Bank failure - happens when a bank becomes insolvent, can't meet its obligations to depositors and other creditors.  Before FDIC, banking industry was affected adversely by the potential problems of uninsured banks:

1. Uninsured depositors might be reluctant to deposit their money in a bank, since it could be hard to tell how financially healthy the banks was.  When uninsured banks failed, the bank's assets were liquidated, and depositors would eventually get something, but usually only a fraction of the value of their deposits.  Without deposits, banks can't make loans, so the banking system doesn't develop, credit markets don't develop to the optimal level.

2. Depositors could not accurately assess the quality of the bank's loan portfolio, leading to widespread bank panics, especially during economic contractions.  Suppose the economy goes into a recession, and historically about 5% of the banks fail during a recession.  Depositors might not be able to tell the strong banks from the weak banks, and you could have a "run" on the bank - all depositors trying to withdraw funds at once - even from the strong banks.   Banks operated on a first-come, first-served basis, leading to a "run" on the bank when depositors suspected trouble.  The spread of bank failures is called the "contagion effect", when there is a run on the banks, and widespread bank panics.

Bank failures were very common before FDIC (1934), and major bank panics happened on a regular basis, every twenty years or so (1819, 1837, 1857, 1873, 1884, 1893, 1907, 1930-1933).  Even during the economic boom of the "Roaring 20s", there were an average of 600 bank failures annually.

After 9000 banks failed in the early 1930s, FDIC was established in 1934 as a government safety net to prevent future bank failures, eliminate runs and bank panics, restore trust, etc. by providing a system of deposit insurance to protect depositors.  Deposits are now protected up to $100,000, so there are no longer runs on banks since depositors know they are now protected even in the extreme case that the bank actually does fail.  From 1934-1981, there were fewer than 15 bank failures per year, so FDIC did a) help stabilize the banking system for a long period, b) eliminate bank panics and runs on the banks and c) prevent a single depositor from losing money from a bank failure up to the limit (in some cases insurance would even cover deposits over the limit).
 

What happens when a bank fails?  FDIC uses two methods to deal with a failing bank:

1. Payoff method - FDIC pays off deposits up to $100,000 limit from their insurance fund from previous premiums, liquidates the assets (loans), and then pays off other creditors and depositors with money over the $100,000 limit.  Typically there is a 90% payoff for deposits over the $100,000 limit, but it may take several years.  Why?

2. Purchase and assumption method - FDIC arranges for another bank to merge and take over the failing bank, usually guaranteeing all deposits, even those over the limit.  FDIC would also help the acquiring bank partner by a) giving subsidized (low interest) loans and b) buying some of the failed bank's weaker or riskier loans.  This was the most common way of dealing with bank failures in the 1980s.
 

POTENTIAL PROBLEMS WITH FDIC:

1. Moral Hazard: Insured parties tend to take on excessive risk, especially when the premiums are not risk-adjusted.  Until recently, deposit insurance premiums were flat-fee based, and were not adjusted for the riskiness of the bank.  Since all banks paid the same deposit insurance premiums: 1) there were no penalty imposed on banks with risky loan portfolios, 2) there was no reward for banks with safe loan portfolios and c) the safe banks ended up subsidizing the risky banks.

2. Insured depositors have no incentive to monitor a bank's financial position, since their funds are insured to $100,000.  Therefore, bank customers impose no discipline on banks, and banks know that they don't have to worry about customers withdrawing deposits.  Banks also know that potential depositors will not investigate or scrutinize the bank's financial position.  For example, someone considering investing $100,000 in the stock or bonds of a commercial bank would certainly investigate the financial condition of the bank, but would not assess the bank's position when depositing $100,000 in a CD of that same bank.  Knowing they are not going to be scrutinized by depositors means that banks won't feel any pressure to convey prudence, safety and sound management to the banking public.  Being insulating from the discipline of bank customers, banks might have a greater incentive to engage in more risky lending behavior.

3. "Too Big To Fail" Policy, another example of Moral Hazard.  At the beginning of the S&L crisis in the mid-1980s, FDIC regulators started to suspect that there could be major problems with impending bank failures, resulting in a possible decline in public confidence about the U.S. banking system.   Regulators adapted and practiced the "Too Big to Fail" policy, where they would not allow any large bank to "fail."  Actually a large bank could technically fail, but a) Regulators would only use the "purchase and assumption method" to find a merger partner for the weak large bank (and provide favorable terms).   Regulators would not exercise the "payoff method" for large  banks, only for small banks.   b) Regulators would pay depositors over the $100,000 limit for large banks.  In other words, large banks got special attention and favorable treatment when they got in trouble that were not available to small banks.

Once depositors knew that they would likely get paid over the $100,000 maximum if a large bank failed, what happened to any monitoring of the bank by large depositors?  _________________  What happened to the level of risk the large banks were willing to take? ___________________
 

HOW TO LIMIT THE MORAL HAZARD PROBLEMS OF DEPOSIT INSURANCE?

1.
 

2.
 

3.
 
 
 

THE S&L BANKING CRISIS OF THE 1980s:

Background: The high and rising interest rates of the 1970s (see page 5), after decades of low and stable interest rates, started putting a financial strain on banks, especially the S&Ls, which specialized in long-term (30 year), fixed-rate home mortgages.  The regulatory structure made the U.S. banking system a "ticking financial time bomb," that was guaranteed to explode during a period of high and rising interest rates.  The duration mismatch and accompanying interest rate risk meant that S&Ls were doomed in a period of rising interest rates, and that period finally happened in the 1970s.  By the early 1980s, over 50% of all S&Ls were financially insolvent on a PV basis.

In addition, the restrictions on branch banking contributed to additional fragility in the banking system, since banks were typically a) small and b) geographically undiversified in their loan portfolios.  Furthermore, the downward sloping yield curve of 1980-1981 (from Fed Chairman Paul Volcker's tight monetary policy) eroded bank profitability significantly since short term interest rates (on deposits) were higher than long term interest rates (on mortgages).  Therefore, the regulatory structure put in place during the Depression worked well as long as interest rates remained low, but the regulations resulted in a disaster during a period of high and rising interest rates.  The regulations resulted in a "ticking financial time bomb" that exploded during the 1980s.

See page 290-291, for a list of banking regulations during the 20th century.  Other than minor legislation in 1956, there were no additional banking laws after the 1930s until 1980, when there were 7 major pieces of banking legislation in fewer than twenty years.

1980 - Obvious that major banking/regulatory reform was needed.  S&Ls were in serious financial trouble, and were starting to become insolvent and fail around 1980.  Financial disintermediation (junk bonds, commercial paper, securitized mortgages) started to adversely affect banks.  Reform was attempted with the Depository Institutions Deregulation and Monetary Control Act of 1980.

Changes in Regulation:
1. Deposit insurance limit was increased from $40,000 to $100,000.
2. Reg Q was lifted, phased out, no more int rate controls on savings.
3. S&L product/asset restrictions were loosened to allow greater diversification - they could have up to 20% of assets in consumer loans, commercial paper and corp bonds.
4. Established uniform reserve requirements on all depository institutions, regardless of charter or type of bank.
5. Approved NOW accounts and ATS accounts so banks could compete with money market mutual funds, and stop the massive financial disintermediation.
6. Banks were allowed to pay interest on checking.

NOW accounts expanded greatly after 1980, but Reg Q was phased out gradually so money market accounts continued to gain market share.  Int rates continued to rise to record levels in 1981-82, so S&Ls were paying record high int. rates and still losing deposits to money market accounts. Over 100 S&Ls failed in 1981, the highest amount since the Depression.  250 failed in 1982.
 

1982 - As the S&L banking crisis escalated, additional reform was attempted in the Depository Institutions Act of 1982.

Changes:
1. Banks were allowed to offer MMDAs (money market deposit accounts), to compete with money market mutual funds.  MMDAs were not affected by the interest rate controls of Reg Q (still being phased out), and were not subjected to reserve requirements, so they became immensely popular with banks.
2. S&Ls could further diversify their loan portfolios, were allowed to invest up to 10% of assets in commercial loans, and consumer loans were increased to max. of 30% from 20%.
3. Reg Q, until phased out, now applied equally to all banks, to put S&Ls and commercial banks on equal footing.
4. Emergency powers were given so that failing S&Ls could either 1) merge across state lines or 2) merge with commercial banks.

Deregulation/reform was a case of too little, too late.  Product restrictions were loosened, but it was too late.  By 1982, it was estimated that 50% of the banks had a negative net worth and were insolvent.  Interest rate risk - DURATION, causing both balance sheet and income statement problems.

Banks were not profitable in the early 1980s, due to excessive regulation, and as they were slowly deregulated with legislation in 1980 and 1982, they sought more and more risky, higher yielding loans to restore profitability.  In some cases, this made the situation worse.  S&Ls eventually could have up to 40% of their assets in commercial real estate loans, 30% in consumer lending, 10% in junk bonds or direct investments (common stocks, real estate, etc.)  After being freed up from almost 50 years of product/loan restrictions and excessive regulation, S&Ls got into further trouble by expanding into areas of credit and finance where they had no expertise, experience or background.
 

OTHER FACTOR CONTRIBUTING TO S&L CRISIS:

1. FDIC contributed to the problem because of the moral hazard problem, since insured parties tend to act more risky.  Flat-fee based deposit insurance premiums contributed to the problem, because banks had no incentive to invest in safe assets and behave prudently to get lower premiums.  Whether the bank had a very risky portfolio of assets (loans) or very safe loans they paid the same insurance premiums.  Safe banks were not rewarded with lower premiums and risky, unsafe banks were not penalized with higher premiums.

2. In addition, depositors and brokers found out how to get around the new $100,000 limit with "brokered deposits."  You have $10m to invest in bank CDs but would only be protected up to $100,000 maximum with FDIC, so a broker breaks the $10m into 100 investments of $100,000 each and buys 100 $100,000 CDs at 100 different banks. The limit was $100,000 per account, not per depositor!  In effect, very wealthy people were getting insured with taxpayers money.

3. High interest rates as a result of the contractionary monetary policy of the early 1980s brought about two severe economic recessions in the early 1980s (see page 9) - and some areas of the country were hit harder than others, e.g. Texas was hit hard.  Defaults on loans increased during the recessions of 1980 and 1982, and this contributed to failing banks in those areas.  Geographical restrictions of the McFadden Act played a role, since banks were not allowed to have diversified loan portfolios.

4. Regulatory forbearance.  Instead of closing down insolvent, bankrupt S&Ls, regulators adapted the stance of regulatory forbearance - they allowed bankrupt institutions to continue to operate.  For example, to allow insolvent banks to meet minimum capital requirements, they allowed banks to count goodwill as an asset to increase the bank's net worth or capital and failing banks were allowed to continue to operate.

Why did FSLIC allow insolvent banks to operate under regulatory forbearance?
a. FSLIC didn't have sufficient funds to pay off depositors of all insolvent S&Ls.
b. Capture theory (where the regulated industry "captures" the regulators)- Federal Home Loan Bank Board was established to encourage the growth of the S&L industry to promote home ownership. The regulators were too close to the people they were supposed to be regulating, and thus were perhaps too tolerant of fiscally irresponsible behavior.
c. Denial - FSLIC and FHLBB didn't want to admit their agencies were in trouble. As fed agencies, they are somewhat insulated from the discipline of competitive market forces.

"Fallacy of escalating/increasing commitment" in organization theory.

Using regulatory forbearance to allow an insolvent bank to continue dramatically increased the moral hazard problem.  Bank owners knew there was no net worth, no equity. They had nothing to lose personally except their job, they had no personal investment capital at risk anymore.  Like having a house with 0 down. Banks owners and managers attempted to throw "Hail Mary passes" at the end, since they knew it was just a matter of time before the bank really would fail. They tried the strategy of "Heads, I Win. Tails, the FSLIC/FDIC/taxpayers pay for it."  S&Ls started to invest in risky securities like currency futures, junk bonds, common stock, real estate, land in Arizona, etc. If you are gambling with somebody else's money in Vegas............. 25 cent slot machine?

5. In addition, regulatory forbearance resulted in zombie institutions with nothing to lose (negative net worth) paying above market interest rates to attract deposits away from safer S&Ls, for risky investments (Hail Mary passes).  Safe S&Ls then had to raise interest rates to compete with zombie banks, and they thus became weaker and less profitable.   Also, zombie S&Ls pursued asset growth by making loans at below-market rates, which forced solvent S&Ls to lower their rates to compete.  This further reduced profitability of safe, solvent S&Ls, and forced many of them into the insolvent, zombie category.  So the zombie banks actually became vampires - by being willing to pay above market rates to attract deposits and accepting below market rates to make loans, they were sucking the profits/lifeblood out of the healthy S&Ls.

6. Principal-Agent Problem, Special Interest Effect and Shortsightedness Effect

Voters/Taxpayers are the principals, ultimately pay the bill for failed banks in the form of higher taxes.  We rely on the politicians to be our agents, to supervise and monitor the banking industry for the long run interests of the country.  However, politicians have a different, shortsighted agenda - to get re-elected, and the most efficient way to generate support and contributions is by appealing to special interest groups like the banking industry.  Banks owners/banking industry make large campaign contributions. Politicians influenced the bank examiners, and were able to get special treatment for certain banks.  See Case Study of Lincoln S&L on 298-299.  Keating made $1.3m in campaign contributions, complained that bank examiners/regulators were being too tough on Lincoln, as it became insolvent.  He and his family were paid $34m in salaries, so $1m in campaign contributions was just a cost of doing business.  Keating was able to convince five senators (including John McCain) to influence the Chair of the FHLB to remove the examiners from the case of investigating Lincoln.

As the S&Ls were deregulated, instead of more accountability, there was less supervision.  Politicians kept trying to sweep the crisis under the rug, and delay the inevitable correction, etc.  Politicians contributed to the S&L crisis by not monitoring the banking industry they were supposed to supervising, due to the shortsightedness effect and the special interest effect of public choice theory.
 

What Happened Next?

1987 - S&L failures continued, and the losses were bankrupting the FSLIC.  Reagan administration sought $15B for FSLIC, a totally inadequate amount, since the estimates were ranging between $150-500B for the S&L bailout.  Only about $11B was provided by Congress and worse, Congress directed the FHLBB to continue regulatory forbearance under the Competitive Equality in Banking Act of 1987.  There was continued denial of the problem in spite of a crisis of epidemic proportions.
 

1989 Savings and Loan Bailout - Financial Institutions Reform, Recovery and Enforcement Act of 1989

Bush administration was forced to deal with a mounting "$500B" crisis, although the PV was closer to $150B.  Passed FIRREA in 1989.

Main changes:
1. FSLIC was declared bankrupt and merged into FDIC.
2. FHLB was dissolved and regulatory power was given to OTS - Office of Thrift Supervision within the Dept. of Treasury.
3. RTC - Resoultion Trust Corp. was established under FDIC to manage insolvent thrifts and sell off their assets.
4. S&Ls assets were now restricted because of abuses and losses and they had to sell all holdings of junk bonds, restrictions on commercial real estate, etc.  The deregulation of the early 1980s caused problems, so the trend was no back toward increased regulations of S&Ls, and their assets were now restricted.
5. Increased enforcement power of S&L regulators to allow them to remove bank managers, impose civil fines and prosecute bank fraud.
6. Didn't solve the underlying moral hazard problems created by deposit insurance, but mandated that Dept of Treasury study and reform FDIC.
 

1991 FDIC Improvement Act of 1991 (FDICIA)

1. Allowed for FDIC to borrow money from the Treasury to stay solvent.
2. Established bank classifications based on riskiness and bank capital - Groups 1-5.  Allowed for early intervention by regulators when banks are in trouble.
Example of bank classifications:
Group 1 - Well capitalized banks that exceed min cap requirements. These banks are allowed certain privileges such as being allowed to engage in securities underwriting.
Group 5 - Critically undercapitalized, equity capital less than 2% of assets, or D/A ratio greater than 98%.
3. Allowed for risk-adjusted premiums for deposit insurance. Banks with the safest, highest ratings paid 4 cents per $100, banks with the lowest ratings paid 31 cents per $100.
4. Very limited future use of "too big to fail" policy.

Conclusion:  FDICIA reduces moral hazard problem by increasing incentives to hold bank capital (lower FDIC premiums) and creates disincentives to limit risk taking (bank capital minimums, bank ratings, more frequent and rigorous enforcement).  Overall effect has been positive.
 

These five major banking legislations from 1980-1991 finally solved most of the major problems with the failing S&Ls, bank failures slowed dramatically by 1993-1994, see page 275.  Also, by 1993 interest rates had been falling steadily since 1980 and had finally come down to about the level of the 1960s (T-bill rate fell below 3% in 1992 and 1993), so the profitability of banks increased, and the banking industry stabilized.  Almost no banks failed from 1995-200 (page 275).

The other two major bank legisltations in the 90s 1) repealed the McFadden Act (1994) and 2) repealed the Glass-Steagall Act (1999), laying the regulatory groundwork for a. universal banking in the U.S.
b. large banks operating in both the commercial and investment banking industries
c. a national banking system where banks have branches nationwide, just like All State Insurance, Merrill-Lynch, Wal-Mart, etc.

SUMMARY: For the first time in more than 200 years, the U.S. banking system will start to resemble banks in other countries, due to the recent deregulation of the banking system.  Deregulation of the banking industry also follows the general trend deregulatory trend in other industries like airlines, trucking, telemcommunications, etc.