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Regulation Magazine

The Cato Review of Business & Government

Bank and Thrift Regulation

William S. Haraf

William S. Haraf is J.E. Lundy a visiting scholar and director
of the financial markets project at the American Enterprise Institute.

When the Reagan Administration took office in January 1981, depository institutions were in trouble and their prospects were gloomy. Inflation and high interest rates had taken a tremendous toll among savings and loans, which were using deposits that paid double-digit rates to fund low-interest mortgages written years earlier. In June of that year Federal Home Loan Bank Board (FHLBB) Chairman Richard T. Pratt predicted that on average one savings and loan per day would hit zero net worth, and he acknowledged that one-third of the industry, with about $200 billion in assets, was not viable under the conditions at the time. In a "down-side," but not "wildly pessimistic," scenario, he estimated that the failure of these insolvent institutions could produce losses of $60 billion-an amount far greater than the reserves of the Federal Savings and Loan Insurance Corporations (FSLIC).

Commercial banks were also experiencing difficulties, although the industry as a whole was in better shape. The inflation of the 1970s had encouraged bank-financed speculation in agriculture, real estate, and commodities, especially oil. The disinflation of the 1980s meant that many of those gambles did not pay off, and banks were suffering the consequences. Bank failures and the Federal Deposit Insurance Corporation's (FIDIC's) list of problem banks were beginning to grow rapidly.

Regulators were having difficulty dealing with the rising number of failures among depository institutions. Federal laws restricting interstate operations and cross-industry mergers were making it difficult for them to find buyers for failing institution.

In addition financial innovations were taking business away from banks and thrifts. Money was streaming into unregulated money-market mutual funds. In 1980 Congress had passed the Depository Institutions Deregulation and Monetary Control Act to phase out interest rate ceilings on deposit accounts, but the new funds continued to gain ground. By the end of 1982 they held over $240 billion. The "securitization" phenomenon was beginning to take hold as well. The mortgage-backed securities market was starting to take off. Corporations were turning to the commercial paper market rather than to banks for their funding needs. And the large mutual fund families were attracting consumer savings.

The Reagan administration's diagnosis was that depository institutions had been overreglated and thus were unable to cope with the new world of volatile interest rates and rapid financial innovation. Early on, the administration made a commitment to deregulate depository institutions to enable them to compete in a changing marketplace. Secretary of the Treasury Donald T. Regan cited restrictions on commercial banks' securities activities, on interstate banking, and on savings-and-loan powers as areas where regulatory reform was needed. Lower interest rates and broader powers, according to Secretary Regan, would solve the industry's problems.

The administration was only partially right. Overregulation had contributed substantially to the industry's difficulties. But it was wrong to conclude that lower interest rates and deregulation would solve the problems of institutions that were already deeply in the red and had nothing to lose by gambling with what amounted to the taxpayer's money. When the next president takes office, the banking and thrift industries will still be troubled and their future prospects dim.

The administration was unable to achieve its goal of deregulating the banking and thrift industries. Only limited progress toward deregulation was made. Interest rate deregulation is now largely completed. Restrictions on interstate operations are gradually being phased out, mostly by the states themselves. And there has been some deregulation of bank and thrift powers as a result of actions by the courts, by the states, and by federal regulators in areas where they had discretion in interpreting existing law. But the administration was unable to get a broad deregulation bill through Congress. Substantial barriers to the integration of banking with other financial services remain.

Even more important from the standpoint of public policy, the savings-and-loan problem and the deeper problems with the management of the deposit insurance system have not been resolved. Indeed, the situation has deteriorated. Most private estimates of the cost of satisfying the claims of depositors in failed savings and loans now exceed Richard Pratt's 1981 estimate of $60 billion. In the meantime there have been dozens of outright bailouts of depository institutions-notable among them, Continental Bank's. There have been hundreds of bank and thrift failures in which large depositors and other creditors have been fully protected. And there are still hundreds, perhaps thousands, of shaky banks and thrifts in operation that could not survive without the federal deposit insurance sticker on their doors. Deposit insurance has become a much more intrusive presence in the financial system. As L. William Seidman, chairman of the FDIC, said in recent testimony before Congress, "The lender of last resort is no longer the Federal Reserve, but the federal deposit insurance system."

New Powers for Banks and Thrifts

The prospects for deregulating the banking and thrift industries originally looked quite good. The administration had an important ally in Senator Jake Gain, chairman of the Banking, Housing and Urban Affairs Committee. In late 1981, following extensive hearings, Senator Gain introduced a bill to grant banks and thrifts some new powers and to give regulators new tools for dealing with failing institutions. The bill took an initial swipe at the Glass-Steagall Act, the depression-era law separating commercial banking and securities activities, by allowing banks to underwrite municipal revenue bonds and to operate mutual funds. In addition Senator Gain laid out an ambitious agenda for 1982 that included further action on interstate branching and on securities, insurance, and real estate powers for banks and thrifts.

Despite the efforts of the administration and Senator Gain, however, the desirable goal of broad deregulation proved elusive. The pressing problems of the thrift industry held center stage in Congress throughout 1981 and 1982. House Banking, Finance and Urban Affairs Committee Chairman Fernand St Germain did not see broad new powers for banks and thrifts as contributing to a solution, and indeed, he was probably right. Moreover, the proposed deregulation of depository institutions encountered powerful opposition from a broad range of lobbying groups representing the securities, insurance, and real estate industries, and community banks. The 1982 Gain-St Germain Act authorized depository institutions to offer new deposit accounts and gave savings and loans some new lending and investment authority. It did not, however, grant depository institutions new securities, insurance, or real estate powers, which remained highly controversial.

The securities industry had opposed Senator Gain's 1981 bill on the grounds that implicit subsidies from deposit insurance gave depository institutions an unfair advantage in the securities business. There are some subtle issues involved in analyzing this assertion, and there was legitimate disagreement among economists over it. In an effort to save the bill, the administration proposed an innovative compromise that would have required banks to conduct their securities activities only in separately capitalized subsidiaries of a bank holding company. The approach offered several important advantages. It created a "level playing Held" in the competition for providing financial services; it protected the deposit insurance funds from possible risks arising from deregulation; and it permitted regulation of the various holding company subsidiaries by function.

This compromise turned out to be the model for the Reagan administration's first and only financial deregulation bill, and for virtually all subsequent deregulation proposals. The Financial Institutions Deregulation Act, introduced in 1983, would have allowed bank and thrift holding companies to use separately capitalized subsidiaries to engage in broad new securities, insurance, and real estate activities. Reform of interstate branching laws, however, was viewed as too controversial to tackle.

The debate over the administration's bill got caught up in a firestorm of controversy surrounding the so-called "nonbank bank" loophole-one of the most interesting and important market innovations of the Reagan years. According to the Bank Holding Company Act's definition, a bank took deposits and made commercial loans. A firm doing one or the other but not both was not a bank, so its parent was not a bank holding company. The nonbank banks themselves were regulated as if they were ordinary banks, but their parent companies were unregulated. Early in 1983 President Reagan's first comptroller of the currency, C. Tod Conover, began chartering nonbank banks for organizations like Merrill Lynch, Sears Roebuck, American Express, and John Hancock. Bank holding companies also obtained nonbank-bank charters to offer services across state lines.

The Federal Reserve System, which has primary responsibility for regulating bank holding companies, was horrified by this development. Insurance, securities, and retail companies were getting into banking without any role for the Fed as watchdog. The loophole seemed to threaten the whole structure of financial regulation. Federal Reserve Board Chairman Paul A. Volcker and Congressman St Germain became strong proponents of loophole closing. Indeed, their concern over the rapid pace of financial restructuring led them to advocate a moratorium freezing the financial marketplace as it stood in January 1983.

The nonbank-bank innovation presented an interesting dilemma for the Reagan administration. The administration acknowledged that non-bank banks were procompetitive and benefited consumers, but it also came to realize that this innovation rendered its carefully crafted, "comprehensive" legislation irrelevant without any apparent adverse side effects. The administration decided to support closing the nonbank-bank loophole only in the context of broader financial reform legislation.

But comprehensive legislation proved to be too controversial to get enacted. The Continental Bank bailout in July 1984 and the weakened condition of the banking and thrift industries were used effectively by opponents of deregulation. The Senate passed a much scaled-down version of the administration's bill in 1984, but the House did not go along. The melee over the nonbank-bank loophole led Comptroller Conover to impose a temporary moratorium on new charters for nonhank banks. Later, new charters were held up by court challenges.

A congressional stalemate lasted until 1987. By then the FSLIC was officially bankrupt, and congressional action was needed to deal with mounting thrift failures. The Competitive Equality Banking Act recapitalized the FSLIC, but it also-over the objections of the administration-closed the nonbank-bank loophole and imposed a one-year moratorium on new powers for bank holding companies. The expiration of the moratorium in March 1988 and an important court decision giving regulators flexibility in interpreting the Glass-Steagall Act led to a new round of congressional debate over bank holding company powers. In March the Senate passed an administration-backed bill that would remove many restrictions on the securities activities of bank holding companies. The House, however, did not act before adjourning.

The Reagan administration's long support for deregulating bank holding companies did not produce any significant successes.

Deposit Insurance

Early on, the next administration will have to deal with the looming FSLIC crisis. The roots of this problem go back a long way. The savings and loan industry was insolvent on a market-value basis as early as 1971. By 1981, at the peak of interest rates, the problem approached catastrophic proportions. Professor Edward J. Kane, of Ohio State University's College of Business, estimated that the net worth of the savings-and-loan industry, after deducting unrealized losses on its mortgages, was $150 billion.
Congressional and regulatory action since then has been designed to shore up confidence in the deposit insurance system, to buy time for depository institutions to work their way out of problems, and to conserve the cash of the deposit insurance agencies.

In 1980 Congress increased the level of deposit insurance coverage from $40,000 to $100,000 to make it cheaper for depository institutions to raise cash. In 1982 it passed a resolution stating that the full faith and credit of the U.S. Treasury was behind the deposit insurance funds. With the Gain-St Germain Act, it allowed regulators to bolster a savings and loan's capital with "net-worth certificates," and it gave them authority to aid sick institutions with loans and other forms of assistance.

Regulators used the net-worth certificates and other accounting gimmicks to make it appear that savings and loans had more capital than they did. The regulators lowered minimum capital standards and encouraged institutions to grow their way out of problems. These policies played into the hands of the industry's plungers and speculators. As a result, the moral-hazard problem long associated with deposit insurance became much more serious. The industry's difficulties with its portfolio of low-interest mortgages peaked in 1981. But serious credit quality problems emerged in the mid-l980s as insolvent and nearly insolvent savings and loans adopted high risk strategies to tly to recoup their losses.

Many people blame deregulation, particularly at the state level, for the depth of the current savings-and-loan problem. But deregulation in Texas, California, and Florida took place after many of the savings and loans in those states were already economically insolvent. Managers of bankrupt savings and loans had nothing to lose by taking high-risk gambles to try to recoup their earlier losses.

Throughout this period the banking industry and the FDIC have been in better shape than the savings and loans and the FSLIC, although not without substantial problems of their own. Capital regulation and failure management by bank regulators have generally been more disciplined than by savings-and-loan regulators. Problems have been addressed more quickly. But in some respects bank regulation has been on the same slippery slope. Bank regulators established a capital forbearance program in 1986 to permit weakened farm and energy banks to operate with substandard capital. In addition banks have long been beneficiaries of informal forbearance. Regulators have not required shaky banks to write down the value of bad loans. Indeed, they sometimes have discouraged banks from doing so on the grounds that it would shake confidence. When failures have occurred, the FDIC has resorted to techniques that protected deposits in excess of legally insured amounts and protected other bank creditors who were not legally insured. Sometimes creditors and shareholders of a failing bank's holding company have received significant protection as well. As a result, the normal disciplines of a competitive market on excessive risk-taking have been short-circuited.

The Reagan administration was the first to undertake a comprehensive study of deposit insurance in order to find ways to place it on sounder footing. The Cabinet Council on Economic Affairs issued a report in 1985 recommending risk-related deposit insurance premiums, significantly higher capital requirements, stronger disclosure requirements, and tougher exam ma-lion and supervision of depository institutions. The interagency Task Group on Regulation of Financial Services, chaired by Vice President George Bush, was established primarily to develop a plan to consolidate and rationalize the responsibilities of federal financial regulatory agencies, but it also recommended deposit insurance reforms. The task group issued recommendations that were similar in most respects to those of the cabinet council, but it went one step further by advocating an end to the protection of uninsured deposits of failed banks and thrifts.

Reforms along these lines could have substantially improved the operation of the deposit insurance system, provided they were properly implemented and strictly enforced. But they were never adopted. The administration and Congress first had to come to grips with the hundreds of insolvent and nearly insolvent depository institutions that had no hope of operating in a more disciplined environment. The FSLIC's resources were far from adequate for the task, and in 1985 there was no interest in providing it with additional resources. The unwillingness to get insolvent savings and loans out of the market prevented needed reforms that could have placed the system on sounder footing.

When the FSLIC was finally recapitalized in 1987, the funds Congress made available were far less than what was needed and what the administration had requested. Problems deepened at the FSLIC and, to a lesser extent, at the FDIC as a result of widespread problems among Texas banks. The agencies, out of necessity, have increasingly resorted to mechanisms to reduce their out-of-pocket cost of managing failures. They have given acquirers of failing institutions assistance packages that include subsidized financing and guarantees against losses from bad loans and changes in interest rates. They have granted special exceptions on capital standards and accounting rules. They selectively have granted powers not available to healthy competitors. They have permitted very shaky banks and thrifts to bid for failing institutions. And they have increased their use of direct assistance, that is, outright bailouts of ailing banks and savings and loans.

The next administration will have to confront the negative consequences of these policies. First, through the accumulation of common and preferred shares, loans, and loan guarantees in these deals, the deposit insurance agencies are bearing a great deal of risk that is likely to result in sizable future outlays. Problems have not been resolved; they have been postponed. Second, these policies have exacerbated moral-hazard problems. In some cases a very large share of a reorganized savings and loan's or bank's capital belongs to a deposit insurance agency. The private owners can be leveraged in the extreme, and may have the same incentives to "go for broke" that led to the current problem. Third, these policies have worked to the disadvantage of healthy firms, which must compete against resurrected or reorganized competitors that have been granted special regulatory advantages. Thus their own capital and profitability have been placed in jeopardy.

Lessons for the Next Administration

The problems of the thrift industry directly and indirectly had an enormous influence over the financial regulation agenda during the Reagan years. The administration was correct in concluding that deregulation was critical to the survival of the banking and thrift industries. It was a fatal mistake, however, to believe that deregulation would solve the problems of firms that were already economically insolvent. In 1981 few appreciated the potential adverse consequences of deregulating an industry that was deeply in the red and had nothing to lose. The reluctance of Congress and the administration to deal with weaknesses in the system prevented action on the broader financial restructuring issues that were the administration's first priority.

The next administration will have to take strong action to clean up the deposit insurance mess and to ensure that it never happens again. Restoring a financial system that is less dependent on government guarantees and more dependent on private capital will require more than simply closing down insolvent institutions. It will require adequately capitalized survivors operating with appropriate incentives. Getting there will not be easy or cheap.

Many economically viable banks and thrifts will need to raise capital over the coming years, but their ability to do so is severely hampered in the current environment. Hundreds of insolvent and nearly insolvent thrifts are still in the market, bidding up deposit rates and taking gambles with taxpayers' money. Scores of resurrected banks and thrifts are operating with special advantages granted by regulators. It is no wonder that managers of healthy institutions find raising capital difficult and without reward.

The first step in turning this situation around is for Congress to enact legislation granting the FSLIC resources sufficient to get insolvent institutions out of the market as expeditiously as possible without resorting to methods that distort incentives and reduce the competitiveness of healthy institutions. Inevitably much of the cost will fall on taxpayers. Some will say that Congress should resist an industry bailout. But bleeding the healthy part of the industry dry is not in the public interest. Moreover, a fair share of the responsibility for the present situation lies in Washington, where regulators have mismanaged depository institutions for decades.

A credible plan must then be instituted to ensure that the mistakes of the past are not repeated. Economists have offered a variety of proposals for improving private incentives in the deposit insurance system under the assumption that, for better or for worse, it is here to stay. Some economists have advocated risk-based deposit insurance premiums. This approach would substantially improve the incentives facing depository institutions, provided that premiums reflect actual differences in risk. It is doubtful, however, that an effective system could be implemented by a federal agency. Other economists have advocated "narrow banking." This would require banks to invest only in perfectly safe assets and spin off all other activities, such as commercial lending, into separately capitalized uninsured affiliates. While this approach could solve the deposit insurance problem, it also has economic costs: it reduces economies of scope in banking. For centuries commercial banks around the world have combined deposit taking and commercial lending without the systemic problems we have today. These problems are the result of gross mismanagement of federal guarantees. They are the not the result of combining deposit taking and commercial lending in the same entity.

Three steps can restore discipline to the nation's deposit insurance system. First, violations of capital standards should involve early and automatic penalties, including fines and restrictions on dividends, growth, and acquisitions. Capital adequacy regulation today does not involve serious penalties. An institution whose capital is below required levels must merely devise a plan for bringing it back up over time. Imposing penalties at an early stage will encourage institutions to manage capital more carefully, take corrective actions sooner, and seek a merger partner before the deposit insurance agencies have to get involved. Second, if owners are unwilling to recapitalize a failing bank or thrift, regulators should have authority to take control before the institution's capital runs out. There are mechanisms for doing this without violating due process for owners. Third, the policy of protecting large depositors and other creditors must stop. Protecting the stability of the financial system does not require protecting all the liabilities of depository institutions. The regulatory agencies have the tools to expose large depositors and other creditors to losses when a failure occurs, while preserving the liquidity of deposit accounts. They can safely apply those tools to banks and to savings and loans of all sizes.

In sum, moral hazard from deposit insurance is manageable with a strong commitment to capital adequacy regulation, prompt action when insolvency occurs, and the restoration of market disciplines that have eroded under current federal failure-management practices. The most important lesson of the savings-and-loan experience is that forbearance on capital standards and insolvency determination is a prescription for disaster. Had capital regulations and limits on deposit insurance coverage been strictly enforced, savings and loans simply could not have gone for broke the way they did. Owners and depositors would have pulled the plug on their own a long time ago.

Finally, there arc important reasons for the next administration to continue the Reagan administration's efforts to deregulate hank holding companies, and a tactical lesson to be learned from its experience as well. The administration never crafted a balanced approach to eliminating entry barriers in the financial services industry. Under the premise that the survival of depository institutions was threatened by overregulation, the administration's 1983 bill offered new powers to bank and thrift holding companies. But nonbanking firms were not granted symmetric entry into banking. The legislation was correctly perceived by securities, insurance, and real estate industry groups as one-sided, allowing banks to encroach on their businesses. Their lobbyists lined up to oppose it. The lesson that should be learned is that if it is to have any chance of passage, legislation proposing holding company deregulation must offer a "two-way street." Bank holding companies should be granted broader powers, but outside firms should be able to acquire banks. None of the Reagan era proposals-the administration's 1983 bill, the 1984 Gain bill, or the 1988 Proxmire bill-offered meaningful opportunities for non-bank firms to acquire banks.

With proper safeguards, the deregulation of bank and thrift holding companies offers prospects for substantial public benefits, not the least of which is the attraction of much needed capital to the industry. In that sense a "two-way street" can be part of a comprehensive solution to the deposit insurance problem.

In addition, there are important changes in international banking markets on the horizon that will make bank holding company deregulation in the United States important for the international competitiveness of U.S. financial services companies. As part of its "1992" project for the full integration of European markets, the European Community has proposed offering a "common bank license," which would enable any banking institution in Europe to engage in a wide range of financial activities throughout Europe, as long as it is permitted to do so at home. If this proposal is adopted, competitive pressures will almost surely push all European nations in the direction of adopting "universal banking systems, in which a broad range of financial services is provided within the same entity. The result is that U.S. financial services firms will increasingly find themselves competing in international markets against large, fully integrated institutions. The ability of U.S. firms to compete effectively could well be adversely affected by laws restricting the range of services they can offer.

Removing domestic restrictions on bank and thrift ownership and affiliations will increase competition, improve the ability of the U.S. financial system to adapt to change, and provide opportunities for synergies from the joint production and marketing of financial services. The enormous improvements in information technologies in recent years have probably increased the advantages of allowing financial institutions to offer multiple services over broader geographic areas. Giving them the authority to do so will lead to a more efficient financial system, one better able to provide quality financial services at attractive prices to both domestic and foreign users of financial services.

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