Lecture 19 - The Savings and Loan Crisis
from last time
bank failures during the Great Depression
why did the 1980's crisis occur?
FIRREA
possible reforms
From Last Time
- 30% of total deposits are not insured; that represents 1% of depositors.
- The FDIC is a government agency.
- The FDIC chooses its course of action after evaluating whether a deposit payoff or a purchase and assumption transaction is cheaper.
- Under a purchase and assumption method, someone buys the failed bank's assets and assumes responsibility for its liabilities. The difference between its assets and liabilities is covered by a cash transfer from the FDIC.
- The idea behind reducing bank competition, to try to come up with a nice rationale for it, might have been to protect bank profits so that they do not have to take on too much risk.
Bank Failures during the Great Depression
Some 8000 banks with $5 billion of deposits became insolvent in 1930-1933. An agricultural depression led to a wave a bank failures throughout the Mid West. Panic then spread to other areas. On March 4, 1933, President Roosevelt invoked the Trading
with the Enemy Act of 1917 to close all banks in the U.S.
Why Did the 1980's Crisis Occur?
Bank failures averaged 15 a year and S&L failures less than 5 a year over the period 1934-1980. After 1981, failures of banks and S&L's rose to levels over ten times greater than in previous years.
Financial innovation in the 1970's and early 1980's produced new financial instruments such as financial futures, junk bonds, swaps, etc. made it easier for banks to take on more risk. Legislation deregulating the banking industry (1980 & 1982)
allowed banks to make loans on commercial real estate and to hold junk bonds.
In 1980, deposit insurance was raised from $40,000 to $100,000. Regulation Q was phased out. So, banks that wanted to take on risky projects could raise funds by offering higher interest rates. With deposit insurance, depositors were happy to make
deposits in banks with the highest interest rates.
The sharp increase in interest rates from 1979 to 1981 produced rapidly rising costs of funds for S&L's that were not matched by higher earnings on their principal assets, long-term residential mortgages.
The 1981-82 recession and the collapse in energy and agricultural prices led to many loan defaults.
About half of the S&L's in the U.S. were insolvent by the end of 1982.
Rather than close down these S&L's, the S&L regulators (the Federal Home Loan Bank Board and the FSLIC) adopted irregular accounting principles such as allowing S&L's to put a high value on "goodwill" as part of their capital. This regulatory
forbearance was practiced because
- the FSLIC did not have sufficient funds to close insolvent S&L's and payoff depositors
- the Home Loan Bank Board was established to encourage the growth of the S&L industry not shut it down
- they hoped the problems would go away
This increased the moral hazard because an operating but insolvent S&L, a zombie S&L, has nothing to lose by taking on greater risk. These zombie S&L's attracted deposits away from healthy S&L's by offering higher interest rates.
The FSLIC fund was bankrupt by the end of 1986. Congress and the administration finally enacted the Financial Institutions Reform, Recovery, and Enforcement Act on August 9, 1989.
FIRREA
- Federal Home Loan Bank Board and the FSLIC were abolished
- Bank Board's regulatory role was given to the Office of Thrift Supervision and the FDIC took over for the FSLIC
- created the Resolution Trust Corporation to manage the resolution of insolvent thrifts
- imposed restrictions on S&L activities similar to those in effect before 1982
- increasaed capital requirements to those adhered to by commercial banks
- increased the enforcement power of thrift regulators
- increased deposit insurance premiums
The cost of the bailout has been estimated at over $500 billion over forty years.
Possible Reforms
- eliminate deposit insurance entirely
- lower the limits on the amount of insurance
- allow deposit insurance only at "narrow banks" that invest only in virtually risk free assets like T-bills
- provide deposit insurance by private insurers]
- base deposit insurance premiums on risk
- eliminate branching restrictions
- use market-value accounting for capital requirements
EC 230, Money and
Banking Files 
