S&Ls: Sharpen up the Shears

On January 10, 1989, shortly before unveiling the Bush administration's plan for bailing out the bankrupt Federal Savings and Loan Insurance Corp. (and the hundreds of insolvent savings and loan institutions FSLIC "insured"), Treasury Secretary Nicholas Brady told congressional leaders that "curtailing deposit insurance is not an option and will not be considered."

Since then, cost estimates for the total S&L bailout have ballooned—to well over $2,000 for every U.S. taxpayer—with no end in sight. Federal Deposit Insurance Corp. chairman L. William Seidman has warned Congress that the deposit-insurance fund for banks is "under great stress" as well. Not only are taxpayers being billed for the mistakes of the past, they remain on the hook for future loan losses by banks and thrifts. Until the current structure of unlimited, flat-rate deposit insurance for all comers is changed, taxpayers will remain vulnerable.

While the dare-to-be-cautious Bush administration prepares to release its reform recommendations after the November elections, other policymakers and financial analysts are stepping forward with calls for taxpayer protection and marketplace discipline. Within the financial industry, William Randall, chief executive of First Interstate Bank of Arizona, has proposed cutting back deposit-insurance coverage levels to somewhere between $50,000 and $75,000. (An estimated 98 percent of all deposit accounts have balances of $20,000 or less.)

Regional Federal Reserve Banks in Cleveland and Minneapolis have offered "coinsurance" plans. This approach would reduce the maximum size of deposits receiving 100-percent coverage (to $10,000 under the Minneapolis plan and $25,000 in Cleveland's version). Higher balances would receive 90-percent coverage under the Minneapolis proposal. The Cleveland plan would establish a sliding scale of 90-percent, 80-percent, and 70-percent coverage.

On Capitol Hill, House Banking Committee Chairman Henry Gonzalez (D–Tex.) has indicated that he intends to protect taxpayers from the risky lending encouraged by the deposit-insurance system. During a February 14 hearing, he called deposit insurance "government guarantees for the most affluent of society" and urged consideration of private insurance, "particularly for high-risk activities and for extended coverage beyond that provided by the federal insurance funds." Sen. Alan Dixon (D–Ill.), who heads the Senate Banking Subcommittee on Consumer and Regulatory Affairs, has advanced a proposal to generate "risk-based" insurance premiums by having the FDIC "reinsure" a small share of its portfolio in the private insurance market.

Perhaps the most popular deposit-insurance reform among lawmakers would limit coverage to $100,000 per person, instead of per account. Under the current system, a depositor can obtain virtually unlimited insurance by maintaining multiple accounts at different institutions. Even Treasury Secretary Brady has hinted that "if you were going to start any place, that would be a place to start."

These proposals would force sophisticated investors and large depositors to monitor the health of their banks and S&Ls. Financially shaky banks will find it difficult and expensive to attract new funds or retain old accounts. This in turn would force regulators to intervene more promptly and head off further losses in insolvent operations.

These reform proposals all focus on tightening the explicit limits on deposit insurance. But one of the biggest obstacles to reform is the informal "too big to fail" policy, which provides de facto coverage for virtually all deposits, whether officially insured or not. Although the law does not mandate protection for unsecured creditors or for deposits over $100,000, the FDIC has a long history of bailing out nearly everyone. Changing this approach is a necessary condition for successful reform. All the other reform ideas will come to nought so long as the too-big-to-fail policy remains in place.

Instead of simply closing a bank and paying off insured depositors (which would impose losses on uninsured large depositors and unsecured creditors), the FDIC prefers to arrange for another ostensibly healthy bank to accept all of the deposits of a failed bank and purchase some of its assets. It then negotiates a cash payment to cover the difference between the two.

In the 1980s, the FDIC briefly experimented with "modified payoffs" that imposed losses on uninsured deposits. But it abandoned the practice when Continental Illinois National Bank failed in 1984; all of the bank's uninsured depositors and unsecured creditors were protected. Since then, the FDIC has insisted that failure of any large bank creates so much administrative complexity and financial instability that the government must protect all depositors.

Complaints that this policy discriminates against smaller institutions have led the FDIC to extend 100-percent coverage to vitually all banks and thrifts. Since 1985, the FDIC has protected 99.5 percent of the value of uninsured deposits in all closed banks. Similarly, it has provided coverage to 99.97 percent of the $62 billion in deposits in failed S&Ls since it took over these duties from the FSLIC in August 1989.

FDIC officials argue that it's nearly always cheaper to pay new investors to take over a failed bank than to shut it down and pay off the insured depositors. But such short-term cost calculations ignore the long-term impact of this policy. As the Bush administration's own fiscal year 1991 budget proposal concluded, such 100-percent de facto insurance "decreases the incentive of uninsured parties to monitor risk-taking, allowing depository institutions to take more risk and increasing the insurance funds' exposure to loss." Indeed, FDIC Chairman Seidman noted last February that "the bulk of the FDIC's costs have been incurred in large bank failures" and conceded that "costs to the insurance fund could be reduced if there is a willingness to inflict losses on large depositors."

In a report submitted to the Treasury Department last March, the American Bankers Association rejected the too-big-to-fail policy. "In a full protection environment, financial soundness is too dependent on regulatory agency performance, and as the thrift crisis demonstrated, regulatory agency performance may not be wholly reliable." The ABA complained that "current FDIC policy short-circuits market discipline in the most important place it can be applied—the market for uninsured deposits." It concluded that de facto 100-percent insurance "has made it too easy for institutions that do not manage risk effectively to attract deposits."

The ABA proposed a new regulatory procedure termed "final settlement payment." Under this proposal, the FDIC would subject the uninsured depositors and other general creditors of all banks and S&Ls to a fixed, known-in-advance loss of about 12 cents on the dollar. This "haircut" amount is based on the FDIC's average recovery rate on assets in failed banks, which has been about 88 percent in recent years.

The ABA mandatory haircut approach would alert uninsured depositors and unsecured creditors that losses are unavoidable in a bank failure; enable them to know in advance the magnitude of the loss; ensure that no bank will ever be more attractive solely because of its size; and increase the pressures for sound banking. "If investors in uninsured deposits are required to absorb their share of losses, they will do more to prevent them," the ABA report concludes.

The banking industry, of course, is under great competitive pressure these days and sees direct advantages in placing new limits on the federal safety net. As the ABA report notes, the expansive deposit guarantee "contributes to the perception and treatment of commercial banks as public utilities." Government protection of uninsured deposits requires ever-increasing worldwide regulatory intervention to control excessive risk taking.

Without some form of mandatory haircuts for uninsured depositors and creditors, other deposit-insurance reforms will either prove illusory or be blocked politically by smaller banks lamenting the "unfairness" of special treatment for large banks. The true test of the Treasury Department's forthcoming deposit insurance report will be the way in which it deals with the too-big-to-fail policy.

Unfortunately, other major participants in the interagency study coordinated by the Treasury Department have already backed away from reforms relying on marketplace discipline for uninsured depositors. Last July, Federal Reserve Board Chairman Alan Greenspan told the Senate Banking Committee that such reforms "raise serious stability concerns" and that the board considers increased capital standards and improved supervision more promising approaches. Later that month, FDIC Chairman Seidman complained to the same committee that the ABA approach would reduce the FDIC's "flexibility" in dealing with failing institutions.

What remains undeniable is that the current system of deposit insurance has failed miserably and at great expense to taxpayers. Most of the taxpayer losses suffered in the thrift industry debacle are irreversible, but future losses in the troubled banking sector can still be headed off by prompt reform.

Two factors will keep driving reluctant Washington politicians toward reform of deposit insurance. First, the unprecedented costs of the current S&L bailout are energizing taxpayers and making officials fearful of asking for more money to cover additional losses. Second, increasing competition from other international and domestic financial intermediaries makes fundamental restructuring of the U.S. financial system an urgent necessity in 1991. But expansion of bank powers across geographic and product barriers will require the political quid pro quo of new limitations on the deposit-insurance safety net. Without the assurance of market-driven haircuts on excessive risk takers, taxpayers will refuse to be scalped again.

Tom Miller is a senior policy analyst for the Competitive Enterprise Institute.