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December 19, 1989
"The Real Problem is that When the Government Decided to Insure Deposits at S&Ls, it Inadvertently Created a Perverse System of Incentives that can Encourage S&L Managers to Drive their Institutions Deep into Bankruptcy. Perverse Incentives for S&L Risk-taking"
San Jose Mercury News
By Timothy Taylor
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THE single biggest cause of the collapse of the savings and loan industry won't ever see the inside of a courtroom. That's because the real problem isn't a person: not Charles Keating nor Alan Cranston nor federal bank regulators. The real problem is that when the government decided to insure deposits at S&Ls, it inadvertently created a perverse system of incentives that can encourage S&L managers to drive their institutions deep into bankruptcy.

If an S&L is on the edge of bankruptcy, management has an incentive to make high-risk loans. If the high risks pay off with high interest rates, the S&L can get back in the black. If they don't pay off -- well, the S&L was headed into bankruptcy anyway. With federal deposit insurance, S&L managers can take these high-risk strategies without worrying that depositors will withdraw their money.

Economists call this a "moral hazard" problem, since the presence of insurance encourages S&L managers to engage in (arguably immoral) speculation, while removing the incentive of private investors to monitor their behavior. The problems of the S&L industry started in the economic turmoil and fluctuating interest rates of the late 1970s and early 1980s, but the perverse incentives of federal deposit insurance magnified these problems into an outright collapse.

So far, the legislative answer to the S&L crisis is the Financial Institutions Reform, Recovery and Enforcement Act of 1989, and FIRREA does take two useful steps toward dealing with the moral hazard problem.

First, it raises the amount of capital that an S&L must hold to 3 percent of total assets by 1994. A higher capital requirement increases the amount that the S&L owners must have on the line, and thus discourages them from making crazy high- risk loans.

Second, FIRREA expands the power of bank regulators to restrict certain risky lending activities. The minimum time it takes to suspend deposit insurance (and thus close down an S&L) will be reduced from more than two years to six months. These provisions should help to nip moral hazard problems in the bud, before S&L managers have had as great a chance to gamble themselves into huge losses.

But few economists believe that FIRREA will solve the incentive problems of deposit insurance completely. In fact, when President Bush signed FIRREA on Aug. 9, he referred to it as only "a first step." FIRREA implicitly recognized its own shortcomings by commissioning studies on long-term reforms for federal deposit insurance. Although those studies probably won't appear until 1991, here is an overview of the sort of reforms being discussed in the economics and banking community.

  • First, there is broad agreement on the need for market-value accounting, rather than book-value accounting. Here's the difference: Consider two loans that are the same in every way, except that one is nearly certain to be repaid and the other is nearly certain not to be repaid. The "book value" of these two loans can appear identical, since they have the same principal and interest payments. However, the "market value" of the two loans, as determined by the amount of money the bank actually expects to receive, is very different. The new and improved capital requirements in FIRREA are based on book values, which means they will not be able to discern when an S&L is healthy, and when it only looks healthy because it is refusing to recognize that its loans are not likely to be repaid.

    Market-based accounting could be a very powerful tool. Jonathan A. Neuberger, an economist at the Federal Reserve Bank of San Francisco, recently wrote: "Two provisions of FIRREA, namely, enhanced capital requirements and prompt closure could be sufficient to eliminate the perverse incentives if these provisions were geared to market values."
  • A second possible reform is adjustable insurance premiums. Current law requires that all S&Ls be charged the same deposit insurance premiums, regardless of the riskiness of their loans. This is a little wacky; just as auto insurance premiums are adjusted for driving record and life insurance premiums are adjusted for age and health, it makes sense that deposit insurance premiums should be adjusted for the chance of the S&L going broke. Adjustable premiums would provide a direct incentive for S&L managers to sidestep moral hazard: They would pay for their risky loans immediately, through higher premiums.

    The main difficulties with market-value accounting and risk- adjusted premiums are practical ones: How can a bank regulator determine the probability that a loan won't be repaid? How can one find out the market value of a loan without selling the loan? But even if market value and risk can't be determined precisely, they can surely be used in a limited way.
  • A third possible reform is to raise the capital requirement still further, perhaps to 6 percent of total assets. Several economists have proposed a twist on this higher capital requirement that I particularly like. They suggest that every S&L be required to raise part of its capital requirement by borrowing from outside investors.

    Those who put up the money for the capital requirement know that if the S&L goes broke, they will lose all of their investment. As a result, they have a high incentive to monitor the S&L. In addition, these outside investors could be allowed to call in their debt -- that is, stop lending -- at any time. If the S&L can't find any outside investors, that would be a strong signal that the institution has lost the trust of the marketplace, and that bank regulators should step in and shut it down.
  • The fourth reform is a matter of process: Troubled S&Ls should be shut down immediately. Edward Kane of Ohio State University estimates that the government could have cleaned up the S&L crisis in 1985 for $22 billion. After four years of hesitation, the cost appears likely to approach $200 billion.

    In theory, everyone agrees that troubled S&Ls should not be left to gamble themselves into higher losses. But 800 operating S&Ls don't currently meet the new FIRREA capital requirements that took effect on Dec. 7. How long will they be allowed to try to speculate their way back to profitability? How many congressmen will delay the process in the meantime?

Market-value accounting, risk-based premiums, higher capital requirements, a requirement for outside debt, and quick shutdowns are all incremental reforms. But more fundamental reforms have also been proposed, reforms that would act to limit deposit insurance itself.

For example, one suggestion has been to limit deposit insurance to less than $100,000 per account, or perhaps to only some percentage of deposits, since that would limit the government's liability and give more investors an incentive to monitor S&Ls lending practices.

A second suggestion would make deposit insurance largely unnecessary by creating "narrow banks," which would invest only in very safe assets, like short-term treasury debt. If your money was invested in a narrow bank, it would be fully protected. If you deposited it anywhere else in search of a higher return, it would not be protected.

Since both of these suggestions would reduce the coverage of federal deposit insurance, they both mean that people must worry more about the risk that their S&L or "wide bank" will go broke. The more deposit insurance is reduced, the greater the likelihood that bank runs will become common again. Before shaking up the financial system on the assumption that deposit insurance can't be made to work, I think it's worth trying the incremental reforms. If they fail to solve the incentive problems, then it may be necessary to reduce deposit insurance in ways like these.

The essential problem of the S&Ls isn't that a wave of lawbreaking swept the industry in the early 1980s. Instead, it's that the economic circumstances of the early 1980s, combined with the presence of deposit insurance, led managers of hundreds of S&Ls to make loans that were legal, but high- risk and ultimately unproductive.

Trying to clean up after the disaster by jailing the S&L managers, censuring the congressmen, or firing the bank regulators is a case of closing the bank door after the money is gone. I'm all for prosecuting those who broke the law, but there's a difference between punishing criminals and looking for scapegoats.

The issue should be to reduce the perverse incentives of deposit insurance, so that the next time economic circumstances make S&Ls (or banks or credit unions) financially shaky, they have built-in reasons to keep their risk-taking under control. Otherwise, even if Keating and Cranston exit the scene, the taxpayer will be on the hook for deposit insurance over and over again.

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