charter applications were
very similar to those used by the OCC, except that state banking codes often contained an
additional element. In Texas, for example, applicants had to establish the existence of a public necessity for the proposed bank, and a public hearing on the application was normally
held. In both California and Florida the “public convenience and advantage” were to be assessed, as well as the community’s ability to support the bank.70 Such additional elements
did not necessarily mean a huge gulf between national and state chartering standards. The
criteria were subjective, and state banking authorities had a good deal of discretion. Nevertheless, it was remarked that the OCC’s new policy made Texas state charters seem relatively harder to obtain.71 The volume of national versus state charters in that state during the
early 1980s appears to bear this out (figure 2.1). California presented a somewhat different
picture. Whereas state charters accounted for approximately two-thirds of the charters in
California during 1980–81, during the next four years national bank charters dominated,
with state charters reduced to approximately one-third of all charters in the state (figure
2.1). Florida provided yet another pattern. Again, national bank charters increased during
the early 1980s, but state charters rose as well, surpassing national charters by 1984 (figure
2.1). These three states are not necessarily representative, but from 1980 to 1994 they did
account for 29 percent of all state charters and 59 percent of all national bank charters. It is
clear that the OCC’s change in policy had a very significant effect on national bank chartering during the 1980s, but national charters certainly did not uniformly replace state charters as the vehicle of choice for new banks.
The FDIC had no direct role in chartering; however, in its role as insurer it had a significant effect on state chartering decisions. New institutions were seldom deemed viable
without federal deposit insurance, and a state was extremely unlikely to grant a commercial
bank charter without the FDIC’s approval of the bank’s application for insurance.72 The
69

Barbara A. Rehm, “Charter Curbs Seen Hurting Competition,” American Banker (April 11, 1989), 2. OCC, Major Issues
(1989), 157–60.
70 See TEX. REV. CIV. STAT. ANN Banks and Banking §342–305 (West, 1991); CAL. Financial Code §361(2–5) (West,
1992); and FLA. STAT. ANN. §658.20–21 (West, 1986, 1991).
71 Zweig, “37 Bank Openings,” 5.
72 The requirement for FDIC insurance was sometimes a legal one—see, for example, FLA. STAT. ANN. Title 38, §658.22.
Almost no uninsured commercial banks were chartered during the period considered by this study.

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FDIC’s evaluation of deposit insurance applications for state nonmember banks, like the
charterers’ evaluation of charter applications, covered capital structure, future earnings
prospects, management, and the needs of the community to be served. In 1980, the FDIC
adopted a policy stating that initial capitalization should be sufficient to provide a ratio of
unimpaired capital to total estimated assets of 10 percent after three years; applicants with
less than $750,000 in initial capital were discouraged. This minimum initial net capital requirement was later raised to $1 million and then, in 1992, to $2 million. Starting in 1992,
initial capital was to be sufficient to provide a ratio of Tier 1 capital73 to total estimated assets of at least 8 percent after three years.74 These requirements would have effectively superseded any more-lenient state regulations on capital.75 National banks and state member
banks received insurance as a matter of law, upon FDIC receipt of certification by either the
OCC or the Federal Reserve. FIRREA in 1989 authorized the FDIC to comment on applications to the other federal banking agencies, and FDICIA in 1991 required all institutions
seeking federal deposit insurance to apply formally to the FDIC for coverage.76
Capital Adequacy
The trend toward deregulation in the 1980s reinforced regulators’ belief that some
level of capital was necessary to maintain the safety and soundness of banking. Capital was
variously viewed as a cushion against unforeseen losses, a means to enhance public confidence in banking institutions, a way to foster prudent growth, and a protection for depositors. There was, however, much debate over what the level should be and what mechanism
should be used in setting it.77 During the 1970s the federal banking agencies’ approach to
evaluating capital adequacy had been to create bank peer groups, set target capital ratios for

73

For the definition of Tier 1 capital, see discussion of capital adequacy below.
FDIC Statement of Policy, March 31, 1980; Federal Register 57 (April 13, 1992), 12882. The FDIC clarified the guidelines for granting insurance to operating institutions in 1987 (see FDIC Statement of Policy, May 28, 1987; Federal Register 52 [June 9, 1987], 21736).
75 State requirements on minimum capital varied widely and often depended on the population of the area being served. In
addition, state banking authorities often had the discretion to set whatever capital levels were deemed appropriate. In 1985,
statutory state capital requirements ranged from $25,000 in some states (for banks in rural areas) to $1.5 million. By 1989,
the range was from $25,000 to $4 million (Conference of State Bank Supervisors, A Profile of State-Chartered Banking
[1986], 107–8, and [1990], 137–41).
76 See 12 U.S. Code 1814; FIRREA, §205 (2)(b)(A), states: “Any application or notice for membership or to commence or resume business shall be promptly provided by the appropriate Federal banking agency to the Corporation and the Corporation shall have a reasonable period of time to provide comments on such application or notice. Any comments submitted
by the Corporation . . . shall be considered by such agency.” For the requirement to apply for insurance, see FDICIA §115,
which amends §5 of the Federal Deposit Insurance Act [12 U. S. Code 1815(a)].
77 For a more detailed discussion of the politics of the debate over capital adequacy during the 1980s, see Reinicke, Banking,
Politics and Global Finance, 134–57.
74

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each group, and then adjust those targets according to the situations of individual institutions.78 There were no specific minimum capital requirements. But bank capital levels
steadily declined during the decade, mostly because of decreased capital at the nation’s
largest banks.79 In addition, several large banks failed, with attendant costs to the FDIC. The
combination of declining capital levels and large-bank failures exacerbated both regulatory
and congressional anxiety, and prompted the regulators to explore new approaches to capital adequacy. First and foremost was the need to create a mandatory capital ratio. This need
was formalized by the establishment, in 1979, of an FFIEC task force to study the issues
and move toward a uniform legal definition of capital.80 But the banking industry resisted
moves to raise and codify capital requirements, and—partly as a result—in 1980 the OCC
backed away from deciding to tighten its own legal definition of capital.81
One of the most contentious issues was the role of subordinated debt, which banks had
increasingly used from the late 1960s onward to prop up declining capital levels.82 The
FFIEC proposed guidelines dividing capital into primary capital, which was characterized
by its permanence, and secondary capital, which included subordinated debt. Primary capital would include common and perpetual preferred stock, surplus, undivided profits, contingency and other capital reserves, mandatory convertible instruments, and loan-loss
reserves. Secondary capital would include limited-life preferred stock, and subordinated
notes and debentures.83 The FFIEC eventually decided to include secondary capital in the
definition of what would constitute regulatory capital, but average maturities would have to
be at least seven years, and secondary capital would be limited (for regulatory purposes) to
50 percent of primary capital. For determining capital adequacy, banks would be placed
into one of three groups, depending on their size. The FDIC, however, held that since subordinated debt cannot be used to absorb unanticipated losses, it ought to be excluded, and

78

Each agency used its own categories and measurements, however. See Arnold A. Heggestad and B. Frank King, “Regulation of Bank Capital: An Evaluation,” Federal Reserve Bank of Atlanta Economic Review 67, no. 3 (1982): 38–39.
79 See FFIEC, Capital Trends in Federally Regulated Financial Institutions (1980), 2–5.
80 FFIEC, Annual Report (1979), 12.
81 The most significant change being contemplated by the OCC was the removal of subordinated debt and loan-loss reserves
from the statutory definition of capital. See Teresa Carson, “CofC May Trim Definition of Capital, Lift Loan Limits,” American Banker (July 24, 1980), 1; and Jay Rosenstein, “Comptroller’s New Definition of Capital Is Viewed by Banks as Too
Restrictive,” American Banker (September 28, 1980), 3. In fact, the OCC announced that it would ease capital requirements for small banks and would count 100 percent of loan-loss reserves as capital for all national banks, as opposed to 50
percent (James Rubenstein, “Comptroller Eases Capital Rules for Small, Well-Managed Banks,” American Banker [March
26, 1981], 1).
82 James G. Ehlen, “A Review of Bank Capital and Its Adequacy,” Federal Reserve Bank of Atlanta Economic Review 68, no.
11 (1983): 54.
83 Federal Register 46 (June 23, 1981), 32498.

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voted against sending the proposal to the agencies. Its Board of Directors eventually rejected both the proposal and, for the time being, uniform capital guidelines.84
In 1981 the Federal Reserve Board and the Comptroller of the Currency adopted a set
of guidelines on capital ratios that mirrored most of the FFIEC proposals. Banks were divided into three groups on the basis of asset size: multinational, regional, and community.
The multinationals—the 17 largest banks—would be treated individually and had no mandated capital requirements but were expected to reverse the decline in their capital positions. The implication was that if multinationals did not significantly better their capital
levels, regulators would establish numerical standards.85 For regional banks (assets between $1 billion and $15 billion), explicit ratio guidelines were set: these banks were expected to operate above a primary-capital-to-assets ratio of 5 percent. Community banks
(assets below $1 billion) were expected to maintain a ratio of at least 6 percent. In addition,
banks were divided into three supervisory zones according to their total-capital-to-assets ratios. Multinational and regional banks with a ratio of 6.5 percent were designated “adequately capitalized,” those between 5.5 and 6.5 percent were “possibly undercapitalized,”
and those below 5.5 percent were “presumed undercapitalized.” Community banks were
ranked similarly, but with ratios set half a percentage higher. Banks that fell into the two
lower zones would receive increasingly greater supervisory attention and would have to
submit plans to rebuild their capital positions.86
The FDIC, still stressing the importance of equity capital, adopted more-stringent
guidelines on capital adequacy. It used a single measure—the ratio of adjusted equity capital to adjusted total assets—and set a 6 percent threshold for all state nonmember banks regardless of size. Chairman William Isaac noted that the agency’s position against counting
limited-life instruments toward capital adequacy had long been known and that it was unfair to vary requirements depending on size, as smaller banks had urged for some time.87
For all banks, the FDIC also set a minimum acceptable ratio of 5 percent. Any institution
falling below this level was to initiate a specific program to remedy the capital deficiency.88
Since most FDIC-supervised institutions had assets under $1 billion, capital adequacy regulation was in fact more consistent than might have appeared on the surface. Thus, a sub-

84

Lawrence, Examination Council, 17; Jay Rosenstein, “Exam Council Gives Views on Capital,” American Banker (November 12, 1981), 1; and Phil Battey, “Regulators Fail on Uniform Bank Capital Policy,” American Banker (December 18,
1981), 1.
85 Reinicke, Banking, Politics and Global Finance, 140.
86 Heggestad and King, “Regulation of Bank Capital,” 39. For the OCC’s view on capital adequacy at this time, see statement
of Comptroller John Heimann before the Senate Banking Committee in April 1981, reproduced in OCC Quarterly Journal,
pilot issue (1981): 37.
87 Battey, “Regulators Fail,” 20.
88 See FDIC Statement of Policy on Capital, PR-86-81 (December 17, 1981).

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stantial amount of codification had been achieved, even though significant differences remained.
The less-developed-country debt crisis provoked the next significant change in capital regulation in 1983.89 The crisis had created great anxiety about the condition of both
U.S. money-center banks and the banking system as a whole.90 During the debate over how
to deal with the situation, many in Congress came to believe that the adverse effects on the
U.S. economy would have been mitigated if the regulators had imposed more rigorous capital standards on multinational banks. Initially neither the OCC nor the Federal Reserve had
indicated a desire to change its capital regulation, and the joint program that the three agencies presented to enhance the supervision of international lending did not address capital
adequacy.91 Legislators held not only the regulators but also the banks responsible for the
crisis, and the industry’s resistance to increased supervision of international lending only
strengthened the legislators’ resolve to stiffen capital standards.
In 1983 the OCC’s authority to impose explicit capital requirements was challenged
in court; the case helped overcome the agencies’ reluctance to accept stronger capital standards. Eventually, the International Lending Supervision Act of 1983 directed each agency
to ensure that all banking institutions maintained adequate capital levels, and failure to do
so was made an unsafe and unsound practice.92 Even before the law passed, the Federal Reserve and the OCC set minimum capital levels for multinational banks at the same level as
for regionals.93
The agencies had also committed themselves to working toward uniform capital standards, and in 1984 each agency published new proposals. The FDIC and OCC plans were
very similar, and set the minimum primary-capital-to-assets ratio for all well-run banks at
5.5 percent, and the minimum total capital ratio at 6 percent. The Federal Reserve Board’s
proposal retained the then-current zone concept with regard to total capital levels but set the
same minimum primary-capital ratio for all institutions—5.5 percent. Even as these proposals were being discussed, the FDIC was pressing to phase in a much higher total capital
ratio of 9 percent, in a combination of a minimum 6 percent equity and up to 3 percent subordinated debt. Chairman Isaac argued not only that this would provide greater cushions for
institutions but also that sophisticated debt holders would impose greater discipline on

89

This discussion is based on Reinicke, Banking, Politics and Global Finance, 142–49.
On the LDC crisis, see Chapter 5.
91 For the proposed program, see Banking Expansion Reporter 2, no. 9 (May 2, 1983): 5.
92 For a detailed discussion of the law, see Cynthia C. Lichtenstein, “The U.S. Response to the International Debt Crisis: The
International Lending Supervision Act of 1983,” Virginia Journal of International Law 25, no. 2 (1985): 401–35.
93 Whereas the OCC imposed regulations, the Federal Reserve Board continued its approach of issuing only guidelines (Banking Expansion Reporter 2, no. 12 [June 20, 1983]: 11).
90

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banks. Federal Reserve Board Chairman Paul Volcker endorsed the plan, as did a Treasury
Department proposal, but it was never acted upon.94 When the final rules were announced
in 1985, the FDIC and OCC regulations were based largely on their proposals, and the Federal Reserve, while keeping the capital zones for supervisory use, also implemented minimums of 5.5 percent primary- and 6 percent total-capital ratios.95 All the agencies also
issued regulations concerning capital directives. Substantial uniformity had been achieved
not only between the agencies but also with respect to banking institutions regardless of asset size.
Even as the banking agencies were making the new rules final, all the regulators were
pronouncing them insufficient.96 The imposition of enforceable capital ratios had motivated
banks to expand off-balance-sheet activities, such as letters of credit, loan commitments,
and interest-rate and currency swaps: such activities incurred risk but did not have to be
backed by capital. One study noted that during the first half of 1985, the inclusion of
standby letters of credit into bank assets would have decreased the primary-capital ratio
among 12 money-center banks by approximately 11 percent.97 Regulators were concerned
that these activities could injure liquidity and undermine safety and soundness, and they
quickly undertook development of risk-based capital standards. These focused on credit
risk, and would link capital requirements to the riskiness of bank activities.98 Off-balance-

94

Robert Trigaux, “Isaac, in a Shift, Warns Convention on Nationalization,” American Banker (October 23, 1984), 45;
William Isaac, “Brief Comment,” American Banker (January 17, 1985), 4; Bartlett Naylor, “Volcker to Propose Risk-Based
Capital Rule,” American Banker (September 12, 1985), 1; and Maggie McComas, “More Capital Won’t Cure What Ails
Banks,” Fortune (January 7, 1985), available: LEXIS, Library: NEWS, File: FORTUN. Industry observers viewed the proposal as a “fishing-expedition” move toward some form of stricter capital standards (Richard S. Vokey and Kevin L.
Kearns, “Issues in Capital Adequacy Regulation,” Bankers Magazine 168, no. 5 [1985]: 40).
95 Banking Expansion Reporter 4, no. 7 (April 1, 1985): 16–17; and Federal Reserve Bulletin (June 1985): 440–41. For a
summary of the new regulations, see R. Alton Gilbert, Courtenay C. Stone, and Michael E. Trebling, “The New Capital Adequacy Standards,” Federal Reserve Bank of St. Louis Economic Review 67, no. 5 (1985): 12–20.
96 See statements by William Isaac of the FDIC, Michael Patriarca of the OCC, and Paul Volcker of the Federal Reserve Board
in, respectively, Jay Rosenstein, “FDIC Raises Capital Ratio Requirements,” American Banker (February 12, 1985), 30;
John P. Forde, “Capital Guidelines Revision Foreseen,” American Banker (March 29, 1985), 1; and Naylor, “Volcker to Propose,” 1.
97 Reinicke, Banking, Politics and Global Finance, 151. The Federal Reserve stated that between year-end 1981 and midyear
1985, letters of credit at multinational banks had increased from 5.8 percent of aggregate assets to 11.5 percent (Banking
Expansion Reporter 5, no. 3 [February 3, 1986]: 3). It was reported that by early 1987 the decision to impose risk-based
capital standards had decreased the use of standby letters of credit (Lisabeth Weiner, “Some Banks Turn More Cautious in
Issuing Standby Credit,” American Banker [February 5, 1987], 1).
98 Risk-based capital was not new in the 1980s; in the 1950s the Federal Reserve Board had used a risk-based system called
ABC (Paul M. Horvitz, “Warming Over the ABC Idea,” American Banker [February 26, 1986], 24; and William R. Keeton,
“The New Risk-Based Capital Plan for Commercial Banks,” Federal Reserve Bank of Kansas City Economic Review 74,
no. 10 [1989], 42, note 2).

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sheet items would be converted into on-balance-sheet credit equivalents and assigned a risk
weight. All three agencies issued preliminary risk-based capital proposals by mid-1986.
The agency approaches differed somewhat, although they were basically very similar, and
the agencies were confident they could reach uniform standards. Both the FDIC and the
Federal Reserve Board favored making risk-based capital a supplement to current capital
standards, whereas the OCC advocated making it a replacement for them.99 In addition, as
of mid-1987, the OCC’s definition of what would become Tier 1 capital included loan-loss
reserves, while the Federal Reserve’s did not. There was also some disagreement on the appropriate risk weighting for longer-term government securities.
Initially larger banks in particular did not favor the risk-based proposals, fearing they
would place U.S. banks at a competitive disadvantage in pricing fee-generating financial
services.100 These objections had less force after U.S. regulators joined their international
counterparts in 1986 in working to create a common set of risk-based requirements.
The Basle Committee on Banking Regulations and Supervisory Practices reached
agreement on a general set of principles in June 1988.101 The standards defined capital and
set risk weights and credit conversions for off-balance-sheet items; the standards were then
implemented by each nation’s banking regulators.102 Capital was defined as consisting of
two tiers: Tier 1 capital included fully paid common stock and perpetual noncumulative
preferred shares; Tier 2 capital included undisclosed reserves, revaluation reserves, general
loan-loss reserves (limited in amount, generally up to 1.25 percent), hybrid debt/equity capital instruments, and subordinated debt (limited to a maximum amount of 50 percent of
Tier 1). U.S. regulators had previously counted loan-loss reserves as primary capital, but an
increasingly strong belief that capital should consist primarily of equity and the need to find
common ground among the international regulators combined to help change that. Banks
were to have a minimum of 4 percent Tier 1 capital and 8 percent total risk-based capital by

99

“Risk-Based Capital Plan,” American Banker (February 26, 1986), 3; Robert Trigaux, “Comptroller Unveils Risk-Based
Plan,” American Banker (March 26, 1986), 1; and Banking Expansion Reporter 5, no. 8 (April 21, 1986): 6–8.
100 Robert M. Garsson, “Comptroller Says Regulators May Issue One Risk-Based Capital Proposal by Fall,” American Banker
(July 11, 1986), 10. The Independent Bankers Association of America (IBAA), which represented smaller banks, was
more receptive, believing that such institutions would benefit from lower capital requirements. See also Robert M. Garsson, “US, British Join in Bank Capital Rules,” American Banker (January 9, 1987), 1; and Bart Fraust, “At Banking Conference, There Was Bad News—And Worse News,” American Banker (April 3, 1987), 8.
101 The committee was made up of representatives of bank regulatory agencies in Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.
102 For further details on capital definition and risk weights, see the text of the Basle agreement, which is reproduced in BNA’s
Banking Report 51, no. 4 (July 25, 1988): 143–55. Earlier Basle proposals had limited Tier 1 capital only to common equity; see Banking Expansion Reporter 7, no. 3 (February 1, 1988): 18.

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the end of 1992. By the end of 1988, the U.S. regulators had set final risk-based capital rules
in a process that involved making further refinements and compromises. 103
Debate continued, however, over what ought to become of the old capital standards.
The FDIC rules retained the old total-capital-to-assets ratio (the leverage ratio), stating that
banks would have to maintain the higher of 6 percent capital or the amount determined by
the risk weighting of assets. The Federal Reserve Board also held to the 6 percent minimum
but suggested it might be lowered in the future. The OCC, which had originally argued for
complete removal of the old ratio, now pressed for a 3 percent minimum capital requirement. Comptroller Clarke argued that maintaining the old ratio would destroy incentives for
banks to retain low-risk assets under the new risk-based rules, and suggested that the OCC
would strengthen the 3 percent standard by excluding loan-loss reserves and incorporating
interest-rate risk.104 The differences between the two agencies persisted because of their
different orientations: the FDIC was primarily concerned with protecting the deposit insurance fund, whereas the OCC wanted banks to be freer to expand profitability. The impasse
was eventually ended with a compromise offered by the Federal Reserve Board which set
the minimum leverage ratio at 3 percent—but only for banks with CAMEL ratings of 1.105
Banks with lower ratings would have to hold between 100 and 200 basis points in additional
capital (and, for the most troubled institutions, possibly more). Most banks would therefore
need to maintain ratios of between 4 and 5 percent, midway between the FDIC and OCC
recommendations.106 In 1991, when FDICIA used both risk-based capital levels and the
leverage ratio to define capital category standards and those categories became the triggers
for PCA, regulatory capital levels acquired even greater importance. Although bank regulators have continued to amend capital standards to better reflect bank risk, as of this writing the dual system of risk-based and leverage capital standards remains in place.

103

For example, the Federal Reserve had pushed for a risk weighting of 100 percent for home mortgages but eventually went
along with 50 percent. The Federal Reserve also believed that longer-term government securities, by virtue of interest-rate
risk, ought to be assigned a risk weight higher than zero, but the final rules placed all Treasury securities, regardless of maturity, in the zero-risk category. See Barbara A. Rehm, “Fed Compromises on Final Risk-Based Capital Rules,” American
Banker (August 4, 1988), 2; and Bart Fraust, “Impact of Risk-Based Capital Rules to be Eased,” American Banker (October 12, 1988), 3.
104 Jim McTague, “FDIC Set to Adopt 6% Capital Minimum,” American Banker (March 14, 1989), 2; and Barbara A. Rehm,
“Comptroller Favors 3% Capital to Back Low-Risk Assets,” American Banker (April 5, 1989), 3.
105 The CAMEL rating system refers to capital, assets, management, earnings, and liquidity. In addition to a rating (from 1
to 5) for each of these individual components, an overall or “composite” rating is given for the condition of the individual
bank. The CAMEL rating system is discussed in detail in Chapter 12.
106 Barbara A. Rehm, “Fed Seeks to Close Gap in Proposal on Capital Ratios,” American Banker (October 26, 1989), 1, 23; Barbara A. Rehm, “Fed Mulls 3% Capital Minimum for Banks in Best Condition,” American Banker (November 24, 1989), 1;
and Barbara A. Rehm, “A Magic Number from Fed Brings Accord on Capital,” American Banker (November 28, 1989), 1.

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Formal Regulatory Forbearance
The formal practice of forbearance was inaugurated with Garn–St Germain’s Net
Worth Certificate Program for savings banks. Qualifying institutions and the insurers exchanged notes that created “regulatory capital,” allowing institutions to meet regulatory requirements and continue to operate.107 Commercial banks were not included then, but soon
afterward weakness in the agricultural and energy sectors began to exact its toll on those institutions. As early as 1983, it was reported that the banking agencies were instructing their
examiners to be lenient in criticizing farm-bank managements that were trying to cope with
increasing credit problems.108 Nevertheless, although cognizant of sectoral economic problems, the FDIC believed that mismanagement contributed significantly to agricultural-bank
failures, and the agency resisted attempts to provide it with authority to allow banks to renegotiate loans with farmers and then write off the losses over a period of years.109 All of the
banking agencies did, however, encourage banks to work with borrowers who were experiencing difficulties, provided the institutions’ practices were generally consistent with safety
and soundness; and all of the agencies also instructed examiners to handle credit problems
“with understanding.”110
But as increasing numbers of agricultural banks continued to fail, congressional and
industry sentiment prompted the regulators to formulate plans to further assist troubled
banks in 1986.111 The three banking agencies opposed proposals that would have either created a new net worth certificate program or permitted loan-loss deferrals; they said they
were reluctant to engage in “accounting gimmicks” that would undermine the integrity of
the banking system.112 The agencies did, however, issue a joint statement reaffirming their
policies not to discourage banks from implementing work-out plans with their agricultural
borrowers when appropriate. The agencies also encouraged banks to take advantage of the
fact that they would not be required to automatically charge-off loans that had been re107

See Chapter 6 for a discussion of the Net Worth Certificate Program, and Chapter 1 for an analysis of the use of forbearance.
108 Lisa J. Mc Cue, “Farm Bankers Urged to Show Forbearance,” American Banker (August 4, 1983), 3.
109 Kim Kaplan and Bartlett Naylor, “FDIC Snubs Bill to Help Farm Banks Cope with Bad Loans,” American Banker (July
25, 1985), 3.
110 The regulators’ response was the subject of a joint policy statement issued on April 3, 1985. See OCC Quarterly Journal
4, no. 2 (1985): 16.
111 The executive director of the Kansas Bankers Association noted in 1985 that, despite claims to the contrary, the banking
agencies were not exercising forbearance (Kaplan and Naylor, “FDIC Snubs Bill,” 7). Another midwestern banker suggested in early 1986 that legislative action might not be necessary, “but the regulators need to give us as much forbearance
as possible to help us take our losses without closing everybody down” (“Severe Problems in the Midwest,” Bankers Magazine 169, no. 1 [1986]: 25).
112 Jay Rosenstein and Bartlett Naylor, “Regulator Says 300 Farm Banks May Fail by ’88,” American Banker (February 24,
1986), 1, 21; and “Comptroller’s Letter on Agricultural Banks,” American Banker (March 6, 1986), 4. For a contemporary
discussion of the issues, see FDIC, “Farm Bank Problems and Related Policy Options” (February 1986).

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structured, as long as future payments of principal and interest at least equaled the face
amount of the loan.113 Most significantly, the regulators agreed on a capital forbearance program not only for the agricultural banks but also for troubled banks involved in the increasingly distressed energy sector. The agencies resolved not to take enforcement action
against banks whose capital-to-assets ratios failed to meet regulatory minimums but were at
least 4 percent. Banks also had to meet the regulatory definition of an “agriculture” or “oiland-gas” bank, and their weakened capital position had to stem from external economic
factors, not mismanagement. Banks were required to submit acceptable plans for capital
restoration, which was to occur within seven years, as well as annual progress reports. The
deadline to apply for forbearance was year-end 1987.114
Banks did not seek to enter the program in large numbers. The OCC noted that by
early June 1986, it had received only 14 applications and had admitted 4 banks. By the end
of that year, 52 banks had been admitted to the program. In early 1987, some legislators
complained that few banks applied to the program because too many hurdles had been
placed in the way of approval. In any case, they believed the program afforded banks insufficient relief.115 In response to industry and congressional pressure and with the growing
realization that banking conditions were still worsening, in mid-1987 the regulators expanded the capital forbearance program considerably by allowing any bank to apply if the
bank could demonstrate that its difficulties resulted primarily from economic problems beyond the control of management. Moreover, the fixed minimum capital ratio of 4 percent
was eliminated, and the program—originally set to expire at the end of 1987—was extended for two additional years.116 After these changes were made, more banks participated
in the program: 156 banks were admitted in 1987, and 93 more were admitted in the program’s final two years, bringing the total admitted to 301. Of this total, one year after leaving the program 201 were operating as independent institutions, while 35 had been merged
without FDIC assistance and 65 had failed. The expanded program was not, however, sufficient to halt congressional moves for a loan-loss amortization program for farm banks,
113

See FRB, Annual Report (1986), 192. Banks were instructed to account for debt restructurings in accordance with GAAP
principles, specifically FASB 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings.” See also
FDIC Bank Letter BL-15-86, April 11, 1986; and OCC Quarterly Journal 5, no. 2 (1986): 51.
114 See FDIC Bank Letter, BL-12-86, March 27, 1986; and OCC Banking Circular no. 212, March 28, 1986, in OCC Quarterly Journal 5, no. 2 (1986): 48–54. The OCC also announced that it would temporarily increase national-bank lending
limits on loans to one borrower for banks that had experienced losses in the two sectors. See Jay Rosenstein, “Comptroller Says Rule Easing Loan Limits for Some Is Final,” American Banker (November 20, 1986), 14. See also Federal Reserve Bulletin 72, no. 6 (June 1986): 392.
115 OCC Quarterly Journal 5, no. 3 (1986): 61; and Paul Tosto, “Bills Seek to Help Plight of Agricultural Banks,” American
Banker (February 4, 1987), 6. In response, two senators, Alan Dixon and Nancy Kassebaum, renewed attempts to pass
loan-loss amortization plans for farm banks. This would become part of CEBA, as discussed below.
116 See John C. Rasmus, “Capital Forbearance for Commercial Banks,” Journal of Agricultural Lending 1, no. 4 (1988):
28–30; FDIC Bank Letter BL-24-87, July 9, 1987; and OCC Quarterly Journal 6, no. 3 (1987): 37.

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which was enacted under the Competitive Equality Banking Act of 1987.117 This program
was substantially smaller in scope. A total of 33 banks were admitted; 27 of these survived
as independent institutions one year after leaving the program, while 2 had merged and 4
had failed.118
Brokered Deposits
Penn Square’s demise in 1982 not only helped the regulators obtain new powers to
deal with failing institutions but also focused attention on another regulatory issue: the increasing use of brokered deposits.119 Starting in the early 1970s, brokered CDs had come to
be used increasingly as funding sources, first by money-center banks and then by regional
and smaller institutions.120 The brokered CD market was divided into two parts: the wholesale institutional market, where CDs were issued in denominations of $100,000 or more,
and the retail market, where CDs were in denominations not exceeding $100,000.121
The potential abuses of brokered deposits received relatively little attention until the
failure of Penn Square, where the amount of brokered funds had risen from less than $20
million to $282 million just before the bank failed.122 By early 1983, the FDIC was expressing concern about deposit brokers that were dividing money into packages of
$100,000 without necessarily conducting any credit analysis to ascertain the conditions of
the offering institutions.123 The deposit insurers feared that brokers were singling out institutions known to have problems in order to earn higher fees. Later that year Representative
St Germain asked the banking regulators for a detailed plan for supervising money brokers
in the wake of Penn Square. By early 1984, both the FDIC and the Federal Home Loan
Bank Board (FHLBB) proposed that brokered deposits be insured only up to $100,000 per
broker per bank.124
117

For a discussion of the program under CEBA, see the section above on that law.
These loan-loss amortization program totals exclude banks that were in both the capital forbearance and loan-loss amortization programs; those banks are included in the totals for the capital forbearance program.
119 See Chapter 9 for a discussion of Penn Square’s failure.
120 Brokered deposits are certificates of deposit issued by a financial institution and purchased by an investor through a thirdparty intermediary; the third party receives a fee or commission from the issuing institution.
121 See Caroline T. Harless, “Brokered Deposits: Issues and Alternatives,” Federal Reserve Bank of Atlanta Economic Review
69, no. 3 (1984): 14–25.
122 Phillip L. Zweig, “Brokered Penn Square Funds Soared Just before Collapse,” American Banker (November 19, 1982), 3.
123 Money brokers disputed this. In 1984 Merrill Lynch said it performed credit reviews on banks and had not marketed CDs
issued by any of the banks that failed in that year. See Jay Rosenstein, “Merrill Lynch Challenges Isaac’s Remarks,” American Banker (December 14, 1984), 3. However, in 1983 Kominz Co., a California broker, said it had “returned” to the practice of analyzing Call Report data from institutions before brokering funds. The company said competitive pressures had
forced it to drop the practice some time before, and agreed that the unregulated money-brokerage business had “gotten out
of hand” (Richard Ringer, “CD Broker Proposes Self-Regulation,” American Banker [August 9, 1983], 1).
124 Lisa J. Mc Cue, “St Germain Asks Regulators to Supervise Money Brokers,” American Banker (September 9, 1983), 1; and
Jay Rosenstein, “Insurance Limits Considered on Pensions, Custody Deposits,” American Banker (October 25, 1983), 1.
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Many observers agreed that some form of regulation was required, but some viewed
the proposal as an overreaction. The CD brokerage industry was obviously concerned, and
argued that this regulation would effectively destroy a business that provided real benefits
to financial institutions. Comptroller C. T. Conover (as a member of the FDIC Board of Directors) had voted against the FDIC proposal, saying it was “like shooting ants with elephant guns.” The Treasury agreed that the proposed regulation was much stronger than
necessary.125 Members of Congress also expressed concern about the proposed regulation,
and the House Committee on Government Operations held extensive hearings on the subject in March. The OCC argued for a supervisory approach that would allow an institution
to accept up to twice its capital in brokered deposits as long as brokered deposits did not exceed 15 percent of total deposits. No institution with a capital ratio under 3 percent would
be allowed to accept any brokered deposits. The Federal Reserve Board shared FDIC and
FHLBB concerns and was willing to support their proposal but urged that a less-sweeping
approach be mandated by legislation. Those testifying on behalf of money brokerage
agreed that the misuse of such funds should be prevented, but they argued that the proposed
regulations would restrict the legitimate and generally helpful use of brokered funds by depository institutions.126
Despite the obviously divided opinion, both the FDIC and the FHLBB decided to
press on with their rule, which was to become effective in October. This prompted one of
the larger money brokers, FAIC Securities, to sue, arguing that the agencies had overstepped their authority. The Securities Industry Association soon followed with another
lawsuit, claiming that the two agencies had “heavy-handedly slammed the door shut on a
mechanism that provides a real service to the nation’s savers and deposit-taking institutions.”127 The situation changed dramatically in June, when the U.S. District Court in Washington, D.C., ruled that the agencies had overstepped their authority, maintaining that the
statutes creating deposit insurance focused on ownership of deposited funds and not on the
manner in which deposits were arranged.128
The FDIC announced its determination to appeal and, in response to the ruling, put a
temporary regulation in place requiring institutions that relied heavily on brokered deposits
to file detailed monthly reports on brokered deposit amounts. The regulatory dynamic became somewhat fractured and uncertain, as did the fate of money brokers and the institu125

Lisa J. Mc Cue, “Agencies Propose Broker Limits,” American Banker (January 17, 1984), 1.
U.S. House Committee on Government Operations, Proposed Restrictions on Money Brokers: Hearing, 98th Cong., 2d
sess., 1984.
127 Andrew Albert, “Broker Sues, Shakeout Seen,” and Richard Ringer, “Isaac Vows Close Supervision,” both in American
Banker (March 28, 1984), 1; and Andrew Albert, “Securities Industry Sues to Void Broker Rules,” American Banker (April
13, 1984), 1.
128 Lisa J. Mc Cue, “Brokered Funds Issue Seen Likely to Go to Congress,” American Banker (June 22, 1984), 1.
126

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tions that used them. Congress continued to debate the issue, but the possibility existed that
the FDIC might win its appeal before legislation could be enacted. Congress was considering three bills on the use of brokered deposits, all of which limited the amount of short-term
insured brokered funds to 15 percent of deposits or 200 percent of unimpaired capital and
surplus, whichever was less. In September a House subcommittee released a report claiming that (a) brokered deposits were not a significant source of deposit growth for most
rapidly growing problem institutions, (b) “forceful use of . . . existing supervisory powers
on a case-by-case basis” would be the most effective regulatory policy, and (c) elimination
of insurance coverage would probably not achieve increased market discipline.129
The agencies that were pressing for regulation insisted that brokered deposits continued to be a growing problem. FDIC Chairman Isaac noted near the end of 1984 that of the
approximately $22 billion in brokered deposits in FDIC-insured banks, more than 40 percent of that amount was in banks with CAMEL ratings of 3, 4, or 5. At the same time, the
Federal Reserve Bank of New York published a research study supporting both the contention that a relationship existed between brokered deposits and weak financial institutions
and the contention that banks with high levels of brokered deposits raised FDIC costs and
were therefore a threat to the insurance fund.130 The study did not, however, completely endorse the FDIC/FHLBB proposal but suggested that a regulatory cap, to be enforced by the
banking agencies in the same manner as capital adequacy, would be a way to address abuses
while not eliminating the benefits of such deposits.
Early in 1985 the court of appeals upheld the decision barring federal regulators from
ending deposit insurance on brokered deposits. The FDIC vowed to appeal further, but
clearly congressional opposition to the proposed regulation remained strong.131 By mid1985 the brokerage industry was willing to accept a bill put forward by Representative Garcia similar to those proposed in 1984. The FDIC reluctantly expressed its willingness to
129

In H.R. 5913, sponsored by Representatives Robert Garcia and Charles Schumer, institutions that failed to meet certain
minimum capital requirements would not be able to accept any new brokered deposits. In Title VIII of S. 2851, sponsored
by Senator Garn, they would not be able to accept any new insured brokered deposits. In S. 2679, sponsored by Senators
D’Amato, Mattingly, Hawkins, and Cranston, they would not be able to hold any insured brokered funds. H.R. 5913 also
contained (a) a requirement that brokers report to the deposit insuring agencies, (b) a provision that deposit insurance coverage be denied for any funds placed through a broker for an agency of the U.S. government or for a depository institution,
and (c) “a general limit on deposit insurance benefits payable on the funds placed by any one person through any one broker to no more than $100,000 in any 4-year period.” See U.S. House Committee on Government Operations, Federal Regulation of Brokered Deposits in Problem Banks and Savings Institutions: Report, 98th Cong., 2d sess., 1984, 8–11.
130 Sherrill Shaffer and Catherine Piché, “Brokered Deposits and Bank Soundness: Evidence and Regulatory Implications,”
Federal Reserve Bank of New York research paper no. 8405 (1984). A study done for Merrill Lynch by Cates Consulting
Analysts argued that brokered CDs did not significantly contribute to bank failure (Sanford Rose, “Refocusing on Brokered Deposits,” American Banker [February 26, 1985], 1).
131 Representative Barnard’s Government Operations Subcommittee prepared another report in April 1985 with conclusions
similar to those of 1984.

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compromise. William Isaac said the cap should be placed at 100 percent rather than 200
percent of net worth but that although “we do not like it, we can accept such a bill.” At the
same time, however, the FDIC kept up its efforts by proposing a new regulation to require
banks to keep records of individuals and institutions that placed money through brokers.
The debate over the proposed regulation ended suddenly in October 1985 when the
court of appeals rejected the two agencies’ request for a rehearing on the court’s decision
and, at the same time, L. William Seidman became chairman of the FDIC. He viewed brokered deposits in a more favorable light and said the proposed insurance limit would have
“eliminated the benefits of the evolution of the financial marketplace.”132 The FDIC decided not to appeal further, and in December it withdrew the proposed insurance-limit regulation. The following June it also abandoned the proposed record-keeping rule. This
decision was doubtless made easier by the fact that from 1984 to 1985 brokered deposits in
commercial banks had dropped significantly. The issue would, however, return to the legislative agenda in the aftermath of the thrift crisis, and both FIRREA in 1989 and FDICIA
in 1991 would mandate limitations on the use of brokered deposits by troubled institutions.
Expanded Powers
As is discussed above, federal legislation during the 1980s provided commercial
banks with few new powers, but congressional action was by no means the only route banks
could take to get them. Action by state legislatures and state banking authorities, as well as
decisions by the federal regulators, could and did fill the vacuum created by the gridlock in
Congress. States, both in response to congressional inaction and as a perceived means to encourage economic growth, were particularly active in providing new powers to their banks
during the 1980s. The states’ ability to do so derived from the fact of the dual banking system, which was the product of a long history reaching back to the beginnings of banking in
the United States. Although the creation of the Federal Reserve System in 1913 and the
FDIC in 1933 had imposed increasing federal regulation on state-chartered banks, the states
were quite deliberately allowed considerable regulatory autonomy, a situation Congress
had refrained from altering. State-chartered nonmember banks, for example, had always
been exempt from Glass-Steagall, and states exercised control over the availability of interstate banking within their borders.
Some observers credit the dual banking system with stimulating innovation in banking, to the benefit of both the industry and consumers. Notable examples of state-level innovations in the 1970s that were eventually adopted nationwide included NOW accounts
132

For William Isaac’s remarks, see American Banker (July 17, 1985), 2. Seidman’s statement was made at the convention of
the U.S. Savings League. See Mark Basch, “Seidman Takes a Conciliatory Stance on Brokered Deposits, But Plans
Curbs,” American Banker (November 6, 1985), 1.

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and ARMs, the former developed in Massachussets and the latter in California. Moreover,
although Congress did not enact nationwide interstate banking until 1994, during the 1980s
many states gradually created a de facto system of interstate banking. Other observers,
however, hold that the dual banking system fostered a dangerous “competition in laxity”
between the states and the chartering authority of national banks, the OCC, with each outbidding the other in making powers available.133
But the determining factor behind the federal regulators’ decisions to permit banks entry into new areas was not necessarily regulatory competition. As has been noted, to varying degrees all three agencies endorsed additional powers for commercial banks. All three
also favored a congressional resolution of the debate, but in the absence of federal legislation, the regulators had the ability to act and were under a great deal of pressure to do so.
The OCC, with its strong support of deregulation, was often the most aggressive in this respect. In 1982 Comptroller C. T. Conover stated the OCC position on bank applications for
new activities: “Very simply, if a bank can make a strong case that a proposed activity is legal, our inclination is to approve it.”134 During the early 1980s, for example, the OCC authorized national banks to offer discount brokerage and investment advisory services,
operate futures-commission merchant subsidiaries, and underwrite credit life insurance. 135
By the late 1980s the Federal Reserve Board was increasingly allowing bank holding companies to enter many new areas.136 The FDIC did not have authority to permit state banks to
engage in new activities, but it did rule in 1984 that insured nonmember banks could establish or acquire subsidiaries that were engaged in securities activities.137
The FDIC ruling was, of course, an acknowledgment that states could allow banks
into such businesses and were in fact doing so. Indeed, from the mid-1980s on, many states
began allowing state-chartered banks to enter not only securities underwriting and brokerage but also real estate development, equity participation, and insurance underwriting and
brokerage. By the end of the decade 29 states permitted state-chartered banks to engage in
some form of securities underwriting, and only 7 barred banks from the securities brokerage business. Half the states allowed banks into some type of real estate development, and

133

See Kenneth E. Scott, “The Dual Banking System: A Model of Competition in Regulation,” Stanford Law Review 30, no.
1 (1977): 1–49; Arthur E. Wilmarth, “The Expansion of State Bank Powers, the Federal Response, and the Case for Preserving the Dual Banking System,” Fordham Law Review 58, no. 6 (1990): 1132–256; and Advisory Commission on Intergovernmental Relations, State Regulation of Banks.
134 C. T. Conover, speech to the American Bankers Association on October 19, 1982, reprinted in OCC Quarterly Journal 2,
no. 1 (1983): 40.
135 Ibid. 3, no. 3 (1984): 19–20.
136 Reinicke, Banking, Politics and Global Finance, 102–13; and Helen Garten, Why Bank Regulation Failed (1991), chap. 4.
137 FDIC, Annual Report (1984), 39.

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23 allowed some form of equity participation. Six states permitted their banks to engage in
insurance underwriting beyond credit life insurance.138
The states’ moves to expand commercial bank powers were not unanimously applauded. Some critics suggested that state legislators were being lured into passing laws by
the specious promise of economic growth. The vice president of the Conference of State
Bank Supervisors, a group that generally supported expanded powers, noted in 1983 that
some proposals were “competitive knee-jerk activities conceived without a hell of a lot of
thought.”139 Nor were federal banking regulators completely sanguine about states’ expansion of bank activities. Federal Reserve Board Chairman Volcker worried that states were
rushing ahead with “little conscious sense of some of the broad public interests at stake”
and said the federal government should impose limits on the power of states to authorize activities that Congress decided were a threat to safety and soundness.140 The FDIC also expressed concern about bank involvement in historically “nonbank” activities, sought
comment in 1983 on the need to regulate such activities, and issued a proposed rule in 1984.
In 1985 the agency proposed an amended rule that FDIC-insured banks be required to place
insurance underwriting and real estate investment or development activities in separately
capitalized subsidiaries to insulate the bank from potential increased risk.141
The FDIC proposal proved controversial. The agency maintained that, as insurer, it
ought to be able to set some guidelines, but state banking authorities, state-chartered banks,
and industry associations all opposed the rule, protesting that it arbitrarily and indiscriminately assigned risks that often did not exist. The agency was accused of overstepping its
authority, violating states’ rights by preempting state legislation, and damaging the dual
banking system. Moreover, the combination of then-current Federal Reserve Board policy
and the proposed FDIC rule would have meant that only state nonmember banks would be
allowed to engage in real estate development at all.142
The other federal regulators had misgivings as well. The OCC opposed the regulation
because it asserted potential FDIC jurisdiction over national banks.143 The Federal Reserve
138

FDIC, “State Bank Powers Study” (1991). See also Saulsbury, “State Banking Powers.”
Richard Ringer, “States Rush to Deregulate,” American Banker (May 9, 1983), 7.
140 Richard Ringer, “Volcker Urges Care on Deregulation,” American Banker (May 10, 1983), 1; and Lisa J. Mc Cue, “Volcker Supports Powers Bill to Give Banks Market Parity,” American Banker (March 28, 1984), 3.
141 FDIC, Annual Report (1984), 41, and (1985), 57. The first rule had also covered travel agency activities and insurance and
real estate brokerage, but the FDIC decided those activities could be adequately dealt with on a case-by-case basis. In January 1985 the FHLBB passed a rule restricting direct investments by S&Ls.
142 Regulation Y permitted bank subsidiaries of bank holding companies to establish a nonbanking subsidiary only if the parent bank was allowed to engage in the activities directly. Since real estate activities were viewed as inherently risky, some
Federal Reserve Board staff saw this “regulatory squeeze” as a positive situation. Bankers and state bank regulators did
not share this view. See Washington Financial Reports 44, no. 3 (January 21, 1985): 75.
143 FDIC, comment letter received from Acting Comptroller of the Currency H. Joe Selby (July 22, 1985).
139

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Board, given its preference for limiting state powers, was broadly sympathetic to the concept behind the proposed rule and was even soliciting comment itself on ways to curtail real
estate activities,144 yet it was leaning toward restricting such activity to nonbank subsidiaries of bank holding companies rather than permitting it in direct subsidiaries of banks
themselves. The Federal Reserve Board was also concerned about the legal issues involved
in the FDIC’s regulating state member banks and bank holding companies and their nonbank affiliates. So while urging coordination between the two agencies, the Board said that
if the FDIC decided to proceed with the rule as proposed, FRB-regulated institutions should
be excluded.145 The FDIC postponed implementing the regulation, and by late 1986 the
FRB proposed its own regulation: not only state member banks but also state-chartered
bank subsidiaries of bank holding companies would be prohibited from direct investment in
real estate, which would be allowed only through a separately incorporated real estate subsidiary of a bank holding company that met certain capital requirements. Banking industry
groups opposed the FRB’s proposal much as they had the FDIC’s.146
The FDIC and the FRB were unable to reach consensus about their respective regulations and in late 1987 the FDIC withdrew its proposed regulation, stating that there was not
yet sufficient evidence about the degree of risk the activities posed to the insurance fund.147
At about the same time, however, the FRB was considering (a) imposing higher capital requirements on holding companies of state-chartered banks that conducted real estate investment through a subsidiary and (b) tightening the regulation of transactions between
banks and real estate subsidiaries.148 The FRB’s proposed real estate rules attracted congressional reaction to the extent that a bill was sponsored in 1989 to prevent the Federal Reserve from exercising control over subsidiaries of state banks within holding companies.
One commentator claimed that the agency allowed the rules to remain as proposals while it
engaged in “de facto rulemaking” by procuring certain commitments from applicants seeking to form or expand holding companies within which a bank subsidiary planned to use its
state-granted real estate powers. It was suggested that the Federal Reserve actually preferred not to implement the rule but, rather, to continue demanding higher capital levels of
institutions that were unwilling to refrain from real estate activities.149 In any case, the FRB
proposal never became a regulation.

144

Washington Financial Reports 44, no. 3 (January 21, 1985): 75.
FDIC, comment letter received from Secretary of the FRB William W. Wiles (February 26, 1985).
146 Washington Financial Reports 47, no. 21 (December 1, 1986): 851–52.
147 FDIC, Annual Report (1987), 30. The Board of Directors indicated that the agency intended to “reevaluate whether a
broad-based regulation for real estate investments . . . [was] necessary.”
148 Barbara A. Rehm, “Fed Weighs Restrictions on Real Estate,” American Banker (November 3, 1987), 1.
149 Barbara A. Rehm, “House Measure May Foil Fed Efforts to Gain Control of State Bank Limits,” American Banker (April
10, 1989), 1; and John D. Hawke, “Fed Needs New Approach to Real Estate,” American Banker (August 16, 1989), 4.
145

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In early 1991, the FDIC again announced plans to limit the authority of state-chartered
banks to invest in real estate and sell insurance. The issue of powers available to statechartered banks, however, was settled later in that year under FDICIA. That law prohibited
insured state-chartered banks from engaging in an activity not permitted for a national bank
unless the FDIC decided that the activity posed no significant risk to the Bank Insurance
Fund and the bank met agency capital standards. The dual banking system was not swept
away and flexibility was not abolished, yet regulatory concerns were addressed.

After the Crisis: Legislation, 1992–1994
FDICIA marks a natural endpoint to a discussion of legislation during the banking crisis of the 1980s and early 1990s, but later legislation usefully places the crisis in context, for
as it became apparent that the banking industry had recovered, attitudes toward regulation
changed. As has been noted, deregulation had never left the legislative and policy agenda,
even when the thrift and banking industries were in greatest difficulty. Not surprisingly, this
held true as times grew better. Two laws enacted in 1994, although they do not reflect an
abandonment of the “reregulatory” provisions of FIRREA and FDICIA, suggest a changed
legislative and regulatory climate: the Riegle Community Development and Regulatory Improvement Act (the CDRI Act) and the Riegle-Neal Interstate Banking and Branching Efficiency Act.150 The first covered a wide variety of issues, including review and elimination of
outmoded and duplicative regulations as well as some change in examination policies. The
second authorized interstate banking and branching for U.S. and foreign banks over a threeyear period. Neither the notion of decreasing the regulatory burden on banks nor that of removing restrictions on geographic expansion was new,151 but their enactment into law is a
measure of the banking industry’s recovery compared with its condition in 1989–91.
First, however, a year before Congress passed the two laws just mentioned, it enacted
(as part of the Omnibus Budget Reconciliation Act of 1993) a national depositor preference
statute, which established a uniform order for distributing the assets of failed insured depository institutions.152 Under depositor preference, a failed bank’s depositors (and the
FDIC, as subrogee in the place of insured depositors it has already paid) have priority over
nondepositors’ claims. Without depositor preference, under a receivership depositors (and
the FDIC as subrogee) are treated as general creditors and, along with other general credi150

Public Laws 103-325 and 103-328.
For example, the Treasury had issued a report on geographic constraints in 1981, and legislation that attempted to reform
the banking laws was introduced in Congress in 1985, 1987, and 1991. See Mark. D. Rollinger, “Interstate Banking and
Branching under the Riegle-Neal Act of 1994,” Harvard Journal on Legislation 33, no. 1 (1996): 195–98.
152 Public Law 103-66. During 1993 Congress also passed the Resolution Trust Corporation Completion Act, which provided
further funding for the RTC, restructured SAIF funding, and set an earlier date for RTC termination in addition to providing for the transfer of its operations and assets to the FDIC.
151

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tors, receive a pro rata share of the proceeds. Depositor preference statutes were already in
force in 28 states and therefore applied to some state-chartered institutions, but not to any
national banks.
The FDIC had recommended national depositor preference in 1983 and had suggested
a national depositor preference statute in the mid-1980s.153 The lack of such a law had implications both for the way in which the FDIC handled bank failures and for the insurance
fund. Most failures were handled through purchase-and-assumption transactions (P&As) in
which general creditors usually received the same treatment as depositors and so were often fully protected. Moreover, contingent liabilities that might later be included among
creditors’ claims, such as letters of credit, could complicate matters even more. The presence of such liabilities made it difficult to estimate the transaction’s cost and might even
make a P&A unworkable, as had been the case with Penn Square in 1982. Depositor preference, it was believed, would not only result in a smaller cash outlay by the FDIC but also
make transactions simpler, more predictable, and significantly less expensive to the insurance fund. In addition, it was believed that depositor preference would restrain bank risk,
since nondepositor creditors would have to be more concerned about the bank’s manner of
doing business. One potential problem was that hitherto-unsecured nondepositors might
seek to become secured creditors, thereby evading the effects of depositor preference and
possibly even increasing resolution costs for the FDIC.154 FDIC savings might also be lessened by shifts from unsecured claims to deposits.
The main impetus for the reemergence of depositor preference was not, however, debate about these issues but, rather, the pursuit of deficit reduction. As one means toward this
end, the Clinton administration had proposed increasing examination fees for statechartered banks. But industry groups representing those institutions opposed that move, and
the search for alternative sources of deficit reduction quickly led to depositor preference as
a potential substitute for increased examination fees.155 Since BIF losses are counted as
budget outlays, the estimated reduction in costs to the FDIC would have the effect of lowering the deficit. National depositor preference was also intended to reduce the FDIC’s
losses from bank failures, but it is not yet clear whether shifts in the liability structure of
troubled institutions will actually have that effect, or how great those savings will be.

153

FDIC, Deposit Insurance in a Changing Environment (1983), III-9-10; FDIC, Annual Report (1985), xv; and American
Banker (March 14, 1986), 3.
154 This discussion is based on Stanley C. Silverberg, “A Case for Depositor Preference,” FDIC Banking and Economic Review (May 1986): 7–9. See also Eric Hirschhorn and David Zervos, “Policies to Change the Priority of Claimants: The
Case of Depositor Preference Laws,” Journal of Financial Services Research 4 (1990): 111–25.
155 One of the most important forces behind this substitute was the Conference of State Bank Supervisors. See Bill Atkinson,
“States Push Alternatives to Hitting Their Banks with Higher Fees,” American Banker (March 30, 1993), 7.

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The two 1994 acts (the CDRI Act and Riegle-Neal) emerged from congressional consideration, in 1993, of several different banking policy issues that were drawn together into
a loose package of banking reforms that would wend their separate ways through the legislative process.156 Together these constituted attempts to satisfy competing interest groups,
such as community development advocates and those who were pressing for financial modernization and regulatory relief. One of the bills included a community banking development proposal; another was a reaction to the regulatory regime that had been instituted in
1989–91 (particularly to its perceived effect on the so-called credit crunch); and a third addressed geographic expansion, which had failed to be enacted in 1991–92.157 All these concerns would be reflected in the two laws passed in 1994.
In 1993 the Clinton administration had put forward a plan that was to provide grants
and other subsidies to community development lenders. One means of gaining support for
that bill was simultaneously to address concerns over regulatory burden. Well before the
1993 legislative session, the banking industry had been pushing for regulatory change. In
May 1992, the American Bankers Association (ABA) and state bankers associations had
announced that approximately 20 provisions of FDICIA and other statutes ought to be repealed or modified. ABA President Alan R. Tubbs noted that “there has been a strong impulse to tar banks with the same brush as the S&Ls” and that undue regulation made “credit
less available to those who need it.”158 The trade groups noted that they were already in discussions with legislators who might introduce the desired legislation; many of their concerns were covered in the bill entitled the Economic Growth and Financial Institutions
Paperwork Reduction Act of 1993 (H.R. 962).159
Clearly congressional support for addressing the regulatory issue was substantial, and
the banking agencies had already begun working toward reforms.160 Perceptions differed,
156

Indeed, for a brief period all were combined in a single bill. See Congressional Quarterly Almanac 50 (1994), 101–2.
The interstate branching issue and concern over the credit crunch were not entirely separate from each other. The Bush administration, in a 1992 reform package that included regulatory relief, noted that interstate branching would “ultimately
improve . . . the quantity of credit available” (BNA’s Banking Report 58, no. 14 [April. 6, 1992]: 579).
158 BNA’s Banking Report 58, no. 18 (May 4, 1992): 769–70.
159 A few regulatory reform proposals had already been passed as attachments to a housing bill in 1992. See Congressional
Quarterly Almanac 48 (1992), 120. The credit crunch received considerable attention in Congress, with numerous hearings held from 1990 to 1993. See, for example, U.S. Senate Committee on Banking, Housing, and Urban Affairs, Credit
Availability: The Availability of Credit in Our Economy and to Try to Determine Whether or Not There Is Currently a Credit
Crunch, 101st Cong., 2d sess., 1990; U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on Domestic Monetary Policy, The Credit Crunch: Hearings, 102d Cong., 1st. sess., 1991; and U.S. House Committee on Government Operations, Subcommittee on Commerce, Consumer, and Monetary Affairs, I, 103d Cong., 1st sess., 1993.
160 For actions that the banking agencies took before 1993, for example, see FFIEC, Study on Regulatory Burden (1992), appendix D. See also U.S. General Accounting Office, Regulatory Burden: Recent Studies, Industry Issues and Agency Initiatives (GAO/GGD-94-28, 1993), appendix 3.
157

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however, as to which regulatory changes could be made without affecting safety and soundness.161 When the bill (H.R. 962) was incorporated into what would become the CDRI Act
in 1994, many provisions had been altered. Much of the final legislation dealt with paperwork reduction (removing duplicative filings, streamlining regulations, simplifying Call
Reports, etc.).162 The law also required the banking agencies both to establish a process
whereby financial institutions could appeal regulatory decisions and to create an ombudsman’s office. The provisions that most directly affected safety-and-soundness supervision
were a modification to FDICIA’s exception to annual examinations: the asset ceiling that
enabled banks to qualify for an 18-month examination cycle was raised from $100 million
to $250 million; in addition, banks with $100 million or less in assets could qualify for the
extended interval if their composite ratings were outstanding or good, whereas under FDICIA, only an outstanding rating made a bank eligible.163 Over the next two years, as a result of the regulatory improvement provisions of the CDRI Act, many agency regulations
were abolished or altered.164
The other significant piece of banking legislation passed in 1994 was the Riegle-Neal
Interstate Banking and Branching Efficiency Act. Like the reform of Glass-Steagall, the removal of restrictions on interstate banking and branching had frequently appeared on the
policy agenda during the 1980s and early 1990s but had never been enacted.165 Restrictions
on interstate banking and branching had long been enshrined in the U.S. banking system and
stemmed from deep-seated mistrust of financial concentration, the belief that a bank should
be tied to its community, and strong notions about states’ rights. All of these had combined
to produce essentially a unit banking industry,166 until economic expansion in the late 19th
century and the increased distances involved in commerce led to a need for more sophisticated financial networks. By the early 20th century, therefore, branching had become increasingly common at the state level, although some banking interests still resisted it.
161

For discussion of these issues, see U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on Financial Institutions Supervision, Regulation and Deposit Insurance, H.R. 962, The Economic Growth and Financial Institutions Regulatory Paperwork Reduction Act of 1993: Hearings, 103d Cong., 1st sess., 1993.
162 This discussion covers only a part of the CDRI Act, which, in addition to community development and paperwork, dealt
with small-business capital formation, money laundering, and national flood insurance.
163 The CDRI Act also gave the banking agencies the power to raise this ceiling by regulation to $175 million two years after
the law had been in effect, as long as the raised ceiling was deemed consistent with safety and soundness.
164 For the response of the banking agencies to the law’s requirements on regulatory reform, see Board of Governors of the
Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of
Thrift Supervision, Joint Report: Streamlining of Regulatory Requirements (September 23, 1996).
165 Congress considered legislation on interstate banking in 1985, 1987, and 1991.
166 Branch banking was not completely absent. In the early years of the republic, both the First and Second Banks of the
United States had branches, and some branch banking systems were present before the Civil War, but when the National
Bank System was established in 1867, it consisted of unit banks only. See David L. Mengle, “The Case for Interstate
Branch Banking,” Federal Reserve Bank of Richmond Economic Review 76, no. 6 (1990): 5.

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During the early decades of the 20th century, debate over the desirability of expanding branching continued; but with state banks able to branch, national banks were at a competitive disadvantage. The 1927 Pepper-McFadden Act somewhat remedied this: if state
banks could branch, national banks were allowed to branch within the city in which they
were located. The Banking Act of 1933 went somewhat further, allowing national banks a
power to branch equal to the power accorded state-chartered institutions. No bank that was
a member of the Federal Reserve System, however, could branch across state lines, and this
remained the case until 1994.167 It should be noted that intrastate branching became increasingly common. In 1977, for example, statewide branch banking was prevalent in 20
states, whereas unit banking was prevalent in 12. By 1990, those numbers had changed to
33 and 3, respectively.168
In addition to restricting branching, federal laws had placed limits on creating interstate banking through acquisitions. The Douglas Amendment to the Bank Holding Company Act of 1956 prohibited a bank holding company (BHC) from acquiring a bank in
another state unless that other state’s laws authorized such out-of-state acquisitions; thus,
control of such expansion was left to the states. Not until 1975 did Maine became the first
state to allow entry by out-of-state bank holding companies.169 The limitations imposed by
the Douglas Amendment were liberalized somewhat in 1982 and 1987, but only to allow
emergency acquisitions in the case of failed, and then of failing, institutions. Aside from
these exceptions, federal law on interstate acquisitions remained unchanged until 1994. The
situation on the ground, however, had changed considerably. By January 1986, 28 states
permitted some form of acquisition by an out-of-state BHC; by May 1990, 46 states did; by
the time Riegle-Neal was passed, only Hawaii did not have such a law, and two-thirds of the
states permitted entry from BHCs in any state.170
Such developments certainly helped to broaden support for legislation allowing interstate banking. As has already been noted, the matter had been under discussion for some
time, but legislation had failed to get through Congress. By 1993, however, with the banking crisis over, a consensus developed that change was required. In 1993 the Clinton administration came out in favor of interstate banking and branching legislation, with
Treasury Secretary Lloyd Bentsen noting that the country already had a de facto system of
167

State nonmember banks could establish interstate branch networks in a state in which such networks were permitted by
law. Several states did permit them; by 1994 and before Riegle-Neal, these included Alaska, Nevada, New York, North
Carolina, Oregon, and Rhode Island. All of these states, however, required reciprocity by the state where the bank seeking entry was headquartered. See Banking Policy Report 13, no. 16 (September 5, 1994): 10.
168 CSBS, Profile (1977), 95, and (1990), 111.
169 Rollinger, “Interstate Banking and Branching,” 185.
170 See CSBS, Profile (1986), 99–104, and (1990), 127ff; and Rollinger, “Interstate Banking and Branching,” 194. These
statutes varied greatly; some states authorized de novo entry, some allowed acquisitions by any BHC in any state, and some
allowed entry only by BHCs in certain regions. The overall trend was certainly toward nationwide interstate banking.

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interstate banking, albeit a patchwork, and that the United States was operating “with laws
and regulations made for another time in America.”171 Such sentiments were echoed by
many as the Riegle-Neal bill went through Congress in 1994. To an extent, therefore, the
legislation was viewed as simply making federal law consistent with reality.
What was still debated, however, was whether such deregulation would lead to overconcentration and how credit availability would be affected, particularly in less-affluent
communities. (Significantly, the community development banking provisions of the CDRI
Act were moving through Congress during the same session.)172 The regional banking
crises that had just passed were a strong argument in favor of allowing geographic expansion: banks would no longer necessarily be tied to the economic well-being of a specific region and would thereby have protection against just the sort of regional downturns that had
occurred in the 1980s and early 1990s.173 One lobbyist for NationsBank believed that the
earlier conflict between large and small banks over interstate expansion had evaporated because small banks had come to believe that they would be able to prosper in the new environment. Moreover, the bill addressed the concerns of state banking authorities about
control of the expansion process.174 As one analyst stated, “Federalism is a key component
of Riegle-Neal.”175
Under Riegle-Neal, adequately capitalized and managed bank holding companies
were allowed to acquire a bank in any state beginning on September 29, 1995; the provisions of the Douglas Amendment were thereby effectively repealed. The law did establish
limits on deposit concentration. Interstate acquisitions would be prohibited if the resultant
BHC would control either (a) more than 10 percent of U.S. bank and thrift deposits or (b)
more than 30 percent of the deposits in the home state of the bank to be acquired (except for
initial entries into a state). However, host states could waive the limit; and state depositconcentration limits, whether higher or lower, would supersede the Riegle-Neal state concentration limit. Acquisitions remained subject to state laws that set a minimum period
during which a target bank had to have been in existence before acquisition, up to a maximum of five years. Compliance with the Community Reinvestment Act and state community reinvestment laws was required. The acquisition of a failed or failing bank by an
out-of-state BHC was not subject to any of the conditions otherwise applicable to the acquisition of an out-of-state bank.
171

Congressional Quarterly Almanac 49 (1993), 161.
Ibid. 50 (1994), 94.
173 For a discussion of these issues, see Rollinger, “Interstate Banking and Branching,” 210–38.
174 For a discussion of the politics surrounding the bill, see Joseph D. Hutnyan, “Interstate Banking Politics,” Banking Policy
Report 13, no. 11 (June 6–20, 1994): 4–6.
175 Carey C. Chern, “Interstate Banking Issues after the Riegle-Neal Act of 1994,” BNA’s Banking Report 65 (September 11,
1995): 415.
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The other main provision of the law allowed adequately capitalized and managed
banks to merge across state lines beginning June 1, 1997; this provision effectively repealed
the restrictions of the McFadden Act. The same U.S. and state concentration limits applied
to this provision, and again the statewide limits did not apply to initial entries into a state
and the limit could be waived by the host state. Neither limit applied to a merger involving
only affiliated banks. Compliance with state minimum-age laws and community reinvestment laws was required, and an exception was provided for mergers involving failed or failing banks. Foreign banks were permitted to establish and operate interstate branches, either
de novo or by acquisition and merger, to the same extent that a bank chartered in the foreign
bank’s home state could, and parallel provision was made for foreign banks to establish and
operate national bank branches.
As noted above, the states were given a great deal of control over the pace and scope
of the expansion of interstate branching. Under the law, states were permitted to “opt out”
of interstate branching by passing, before June 1, 1997, an explicit law prohibiting it. Conversely, states were also allowed to “opt in,” or permit interstate branching, by enacting appropriate legislation before June 1, 1997.176 By enactment of appropriate legislation, states
could also permit interstate bank mergers involving the acquisition of a branch, but without
the acquisition of the bank.177
Given the gradual moves that had been made at the state level, the Riegle-Neal Act
was not as revolutionary as it would have been if it had been enacted in 1985. Still, nationwide interstate banking and branching are likely to shape—and may accelerate—existing
trends toward increased consolidation and concentration within the banking industry. However (as a recent study has noted), passage of the act does not mean its provisions will be
used by most, let alone all, of the industry. The law “only increases the structural alternatives available . . . Neither it nor the marketplace mandates that all banking organizations
select an identical structure.”178
One additional post-FDICIA statute, rooted in the solutions adopted to deal with the
S&L debacle, was the Deposit Insurance Funds Act of 1996.179 It effectively closed the

176

For a discussion of the “opt-in/opt-out” debate, see Edward J. Kane, “De Jure Interstate Banking: Why Only Now?” Journal of Money, Credit and Banking 28, no. 2 (1996): 141–61.
177 This overview of Riegle-Neal is drawn from a summary of the law prepared by the FDIC (unpublished FDIC document,
April 1995). The law includes other provisions not discussed here. A detailed summary of Riegle-Neal appears in Chern,
“Interstate Banking Issues.”
178 David Holland et al., “Interstate Banking—The Past, the Present and Future,” FDIC Banking Review 9, no. 1 (1996): 10.
179 Public Law 104-208. See Title II, Economic Growth and Regulatory Paperwork Reduction, Subtitle G, §2701 et seq.
Some of this discussion on the SAIF is drawn from material in an unpublished FDIC briefing document compiled by Christine Blair and James McFadyen (January 1997).

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chapter on the S&L crisis. As noted above, in 1989 FIRREA had created two deposit insurance funds, the BIF and the SAIF, the latter replacing the insolvent FSLIC fund. Both insurance funds were required to be capitalized at a reserve ratio of 1.25 percent of insured
deposits. The BIF reached this goal in May 1995. The SAIF, however, remained undercapitalized, and as of March 31, 1995, had a reserve ratio of just 0.31 percent. Eighteen months
later the SAIF had a reserve ratio of 0.59 percent, approximately $4.5 billion short of full
capitalization.180 The reason the SAIF failed to reach the reserve ratio was that by statutory
requirements SAIF premiums were diverted to other purposes, notably the payment of interest on bonds issued by the Financing Corporation (FICO) created in 1987 under
CEBA.181
By 1994, the SAIF’s condition began to generate serious concern.182 Deposits in savings associations had been expected to grow but instead were declining, and the decline
raised the possibility of default on payments due on the FICO bonds.183 In addition, on July
1, 1995, the SAIF would assume the Resolution Trust Corporation’s responsibility for the
resolution of failed member institutions; in its then-undercapitalized condition, the fund
might have been rendered insolvent by a single large failure. Moreover, as the BIF drew
closer to its designated reserve ratio, the assumption was that the FDIC would respond by
reducing BIF assessment rates, putting SAIF-insured institutions at a long-term competitive

180

For insurance-fund reserve ratios during this period, see FDIC, Quarterly Banking Profile (1995 and 1996).
The FICO was created as the vehicle for recapitalizing the FSLIC. The law authorized the FICO to raise funds for the
FSLIC by selling bonds to the public (Huber, “CEBA,” 293–4). The FICO had an annual draw of up to $793 billion against
SAIF assessments until the year 2019. But not all SAIF assessment revenue could be used to meet interest on the FICO
obligations. The assessment revenue that could not be used was that from “Oakar” and “Sasser” institutions. (Oakar institutions are BIF-member banks that have acquired SAIF-insured deposits and pay deposit insurance premiums to both the
BIF and the SAIF. Sasser institutions are commercial banks or state savings banks that have changed charter from a savings association to a bank but remain members of the SAIF.) In addition, under FIRREA, SAIF assessments were diverted
not only to the FICO but also to payments to the FSLIC Resolution Fund and the Resolution Funding Corporation (a quasiprivate agency which was created under FIRREA to raise $30 billion for the RTC by selling 30-year bonds). See U.S.
House Committee on Banking, Housing and Urban Affairs, The Condition of the Savings Association Insurance Fund
[SAIF], 104th Cong., 1st sess., July 28, 1995, 85.
182 See U.S. General Accounting Office, Deposit Insurance Funds: Analysis of Insurance Premium Disparity between Banks
and Thrifts (GAO/AIMD-95-94, 1995). This report was prepared in response to a June 10, 1994, request by Congress. For
some time, however, the FDIC had been concerned about the condition of the SAIF and about the disparity between BIF
members and SAIF members. See, for example, the January 1992 letter from FDIC Chairman William Taylor to Richard
G. Darman, director, Office of Management and Budget, and the September 1993 letter from Acting FDIC Chairman Andrew C. Hove, Jr., to Representative James Leach, both of which are reproduced in U.S. House Committee on Banking and
Financial Services, Subcommittee on Financial Institutions and Consumer Credit, Condition of the Deposit Insurance
Funds and the Impact of the Proposed Deposit Insurance Premium Reduction on the Bank and Thrift Industries: Hearings,
104th Cong., 1st sess., 1995, 222–25.
183 Jim McTague, “Thrift Crisis, The Sequel,” Barrons (August 29, 1984): 34.
181

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disadvantage. (This did occur in 1995.)184 Such a situation would create an incentive for institutions to shift deposits from SAIF to BIF insurance, and although the attendant shrinkage in the SAIF assessment base would mean the fund would become capitalized more
swiftly, the stronger SAIF members would most likely be the ones able to succeed in moving deposits to the BIF, leaving weaker institutions covered by an insurance fund with a
higher risk profile.185 Moreover, the migration of deposits would end up diluting the BIF.
Movement toward a legislative solution began in earnest in 1995 but was not uncontentious. Many bankers felt that SAIF-insured institutions were attempting to shirk their responsibility for capitalizing the SAIF and were hoping to push Congress into having the
banks help pay for the S&L debacle. In June 1995, the position of the ABA president was
that Congress should not act, but watch and wait.186 By contrast, the bank regulatory agencies, the Treasury, the GAO, and many in Congress believed that a swift solution was necessary. The FDIC, the Office of Thrift Supervision, and the Treasury worked together to
create a plan for presentation to Congress that would be acceptable to the diverse elements
within the banking and thrift industries. By July 1995, the main elements in this framework
had been developed: to capitalize the SAIF fully, there would be a special assessment on institutions with SAIF-insured deposits; FICO payments would be spread over all FDICinsured institutions; and there would be a call for the merger of the deposit insurance funds.
The 1995 version of the bill failed to become law when President Clinton vetoed the Budget Reconciliation Bill, of which it was a part. The plan was eventually enacted as part of
the Budget Act for fiscal 1997.
The law imposed a one-time special assessment on SAIF-assessable deposits, payable
within 60 days of enactment. (On October 8, 1996, the FDIC Board of Directors set the assessment at 65.7 basis points, payable on November 27, 1996, thereby raising $4.5 billion
and fully capitalizing the fund.)187 In addition, the law expanded the FICO’s assessment au184

The FDIC’s Board of Directors lowered BIF assessment rates after the fund reached its reserve ratio. Effective in May
1995, the average rate fell from 23.2 basis points to 4.4 basis points, with the risk-based assessment range between 4 and
31 basis points. BIF assessment rates were lowered again in November 1995, effective January 1, 1996, with a range of 0
to 27 basis points. By contrast, as of September 1996, SAIF assessment rates remained at the much higher level of 23 to
31 basis points, with an average assessment rate of 23.4 basis points. Even after full capitalization of the SAIF, the FICO
payments were expected to keep SAIF rates significantly higher until 2019, when the last of the FICO bonds will mature.
185 By mid-March 1995, six SAIF-insured thrifts with $80 billion in deposits had announced their intention to form banking
affiliates (see Steve Cocheo, “Is It a Bank? Is It a Thrift? It’s a Colossal Flanking Maneuver,” ABA Banking Journal 87,
no. 5 [May 1995]: 7).
186 Howard McMillan, Jr., “What SAIF Crisis?” ABA Banking Journal 81 (June 1995): 13.
187 “Weak” institutions and certain other ones [see §2702(f)(1–3)] were exempted from paying the assessment. Exempted institutions were to continue to pay SAIF assessments at rates of 23 to 31 basis points per year for up to three years. For purposes of the special assessment, the SAIF deposits of certain BIF-member Oakar institutions and converted savings
associations were decreased by 20 percent. These Oakar institutions also received a permanent 20 percent reduction in
their SAIF-assessable deposits for future regular assessments.

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thority to all FDIC-insured institutions and separated the FICO rate-setting process from
that of deposit insurance. The law provided that the FICO assessment on BIF-assessable deposits was to be set at one-fifth the assessment imposed on SAIF-assessable deposits. Beginning either on January 1, 2000, or on the date when there are no longer any savings
associations (whichever is earlier), all insured institutions will pay equal FICO premiums.
The law also required that before January 1, 1999, SAIF assessment rates not be lower than
BIF rates; and it eliminated the previous minimum semiannual assessment of $1,000. 188 Finally, the law called for the merger of the BIF and the SAIF on January 1, 1999, but only “if
no insured depository institution was a savings association on that date.”

Conclusion
Between 1980 and 1994 there was clearly a tremendous amount of legislative and regulatory change. In Congress, in the federal regulatory agencies, and in the states, many
processes were taking place simultaneously. For example, at the same time that legislation
sought to provide new powers for banks, the banking agencies (pushed by Congress) were
also moving toward uniform capital requirements. But despite the many overlapping and
contrasting movements, the pattern that clearly emerges, particularly in legislation, is this:
at the beginning of the 1980s, with passage of both DIDMCA and Garn–St Germain, deregulation of the financial services industry, and especially thrifts, was dominant. Then as the
S&L crisis deepened and the banking crisis evolved, the emphasis turned to what has been
described as reregulation. This development was most evident in FIRREA and FDICIA,
both of which produced a great deal of change in the regulatory area. By 1994, with the
banking industry’s evident return to good health, deregulation was more acceptable—but
when and how far the pendulum will swing back are questions for the future.
188

On December 11, 1996, because the SAIF was fully capitalized, the FDIC Board of Directors lowered SAIF assessments
to a range of 0 to 31 basis points and adopted a rule, identical to that already in place for the BIF, that would allow further
adjustments within a 5-basis-point range without notice and comment; the Board then immediately reduced SAIF assessment rates to a range of 0 to 27 basis points.

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Chapter 3

Commercial Real Estate
and the Banking Crises
of the 1980s
and Early 1990s
Introduction
In the era of federal deposit insurance, the 1980s and early 1990s were unique periods
for the commercial banking industry: both the number of banks that failed and the volume
of losses they suffered were unprecedented. Behind banking’s problems lay large-scale
changes in the economic and regulatory environment. In addition, banks greatly increased
their exposure to commercial real estate markets during this era, only to have those markets
develop substantial problems.1
The demand for commercial real estate projects boomed during the early 1980s and
reached a speculative pitch in many markets. Real estate financing by commercial banks
and other institutions grew to meet the demand, because deregulation and other factors had
created an environment in which commercial real estate lending was lucrative for lenders,
especially with its large up-front fees. As a consequence, after 1980 commercial banks dramatically increased the volume of such credits.
But historically the commercial real estate industry had been cyclical, and that, combined with the banks’ aggressive lending, made it likely that lenders would eventually suffer financial losses when markets turned. When the bust did arrive in the late 1980s and
continued into the early 1990s, the banking industry recorded heavy losses, many banks
failed, and the bank insurance fund suffered accordingly. Compounding the magnitude of
these losses was the fact that many banking organizations active in real estate lending had
weakened their underwriting standards on commercial loan contracts during the 1980s.

1

For the discussion of market activity in this chapter, “commercial real estate” refers to office, retail, and industrial
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This chapter presents an account of the boom and bust in commercial real estate markets in the 1980s and highlights the role commercial banks played in this process. The first
two sections discuss the risks associated with commercial real estate investments and the
ways in which tax-law changes during the 1980s influenced the climate for commercial real
estate investing. (The appendix to the chapter illustrates how specific tax-law changes affected the viability of commercial real estate investments.) The third section surveys trends
in supply, demand, and asset prices during the boom and bust. The following section highlights the involvement of commercial banks in the commercial lending boom, and is followed by a section on the changing underwriting standards and another on the changing
appraisal policies of lenders during this period (an account of the reforms subsequently enacted is also included). The final section discusses the relationship between bank failures
and losses on commercial real estate.

Risks Inherent in Commercial Real Estate Markets
Investments in commercial real estate (for example, office buildings, retail centers,
and industrial facilities)—at any stage of the development process—have traditionally been
quite risky. Real estate markets as a whole are traditionally cyclical, so that even the most
well-conceived and soundly underwritten commercial real estate project can become troubled during the periodic overbuilding cycles that characterize these markets. For this reason, historically federal bank regulators have supervised the terms of loans made to
commercial real estate ventures and have prohibited federally chartered banks from investing directly in such ventures.2
The riskiness of investments in commercial real estate has a number of aspects. First,
the demand for commercial real estate is affected not only by local economic factors and regional developments but also by national economic trends. This is because firms seeking
commercial floor space typically can choose between a number of locations in different
parts of the country. Thus, the developer of an industrial park in New Jersey, for example,
would have to be concerned not only about how both existing and future developments in
that state might affect demand for the project but also about how market conditions in competing locations—for example, Florida or Texas—might affect the northeastern developer’s
ability to attract and keep tenants.
Another factor complicating investments in commercial real estate is that information
about specific projects and markets is often difficult to obtain. These are not highly organized markets, so data on market developments cannot be easily gathered. Moreover, many
2

However, while not involved in direct equity investing, banks own and manage substantial amounts of commercial real estate acquired through loan foreclosures.

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transactions are private, and the major terms of the investments may not be available to the
public. (Construction costs, for example, are a private matter between the developer and the
contractor.) In addition, widespread statistical data are not available on transaction prices as
they are for single-family structures, so gauging selling prices or rental income is difficult—and even if the statistical data were available, it would be difficult to account for the
many complex financing techniques (such as tenant improvements and rent “discounting”)
involved in commercial sales and rents.
Other risks are also associated with the financing aspects of most commercial real estate investments, which adds to the volatility of the markets and the prices of commercial
properties. Most real estate projects are highly leveraged—that is, they are funded primarily by debt as opposed to equity capital by the investor. The effect that leverage has on both
the borrower’s and lender’s risk helps add to the volatility of the commercial real estate
markets. Generally, leveraged investments will be highly sensitive to changes in interest
rates and overall credit conditions. For this reason, the prices of commercial real estate can
decline precipitously during periods of rising interest rates, and vice versa.
Risk in commercial real estate also derives from government tax and other policies.
Since World War II, depreciation allowances and tax rates have changed periodically, and
these changes have affected the demand for and the profitability of real estate investments.
During the 1980s, changes in the federal tax code were important factors influencing both
the boom and to some extent the bust conditions in commercial markets (tax issues are discussed in the next section). In addition, federal mandates requiring cleanup of existing environmental hazards may impose unforeseen costs on investors. Changes in state and local
laws governing environmental restrictions on new construction may add unexpected costs
to a project, or may even bar its intended use. Similarly, an unanticipated zoning change can
have a positive or negative effect on the prospects of an investment.
Also contributing to the challenges of these investments is the nature of the production process itself when construction lending is involved. Real estate construction projects,
and especially large commercial development projects, typically have long gestation periods, and these are superimposed on the traditional cyclicality of the economy and of real estate markets. Thus, the economic prospects for a real estate construction project can change
considerably between inception and completion.
Other risks associated with commercial real estate investing are related to macroeconomic changes in the economy. The value of commercial property is highly sensitive to
changes in the availability of credit. When financial institutions cut back or restrict funding
for these types of investments over the business cycle, prices of existing properties can fluctuate widely and the volume of new investments can be severely affected. In part, this produces the well-known feast-or-famine cycle in commercial real estate markets. An extreme

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example of this scenario is the “credit crunch” in the early 1990s, which diminished access
to credit and restricted demand for commercial real estate investments across the nation,
thereby eliminating some potential investors from the market. Consequently, during this period the demand for and prices of commercial real estate declined significantly.3
Finally, the structure of most commercial loans involves unique risks for the lender.
Commercial loans are complex legal documents that usually have “nonrecourse” provisions
prohibiting lenders from satisfying losses from other borrower assets. Nonrecourse provisions provide borrowers with extra bargaining power to force lenders to accept modifications in the event of problems. Moreover, commercial borrowers are usually sophisticated
and possess the resources to contest lender actions. Furthermore, in the event of foreclosure,
banks often have little specialized in-house expertise for dealing with the unique problems
of commercial REO (foreclosed real estate) sale and management. All of these factors can
make investing in commercial real estate projects a risky business for all parties involved in
the transaction.

The Effect of Major Tax Legislation
Two major pieces of tax legislation—the Economic Recovery Tax Act of 1981
(ERTA) and the Tax Reform Act of 1986—had unusually strong effects on commercial real
estate markets during the 1980s.4 ERTA included several provisions that improved the rate
of return on commercial real estate and increased demand for these investments. Five years
later, the Tax Reform Act repealed many of these same benefits. (A numerical example of
the effect that both sets of tax-law changes had on commercial real estate investment returns
is presented in the appendix to this chapter.) Among ERTA’s most important provisions
were a lowering of ordinary income tax rates (the rate for the highest earners, for example,
fell from 70 percent to 50 percent) and a lowering of the capital gains tax rate from 28 percent to 20 percent. However, what distinguished this tax act from earlier ones was the
change in depreciation rules for commercial real estate. Specifically, an “Accelerated Cost
Recovery System” (ACRS) was introduced. ACRS allowed investors in commercial property to depreciate a building over 15 years—a period considerably shorter than its economic
life. Under earlier tax legislation, 40 years was the standard. Moreover, this new cost recovery system also permitted the use of a 175 percent declining-balance method rather than
3

4

The dramatic reduction in bank lending in the early 1990s for the purchase and development of commercial real estate was
brought on by many factors, including the 1990–91 national recession, the closing of insolvent thrift institutions, the implementation of new risk-based capital standards for commercial banks, and the generally closer supervision of financial institutions after passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. These issues are
discussed below.
Investments in residential real estate are also affected by federal tax laws, but this chapter focuses primarily on investments
in commercial real estate properties.

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simple, straight-line depreciation, and thereby increased, or “accelerated,” the tax deductions
available in the early years of a property’s holding period. These new provisions had the effect of increasing the after-tax return on commercial real estate investments relative to other
classes of assets. This was accomplished by deferring taxes and later, upon sale of the property, “recapturing” much of the earlier depreciation at a lower tax rate than the rate that had
applied to the previous depreciation deductions. These provisions were a major reason for
the accelerated production cycle of commercial real estate during the first half of the 1980s.
The Tax Reform Act of 1986 further lowered all marginal tax rates, including the rate
for the highest earners (from 50 percent to 38.5 percent), but it countered that change by
eliminating not only the ACRS but also the ability of taxpayers to offset other income with
“tax losses” from “passive” investments in commercial real estate. Deductions and losses
from one business or rental activity had generally been allowed to offset income from other
business activities and investments. After 1986, losses from passive activities (generally defined as those activities in which the taxpayer does not materially participate, and any rental
activity) were allowed to offset only income from other passive activities, and credits from
passive activities were applicable only to the tax attributable to income from such activities.
The consequences of these provisions was to dampen the demand for commercial real estate investments during the late 1980s and early 1990s, and the dampening of demand
helped soften real estate prices.
The importance of these tax considerations is reflected in the rise and fall of real estate limited partnerships during the 1980s. According to data from the Roulac Group (a real
estate consulting unit of Deloitte & Touche), the market for this investment vehicle had
grown fivefold between 1981 and 1985. After reaching a high point of attracting $16 billion
in new capital in 1985, real estate limited partnership sales fell precipitously over the next
four years, gathering only $1.5 billion in new capital in 1989.

Boom and Bust: Trends in Commercial Real Estate Supply,
Demand, and Asset Prices
As the nation’s commercial real estate markets entered the 1980s, supply and demand
for commercial real estate were in relative balance and investment returns were attractive.5
Heavy demand in the late 1970s had absorbed much of the excess space remaining from the
burst in construction activity of the early 1970s and had trimmed vacancy rates in most markets to below 10 percent.6 In the late 1970s sharp, unanticipated inflation set off a wave of
5

6

According to data from the National Council of Real Estate Investment Fiduciaries and the Frank Russell Company (these
two groups together produced the Russell-NCREIF report), returns on the office properties owned by institutional investors
in the late 1970s and early 1980s averaged 21.9 percent; returns on warehouse/industrial and retail properties were 16.5 percent and 11.7 percent, respectively. In 1995 the Russell-NCREIF Report ceased publication.
CB Commercial Torto/Wheaton Research.

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speculative demand for real estate—and commercial real estate markets experienced an unprecedented building boom (particularly in the office sector) that lasted in one region of the
country or another throughout the 1980s. From 1980 to 1990, the annual average value of
new nonresidential construction put in place was $108 billion (in 1992 dollars)—up from
approximately $71 billion during the period 1975–79 (see figure 3.1).7 The boom collapsed
starting in the late 1980s, however, and the decade of the 1980s closed with many markets
across the nation severely depressed, affected by historically high vacancy rates and falling
prices and rents. Construction activity on commercial properties declined to about the levels of the early 1980s.
The regions where the boom-and-bust scenario played out included the Southwest,
Alaska, Arizona, the Northeast, and California. In Texas, major markets such as Austin,
Dallas, and Houston experienced the building cycle early, spurred in part by robust local
economic growth during the late 1970s and early 1980s which significantly increased office
vacancy rates (see figure 3.2); it was followed by the bust in the late 1980s. More or less simultaneously, markets in Louisiana and Oklahoma had similar boom-and-bust experiences,
Figure 3.1

Total Nonresidential Construction Put in Place,
1970–1994 (1992 Dollars)

$Billions
125

100

75

50

1970

1975

1980

1985

1990

1994

Source: U.S. Department of Commerce, Bureau of the Census, Current
Construction Reports, series C30, monthly.
Note: “Put in place” refers to the dollar value of new construction completed.

7

“Put in place” refers to the dollar value of new construction completed.

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Figure 3.2

Office Vacancy Rates in Major Texas Cities,
1980–1994

Percent
40

Austin

30

Dallas

20

Houston

10
0

1980

1982

1984

1986

1988

1990

1992

1994

Source: CB Commercial/Torto Wheaton Research.
Note: Data for Austin are not available before 1985.

to be followed by Alaska. In Arizona, commercial real estate activity (as measured by the
value of new permits issued) more than doubled between 1983 and 1985, then declined 56
percent during the next six years. In New England and other northeastern states, commercial construction boomed in the mid-1980s. New permit activity was up 100 percent in
Massachusetts between 1983 and 1986, 137 percent in Connecticut between 1983 and
1987, and 87 percent in New Jersey between 1983 and 1989. In all cases, severe overbuilding was followed by high vacancy rates and then by sharp declines in new construction activity, as evidenced by the decline in new building permits (see figure 3.3). In California the
value of newly issued commercial permits increased by almost 50 percent from 1983 to
1988 before plunging 31 percent between 1988 and 1991.8
Although overbuilding and a subsequent run-up in vacancy rates characterized most of
the major commercial property types (office and retail), nationally the office sector was particularly affected (see figure 3.4). After surging 221 percent between 1977 and 1984, office
construction put in place was pared back somewhat during the second half of the decade before declining rapidly during the early 1990s. Because the production process is generally
much longer for office buildings than for retail or industrial properties, the adjustment to
8

Chapters 9–11 describe the events in the Southwest, the Northeast, and California, respectively.

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Figure 3.3

Commercial Real Estate Cycles in Selected States,
1980–1994
(Value of Newly Issued Nonresidential Permits)

$Billions
3.00

Massachusetts
2.25

New Jersey

Arizona

1.50

0.75

Connecticut
0

1980

1982

1984

1986

1988

1990

1992

1994

Source: U.S. Department of Commerce, Bureau of the Census, Building Permits
Division.

market conditions is correspondingly slower. As a result, the office sector remained out of
balance during the entire decade.
In both dollars and square feet, the magnitude of the 1980s office boom was extraordinary. In dollars, the nationwide upswing in new construction that began in 1977 with $11
billion worth of office construction put in place peaked eight years later with $41 billion
worth of space produced (figure 3.4). In terms of floor space, during the five-year period
1975–79, in the 31 largest office markets around the country, an annual average of 33.6 million square feet per year were completed (see table 3.1). In the next five-year period, completions of new floor space almost tripled, reaching an annual average of 97.8 million
square feet. From 1985 to 1989, the pace of completions remained at about the same level;
then starting in 1990, it plunged to an average of 28.1 million square feet per year over the
next four years.
The demand for new office space tracked the conditions in the office job market. During the late 1970s, office job growth exceeded 4 percent annually (see figure 3.5).9 Office
9

Office employment is defined as the finance, insurance, and real estate sectors as well as office-using services, such as accounting, advertising, personnel services, mailing, and computer processing.

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Figure 3.4

Nonresidential Construction Put in Place,
1975–1994 (1992 Dollars)

$Billions
40

Other*

30

Industrial

20

Office

10
1975

1980

1985

1990

1994

Source: U.S. Department of Commerce, Bureau of the Census, Current
Construction Reports, series C30, monthly.
* “Other” includes retail construction.

Table 3.1

Production of New Office Space,
31 Major Markets, 1975–1994
Period

New Completions*
(Millions of sq. ft.)

Absorptions†
(Millions of sq. ft.)

1975–1979
1980–1984
1985–1989
1990–1994

33.6
97.8
100.7
28.1

44.3
64.2
73.6
33.3

Source: CB Commercial/Torto Wheaton Research.
*Annual average during the period.
†“Absorptions” refers to the net change in occupied space over a defined period.

employment continued to exceed 4 percent annually from 1980 through 1989 with the exception of the recession-related respite in 1982. As a consequence, the absorption of new
office space increased sharply during most of the decade as well.
However, even though demand as measured by absorption rates increased substantially during the 1980s, it was outpaced by the booming construction (supply) of new office
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Figure 3.5

Office and Total Employment Growth,
1976–1994

Percentage Change
8

6.8
4.8

4

7.7
6.7

6.2
4.9

4.3 4.5

Office
Employment

4.34.3 4.5

3.0

3.9
2.0

1.8

0.5

0

Total
Employment
-4

3.1 2.9

-2.7

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994

Source: CB Commercial/Torto Wheaton Research.

space. In major markets, new completions exceeded absorptions every year from 1980 to
1992 (see figure 3.6). As a result, vacancy rates in major markets rose to unprecedented levels, nearly quadrupling between 1980 and 1991 from 4.9 percent to a peak of 18.9 percent.
Office job growth diminished after 1989, as corporate downsizing, mergers, and consolidations became commonplace in the service sector, reducing the demand for office space (figures 3.5 and 3.6).
Like the office sector, the retail sector also boomed nationwide during the 1980s. Favorable underlying demographics and economic growth led to gains in retail sales that averaged 6.8 percent per year between 1982 and 1987—far above long-run trends.10 That
growth provided the stimulus for retail development. “Other” construction activity, which
is dominated by the retail sector, rose sharply during 1984–85 and then remained steady
during the second half of the 1980s, averaging about $35 billion in construction put in place
annually (figure 3.4). This level was up from an annual average of approximately $24 billion during the first half of the decade.
Estimates of aggregate supply and demand for retail properties for 56 major markets
across the country are presented in figure 3.7. Between 1984 and 1990, construction of new
10

U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business.

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Figure 3.6

Office Market Conditions, 1980–1994
(31 Major Markets)

Millions of Square Feet
160

Net New
Supply

120

Vacancy Rate Percent
20

16

Vacancy
Rate

12

80

Increase in
Occupied Space

40

0

1980

1982

1984

1986

1988

8

1990

1992

1994

4

Source: CB Commercial/Torto Wheaton Research.

Figure 3.7

Retail Market Conditions, 1980–1994
(56 Major Markets)

Millions of Square Feet

Vacancy
Rate

Net New
Supply

120

Vacancy Rate Percent
12

8

80

4

40

Increase in
Occupied Space
0

1980

1982

1984

1986

1988

1990

1992

1994

0

Source: CB Commercial/Torto Wheaton Research.

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retail space is estimated to have averaged 94.8 million square feet annually in these markets. During the same period new demand for retail space also increased strongly, averaging 51.6 million square feet, but failed to keep pace with the supply of new product. As a
result, retail vacancy rates are estimated to have risen from 4.9 percent in 1983 to 10.8 percent in 1991. From 1991 to 1994, completions of new retail space fell 28 percent to 64.8
million square feet—well below the demand for new space. As a consequence, retail vacancies retreated to 7.6 percent by 1994.11
Unlike the office and retail sectors of the commercial real estate market, the industrial
real estate sector did not experience a boom during the 1980s (figure 3.4). Industrial construction surged nationwide in the late 1970s, reaching a peak of about $26 billion in 1979
(measured in 1992 dollars). During much of the 1980s activity trended downward before
leveling off in the early 1990s. Because of adjustments in production, the balance between
supply and demand for industrial space in the 1980s was relatively good for several years
during the decade. Nevertheless, as in the other sectors, net new supply still exceeded demand for most of the decade, and vacancy rates rose.
Data on supply and demand conditions in 31 major markets illustrate that pattern (see
figure 3.8). The supply of new industrial floor space peaked in 1978–79, then trended
downward during the early part of the 1980s before leveling off during the remainder of the
decade. On average, 133 million square feet of new supply came to market each year during the decade. At the same time, demand for industrial floor space averaged only 104 million square feet annually. As a result, the overall vacancy rate in these 31 major markets rose
from 4.6 percent in 1979 to 10.7 percent in 1991.
Starting in the late 1980s and continuing into the early 1990s, the condition of real estate markets changed dramatically. “Boom” conditions turned into “bust” conditions for all
types of commercial properties.12 A number of factors accounted for this sharp deterioration. The closing of hundreds of insolvent thrift institutions by the Resolution Trust Corporation starting in 1989 dried up an important source of financing for real estate ventures. At
the same time, risk-based capital standards were being phased in for the banking industry;
these standards required higher capital levels behind commercial real estate loans and
helped reduce the supply of new loans at that time.13 Regulatory officials were also sub11

12

13

Commercial activity in the form of hotel/motel construction (not discussed above) was also volatile during this period, tracing a pattern similar to the retail sector, rising 315 percent between 1975 and 1985, leveling off, and declining 64 percent
between 1990 and 1992.
For a good discussion of the issues associated with the boom-and-bust conditions of real estate markets during the 1980s,
see Patric H. Hendershott and Edward J. Kane, “Causes and Consequences of the 1980s Commercial Construction Boom,”
Journal of Applied Corporate Finance (spring 1992): 61–70.
See, for example, Diana Hancock and J. A. Wilcox, “Bank Capital and the Credit Crunch: The Roles of Risk-Weighted and
Unweighted Capital Regulations,” AREUEA 22 (January 1993): 59–94.

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jecting commercial banks to more frequent examinations and closer supervisory scrutiny,
given passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989
(FIRREA) and the increasing number of bank and thrift failures. The national recession of
1990–91 reduced the demand for commercial space, and the combination of reduced demand and the overbuilding of the 1980s produced significant declines in rents, prices, and
returns for commercial real estate properties. As a consequence, credit quality for outstanding real estate loans on the books of surviving institutions was also declining rapidly. This
induced many real estate lenders to cut back on the origination of new commercial real estate loans and to tighten underwriting standards.14 Primarily for these reasons, new commercial real estate construction plunged during the 1990s.
In the office sector, new construction activity almost came to a halt. In the 31 major
markets tracked by CB Torto/Wheaton Research, only 1.7 million square feet were completed in 1994. The pace of both retail and industrial construction similarly slackened, having peaked in the mid-1980s. By 1994, completions of new retail space had fallen almost 50
percent (figure 3.7), while construction of new industrial buildings was only a small portion
of its previous peak (figure 3.8). Furthermore, bank lending for construction and land deFigure 3.8

Industrial Market Conditions, 1977–1994
(31 Major Markets)

Millions of Square Feet

Net New
Supply

200

Vacancy Rate Percent

Vacancy
Rate

12

150

10

100

8

Increase in
Occupied
Space

50
0
-50

1978 1980 1982 1984 1986 1988 1990 1992 1994

6
4
2

Source: CB Commercial/Torto Wheaton Research.

14

It is generally recognized that industry-wide underwriting standards for most types of commercial real estate loans declined
during the 1980s and, in the face of mounting real estate losses during the 1990s, were revised upward. These issues are
discussed below.

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velopment, which peaked in 1989 at almost $136 billion, by 1993 fell to a ten-year low of
just over $66 billion.
The drop-off in new construction activity allowed the existing overhang for all types
of commercial properties to be absorbed. By the early 1990s, the demand for commercial
properties exceeded the new supply for the first time since the commercial real estate boom
had begun. Demand has continued to outpace supply since that time, with vacancy rates
falling (figures 3.6, 3.7, and 3.8).
As mentioned above, the overbuilding in the commercial real estate markets during
the 1980s resulted in declining rental rates, falling property values, and decreasing returns
to investors. Although no comprehensive data are available on rents, asset prices, and returns for commercial real estate, the National Real Estate Index (NREI) and the RussellNCREIF index provide information on limited sets of commercial properties. As such,
these data may not be representative of the entire market.
According to the NREI, in 51 major metropolitan markets both the mean prices and
rents per square foot and the mean sale prices per square foot of office, industrial, and retail
properties began to slide between mid-1989 and mid-1990. Although all three types of commercial properties experienced declines, the drop in rents and prices was most pronounced
for office properties. For example, from the middle of 1989 through the first quarter of
1994, the average sale price per square foot of commercial office property declined from
$182 to $133, a drop of approximately 27 percent. Office rents declined a more modest 17
percent, from approximately $24 to $20 per square foot.15
At the same time that rent levels were restrained by rising vacancy rates and leasing
concessions, operating expenses climbed. According to the Russell-NCREIF index, which
tracks prime-quality office properties, between 1982 and 1991 net operating income (NOI)
for these properties declined by an average annual rate of 0.9 percent (the rate was weighted
by the 3.4 percent rate of average annual decline in NOI between 1986 and 1990). In addition, on the basis of appraisal and sales data, the same properties lost just over 26 percent in
value from 1987 to 1993.16 Falling NOI and property values resulted in negative overall returns. The NCREIF data show that overall returns on all of these commercial real estate
properties plummeted from a total return of 18.1 percent in 1980 to a negative 6.1 percent
in 1991.17 Returns continued to be negative or close to zero until 1994.
A 1993 study involving FDIC receivership assets provides additional empirical evidence of the dramatic change in commercial real estate prices during this period. The study
15
16
17

National Real Estate Index, Market Monitor (1989–1994).
The Russell-NCREIF Real Estate Performance Report (fourth quarter 1994).
Ibid.

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analyzed changes in collateral values on a loan-by-loan basis, using data on assets that the
FDIC’s Division of Liquidation managed after obtaining them from failed banks.18 Approximately 224 loans were reviewed from a random sample of 400 loans, evenly distributed regionally and selected from a population of the approximately 6,000 nonperforming
commercial real estate loans held by the FDIC receiverships as of mid-1992. Because the
loans analyzed were obtained from failed banks, they may not be representative of the
changes in value for the commercial real estate market as a whole during the 1980s.
The results indicate that the average decline in collateral value for the 224 loans reviewed was 54 percent. Furthermore, for three-quarters of the loans the 1992 collateral
value was at least 25 percent below the original evaluation; and for almost one-half, the collateral lost at least 50 percent of its former assigned value. In contrast, less than one-tenth
of the collateral had appreciated in value after the loan was originated. As expected, these
losses varied according to region. For example, one-half of the loans reviewed from Connecticut lost 63 percent or more of their original valuation, and one-half of the loans from
Texas and Louisiana lost 58 percent or more of their original valuation. Loans from states
affected less severely by commercial real estate problems, such as California and Florida,
lost about 30 percent and 34 percent, respectively, of original appraised value.

The Involvement of Banks
During the 1980s, as the levels of total loans to total assets on the balance sheets of
U.S. commercial banks increased, bank loan portfolios also became relatively riskier.
Banks reallocated resources toward more real estate loans, emphasizing commercial real
estate loans.19 The increases in total loans, in real estate loans, and in commercial real estate loans eventually had implications for the number of bank failures and the size of losses
to the bank insurance fund.
These trends are presented in table 3.2. Between 1980 and 1990, total loans and leases
increased from 55 to 63 percent of total assets—a record high. Total real estate loans increased sharply as well, going from approximately 18 to over 27 percent of total assets,
whereas total consumer loans grew only slightly, from approximately 10 percent to 11 percent, and total commercial and industrial loans declined, dropping from approximately 20
percent to 17 percent of total assets.

18

19

James L. Freund and Steven A. Seelig, “Commercial Real-Estate Problems: A Note on Changes in Collateral Values Backing Real-Estate Loans Being Managed by the Federal Deposit Insurance Corporation,” FDIC Banking Review 6, no. 1
(spring/summer 1993): 26–30.
Commercial real estate loans consist of loans for construction and land development, loans secured by nonfarm nonresidential properties, and loans secured by multifamily properties.

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The changes in the composition of banks’ real estate loan portfolios over this period
are presented in figure 3.9. Construction and land development loans increased from nearly
2 to 4 percent; loans secured by 1- to 4-family properties rose from 10 to 14 percent of assets; nonfarm nonresidential real estate loans increased from approximately 4 to over 7 percent. Finally, loans originated on multifamily properties were relatively unchanged over the
period. In dollar terms, between year-end 1980 and year-end 1990 total loans and leases
held by banks more than doubled, from $1.0 trillion to $2.1 trillion (not shown). During the
Table 3.2

Major Loan Categories of U.S. Banks as a
Percentage of Total Assets, 1980 and 1990
1980
(Percent)

1990
(Percent)

17.8
19.5
9.6
55.4

27.1
17.1
11.3
62.8

Real estate loans
Commercial and industrial loans
Consumer loans
Total loans and leases

Figure 3.9

Percent

Real Estate Loan Portfolio of U.S. Banks
as a Percentage of Total Assets,
1980 and 1990
1980
1990

13.9

12
10.2

8

7.3
3.7

4
1.9

0

152

3.9
1.1 1.0

Multifamily
Construction 1- to 4-Family Nonfarm
Residential Nonresidential Properties
and Land
Development Properties
Properties

0.4 0.5
All Other

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same period, total real estate lending more than tripled, from $269 billion to $830 billion;
and commercial real estate loans almost quadrupled, from $64 billion to $238 billion.
In the wake of the significant loan-portfolio expansion during the 1980s, the overall
quality of the banks’ loans deteriorated. Between 1984 and 1991, nonperforming loans rose
from 3.1 percent to 5.2 percent, while net loan charge-offs jumped from 0.7 percent to a
peak of 1.6 percent (see table 3.3). The loss experience with commercial real estate credits,
however, was more pronounced than the loss experience for the overall portfolio. Although
data are not available until 1991, in that year the proportion of commercial real estate loans
that were nonperforming or foreclosed stood at 8.2 percent, and in the following year net
charge-offs for commercial real estate loans peaked at 2.1 percent.

Loan Underwriting Standards
The amount of the commercial real estate–related losses recorded by the banking industry was compounded somewhat by the loosening of underwriting standards on commercial loan contracts. It is generally recognized that many banks, under intense competitive
pressure from other banks, thrifts, and other financial institutions, relaxed contract terms

Table 3.3

Real Estate Loan Portfolio Quality,
U.S. Banks, 1984–1994

Year

Nonperforming
Loans/Total
Loans*

Net Charge-offs/
Total Loans

Noncurrent
Commercial Real
Estate Loans/Total
Commercial Real
Estate Loans†

1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

3.1%
2.9
3.1
3.7
3.3
3.6
4.8
5.2
4.4
2.8
1.8

0.7%
0.8
0.9
0.8
0.9
1.1
1.4
1.6
1.3
0.8
0.5

NA
NA
NA
NA
NA
NA
NA
8.2%
7.0
4.7
1.4

Charge-offs on
Commercial Real
Estate Loans/Total
Commercial Real
Estate Loans
NA
NA
NA
NA
NA
NA
NA
2.0%
2.1
1.4
0.8

Note: Data are not available for years before 1984.
*Nonperforming loans include loans 90 days past due, non-accruing loans, and repossessed real estate.
†Noncurrent commercial real estate loans include non-accruing loans and repossessed real estate.

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during the 1980s and therefore assumed more credit risk.20 However, because little empirical evidence exists to document these trends, the discussion in this section is based primarily upon information gathered directly from interviews with a variety of sources, including
(1) field examiners of the federal bank regulatory agencies who had direct experience reviewing real estate loans in the 1980s, (2) other federal bank regulatory staff who tracked
these issues during the period, and (3) commercial bankers who had knowledge of banking
practices during this decade.21
The heightened competition banks faced during the 1980s was a result of many factors, including the removal of deposit interest-rate ceilings, which significantly increased
the cost of doing business; the granting of expanded lending and investment powers to thrift
institutions; the increase in the number of newly chartered banks (approximately 2,800 new
charters were granted during the 1980s); pressure from bank stockholders to improve earnings; the large-scale conversion of savings banks from mutual to stock ownership, a conversion that increased demand for new investments; and the loss of a sizable portion of the
commercial and industrial lending business to the commercial paper market. Under these
circumstances, many banks adopted riskier loan polices in an attempt to increase revenue
and to maintain market share vis-à-vis other lending institutions. Both examiners and commercial bankers themselves who were familiar with the issues of that time suggested that
banks had increasing difficulty coping with the new environment and that many conservatively managed institutions assumed greater risks because of the general belief that “if we
don’t make the loan, the institution across the street will.”
In this environment, commercial real estate lending was attractive to many institutions. These credits brought large up-front fees, which generated immediate income (particularly from construction loans). Such fee income became essential to many struggling
institutions. The experts who were interviewed observed that as commercial real estate
lending expanded, underwriting standards for the major types of commercial real estate
loans (land, construction, and mortgage) were loosened significantly. The key changes
noted dealt with two fundamental areas of risk control: (1) ensuring that the income gener-

20
21

For a discussion of these issues, see Hendershott and Kane, “Causes and Consequences,” 65–67.
From April to June 1995, FDIC staff conducted a series of interviews with regulatory officials from the FDIC, the Federal
Reserve System, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision, some of whom were
located in the six cities listed below and some of whom were senior officials at the agencies’ headquarters in Washington,
D.C. Also interviewed were commercial bankers in the six locations: Atlanta, Boston, Dallas, Kansas City, New York, and
San Francisco. Altogether approximately 150 regulatory officials and bankers were interviewed for this analysis.

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ated by a project is sufficient to cover the interest and principal payments on borrowed
funds, and (2) establishing adequate loan-to-value guidelines.22
Traditionally, decisions to extend loans that are collateralized by commercial real estate property are evaluated by lenders primarily on the borrower’s ability to generate earnings from the investment sufficient to cover the existing debt payments. This is a
fundamental tenet of the lending function. As a backup source of security, lenders evaluate
the worth of the investment property as potential collateral to cover the loan value in the case
of default by the borrower. Starting in the late 1970s and continuing for most of the following decade, examiners observed that lenders loosened loan terms relating to debt-service
coverage and placed relatively more emphasis on the value of the collateral in making funding decisions. This change in loan procedures was based primarily on the assumption that
real estate values (collateral values) would continue to rise in the future as they had in the recent past. In this respect, many lenders mistakenly anticipated that the demand for commercial space (office, retail, and industrial) would remain strong and would keep pace with
construction activity. When the real estate markets collapsed starting in the late 1980s, many
lenders discovered that collateral values were often insufficient to cover existing loan losses.
Also with respect to debt-service issues, lenders often liberalized the frequency and
timing of principal payments. In some situations, examiners found credits in which the
lender allowed the principal payments to be renewed repeatedly.23 Or when interest payments fell into arrears, the unpaid interest was frequently added back to the unpaid principal, or “capitalized.” According to experts, this practice of capitalizing interest payments
had been relatively uncommon before the 1980s.
Examiners also noted important changes in the loan-to-value criteria adopted by
banks during the 1980s. To maintain market share, many banks chose to raise their maximum loan-to-value ratios, thereby decreasing the amount of borrower’s equity at risk and
increasing the risk to the lender. Moreover, appraised property values, which constitute the
denominator in the loan-to-value ratio, frequently provided overly favorable collateral values and/or were often based on speculative premises.24 In addition to standards on debtservice capacity and loan-to-value ratios, other basic underwriting standards were also
relaxed in many regions of the country. For example, secondary repayment sources—the re22

23
24

Sound underwriting policies in lending institutions require that borrowers invest some percentage of their own funds into
a project, with the balance being placed by the lender. This standard provision is referred to as the loan-to-value ratio (the
total amount financed by the lender as a percentage of the total investment or value of the collateral). The lower the amount
of borrower’s funds as a percentage of the total investment, generally the larger the credit risk for the lending institution.
Whether this principal “workout” provision was more common in the real estate transactions of the 1980s than in other
decades is not known.
Appraisal policies on commercial properties during the 1980s are discussed in the next section.

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course, or the guarantors of the original loan amount—often were not actively scrutinized
by the lender. In contrast, the traditional practice usually involves a detailed analysis of the
recourse party’s repayment capacity.
According to examiners and bankers, during the 1980s many banks also abandoned
their traditional reluctance to lend outside their local areas and often became involved in
lending on real estate projects for which they had little or no direct experience. Lenders either provided direct funding to out-of-area projects or purchased loan participations from
out-of-area institutions, and often the bank acquiring the loan participation had only a limited relationship with the out-of-area financial institution. Moreover, in their eagerness to
participate in the burgeoning commercial development market, many institutions became
involved in real estate transactions without having had adequate experience in structuring,
monitoring, or administering specialized commercial real estate credits. As a consequence,
many of these projects later ended up in default.

The Role of Appraisers and Subsequent Reforms
Current federal regulations require that federally insured depository institutions obtain an “outside” or independent opinion on the collateral value for most real estate loans
before committing funds. The premise underlying the rule is that the real estate appraiser is
the only “independent” or “neutral” party involved in the transaction, whereas both borrowers and lenders have vested interests. An experienced appraiser is assumed to bring specialized knowledge of local real estate markets to the transaction and, if conservative
loan-to-value rules are followed, is expected to serve as a potential check on the amount of
funds being committed to a project. Thus, the appraisal is expected to be an integral part
of the loan decision and to provide another perspective from which to evaluate the viability
of the project.
Evidence about appraisal polices during the 1980s shows that flawed and fraudulent
appraisals were often used by federally insured financial institutions, especially thrift institutions, and that these practices were associated with most depository-institution failures
during the period.25 The paragraphs that follow summarize the comments of the bank ex-

25

See Patric H. Hendershott and Edward J. Kane, “U.S. Office Market Values during the Past Decade: How Distorted Have
Appraisals Been? Real Estate Economics 23 (1995): 101–116. The U.S. House Committee on Government Operations,
which investigated depository institutions’ appraisal policies during the 1980s and early 1990s, found widespread evidence
of incompetence and fraud associated with appraisal practices, primarily at thrift institutions but to some extent at commercial banks. It was noted in the public record that these appraisal policies caused or were associated with most depository-institution failures. As a consequence of the investigations, major reforms in the area of appraisals were enacted in
FIRREA in 1989 (these reforms are discussed below). See the U.S. House Committee on Government Operations, Impact

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aminers and commercial bankers interviewed about the appraisal process during the 1980s
(see footnote 21). They are followed by a brief description of the reforms legislated in 1989.
In the 1980s, appraisals ceased to be as useful a part of the commercial loan process
as they had been in previous years. During the early to middle years of the decade, when
many markets experienced unprecedented boom conditions and both borrowers and
lenders believed the conditions would continue for some time, appraisers generally went
along with the prevailing inflationary expectations and reflected them in their cash-flow
assumptions and analyses. Thus, appraisals often failed to check or slow down the amount
of funds being committed to specific projects.
The quality of appraisals became less rigorous during the 1980s as rapid expansion
in real estate development led to the hiring of many new and inexperienced appraisers. Entry into the field required few credentials in the form of academic requirements, training,
or on-the-job experience. Thus, many people with only marginal experience in such complex matters were writing opinions on these subjects. In addition, the appraisal industry
was fragmented into numerous associations and membership designations, with no general uniformity in performance standards. Finally, real estate appraisers were mostly unregulated during the 1980s: state licensing requirements were nearly nonexistent, and the
federal bank regulators provided little oversight of appraisal procedures or practices at insured institutions.
In some instances the ethical standards of the appraisal process were reported to
have been compromised by fraudulent activity. Appraisers would often fail to render unbiased, independent opinions. And except in the most egregious cases, appraisers were
generally not held accountable for deficient and/or overstated appraisals. The existence of
malpractice and fraud resulted in major reforms in appraisal procedures involving federal
insured institutions in 1989. (See discussion of FIRREA below.)
On the regulatory side, bank examiners had little formal training in evaluating appraisals and were not in a position to challenge their accuracy. Although examiners routinely reviewed and evaluated credit-file appraisals and periodically questioned them, in
most instances they deferred to the judgment of the “qualified” appraiser. Moreover, with
the use of increasingly sophisticated discounted-cash-flow models, appraisal reports were
becoming more complicated and thus more difficult for examiners to evaluate.

of Faulty and Fraudulent Real Estate Appraisals on Federally Insured Financial Institutions and Regulated Agencies of
the Federal Government: Hearings, 99th Cong., 1st sess., December 11 and 12, 1985; and House Committee on Government Operations, Subcommittee on Commerce, Consumer, and Monetary Affairs, Implementation of Title XI, The Appraisal Reform Amendments of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA):
Hearings, 101st Cong., 2d sess., May 17, 1990. See also the House Committee on Government Operations, Status of the
Implementation of Title XI, The Appraisal Reform Amendments of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 28th report, 101st Cong., 2d sess., November 14, 1990.

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In 1987, after Congress investigated the appraisal practices of the 1980s, the federal
bank-regulatory agencies issued interagency guidelines addressing appraisal policies, standards, and procedures for depository institutions.26 In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) became law, requiring bank
regulatory officials to establish licensing and certification standards for anyone who conducts appraisals for federally insured depositories. Licensing and certification are state
functions that would be overseen by the Appraisal Subcommittee of the Federal Financial
Institutions Examination Council (FFIEC).27
The legislation assigned four primary responsibilities to the FFIEC Appraisal Subcommittee: (1) monitoring the adequacy of state requirements for certification and licensing as well as standards of professional conduct; (2) monitoring the regulations of the
banking agencies, the Resolution Trust Corporation,28 and the National Credit Union Administration; (3) monitoring the activities of the appraisal foundation;29 and (4) maintaining
a national registry of state-certified and licensed appraisers.

Commercial Real Estate Lending and Bank Failures
Many of the banks that failed during the 1980s and early 1990s were active participants in the regional real estate market booms, particularly the booms in commercial real
estate. The connection between participation in the real estate booms and bank failure can
be seen if one compares the commercial real estate loan concentrations of banks that subsequently failed with those of banks that did not fail.30 In all years between 1980 and 1993,
the concentrations of commercial real estate loans relative to total assets were higher for

26

27

28
29

30

FDIC Bank Letter 40-87 dated December 14, 1987, details specific guidelines for real estate appraisal policies and review
procedures. These guidelines were adopted jointly by the FDIC, the Federal Reserve Board, and the Office of the Comptroller of the Currency. Before 1987 only the Federal Home Loan Bank Board had promulgated regulations regarding appraisal policies, practices, and procedures involving federally insured thrift institutions.
The Appraisal Subcommittee consists of officials from the Federal Deposit Insurance Corporation, the Federal Reserve
Board, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the U.S. Department of Housing and Urban Affairs. The Appraisal Subcommittee is responsible for monitoring certification and licensing requirements, banking agency regulations, and appraisal organizations.
The Resolution Trust Corporation ceased its activities at year-end 1995.
The appraisal foundation is a private sector organization that has established an Appraiser Qualification and Standards
Board. The purpose of the board is to professionalize the appraisal industry and establish coordination between the industry and federal and state officials in developing a national system of qualification and supervision.
As stated above, commercial real estate loans are defined as loans for construction and land development, loans secured by
nonfarm, nonresidential properties, and loans on multifamily properties.

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banks that subsequently failed than for nonfailed banks. In 1980, commercial real estate
loans of banks that subsequently failed constituted approximately 6 percent of their total assets; in 1993, almost 30 percent (see figure 3.10). Among nonfailed banks, commercial real
estate loans also constituted approximately 6 percent of total assets in 1980, but in 1993 the
figure had risen only to 11 percent. A similar pattern is observed for commercial real estate
loans relative to total real estate loans (see figure 3.11). In 1980, banks that subsequently
failed had 43 percent of their total real estate loan portfolio in commercial real estate loans;
by 1993 this had increased to about 69 percent. In contrast, nonfailed banks were more conservatively invested: in 1980, 32 percent of their total real estate loan portfolio was invested
in commercial real estate loans, and by 1993 the percentage was still approximately the
same.

Figure 3.10

Percent

Commercial Real Estate Loans
as a Percentage of Total Assets,
Failed and Nonfailed Banks, 1980–1994

30

Banks That
Subsequently
Failed*

20

Banks That
Did Not Fail

10

0

1980

1982

1984

1986

1988

1990

1992

1994

Note: Ratios are unweighted averages. Open-bank assistance cases are not
counted as failures.
* Banks that failed in 1994 did not report year-end financials.

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Figure 3.11

Commercial Real Estate Loans
as a Percentage of Total Real Estate Loans,
Failed and Nonfailed Banks, 1980–1994

Percent
70

60

Banks That
Subsequently
Failed*

50

Banks That
Did Not Fail

40

30

1980

1982

1984

1986

1988

1990

1992

1994

Note: Ratios are unweighted averages. Open-bank assistance cases are not
counted as failures.
* Banks that failed in 1994 did not report year-end financials.

These exposures to volatile commercial real estate markets contributed to the assetquality problems of many banks. Although data on nonperforming commercial real restate
loans were not available before 1991, data on nonperforming real estate assets were available beginning in 1984. Nonperforming real estate assets of banks that subsequently failed
constituted 34 percent of their nonperforming assets in 1984 but rose to 87 percent by
1993.31 Nonfailed banks’ nonperforming real estate assets rose as well but not nearly as
much, from almost 40 percent of total nonperforming assets in 1984 to more than 62 percent by 1993 (see figure 3.12).
Finally, the high concentrations in the volatile commercial real estate market contributed to overall losses. For subsequently failed banks, gross charge-offs on real estate
loans constituted only 8 percent of total charge-offs in 1984 but rose to 43 percent by 1993.
Nonfailed banks’ real estate charge-offs constituted 12 percent of total charge-offs in 1984
and rose to only approximately 20 percent in 1993 (see figure 3.13). These statistics indicate no bank was totally immune to the real estate market conditions of the period.
31

Nonperforming real estate assets were defined as the sum of real estate loans past due 90 days or more, non-accrual real estate loans, and repossessed real estate (excluding direct investments in real estate).

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Figure 3.12

Nonperforming Real Estate Assets
as a Percentage of Total Nonperforming Assets,
Failed and Nonfailed Banks, 1984–1994

Percent
90
80

Banks That
Subsequently
Failed*

70
60
50

Banks That
Did Not Fail

40
30

1984

1986

1988

1990

1992

1994

Note: Ratios are unweighted averages. Open-bank assistance cases are not
counted as failures.
* Banks that failed in 1994 did not report year-end financials.

Conclusion
In the early 1980s, a large demand for real estate investments produced a boom in
commercial construction activity. Public policy actions further stimulated the boom: tax
breaks enacted as part of the Economic Recovery Act of 1981 greatly enhanced the aftertax returns on real estate investment, and the Garn–St Germain Act of 1982 expanded the
nonresidential-lending powers of savings associations.
In pursuit of the construction boom, many banks moved aggressively into commercial
real estate lending. Total real estate loans of banks more than tripled, and commercial real
estate loans nearly quadrupled. Generally, bank underwriting standards were loosened, often unchecked either by the real estate appraisal system or by supervisory restraints. In addition, overly optimistic appraisals, together with the relaxation of debt coverage, the
reduction in the maximum loan-to-value ratios, and the loosening of other underwriting
constraints, often meant that borrowers frequently had little or no equity at stake, and in
some cases lenders bore most or all of the risk.
As a result, overbuilding occurred in many markets, and when the bubble burst starting in the late 1980s, real estate values collapsed. At institutions heavily exposed to real esHistory of the Eighties—Lessons for the Future

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Figure 3.13

Real Estate Charge-offs as a Percentage of
Total Charge-Offs, Failed and Nonfailed Banks,
1984–1994
Percent
50
40

Banks That
Subsequently
Failed*

30
20

Banks That
Did Not Fail

10
0

1984

1986

1988

1990

1992

1994

Note: Ratios are unweighted averages. Open-bank assistance cases are not
counted as failures.
* Banks that failed in 1994 did not report year-end financials.

tate lending, loan quality deteriorated significantly. This deterioration eventually caused
many banks to fail. Compared with surviving banks, banks that subsequently failed in the
1980s had higher ratios of (1) commercial real estate loans to total assets, (2) commercial
real estate loans to total real estate loans, (3) noncurrent commercial real estate loans to total commercial real estate loans, and (4) real estate charge-offs to total charge-offs.

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Appendix

Illustration of the Effects of
Major Tax Legislation
To illustrate how commercial real estate investment returns were affected by the
changes in tax law during the 1980s (see table 3-A.1), an example is presented here (see
table 3-A.2) that compares the after-tax internal rate of return on a hypothetical incomeproducing commercial real estate property acquired in three different years: 1980 (before
passage of the Economic Recovery Tax Act of 1981 [ERTA]); 1982 (after passage of
ERTA); and 1987 (after passage of the Tax Reform Act of 1986).
The example assumes that the real estate investor was in the highest tax bracket and
that 75 percent of the purchase price was financed. The property had a pre-tax operating net
income of $100,000 for the first year (approximately 10 percent of the purchase price), inflating at a rate of 5 percent per annum thereafter. The holding period for the property was
seven years. The example also assumes that the investor had other sources of income to
which he or she could apply the tax losses generated by the subject investment.
In this example, the difference in the pre- and post-ERTA after-tax rates of return was
significant (14.1 percent versus 21.5 percent). Much of this difference results from the aggressive depreciation deductions allowable under ERTA in the early years of the property’s
holding period. Specifically, $521,651 in depreciation deductions were taken against taxTable 3-A.1

Major Tax Law Provisions Affecting Returns on
Commercial Real Estate Investment

Allowable depreciation life,
commercial real estate
Allowable depreciation method
Passive losses deductible?
Max. ordinary income tax rate
Capital gains tax rate

Pre–Economic
Recovery Tax Act
of 1981

Post–Economic
Recovery Tax Act
of 1981

Post–Tax
Reform Act
of 1986

40 years
Straight-line
Yes
70%
28%

15 years
175% Declining balance
Yes
50%
20%

31.5 years
Straight-line
No
38.5%
28%

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Table 3-A.2

Hypothetical Investment Illustrating the Economic Effects of Major Tax
Legislation on Commercial Real Estate Investment

Initial price of property (loan amt. $820,000)
Cumulative net operating income
(before depreciation, debt service, and taxes)
Cumulative depreciation
Cumulative taxable income (loss) (net of
property depreciation and mortgage interest)
Cumulative income tax liability (credit)
Cumulative after-tax income
(net of annual income taxes and
mortgage payments)
Gross sale proceeds
Gross taxes due upon sale
Ordinary income taxes on excess
accelerated depreciation over straight-line
Capital gains taxes on straight-line
depreciation recapture
Capital gains taxes on difference between
property purchase and sale price
Net sale proceeds (net of recapture, taxes,
and loan payoff)
After-tax internal rate of return

Pre–Economic
Recovery Tax Act of
1981

Post–Economic
Recovery Tax Act of
1981

Post–Tax
Reform Act of
1986

$1,094,745

$1,094,745

$1,094,745

809,342
153,258

809,342
521,651

809,342
194,621

45,317
31,722

(323,076)
(161,538)

3,954
1,502

147,550
1,399,916
128,359

340,810
1,399,916
199,249

177,770
1,399,916
139,941

0

56,475

0

42,912

81,740

54,494

85,447

61,034

85,447

470,872
14.1%

399,983
21.5%

459,290
14.5%

Note: The analysis in this table is based on the following assumptions:
1. Real estate investor is in the highest tax bracket; 75 percent of the purchase price is financed.
2. Property has a pre-tax net operating income of $100,000 in the first year, inflating at a rate of 5 percent per annum
thereafter.
3. Property has a seven-year holding period.
4. Investor has other sources of income against which to apply tax losses generated by the property.

able income over the seven-year holding period (with $272,226 taken in the first three years
alone). At the highest ordinary income tax rate of 50 percent, this allowed for tax deferral
of $260,825. A $161,538 tax loss was generated that was used to offset other taxable income. This benefit far outweighed the $138,215 tax liability for “recaptured depreciation”
due upon sale of the property.
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These differences are even more stark when we account for the positive time preference of money. The $260,825 in cumulative tax savings taken during the life of the project
had a net present value of $188,548 (assuming a discount rate of 10 percent per year). The
net present value of the $138,215 tax liability due at termination of the investment, assuming the same discount rate, was $70,926. Thus, on a discounted basis the investor had to repay only $0.38 for each dollar of taxes deferred under the Accelerated Cost Recovery
System.
In the post-1986 tax regime, the same example shows that the after-tax rate of return
becomes nearly exactly what it had been pre-ERTA (14.1 percent before ERTA, 21.5 percent under ERTA, 14.5 percent post-1986). This happened largely because the accelerated
depreciation methods were eliminated and straight-line was reinstated, with a lengthening
of the depreciable life of commercial real estate from 15 years to 31.5 years. Other significant changes were that passive losses could no longer offset nonpassive income, and the
capital gains tax rate increased from 20 percent to 28 percent.

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165

Chapter 4

The Savings and Loan Crisis
and Its Relationship
to Banking
Introduction
No history of banking in the 1980s would be complete without a discussion of the
concurrent crisis in the savings and loan (S&L) industry. A review of the S&L debacle (as
it is commonly known today) provides several important lessons for financial-institution
regulators. Moreover, legislation enacted in response to the crisis substantially reformed
both bank and thrift regulation and dramatically altered the FDIC’s operations.
The causes of this debacle and the events surrounding its resolution have been documented and analyzed in great detail by academics, governmental bodies, former bank and
thrift regulators, and journalists. Although the FDIC had a role in monitoring events as they
unfolded and, indeed, played an important part in the eventual cleanup, until 1989 S&Ls
were regulated by the Federal Home Loan Bank Board (FHLBB, or Bank Board) and insured by the Federal Savings and Loan Insurance Corporation (FSLIC) within a legislative
and historical framework separate from the one that surrounded commercial banks. This
chapter provides only an overview of the savings and loan crisis during the 1980s, with an
emphasis on its relationship to the banking crises of the decade. The discussion also highlights the differences in the regulatory structures and practices of the two industries that affected how, and how well, failing institutions were handled by their respective deposit
insurers.
A brief overview of insolvencies in the S&L industry between 1980 and 1982, caused
by historically high interest rates, is followed by a review of the federal regulatory structure
and supervisory environment for S&Ls. The government’s response to the early S&L crisis
is then examined in greater detail, as are the dramatic developments that succeeded this response. The corresponding competitive effects on commercial banks during the middle to
late 1980s are outlined. Finally, the resolution and lessons learned are summarized.

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The S&L Industry, 1980–1982
In 1980, the FSLIC insured approximately 4,000 state- and federally chartered savings and loan institutions with total assets of $604 billion. The vast majority of these assets
were held in traditional S&L mortgage-related investments. Another 590 S&Ls with assets
of $12.2 billion were insured by state-sponsored insurance programs in Maryland, Massachusetts, North Carolina, Ohio, and Pennsylvania.1 One-fifth of the federally insured S&Ls,
controlling 27 percent of total assets, were permanent stock associations, while the remaining institutions in the industry were mutually owned. Like mutual savings banks, S&Ls
were losing money because of upwardly spiraling interest rates and asset/liability mismatch.2 Net S&L income, which totaled $781 million in 1980, fell to negative $4.6 billion
and $4.1 billion in 1981 and 1982 (see table 4.1).
During the first three years of the decade, 118 S&Ls with $43 billion in assets failed,
costing the FSLIC an estimated $3.5 billion to resolve. In comparison, during the previous
45 years, only 143 S&Ls with $4.5 billion in assets had failed, costing the agency $306 million. From 1980 to 1982 there were also 493 voluntary mergers and 259 supervisory mergers of savings and loan institutions (see table 4.2). The latter were technical failures but
Table 4.1

Selected Statistics, FSLIC-Insured Savings and Loans, 1980–1989
($Billions)

Year

Number Total
Net
of S&Ls Assets Income

Tangible
Capital

Tangible Capital/ No. Insolvent
Assets in
FSLIC
Total Assets
S&Ls*
Insolvent S&Ls* Reserves

1980

3,993

$ 604

$ 0.8

$32

43

$ 0.4

1981

3,751

640

−4.6

25

4.0

5.3%

112

28.5

$ 6.5
6.2

1982

3,287

686

−4.1

4

0.5

415

220.0

6.3

1983

3,146

814

1.9

4

0.4

515

284.6

6.4

1984

3,136

976

1.0

3

0.3

695

360.2

5.6

1985

3,246

1,068

3.7

8

0.8

705

358.3

4.6

1986

3,220

1,162

0.1

14

1.2

672

343.1

−6.3

1987

3,147

1,249

−7.8

9

0.7

672

353.8

−13.7

1988

2,949

1,349

−13.4

22

1.6

508

297.3

−75.0

1989

2,878

1,252

−17.6

10

0.8

516

290.8

NA

* Based on tangible-capital-to-assets ratio.

1

U.S. League of Savings Institutions, Savings and Loan Sourcebook, (1982), 37. It should be noted that during the 1980s, the
state-sponsored insurance programs either collapsed or were abandoned.
2 For a discussion of these issues, see Chapter 6.

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Table 4.2

S&L Failures, 1980–1988
($Thousands)

Number of
Failures

Total Assets

Estimated
Cost

1980

11

$ 1,348,908

$

158,193

21

63

1981

34

19,590,802

1,887,709

54

215

1982

73

22,161,187

1,499,584

184

215

1983

51

13,202,823

418,425

34

83

1984

26

5,567,036

886,518

14

31

1985

54

22,573,962

7,420,153

10

47

1986

65

17,566,995

9,130,022

5

45

1987

59

15,045,096

5,666,729

5

74

1988

190

98,082,879

46,688,466

6

25

Year

Supervisory
Mergers

Voluntary
Mergers

Sources: FDIC; and Barth, The Great Savings and Loan Debacle, 32–33.

resulted in no cost to the FSLIC. Despite this heightened resolution activity, at year-end
1982 there were still 415 S&Ls, with total assets of $220 billion, that were insolvent based
on the book value of their tangible net worth.3 In fact, tangible net worth for the entire S&L
industry was virtually zero, having fallen from 5.3 percent of assets in 1980 to only 0.5 percent of assets in 1982. The National Commission on Financial Institution Reform, Recovery and Enforcement estimated in 1993 that it would have cost the FSLIC approximately
$25 billion to close these insolvent institutions in early 1983.4 Although this is far less than
the ultimate cost of the savings and loan crisis—currently estimated at approximately $160
billion—it was nonetheless about four times the $6.3 billion in reserves held by the FSLIC
at year-end 1982.5

3

Tangible net worth is defined as net worth excluding goodwill and other intangible assets. In an accounting framework,
goodwill is an intangible asset created when one firm acquires another. It represents the difference between the purchase
price and the market value of the acquired firm’s assets. The treatment of goodwill in supervisory mergers of S&Ls is discussed in more detail below.
4 This estimate is based on the assumption that the liabilities of insolvent institutions exceeded their tangible assets by 10 percent. National Commission on Financial Institution Reform, Recovery and Enforcement, Origin and Causes of the S&L Debacle: A Blueprint for Reform: A Report to the President and Congress of the United States (1993), 44, 79.
5 In its audit of the Resolution Trust Corporation’s 1994 and 1995 financial statements, the U.S. General Accounting Office
estimated the total direct and indirect cost of resolving the savings and loan crisis at $160.1 billion. This figure includes
funds provided by both taxpayers and private sources. See U.S. General Accounting Office, Financial Audit: Resolution
Trust Corporation’s 1995 and 1994 Financial Statements (1996), 13.

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Federal Regulatory Structure and Supervisory Environment
Federal regulation of the savings and loan industry developed under a legislative
framework separate from that for commercial banks and mutual savings banks. Legislation
for S&Ls was driven by the public policy goal of encouraging home ownership. It began
with the Federal Home Loan Bank Act of 1932, which established the Federal Home Loan
Bank System as a source of liquidity and low-cost financing for S&Ls. This system comprised 12 regional Home Loan Banks under the supervision of the FHLBB. The regional
Banks were federally sponsored but were owned by their thrift-institution members through
stock holdings. The following year, the Home Owners’ Loan Act of 1933 empowered the
FHLBB to charter and regulate federal savings and loan associations. Historically, the Bank
Board promoted expansion of the S&L industry to ensure the availability of home mortgage
loans. Finally, the National Housing Act of 1934 created the FSLIC to provide federal deposit insurance for S&Ls similar to what the FDIC provided for commercial banks and mutual savings banks. However, in contrast to the FDIC, which was established as an
independent agency, the FSLIC was placed under the authority of the FHLBB. Therefore,
for commercial banks and mutual savings banks the chartering and insurance functions
were kept separate, whereas for federally chartered S&Ls the two functions were housed
within the same agency.
For a variety of reasons, the FHLBB’s examination, supervision, and enforcement
practices were traditionally weaker than those of the federal banking agencies. Before the
1980s, savings and loan associations had limited powers and relatively few failures, and the
FHLBB was a small agency overseeing an industry that performed a type of public service.
Moreover, FHLBB examiners “were subject, unlike their counterparts at sister agencies, to
stringent OMB and OPM limits on allowable personnel and compensation.” 6 It should be
noted that the S&L examination process and staff were adequate to supervise the traditional
S&L operation, but they were not designed to function in the complex new environment of
the 1980s in which the industry had a whole new array of powers. Accordingly, when much
of the S&L industry faced insolvency in the early 1980s, the FHLBB’s examination force
was understaffed, poorly trained for the new environment, and limited in its responsibilities
and resources.7 Qualified examiners had been hard to hire and hard to retain (a governmentwide hiring freeze in 1980–81 had compounded these problems). The banking agencies
generally recruited the highest-quality candidates at all levels because they paid salaries 20
6
7

William K. Black, Examination/Supervision/Enforcement of S&Ls, 1979–1992 (1993), 2.
James R. Adams referred to the FSLIC and the Bank Board as “the doormats of financial regulation” (The Big Fix: Inside
the S&L Scandal: How an Unholy Alliance of Politics and Money Destroyed America’s Banking System [1990], 40). See also
Martin E. Lowy, High Rollers: Inside the Savings and Loan Debacle (1991), 111–12; Norman Strunk and Fred Case, Where
Deregulation Went Wrong: A Look at the Causes behind Savings and Loan Failures in the 1980s (1988), 120–45; and Black,
Examination/Supervision/Enforcement.

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to 30 percent higher than those the FHLBB could offer. In 1984, the average FHLBB examiner’s salary was $24,775; this figure was $30,764, $32,505, and $37,900 at the Office
of the Comptroller of the Currency, the FDIC, and the Federal Reserve Board, respectively.8
And retention was a problem because experienced examiners were regularly recruited by
the S&L industry, which offered far greater remuneration than the FHLBB could. Furthermore, FHLBB training resources were constrained by budget limitations and by a lack of
seasoned examiners available to instruct less-experienced ones.
The Bank Board’s examination and supervision functions were organized differently
from those in the banking agencies. The examinations of S&Ls were conducted completely
separately from the supervisory function. Examiners were hired by and reported to the Office of Examination and Supervision of the Bank Board (OES). The supervisory personnel,
with authority for the System, resided within the Federal Home Loan Bank System and, in
effect, reported only to the president of the local FHLB. Thus, in contrast to the banking
agencies, no agency had a single, direct line of responsibility for a troubled institution.
Regulators interviewed for this study noted that the examination philosophy was to
identify adherence to rules and regulations, not adherence to general principles of safety
and soundness. Because most S&L assets were fixed-rate home mortgages, credit-quality
problems were rare. Loan evaluations were appraisal driven, and in the past the value of
collateral had consistently appreciated. Thus, losses on home mortgages were rare, even in
the event of foreclosure. Nevertheless, not until 1987 did S&L examiners have the authority either to classify assets according to likelihood of repayment or to force institutions to
reserve for losses on a timely basis. Moreover, examiner recommendations were often not
followed up by supervisory personnel.
Supervisory oversight of the S&L industry was both decentralized and split from the
examination function. The FHLBB designated each regional Federal Home Loan Bank
president as the Principal Supervisory Agent (PSA) for that region; senior Bank staff acted
as supervisory agents. However, field examiners reported to the FHLBB in Washington
rather than to the regional PSA, and the regional PSA effectively reported to no one. In fact,
according to one insider, the regional Federal Home Loan Banks “operated like independent duchies.”9 Because the regional Banks were owned by the institutions they supervised,
the potential for conflicts of interest was quite strong. In any event, supervisory agents did
not receive exam reports until after they had undergone multiple layers of review—sometimes months after the “as of” date.

8
9

Black, Examination/Supervision/Enforcement, 2.
Ibid., 11.

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This system generated mistrust and disrespect between the S&L examiners, who were
federal employees, and the supervisory agents, who were employees of the privately owned
regional Banks. Supervisory agents and PSAs were compensated at levels far above those
of the FHLBB staff, and while examiners suspected the supervisors of being overpaid industry friends, supervisory agents and PSAs viewed the Bank Board examiners as “low
paid, heavy drinking specialists in trivial details.”10 Clearly, even the most diligent S&L examiner faced considerable difficulties in reporting negative findings and in seeing those
findings acted upon.
Although the FHLBB legally had enforcement powers similar to those of the banking
agencies, it used these powers much less frequently.11 The S&L supervisory environment
simply was not conducive to prompt corrective enforcement actions. As indicated above,
S&Ls were traditionally highly regulated institutions, and before the 1980s the industry had
exhibited few problems of mismanagement. The industry’s significant involvement in its
own supervision stemmed from its favorable image and protected status with lawmakers.
As one S&L lobbyist later wrote: “When we [the U.S. League of Savings Institutions] participated in the writing of the supervisory law, hindsight shows that we probably gave the
business too much protection against unwarranted supervisory action” (emphasis added).12
Because enforcement was a lengthy process if contested by the institution, the Bank
Board preferred either to use voluntary supervisory agreements or to rely on the states to
use their powers. More important, the lack of resources and the limited number of enforcement attorneys (generally only five through 1984) led the FHLBB to adopt policies that
made it unlikely an institution would contest a case. For example, enforcement staff would
compromise on the terms of a cease-and-desist order, pursue only the strongest cases, and
generally—because of lack of precedents—avoid cases alleging unsafe and unsound practices. Unfortunately, these policies undermined the effectiveness of both contemporary and
future enforcement actions.

Government Response to Early Crisis: Deregulation
The vast number of actual and threatened insolvencies of savings and loan associations in the early 1980s was predictable because of the interest-rate mismatch of the institutions’ balance sheets. What followed, however, was a patchwork of misguided policies
that set the stage for massive taxpayer losses to come. In hindsight, the “government proved
10

Ibid., 12.
They included the power to issue a cease-and-desist order (C&D) requiring an institution to cease unsafe and unsound practices or other rules violations, and the power to issue a removal-and-prohibition order (R&P) against an employee, officer,
or director, permanently removing the person from employment in the S&L industry.
12 Quoted from p. 2 of Norman Strunk’s memorandum to Bill O’Connell, attached as exhibit 3 in Black, Examination/Supervision/Enforcement.
11

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singularly ill-prepared to deal with the S&L crisis.”13 The primary problem was the lack of
real FSLIC resources available to close insolvent S&Ls. In addition, many government officials believed that the insolvencies were only “on paper,” caused by unprecedented interest-rate levels that would soon be corrected. This line of reasoning complemented the view
that as long as an institution had the cash to continue to operate, it should not be closed. Former Assistant Secretary of the Treasury Roger Mehle even testified to that effect when a
failed savings and loan sued the Bank Board.14 Although Mehle maintained he was testifying “as a private citizen,” on other occasions he did take the position that thrifts did not have
a serious problem, because their income came in the form of mortgage payments whereas
most of their expenses were in the form of interest credited to savings accounts but not
withdrawn. Mehle stated, “I wish my income was in cash and my expenses in the form of
bookkeeping entries.”15
Most political, legislative, and regulatory decisions in the early 1980s were imbued
with a spirit of deregulation. The prevailing view was that S&Ls should be granted regulatory forbearance until interest rates returned to normal levels, when thrifts would be able to
restructure their portfolios with new asset powers. To forestall actual insolvency, therefore,
the FHLBB lowered net worth requirements for federally insured savings and loan associations from 5 percent of insured accounts to 4 percent in November 1980 and to 3 percent
in January 1982.16 At the same time, the existing 20-year phase-in rule for meeting the net
worth requirement, and the 5-year-averaging rule for computing the deposit base, were retained. The phase-in rule meant that S&Ls less than 20 years old had capital requirements
even lower than 3 percent. This made chartering de novo federal stock institutions very attractive because the required $2.0 million initial capital investment could be leveraged into
$1.3 billion in assets by the end of the first year in operation. 17 The 5-year-averaging rule,
too, encouraged rapid deposit growth at S&Ls, because the net worth requirement was
based not on the institution’s existing deposits but on the average of the previous five
years.18
Reported capital was further augmented by the use of regulatory accounting principles
(RAP) that were considerably more lax than generally accepted accounting principles
(GAAP). However, where GAAP was more lenient than RAP, the Bank Board adopted the
13

National Commission, Origins and Causes of the S&L Debacle, 32.
Mehle’s action has been described as a “remarkable step” (Kathleen Day, S&L Hell: The People and the Politics behind the
$1 Trillion Savings and Loan Scandal [1993], 93).
15 Sanford Rose, “The Fruits of Canalization,” American Banker (November 2, 1981), 1.
16 In contrast, commercial banks were required to have a percentage of assets, a larger base than insured deposits, as a capital
cushion. For the bank capital requirements, see section on capital adequacy in Chapter 2.
17 James R. Barth, The Great Savings and Loan Debacle (1991), 54.
18 National Commission, Origins and Causes of the S&L Debacle, 35–36.
14

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former. As of September 1981, troubled S&Ls could issue income capital certificates that
the FSLIC purchased with cash, or more likely with notes, and they were included in net
worth calculations. That same month, the FHLBB began permitting deferred losses on the
sale of assets when the loss resulted from adverse changes in interest rates. Thrifts were allowed to spread the recognition of the loss over a ten-year period, while the unamortized
portion of the loss was carried as an “asset.” Then in late 1982, the FHLBB began counting
appraised equity capital as a part of reserves. Appraised equity capital allowed S&Ls to recognize an increase in the market value of their premises.
Perhaps the most far-reaching regulatory change affecting net worth was the liberalization of the accounting rules for supervisory goodwill.19 Effective in July 1982, the Bank
Board eliminated the existing ten-year amortization restriction on goodwill, thereby allowing S&Ls to use the general GAAP standard of “no more than 40 years” in effect at the time.
This change was intended to encourage healthy S&Ls to take over insolvent institutions,
whose liabilities far exceeded the market value of their assets, without the FSLIC’s having
to compensate the acquirer for the entire negative net worth of the insolvent institution.20
Not surprisingly, between June 1982 and December 1983 goodwill rose from a total of $7.9
billion to $22 billion, the latter amount representing 67 percent of total RAP capital. The
FHLBB also actively encouraged use of this accounting treatment as a low-cost method of

19

Supervisory goodwill was created when a healthy S&L acquired an insolvent one, with or without financial assistance from
the FSLIC. It is known as “supervisory” goodwill because the FHLBB allowed it to be included as an asset for capital purposes. For a more in-depth discussion of goodwill accounting, see National Commission, Origins and Causes of the S&L
Debacle, 38–39, and Lowy, High Rollers, 38–41.
20 An example of a typical transaction will help to explain the relevance of this change. The assets and liabilities of the thrift
would be “marked-to-market,” and since interest rates were very high, this usually resulted in the mortgage assets of the
thrift being valued at a discount. For example, a $100,000 loan paying 8 percent might have been marked down to $80,000
so that it was paying a market rate. However, the liabilities of the institution were generally valued at near book, so a
$100,000 deposit was still worth $100,000. Even if the acquirer paid nothing for the thrift, the acquirer was taking on an asset worth $80,000 and a liability of $100,000, a $20,000 shortfall. This would be recorded as an asset called goodwill with
a value of $20,000. One should note that the borrower would still have a $100,000 loan outstanding and would be expected
to pay back the entire loan balance. The $20,000 would be booked as an off-balance-sheet item called a “discount.” The accounting profession considered the goodwill and the discount two independent entries.
After the merger, the goodwill would be amortized as an expense over a set period. The discount would be “accreted”
to income over the life of the loan, usually around 10 years. Under RAP accounting, before June 1982, goodwill was amortized over the same 10-year period. Afterward, the accounting picture changed dramatically. Under GAAP, the goodwill
could be amortized over as many as 40 years. The expenses for the amortization of goodwill would be much lower than the
income from the accretion of the discount for many years. This “allowed thrift institutions to literally ‘manufacture’ earnings and capital by acquiring other thrift institutions” (Office of Thrift Supervision Director Timothy Ryan, testifying before the U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on General Oversight and
Investigations, Capital Requirements for Thrifts As They Apply to Supervisory Goodwill: Hearing, 102d Cong., 1st sess.,
1991, 31).

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resolving troubled institutions. Unfortunately, like other Bank Board policies that resulted
in the overstatement of capital, the liberal treatment of supervisory goodwill restricted the
FHLBB’s ability to crack down on thinly capitalized or insolvent institutions, because enforcement actions were based on regulatory and not tangible capital.21
The Bank Board also attempted to attract new capital to the industry, and it did so by
liberalizing ownership restrictions for stock-held institutions in April 1982. That change
proved to have a dramatic effect on the S&L industry.22 Traditionally, federally chartered
stock associations were required to have a minimum of 400 stockholders. No individual
could own more than 10 percent of an institution’s outstanding stock, and no controlling
group more than 25 percent. Moreover, 75 percent of stockholders had to reside or do business in the S&L’s market area. The elimination of these restrictions, coupled with the relaxed capital requirements and the ability to acquire an institution by contributing “in-kind
capital” (stock, land, or other real estate), invited new owners into the industry. With a minimal amount of capital, an S&L could be owned and operated with a high leverage ratio and
in that way could generate a high return on capital.
Legislative actions in the early 1980s were designed to aid the S&L industry but in
fact increased the eventual cost of the crisis. The two principal laws passed were the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and the
Garn–St Germain Depository Institutions Act of 1982 (Garn–St Germain).23 DIDMCA reduced net worth requirements and Garn–St Germain wrote capital forbearance into law.
DIDMCA replaced the previous statutory net worth requirement of 5 percent of insured accounts with a range of 3–6 percent of insured accounts, the exact percentage to be determined by the Bank Board. Garn–St Germain went even further in loosening capital
requirements for thrifts by stating simply that S&Ls “will provide adequate reserves in a
form satisfactory to the Corporation [FSLIC], to be established in regulation made by the
Corporation.”24 Garn–St Germain also authorized the FHLBB to implement a Net Worth

21

Recognizing that the use of supervisory goodwill had contributed to the magnitude of the thrift crisis, Congress legislated
a five-year phaseout of goodwill that had been created on or before April 12, 1989. This change, and tighter capital requirements for thrifts, rapidly forced a number of S&Ls into insolvency or near-insolvency. Many of these institutions sued
the federal government, and on July 1, 1996, the Supreme Court ruled in favor of three of them in United States v. Winstar
Corp. See, for example, Linda Greenhouse, “High Court Finds Rule Shift by U.S. Did Harm to S&Ls,” The New York Times
(July 2, 1996), A3; and Paul M. Barrett, “High Court Backs S&Ls on Accounting, Declines to Hear Affirmative-Action
Case,” The Wall Street Journal (July 2, 1996), 1.
22 National Commission, Origins and Causes of the S&L Debacle, 37.
23 In addition, the Economic Recovery Tax Act of 1981 contributed to the boom in commercial real estate projects. For a detailed description of all of these laws, see Chapters 2 and 3.
24 Public Law 97-320, § 202(d).

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Certificate Program for S&Ls. (Ironically, this form of capital forbearance was used more
extensively and more effectively by the FDIC for mutual savings banks.)25
These two laws also made a number of other significant changes affecting thrift institutions, including giving them new and expanded investment powers and eliminating deposit interest-rate ceilings. But although such deregulation had been recommended since
the early 1970s,26 when finally enacted it failed to give attention to corresponding recommendations for deposit insurance reform and stronger supervision. Particularly dangerous
in view of these omissions were the expanded authority of federally chartered S&Ls to
make acquisition, development, and construction (ADC) loans, enacted in DIDMCA, and
the subsequent elimination in Garn–St Germain of the previous statutory limit on loan-tovalue ratios. These changes allowed S&Ls to make high-risk loans to developers for 100
percent of a project’s appraised value.
DIDMCA also increased federal deposit insurance to $100,000 per account, a major
adjustment from the previous limit of $40,000 per account. The increase in the federal deposit insurance level and the phaseout of deposit interest-rate controls were designed to alleviate disintermediation, or the flow of deposits out of financial institutions into money
market mutual funds and other investments. However, the increase in insured liabilities
added substantially to the potential costs of resolving failed financial institutions, and has
been cited as exacerbating the “moral-hazard” problem much discussed throughout the
1980s.27
Deregulation of asset powers at the federal level prompted a number of states to enact
similar, or even more liberal, legislation. This “competition in laxity” has been attributed to
a conscious effort by state legislatures to retain and attract state-chartered institutions that
otherwise might apply for federal charters, thereby reducing the states’ regulatory roles and
fee collections.28 An oft-cited example is California’s Nolan bill, enacted in 1982 after

25

The National Commission attributed the greater success of the FDIC’s forbearance policy to several factors, including a
more limited use of accounting gimmicks and growth restrictions for savings banks (National Commission, Origins and
Causes of the S&L Debacle, 32, 37). For a comparison of the two Net Worth Certificate Programs, see U.S. General Accounting Office, Net Worth Certificate Programs: Their Design, Major Differences, and Early Implementation (1984).
26 For details on the debate over deregulation, see Chapter 6.
27 “Moral hazard” refers to the incentives that insured institutions have to engage in higher-risk activities than they would
without deposit insurance; deposit insurance means, as well, that insured depositors have no compelling reason to monitor
the institution’s operations. The National Commission on Financial Institution Reform, Recovery and Enforcement concluded that federal deposit insurance at institutions with substantial risk was a “fundamental condition necessary for collapse” and that “[r]aising the insurance limit from $40,000 to $100,000 exacerbated the problem” (National Commission,
Origins and Causes of the S&L Debacle, 5–6). For further discussion of the increase in the deposit insurance limit, see
Chapter 2.
28 Lawrence J. White, The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation (1991), 73.

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many of the state’s largest thrifts converted to federal charters.29 Effective January 1, 1983,
state-chartered S&Ls in California had unlimited authority to invest in service corporations
and in real estate. Another state notable for its liberalizing legislation was Florida, whose
state-chartered thrift industry was “virtually nonexistent” before the enactment of a series
of liberal laws between 1980 and 1984.30 Supervision of these institutions remained under
the state’s controller and remained weak. California and Florida, along with Texas, had
some of the nation’s most liberal state laws for thrifts. Unfortunately, as is detailed below,
the more liberal powers afforded by some states to their S&Ls added significantly to the
losses that eventually had to be made good by the federal government.
Finally, it should be noted that the Reagan administration was more directly involved
with the regulation of S&Ls than with the regulation of the banking industry. In other
words, the FDIC and the Federal Reserve System traditionally had more political independence than the FHLBB (and therefore than the FSLIC). During the early years of the administration, responsibility for the unfolding thrift crisis lay with the Cabinet Council on
Economic Affairs, chaired by Treasury Secretary Donald Regan. Its members included senior officials from OMB and the White House. Firm believers in “Reaganomics,” this
group crafted the policies of deregulation and forbearance and adamantly opposed any governmental cash expenditures to resolve the S&L problem.31 Furthermore, the administration
did not want to alarm the public unduly by closing a large number of S&Ls. Therefore, the
Treasury Department and OMB urged the Bank Board to use FSLIC notes and other forms
of forbearance that did not have the immediate effect of increasing the federal deficit.
The free-market philosophy of the Reagan administration also called for a reduction
in the size of the federal government and less public intervention in the private sector. As a
result, during the first half of the 1980s the federal banking and thrift agencies were encouraged to reduce examination staff, even though these agencies were funded by the institutions they regulated and not by the taxpayers. This pressure to downsize particularly
affected the FHLBB, whose budget and staff size were closely monitored by OMB and subjected to the congressional appropriations process.32 The free-market philosophy affected
not only regulatory and supervisory matters but also thrift and bank chartering decisions.
Before the 1980s, new charters had been granted on the basis of community need. Under the
29

From 1980 to 1982 the number of state-chartered S&Ls in California fell from 126 with $82 billion in assets to 107 with
less than $30 billion (Barth, The Great Savings and Loan Debacle, 55). Day notes that “funding for California’s supervisory department diminished proportionately”—staff fell from 178 in 1978 to only 44 in 1983 (Day, S&L Hell, 124).
30 Strunk and Case, Where Deregulation Went Wrong, 59, and for examples of liberal state laws, 60–66.
31 For a discussion of Reaganomics and the early years of the thrift crisis, see Day, S&L Hell, 73–81; and Lowy, High Rollers,
20–26.
32 Strunk and Case, Where Deregulation Went Wrong, 141. It is important to note, as discussed in Chapter 12, that the banking agencies themselves believed the number of exams could be reduced through greater reliance on computers and off-site
monitoring.

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Reagan administration, the FHLBB and the Office of the Comptroller of the Currency approved any application “as long as the owners hired competent management and provided
a sound business plan.”33 The devastating consequences of adding many new institutions to
the marketplace, expanding the powers of thrifts, decontrolling interest rates, and increasing deposit insurance coverage, coupled with reducing regulatory standards and scrutiny,
were not foreseen.
Developments after Deregulation
The savings and loan industry changed swiftly and dramatically after the deregulation
of asset powers and interest rates. The period from year-end 1982 to year-end 1985 was
characterized by extremely rapid growth, as the industry responded to the new regulatory
and legislative climate. Total S&L assets increased from $686 billion to $1,068 billion, or
by 56 percent—more than twice the growth rate at savings banks and commercial banks
(approximately 24 percent). As discussed below, S&L growth was fueled by an influx of deposits (often via money brokers) into institutions willing to pay above-market interest rates.
In 1983 and 1984, more than $120 billion in net new money flowed into savings and loan
associations.34
With money flowing so plentifully, risk takers gravitated toward the S&L industry, altering ownership characteristics. Although more than a few of these new owners engaged in
Table 4.3

Number of Newly Chartered FSLIC-Insured S&Ls, 1980–1986
Year

State-Chartered

Federally Chartered

Total

1980

63

5

68

1981

21

4

25

1982

23

3

26

1983

36

11

47

1984

68

65

133

1985

45

43

88

1986

13

14

27

TOTAL

348

144

492

Source: Lawrence White, The S&L Debacle, 106.
Note: Excludes state-chartered thrifts that converted from state-sponsored insurance funds to the FSLIC.
33
34

Day, S&L Hell, 100. For further discussion of these issues, see Chapter 2, the section on entry.
National Council of Savings Institutions, 1986 National Fact Book of Savings Institutions (1986), 10, 16; and FDIC, Historical Statistics on Banking: A Statistical History of the United States Banking Industry 1934–1992 (1993), 219–21.

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highly publicized cases of fraudulent activity, many others were just greedy.35 Sharp entrepreneurs realized the large potential profit from owning an S&L, whose charter now allowed a wide range of investment opportunities without the corresponding regulation of
commercial banks. Little capital was required to purchase or start an S&L, and the growth
potential was great. A variety of nonbankers entered the S&L industry, ranging from dentists, with no experience in owning financial institutions, to real estate developers, who had
serious conflicts of interest. To gain entry into the S&L industry, one either acquired control
of existing institutions (many of which had converted from mutual to stock) or started de
novo institutions. Between 1980 and 1986 nearly 500 new S&L charters were issued (see
table 4.3), with more than 200 of these issued in just two years—1984 and 1985. In 1981
stock S&Ls had constituted 21 percent of the industry; in 1986 they constituted 38 percent
and controlled 64 percent of the industry’s total assets.
Another major change resulting from deregulation was that, beginning in 1982, S&L
investment portfolios rapidly shifted away from traditional home mortgage financing and
into new activities. This shift was made possible by the influx of deposits and also by sales
of existing mortgage loans. By 1986, only 56 percent of total assets at savings and loan associations were in mortgage loans, compared with 78 percent in 1981 (see figure 4.1). In
Figure 4.1

Percentage of S&L Assets in Mortgage Loans,
1978–1986
Percent

80

70

60

1978

35

1979

1980

1981

1982

1983

1984

1985

1986

National Commission, Origins and Causes of the S&L Debacle, 47.

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some states, direct investments in real estate, equity securities, service corporations, and operating subsidiaries were allowed with virtually no limitations.36 S&Ls invested in everything from casinos to fast-food franchises, ski resorts, and windmill farms. Other new
investments included junk bonds, arbitrage schemes, and derivative instruments. It is important to note, however, that while windmill farms and other exotic investments made for
interesting reading, high-risk development loans and the resultant mortgages on the same
properties were most likely the principal cause for thrift failures after 1982. A large percentage of S&L assets was devoted to acquisition, development, and construction (ADC)
loans; these were very attractive because of their favorable accounting treatment and the
potential for future profit if the projects were successful. As discussed below, the entry of
so many S&Ls into commercial real estate lending helped fuel boom-to-bust real estate cycles in several regions of the country.
In 1983, even when a sharp drop in interest rates returned many traditional S&Ls to
profitability, 10 percent of the industry was still insolvent on a GAAP basis and 35 percent
of the industry’s assets were controlled by S&Ls that were insolvent on a tangible basis—
yet these institutions were permitted to grow along with the rest of the industry, and to substitute credit risk for interest-rate risk. The high-growth period between 1982 and 1985 was
also the period when examination and supervision were weakest.37 States that had enacted
liberal S&L laws, such as California, Florida, and Texas, were soft on supervision; and in
some cases, state-chartered institutions had close political ties to elected officials and to a
state’s regulators.38 In the Southwest, existing weaknesses in the Bank Board’s supervision
of federally chartered S&Ls were compounded by the relocation in September 1983 of the
Ninth District of the Federal Home Loan Bank System from Little Rock, Arkansas, to Dallas, Texas. The number of examinations in the district fell by one-third and remained low
during the critical years of 1984 and 1985.39 Moreover, after it was realized in 1984 that a
number of fast-growing S&Ls were dangerously abusing their new powers, the FHLBB’s
attempts to crack down were bitterly opposed by the industry, the administration, and those
key members of Congress who had been persuaded by S&L operators and real estate developers that regulators had become “Gestapo-like” and “heavy-handed.”40 Nevertheless,
in late 1984 the Bank Board began to tighten the S&L regulatory system by imposing a
number of regulations designed to (a) curb rapid growth and direct investments by thrifts
36

In January 1985, the Bank Board adopted a rule restricting direct investments by FSLIC-insured thrifts to 10 percent of assets unless permission was granted to exceed that level.
37 National Commission, Origins and Causes of the S&L Debacle, 43.
38 See, for example, Strunk and Case, Where Deregulation Went Wrong, 57–60; National Commission, Origins and Causes of
the S&L Debacle, 48; and Day, S&L Hell, 124.
39 White, The S&L Debacle, 89–90.
40 One of the major themes of Martin Lowy’s book (High Rollers) is that thrifts were able to buy political favor in order to
keep regulators from interfering in their operations.

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with low net worth, (b) increase net worth standards, and (c) reform accounting practices.41
In 1985, the FHLBB took the unusual step of transferring its examination staff to the Federal Home Loan Banks in order to become independent of OMB’s restrictions on pay and
staffing levels.
Although these measures would help control future abuses, they could not reverse the
losses already incurred and those that would soon result from rapid declines in overbuilt
real estate markets. Furthermore, the FHLBB was trapped by its own policies: the agency
had to wait until an institution was insolvent under the relatively lax RAP before taking action, and accounting distortions favored high-growth S&Ls that continued to report healthy
returns on assets and regulatory net worth. Independent of these problems, the FSLIC, with
reserves of only $5.6 billion at year-end 1984, did not have the resources to close even the
RAP-insolvent institutions, which at that time numbered 71 with assets of $14.8 billion. 42
Within two years, these figures had ballooned to 225 institutions with assets of $68.1 billion, largely as a result of the deflated southwestern economy. The Southwest’s problems
caused severe losses in the commercial banking industry as well (and are discussed in
Chapter 9). In fact, the unfolding S&L crisis in general, not just in the Southwest, negatively
affected the banking industry.

Competitive Effects on the Banking Industry
Enactment of Garn–St Germain and the deregulation of asset powers by several key
states led many S&Ls to change their operating strategies. These changes substantially intensified the competitive environment of commercial banks and placed downward pressure
on bank profitability. Although in a free-market economy competition is normally considered healthy, regulatory forbearance in the thrift industry and moral hazard created market place distortions that penalized well-run financial institutions.43 On the liability side of the
balance sheet, the bidding up of deposit interest rates by aggressive and/or insolvent S&Ls
increased the cost of funds, adversely affecting both commercial banks and conservatively
run thrifts. On the asset side of the balance sheet, commercial banks were negatively influenced by the entrance of inexperienced and, in some cases, rogue S&Ls into commercial
and real estate lending.
The genesis of the bidding up of deposit interest rates was the S&L industry’s dramatic growth between 1982 and 1985. This growth was facilitated by a flood of deposits
41

For a chronological listing of these regulations, see, for example, National Commission, Origins and Causes of the S&L Debacle, 98–99; and Barth, The Great Savings and Loan Debacle, 130–32, 137–41.
42 For a listing of RAP-insolvent and tangible-insolvent thrifts from 1981 to 1987, see White, The S&L Debacle, 114.
43 Eugenie D. Short and Kenneth J. Robinson, “Deposit Insurance Reform in the Post-FIRREA Environment: Lessons from the
Texas Deposit Market,” Federal Reserve Bank of Dallas Financial Industry Studies Working Paper (December 1990), 3.

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into institutions willing to pay above-market interest rates to attract money to invest in new
activities. S&Ls would advertise their rates both locally and nationally, use in-house
“money desks,” or get in touch with brokerage firms that were happy to help move money
in large bundles to thrifts that were seeking to grow. In June 1984, when thrifts with annual
growth rates of less than 15 percent had more than 80 percent of their liabilities in traditional retail deposits (generally in accounts of less than $100,000), the comparable figure
for thrifts growing at rates in excess of 50 percent per year was only 59 percent. This latter
group relied more heavily on large-denomination deposits and repurchase agreements,
which together accounted for more than 28 percent of their liabilities.44
Growth among thrifts was particularly strong in the Sunbelt and in states whose
economies were energy related and booming in the early 1980s. These included Arizona,
Arkansas, California, Kansas, Oklahoma, and Texas. Texas S&Ls were among the most aggressive growers. Assets at the state’s thrifts increased by 117 percent between 1982 and
1985, a rate twice the national average.45 This growth was concentrated in a number of
small but fast-growing institutions known as highfliers. One of the most egregious of these,
Empire Savings & Loan Association of Mesquite, grew between 1981 and 1983 from approximately $13 million in assets to more than $300 million.46 When Empire failed in
March 1984, large certificates of deposit accounted for more than 90 percent of liabilities.
To attract this “hot money,” Empire and other Texas S&Ls paid about 100 basis points (1
percent) more than commercial banks for certificates of deposit.47
After Empire Savings & Loan failed, the FHLBB imposed a regulation restricting
growth at undercapitalized thrifts to a rate equal to the interest credited on existing deposits.
S&Ls that met their net worth requirements could not grow at rates exceeding 25 percent
per year without supervisory approval. As a result, industry-wide asset growth dropped
from nearly 20 percent in 1984 to less than 10 percent in 1985. However, additional pressure on deposit interest rates came from thrifts that were insolvent but still operating, such
as those in the FHLBB’s Management Consignment Program (MCP).48 For as the true con-

44

In a repurchase agreement, a thrift would “sell” mortgages or mortgage-backed securities to an investment banking firm and
promise to “repurchase” them at a future date and higher price. These transactions were essentially collateralized borrowing (White, The S&L Debacle, 88).
45 Strunk and Case, Where Deregulation Went Wrong, 105.
46 It should be noted that not all “highfliers” were located in Texas. American Diversified Savings Bank of Lodi, California,
grew from $11 million in 1982 to $978 million in 1985, while Bloomfield Savings and Loan of Birmingham, Michigan,
grew during the same period from $2 million to $676 million.
47 Lowy, High Rollers, 105, 127.
48 The MCP was designed to remove owners and managers of the worst-run insolvent institutions. Essentially, the FHLBB
would structure a pass-through receivership, recharter the S&L as a federal mutual association, and consign a group of managers to run it. Between 1985 and 1988, the Bank Board placed over 100 S&Ls in the program.

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dition of the S&L industry became common knowledge, these institutions had to pay higher
rates than solvent institutions to attract and retain deposits.49
Because Texas S&Ls had been among the most aggressive growers, the situation there
was particularly acute. By year-end 1987, insolvent Texas S&Ls accounted for 44 percent
of the assets in all RAP-insolvent S&Ls in the country, and the unprofitable Texas thrifts accounted for 62 percent of all losses nationwide. The troubled condition of the state’s thrift
industry resulted in higher interest rates for all financial institutions in Texas: to maintain
their funding base, even well-capitalized banks and thrifts had to pay the so-called Texas
premium, estimated to be 50 basis points or more.50 The ensuing bidding wars between solvent and insolvent financial institutions resulted in a situation that was “just out of control,”
according to a Texas thrift executive.51 The higher operating expenses associated with the
Texas premium not only increased the cost of resolving insolvent S&Ls but also weakened
the financial condition of healthier institutions.
Deposit premiums paid by Texas banks and thrifts peaked in mid-1987 and declined
thereafter in response to regulatory actions to resolve troubled institutions, so that by yearend 1989, the average cost of deposits at Texas banks was only eight basis points higher
than in the rest of the United States.52 One of those regulatory actions was a program that
the Federal Home Loan Bank of Dallas initiated in 1988 replacing high-cost deposits in insolvent Texas thrifts with lower-cost deposits gathered from solvent thrifts. Another was the
FHLBB’s merging of some of the top rate payers as part of its Southwest Plan.53 However,
because of continuing uncertainty about the FSLIC’s ability to close insolvent thrifts, the
deposit premium for these institutions rose throughout 1989, until Congress passed the Fi-

49

Elijah Brewer and Thomas H. Mondschean (The Impact of S&L Failures and Regulatory Changes on the CD Market, 19871991) noted a significant relationship between deposit interest-rate premiums (that is, the spread over comparable Treasury
bill rates) and the capital-to-assets ratio and measures of S&L risk exposure for both wholesale and retail deposits. In the
case of wholesale deposits (over $100,000), the premium was attributed to risk compensation for uninsured depositors. In
the case of retail or fully insured deposits, the premium was attributed to “moral hazard,” or the incentive for insolvent
S&Ls, with nothing to lose, to bid up rates in a gamble for resurrection.
50 The Federal Reserve Bank of Dallas published several studies on the “Texas premium.” See, for example, Eugenie D. Short
and Jeffery W. Gunther, The Texas Thrift Situation: Implications for the Texas Financial Industry (1988).
51 “Texas Marketers Battle High Rates and Bad Publicity,” Savings Institutions (September 1988): 84.
52 Short and Robinson, “Deposit Insurance Reform in the Post-FIRREA Environment,” 10.
53 The Southwest Plan sought to consolidate and shrink the Texas thrift industry by allowing groups of insolvent thrifts to be
acquired. To conserve cash, the FSLIC used notes and other forms of future payments, such as yield maintenance and capital loss coverage. The FSLIC also heavily advertised the tax advantages of acquiring an insolvent thrift before the end of
1988, when the law allowing S&L losses to offset other taxes would expire. The Southwest Plan became controversial because for wealthy acquirers it allowed substantial tax benefits to accrue but required little capital investment.

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nancial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).54 Once
regulators had the money to pay down high-cost deposits and take over insolvent institutions, deposit premiums quickly declined.
After deregulation, commercial banks also faced competitive pressure from S&Ls on
the asset side of the balance sheet. Much of the growth in S&L assets between 1982 and
1985 was concentrated in commercial real estate lending. During that period the proportion
of total thrift assets invested in commercial mortgage loans and land loans rose from 7.4
percent to 12.1 percent—an increase of $78.6 billion. By June 1984 aggressive thrifts,
growing at annual rates greater than 50 percent, already had 16.6 percent of their assets in
these two categories.55 Real estate lending and investing were potentially very lucrative for
S&Ls. Changes in the federal tax code for real estate investments in 1981 and favorable expectations regarding oil prices led to a boom in commercial real estate projects, especially
in the Southwest.56 Because S&Ls were allowed to take an equity interest in real estate development projects, they stood to share in the upside of a booming market. Additionally, interest rates on construction loans are much higher than on other forms of lending; and
regulatory accounting practices allowed S&Ls to book loan origination fees as current income, even though these amounts were actually included in the loan to the borrower. For
example, a borrower might have requested a $1 million loan for two years for a housing development; the institution might have charged four points for the original loan and 12 percent annual interest. However, instead of requiring the borrower to pay the interest
($240,000) and the fee ($40,000), the S&L would have included these two items in the original amount of the loan (which would have increased to $1.28 million), and paid the institution out of the loan proceeds.
There are many notorious examples of how this system was abused by unscrupulous
S&L owners reporting high current income on ADC loans while milking the institution of
cash in the form of dividends, high salaries, and other benefits.57 A rapidly growing S&L
could hide impending defaults and losses by booking new ADC loans. The rush into construction lending by S&Ls was such that “among the fastest growers, loan fees accounted
for substantially all net income in the crucial years 1983 and 1984.” 58 Moreover, although
the majority of S&Ls were not fraud-ridden, few had the management expertise necessary
54

The U.S. General Accounting Office declared the FSLIC insolvent on the basis of its contingent liabilities at year-end 1986.
In 1987, Congress passed the Competitive Equality Banking Act of 1987, which authorized the FSLIC to borrow up to
$10.825 billion but placed a $3.75 billion limit on borrowing in any 12-month period. For a discussion of this legislation,
see White, The S&L Debacle, 102–103.
55 Ibid.
56 These topics are discussed in greater detail in Chapters 3 and 9.
57 William K. Black, “Cash Cow” Examples (1993).
58 Lowy, High Rollers, 77.

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for dealing with the new lending opportunities, particularly the inherently risky ADC lending. In many cases, prudent underwriting standards were not observed, and the necessary
documents and controls were not put in place. Lending on construction projects was appraisal driven and was often “based on the overly optimistic assumption that property values would continue to rise.”59 S&Ls sometimes loaned the entire amount up front, including
interest, fees, and even payments to developers, but did not check to ensure that projects
were being completed as planned. Moreover, S&L ADC loans frequently were nonrecourse: the borrower was not required to sign a legally binding personal guarantee.
S&Ls entered the commercial real estate lending arena at a time when banks were increasing their own investments in commercial real estate loans, having lost many of their
traditional corporate clients to the commercial-paper and bond markets. At the same time,
chartering activity of de novo banks and thrifts was high. The result was simply a matter of
too many lenders chasing too few loans. The rush of new competitors, all eager to lend to
developers, had a negative effect on existing commercial banks, on their underwriting standards, and on the quality of their loans. Field examiners and bank regulators have noted that
in the 1980s borrowers could generate bidding wars between banks and S&Ls. Everyone
wanted to lend money and everyone wanted to grow. Although for the most part S&Ls lent
to lesser-qualified borrowers,60 their presence in the marketplace contributed to the overall
decline in bank lending standards during the 1980s.61 As S&Ls used lax underwriting standards to lure customers away from commercial banks, the banks began to imitate such S&L
practices as the up-front fee structure, interest reserves, and the small amount of equity investment by developers. This “contamination effect” has been called a variation of Gresham’s Law that bad money drives out good. In this variation, “risk-hungry institutions will
force careful institutions into taking greater risks as well.”62 Or in the words of Hugh McColl, chairman of NCNB (now NationsBank): “We may have the wisest underwriting policy (for loans) in the world. But if your next-door neighbor has a poor policy, it can cause
oversupply of space and crush even your wisest decision.”63
Competitive pressures from S&Ls were felt most acutely in states with a large number of aggressive and/or insolvent thrifts. Interviews with regional supervisory personnel
have indicated that Arizona, California, Florida, and Texas were states where banks were
59

Strunk and Case, Where Deregulation Went Wrong, 101.
Most accounts of the S&L debacle have noted this trend. It has been variously attributed to inexperience, fraud, rapid
growth, and the need to invest in high-risk ventures due to higher money costs.
61 Changes in commercial bank underwriting standards during the 1980s are discussed in greater detail in Chapter 3.
62 Eric I. Hemel, “Deregulation and Supervision Go Together,” Outlook of the Federal Home Loan Bank System (November/December 1985): 10.
63 Mindy Fetterman, “ NCNB Chairman Hugh McColl Touts His High-Rise’s Success, Despite Banking’s Towering RealEstate Woes,’’ USA Today (May 28, 1991), 1B.
60

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particularly affected by S&L lending practices. Additionally, the flood of mutual-to-stock
conversions of savings banks in New England during the middle to late 1980s contributed
to the boom-to-bust real estate cycle there.64 Clearly, competition from savings and loans
did not cause the various crises experienced by the commercial banking industry during the
1980s; these crises would have occurred regardless of the thrift situation. But the channeling of large volumes of deposits into high-risk institutions that speculated in real estate development did create marketplace distortions. These high-risk, speculating institutions
raised the cost of funds marketwide and encouraged risk taking by competitors. The flow of
capital was directed to geographic areas, like Texas, where real estate was being developed
far beyond the market’s ability to absorb it. This oversupply contributed to the eventual bust
in real estate values and slowed economic recovery. In hindsight, the “go-go” mentality in
certain regions of the country during the 1980s affected not only banks and S&Ls but also
their regulators, who were slow to understand that some markets were being extravagantly
overbuilt.

Resolution of the Crisis
Throughout the decade, losses in the S&L industry continued to mount as the decline
in real estate values deepened and affected various regions of the country. Efforts to recapitalize the FSLIC in 1986 and 1987 were bitterly fought by the industry, which had considerable influence with members of Congress. Although the Competitive Equality Banking
Act of 1987 provided the FSLIC with resources to resolve insolvent institutions, the amount
was clearly inadequate. Nevertheless, under the new FHLBB chairman, Danny Wall, the
FSLIC resolved 222 S&Ls, with assets of $116 billion, in 1988. These transactions were effected with minimal cash outlays and maximum use of notes, guarantees, and tax advantages, all of which made these transactions more expensive than they would have been had
the FSLIC had adequate funds. But despite these resolutions, at year-end 1988 there were
still 250 S&Ls, with $80.8 billion in assets, that were insolvent based on regulatory accounting principles. Resolution of the S&L crisis did not really begin until February 6,
1989, when newly inaugurated President George Bush announced his proposed program,
whose basic components were enacted later that year in FIRREA.65 It is amazing that such
a monumental crisis, and one given top priority by the new administration, had been virtually ignored as an issue during the 1988 presidential campaign. This invisibility has been attributed partly to Chairman Wall’s successful effort to downplay the problem during 1988,
partly to the continued reluctance to admit that taxpayer dollars would be required, and
64

See Jennifer L. Eccles and John P. O’Keefe, “Understanding the Experience of Converted New England Savings Banks,”
FDIC Banking Review 8, no. 1 (1995): 1–17. The New England crisis is also discussed in Chapter 10.
65 For a detailed summary of the law’s provisions, see Encyclopedia of Banking and Finance, ed. Charles J. Woelfel, 10th ed.
(1994), 446–52. For a review and critique of FIRREA, see also White, The S&L Debacle, 176–93.

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partly to the fact that members of both political parties were vulnerable to criticism for their
role in the crisis.66
It must be concluded that the savings and loan crisis reflected a massive public policy
failure. The final cost of resolving failed S&Ls is estimated at just over $160 billion, including $132 billion from federal taxpayers67—and much of this cost could have been
avoided if the government had had the political will to recognize its obligation to depositors
in the early 1980s, rather than viewing the situation as an industry bailout. Believing that
the marketplace would provide its own discipline, the government used rapid deregulation
and forbearance instead of taking steps to protect depositors. The government guarantee of
insured deposits nonetheless exposed U.S. taxpayers to the risk of loss—while the profits
made possible by deregulation and forbearance would accrue to the owners and managers
of the savings and loans.
The S&L crisis overlapped several regional banking crises in the 1980s and at first
was similar to the crisis involving mutual savings banks (MSBs). However, in contrast to
the FSLIC, the FDIC had both the money to close failing MSBs and the regulatory will to
put others on a tight leash, while allowing some forbearance in the form of the Net Worth
Certificate Program. To be sure, some MSBs later got into trouble with poor investments
and failed, but the cost of these failures pales in comparison with the cost of the failures in
the S&L industry, which was encouraged to grow and engage in risky activities with little
supervision. When the Bank Board realized that its strategies had failed, it attempted to correct the problem through regulation. In contrast, federal bank regulators used supervisory
tools and enforcement actions to limit growth and raise capital levels at commercial banks
and mutual savings banks. But both banks and S&Ls, and their regulators, got caught up in
boom-to-bust real estate cycles.
In the 1980s, a “go-go” mentality prevailed, along with the belief in many regions that
the economies in those regions were recession proof. In both the Southwest and New England, the high-growth strategy pursued by many S&Ls increased the competition for deposits and therefore raised interest expense for both banks and thrifts. This situation
persisted and worsened as deeply insolvent S&Ls remained open because the FSLIC lacked
reserves. Banks also faced competitive pressures from the thrifts that aggressively entered
commercial mortgage lending markets and aggravated the risk taking already present in
commercial banking.
In response to the problems that arose in the 1980s, Congress enacted two major
pieces of legislation, both of which affected the FDIC. One was FIRREA, which abolished
66
67

Day, S&L Hell, 295–96.
U.S. General Accounting Office, Financial Audit, 13.

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the FHLBB and the FSLIC and gave the FDIC initial responsibility for managing the Resolution Trust Corporation (RTC) and permanent responsibility for operating the new Savings Association Insurance Fund (SAIF). The other, passed in response not only to the
problems of the 1980s but also to the S&L-caused taxpayer losses and the FDIC’s near insolvency in the early 1990s, was the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA), which dramatically changed the agency’s operations.

Conclusion
The regulatory lessons of the S&L disaster are many. First and foremost is the need for
strong and effective supervision of insured depository institutions, particularly if they are
given new or expanded powers or are experiencing rapid growth. Second, this can be accomplished only if the industry does not have too much influence over its regulators and if
the regulators have the ability to hire, train, and retain qualified staff. In this regard, the
bank regulatory agencies need to remain politically independent. Third, the regulators need
adequate financial resources. Although the Federal Home Loan Bank System was too close
to the industry it regulated during the early years of the crisis and its policies greatly contributed to the problem, the Bank Board had been given far too few resources to supervise
effectively an industry that was allowed vast new powers. Fourth, the S&L crisis highlights
the importance of promptly closing insolvent, insured financial institutions in order to minimize potential losses to the deposit insurance fund and to ensure a more efficient financial
marketplace. Finally, resolution of failing financial institutions requires that the deposit insurance fund be strongly capitalized with real reserves, not just federal guarantees.

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Chapter 5

The LDC Debt Crisis
Introduction
The spark that ignited the LDC (less-developed-country) debt crisis can be readily
identified as Mexico’s inability to service its outstanding debt to U.S. commercial banks
and other creditors. The crisis began on August 12, 1982, when Mexico’s minister of finance informed the Federal Reserve chairman, the secretary of the treasury, and the International Monetary Fund (IMF) managing director that Mexico would be unable to meet its
August 16 obligation to service an $80 billion debt (mainly dollar denominated). The situation continued to worsen, and by October 1983, 27 countries owing $239 billion had
rescheduled their debts to banks or were in the process of doing so. Others would soon follow. Sixteen of the nations were from Latin America, and the four largest—Mexico, Brazil,
Venezuela, and Argentina—owed various commercial banks $176 billion, or approximately
74 percent of the total LDC debt outstanding.1 Of that amount, roughly $37 billion was
owed to the eight largest U.S. banks and constituted approximately 147 percent of their capital and reserves at the time.2 As a consequence, several of the world’s largest banks faced
the prospect of major loan defaults and failure.
This chapter provides a survey of the LDC debt crisis for the years 1973–89. The discussion covers the crisis year of 1982, as well as two periods that preceded it and one that
followed. The opening sections examine the first two periods, 1973–78 and 1979–82, enabling us to gain some understanding of the economic conditions and prevailing psychology that not only generated increased LDC borrowing but also produced overlending by the
banks. The role bank regulators played during the years leading up to the outbreak of the
crisis is also explored, as are contemporary opinions on the LDC situation. The final section
of the chapter discusses the post-1982 crisis years that consumed bank regulatory officials
and the international banks with damage-control activity, including restructuring existing

1
2

Philip A. Wellons, Passing the Buck: Banks, Government and Third World Debt (1987), 225. In this chapter, the term
“Latin America” refers to all Caribbean and South American nations.
Federal Financial Institutions Examination Council (FFIEC), Country Exposure Report (December 1982), 2; and FDIC,
Reports of Condition and Income (December 31, 1982).

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loan portfolios, preventing the failures of large banking organizations, and containing the
repercussions for the U.S. financial system.

Roots, 1973–1978
The causes and consequences of the Third World debt crisis have been analyzed by
scholars for more than a decade.3 Its origin lay partly in the international expansion of U.S.
banking organizations during the 1950s and 1960s in conjunction with the rapid growth in
the world economy, including the LDCs. For example, for more than a decade before oil
prices quadrupled in 1973–74, the growth rate in the real domestic product of the LDCs averaged about 6 percent annually. For the remainder of the 1970s, the growth rate slowed but
averaged a respectable 4 to 5 percent.4 Such growth generated new U.S. corporate investment in these markets, and the international banks followed by establishing a global presence to support such activity. This multinationalism in providing financial services
contributed to the emergence of a new international financial system, the Eurodollar market, which gave U.S. banks access to funds with which they could undertake Third World
loans on a large scale.
The sharp rise in crude oil prices that began in 1973 and continued for almost a decade
accelerated this expansion in lending (see figure 5.1). In addition to generating inflationary
pressures around the industrial world, these price movements caused serious balance of
payments problems for developing nations by raising the cost of oil and of imported goods.
Developing countries needed to finance these deficits, and many began to borrow large
sums from banks on the international capital markets.5 The oil price rise that caused the
deficits also increased the quantity of funds available in the Eurodollar market through the
dollar-denominated bank deposits of oil-exporting countries, thereby fueling the lending
boom.6 The banks rechanneled the funds to the oil-importing developing countries as loan
credits. In addition to having those effects, the rise of oil prices in 1973 helped to bring on
the world recession of 1974–75, which would eventually produce a decline in world com-

3

4
5
6

See especially William R. Cline, International Debt (1984); Raul L. Madrid, Overexposed (1990); and Michael P. Dooley,
“A Retrospective on the Debt Crisis,” working paper no. 4963, National Bureau of Economic Research, Inc., New York,
1994.
David C. Beek, “Commercial Bank Lending to the Developing Countries,” Federal Reserve Bank of New York Quarterly
Review (summer 1977): 1.
Between year-end 1973 and 1975, current-account trade deficits for the non-oil-producing LDCs increased from approximately $8 billion to $31 billion (Benjamin J. Cohen, Banks and the Balance of Payments [1981], 10).
Between 1972 and year-end 1974, the annual oil revenues of the Organization of Petroleum Exporting Countries (OPEC)
increased from $14 billion to nearly $70 billion. In 1977, OPEC revenues were $128 billion. By year-end 1978, OPEC had
approximately $84 billion in bank deposits, mostly in the Eurodollar market. See Cohen, Banks and the Balance of Payments, 7, 32.

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The LDC Debt Crisis

Figure 5.1

U.S. Crude-Oil Refiner Acquisition Cost, 1970–1988
$/Barrel
40

(Constant 1982 Dollars)

30

20

10
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988
Source: Energy Information Administration, Annual Energy Review (1988).

modity prices for minerals and agricultural goods, thereby further exacerbating the developing countries’ debt burden (see figure 5.2).
In Latin America borrowing had increased steadily in the early 1970s, and after the
1973 oil embargo it escalated significantly. As of year-end 1970, total outstanding debt
from all sources amounted to only approximately $29 billion. By year-end 1978, these outstandings had risen to approximately $159 billion—an annual compound growth rate of almost 24 percent (see figure 5.3).7 It was estimated that approximately 80 percent of this
debt was sovereign.8 The range in the annual growth rate of outstandings went from a low
of 12 percent for Argentina to a high of 42 percent for Venezuela. In absolute terms, however, Mexico and Brazil accounted for approximately $89 billion, or more than half of the
total outstanding debt as of December 31, 1978.
The typical LDC loan consisted of a syndicated medium- to long-term credit priced
with a floating-rate contract. The variable rate was tied to the London Interbank Offering
7

8

The burden of the debt was more moderate after adjustments were made for the inflation of the 1970s. However, the weight
of this burden increased dramatically with the world recession and deflation of the early 1980s. See Cline, International
Debt, 4.
World Bank, World Debt Tables (1990–91 ed.), cited in Robert Grosse and Lawrence G. Goldberg, “The Boom and Bust of
Latin American Lending, 1970–92” (1995), table 1. Sovereign debt refers to claims owed by national governments, by government agencies, or by private firms with public guarantees.

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Figure 5.2

Index

Monthly Commodity and Consumer Prices,
1970–1994

140

CPI Urban

(1982–84=100)

100

Commodity
Prices

60

20

(1992=100)

1970

1975

1980

1985

1990

1994

Source: Haver Analytics.

Figure 5.3

Total Latin American Debt Outstanding, 1970–1989
$Billions
500

400
300
200
100
0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988

Source: World Bank, World Bank Debt Tables (1990–91 ed.).

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The LDC Debt Crisis

Rate (LIBOR), which repriced approximately every six months. It was estimated that approximately two-thirds of outstanding developing-country debt was tied to floating LIBOR
rates.9 Thus, these credits were especially vulnerable to repricing risk driven by changes in
the macroeconomic conditions of the creditor nations.
The largest portion of Latin American claims originated from U.S. banking organizations, primarily the money-center banks, which specialized in managing large syndicated
Eurodollar loans. Mid-sized regional and other non-money-center banks often participated
in these credits, as well as competing for smaller, trade-related credits. LDC lending by U.S.
banks overall increased rapidly in the 1970s, and it especially increased for the eight largest
money-center banks. By year-end 1978, they held approximately $36 billion in outstanding
credits to Latin America (see figure 5.4). This accounted roughly for 9 percent of total assets and 208 percent of total capital and reserves for the average of the eight money-center
banks (see table 5.1a).10
The primary motivation for overseas expansion of U.S. banks during the 1970s was
the search for new markets and profit opportunities in response to major structural changes

Figure 5.4

$Billions

Total Outstanding LDC Loans by the
Largest U.S. Banks, 1977–1989

60

50

40

30

1977

1979

1981

1983

1985

1987

1989

Source: FFIEC, Country Exposure Report (year-end reports, 1977–89).

9
10

World Bank, World Debt Tables (1981–82 ed.), xvi.
This total excludes Continental Illinois, which received open-bank assistance in 1984.

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Table 5.1a

Average Financial Ratios for Eight Money-Center Banks, 1974–1989
(Percent)

Year

Net Income/
Capital

Net Income/
Assets

LDC Loans/
Total Assets

LDC Loans/
Total Loans

LDC Loans/
Capital

LDC Loans/
Cap + Reserves

1974

13.8

0.51

N/A

N/A

N/A

N/A

1975

13.3

0.53

N/A

N/A

N/A

N/A

1976

11.5

0.49

N/A

N/A

N/A

N/A

1977

10.9

0.45

9.4

16.9

227.9

205.8

1978

12.4

0.49

9.1

16.5

232.0

207.6

1979

13.5

0.51

9.7

17.9

256.3

228.1

1980

13.8

0.53

9.7

17.3

251.7

224.3

1981

12.9

0.51

10.3

17.2

263.9

232.6

1982

12.4

0.51

10.0

16.4

247.1

217.3

1983

11.8

0.53

10.3

16.5

230.1

201.6

1984

10.6

0.51

10.4

16.3

219.5

190.2

1985

9.0

0.43

9.5

15.6

200.5

168.0

1986

8.8

0.44

9.0

15.0

179.2

145.7

1987

−22.2

−0.93

8.9

15.6

211.3

125.3

1988

21.3

1.09

8.5

14.8

167.2

107.3

1989

−9.9

−0.45

7.5

12.7

164.7

93.2

in the domestic market.11 U.S. commercial banks had been losing their share of household
savings to other types of intermediaries and to the capital markets for decades, and shares
of traditional loan products had dwindled.12 For example, since the early 1970s, commercial banks had been losing some of their best clients to the commercial paper market, which
would grow rapidly in the 1970s and 1980s (see figure 5.5).13 L. William Seidman, former
chairman of the FDIC, noted in retrospect that “banks’ troubles began when they lost their
big corporate customers to the commercial paper market early in the 1970s.”14 This reduced
share of one of the banks’ primary staples, the working capital loan, placed pressure on

11

12
13
14

The 1970s were relatively unprofitable for the largest commercial banks in the U.S. market. The domestic earnings of the
13 largest U.S. banks actually declined in real terms during the first half of the decade (Thomas H. Hanley, United States
Multinational Banking: Current and Prospective Strategies [1976], 13).
Board of Governors of the Federal Reserve System, Flow of Funds Accounts (various years).
Commercial paper consists of short-term borrowings or IOUs by the largest and best-known corporate organizations.
L. William Seidman, Full Faith and Credit: The Great S&L Debacle and Other Washington Sagas (1993), 39.

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Table 5.1b

Aggregate Financial Data for Eight Money-Center Banks, 1974–1989
($Millions)

Year

Total
Assets

Total
Capital

Net
Income

Total
Loans

LDC
Loans

Total
Reserves

1974

$265,916

$ 9,803

$1,348

N/A

N/A

N/A

1975

275,393

11,014

1,461

N/A

N/A

N/A

1976

304,307

12,950

1,486

$169,615

N/A

1977

347,495

14,282

1,554

192,571

1978

392,572

15,437

1,911

1979

451,834

17,166

2,320

1980

490,753

18,918

1981

519,436

1982
1983

Provisions
for Loans
$

547

Total Loan
Charge-offs*
N/A

1,127

N/A

$ 1,431

1,136

$1,084

$32,554

1,538

905

829

217,269

35,811

1,814

866

598

246,468

43,999

2,123

751

447

2,614

274,920

47,614

2,310

873

667

20,348

2,629

312,275

53,703

2,736

1,065

654

546,729

22,115

2,764

332,799

54,655

3,036

1,583

1,254

541,968

24,211

2,853

337,542

55,704

3,416

1,933

1,518

1984

560,921

26,655

2,835

359,018

58,515

4,107

2,575

1,957

1985

593,235

28,233

2,550

361,849

56,595

5,451

4,301

3,003

1986

605,566

30,343

2,659

362,495

54,387

6,988

4,779

3,426

1987

593,584

24,954

−5,529

338,617

52,720

17,107

13,065

2,875

1988

577,589

29,397

6,268

332,452

49,146

16,390

2,270

2,793

1989

584,847

26,438

−2,616

344,130

43,543

20,284

9,535

5,544

* Total loan charge-offs are net of annual recoveries.

banks to seek new sources of revenue and provided an impetus for them to turn to the lucrative overseas loan markets.15
The potential risks of the growing involvement of U.S. banks in LDC debt were not
unnoticed. Economists, government officials, and other observers warned of the possible
dangers for both individual institutions and the banking system as a whole. In 1977 Arthur
Burns, chairman of the Federal Reserve Board, criticized commercial banks for assuming
excessive risks in their Third World lending, noting in a speech at the Columbia University
Graduate School of Business on April 12 that
under the circumstances, many countries will be forced to borrow heavily, and lending institutions may well be tempted to extend credit more generously than is prudent. A major
risk in all this is that it would render the international credit structure especially vulnerable in the event that the world economy were again to experience recession on the scale of
15

Short-term working capital loans were a relatively low-risk product for banks in comparison to the typical medium- to
long-term Third World syndicated credit.

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Figure 5.5

U.S. Commercial Paper Outstanding, 1973–1989
$Billions
600

(Seasonally adjusted, all issuers)

400

200

0

1973

1975

1977

1979

1981

1983

1985

1987

1989

Source: Haver Analytics.

that from which we are now emerging . . . commercial and investment bankers need to
monitor their foreign lending with great care, and bank examiners need to be alert to excessive concentrations of loans in individual countries.16

Other economists argued that international organizations should take a more active role in
the recycling efforts and warned that the U.S. government would be forced to bail out any
U.S. banking organizations that failed.17
Congress held hearings on the LDC issue in 1975 and expressed concern about the excessive concentration of Third World loans and its related threat to the capital position of
U.S. banks. A 1977 published staff report from the Senate Subcommittee on Foreign Relations noted, “The most immediate worry is that the stability of the U.S. banking system and
by extension the international financial system may be jeopardized by the massive balance
of payments lending that has been done by commercial banks since the oil price hike.”18

16

17
18

Arthur F. Burns, “The Need for Order in International Finance,” Address (April 12, 1977), 4, 5, 13. Seidman recalled that
when Burns brought up his misgivings about Latin American debt with the Ford administration, he was not taken seriously
(Full Faith and Credit, 37–38).
Marina Whitman, “Bridging the Gap,” Foreign Policy 30 (spring 1978): 148–56.
U.S. Senate Committee on Foreign Relations, Subcommittee on Foreign Relations, International Debt, the Banks, and U.S.
Foreign Policy, 95th Cong., 1st sess., 1977, 5.

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The LDC Debt Crisis

Such pronouncements, however, were frequently greeted as exaggerated even by those who
felt some caution was appropriate with regard to LDC debt, and belief in the likelihood of
a crisis was not widespread.19

Prelude, 1979–1982
During the late 1970s, the signs of impending crisis began to become clearer and were
more widely recognized. Some observers believed that the ability of the LDCs to continue
servicing their debts (interest on short- and long-term debt plus amortization of long-term
debt) was deteriorating quickly. The second major oil shock of the decade occurred in 1979,
intensifying LDC debt-service problems.20 At this time, the debt-service ratios of Latin
American nations averaged more than 30 percent of export earnings, a level above what
bankers traditionally considered acceptable. Some developing countries, such as Brazil,
had debt-service ratios near 60 percent during this period. In addition, rising dollar exchange rates in response to the high U.S. interest rates of the early 1980s increased the difficulty of meeting debt commitments. The value of the dollar increased by 11 percent in
1981 and 17 percent through most of 1982 against the strongest currencies (see figure 5.6).
Because the bulk of LDC debt was placed in dollars, the burden of servicing dollar debt became increasingly more difficult over time.21 Capital flight was also taking place because
overvalued exchange rates for some of the larger LDC nations generated fears of devaluation and added to liquidity problems.22
Nevertheless, Latin American nations continued their heavy borrowing during these
years. Between the start of 1979 and the end of 1982 total Latin American debt more than
doubled, increasing from $159 billion to $327 billion (figure 5.3). In response to this demand, U.S. banks increased their lending to the LDCs during the crucial four years leading
up to the outbreak of the crisis: the outstanding loans of the eight largest money-center
banks rose from approximately $36 billion to $55 billion, more than a 50 percent increase
(figure 5.4 and table 5.1b). This overall risk exposure was reflected in the concentration of
LDC loans to total capital and reserves, which was 217 percent at the end of 1982 for the
average money-center bank (table 5.1a). This heavy concentration put some of the largest
international banks at risk.
19

20
21
22

See, for example, Beek, “Commercial Bank Lending,” 1–8. One observer noted that “developing countries look to be good
credit risks worthy of a continued flow of new loans as well as refinancing. . .” (Robert Solomon, “A Perspective on the
Debt of Developing Countries,” Brookings Papers on Economic Activity 2 [1977], 479). As late as 1979, an editorial in a
daily newspaper described the LDC debt situation as a “major nonproblem” (American Banker [March 28, 1979], 4).
Between year-end 1978 and October 1980, the price of oil more than doubled, reaching $30 per barrel, while the import
bill of all non-oil-producing developing nations rose from $26 billion to $63 billion (Madrid, Overexposed, 76).
Ibid., 77.
The World Bank estimated that between 1979 and 1982, capital flight from Argentina, Mexico, and Venezuela was almost
$70 billion, or 67 percent of gross capital inflows (World Development Report [1985], 64).

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Figure 5.6

German Mark and Japanese Yen
U.S. Dollar Exchange Rates, 1971–1994
JPY/USD
400

DEM/USD
4.5

JPY/USD

300

3.5

200

2.5

100

1.5

DEM/USD
1971

1975

1980

1985

1990

1994

Source: Haver Analytics.

As the LDC debt increased after 1979, so did the warnings of possible problems for
U.S. banks. Paul Volcker, the chairman of the Federal Reserve Board during this period,
suggested that rising oil prices would mean some rescheduling of debts owed by developing countries.23 Henry Wallich, a Federal Reserve Board governor, criticized the rapid
growth in LDC debt and indicated that the money-center banks’ exposure to sovereign risk
placed their capital in jeopardy. He believed that additional lending should be restrained by
regulatory officials.24 Others also warned about the potential implications of the accumulation of LDC debt for the U.S. and world financial systems. The Wall Street Journal noted in
1981:
It doesn’t show on any maps, but there’s a new mountain on the planet—a towering $500
billion of debt run up by the developing countries, nearly all of it within a decade . . . to
some analysts the situation looks starkly ominous, threatening a chain reaction of country
defaults, bank failures and general depression matching that of the 1930s.25
23
24
25

James Grant, “Day of Reckoning? Foreign Borrowers May Have Trouble Repaying Their Debts,” Barron’s (January 7,
1980): 7.
Henry C. Wallich, “LDC Debt: To Worry or Not to Worry,” Challenge (September/October 1981): 8–14.
The Wall Street Journal (January 23, 1981), 25–28.

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The LDC Debt Crisis

But although increasing numbers of observers were paying attention to the signs of
approaching problems, the financial markets were generally not sending explicit signals of
an impending crisis. For example, an analysis of the trend in annual stock prices for the U.S.
money-center and regional banks against the S&P 500 market averages indicates no significant discounting of prices by the market in the years leading up to the crisis (see figure 5.7).
For the most part, even up through 1986 the index of stock prices paralleled changes in the
overall market averages. From 1987 through the early 1990s, the broader market averages
appear to have outperformed bank stocks, producing a gap that partially reflected the effect
on bank earnings of the heavy provisioning for LDC loan losses as well as the commercial
real estate problems in the late 1980s (see Chapter 3).26
Nor did corporate bond ratings of the money-center banks reveal any trend toward
weakness or deterioration in the financial position of these institutions in the years leading
Figure 5.7

Share Price of Money-Center Banks and
Regional Banks vs. S&P 500, 1970–1995
Banks ($)

S&P 500 ($)

300

600

Regional
Banks

200

400

Money-Center
Banks
100

200

S&P 500
0

1970

1975

1980

1985

1990

1995

0

Source: Salomon Brothers, Bank Annual (1996 ed.).

26

However, at least one study found that from 1966 through 1979 the stock market reacted adversely to the large syndicated
loans made to Latin American countries by the money-center banks. According to this study, “syndicated loans to Latin
American countries, mainly for the years 1966 to 1979, are associated with significant reductions in shareholder wealth of
the participating banks. The continued issuance of these loans throughout the 1970s raises questions about the motives of
bank managers or their susceptibility to political pressure or both” (William L. Megginson et al., “Syndicated Loan Announcements and the Market Value of the Banking Firm,” Journal of Money, Credit and Banking 27 [May 1995]: 498).

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Table 5.2

Long-Term Debt Ratings of U.S. Money-Center Banks, 1977–1989
Organization

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

BankAmerica

Aaa

Aaa

Aaa

Aaa

Aaa

Aa1

Aa2

Aa3

Aa3

Baa1

Ba1

Ba3

Baa2

Bankers Trust New
York

Aaa

Aa

Aa

Aa

Aa

Aa2

Aa2

Aa2

Aa2

Aa2

Aa3

A1

A1

Chase Manhattan

N/A

N/A

Aaa

Aaa

Aaa

Aa1

Aa1

Aa2

Aa2

Aa2

A2

Baa1

Baa1

Chemical New York

Aaa

Aaa

Aaa

Aaa

Aaa

Aa2

Aa2

Aa2

Aa2

Aa2

A2

Baa1

Baa1

Citicorp

Aaa

Aaa

Aaa

Aaa

Aaa

Aa1

Aa1

Aa1

Aa1

Aa1

A1

A1

A1

First Chicago

Aaa

Aaa

Aaa

Aa

Aa

Aa3

Aa3

Aa3

A1

A3

A2

A3

A2

Manufacturers Hanover

Aaa

Aaa

Aaa

Aaa

Aaa

Aa2

Aa2

Aa3

Aa3

A1

A3

Baa3

Baa3

J. P. Morgan & Co.

Aaa

Aaa

Aaa

Aaa

Aaa

Aaa

Aaa

Aaa

Aaa

Aaa

Aaa

Aa1

Aa1

Source: Moody’s Bank and Finance News Reports.

up to the crisis (see table 5.2).27 Primarily because of income from overseas loans, the
1970s and early 1980s were periods of average profitability for the money-center banks.
From 1974 to 1982, for example, the average money-center bank averaged a 12.7 percent
return on equity and a 0.50 percent return on assets (table 5.1a), approximately equal to and
slightly below the overall industry averages of 12.0 percent and 0.70 percent for the same
period. Also during this period, for almost all of the large banks, interest and fee income on
overseas loans accounted for a substantial portion of total income.28 Thus, at that time the
bond rating agencies did not appear to foresee the consequences of Third World lending.
The corporate bond ratings of the money-center banks did, however, begin to deteriorate in 1982 and continued deteriorating for the remainder of the decade, as LDC losses
mounted. In 1982, Bankers Trust New York Corporation, Chemical New York Corporation,
First Chicago Corporation, and Manufacturers Hanover Corporation were downgraded below Aaa or the highest levels of Aa status. By 1989, four of the eight organizations
(BankAmerica Corporation, Chase Manhattan Corporation, Chemical New York Corporation, and Manufacturers Hanover Corporation) were rated only slightly above investment
grade. Citicorp was rated Aa1 in 1982, and by 1987 its rating had deteriorated to A1. Only

27
28

The only exceptions were Bankers Trust Co., which was downgraded from Aaa to Aa in 1978, and First Chicago Corporation, from Aaa to Aa in 1980.
Between 1977 and 1981, the largest U.S. banks earned $3.4 billion in pre-tax income from Third World loans (Office of the
Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, Developing Country Lending Profitability Survey [1989], 6).

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The LDC Debt Crisis

J. P. Morgan & Co. Incorporated managed to retain its triple-A rating until 1988, when it
was downgraded to Aa1.
In the years leading up to the outbreak of the crisis, bank regulatory authorities were
aware of the heavy concentration of Third World lending in the large international banks
and the threat it posed to bank capital, and they attempted to deal with it in a variety of
ways. Trying to slow down the growth of LDC loans, they issued “warning letters” to the
boards of lending banks, urging voluntary restraint in new lending. In addition, in 1979 the
Interagency Country Exposure Review Committee (ICERC)—composed of officials of the
Office of the Comptroller of the Currency (OCC), the Federal Reserve Board, and the
FDIC—was established to monitor the exposure of U.S. banks to foreign lending as part of
the broader bank examination process. The committee adopted a uniform examination system for evaluating and commenting on country risk to U.S. banks that had relatively large
foreign lending exposure. The system became effective in the spring of 1979 and entailed
identifying countries with actual or potential debt-servicing problems, drawing bank management’s attention (in examination reports) to loans to these countries, and evaluating
bank internal country-exposure management systems. The overall objective was to ensure
adequate diversification of bank foreign-lending risk.
However, the efforts made by the regulators appear to have had no significant effect
upon the rate of bank lending during the late 1970s and the early 1980s. An analysis of the
program by the U.S. General Accounting Office in 1982 suggested that the “special comments by bank examiners have had little impact in restraining the growth of specially commented exposures.”29 These findings were supported by data that showed continued strong
growth of LDC lending by the heavily exposed U.S. money-center banks leading up to the
outbreak of the crisis in August 1982 (figure 5.4).
One key bank regulatory decision that did have a bearing on the crisis, however, came
in 1979, when the OCC issued a new interpretation of a statute that set limits on the amount
of loans a bank could make to a single borrower:30 by law a national bank was not permitted to make loans to a single borrower in excess of 10 percent of the bank’s capital and surplus.31 In reality, some of the largest U.S. banks had loaned more than 10 percent of their
capital to the various government agencies and government-related corporations of LDCs
like Mexico and Brazil during the 1970s (and they would continue doing so into the early
1980s). Such exposure appeared to be in violation of the 10 percent rule.
29
30
31

See U.S. General Accounting Office, Bank Examination for Country Risk and International Lending, GAO/ID-82-52
(1982).
The OCC is the chartering and primary regulatory authority for all national banks, a category that includes all moneycenter banks and almost all large U.S. banking organizations.
Title 12 U.S. Code, sec. 84, established 10 percent of capital as a limit of total loans to a single borrower for all national
banks. These limits held until passage of the Garn–St Germain Act of 1982, which expanded the limit to 15 percent of capital, and if certain collateral conditions were satisfied, this limit could increase to 25 percent.

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In January 1978, the OCC issued a proposed interpretation of the law to address the
question of whether all public sector corporations and agencies should be considered one
“person” under the loans-to-one-borrower rule and should thus be combined into one group
for purposes of regulatory action. In 1979, after 15 months, the OCC issued its final ruling:
it concluded that public sector borrowers did not have to be counted as part of a single entity if each borrower had the “means to service its debt” and if the “purpose of the loan involved the borrower’s business.”32 The OCC delegated authority for making decisions on
these issues to the lending banks. The banks in turn relied upon the statements of the public
sector corporations and host governments for compliance with the “purpose” and “means”
tests. If the ruling had been that the borrowers should be combined, during the LDC crisis
years almost all the money-center banks would have been in violation of the 10 percent requirement.
According to at least one scholar, the OCC’s interpretation of this statute during the
debt buildup in the late 1970s was an example of regulatory forbearance.33 This individual
maintains that the OCC’s ruling gave the large banks tacit approval to continue lending and
sent a message from the regulatory authorities that such concentrations of LDC loans did
not constitute “unsafe and unsound” banking practices. A Senate committee that examined
this issue at the time questioned the effectiveness of the 10 percent rule as interpreted by the
OCC, noting that “a single U.S. bank may have loans outstanding to 20 different public entities in Brazil, none of which individually exceeds 10 percent of the bank’s capital, but
which taken together may far exceed the limit, and still not be in violation of the rule.” 34
The decision bank regulatory officials made in 1979 to reinterpret the key loans-to-oneborrower rule may have rested partly on the historical differences between domestic and international regulation of financial institutions. That is, the regulation of the international
activities of the nation’s largest banks may have been influenced more by issues of competition, trade, and foreign policy than by concerns about domestic safety and soundness.35
Traditionally banks had greater leeway in their international operations than they were allowed at home, so that U.S. banks had the opportunity to finance Third World deficits while
at the same time assuming greater concentrations of risky overseas loans in their portfolios.
Regulatory authorities apparently were not anxious to interfere with the overseas lending
operations of the international banks. Furthermore, there is some evidence that political
pressure was put on bank regulators not to interfere with the Third World lending.36
32
33
34
35
36

Federal Register 44 (April 17, 1979): 22712.
See Wellons, Passing the Buck, 100–112.
Ibid., 107.
Ibid., 99–100.
Wellons (99–100) discusses these issues in detail. Seidman discusses attempts by authorities in the executive branch to interfere with the policies of the bank regulatory agencies (Full Faith and Credit, 121–24).

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Chapter 5

The LDC Debt Crisis

Eruption, August 1982
The record-high interest rates of the early 1980s (see figure 5.8), caused by the Federal Reserve’s efforts to curb the oil-based inflation of the 1970s, brought on a global recession and helped to trigger the overall crisis.37 Because most Third World credits were
priced to LIBOR rates, debt-service costs grew progressively greater as these rates reached
record levels.38 This situation, coupled with the slowdown in world growth and the drop in
commodity prices for the second time in eight years (figure 5.2), left exports stagnant and
debt-service commitments hard to meet. Many scholars point to another factor that com-

Figure 5.8

Monthly Treasury Bill Rate (3-Month), 1970–1994

Percent
16

12

8

4
1970

1975

1980

1985

1990

1994

Source: Haver Analytics.

37

38

As mentioned, the crisis began with the Mexican government’s notification that it was unable to meet its debt-service requirements in August 1982. What specifically triggered the Mexican situation was the combination of high interest rates,
which exacerbated debt-service costs for Mexico and the other debtor nations, and the sharp decline in oil prices in 1982.
Falling revenues associated with lower oil prices made it especially difficult for Mexico and other oil-exporting debtor nations to service existing debts on schedule.
LIBOR rates were sensitive to changes in short-term U.S. interest rates because Eurocurrency deposits were primarily a
dollar-denominated market. LIBOR rates averaged 10.2 percent through 1980; for 1981 and 1982 they averaged 15.8 percent (IMF, International Financial Statistics [1983], 92). It was estimated that for every percentage point increase in
LIBOR, debt-service costs for all developing nations rose by $2 billion. For these countries, interest payments almost
tripled during 1978–80, rising from $15.8 billion to $41.1 billion (Madrid, Overexposed, 76).

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pounded the debt-service problems: most of the new bank loans to the LDCs from 1979 to
1982 went to cover accrued interest on existing debt and/or to maintain levels of consumption, rather than for productive investments.39
In August 1982 the Mexican finance minister indicated that his nation could no longer
meet interest payments. By year-end 1982, approximately 40 nations were in arrears in their
interest payments, and a year later 27 nations—including the four major Latin American
countries of Mexico, Brazil, Venezuela, and Argentina—were in negotiations to restructure
their existing loans. For the remainder of the decade bank lending declined significantly, as
many banks refrained from new overseas lending and attempted to collect on and restructure existing loan portfolios. From the end of 1983 to 1989, money-center bank loans outstanding to Latin America decreased from $56 billion to $44 billion, a decline of more than
20 percent (figure 5.4 and table 5.1b).
In hindsight, many observers have asked what role, if any, outside pressure played in
affecting the banks’ lending decisions. There is no evidence to suggest that creditor governments or international organizations forced or pressured banks to make loans in order to
recycle funds to Third World nations. Clearly, however, banks were encouraged to do so.40
Seidman, former economic counselor to President Ford, later remarked that “the entire Ford
Administration, including me, told the large banks that the process of recycling petrodollars
to the less developed countries was beneficial, and perhaps a patriotic duty.”41 Both the U.S.
and other creditor governments believed resources would be allocated more efficiently
through private financial intermediaries.42 Moreover, creditor governments and international organizations such as the World Bank and the IMF did not possess sufficient resources to deal with the recycling issue.43

39
40
41

42
43

Seidman, Full Faith and Credit, and others (for example, Cline, International Debt, and Madrid, Overexposed) discuss this
issue at some length.
As previously indicated, if any outside pressure had been exerted, it would have been directed at regulatory officials to restrain them from interfering with the international banks’ LDC lending.
Seidman, Full Faith and Credit, 38. Seidman also noted that in the 1970s the Ford administration “had a chance to deal
with the creation of the LDC debt problem as well as other problems in the financial system, but we just did not see the
magnitude of the trouble ahead. We saw only the short-term benefits of the loans to our industry and finance. But then,
long-range planning has never been an outstanding attribute of our governmental process.”
Margaret Garritsen DeVries, The International Monetary Fund, 1972–1978: Cooperation on Trial (1985), 923–42.
According to one researcher, profit was the primary motive behind commercial bank lending, and direct political pressure
played no important role. The same researcher also posited that the banks thought creditor governments or international
organizations might rescue the debtor nations in the event of default so that the threat to the banks’ capital would have been
limited (Madrid, Overexposed, 44–60). To what extent this belief led to the psychology of overlending that helped produce
the crisis is not known.

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Chapter 5

The LDC Debt Crisis

Resolution, 1983–1989
The seven-year period after the most serious international financial crisis since the
1930s was devoted to restructuring existing loans, setting aside loss reserves, and attempting to protect the solvency of the U.S. financial system. A decade or more would pass after
the crisis before the economies of the LDCs would recover and the banks would clear their
books of the bad loans. Bank advisory committees were established to represent the banks
in bilateral negotiations with the individual debtor countries for debt reschedulings. These
talks lasted until the end of the 1980s and were supported by creditor governments and international financial institutions.
Unlike some European regulatory authorities, immediately after the Mexican crisis
U.S. banking officials did not require that large reserves be set aside on the restructured
LDC loans or on the succeeding arrearages by other LDC nations.44 Such a policy was not
feasible at the time and might have caused a financial panic because the total LDC portfolio held by the average money-center bank was more than double its aggregate capital and
reserves at the end of 1982 (table 5.1a). Thus, regulatory forbearance was also granted to
the large banks with respect to the establishment of reserves against past-due LDC loans.
According to Seidman, this forbearance was necessary because seven or eight of the ten
largest banks in the U.S. might have been deemed insolvent, a finding that would have precipitated an economic and political crisis.45 He noted that “U.S. bank regulators, given the
choice between creating panic in the banking system or going easy on requiring our banks
to set aside reserves for Latin American debt, had chosen the latter course. It would appear
that the regulators made the right choice.”46

44

45

46

In fairness to the U.S. banks, it should be noted that the European banks were able to establish “hidden reserves” by agreement between regulatory officials and the banks that to some extent were shielded from public scrutiny. In addition, the
European banks had less exposure to Third World lending than did the U.S. banks, which made establishing reserves less
difficult (Seidman, Full Faith and Credit, 127–28).
The regulatory authorities did begin to raise capital standards in the banking industry starting with the OCC’s decision to
raise minimum capital requirements in 1979 for national banks. Furthermore, the International Lending Supervision Act
of 1983 (ILSA) required that all bank regulators achieve and maintain adequate capital standards in the industry by establishing minimum capital levels regardless of whether an institution was heavily involved in international lending. As a
consequence of ILSA, all financial agencies established rules that for the first time set uniform capital requirements for all
commercial banks, effective April 1985.
Seidman, Full Faith and Credit, 127. Another analysis concluded: “Had these institutions been required to mark their
sometimes substantial holdings of underwater debt to market or to increase loan-loss reserves to levels close to the expected losses on this debt (as measured by secondary market prices), then institutions such as Manufacturers Hanover,
Bank of America, and perhaps Citicorp would have been insolvent.” See Robert A. Eisenbeis and Paul M. Horvitz, “The
Role of Forbearance and Its Costs in Handling Troubled and Failed Depository Institutions,” in Reforming Financial Institutions in the United States, ed. George G. Kaufman (1993), 49–68.

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In retrospect, this strategy proved to be successful by avoiding a major domestic or international financial crisis. During this period no large U.S. banks failed because of delinquent or nonperforming LDC loans.47 The large banks were able to maintain funding and
liquidity while being given time to raise capital and increase reserves. The overall debt
strategy also forced structural adjustments in the LDCs, such as trade liberalization, privatization, deregulation, and tax reform, that eventually brought both growth and investment
to several LDC nations. Seidman contrasted the regulatory forbearance of the debt crisis
with that of the savings and loan crisis in the United States during the 1980s:
Sometimes forbearance . . . is the right way to go, and sometimes it is not. In the S&L
industry, all rules and standards were conveniently overlooked to avoid a financial collapse and the intense local political pressure that such a collapse would have generated.
But in this case there was not a visible plan for a recovery, so the result of this winking at
standards was, as we know, a national financial disaster. On the other hand, in the case of
Latin American loans, forbearance gave the lending banks time to make new arrangements with their debtors and meanwhile acquire enough capital so that losses on Latin
American loans would not be fatal. Like medicine and the other healing arts, bank regulation is an art, not a science.48

The average profitability of money-center banks in the earlier periods contrasts
sharply with that in the post-1982 years. For the average money-center bank during the
1983–89 period, net income to total capital and net income to total assets averaged only 4.2
percent and 0.23 percent—returns significantly below the industry averages of 9.0 percent
and 0.55 percent. Moreover, for the years 1987 and 1989, the average money-center bank
experienced negative returns (table 5.1), bringing down total earnings for the U.S. banking
industry during the two years (see figure 5.9).
This slowdown in earnings was reflected in the substantial buildup in loan chargeoffs, loan-loss provisions, and the accumulation of total reserves recorded over the 1983–89
period (tables 5.1a and 5.1b). Although between 1982 and 1986 the loan-loss reserves for
the average international bank more than doubled, as of year-end 1986 they were still only
approximately 13 percent of the total LDC loan exposure. Starting in 1987, however, the
money-center banks began to recognize massive losses on LDC loans that in some instances had been carried on the books at par for more than a decade. After extensive bilateral negotiations with the LDCs beginning in 1983, the banks realized that a large portion
of the loans would not be repaid. In May 1987 Citicorp was the first major bank to break
ranks and recognize a loss, establishing loss provisions for $3.3 billion, or more than 30
percent of its total LDC exposure. Shortly thereafter all of the other major banks followed
47
48

Continental Illinois National Bank failed in 1984 primarily because of losses on energy and energy-related loans.
Seidman, Full Faith and Credit, 128.

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Chapter 5

The LDC Debt Crisis

Figure 5.9

Percent

Return on Assets,
U.S. Banking Industry, 1970–1994

1.2

0.8

0.4

0

1970

1975

1980

1985

1990

1994

suit. By year-end 1989, the average money-center bank had total reserves that were almost
50 percent of their total outstanding LDC loans.
The creation of a plan in 1989 by Nicholas Brady, secretary of the treasury in the Bush
administration, was a recognition by the U.S. government that troubled debtors could not
fully service their debts and restore growth at the same time; the plan therefore sought permanent reductions in principal and existing debt-servicing obligations. This recognition
paved the way for negotiations between the creditor banks and debtor nations to shift primary focus from debt reschedulings to debt relief. As part of the process, substantial funds
were raised from the IMF, the World Bank, and other sources to facilitate debt reduction.
Debtor nations used such funds to exercise options such as debt-equity swaps, buybacks,
exit bonds, and other solutions. To qualify for borrowing privileges, debtor countries had to
agree to introduce economic reforms within their domestic economies in order to promote
growth and enhance debt-servicing capacity. It is estimated that under the Brady Plan agreements between 1989 and 1994, the forgiveness of existing debts by private lenders
amounted to approximately 32 percent of the $191 billion in outstanding loans, or approximately $61 billion for the 18 nations that negotiated Brady Plan reductions. These losses
accrued primarily to the shareholders of lending banks.49
49

See William R. Cline, International Debt Reexamined (1995), 234–35. The losses mentioned here accounted for the majority of all losses derived from the LDC crisis. Some additional losses accrued to individual creditor nations that forgave
direct loans to various LDC countries.

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The Brady Plan set the stage, therefore, for finally solving the LDC debt problem. But
negotiations were tedious, and they dragged on for years under the direction of the United
States, other creditor nations, and the international lending organizations. In the end, the
Brady Plan was the only basis on which a comprehensive solution to the Third World debt
problem could be achieved. As one money-center banker stated, “It’s an imperfect, inefficient, frustrating system but in the end, it’s the best that we’ve been able to devise.”50

Conclusion
From the middle to late 1970s, a number of economists, government officials, and
journalists expressed concerns that the volume of lending to less-developed countries could
entail serious problems for U.S. money-center banks and the international financial system.
At the same time, however, the market—as reflected in both money-center bank equity
prices and corporate bond ratings—apparently did not perceive a problem until the crisis
actually broke out. Regulators’ attempts to urge banks to curtail LDC lending appeared to
have had no significant effect on lending practices, even as evidence suggested that Latin
American nations were having increasing difficulty meeting current debt obligations. The
regulatory system therefore broke down and was unable to forestall the crisis. In the final
stages, the realization that banks would not recover the full principal value of existing loans
turned international efforts from debt rescheduling to debt relief, and substantial funds were
raised through the IMF and the World Bank to facilitate debt reduction. The shareholders of
the world’s largest banks assumed the losses under the Brady Plan, which ended the crisis
after a decade of negotiations.
The LDC experience, as reflected in the regulators’ handling of large banks after the
crisis erupted, illustrates the high priority given by banking authorities to maintaining stability in the banking system. It also represents a case of regulatory forbearance with respect
to certain supervisory rules and standards. The 1979 interpretation of the loans-to-oneborrower rule allowed banks to continue lending, and the delay in recognizing loan losses
avoided the repercussions that could have threatened the banks’ solvency. Over time forbearance proved to be successful, however, because loss reserves and charge-offs were
greatly increased and no money-center bank failed because of LDC lending.

50

Interview published in Latin Finance (March 1989): 39, as cited in Madrid, Overexposed, 110.

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Chapter 6

The Mutual Savings
Bank Crisis
Introduction
The first major crisis the FDIC had to confront in the 1980s was the threatened insolvency of a large number of mutual savings banks (MSBs). Historically, state laws had restricted these thrift institutions to investing in long-term, fixed-rate assets; and traditionally,
the majority of MSB liabilities were in passbook savings accounts paying a low rate of interest. Until the 1970s, this manner of operating had enabled mutual savings banks to prosper throughout most of their history. However, in the 1970s the combined forces of rising
interest rates, increased competition for deposits, and legal restrictions on diversifying the
asset side of the balance sheet quickly overwhelmed many thrift institutions. During the
first three years of the 1980s the mutual savings bank industry sustained operating losses of
nearly $3.3 billion, an amount equivalent to more than 28 percent of the industry’s general
reserves at year-end 1980. Losses at some individual MSBs were even higher, and these institutions experienced a rapid depletion of capital. This chapter describes the relatively
unique development and history of mutual savings banks in the United States and the causes
of the crisis that peaked in the early 1980s; it also discusses the regulatory and congressional responses to the problem.

Background
Mutual savings banks in the United States date to 1816, when the Philadelphia Saving
Fund Society began operations on a voluntary basis and the Provident Institution for Savings in Boston was granted the first savings bank charter.1 Originally MSBs were organized
to help the working and lower classes by providing a safe place where the small saver, then
shunned by commercial banks, could deposit money and earn interest. Unlike savings and
loan associations (S&Ls), whose purpose was to facilitate the home ownership of members
1

For a more complete discussion of MSB history, see Franklin Ornstein, Savings Banking: An Industry in Change (1985),
16–26; Alan Teck, Mutual Savings Banks and Savings and Loan Associations: Aspects of Growth (1968), 4–55; and Weldon Welfling, Mutual Savings Banks: The Evolution of a Financial Intermediary (1968), 8–69.

An Examination of the Banking Crises of the 1980s and Early 1990s

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by pooling their savings and allocating housing loans, the early mutual savings banks were
largely the result of a philanthropic impulse: wealthy, public-spirited individuals contributed start-up capital and served as trustees of the bank, overseeing operations without
the benefit of remuneration.2 Initially the investment of MSB funds was restricted to federal
and state government bonds. Although depositors in a mutual savings bank technically own
the institution’s assets and share in its profits, they are neither stockholders nor members,
and have no voting rights or influence over how their money is invested.
Soon after the early success of the Philadelphia and Boston banks, MSBs were chartered in a number of states, primarily in the Mid-Atlantic region and the industrial Northeast, where there were large numbers of wage earners seeking a safe haven for their savings.
In contrast, demographic and economic conditions in the South and the expanding West favored the development of commercial banks and stock savings associations. Although
eventually MSBs were chartered in 19 states, historically more than 95 percent of total deposits in mutual savings banks were accounted for by only 9 states—Connecticut, Maine,
Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, and
Washington.3
The earliest MSB charters contained no restrictions on investment powers. In practice,
however, the trustee system of savings bank operations fostered conservative management,
and this was reflected in most state laws governing mutual savings banks. 4 These statutes
specified the types of investments permitted; set ceilings on the percentage of assets or deposits permitted in each type; and laid out detailed criteria for evaluating eligibility. Originally confined to investing in government securities, MSBs were soon permitted to invest
in high-grade municipal, railroad, utility, and industrial bonds; blue-chip common and preferred stocks; first mortgage loans on real estate; and other collateralized lending. The expanded investment powers went hand in hand with the rapid growth in both the number of
mutual savings banks and their deposits. Between 1820 and 1910, the number of MSBs in
the United States grew from 10 to 637, while total deposits grew from $1 million to more
than $3 billion.5

2
3

4

5

As savings banks expanded, management was delegated to professionals appointed by the trustees.
The other ten states in which MSBs were chartered were Alaska, Delaware, Florida, Indiana, Maryland, Minnesota, Ohio,
Oregon, Vermont, and Wisconsin. MSBs were also chartered in Puerto Rico and the U.S. Virgin Islands (National Association of Mutual Savings Banks, 1980 National Fact Book of Mutual Savings Banking [1980], 17).
Ornstein, Savings Banking, 21. Notable exceptions were Delaware and Maryland, which left the investment of funds to
management’s discretion. Ornstein notes, however, that savings banks in these states were “subject to exhaustive examinations by the respective banking departments” (18). Traditionally, investment powers were relatively broad in the New England states and very restricted in New York and Pennsylvania.
John Lintner, Mutual Savings Banks in the Savings and Mortgage Markets (1948), 49; and FDIC, Annual Report (1934),
112–13.

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The Mutual Savings Bank Crisis

The considerable success of mutual savings banks during the first century of their history has been attributed to lack of competition for small deposits and to the rapid industrial
and economic growth of the areas they served. In addition, mutual savings banks traditionally enjoyed a reputation of providing a high level of safety for depositors. 6 (An FDIC study
conducted in 1934 suggested that this reputation might have been exaggerated; nevertheless, during the 1930s MSBs were far less prone to bank runs than either commercial banks
or savings and loan associations.7 Indeed, nearly every year during the 1930s MSBs experienced a net savings inflow.)8 Although interest in chartering new MSBs diminished after
1910, existing institutions continued to prosper during and long after the Depression. In
1975 the average MSB had more than $250 million in assets, compared with approximately
$66 million for commercial banks and $69 million for savings and loan associations (see
table 6.1).
The increased demand for housing after World War II meant that a greater proportion
of MSB assets were invested in mortgage loans, with the remainder invested primarily in
permissible securities. Mortgage loans as a proportion of total assets peaked at more than
75 percent during the mid-1960s, but in the late 1970s mortgage investments (including
mortgage-backed securities) still accounted for approximately two-thirds of mutual savings
bank assets (see table 6.2). In comparison, in 1975 savings and loan associations, whose
primary purpose was to provide funds for housing, held more than 82 percent of their assets
in mortgage loans, while commercial banks held only 14 percent.9
Until the mid-1960s, savings banks, like other financial institutions, operated in a relatively stable economic environment. By investing in fixed-rate mortgages and high-quality, long-term bonds, MSBs were able to provide an acceptable return on deposits (which
were primarily passbook accounts) and build a comfortable capital base. Average reserve
ratios at year-end 1975 ranged from 6 percent of assets in New Jersey and Pennsylvania to

6
7
8

9

For example, see Ornstein, Savings Banking, 154; and Teck, Mutual Savings Banks, 118.
FDIC, Annual Report (1934), 111–13. For a more detailed discussion, see Arthur Castro et al., Public Policy toward Mutual
Savings Banks in New York State: Proposals for Change (1974), 86–91.
Ornstein, Savings Banking, 54; and Welfling, Mutual Savings Banks, 84. As a result of both the paucity of bank runs and the
savings inflows, mutual savings banks were generally reluctant to join the FDIC in its infancy and, when the permanent deposit insurance fund began operations in August 1935, only 56 MSBs—less than 12 percent of the total number—were
members. Several states organized their own deposit insurance funds, but over the years these were largely abandoned as
state laws came to require federal deposit insurance. By 1975, approximately 70 percent of the mutual savings bank industry was FDIC-insured; the remaining 30 percent consisted of Massachusetts savings banks insured by the Mutual Savings
Central Fund, Inc. In 1985, as a result of the private insurance crises in Ohio and Maryland, all the Massachusetts savings
banks insured by the Mutual Savings Central Fund applied for federal deposit insurance. By late 1986, all those applications
had been granted (see Ada Focer, “Savings Banks Get FDIC Protection,” American Banker [October 27, 1986], 1).
U.S. League of Savings Associations, S&L Fact Book 1976, 81.

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Table 6.1

Number, Total Assets, and Average Assets of Selected Types of
Financial Institutions, Selected Years, 1900–1975
($Millions)

Mutual Savings Banks

Commercial Banks

Total
Assets

Average
Assets

Average
Assets

Number

Total
Assets

Savings and Loan Associations
Total
Assets

Average
Assets

Year

Number

1900

626

$ 2,328

$ 3.7

12,427

$ 9,059

$ 0.7

5,356

571

$ 0.1

1910

637

3,598

5.6

24,514

19,324

0.8

5,869

932

0.2

1920

618

5,586

9.0

30,291

47,509

1.6

8,633

2,520

0.3

1930

592

10,496

17.7

23,679

64,125

2.7

11,777

8,829

0.7

1940

540

11,919

22.1

14,534

67,804

4.7

7,521

5,733

0.8

1945

532

17,013

32.0

14,011

160,312

11.4

6,149

8,747

1.4

1950

529

22,446

42.4

14,121

168,932

12.0

5,992

16,846

2.8

Number

$

1955

528

31,346

59.4

13,716

210,734

15.4

6,071

37,533

6.2

1960

515

40,571

78.8

13,472

257,552

19.1

6,276

71,314

11.4

1965

506

58,232

115.1

13,804

377,264

27.3

6,185

129,459

20.9

1970

494

78,995

159.9

13,686

576,242

42.1

5,669

176,076

31.1

1975

476

121,056

254.3

14,633

964,900

65.9

4,931

338,233

68.6

8.9 percent in New Hampshire, while the ratio for all mutual savings banks nationwide was
7 percent (see table 6.3).10

Economic and Legislative Developments in the 1970s
Inflationary pressures in the middle to late 1960s caused interest rates generally to rise
throughout the 1970s until, in 1979, they reached unprecedented highs. But already in 1966,
1969–70, and 1973–74, thrift institutions had experienced financial disintermediation and
earnings pressures.11 In 1966 the regulatory agencies tried to help thrift institutions by extending deposit interest-rate ceilings to them, to reduce their cost of liabilities and protect
them from deposit rate wars; nevertheless, the ceilings on deposits (although somewhat
10

11

Table 6.3 also illustrates the effect of different state laws governing permissible investments, particularly the “other loans”
category, which reflects not only differences in consumer lending powers but also the leeway provisions incorporated in
many state savings bank statutes. It should be noted that states whose MSBs had the lowest levels of total loans, such as
New York, New Jersey, and Pennsylvania, also had the highest concentrations of corporate (and other) bonds—and (as discussed below) produced several of the earliest failures.
Disintermediation is the withdrawal of funds from interest-bearing accounts at banks or thrifts when rates on competing investments, such as Treasury bills or money market mutual funds, offer the investor a higher return.

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The Mutual Savings Bank Crisis

Table 6.2

Composition of Assets of Mutual Savings Banks,
Selected Years, 1900–1980
($Millions)

Mortgage Investments
GNMA MortgageBacked

Securities
U.S.
Gov’t

Corporate
and Other

Other
Loans

Cash and
Other Assets

Total
Assets

$ 567

$ 462

$ 169

$ 167

$ 2,328

765

906

194

220

3,598

783

650

1,213

336

313

5,586

499

920

2,278

312

520

10,164

0

3,193

612

1,429

82

1,764

11,916

0

10,650

84

1,116

62

849

16,962

8,039

0

19,877

96

2,260

127

1,047

22,446

17,279

0

8,463

646

3,364

211

1,382

31,346

26,702

0

6,243

672

5,076

416

1,463

40,571

44,433

0

5,485

320

5,170

862

1,962

58,232

Year

Mortgage

1900

$ 858

0

$ 105

1910

1,500

0

13

1920

2,291

0

1930

5,635

0

1940

4,836

1945

4,202

1950
1955
1960
1965

$

State and
Local

1970

57,775

85

3,151

197

12,791

2,255

2,741

78,995

1975

77,221

3,367

4,740

1,545

24,626

4,023

5,535

121,056

1980

99,865

13,849

8,949

2,390

25,433

11,733

9,344

171,564

1900

36.9

0.0

4.5

24.4

19.8

7.3

7.2

100

1910

41.7

0.0

0.4

21.3

25.2

5.4

6.1

100

1920

41.0

0.0

14.0

11.6

21.7

6.0

5.6

100

(Percentage Distribution)

1930

55.4

0.0

4.9

9.1

22.4

3.1

5.2

100

1940

40.6

0.0

26.8

5.1

12.0

0.7

14.8

100

1945

24.8

0.0

62.8

0.5

6.9

0.4

4.7

100

1950

35.8

0.0

48.5

0.4

10.1

0.6

4.6

100

1955

55.1

0.0

27.0

2.1

10.7

0.7

4.4

100

1960

65.8

0.0

15.4

1.7

12.5

1.0

3.7

100

1965

76.3

0.0

9.4

0.6

8.9

1.5

3.3

100

1970

73.1

0.1

4.0

0.2

16.2

2.9

3.5

100

1975

63.8

2.8

3.9

1.3

20.3

3.3

4.6

100

1980

58.2

8.1

5.2

1.4

14.8

6.8

5.5

100

Source: Ornstein, Savings Banking, 260.

History of the Eighties—Lessons for the Future

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Table 6.3

Percentage Distribution of Assets and Liabilities of Mutual Savings Banks,
by State, Year-end 1975
Item

Total

NY

MA

CT

PA

NJ

WA

NH

ME

RI

MD

All
Other
States

ASSETS
Cash and due from banks

1.9

2.0

1.2

2.0

1.7

2.6

3.2

2.2

2.0

1.3

2.1

3.1

U. S. government
obligations

3.9

3.6

4.9

3.2

3.0

5.0

2.8

4.8

5.8

3.7

8.9

5.5

Federal agency obligations

2.3

1.6

4.1

1.8

2.7

3.6

2.8

3.3

2.9

4.9

2.1

2.1

State and local obligations

1.3

1.6

0.7

1.0

1.6

0.9

0.4

0.5

0.9

0.1

0.5

1.2

Mortgage-backed securities

2.8

3.2

1.3

0.8

4.0

6.4

3.0

1.1

1.2

2.4

1.7

0.9

Corporate and other bonds

14.5

15.4

12.3

7.4

27.6

15.3

8.6

5.2

8.5

4.9

7.9

13.6

3.6

3.1

4.7

6.5

2.4

1.8

2.5

6.0

5.5

4.3

1.7

3.0

67.1

66.8

68.8

74.2

54.8

62.2

72.7

74.6

70.9

74.6

71.4

67.9

63.8

64.3

64.3

68.4

52.8

59.8

68.2

67.0

65.2

68.8

60.0

64.8

Corporate stock
Total loans
Mortgage loans
Other loans
Bank premises owned

3.3

2.5

4.5

5.8

2.0

2.4

4.5

7.6

5.7

5.8

11.4

3.1

0.9

0.8

0.9

1.0

0.6

1.1

1.3

1.3

1.4

1.7

0.7

1.2

Other real estate

0.4

0.3

0.3

0.8

0.1

0.1

1.4

0.3

0.1

0.2

*

0.3

Other assets

1.4

1.6

0.9

1.3

1.6

1.1

1.1

0.8

0.7

2.1

3.1

1.2

TOTAL ASSETS

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

LIABILITIES
Total deposits

90.8

90.0

90.3

89.7

92.1

91.7

91.9

89.0

90.8

89.1

88.8

90.5

Ordinary savings

57.5

58.2

57.1

58.2

55.7

55.2

56.4

59.0

65.0

47.9

70.7

48.3

Time deposits

32.7

32.3

33.1

31.3

35.8

34.1

35.2

29.7

25.5

41.1

15.0

41.1

Other deposits
Borrowings
Other liabilities
TOTAL LIABILITIES

0.5

0.4

0.1

0.2

0.6

2.3

0.3

0.2

0.3

0.2

2.6

1.1

0.5

0.4

0.1

0.8

0.2

0.7

1.1

0.4

0.2

1.2

-

1.8

1.8

2.0

1.7

1.6

1.7

1.6

0.9

1.7

1.0

2.1

3.3

1.3

93.0

93.3

92.1

92.0

94.0

94.0

93.9

91.1

92.0

92.4

92.1

93.6

Capital notes and
debentures

0.2

0.1

*

0.4

0.6

0.3

0.2

0.2

*

-

-

0.4

Other general reserves

6.8

6.6

7.9

7.6

5.5

5.7

5.9

8.7

8.0

7.6

7.9

6.0

7.0

6.7

7.9

8.0

6.0

6.0

6.1

8.9

8.0

7.6

7.9

6.4

TOTAL GENERAL
RESERVE ACCOUNTS
TOTAL LIABILITIES
AND GENERAL
RESERVE ACCOUNTS

100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Source: National Association of Mutual Savings Banks, 1976 National Fact Book of Mutual Savings Banking.
*Less than .05 percent.

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higher for thrifts than for commercial banks) caused outflows from financial institutions
into higher-yielding investments such as capital market instruments, government securities,
and—later—money market mutual funds.12
From a public policy perspective, disintermediation had several undesirable consequences. Most important, it both restricted the availability of credit to consumers and increased its cost, particularly for home mortgages; the same consequences affected small
and medium-sized businesses that did not have access to the commercial paper market. In
addition, because normal cash outlays increased to meet deposit withdrawals while cash inflows decreased as new funds were diverted to alternative investments, disintermediation
slowed the growth of financial institutions and caused them liquidity concerns. To have the
cash available to meet withdrawal demands, banks and thrifts were often forced either to
borrow money at above-market interest rates or to sell assets, often at a loss from book
value. The former had a negative effect on earnings, the latter on book value capital.
As early as 1971 these problems were widely recognized at the federal level. In that
year the President’s Commission on Financial Structure and Regulation, better known as
the Hunt Commission, issued its report recommending additional powers for commercial
banks and thrifts; it also recommended a variety of other reforms on the liability side of the
balance sheet, including a lifting of interest-rate ceilings. These recommendations subsequently received widespread support and, in both 1973 and 1975, were introduced as proposed legislation. The Senate passed the 1975 bill, but the House Committee on Banking,
Currency and Housing instead commissioned its own study, Financial Institutions in the
Nation’s Economy (FINE), which resulted in a set of discussion principles and the drafting
of the Financial Reform Act of 1976—but again no legislation was passed.
The failure to enact financial reform during the 1970s can be attributed to conflicting
public policy concerns, a lack of consensus among financial institutions, and the successful
efforts of special-interest groups to block legislation they perceived as harmful.13 One example of conflict was the attitudes of different groups toward interest-rate deregulation and
expanded powers for thrifts: housing groups and many members of Congress feared that
both would adversely affect the cost and availability of mortgage credit; thrifts, too, feared
12

13

Commercial banks had been subjected to interest-rate ceilings on deposits since the Banking Act of 1933. The extension of
Regulation Q to thrift institutions was accompanied by a differential allowing a higher ceiling for thrifts than for commercial banks, in order to encourage depositors to keep their savings at thrifts (which were not allowed to offer checking accounts). The differential, originally 75 to 100 basis points, was reduced to 50 basis points in 1970 and to 25 basis points in
1973.
See Donald D. Hester, “Special Interests: The FINE Situation,” and James L. Pierce, “The FINE Study,” both in Journal of
Money, Credit and Banking 9 (November 1977): 652–61 and 605–18; and Kenneth A. McLean, “Legislative Background
of the Depository Institutions Deregulation and Monetary Control Act of 1980,” in Federal Home Loan Bank of San Francisco, Savings and Loan Asset Management under Deregulation: Proceedings of the Sixth Annual Conference in San Francisco, California, December 8–9, 1980, 17–30.

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the loss of the differential, and they were reluctant to compete directly with banks; and commercial banks supported expanded powers for thrifts only if the differential on deposit rate
ceilings was immediately removed.14 In addition, the regulatory agencies were concerned
over the FINE Study’s proposal to consolidate regulatory authority. Without a unified constituency, Congress was unable to find a formula for financial reform and abandoned such
efforts at the end of 1977.15
In the following year Congress turned its attention to other matters of regulatory concern: insider transactions and several highly publicized bank failures in the mid-1970s led
to passage of the Financial Institutions Regulatory and Interest Rate Control Act of 1978
(FIRIRCA). In addition to placing restrictions on insider lending, this legislation significantly strengthened regulatory enforcement powers by authorizing the agencies to issue
cease-and-desist orders against individual bank officials, impose civil money penalties, remove directors of financial institutions, and disapprove changes in control. FIRIRCA also
extended for two years the banking and thrift regulatory agencies’ ability under Regulation
Q to set interest-rate ceilings on deposits and, by allowing existing mutual savings banks to
convert from state to federal charters, extended the dual banking system to all types of depository institutions.16
In response to the problems caused by disintermediation, regulatory efforts during the
late 1970s and early 1980s were aimed at providing the means for commercial banks and
thrift institutions to compete more effectively with money market mutual funds. Thus, regulators authorized a greater variety of time deposit instruments with ceilings that varied
with market rates. The most important of these instruments was the six-month money market certificate of deposit (MMCD), which was introduced on June 1, 1978. These certificates required a minimum deposit of $10,000, and thrift institutions were permitted to pay
a maximum rate of interest equivalent to the Treasury auction discount rate on six-month
Treasury bills plus 25 basis points. The introduction of the six-month MMCD was a dramatic change for the savings bank industry. In his remarks to the Savings Banks Association
of Massachusetts in October 1978, Saul Klaman, then-president of the National Association
of Mutual Savings Banks, noted that June 1, 1978, “will be recorded as the day when the philosophy of fixed deposit interest rate ceilings was shattered” and the industry was “permitted
to slug it out toe to toe with high-flying money market instruments.”17 Although this new instrument helped slow deposit outflows at mutual savings banks, it also served to raise the institutions’ average cost of funds, since a large proportion of these certificates represented
14
15
16
17

Andrew S. Carron, The Plight of the Thrift Institutions (1982), 8.
McLean, “Legislative Background,” 18.
For a detailed summary of FIRIRCA’s provisions, see Encyclopedia of Banking and Finance, ed. Charles J. Woelfel, 10th
ed. (1994), 452–55.
Saul B. Klaman, “The Changing World of the Savings Bank Industry,” American Banker (October 23, 1978), 41.

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transfers from low-cost passbook accounts. Less than two years after the certificates were
introduced, more than 30 percent of MSB deposits were in money market certificates.18 By
curbing deposit outflows, bank regulators had been able to forestall thrift failures due to liquidity pressures, a problem that was particularly acute at mutual savings banks because
most were not members of the Federal Home Loan Bank (FHLB) System and therefore did
not have access to that source of liquidity.19
In March 1980, as interest rates rose to record levels, Congress returned to efforts at
bank reform and enacted the Depository Institutions Deregulation and Monetary Control
Act of 1980 (DIDMCA). Among the legislation’s major provisions were the six-year phaseout of Regulation Q interest ceilings, nationwide authority for all institutions to offer negotiable order of withdrawal (NOW) accounts,20 and an increase in the federal deposit
insurance limit from $40,000 to $100,000. DIDMCA also preempted state usury laws for
mortgage loans and provided expanded lending powers for federally chartered S&Ls. Finally, the act authorized federal savings banks to invest up to 5 percent of their assets in
commercial loans and to accept demand deposits from businesses to which credit had been
extended.
Although DIDMCA enacted many of the financial reforms that had been debated for
more than a decade, in many respects these changes came too late for MSBs. At the time of
enactment, all of them were still operating under state charters, and many states restricted
their ability to diversify their asset structure or to invest in higher-yielding assets. Some
actions were taken at the state level to liberalize asset powers of thrifts and to alleviate the
burden of restrictive usury ceilings, but these measures, like those at the federal level, came
too late.
More important, however, the federal tax code continued to provide a strong disincentive for S&Ls and MSBs to diversify their assets. Although the Revenue Act of 1951 had
changed the tax-exempt status of thrifts, these institutions could still deduct up to 100 percent of taxable income through the establishment of a bad-debt reserve, whether or not
losses actually occurred. Under the provisions of the Tax Reform Act of 1969, the maxi18
19

20

U.S. House Committee on Banking, Finance and Urban Affairs, The Report of the Interagency Task Force on Thrift Institutions, 96th Cong., 2d sess., 1980, 6.
The Federal Home Loan Bank System was established in 1932 to provide a central credit system for mortgage lending institutions. The System makes advances to member institutions at interest rates lower than those in the commercial market
and thus provides members with an important source of liquidity during periods of disintermediation.
In April 1979 the U.S. Court of Appeals for the District of Columbia had ruled that federal regulators exceeded their authority when they approved automatic transfer (ATS) accounts for commercial banks, share draft accounts for credit
unions, and remote service units for savings and loans. All of these accounts were the functional equivalent of interest-bearing checking accounts. At that time, NOW accounts were permitted only in the six New England states. The ruling gave
Congress one year to validate the regulations; otherwise, financial institutions would be required to terminate the services
and disrupt millions of account holders (McLean, “Legislative Background,” 19).

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mum deduction for additions to bad debts was allowed only if a mutual savings bank had
72 percent (or an S&L 82 percent) of its total assets in certain qualifying assets (generally
mortgages and government securities), and the deduction was lost entirely if less than 60
percent of the institution’s assets met the investment standard. Moreover, once an institution failed the qualifying asset test, it was required to recapture some of the previous deduction and incur what might be a substantial tax liability. Therefore, even in states that did
expand consumer lending powers during the 1970s, there was no dramatic shift of MSB
funds into consumer and other nonmortgage loans.21 It should be noted, however, that this
situation must also be attributed to the fact that prudently building up a portfolio of such
loans would have been a difficult and lengthy process.

The FDIC’s Response
Although no one could predict the future course of interest rates, it was fairly apparent throughout the 1970s that MSBs (the only thrifts insured by the FDIC) were at risk in a
rising rate environment. The FDIC’s monitoring of industry trends and surveillance of individual institutions increased during 1977–78, when short-term interest rates rose from approximately 4.5 percent to more than 9 percent (see figure 6.1). The FDIC began a monthly
survey of large mutual savings banks and also received periodic reports from the National
Association of Mutual Savings Banks (NAMSB). The agency used the surveys to judge the
rates of both internal disintermediation (from traditional savings accounts to MMCDs) and
external disintermediation and to project the effect of increased interest expense on future
earnings. Although in mid-1978 the outlook for savings banks appeared favorable barring a
significant increase in interest rates, FDIC staff nevertheless began exploring options available to the agency in the event a large savings bank were to fail.
Because of an accelerating inflation rate in 1978 and a shift in monetary policy in October 1979, interest rates rose almost continuously until the spring of 1980. Mutual savings
banks, particularly those located in New York City and Boston, sustained 13 consecutive
months of external disintermediation from March 1979 to April 1980, when a record $10.7
billion in deposits left MSBs.22 In addition to closely monitoring deposit flows and earnings, FDIC staff participated in an interagency task force on thrifts and evaluated a variety
of measures proposed by the industry that were designed to permit MSBs to earn market
rates of interest on assets. These proposals included expanded powers, mortgage warehousing programs, and reinstatement of the differential on six-month MMCDs which
DIDMCA had removed.
21
22

U.S. Senate Committee on Banking, Housing, and Urban Affairs, Deposit Interest Rate Ceilings and Housing Credit: The
Report of the President’s Inter-Agency Task Force on Regulation Q, 96th Cong., 1st sess., 1979, 37–45.
NAMSB, 1980 National Fact Book, 7.

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Figure 6.1

Monthly Treasury Bill Rate (3-Month), 1977–1983
Percent

16

12

8

4
1977
1978
1979
Source: Haver Analytics.

1980

1981

1982

1983

An internal FDIC interdivisional task group, known as the Mutual Savings Bank Project Team, was formed in 1980 to develop plans to handle the possible failures of a large
number of savings banks. Among other things, the group developed estimates of the potential magnitude of the problem under various economic scenarios, developed and evaluated
options for handling the situation, and developed a strategic plan for each contingency. The
recommendations prepared by this group shaped the structure of the ensuing assisted savings bank transactions (discussed below).

Mutual Savings Bank Failures, 1981–1982
Savings bank earnings, which had exceeded $1 billion in 1979, deteriorated very
rapidly as the cost of funds began to exceed the yield on asset portfolios. The industry sustained losses of $123 million in 1980, the first year since World War II that it reported a negative income. In 1981, operating losses escalated to nearly $1.7 billion.23 By early 1982,
aggregate annual losses at FDIC-insured savings banks were running at approximately 1.25
23

NAMSB, 1981 National Fact Book of Mutual Savings Banking (1981) and National Fact Book of Savings Banking (1982).

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percent of assets. The problem was more severe in New York City, where some of the
weaker institutions were experiencing losses of 3.5 percent of assets, a devastating trend
considering that at year-end 1981 total reserves for all MSBs in New York State had been
only 4.8 percent.24
The plight of New York’s mutual savings banks was discussed in a public forum as
early as 1979, when Anita Miller of the Federal Home Loan Bank Board, in an address before an annual conference on the savings and loan industry, termed their condition “particularly worrisome.”25 New York’s MSBs were constrained by limited lending powers, a
restrictive usury ceiling, and unfavorable tax treatment at both the state and city levels. 26
Additionally, deposit growth and asset turnover were lower than average in New York City
because of a high degree of competition from large money-center banks and money market
funds and a heavy concentration of long-term bonds in the portfolios of many mutual savings banks. The MSBs could not sell these bonds without incurring a severe loss. Given the
market value of the securities portfolios of the ten largest MSBs in New York City, Harry V.
Keefe, Jr., chairman of Keefe, Bruyette & Woods, Inc., declared in December 1980 that “the
nation’s mutual savings banks, as an industry, are in fact bankrupt and Congress should act
immediately to rescue them from eventual collapse.” Keefe further warned that the problems of Chrysler and Lockheed were “peanuts compared to those of the mutual savings
banks” and that if they were to fail, “the liability facing the Federal Deposit Insurance Corp.
would exceed the $10 billion now in the fund.”27
The FDIC’s dilemma, from the standpoint of potential exposure of the deposit insurance fund, was very different from any the agency had faced earlier in its history. Unlike the
situation with most commercial bank failures, asset quality was not a problem. However, as
Keefe noted, a large number of MSBs were facing “book” insolvency, with the market
value of their assets actually 25 to 30 percent below outstanding liabilities. If the FDIC had
been forced to absorb this market depreciation, the deposit insurance fund would have incurred enormous losses. Resolutions that used either a purchase-and-assumption transaction or a deposit payoff probably would have entailed such absorption. Payoffs would also
have entailed large cash outlays up front, since almost all MSB liabilities consisted of fully

24
25
26

27

FDIC, Federal Deposit Insurance Corporation: The First Fifty Years (1984), 99; and NAMSB, 1982 National Fact Book.
Washington Financial Report (October 22, 1979), A-22.
Banking institutions in New York were taxed at the higher of two alternative tax methods, one based on net income and the
other based on a percentage of deposits. Despite aggregate negative earnings, therefore, MSBs operating in New York City
were burdened by a significant tax liability to both the city and state governments, a liability that exacerbated the problem
of declining surplus accounts.
Gary M. Hector, “Keefe Warns on State of Savings Bank Industry; Urges Federal Assistance Now,” American Banker (December 9, 1980), 1.

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insured deposits. The FDIC’s principal concern was therefore to keep the cost of handling
failing savings banks at a reasonable level without undermining the public’s confidence in
the industry or in the agency.28 The FDIC also sought to ensure that any financial institution
resulting from a merger with a failing savings bank would be financially sound, would have
the ability to compete effectively in its market, and would continue to serve the credit needs
of its community free of excessive government control.
Pressure on the industry and on the FDIC mounted during 1981, as the growing volume of losses (particularly at the ten largest New York City mutuals) was disclosed. In midAugust it was reported that at least four mutuals with total assets of almost $9 billion were
“said to have approached the FDIC with applications or proposals for aid to boost their flagging net worth.”29 Losses were most severe at the 148-year-old Greenwich Savings Bank,
which was forced to turn to the Federal Reserve’s discount window to borrow more than
$100 million after a group of foreign banks refused to roll over approximately $75 million
in collateralized Eurodollar notes.30 On October 28 it was reported that state and federal
bank regulators had met behind closed doors with representatives from a number of major
banks to discuss Greenwich’s fate. The next day this story was picked up by The New York
Times and major wire services, while a New York radio station mistakenly announced that
Greenwich had failed. These reports prompted heavier-than-usual activity at the bank and
led the FDIC to issue a press release reassuring Greenwich’s depositors that their money
was safe. This statement, possibly unprecedented in the agency’s history, acknowledged
that the FDIC was seeking a buyer for Greenwich Savings Bank and that it would arrange
“an orderly transaction which will insure that no depositors—whether insured or uninsured—will experience any loss of any principal or interest.” 31
On November 4, 1981, the FDIC announced the assisted merger of the Greenwich
Savings Bank into Metropolitan Savings Bank, New York—a transaction effected under
Section 13(e) of the Federal Deposit Insurance Act, which authorizes the agency to reduce
or avert a threatened loss to the insurance fund by providing assistance to facilitate a merger
between a failing insured bank and another insured bank. Although the FDIC had always
had this authority and had used it frequently in the early years, it had used it only once in

28
29
30

31

It should be noted that no FDIC-insured mutual savings bank had failed since 1938.
Karen Slater, “Mutuals Ask for Capital Aid; FDIC Resisting Action,” American Banker (August. 14, 1981), 1.
Although DIDMCA authorized thrifts to borrow from the discount window, Greenwich was one of the earliest institutions
to borrow under the Federal Reserve’s new program to provide extended credit to banks and thrifts that were under sustained liquidity pressures.
Laura Gross and Gordon Matthews, “FDIC Assures on Greenwich; Tells Depositors Funds Are Safe; Seeks Buyers,” American Banker (October 30, 1981), 1.

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the decade before 1981, largely because the agency was reluctant to provide financial assistance that would benefit the stockholders and management of a failing institution.32
Assisted mergers had frequently been used by the Federal Savings and Loan Insurance Corporation (FSLIC) in handling S&L failures, and the FDIC had concluded that, under appropriate circumstances, assisted open-bank mergers could be a desirable way to
handle failing MSBs. Two important considerations were that Section 13(e) assistance required neither new legislation nor a finding by the FDIC’s Board of Directors that the institution was essential to its community. Other advantages to this approach over a closed-bank
transaction were that it preserved tax-loss carry-forwards,33 gave the acquiring institution
greater flexibility to continue leases and other contractual arrangements, and received
greater cooperation from state supervisors. In addition, it was thought that depositors in
other mutual savings banks would react more favorably if the failing institutions were not
officially closed. The Greenwich/Metropolitan transaction was notable for several reasons.
With more than $2.5 billion in assets, Greenwich at that time was the third-largest bank failure in the FDIC’s history.34 More important, the initial estimated cost of the transaction—
$465 million—was more than the reported cost of handling all previous failures of insured
banks. Finally, as the first assisted merger, this transaction served as a prototype for subsequent assisted mergers in its basic structure and procedures.
The primary strategy developed by the Mutual Savings Bank Project Team was to
structure assistance around what was called an Income Maintenance Agreement (IMA).35
Under an IMA, the FDIC agreed to make periodic payments to the acquiring institution on
the basis of the difference between the yield on the declining balance of acquired earning
assets and the average cost of funds to savings banks, plus a spread to cover administrative
and overhead expenses associated with these assets. This structure allowed the agency to
fund long-term assets at short-term rates, resulting in a significant cost saving relative to the
cost if the bank were to be liquidated. Additionally, it provided protection against the possibility that a windfall gain would accrue to the acquirer if market rates fell. Conversely, an
IMA exposed the FDIC to increased costs in a rising interest-rate environment. From the
acquirer’s perspective, acquired assets were completely insulated from interest-rate risk,
32

33
34

35

U.S. House Committee on Banking, Finance and Urban Affairs, Report, 173–74. In all assisted mergers of failing mutual
savings banks, the FDIC insisted that senior management and most trustees would not be able to serve with the surviving
institution. In cases where the failing MSB had subordinated debt outstanding, the note holders were required, as a condition of the transaction, to take a substantial “hit,” in the form of either a lower interest rate or an extended maturity.
Tax-loss carry-forwards allow previously incurred taxable losses to be applied to future taxable income, thereby reducing
tax liability in profitable years.
In 1980, the FDIC provided open-bank assistance to prevent the failure of the nearly $8 billion First Pennsylvania Bank,
N.A. The largest bank failure before that had been Franklin National Bank of New York, with assets of $3.6 billion, in
1974.
Both the FSLIC and the FDIC had previously provided assistance along these general lines in a limited number of cases
(FDIC, First Fifty Years, 100).

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whereas the benefits of the reinvestment spread on the cash flow from existing assets provided an increasing source of income. Income maintenance agreements were used in 10 of
the 17 assisted mergers of failing savings banks between 1981 and 1985 (see table 6.4).36
With respect to the “cost of funds” used to compute IMA payments, the FDIC was reluctant to use a measure that was under the control of the resultant institution. Thus in the
case of a surviving savings bank, the index normally used was based on a group of peer
institutions; in the two instances when the resulting institution was a commercial bank, a
market-based index was used. As part of the assistance agreement, a schedule of remaining
asset balances and average yields was agreed upon for the term of the IMA, and payments
were based on this fixed schedule. This arrangement made it unnecessary for the bank to
maintain separate records and for the FDIC to perform periodic audits, and allowed the acquiring institution to hold or sell a particular asset on the basis of considerations other than
assistance payments.
In the 12 months from November 1981 through October 1982, the FDIC consummated 11 assisted mergers of mutual savings banks with total assets of nearly $15 billion,
more than the total assets of all failed commercial banks since the FDIC’s inception. The
cost of these failures was approximately $1.8 billion, or approximately 12 percent of assets.
Most of the acquiring institutions were other MSBs, although for the first time in FDIC history commercial banks were the winning bidders—for Farmers and Mechanics Savings
Bank (F&M), Minneapolis, Minnesota, and for Fidelity Mutual Savings Bank, Spokane,
Washington. The merger of F&M, with assets in excess of $980 million, into the $350million-asset Marquette National Bank created the fourth-largest commercial bank in the
state of Minnesota. In this case the bidding process was facilitated by the passage of emergency legislation in Minnesota permitting an out-of-state bank holding company to acquire
F&M as a commercial bank. This legislation was thought to have saved the FDIC $50 million.37 The merger of Fidelity Mutual into First Interstate Bank of Washington, N.A., Seattle, Washington, also involved an interstate bidding process that saved the FDIC an
estimated $20 million.38
The drastic drop in interest rates that occurred in the second half of 1982 significantly
reduced the earnings pressure on the industry and brought most savings banks to or above
the break-even level. However, even in the late-1982 interest-rate environment several
large banks were still losing money. The Garn–St Germain Depository Institutions Act of
36
37

38

Other forms of assistance generally included cash, notes, and the assumption of Federal Reserve or Federal Home Loan
Bank debt.
William M. Isaac, “Depository Institutions—The Challenge of Today’s Problems and Tomorrow’s Opportunities” (address
to the 52d annual convention of the Independent Bankers Association of America, Sheraton-Waikiki Hotel, March 16,
1982), 2.
FDIC, Annual Report (1982) , 4.

History of the Eighties—Lessons for the Future

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Table 6.4

Failed and Assisted Savings Banks, 1981–1985
Date

Failed Bank/Acquirer and
Location

11-04-81

Greenwich SB/Metropolitan SB
New York City

12-04-81

Central SB/Harlem SB
New York City
Union Dime SB / Buffalo SB
New York City

12-18-81

01-15-82
02-20-82
03-11-82
03-11-82
03-26-82
04-02-82
09-24-82

10-15-82
02-09-83

08-05-83
10-01-83
09-28-84
10-01-85
12-31-85

Western NY SB/Buffalo SB
Buffalo, NY
Farmers & Mechanics
SB/Marquette NB
Minneapolis, MN
U.S. SB/Hudson City SB
Newark, NJ
Fidelity Mutual SB/First
Interstate NB
Spokane, WA
The New York Bank
for Savings/Buffalo SB
New York City
Western Savings Fund Society/
Philadelphia Saving Fund Society
Philadelphia, PA
United Mutual SB/American SB
New York City
Mechanics SB/Syracuse SB
Elmira, NY
Dry Dock SB/Dollar SB
New York City

Oregon Mutual SB/Moore
Financial Corp.
Portland, OR
Auburn SB/Syracuse SB
Auburn, NY
Orange SB/Hudson City SB
Livingston, NJ
Bowery SB/Ravitch Investor Group*
New York City
Home SB/Hamburg SB
Brooklyn, NY
Total—17 assisted mergers

Assets
($Millions)
$2,475
910
1,453

1,028
1,010

Outcome
Renamed Crossland, FSB, in 1984.
Converted to stock in 1985.
Failed in 1992 (pass-through receivership).
Renamed Apple Bank for Savings in 1983.
Converted to stock in 1985.
Renamed Goldome Bank for Savings in 1983.
Converted to FSB in 1984; to stock in 1987.
Converted back to state charter in 1988.
Failed in 1991 (purchased by KeyCorp
and First Empire State Corporation).
See Goldome (12-18-81).

688

Renamed Marquette Bank of Minneapolis,
NA, in 1985.
Acquired by First Bank, NA, in 1993.
Hudson City SB is a state-chartered MSB.

696

First Interstate Bank of Washington, NA

3,504

See Goldome (12-18-81).

2,126

PSFS converted to stock in 1983.
Renamed Meritor SB in 1985.
Failed in 1992 (purchased by Mellon Bank Corp.).
Converted to FSB in 1983.
Converted to stock in 1985.
Converted back to state charter in 1989.
Failed in 1992 (acquired by eight different banks).
Syracuse SB failed in 1987
(acquired by Fleet Bank).
Renamed Dollar–Dry Dock Savings Bank.
Renamed Dollar–Dry Dock Bank in 1988.
Failed in 1992 (acquired by Emigrant SB and
Apple Bank for Savings [one branch]).
Renamed Oregon First Bank.
Renamed West One Bank in 1989.

833

55
2,452

266
133
513
5,277
414

Syracuse SB failed in 1987
(acquired by Fleet Bank).
Hudson City SB is a state-chartered MSB.
Sold in 1988 to H. F. Ahmanson & Co.
Renamed Home Savings of America, FSB, in 1992.
Retained the Home SB name.
Acquired by H. F. Ahmanson & Co. in 1990.

$23,835

* The FDIC provided financial assistance to recapitalize the Bowery SB and merge it into a newly chartered stock savings
bank that was then acquired by the Ravitch Investor Group.

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The Mutual Savings Bank Crisis

1982 enabled the FDIC both to adopt a “wait-and-see” approach and to be more flexible in
dealing with these institutions. For mutual savings banks, one of the most important provisions of this legislation was contained in Title II, which authorized the FDIC to establish a
Net Worth Certificate Program.

Net Worth Certificate and Voluntary Merger Programs
On December 7, 1982, FDIC Chairman William M. Isaac announced details of the Net
Worth Certificate (NWC) Program, in conjunction with a voluntary merger plan designed
to induce savings banks to create their own proposals for assisted mergers. The NWC Program was intended to allow savings banks with capable management and good-quality assets a chance to recover if interest rates should drop from the high levels they were at when
Garn–St Germain was passed in October 1982. Recognizing that “a few firms may have to
be merged almost irrespective of what happens to rates” and that “mergers may be the only
practical longer-range solution” for others, the agency’s voluntary merger plan provided
tangible financial assistance to encourage mergers involving savings banks when one of the
participants was eligible for aid under the NWC Program.39
To qualify for assistance under the NWC Program, an institution was required to have
(1) net worth equal to or less than 3 percent of assets, (2) losses incurred during the two previous quarters but not as a result of transactions involving mismanagement, and (3) investments in residential mortgages or in securities backed by such mortgages aggregating to at
least 20 percent of loans. Institutions were required to apply by letter with a comprehensive
business plan that included a strategic plan, lending and investment policies, plans for managing liquidity positions and rate-sensitivity gaps, plans to reduce expenses, and a two-year
budget. Additional restrictions were placed on bank operations, particularly employment
contracts with senior management; and participating banks were not permitted to change
charter, convert to stock form, merge, or otherwise change the nature of their business or
ownership without the prior approval of the FDIC. Conversely, however, MSBs that applied
for assistance were required to sign a restrictive covenant obligating them to convert to
stock form at the request of the FDIC.
Essentially, the FDIC increased or maintained the capital of participating institutions
(for regulatory purposes) by purchasing NWCs in an amount equal to a percentage of operating losses over the preceding six-month period, in exchange for promissory notes under
exactly the same terms as the NWC. The certificates counted as surplus for regulatory purposes but had no effect on the net cash flows or income of the institution.40 Therefore, the
39
40

FDIC Press Release PR-99-82 (December 7, 1982).
However, some institutions did benefit from the exemption from state and local franchise taxes that was granted in Title II
of Garn–St Germain.

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NWC Program was basically a form of capital forbearance. The certificates remained outstanding until the institution became profitable. At that time, repayment was at a rate of onethird of net operating income and was accomplished through the retirement of an equal
amount of promissory notes. Additionally, the FDIC could notify any institution that still
held certificates seven years after issuance that it would have to repay all or a portion within
six months.
A total of 29 savings banks with assets of approximately $40 billion participated in the
original NWC Program (see table 6.5).41 Nearly $720 million in net worth certificates were
issued between 1982 and 1986, and the total amount outstanding at any one time peaked at
$710.4 million at year-end 1985.42 The decline in interest rates during the middle and late
1980s allowed the majority of participating banks to return to profitability. All but three institutions had retired their certificates by year-end 1988, and the last certificate was retired
in 1992.
After introduction of the Net Worth Certificate Program, interest-rate mismatch led to
six mutual savings bank failures, including three in 1983, one in 1984, and two in 1985. 43
Five of these were resolved under the FDIC’s voluntary merger plan. The sixth, Oregon
Mutual Savings Bank of Portland, Oregon, was acquired by Moore Financial Group, Inc.,
of Boise, Idaho. This acquisition was made possible by newly enacted state legislation that
allowed Oregon Mutual to convert to a stock-form, state-chartered commercial bank and be
acquired by a bank holding company in a contiguous state. The assistance agreement between the FDIC and Moore Financial provided that Oregon Mutual’s net worth certificates
be prepaid.
Net worth certificates were also prepaid in the assisted merger of Orange Savings
Bank with Hudson City Savings Bank, both in New Jersey. In the four other voluntary
mergers, outstanding net worth certificates were retained, and the surviving institution remained in the NWC Program. One of these transactions was a financial assistance package
to recapitalize the Bowery Savings Bank and merge it into a newly chartered stock savings
bank in order to facilitate its acquisition by a private investor group. The Bowery and Dollar–Dry Dock eventually retired their certificates, whereas Syracuse Savings Bank and
Home Savings Bank failed with net worth certificates still outstanding. These were retired
as part of FDIC-assisted mergers with other institutions.

41
42
43

The NWC Program, as authorized by the Garn–St Germain Depository Institutions Act of 1982, was due to expire after
three years. However, Congress granted two extensions, and the program expired on October 13, 1986.
FDIC, Report of Activities under Title II of the Garn–St Germain Depository Institutions Act of 1982 (1983–1987).
A seventh failure (Syracuse Savings Bank) in May 1987 was attributable to a bankrupt real estate investment tax shelter. In
this case the FDIC’s assistance was limited to indemnifying the acquirer, Norstar Bancorp, against certain contingent liabilities.

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Table 6.5

FDIC Net Worth Certificate Program
($Thousands)

Bank Name

City/State

Auburn SB*

Auburn, NY

Beneficial Mutual
Bowery SB*
Cayuga County SB
Colonial Mutual SB
Dime SB of NY, FSB
Dime SB of Williamsburgh
Dollar–Dry Dock SB†
Dry Dock SB*
East River SB, FSB
Eastern SB
Elizabeth SB
Emigrant SB
Greater NY SB
Home SB*
Inter-County SB
Lincoln SB, FSB
National SB of the City of Albany
Niagara County SB
Orange SB*
Oregon Mutual SB*
Rochester Community SB
Roosevelt SB
Sag Harbor SB
Savings Fund Society of Germantown
Seamen’s SB, FSB†
Skaneateles SB
Syracuse SB*
Williamsburgh SB

Philadelphia, PA
New York, NY
Auburn, NY
Philadelphia, PA
New York, NY
New York, NY
New York, NY
New York, NY
New York, NY
New York, NY
Elizabeth, NJ
New York, NY
New York, NY
White Plains, NY
New Paltz, NY
New York, NY
Albany, NY
Niagara Falls, NY
Livingston, NJ
Portland, OR
Rochester, NY
New York, NY
Sag Harbor, NY
Bala Cynwyd, PA
New York, NY
Skaneateles, NY
Syracuse, NY
New York, NY

Total—29 institutions

Certificates
Assets at Entry (Maximum
into Program Amount Held)
$ 125,646

$ 1,640

1,628,630
4,999,357
189,957
70,732
6,393,743
573,858
4,972,787

18,862
220,100
788
776
72,120
3,559
41,321

1,777,519
785,962
31,695
2,968,586
1,816,836
427,402
123,366
2,090,289
391,205
291,887
531,087
260,000
1,371,335
858,852
203,612
1,373,089
1,825,504
136,092
1,180,471
2,215,133
$39,614,632

26,430
13,712
351
90,037
23,054
5,628
1,588
65,865
1,123
464
3,509
1,489
4,993
5,757
1,412
17,706
31,320
524
See Auburn SB§
63,945

Date Retired
Retained by
Syracuse SB in 1983—
Assisted merger
1991
1992
1986
1984—Acquired
1986
1987
1986
See Dollar-Dry Dock SB‡
1987
1986—Merger
1983—Merger
1991
1987
1986—Assisted merger
1986
1987
1985
1986—Merger
1984—Assisted merger
1983—Assisted merger
1986
1986
1987
1987
1986
1986
1987—Assisted merger
1987—Merger

$718,073

* Failed or was assisted while in NWCP.
† Failed after NWCP participation.
‡ Certificates issued to Dry Dock SB were retained when that institution was acquired by Dollar SB. Subsequently,
Dollar–Dry Dock acquired additional certificates.
§ Certificates issued to Auburn SB were retained when that institution was acquired by Syracuse SB. Syracuse SB failed in 1987.

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The Net Worth Certificate Program succeeded in providing 22 potentially failing savings banks with the opportunity to return to profitable operations. Although 7 of the participating institutions did require additional FDIC assistance, the cost of these transactions
was less than $420 million, or approximately 4.1 percent of the $10.2 billion in total assets
held by these 7 institutions at the time of their failures. This figure is substantially below the
average loss rate of 12 percent for the savings banks that were resolved before the NWC
Program, and it is certainly far less than what it would have cost the FDIC to close all 29
savings banks had there been no Net Worth Certificate Program. It should be noted that two
institutions failed after having paid off their net worth certificates: the Seamen’s Savings
Bank (1990) and Dollar–Dry Dock (1992). These failures occurred more than four years after the banks had paid off their net worth certificates, and therefore were probably a result
of actions the institutions took after leaving the NWC Program.
The success of the FDIC’s Net Worth Certificate Program depended on interest-rate
levels, which were beyond the agency’s control. However, the program’s success was also
due to several of its key aspects. Stringent application requirements helped ensure that only
banks with capable management, good-quality assets, and the ability to be profitable in a
favorable interest-rate environment received assistance. Equally important, banks in the
program were closely monitored and supervised, and were not permitted to attempt to grow
out of their problems. In sum, the Net Worth Certificate Program minimized the FDIC’s potential exposure to loss while providing capital forbearance to savings banks.44

Conclusion
In the early 1980s, many mutual savings banks failed because both macroeconomic
forces and changes in the financial services marketplace were inhospitable to the industry’s
traditional mode of operating. By law and regulation, MSB assets were permitted to be invested primarily in fixed-rate mortgages and long-term bonds, but as short-term interest
rates rose to historically high levels between 1979 and 1982, the market value of these assets plunged. At the same time, MSB liabilities were composed almost exclusively of shortterm deposits paying rates of interest subject to deposit interest-rate ceilings—and as
market rates rose, even small savers began to think like investors. MSB deposits were withdrawn and placed in higher-yielding investments. Regulators fought this disintermediation
by permitting the introduction of a variety of time deposits paying market rates of interest.
These certificates of deposit helped MSBs retain funds, but they also raised the industry’s
cost of funds. Yields on assets rose much more slowly, and net interest margins shrank and

44

After so many mutual savings banks converted to the stock form of ownership, the industry is now collectively referred to
as the savings bank industry.

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The Mutual Savings Bank Crisis

became negative. Operating losses were so great that capital levels built up over a century
or more of profitable operations quickly eroded.
MSB failures were predictable and, arguably, preventable. The problems facing the
thrift industry were recognized early and were debated throughout the 1970s.45 However,
Congress’s attempts to enact sweeping financial reform were stalemated by the competing
interests of various industry groups, the overlapping layers of state and federal regulators,
and the additional public policy concern of ensuring a continued supply of funds for home
mortgage lending. Thus, despite years of studies and proposals, no consensus could be
reached on how best to proceed with financial deregulation. As a result, changes were enacted on a piecemeal basis and only when a crisis was clearly evident.
From the FDIC’s perspective, the problems of the mutual savings bank industry in
1980 were the most serious challenge the agency had faced since its inception in 1933. Potential losses to the deposit insurance fund were enormous. What made MSB failures particularly costly were the sizes of the institutions, the large percentage of fully insured
deposits, and the low market value of otherwise good-quality assets. This potential cost
prompted the FDIC to develop strategies to deal with MSB failures that were different from
the traditional methods used to resolve commercial bank failures.
The predictability of the failures benefited the agency by giving it some planning
time. Moreover, the threat of deposit runs was greatly reduced because a large proportion of
deposits held by the MSB industry were fully insured. Finally, unlike the bank crisis of the
1930s, this crisis was not compounded by a sense of public panic.
The principal strategy the FDIC used was to provide open-bank merger assistance
with healthier institutions. This procedure was acceptable to the agency because, given the
absence of stockholders in mutual savings banks, only depositors would have to be protected in the transactions. Moreover, the problems facing MSBs at this time were not the result of mismanagement or fraud but were caused by forces outside the banks’ control.
Another consideration was the desire to avoid cash outlays. This was a major concern not
only to the FDIC but also to the U.S. Treasury Department because FDIC expenditures, although not charged to the Treasury, are reflected in the unified budget. Therefore, wherever
possible the FDIC attempted to substitute notes and periodic income maintenance payments
(which were dependent on future interest rates) for direct up-front cash assistance. The
1982 Garn–St Germain Act granted the agency additional time and flexibility and authorized the ensuing Net Worth Certificate Program.

45

This chapter covers only the FDIC’s experience during the 1980s. Savings and loan associations also encountered problems of asset/liability mismatch early in the decade, but those institutions were regulated by the Federal Home Loan Bank
Board and insured by the Federal Savings and Loan Insurance Corporation. For a discussion of that crisis, see Chapter 4.

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Using all these procedures, the agency largely succeeded in managing the mutual savings bank crisis of the early 1980s. Between late 1981 and year-end 1985, the agency conducted 17 assisted mergers or acquisitions of mutual savings banks with total assets of
nearly $24 billion. These MSBs accounted for more than 15 percent of the total assets of
FDIC-insured mutual savings banks as of year-end 1980. At year-end 1995, the cost of
these failures was estimated at $2.2 billion.46 This figure is nearly equivalent to the estimated cost of these transactions when they were consummated, notwithstanding the variable nature of some of the components. Although the FDIC benefited from the effect of
declining interest rates on eventual income-maintenance payments, in several transactions
the agency incurred a greater-than-expected loss from the liquidation of assets it purchased.
Nevertheless, the strategies that were used in these assisted mergers minimized both losses
and cash outlays.
It should be noted that although a number of mutual savings banks were able to survive the crisis by the capital forbearance provided in the NWC Program and/or by virtue of
being extremely well managed, a number of others failed between 1985 and 1994 (a list of
these failures appears in the appendix to this chapter). For the most part, these institutions
failed for reasons other than asset/liability mismatch and therefore are not discussed in this
chapter. The question arises, however, whether the FDIC could have prevented these failures, many of which occurred as a result of the expanded powers granted by deregulation.
Notably, several of these post-1985 failures were from assisted mergers that had taken
place in the early 1980s. American Savings Bank, CrossLand FSB (formerly Metropolitan
Savings Bank), Dollar–Dry Dock Bank, Goldome Bank (formerly Buffalo Savings Bank),
and Meritor Savings Bank (formerly Philadelphia Saving Fund Society) all failed in 1991
or 1992. These failures, occurring a decade after the institutions had participated in FDICassisted mergers, were attributable to activities in which the banks became involved after
the introduction of expanded powers. Most of the institutions had long since stopped receiving any type of FDIC assistance and were operating profitably before they encountered
the problems that led to failure. Estimates are not available as to what it might have cost the
FDIC to resolve these institutions separately, nor can it be determined what might have happened to the institutions if they had not participated in FDIC-assisted mergers. Nevertheless, it should be recognized that not all of the assisted merger combinations were a total
success. In addition, a number of savings banks in the New England region, which had
largely been spared in the early 1980s, failed during the early 1990s. These banks, many of

46

The figure was approximate because several cases were still listed as active on the FDIC’s books.

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The Mutual Savings Bank Crisis

which had converted to the stock form of ownership, failed after investing in the boom-tobust New England real estate cycle (see Chapter 10). 47
In conclusion, the mutual savings bank industry underwent a profound change between 1980 and 1994. The number of banks declined because of mergers, failures, and conversions to commercial banks. Approximately 30 percent (including many of the largest
savings banks) converted to stock form. Many savings banks benefited from a favorable environment and returned to profitability. (Future success depends on the ability of these
banks to adapt as the financial services industry continues to evolve.) As for the FDIC, in
its handling of the MSB crisis in the early 1980s it gained experience that would prove valuable, for as the decade unfolded, this crisis turned out to be only the first of many the agency
had to confront in rapid succession.

47

Jennifer L. Eccles and John P. O’Keefe, “Understanding the Experience of Converted New England Savings Banks,” FDIC
Banking Review 8, no. 1 (1995): 1–17.

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Appendix
Table 6-A.1

BIF-Insured Savings Banks That Failed, 1986–1994 ($Thousands)
Institution Name
American Savings Bank
Amoskeag Bank
Attleboro Pawtucket SB
Banco de Ahorro FSB
Bank Five for Savings
Bank for Savings
Bank Mart
Bank of Hartford Inc.
Beacon Co-op Bank
Brooklyn Savings Bank
Burritt InterFinancial Bcorp.
Central Bank
Central Savings Bank
Colony Savings Bank
Connecticut Savings Bank
Coolidge Corner Coop Bank
Crossland Savings FSB
Dartmouth Bank
Dollar Dry Dock Bank
Eastland Savings Bank
Eliot Savings Bank
First American Bank for Savings
First Constitution Bank
First Mutual Bank for Savings
First Service Bank for Savings
Goldome
Granite Co-op Bank
Heritage Bank For Savings
The Howard Savings Bank
Iona Savings Bank
Landmark Bank for Savings
Lowell Institution for Savings
Ludlow Savings Bank
Maine Savings Bank
Mechanics & Farmers SB, FSB
MerchantsBank of Boston
Meritor Savings Bank
Milford Savings Bank
Monroe Savings Bank FSB
New England ALLBANK for Savings
New England Savings Bank
New Hampshire Savings Bank
Numerica Savings Bank FSB
The Permanent Savings Bank
Plymouth Five Cents SB
Riverhead Savings Bank
Seacoast Savings Bank
Seamen’s Bank for Savings FSB
Southstate Bank for Savings
Suffield Bank
Syracuse Savings Bank
Union Savings Bank
The U. S. Savings Bank of America
Vanguard Savings Bank
Winchendon Savings Bank
Woburn Five Cents SB
Workingmens Co-op Bank
Yankee Bank Finance & Savings, FSB

234

City, State

Failure
Date

Total Assets

Resolution
Cost

White Plains, NY
Manchester, NH
Attleboro, MA
Mayaguez, PR
Arlington, MA
Malden, MA
Bridgeport, CT
Hartford, CT
Boston, MA
Danielson, CT
New Britain, CT
Meriden, CT
Lowell, MA
Wallingford, CT
New Haven, CT
Brookline, MA
Brooklyn, NY
Manchester, NH
White Plains, NY
Woonsocket, RI
Boston, MA
Boston, MA
New Haven, CT
Boston, MA
Leominster, MA
Buffalo, NY
Quincy, MA
Holyoke, MA
Newark, NJ
Tilton, NH
Whitman, MA
Lowell, MA
Ludlow, MA
Portland, ME
Bridgeport, CT
Boston, MA
Philadelphia, PA
Milford, MA
Rochester, NY
Gardner, MA
New London, CT
Concord, NH
Manchester, NH
Niagara Falls, NY
Plymouth, MA
Riverhead, NY
Dover, NH
New York, NY
Brockton, MA
Suffield, CT
Syracuse, NY
Patchogue, NY
Seabrook, NH
Holyoke, MA
Winchendon, MA
Woburn, MA
Boston, MA
Boston, MA

06/12/92
10/10/91
08/21/92
05/30/86
09/20/91
03/20/92
12/13/91
06/10/94
06/21/91
10/19/90
12/04/92
10/18/91
02/14/92
02/27/92
11/14/91
03/14/91
01/24/92
10/10/91
02/21/92
12/11/92
06/29/90
10/19/90
10/02/92
06/28/91
03/31/89
05/31/91
12/12/91
12/04/92
10/02/92
10/11/91
06/12/92
08/30/91
10/21/94
02/01/91
08/09/91
05/18/90
12/11/92
07/06/90
01/26/90
12/12/90
05/21/93
10/10/91
10/10/91
07/13/90
09/18/92
06/12/92
08/28/92
04/18/90
04/24/92
09/06/91
05/13/87
08/28/92
07/27/90
03/27/92
08/14/92
06/07/91
05/29/92
10/16/87

$ 3,202,492
937,259
632,450
33,961
386,572
397,979
578,220
321,457
31,806
130,931
523,850
654,715
369,110
35,664
1,044,990
83,699
7,431,636
877,159
4,028,368
515,301
479,461
526,176
1,571,240
1,129,946
880,658
9,890,866
103,814
1,288,435
3,461,421
31,180
62,124
386,363
222,671
1,182,519
1,083,920
392,219
4,126,701
328,062
520,587
173,269
914,884
1,171,673
509,074
329,994
220,972
388,806
84,808
3,391,988
285,923
294,777
1,183,321
491,100
12,416
427,949
65,213
247,219
223,665
525,481

$ 469,713
190,355
32,210
6,985
99,306
28,620
97,785
23,326
4,210
29,791
76,931
246,047
32,594
6,107
206,959
16,502
547,864
224,749
356,622
16,735
220,492
137,203
126,526
181,037
292,365
847,933
14,768
21,566
87,087
5,334
13,082
126,303
16,681
5,614
323,197
96,581
0
137,790
25,508
70,404
115,216
234,637
112,154
0
7,078
0
7,537
188,916
16,692
86,222
0
118,874
1,511
126,739
7,745
44,154
14,583
65,689

History of the Eighties—Lessons for the Future

Chapter 7

Continental Illinois and
“ Too Big to Fail”
Introduction
One of the most notable features on the landscape of the banking crises of the 1980s
was the crisis involving Continental Illinois National Bank and Trust Company (CINB) in
May 1984, which was and still is the largest bank resolution in U.S. history. Although it
took place before the banking crises of the decade gathered strength, the Continental
episode is noteworthy because it focused attention on important banking policy issues of
the period. Among the most significant of these was the effectiveness of supervision: in the
wake of the bank’s difficulties, some members of Congress questioned whether bank regulators (in this case, the Office of the Comptroller of the Currency in particular) could adequately assess risk within an institution. The economic dislocation such a large bank failure
might bring also engendered increased scrutiny of the supervisory process. In addition,
Continental was a particularly telling example of the problem that bank regulators faced
when attempting to deal with safety-and-soundness issues in an institution that had already
been identified as taking excessive risks but whose performance had not yet been seriously
compromised.
Continental’s size alone made it consequential. Large-bank failures in the 1980s and
early 1990s would prove to have serious consequences for the Bank Insurance Fund (BIF).
For example, although only 1 percent of failed institutions from 1986 to 1994 had more
than $5 billion in assets, those banks made up 37 percent of the total assets of failed institutions and accounted for 23 percent of BIF losses during that period.1 Moreover, continuing industry consolidation can only serve to make the issues involved in the handling of
large-bank failures more significant.2

1
2

FDIC, Failed Bank Cost Analysis 1986–1994 (1995), 12, 32.
At year-end 1984, only 24 commercial banks had more than $10 billion in assets; by year-end 1994, the number was 64.
During the same ten-year period, total assets at such banks had risen from $865 billion to $1.94 trillion.

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As the nation’s seventh-largest bank, Continental forced regulators to recognize not
only that very large institutions could fail but also that bank regulators needed to find satisfactory ways to cope with such failures. The methods adopted in the resolution of Continental gave rise to a great deal of controversy, with the debate centering on whether large
banks like Continental had to be treated differently from smaller institutions (the policy of
differential treatment was soon given the rather inaccurate sobriquet of “too big to fail”
[TBTF]). In fully covering all deposits in Continental, the FDIC used a method that contrasted sharply with its continuing use of deposit payoffs in some smaller resolutions. Perceptions of inequity in the treatment of banks depending on their size were brought into
even greater relief by the fact that the Continental assistance package was put together soon
after the FDIC had implemented a pilot program of “modified payoffs” in which only a proportion of the amount owed to uninsured depositors and other creditors was paid, based on
the estimated recovery value of the institution’s assets. The FDIC, seeking to encourage depositor discipline, had hoped to expand the modified payoff to all banks regardless of size.
However, the Continental assistance package effectively ended the program. At the Senate
hearings for his confirmation as FDIC chairman in September 1985, L. William Seidman
testified that it was important not to have bank size lead to differential treatment—but he
would later write that regulators were largely unsuccessful in remedying the problem.3 The
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) took significant steps toward dealing with TBTF, but since then no very large bank has failed, so the
law’s effect on how regulators would respond to such a failure has not yet been tested.

Continental’s Growth through 1981
The story of Continental Illinois is now well known, but before 1982 few observers
would have nominated it as the institution that would become emblematic of TBTF.4 The
bank had long been conservative, but in the mid-1970s its management began to implement
a growth strategy focused on commercial lending, explicitly setting out to become one of
the nation’s largest commercial lenders.5 By 1981, management had accomplished this and
more: Continental was the largest commercial and industrial (C&I) lender in the United
States. CINB’s emphasis on C&I lending can be seen clearly when it is compared with
other money-center banks. Between 1976 and 1981, CINB’s C&I lending jumped from ap3
4

5

L. William Seidman, Full Faith and Credit: The Great S&L Debacle and Other Washington Sagas (1993), 75–76.
See Irvine Sprague, Bailout: An Insider’s Account of Bank Failures and Rescues (1986), pt. 4; James P. McCollum, The
Continental Affair: The Rise and Fall of the Continental Illinois Bank (1987); and William Greider, Secrets of the Temple:
How the Federal Reserve Runs the Country (1987), chaps. 14 and 17. The discussion here also owes much to FDIC, “Report on Continental Illinois” (unpublished paper), 1985.
U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on Financial Institutions Supervision, Regulation and Insurance, Inquiry into Continental Illinois Corp. and Continental Illinois National Bank: Hearings, 98th
Cong., 2d sess., 1984, 39; and “Continental Illinois Sails into a Calm,” Business Week (May 14, 1979): 114.

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Continental Illinois and “Too Big to Fail”

proximately $5 billion to more than $14 billion (180 percent), while its total assets grew
from $21.5 billion to $45 billion (110 percent). During the same period, Citibank’s C&I
lending rose from $7.7 billion to $12.5 billion (62.5 percent), while its total assets rose from
$61.5 billion to $105 billion (70 percent). Growth at Continental Illinois substantially outstripped that at institutions such as Chemical Bank, Morgan Guaranty, and its Chicago competitor, the First National Bank of Chicago. (See table 7.1.)
Continental’s management, the bank’s aggressive growth strategy, and its returns
were lauded both by the market and by industry analysts. A 1978 article in Dun’s Review
pronounced the bank one of the top five companies in the nation; an analyst at First Boston
Corp. praised Continental, noting that it had “superior management at the top, and its management is very deep”; in 1981, a Salomon Brothers analyst echoed this sentiment, calling
Continental “one of the finest money-center banks going.”6 Continental’s share price reflected the high opinions of and performance by the bank. In 1979, an article noted that
while the stocks of other big banking companies have hardly budged, “ . . . Continental’s . . .
has doubled in price—rising from about $13 to $27 . . . since the end of 1974, compared
Table 7.1

Growth in Assets and Domestic C&I Lending at the Ten Largest U.S. Banks,
1976–1981
($Billions)

1976
Bank
Bank of America
Citibank

1981

Domestic
C&I as %
of Assets

Total
Assets

Domestic
C&I

Domestic
C&I as %
of Assets

1976–1981

Total
Assets

Domestic
C&I

Asset
Domestic
Growth C&I Growth

$72.94

$7.06

9.67

$118.54

$12.10

10.21

62.52%

71.51%

61.50

7.71

12.54

104.80

12.54

11.97

70.40

62.57

Chase Manhattan

44.75

9.24

20.66

76.84

10.05

13.07

71.69

8.67

Manufacturers Hanover

30.10

4.43

14.73

54.91

9.46

17.22

82.44

113.39

Morgan Guaranty

28.49

3.07

10.79

53.72

5.61

10.44

88.57

82.43

Chemical Bank

26.08

4.65

17.82

45.11

10.82

23.98

72.94

132.74

Bankers Trust

21.76

3.06

14.04

33.00

5.23

15.84

51.66

71.08

Continental Illinois

21.44

5.09

23.74

45.15

14.27

31.61

110.56

180.42

First National Bank of Chicago

18.68

4.04

21.61

32.55

5.59

17.16

74.25

38.42

Security Pacific

16.15

2.49

15.43

30.46

5.91

19.38

88.59

136.98

6

“Here Comes Continental,” Dun’s Review 112, no. 6 (1978): 42–44; and “Banker of the Year,” Euromoney (October 1981):
134.

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with a 10% gain for the average money-center bank.”7 And even as its share price was deteriorating during late 1981 and early 1982 (see figure 7.1), many stock analysts continued
to recommend purchase of Continental shares.8
It is not surprising that few observers recognized the problems inherent in Continental’s rapid growth; most indicators of the bank’s financial condition were good, and some
were outstanding. For example, for the five-year period from 1977 to 1981, the bank’s average return on equity was 14.35 percent, which was second only to Morgan Guaranty (14.83
percent) among other large commercial banks. Over the same period Citibank’s average was
13.46 percent, and Continental’s cross-town rival First Chicago had an average of only 9.43
percent. Continental’s return on average assets was also acceptable, exceeded only by the returns of Security Pacific, Morgan Guaranty, and Citibank (see table 7.2). Continental did
have one of the lower equity levels of the large banks, with its average of 3.78 percent putting
Figure 7.1

Continental Illinois Corporation:
Average Weekly Share Price, 1981–1984
Dollars
40

30

20

10

0
1981

1982

1983

1984

Source: Dow Jones News/Retrieval.

7
8

“Continental Illinois Sails into a Calm,” Business Week (May 14, 1979): 114.
See, for example, Wall Street Transcript (January 25, 1982), where a Morgan Stanley analyst described Continental as “attractive,” and Keefe Nationwide Bankscan (March 15, 1982), where market dissatisfaction with Continental was viewed as
“a gross overreaction to the year-end increase in the bank’s nonperforming assets.” Two weeks after this comment, an analyst at the Bank of New York raised his rating on Continental from hold to buy (Wall Street Transcript [March 29, 1982]).
All of these are cited in FDIC, “Report on Continental Illinois.”

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Continental Illinois and “Too Big to Fail”

Table 7.2

Average Returns and Equity Ratios at the Ten Largest U.S. Banks, 1977–1981
Average
ROA*

Average
ROE†

Average Equity/
Assets Ratio

Bank of America

0.50%

13.91%

3.57%

Bankers Trust

0.42

10.84

3.92

Chase Manhattan

0.44

11.04

4.01

Chemical Bank

0.38

10.96

3.52

Citibank

0.59

13.46

4.40

Continental Illinois

0.54

14.35

3.78

First National Bank of Chicago

0.38

9.43

3.99

Manufacturers Hanover

0.45

12.92

3.53

Morgan Guaranty

0.65

14.85

4.37

Security Pacific

0.66

14.31

4.60

Bank

*Return on assets is year-end net income divided by year-end assets.
†Return on equity is year-end net income divided by year-end equity.

it seventh out of ten; however, only three banks had ratios significantly over 4 percent.
Moreover, asset and loan growth at Continental was at least matched by growth in the bank’s
equity ratio, which rose from 3.55 percent at year-end 1976 to 4.31 percent at year-end 1982.
If there were signs of trouble, that was not obvious from Continental’s earnings.
There were, however, two aspects of Continental’s financial profile that, with the benefit of hindsight, were indicators of the increased risk the bank took on during its growth period. First, Continental’s loans-to-assets ratio increased dramatically—from 57.9 percent in
1977 to 68.8 percent (see appendix, table 7-A.3) by year-end 1981, when it was the highest
of the ten banks. This alone suggests that the bank was riskier; the greater the proportion of
its portfolio a bank holds in loans, the more exposed the firm is to default risk. Second, although Continental’s return on assets was adequate over this period, it hovered at around
.51 percent; with a higher percentage of assets in loans, the average loan had to have been
earning less at the end of the period than it had been at the beginning, implying that over
time, Continental was originating loans with lower interest rates than those on the books in
1978. Given the large increase in interest rates over this same period, such a scenario indicates the bank might have adopted a below-market pricing strategy, a possibility some observers noted at the time.
As this suggests, intimations that Continental’s lending style might be overly aggressive had not been altogether lacking. The bank’s growth was attributed partly to its “zeal for
occasional transactions that carry more than the average amount of risk.” One bank officer
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stated, “We hear that Continental is willing to do just about anything to make a deal.”9 Another observer noted that Continental had “sold the hell out of the corporate market by taking more than the average risks in selected areas.”10 One of the most significant of those
areas was the energy sector, where Continental had a long history and the bank could claim
a great deal of expertise.11 Continental’s growth was also perceived to stem from aggressive pricing. A published news report stated that when Continental wanted to do business
with a corporation badly enough, the bank would offer “a cheap deal . . . the financial officer can’t refuse.”12 A Chicago competitor noted in 1981 that “even with a 20% prime they
were doing 16% fixed rate loans. I don’t know how they do it.”13 But while some were suggesting that the bank’s aggressive lending style might be too risky, few thought so before
1982, and Continental’s management dismissed such views.14
Late in 1981, however, problems were beginning to surface. The bank’s secondquarter earnings fell 12 percent, a drop that CEO Roger Anderson explained was largely the
result of backing interest rates the wrong way. (It was reported that the fall would have
been much greater had the bank not taken some extraordinary gains during the quarter.)15
In September 1981, Continental’s senior vice president in charge of oil and gas dismissed
the 1981 drop in oil prices—which would in fact continue steadily— as “just a little blip.”16
In addition, some of Continental’s corporate customers began to have severe problems. For
example, in the first six months of 1982, Nucorp Energy lost more than $40 million, and
Continental held a large portion of the company’s debt. Continental had also lent $200 million to the near-bankrupt International Harvester, and one bank analyst suggested that Continental had “taken some bad credit gambles that aren’t paying off . . . and it is costing them
now.”17 After peaking at approximately 42 in June 1981, Continental’s share price declined
almost 37 percent during the next year. Many stock analysts believed the reaction was
overdone and the downturn in stock price more psychological than fundamental; nevertheless, the increasing volume of nonperforming loans was viewed as at least a short-term

9
10
11

12
13
14
15
16
17

Both of these citations are from “Continental Sails,” 114.
“On the Offensive,” The Wall Street Journal (October 15, 1981), 1.
See Sanford Rose, “A Well-Heeled Gambler’s Half-Hearted Reformation,” American Banker (August 18, 1981), 4; and
Laurel Sorenson, “In the Highflying Field of Energy Finance, Continental Illinois Bank Is Striking It Rich,” The Wall Street
Journal (September 18, 1981), 33.
Neil Osborn, “Continental Illinois Shakes Up the Competition,” Institutional Investor 14, no. 10 (1980): 178–79.
“On the Offensive,” 1.
Sorenson, “Highflying Field,” 33.
“Banker of the Year,” 135; and Sanford Rose, “Will Success Spoil Continental Illinois?” American Banker (August 25,
1981), 4.
Sorenson, “Highflying Field,” 33.
Greider, Secrets, 522; and The Wall Street Journal (June 1, 1982), 1.

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Continental Illinois and “Too Big to Fail”

problem. Yet in March 1982, when Fitch’s Investors Service Inc. downgraded six large
banks’ ratings, Continental retained its AAA rating.18

After Penn Square
Optimism about Continental’s condition ended abruptly in July 1982, when Penn
Square Bank, N.A., in Oklahoma failed.19 Penn Square had generated billions of dollars in
extremely speculative oil and gas exploration loans, many of which were nearly worthless,
and Continental had purchased a monumental $1 billion in participations from Penn
Square. While Continental and the other “upstream” banks pressed regulators to find a way
to prevent a deposit payoff of Penn Square, a course that would also have been preferred by
both the Federal Reserve and the OCC, the larger banks involved refused either to inject
money into Penn Square or to waive their claims on the bank. The refusal to waive their
claims meant that the contingent liabilities the FDIC would have incurred militated against
every course except a deposit payoff.20 Penn Square became the largest bank payoff in the
history of the FDIC, and remained so until 1992.21
News of Continental’s relationship with Penn Square caused great anxiety among investors, and many stock analysts quickly halved earnings estimates and downgraded their
opinions on the company.22 During July the share price had dropped to nearly 16, a 62 percent decline from a year before. The major rating agencies swiftly downgraded the bank’s
credit and debt ratings. Continental’s lending involvement with three of the largest corporate bankruptcies of 1982 helped turn perceptions of the bank increasingly negative. Such
perceptions were reinforced by the advent of the less-developed-country (LDC) debt crisis
brought on by Mexico’s default in August 1982; Continental had significant LDC exposure.23 The aggressiveness and loan policies that had met with so much praise during the
“go-go” years were now seen in a far more critical light. The financial press began to write
about faults in the bank’s management, internal controls, and loan pricing.24 CEO Ander18
19
20
21
22
23
24

Dow Jones New Service: The Wall Street Journal combined stories (April 20, 1982). Moody’s Investors Service had downgraded Continental’s debt rating from AAA to AA in March.
For the story of Penn Square’s failure, see Chapter 9; and Phillip L. Zweig, Belly Up: The Collapse of the Penn Square
Bank (1985).
See Sprague, Bailout; and Greider, Secrets, 497–500.
Penn Square had $390 million in deposits and $436 million in assets. In 1992, there was a deposit payoff of the Independence Bank of Los Angeles ($548 million in deposits and $536 million in assets). Data are for the quarter before failure.
For example, within a month of Penn Square’s failure, revised positions were taken by analysts at Keefe, Bruyette and
Woods; Smith Barney Harris Upham and Co.; and Donaldson, Lufkin, Jenrette (FDIC, “Report on Continental Illinois”).
See Chapter 5 for a discussion of the LDC debt crisis.
See, for example, “The Stain from Penn Square Keeps Spreading, “ Business Week (August 2, 1982), available: LEXIS, Library: NEWS, File: BUSWK; “Forgetting the Rules,” Newsweek (August 2, 1982), available: LEXIS, Library: NEWS,
File: NWEEK; and “Continental Illinois’ Most Embarrassing Year,” Business Week (October 11, 1982), available: LEXIS,
Library: NEWS, File: BUSWK.

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son, while admitting that Continental’s system had broken down, defended the bank’s lending policies and stated that the bank “had no intention of pulling in its horns.”25
Analysts’ reactions to Continental’s statements about its condition were mixed, but
during 1983 the stock price did gradually recover into the mid-20s. While Continental furnished an image of a sober institution dealing with its problems, the bank’s mistakes had
meant a loss of credibility in the domestic money markets. This was particularly significant
because Continental had little retail banking business and therefore relatively small
amounts of core deposits. The bank’s ability to generate retail business was severely circumscribed by the combination of federal banking laws restricting geographic expansion
and Illinois law strictly requiring unit banking in the state.26 In 1977 core deposits made up
30 percent of total deposits; by 1981 they had declined to just under 20 percent. (See appendix, table 7-A.1.) Instead, the bank relied on fed funds and large CDs. In addition, management favored issuing shorter-term, more volatile but less-expensive instruments rather
than longer-term ones that were both more stable and more expensive. Continental therefore continually needed to roll over large volumes of deposits and search for new sources of
funds, but the loss of confidence due to Penn Square meant the bank had to pay substantially higher rates on its CDs. Within three weeks of Penn Square’s failure, Continental removed itself from the list of top-graded banks whose CDs traded interchangeably in the
secondary markets. Unable to fund its domestic operations adequately from domestic markets, Continental increasingly turned to foreign money markets (at higher rates). Its dependence on these funds would figure significantly in the bank’s crisis in 1984.27
During the first half of 1983 Continental’s situation appeared to have stabilized somewhat, but the bank’s recovery was far from certain. Although the bank apparently had made
efforts to tighten its internal controls and lending procedures, its nonperforming loans continued to mount. Earnings were bolstered by a series of extraordinary gains, while operating earnings declined. One reporter noted an example of gallows humor among bank
employees: “[The only] difference between Continental and the Titanic is that the Titanic
had a band.”28 Many institutional investors were deserting the ship, including major shareholders such as U.S. Steel & Carnegie Pensions and Mathers & Co. (a Chicago-based

25
26

27
28

McCollum, Continental Affair, 248.
Concerning federal law, see the discussion in Chapter 2 on the Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994. Until after the Continental open-bank assistance, Illinois law prohibited branching, only permitting one “facility” within 1,500 feet and another within 3,500 yards of the main banking premises (Conference of State Bank Supervisors, A Profile of State-Chartered Banking [1977], 98; and ibid. [1986], 86).
FDIC, “Report on Continental Illinois,” 7–12.
A. F. Ehrbar, “Toil and Trouble and Continental Illinois,” Fortune (February 7, 1983), available: LEXIS, Library: BUSFIN,
File: FORTUN.

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Chapter 7

Continental Illinois and “Too Big to Fail”

money management firm), both of which sold their entire stock positions.29 The firstquarter 1984 results confirmed Continental’s troubles: nonperforming loans increased
$400 million to a record $2.3 billion, with more than half the increase coming from Latin
American loans; if not for the sale of its profitable credit card business to Chemical for $157
million, Continental would have reported a loss for the quarter. This news prompted
Moody’s to announce yet another review of its debt ratings on Continental.30 By the end of
April, Continental’s share price had sunk from a post–Penn Square high of 26 in September
1983 to less than 14.

The Bank Run and Government Assistance
The deterioration in Continental’s condition and earnings, coupled with its reliance on
the Eurodollar market for funding, helped make the bank vulnerable to the high-speed electronic bank run that took place in May 1984. Among the factors that caused the run to start
and made stopping it difficult, rumor was prominent. On May 9, Reuters asked Continental to comment on rumors that the bank was on the road to bankruptcy; the bank condemned
the story as “totally preposterous.” In addition, stories circulated that a Japanese bank was
interested in acquiring Continental, or that the OCC had asked other banks and securities
firms to assist Continental.31 Anxious overseas depositors began to shift their deposits
away from Continental, and it was reported that Chicago’s Board of Trade Clearing House
had done the same. In an effort to calm the situation, the Comptroller of the Currency, departing from the OCC’s policy of not commenting on individual banks, took the extraordinary step of issuing a statement denying the agency had sought assistance for Continental
and noting that the OCC was unaware “of any significant changes in the bank’s operations,
as reflected in its published financial statements, that would serve as the basis” for rumors
about Continental.32 The run, however, continued, and by Friday May 11, Continental had
had to borrow $3.6 billion at the Federal Reserve’s discount window to make up for its lost
deposits.33 During the following weekend Continental attempted to solve its problems by

29
30
31

32

33

Lynn Brenner, “Chicago Giant’s Top Holder Isn’t Fazed: Batterymarch Financial Management Still Owns 2 Million
Shares,” American Banker (May 23, 1984), 3.
The Wall Street Journal (May 2, 1984), 41.
See Jeff Bailey and Jeffrey Zaslow, “Continental Illinois Securities Plummet amid Rumors Firm’s Plight Is Worsening,”
The Wall Street Journal (May 11, 1984), 3; Robert A Bennett, “Continental Fighting Rumors,” The New York Times (May
11, 1984), sec. 4, p. 1; and Sprague, Bailout, 152–53.
For the text of the OCC press release, see U.S. House, Inquiry, 285. It was noted that the last time the government had
made such a statement had been in 1974, ten years earlier; the bank was Franklin National, and it later failed (The Wall
Street Journal [May 21, 1984], 3).
“ ‘Smart Money Bank’: What Went Wrong,” The New York Times (May 18, 1984), sec. 4, p. 15.

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creating a $4.5 billion loan package provided by 16 banks, but this proved insufficient to
stop the run; Continental’s domestic correspondent banks also began to withdraw funds
from the bank.
As the situation continued to deteriorate, bank regulators were faced with a potential
crisis that might envelop the entire banking system. The run had to be stopped, and so the
three bank regulatory agencies decided to provide a $2 billion assistance package to Continental: the FDIC provided $1.5 billion, and participated an additional $500 million to a
group of commercial banks. The capital infusion was in the form of interest-bearing subordinated notes at a variable rate 100 basis points higher than that on one-year Treasury
bills. The Federal Reserve stated that it would meet any liquidity needs Continental might
have, and a group of 24 major U.S. banks agreed to provide more than $5.3 billion in funding on an unsecured basis while a permanent solution was sought. In what was perhaps the
most controversial move by the regulators, the FDIC promised to protect all of Continental’s depositors and other general creditors, regardless of the $100,000 limit on deposit insurance. The assistance package was to remain in place while the regulators searched for a
permanent solution to Continental’s problems.34
The regulators spent two months searching for a suitable and willing merger partner
for Continental, but none could be found. Moreover, the temporary assistance package had
not ended deposit outflows from Continental. In July the bank regulators agreed on a complex and controversial resolution. The plan consisted of the FDIC’s purchase from the bank
of $4.5 billion in bad loans. These troubled loans would then be managed for the FDIC by
the bank under a servicing contract. The structure of the loan transfer involved a charge-off
to the bank of $1 billion, but the permanent assistance plan also infused $1 billion in capital into the bank through the FDIC’s acquisition of preferred stock in Continental Illinois
Corporation (CIC), which the holding company was required to downstream to the bank as
equity. The FDIC wanted to place the new capital directly into the bank but was prevented
from doing so by outstanding indenture agreements with the holding company.35 The bank
also continued to receive liquidity support from the Federal Reserve, and the funding facility that had been provided by a group of U.S. commercial banks remained in place. Finally,
the permanent assistance plan removed Continental’s top management and board of direc-

34
35

See OCC, FDIC and FRB, Joint News Release (May 17, 1984).
Placing the capital in the holding company was controversial because holding company bondholders were protected, but
no other avenue to effect the resolution could be found. See John Riley, “Inside the Bailout: Continental Leaves a Wide
Wake,” National Law Journal (October 22, 1984): 29. Continental’s shareholders were substantially wiped out, though
they did have the prospect of some return, depending on the losses the FDIC incurred under the agreement.

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Continental Illinois and “Too Big to Fail”

tors and put John Swearingen and William Ogden in place as executive officers of CIC and
CINB, respectively.36 In September Continental’s shareholders approved the plan.37

Policy Implications: Supervision
Continental continued in existence, though as a substantially different entity, but both
the need for intervention as well as the character of the intervention highlighted several important policy debates. Even if one did not take issue with the regulators’ permanent solution (and many did), the effectiveness of the OCC’s supervisory activities before the
Continental assistance plan remained open to question. There was little doubt that the
bank’s management had embarked on a growth strategy built on decentralized credit evaluation unconstrained by any adequate system of internal controls and that the bank had relied on volatile funds. But how well had the responsible bank regulators assessed
Continental’s situation, and should they have been more assertive in requiring the bank to
change its lending and other high-risk practices?
A staff report of the House Banking Subcommittee in 1985 expressed reservations
about both the OCC’s and the Federal Reserve’s supervision of Continental. Among its criticisms, the report found that the OCC failed to take “decisive action” to slow the bank’s
growth or increase its equity-to-assets ratio before 1983 and failed to require Continental to
remedy known problems in its loan management system before 1982. The report also held
that despite the OCC’s awareness of Continental’s growing concentrations in oil and gas,
the agency did not “consistently and forcefully” point out potential dangers to management,
and that OCC examination reports in general were too ambiguous to provide a clear message to the bank about its problems. The OCC’s sampling technique for loan evaluation
was also thought to be insufficient in the case of Continental because it relied too much on
the bank’s own internal controls, which in this case were themselves woefully deficient.
The report criticized the Federal Reserve on the grounds that although its supervision of the
holding company identified potential risks from the reliance on volatile funding, the agency
did not communicate these warnings consistently over time. The report also noted that the
36
37

See OCC, FDIC, FRB, “Permanent Assistance Program for Continental Illinois National Bank and Trust Company,” PR87-84 (July 26, 1984).
As of 1997, the estimated cost to the FDIC of resolving Continental is approximately $1.1 billion. At this writing, a small
number of assets are still to be disposed of, but are not expected to change the final cost significantly. Although many criticized the Continental resolution, the FDIC’s estimated cost was considerably smaller than the costs for First Republicbank
Corp. ($3.77 billion) and MCorp-Dallas ($2.85 billion). Moreover, if one considers estimated losses as a percentage of assets, Continental (3.27 percent) ranks behind Texas American Bancshares (22.67 percent), MCorp (18.12 percent), First
Republic (11.69 percent), First City Bancorporation [its 1988 failure] (9.55 percent), New Hampshire Savings Bank (9.55
percent), Goldome Federal Savings Bank (9.24 percent), CrossLand Federal Savings (7.50 percent), and Bank of New
England Corp. (3.40 percent). These percentages are calculated using asset size either at the time of closure or at the time
of the assistance transaction, whichever is applicable.

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Federal Reserve’s continuing approval of the holding company’s applications to expand its
activities—despite numerous examinations containing critiques of the bank’s capitalization, asset quality, and funding—“may have conveyed to CIC and the public that the Federal Reserve basically approved of the operating and financial characteristics” of both the
holding company and the bank.38
C. T. Conover, the Comptroller of the Currency, noted in his testimony before Congress in 1984 that the OCC had considered whether the agency ought to have taken action
as early as 1976 to stop Continental from implementing its growth strategy. Conover said
he believed that this would have been inappropriate but that the OCC could have placed
“more emphasis on . . . evaluation and criticism of Continental’s overall management
processes.”39 This issue touches on a central quandary that bank regulators faced. On the
one hand, as Federal Reserve Board General Counsel Michael Bradfield noted, “The real
failure of supervision [was that] . . . nobody did anything about Continental in the late seventies and early eighties,” but on the other hand, as Federal Reserve Board Governor
Charles Partee pointed out, “To impose prudential restraints is meddlesome and it restricts
profits. If the banking system is expanding rapidly, if they can show they’re making good
money by the new business, for us to try to be too tough with them, to hold them back, is
just not going to be acceptable.”40
A different situation obtained, however, after Penn Square had made Continental’s
shortcomings obvious. Conover noted that in 1983, at the OCC’s direction, Continental had
entered into a formal agreement with the agency requiring the bank to deal with problems
in asset and liability management, loan administration, and funding. Continental’s plan
called for a reduction in assets and a more conservative lending policy. The OCC believed
that management and organizational changes to help recovery were being implemented but
that economic conditions, such as rising interest rates and a continuing decline in the energy
sector, made the plan’s goals unachievable. This further deterioration was noted in the 1983
OCC examination of Continental, when the bank’s composite CAMEL rating slipped to
a 4.41 The bank’s decline continued, and Conover stated that at that point there was little the
regulators could have done to increase market confidence in the bank in a manner that
would have changed the outcome in May 1984.
38

39
40
41

U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on Financial Institutions Supervision, Regulation and Insurance, Continental Illinois National Bank: Report of an Inquiry into Its Federal Supervision and Assistance, Staff Report, 99th Cong., 1st sess., 1985, 7–10.
U.S. House, Inquiry, 212–13.
Cited in Greider, Secrets, 524–25.
The CAMEL rating system refers to capital, assets, management, earnings, and liquidity. In addition to a rating for each of
these individual or “component” categories, an overall or “composite” rating is given for the condition of the bank. Banks
are assigned ratings between 1 and 5, with 5 being the worst rating a bank can receive. See Chapter 12 for a detailed explanation of CAMEL ratings.

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Continental Illinois and “Too Big to Fail”

The Comptroller noted that removing the bank’s top management following Penn
Square was viewed as unnecessary—management was perceived as capable and had put a
program in place to correct problems within the bank; moreover, the officers directly responsible for Continental’s Penn Square difficulties had been removed. Forcing Continental to cease dividend payments was another option, but the bank’s management and board
of directors felt the dividend was crucial to regaining market confidence, and in any case
the amount of money involved would not have added appreciably to the bank’s capital.
Conover stated that after mid-1982 “there was nothing more that we could have done to
speed Continental’s recovery.”42
A later account by William Greider, however, suggests that the regulators did informally attempt to do more after Penn Square but believed it inadvisable to impose a formal action, such as a cease-and-desist order. According to Greider, in 1982 Federal Reserve Board
Chairman Paul Volcker advised Continental’s directors to make changes in both management
and lending policy, but the directors refused. FDIC Chairman William Isaac remembered
that “when Volcker and Conover presented their recommendations to the Continental Illinois
directors, . . . the directors said to them: ‘Well, this will be the end of the bank and you will
be to blame.’ ” Isaac noted that it would have been difficult for a regulator to proceed in the
face of the directors’ refusal. “It takes real gumption for a regulator to sit there and say, ‘I’ll
take the responsibility. . .’ We’re talking about one of the biggest banks in the world. No one
knows what will happen.” Michael Bradfield made the same point about any Federal Reserve attempt to deny a bank access to the discount window as a way of forcing its hand, noting that “the consequences of refusing to supply liquidity support to a bank are too severe.”
It appears, therefore, that in 1982 regulators believed more should have been done but were
unwilling openly to require the removal of Continental’s top management or take other formal actions, such as demanding a dividend cut. However, it also seems likely that, as Bradfield noted, by the time Penn Square failed, the damage had already been done.43

Policy Implications: “Too Big to Fail”
Just as Continental’s supervision had raised fundamental questions about regulatory
policy, so did the bank’s resolution. Some critics objected simply to the notion of a government agency’s acquiring 80 percent ownership in a bank—the word “nationalization”

42
43

U.S. House, Inquiry, 211.
Greider, Secrets, 522–25. William Isaac noted that “what should have been done right away was the board of directors
should have fired the management, brought in strong management from outside, taken a huge loan write-off and eliminated
its dividend to stockholders. They might have failed anyway, but . . . there was a substantial chance they could [have] survive[d]” (Greider, Secrets, 522).

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was often invoked to describe the assistance package.44 Others objected to the methods
adopted in this case: the combination of the FDIC guarantee of protection to all depositors
and creditors, the apparent possibility that Continental shareholders might retain some of
their investment, and the protection of CIC’s bondholders. Overarching all of these issues
and far outlasting the immediate aftermath was the question of whether certain banks were
“too big to fail.” If they were, then the obvious corollary was that most banks were not, and
this pointed up what many believed to be a significant inequity in the deposit insurance system.45
Until 1950, the FDIC had basically had two options in dealing with failed and failing
banks: close the institution and pay off the insured depositors, or arrange for the bank’s acquisition. After 1950, a third option was available if the FDIC Board of Directors deemed
a bank “essential” to its community: keep a failing bank open through direct infusion of
funds (as was done with Continental).46 Also after 1950, and until the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991, the FDIC operated under a
cost test for determining which method to use: it was required to estimate the cost of a payoff and liquidation as the standard of comparison, and could adopt an alternative resolution
if the alternative was expected to be less costly than the standard. But the FDIC was also
allowed to use an alternative method under the essentiality provision, and the statutory language was sufficiently general to provide the FDIC with discretion to extend essentiality
beyond local economic dislocation (as was done with Continental).47 When essentiality
was invoked, cost considerations could be ignored. In practice, most larger bank failures
were handled by purchase-and-assumption (P&A) transactions rather than payoffs, and the

44

45

46

47

Bank analyst David Cates, however, noted at the time that the fact that the FDIC shares would have voting rights only after they were sold indicated the FDIC wanted to return the bank to the private sector as soon as possible, so nationalization
was not the most accurate term to describe the assistance package (“All Debits, No Credits: A Hard Look at the Government’s Takeover of Continental Illinois,” Barron’s [July 30, 1984]: 6).
There was a correlation between bank size and resolution method. During the period 1986–91, for example, the average
asset size of institutions that were resolved by insured-deposit payoff and liquidation was approximately $65 million,
whereas the average asset size of institutions that were resolved through either acquisition or open-bank assistance, both of
which meant uninsured depositors were protected, was about $200 million (FDIC, Failed Bank Cost Analysis 1986–1995
[1996], 11).
See §13(c)(1) of the Federal Deposit Insurance (FDI) Act, 12 U.S. Code §1823(c)(1). When this change was made to the
law, the FDIC noted that it was “the intent of the Corporation to exercise this authority sparingly” (FDIC, Annual Report
[1950], 6); and indeed, it was not invoked until 1970, and since then has been used relatively infrequently.
See the FDI Act, §13(c). For a discussion of the history of the essentiality issue, see Henry Cohen, “Federal Deposit Insurance Corporation Assistance to an Insured Bank on the Ground That the Bank Is Essential in Its Community,” Congressional Research Service, Library of Congress (October 1984), 8. Cohen notes that before Continental, essentiality had
been used five times, all of them between 1971 and 1980: Unity Bank and Trust (Boston, MA 1971), the Bank of the Commonwealth (Detroit, MI 1972), the American Bank and Trust Company (Orangeburg, SC 1974), the Farmers Bank of the
State of Delaware (Wilmington, DE 1976), and First Pennsylvania Bank, NA (Philadelphia, PA 1980).

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Continental Illinois and “Too Big to Fail”

uninsured depositors were protected.48 The FDIC recognized the inequities of its practice,
but also desired to minimize local economic disruptions. Thus it often selected a resolution
method that protected all deposits even with smaller banks if allowed under the cost test.49
Overall, the FDIC weighed the particular circumstances in deciding on failure-resolution
methods, and for the most part this meant that when uninsured depositors suffered losses, it
was in smaller institutions—a practice that created incentives for depositors to place large
deposits in larger banks, and that fueled concern over TBTF.
As has been noted, however, TBTF was an inaccurate term: “too big to liquidate”
would have been more appropriate. Large banks did fail during the period, with shareholders losing their investments and managements being removed. In significant ways, Continental “failed.” But as one regulator observed, the banking agencies were “reluctant to
tolerate the sudden and uncontrolled failure of large institutions and therefore generally
opt[ed] for managed shrinkage, merger, or recapitalization.”50 There were several reasons
for adopting such an attitude, the most important of which was “systemic risk.” This rubric
covered “potential spillover effects leading to widespread depositor runs, impairment of
public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlement systems.”51 In addition to systemic risk, the logistical
difficulties and potential expense of liquidating a large bank also contributed to regulatory
reluctance to close such a bank and pay off insured depositors. Moreover, liquidation
would mean tying up uninsured depositors’ funds during the lengthy proceedings, a situation that could have a very disruptive effect on a bank’s community.52 For all these reasons
combined, the larger the bank, the more likely it was that bank regulators would look for alternatives to closing the bank and paying off the insured depositors.
48

49
50
51

52

In a P&A, all deposits and other nonsubordinated liabilities of the failed bank are assumed by another institution. Even
without the too-big-to-fail policy, it is likely that large banks would have been resolved more often through P&As than
through deposit payoffs because they had greater franchise value and marketability. The latter may have stemmed from
large banks’(1) greater flexibility in seeking new markets and offering new product lines, (2) location in states where the
absence of restrictions on geographic expansion meant a greater number of qualified bidders, and (3) earlier resolution action (to the extent that disclosure requirements applicable to publicly traded companies alerted regulators to problems at an
earlier stage).
FDIC, “Systemic Risk (Too Big to Fail)” (unpublished paper), 1995.
E. Gerald Corrigan, “A Perspective on Recent Financial Disruptions,” Federal Reserve Bank of New York Quarterly Review 14, no. 4 (winter 1989–90): 12.
Statement of John P. LaWare, U.S. House Committee on Banking, Finance and Urban Affairs, Subcommittee on Economic
Stabilization, Economic Implications of the “Too Big to Fail” Policy: Hearing, 102d Cong., 1st sess., 1991, 113. Cited in
Charles Moyer and Robert E. Lamy, “‘Too big to fail’: Rationale, Consequences and Alternatives,” Business Economics
27, no. 3 (1992): 21.
Ibid. For other discussions of TBTF, see Walker F. Todd, “An Insider’s View of the Political Economy of the Too Big to
Fail Doctrine,” working paper 9017, Federal Reserve Bank of Cleveland, 1990; and Robert L. Hetzel, “Too Big to Fail:
Origins, Consequences, and Outlook,” Federal Reserve Bank of Richmond Economic Review 77, no. 6 (November/December 1991): 6ff.

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Regulators had another concern besides inequity and local economic disruption. They
and industry observers worried that the perception of de facto 100 percent deposit insurance
for many banks led depositors to believe they needed to devote little if any attention to
where they placed their money, a situation that could induce some banks to take excessive
risks. But some commentators thought moves to increase depositor discipline flew in the
face of “too big to fail”; the issue of depositor discipline therefore became attached to the
TBTF debate. During the early 1980s, the FDIC did seek ways to increase market discipline as a means of controlling inordinate risk taking. A solution proposed in 1983 was the
creation of the so-called modified payoff. In such a resolution, insured depositors’ claims
would be settled as they always had been. Rather than being made whole, however, other
claimants would receive a proportion of their money based on an estimate of the total value
of bank assets that would have been recovered in a liquidation. The agency expected that
both the insured-deposit settlement and the “advance” could be handled by transfer to an
operating institution.53 The FDIC began to experiment with the method in 1983 and used it
in 13 resolutions in 1983–84, most of which took place in March and April 1984, just before the Continental assistance package was put in place.54 The experiments had been
viewed as possibly leading to regular use of the method, but the Continental assistance
package effectively ended the modified payoff as a means to instill market discipline.55 Almost a year after Continental, the FDIC sought public comment on the possible use of modified payoffs in all resolutions, but it did not pursue the policy at that time.56
With regard to Continental Illinois, the regulators’ greatest concern was systemic risk,
and therefore handling Continental through a payoff and liquidation was simply not considered a viable option. Continental had an extensive network of correspondent banks, almost 2,300 of which had funds invested in Continental; more than 42 percent of those
banks had invested funds in excess of $100,000, with a total investment of almost $6 billion. The FDIC determined that 66 of these banks, with total assets of almost $5 billion, had
more than 100 percent of their equity capital invested in Continental and that an additional
113 banks with total assets of more than $12 billion had between 50 and 100 percent of their
equity capital invested.

53
54
55

56

FDIC, Deposit Insurance in a Changing Environment (1983), III-4-5. See also William Isaac, address before the Management Conference of the National Council of Savings Institutions (FDIC PR-92-83, December 6, 1983).
See Eugenie D. Short, “FDIC Settlement Practices and the Size of Failed Banks,” Federal Reserve Bank of Dallas Economic Review (March 1985): 19.
FDIC, Mandate for Change: Restructuring the Banking Industry (1987), 112. For the reaction of a depositor (after the
Continental assistance package) at a bank resolved through the modified payoff, see Pam Belluck, “Continental Illinois
Rescue May Doom FDIC Plan to Share the Insurance Risk,” National Journal (August 11, 1984), available: LEXIS, Library: BANKING, File: NTLJNL.
Federal Register 50 (May 6, 1985): 19088.

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Continental Illinois and “Too Big to Fail”

The House Banking Committee staff found that this analysis—inasmuch as it did not
take into account either the $100,000 payment on insured deposits or the banks’ likely recovery from the disposition of Continental’s assets—overstated the true exposure of the
creditor institutions and thus the numbers of correspondent banks that fell into the abovementioned categories. In reply, FDIC Chairman William Isaac noted that the FDIC had
never suggested that all these banks would fail but that these small banks would probably
have lost more than $1 billion and that such losses would have led to a number of failures.
In addition, the assets involved would have been frozen while the bank was liquidated, and
liquidation is a protracted process.57
The potential impact on the correspondent banks was not the only problem. Regulators were afraid of ripple effects on other large institutions that were perceived to be in vulnerable financial condition, banks such as First Chicago, Manufacturers Hanover, and Bank
of America. The financial markets’ worry about such banks was amply demonstrated just a
week after the Continental assistance package was announced, when rumors about funding
difficulties at Manufacturers Hanover caused its share price to drop 11 percent in one day,
with other major banks’ shares falling as a result.58 Regulators feared that if Continental
were allowed to close, a series of large institutions might be next; given this perception,
open-bank assistance under the “essentiality” clause was viewed as the only viable option.59
The Continental assistance package sharpened the public’s focus on TBTF, and not
only because the bank’s size ensured notoriety. C. T. Conover’s statement before Congress
that regulators would be unable to do a deposit payoff of the 11 largest banks seemed an explicit confirmation that large banks were inherently treated differently from smaller ones.60
Even if this appeared to codify TBTF, it should be noted that many of the characteristics of
Continental’s resolution most relevant to TBTF were not unique to Continental. The FDIC
had assisted a large bank before: only four years earlier, it had provided assistance in the
form of a $325 million loan to First Pennsylvania, a $9 billion institution. Nor was the controversial guarantee that all depositors would be protected a novelty: the FDIC had made
the same promise in the case of Greenwich Savings Bank in 1982.61 Except for the FDIC’s
57
58
59

60

61

U.S. House, Inquiry, 435–36, 444–45, 471–73.
Greider, Secrets, 626–27, 632–33.
For FDIC memos on FDI Act §13(c)(2) assistance under the essentiality provision, see U.S. House, Inquiry, 522–25. Stanley C. Silverberg notes that another factor militated against a deposit payoff in the case of Continental: that “the FDIC did
not have the system and capability to pay off Continental’s depositors in a reasonable time period and without looking incompetent.” See volume 2 of this study.
While noting that he would have preferred it to be otherwise, Conover admitted there was then no mechanism for treating
large and small banks “in a consistent way that is fair to them,” and he essentially agreed that the regulators could not allow any of the money-center banks to be liquidated in a payoff as they might allow smaller institutions to be (U.S. House,
Inquiry, 299–300).
See Chapter 6.

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involvement as primary shareholder in the resurrected bank, the steps taken in the Continental assistance package were not really unprecedented.

TBTF after Continental
Despite reservations on the part of both regulators and industry about whether TBTF
should be used, it remained in place into the 1990s, when its most famous exemplar was the
resolution of three banking subsidiaries of the Bank of New England Corporation (BNEC),
with total assets (at the time of failure) of $21.9 billion, in January 1991.62 Although questions about unfairness and depositor discipline remained, the increasingly parlous state of
the Bank Insurance Fund and the attendant increases in deposit insurance premiums made
the issue more urgent, and attempts to restrict the policy formed an important part of the debate over FDICIA. Some members of Congress wanted to prohibit the government from
protecting uninsured depositors altogether, but most regulators as well as many legislators,
though wanting to limit the application of TBTF, favored retaining regulatory flexibility to
deal with the relatively rare problem of systemic risk. 63 All depositors in some large banks
would need to be protected, Federal Reserve Board Chairman Alan Greenspan noted, “in
the interests of macroeconomic stability,” but there would “also be circumstances in which
large banks fail with losses to uninsured depositors but without undue disruption to financial markets.”64
FDICIA as enacted essentially took this road, attempting to place limits on regulatory
activities associated with TBTF but still leaving regulators the ability to invoke it under certain circumstances.65 FDIC resolutions were now required to proceed according to a “leastcost” test, which would mean that uninsured depositors would often have to bear losses.
The FDIC was prohibited from protecting any uninsured deposits or nondeposit bank debts
in cases in which such action would increase losses to the insurance fund. One important
effect of the least-cost provision was that the FDIC would not be able to grant open-bank
assistance unless that course would be less costly than a closed-bank resolution; thus FDICIA limited the discretion the agency had exercised under the old cost test and essentiality
provisions of the FDI Act. These changes have had a significant effect on the protection of
62

63
64
65

TBTF, specifically defined as the invocation of the essentiality clause with regard to an institution, was actually used only
three times between the resolutions of Continental and BNEC. The other cases were First National Bank and Trust Company of Oklahoma City ($1.6 billion in assets) in 1986, First Republicbank of Dallas ($32.2 billion in assets) in 1988, and
MCorp of Houston ($15.7 billion) in 1989 (assets are as of time of failure). See U.S. House, Economic Implications, 83.
For a discussion of BNEC, see Chapter 10.
See BNA’s Banking Report, 56, no. 18 (May 6, 1991): 853ff., and no. 19 (May 13, 1991): 910ff. See also statements by
L. William Seidman, Robert Clarke, and John LaWare, U.S. House, Economic Implications.
Congressional Quarterly (May 11, 1991): 1174.
For a discussion of the post-FDICIA period, see Larry D. Wall, “Too-big-to-fail after FDICIA,” Federal Reserve Bank of
Atlanta Economic Review 78, no. 1 (January/February 1993): 1–14.

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uninsured depositors. From 1986 through 1991, 19 percent of bank failure and assistance
transactions resulted in the nonprotection of uninsured depositors. From 1992 through
1994, the figure rose to 62 percent. On the basis of total assets, the average percentage of
uninsured depositors suffering a loss was 12.3 percent from 1986 through 1991, but from
1992 through 1994 it increased to 65 percent.66
The law made an exception to the least-cost requirement in cases of systemic risk, but
provided for a specific decision-making process to increase governmental accountability
and limit the application of the exception. At least two-thirds of both the FDIC Board of
Directors and the Board of Governors of the Federal Reserve must recommend that an exception be made, and this recommendation must then be acted upon by the secretary of the
treasury in consultation with the president.67 The General Accounting Office then reviews
any such actions taken and reports its findings to Congress. In addition, FDICIA establishes a relationship between a bank’s capitalization and the Federal Reserve’s ability to
provide assistance through the discount window: for critically undercapitalized banks, the
Federal Reserve has to demand repayment within no more than five days, and if that limit
is violated the Federal Reserve is liable for increased costs to the FDIC. As one economist
who has recently examined FDICIA notes, the law clearly moves toward the elimination of
TBTF as an operating principle and it gives the accountable agencies political incentives to
avoid resorting to the systemic-risk exception. He concludes by observing that “although
FDICIA does not ban the too-big-to-fail doctrine, it has substantially reduced the likelihood
of future large bank bailouts.”68

Conclusion
The crisis at Continental Illinois highlighted concerns about both large-bank supervision and large-bank failure and resolution. Given the regulators’ anxiety about Continental’s correspondent banks and their worries about overall systemic risk, it was very unlikely
they would have pursued a course different from the one taken in 1984. Regulatory options
were further limited by Continental’s peculiar characteristics: although very large, it had
proportionately few core deposits, no retail branches, and little franchise value. The Continental assistance package brought debate over TBTF to the fore, and although regulators
would have preferred otherwise (a preference that did not mean regulators had a solution to
66
67

68

FDIC, Failed Bank Cost Analysis (1996), 10–11.
If the systemic-risk exception is invoked, the FDIC must “expeditiously” recover the loss to the appropriate insurance fund
through one or more special assessments on the members of the insurance fund of which the relevant institution is a member. (The assessment is to be equal to the product of an assessment rate established by the FDIC and “the amount of each
member’s average total assets during the semiannual period, minus the sum of the amount of the member’s average total
tangible equity and the amount of the member’s average total subordinated debt.”) See Public Law 102-242, §141(a).
Wall, “Too-big-to-fail after FDICIA,” 11.

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put in its place), TBTF essentially remained in place until addressed by law in 1991.69 Nevertheless, after Continental there were some significant changes as the banking agencies acquired greater experience with large-bank failures. For example, regulators were given
more flexibility, which allowed them to deal with large-bank failures more efficiently. The
most important addition to the regulatory arsenal was the bridge-bank authority granted by
Congress in 1987.70 Moreover, without addressing TBTF directly, by the late 1980s regulators were no longer, in L. William Seidman’s words, “ as solicitous of the interests of the
bank’s owners and bondholders” as they had been in the case of Continental. This changed
policy had partly evolved by the time of the First City Bancorporation assistance in 1988,
and was clearly evident in the case of First Republic, also in 1988, when FDIC money was
channeled directly into the banking subsidiaries and not into the holding company.71 By the
early 1990s, many of the issues surrounding TBTF had been addressed under FDICIA, but
the problem of systemic risk remains, as does the question of how regulators would respond
today to a dilemma similar to the one they confronted in May 1984.

69

70
71

One effort to try to get beyond TBTF was described by Seidman, who noted that E. Gerald Corrigan, president of the Federal Reserve Bank of New York, proposed that regulators use a policy of “constructive ambiguity” to prevent any institution or its depositors from being certain they would be protected under TBTF. Seidman stated that although regulators
agreed to follow such a course, “the markets knew that the largest institutions would always be known as too big to fail”
(Seidman, Full Faith and Credit, 150).
See the section on CEBA in Chapter 2.
Seidman, Full Faith and Credit, 143–54.

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Appendix
Table 7-A.1

Continental Illinois National Bank and Trust:
Consolidated Statement of Condition, 1977–1983
($Millions)

1977

1978

1979

1980

1981

1982

1983

$ 3906

$ 738

$ 3883

$ 4016

$ 4992

$ 1819

$ 3483

2759

2635

2896

2817

2482

3009

2175

14462

17489

21871

25725

31071

32185

30103

Commercial Loans

5618

7120

9339

10980

14272

16183

14350

Real Estate Loans

555

869

1645

1926

2584

3092

3284
6640

ASSETS
Interest-Bearing Deposits
Securities
Loans and Leases
Selected Loan Categories

3672

4376

5502

7310

8337

7287

LESS: Reserve for Loan Losses

Foreign Office Loans

154

173

191

225

265

364

368

Fed Funds and Reverse Repos

183

362

308

416

494

434

665

21157

24050

28769

32749

38774

37083

36059

Total Earning Assets
Cash and Due from Banks

2740

3904

3337

4359

2512

2189

2559

Other Assets

1078

1984

2188

3179

3860

2028

2052

Total Assets

24975

29938

34294

40287

45156

41300

40670

LIABILITIES
Core Deposits

5581

6009

6254

6242

5822

6404

6595

Large Time Deposits

4525

6117

6260

7371

9174

6234

6836

Foreign Office Deposits

8337

8767

11222

13497

14884

15741

16442

Fed Funds and Repos

4403

5152

5914

7257

7886

5893

4811

256

1151

1247

1475

1917

3340

2041

Other Borrowings
Other Liabilities

772

1516

1997

3901

3685

1652

1905

Total Liabilities

23874

28712

32934

38743

43370

39521

38839

Total Equity Capital
Total Liabilities and Capital
Average Total Assets

1102

1226

1360

1544

1776

1779

1831

24975

29938

34294

40287

45146

41300

40670

$22892

$26359

$32035

$37846

$42320

$44084

$39020

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Table 7-A.2

Continental Illinois National Bank and Trust:
Consolidated Statement of Income, 1977–1983
($Millions)

1977

1978

1979

1980

1981

1982

1983

$ 217

$ 293

$ 430

$ 615

$ 722

$ 487

$ 209

162

165

199

253

253

223

183

1012

1469

2346

3315

4661

4585

3404

INTEREST INCOME
Interest on Deposits
Securities Income
Interest and Fees on Loans and Leases
Interest on Fed Funds and Reverse Repos
Total Interest Income

12

39

62

66

81

46

28

1402

1967

3036

4248

5716

5342

3825

INTEREST EXPENSE
Interest on Large Time Deposits

183

335

495

692

1138

880

324

Interest on Other Deposits (incl. Foreign)

495

703

1233

1668

2178

2323

1932

Interest on Fed Funds and Repos

255

398

676

1041

1390

1054

508

17

28

72

132

224

229

234

Total Interest Expense

951

1465

2475

3532

4929

4485

2998

NET INTEREST INCOME

451

502

561

716

787

856

827

Interest on Other Borrowings

OPERATING INCOME
Non-Interest Income

115

149

188

234

284

306

359

Overhead Expense

310

374

451

539

605

648

691

52

57

65

91

114

477

359

205

221

233

320

352

38

137

Provision for Loan Losses
Pre-Tax Operating Income
Income Taxes (Credit)
NET OPERATING INCOME
Securities Gains (Losses)
NET INCOME
Dividends Upstreamed

256

64

62

51

101

116

(34)

34

141

159

182

218

236

72

103

(2)

(1)

2

1

(5)

(2)

1

139

158

184

219

231

70

104

50

34

50

30

0

62

50

History of the Eighties—Lessons for the Future

Chapter 7

Continental Illinois and “Too Big to Fail”

Table 7-A.3.

Continental Illinois National Bank and Trust:
Financial Ratios, 1977–1983
1977

1978

1979

1980

1981

1982

1983

15.64
11.05
57.91

12.49
8.80
58.42

11.32
8.44
63.78

9.97
6.99
63.85

11.06
5.50
68.81

4.40
7.29
77.93

8.56
5.35
74.02

22.49
2.22
14.70
0.62
0.73

23.78
2.90
14.62
0.58
1.21

27.23
4.80
16.04
0.56
0.90

27.25
4.78
18.14
0.56
1.03

31.61
5.72
18.46
0.59
1.09

39.18
7.49
17.64
0.88
1.05

35.28
8.07
16.33
0.90
1.64

22.35
18.12
33.38
17.63
1.03
3.09
95.59
4.41

20.07
20.43
29.28
17.21
3.84
5.06
95.90
4.10

18.24
18.25
32.72
17.24
3.64
5.82
96.03
3.97

15.49
18.30
33.50
18.01
3.66
9.68
96.17
3.83

12.89
20.32
32.96
17.46
4.25
8.16
96.04
3.93

15.51
15.09
38.11
14.27
8.09
4.00
95.69
4.31

16.22
16.81
40.43
11.83
5.02
4.68
95.50
4.50

0.95
0.71
4.42
0.05
6.12

1.11
0.63
5.57
0.15
7.46

1.34
0.62
7.32
0.19
9.48

1.63
0.67
8.76
0.17
11.22

1.71
0.60
11.01
0.19
13.51

1.10
0.51
10.40
0.10
12.12

0.54
0.47
8.72
0.07
9.80

0.80
2.16
1.11
0.07
4.15

1.27
2.67
1.51
0.11
5.56

1.55
3.85
2.11
0.22
7.73

1.83
4.41
2.75
0.35
9.33

2.69
5.15
3.28
0.53
11.65

2.00
5.27
2.39
0.52
10.17

0.83
4.95
1.30
0.60
7.68

NET INTEREST INCOME (NIM)

1.97

1.90

1.75

1.89

1.86

1.94

2.12

OPERATING INCOME
Non-Interest Income
Overhead Expense
Provision for Loan Losses
Pre-Tax Operating Income

0.50
1.35
0.23
0.90

0.57
1.42
0.22
0.84

0.59
1.41
0.20
0.73

0.62
1.42
0.24
0.85

0.67
1.43
0.27
0.83

0.69
1.47
1.08
0.09

0.92
1.77
0.92
0.35

Income Taxes (Credit)
NET OPERATING INCOME

0.28
0.62

0.24
0.60

0.16
0.57

0.27
0.58

0.27
0.56

-0.08
0.16

0.09
0.26

0.61
12.61

0.60
12.89

0.57
13.53

0.58
14.18

0.55
13.01

0.16
3.93

0.27
5.68

Ratio to Total Assets of:
ASSETS
Interest-Bearing Deposits
Securities
Loans and Leases
Selected Loan Categories
Commercial Loans
Real Estate Loans
Foreign Office Loans
LESS: Reserve for Loan Losses
Fed Funds and Reverse Repos
LIABILITIES
Core Deposits
Large Time Deposits
Foreign Office Deposits
Fed Funds and Repos
Other Borrowings
Other Liabilities
Total Liabilities
Total Equity Capital
Ratio to Total Average Assets of:
INTEREST INCOME
Interest on Deposits
Securities Income
Interest and Fees on Loans and Leases
Interest on Fed Funds and Reverse Repos
Total Interest Income
INTEREST EXPENSE
Interest on Large Time Deposits
Interest on Other Deposits (incl. Foreign)
Interest on Fed Funds and Repos
Interest on Other Borrowings
Total Interest Expense

Return on Assets (ROA)
Return on Equity (ROE)

History of the Eighties—Lessons for the Future

257

Chapter 8

Banking and the
Agricultural Problems
of the 1980s
Introduction
Agricultural markets severely deteriorated in the 1980s, with attendant effects on agricultural banks. The roots of the deterioration lay in the events of the previous decade. In the
early 1970s the demand for farm commodities significantly increased; the increased demand caused farm prices to grow at a much faster rate than expenses; and farm income
therefore began rising rapidly. By 1973, real farm income had reached a record high of
$92.1 billion, nearly double the $48.4 billion of three years earlier.1 The combination of rising farm income and high inflation caused the value of farmland to escalate, while at the
same time a ready availability of credit caused farm debt to rise sharply. In the late 1970s,
however, the boom period came to an end: interest rates soared after the Federal Reserve
Board tightened monetary policy to fight inflation, and changing conditions in worldwide
supply and demand caused export demand for farm commodities to decrease sharply. Real
farm income fell to $22.8 billion in 1980 and to $8.2 billion in 1983; and in 1981 prices for
farmland began a dramatic contraction.2
The financial performance of banks with a large proportion of farm loans generally
coincides with the performance of the farm economy. Loan demand usually increases as
farm income grows; and the volume of nonperforming loans and loan losses expands when
the farm sector is in a downturn. The correlation between the farm economy and banks in
the agricultural sector continued to hold true during the 1980s. Events in the farm economy
were reflected in farm bank failures in 1981 and 1985: in 1981 only 1 agricultural bank was

1
2

Kevin L. Kliesen and R. Alton Gilbert, “Are Some Agricultural Banks Too Agricultural?” Federal Reserve Bank of St. Louis
Review 78, no. 1 (January/February 1996): 26.
Ibid.

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

among the nation’s 10 bank failures, but in 1985, 62 agricultural banks failed, accounting
for over half of the nation’s bank failures that year.3
In this chapter we examine, first, the farm economy of the 1970s and 1980s: the history and causes of the agricultural boom-and-bust cycle of those two decades, and the degree to which forecasts accurately predicted the problems that arose. Next we survey the
various nonbank sources of farm credit, and then we examine the effect the downturn in the
farm economy had on the banking system—more particularly, on institutions with sizable
holdings of farm loans. Finally, we analyze financial data for agricultural banks and compare them with data for small non-agricultural banks.

The Agricultural Cycle in the 1970s and 1980s
Agriculture is by nature a cyclical industry. The cycle in its most simplistic form
traces the following course: when crops are plentiful, prices drop, so plantings are reduced
the next year. The attendant reduction in supply then generally causes prices to rise. The
higher prices lead to increased plantings and excessive production; prices decline; and the
cycle repeats itself. Obviously, external forces may affect this pattern. For example, studies
conducted by Louis M. Thompson, emeritus associate dean of agriculture at Iowa State
University, suggest that there is a global weather pattern which, in his opinion, drives the
economic cycle in agriculture.4 Or some event may alter the economic outlook, providing
new opportunities for profits. When that happens, the opportunities may be seized and
sometimes are overdone to such an extent that the usual agricultural cycle is transformed
into a cycle of speculative excess followed by a reaction of crisis and panic. (Such speculative cycles have been common historical occurrences.)5 In the speculative, or manic, phase,
characteristically individuals with wealth or credit employ available funds to purchase financial assets. The unsustainable prices may persist for years, but eventually they reverse
themselves.6 Few of the participants in such speculative bubbles are able to anticipate reversals perfectly and therefore cannot avoid substantial losses when the bubble bursts.
Agriculture went through such a period of speculative excess in the 1970s and then
encountered significant problems—the reversal—in the 1980s. This boom/bust cycle was
vastly different from the usual agricultural ups and downs. Indeed, the dynamic was far
more reminiscent of a speculative bubble than a “normal” agricultural cycle.

3
4
5
6

An agricultural bank is defined as a bank in which farm loans make up 25 percent or more of total loans.
See Louis M. Thompson, “The Boom and Bust Cycle in the Agricultural Economy,” Journal of Agricultural Lending 2, no.
2 (summer 1988): 20–21.
Charles P. Kindleberger, Manias, Panics, and Crashes (1978), 4.
Burton G. Malkiel, A Random Walk down Wall Street (1981), 32.

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History of the Eighties—Lessons for the Future

Chapter 8

Banking and the Agricultural Problems of the 1980s

The boom in the 1970s was stimulated essentially by a substantial rise in crop prices
during the first half of the decade (see figure 8.1). An important component of the boom—
one that would have a significant effect on the problems of the 1980s—was the escalating
value of farm real estate. There were several factors that combined to bring about the increased demand for and rising price of farmland, including inflation, rising farm income
(partly caused by farm enlargement), the export market, and credit availability.7
The high inflation of the 1970s meant that real capital gains on farm real estate (excluding operators’ dwellings) dwarfed those of preceding decades (the total real capital gain
on farm real estate for 1972 through 1979 was $447 billion in 1983 dollars—an annual average of $56 billion).8 This new wealth led many farmers to purchase additional acreage.
Furthermore, the sharp rise in farmland prices helped create a speculative frenzy and
brought many outside investors into the farm real estate market as well. Neil Harl, an Iowa
State University economist, noted the volume of investments being made in farmland and
Figure 8.1

Index of Prices Received by Farmers for All Crops,
1970–1989

Dollars
160

120

80

40

0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988

Source: Index compiled by National Agriculture Statistics Service,
U.S. Department of Agriculture.
Note: 1977=100

7
8

C. Stassen Thompson, “The Effects of the 1970s Farmland Market on Today’s Agriculture Crisis,” The Appraisal Journal
(January 1988): 18.
Emanuel Melichar, “A Financial Perspective on Agriculture,” Federal Reserve Bulletin 70, no. 1 (January 1984): 5.

History of the Eighties—Lessons for the Future

261

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

commented at the time that “anytime you see an asset growing in value about 25% a year
for several years, everybody wants in on the action.”9
The demand for farmland in the 1970s also increased because of rising farm income.
Net farm income in the 1970s was volatile but, for the decade as a whole, was approximately twice the income of the 1960s. Nominal income (which does not reflect the effect of
inflation) per farm jumped from $4,900 in 1970 to $12,200 in 1973, then declined to $7,800
by 1977, before rising to $13,300 in 1979.10 This increase in farm income boosted returns
on investments in farm real estate so that farmland became an even more attractive investment, and the demand for it grew greater still.
An important contributor to the rise in farm incomes, and therefore to the escalating
demand for farmland, was the availability of improved technologies that made possible a
more efficient use of farm labor. This prompted farmers to make substantial purchases of
farmland in order to spread fixed costs and to reach sufficient size so they could employ the
new technology. Many farmers’ attitudes about expensive machinery reinforced the demand for farmland as a means toward enlarging their farms.11
Increased demand for farmland was also fueled by a sharp rise in farm exports in the
1970s, an important component of the decade’s agricultural prosperity. In 1970, exports of
agricultural products were $6.7 billion (approximately 11 percent of U.S. farm production);
nine years later they had risen to $31.9 billion (nearly 22 percent of U.S. production). 12 This
jump in exports was stimulated by increased worldwide global liquidity, rising incomes,
and several crop shortfalls in other parts of the world.13 Another reason foreign demand expanded was that the cost of U.S. crops declined as a result of a depreciating dollar and reduced U.S. price-support levels.14 In 1980, the export market for U.S. farm commodities
looked so promising that Secretary of Agriculture Robert Bergland declared, “The era of
chronic overproduction . . . is over.”15
Finally, the availability of almost unlimited amounts of credit played an important role
in expanding the farmland market of the 1970s. Commenting on the heady economic out9
10
11
12
13
14
15

“Land Boom in the Farm Belt,” Forbes (April 15, 1977), available: LEXIS, Library: NEWS, File: FORBES.
C. S. Thompson, “Effects of Farmland Market,” 19.
Porter Martin, who assembled limited partnerships for farm investors, explained that machinery was a “status symbol” and
noted, “These guys own too much of it and they’re eager to spread the cost” (cited in “Land Boom”).
C. S. Thompson, “Effects of Farmland Market,” 19. The statistics in this article were derived from the U.S. Department of
Agriculture, Agriculture Statistics (1983), 517.
Kenneth L. Peoples, David Freshwater, Gregory D. Hanson, Paul T. Prentice, and Eric P. Thor, Anatomy of an American
Agricultural Credit Crisis (1992), 14.
John Rosine and Paul Balides, “Perspectives on the Food and Agricultural Situation,” Federal Reserve Bulletin 68, no. 1
(January 1982): 4–5.
Gregg Easterbrook, “Making Sense of Agriculture: A Revisionist Look at Farm Policy,” The Atlantic 256 (July 1985),
available: LEXIS, Library: NEWS, File: ASAPII.

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History of the Eighties—Lessons for the Future

Chapter 8

Banking and the Agricultural Problems of the 1980s

look of the period, Michael E. Fitch, vice president of Wells Fargo’s Agribusiness Affairs
Division, noted that everyone “concluded that never again were we going to experience depressed farm prices; that our biggest challenge was to gear up our productive capacity. As a
result, there were tremendous resources placed in agriculture, one of which was credit.”16 It
is not surprising that this environment led farmers as well as lenders to change their attitudes toward credit-financed farmland purchases.17
The expansion of credit was greatly facilitated by the fact that many agricultural
bankers continued basing their farm loans on collateral value rather than on cash-flow
analysis. As a result, farmers were able to use leverage as a means to benefit from the increasing value of farmland. They would purchase farm real estate with modest down payments and, after the value of this newly purchased land increased, would use the equity to
buy additional farmland with minimal down payments. A telling example of the easy access
to credit during this period is the story of Benjamin R. Riensche. When he graduated from
high school in the late 1970s, land prices around Jesup, Iowa, were climbing so fast that it
was possible for him—a teenager—to borrow a considerable amount of money from a
bank. He purchased 80 acres of farmland for $228,000.18
Farmers’ ability to obtain loans easily in order to purchase farm real estate made it
possible for farm debt to rise in tandem with soaring real estate values, even though farm
income levels were frequently insufficient to support the higher debt burdens. Between
1970 and 1979 farm real estate debt rose from $29 billion to $71 billion.19 This increase in
debt may not appear excessive when compared with the rise in farm values, but if the income generated from the additional acreage purchased should prove insufficient to meet the
higher debt-service payments, financial difficulties could ensue. Moreover, the substantial
increase in farm real estate debt was a major factor in the rise of total liabilities of farm businesses, from $52 billion in 1970 to $162 billion in 1979.20
Higher levels of real estate debt were supplemented by debt incurred to finance machinery and equipment to maintain the larger farms. But not all the machinery acquired was
economically justified. Such purchases might have contributed to the later financial problems of some farmers.
16
17
18

19
20

“In Search of a Solution to the Farm Crisis,” ABA Banking Journal (April 1985), available: LEXIS, Library: BANKING,
File: ABABJ.
C. S. Thompson, “Effects of Farmland Market,” 20.
Scott Kilman, “High Grain Price Lifts Farmers, But Will They Overexpand As Before?” The Wall Street Journal (March
21, 1996), A1, A8. Another insight into the ready availability of credit comes from Pat Meade, a farmer from Milo, Iowa,
who recalled that “during the 1970s there were times when lenders quite literally drove up and down the road, knocked on
people’s doors, and asked them if they could use more credit.” See Easterbrook, “Making Sense of Agriculture.”
C. S. Thompson, “Effects of Farmland Market,” 18.
Data supplied by Haver Analytics; from the Flow of Funds Accounts of the United States.

History of the Eighties—Lessons for the Future

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Volume I

The optimism of the 1970s came to an end late in the decade because of changes in
domestic economic policies and in the worldwide supply and demand conditions for agricultural commodities.
In the fall of 1979, the Federal Reserve Board tightened its monetary policy to fight
inflation. As a result, interest rates soared—the prime rate averaged 15.3 percent in 1980.
The high interest rates contributed immensely to the decline in farmland values and to the
overall reversal of conditions in the agricultural sector. The elevated interest rates significantly increased farm operating costs, such as the interest cost of money borrowed to cover
planting expenses. This led to reduced net-income expectations and, in some cases, to cashflow problems. Moreover, high interest rates automatically deflated the price of productive
assets—such as farmland—by reducing the capitalized value of the land’s earning
capacity.21
When the high interest rates helped send the farm sector on a downward spiral in the
early 1980s, many farmers found themselves unable to service their debts. Although many
lenders tried to accommodate the farmers, the problems were often insuperable. Oliver
Hansen, president of an Iowa bank, noted, “We are working with customers if at all possible. But for any farmer who has become overextended, I am sure it is going to be hell.”22
Farmers whose loans contained variable-interest-rate clauses found the soaring interest
rates of the early 1980s particularly onerous. One Iowa farmer who had been forced to declare bankruptcy complained, “They said I had nothing to worry about—that rates had varied only a fraction of a point since 1970. My rate went from 7 percent to 18.5 percent.” 23
The blow dealt by changes in the worldwide supply and demand for agricultural commodities—causing foreign demand for domestic agricultural products to decline at a time
of expanded domestic production—did serious damage as well. For example, the volume of
U.S. exports of agricultural products increased at an annual rate of 5.9 percent between
1973 and 1980 and peaked at $44 billion in 1981, but by 1986 it had dropped to only $26
billion. Over the same period, agriculture’s share of total U.S. exports fell from 19 percent
to 13 percent.24 Fred W. Greer, Jr., chairman of the Agricultural Bankers Division of the
American Bankers Association (ABA), noted in 1984 that “farming is not an isolated sec-

21
22
23
24

Peoples et al., Anatomy, 33.
“A Credit Drought Hits the Farmers,” Business Week (December 20,1982), available: LEXIS, Library: NEWS, File:
BUSWK.
Easterbrook, “Making Sense of Agriculture.”
Dallas S. Batten and Michael T. Belongia, “The Recent Decline in Agricultural Exports: Is the Exchange Rate the Culprit?”
Federal Reserve Bank of St. Louis Review 66, no. 8 (October 1984): 5; and Gerald H. Anderson, “The Decline in U.S. Agricultural Exports,” Federal Reserve Bank of Cleveland Economic Commentary (February 15, 1987): 1.

264

History of the Eighties—Lessons for the Future

Chapter 8

Banking and the Agricultural Problems of the 1980s

tor of the economy and we are not an isolated country. We have competition from around
the world that we didn’t have a few years ago.”25
Export demand was dampened by unfavorable monetary exchange rates and by the
less-developed-country (LDC) debt crisis (see Chapter 5). High domestic interest rates
caused a significant strengthening of the dollar. From the third quarter of 1980 to the first
quarter of 1985, the Federal Reserve Board’s trade-weighted average index for the dollar
rose by 83 percent.26 This rapid appreciation in the value of the dollar made U.S. exports
more expensive in foreign currencies, not only reducing foreign demand but also encouraging foreign supply.27 In addition, many developing countries that had previously been
major importers of American farm products had debt problems, which led them to restrict
agricultural imports in order to conserve foreign exchange. Banks in those countries reduced credit to finance agricultural imports. Moreover, creditor banks or the International
Monetary Fund required austerity programs as a condition for restructuring existing loans.
The decline in foreign demand caused by both the unfavorable exchange rates and the LDC
debt crisis led in turn to an accumulation of huge surpluses of farm commodities in the early
1980s.28

25
26
27

28

Nancy Buckwalter, “Agricultural Banking Crisis; Bankers Struggling with Workouts to Help Farm Customers Survive,”
United States Banker (September 1984): national edition, available: LEXIS, Library: BUSFIN, File: BIS.
Anderson, “Decline in Exports,” 4.
Dallas S. Batten and Michael T. Belongia, “The Recent Decline in Agricultural Exports: Is the Exchange Rate the Culprit?”
Federal Reserve Bank of St. Louis Review 66, no. 8 (October 1984): 5. The authors conclude that foreign income, not exchange rates, is the primary determinant of agricultural exports. However, Barbara Chattin and John E. Lee, Jr., attributed
at least half of the export decline in 1982 and 1983 to the appreciation of the U.S. dollar (“United States Agricultural Policy in a ‘Managed Trade’ World,” United States Farm Policy in a World Dimension, special report 305, Agricultural Experiment Station, University of Missouri–Columbia [November 1983], 18–27). According to Batten and Belongia, causal
relationships between exchange rates and agricultural exports were reported by Robert G. Chambers and Richard E. Just,
“An Investigation of the Effect of Monetary Factors on Agriculture,” Journal of Monetary Economics (March 1982):
235–47; Luther Tweeten, “Economic and Policy Outlook for U.S. Agriculture,” United States Farm Policy in a World Dimension, special report 305, Agricultural Experiment Station, University of Missouri–Columbia (November 1983), 13–17;
Dale E. Hathaway, “Agricultural Trade: 1984 and Beyond,” United States Farm Policy in a World Dimension; special report 305, Agricultural Experiment Station, University of Missouri–Columbia (November 1983); and G. Edward Schuh,
“Future Directions for Food and Agricultural Trade Policy,” American Journal of Agricultural Economics (May 1984):
242–48.
In an effort to deal with the problem of overproduction, the Reagan administration introduced its “Payment in Kind” (PIK)
program in 1983. Under this program, farmers who agreed to reduce plantings were compensated with surplus commodities from federal stockpiles of the same type they typically planted. The PIK program was especially attractive to cotton
and grain (wheat, corn, sorghum, and rice) farmers, who took 82 million acres, more than a third of their total productive
acreage, out of production. The program succeeded in helping to reduce the huge surplus of federally owned farm commodities. Commenting on the PIK program, Alan Tubbs, vice chairman of the ABA’s Agricultural Bankers Division and
president of First Central Bank in DeWitt, Iowa, said, “It bought a year for those who took part in it. It helped the farmers
who were able to benefit from it to hold their own, and it held up the price of grain for everybody” (Buckwalter, “Agricultural Banking Crisis”).

History of the Eighties—Lessons for the Future

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In 1981, as inflation declined and the problems of the agricultural sector increased,
farmland prices began sliding downward. Farmland values for the United States and Iowa
between 1970 and 1990 demonstrate both the boom-and-bust cycle and the dramatic
changes that occurred within some states (see figure 8.2). In the nation as a whole, the value
of farmland per acre rose 355 percent between 1970 and its peak in 1982 (from $157 to
$715) but then declined 34 percent from 1982 to 1987 (down to $471). In Iowa, farmland
value per acre soared from $319 in 1970 to $1,694 in 1982, an increase of 431 percent, but
then dropped 62 percent by 1987 (down to $652).
The boom in farmland values had been supported by an explosive growth in farm
debt. That growth and the subsequent contraction are illustrated by the annual data for nonmortgage bank loans and total liabilities for farm businesses from 1970 through 1990. From
1970 through 1984, nonmortgage bank loans increased from $11.2 billion to $39.9 billion,
a rise of 256 percent, but then in 1987 they declined to $29.1 billion, a drop of 27 percent.
Similarly, from 1970 through 1983, total liabilities of farm businesses rose from $52.3 billion to $207.0 billion, a 296 percent increase, and then in 1988 fell to $145.5 billion, a decline of 30 percent (see figure 8.3). A large portion of the decline in farm debt that began in
the mid-1980s was due to the rapid liquidation and restructuring of troubled loans. An additional source of debt reduction, however, was the behavior of those farmers who were in
sound financial condition: when returns on liquid assets fell below the interest rates being
Figure 8.2

Farmland Value per Acre, U.S. and Iowa,
1970–1990
$Hundreds
18
15
12

Iowa

9
6
3
0

US

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990

Source: Economic Research Service, U.S. Department of Agriculture.

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History of the Eighties—Lessons for the Future

Chapter 8

Banking and the Agricultural Problems of the 1980s

Figure 8.3

$Billions
250
200

Farm Debt, 1970–1990
Total Liabilities,
Farm Businesses

150
100

Nonmortgage
Bank Loans

50
0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990

Source: Haver Analytics.

paid on farm debt, many prosperous farmers chose to use their available cash to reduce or
eliminate their debt. Repayment of farm debt might also be attributed to a change in attitude
among farmers. Leslie W. Peterson, president of Minnesota’s Farmers State Bank of Trimont, observed in 1985 that many farmers “now realize that debt is nothing but a noose
around their neck.”29
Assessing the decision-making processes of the 1970s and early 1980s requires evaluating the correlation between the escalating farmland values and the profitability of agriculture. For both the United States and Iowa farmland value per acre increased every year
from 1970 through 1981, but gross income per acre actually experienced several year-toyear decreases. For example, gross income per acre for corn and soybeans generally declined during 1973–75, 1976–77, and 1980–81 (see table 8.1). Thus, farmland values and
investment returns were decoupled. More particularly, from 1970 through 1973 both land
values and returns on investment increased, but in 1974–75, while land values continued to
rise, returns declined—though they still compared favorably with those of 1970–71. Beginning in 1976, however, returns fell significantly below those of the early 1970s, even as
farmland values continued to increase dramatically.
29

John N. Frank et al., “The Farm Rut Gets Deeper,” Business Week (June 17, 1985), available: LEXIS, Library: NEWS, File:
BUSWK.

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Table 8.1

Gross Income per Acre and Return on Farmland Investment,
U.S. and Iowa, 1970–1990

Year
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

U.S.
Corn
Soybeans
Gross
% Return
Gross
% Return
Income
on
Income
on
per Acre
Investment
per Acre
Investment
$ 96
95
152
233
217
219
189
183
227
272
284
269
289
260
281
263
179
232
215
274
270

61
57
84
115
85
76
56
45
50
51
45
38
40
38
41
44
35
49
44
53
50

$ 76
83
121
158
157
142
178
180
196
202
201
183
180
205
164
172
159
199
200
184
196

48
50
67
78
62
49
53
45
43
38
32
26
25
30
24
29
31
42
41
35
36

Iowa
Corn
Soybeans
Gross
% Return
Gross
% Return
Income
on
Income
on
per Acre
Investment
per Acre
Investment
$108
106
191
276
238
225
187
171
250
311
330
293
323
271
281
255
190
246
206
270
278

34
32
55
70
46
36
23
15
21
23
20
16
19
18
21
27
26
38
26
30
30

$ 92
100
171
192
178
173
219
210
249
231
286
238
214
272
179
190
196
260
227
219
234

29
31
50
49
35
28
27
19
21
17
17
13
13
18
13
20
27
40
29
24
25

Source: Raw data are from U.S. Department of Agriculture.
Note: Gross income per acre is yield per acre in bushels multiplied by average price per bushel during the year. Return on
investment is gross income per acre divided by the farmland value per acre for each year.

When U.S. farmland values reached their zenith in 1982, returns on investment for
corn and soybeans were less than two-thirds of their 1970 level and only approximately
one-third of what they had been in 1973. Similarly, when Iowa farmland values peaked in
1981, investment returns for corn and soybeans were less than half what they had been in
1970, and only approximately a quarter of their 1973 level (table 8.1).
From 1981 onward, U.S. farmland prices declined. At the same time, returns for corn
showed virtually no improvement, and those for soybeans grew only moderately. Returns
during the period 1983–90 for both crops based on land prices were never close to those of
1970. Moreover, although returns for corn and soybeans in 1990 were 25 and 44 percent
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Banking and the Agricultural Problems of the 1980s

higher than they had been in 1982, they remained less than half of the returns attained in
1973. Iowa’s trends were somewhat different. Here again, farmland prices began declining
in 1981, but returns rose and compared reasonably well with those of 1970; returns in 1990
for corn and soybeans were almost twice those of 1981. Nevertheless, returns continued at
levels half what they had been in 1973, or even less. A significant conclusion can be drawn
from these pre- as well as post-1982 trends: the spectacular increases in farmland prices
from 1976 through the early 1980s could not be justified by high or rising investment returns. The dramatic rise in the value of farmland had been the result of a speculative boom.
Although the review of the agricultural cycle of the 1970s and 1980s has focused on
agriculture nationally, it is important to point out that the effects of this cycle on agricultural
banks and the resulting bank failures were primarily regional in nature (see figure 8.7,
p. 278). Problems for agricultural producers and commercial banks largely occurred in the
Midwest—Iowa, the Dakotas, Nebraska, Kansas, Illinois, Minnesota, Missouri—as well as
in Oklahoma and Texas. The primary reason for this is, of course, that substantial agricultural production took place in the Midwest and the economies in these states were more dependent on agriculture than the economies in most other states. Thus, a large majority of
agricultural banks, and therefore most failures, were located in this region. In 1986 approximately 70 percent of the nation’s agricultural banks were located in the West North Central
census region (North and South Dakota, Minnesota, Nebraska, Iowa, Kansas, and Missouri—the Midwest) and the West South Central region (Oklahoma, Arkansas, Texas, and
Louisiana).30 However, there may be another reason for the midwestern location of agricultural banking problems. The types of crops produced in these states, such as wheat, corn,
and soybeans, were greatly influenced by the export boom of the 1970s. Consequently, the
Midwest experienced unusually large increases in farm real estate prices during this period.
For example, from 1974 through 1978, when the price of an acre of farmland nationally
rose at an average annual rate of 15 percent, in Iowa and Illinois the increase was approximately 22 percent annually.31 In the 1980s, declines in midwestern farmland prices were
similarly dramatic. For example, after peaking in 1981, farmland prices had fallen by 49
percent in Iowa, 46 percent in Nebraska, 42 percent in Illinois, 39 percent in Minnesota, and
38 percent in Missouri.32 The financial difficulties caused by these declines, coupled with
the substantial debt midwestern farmers had incurred for purchases of farmland and machinery to support crop expansion during the export boom, made farmers in the region
30
31
32

Lynn A. Nejezchleb, “Declining Profitability at Small Commercial Banks: A Temporary Development or a Secular Trend?”
FDIC Banking and Economic Review (June 1986): 12.
Linda Snyder Hayes and Kathleen Carroll Smyth, “Investors in Farmland Are on Dangerous Ground,” Fortune (January
29, 1979), available: LEXIS, Library: NEWS, File: FORTUN.
Timothy B. Clark, “Borrowing Trouble,” National Journal 17, no. 36 (September 7, 1985), available: LEXIS, Library:
NEWS, File: NTLJNL.

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much more vulnerable than farmers in other parts of the country to the declines in exports
of wheat, corn, and soybeans, as well as to the higher interest rates of the 1980s.
In summary, agriculture flourished in the 1970s: in the first half of the decade crop
prices soared, farm exports escalated, and real farm incomes reached all-time highs. This
prosperous environment, combined with high levels of inflation, led farm real estate values
to skyrocket. The bubble burst in the early 1980s, after monetary policy was tightened to
fight inflation and, at the same time, foreign demand for domestic agricultural products
plummeted. In 1981, farmland prices began a devastating spiral. Farm debt, which had supported the agricultural expansion and farmland speculation by almost quadrupling from
1970 through 1983, became a painful burden to farmers. However, by 1988, total liabilities
had declined 30 percent.

The Reliability of Forecasts
The kinds of economic information available to bankers as they loaned funds to the
agricultural sector are indicated by contemporary views on the agricultural situation. In this
section we focus on forecasts for the boom years of 1976 and 1978; for the period 1980–82,
when the expansion was winding down; and for 1985—the middle of the contraction phase.
The outlook for agriculture for the first half of 1976 was quite positive.33 Rising gross
income was expected to more than offset higher farm production expenses, so analysts anticipated a sizable increase in net farm income. Farm product exports were expected to set
a record in Fiscal Year 1976, increasing approximately $1 billion from Fiscal Year 1975 to
nearly $23 billion. Unlike the previous year’s rise, this one was projected to come from
larger volume rather than higher prices.
By 1977, however, in contrast to what had been forecast, the farm sector had begun to
experience difficulties. Bernard Johnson, president of the Production Credit Association of
Fargo, North Dakota, noted that “some of our farmers are in a real financial strain. Many
are just hanging on by their boot straps. And some we’ve had to close out. The problem is,
there is no profit at $2.50 for wheat.”34
Forecasts for 1978 were in accord with such experiences: the nation’s farmers were
expected to endure a year of relatively low prices and incomes. 35 Net farm income, which
33

34
35

Forecast is taken from Sada L. Clarke, “Outlook for Agriculture Optimistic,” Federal Reserve Bank of Richmond Economic Review 62, no. 1 (January/February 1976): 19–21, and is based on the U.S. Department of Agriculture’s National
Agricultural Outlook Conference held in November 1975.
“Bountiful Crops—So Why Are Farmers and Bankers Worried?” U.S. News & World Report (June 27, 1977), available:
LEXIS, Library: NEWS, File: USNEWS.
Forecast is taken from Sada L. Clarke, “The Outlook for Agriculture in ’78,” Federal Reserve Bank of Richmond Economic
Review 64, no. 1 (January/February 1978): 7–11, and is based on the U.S. Department of Agriculture’s National Agricultural Outlook Conference held in November 1977.

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had fallen 27 percent during the previous two years, was expected to improve little, if at all,
in 1978. A combination of lower crop prices and moderate increases in farm production expenses was anticipated. In addition, the value of U.S. farm exports was expected to decline
from $24 billion in Fiscal Year 1977 to approximately $22 billion in Fiscal Year 1978.
In contrast to these somewhat pessimistic forecasts, 1978 turned out to be an excellent
year for farmers. Although lower crop prices were anticipated, the index of prices received
by farmers for all crops increased 5 percent from 1977 to 1978. While farm production expenses rose 12 percent from 1977 to 1978, gross income from farming increased by 17 percent during the same period. As a result, net farm income jumped 46 percent from 1977 to
1978. Finally, U.S. farm exports soared from $24 billion in 1977 to $29 billion in 1978,
rather than declining, as had been expected.
Predictions for 1980 (and these were made before the January 1980 embargo on grain
exports to the Soviet Union) foresaw farm income falling sharply from the 1979 level, perhaps by as much as 20 percent, primarily because of surging production costs.36 Agricultural exports were expected to increase by approximately 19 percent, from $32 billion in
1979 to $38 billion in 1980. And the value of farmland was expected to increase by only 5
to 10 percent in 1980, compared with an actual increase of 14 percent the previous year.
These projections proved to be quite accurate: in 1980, net farm income declined by 20 to
25 percent; exports exceeded $40 billion; and farm real estate values increased 7 to 12 percent.
A considerable rebound in net farm income was anticipated for the following year.37
In addition, exports of U.S. farm products were expected to rise as much as 20 percent above
the 1980 record level of more than $40 billion, and farm real estate values were projected to
increase by between 11 and 16 percent. Exports did increase to just under $44 billion and
farm real estate values did rise approximately 11 percent, but farm income failed to keep
pace with the optimistic projections. Indeed, farm income was disappointing for the second
consecutive year, and many farmers developed serious cash-flow problems. By mid-1981,
Marlin Jackson, chairman of the ABA’s Agricultural Bankers Division, confirmed that farm
income had failed to meet expectations, noting, “The uncertainty for farm production combined with ever-increasing production expenses for energy, chemicals, and the cost of loanproduction funds will eat seriously into an increased gross farm income, resulting in another

36

37

Forecast is taken from Sada L. Clarke, “The 1980 Outlook for Agriculture,” Federal Reserve Bank of Richmond Economic
Review 66, no. 1 (January/February 1980): 14–18, and is based on the U.S. Department of Agriculture’s 1980 Agricultural
Outlook Conference held in November 1979.
Forecast is taken from Sada L. Clarke, “The Outlook for Agriculture in ’81,” Federal Reserve Bank of Richmond Economic
Review 67, no. 1 (January/February 1981): 21–26, and is based on the 1981 Agricultural Outlook Conference held in November 1980.

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marginal net-farm-income year.”38 The forecasts and results for 1981 were classic endings
to a boom period. With expenses rising more quickly than gross income, net income was
clearly declining. The market price of overvalued collateral peaked and began a major,
long-term descent. The transition from boom to bust may take a few years, but eventually a
virtual free-fall occurs. On this occasion, the free-fall began in 1981.
Little improvement in net farm income was anticipated for 1982, but exports were expected to increase approximately 4 percent to $45.5 billion, which would have set a record
for the 13th consecutive year.39 As had been expected, farm income was low, and cash-flow
difficulties grew as cash receipts declined while production expenses continued to rise.
What exacerbated the problem, though, was that exports not only failed to increase but actually plunged 11 percent.
By the end of 1984, the farm sector was suffering from a variety of economic and financial problems, so the prospects for 1985 were considered bleak. The adverse trends that
had been plaguing the agricultural sector since the early 1980s—low income, inadequate
cash flow, and declining farmland prices—were expected to continue and possibly deteriorate further in 1985.40 Agricultural net cash income in 1985 was expected to be the lowest
since 1980, and the volume of U.S. exports was expected to continue declining. The future
for the farming sector appeared so hopeless that sociologist Paul Lasley of Iowa State University believed “the current agriculture crisis is likely to change the face of rural America
drastically, leaving it with fewer people, fewer businesses and more dependent on government aid.”41
The projections made for the period 1980 through 1982 had generally been accurate
except in two important respects: a substantial recovery in net farm income had been forecast for 1981 but did not occur, and the export market was expected to increase in 1982,
whereas in fact it began declining. But these forecasting failures were critical, for they
meant that there was no warning of the massive regional and national agricultural problems
that began in 1981. Once the downturn in agriculture had started, of course, analysts recognized the nature and severity of the problems and, as the outlook for 1985 indicated, correctly anticipated their continuation.
38
39

40

41

Phil Battey, “High Interest Rates Squeeze Farmers and Their Lenders; Bankers Across US Note Decline in Quality of Agricultural Loan Portfolios,” American Banker (June 25, 1981), 2.
Forecast is taken from Sada L. Clarke, “The Outlook for Agriculture in ’82,” Federal Reserve Bank of Richmond Economic
Review 68, no. 1 (January/February 1982): 25–29, and is based on the 1982 Agricultural Outlook Conference held in November 1981.
Forecast is derived from Raymond E. Owens, “The Agricultural Outlook for 1985 . . . Little Promise Seen,” Federal Reserve Bank of Richmond Economic Review 71, no. 1 (January/February 1985): 27–32, and is based on the 1985 Agricultural Outlook Conference held in December 1984.
C. Robert Brenton, “How Can Agricultural Bankers Weather the Storm?” The Magazine of Bank Management (January
1986), available: LEXIS, Library: BUSFIN, File: BJS.

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Banking and the Agricultural Problems of the 1980s

Nonbank Sources of Farm Credit
Banks were a major provider of farm credit, but farmers also had other important
sources to which they could turn. A substantial amount of agricultural credit was originated
through the Farm Credit System (FCS), a nationwide network of financial institutions
owned by borrower-stockholders. The elements of the FCS were established by the government between 1917 and 1933 to serve the credit needs of agricultural producers.42 The
FCS’s major lending arms were the Federal Land Banks (FLBs), the Federal Intermediate
Credit Banks (FICBs), and the Banks for Cooperatives (BCs). The FCS was organized into
12 districts, and all three types of lenders were located within every district. In addition, a
Central Bank for Cooperatives, located in Washington, D.C., helped finance loan requests
that were too large to be handled by a single district cooperative bank. 43 The FCS was (and
still is) regulated by the Farm Credit Administration, an independent agency that is not financed by the federal government but generates funds for lending by selling bonds and
notes in the national money markets.44
The FCS attracted borrowers by aggressively offering loans equal to a high proportion
of collateral value and at lower interest rates than the rates charged by other primary farm
lenders, including commercial banks. In 1985, the FCS held more than $74 billion in agricultural debt nationwide and was thus the largest single source of credit for agriculture. The
FLBs provided long-term farmland mortgages, and in 1985 held $51 billion in farm debt
through 437 affiliated offices. The FICBs provided operating loans to farmers and competed directly with commercial banks. The FICBs generated loans through their Production
Credit Associations (PCAs), which held $17 billion in farm debt in 1985. 45
Because of the FCS’s substantial holdings in farmland mortgages, it was particularly
devastated by the steep drop in farmland values that began in 1981. Since the 1930s the FCS
had not incurred deficits, but by 1985 its financial condition had deteriorated so severely
that it was forced to ask Congress for $6 billion in federal aid to prevent its own collapse.
The situation in which the FCS found itself was put succinctly by its chief spokesman when
he was requesting aid before Congress: “Our request for assistance is one of the most difficult decisions we have ever made. But we have no choice.”46
The FCS was not the only important nonbank source of farm credit: the Farmers
Home Administration (FmHA), the principal credit agency of the U.S. Department of Agri42
43
44
45
46

W. Gifford Hoag, The Farm Credit System: A History of Financial Self-Help (1976), 1.
Gene D. Sullivan, “Changes in the Agricultural Credit Delivery System,” Federal Reserve Bank of Atlanta Economic Review 75, no. 1 (January/February 1990): 13.
“Hat in Hand; Farm Credit Begs for Bailout,” Time (November 11, 1985), available: LEXIS, Library: NEWS, File: TIME.
Patrick Eugene McNerney, “Evaluating and Managing Ag Credit Risk in the Midst of the Farm Debt Crisis” (thesis, Stonier
Graduate School of Banking, 1986), 29–31.
“Hat in Hand.”

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culture, also served in this role. The FmHA was established in 1946 as the successor to the
Farm Security Administration to function as a lender of last resort for farmers who were unable to obtain credit from other lending sources.47 As a result, FmHA credits were generally
lower in quality and riskier than loans of commercial banks or the FCS. During periods of
economic weakness from 1974 to 1977, many loans that might have caused losses to banks
were refinanced at the FmHA. In addition, from 1978 to 1981 the FmHA lent $6.6 billion
under the Economic Emergency Credit Act of 1978. Declining farm income in the early to
mid-1980s, as well as adverse weather conditions in parts of Iowa in 1983 and 1984, led
many farm operators to turn to the FmHA for some or all of their borrowing needs. In late
1984, about 30 percent of the $22 billion in FmHA loans outstanding were delinquent.48
After Vance Clark’s appointment as secretary of agriculture in August 1985, a significant change was made at the FmHA. Clark had inherited a little-used FmHA program under which the government would guarantee 90 percent of an agricultural loan, and a private
lender would assume the risk of the remaining 10 percent. Clark stressed the need to expand
this program because it allowed borrowers to do business with local banks instead of the
government while reducing the government’s lending risk by 10 percent. An increasing
number of banks became participants in the program; as a result, direct lending by the
FmHA decreased from $115 million in Fiscal Year 1988 to $50 million in 1990.49
An analysis of the proportions of outstanding real estate and non–real estate debt held
by commercial banks and other major agricultural lenders from 1975 to 1988 reveals that
commercial banks provided a relatively small quantity of farm real estate financing. Indeed,
banks’ share of farm real estate debt steadily declined from 1975 to 1981, the period of
booming farmland prices. Conversely, during the same period the share of financing provided by the Federal Land Banks continued to increase. Meanwhile, the FmHA exhibited
fairly steady, though moderate, increases in its share of farm real estate debt from 1978 to
1988 (see figure 8.4).
For non–real estate farm credit, banks were the dominant providers from 1975 to
1988. Contrary to what might have been expected, the proportion of non–real estate farm
loans held by banks declined continuously from 1976 to 1981, the final years of agriculture’s boom period, but remained quite stable during agriculture’s troubled years, 1983–86.
FmHA lending significantly increased in importance, as its share of non–real estate debt increased more than sixfold, from 3.6 percent in 1976 to 22.8 percent in 1987 (see figure 8.5).

47
48
49

Marvin Duncan, “Government Lending: Some Insights from Agriculture,” Federal Reserve Bank of Kansas City Economic
Review 68, no. 8 (September/October 1983): 5.
McNerney, “Ag Credit Risk,” 32–33.
Gordon S. Carlson, “Vance Clark: Looking Back,” Journal of Agricultural Lending 2, no. 4 (April 1989): 12–14.

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Figure 8.4

Lender Shares of Farm Real Estate Debt,
1975–1988
Percent
80

60

7

7

6

6

8

8

14 14 14 15 14 13
40

8

8

12 12

9 10 11 11 12
8
11 11 11 12 11 12

32 33 34 34 34 37 41 43 43 44 42 39 37 36

20

0

12 12 12 12 10 9
1975

1977

1979

Commercial Banks
FLBs

8
1981

7

8
1983

9

11 13 17 19
1985

1987

Life Insurance Companies
FmHA

Source: Gene D. Sullivan, “Changes in the Agricultural Credit Delivery System,”
Federal Reserve Bank of Atlanta Economic Review 75, no.1 (1990): 18.

The Effect of Agricultural Problems on Banks
Between the Great Depression and the early 1980s, few agricultural banks failed. In
1984, however, the number of agricultural bank failures began increasing dramatically, and
it remained high through 1987.50 Thereafter it rapidly declined (see figure 8.6). Between
1983 and 1985 the proportion of agricultural bank failures among all bank failures more
than quadrupled, going from 12.5 percent to 51.7 percent. With the farm economy’s subsequent improvement, however, agricultural banks became a relatively small factor in the
bank failures of the late 1980s. Although agricultural banks constituted 37.4 percent of all
bank failures (205 out of 548) from 1984 through 1987, the comparable figure for the years
1988 through 1990—a period when bank failures nationally remained very frequent—was
only 9.5 percent (62 out of 655). It is noteworthy that even though farmland prices peaked
around 1981 and net farm income began declining in the early 1980s, agricultural bank fail50

The large number of agricultural bank failures led to two forbearance programs: a capital forbearance program established
by the regulatory agencies and a loan-loss amortization program instituted by Congress. For discussions of these forbearance programs, see Chapters 1 and 2.

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Figure 8.5

Lender Shares of Farm Non–Real Estate Debt,
1975–1988

Percent
80
60

4

4

5

8

11 13 15 15 15 16 19 22 23 22

26 26 25 24 24 25 24 23 21 20 17 15 15 14

40
20
0

48 48 46 44 41 39 37 40 42 43 44 44 45 45

1975

1977

1979

Commercial Banks

1981

1983

1985

Production
Credit Associations

1987
FmHA

Source: Gene D. Sullivan, “Changes in the Agricultural Credit Delivery System,”
Federal Reserve Bank of Atlanta Economic Review 75, no.1 (1990): 18.

ures did not increase significantly until 1984. This suggests that the equity amassed by
farmers and bankers during the boom years was sufficient to absorb losses and postpone
bank failures for several years.
There was a pronounced geographic clustering among the agricultural bank failures,
with the majority occurring in the Midwest and in the two southwestern states of Oklahoma
and Texas (see figure 8.7). There were 22 or more failures in seven states—Iowa, Kansas,
Minnesota, Missouri, Nebraska, Oklahoma, and Texas—while no other state had more than
9 failures.51 As another example of this clustering, in 1985, 62 agricultural banks failed, 52
of which were located in six of these seven states (all except Texas).52
Fortunately for the deposit insurance fund, agricultural banks were relatively small.
For example, the average asset size of agricultural banks was only approximately $18 million in December 1979, $28 million in December 1984, and $32 million in December
51
52

Energy and real estate problems may have contributed to the large number of agricultural bank failures in Texas and Oklahoma. See Chapter 9 for further discussion of the effect of agricultural problems on banks in these two states.
“Agricultural Conditions and the Prospects for Farm Banks,” FDIC Banking and Economic Review (March 1986): 5–6.

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Figure 8.6

Agricultural Bank Failures versus All Bank Failures,
1980–1990
Number of Bank Failures

300

Percent

60

Agricultural Bank
Failures as Percentage
of All Bank Failures

225

45

150

30

75

15

0

1980

1982

1984

1986

Agricultural Bank Failures

1988

1990

0

All Bank Failures

1989.53 Moreover, from 1980 through 1990, when agricultural banks constituted at least 23
percent of all banks annually, they were less than 1 percent of all banks with more than $200
million in assets—and in no year in the 1980s did more than nine agricultural banks have
over $200 million in assets. Despite their small size, however, agricultural banks were a
very significant factor in the farm economy. Each year from 1980 through 1990, although
agricultural banks had less than 5 percent of all bank assets, they held at least 44 percent of
all commercial bank farm loans (see table 8.2).
The small size of agricultural banks meant that deposit insurance fund losses remained relatively low even when the proportion of such bank failures was at its highest level
(see table 8.3). From 1984 through 1987, years when agricultural bank failures constituted
37.4 percent of all bank failures, deposit insurance fund losses averaged approximately $1.6
billion per year, or less than $12 million per failed bank. Indeed, in 1985 when the 62 failed
agricultural banks accounted for 51.7 percent of all bank failures, deposit insurance fund
losses were the lowest for the period from 1982 through 1990, totaling approximately $1.0
billion, or just $8.4 million per bank. In contrast, from 1988 through 1990, when agricultural
53

The comparable measures for all commercial banks were $125 million, $182 million, and $263 million.

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Figure 8.7

Number of Agricultural Bank Failures and Percentage
of Failed Agricultural Bank Assets in U.S., 1977–1993
1
2

6

4
1

29

5

1

1
39

33
8

9

48
31
36

4

22
5

2
4
1

5

Percentage of Failed Agricultural Bank Assets
10% or more

5–10%

Under 5%

Note: Agricultural banks are banks in which agricultural loans are at least 25 percent of total
loans and leases.

banks accounted for only 9.5 percent of all bank failures, deposit insurance fund losses
averaged $5.3 billion per year, more than $26 million per bank.
An analysis of the geographic pattern of agricultural bank failures suggests that factors other than the local economy underlay many such failures. Most of the failed farm
banks were located in rural counties where other farm banks continued to operate profitably.54 More significantly, few counties in agricultural areas had more than one failed farm
54

See Michael T. Belongia and R. Alton Gilbert, “The Effects of Management Decisions on Agricultural Bank Failures,”
American Journal of Agricultural Economics (November 1990): 901. As noted above in footnote 3, the term agricultural
bank is used in this chapter to refer to banks whose farm loans are 25 percent or more of total loans. The Belongia–Gilbert
study examines banks with heavy agricultural loan exposure, which the authors define as banks whose ratio of agricultural
loans to total loans is greater than the national average (a definition generally attributed to Emanuel Melichar). Therefore,
the term farm banks is used to refer specifically to the banks discussed by Belongia and Gilbert. At year-end 1986, the ratio of farm loans to total loans for farm banks exceeded 15.7 percent. Also at year-end 1986, farm loans averaged 2.9 percent of total loans at all banks, and 35 percent at the 4,700 farm banks (statistics are from Emanuel Melichar, “Turning the
Corner on Troubled Farm Debt,” Federal Reserve Bulletin 73, no. 7 [July 1987]: 532).

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Table 8.2

Farm Loans and Bank Assets, Agricultural Banks versus All Banks, 1979–1990
Report Date

Number of Banks
Ag.
All
% Ag.

Number of Banks over
$200 Million in Assets
Ag.
All
% Ag.

Ag.

Farm Loans
($Billions)
All
% Ag.

Ag.

Bank Assets
($Billions)
All

% Ag.

4,365

14,688

29.72

7

875

0.80

$20.80

$40.03

51.95

$ 81.85

$1,838.98

4.45

12/80

4,316

14,758

29.25

8

940

0.85

20.80

40.86

50.91

88.80

2,008.27

4.42

12/81

4,214

14,745

28.58

7

989

0.71

21.26

42.01

50.61

95.54

2,185.08

4.37

12/82

4,107

14,768

27.81

8

1,076

0.74

22.99

45.40

50.64

102.61

2,349.48

4.37

12/83

4,064

14,747

27.56

9

1,180

0.76

24.83

49.23

50.44

110.91

2,474.99

4.48

12/84

3,918

14,774

26.52

5

1,281

0.39

25.05

50.60

49.51

109.51

2,686.30

4.08

12/85

3,685

14,796

24.91

7

1,412

0.50

21.88

47.50

46.07

103.59

2,933.22

3.53

12/86

3,513

14,668

23.95

5

1,510

0.33

19.90

44.31

44.90

101.75

3,174.34

3.21

12/87

3,337

14,186

23.52

7

1,542

0.45

19.51

43.86

44.48

99.19

3,259.51

3.04

12/88

3,241

13,613

23.81

9

1,599

0.56

20.12

45.74

44.00

98.84

3,412.54

2.90

12/89

3,174

13,196

24.05

8

1,685

0.47

21.34

47.85

44.60

101.29

3,475.59

2.83

12/90

3,093

12,815

24.14

11

1,699

0.65

22.70

50.65

44.82

106.77

3,647.83

2.93

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Table 8.3

Total Deposit Insurance Fund Losses
and Average Loss per Bank, 1980–1990
($Millions)

Year
1980
1981

Total
Deposit Insurance
Fund Losses
$

Average Loss
per Bank

30.59

$ 2.78

776.16

77.62

1982

1,148.28

27.34

1983

1,425.12

29.69

1984

1,494.91

18.69

1985

1,007.70

8.40

1986

1,724.53

11.89

1987

2,020.68

9.95

1988

6,871.88

31.09

1989

6,123.14

29.58

1990

2,813.17

16.65

bank from 1984 through 1986: 105 farm banks failed in 96 different agricultural counties.
Had the farm bank failures primarily reflected conditions in the local agricultural economy,
a pronounced geographic clustering would have appeared. Moreover, research related to
these bank failures demonstrated that at the approximate peak of farmland prices in 1981,
farm banks that later failed had significantly higher ratios of total loans to assets than did
other banks in the same counties. These findings suggest that total loans-to-assets ratios of
farm banks are important to the assessment of failure risk.55
To determine which factor is the best long-range predictor of agricultural bank failure,
researchers studied eight measures of bank risk. The eight measures were (1) loans-to-assets
ratio, (2) return on assets, (3) asset growth from the previous year, (4) loan growth from the
previous year, (5) operating expenses to total expenses, (6) average salary expenses, (7) in55

Belongia and Gilbert, “The Effects of Management Decisions,” 902. A high loans-to-assets ratio by itself would not necessarily indicate a problem bank because not all banks with high ratios failed or became problem banks. Agricultural banks
with elevated loan ratios that diversified their loan portfolios and maintained rigorous underwriting standards, including
performing thorough cash-flow analysis on their borrowers, might have been safer than those with lower ratios that did neither. It should be noted that banks in most agricultural areas cannot effectively diversify their loan portfolios. Loans to
farm-implement dealers or to the local feed store probably have risks related to agricultural prices that are similar to the
risks inherent in farm loans.

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terest on loans and leases, and (8) interest plus fees on loans and leases.56 To assess whether
timing or various risk factors affected agricultural banks, the researchers studied two sets of
banks, one each in two different time periods. The first group included all agricultural banks
that existed in 1980 and either failed in 1984 or 1985 or never failed; the second group included all agricultural banks that existed in 1982 and either failed in 1986 or 1987 or never
failed. In each set, each bank was ranked from high to low within each financial ratio. The
ranked banks were then divided into five groups, and each of these smaller groups was analyzed for each risk measure to determine which measure was the best predictor of failure.
For both of the specified periods, banks in the highest loans-to-assets group had the highest
probability of failure, a finding that confirmed previous research. For the 1980 banks, the
highest loans-to-assets group had a failure rate of 6.2 percent, over five times as high as the
failure rate for the rest of the agricultural banks (see figure 8.8). For the 1982 banks, the
Figure 8.8

Comparison of Selected Factors in Predicting
Agricultural Bank Failures Four and
Five Years Forward, 1980

Percent
6.0

6.2%
5.5%

4.5
3.0
1.5
0

2.4%
1.6%

1.2%

Loans to Assets

Loan Growth

Percent of Banks in
Highest Quintile that
failed in 1984 or 1985.

2.0%

Average Salary

Percent of Banks in all
other Quintiles that failed
in 1984 or 1985.

Note: These three factors represent the two highest risk factors (left and
center) and the lowest risk factor (right) in predicting bank failures.

56

For a complete description of this analysis, see Chapter 13, the section entitled “Analysis by Risk Groups.”

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Figure 8.9

Comparison of Selected Factors in Predicting
Agricultural Bank Failures Four and
Five Years Forward, 1982

Percent
12

10.3%
9

7.0%
6

3

0

3.1% 3.1%
1.6%

1.7%

Loans to Assets

Interest Yield

Percent of Banks in
Highest Quintile that
failed in 1986 or 1987.

Average Salary

Percent of Banks in all
other Quintiles that failed
in 1986 or 1987.

Note: These three factors represent the two highest risk factors (left and
center) and the lowest risk factor (right) in predicting bank failures.

highest loans-to-assets group had a failure rate of 10.3 percent, more than six times as high
as the remaining agricultural banks (see figure 8.9). Because the proportion of loans to assets can be largely controlled through decisions made at each bank, management prudence
with regard to risk, to underwriting standards, or to the concentration of agricultural lending apparently could have improved the probability that a bank would survive.

Analysis of Agricultural Bank Data
The geographic pattern of farm bank failures and the ratio analysis indicate that management decisions were the crucial determinants of bank survival. At the same time, it is apparent that the agricultural problems of the 1980s caused the failures of many banks that
might otherwise have continued to operate. The adverse effect of the weakening farm economy on agricultural banks is clearly evident in the sharp increase in these banks’ levels of
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Banking and the Agricultural Problems of the 1980s

nonperforming loans and the deterioration of their CAMEL ratings.57 Nevertheless, for
most agricultural banks the statistics related to capital and profitability continued to be favorable, which is another fact suggesting that more-conservative management practices
could have prevented many failures.
The CAMEL ratings of agricultural banks generally mirrored the slumping farm economy (see tables 8.4a and 8.4b). For example, among all agricultural banks, the proportion
of CAMEL 1-rated agricultural banks declined steadily between year-end 1981 and yearend 1986, from 43.8 percent to 20.8 percent. Similarly, during the same period the percentage of 4-rated banks among all agricultural banks increased from 0.9 percent to 13.7
Table 8.4a

CAMEL Ratings for All Agricultural Banks, 1981–1990
Report
Date
(Year-end)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Agricultural Banks/Percentage of Total
1

2

1,858
43.8
1,691
40.5
1,501
36.4
1,265
32.5
936
25.6
727
20.8
683
19.8
726
22.0
758
24.0
818
26.5

2,184
51.5
2,118
50.8
2,039
49.5
1,752
45.0
1,556
42.5
1,483
42.4
1,669
48.3
1,742
52.7
1,765
55.8
1,714
55.6

CAMEL Ratings
3
164
3.9
281
6.7
426
10.3
563
14.5
689
18.8
735
21.0
685
19.8
558
16.9
438
13.8
388
12.6

4

5

Total

36
0.9
72
1.7
133
3.2
283
7.3
424
11.6
477
13.7
342
9.9
234
7.1
167
5.3
135
4.4

3
0.1
9
0.2
21
0.5
34
0.9
54
1.5
73
2.1
74
2.1
46
1.4
36
1.1
28
0.9

4,245
100%
4,171
100
4,120
100
3,897
100
3,659
100
3,495
100
3,453
100
3,306
100
3,164
100
3,083
100

Note: Examination ratings were obtained from the FDIC’s historical database. In some instances examination ratings were
missing; however, from 92 to 99 percent of banks’ ratings were in the database. As a result, the number of CAMEL-rated
banks each year was slightly smaller than the total number of agricultural banks in other tables.
57

The CAMEL rating system refers to capital, assets, management, earnings, and liquidity. In addition to a rating for each of
these individual or “component” categories, an overall or “composite” rating is given for the condition of the bank. Banks
are assigned ratings between 1 and 5, with 5 being the worst rating a bank can receive. See Chapter 12 for a detailed explanation of CAMEL ratings.

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Table 8.4b

CAMEL 4- and 5-Rated Institutions, Agricultural Banks
versus Small Non-Agricultural Banks, 1981–1990
Report Date
(Year-end)

Number of Banks/Percentage of Total
Agricultural Banks
Small Non-Agricultural Banks

Total

1981

39
21.5

142
78.5

181
100%

1982

81
21.6

294
78.4

375
100

1983

154
27.7

402
72.3

556
100

1984

317
41.1

454
58.9

771
100

1985

478
44.2

604
55.8

1,082
100

1986

550
42.5

745
57.5

1,295
100

1987

409
35.5

744
64.5

1,153
100

1988

278
28.4

702
71.6

980
100

1989

203
23.2

671
76.8

874
100

1990

163
19.9

655
80.1

818
100

Note: Small non-agricultural banks are defined as those with less than $100 million in assets.

percent. By mid-1987, both measures had begun what would turn out to be a steady improvement. The percentage of agricultural banks among all 4- and 5-rated banks also reflected the farm economy (table 8.4b): at year-end 1981, only 21.5 percent of all 4- and
5-rated banks were agricultural banks, but this ratio rose steadily until year-end 1985, when
the comparable figure was 44.2 percent. In absolute numbers, in 1981 only 39 agricultural
banks were 4 and 5 rated; in 1986, 550 were. From 1986 to the end of the decade, both the
percentage and the number of 4- and 5-rated agricultural banks declined steadily.
A primary cause of the deterioration in agricultural bank CAMEL ratings was a rapid
rise in the nonperforming loans of agricultural banks (see figure 8.10). Between year-end
1982 and midyear 1986, nonperforming loans as a percentage of all loans at agricultural
banks went from 2.8 percent to 6.7 percent. The percentage then declined steadily, reaching
2.6 percent at year-end 1990. In contrast, for other small banks (defined as those with less
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Banking and the Agricultural Problems of the 1980s

Figure 8.10

Agricultural Banks versus Small
Non-Agricultural Banks: Nonperforming Loans
as a Percentage of All Loans, 1982–1990

Percent

6.0

Agricultural
Banks

4.5
3.0

Other Small
Banks*

1.5
0

1982 1983 1984 1985 1986 1987 1988 1989 1990
Year-end

*Small banks are banks with assets of less than $100 million.

than $100 million in assets) the ratio of nonperforming loans was relatively constant between 1982 and 1990, reaching a low of 2.9 percent in 1984 and a high of 3.9 percent in
mid-1987.
Despite the severe problems many agricultural banks had in the 1980s, by certain aggregate measures agricultural banks actually compared favorably with small non-agricultural banks (see table 8.5). For example, every year from 1979 through 1990 the median
ratio of equity to assets for agricultural banks exceeded that of other small banks.58 In addition, profitability ratios of agricultural banks were equivalent to or higher than the ratios for
other small banks: the median return on assets was higher for agricultural banks than for
small non-agricultural banks in 10 of the 12 years from 1979 through 1990, while the median return on equity was higher in 8 of those 12 years.
More significantly, when we compare agricultural and small non-agricultural banks in
terms of the percentage that incurred losses in the 1980s, we find that for agricultural banks
the percentage was far lower (see figure 8.11)—only in 1985 did the percentage of agricul58

It is noteworthy that the equity-to-assets ratio for agricultural banks was quite stable during the agricultural downturn of
the 1980s. This stability is probably due to the fact that many agricultural banks with relatively low ratios of equity to
assets had failed.

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Table 8.5

Median ROA, ROE, and Equity Ratios, Agricultural Banks versus Small
Non-Agricultural Banks, 1979–1990
Number of Banks
Report Date
(Year-end)
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Ag. Banks

Small
Non-Ag.

4,365
4,316
4,214
4,107
4,064
3,918
3,685
3,513
3,337
3,241
3,174
3,093

8,584
8,543
8,471
8,416
8,238
8,236
8,241
7,911
7,615
7,083
6,735
6,360

ROA

ROE

Ag. Banks

Small
Non-Ag.

1.24
1.31
1.30
1.22
1.12
0.93
0.83
0.70
0.80
0.94
1.01
0.97

1.05
1.05
1.02
0.99
0.93
0.90
0.90
0.78
0.75
0.78
0.84
0.78

Equity to Assets

Ag. Banks

Small
Non-Ag.

Ag. Banks

Small
Non-Ag.

14.40
14.82
14.42
13.46
12.03
10.01
8.91
7.59
8.52
9.91
10.47
10.21

13.14
12.63
12.07
11.83
11.41
10.98
10.83
9.47
8.99
9.30
9.73
9.04

8.43
8.66
8.71
8.86
8.98
8.87
8.83
8.67
8.74
8.89
9.01
8.88

8.04
8.24
8.25
8.26
8.16
8.10
8.14
7.96
8.07
8.10
8.21
8.15

Note: Small non-agricultural banks are defined as those with less than $100 million in assets.

tural banks significantly exceed that of small non-agricultural banks. And whereas the proportion of agricultural banks with negative net income rose dramatically from 1980 through
1986 (consistent with the deterioration in the farm economy) and declined sharply after
1986 (as the farm economy gradually improved), the proportion of small non-agricultural
banks with negative net income not only increased rapidly through 1986 but also remained
high through 1990.
Data on equity and reserves to assets also demonstrate that the majority of agricultural
banks were in sound financial condition during the 1980s (see tables 8.6a and 8.6b). From
1979 through 1983, an average of 21.8 percent of agricultural banks had a ratio of equity
and reserves to assets exceeding 11 percent. From 1984 through 1987 the average proportion of agricultural banks with such ratios increased to 29.1 percent, even with agricultural
bank failures constituting a large percentage of all bank failures. These figures are quite favorable when compared with data for other small banks: the measures for the same periods
for such banks were 18.7 percent and 21.1 percent. In addition, throughout the 1980s at
least 30 percent of agricultural banks had a ratio of equity and reserves to assets of between
9 and 11 percent, and the proportion of such banks in that category held steady: from yearend 1979 through 1983 it averaged 32.6 percent, and from 1984 through 1987, 32.0 percent.
In contrast, less than 27 percent of other small banks had ratios of equity and reserves to assets of 9 to 11 percent each year. Finally, the percentage of agricultural banks with very low
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Figure 8.11

Agricultural Banks versus Small Non-Agricultural
Banks: Percentage of Institutions with
Negative Net Income, 1980–1990
Percent

25
20

Other Small
Banks*

15
10

Agricultural
Banks

5
0

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

*Small banks are banks with assets of less than $100 million.

ratios (less than 5 percent) of equity and reserves to assets was minimal before the wave of
agricultural bank failures, never exceeding 0.4 percent of all agricultural banks from 1979
through 1984. In contrast, for other small banks during the same period this ratio ranged
from 0.7 percent to 1.4 percent. Such patterns indicate that low capital ratios were not a significant contributor to the large number of agricultural bank failures after 1983. The percentage of agricultural banks with less than 5 percent equity and reserves to assets rose after
1984, following the downturn in the farm economy, and reached a peak of 2.0 percent in
1987. In comparison, the ratio for other small banks peaked at 3.9 percent in 1988.

Conclusion
Agriculture prospered in the 1970s. Real farm incomes reached historical highs, farm
exports increased sharply, and long-term prospects were believed to be excellent. An important component of the agricultural boom of the 1970s, and one that had a significant effect on the problems of the 1980s, was the escalating value of farm real estate. In order to
invest in or purchase farm real estate, farmers assumed a substantial amount of debt. Because many agricultural bankers continued basing their farm loans on collateral value rather
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Table 8.6a

Equity and Reserves to Assets of Agricultural Banks, 1979–1990
Report
Date
(Year-end)
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

<5.0
7
0.2
4
0.1
4
0.1
6
0.2
17
0.4
17
0.4
28
0.8
68
1.9
66
2.0
54
1.7
34
1.1
24
0.8

Number of Banks/Percentage of Total
Equity Capital and Reserves to Total Assets
5.0–7.0
7.0–9.0
9.0–11.0
278
6.4
202
4.7
199
4.7
201
4.9
200
4.9
176
4.5
179
4.9
244
7.0
185
5.5
141
4.4
118
3.7
132
4.3

1,991
45.6
1,799
41.7
1,744
41.4
1,551
37.8
1,433
35.3
1,349
34.4
1,179
32.0
1,123
32.0
1,022
30.6
935
28.9
873
27.5
979
31.7

1,321
30.3
1,446
33.5
1,372
32.6
1,395
34.0
1,324
32.6
1,276
32.6
1,213
32.9
1,109
31.6
1,026
30.8
1,014
31.3
1,023
32.2
916
29.6

> 11.0

Total

768
17.6
865
20.0
895
21.2
954
23.2
1,090
26.8
1,100
28.1
1,086
29.5
969
27.6
1,038
31.1
1,097
33.9
1,126
35.5
1,042
33.7

4,365
100%
4,316
100
4,214
100
4,107
100
4,064
100
3,918
100
3,685
100
3,513
100
3,337
100
3,241
100
3,174
100
3,093
100

than on cash-flow analysis, farm debt rose in tandem with soaring real estate values, even
though farm income levels were frequently insufficient to support the higher debt burdens.
The optimism of the early and middle 1970s came to an end late in the decade as interest rates soared and foreign demand for domestic agricultural products declined. Real
farm income fell rapidly, as did farm real estate values. Many banks with a large proportion
of farm loans were adversely affected by the downturn in the farm economy, and the number of agricultural bank failures increased dramatically in 1984 and 1985 and remained high
through 1987, before rapidly declining. Fortunately, because these institutions were small,
deposit insurance fund losses were relatively low even when the proportion of agricultural
bank failures was at its highest levels.
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Table 8.6b

Equity and Reserves to Assets of Small Non-Agricultural Banks, 1979–1990
Report
Date
(Year-end)
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Banks/Percentage of Total
<5.0
67
0.8
62
0.7
80
0.9
99
1.2
112
1.4
110
1.3
115
1.4
188
2.4
246
3.2
275
3.9
217
3.2
183
2.9

Equity Capital and Reserves to Total Assets
5.0–7.0
7.0–9.0
9.0–11.0
1,209
14.1
978
11.5
979
11.6
995
11.8
1215
14.8
1,127
13.7
959
11.6
1,104
14.0
838
11.0
717
10.1
642
9.5
597
9.4

3,813
44.4
3,667
42.9
3,588
42.4
3,482
41.4
3,272
39.7
3,357
40.8
3,372
40.9
3,117
39.4
2,971
39.0
2,728
38.5
2,510
37.3
2,416
38.0

2,092
24.4
2,285
26.8
2,231
26.3
2,154
25.6
1,976
24.0
1,929
23.4
2,045
24.8
1,904
24.1
1,883
24.7
1,771
25.0
1,750
26.0
1,612
25.4

> 11.0

Total

1,403
16.3
1,551
18.2
1,593
18.8
1,686
20.0
1,663
20.2
1,713
20.8
1,750
21.2
1,598
20.2
1,677
22.0
1,592
22.5
1,616
24.0
1,552
24.4

8,584
100%
8,543
100
8,471
100
8,416
100
8,238
100
8,236
100
8,241
100
7,911
100
7,615
100
7,083
100
6,735
100
6,360
100

Most of the agricultural bank failures occurred in the Midwest, not only because of the
concentration of the agricultural industry in those states but also because the crops produced in those states were greatly affected by the export boom of the 1970s. It should be
noted, however, that despite the sharp increase in the number of agricultural bank failures,
most such banks did not fail. Because agricultural bank failures were widely spread across
many midwestern counties, local economic conditions apparently did not play a significant
role in causing these failures; rather, it appears that agricultural banks with the highest
loans-to-assets ratios were more likely to fail than those that pursued more conservative
lending strategies.
After the downturn in the farm economy of the 1980s, agricultural banks recovered,
but this does not necessarily mean they will be immune to a similar episode in the future.
Almost by definition, such institutions lack diversification in their loan portfolios. A 1996
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study by two Federal Reserve economists found that agricultural banks had not greatly diversified their credit risk and that although the number of banks with high ratios of agricultural loans to total loans had decreased, many agricultural banks were continuing to invest
very significant proportions of their loans in agriculture. Moreover, as of 1994 most agricultural banks were still within small banking organizations that accounted for approximately two-thirds of total agricultural loans by agricultural banks. By not affiliating
themselves with larger banking organizations, banks with the greatest exposure to the agricultural sector had not reinforced their ability to withstand a downturn in the sector.59
On the other side of the coin, there are suggestions that agricultural banks and farmers were chastened by their experiences in the 1980s. In the mid-1990s bankers often required larger down payments on loans, and performed extensive analyses to determine if a
borrower could generate sufficient cash flow to meet loan payments. Moreover, some banks
became reluctant to permit farmers to use the rising value of their land to increase their borrowing power. As an Iowa bank president declared in early 1996, “We’re not going to lend
on a grain rally that could be a flash in the pan.” Some farmers, too, have learned from the
past: An Iowa farmer stated that “in the 1970s we concentrated on producing crops. Now
it’s the financials I worry the most about. We need the computer to figure our cash flows.”
Another noted that “a lot has changed since the 1970s. We don’t do things by the seat of our
pants anymore.”60 But despite such developments and the small size of agricultural banks—
both of which make such banks seem less of a threat to the Bank Insurance Fund than larger
banks with a comparable lack of diversification—the large number of agricultural banks
warrants continued regulatory concern.

59
60

Kleisen and Gilbert, “Are Some Agricultural Banks Too Agricultural?” 30–32.
All the quotations in this paragraph are reported in Kilman, “High Grain Price,” A.1. Kleisen and Gilbert, however, note
that although agricultural banks responded to the problems of the 1980s by increasing lending collateral requirements, by
1994 requirements had fallen back to the levels of the mid-1970s, a trend the authors see as “inconsistent with the argument
that these banks have changed their lending practices to reduce . . . credit risk” (“Are Some Agricultural Banks Too Agricultural?” 31).

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in the Southwest
Introduction
The most severe of the regional banking crises was the one in the southwestern region,
defined here as Texas, Oklahoma, Louisiana, New Mexico, and Arkansas.1 Of the total failure-resolution costs borne by the FDIC from 1986 to 1994, half ($15.3 billion) was accounted for by southwestern bank failures. (This included losses of nearly $6.3 billion in
1988 and $5.1 billion in 1989—91.1 percent and 82 percent, respectively, of total FDIC
failure-resolution costs for those two years.) From 1987 through 1989, 71 percent of the
banks that failed in the United States were southwestern banks (491 out of 689), and so
were some of the most significant failures, such as banks within the First City Bancorporation, First RepublicBank Corporation, and MCorp holding companies. The pervasiveness
of the problems facing the region’s depository institutions is indicated by the fact that the
biggest savings and loan debacle also occurred in the Southwest, with Texas alone accounting for 18.3 percent of the Resolution Trust Corporation’s resolutions and 29.2 percent of its resolution costs (see Chapter 4).
The banking collapse in the Southwest was especially devastating to the Texas banking industry. From 1980 through 1989, 425 Texas commercial banks failed, including 9 of
the state’s 10 largest bank holding companies. In 1988, 175 Texas banks failed with assets
of $47.3 billion—25 percent of the state’s 1987 year-end banking assets. The following year

1

The sequence in which the states are listed reflects the severity of each state’s banking crisis. From 1980 through 1994,
Texas had 599 bank failures and $60.2 billion in failed-bank assets (43.8 percent of the state’s total bank assets); Oklahoma:
122 failures, $5.8 billion in failed-bank assets (23.8 percent of total state banking assets); Louisiana: 70 failures, $4.1 billion in assets (17.4 percent of total); New Mexico: 11 failures, $568 million in assets (9.5 percent of total); and Arkansas:
11 failures, $161 million in assets (1.5 percent of total). The discussion in this chapter focuses on Texas, Oklahoma, and
Louisiana because banking problems were concentrated in those states. However, data for the Southwest cover all five
states. (Note: The number of bank failures refers to FDIC-insured commercial and savings banks that were closed or received FDIC assistance. Asset data refer to assets of banks existing in each state at year-end 1979 plus assets of newly
chartered banks as of the date of failure, merger, or December 31, 1994, whichever is applicable.)

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134 Texas banks failed with assets of $23.2 billion—13.6 percent of the state’s banking assets.
Oil was both the foundation of the region’s economy and the primary force behind the
region’s banking crisis. In January 1973, the U.S. average monthly import price for crude
oil was $2.75 per barrel; after a series of unprecedented international economic and political events, this price rose to a peak of $36.95 per barrel in April 1981. The soaring price of
oil worldwide fueled the oil boom in the Southwest and became the basis for regional economic prosperity, supported by bank lending to the energy markets.
But oil prices peaked in 1981, an event that roughly coincided with the beginning of
deterioration in the banking sector. Between 1981 and 1985 the price of oil slowly but
steadily declined as a result of several factors: conservation efforts led to decreased demand, oil production increased, and the international political environment changed. This
was the initial period of increased southwestern bank failures, caused primarily by problems with energy loans. As oil prices continued to weaken, southwestern banks sought new
investment opportunities and therefore increased their lending to the then-booming real estate markets, particularly commercial real estate. In hindsight this strategy proved to be unwise, for the health of the real estate markets was tied to the hitherto-strong energy markets.
Indeed, indications of potential problems may have come early: from 1981 through 1983
office vacancy rates were escalating even while commercial real estate construction expenditures remained extremely high. In 1986 oil prices dropped precipitously, devastating the
region’s economy, and the price decline and subsequent economic devastation contributed
to the collapse of the overbuilt southwestern real estate market in the remaining years of the
decade. As a result, the region’s banks suffered substantial losses on real estate loans. These
losses, coming when the banks were already weakened by energy-loan difficulties and by
intense competition from recently deregulated savings and loan (S&L) institutions, were
largely responsible for the escalating number of southwestern bank failures in the second
half of the decade.
Because oil played such an important role in the region’s economy, the history and
causes of the oil boom and bust are reviewed first. And because bankers reacted to the
weakening of oil prices by increasing their real estate lending, helping to support the substantial growth in real estate development in the Southwest, the southwestern real estate
markets are discussed next. The emphasis is on Texas, the state most affected by the oil cycle. The final section on the region’s economy highlights the effects of agricultural problems, especially in relation to Texas, Louisiana, and Oklahoma. The remaining sections of
the chapter focus on banking: the banking environment (new charters, and competition
from S&Ls), the effect of the economy on the region’s banks, bank failures in the region
(the failures of Penn Square and the First National Bank of Midland are looked at in detail),
and regional bank data. An analysis of these data suggests that although the number of
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southwestern bank failures did not begin to increase substantially until 1983 and reached a
peak in 1988, the beginning of the collapse can be observed in bank data as early as 1981.

Energy and the Southwestern Economy: Boom and Bust
Energy—oil and natural gas—was a vital component of the southwestern economy,
and trends in the prices of these two products determined regional economic trends. In the
1970s and 1980s the price of both oil (the cornerstone of the economy) and natural gas
(which also played an important role) went through a boom and bust that had a tremendous
impact on the region (see figure 9.1). Between 1979 and 1982, when the prices of the two
sources of energy were high, the average growth rate in the Southwest exceeded that of the
nation as a whole by a substantial margin; from 1985 to mid-1987, when energy prices were
depressed, the region’s average growth rate was significantly less than the nation’s (see figure 9.2).
The price of oil was extremely volatile in the 1970s and 1980s. In January 1973 the
average monthly import price per barrel was $2.75, but between then and April 1981 a series of international economic and political events combined to push the price to a peak of
Figure 9.1

Domestic Crude-Oil Refiner Acquisition Cost versus
Average Number of Rotary Rigs, 1972–1988
$/Barrel
40

Number (Thousands)
4

Rotary
Rigs
30

3

20

in Current
(1988) Dollars

10

0

2

Cost

1972

1974

1976

1978

1980

1982

1984

1

1986

1988

0

Sources: U.S. Department of Commerce, International Trade Administration,
Industrial Outlook (1990), 3-5; and Energy Information Administration, Annual
Energy Review 1988 (Cited in John O’Keefe, “The Texas Banking Crisis,” FDIC
Banking Review 3, no. 2 (1990), 17.

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Figure 9.2

Changes in Southwest Gross Product versus
Changes in U.S. Gross Domestic Product,
1980–1994

Percent
9

Southwest
6

U.S.

3

0

-3

1980

1982

1984

1986

1988

1990

1992

1994

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

$36.95 per barrel. By August 1986, however, because of energy conservation, increased
production, and a drastic change in the world political environment, imported oil prices
plunged to $10.00 per barrel. These substantial movements in the price of oil profoundly
destabilized the Southwest’s economy and its banks.
Throughout the 1950s and 1960s, oil had been inexpensive and plentiful, partly because new oil fields opened in the Middle East, Southeast Asia, and Africa.2 During the
1950s, annual imports of crude oil and refined oil products increased 176 percent and net
imports as a share of domestic consumption rose from 6 to 17 percent. In 1959, the low
price of oil led domestic producers to persuade the Eisenhower administration to impose
import quotas on crude oil and petroleum products as protection against foreign competition. Despite this action, the net import market share continued to grow, reaching 22 percent
in 1969. Dependence on imported oil continued to increase as the production of domestic
oil peaked in 1970 and then began a gradual but continuous decline (which was interrupted
only briefly by the opening of the Trans-Alaska oil pipeline in 1977). By 1972, imported oil
2

Information in this section, unless otherwise noted, is from Jack L. Hervey, “The 1973 Oil Crisis: One Generation and
Counting,” Federal Reserve Bank of Chicago Chicago Fed Letter, no. 86 (October 1994): 1–2.

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amounted to 28 percent of domestic consumption. The reduction in domestic crude production was accompanied by a 16 percent increase in consumption between 1969 and 1972.
As a result, crude oil prices, which had been rising at an average annual rate of approximately 1.25 percent, rose nearly 8 percent in 1971 alone. In response to growing oil shortages and rising prices, the oil import quotas were eliminated by presidential order in 1973.
Nevertheless, the U.S. monthly average import price for crude oil rose 23 percent between
January and September of that year (from $2.75 to $3.38 per barrel).
The political ramifications of the Arab-Israeli war in 1973 had an enormous impact on
oil prices. Several Arab members of the Organization of Petroleum Exporting Countries
(OPEC) decided to impose a selective embargo on oil shipments to countries that supported
Israel.3 However, cartels tend to be unstable, and in this case the embargo’s effectiveness
was undercut by the Arab nations’ dependence upon oil as their primary source of revenues.4 Nonetheless, OPEC quadrupled the price of oil from roughly $3 a barrel in October
1973 to around $12 by January 1974, causing an “oil shock” that was felt by economies
around the world.
After that initial price upheaval, oil prices trended upward and then remained around
$13.50 per barrel throughout 1978.5 In response to the higher oil prices, many oil-producing countries, members and nonmembers of OPEC alike, had increased their output by the
late 1970s. In addition, crude oil extracted from both the Alaskan North Slope and newly
opened fields in the North Sea became available on the world market. At the same time, the
United States and other industrial nations had instituted conservation measures that significantly reduced their consumption of oil.6
Faced with reduced demand and the prospect of losing some control over the crude oil
and petroleum markets, in 1979 OPEC again cut production and raised oil prices by 14.5
percent. OPEC’s success was facilitated by the Iranian revolution of 1979, which disrupted
crude oil production in that country. OPEC’s actions launched the second wave of oil price
increases and had a profound impact on the global economy.7 By April 1981, the average
monthly import price for crude oil in the United States hit a peak of $36.95 per barrel.
3

4
5
6
7

OPEC was founded in 1960 for the purpose of coordinating the petroleum policies of member countries and safeguarding
their interests. Its charter members were Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. By November 1973, it had eight
additional members: Algeria, Ecuador, Gabon, Indonesia, Libya, Nigeria, Qatar, and the United Arab Emirates. Ecuador and
Gabon withdrew from the cartel in 1992 and 1996, respectively, leaving OPEC with 11 members as of June 1997.
David Ivanovich, “It Was a Disaster; 1973 Arab Oil Embargo Still Scratches at Scar of Distrust,” Houston Chronicle (October 16, 1993), available: LEXIS, Library: NEWS, File: HCHRN.
Hervey, “The 1973 Oil Crisis,” 1–3.
Ibid.
For example, the Organization for Economic Cooperation and Development (OECD) estimated that the level of GNP in the
24 OECD member countries would be some 6 percent, or about $500 billion, lower by the beginning of 1982 than it would
have been in the absence of the oil price rise (Economic Report of the President, Transmitted to the Congress [1981], 190.)

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In response to these prices, the United States and other industrial nations continued to
reduce oil consumption by making stringent conservation efforts, while at the same time
non-OPEC countries were further increasing their oil output. As a result, OPEC’s ability to
maintain a fixed price of oil was under mounting pressure. In addition, the cartel’s unity deteriorated as individual members began to boost their own oil output, selling more than their
OPEC quota at reduced prices on world markets. This breakdown in the cartel’s discipline
eventually contributed to a break in oil prices, and by early 1983 the prices of imported oil
had fallen below $30 per barrel.8 Then in late 1985, Saudi Arabia unilaterally engineered a
substantial reduction in the price of oil by increasing its daily production of crude from two
million to four million barrels.9 As a result, oil prices that had averaged approximately $30
a barrel in late November dropped to approximately $25 a barrel by January 15, 1986. 10 The
subsequent flood of OPEC oil caused prices to continue plummeting, falling to less than
$13 a barrel by March 1986 and to $10 a barrel by August 1986, the lowest price since
1974.11
The explosion and collapse of oil prices had a profound effect on oil drilling, especially in the states of Texas, Oklahoma, and Louisiana. Throughout the 1960s oil drilling
had been declining, as U.S. fields were steadily drained of oil that could be profitably extracted at $2 a barrel. As a result, the rig count in the United States had dropped from 2,000
in the early 1960s to just below 1,000 by the early 1970s.12 However, the steep increases in
oil prices beginning in 1973 quickly affected drilling activity, allowing U.S. producers to
reach record levels of drilling for crude oil despite enduring high production costs relative
to those in many other oil-producing nations.13 In late October 1973, one Houston producer
noted: “Drilling is booming. All inland rigs that I know of are booked until after the end of
this year. I’ll drill about 15 wells this year—about 10 more than I would have had we not

8

Hervey, “The 1973 Oil Crisis,” 2.
Saudi Arabia has the world’s largest oil reserves and could afford to increase output sufficiently to prevent its oil revenues
from declining despite a substantial drop in crude oil prices; this was not the case for other OPEC members. Saudi Arabia
increased output and drove oil prices lower to force other OPEC members to adhere to agreed-upon production quotas. See
Dermot Gately, “Lessons from the 1986 Oil Price Collapse,” Brookings Papers on Economic Activity 2 (1986): 237–38,
251–53, 265.
10 “As Oil Prices Continue to Slide, Texas Banks Confront a Grim ’86: Further Deterioration Expected in Energy and Real
Estate Lending,” American Banker (February 11, 1986), 2.
11 David LaGesse, “Banker Predicts Rebound in Oil Prices,” American Banker (March 27, 1986), 1; and Hervey, “The 1973
Oil Crisis,” 2.
12 James Fallows, “A Permanent Boomtown, Houston,” Atlantic Monthly 256 (July 1985), available: LEXIS, Library:
NEWS, File: ATLANT.
13 For example, to extract U.S. oil that was difficult to pump, it was necessary to employ enhanced recovery methods that
were unprofitable when oil was priced below $15 a barrel. In contrast, Saudi Arabian wells were shallow and comparatively free flowing and could be profitable even when oil was sold at $5 a barrel (Thomas C. Hayes, “West Texas Oilmen
Struggle to Endure,” The New York Times [March 18, 1986], available: LEXIS, Library: NEWS, File: NYT).
9

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gotten the free market price for new oil.”14 Oilmen bought rigs and added employees without concern in the early 1980s, for both they and many bankers expected oil prices to reach
$60 a barrel in the next few years.15 As a result, between 1979 and 1981 drilling expenditures increased from $16.5 billion to $38 billion.16 In 1981, the monthly average number of
active rotary rigs reached a peak of approximately 4,000 (figure 9.1). When oil prices subsequently crashed, the number of profitable drilling opportunities became severely limited,
leading to plunging values of drilling equipment, limited demand for oil-related loans, and
losses to banks on outstanding oil-sector loans. The number of active rigs declined along
with oil prices, reaching a new postwar low of 757 in May 1986.17
The plunge in oil prices inflicted severe hardship on many, including oil driller Don
Hughes. Hughes had been perhaps the busiest drilling contractor in Oklahoma, but the precipitous drop in oil prices caused drilling in Oklahoma virtually to cease, bringing down the
Hughes Drilling Company, which had once employed 400 and grossed $4 million a month.
Hughes reminisced about the glory days while he was in the process of handing over everything he had bought to the Continental Illinois National Bank and Trust Company:
During the boom everybody was screaming and hollerin’ for rigs. There was not a week
that at least three bankers from the major banks weren’t here trying to loan me more
money for more rigs. They told me I was a shining star. We were written up in Inc. magazine as one of the fastest-growing companies. Bear Stearns tried to get me to go public. I
kept believing what all these people were telling me.18

Other drillers still in business at that time were justifiably worried. Mac McGee, marketing director of the Cactus Drilling Company, one of the largest drillers in West Texas, observed in early 1986 that “everybody geared up and borrowed. The banks can’t afford to
carry companies very long. If things don’t pick up some, it’s going to be a real tragedy.”19
The situation, however, only worsened. The changing times were tellingly reflected in the
prevailing bumper stickers. Oil-patch workers’ bumper stickers had read “$85 [a barrel] in
’85.” In contrast, a slogan displayed in late 1986 read “Chapter 11 in ’87.”20
14
15
16
17

18
19
20

Darnel Peacock, “Price Boosts Will Hasten Exploration,” Houston Post (October 21, 1973), CC4.
See Robert Dodge, “The Long Road Back in Texas,” United States Banker (July 1985), available: LEXIS, Library: NEWS,
File: USBANK; and Hayes, “Oilmen Struggle.”
U.S. Congress, Joint Economic Committee, The Economic Impact of the Oil Price Collapse: Hearing before the Subcommittee on Trade, Productivity, and Economic Growth of the Joint Economic Committee, 99th Cong., 2d sess., March 12, 1986, 68.
Peter Behr and Hobart Rowen, “Fall in Price of Oil Hurts U.S. Fields; Drop in Drilling, Permanent Loss of Production Apparent,” The Washington Post (March 9, 1986), available: LEXIS, Library: NEWS, File: WPOST; and Thomas C. Hayes,
“Oil’s Plunge Drags Gas Down,” The New York Times (May 23, 1986), available: LEXIS, Library: NEWS, File: NYT.
Robert Reinhold, “Desperation Descends on Oklahoma,” The New York Times (May 11, 1986), available: LEXIS, Library:
NEWS, File: NYT.
Hayes, “Oilmen Struggle.”
“A Dream Dies in Texas; Once a Land of Unlimited Promise, the Lone Star State Has Lost Its Shine and Now Has a Barrel of Troubles,” People (November 10, 1986), available: LEXIS, Library: NEWS, File: PEOPLE.

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Natural gas also went through a boom-and-bust cycle, but here the important factor
was federal regulation of natural gas prices. The government had been involved in regulating natural gas prices since passage in 1938 of the Natural Gas Act, which charged the Federal Power Commission (FPC) with regulating rates charged by interstate pipeline
companies.21 Regulation of rates for intrastate pipelines and local utilities was left to state
authorities. Throughout the 1960s wellhead gas prices were frozen at 1959 levels, resulting
in a noticeable decline in drilling activities. By 1968, consumption exceeded additions to
reserves.
In 1970, the intrastate price of natural gas, which most state regulators had left free of
controls, climbed above federal price ceilings. As a result, producers began to reduce their
commitments to interstate pipelines and, whenever possible, diverted natural gas to intrastate markets (mainly Texas, Oklahoma, and Louisiana). This response to the federal
price-control framework was the chief cause of the so-called energy crisis during the 1970s
for natural gas consumers in the Northeast and Midwest. Because of these events, in the
winter of 1970–71 the FPC raised ceiling prices from their 1960s level. Then in 1974 the
FPC adopted a single national price ceiling for natural gas, superseding the areawide pricing formula adopted in 1960 under which the nation had been carved into five regions, each
of which was assigned its own price ceiling. However, because of political pressure, the
FPC set a ceiling price about half as high as the market price for natural gas. This caused
shortages to continue, since suppliers still had little incentive to commit gas for interstate
sales.
Supply problems proliferated and in 1978 nearly 41 percent of the nation’s annual gas
sales were intrastate sales, which meant that 47 states were sharing less than 60 percent of
the nation’s delivered natural gas. The distorted supply situation was the impetus behind
passage of the Natural Gas Policy Act of 1978. The act provided for a phased deregulation
of all types of gas prices through 1985, except for “old” gas (from wells drilled before April
1977), which was to remain controlled, and “deep” gas (from wells below 15,000 feet),
which immediately became free of all price controls.
The act had a significant effect on the production and price of natural gas. After its
passage, the price of so-called deep gas soared to $10 per 1,000 cubic feet and higher—
more than four times the price of regulated shallow gas.22 As a result, a boom developed in
the deep-gas drilling sector. A major beneficiary of the escalating prices was Oklahoma’s
21
22

Unless otherwise noted, the information here on natural gas prices and on the industry is from Frederick S. Carns, “The
Role of Federal Regulation in the Natural Gas Industry,” FDIC Banking and Economic Review 4, no. 5 (June 1986): 3–8.
Unless otherwise noted, the information in this paragraph and the next is from Douglas Martin, “Penn Square’s Oil Connection,” The New York Times (July 19, 1982), available: LEXIS, Library: NEWS, File: NYT; and “Oklahoma Oil and Gas;
This Time the Hurting Won’t Heal,” Economist (August 21, 1982), available: LEXIS, Library: NEWS, File: ECON.

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Anadarko Basin, where most of the drilling activity was centered. The expansion in drilling
for the basin’s higher-priced deep gas is reflected in the increased number of on-shore well
completions, which went from 47,413 in 1978 to 77,505 in 1981. These events contributed
to the huge natural-gas surpluses of the early 1980s.
Demand for natural gas was subsequently reduced by its rising price and by the national economic recession of the early 1980s. By early 1982, therefore, pipeline companies
had halved the price they were prepared to pay for deep gas. Subsequently, natural gas
prices collapsed along with oil prices. For example, after a 33 percent decline in natural gas
prices in 1985, from January through mid-May of 1986 spot market prices dropped another
34 percent (from $1.90 to $1.26 per million British thermal units [BTUs]). 23 These events
were devastating to producers, who were already having problems because deep drilling
had been more costly than anticipated.
For banks, the erosion of oil prices beginning in 1981 led to problems with energy
loans that were largely responsible for the initial increase in the number of bank failures in
1983. Compounding the difficulties caused by the weakening energy markets was the excessive emphasis that some banks had placed on making energy loans to maintain market
share in an environment in which the competition to keep oil and gas customers (during
1981 and 1982) was intense. For example, in 1981 officials of Republic Bank of Texas were
feeling pressure from members of the board of directors to preserve the bank’s market share
in energy lending. It was reported that Chairman James D. Berry summoned the bank’s top
energy lenders to his office and told them he wanted to make more energy loans. The
lenders, who knew the industry was gripped by a gold-rush psychology, “all sat there and
blinked at the chairman, like a bunch of owls in a tree.” But lenders at other institutions
were assuming the price of oil would climb to $60 a barrel or more and had lowered their
lending standards to grab new business.24 Republic’s customers were going to those other
banks.
In hindsight, although bankers might have been more prudent regarding the quality of
their energy loans, there appears to have been little they could do to protect themselves from
the unexpected and precipitous decline in oil prices that occurred in 1986. In mid-January
1986, when oil futures fell below $20 a barrel,25 Frank Anderson, an analyst with Weber,
Hall, Sale & Associates in Dallas, expressed the following opinion:
23

24
25

Detta Voesar, “Economic Conditions in Oklahoma,” FDIC Banking and Economic Review 4, no. 8 (November/December
1986): 22. The spot market is a market for buying and selling commodities for immediate—as opposed to future—delivery and for cash payment; a BTU is the quantity of heat required to raise the temperature of one pound of water by one degree Fahrenheit.
Robert Dodge, “The Long Road Back in Texas.”
A futures contract is an agreement to deliver or to receive some commodity (in this instance, oil) at a specified price at some
specified future time.

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At $18 a barrel, you’ll start seeing a little squirming. . . If oil prices come down gradually,
the banks have a number of things they can do to their energy credits, like add more collateral or restructure the loans. They have a lot more flexibility. But if the price drops suddenly to $15 a barrel, they will have no time to react.26

As noted above, by August 1986 oil prices had plummeted to $10 a barrel.
Many banks compounded their troubles by presuming that the weakening in oil prices
was merely temporary. For example, James Cochrane, chief economist of Texas Commerce
Bancshares, argued that the low level of exploration in mid-1985 would result in future
shortages of oil and gas supplies and that “by the end of the decade, we will have a serious
inability to supply energy products. . .We continue to believe in the long-term future of the
industry.”27 In March 1986, Eugene C. Fiedorek, executive vice president of RepublicBank
of Dallas, told financial analysts that “RepublicBank remains committed to the energy industry; it will make new loans based on expectations that oil prices will soon rebound to
about $18 a barrel.”28 In late April 1986, James Bruce, chief financial officer of Banks of
Mid-America of Oklahoma, said, “I don’t know anyone who in their gut believes that prices
will stay at these levels. The feeling here is that Saudi Arabia is going to prove its point [by
flooding the market with oil] and then prices will recover. A hell of a lot of money that’s
fairly smart says they’re going to recover.”29 Even when a continued fall in oil prices was
considered possible, bankers sometimes displayed a relaxed or indifferent attitude toward
the eventuality. For example, in late 1985, when oil fell in just a couple of weeks from $32
to around $25 a barrel, Larry Helm, executive vice president and head of the energy division of InterFirst Corp. of Dallas, felt that “if the price [of oil] drops to the $20 range, that
might cause some problems on some credits but the magnitude of those problems would not
be so great.”30
Some analysts, however, did not believe that the drop in oil prices was temporary or
of little significance. In late 1985, Sandra Flannigan, a vice president at Paine, Webber,
Jackson & Curtis Inc. in Houston, believed that “if we see oil prices go below [$20 a barrel] and remain there for an extended period, we’ll have substantial problems.”31 Flannigan
also observed at the time that the spillover effects of an oil price decline could reach into
real estate and other areas of the Texas economy that were dependent on oil. Another warn26
27
28
29
30
31

Lisabeth Weiner and Richard Ringer, “Falling Oil Prices Could Bleed Portfolios of Energy Banks,” American Banker (January 22, 1986), 2.
Dodge, “The Long Road Back in Texas.”
David LaGesse, “Banker Predicts Rebound in Oil Prices,” 1.
John Morris, “Banks of Mid-America Treads Water, Waits for Cheap-Oil Flood to Subside,” American Banker (April 30,
1986), 8.
Lisabeth Weiner and John P. Forde, “Oil Price Drop Having Little Effect on Banks: Industry Well Insulated Against Price
Changes, Analysts Say,” American Banker (December 12, 1985), 8.
Ibid.

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ing came in early February 1986, when James W. McDermott, Jr., a bank analyst with
Keefe, Bruyette & Woods, Inc., of New York, cautioned that “we are likely to see a continuation of weak oil prices and a worsening of the financial performance of the Texas
banks.”32 Few bankers appeared to heed such warnings.

Southwestern Real Estate Markets
The tremendous rise in oil prices relative to the increases in other prices resulted in a
substantial transfer of wealth from oil-consuming to oil-producing areas (see figure 9.3).
And even after oil prices weakened, the affluence resulting from the oil boom and expectations that oil prices would rebound kept southwestern real estate markets robust.33 Moreover, commercial real estate in the Southwest was favorably affected not only by internal
but also by external factors.34 Entering the 1980s, the nation’s real estate markets were
Figure 9.3

Domestic Crude-Oil Refiner Acquisition Cost versus
Gross Domestic Product, 1970–1988
$/Barrel
40

GDP Price Deflator
125

GDP

(1987=100)

30

100

Cost

in Constant
(1982) Dollars

75

20

10

Cost

50

in Current
(1988) Dollars

0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988

25

Sources: Economic Report of the President (1993), 352; and see source to
Figure 9.1.
32
33

34

“As Oil Prices Continue to Slide,” 2.
For example, Schmidt noted that despite falling oil prices through most of the year, the rapid increase in the rig count in
1981 was based on expectations that prices could rise to $50 per barrel in the next few years (Ronald H. Schmidt, “The Effect of Price Expectations on Drilling Activity,” Federal Reserve Bank of Dallas Economic Review [November 1984],
1–2). Furthermore, one article noted that banks in 1981 were assuming oil prices would go much higher, not lower, and that
overly aggressive energy lending was tied to a rosy view of post-1981 oil prices (Brian A. Toal, “Credit Where Credit Is
Due,” Oil and Gas Investor 7, no. 9 [April 1988]: 30).
See Chapter 3.

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healthy: elevated inflationary expectations set off speculative demand, which led to attractive returns on real estate investments, and two public policy actions facilitated and probably intensified the demand for commercial real estate. These were the Economic Recovery
Tax Act of 1981, which created substantial tax breaks that raised the returns on commercial
real estate investments, and the Garn–St Germain Act of 1982, which greatly increased the
investment and lending powers of thrift institutions.
The strong southwestern real estate markets attracted investors and bankers who were
seeking new investment opportunities for the wealth and liquidity that had been accumulated over the years of oil prosperity, and the result was a financial environment in which
lenders were aggressively providing funds for real estate development. This contributed to
the substantial growth in such development, especially commercial real estate, and was the
basis for the continued expansion of the southwestern economy during the first half of the
1980s. Eventually real estate development itself reached boom proportions, as evidenced by
the doubling in the number of residential permits issued, from 211,705 in 1981 to 424,854 in
1983, and the increase in the value of nonresidential permits from $7.6 billion in 1980 to approximately $10 billion to $12 billion annually between 1981 and 1985 (see table 9.1)
By the mid-1980s, there was concern that the amount of real estate development was
becoming excessive. For example, in May 1984 Kenneth Rosen, a real estate expert, told a
Table 9.1

Construction Permits in the Southwest, 1980–1994

302

Year

Number of
Residential
Permits Issued

1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

211,096
211,705
295,365
424,854
342,189
256,160
189,349
114,671
92,074
83,503
87,856
94,544
120,696
145,183
190,246

Value of
Nonresidential
Permits
($Thousands)
$ 7,612,364
10,402,804
10,016,236
9,555,382
11,767,921
11,831,367
8,447,611
7,210,674
5,898,880
6,890,954
6,166,786
5,273,940
6,186,262
6,777,214
8,095,027

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session of the American Bankers Association’s national conference on real estate finance
that “commercial developers will take the money and build without looking at demand.”35
In the spring of 1985, a Dallas Morning News article noted that Dallas had 34 million
square feet of unleased office space—more than the total office space in Miami. Such statements indicated the beginning of a slow realization that real estate markets were overbuilt.36
When the sharp contraction in oil prices in 1986 weakened the regional economy, demand
for office space was curtailed; this reduced demand, coupled with the huge volume of new
properties, put downward pressure on real estate prices.
Although the value of nonresidential permits fell from 1985 through 1988, the decline
came too late to prevent serious problems. The office space added during the decade far exceeded demand, and office vacancy rates kept escalating (see figure 9.4). For example, from
1980 to 1987 office vacancy rates in Dallas jumped from 8 percent to 28 percent; in Houston, from 11 percent to 31 percent; and in Oklahoma City, from 2 percent to 28 percent. The
oversupply of office space is indicated by the fact that between 1980 and 1987 the square
Figure 9.4

Office Vacancy Rates, Southwestern Cities
versus U.S., 1980–1994

Percent

Houston
30

20

Oklahoma
City
Dallas
Total U.S.

10

0

1980

1982

1984

1986

1988

1990

1992

1994

Source: CB Commercial/Torto Wheaton Research, The Office Outlook Report
(Fall 1995).

35
36

David LaGesse, “Shakeout Forecast for Commercial Real Estate,” American Banker (May 8, 1984), 3.
Frederick E. “Shad” Rowe, Jr., “Texas Has a Lesson for the Rest of Us,” Fortune (August 1, 1988), available: LEXIS, Library: NEWS, File: FORTUN.

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footage of space per office employee increased by 83 percent in Dallas, 65 percent in Houston, and 56 percent in Oklahoma City (as a comparison, the national average increased by
just 22 percent). Although vacancy rates reached their highest point in about 1987, as late
as year-end 1994 these southwestern cities still had excess office space: vacancy rates in all
three exceeded 20 percent, compared with a national average of 15 percent.37
It is noteworthy that from 1981 through 1983, while office vacancy rates were escalating, commercial real estate construction expenditures and bank funding of projects remained extremely high. The explanations for continued heavy lending for commercial real
estate construction despite the rising vacancy rates include the following: (1) A substantial
increase in the number of newly chartered banks in the Southwest put competitive pressure
on existing institutions to retain market share. (2) Commercial real estate credits contained
higher underlying risk and could therefore be priced above traditional residential real estate
or consumer loans, to increase margins. (3) Perhaps even more attractive to lenders was the
“up-front” fee income generated by commercial real estate loans, particularly construction
loans. (4) Lenders loosened traditional standards relating to debt-service coverage on the assumption that commercial real estate markets would remain prosperous and demand would
keep pace with new construction in progress. (5) Inadequate feasibility studies, which evaluated only an individual project and failed to take into account other activity in progress,
might have made imprudent loans appear attractive. (6) A related problem was that the real
estate appraisal process failed to act as a check on questionable underwriting practices.38

Agricultural Problems
After energy and real estate, agriculture was a source of problems for many southwestern banks.39 First Oklahoma and then Texas suffered severely from the farm crisis;
Louisiana and Arkansas, as well, experienced some agricultural difficulties.
The financial difficulties suffered by Oklahoma’s farmers in the mid-1980s were due
to high production, soft export markets, low prices, and diminishing values of farmland. 40
Compounding these difficulties was the fact that by 1986, farmers could no longer count on
receiving oil and gas royalties to supplement their income: when the price of oil plummeted,
37

38

39
40

Information on Dallas, Houston, and Oklahoma City is from “The Office Market in 1995 and the Outlook” (chap. 4, table
4.2) and “Metropolitan Markets: The Office Outlook” (chap. 6, table 7), in CB Commercial Torto/Wheaton Research, The
Office Outlook, vols. 1 and 2 (1995).
According to regulators who were active in the region, many appraisals were apparently out of touch with reality, and some
regulators believed that inflated appraisals were easy to obtain. For example, it was not unheard of for a development project that cost $1 million to be appraised at $1.8 million. Thus, if a bank lent $1.3 million on this deal, the loan would appear conservative. For a comprehensive discussion of both the appraisal process and the reasons banks strongly supported
the commercial real estate markets, see Chapter 3.
For a general discussion of the agricultural crisis of the 1980s, see Chapter 8.
See Voesar, “Economic Conditions in Oklahoma,” 21–26.

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many drillers abandoned wells they had formerly operated on farmers’ spare acreage. Ripple effects stemming from farmers’ financial problems hit rural towns in Oklahoma particularly hard, causing many merchants to go out of business and many residents to move to
urban areas. As one observer noted, small rural towns in Oklahoma rapidly became an endangered species in the mid-1980s.
Texas has substantial agricultural interests, ranking second among all states in farm
income and third in farm marketings in 1985.41 Texas was therefore not immune to the
worst farm crisis since the Depression, but felt the effects of the crisis about two years later
than the agricultural heartland.42 The price of farmland in Texas had not skyrocketed in the
1970s as it had in farm-belt states (James Rogers, president of the Farm Credit Banks of
Texas, said, “It was not uncommon for land in the Farm Belt to be worth about $3,000 an
acre at its height, while the very best land in Texas only climbed to around $1,500 an
acre”).43 And in 1981–85, when land prices in other farm-belt states declined by as much as
50 percent from their highs, Texas farmland increased by 45 percent—the largest increase
in the country.44 Nevertheless, by 1986 farmers in Texas were feeling the effects of many
years of rising costs and low commodity prices. “The number of farmers with heavy debt
has increased dramatically over the last three to four years,” said James L. Sexton, the Texas
banking commissioner, in 1986. “The small-farm producer is in a pinch trying to make the
proceeds of his crop pay off his costs, plus trying to make a living.”45
The region’s agricultural problems had a significant effect on banks, especially in
Texas. Until 1985 the state’s agricultural banks had escaped many of the problems encountered by farm-bank lenders in the Midwest and Central Plains states, primarily because of
the state’s diverse economy and the bankers’ own cautious lending policies.46 But by 1986,
the increased burden on farmers caused Texas banks to experience mounting levels of troubled loans and foreclosures.47 Between 1977 and 1993, Texas had 36 agricultural-bank
failures, the third largest of any state.48 During the same period, Oklahoma had 31
agricultural-bank failures, the fifth-largest number. Texas and Oklahoma were two of four
41

Department of Commerce, Bureau of the Census, National Data Book and Guide to Sources: Statistical Abstract of the
United States 1988, 108th ed., (1988), 618–19. Farm marketings represent agricultural products sold by farmers multiplied
by prices received per unit of production at the local market.
42 Andrea Bennett, “Diversity, Caution Help Texas Weather Farm Crisis in Good Shape,” American Banker (November 18,
1985), 14, 20.
43 Ibid., 14, 18.
44 Ibid, 14.
45 “Farm Banks in Texas Beginning to Feel Lending Sting All Too Familiar to Their Midwestern Counterparts,” American
Banker (May 1, 1986), 40.
46 Bennett, “Diversity, Caution,” 14.
47 “Farm Banks in Texas Feel Sting.”
48 Agricultural banks are banks where agricultural loans are at least 25 percent of total loans and leases.

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states that each held 10 percent or more of all failed agricultural-bank assets in the U.S. In
the rest of the region, Louisiana and Arkansas each had 5 agricultural-bank failures, while
New Mexico had none.

The Boom and Bust in Texas
Initially the expansion of construction in Texas was tied to the rapid growth in the
state’s economy due largely to the escalating oil prices between early 1974 and early 1981.
During this period, nonresidential construction activity more than quadrupled, while office
vacancy rates fell from 15 percent to 7.6 percent in Dallas and from 7.8 percent to 5.7 percent in Houston.49 Beginning in 1982, however, despite falling oil prices and downturns in
the Texas and U.S. economies, the construction sector continued to surge. The magnitude
of construction activity was tremendous, leading Texans to joke that the construction crane
should replace the mockingbird as the official state bird. The divergence between the weak
Texas economy and the high levels of construction continued until the mid-1980s, and the
space that was added during this period far exceeded demand.
Texas banks, seeking both refuge from problem oil loans and new investment opportunities, strongly supported the real estate boom. Boom conditions often attract poorly qualified participants who see an opportunity to earn easy money, and that happened here. As
Ken Sanstead, resident manager of Coldwell, Banker & Co., observed in 1985, “Forty
novice developers who can call on little or no experience in the development game are involved in construction projects in Dallas [and] most of the current overbuilding is being
done by the novices.”50
In 1986, however, construction in Texas began a prolonged decline, mostly because of
plummeting oil prices and the consequent severe recession in the Texas economy (and
partly because of the effects of the 1986 Tax Reform Act).51 According to one estimate, each
$1 drop in the price of crude oil resulted in the loss of 25,000 jobs and $100 million in revenue in Texas.52 Typically, the layoffs began in the oil fields themselves and were followed
by losses in related jobs, such as those held by geologists and engineers. Next, service companies began to fold, including not only oil-related companies but also motels, restaurants,
and grocery and clothing stores. By the end of September 1986, 743,000 Texans were unemployed, and the unemployment rate in Houston had reached 10.5 percent, compared with
only 7.4 percent in January 1986 (in contrast, the national unemployment rate fell from 7.3
49
50
51
52

Information in this paragraph is from D’Ann M. Petersen, Mine K. Yucel, and Keith R. Phillips, “The Texas Construction
Sector: The Tail That Wagged the Dog,” Federal Reserve Bank of Dallas Economic Review (second quarter 1994): 23–24.
Carl Hooper and Eileen O’Grady, “Overbuilding Softens Dallas Office Market: Projects Canceled, Postponed,” Houston
Post (September 29, 1985), 3E.
See the appendix to Chapter 3 for a discussion of the effects of this legislation.
“A Dream Dies in Texas,” People (November 10, 1986), 46.

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percent in January 1986 to 6.8 percent in September 1986).53 In 1986 employment in Texas
fell by approximately 250,000, and people began leaving the state.
With the outward migration adding to the pressure on already high apartment and office vacancy rates, construction activity collapsed. In 1986 the state lost almost 100,000
construction jobs—40 percent of the state’s total job decline, even though construction accounted for only 6.7 percent of Texas employment in 1985.54 The volume of construction
continued to fall throughout the late 1980s despite a turnaround in the Texas economy in
1987.
The commercial markets were not the sole source of the Texas real estate problems.
For example, Houston was hit especially hard by a collapse in the residential real estate
market.55 The single-family housing boom there surpassed that in other oil-patch cities,
leading to a greater oversupply of single-family houses and a sharper drop in prices when
the bust came. Between 1983 and 1988, median home resale prices in Houston declined by
23 percent, from $79,900 to $61,800 (see figure 9.5). This contrasted significantly with the
Figure 9.5

$Thousands
100

Median Home Resale Prices,
Houston versus U.S., 1980–1990

90

Houston

U.S.

80

70

60

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Source: National Association of Realtors, Home Sales.

53
54
55

Ibid.; and Frederick S. Carns, “Economic Conditions in Louisiana, Oklahoma and Texas,” FDIC Banking and Economic
Review (April 1986): 12.
Petersen et al., “The Texas Construction Sector,” 26.
The discussion of Houston that follows is based on Steve Frazier, “Suburban Blight: Housing-Market Bust in Houston Is
Creating Rash of Instant Slums,” The Wall Street Journal (February 5, 1987), available: WESTLAW, File: WSJ.

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national trend, where home prices increased by 27 percent, from $70,300 to $89,300, during the same period.
The root cause of Houston’s difficulties was the frenetic overbuilding that had continued despite the beginning of the end of the oil boom. Even though employers had laid off
160,000 workers in 1982 and 1983, residential building continued at a record pace. From
1980 to 1982 the number of newly issued building permits for residential construction in
Houston jumped 88 percent, and the number of single-family housing starts rose 46 percent.
Nationally during the same period, building permits and housing starts were declining 17
percent and 22 percent, respectively (see figures 9.6 and 9.7). The magnitude of Houston’s
bust is reflected in the 91 percent plunge in the number of permits and the 75 percent drop
in housing starts from 1982 to 1987. Nationally during the same period, the number of
building permits for residential construction increased by 52 percent, while single-family
housing starts climbed by 73 percent. As Pamela Minich, a local real estate analyst, observed, “There were problems in the [Houston] housing market long before the price of oil
went through the floor. Builders just went crazy. Many, many of the neighborhoods that are

Figure 9.6

Newly Issued Building Permits (Residential),
Houston versus U.S., 1980–1990

Houston Units
(Thousands)
80

U.S. Units
(Thousands)
2,100

Houston
60

1,800

40

1,500

U.S.
1,200

20

0

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

900

Source: U.S. Department of Commerce, Construction Review (data cited in FDIC,
The Real Estate Report, Dallas Region [January 1, 1992]).

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Figure 9.7

Housing Starts, Houston versus U.S., 1976–1995
Houston Units
(Thousands)
35

U.S. Units
(Thousands)
1,800

30

1,600

Houston
25

U.S.

1,400

20

1,200

15

1,000

10

800

5

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994

600

Source: F. W. Dodge/McGraw Hill, Real Estate Analysis and Planning Service (1992);
and U.S. Department of Commerce, Bureau of the Census, Current Construction
Reports.

having troubles [in 1987] are ones that shouldn’t have been built.”56 Between 1983 and
1987, numerous attractive Houston communities had been transformed into blighted, declining neighborhoods, representing the costliest housing-market debacle since the Great
Depression.
At the beginning of 1987, one in six homes and apartments in Houston stood vacant.
In early 1987, because of the associated plunge in property values, the tax rolls of Harris
County (where Houston is located) had declined by an estimated $8 billion. The magnitude
of the collapse in property values—more than 50 percent in some suburbs—caused many
homeowners simply to walk away from their homes and their mortgage payments. In some
communities, foreclosure rates were in excess of 60 percent. Projections at the end of 1985
had indicated that total foreclosures in Houston for 1984–86 would exceed 70,000—about
the same number of houses that were built during 1986 in the cities of Detroit, Chicago, and
Seattle combined. Later some depressed neighborhoods deteriorated further because of

56

Frazier, “Suburban Blight.”

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vandalism and other damage to vacant properties. Some properties were damaged so severely that the repossessed dwellings could be unloaded only for their raw-land value.
Although many analysts did not anticipate the damage that real estate loans would inflict on Texas banks,57 certainly there were some who foresaw problems. For example,
Ronald J. Hoelscher, president of the Horne Co., told the Houston Outlook ’83 conference
that “declining building permits for office space [in Houston] will continue through 1983
and while developers have slowed the construction of industrial space, the demand is
falling so that the supply is still over-abundant.”58 In addition, a local real estate firm observed in 1984 that “there is already at least a 10-year supply of housing in Dallas County,
while normal markets generally carry about a nine-month supply.”59 Furthermore, in September 1984 the Houston Apartment Association warned that vacancy rates would continue
to increase unless leases were signed for a substantial percentage of the 20,000 new units
scheduled to be completed in Metropolitan Houston that year.60

The Boom and Bust in Louisiana and Oklahoma
Although the multifaceted debacle in Texas was the major story in the Southwest, the
collapse of the energy and real estate markets and the accompanying agricultural problems
also had devastating effects on the economies of Louisiana and Oklahoma as well as on the
banks in those states. Between 1980 and 1994 there were 70 bank failures in Louisiana—
22.4 percent of the state’s banks. Oklahoma endured 122 bank failures—22.0 percent of its
banks.61 During the same period, assets of failed banks at the time of failure amounted to
$4.1 billion in Louisiana and $5.8 billion in Oklahoma.

57

58
59
60
61

For example, in 1986 Frank Anderson, a banking analyst with the firm of Weber, Hall, Sale & Associates Inc. in Dallas,
stated that “we won’t see the debacle in real estate that we have in energy.” Such opinions were based on the fact that real
estate had a relatively higher value than much of the energy-loan collateral. For example, even Houston properties generally brought at least 50 cents on the dollar, whereas oil rigs and equipment were often valued at pennies on the dollar. See
two articles by Richard Ringer: “Real Estate Joins Energy in Harrying Texas Banks: As Energy Chargeoffs Diminish RealEstate Problems Grow,” American Banker (May 2, 1986), 3; and “Drop in Oil Prices Worries Banks in Texas and Oklahoma: Biggest Energy Lenders Construct Damage Scenarios While Waiting for Volatile Market to Stabilize,” American
Banker (February 18, 1986), 1, 28.
“Real Estate’s Upturn to Lag, Parley Hears,” Houston Post (January 21, 1983), D2.
Andrew Albert and Richard Ringer, “Dallas County Housing Glut Hurts Local Lenders: Empire Savings Cited as One of
Several S&Ls That Financed ‘Real-Estate Monster,’ ” American Banker (March 20, 1984), 16.
Carl Hooper, “Tenant Wars Escalate: Year of Free Rent Latest Gimmick,” Houston Post (September 6, 1984), F10.
The number of bank failures refers to FDIC-insured commercial and savings banks that were closed or received FDIC assistance. The percentage of banks that failed is based on the total number of banks existing in each state at year-end 1979
plus banks newly chartered in each state from 1980 through 1994.

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In the mid-1980s, the state economies of Louisiana and Oklahoma (as well as Texas)
were five times more dependent on energy production than the nation as a whole.62 In 1986,
for example, nearly 40 percent of Louisiana’s state revenues came from oil and natural gas
production, and in 1985 depressed energy prices held economic growth to under 1 percent
(in Oklahoma as well). In June of that year, Louisiana’s unemployment rate was 11.5 percent, the second-highest in the nation. In addition, residential building permits issued in the
state in 1985 declined by more than 25 percent from levels a year earlier.
Despite signs of economic weakness, as of late 1985 Louisiana banks—unlike banks
in Texas and Oklahoma—had not had significant problems related to declining energy
prices. One reason for this, according to Michael D. Charbonnet, a principal with Lyons,
Merrigan & Charbonnet, a New Orleans–based bank consulting firm, was that “Louisiana
banks were not big enough to finance the major oil and gas development projects. Texas and
Oklahoma banks mainly kept that business to themselves.”63 Instead, Louisiana banks had
concentrated on the service companies, such as equipment supplies. But in late 1985 and
early 1986, when energy prices collapsed, the state’s economic woes escalated. “I haven’t
seen New Orleans this way since I was a child in the 1930s,” said Ruth McCusker, chairman of the New Orleans Public Library Board, in early 1986. “It’s not looking real good
around here. People are out on the street. It is depressing.”64 Louisiana banks came under
increasing pressure as the companies they financed faced mounting difficulties, and bank
failures in the state soon escalated.
Unlike Louisiana’s economy, Oklahoma’s economy was based primarily on energy
and agriculture, and boom-and-bust cycles had been part of the state’s history.65 But in the
past, when one of the two sectors weakened, typically the state’s economy would be buoyed
by the relative health of the other. This general pattern held until 1985, when the energy industry was collapsing at the same time that the agriculture sector was already ailing. The simultaneous weaknesses dealt a severe blow to the state’s economy.
In the mid-1980s, Oklahoma was the fifth-ranking state in oil production. But approximately 60 percent of its oil production came from “stripper” wells, which yield 10 bar62

63
64

65

Information in this paragraph is derived from the following sources: Herbert Swartz and Lan Sluder, “La. Banks Battle
Tough Times for Profits, Equity,” New Orleans Business (February 3, 1986), available: LEXIS, Library: NEWS, File:
BUSDTL; and Bart Fraust, “A Year of Upheaval for Louisiana Banking: State’s New Multibank Law Has Spurred a Dramatic Changing of the Guard,” American Banker (October 19, 1985), 16–18; testimony by Robert V. Shumway, director of
the FDIC’s Division of Bank Supervision, before the U.S. Senate Committee on Energy and Natural Resources on March
25, 1986, as reported in: “FDIC,” American Banker (April 17, 1986), 4–7.
Fraust, “A Year of Upheaval.”
David Maraniss, “Oil Slump’s Damage Spreading; Academic, Social, Cultural Advances Threatened in Three Energy
States; Recovery May Take Years,” The Washington Post (April 9, 1986), available: LEXIS, Library: NEWS, File:
WPOST.
Unless otherwise noted, the information on Oklahoma is from Voesar, “Economic Conditions in Oklahoma.”

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rels or less of oil per day and are expensive to operate. As of May 1986, there were more
than 80,000 stripper wells operating in Oklahoma, many of which could not operate profitably with oil prices below $15 a barrel. The plummeting oil prices therefore had a particularly devastating effect on that state. For example, at the end of 1981, when the number of
drilling rigs operating in the state was at its peak, there were nearly 900 of them, but as of
May 1986 there were only 128. Oklahoma’s gas industry also suffered from plummeting
prices, as described above, and producers began to shut down their wells.
The collapse in energy prices caught many Oklahoma bankers by surprise. In early
1986, Fred Moses, president of Liberty National Bank and Trust Co. (Oklahoma City), observed, “This happened so damn quickly—in 90 days. We all expected a dip, but none of us
assumed it would be such a precipitous drop.”66 The extent of the damage in the state in
1986 was indicated by Diane Gower, assistant to the director of Neighbor for Neighbor, a
nonprofit social services program in Tulsa, who observed that “we’re seeing more and more
in the middle-income family bracket. Some are unemployed, some are working at minimum wage. We have a lot where husband and wife are working McDonald’s and Arby’s
type jobs, and it’s difficult for them to make it. Some had good jobs and lost them. Oil has
made this part of Oklahoma a disaster area.”67
In addition to the difficulties with energy and agriculture, problems with real estate
also affected Oklahoma’s economy and banks. Oklahoma State Banking Commissioner
Wayne Osborn noted the predicament faced by Oklahoma bankers with regard to the real
estate they had acquired through foreclosures: “The dilemma is that banks lose money on
earnings if they hold the property because of the upkeep expenses and the significant vandalism problems from abandoned property. A lot of real estate investors are willing to buy
the property, but they want a low price and with financing at a preferential treatment. You’re
sort of damned if you do and damned if you don’t.”68
As has been described, the booming oil markets of the 1970s and early 1980s were the
foundation of a prosperous southwestern economy, particularly in Texas, Oklahoma, and
Louisiana. This prosperity supported a tremendous expansion in the real estate markets, especially commercial real estate. The southwestern economy was adversely affected when
oil prices began drifting downward in 1981, since much of the region’s vitality and optimism was based on the expectation that oil prices would continue to rise to ever-higher levels. Then in 1986 oil prices plunged, contributing to the collapse in the real estate markets.
The Southwest in general and Texas in particular were forced to cope with serious eco66
67
68

Morris, “Banks of Mid-America Treads Water,” 8.
Maraniss, “Oil Slump’s Damage Spreading.”
Teresa McUsic, “Bank Closings to Continue,” Tulsa World 83, no. 163 (February 26, 1988), available: LEXIS, Library:
NEWS, file: TLSWLD.

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nomic problems. The 1981 weakening of oil prices and the subsequent oil price crash and
real estate debacle (in the mid-1980s) caused substantial losses on the energy and real estate loans made by the region’s banks, and the result (as discussed in greater detail below)
was an escalation in the number of bank failures later in the decade.

The Banking Environment in the Southwest
Two factors made southwestern banks particularly aggressive participants in the
booming regional economy: (1) prosperity caused their numbers to increase, as chartering
activity tremendously expanded during the first half of the 1980s, and (2) S&Ls were newly
empowered competitors (the Garn–St Germain Depository Institutions Act of 1982 broadened their lending powers).
The increase in the number of newly chartered southwestern banks in the early 1980s
was dramatic: the number jumped from 62 in 1980 to a peak of 168 by 1984 (see figure
9.8).69 After 1984, however, the rate of chartering declined rapidly, and very few new bank
charters were issued in the region from 1987 through 1990. All told, from 1980 to 1990, 745
banks were chartered there. But newly chartered banks tend to fail more frequently than esFigure 9.8

Newly Chartered Banks, Southwest versus U.S.,
1974–1994

Number
500
400

U.S.
300
200

Southwest

100
0

69

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994

New southwestern bank charters from 1980 through 1984 were concentrated in Texas, where there were 442. During the
same period, Oklahoma had 56 new bank charters; Louisiana, 44; New Mexico, 11; and Arkansas, 5.

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tablished banks, and this certainly was what happened in the Southwest. From 1980 through
1994, 33 percent of the southwestern banks that had been chartered from 1980 through
1990 failed, compared with only 21 percent of southwestern banks that were in existence on
December 31, 1979. The rapid growth of newly chartered banks, therefore, appears to have
contributed to the large number of failures in the region.
The problems that might follow from large increases in the number of new entrants
were not ignored by observers at the time. Regulators and bankers noted that part of the reason for the highly competitive banking environment was that so many new banks had been
chartered that they seemed to be pursuing the same business. Bob Lehman, president of
Charter Bank-Arena, expressed the problem well in 1984 when he pointed out that “too
many new independent banks are chasing too few good loans for everyone to succeed.”70
Interviews that FDIC researchers conducted with regulators who had been active in the area
at the time suggest that the apparently excessive number of new institutions could be at least
partly attributed to chartering authorities’ laissez-faire approach to new charters. Among the
specific lapses that some regulators observed with regard to the chartering of new institutions were the failure to test for the community need of a new bank, the lack of feasibility
studies, and reliance primarily on the availability of certain amounts of capital, with few
other requirements.
Chartering activity was especially pronounced in Texas, where the number of commercial banks chartered went from 45 in 1980 to 131 in 1983 but then to 0 in 1989. Commercial banks chartered in Texas were approximately 37 percent of all new commercial
banks chartered in the United States in 1983 and 1984 but only 7 percent of the number
chartered in 1987. The large number of Texas banks chartered in the 1980s had significant
consequences: one study suggests that newly established Texas banks were much more aggressive than their mature counterparts in pursuing high-risk strategies. Specifically, these
banks had, on average, a significantly higher concentration of commercial and industrial
loans and a substantially lower proportion of assets in U.S. government securities and
funded a far higher proportion of their assets with large certificates of deposit. These highrisk strategies help explain why Texas banks established during the 1980s had a relatively
high incidence of failure.71
Intense competition from S&Ls also contributed to the poor financial condition of
some southwestern banks.72 The savings and loan industry expanded dramatically in the
70
71

72

Eileen O’Grady, “Soft Real-Estate Market Bad News for Banks,” Houston Post (April 23, 1984), F4.
The study results are taken from Jeffery W. Gunther, “Financial Strategies and Performance of Newly Established Texas
Banks,” Federal Reserve Bank of Dallas Financial Industry Studies (December 1990): 10. For further discussion of chartering policy and Texas banks, see Chapter 2, the section on entry.
See Chapter 4.

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early 1980s after Garn–St Germain gave the industry broader lending powers, and the expansion was especially pronounced in the Southwest because of that region’s strong southwestern energy markets. S&Ls in Texas were particularly aggressive in their pursuit of
growth and were willing to pay above-market interest rates to attract funds for new investment activities. This behavior forced even well-capitalized banks to pay the so-called Texas
premium, estimated to be 50 basis points or more, in order to maintain their funding base.
S&Ls competed vigorously to initiate commercial real estate loans, and the competitive pressure led some banks to lower their underwriting standards, liberalizing lending
terms and minimizing equity requirements. Regulators and bankers who participated in
southwestern banking activities observed that developers were receiving loan offers from
both banks and S&Ls; bankers seemed to believe it was inadvisable to turn down requests
from their customers because the customers could easily obtain credit elsewhere. The
S&Ls’ above-market interest rates placed downward pressure on bank profitability, and the
lowered lending standards contributed to the excessive real estate development, the oversupply, and the eventual collapse of southwestern real estate values.

The Effect of the Economy on Southwestern Banks
The booming economy was reflected in rising asset growth rates and in increasing ratios to assets of loans, of commercial and industrial loans, and of real estate loans. Thus, the
level of risk in the banking system rose. By the same token, the subsequent oil and real estate problems were reflected in the rapidly rising levels of nonperforming assets and
charge-offs, in the sharp decline in banks’ return on assets, and in the escalating numbers of
bank failures.
With bank loans providing important support to the oil boom, bank asset growth rates
for the region increased steadily from an annual rate of 10.8 percent in 1975 to 18.8 percent
in 1981 (see figure 9.9). But after oil prices peaked in 1981, the region’s bank asset-growth
rate began to decline and, from 1986 through 1988, was actually negative.
Another reflection of the increasing participation of southwestern banks in the energy
markets was the substantial rise in the median ratio of commercial and industrial (C&I)
loans to assets: between 1979 and 1982, the ratio rose from approximately 12 percent to
over 16 percent (see figure 9.10). During the same period, the percentage for the nation as
a whole increased minimally, from just under to just over 10 percent. After oil prices
plunged, the C&I loans-to-assets ratio dropped from over 16 percent in 1982 to less than 7
percent in 1992. During the same period the ratio for the nation as a whole also declined,
but far less dramatically—from approximately 10 percent to 7 percent.
After the energy boom had peaked, real estate loans became an increasingly larger
portion of the loan portfolio of the banks in the region. The banks’ median ratio of real esHistory of the Eighties—Lessons for the Future

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Figure 9.9

Asset Growth Rates, Southwest versus U.S.,
1975–1994
Percent

20

Southwest
Banks

10

U.S.
Banks

0

-10

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994

Year-end

Figure 9.10

Median Commercial and Industrial Loans,
Southwest versus U.S., 1974–1994

Percent of Assets
18

Southwest
Banks

15

12

U.S.
Banks

9

6

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994

Year-end

316

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Chapter 9

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tate loans to assets rose from 12 percent in 1981 to a peak of 21 percent in 1987 (see figure
9.11). Residential real estate loans increased significantly (from 4.5 percent of bank assets
in 1980 to 7.6 percent in 1985 and then to 9.8 percent in 1994), but it was the rise in commercial real estate loans that had the greatest effect on the banks: commercial real estate
loans went from just over 4.5 percent of bank assets in 1981 to a peak of 8.8 percent in 1986
(see figure 9.12). The volume of bank lending to the real estate markets appears to have
greatly affected loan concentrations: the median loans-to-assets ratio for southwestern
banks rose from just under 50 percent in 1980 to 57 percent in 1985 but then declined to 43
percent in 1992 (see figure 9.13). This decline was in noticeable contrast to the national
trend, where loan concentrations increased slightly between 1985 and 1990.
The most profitable period for the Southwest’s banks was during the oil boom. Between 1978 and 1981 the median return on assets (ROA) for southwestern banks rose
steadily from 1.12 percent to 1.32 percent (see table 9.5, on p. 330). However, ROA began
to decline in 1982 and fell continuously to 0.32 percent in 1987. This downturn in ROA coincided with the weakening of the oil sector as well as the increased importance of real estate lending, and much of the decline in profitability can be attributed to escalating levels of
nonperforming assets between 1982 and 1987 (see figure 9.14) and high loss rates on these
assets (see figure 9.15). The especially steep rise in the nonperforming assets of southwestFigure 9.11

Median Total Real Estate Loans,
Southwest versus U.S., 1974–1994
Percent of Assets
35
30

U.S.
Banks

25
20
15

Southwest
Banks

10
5

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

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Figure 9.12

Median Commercial Real Estate Loans,
Southwest versus U.S., 1980–1994

Percent of Assets
10
9

U.S.
Banks

8

Southwest
Banks

7
6
5
4

1980

1982

1984

1986
1988
Year-end

1990

1992

1994

Figure 9.13

Median Gross Loans and Leases,
Southwest versus U.S., 1976–1994
Percent of Assets
60

55

U.S.
Banks
50

Southwest
Banks

45

40

318

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

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Chapter 9

Banking Problems in the Southwest

Figure 9.14

Median Total Nonperforming Assets,
Southwest versus U.S., 1982–1994
Percent of Assets

4

Southwest
Banks

3

2

U.S.
Banks

1

1982

1984

1986

1988
Year-end

1990

1992

1994

Figure 9.15

Median Net Charge-Offs on Loans and Leases,
Southwest versus U.S., 1976–1994
Percent of Assets
0.8

0.6

Southwest
Banks
0.4

0.2

0

U.S.
Banks
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

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ern banks between 1985 and 1987 indicates how banks were ravaged by both the oil price
collapse beginning in late 1985 and the increasing real estate problems. The performance of
the region’s banks from 1985 to 1987 diverged from the national trend, in which the percentage of nonperforming assets was falling at a moderate rate. In contrast, the rising trend
of charge-offs at southwestern banks more closely followed the national trend, although the
rate of increase of net charge-offs from 1982 to the peak in 1986 was far greater in the
Southwest than nationally.

Bank Failures in the Southwest
The deterioration in the financial health of the southwestern banks eventually led to a
dramatic increase in the number of bank failures in the region, from only 5 in 1983 to a peak
of 214 in 1988 (see figure 9.16). Southwestern bank failures as a percentage of all bank failures jumped from 10.4 percent in 1983 to a peak of 80.7 percent in 1989. From 1987
through 1989, 71.3 percent of the bank failures in the United States were southwestern
banks (491 out of 689). Southwestern banks accounted for the largest portion of U.S. bank
failures in the 1980s, not only in number but also in total failed-bank assets. As noted in the
introduction to this chapter, in 1988 losses to the FDIC as a result of southwestern bank failures were nearly $6.3 billion (91 percent of total U.S. failure-resolution costs that year), and
Figure 9.16

Number
300

Bank Failures, Southwest versus U.S.,
1980–1994

Percent
100

240

80

180

60

Southwest
as a Percentage
of Total

120

40

60
0

20

1980

1982

1984

1986

Southwest Bank Failures

320

1988

1990

1992

1994

0

Total Bank Failures

History of the Eighties—Lessons for the Future

Chapter 9

Banking Problems in the Southwest

in 1989 were approximately $5.1 billion (or 82 percent of national failure costs). In 1990
losses from southwestern failures fell to approximately $1.1 billion, or 38 percent of national failure costs; and in 1991 to only $282 million, approximately 4.7 percent of failure
costs.
The initial surge in the number of southwestern bank failures was caused primarily by
problems with energy loans. The second wave of failures of many of the area’s banks, in the
middle to late 1980s, was caused primarily by the asset-quality problems connected with
the expansion of commercial real estate lending, especially among Texas banks. Banks suffered as completion rates and office vacancy rates rose, leading to defaults on many real estate loans. Banks that eventually failed in the Houston, Dallas, and Oklahoma City markets
had substantially higher concentrations of commercial real estate loans than did banks that
survived (see figure 9.17). The collapse of the southwestern real estate markets in the late
1980s was certainly the final blow to many banks, but it is important to remember that the
previous weakening of the energy sector and the declines in energy prices had already
caused many banks to suffer loan losses, and these had made the banks too vulnerable to
withstand the additional losses on real estate loans.
By far the most severely affected state in the Southwest was Texas. From 1980 through
1989, 367 Texas commercial banks failed. Although in 1983 only three Texas banks failed,
in 1988 the number was 175, with assets of $47.3 billion—24.7 percent of the state’s 1987
year-end banking assets. The following year there were 134 failures, with assets of $23.2 billion—13.6 percent of the state’s banking assets. In contrast, in the region’s four other states
(Oklahoma, Louisiana, Arkansas, and New Mexico), assets of failed banks were less than 3.5
percent of each state’s banking assets in any given year. In 1988 and 1989, failed Texas banks
accounted for 85 percent of total U.S. failed-bank assets. A list of the Southwest’s largest
bank failures indicates the severity of the situation in Texas (see table 9.2).
Certain patterns were evident among failed Texas banks.73 Most Texas commercial
banks that failed in the 1980s had reacted quickly to oil price movements. Concentrations
of C&I loans, which include loans to oil and gas producers, increased from 1978 through
1981 along with oil prices, peaked in 1982 shortly after oil prices began to drop, and subsequently declined along with oil prices. In addition, failed Texas commercial banks had
generally increased their concentrations in construction and land development loans long
after the local real estate markets began declining. Finally, failed Texas banks had continued to fund completed construction projects even though commercial real estate vacancy
rates were growing (traditionally, long-term financing of completed commercial properties
was provided by nonbank financiers).

73

These patterns are identified in O’Keefe, “The Texas Banking Crisis,” 1.

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It is noteworthy that healthy equity ratios in the early 1980s did not prevent large
Texas banks from eventually failing. Nine of the ten largest Texas bank holding companies
were recapitalized in the 1980s. Between 1980 and 1982 equity capital ratios for those nine
organizations were, on average, more than 25 percent higher than the equity capital ratios
Figure 9.17

Commercial Real Estate Lending in Houston, Dallas, and Oklahoma City,
Failed versus Nonfailed Banks, 1974–1994
(Median Percent of Assets)

Houston

Percent

Dallas

Percent

18

20

15

15

12

10
9

5

6
3

1975

1980

1985
Year-end

Percent

1990

1994

0

1975

1980

1985
Year-end

1990

1994

Oklahoma City

12
9
6
3
1975

1980

1985
Year-end

Banks That Subsequently Failed

322

1990

1994

Banks That Did Not Fail

History of the Eighties—Lessons for the Future

Chapter 9

Banking Problems in the Southwest

Table 9.2

Large Southwestern Bank Failures, 1980–1994
Name of Institution

Date of
Failure

Penn Square Bank, N.A.
Abilene National Bank*
The First National Bank of Midland
First Oklahoma BC
BancOklahoma Corp
BancTexas Group
First City Bancorp
First Republic
MCorp
Texas American
National Bancshares

07/05/82
08/06/82
10/14/83
07/11/86
11/24/86
07/17/87
04/20/88
07/29/88
03/29/89
07/20/89
06/01/90

Assets at
Failure
($Millions)
$

436
437
1,410
1,754
468
1,181
12,374
31,277
15,641
4,665
1,594

Resolution
Cost
($Millions)
$

65
0
526
168
79
150
1,101
3,762
2,844
1,077
213

Cost as %
of Assets

State

14.9%
0
37.3
9.6
16.9
12.7
8.9
12.0
18.2
23.1
13.4

OK
TX
TX
OK
OK
TX
TX
TX
TX
TX
TX

Note: “Large” is defined as more than $400 million in assets.
* Received open-bank assistance.

of their peers. By 1987, however, this capital cushion had dissipated, and the nine holding
companies held a third less capital than their peers.74
Generally, stringent regulation prevented the “moral-hazard” problem from affecting
banks as it did many thrift institutions during the 1980s.75 (Simply put, the moral-hazard
feature of deposit insurance is that an insured depository institution’s ability to put at risk
funds that are guaranteed by the government may encourage it to participate in risky ventures it might otherwise avoid.) Nevertheless, one study found that moral hazard provides
at least a partial explanation for the financial difficulties of so many Texas banks.76 This
74
75

76

Ibid.
As indicated in Chapters 1 and 12 of this study, problem banks experienced reduced growth and dividend rates and increased capital infusions following regulatory intervention. Another study found that during the 1985–89 period undercapitalized banks generally did not grow rapidly, pay dividends, or make loans to insiders, all of which are behavior
patterns normally associated with high-risk strategies (R. Alton Gilbert, “Supervision of Undercapitalized Banks: Is There
a Case for Change?” Federal Reserve Bank of St. Louis Review 73, no. 3 [May/June 1991]: 17, 21, 24–26). Chapters 1 and
12 of this study also present estimates of the cost savings that might have been gained from earlier closing of failed banks.
Another study found no relationship between, on the one hand, the level of capital one year before failure or the length of
time a bank was undercapitalized and, on the other hand, its resolution cost (R. Alton Gilbert, “The Effects of Legislating
Prompt Corrective Action on the Bank Insurance Fund,” Federal Reserve Bank of St. Louis Review 74, no. 4 [July/August
1992]: 10, 12).
Jeffery W. Gunther and Kenneth J. Robinson, “Moral Hazard and Texas Banking in the 1980s: Was There a Connection?”
Federal Reserve Bank of Dallas Financial Industry Studies (December 1990): 1–7.

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study revealed that as long as Texas banks possessed the ability to expand their lending,
lower growth rates of capital were associated with larger increases in lending, as moral hazard would suggest.77 The implication of this finding is that managers of Texas banks that
were in a weakened financial position, as indicated by a decline in capital growth, had proportionally less of their own equity funds at stake and hoped to increase expected earnings
by assuming additional risks. This increase in the risk profiles of many banks, which is consistent with moral hazard, may have led to an expanded number of Texas bank failures.

The Failures of Penn Square and First National
Two significant failures of southwestern banks that occurred during the first half of
the 1980s were those of Penn Square Bank, N.A., of Oklahoma City and the First National
Bank of Midland, Midland, Texas. The failures of these banks were important not only because at the time the two banks were relatively large and their failures foreshadowed the
problems the Southwest would face in the second half of the 1980s, but also because they
glaringly illustrated the results of speculative energy lending.
The first major failure of a southwestern bank was Penn Square, a $436 million bank
that was closed on July 5, 1982.78 Penn Square was the seventh-largest bank in Oklahoma
at the time of closing, and the effect of its failure on other major banks was devastating. The
First National Bank of Midland was a $1.4 billion bank that was closed on October 14,
1983. It was Texas’s largest independent bank, the largest bank in the Midland-Odessa oil
region, and the second-largest commercial bank (at the time) to fail in FDIC history.79
Penn Square, a one-office bank in a shopping mall on Oklahoma City’s north side, had
been an aggressive lender principally to small oil and gas producers.80 (Approximately 80
percent of its loans had been made to energy-related businesses, as compared with the 20
percent favored by the more-conservative Oklahoma City banks.)81 In the five years ending
March 1982, Penn Square’s assets grew from $30 million to a $436 million.82 This phenomenal growth was held by some oil industry and financial sources to be the result of Penn

77

78
79
80
81
82

Ibid., 6. Gunther and Robinson also note that once banks were more exposed to risk, institutions with lower capital growth
recorded statistically insignificant differences in lending from banks with greater increases in capital. Although this finding is inconsistent with moral hazard, it points out the potential importance of both regulatory and liquidity constraints.
A detailed discussion of Penn Square is available in Phillip L. Zweig, Belly Up: The Collapse of the Penn Square Bank
(1985).
The material on the First National Bank of Midland is based largely on the FDIC’s 1983 Annual Report (1984), 10, 12.
Some of the information on Penn Square is from two FDIC publications: The First Fifty Years: A History of the FDIC
1933–1983 (1984), 97–98; and 1982 Annual Report (1983), 6.
Martin, “Penn Square’s Oil Connection.”
“Chain Letter from Your Penn Pal in Oklahoma City,” Economist (July 10, 1982), available: LEXIS, Library: NEWS, File:
ECON.

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Square’s willingness to lend money on almost any oil venture.83 Moreover, Penn Square
appears to have had extremely lenient loan standards. One oil executive said that whereas
the common banking practice was to accept about half of a company’s claimed proven reserves of oil and gas and then base loans on 30 percent of that figure, Penn Square regularly
accepted 75 percent of the gross value as collateral.84
To support its phenomenal growth, the bank relied heavily on purchased deposits and,
to a much greater extent, on a program of selling participations in many of the risky energy
loans it originated to large regional and money-center banks. Penn Square then collected
fees for servicing the loans.85 Two of the more notable banks that purchased loans sold by
Penn Square were Chicago’s Continental Illinois Bank ($1 billion) and Chase Manhattan
Bank of New York ($212 million).86 Chase would later file a suit claiming it was defrauded
when it bought Penn Square loans that were backed with bogus collateral, ranging from oil
rigs to thoroughbred race horses.87 Continental would later suffer huge deposit withdrawals
that were related to the problem loans it had purchased from Penn Square.88
The energy loans in which Penn Square was so heavily invested had been based on extremely high oil and gas prices. When the energy markets deteriorated, a huge volume of
loans defaulted and the value of supporting collateral was minimized, leading to Penn
Square’s failure. (Continental Illinois received open-bank assistance two years later.)
Like Penn Square’s management, First National’s management decided (in early
1980) to invest heavily in energy. At that time the oil-producing area under Midland, known
as the Permian Basin, accounted for 20 percent of the hydrocarbon production in the United
States.89 First National concentrated its loans on drilling and exploration ventures and financed its loan expansion partly by soliciting large deposits from Wall Street investors. By
year-end 1981, the bank had doubled its assets.90
Euphoric about the energy boom, the bank departed from prudent banking practices in
evaluating loans; for example, it allowed customers to determine the value of their own collateral.91 The bank was known for the “handshake” loans it made on long-shot oil and gas
83
84
85
86
87
88
89
90
91

Martin, “Penn Square’s Oil Connection.”
Ibid.
G. David Wallace, “The ‘Wild Bunch’ at Penn Square; Funny Money,” Business Week (May 27, 1985), sec. Books, available: LEXIS, Library: NEWS, File: BUSWK.
Gordon Matthews, “FDIC: Chase Used Threats, Coercion on Penn Square,” American Banker (October 17, 1983), 1; and
Martin, “Penn Square’s Oil Connection.”
Matthews, “FDIC: Chase Used Threats.”
For further discussion of Continental Illinois, see Chapter 7.
John P. Forde, “Republic Begins to Rebuild ‘Brand New’ Midland Bank,” American Banker (October 18, 1983), 48.
“Burying Mother; Oil Woes Break a Texas Bank,” Time (October 24, 1983), available: LEXIS, Library: NEWS, file: TIME.
“A New Wave of Fear Washes over Midland; Business Community Afraid the FDIC Will Foreclose on Many Loans,”
American Banker (November 9, 1983), 3, 39.

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ventures.92 (These activities contributed to the bank’s energy-related loan losses and eventually to its collapse, a sequence of events that would prove common among energy banks
in the Southwest.)
In the 16 months before First National’s failure, falling oil prices and the recession of
1982 caused the bank substantial losses on energy-related loans.93 In 1983 the percentage
of the bank’s nonpaying loans was approximately 25 percent of assets, the highest percentage of any large bank in the United States at the time.94 In early October 1983, First National reported that “nonperforming energy loans were the primary contributors to its
$120.8 million in losses over the first three quarters of 1983.”95 Widespread publicity about
the bank’s losses eroded public confidence and led to a run on deposits.

Data on Performance of Southwestern Banks
At the beginning of the 1980s, southwestern banks were healthy and compared quite
favorably with other banks. As of December 1980, median return-on-assets, return-onequity, and equity-to-assets ratios for southwestern banks exceeded the ratios for other
banks, while equity and reserves to assets was favorable in comparison with the percentages for nonsouthwestern banks. At the same time, a smaller percentage of southwestern
banks had negative net income than did other banks. In addition, the earliest data available
show that average CAMEL ratings of southwestern banks were higher than the average ratings of all U.S. banks (year-end 1981), while southwestern and nonsouthwestern banks had
roughly equal nonperforming loans as a percentage of all loans (year-end 1982).96 With regard to risk, southwestern banks had a higher ratio of C&I loans to assets than other banks
in 1980. Nevertheless, overall in 1980 the risk exposure of the region’s banks was similar
to, if not less than, the risk exposure of the other banks because of southwestern banks’
lower percentages of loans to assets and real estate loans to assets and comparable percentages of commercial real estate loans to assets.
Analysis demonstrates that during the first half of the 1980s southwestern banks exhibited signs of weakening and then, beginning in the mid-1980s, experienced drastic, pervasive deterioration. As the discussion below indicates, CAMEL ratings degenerated;
92
93
94
95
96

“Burying Mother; Oil Woes Break a Texas Bank.”
Ibid; and FDIC, Press Release (PR-81-83), October 14, 1983.
“Burying Mother; Oil Woes Break a Texas Bank.”
Andrew Albert and Robert E. Norton, “Out-of-State Buyers Eyed for Midland: Regulators Set to Deal If Texas Banks
Cool,” American Banker (October 14, 1983), 9.
The CAMEL rating system refers to capital, assets, management, earnings, and liquidity. In addition to a rating for each of
these individual or “component” categories, an overall or “composite” rating is given for the condition of the bank. Banks
are assigned ratings between 1 and 5, with 5 being the worst rating a bank can receive. See Chapter 12 for a detailed explanation of CAMEL ratings.

326

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returns on assets and equity, equity to assets, and nonperforming loans compared poorly
with those of other banks; and the percentage of southwestern banks with negative net income rose sharply.
CAMEL ratings of the region’s banks worsened along with the area’s economy (see
tables 9.3a and 9.3b). For example, between year-end 1981 and year-end 1989 the percentage of 1-rated banks declined from 54.5 percent of all southwestern banks to 13.5 percent.
At the same time, the percentage of 1-rated U.S. banks also declined, but not as dramatically, from 39.3 percent to 21.4 percent (see table 9.4). Similarly, during the same period the
percentage of 4-rated southwestern banks rose continually, from 0.8 percent to 17.1 percent
(compared with an increase from 1.4 percent to 6.1 percent for all banks); and the percentage of 5-rated banks jumped from 0.2 percent to 7.4 percent (versus a rise of 0.3 percent to
1.9 percent for all banks). Moreover, during the same period the percentage of all 4- and 5rated banks located in the Southwest rose from 11.6 percent to 54.5 percent.
Table 9.3a

CAMEL Ratings for All Southwestern Banks, 1981–1990
Report
Date
(Year-end)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Banks/Percentage of Total
1

2

CAMEL Rating
3

4

5

Total

1,437
54.5
1,368
51.0
1,269
44.9
1,108
37.5
950
31.5
645
21.0
464
16.3
349
13.8
311
13.5
286
13.3

1,063
40.3
1,074
40.1
1,145
40.5
1,324
44.7
1,330
44.0
1294
42.1
1148
40.4
990
39.2
940
40.8
905
42.0

110
4.2
154
5.8
273
9.7
343
11.6
421
13.9
623
20.3
629
22.1
593
23.5
488
21.2
481
22.3

21
0.8
78
2.9
125
4.4
159
5.4
266
8.8
415
13.5
450
15.8
430
17.0
395
17.1
325
15.1

6
0.2
6
0.2
17
0.6
25
0.8
54
1.8
99
3.2
150
5.3
166
6.6
170
7.4
159
7.4

2,637
100%
2,680
100
2,829
100
2,959
100
3,021
100
3,076
100
2,841
100
2,528
100
2,304
100
2,156
100

Note: Examination ratings were obtained from the FDIC’s historical database. In some instances examination ratings were
missing, and as a result, the number of CAMEL-rated banks each year was slightly smaller than the total number of southwestern banks in other tables.

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Table 9.3b

CAMEL 4- and 5-Rated Institutions, Southwestern Banks versus
Banks in Rest of U.S., 1981–1990
Report
Date
(Year-end)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of 4- and 5-Rated Banks/Percentage of Total
Southwestern
Other
Banks
Banks
Total
27
11.6
84
17.7
142
21.5
184
20.6
320
26.2
514
35.2
600
46.2
596
53.0
565
54.5
484
45.9

206
88.4
390
82.3
520
78.6
708
79.4
903
73.8
946
64.8
700
53.9
528
47.0
472
45.5
571
54.1

233
100%
474
100
662
100
892
100
1,223
100
1,460
100
1,300
100
1,124
100
1,037
100
1,055
100

Examination of southwestern banks’ return on assets and capital ratios is also enlightening (see table 9.5). From 1978 through 1983 southwestern banks had a higher median
ROA than other U.S. banks, but for the rest of the decade, a lower ROA. From 1978 through
1983 median return on equity for southwestern banks exceeded the ratios for other banks
each year, but for the rest of the decade it was lower. For each year from 1978 through 1985
except 1981, southwestern banks’ median equity-to-assets ratios were greater than those of
other banks, but for the rest of the decade were lower. Furthermore, the percentage of southwestern banks with very low (less than 5 percent) ratios of equity and reserves to assets was
lower than that for other banks from 1978 through 1984, comparable in 1985, and considerably higher from 1986 through 1989 (averaging 7.9 percent annually for southwestern
banks and 1.3 percent for other banks) (see tables 9.6a and 9.6b). On the positive side, the
percentage of strong southwestern banks—those with equity and reserves to assets exceeding 11 percent—was actually slightly higher during the decade’s most troubled years, 1986
through 1989, than during the prosperous years of 1980–82.
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Table 9.4

CAMEL Ratings for All U.S. Banks, 1981–1990
Report
Date
(Year-end)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Banks/Percentage of Total
Camel Rating
1

2

3

4

5

Total

5,659
39.3
5,281
36.5
4,908
33.9
4,474
31.1
3,857
26.9
3,264
22.8
2,999
21.7
2,879
21.6
2,769
21.4
2,625
20.9

7,651
53.1
7,550
52.2
7,450
51.5
7,328
50.9
7,248
50.5
7,319
51.1
7,400
53.5
7,357
55.3
7,394
57.2
7,024
55.9

863
6.0
1,172
8.1
1,456
10.1
1,704
11.8
2,023
14.1
2,270
15.9
2,147
15.5
1,944
14.6
1,718
13.3
1,868
14.9

194
1.4
392
2.7
555
3.8
753
5.2
1,033
7.2
1,213
8.5
1,018
7.4
875
6.6
786
6.1
788
6.3

39
0.3
83
0.6
107
0.7
139
1.0
190
1.3
247
1.7
282
2.0
249
1.9
251
1.9
267
2.1

14,406
100%
14,478
100
14,476
100
14,398
100
14,351
100
14,313
100
13,846
100
13,304
100
12,918
100
12,572
100

One area of particular weakness for southwestern banks was nonperforming loans
(see figure 9.18). Every year from 1982 through 1990 the percentage of nonperforming
loans for southwestern banks was greater than for other banks. For example, from 1986
through 1989 the percentage of nonperforming loans of southwestern banks averaged 8.8
percent, compared with 3.1 percent for other banks.
Perhaps the most telling indicator of the pervasive weakness of the southwestern
banks is the percentage of those institutions with negative net income in the 1980s (see figure 9.19). From 1980 through 1982 this percentage was lower for southwestern banks than
for other banks, but for the rest of the decade it was higher. From 1982 to 1987 the percentage of southwestern banks with negative net income jumped from 8.0 percent to 39.2 percent, while at the same time the percentage for other banks remained in the range of 10 to
15 percent. Incredibly, from 1985 through 1989 an average of 31.5 percent of southwestern
banks had negative net income, a percentage illustrating how widespread was the adverse
effect of the region’s economic problems.
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Table 9.5

Median ROA, ROE, and Equity Ratios, Southwestern Banks versus Banks in
Rest of U.S., 1979–1990
Report
Date
(Yearend)
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Banks
SW Banks

Other
Banks

2,474
2,517
2,580
2,647
2,737
2,890
3,046
3,125
3,139
2,873
2,557
2,325
2,179

12,242
12,171
12,178
12,098
12,031
11,857
11,728
11,671
11,529
11,313
11,056
10,871
10,636

ROA

ROE

SW Banks

Other
Banks

1.12
1.22
1.29
1.32
1.25
1.04
0.89
0.78
0.39
0.32
0.51
0.69
0.72

0.96
1.06
1.07
1.02
0.99
0.95
0.91
0.92
0.86
0.88
0.92
0.95
0.88

Equity to Assets

SW Banks

Other
Banks

SW Banks

Other
Banks

13.93
15.11
15.47
15.89
15.08
12.52
10.93
9.65
5.41
4.56
6.83
8.74
9.16

12.32
13.27
12.94
12.26
11.89
11.64
11.06
11.17
10.40
10.33
10.68
10.87
10.04

8.05
8.08
8.27
8.19
8.35
8.29
8.10
8.07
7.69
7.53
7.37
7.45
7.37

7.79
8.01
8.19
8.20
8.18
8.10
8.02
8.02
7.90
8.09
8.16
8.26
8.19

Were there characteristics that distinguished southwestern banks that failed from
those banks that survived? Banks generally do not fail suddenly. The process of bank failure takes many years to develop, and failure is the result of decisions and strategies implemented at least four or five years beforehand.97 These strategies and decisions are the
underlying causes of either success or failure in difficult economic times. To study the effects of these decisions on a bank’s subsequent failure or survival, FDIC researchers analyzed various financial ratios, or risk factors, that might identify risky operating strategies.98
To determine how these risk factors affected southwestern banks, the researchers
ranked each bank from low to high within each financial ratio. They then separated the
banks into five risk groups in order to perform the analysis for the years 1982 (for banks that
failed or survived in 1986 and 1987), 1984 (for banks that failed or survived in 1988 and
1989), and 1986 (for banks that failed or survived in 1990 and 1991). These correspond to
the years during which the greatest number of failures occurred—1986 through 1991. For
97
98

For a discussion of the interval between the time when a strategic decision is made and the time when the effects of the decision become evident—the life cycle of a failed bank—see Chapter 13.
The eight risk factors are loans-to-assets ratios, return on assets, asset growth from the previous year, loan growth from the
previous year, operating expenses to total expenses, average salary expenses, interest on loans and fees, and interest on
loans and leases plus fee income on loans and leases.

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Banking Problems in the Southwest

Table 9.6a

Equity and Reserves to Assets of Southwestern Banks, 1978–1990
Report
Date
(Year-end)
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Banks/ Percentage of Total
<5.0
27
1.1
14
0.6
11
0.4
13
0.5
12
0.4
23
0.8
25
0.8
46
1.5
141
4.5
221
7.7
269
10.5
203
8.7
138
6.3

Equity Capital and Reserves to Total Assets
5.0–7.0
7.0–9.0
9.0–11.0
354
14.3
346
13.8
284
11.0
296
11.2
298
10.9
384
13.3
436
14.3
427
13.7
594
18.9
490
17.1
407
15.9
366
15.7
359
16.5

1,124
45.4
1,135
45.1
1,133
43.9
1,201
45.4
1,151
42.1
1,130
39.1
1,189
39.0
1,173
37.5
995
31.7
917
31.9
840
32.9
792
34.1
824
37.8

630
25.5
668
26.5
730
28.3
704
26.6
758
27.7
739
25.6
743
24.4
781
25.0
750
23.9
669
23.3
540
21.1
521
22.4
473
21.7

> 11.0
339
13.7
354
14.1
422
16.4
433
16.4
518
18.9
614
21.3
653
21.4
698
22.3
659
21.0
576
20.1
501
19.6
443
19.1
385
17.7

Total
2,474
100%
2,517
100
2,580
100
2,647
100
2,737
100
2,890
100
3,046
100
3,125
100
3,139
100
2,873
100
2,557
100
2,325
100
2,179
100

each period studied, the banks that failed four or five years later were isolated from the
banks that were still in existence at the end of the five-year period and subsequently never
failed. Each risk group of each risk variable was analyzed to determine which variable was
the best predictor of failure. For each of the three time periods, banks in the highest loansto-assets group had the highest incidence of failure: 12.5 percent for banks that existed in
1982 and failed in 1986 or 1987, 21.9 percent for banks that existed in 1984 and failed in
1988 or 1989, and 11.3 percent for banks that existed in 1986 and failed in 1990 or 1991. A
bank in the highest-risk loans-to-assets group was three to five times more likely to fail than
the banks in lower-risk loans-to-assets groups (see figure 9.20). These results indicate that
banks with very high loans-to-assets ratios may be at greater risk of failure, on average, than
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Table 9.6b

Equity and Reserves to Assets of Nonsouthwestern Banks, 1978–1990
Report
Date
(Year-end)
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990

Number of Banks/ Percentage of Total
<5.0
167
1.4
131
1.1
143
1.2
199
1.6
245
2.0
220
1.9
205
1.7
165
1.4
183
1.6
160
1.4
140
1.3
107
1.0
128
1.2

Equity Capital and Reserves to Total Assets
5.0–7.0
7.0–9.0
9.0–11.0
2,289
18.7
1,811
14.9
1,563
12.8
1,576
13.0
1,655
13.8
1,957
16.5
1,813
15.5
1,657
14.2
1,808
15.7
1,259
11.1
1,110
10.0
1,024
9.4
919
8.6

5,458
44.6
5,381
44.2
5,167
42.4
5,022
41.5
4,821
40.1
4,558
38.4
4,612
39.3
4,669
40.0
4,614
40.0
4,577
40.5
4,374
39.6
4,147
38.1
4,181
39.3

2,664
21.8
2,958
24.3
3,233
26.5
3,153
26.1
3,063
25.5
2,844
24.0
2,787
23.8
2,860
24.5
2,716
23.6
2,794
24.7
2,872
26.0
2,905
26.7
2,790
26.2

> 11.0

Total

1,664
13.6
1,890
15.5
2,072
17.0
2,148
17.8
2,247
18.7
2,278
19.2
2,311
19.7
2,320
19.9
2,208
19.2
2,523
22.3
2,560
23.2
2,688
24.7
2,618
24.6

12,242
100%
12,171
100
12,178
100
12,098
100
12,031
100
11,857
100
11,728
100
11,671
100
11,529
100
11,313
100
11,056
100
10,871
100
10,636
100

banks with lower levels of loans because, for banks in the very high group, a larger percentage of their portfolios can default. This finding is consistent with the findings of the
same analysis performed for banks throughout the country in these same years (see Chapter 13).
A review of the data for southwestern banks shows that although the number of southwestern bank failures did not begin to increase substantially until 1983 and reached a peak
in 1988, beginning in 1981 banking statistics provided warnings of potential problems. For
example, both the asset growth rates and the return on assets began declining in 1981 and
fell continuously through 1987. In addition, nonperforming assets increased from 1982
332

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Banking Problems in the Southwest

Figure 9.18

Nonperforming Loans as a Percentage of All Loans,
Southwest versus Rest of U.S., 1982–1990

Percent
12
10
8

Southwest
Banks

6

Banks
in Rest
of U.S.

4
2

1982

1983

1984

1985

1986 1987
Year-end

1988

1989

1990

Figure 9.19

Percentage of Banks with Negative Net Income,
Southwest versus Rest of U.S., 1978–1990

Percent
40

30

Southwest
Banks

20

Banks
in Rest
of U.S.

10

0

1978

1980

History of the Eighties—Lessons for the Future

1982

1984

1986

1988

1990

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Figure 9.20

Comparison of Selected Factors in Predicting Southwest Bank Failures
Four and Five Years Forward, 1982, 1984, and 1986
1982

Percent
12

25

12.5%
10.5%

6

0

Loans to Assets

18.7%

15

7.0%

3

21.9%

20

9

3.3%

1984

Percent

10.8%
10

4.8%

3.6%

6.5%

7.5%

8.5%

5
Interest Yield

Loans to Assets Return on Assets

1986

Percent
12

0

Average Salary

11.3%

9

8.3%
5.5% 5.8%

6
3
0

Interest and
Fees to Loans

3.2%
2.0%

Loans to Assets Return on Assets

Percent of Banks in Highest
Quintile that failed four or
five years forward

Interest and
Fees to Loans

Percent of Banks in all
other Quintiles that failed
four or five years forward

Note: These three factors represent the two highest risk factors (left and
center) and the lowest risk factor (right) in predicting bank failures.

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Banking Problems in the Southwest

through 1987, while charge-offs began rising in 1981 and did not peak until 1986. Similarly,
the percentage of banks with negative net income increased consistently from 1981 through
1987. Finally, CAMEL ratings of southwestern banks began their pervasive deterioration in
1981.
When one looks back at the history of the region’s economy, it is not surprising to see
that 1981 proved to be the beginning of the downturn for southwestern banks. First, as discussed above, 1981 was the peak year for both oil prices and drilling activity. Many oilrelated loans were based not only on the high oil prices of 1981 but also on the expectation
that oil prices would continue to escalate. A number of banks began experiencing difficulties simply because oil prices failed to continue climbing. Second, 1981 was the year when
office vacancy rates in Houston, Dallas, and Oklahoma City began a sharp, multiyear increase, while commercial real estate loans as a percentage of bank assets rose dramatically
from 1981 to 1987. The combination of declining oil prices, weakening commercial real estate markets, and high levels of commercial real estate loans was the basis of the eventual
demise of many southwestern banks.

Conclusion
A number of factors contributed to the banking debacle that occurred in the Southwest
in the second half of the 1980s. The region’s economy was highly dependent on oil, a sector heavily supported by the banks; and when a boom occurs in such an important segment
of a region’s economy, the potential clearly exists for serious difficulties when the boom period ends. The danger was especially acute in the Southwest because many lenders were initiating loans that were based on the assumption of ever-increasing oil prices. Some banks
were therefore vulnerable even if oil prices did not decline but simply stopped increasing.
The boom helped create an excessively optimistic mind-set among some southwestern bankers, which led them to make numerous lending errors. For example, overly sanguine expectations about the future of oil prices drew bankers into a destructive competition
to keep oil customers in the early 1980s. Then, faced with deteriorating energy loans, many
banks only compounded the difficulties by pushing to invest in real estate as an antidote to
their energy-loan problems. The boom atmosphere contributed here as well, blinding
bankers to the potential adverse effects of weakening oil prices and concomitant increases
in vacancy rates on real estate projects as well as making them more liable to base real estate loans on inaccurate feasibility studies and on unrealistic appraisals and income projections. In this area, too, bankers’ lending strategies reflected unrealistic beliefs about prices:
believing that real estate loans’ prices rarely declined, they acted as if real estate loans entailed minimal risk, and extended credit unwisely.
In addition, the intense competition among financial institutions might also have warranted additional vigilance. The competitive intensity was generated both by the striking inHistory of the Eighties—Lessons for the Future

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An Examination of the Banking Crises of the 1980s and Early 1990s

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crease in the number of newly chartered southwestern banks during the first half of the
1980s and by Congress’s 1982 broadening of thrifts’ powers. The problems could have been
contained if regulatory standards in the chartering of new banks had been more stringent
and if legislation had been attentive to the implications of deregulation.
In sum, although extraordinary events such as the oil price crash in late 1985 and 1986
and the southwestern real estate debacle are difficult if not impossible to predict, nevertheless the euphoric attitude among many southwestern bankers was highly conducive to critical errors in judgment. The simplest lesson that can be learned from the story of the
banking collapse in the Southwest is that obvious excesses, in both expectations and competitive behavior, have the potential to cause serious problems, no matter how favorable a
situation may seem at the time.

336

History of the Eighties—Lessons for the Future

Chapter 10

Banking Problems
in the Northeast
Introduction
The banking problems in the Northeast were indissoluble from the region’s real estate
problems.1 Fueled by a strong regional economy, both residential and commercial real estate markets in the region boomed during the 1980s, but the boom eventually led to overbuilding and rampant real estate speculation. Late in the decade, when the regional
economy weakened and a high volume of new construction projects coincided with diminished demand, the real estate market boom turned into a bust. During the early 1990s, an
oversupply of completed projects came on the market and real estate prices went into a
sharp decline. In an environment of increased real estate loan defaults, a significant number
of northeastern banks failed: 16 in 1990, 52 in 1991, and 43 in 1992.2 These failures accounted for substantial portions of the nation’s total volume of failed-bank assets and of the
FDIC’s bank-failure resolution costs for those years. Losses from northeastern bank failures
totaled $1.3 billion in 1990, $5.5 billion in 1991, and $2.8 billion in 1992—and constituted
45 percent, 91 percent, and 77 percent, respectively, of total FDIC failure-resolution costs
for those years. Failures were particularly prominent in 1991, when assets of failed banks
represented 25.4 percent of prior year-end banking assets in New Hampshire, 18.3 percent
in Connecticut, 15.2 percent in Maine, and 12.0 percent in Massachusetts.3
The 1991 failure of three subsidiaries of the Bank of New England Corporation (the
Bank of New England, Connecticut Bank and Trust Co., and the Maine National Bank), a
failure which many would identify as the last major failure of the banking crises of the
1980s and early 1990s, was especially significant. The Bank of New England’s failure re1
2

3

The Northeast includes the six New England states (Maine, New Hampshire, Vermont, Massachusetts, Rhode Island, and
Connecticut) plus New York and New Jersey.
Throughout this chapter, “banks” refers to commercial banks and savings banks supervised by the FDIC, the Office of the
Comptroller of the Currency (OCC), or the Federal Reserve. Savings and loan associations supervised by the Federal Home
Loan Bank Board until 1989 and then by the Office of Thrift Supervision (OTS) are not included.
These ratios were calculated from assets at failure as a percentage of prior year-end state banking assets for all banks failed
and open.

An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

sulted in the first use of the cross-guarantee provision of the Financial Institutions Reform,
Recovery and Enforcement Act of 1989 (FIRREA) to close an institution (Maine National
Bank). In addition, the participation of Kohlberg, Kravis, Roberts & Co. as a partner with
Fleet/Norstar in the acquisition of the three subsidiaries of the Bank of New England Corporation marked the first time that a nonbank “financial” buyer participated in the purchase
of a failed commercial bank. This company’s involvement not only allowed capital to enter
the banking industry from nonbanking sources but was also expected to increase the number of potential bidders in future bank failures.4 Finally, the decision to protect all deposits
of the three subsidiaries of the Bank of New England Corporation again focused attention
on the “too-big-to-fail” bank disposition policy. Later in 1991, Congress included provisions in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)
that made it more difficult to resolve bank failures in ways that would protect uninsured deposits.5
The problems of the northeastern banks arose to a large extent because they had been
aggressive participants in the prosperous real estate markets of the 1980s. Between 1983
and 1989 the median ratio of real estate loans to assets rose from approximately 25 percent
to 51 percent. Both residential and commercial real estate loans contributed to the increase,
but the increase in the median commercial real estate loan concentration is widely held to
have been a primary reason for the asset-quality problems and eventual failure of many of
the region’s banks in the late 1980s and early 1990s; commercial real estate loan portfolios
as a percentage of bank assets rose from 6.5 percent in 1982 to 14 percent in 1989 and 1990.
Since real estate lending played such an important role in the expansion and collapse
of banks in the Northeast, the area’s real estate markets of the 1980s are discussed in some
detail, with the focus first on New England and then on New York and New Jersey. The
chapter then provides an overview of banking’s relationship to real estate in the region as a
whole and then specifically in New England and in New York and New Jersey. The two succeeding sections present and analyze data on bank performance in the region and on bank
failures by state. Finally, the rise and fall of the Bank of New England Corporation is recounted.

The Northeastern Economy and Real Estate
The Northeast recovered quickly from the 1981–82 national recession. Between the
end of the recession and 1988, the region’s rate of change in gross product outperformed
that of the nation as a whole, and its commercial and residential real estate markets boomed,

4
5

John W. Milligan, “KKR, Member FDIC,” Institutional Investor 25, no. 7 (June 1991): 59.
See Chapter 7, “Continental Illinois and ‘Too Big to Fail.’ ”

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Banking Problems in the Northeast

fueled by the strong regional economy as well as by employment growth. But late in the
decade—partly because of a slowdown in the growth of military spending as the Cold War
came to an end, a decline in the computer industry in the Boston area, and cuts by Wall
Street firms after the stock market crash in October 1987—the regional economy weakened. Employment fell, growth in personal income slowed, and from 1989 through 1992
the region’s rate of change in gross product underperformed the nation’s (see figure 10.1).
The weakening of the regional economy exacerbated the problems of the overbuilt
real estate markets, and these markets fell off dramatically. For example, the total value of
nonresidential construction permits in the region, having jumped from $4.4 billion in 1980
to $10.2 billion in 1988, then declined to $6.5 billion by 1991. And the number of newly issued permits for residential construction, after soaring 172 percent between 1982 and 1986,
plummeted by 67 percent between 1986 and 1991 (see table 10.1).
New England
In 1988, when the New England economy began to weaken, many were caught by surprise. Until then New England had been one of the most prosperous areas of the country. Its
unemployment rate had fallen to 3 percent and its per capita income had climbed to 123 per-

Figure 10.1

Changes in Northeast Gross Product versus
Changes in U.S. Gross Domestic Product,
1980–1994
Percent
8

6
4
2

Northeast

0

U.S.

-2
-4

1980

1982

1984

1986

1988

1990

1992

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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Table 10.1

Nonresidential and Residential Construction,
Northeast Region, 1980–1994
Year

Value of
Nonresidential Permits
($Thousands)

Number of Residential
Permits Issued

1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

4,415,720
5,415,443
5,584,465
5,273,951
6,966,098
8,988,867
9,348,328
10,049,755
10,178,196
9,915,156
8,037,836
6,510,983
6,519,954
7,448,605
7,338,631

87,840
85,502
84,454
130,848
161,348
216,146
229,816
216,992
176,343
133,473
88,643
75,173
86,531
93,395
98,258

Source: Bureau of the Census (Building Permits Section, Manpower and Construction Statistics Branch).

cent of the national average, up from 106 percent in 1980.6 Yet despite many favorable aspects of New England’s economy, some signs of potential problems had been evident. In
the mid-1980s the computer industry, a regional specialty, had begun to confront a more
competitive environment, and New England firms had found themselves with products and
strategies that did not necessarily fit the changing marketplace. In addition, defense contractors in the region were facing the end of the Reagan defense buildup. Finally, the cost of
doing business in the region had escalated during the prosperous times, causing some manufacturers to move their operations to less-expensive parts of the country. Although none of
these factors had appeared to be especially harmful in itself and the resulting job losses in
any one year had not been particularly noteworthy, together they added up over time. For
example, between 1984 and 1988, manufacturing employment in New England declined by
140,000 jobs, or approximately 9 percent.
New England’s real estate markets turned down along with the economy, and the commercial real estate markets were hit particularly hard. The decline in the commercial mar6

This discussion is based on Lynn E. Browne, “Why New England Went the Way of Texas Rather Than California,” Federal
Reserve Bank of Boston New England Economic Review (January/February 1992): 24, 33.

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kets was surprising to the many who believed that development in New England had been
relatively cautious and that the region would not experience the problem of overbuilding
that had occurred in the Southwest. For example, the president of Fleet Real Estate Inc. in
Providence stated in June 1987 that “the builders [around] Boston are not going hog-wild
like they did in Houston. The New England marketplace, I think, is a sensible market.”7 Another reason the downturn was unexpected was that vacancy rates in New England’s major
office and industrial markets were not markedly different in 1988, at the end of the boom,
from what they had been in 1984, at its beginning (see figure 10.2).8 Nevertheless, as the
head of the Bank of Boston’s structured real estate department noted late in 1989, “Overbuilding has resulted in high vacancy rates and revenue shortfalls of 10% to 30% or more
for many projects.”9
The deterioration in the New England commercial real estate markets was evidenced
by the 22 percent decline between 1988 and 1991 in the Torto Wheaton Rent Index for
Boston, and the 17 percent decline between 1990 and 1991 in the index for Hartford (see
Figure 10.2

Percent
20

Office Vacancy Rates in Boston,
1980–1994

15

10

5

0

1980

1982

1984

1986

1988

1990

1992

1994

Source: CB Commercial/Torto Wheaton Research, The Office Outlook (spring
1997), vol. 1.

7
8
9

Michael Weinstein, “New England Banks Finance a Healthy Real Estate Market,” American Banker (June 4, 1987), 12.
Browne, “Why New England Went the Way of Texas,” 25.
David Neustadt, “Bank of Boston Acts to Stem Losses,” American Banker (December 5, 1989), 6.

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figure 10.3).10 Nationally over both time periods, this index fell only about 1 percent. But
as dramatic as the rent index declines were, they probably did not reflect the full extent of
the collapse in New England real estate values. According to one contemporary study, if
commercial values at the end of 1992 had been based on then-current rental agreements and
occupancy rates, the value of the office stock in the Boston metropolitan area would appear
to have fallen more than 70 percent since 1987.11
The collapse of commercial real estate is further illustrated by the jump in the amount
of repossessed property in Massachusetts between year-end 1988 and year-end 1989, from
$339 million to $1.5 billion.12 In 1990, many real estate professionals believed that troubled
properties represented the fastest-growing segment of the Metropolitan Boston commercial
real estate market. These problems arose in part because the “Massachusetts Miracle” had
lured novice developers—many with weak business plans often based on little or poor market research—into the real estate game. Some commercial projects were 100 percent fiFigure 10.3

Rent Indices, Boston and Hartford versus U.S.,
1980–1995

Level ($)

Hartford

Boston

20

16

U.S.
12

8

1980

1982

1984

1986

1988

1990

1992

1994

Source: CB Commercial/Torto Wheaton Research, The Office Outlook (fall
1996), vol. 1.

10
11
12

The Torto Wheaton Rent Index is a statistically computed dollar value for a five-year, 10,000-square-foot lease for an existing high-rise building in the statistical average of the metro area.
Lynn E. Browne and Eric S. Rosengren, “Real Estate and the Credit Crunch: An Overview,” Federal Reserve Bank of
Boston New England Economic Review (November/December 1992): 28.
Information in this paragraph is derived from Paul Korzeniowski, “Distress for Success,” Metro Business, Danvers, MA
(October 1990), available: DIALOG, File: 635: Business Dateline.

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nanced and based on such unrealistic expectations as the continuation of 10 percent annual
price hikes into the 1990s. “Many projects simply should not have been built,” observed the
principal at Richard Flier Interests, a Brookline real estate firm.13
Some of the most serious difficulties in the commercial real estate markets occurred
in New England’s condominium market, where some developers went bankrupt when units
failed to sell.14 The condominium market in Connecticut was so glutted in early 1990 that
just absorbing the units then available was expected to take two years.15 An illustration of
the depth of the problem was an action taken by the Collaborative Co., one of Boston’s
leading specialists in marketing troubled properties, which made news in the spring of 1990
by halving prices at the St. George condominium development in Revere.16
The commercial real estate debacle was graphically demonstrated by banking analyst
Gerard Cassidy of Tucker, Anthony Inc., Portland, Maine, who developed a 40-mile guided
tour of New England real estate lending disasters for potential investors. One stop on a 1990
tour was a rubble-strewn development site in the Boston suburb of Weymouth, with a
ghostly row of unfinished condominium units long abandoned by builders. A bank had lent
$25 million for the development of the property and had foreclosed in June 1990. Another
stop, this one in Boston’s high-tech heartland, revealed empty commercial space with
boarded-up windows—ten empty buildings within an area of a mile and a half. “I thought I
knew how bad it was,” said a portfolio manager at Fidelity Investments who took the tour,
“but it was worse than I anticipated. I mean, 20-story towers of see-through tinted green
glass: What I saw was no different than Dallas during the worst days of the slump.”17
The commercial real estate market was not alone in its volatility. The New England
housing market, too, had a turbulent decade. As the region emerged from the national recession of 1981–82, housing was not much more expensive in New England than in the rest
of the country. In 1983, the median home resale price in Boston was $82,600, 17 percent
above the national median of $70,300 (see figure 10.4). In Providence in the first quarter of
1983 the median was 26 percent below the national median. But strong pent-up housing demand and slowly responding supply led to a boom in housing prices throughout New England from 1983 to 1987. In Boston, resale prices rose 21 percent in 1984, 34 percent in
1985, and 19 percent in 1986. In 1987, Boston’s median home resale price reached
13
14
15
16
17

Ibid.
Margot E. Jenks et al., “New England Economic Summary, First Quarter 1990,” Federal Reserve Bank of Boston New
England Economic Indicators (August 1990): ix.
Katherine Morrall, “Weakening Northeast Real Estate Market Raises Concerns,” Savings Institutions 111, no. 4 (April
1990): 13.
Korzeniowski, “Distress for Success.”
This paragraph is based largely on Tom Leander, “New England Graveyard Tour: Here Lie Nonperforming Loans,” American Banker (September 12, 1990), 1, 16–17.

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Figure 10.4

Median Home Resale Prices, Boston versus U.S.,
1982–1995

$Thousands
200

160

Boston

120

U.S.
80

40

1982

1984

1986

1988

1990

1992

1994

Source: National Association of Realtors

$177,200, which was 115 percent higher than in 1983 and more than twice the national median price (which had increased by only 22 percent during the same four years). The price
boom lagged one year in Providence and two years in Hartford, where the most rapid increases occurred in 1986 and 1987, respectively. Nevertheless, the result was the same: by
1988, housing in New England was more than twice as expensive as comparable housing in
most other parts of the country.18
Favorable economic conditions certainly played an important role in the housingprice escalation in New England.19 For example, a building boom coupled with expansion
in the region’s trade and service sectors created a substantial increase in the demand for labor. This helped personal income increase more rapidly in New England than in any other
part of the country between 1984 and 1988. Higher home prices were also supported by advantageous tax laws, favorable demographics, lower interest rates, and an accommodating
banking sector. Yet despite these positive economic circumstances, economists Karl E.
Case and Robert J. Shiller argued that fundamentals alone were insufficient to explain the
18
19

Data on Boston housing prices were obtained from the National Association of Realtors. Other housing price information
in the paragraph was derived from Jenks et al., “New England Economic Summary,” viii, ix.
Information in this paragraph is derived primarily from Karl E. Case, “The Real Estate Cycle and the Economy: Consequences of the Massachusetts Boom of 1984–87,” Federal Reserve Bank of Boston New England Economic Review (September/October 1991): 37–39.

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extent of the price increases, at least in Boston. For example, Case’s 1986 model, which
took into account a number of variables that affected prices, predicted a 15 percent increase
in single-family housing prices in Boston between 1983 and 1986, whereas in fact the
prices approximately doubled. Case and Shiller also wrote articles in 1988, 1989, and 1990
contending that home buyers were significantly influenced by boom psychology.20 In other
words, reacting to rising prices and generally favorable economic conditions, home buyers
paid inflated prices in anticipation of future price increases and capital gains.
Some individuals were indeed worried about potential problems from the escalating
real estate prices. For example, in mid-1987 a senior vice president at Moseley Securities
Corp. in Boston expressed concern because “we’ve had enormous inflation in real estate
values. If there’s a slight hiccup up here, there could be serious repercussions.”21 Nevertheless, despite occasional views such as these, most observers were far more anxious about
the long-term consequences of high housing prices on the region’s ability to attract workers. In fact, the rising prices of real estate were generally seen as a sign of economic health
in the short term.22
The escalation in home prices occurred even though the population of the region grew
at a very slow pace.23 Prices were therefore rising not because more people wanted to live
in New England but because the optimism of those who lived there led them to purchase
larger, more expensive dwellings in the expectation of future price increases. As a result,
when residential construction finally caught up with the price explosion, the region overbuilt and overbuilt quickly. Excess supply began to appear in areas of New England as early
as 1987. (Compounding the problem, the regional economy began faltering at the end of the
decade, exhibiting falling employment and slow growth in personal income.) The combination of overproduction and slowing demand led to a softening, though not a collapse, of
home prices throughout the area. For example, median home resale prices in the Boston
area increased by less than 1 percent from 1988 to 1989 and then fell 4 percent from 1989
to 1990 and another 2 percent from 1990 to 1991.
New York and New Jersey
In New York and New Jersey, too, the commercial real estate sector was overbuilt and
exhibited serious problems. In New York City, for example, zoning and tax incentives had
prompted a flurry of excess building, with the result that office vacancy rates escalated
throughout the 1980s, leaving Manhattan with about 25 million square feet of vacant office
20
21
22
23

Citations for the other articles referenced in this paragraph can be found in Case, “The Real Estate Cycle,” 46.
Weinstein, “New England Banks.”
Browne, “Why New England Went the Way of Texas,” 36.
Information in this paragraph was derived primarily from Jenks et al., “New England Economic Summary,” ix.

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space by mid-1990 (see figure 10.5).24 At the same time, office vacancy rates were even
higher in the New York suburbs than in Manhattan.25
The substantial amount of vacant office space put downward pressure on rents. Between 1988 and 1992 the Torto Wheaton Rent Index for Long Island showed a 25.3 percent
decline, and between 1988 and 1993 the index for New York City showed a 23.0 percent decline (see figure 10.6). Nationally over the same periods this index fell 5.4 percent and 7.3
percent, respectively. Official statistics on rental rates were likely to have masked the pattern of newly negotiated contracts, which probably showed a greater response to the depressed market. Falling rents notwithstanding, between 1987 and the last quarter of 1991 the
vacancy rate for downtown office space grew from just over 10 percent to over 20 percent.26
The residential market in New York also weakened significantly. During the 1980s,
residential home prices in New York rose at rates considerably above the national average.
By 1988, the median single-family home in the New York metropolitan area sold for as
Figure 10.5

Percent
20

Office Vacancy Rates in New York City,
1980–1994

15

10

5

0

1980

1982

1984

1986

1988

1990

1992

1994

Source: CB Commercial/Torto Wheaton Research, The Office Outlook (spring
1997), vol. 2.

24

25
26

Stephen Kleege, “Fate of Banking in the 1990s Hinges on Real Estate Loans,” American Banker (October 15, 1990), 1,
24; and Larry Light and John Meehan, “The Walls Keep Closing In on New York Developers,” Business Weekly (July 2,
1990): 72.
Light and Meehan, “The Walls Keep Closing In,” 72.
David Brauer and Mark Flaherty, “The New York City Recession,” Federal Reserve Bank of New York Quarterly Review
17, no.1 (spring 1992): 70.

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Banking Problems in the Northeast

Figure 10.6

Rent Indices, New York City and Long Island
versus U.S., 1980–1995

Level ($)
30

New York
City

25

Long
Island

20

15

U.S.
10

1980

1982

1984

1986

1988

1990

1992

1994

Source: CB Commercial/Torto Wheaton Research, The Office Outlook (fall
1996), vols. 1 and 2.

much as $194,000, more than double the national average and almost triple what the median
price of a home had been in the New York area in 1981.27 However, after 1988 prices began
declining. In the New York City area, for example, prices of homes fell approximately 5 percent in 1989.28 By mid-1990, the weak housing market increased the average time needed to
sell a residential unit to six months, double the time that had been required in 1987.29 Residential prices continued to fall, and by the fourth quarter of 1991, median single-family
home prices in the New York metropolitan area had declined by 12 percent from their peak,
to $170,800.30 Cooperatives and condominium units were hit particularly hard and many developments were as empty as mausoleums—despite falling prices.31 In fact, the price declines of condominium developments were sometimes staggering. For example, in
mid-1990 in New York City, broker Saul Stolzenberg tried to sell an empty 66-unit building
that he said had a value of $14.5 million. The only offer he received was $6 million.32 There
27
28
29
30
31
32

Ibid.
Michael Quint, “Northeast Banks Face Heavy Losses on Problem Loans,” The New York Times (December 15, 1989),
available: LEXIS, Library: NEWS, File: NYT.
Light and Meehan, “The Walls Keep Closing In,” 73.
Brauer and Flaherty, “The New York City Recession,” 70.
Light and Meehan, “The Walls Keep Closing In,” 72.
Ibid., 73.

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are indications that portions of the New Jersey housing market suffered similar declines.
For example, from 1989 to 1990 the National Association of Realtors’ median sales price of
existing single-family homes declined by 8 percent for Bergen and Passaic, and 3 percent
for Middlesex, Somerset, and Hunterdon.

Banking and Real Estate in the Northeast
The northeastern region is a highly concentrated banking market. As of year-end
1994, it was the nation’s largest in terms of domestic banking assets. At the end of 1980,
when the region contained only 5 percent of U.S. commercial and savings banks, these
banks nevertheless accounted for 17 percent of domestic bank assets. By year-end 1994,
when northeastern banks constituted 7 percent of U.S. banks, their share of domestic bank
assets had increased to more than 24 percent. Although much of this bank asset concentration can be attributed to the large money-center banks located in New York, many of the
other northeastern states contain densely populated urban centers with strong banking markets that have been fostered not only by the region’s high population density but also by its
well-established educational, commercial, industrial, and manufacturing industries. Moreover, the region’s state legislatures have been very supportive of the banking industry, typically leading the nation in expanding bank products and powers.
Many northeastern banks aggressively participated in the booming real estate markets
of the 1980s. Between 1983 and 1986, bank asset growth for the region increased from an
annual rate of less than 1 percent to nearly 12 percent (see figure 10.7). This growth was
supported by substantial new capital investment during the 1980s resulting from increases
in mutual-to-stock-form bank conversions, capital restructuring, retention of high levels of
income, and an increase in bank chartering.
The conversion of savings banks from mutual to stock ownership was especially significant for asset growth.33 Mutual-form institutions have no equity shareholders and therefore must rely solely upon internally generated capital. Conversion to stock form provided
institutions with access to equity capital and an expanded potential for loan growth, thus
augmenting an institution’s ability to participate in the region’s booming real estate markets. In addition, conversion to stock form often caused an institution to feel pressure to
33

The Northeast is home to a substantial portion of the savings bank industry, and savings banks and savings associations
were historically mutual-form institutions. As of 1986, approximately 32 percent of the region’s depositories were savings
banks, 23 percent were savings associations, and 45 percent were commercial banks. In the early 1980s, many northeastern states legalized mutual-to-stock-form conversions. Between 1985 and 1990, 199 mutual-form depositories in the
Northeast—a third of the 586 savings banks and savings associations in the region as of year-end 1984—converted to stock
form. The converted institutions typically exhibited rapid asset growth, which also contributed to a significant number of
failures. For further discussion of this subject, see Jennifer L. Eccles and John P. O’Keefe, “Understanding the Experience
of Converted New England Savings Banks,” FDIC Banking Review 8, no. 1 (winter 1995).

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Figure 10.7

Asset Growth Rates, Northeast versus U.S.,
1975–1994
Percent
20
15

Northeast
Banks

10
5
0
-5

U.S.
Banks

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

seek substantial increases in earnings: conversion led to a significant increase in an institution’s capitalization, thereby diluting returns on equity. To maintain competitive returns on
equity, a rise in the volume of loans and other earning assets was therefore needed.
Chartering activity, which was also an important contributor to the expansion of the
northeastern banking markets, escalated in the Northeast as the economy prospered: during
the 1980s the annual number of new charters soared from 3 in 1980 to a peak of 39 in 1987,
and the total number of banks chartered in the region was 212. After the region’s economy
weakened, chartering steadily declined, and in 1994 only 3 charters were issued.
Overall lending concentrations at the region’s banks rose substantially during the
1980s, primarily because of real estate loans (which had represented a sizable portion of
northeastern banks’ loan portfolios even before the real estate market boom). Between 1983
and 1988 the median loans-to-assets ratio for northeastern banks jumped from a low of just
under 55 percent to a peak of 73 percent, an increase that significantly exceeded the national trend (see figure 10.8), and between 1983 and 1986 the median total real estate loan
concentration as a percentage of bank assets rose from approximately 25 percent to nearly
39 percent; in 1989, it reached a high of 51 percent (see figure 10.9). (It should be noted that
a portion of this growth is attributable to the fact that a large number of state-insured savings banks obtained FDIC insurance between 1980 and 1986 and began reporting financial
data to federal bank regulators. The savings banks’ real estate activity is therefore not fully
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Figure 10.8

Median Gross Loans and Leases,
Northeast versus U.S., 1976–1994

Percent of Assets
75
70

Northeast
Banks

65
60

U.S. Banks

55
50

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

Figure 10.9

Median Total Real Estate Loans,
Northeast versus U.S., 1974–1994
Percent of Assets
60
50
40
30

Northeast
Banks

U.S. Banks

20
10

350

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end
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Chapter 10

Banking Problems in the Northeast

reflected in the data until 1986.)34 This expansion in real estate lending may have been due
partly to the shrinkage of the banks’ traditional loan markets, as is indicated by the decline
in the concentrations of commercial and industrial loans throughout the 1980s (see figure
10.10).
The higher concentrations of real estate loans reflected activity in both residential and
commercial real estate lending. The median ratio of residential real estate loans to bank assets rose from about 19 percent in 1980 to approximately 23 percent in 1986 and then
climbed to 32 percent in 1994 (see figure 10.11). More significant was the growth in commercial real estate lending, particularly the relatively risky short-term loans secured by
properties in development whose income-generating potential was uncertain at the time the
Figure 10.10

Median Commercial and Industrial Loans,
Northeast versus U.S., 1974–1994
Percent of Assets
12

U.S. Banks

10
8

Northeast
Banks

6
4
2

34

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

In the Northeast, the number of savings banks reporting to federal bank regulators rose from approximately 287 in 1980 to
444 by 1986. Events in Massachusetts accounted for a large proportion of this increase. After the failure of Ohio’s private
deposit insurance fund, privately insured mutual savings banks and cooperative banks in the Commonwealth of Massachusetts recognized the potential for a loss of public confidence in their private fund. The Massachusetts Banking Department required approximately 200 savings banks to acquire federal deposit insurance from either the FDIC or the Federal
Savings and Loan Insurance Corporation. Most of the institutions obtained FDIC deposit insurance (FDIC, Annual Report
[1985], 16–17). The failure of many savings banks and the industry’s consolidation by the late 1980s and early 1990s reduced the number of savings banks in the Northeast at year-end 1994 to 367.

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Figure 10.11

Median Residential Real Estate Loans,
Northeast versus U.S., 1974–1994
Percent of Assets
35
30
25

Northeast
Banks

20
15

U.S. Banks

10
5

1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

loans were made.35 The median commercial real estate loan concentration for the region’s
banks, as a percentage of bank assets, rose from 6.5 percent in 1982 to a peak of 14 percent
in 1989 and 1990 (see figure 10.12).
The loan expansion of the early 1980s was initially successful in augmenting profits
by generating substantial interest and non-interest income, as is indicated by the rise in the
median return on assets (ROA) for northeastern banks from 0.72 percent in 1980 to 1.06
percent by 1986 (see table 10.4 on p. 365). However, the weakening real estate market of
the late 1980s led the northeastern banks’ ROA to drop to only 0.20 percent in 1990. (Interestingly, the rise in northeastern banks’ ROA occurred while the ROA for banks outside the
Northeast was declining, and conversely the decline in the northeastern banks’ ROA occurred during a generally rising trend in ROA for other banks.) This drop in the Northeast
was largely attributable to problems of asset quality—problems widely held to have been
caused primarily by the increase in commercial real estate lending—as the regional recession and real estate market bust led to rising levels of nonperforming assets and increasing
loss rates on these assets (see figures 10.13 and 10.14).

35

See Chapter 3.

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Banking Problems in the Northeast

Figure 10.12

Median Commercial Real Estate Loans,
Northeast versus U.S., 1980–1994
Percent of Assets
16

Northeast
Banks

12

8

U.S. Banks

4

0

1980

1982

1984

1986
1988
Year-end

1990

1992

1994

Figure 10.13

Median Total Nonperforming Assets,
Northeast versus U.S., 1982–1994
Percent of Assets
6.0

4.5

Northeast
Banks
3.0

1.5

0.0

U.S.
Banks
1982

1984

History of the Eighties—Lessons for the Future

1986

1988
Year-end

1990

1992

1994

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Figure 10.14

Median Net Charge-Offs on Loans and Leases,
Northeast versus U.S., 1976–1994
Percent of Assets

0.5

Northeast
Banks

0.4
0.3
0.2

U.S.
Banks

0.1
0

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994
Year-end

Bankers in the Northeast remember 1990 as the year they were hit harder than bankers
in any other region by losses precipitated by a plunge in real estate values.36 With office vacancy rates reaching 25 to 30 percent in places like central New Jersey and Stamford, Connecticut, and with many condominium developments only half filled after two years on the
market, a number of developers were unable to repay their bank loans. L. William Seidman,
chairman of the FDIC, noted in late 1989 that certain northeastern areas “have some of the
highest commercial vacancy rates in the country.”37 Even more disturbing was the fact that
eight of the ten states whose banks showed the highest increase in bad real estate loans in
1989 were in the Northeast. In addition, according to an analysis of second-quarter 1990 results prepared by Veribanc Inc., a Wakefield, Massachusetts, consulting firm, the 15 U.S.
banks whose problem domestic loans were most in excess of equity and reserves were all in
the Northeast.38 Robert Clarke, the Comptroller of the Currency, stated in early 1990 that
real estate was the main cause of weakness among national banks in the Northeast, noting
36
37
38

Marian Courtney, “The Great Loss: Analyzing the Northeast Banking Crisis,” Business Credit 93, no. 6 (June 1991): 10.
Quint, “Heavy Losses on Problem Loans.”
Ibid; and Charles McCoy and Ron Suskind, “FDIC’s Expected Losses Reflect Slump in Northeast: Increase in Reserves
Stems from the Agency’s Fear of Major Bank Failures,” The Wall Street Journal (December 20, 1990), available: WESTLAW, File: WSJ.

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that “during 1989, nonperforming real estate loans jumped to $9.1 billion from $3.6 billion
at Northeastern banks.”39
The root of these problems, according to some analysts, was overzealous lending by
institutions that sought new markets because opportunities to lend to businesses had dwindled and foreign lending frequently resulted in losses. This eagerness to lend led to an excessive number of new buildings flooding the market in many areas.40 Losses on real estate
loans hit savings banks in the Northeast particularly hard, according to Don J. Fauth, an analyst at the First Albany Corporation, a securities firm. He noted that savings banks raised
additional capital by issuing stock to investors during the 1980s and then attempted to increase profits through risky lending on construction projects rather than stay with their traditional home mortgage lending business.41
The real estate problems that hit the northeastern banks beginning in 1989 had been
quite unexpected just two years earlier. Bankers’ confidence in northeastern real estate had
been strong because the commercial real estate markets in the region remained robust despite problems nationwide. Nationally the Comptroller of the Currency expected troubled
commercial real estate loans to be one of the factors behind lower bank earnings in 1987,
stating in mid-1987 that “the number of nonperforming assets is high and it’s going to get
higher.”42 Others, too, believed that problems with commercial real estate loans nationally
would worsen before improving. For example, Robert Grossman, a bank analyst at Standard & Poor’s Corp., said in 1987, “I think it’s a while before we hit bottom.” By contrast,
real estate in the Northeast appeared to be in excellent shape. James F. Murray, senior vice
president at Chase Manhattan Bank, observed in mid-1987 that “the whole Northeast corridor is much stronger than the rest of the country.”
Even though many bankers in the Northeast became cautious soon thereafter and began cutting back on new lending and tightening loan standards as early as 1988, they were
still overwhelmed by the real estate market’s rapid deterioration.43 It quickly became apparent that real estate would cause severe problems for many banks. Commenting on the
situation, Michael Zamorski, deputy regional director for the FDIC, observed in mid-1991
that “banking problems shift geographically with the economy. Troubles in agriculture led

39
40
41
42
43

Barbara A. Rehm, “Banks Binging Despite Realty Hangover,” American Banker (March 8, 1990), 1.
Quint, “Heavy Losses on Problem Loans.”
Ibid.
All quotations in this paragraph are from Nina Easton, et al., “Shaky Real Estate Loans Hitting Banks,” American Banker
(June 4, 1987), 10.
Quint, “Heavy Losses on Problem Loans.”

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to bank failures in the Midwest, then falling energy prices caused problems in the Southwest. Now the focus is in the Northeast, where the worst real estate problems are.”44
New England
The boom and bust in New England real estate took its toll on the area’s banks, which
had been among the healthiest in the nation during much of the 1980s but which later experienced high rates of failure, primarily because of their extensive exposure to real estate
loans. During the 1980s, real estate portfolios at New England banks grew at twice the national rate, and some lenders, in the belief that “we’ve just had such a terrific market, it’s
hard to make mistakes,” became lax. Moreover, bankers generally believed that New England’s diversified economy would protect the region from a real estate debacle. Said one
banker, “I don’t see any disasters out there.”45
At the end of the 1980s, when economic growth and nominal real estate prices began
to decline in New England, cash-flow problems as well as the diminished collateral values
led many borrowers to stop making their loan payments.46 By early 1989, according to one
analyst at Merrill Lynch, everyone was “very jittery about real estate.”47 The anxiety may
have stemmed from credit-quality problems that had begun to surface rather frequently at
many New England banks and other financial institutions. Yet at the beginning of 1989, despite mounting problems with real estate–related loans, most analysts and bankers continued to remain cautiously optimistic because of New England’s basically healthy and
diversified economy. Dennis F. Shea, who followed New England banks for Morgan Stanley & Co., said in early 1989 that “I’m not expecting a debacle. I think it’s a very good
banking market. I think what it’s suffering from is indigestion.”48
The banks, however, turned out to be more than dyspeptic. For example, during the
first quarter of 1989, while the nation as a whole exhibited a decline in foreclosures, in New
Hampshire foreclosures on conventional mortgages rose from 0.05 percent of all such mortgages a year earlier to 2.41 percent—the largest such gain in any state. The second-largest
increase was in Massachusetts, from 0.10 percent to 0.49 percent.49 Cynthia Latta, senior financial economist for DRI/McGraw Hill Inc., explained this rise in foreclosures by noting

44
45
46
47
48
49

Courtney, “The Great Loss,” 10–11.
Both comments were made in 1987. See Weinstein, “Healthy Real Estate Market,” 12, 18.
Joe Peek and Eric S. Rosengren, “The Capital Crunch in New England,” Federal Reserve Bank of Boston New England
Economic Review (May/June 1992): 21, 24.
Michael Weinstein, “Slower Growth Forecasted for New England Financial Institutions,” American Banker (January 10,
1989), 28.
Ibid.
Phil Roosevelt, “Home Loan Defaults Rise in Northeast; Region Shows Foreclosure Gains as US Figure Decreases,”
American Banker (June 22, 1989), 2. Quotations and information in the balance of this paragraph are from the same source.

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that home buyers throughout the Northeast “have had to really stretch themselves to the
limit to buy homes in the past two years” (at the time, fixed-rate-mortgage monthly payments in the Northeast were about $1,000, compared with $620 nationwide) and, she said,
their burden became heavier as “buyers who took adjustable mortgages in the past two
years experienced steady payment increases, first as the loans adjusted from their introductory ‘teaser’ rates and then as market rates increased.” Robert Rosenblatt, an economist
with the Mortgage Bankers Association, said he “had found anecdotal evidence that many
lenders in New England qualified borrowers based on payment sizes as set by teaser rates,
rather than second-year rates” (secondary markets generally require borrowers to be qualified on the basis of the maximum second-year rates). Moreover, New England lenders
tended to retain loans—and thus the risk of default—in their own portfolio rather than sell
them in the secondary market.
A rapid increase in nonperforming loans led to serious problems for New England
banks in 1989.50 The banks were hit particularly hard by commercial real estate loan losses.
Many commercial projects were highly leveraged, and the owners were frequently individuals or partnerships whose assets either were unavailable to banks or were concentrated in
real estate whose value was declining. Banks were therefore forced to absorb much of the
loss on commercial real estate projects. As it became clear that loan losses would be substantially greater than anticipated, banks dramatically increased loan-loss reserves, thereby
causing a rapid deterioration in bank capital throughout the region. Coincident with this
substantial erosion of the capital base of New England banks, regulators were placing increased emphasis on bank capital ratios. Banks with substandard capital-to-assets ratios
were required to either increase equity capital or shrink their asset portfolios. Since loan
losses prevented banks from increasing capital through retained earnings, the only realistic
alternative for raising capital was to issue new shares. For many institutions, however, such
an option was not feasible, because investors required a large risk premium, which made it
difficult to sell stock at a reasonable price. As a result, the only choice open to many New
England banks that were trying to satisfy their capital-to-assets ratio requirements was to
reduce the size of their institution. Thus, New England banks substantially contracted during the early 1990s. Although some shrinkage was inevitable after the collapse of the area’s
real estate markets and slowdowns in both the New England and the national economies,
some observers believed that the effects were aggravated by the increased emphasis on
bank capital ratios.51

50
51

The discussion in this paragraph is based on Browne and Rosengren, “Real Estate and the Credit Crunch,” 28; and Peek
and Rosengren, “Capital Crunch,” 24, 26–27, 30.
For a discussion of the development of capital standards, see Chapter 2.

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New York and New Jersey
New Jersey’s real estate experience was similar to New England’s and caused problems for many of the state’s banks. During the 1980s, New Jersey’s strong economy made
it one of the most desirable banking areas in the country.52 By the end of the decade, although the state’s commercial real estate boom was over, banks expected a soft landing, not
a collapse such as had shaken the Southwest and New England. This expectation was based
partly on the diversification of the state’s economy. As an analyst with a New York brokerage firm noted, “Five hundred of the Fortune 1,000 have a significant presence in New Jersey.”53 But later that same year (1989) the same analyst stated, “Every bank in [New Jersey]
has experienced a significant increase in nonperforming loans.”54 In the third quarter of
1989, for a group of New Jersey banks rated by Thomson BankWatch, nonperforming loans
of all types were up 25 percent.55 By late 1990, major New Jersey banks had suffered
through a severe slide in real estate values and, according to a report by Fitch Investors Service, Inc., were not likely to feel relief soon.56 The credit rating firm noted that “sharply deteriorating asset quality is destroying earnings and eroding capital ratios at most major New
Jersey banks.”57 Even the $24 billion Midlantic Corporation in Edison, New Jersey, the
second-largest banking company in the state and, according to analysts, one of the best run,
suffered greatly from real estate loan losses.58
By mid-1991, the collapsing real estate markets caused many bankers to abandon
their belief that such problems would solve themselves because the property market would
inevitably recover.59 “The typical banker’s approach was always to give developers time to
work out their problems,” said an executive in charge of real estate lending at a New York
money-center bank. “Now, bankers believe the change in value is permanent. Prices aren’t
coming back to their old levels.”60
In New York the story was similar. Primarily because of the weak real estate markets,
the seven largest New York banks ended 1990 with $30.7 billion worth of nonperforming

52
53
54
55
56
57
58
59
60

Gordon Matthews, “New Jersey Banks Won’t Rebound Anytime Soon, Rating Agency Says,” American Banker (November 16, 1990), 24.
David Neustadt, “Jersey Braces for Lending Slowdown; Vacancy Rates Drop, But So Does Demand for Space,” American
Banker (November 21, 1989), 10.
Ibid.
Ibid.
Matthews, “New Jersey Banks Won’t Rebound Soon,” 24.
Ibid.
Courtney, “The Great Loss,” 11; and Michael Quint, “A Crystal Ball for Banking’s Ills,” The New York Times (January 12,
1991), available: LEXIS, Library: NEWS, File: NYT.
John Meehan, Larry Light, Geoffrey Smith, Joseph Weber, and bureau reports, “For Banks, the Panic Is Coming to an
End,” Business Week (June 17, 1991): 87.
Ibid.

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assets, compared with $24.1 billion at year-end 1989.61 The New York money-center banks
suffered relatively greater losses than the smaller banks. For example, Citicorp, then the nation’s biggest banking organization with assets of $217 billion, lost $382 million in the
fourth quarter of 1990.62 Chase Manhattan, then the nation’s third-largest bank, continued
to reel from its $9.5 billion portfolio of deteriorating commercial real estate loans, adding
$200 million to its provision for possible credit losses in the fourth quarter of 1990 while
charging off $230 million worth of domestic loans.63 Chemical Bank recorded high real estate–related loan losses in its New York–New Jersey home base, where problem assets were
27 percent higher in the fourth quarter of 1990 than in the third quarter.64
The collapsing real estate markets hit the two states’ savings banks with a vengeance.
Several large savings banks suffered huge losses, primarily from nonperforming real estate
loans, and failed in 1992. These included CrossLand Savings Bank (New York, $7.4 billion
in assets), Dollar–Dry Dock (New York, $4.0 billion in assets), The Howard Savings Bank
(New Jersey, $3.5 billion in assets), and American Savings Bank (New York, $3.2 billion in
assets).
CrossLand was a particularly interesting case because of the circumstances leading to
its collapse as well as the methods used to resolve the failure (see footnote 70). Although it
lost millions in the junk bond market, losses on commercial real estate loans were the primary cause of its failure. In early 1986, CrossLand Savings converted from mutual to stock
ownership and, by early 1989, had increased its asset size from $8 billion to just over $15
billion.65 The once-specialized thrift that was primarily a lender on apartment buildings and
other commercial real estate in the New York metropolitan market became a diversified financial services company that operated up and down both coasts through acquisitions of
other financial institutions. CrossLand’s activities included mortgage banking, commercial
and consumer lending, discount brokerage and life insurance services, and real estate development.
In the first quarter of 1990, CrossLand realized a loss of $136.5 million.66 Much of the
problem was due to the Office of Thrift Supervision’s (OTS) new rule that disallowed the inclusion of CrossLand’s $363 million of cumulative preferred stock as core capital, thereby
creating a capital deficiency of $113 million. Because it was undercapitalized, CrossLand
61
62
63
64
65
66

Jed Horowitz, “NY Bank Profit Disappointing as Loans Falter,” American Banker (February 8, 1991), 1.
Courtney, “The Great Loss,” 11.
Horowitz, “NY Bank Profit Disappointing,” 13.
Ibid.
Information in this paragraph was taken from Mark R. Wolff, “CrossLand Savings, Before and After,” Bottomline 6, no. 3
(March 1989): 44, 46.
Unless otherwise noted, information in this paragraph was taken from John Liscio, “Star-Crossed CrossLand: But a Recap
Plan Could Revive the Thrift’s Prospects,” Barron’s 70, no. 18 (April 30, 1990): 30–31.

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was forced to sell its junk bond portfolio in a weak market, suffering a substantial loss. In
early 1990, CrossLand had 22 percent of its assets in Metropolitan New York City commercial real estate loans, and the bank was adversely affected in 1990 and 1991 by the decline
in the area’s real estate market. Further, management asset-allocation decisions left CrossLand highly vulnerable to the fortunes of the real estate markets, as could be seen at yearend 1990 when approximately 49 percent of the bank’s portfolio was composed of high-risk
real estate investments and acquisition, development, and construction loans.67 As of September 30, 1991, regulators had classified 21.5 percent ($1.68 billion) of CrossLand’s assets
as substandard or lower.68 These circumstances resulted in CrossLand’s incurring net losses
of $421 million in 1990 and an additional $308 million for the first nine months of 1991,
which wiped out its equity capital.69 On January 24, 1992, CrossLand Savings of Brooklyn
was closed by the OTS, and the FDIC was appointed receiver of the institution.70
The Howard Savings Bank was another notable loser in the floundering real estate
markets. The 70-branch, state-chartered savings bank based in Livingston, New Jersey, was
the largest bank failure in New Jersey’s history.71 By the mid-1980s, the bank’s portfolio
had become heavily concentrated in commercial real estate loans. The assets of the bank
peaked near $5.2 billion in 1988 and then declined to $3.5 billion by October 1992. Although the overall rate of asset growth was relatively moderate during the 1980s, loans and

67
68
69

70

71

“CrossLand Savings, Brooklyn, Placed in Receivership; Depositors Protected,” U.S. Newswire (January 24, 1992), available: LEXIS, Library: NEWS, File: WIRES.
Ibid.
Susan Benkelman and Timothy L. O’Brien, “CrossLand Bailed Out; Seized Thrift Gets $1.2B from FDIC,” Newsday (January 25, 1992), available: LEXIS, Library: NEWS, File: NEWSDY; and Phil Roosevelt and Barbara Rehm, “CrossLand
Seized as Regulators Reject Bids,” American Banker (January 27, 1992), 10.
In response to the FDIC’s solicitation of bids for the failed bank, the best offer submitted was only $17 million for CrossLand’s branches. Accepting that offer would have left the FDIC with the task of disposing of billions of dollars’ worth of
real estate loans and investments. As a result, under what then-Chairman William Taylor called his “bank hospital” plan,
the FDIC decided to spend $1.2 billion to keep the bank open, intending to nurse it back to health and sell it for more than
it would bring in January 1992. Chairman Taylor believed that this was a less-expensive course of action than closing
CrossLand; in addition, he said the FDIC “wanted to let [the bidders] know that we have alternatives” and that the FDIC
was willing to keep banks open rather than give them away. Under the “hospital plan,” CrossLand executives renegotiated
with borrowers rather than automatically foreclosing and selling off their holdings, according to Richard Kraemer, the veteran banker whom the FDIC had installed as CrossLand’s president. According to an April 1994 GAO report, the FDIC expected savings of $517 million as a result of having used this method of dealing with CrossLand’s failure. In August 1993,
the FDIC sold CrossLand by public offering and realized savings from the conservatorship sale (adjusted as if savings had
been realized in 1992) of around $333 million (Jerry Knight, “FDIC’s ‘Hospital’ Plan a Bitter Pill for Some; Government
Takeover of Ailing CrossLand Savings Bank Called Unfair, Uneconomical,” The Washington Post [March 1, 1992], available: LEXIS, Library: NEWS, File: WPOST; and U.S. General Accounting Office, Failed Bank: FDIC Sale of CrossLand
Conservatorship Satisfied Least-Cost Test [GAO-GGD-94-109, April 1994], 8–9).
Information about The Howard Savings Bank is taken from James L. Freund, “Howard Savings Bank: Observations of
Regulator/Banker Differences in Evaluating Commercial Real Estate Risks” (unpublished paper, FDIC, 1996).

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real estate investments nearly doubled between 1984 and 1989 (from $2 billion to approximately $3.7 billion). By 1988, The Howard was already burdened with severe commercial
real estate problems. The Report of Examination for 1988 noted a rapid increase in total
classified loans due to “poor credit underwriting and administration and a desire for loan
growth and out-of-area lending.” As the economy weakened in the late 1980s, The Howard
experienced massive asset deterioration and debilitating losses; the bank’s CAMEL rating
dropped from a 2 in 1988 to a 5 January 1992.72 After three successive years of substantial
losses resulting from its aggressive real estate lending practices, The Howard was declared
insolvent and placed in receivership on October 2, 1992. It was a somber ending for the
135-year-old institution, which had been able to survive the Great Depression but succumbed to the real estate bust.

Bank Performance
The northeastern banking markets had historically been extremely stable, and until the
1990s, few banks had failed. Even during the turbulent 1980s there was an average of only
three bank failures a year in the region (see figure 10.15). Moreover, in 1986 and 1987,
when the northeastern real estate markets were still healthy, the region’s banks were sound
and compared very favorably with banks outside the Northeast. For those two years,
CAMEL ratings of northeastern banks were superior, on average, to those of all U.S. banks;
return on assets and return on equity were vastly superior to the U.S. average; the percentages of nonperforming assets to total assets and charge-offs to total assets were well below
those of all U.S. banks; a far lower percentage of northeastern banks had negative net income than did other banks; and northeastern banks had lower ratios of commercial and industrial (C&I) loans to assets than other banks. On the other hand, during those two years
the region’s banks had substantially higher percentages of total loans to assets, real estate
loans to assets, and commercial real estate loans to assets.
Despite the very sound condition of the region’s banks in 1986 and 1987, analysis
demonstrates that beginning in 1989 they experienced drastic, pervasive deterioration. As
the discussion below indicates, CAMEL ratings degenerated; ratios of median return on assets and nonperforming loans compared poorly with the ratios at other banks; the percent-

72

The CAMEL rating system refers to capital, assets, management, earnings, and liquidity. In addition to a rating for each of
these individual or “component” categories, an overall or “composite” rating is given for the condition of the bank. Banks
are assigned ratings between 1 and 5, with 5 being the worst rating a bank can receive. See Chapter 12 for a detailed explanation of CAMEL ratings.

History of the Eighties—Lessons for the Future

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Figure 10.15

Number
60

Northeast Bank Failures, 1980–1994

45

30

15

0

1980

1982

1984

1986

1988

1990

1992

1994

age of northeastern banks with negative net income skyrocketed; and the number of failures
escalated.
CAMEL ratings of the region’s banks worsened along with the area’s real estate problems (see table 10.2). For example, from 1983 through 1988, approximately 24 to 26 percent of all northeastern banks were rated 1; the comparable figure as of year-end 1991 was
10 percent. In addition, from year-end 1988 to year-end 1991, the percentage of 4-rated
northeastern banks rose from 2.1 percent to 16.5, percent and the percentage of 5-rated
banks rose from 0.6 percent to 6.7 percent. (In other words, the percentage of northeastern
banks that were rated 4 and 5 rose from 2.7 percent to 23.2 percent.) At the same time, the
percentage of all 4- and 5-rated banks that were located in the Northeast rose from 2.4 percent to 19.4 percent (see table 10.3).
Examination of the capital ratios of northeastern banks is also enlightening (see table
10.4). The ratio of equity to assets for northeastern banks remained fairly stable during the
troubled years and actually compared favorably with the percentages for the region’s banks
during the first half of the 1980s. For example, from 1980 through 1984 the average ratio of
equity to assets for northeastern banks was only 6.9 percent, but from 1988 through 1992 it
increased to 7.8 percent. In contrast, the equity-to-assets ratio for other banks remained constant at 8.2 percent for both periods. The improvement in the capital ratios of northeastern
362

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Chapter 10

Banking Problems in the Northeast

banks can be attributed largely to the substantial amounts of equity that resulted after savings banks converted to stock form.73
Table 10.2

CAMEL Ratings for All Northeastern Banks, 1981–1994
Report
Date
(Year-end)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

Number of Banks/Percentage of Total
1

2

CAMEL Rating
3

4

5

Total

213
22.8
204
22.0
210
24.3
216
25.7
242
26.2
263
26.4
263
26.5
249
25.0
200
20.2
130
13.4
91
10.1
83
9.9
118
14.3
167
21.3

584
62.5
568
61.4
540
62.4
508
60.6
573
62.0
644
64.6
646
65.1
635
63.6
621
62.6
486
50.1
364
40.5
386
45.8
473
57.3
475
60.6

100
10.7
110
11.9
81
9.4
73
8.7
76
8.2
63
6.3
64
6.5
87
8.7
113
11.4
196
20.2
236
26.3
225
26.7
147
17.8
98
12.5

28
3.0
26
2.8
18
2.1
24
2.9
15
1.6
16
1.6
15
1.5
21
2.1
40
4.0
117
12.1
148
16.5
123
14.6
70
8.5
36
4.6

9
1.0
17
1.8
16
1.9
18
2.2
18
2.0
11
1.1
5
0.5
6
0.6
18
1.8
41
4.2
60
6.7
25
3.0
18
2.2
8
1.0

934
100%
925
100
865
100
839
100
924
100
997
100
993
100
998
100
992
100
970
100
899
100
842
100
826
100
784
100

Note: Examination ratings were obtained from the FDIC’s historical database. In some instances examination ratings were
missing; however, from 92 to 99 percent of banks’ ratings were in the database. As a result, the number of CAMEL-rated
banks each year was slightly smaller than the total number of northeastern banks in other tables.
73

The total capital raised by converted savings banks in Massachusetts alone in 1986 was approximately $1.1 billion, sufficient capital to support a 17.5 percent increase in the state’s banking assets (assuming a 4.8 percent capitalization rate on
the additional assets). As a comparison, the largest bank in Massachusetts at year-end 1986 had equity capital of $1.2 billion (information derived from Eccles and O’Keefe, “The Experience of Converted New England Savings Banks,” 1).

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Table 10.3

CAMEL 4- and 5-Rated Institutions, Northeastern Banks versus
Banks in Rest of U.S., 1981–1994
Report
Date
(Year-end)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

Number of 4- and 5-Rated Banks/Percentage of Total
Northeastern
Other
Banks
Banks
Total
37
15.9
43
9.1
34
5.1
42
4.7
33
2.7
27
1.9
20
1.5
27
2.4
58
5.6
158
15.0
208
19.4
148
20.2
88
22.5
44
19.7

196
84.1
431
90.9
628
94.9
850
95.3
1,190
97.3
1,433
98.2
1,280
98.5
1,097
97.6
979
94.4
897
85.0
863
80.6
584
79.8
303
77.5
179
80.3

233
474
662
892
1,223
1,460
1,300
1,124
1,037
1,055
1,071
732
391
223

Total
Northeastern
Banks/
% Rated
4 and 5
934
4.0
925
4.7
865
3.9
839
5.0
924
3.6
997
2.7
993
2.0
998
2.7
992
5.9
970
16.3
899
23.2
842
17.6
826
10.7
784
5.6

Moreover, although the percentage of northeastern banks with very low (less than 5
percent) ratios of equity and reserves to assets rose from 1.3 percent in 1988 to 4.7 percent
in 1990, this ratio was still much lower than it had been for 1981–84, when it averaged 10.3
percent (see tables 10.5 and 10.6). In addition, the percentage of strong northeastern
banks—those with equity and reserves to assets exceeding 11 percent—remained fairly
steady through the troubled years. It is noteworthy that in 1986 there was a large increase in
the percentage of northeastern banks with capital ratios greater than 11 percent. This jump
can be attributed primarily to the influx of mutual savings banks into the FDIC fund be364

History of the Eighties—Lessons for the Future

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Banking Problems in the Northeast

Table 10.4

Median ROA, ROE, and Equity Ratios of Northeastern Banks versus
Banks in Rest of U.S., 1980–1994
Report
Date
(Year-end)
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

Number of Banks
NE Banks

Other
Banks

1,030
1,010
974
898
883
982
1,055
1,064
1,061
1,049
1,016
925
858
838
792

13,728
13,735
13,794
13,849
13,891
13,814
13,613
13,122
12,552
12,147
11,799
11,445
11,123
10,714
10,270

ROA

ROE

NE Banks

Other
Banks

0.72
0.72
0.75
0.77
0.82
1.02
1.06
0.97
0.81
0.60
0.20
0.26
0.65
0.89
0.89

1.13
1.09
1.04
0.98
0.91
0.89
0.77
0.79
0.88
0.94
0.89
0.92
1.10
1.16
1.11

Equity-to-Assets

NE Banks

Other
Banks

NE Banks

Other
Banks

10.26
10.36
10.55
11.59
11.61
14.49
14.45
12.51
9.90
7.05
2.78
3.42
8.04
9.92
9.87

13.52
12.96
12.44
11.79
11.00
10.64
9.33
9.30
10.19
10.75
10.24
10.51
12.30
12.39
11.92

7.15
7.08
6.86
6.57
6.62
6.93
7.21
7.73
7.83
7.92
7.71
7.63
7.91
8.49
8.68

8.26
8.26
8.28
8.21
8.11
8.10
7.90
8.02
8.06
8.17
8.09
8.21
8.51
8.90
8.90

tween 1980 and 1985, many of which converted from mutual to stock form in 1986 and increased their equity capitalization substantially. The percentage of commercial banks with
capital ratios of 11 percent or more increased only slightly from year-end 1985 to year-end
1986 (from 14.6 percent to 15.1 percent). For savings banks, however, this ratio jumped
from 7.7 percent to 20.3 percent over the same period.
The percentage of nonperforming loans of northeastern banks reflected the deterioration in the region’s real estate markets. From 1982 to 1987 the percentage was lower than
for other banks, but from 1988 through 1994 it was higher (see figure 10.16). During the
most troubled years, 1990–92, this percentage averaged 7.9 percent for northeastern banks,
compared with 3.6 percent for other banks. This high level of nonperforming loans led to a
substantial increase in the percentage of northeastern institutions with negative net income:
9.4 percent in 1988, 40.2 percent in 1990, and 35.2 percent in 1991 (see figure 10.17). Over
the same period, this ratio for other banks dropped from 14.9 percent to 10.5 percent.
This declining performance of the northeastern banks resulted in an enormous increase in the number of failures (see table 10.7). In 1989 there were 5; in 1990, 16; in 1991,
52; and in 1992, 43 (in 1993, the number tumbled to only 3). In 1991 and 1992, 5.6 percent
and 5.0 percent, respectively, of northeastern banks failed. Northeastern bank failures as a
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Table 10.5

Equity and Reserves to Assets, Northeastern Banks, 1980–1990
Report
Date
(Year-end)
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

Number of Banks/Percentage of Total
<5.0
66
6.4
104
10.3
114
11.7
87
9.7
85
9.6
55
5.6
34
3.2
17
1.6
14
1.3
25
2.4
48
4.7
42
4.5
15
1.8
12
1.4
4
0.5

Equity Capital and Reserves to Total Assets
5.0–7.0
7.0–9.0
9.0–11.0
318
30.9
289
28.6
305
31.3
355
39.5
346
39.2
348
35.4
344
32.6
244
22.9
206
19.4
167
15.9
144
14.2
146
15.8
106
12.4
52
6.2
55
6.9

355
34.5
336
33.3
304
31.2
251
28.0
270
30.6
340
34.6
353
33.5
406
38.2
414
39.0
400
38.1
378
37.2
331
35.8
306
35.7
271
32.3
244
30.8

176
17.1
156
15.5
142
14.6
114
12.7
92
10.4
121
12.3
142
13.5
167
15.7
210
19.8
217
20.7
225
22.2
221
23.9
238
27.7
263
31.4
242
30.6

>11.0
115
11.2
125
12.4
109
11.2
91
10.1
90
10.2
118
12.0
182
17.3
230
21.6
217
20.5
240
22.9
221
21.8
185
20.0
193
22.5
240
28.6
247
31.2

Total
1,030
100%
1,010
100
974
100
898
100
883
100
982
100
1,055
100
1,064
100
1,061
100
1,049
100
1,016
100
925
100
858
100
838
100
792
100

percentage of all bank failures went from 2.4 percent in 1989 to 40.9 percent in 1991 and to
35.2 percent in 1992. Northeastern bank failures in the early 1990s accounted for substantial portions of the volume of failed-bank assets and of the FDIC’s bank-failure resolution
costs (see table 10.8).
Since recently chartered institutions generally fail at higher rates than established
banks, the sizable number of newly chartered northeastern banks (see above, “Banking and
Real Estate in the Northeast”) contributed to the substantial number of bank failures in the
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Table 10.6

Equity and Reserves to Assets, Nonnortheastern Banks, 1980–1990
Report
Date
(Year-end)
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

Number of Banks/Percentage of Total
<5.0
88
0.6
108
0.8
143
1.0
156
1.1
145
1.0
156
1.1
290
2.1
364
2.8
395
3.1
285
2.3
218
1.8
139
1.2
73
0.7
15
0.1
34
0.3

Equity Capital and Reserves to Total Assets
5.0–7.0
7.0–9.0
9.0–11.0
1,529
11.1
1,583
11.5
1,648
11.9
1,986
14.3
1,903
13.7
1,736
12.6
2,058
15.1
1,505
11.5
1,311
10.4
1,223
10.1
1,134
9.6
920
8.0
611
5.5
352
3.3
490
4.8

5,945
43.3
5,887
42.9
5,668
41.1
5,437
39.3
5,531
39.8
5,502
39.8
5,256
38.6
5,088
38.8
4,800
38.2
4,539
37.4
4,627
39.2
4,374
38.2
3,844
34.6
3,145
29.4
2,989
29.1

3,787
27.6
3,701
26.9
3,679
26.7
3,469
25.0
3,438
24.7
3,520
25.5
3,324
24.4
3,296
25.1
3,202
25.5
3,209
26.4
3,038
25.7
3,184
27.8
3,543
31.9
3,771
35.2
3,331
32.4

>11.0
2,379
17.3
2,456
17.9
2,656
19.3
2,801
20.2
2,874
20.7
2,900
21.0
2,685
19.7
2,869
21.9
2,844
22.7
2,891
23.8
2,782
23.6
2,828
24.7
3,052
27.4
3,431
32.0
3,426
33.4

Total
13,728
100%
13,735
100
13,794
100
13,849
100
13,891
100
13,814
100
13,613
100
13,122
100
12,552
100
12,147
100
11,799
100
11,445
100
11,123
100
10,714
100
10,270
100

region.74 During 1991 and 1992 approximately 12 percent of the banks in the Northeast that
had been in existence for five years or less failed annually, compared with an annual failure
74

See John P. O’Keefe, “Risk-Based Capital Standards for Commercial Banks: Improved Capital Adequacy Standards?”
FDIC Banking Review 6, no. 1, (spring/summer 1993): 1–15. De novo bank failure rates are discussed in note 23 of the article.

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Figure 10.16

Nonperforming Loans as a Percentage of All Loans,
Northeast versus Rest of U.S., 1982–1990
Percent
10
8

Northeast
Banks

6

Banks in
Rest of U.S.

4
2
0

1982

1984

1986

1988

1990

1992

1994

Figure 10.17

Percentage of Banks with Negative Net Income,
Northeast versus Rest of U.S., 1980–1994

Percent
50
40

Northeast
Banks

30

Banks in
Rest of U.S.

20
10
0

1980

1982

1984

1986

1988

1990

1992

1994

rate of less than 5 percent for all other banks in the region. The large number of mutual savings banks that converted to stock form during the 1980s also contributed to failures in the
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Table 10.7

Bank Failures, 1980–1994
Year

Northeastern
Banks

All Banks

Northeast as a
Percent of
All Failures

1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

1
3
6
3
1
3
0
4
1
5
16
52
43
3
4

11
10
42
48
80
120
145
203
279
207
169
127
122
41
13

9.1%
30.0
14.3
6.3
1.3
2.5
0.0
2.0
0.4
2.4
9.5
40.9
35.2
7.3
30.8

Table 10.8

FDIC Bank-Failure Resolution Costs, 1990–1994
Year

Losses to FDIC from
Northeastern Failures
($Millions)

Percent of Total
U.S. Failure Costs

1990
1991
1992
1993
1994

$1,300
5,500
2,800
192
46

45%
91
77
29
22

Northeast. These conversions led to rapid growth and increased risk taking at such institutions. More than 20 percent of the stock savings banks that existed at year-end 1989—32 of
149—failed between 1990 and 1994. Only 8 percent of the mutual savings banks that existed at year-end 1989 failed during the same period.
A major reason for the large number of northeastern bank failures in the early 1990s
was the combination of a regional recession in the late 1980s and a national recession between 1990 and 1991. But each of the recessions was rapidly followed by a regional or national economic recovery; and between 1991 and 1993 the yield curve became very
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favorable, leading to record-high net interest margins for banks. Further, mortgage rates began declining substantially in 1991 and reached a 30-year low in 1993, bolstering the recovery of real estate markets. The drop in mortgage rates led to an increase in first-time
home ownership and a wave of mortgage refinancing, resulting in substantial fees for mortgage lenders. These conditions no doubt helped reduce the number of northeastern bank
failures to only three in 1993 and four in 1994.
As in other regional recessions, the rapid economic decline in the Northeast did not affect all banks in the same way. Even with the large number of northeastern bank failures
(111 between 1990 and 1992), most of the approximately 1,000 banks in the region as of
December 1989 survived the turmoil. The FDIC has conducted research to determine if
there were characteristic differences between the banks that survived and those that failed.
As is shown in Chapter 13, many years before a bank fails, it usually has a riskier operating
strategy than do surviving banks.
To see if this pattern existed in the Northeast, the FDIC researchers studied two cohorts of banks. The first consisted of all northeastern banks that existed in 1986 and either
failed in 1990 or 1991 or never failed. The second cohort consisted of banks that existed in
1988 and either failed in 1992 or 1993 or never failed. To analyze the effect of risky bank
strategies, the researchers used eight financial ratios.75 To assess how varying degrees of
risk affected northeastern banks, they ranked each bank for each financial ratio. Each ranking was then divided into five risk groups, and the failure rate was determined for each
group. For the 1986 cohort, banks in the highest loans-to-assets group had the highest percentage of failure four to five years later—10.6 percent. This was 3.8 times as high as the
percentage of failures for the remainder of the banks (see figure 10.18). In the 1988 cohort,
the banks with the highest asset growth had the highest incidence of failure—10.1 percent,
3.2 times as high as for slower-growing banks (see figure 10.19). The finding for 1986—
that banks in the highest loans-to-assets quintile had the highest failure rate—is consistent
with the findings for banks nationwide in that period.76 However, the results for 1988 are
not the same as those for the nation as a whole. As noted above, the large-scale conversion
of mutual savings banks to stock form and their subsequent rapid asset growth was a distinguishing feature of the Northeast’s banking environment. Growth rates of converted savings banks in the Northeast were very high, and a disproportionate percentage of these
institutions failed as compared with failure rates in the rest of the country (thus, high growth
rates in 1988 were a better predictor of future failure in the Northeast than they were for
banks nationwide).
75

76

The eight risk factors are loans-to-assets ratio, return on assets, asset growth from the previous year, loan growth from the
previous year, operating expenses to total expenses, average salary expenses, interest on loans and leases, and interest plus
fees on loans and leases.
See Chapter 13, “Off-Site Surveillance Systems.”

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Banking Problems in the Northeast

Figure 10.18

Comparison of Selected Factors in Predicting
Northeastern Bank Failures Four and
Five Years Forward, 1986

Percent
12

10.6%
9.4%

8.5%

9

6

3

0

3.4%

2.8%

Loans to Assets

Asset Growth

Percent of Banks in
Highest Quintile that
failed in 1990 or 1991

4.4%

Loan Growth

Percent of Banks in all
other Quintiles that failed
in 1990 or 1991

Note: These three factors represent the two highest risk factors (left and
center) and the lowest risk factor (right) in predicting bank failures.

Data on Bank Failures by State
The impact of the northeastern banking crisis varied depending on the state, but the
adverse effects tended to be fairly concentrated in time, peaking between 1991 and 1992. In
terms of failed-bank assets relative to each state’s total banking assets, the most severely affected state was New Hampshire: in 1991, 12 banks failed with assets of $5.2 billion (25.4
percent of the state’s prior year-end assets). Comparable figures were 18.3 percent in Connecticut, 15.2 percent in Maine, and 12.0 percent in Massachusetts. In contrast, an average
of only about 3.0 percent of bank assets failed in the region’s other states (New Jersey, New
York, Rhode Island, and Vermont).77

77

Most of the franchise of a failed bank, both assets and liabilities, typically remains within the same geographic market after the bank’s closure. This is because the typical way to resolve bank failures is by selling portions of the assets and liabilities to healthy former competitors in the state. Consequently, one should not infer that failed-bank assets are “lost” to
these markets.

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Figure 10.19

Comparison of Selected Factors in Predicting
Northeastern Bank Failures Four and
Five Years Forward, 1988

Percent
12

10.1%

9.8%

9

5.7%

6

3

0

3.2%

3.4%

Asset Growth

Loan Growth

Percent of Banks in
Highest Quintile that
failed in 1992 or 1993

3.3%

Operating Expenses

Percent of Banks in all
other Quintiles that failed
in 1992 or 1993

Note: These three factors represent the two highest risk factors (left and
center) and the lowest risk factor (right) in predicting bank failures.

Included among the region’s bank failures were many of the Northeast’s larger banking organizations (see table 10.9). It is noteworthy that in New York and New Jersey, although the percentage of failed-bank assets was relatively small, there were several major
failures, including Goldome ($9.9 billion), Dollar–Dry Dock ($4.0 billion), Seamen’s ($3.4
billion), and American Savings Bank ($3.2 billion), as well as CrossLand Savings Bank
($7.4 billion) and The Howard Savings Bank ($3.5 billion), as discussed above.
The 1990s northeastern bank-failure experience will perhaps be most remembered for
two events. The first was the failure of the Bank of New England Corporation (BNEC) on
January 6, 1991. (This failure is described in the next section.) BNEC had a significant regional presence through the Bank of New England (Boston), Connecticut Bank and Trust
Co. (Hartford), and Maine National Bank (Portland). BNEC had assets of approximately
$22 billion at the time of its failure, and its resolution cost the FDIC approximately $733
million. The second memorable event was the failure of seven New Hampshire banks on
October 10, 1991. These seven failed banks included four of the state’s ten largest
(Amoskeag Bank, Dartmouth Bank, Bankeast, and Numerica Savings Bank) as well as
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Table 10.9

Large Northeastern Bank Failures in the 1990s
Institution
The Seamen’s Bank for Savings,
FSB
Bank of New England Corporation
Connecticut Bank & Trust Co.
Bank of New England
Maine National Bank
Maine Savings Bank
First National Bank of Toms River
Goldome
First Mutual Bank for Savings
Citytrust
Mechanics & Farmers Savings
Bank, FSB
Connecticut Savings Bank
CrossLand Savings Bank
Dollar–Dry Dock
American Savings Bank
First Constitution Bank
The Howard Savings Bank
Heritage Bank for Savings

Failure
Date

Assets
($Millions)

Resolution
Costs
($Millions)

04-18-90
01-06-91
01-06-91
01-06-91
01-06-91
02-01-91
05-22-91
05-31-91
06-28-91
08-09-91

$ 3,392
21,886
7,211
13,429
1,046
1,183
1,418
9,891
1,130
1,919

$189
733
152
581
0
6
132
848
181
505

08-09-91
11-14-91
01-24-92
02-21-92
06-12-92
10-02-92
10-02-92
12-04-92

1,084
1,045
7,432
4,028
3,203
1,571
3,461
1,288

323
207
548
357
470
127
87
22

Cost as a
Percentage
of Assets

State

5.57%
3.35
2.11
4.33
0.00
0.47
9.31
8.57
16.02
26.32

NY
CT
MA
ME
ME
NJ
NY
MA
CT

29.80
19.81
7.37
8.86
14.67
8.08
2.51
1.71

CT
CT
NY
NY
NY
CT
NJ
MA

Note: Resolution costs are as of year-end 1995.

three relatively large banks (Nashua Trust Company, New Hampshire Savings Bank, and
Bank Meridian). These seven New Hampshire failures represented approximately 25 percent of the state’s commercial and savings bank assets.

The Rise and Fall of the Bank of New England Corporation
The “new” Bank of New England Corp. (BNEC), headquartered in Boston, was
formed in June 1985 after the merger of the “old” Bank of New England Corp. of Boston
($7 billion in assets) and CBT Corp. (Connecticut Bank & Trust) of Hartford ($6.8 billion
in assets).78 The merger was designed to take advantage of the best features of both institutions—Bank of New England Corp.’s expertise in real estate lending and CBT’s knowledge
78

Alan Lavine, “Bank of New England Corp. Takes Its Name Seriously with Ambitious Acquisition Strategy in Four States,”
American Banker (September 2, 1986), 24; and John P. Forde, “ ‘New’ Bank of New England’s Rosy Prospects,” American Banker (December 19, 1985), 3.

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of retail banking.79 The reaction to the merger was favorable. An analyst at Goldman, Sachs
& Co. said, “The ‘new’ Bank of New England Corp. is a well managed, $14 billion–asset
bank holding company located in a booming region.”80 James J. McDermott, Jr., an analyst
at Keefe, Bruyette & Woods Inc. in New York, believed that “the Bank of New England and
CBT merger was one of the more brilliant strokes in banking. Two strong retail and wholesale markets were merged.”81
After the merger, BNEC initiated a growth strategy in which it spent over $1.4 billion,
mostly in stock swaps, to buy leading banks in key economic areas of New England. For example, in December 1985 it completed a merger with Maine National Bank of Portland
(MNB), a $700 million institution.82 These acquisitions helped BNEC grow to $24 billion
in assets within 20 months.83 By mid-1988, BNEC had executed mergers with more than a
dozen institutions and had captured a major share of the New England market, with about
12 percent of domestic deposits and about 19 percent of commercial loans.84 As of July
1989, BNEC had $32 billion in assets, 8 subsidiary banks, and 482 branches in the states of
Connecticut, Maine, Massachusetts, and Rhode Island.85
BNEC’s spectacular growth ended when problems began to develop in the late 1980s
as the regional economy declined and real estate markets became troubled. By the end of
the first quarter of 1989, BNEC’s banks had $551 million in nonperforming loans—2.2 percent of the banks’ total loans. The depth of BNEC’s problems was indicated by Kidder
Peabody’s mid-1989 recommendation that its clients sell their stock in the company.86
The growing financial problems of BNEC’s banks, especially its lead bank, the Bank
of New England, Boston (BNE), were of increasing concern to the Office of the Comptroller of the Currency (OCC).87 The results of the agency’s year-end 1988 examination (completed in May 1989) of BNE and each of its affiliated banks were such that BNE and its
directors consented to a formal agreement on August 10, 1989, to correct deficiencies the
OCC examiners had identified in the banks’ real estate lending practices. Beginning in September 1989, the OCC had examiners in BNE on a continuous basis. However, the finan-

79
80
81
82
83
84
85
86
87

Alice Arvan, “The Regionals That Roar,” Bankers Monthly 105, no. 5 (May 1988): 68.
Forde, “ ‘New’ Bank of New England’s Rosy Prospects,” 3.
Lavine, “Bank of New England Corp. Takes Its Name Seriously,” 23.
Forde, “ ‘New’ Bank of New England’s Rosy Prospects,” 3; and Lavine, “Bank of New England Corp. Takes Its Name Seriously,” 24.
Lavine, “Bank of New England Corp. Takes Its Name Seriously,” 24.
Arvan, “The Regionals That Roar,” 68.
Alan Wade, “Bank of New England’s Woes,” United States Banker 98, no. 7 (July 1989): 46; and Arvan, “The Regionals
That Roar,” 68.
Wade, “Bank of New England’s Woes,” 48–49.
For the OCC’s views on BNE, see Clarke statement, testimony in OCC Quarterly Journal 10, no. 2 (June 1991): 31–32.

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cial deterioration continued, and in late 1989 the OCC began to increase its supervision of
the bank’s day-to-day operations.
In January 1990, the chairman of BNEC (who was also chairman of BNE) resigned
after the corporation announced that its constituent banks had lost $1.1 billion in 1989. On
January 22, 1990, BNE found it necessary to borrow $225 million at the Federal Reserve’s
discount window in order to meet its immediate liquidity needs. On February 26, 1990,
BNE and its directors consented to a cease-and-desist order with the OCC; the order served,
among other things, to prevent further dissipation of the bank’s assets. The OCC executed
similar cease-and-desist orders in April and May with, respectively, CBT and MNB and
their directors.88
Despite the efforts of a new management team to improve performance, BNE lost another $80 million in the first half of 1990; and by year-end 1990, $3.2 billion, or 20 percent,
of BNEC’s loans were nonperforming.89 On January 4, 1991, after BNEC announced that it
expected a $450 million fourth-quarter loss that would render both the holding company
and BNE technically insolvent, depositors mobbed BNE’s branches and withdrew $1 billion.90 On Sunday, January 6, 1991, the OCC formally declared BNEC’s three major banking units—BNE, CBT, and MNB—insolvent and appointed the FDIC as receiver. On the
same day the FDIC announced that (1) the OCC had chartered three new bridge banks (New
Bank of New England, N.A., Boston; New Connecticut Bank & Trust Company, N.A.,
Hartford; and New Maine National Bank, Portland) to assume the assets and liabilities of
the three insolvent banks; (2) the bridge banks would be open for business as usual on Monday, January 7, 1991; and (3) all deposits of the three insolvent banks would be protected,
even those over the $100,000 insured limit.91
The insolvencies of CBT and MNB were triggered by the failure of BNE. Because of
BNE’s insolvency, CBT was unable to recover $1.5 billion in federal funds it had loaned to
BNE. The FDIC charged the resulting loss against the capital accounts of CBT, with the result that CBT had an equity capital deficiency of $49 million.92 The OCC then declared
CBT insolvent and placed it in receivership. Furthermore, under the cross-guarantee provision contained in the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 (FIRREA), the FDIC demanded immediate payment from MNB of an amount equal
88
89
90
91

92

Ibid., 32.
Geoffrey Smith, “Lawrence Fish’s Best May Not Be Good Enough,” Business Week (October 22, 1990): 98–99; and “Bank
of New England: Here We Go?” Economist 318 (January 12, 1991): 72.
“Bank of New England: Here We Go?” 72; and Clarke testimony, 32.
FDIC News Release PR-3-91, “FDIC Establishes Three New Banks to Assume Deposits of Bank of New England, N.A.,
Boston, Massachusetts, Connecticut Bank & Trust Company, N.A., Hartford, Connecticut, and Maine National Bank, Portland, Maine,“ January 6, 1991.
Clarke testimony, 32–33.

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to the FDIC’s expected loss as receiver of BNE.93 When MNB was unable to make the payment, the OCC declared it to be insolvent and placed it in receivership. This was the first
time the cross-guarantee provision of FIRREA had been used to close a bank.
On April 22, 1991, the FDIC announced that the three bridge banks would be acquired
by Fleet/Norstar Financial Group, Inc., of Providence and investment managers Kohlberg,
Kravis, Roberts & Co. (KKR). Fleet agreed to raise $683 million in capital for the banks
within three months; KKR would provide $283 million, and the bank planned to raise the
remaining $400 million in stocks and bonds. The participation of KKR as a partner with
Fleet/Norstar in the acquisition of the three bridge banks was the first time that a nonbank
“financial” buyer participated in the purchase of a failed commercial bank. KKR’s involvement not only allowed capital to enter the banking industry from nonbanking sources but
was also expected to increase the number of potential bidders in future bank failures.94
The decision to protect all deposits of the three BNEC banks again focused attention
on the “too-big-to-fail” bank disposition policy. During congressional hearings held on January 9, 1991, many members of the House Banking Committee had expressed the view that
paying depositors of large institutions in full was not only unfair to those with deposits in
small banks but also undermined depositor discipline.95 FDICIA consequently included
provisions making it more difficult for bank failures to be resolved in ways that would protect uninsured deposits.96
After the failure of the BNEC banks, the chairman of the Senate Banking Committee
asked the U.S. General Accounting Office (GAO) to review the factors that had caused the
failure. The 1991 GAO report noted that between 1985 and 1989, the assets of BNEC banks
grew from $7.5 billion to $32.6 billion, primarily through aggressive acquisitions and increased real estate lending.97 The GAO believed that this expansion should have caused the
OCC to conduct a thorough and aggressive examination early in the period to assess the potential adverse affects of both BNEC’s rapid growth and its concentration in commercial
real estate lending.98
93
94

95

96
97
98

The cross-guarantee provision of FIRREA provides that an insured depository institution can be held liable for any loss that
the FDIC expects to incur in connection with the default of a commonly controlled insured depository institution.
FDIC News Release PR-61-91, “FDIC to Sell Bank of New England Franchise to Fleet/Norstar,” April 22, 1991; Barbara
A. Rehm, “How the Acquisition by Fleet Will Work,” American Banker (April 24, 1994), 8; and Milligan, “KKR, Member
FDIC,” 59.
U.S. House Committee on Banking, Finance and Urban Affairs, Failure of the Bank of New England: Hearing, 102d
Cong., 1st sess., January 9, 1991, 1–50 (comments by various members of the committee and by Mr. Seidman and Mr.
Clarke).
FDIC, “Systemic Risk (‘Too Big to Fail’)” (unpublished paper), 1995, 7.1-1 to 7.1-5. For additional information, see Chapter 7.
U.S. General Accounting Office, Bank Supervision: OCC’s Supervision of the Bank of New England Was Not Timely or
Forceful (GAO/GGD-91-128, September 1991), 1.
Ibid, 22.

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The GAO report also pointed out that during BNEC’s high-growth years OCC examiners repeatedly identified and reported problems with BNEC banks’ controls over lending
operations and strategies, but not until 1989 did the OCC take enforcement action to compel corrective measures.99 For example, the OCC found that over half of the commercial
real estate loans reviewed at BNE during the December 1987 examination were 100 percent
financed and that nearly half of the loans reviewed had inadequate or stale credit information on borrowers, but the agency generally relied on BNEC management’s assurances that
it would address problems such as these.100
The GAO concluded that the BNEC banks failed as a result of their liberal lending
practices, poorly controlled growth, and concentration in commercial real estate loans in a
severely declining regional economy.101 The GAO findings indicated that the OCC had
failed to take timely and forceful supervisory actions to compel BNEC to correct problem
areas before they adversely affected capital adequacy. Although the GAO could not say
with certainty that close supervisory scrutiny would have saved BNEC’s banks, the agency
did believe that more vigilant supervision could at least have reduced losses.102
Although the “new” Bank of New England had been established with great expectations in 1985, by early 1991 it was the country’s third-largest bank failure (after First RepublicBank Corporation and Continental Illinois). BNEC’s aggressive lending practices
had produced a large concentration of real estate loans, and when New England’s construction boom faltered, BNE’s loan book was “reduced to rubble.”103 There were other factors
in BNE’s collapse. Former executives, competitors, and customers told “a tale of confused
and haphazard management.” Lines of authority and responsibility were blurred, lending
standards were often lax, and numerous unwise real estate loans were made. It was reported
that the former chairman had personally courted large real estate developers and, in an effort to complete a transaction, sometimes offered bargain-priced loans without seeking any
collateral. Some former executives alleged that the chairman had “often made such loans
without even consulting his lending officers.”104 While these activities were certainly examples of poor bank management, they were not illegal. In fact, it was reported the chairman was not only allowed to retire rather than resign, thereby becoming eligible for lifetime

99
100
101
102
103
104

Ibid, 5.
Ibid, 13–15.
Loans were issued with favorable terms, such as 100 percent financing, no collateral except the development project on
which the loan was made, and interest-only payments for a number of years.
U.S. GAO, OCC’s Supervision of the Bank of New England, 38.
“Bank of New England: Here We Go?” 70, 72–73.
Laura Jereski, “A Stomachache for the Bank That Ate New England,” Business Week (February 5, 1990): 68–69.

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An Examination of the Banking Crises of the 1980s and Early 1990s

Volume I

retirement benefits of approximately $1 million a year, but was also offered a severance
package worth several million dollars.105

Conclusion
The banking problems in the Northeast in the 1980s and early 1990s were associated
with the third in a series of four rolling regional recessions that had been preceded by speculative booms (the first two were in the farm belt and the Southwest; the fourth was in California). The Northeast’s regional problems were exacerbated by the national recession that
took place during 1990–91. With respect to banking problems, the most important element
of the region’s boom was real estate—particularly commercial real estate. Expecting a continuation of the substantial gains that accompanied the building boom of the mid-1980s, numerous banks throughout the region lent aggressively into projects that, in many cases,
became increasingly marginal, especially as the economy worsened. As in the Southwest,
vacancy rates shot up and many real estate loans made during the boom turned into problem loans. Although many observers believed that the Northeast’s diversified economy
would cushion the region against a Texas-style collapse, that assessment proved inaccurate.
As had been the case in the farm belt and in the Southwest, the end of the boom led to significant numbers of bank failures. In 1989 only five banks failed in the region, but two years
later, in 1991, the number had risen more than tenfold to 52. Also like the Southwest, the
Northeast experienced a number of large-bank failures. In the New York area, several large
savings banks failed, including Goldome, CrossLand, and Dollar–Dry Dock. The most notable failure was undoubtedly that of the Bank of New England in January 1991, the resolution of which created pressure for legislative action to deal with the “too-big-to-fail”
issue; Congress responded with FDICIA.
One important element of the banking problems in the Northeast was peculiar to the
region: the presence of large numbers of mutual savings banks that converted to stock form
during the period. Between 1985 and 1990, approximately 40 percent of all the mutual saving banks in the region as of year-end 1984 took this course. Converted institutions experienced significant increases in capitalization and therefore increased their loan growth in
order to sustain returns on equity. Many of these savings banks had concentrated on traditional residential real estate lending, but upon conversion they pushed into unfamiliar commercial real estate in new geographic markets where their managements had little
experience. Converted savings banks therefore became a uniquely northeastern element in
the series of boom-to-bust cycles that had occurred in the Midwest and the Southwest in the
middle to late 1980s and would occur once more, in California in the early 1990s.
105

Jed Horowitz, “Grapevine: That Conn