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N696 I The Heritage Foundation 214 Massachusetts Avenue N.E. Washington, D.C. 20002 (202)5464400 The Thomas A. Roe Institute for Economic Policy Studies C March 16,1989 BEYOND THE BAUDUE LONG-TERM SOLUTIONS TO 'IW3 CR&S IN INTRODUCI'XON FSLIC The I Th; high pnce tag, however, is not the main problem with the Bush p lan.

Fundhehilly d-5 more troubling is that neither the plan nor the public debate over'Qe fu&&g for the bailout addresses the key question of how the federal depgsiLnsurance system should be reformed to prevent a future crisis.

B&i?s.p&oposal focuses on bailing out FSLIC and reorganizing some aspects 089" exishg regulatory structure, but fails to address the underlying cause the thrift crisis a deposit insurance system that encourages and subsidizes irisk lending by managers of thrifts The Federal Deposi t Insurance Foporation (FDIC which insures bank depositors, is built on the same stqctural flaw Ldorrecting the Structural Defect. The basic problem shared by FSLIC and mIC is that, unlike most forms of private insurance, the premiums paid by thrifts and b a nks do not reflect the risks actually covered by the insurer. They are flat rate premiums, based on the total deposits of each institution.The result: institutions that engage in risky loans and investments pay the same premiums as more prudent institutio n s for the same protection extended to depositors. Unless this structural defect is corrected, a future crisis is likely in the American thrift industry, and perhaps even in the banking industry 4 I Note: Nothing mitten hem is to be construed as necessaril y reflecting the views of The Heritage Foundation or as an attempt to aid 01 him the passage of any bill betore Congms. g When considering the bailout plan, lawmakers must recognize that the bankruptcy of FSLIC is not the result of regulatory ineptitude th a t can be solved by hiring more and better regulators. Although FSLICs parent, the Federal Home Loan Bank Board, apparently has mismanaged the crisis, the potential for financial disaster is built into the very structure of federal deposit insurance system . Similarly, although fraud and ineptitude on the part of managers played a major role in the insolvency of many thrifts, it would be a mistake to assume that better management would have prevented the problem Encouraging Risk. The fact is that financial i n centives created by the current structure of federal deposit insurance encourage even the most honest and competent thrift managers to pursue imprudently risky investment strategies financial markets; renewed regulation thus is no answer. The thrift indus try was sinking long before the limited deregulation enacted in 1980 and 1982.

Re-regulation simply would make thrifts less able to compete domestically and internationally with other institutions. They would be weakened, not strengthened, by new regulatio n federal deposit insurance have been suggested. The most attractive would reduce the role of govemment regulators and strengthen the role of market prices in controlling excessive risk-taking. These proposals range from varying insurance premiums to acco u nt for risk as proposed in 1984 by then-Vice President Bushs Task Group on Regulation of Financial Sewices to limiting the insurance coverage available to each depositor. Under one proposal, the total federal insurance guarantee would be capped at its pre sent level and institutions would be issued tradeable insurance certificates.

In addition, the federal deposit insurance system regardless of the extent of reform -would benefit from loosening financial services regulation.

Deregulation should go beyond a restructuring of financial services regulation a euphemism for redrawing regulatory turf boundaries and allow institutions greater authority to diversify their risks.The stabilizing influences of greater liberalization would decrease the risk faced by th e federal deposit insurance system, to the benefit of taxpayers and depositors Similarly, the FSLIC crisis is not due to deregulation of the nations Beyond Restructuring. Several plans to correct the inherent problems in THE DECLINE AND FALL OF THE SAVINGS AND LOAN INDUSTRY The scale of the problem in the United States savings and loan industry is staggering. Nationwide there are about 3,000 thrifts, with assets totalling about $1.3 trillion. Some 1,000 thrifts are insolvent or nearly so.The latest estimate d cost of the Bush Administrations bailout plan to stabilize the industry is $126 billion over the first ten years and likely will total much more 2 Some policy makers blame the industrys enormous troubles on the partial deregulation of thrifts in the earl y 1980s. But the seeds of todays disaster actually were sown in 1932, with the creation of the present thrift regulatory system. The most important purpose of federal deposit insurance, introduced for banks in 1933 and thrifts in 1934, was to protect the m oney of small savers from bank runs. But other goals were sought by the bank and thrift regulations, such as fostering home ownership and local banking.

Keeping Banks at Home. As a result, thrift industry activities long were essentially limited to investi ng in home mortgages. Banks and thrift institutions also were barred from operating outside their home state, or, in some areas, even their home city.The effect of these regulations, many of which are still in force, was to prevent diversification of risk and guarantee instability in the financial services industry.

The condition of thrifts deteriorated significantly in the late 1970s. During this period, the development of innovative financial products outside the banking and thrift industries, such as mo ney-market accounts, combined with high interest rates, forced thrifts to increase substantially the interest they paid depositors in order to keep their customers.This in turn caused thrift profits to plunge as the return on mortgage portfolios fell belo w depositor interest rates. In some cases, due to interest rate limits, thrifts were even unable to offer the rates needed to attract and retain savers. As a result before ,any significant deregulation, the industrys liabilities exceeded the market value o f its assets by more than $150 billion.The thrifts were in serious trouble, and Congress tried to help.

More Powers for Thrifts. The response was a series of deregulatory steps.

Under t he Depository Institutions Deregulation and Monetary Control Act of 1980, ceilings on interest rates paid by banks and thrifts gradually were lifted, and thrifts were permitted to offer new types of loans and interest bearing checking accounts. In 1982, t he Gam-St.Germain Act increased the powers of thrifts, so that they began to look even more like banks. The 1982 Act even allowed thrifts to invest funds in certain activities closed to banks.

Thrifts also were permitted to make equity or direct investments in high-risk speculative commercial real estate ventures.

By the time of this limited deregulation, however, a large portion of the savings and loan industry already was unprofitable or insolvent. At least granting additional new powers to healthy thrif ts probably prevented the failure of many marginal institutions. By contrast, giving these same powers to insolvent thrifts was a major mistake; they now had nothing to lose by making excessively risky investments in a desperate attempt to get back into t he black.

Growing Crisis. Making matters worse, since flat rate federal deposit insurance treats all firms the same, depositors had no reason to avoid the riskier institutions in fact, they were attracted to them, because they tended to offer the highest r ates. At the same time, the maximum insured amount per depositor per bank was increased in 1980 from $40,000 to $lOO,OOO further encouraging the flow of deposits to insolvent or nearly insolvent I 3 thrifts.The Federal Home Loan Bank Board (FHLBB) contrib u ted to the growing Crisis by relaxing its enforcement of capital standards and delaying insolvency determhations Preventing Balanced Portfolios. Despite this lax regulatory attitude to weak thrifts, other aspects of the thrift industry remained dangerousl y overregulated, weakening the stronger thrifts. For example, stringent laws prevent geographic expansion especially across state lines. These restrictions have made it difficult and costly for financial institutions to balance their loan portfolios across different regions of the nation. This over-concentration of thrift loan portfolios has been a major cause of thrift failures. A high proportion of todays sick thrifts, for instance, are in the oil patch states -Louisiana, Oklahoma, and Texas. When the eco n omies of these states soured in the mid-l980s, due to the drop in energy prices, these thrifts suffered heavily because their loans were dependent on the economies of their states. Similarly, many farm state banks and thrifts failed earlier in the decade w hen the farm economy soured. Had the portfolios of these institutions been mors balanced geographically, many of these failures could have been prevented THE PERVERSE INCENTIVES OF FEDERAL DEPOSIT INSURANCE The root problem that must be confronted by poli c y makers seeking a permanent solution to the thrift crisis is the fact that risk is subsidized by the deposit insurance system. Without reform, the perverse incentives flowing from this subsidy will make it impossible to bring long-term stability to the i n dustry -no matter how much is spent to bail out FSLIC concept refers to the incentive for insured parties to alter their behavior after the insurance contract has been written, in ways that increase the insurers risk. Simply put, individuals and firms ten d to be more careless if they know that their losses will be paid by someone else. Private insurance companies deal with moral hazard in a variety of ways. Automobile insurance companies, for example, adjust .rates to reflect the driving records of their c u stomers Any insurance system must deai with the problem of moral hazard. This 1 See Bert EIy, The Big Bust: The 1930-1933 Banking Collapse Its Causes, Its Failures, Its kssons, in Catherine England and Thomas Huertas, e&, The Financial Services Revolution : Policy Diections for the Fuhue Washington, D.C.: Cat0 Institute, 1988 2 The value of geographic balance perhaps was best illustrated during the Great Depression. Although large numbers of US. banks failed during that period, Canada, which faced similar e c onomic problems but allowed nationwide banking, did not experience a single bank failure 1 4 The federal deposit insurance system, however, does nothing to control moral hazard. Because federal deposit insurance rates are the same for all institutions, re gardless of their practices, and because depositors can be confident that the federal government will cover all losses, the institutions and their customers are free to play a game of heads I win, tails you lose.

Discouraging Savers Oversight. Risk-taking effectively is subsidized because making risky loans or other investments results neither in higher insurance premiums nor in loss of anxious depositors. Similarly, savers have no incentive to monitor the financial position of their bank or thrift. In fac t the thrift regulators actually have discouraged such monitoring. Last December, for instance, the Federal Home Loan Bank of Topeka, which, as part of the Home Loan Bank system is the thrift regulator for that part of the country, admonished local thrifts not to use phrases such as most secure safest, or best-managed to attract depositors. The relative strengths or weaknesses of an institution, the regulator explained, have no bearing on Federal Savings and Loan Insurance Corporation protection to insured d epositors on thrifts, in which savers are encouraged to move their funds to riskier institutions (since these typically pay above market rates) and away from more prudent institutions.This, in turn, has forced healthy t3rifts axid other financial institut ions to pay artificially inflated interest rates. More generally the moral hazard problem has resulted in skewed investment in the economy as financial resources have been misallocated to projects that otherwise would not have been funded.

Covering State R egulators. The moral hazard problem also extends to regulators. Many financial institutions insured by FSLIC and FDIC are chartered and regulated by the states. Federal deposit insurance, however creates incentives for state regulators to adopt unwise reg u lations. For example, if state banking regulators allowed popular but unsound banking practices, federal deposit insurance would cover any depositor who suffered 1osses.The state regulators thus can take credit for any benefits from their regulations, but suffer no harm for problems they may cause!

The Bush Administration proposes that a substantial portion of the FSLIC bailout should be paid for by additional deposit insurance assessments on all thrifts. Some lawmakers propose using funds from banks. Yet this merely would penalize the cautious and well-managed institutions. In effect, funds 3 The result of this federal insurance policy has been a kind of reverse run 3 The problems of federal deposit insurance have long been recognized and discussed in the scholarly literature See, for hstance, Edward be, The Gathering Crisis in Federal Deposit Insurance (Cambridge 4 Cited in Warren Brookes, Market-based S&L Reform? Waslrington ?imes, January 12,1989 5 See Genie D. Short and James W. Gunther, TheTexasThrift Situation: Implications for theTexas Financial Industry, Financial Industry Studies Department, Federal Reserve Bank of Dallas, September 1988 6 See Henry N. Butler and Jonathan R. Macey, The Myth of Competition in the Dual Banking System Comell Law Revie w , May 1988 Mass MlT Press, 1985 5 c J would be moved from prudent institutions to compensate the depositors of the less prudent.This would do nothing to correct the basic moral hazard problemThe subsidy of risky institutions by the more prudent would cont i nue IS BEmR REGULATION THE SOLUTION Reviewing the failures of past regulatory mistakes, some lawmakers now propose improved regulation as the answer to the thrift problem. In addition the Bush Administration plan includes tougher government oversight of i n dustry lending practices and other new rules The management of the savings and loan insurance fund, for instance, would be placed in the hands of the FDIC, while federal regulators would be able to overrule state regulators to ensure the safety and soundn e ss of thrifts Seeking an Accurate Picture. Federal regulators also are trying to improve regulations and enforcement procedures. For example, the Federal Home Loan Bank Board finally is moving toward the adoption of Generally Accepted Accounting Principle s (GAAP the accounting system used almost universally in the private sector. Until now, it has used a system known as Regulatory Accounting Principles (RAP which provides a less accurate picture of an institutions financial situation. An even better form o f accounting for thrifts would be market value accounting, which records asset values according to their real market value.

The Bank Board also has proposed new regulations that would raise the cash cushion that thrifts are required to maintain. Current re gulations require thrifts to maintain cash, Treasury bills, or other such low-risk liquid forms of capital equal to 3 percent of total assets.The Bank Board has proposed increasing the amount of capital that thrifts must maintain and tightening the defini t ion of what constitutes capital. This would ensure that a higher level of equity capital is available. to back a thrifts liabilities. The proposed new rules also would link capital requirements to the risk levels of a thrifts loans and other investments. H igh-risk equity investments in commercial enterprises for example, would require six times the capital required by a home mortgage. Alternatively, under the Bush plan, thrifts wouldbe placed directly under FDIC capital rules, which are tougher than the Ba n k Boards current rules and already tied to risk immediate imposition of these guidelines could help drive hundreds more thrifts into insolvency. But the capital adequacy guidelines would be meaningless unless coupled with strict rules calling for the auto matic closing of institutions that fall below minimum standards.

Another major problem with risk-based capital adequacy requirements is that they distort the lenders incentive structure in a way that interferes with the role of the market in channeling financial capital to its best uses.

Favorable treatment of home mortgage loans, for example, artificially Interfering with the Market. The regulators dilemma, however, is that the C 6 increases the supply of the funds available for home mortgages and draws t hem away from potentially more valuable uses.

Despite these problems, several changes could be made that would aid regulators (and depositors) in identifying problem banks and thrifts at an early stage and thus reduce the likelihood of large taxpayer loss es in the future. The use by regulators of market value accounting, for instance, would give a better picture of an institutions financial condition. Similarly, rules should be established to require the automatic closure of thrifts when the market value n et worth falls below a certain fraction of total assets. A prompt closure rule would allow for the liquidation of firms without substantial losses to the insurance fund. It also would reduce the moral hazard problem by preventing thrifts from getting deep e r into trouble as they pursue an all-or-nothing suMval strategy Lagging Behind. Despite their advantages, however, the limitations of such regulatory tools also must be recognized by policy makers. Regulations that depend on accurate accounting informatio n , whether under Generally Accepted Accounting Principles or market value accounting, are inadequate by themselves because by its very nature accounting information takes time to collect and process.Thus, although the gathering of more accurate information will help, the picture it gives always will lag behind the real economic situation. Moreover, there simply are too many thrifts to be watched as closely as is necessary. No matter how accurate the accounting information is, an institutions financial statu s could shift quickly from bad to bankrupt between the periodic visits by regulators.

Good regulatory oversight clearly is necessary to improve the operation of federal deposit insurance. Indeed, when there are no market incentives for controlling risk, re gulation is crucial to the protection of the federal insurance fund. But it cannot be a permanent substitute for deeper structural reforms that would introduce continuous, powerful market incentives to encourage good thrift management PROPOSALS FOR LONG-T E RM REFORM A fundamental reform of deposit insurance should aim at increasing market incentives in the system. Ideally the system should be transferred to the private sector. Deposit insurance is simply too important to be left in federal hands. Private de posit insurers would have the normal insurance incentives to structure insurance contracts to encourage banks to control their insolvency risk and thus reduce overall risk to the banking system.

Several plans for such private insurance have been outlined, either using 7 third-party insurance.companies or cross-guarantees among insured financial institutions If privatization should prove politically difficult in the short run, other options are av ailable that would capture at least some of the benefits of market incentives within the overall system of federal deposit insurance.

Among them lending portfolio replaced with premiums based on the risk associated with each thrifts management policies and investment portfolio. In this way, the premium would reflect the true risk of default by the institution. This would force banks and thrifts with speculative investments to pay higher insurance premiums to cover the increased risk for the FDIC or FSLIC. T hiswas endorsed in 1984 by then-Vice President Bushs Task Group on Regulation of Financial Services Tie insurance premiums to the risk associated with each institutions Under this approach, the current system of flat-rate premiums would be The main proble m with this otherwise attractive approach is that it is unlikely that government regulators would able to estimate risk accurately without a market to guide them. The are, moreover, subject to strong political constraints that could skew their decisions. I t would be very difficult for example, for government regulators to increase insurance premiums for a troubled institution because of inevitable political pressures to aid a firm in need Reduce the amount of insurance per depositor.

Each account in a bank or thrift is now insured up to $100,0

00. Ronald Reagans Council of Economic Advisors recommended early this year that this be lowered to $40,000 or 1ess.They noted that the current level of coverage is well beyond the coverage envisioned when the federal deposit system was created in the 193Os, with a per account limit of $2,500.The limit also could be applied to individual depositors, rather than to each account.

By reducing the limit of protection, large depositors would have the incentive to monitor t he performance of financial institutions, in the same way that stockholders monitor publicly traded corporations. These depositors unlike federal regulators, would have their own money at stake and would not be subject to political or bureaucratic constra ints.

By protecting deposits up to $40,000, the bulk of deposits would remain insured.The average thrift deposit today is only about $8,4

00. Even those with larger deposits would be better off.Though their insurance limits would be lower, their savings a nd tax dollars -would be safer due to the market discipline introduced by the change 7 Catherine England and John Palffy, Replacing the FDIC Private Insurance for Bank Deposits, Heritage Foundation Buc&g?uunder No. 229, December 2,1982; Bert Ely, Private Sector Depositor Protection is Still A Viable Alternative to Federal Deposit Insurance, Issues in Bank Regulution, Winter 1986, pp. 40-47. a Stop compensating uninsured deposits.

Even with a $100,000 limit, many bank and thrift accounts nevertheless exceed that level. Yet in practice these deposits often are treated as if they are fully insured. This is because, under current policies, FSLIC and the FDIC often a1 reorganize an institution to prevent it from closing. To make sure large depositors have an in centive to monitor the financial health of institutions, Congress sh uld declare its clear intent that uninsqed deposits should not be protected. 8 Introduce co-insurance and deductibles.

Under a co-insurance plan, deposit insurance coverage could be limit ed to a portion, say 80 percent, of the total amount deposited (up to the maximum amount). Depositors thus would lose up to 20 percent of their account in the event the bank or thrift failed. If there were a deductible, depositors would pay a portion of t h eir own losses before federal insurance is triggered. This would give depositors a greater incentive to monitor the quality of the financial institution in which they keep their funds Establish narrow banks Under a plan suggested by Brookings Institution e conomist Robert Litan federal insurance would be made available only to institutions investing in low-risk assets, such asTreasury securities, commercial paper, and perhaps Federal Reserve Deposits. Such narrow banks would operate like money market mutual funds investing in safe assets -except that they would have direct access to Federal Reserve funds and other aspects of the banking system.

Other institutions still could make loans and invest in other activities, such as banks and thrifts do today, but t heir depositors would not be eligible for federal insurance guarantees. In this way, federally insured institutions could not use the federal guarantee to engage in risky business activities.

Depositors could keep their money in safe, cautious institutions, but they also would have the option to invest elsewhere at their own risk if they desired a higher interest rate.

Separating Risky Assets. Through this system, depositors who desired to protect their savings fully from losses would be able to do so, fu lfilling the most important function of federal deposit insurance. Moreover, taxpayers would bear little risk, as the institutions would be inherently safe. At the same time, the bulk of deposit and lending activity likely would be conducted outside the f e deral safety net using private methods of risk control. By separating risky assets from federal insurance, the narrow bank proposal would relieve the structural problems of federal deposit insurance 8 See Kenneth E. Scott, Deposit Insurance and Bank Regul a tion: The Policy Choices, Workiag Paper No. 46 The John M. Oh Program in Law and Economics, Stanford Law School, August 1988 9 t I Y One potential problem with this narrow banking proposal, however, is that it might cause a massive reduction in insured de p osits. Because their low-risk investments would have low yields, narrow banks would only be able to pay very low interest rates on deposits, probably even less than pass book accounts before bank deregulation As a result, most funds likely would tend to f l ow to non-insured institutions. Nevertheless, narrow banks would offer an essentially riskless alternative to the current system certificates deposit guarantee -and thus the total exposure of the taxpayer. A plan proposed by Fred Smith and MelanieTammen o f the Washington-based Competitive Enterprise Institute, however, would cap the aggregate federal guarantee and create a market for insurance certificates.The total federal guarantee would be capped at its present level, which is now about $2.7 trillion of bank, thrift, and credit union deposits. Each insured institution would be assigned itspro rata share of this guarantee, in the form of insurance certificates. Financial institutions then could trade these certificates to insure some or all of their accou n ts insurance would be created, with a defo~ro cost for risk. High risk institutions would likely find themselves unabIe to attract depositors unless they not only retained theirpm rata share of deposit insurance certificates, but purchased additional cert i ficates in the market to cover their deposits. They would have to pay for these extra certificates; this would be a disincentive to excessive risk-taking. Institutions with a reputation for safe and sound banking practices, by contrast, would be able to s e ll some of their certificates, perhaps offering their depositors a choice of government insured, privately insured and uninsured accounts. Well managed institutions might be able to sell most of their federal deposit insurance certificates. Poorly managed institutions would have to purchase additional insurance certificates if they desired to increase their deposits.

The plan also would limit the federal guarantee in a politically palatable manner. Unlike an across-the-board reduction in the level of cover age for depositors, no depositor would be forced to accept reduced insurance coverage. Instead, depositors would enjoy a range of options -they could move savings to an institution offering insurance, or keep them in a riskier institution offering higher rates but With less insurance protection. Moreover since the total amount of federal insurance would be capped at a certain level, the importance of federal insurance would shrink over time as the economy and total deposits grew.

Tempting Regulators. A potential problem with the Smith-Tagmen plan however, is that the transfer of insurance certificates could result in a greater total risk than under the current system, even though the total amount of insured deposits at risk would r emain the same.The reason for this is that since risky thrifts naturally would value insurance more than safer thrifts Cap the total federal guarantee and issue tradeable insurance Under the current system, there is no limit on the total size of the feder a l Selling Insurance Certificates. Under this plan, a market for deposit c 10 transfers of insurance certificates would tend to be from lower-risk to higher-risk institutions. Smith and Tammen attempt to,deal with this adverse selection problem by allowing federal regulators to veto transfers.

This adds to the complexity and cost of an otherwise simple idea In addition regulators would be tempted to interfere with the operation of the insurance certificate market to reduce the governments exposure.

The Smi th-Tammen plan could be improved by coupling it with some of the features of the other proposals. A major step would be to encourage depositors to take a more active interest in institutions by reducing the per depositor coverage before determining the si z e of the federal guarantee A second potential problem that should be explored is the fact that although the cost of insurance certificates would reduce some of the incentives for excessive risk-taking, the risk premium would go to the holders of the certi f icates, not into the insurance fund. Regulators faced with increasingly risky institutions would receive no funds to cover the cost of that risk CONCLUSION The FSLIC crisis demonstrates dramatically that the time has come for substantial reforms in the en t ire deposit insurance system. Unless the $126 billion plus bailout for FSLIC is accompanied by fundamental insurance reforms, it will be nothing more than an expensive short-term fix. Congress thus must combine the short-term bailout of FSLIC with structu ral reform of the federal deposit insurance system Dealing with the Primary Culprit. These reform should not include re-regulation. In some areas, supervisory rules may have to be tightened.

Accounting and closure rules, for instance, should be made toughe r. But regulatory changes will not go to the heart of the problem.The primary culprit is the federal deposit insurance system, which creates perverse incentives for bank and thrift managers, depositors, and state and federal regulators.The incentives crea ted by the current system subsidize managers who take excessive risks with deposits.

So far, the Bush plan for the thrift industry contains little addressing the fundamental problems of deposit insurance. He has proposed that the Treasury Departmentunderta ke an eighteen-month study of the federal deposit insurance system, and make recommendations for reform. But this likely will be too little, too late. Once bailout money for FSLIC is approved by Congress, there will be no pressure for far-reaching reform u ntil the next crisis 11 Toward an Ultimate Solution. Various reforms of the insurance system have been offered, ranging from risk-related insurance premiums to tradeable insurance coverage. The ultimate solution may be a combination of the various plans. What lawmakers should do is to evaluate such reform ideas carefully not just bail out FSLIC and dssume that the underlying problem has disappeared.

Prepared forme Heritage Foundation by Associate Dean, Associate Professor of Law, and Director of the Law and Economics Center at George Mason University Henry N. Butler 12