Saving Troubled Financial Institutions, the U.S. Crisis

1981-1994

Outline

• I. Overview of Banking System

• II. Overview of Supervisory and Regulatory System

• III. The Banking and S&L Crisis 1981-1994

• IV. The Government’s Role in the Crisis

• V. Conclusion

The Financial System: Overview • Commercial Banks

– Dual banking system• National banks are banks that receive their charter

from the federal government

• State banks receive their charter from state government.

– Fed Membership• All national banks must be members of the Federal

Reserve system. State banks may choose to be members.

Commercial Banks

• Commercial banks comprise the largest group of depository institutions in size.

• They accept deposits and make loans.– Commercial, consumer and real estate.

• There are approximately 9,000 commercial banks in the U.S, but that number is falling as the industry consolidates.

The Financial System: Overview

• Savings Institutions– Mutual savings banks

• Banks that are mostly mutually owned that specialize in residential mortgages funded by deposits.

– Savings and loans• Banks that specialize in residential mortgages,

mostly backed by short-term deposits.

• There are approximately 1400 S&Ls in the U.S.

Government Regulation

• Financial institutions in the United States have been and continue to be heavily regulated.

• They face government restrictions that limit– The services they can offer– The makeup of their portfolios of assets,

liabilities and capital– The price they can charge for their services, and– Until 1994, the territories they could enter

Focus of Bank Regulation and Supervision

• Safety and soundness supervision ensures that banks are managed prudently and in ways that maintain the stability of the banking system.

• Enforcement of anti-trust laws in banking seeks to foster open and competitive markets that provide high quality banking at minimum prices.

Focus of Bank Regulation and Supervision

• Consumer protection laws make sure consumers are fully informed about the most critical characteristics of banking products and services.

• The Community Reinvestment Act ensures that banks meet the financial service needs of their local communities, particularly the needs of low and moderate income areas.

Supervision and Regulation

• Supervisory and regulatory responsibilities for the banking industry are shared among several entities:– Federal Reserve (Fed)– Office of the Comptroller of the Currency (OCC)– Federal Deposit Insurance Corporation (FDIC)– Office of Thrift Supervision (OTS)– 50 State Banking Commissions

Supervision: Overview• Statutes and agreements among the various

authorities divide up supervisory authority so that regulatory overlap is minimized.– The Fed is the primary federal regulator for state-

member banks and bank holding companies.– The OCC is the primary federal regulator for

national banks.– The FDIC is the primary federal regulator for

insured state non-member banks.– The states are the primary regulators for state banks.

The Federal Reserve

• Supervises and regularly examines all state-chartered banks operating in the U.S.

• Imposes reserve requirements on deposits held by all depository institutions and grants temporary loans of reserves.

• Approves all applications of member banks to merge or establish branches.

The Federal Reserve

• Supervises international banking corporations organized by U.S. banks and foreign banks operating in the U.S.

• Regulates and examines all bank holding company activities in the U.S.

• Conducts monetary policy to control the growth of money and credit in the financial system.

Comptroller of the Currency

• Issues charters for new national banks.

• Regulates and regularly examines all national banks.

• Approves all national banks’ applications for new branch offices, mergers, and consolidations.

• Declares insolvent national banks closed.

Federal Deposit Insurance Corporation

• The FDIC is an independent insurance agency for member banks and savings associations.

• It has three functions:– To act as an insurer of deposits.– To act as a supervisor of banks.– To act as a receiver for all national banks

declared insolvent and for state banks when requested by a state banking commission.

Federal Deposit Insurance Corporation

• Insures deposits of banks and savings institutions conforming to its regulations up to $140,000.

• Approves all applications of insured banks to establish branches or merge

• Requires all insured banks to submit reports on their financial condition.

State Bank Commissions• Issue charters for new state banks.

• Supervise and regularly examine all state-chartered banks.

• Approve applications of state banks to form a holding company, acquire subsidiaries, or establish branches.

• Declare insolvent state-chartered banks closed and appoint a receiver (such as the FDIC) to liquidate the assets of the failed bank.

The Office of Thrift Supervision

• Established in 1989, this office charters and examines all federal S&Ls.– State chartered S&Ls are examined by state

agencies.

• It supervises all S&L holding companies.

• The FDIC oversees and manages the Savings Association Insurance Fund (SAIF).

Bank Crisis

• The source of the banking crisis began in the 1970s when a variety of new financial products decreased the profitability of certain traditional businesses for commercial banks.– Banks now faced increased competition for

their sources of funds from money markets.– Banks now began losing commercial lending

business to securitization and the commercial paper market.

Bank Crisis

• Innovations Increasing Competition– Money market mutual funds– Junk bonds– Commercial paper market

Weakness• By 1980, large banks were showing clear 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 banks.

– Price/earnings ratios for money-center banks trended downward relative to S&P 500 price-earnings ratios.

– For the 25 largest bank holding companies, the market value of capital decreased and fell below its book value.

Bank Crisis

• By the mid 1980s commercial banks were forced to seek out new and potentially risky business to maintain their profits.– They placed a greater percentage of their total

loans in real estate and in credit extended to assist corporate takeovers and leveraged buyouts.

Bank Crisis

• The existence of bank deposit insurance increased moral hazard for the banks and provided them with an incentive to take on too much risk.

• In addition, financial innovation produced new financial instruments that widened the scope for risk taking.

Bank Crisis

• One financial innovation that made it easier for banks to raise funds was known as brokered deposits.– A large depositor who has $10 million goes to a

broker, who breaks the $10 million into 100 packages of $100,000 each and then buys $100,000 CDs at 100 different banks.

• The depositor circumvents the $100,000 limit on deposit insurance and the banks have access to the funds.

Bank Crisis• Then in 1980, Congress increased the amount of

federal deposit insurance from $40,000 to $100,000, and phased out Regulation Q.– Banks that wanted to pursue rapid growth and take on

risky projects could now attract the necessary funds by issuing larger-denomination insured certificates of deposit with interest rates much higher than their competitors.

• Without insurance, depositors would not have been as willing to provide funds for aggressive banks for fear that they would lose their money.

Bank Crisis• As commercial banks took on more risk, they

began to suffer losses.

• These losses were made worse by a series of recessions that rolled through the economy during the 1980s.

• Between 1980 and 1994, 1617 banks with $302.6 billion in assets were closed or received financial assistance.

• At the peak of the crisis, 200 banks failed per year.

Bank Crisis: Recessions

• Bank failures were generally associated with regional recessions that had been preceded by rapid regional expansions.– The “boom-and-bust” pattern of economic

activity

• Bank loans helped to fuel the boom, and when economic activity fell, some of the loans defaulted.

Bank Crisis: Recession

• There were four major regional and sector recessions that were associated with widespread bank failures.– A downturn in agricultural prices in the early

and middle 1980s after years of rapid increases led to reductions in net farm income and farm real estate values and a consequent rise in the number of failures of banks with heavy concentrations of agricultural loans.

Recession

– The second recession occurred in Texas and other energy producing southwestern states when oil prices decreased in 1981 and again in 1985.

– The third recession occurred in the northeastern states, which experienced negative growth in gross state product in 1990-91.

– The final recession occurred in California in 1991-92.

Recession

• In all four recessions, speculative activity was evident and there were wide swings in real estate activity. – Commercial real estate markets in particular were one of

the main causes of losses in both failed and surviving banks.

• The real estate 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.

Bank Failures

• Of the 1617 bank failure and assistance cases, 78 percent were located in the regions suffering recessions, or were in agricultural banks outside these regions.

• These failures accounted for 71% of the assets of failed banks over the 1981-1994 period.

Bank Crisis: Successes• The conditions that enabled many banks with high-

risk financial characteristics to avoid failure were:– Strong equity and reserve positions to absorb losses– Superior lending and risk-management skills– Changes in policies before the high risk resulted in

losses– Improvement in local economic conditions– Timely supervisory actions.

S&L Crisis

• The source of the S&L crisis occurred in 1933, when the Federal Home Loan Bank Board was created to charter and insure savings and loans specializing in long-term, fixed-interest rate mortgages funded with short-term savings deposits.

S&L Crisis

• As long as interest rates remained low and stable, the S&Ls prospered.– They paid their depositors a low rate of interest

and then loaned the money at a slightly higher rate.

• But, in 1978, interest rates rose unexpectedly, peaking at over 20% in late 1980.

S&L Crisis• The rise in rates caused the market value of the

mortgages and other fixed-interest obligations held by the S&Ls to drop.– For example, a $50,000, 20 year 8% mortgage is

worth only $31,761 when interest rates are 15%.

• The drop in the market value of the S&L’s portfolio did not mean, however, that they were no longer legally solvent because S&L’s were not required to record their assets and liabilities at market value.

S&L Crisis

• S&Ls were not permitted to pay market rates of interest to their depositors, and for a short time this saved the institutions, but

• Money market mutual funds began offering market rates to consumers, a massive disintermediation began.

S&L Crisis

• At this point, the government had two choices:– It could close the insolvent S&Ls and closely

supervise the weak ones or– It could allow economically insolvent institutions

to stay open and reduce regulatory capital requirements to keep them from becoming legally bankrupt.

• It chose to keep them open.

S&L Crisis

• Between 1980 and 1994, 1,295 savings and loan institutions with $621 billion in assets were either closed or received financial assistance.

Regulation

• During the crisis, policy differences existed among the federal bank regulators.

• All were sensitive to issues of safety and soundness as well as to the importance of modernizing bank powers, but on specific issues they differed.

Regulatory Differences

• The Office of the Comptroller of the Currency (OCC) 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.

• The Federal Reserve often took a middle-of-the-road position.

Regulatory Differences

• The differences between the OCC and FDIC reflected:– The problem of how to strike the correct

balance between encouraging increased competition and preserving stability and safety.

– The different responsibilities of an insurer (FDIC) and a chartering agency (OCC).

Regulatory Differences: Example

• Entry of new banks– The OCC and the states sharply increased

chartering in the 1980s.• To do so, the OCC revised its requirements for

approving new charters.

– When a disproportionate number of banks failed, the FDIC objected.

• The issue was that Federal Reserve member banks and national banks receive insurance upon being chartered by law.

Regulatory Differences: Example

• Brokered Deposits– The FDIC proposed that brokered deposits be

insured only up to $100,000 per broker per bank.

– The OCC favored a less stringent approach.• Ultimately, FDICIA and FIRREA limited the use of

brokered deposits by troubled institutions.

Regulatory Differences: Example

• Formal Capital Requirements– All of the regulatory agencies favored the

objective of explicit capital standards, but initially they differed on the specifics.

• The FDIC favored higher capital requirements than the OCC.

Legislative Developments

• Banking legislation played a role in the bank and S&L failure experience.

• This legislation was shaped by 2 broad factors:– Widespread recognition that banking statutes

should be modernized and adapted to new marketplace realities

– The need to respond to the outbreak of bank and thrift failures.

Legislative Developments

• In the early 1980s, the focus was on the attempt to modernize– Congressional activity was dominated by

actions to deregulate the product and service powers of thrifts and to a lesser extent of banks.

– These deregulatory actions were generally unaccompanied by actions to restrict the increased risk taking they made possible, and so contributed to bank and thrift failures.

Key Federal Laws

• The Depository Institutions Deregulation and Monetary Control Act of 1980– Phased out deposit interest-rate ceilings– Broadened the powers of thrift institutions– Raised the deposit insurance limit from $40,000

to $100,000.

Key Federal Laws

• Garn-St Germain Depository Institutions Act (1982).– Authorized banks and savings and loans to

offer money market deposit accounts to stem disintermediation

– Granted savings and loans additional commercial and consumer lending powers Granted federal regulators new powers to deal with troubled depository institutions.

Legislative Developments

• As the decade continued and the number of bank failures mounted, the legislative emphasis shifted to recapitalizing the depleted deposit insurance funds and providing regulators with stronger tools, while at the same time restricting their discretion.

Key Federal Laws

• Competitive Equality Banking Act of 1987– As the thrift crisis deepened and commercial

bank problems were developing, CEBA provided for the recapitalization of FSLIC

– Authorized a forbearance program for farm banks

– Extended the full-faith-and-credit protection of the US government to federally insured deposits, and authorized bridge banks.

Key Federal Laws• Financial Institutions Reform, Recovery, and

Enforcement Act of 1989 (FIRREA)– Authorized the use of taxpayer funds to resolve

failed thrifts– Abolished the existing thrift regulatory structure– Moved thrift deposit insurance to the FDIC– Mandated that bank and thrift insurance fund

reserves be increased to 1.25% of insured deposits.

Key Federal Laws• Federal Deposit Insurance Corporation

improvement Act of 1991 (FDICIA)– Prescribed a series of specific “prompt corrective

actions” be taken as capital ratios of banks and thrifts declined to certain levels.

– Mandated annual examinations and audits.– Prohibited the use of brokered deposits by

undercapitalized institutions.– Restricted state bank activities.

Key Federal Laws

• Omnibus Budget Reconciliation Act of 1993– Provided that a failed bank’s depositors and the

FDIC standing in the place of insured depositors it had already paid have priority over non-depositors’ claims.

• It was believed that this law would make failure transactions simpler and less expensive to the insurance fund and would encourage non-deposit creditors to monitor bank risk more closely.

Role of the FDIC

• The FDIC acts as an insurer, receiver and a supervisor.– The roles of insurer and receiver require the

FDIC to play an active role in resolving failing and failed FDIC insured institutions.

FDIC: Insurer

• The FDIC was established to insure bank deposits.

• It fulfills this role when a bank fails by paying insured depositors either by direct payment or arranging for the assumption of the deposits by another financial institution.

FDIC: Receiver

• When a depository institution fails, the FDIC is normally appointed receiver of the institution by the courts or other authority having jurisdiction.

• When acting as receiver, the FDIC has broad statutory authority and expansive powers to ensure the efficiency of the receivership process.

The Resolution Trust Corporation (RTC)

• The RTC existed from August 1989 through December 1995.

• It was established by Congress as a temporary federal agency to clean up the S&L crisis after the Federal Savings and Loan Insurance Fund (FSLIC) became insolvent.

• The RTC’s roles were to act as conservator and receiver of insolvent thrifts.

RTC Conservator

• Objectives:– Establish control and oversight while

promoting consumer confidence– Evaluate the condition of the institution and

determine the most cost-effective method of resolution

– Operate the institution in a safe and sound manner pending resolution

RTC Receiver

• The RTC was appointed as receiver of the failed S&Ls by the Congress

• When acting as receiver, the RTC had broad statutory authority and expansive powers to ensure the efficiency of the receivership process.

Objectives: RTC

• Maximize the net present value return from the disposition of failed thrifts and their assets

• Minimize the effect of such transactions on local real estate and financial markets

• Maximize the availability and affordability of residential real property for low and moderate income individuals.

Methods of Handling the Failures

• Purchase and Assumption Method– A resolution transaction where a healthy

insured institution purchases some or all of the assets and assumes, at a minimum, all insured deposits and may assume all of the deposit liabilities of a failed bank or thrift.

Methods of Handling the Failures

• Purchase and Assumption Method– P&A was the favored resolution policy of the

FDIC and the RTC during the crisis. • From 1980-1994, the FDIC handled 73.5% of the failing

institutions with P&As. Similarly,67.4% of the assets and 69.2 % of the deposits were handled through P&A transactions

• The RTC handled 66.5% of the institutions and 73% of the deposits were handled with P&As

Methods of Handling the Failures

• Deposit Payoff Method– The FDIC or RTC allowed the bank to fail and paid off

depositors up to the $100,000 insurance limit.– Deposit payoffs were used when no acquirer could be found

or if the FDIC or the RTC did not receive a less costly bid for a P&A transaction.

– Depositors with uninsured funds were given receivership certificates entitling them to a share of the net proceeds from the sale of the institution.

– Deposit payoffs were used with 7.4% of the failed banks and 12.3% of the S&Ls

Methods of Handling the Failures

• Deposit Payoff Method/ Insured Deposit Transfer– in 1983, the FDIC introduced the insured deposit

transfer (IDT).• An IDT involves the transfer of insured deposits and

secured liabilities of the failed bank to a healthy institution that agrees to act as the FDIC’s agent.

• The IDT saved the FDIC and the RTC overhead expense and provided an opportunity for the agent bank to attract new customers.

• IDTs were used with 10.9% of the failed banks and 21.2% of the S&Ls.

Methods of Handling the Failures

• Open Bank Assistance– Open bank assistance was a resolution method in

which the FDIC provided an insured bank at risk of failure with financial help in the form of loans, contributions, deposits, asset purchases, or the assumption of liabilities.

– Generally, the FDIC required new management and called for a private sector capital infusion.

OBA

• OBA was used to facilitate the acquisition or merger of a failing bank or thrift by a healthy institution.

• A major criticism of OBA was that the shareholders of failing institution benefited from government assistance even though the FDIC required shareholders to dilute their interest.

• OBAs were used with 8.2% of the failed banks

Forbearance Programs

• Regulatory forbearance occurs when regulators refrain from exercising their regulatory right to put insolvent institutions out of business. Two examples of regulatory forbearance were:– Income Maintenance Agreements– Net Worth Certificates

Income Maintenance Agreements

• One of the FDIC’s strategies was to force weaker savings banks to merge into healthier banks or thrifts by guaranteeing a market rate of return on the acquired assets through an income maintenance agreement.– The FDIC paid the acquirer the difference between the

yield on acquired earning assets and the average cost of funds for savings banks.

• If interest rates declined to where the cost of funds was below the yield on earning assets, the acquirer was required to pay the FDIC

Net Worth Certificates

• The NWC program’s purpose was to buy time for savings banks to correct rate sensitivity imbalances and restore capital to acceptable levels.

• Eligible institutions received promissory notes from the FDIC representing a portion of current period losses in exchange for certificates that were to be considered as part of the institution’s capital

Net Worth Certificates

• The NWC program allowed solvent, well-managed institutions to survive until the results of restructured balance sheets produced profitable operations or until unassisted mergers with stronger institutions could be arranged.

Bridge Banks

• Beginning in 1987, with the passage of CEBA, the FDIC began using bridge banks.

• A bridge bank is a temporary national bank that is controlled by the FDIC and designed to take over the operations of a failing bank and maintain banking services for the customers.

• Between 1987 and 1994, the FDIC used bridge banks 10 times.

Bridge Banks

• The RTC did not have bridge bank authority, but it was empowered with conservatorship authority which operates similarly.

• Because the RTC inherited so many failed institutions (262), the RTC used conservatorships to a much greater extent than the FDIC used bridge banks.

Bridge Banks and Conservatorships

• Bridge banks and conservatorships provided the FDIC and the RTC broad powers to operate and manage large, complex failing financial institutions.

• Both are temporary measures designed to facilitate organization and stability.

• The goals were to preserve any existing franchise value of the failing institution, reduce the cost to the insurance funds, and lessen any disruption to the local community.

Conclusion

• Both the FDIC and the RTC made mistakes as they struggled to find a solution to the challenge of solving the bank and S&L crisis.

• Some saw the agencies as too bureaucratic

• Others complained that assets were sold too quickly and at below market prices.

• Nevertheless, they accomplished their objectives.

Cost of Banking Crises

Date Country Cost as a % of GDP

1980-82 Argentina 551981-83 Chile 411994-95 Venezuela 181995 Mexico 12-151994-95 Brazil 5-101991-93 Finland 81981-84 Uruguay 71991 Sweden 61982-87 Colombia 51987-89 Norway 41984-1991 USA 3