Saving Troubled Financial Institutions, the U.S. Crisis 1981-1994

1. Saving Troubled Financial Institutions, the U.S. Crisis 1981-1994

2. 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

3. 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.

4. 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.

5. 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.

6. 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

7. 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.

8. 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.

9. 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

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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).

18. 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.

19. Bank Crisis • Innovations Increasing Competition • Money market mutual funds • Junk bonds • Commercial paper market

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. 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).

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. 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.

50. 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.