After the stock crash of 1929 and over a thousand bank failures, congress and President Franklin D. Roosevelt created the Federal Deposit Insurance Corporation (FDIC) in 1933 in order to provide a federal government guarantee of deposits and maintain stability and public confidence in the banking system of the United States. A year earlier, the Federal Home Loan Bank Act of 1932 established the Federal Home Loan Bank System (FHLBB) as a source of liquidity and low-cost financing for the Savings and Loan Industry (S&L) for which legislation was driven by the public policy goal of encouraging home ownership. The same year as the formation of the FDIC the Home Owners Loan Act of 1933 empowered the FHLBB to charter and regulate federal savings and loan associations promoting the expansion of the S&L industry to ensure the availability of home mortgage loans. Therefore, a year later the National Housing Act of 1934 created the Federal Savings and Loan Insurance Corporation (FSLIC) to provide federal deposit insurance for S&L’s similar to what the FDIC provided for commercial banks and mutual savings banks. However, while the FDIC was established as an independent agency, the FSLIC was placed under the authority of the FHLBB which meant that for commercial banks and mutual savings banks the chartering and insurance functions were kept separate while for federally chartered S&L’s both functions were under the supervision of the same agency. The FHLBB proved to be weaker in its examination, supervision, and enforcement practices than that of federal banking agencies, and thus would in part cause the failure of the FSLIC (CBB).
Since before 1980, savings and loan associations had limited powers and relatively few failures and since the FHLBB was a small agency, its staff and examination process was not adequate to supervise in the new environment which it was forced into. The examination force was understaffed and poorly trained for the new tasks needed by the savings and loan industry and had limited resources. Qualified staff was hard to find and even harder to keep especially due to a wide government hiring freeze in 1980-1981. Banking Agencies could pay salaries that were 20-30 percent higher than those of the FHLBB. While an annual Salary of a FHLBB staff member was $24,775, the average salary for staff at the FDIC was 32,505. Thus, even if the FHLBB did have qualified staff members, they were soon recruited by other higher paying organizations leaving the FHLBB. This resulted in the FHLBB not only with a lack of qualified staff but also with a lack of older staff to teach younger employees (Industry Analysis).
Another problem of the FSLIC streamed from an organization of duties issue. The examinations of S&L’s were made separately from supervisory functions. The examiners reported to the Office of Examination and Supervision of the Bank Board (OES). The supervisory staff was kept entirely within the Federal Home Loan Bank (FHLB) System, and reported to the president of the Local FHLB only. Therefore, no agency had a single direct pathway of fault for a troubled organization. The other problem was that S&L regulators were much more concerned with rules and regulations than the safety and soundness of the loans. The problem was that most S&L assets were fixed-rate mortgages and since value of collateral had consistently appreciated, losses on home mortgages were rare. Not until 1987, did S&L examiners have the authority to classify assets according to likelihood of repayment or to enforce reserves. The supervisory personnel also did not follow up on examiner recommendations (Industry Analysis).
There was a special connection between the supervisory agents and the Federal Home Loan Banks. The FHLBB gave each Federal Home Loan Bank president the power of the Principal Supervisory Agent (PSA) for that region, although field examiners reported to the FHLBB in Washington and not to the PSA. Another issue was that the PSA reported to no one and had a special interest since the regional Banks were owned by the institutions they supervised. There was a large distrust between the S&L examiners who were federal employees and the employees of the privately owned regional Banks who were the supervisory agents (Industry Analysis).
Legally, the FHLBB had problems enforcing laws. It was a lengthy process and since they only had about five enforcement attorneys through 1984 and scarce resources, they would only pursue the strongest cases. They would therefore compromise on cease-and-desist orders and avoid cases alleging unsafe and unsound practices due to lack of precedent. It was strongly believed in government that as long as the S&L’s had the money to operate, the situation of their balance sheets would be solved as interest rates changed. Due to this belief and to prevent insolvency at that point, the FHLBB lowered the net worth requirements of federally insured savings and loan associations from 5 percent to 4 percent in November 1980 and to 3 percent in January of 1982. There was also a 20 year phase in rule for these requirements which mean that institutions less than 20 years old had capital requirements lower than 3 percent. They also used regulatory accounting principles to report capital that were considerably more relaxed than generally accepted principles, and used the latter when more lenient. This was seen as a low cost way to allow healthy S&L’s to take over insolvent institutions however provided for moral hazard more than anything else as institutions that were insolvent and should have closed were allowed to remain open and provide for more financial troubles (Industry Analysis).
Other laws such as the Depository Institutions Deregulation and Monetary Control Act of 1980 reduced net worth requirements of 5 percent of insured accounts to a range of 3-6 percent of insured accounts. It increased the federal deposit insurance to $100,000 per account up from the $40,000 they used to insure. This added to the costs of resolving failed financial institutions and increased moral hazard. Along with the Garn-St Germain Depository Institutions Act of 1982, these laws gave S&L’s new and expanded powers along with eliminating deposit interest-rate ceilings (Industry Analysis).
When Reagan came to the presidency, there was a call for a reduction in the size of the federal government and less public intervention in the private sectors in such institutions as the Savings and Loan. During the first half of the 1980’s the federal banking and thrift agencies were encouraged to reduce examination staff. Thus, the S&L’s were given more power to regulate themselves (Industry Analysis).
After this deregulation occurred, total S&L’s assets increased from $686 Billion to $1,068 Billion (56 percent). This was twice the growth of the savings banks and commercial banks. They were swamped with deposits due to the fact that they were willing to pay above-market interest rates due to lack of a ceiling. In 1983 and 1984 more than $120 Billion in net new money flowed into savings and loan associations. With the increase in deposits, S&L’s had the ability to go into other services other than mortgage loans which in 1986 only accounted for 56 percent of total assets compared to 78 percent in 1981 (Industry Analysis).
Deregulation was such a problem that S&L’s were allowed to make direct investments in real estate, equity securities, service corporations, and operating subsidiaries and they invested in everything from casinos, fast-food franchises, ski resorts, and windmill farms. In 1982-1985 supervision was weakest as state-chartered institutions had close political ties to elected officials and to state’s regulators. The FHLBB at that point wanted to tighten regulations but found it very difficult due to the many deregulatory provisions. Looking for help, the FHLBB transferred its examination staff to the Federal Home Loan Banks in order to become independent and have more control on salaries for their staff. However, the damage was too badly done to save the institutions. With relaxed accounting regulations, an S&L could report what looked like healthy reports and the FHLBB could not take any action until an institution was insolvent (Industry Analysis).
The FSLIC at the time had reserves of only $5.6 Billion at the end of 1984 and did not have the funds needed to close the insolvent institutions who followed regular accounting practices rather than generally accepted practices numbered 71 with 14.8 Billion assets. After two years, insolvent S&L’s numbered 225 institutions with assets of $68.1 Billion (Industry Analysis).
In 1980 the Federal Savings and Loan Insurance Company insured about 4000 state and federally chartered savings and loan institutions with about $604 billion worth of assets, a majority of which were held in traditional S&L mortgage related investments. The mortgages began losing money because of upward rising interest rates and a wide asset liability gap. Overall S&L income which was about $781 million in 1980 fell to negative $4.6 billion and $4.1 billion in 1981 and 1982 respectively. These circumstances caused 118 S&L’s with $43 billion in assets to fail, costing the FSLIC about $3.5 billion to resolve the situation and pay back the claims. This was a big difference compared to the previous 45 years where only 143 S&L’s totaling only $4.5 billion had failed costing the agency a mere $306 million (Industry Analysis).
An end was not in sight as by the end of 1982 there were 415 S&L’s with total assets of $220 billion which were insolvent based on the book value of their tangible net worth which was close to 0 for the entire S&L industry falling to 0.5 percent of assets in 1982 from 5.3 in 1980. The National Commission on Financial Institution Reform, Recovery and Enforcement, in 1993, estimated that it would have cost the FSLIC approximately $25 billion to close the insolvent S&L’s even though it was four times the $6.3 billion in reserves held by the FSLIC at the end of 1982 (Industry Analysis).
There was however one last ditch effort to save the FSLIC in 1986 and 1987. The Competitive Equality Banking Act of 1987 provided the FSLIC with resources to resolve the insolvent institutions, however the amount was far too scarce to solve the problem. In 1988 they did manage to resolve 222 S&L’s with assets of $116 billion, even though this was very expensive since the FSLIC did not have adequate funds and had to use notes, guarantees, and tax advantages. Even though, there were still 250 S&L’s with $80.8 billion in assets that were insolvent based on regulatory accounting principles. The final resolve of failed S&L’s was estimated at $160 Billion with $132 Billion of that coming from federal taxpayers. The insured deposits made US taxpayers vulnerable to the risk while the deregulation allowed profits for the owners and managers of the savings and loans (Industry Analysis).
There was also another attempt to save the FSLIC. Once the Savings and Loan Insurance Corporation became insolvent, Congress developed the Financing Corporation (FICO) in 1987 in hopes of saving the agency. In order to accomplish this, FICO issued over $8 billion worth of bonds from 1987-1989. In theory the funds were supposed to be repaid with funds from the Federal Home Loan Bank System and S&L deposit insurance premiums. This idea was counteracted in 1995 when the Treasury Department and the FDIC wanted to back up interest payments due to public concern regarding the default on bonds. This, however, also backfired as it created moral hazard as all government sponsored enterprises were relieved of bond-market limits. Once the FSLIC began to default, the FDIC administered the Savings Association Insurance Fund which was supposed to be able to pay off the bond payments incurred that were supposed to be paid off by the FSLIC. They were thus not inclined to enter into safe investments but rather into more risky ventures since they were sure that they would be backed up by the government (Leggett).
This begs the question as to why the FDIC has not been running into similar problems and losses as the FSLIC. In fact, the FDIC was faced with the mutual savings banks (MSB) problem at the same time of the FSLIC crisis. However, the difference was that the FDIC had the money to close out failing MSB’s and the regulations needed in order to tighten their controls over the industry. They instituted a Net Worth Certificate Program much like the Garn-St Germain Depository Institutions Act of 1982 allowed for the S&L’s except it was managed and regulated much more effectively. Although some MSB’s in fact failed, it was much less in comparison with the S&L’s. The federal bank regulators used supervisory and enforcement implementation in order to limit growth and raise capital levels at commercial banks and mutual savings banks (Industry Analysis).
In response to history, congress enacted the Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA) which abolished the FHLBB and the FSLIC and gave the FDIC the sole responsibility for operating the new Savings Association Insurance Fund (SAIF) and the Resolution Trust Corporation along with the Bank Insurance Fund (BIF). The Federal Deposit Insurance Corporation Improvement Act of 1991 was also passed to change the agency’s operations since the FDIC was almost near insolvency itself in the early 1990’s.
There has been word that the FDIC may be facing the same demise as the FSLIC This is due to the BIF being economically insolvent due the market value of its accumulated insurance reserves no longer being large enough to absorb the cost of resolving known insolvencies. Many are now arguing that the FDIC is not reporting their loss in value adequately enough (Kane). The FDIC has tried to counteract these issues by increasing the FDIC insurance premiums from 8.3 cents to 12 cents per $100 of deposits in 1990 followed by an increase to 23 cents per $100 in 1991. Also that year, Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) legislation increased FDIC borrowing capacity, imposed least cost-resolution, and had too-big-to-fail procedures written into law and a risk-based premium was created. In 1993, banks began paying FDIC premiums based on their risk (CBB). The FDIC assesses risk-based insurance premiums by assigning a risk classification to each insured institution. These are adjusted semiannually to reflect the relative risk posed by the institutions. Those who present a greater supervisory risk to the FDIC pay higher premiums offsetting somewhat the risk that institutions take (Risk-Based Assessment System- Overview).
Although some people are still skeptical. They say that the FDIC already rates 10 percent of their insured institutions in the problem bank category in an industry with $2 trillion worth of deposits. There is some skepticism that unless deregulation moves to the privatization of deposit insurance, the nation will face a crisis similar to the one faced by the S&L’s and the FSLIC throughout the banking industry (Hummel).
Concludingly, it doesn’t seem likely that the FDIC will lead to the same consequences as the FSLIC. This is due to the fact that the FDIC is regulating its agencies under strict ties, all subsidiary agencies reporting back to the FDIC having a clear chain of command. They also have the ability to hire regulators and examiners who are not to be influenced or have mixed interests in the industry. They are able to effectively supervise growth of institutions as not to lead to insolvency. With an added amount of resources, the FDIC is able to provide for the legal function needed in order to enforce policies and make sure that all institutions follow the rules set for the institutions. The most important factor however is the ability to enforce the closure of insolvent institutions and enforce reserve requirements. This will back the failed institutions with real reserves and not just government funds coming out of the tax payers pockets. Lastly, since the FDIC implements interest risk premiums, this is the process by which institutions will limit their moral hazard and provide for healthier institutions with a decreased insolvency risk.
“The History of FDIC.” Community Business Bank. (2003) 15 Oct. 2003. http://www.cbbwi.com/fdic.htm.
Kane, E.J. “Deposit insurance: A feeling of deja vu.” USA Today Magazine. Jan92. Vol. 120 Issue 2560, p14, 2p.
Leggett, Keith J. “The Financing Corporation, government-sponsored enterprises, and
moral hazard.” CATO Journal. Fall97. Vol. 17 Issue 2, p179, 9p, 1.
“Risk-Based Assessment System- Overview.” FDIC. 10 Nov. 2003. http://www.fdic.gov/deposit/insurance/risk/rrps_ovr.html.
“Industry Analysis.” FDIC. 25 Oct. 2003. http://www.fdic.gov/bank.