S&Ls: Insuring a Crisis


Will deregulation survive the savings and loan disaster? When the thrifts were partly freed from government control, starting in 1980, some went on an orgy of bad investments, self-dealing, and outright looting. The total waste could easily reach $300 billion, a charge of $1,200 on every man, woman, and child in the United States. Even worse, sensible steps to avert this disaster ran into resistance from Reagan White House officials who invoked the cause of deregulation.

Ed Gray, the former chief regulator of the savings and loan industry, feuded bitterly with the Office of Management and Budget and his archenemy, White House Chief of Staff Donald Regan, in attempts to increase his corps of thrift examiners. "You don't understand the purpose of the administration," he says he was told. "We want to get government off the back of business. We ought to be reducing the number of examiners, not increasing them." Gray, a press spokesman and writer for Ronald Reagan during seven years of his California governorship and the press secretary for the 1980 presidential campaign, was attacked as a "reregulator."

The foes of Reaganomics are busily exploiting the thrift debacle to discredit the entire policy of deregulation. But the real cause of the disaster was the failure to deregulate consistently. A series of statutes removed controls on thrift owners while increasing their government subsidy, federal deposit insurance. The 1980 act that started the erosion of government controls, to a large extent quite properly, also more than doubled the maximum size of accounts covered by the deposit insurance funds, from $40,000 to $ 100,000. With this backing, depositors had no need to worry about the safety of their S&Ls.

Deposits chased the highest interest rates, helped by the burgeoning deposit brokerage industry. The riskiest thrifts offered the highest rates and raked in brokered deposits from around the country. (It may have helped that the largest of the deposit brokers was Merrill Lynch, Donald Regan's former employer.) The government picked up the risk, all $300 billion worth.

Deposit insurance turned incentives upside down, so that the worst thrifts in the country were also the fastest growing. Market discipline completely vanished, as the earliest critics of the program had predicted they would. It was for this reason that Franklin Delano Roosevelt had threatened to veto the establishment of the Federal Deposit Insurance Corporation back in 1934.

The S&L rescue plan does nothing to change the perverse incentives of deposit insurance, and U.S. Treasury officials pooh-pooh the potential of market discipline for keeping bankers honest, so this crisis contains the seeds of the next one. The substantial minority of troubled banks, estimated at 1,000 out of 13,000 covered by federal guarantees, may well do to the Federal Deposit Insurance Corporation what the defunct thrifts did to the Federal Savings and Loan Insurance Corporation—drive it bankrupt.

The other great lesson of the thrift crisis, the distinction between regulation and supervision, has also been slow to penetrate Washington. When Ed Gray asked for more examiners, he was doing more to protect free-market forces than were the false deregulators who opposed him. The principle here involves the flow of information. Unlike any other industry in the country, banks and thrifts have the power—in fact, the legal obligation—to conceal their true condition from the public. Their business is making loans, but neither they nor their federal supervisors are allowed to divulge details about the quality of those loans. In fact, examiners can be penalized heavily for breaching confidentiality.

This fetish of bank secrecy is supposed to maintain public confidence and protect against bank runs, but the impact could be quite the opposite. By making it difficult for depositors to distinguish between sound institutions and shaky ones, in a time of stress this secrecy could foster a general financial panic.

By denying the public access to this information, the government further insulates banks and thrifts from market discipline. In return, the regulators provide the far inferior alternative of regular examinations. Four separate federal bureaucracies and their equivalents in each state send out examiners to pore over ledgers and loan portfolios. By most accounts, the examiners have done a better job than anyone had a right to expect, given their limited resources, but their findings never reach the public. Reports go to the senior regulators, who are supposed to use their supervisory powers to control bad management and kick out the crooks. The most dramatic failures have been at the senior level.

At the beginning of deregulation, there were some, including senior regulators such as Ed Gray, who warned that the relaxation of government control should be accompanied by an increase in supervision and a limit on the subsidy of federal deposit insurance. Instead, the White House and Congress pursued the disastrous course of increasing the subsidy and encouraging corrupt political interference with the supervisors.

None of the thrift losses could have occurred under true deregulation. The perverse incentives of deposit insurance could have been reduced even without eliminating the program. All that one had to do was restrict coverage to $100,000 an individual, rather than the current limit of $100,000 per individual per bank. The stricter limit would drive the deposit brokers out of the business and force large depositors to exercise extreme care in placing their money.

The information flow could, and should, be greatly expanded by publishing examination summaries. In the absence of bloated deposit insurance, the marketplace would do the rest. The industry lobby would fight these measures tooth and nail, because they would quickly drive the frauds and crooks out of business. But that is what market discipline is all about.

James Ring Adams is a former member of The Wall Street Journal editorial page and author of The Big Fix: Inside the S&L Scandal, published by John Wiley & Sons.