No description of the savings and loan and banking crises of the eighties is complete without mention of federal deposit insurance. Deposit insurance gets mixed reviews. On the one hand it is credited with preventing a banking panic à la the Great Depression of the thirties, while on the other it is blamed for creating and magnifying the debacle. As a result federal deposit insurance reform has come under greater public scrutiny than at any time since its enactment in 1933.
Federal deposit insurance became law for commercial banks in 1933 as part of the Glass-Steagall Act, and for S&Ls in 1934. Although a number of state governments had provided deposit insurance before 1933, most state programs had failed and all had been disbanded by then. The federal program was enacted only after long debate.
The Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC) were both established in 1934. As initially conceived in the legislation, coverage was to be on a sliding scale, insuring 100 percent of the first $5,000 of deposits and progressively lower percentages of larger amounts. But this plan was never adopted, and 100 percent insurance was provided for only the first $2,500 per account. This was quickly increased to $5,000 in mid-1934 and, in a number of steps, to $100,000 per account in 1980. The insurance coverage was funded by a flat annual premium on banks, initially set at 0.5 percent of insured deposits. That was lowered shortly thereafter to 1/12 of 1 percent or less of total domestic deposits before being increased again in the late eighties to pay for the large losses then occurring.
The early advocates of federal deposit insurance argued that it would provide safety and liquidity for small depositors, would protect the smooth working of the national payments (check-clearing) system, and most important, would protect against bank runs. A bank run occurs when many depositors, fearing their bank's ability to make good on deposits, withdraw their money. No bank can refund all, or even a substantial portion, of its deposits at once. To meet the depositors' demands, therefore, the bank has to sell assets quickly and possibly suffer fire-sale losses that could lead to its failure.
Advocates of deposit insurance feared that such runs could spread to other banks, making solvent banks insolvent and reducing the amount of money in the economy. Sudden reductions in the supply of money can throw the economy into recession or even depression. Although the proponents of deposit insurance overstated the damage caused by bank runs (see Bank Runs), insurance did reduce runs and bank failures. From the advent of deposit insurance until the late seventies, only rarely did more than ten banks fail in a year. Runs on troubled banks effectively disappeared for all but small, nonfederally insured institutions. If the government promised to make depositors whole, regardless of a bank's solvency, why bother removing deposits?
Opponents of deposit insurance argued, based in part on the experience of the state funds, that insurance would weaken the incentive for depositors to care whether their banks and S&Ls took excessive risks. Because the rates for deposit insurance were the same for the stodgy low-risk lender as they were for the high-flying, risk-taking lender, the low-risk banks and S&Ls would end up subsidizing the high-risk ones. As the S&L crisis and the bank crisis of the eighties and early nineties show, they were right. Over time the insurance-induced weakening of depositor discipline over banks caused a mostly unnoticed weakening of the financial condition of individual banks.
In the thirties, before deposit insurance, banks held capital of almost 15 percent of assets. (Capital, which consists of money put up by shareholders, is the "cushion" to absorb losses.) Moreover, bank owners had personal double liability. They were liable not only for the amount of their investment, but also for an additional amount up to the par value—the price at which the shares were initially offered—of their shares. By the late seventies bank capital ratios had fallen to only 6 percent of assets and double liability had been abolished. Banks also increased the riskiness of their loan portfolios by making more loans to less developed countries, to commercial real estate, and to corporations heavily indebting themselves to restructure. S&Ls increased their exposure both to credit risk and, by making long-term, fixed-rate mortgages financed by short-term deposits, to increases in interest rates. It would not take much of a shock to such portfolios to wipe out the low capital base. And in the eighties the shock happened, first to the S&Ls, from increases in interest rates, and then to both the S&Ls and the banks, from losses on loans.
Before deposit insurance, banks that were close to being insolvent would have experienced runs and would not have been able to attract replacement deposits. But deposit insurance prevented this self-regulating mechanism. The FDIC made matters even worse by saying that it would often guarantee deposits even in excess of $100,000, especially for larger banks deemed "too large to fail." Insolvent institutions could thus remain in business and attract nearly all the funds they wanted by paying high interest rates on deposits. Runs occurred, but unlike the earlier ones, the new runs were from safer banks to riskier banks that offered higher rates on federally insured deposits. Without any capital of their own, the insolvent institutions frequently increased their risk exposures and incurred even larger losses. In effect, they were gambling with taxpayer money. If their risky loans paid off, they got to keep the profits. If the borrowers defaulted, the FDIC, the FSLIC, and ultimately the taxpayer got stuck with the loss.
If the losses that S&Ls incurred had been officially recognized when they happened, they would have depleted the reserves of the FSLIC by the early eighties. But officials at the FSLIC feared igniting runs at other S&Ls and even banks if they closed insolvent institutions too soon, felt political pressure from the industry, at times transmitted through members of Congress (e.g., the "Keating five") to keep insolvent institutions open, and feared personal embarrassment from both admitting a large number of insolvencies and asking for additional industry contributions and taxes. Therefore, these officials did not recognize the losses formally. Instead, the FSLIC permitted insolvent S&Ls to continue operating and maintained a facade of solvency.
When interest rates shot up in the seventies and early eighties, many S&Ls were technically bankrupt. They had to pay higher short-term interest rates to attract deposits, but their interest income from long-term, fixed-rate mortgages was unchanged. In addition the market value of these mortgages had plummeted. Most appeared solvent (they had enough resources to pay interest and meet withdrawals) simply because they did not have to write down their mortgages to market value. The sharp decline in interest rates from 1982 through 1986 reversed S&L losses from interest rate risk. But many S&Ls, either through deliberate increases in risky loans or because they were in the energy belt centered in Texas or in other regions of the country that also suffered significant recessions, incurred large loan defaults that more than offset the gains from interest rate reductions. Industry losses increased sharply, and the negative economic net worth of insolvent S&Ls expanded rapidly from some $20 billion in 1985 to near $100 billion in 1988.
Belatedly, the FSLIC attempted to resolve the insolvencies but was short of funds. Therefore, it used expensive techniques to delay cash outlays to later periods and offered tax concessions to buyers of failing S&Ls that reduced revenues to the U.S. Treasury. The White House and Congress belatedly recognized both the seriousness of the problem and the need for federal funds to resolve insolvencies efficiently and make the depositors whole. In early 1989 President Bush introduced, and Congress enacted, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).
FIRREA punished the most visible villain by abolishing the FSLIC and its parent Federal Home Loan Bank Board and transferring its insurance powers over S&Ls to a new Savings Association Insurance Fund (SAIF) operated by the FDIC, which claimed that it could do better. Insurance premiums also increased sharply. Commercial banks were transferred to a new Bank Insurance Fund (BIF), also operated by the FDIC. Unfortunately, FIRREA was based on an underestimate of the cost of the bailout and on a mistaken view of the cause. It did little to correct the underlying faults in the structure of deposit insurance. Riskier banks and S&Ls still did not pay higher deposit insurance rates, and depositors still had little or no incentive to monitor the loan portfolios of their banks and S&Ls. Regulators still could delay resolving insolvencies.
Unfortunately, the FDIC has not done much better than the FSLIC. Mainly due to sharp declines in commercial real estate values in the late eighties and early nineties, the number of commercial bank failures increased sharply from around ten annually at the beginning of the decade to more than two hundred near the end. Many large banks failed, including nine of the ten largest banks in Texas. For many of the same reasons that motivated the FSLIC, the FDIC has repeated the FSLIC's pattern. It delayed recognizing many insolvencies, particularly for large banks it considered too large to fail, denied that it was encountering financial difficulties, and increasingly resolved insolvencies at a high cost to itself and to the U.S. Treasury.
Finally, in early 1991, the potential insolvency of the FDIC could no longer be disguised. Proposals for increasing the fund and for significantly reforming the insurance structure received serious public policy attention. Legislative proposals included reducing the amount of insurance coverage per account, particularly eliminating coverage of multiple accounts by the same depositor, to enhance depositor discipline; abolishing the "too-large-to-fail" doctrine; restricting insured banks to only safe investments (so-called "narrow" banks); allowing banks and S&Ls to broaden their product lines and to expand into other regions, in order to reduce risk through greater diversification; basing deposit premiums on bank risk; increasing capital requirements; and instituting earlier and progressively harsher regulatory intervention on a structured basis according to tiers, or zones, of bank capital in order to catch and recapitalize troubled institutions before they became insolvent.
The FDIC Improvement Act, which was passed at the end of 1991, gave the FDIC the power to intervene earlier in the affairs of insured institutions that are financially troubled. It also requires recapitalization of troubled institutions either by existing shareholders or by merger, sale, or liquidation before their capital is fully depleted. If the early intervention or the recapitalization succeeds, losses from failure are limited to the institution's shareholders and not spread to its depositors or the FDIC. The 1991 act also restricts the FDIC's ability to make uninsured depositors whole in too-big-to-fail resolutions and requires the FDIC to introduce risk-based premiums. These changes, if enforced, will reduce the flaws in deposit insurance and make the banking system safer.
George G. Kaufman is the John F. Smith Professor of Finance and Economics at Loyola University in Chicago. He also is a member of the Shadow Financial Regulatory Committee.
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