Financial Crisis: A View from the Left

[Spring Onion]

The Financial Crisis: A View from the Left

by Dan La Botz
Faced with the failure of the financial sector and the possible collapse of the economic system, Republicans and Democrats are working together feverishly to come up with a plan and find the funds to save the American financial system. The Congress that has been unable to provide adequate funding to health, education, housing, public transportation, social welfare, and environmental programs has suddenly found billions of dollars to save the banks and insurance companies. When the crisis was ours, they had had no money and no answers. When the crisis is theirs, they find both the funds and a plan.

The bankers and financiers, who fought for deregulation arguing that the free market would regulate itself, now call for government intervention to save the market from collapse. The Republicans, who have argued against virtually any social control or social distribution of wealth, have suddenly become advocates of socialization: the socialization of the economic crisis. The American people who have seen their standard of living stagnate and then decline while the banks and corporations enriched themselves are now expected to absorb the cost of the bankers' failures and losses.

Those who for years fought a national public health program for our citizens as socialism, now call for socialism for the financiers. While factories and jobs could not be saved, while homes and health care insurance were lost, the banks must now be saved. When the economy prospered the notion of sharing the abundance was unthinkable, but when the economy fails the idea of sharing the losses and the debt with the people becomes the solution.

Their Solution: State Capitalism

The financial crisis, the most serious since the Great Depression, has led the George W. Bush administration to propose measures that would suddenly transform the American economy -- and least temporarily -- into a kind of authoritarian state capitalism. To prevent the collapse of the American financial system, and the paralysis of the entire economy, the Treasury Secretary Henry M. Paulson and Federal Reserve Chairman Ben S. Bernanke propose that Congress spend hundreds of billions of dollars, though the cost might go as high as three trillion dollars, to buy up mortgages, other securities, and virtually any financial instrument that's in trouble. While the funds to carry out this operation immediately will come from lenders in China, Japan, Europe, and the Middle East, American taxpayers will ultimately have to pay for this rescue.

The result of the bailout would be that the government would virtually control many of the largest financial institutions in the country. The U.S. government and the banks of the country would suddenly be fused -- or perhaps entangled would be a better word -- into one extremely powerful political-economic entity. While the proposal does not envision state control of the economy as a long-term proposition, merely long enough to save the bankers, still the impact of the current proposals now being debated in Congress will be far-reaching. The American government and the people have suddenly found themselves at a turning point which was not foreseen and for which no one was prepared.

The implications of all of this cannot be predicted, though the possibilities can be explored and evaluated. We ask here: Why have the financial institutions such as Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, and American International Group (AIG) suddenly failed? Why is the economy on the verge of collapse? What options have been proposed? What role can the radical, democratic, socialist left play in responding to this crisis? What do we propose to put in the place of the existing system?

Mortgage Madness

As we are now only too well aware, banks made many bad loans to home buyers, loans that were subsequently bundled together and sold off to Fannie Mae and Freddie Mac which in turn marketed them as mortgage-backed securities, guaranteeing both the principal and the interest. The growing awareness that the mortgages and securities lacked the capital to back them up threatened a creditors' run for their money that sparked the current financial crisis. It is those insecure instruments that the American government will now acquire. Or as New York Times columnist Paul Krugman put it in his column, "Cash for Trash."

The mortgage paper, however, formed only one wing of a much larger house of cards that had arisen in the last couple of decades as financiers created new, almost entirely unregulated instruments called derivatives. While derivatives such as such options and futures (gambling on the future value of a stock or a commodity) have been part of the capitalist financial system virtually since its inception, other derivatives, such as credit default swaps, were more recent creations. Essentially a form of insurance against the failure of an investment arrived at by private contract and unregulated by the government, swaps were an attempt to hedge against the very nature of competitive capitalism. These swaps now amount to more than $60 trillion.

The Derivative Disaster

The derivates -- futures and forwards, caps and collars, options and swaps -- were all derived from the performance of some ever more distant asset. Financiers invested and speculated in these instruments both in order to skim off the value of the assets and to protect themselves from risk. All of this trading was highly leveraged, which is to say that collateral in actual assets was far, far less than the supposed value of the derivatives. A series of failures related to these derivative markets signaled a warning: the bankruptcy of Orange County in 1998 and of Long-Term Capital Management in 2000, the collapse of Amaranth Advisors in 2006, and the $7.2 billion dollar loss by Société Général in early 2008. Now the entire complex and fragile system of derivatives threatens to disintegrate.

The U.S. government deregulated the banking industry leaving many of these transactions unregulated while in other areas it reduced the amount of collateral that financial firms were obligated to hold. At the same time, an international derivative market developed, meaning that the increasingly insecure investments became part of the fabric of global financial transactions. Consequently, the crisis in mortgages and mortgage-backed securities and the possible collapse of the American financial market threatens to become a world economic crisis. With American capitalism teetering on the brink of the Second Great Depression, the theory of the self-regulating free market is dead for both conservatives and liberals.

The Failure of the Second American Century

The financial crisis rests upon a much deeper and broader crisis of American capitalism. While the linkages between one aspect of this and another can only be sketched here, the financial crisis is inseparable from several developments which have undermined the overall strength of the U.S. economy.

First of all is the cost of the Iraq War, which has cost more than a $1 trillion while the Bush administration and the U.S. Congress refused to raise taxes to pay for it. Bush is now asking Congress to raise the U.S. debt ceiling to $11.3 trillion dollars, or 79 percent of our $14.3 billion GDP, the highest since World War II. Some 24 percent of that debt is owed to foreign banks. China holds about $500 billion and Japan about $600 billion in U.S. treasuries. Saudi Arabia, Russia, and Brazil are also large U.S. creditors. The value of the dollar, however, is falling and threatens to cost U.S. creditors a lot of money, making it likely that they will invest their money elsewhere. That would mean a rise in the cost of credit in the United States, making business and government more expensive.

Second, the U.S. wars in Afghanistan and Iraq, which were intended to solidify the dominance of the United States for a second American Century, have failed. If the U.S. commanded the Middle East and Central Asia, it would have had its hand on the petroleum spigot giving it a tremendous advantage over Europe, Japan, and China. But the wars have dragged on for years and the United States has failed to impose its will in Iraq, and is mired in a mess in Afghanistan, and has been impelled by its failure there to expand the conflict into Pakistan. Consequently none of the geopolitical and petroleum benefits have materialized. Thought it may not immediately be apparent, the failure of the U.S. in these wars means effectively the failure of a U.S.-dominated world empire. It also means the opening of a new era of world imperialism as the great powers and near-great powers struggle to dominate the world market and global politics through economic might, political intervention, diplomacy, and war.

Petroleum Problems

Third, all of this has been taking place as world petroleum resources dwindled and refining capacity became a problematic bottleneck leading to a rise in fuel prices that dramatically impacts the real economy. Not only the obvious sectors like airlines and truckers or plastics and chemical manufacturers, but every aspect of American and world business has been affected. The fuel costs for ships that carry the containers in which world commerce moves have risen to levels that begin to inhibit trade.

Global Expansion -- National Decay

Finally, the globalization of the world economy, including world production, has meant a complete transformation of American society. The system of industrial production, labor union contracts, social welfare, and consumerism as well as the corporations, communities, and broader society of the United States have been altered in ways that make the country today virtually unrecognizable to someone who grew up in the 1960s or 1970s. Education, health, housing, and social welfare have all failed to keep pace with the demands of the contemporary global economy. Or put differently, the U.S. has competed by degrading resources committed to education, health, housing and social welfare which made it immediately more competitive while simultaneously and grotesquely corroding the foundations of our society, and probably also its ultimate competitiveness, not to mention the degradation of our humanity. The disjuncture between world economic expansion and the decay of the national physical and social infrastructure represents an obstacle to American economy supremacy.

China, India, and Brazil, the three largest developing economies, wrestle with the same issue of the disjuncture between national development and insertion in the international economy, but from the point of view of their ascending economies. Europe and Japan -- after passing through serious problems in the 1980s -- have done better in maintaining equilibrium between world economic developments and their national economies, but all nations face the same problem of finding some position of social poise in a world of international competition. No industrialized nation has done as poorly in dealing with these issues as the United States where official statistics put poverty at 12 percent and other estimates at double that.

The Plan for Salvation

President Bush and Treasury Secretary Paulson have proposed a plan that would simply have the U.S. government rescue the bankers by taking off their hands the devalued assets that they hold at a cost of $700 billion. With the U.S. government taking out the trash, the bankers would have a clean house, prepared once again to make loans and finance business. The Bush plan would give the Treasury Secretary the power to hire Wall Street firms or executives to manage the newly acquired assets; if done by private firms, they would make millions as government managers. Virtually no other details of the plan have been developed and made public.

House Speaker Nancy Pelosi indicated that while the Democrats support the general thrust of the Republican plan, they will also call for Congressional oversight, for assistance to distressed homeowners, and for limits on compensation to corporate executives employed to manage the plan. According to the New York Times, ". . .Democrats said they planned to consider the bailout proposal separately from an economic recovery program that would include new public works spending, aid to states and added unemployment and food-stamp benefits." Virtually no one in business, government, or the media expresses any confidence that this broad plan will work.

Both presidential candidates, John McCain and Barack Obama, support the Paulson plan with reservations, calling for more oversight. Everyone understands that with a new administration there will have to be a re-regulation of the economy, though on exactly what terms is unclear. McCain would no doubt prefer minimal government oversight and Obama more regulatory action, yet neither candidate has developed a plan that derives from the needs of the American people.

Why the Plan Will Fail

The Paulson plan by itself will fail because it seeks only to restart the economy on the same basis, with all of the problems already touched on above. Everyone recognizes that the plan itself is not enough, but McCain's proposal of mere oversight ignores the reality of the economic disaster that has befallen us and the capitalists' need for intervention, while Obama's economic program is too moderate and too modest to have much impact on a disaster of this scope.

Even if the Paulson plan passes, the next administration will face a continued unraveling of the financial system, the persistence of recession, and the broader issues which derive from both the decline of the United States as a world power and the coming end of the petroleum-based economy, and, we should also note, the environmental crisis. What is needed is not a program aimed to save the bankers and the capitalist system, but one which begins with what we so often erroneously call the American middle class, but would be better called working people, and with the working poor, the casual laborers, and the just plain poor.

We need at once a moratorium on foreclosures, an end to adjustable rate mortgages, renegotiation of 30- and 40-year mortgages and creation of a financial program to aid struggling homeowners. We must tax the banks, insurance companies, and corporations which have profited in the course of creating the financial crisis and make them pay the costs of reconstruction of the financial system, a new system. We need to create affordable and attractive public housing to meet the needs of those who now struggle to pay market rents. We must re-regulate the financial sector and create state and social credit agencies. Still, all of this will only be a bridge over troubled waters, and we may cross the bridge only to find a rising tide on the other side.

A Socialist Alternative

The socialist alternative begins with the understanding that the economic crisis provides an opportunity to rethink and then to redo our economy and our society. While we oppose the efforts to save the capitalist system, we need to demand programs to support its victims. If we are going to spend billions and trillions of dollars to revamp the economy, then it should not be to save the bankers, financiers, and speculators who have brought us to ruin, but rather to keep people in their homes, to find them jobs, and to win them health insurance. If the government is to own things, then it should own not only financial institutions, but also productive industries and construction companies so that we might build a national rail system. If the government owns things, then we should have a national plan for the economy, elaborated through democratic institutions.

To create such a system of democratic socialism which represents the human alternative to an economic crisis suggests a political struggle, which means the building of a new political party to the left of the Democrats. To build such a party that can fight to change the direction of society and build a democratic and socialist alternative will require new social movements larger and more powerful than the civil rights and anti-war movements of the 1960s or even the militant labor movement of the 1930s. Acorn, national network of community organization that focuses on housing issues, called demonstrations around the country saying save homeowners, not bankers. Such demonstrations represent an important beginning of building such a movement.

Everything, however, starts with rejecting the idea that we should save capitalism or reform capitalism. It begins by putting human beings rather than banks at the center of our economic thinking to build a socialist society.


Dan La Botz, "The Financial Crisis: A View from the Left"
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Dan La Botz is a Cincinnati-based teacher, writer, and activist. He is the author of Rank-and-File Rebellion: Teamsters for a Democratic Union (1990), Mask of Democracy: Labor Suppression in Mexico Today (1992), and Democracy in Mexico: Peasant Rebellion and Political Reform (1995), Made in Indonesia: Indonesian Workers Since Suharto (2001) and the editor of Mexican Labor News & Analysis, a monthly collaboration of the Mexico City-based Authentic Labor Front (FAT), the Pittsburgh-based United Electrical Workers (UE), and the Resource Center of the Americas. His writing has also appeared in Against the Current, Labor Notes, and Monthly Review among other publications.

Dan La Botz, "The Financial Crisis: A View from the Left"

 

[Spring Onion]

The U.S. Banking Debacle of the 1980s: A Lesson in Government Mismanagement

By George G. Kaufman


I. Introduction

In the 1980s, the United States experienced its most serious banking crisis since the 1930s and the second most serious crisis in its 200-plus year history. The crisis affected commercial banks, savings banks and savings and loan associations (S&Ls). Between 1980 and 1991, when fundamental corrective laws were enacted, some 1,500 commercial and savings banks (insured by the Federal Deposit Insurance Corporation) and 1,200 savings and loan associations (insured by the former Federal Savings and Loan Insurance Corporation) failed and were resolved by the regulatory agencies. These resolutions represented about 10 percent of a banks at the beginning of the period and 25 percent of all S&Ls. In addition, an even larger number of institutions were in precarious financial condition at some time during this period. The costs of the failures were high, not only to the shareholders of the failed institutions, but also to the surviving institutions, which were required to pay premiums to the deposit insurance agencies,and to U.S. taxpayers, who were forced to make good on the losses after the resources of the S&L insurance fund had been exhausted. For banks, the loss to the FDIC and thus to other solvent banks was about $40 billion. For S&Ls, the loss was near $200 billion, some $150 billion of which was beyond the resources of the FSLIC and was therefore charged to U.S. taxpayers.

The losses accrued primarily to the federal insurance agencies and taxpayers rather than to depositors and other creditors because the insurance effectively guaranteed the par value of deposits up to $100,000 per account de jure and, except at some small banks, almost any amount of deposits and even borrowings de facto, regardless of the value of the bank's assets. The FDIC and the former FSLIC were funded by premiums imposed on banks and S&Ls, respectively, and both had implicit access to the U.S. Treasury that legislators were unwilling either to challenge or to make explicit until near the end of the debacle.

The crisis ended in the early 1990s, when interest rates declined, the yield curve turned steeply upward sloping, a series of rolling geographic recessions in various regions of the country came to an end, the aggregate economy slowly expanded, the real estate market bottomed out, and newly adopted legislation increased the cost of poor performance and failure to both the institutions and the regulators. By 1994, both the banking and thrift industries were in their best financial condition since the early 1960s and were realizing record profits. The number of failed and problem institutions declined sharply.

II. Background
Banking has always been a volatile industry in the United States, but until the 1930s not an unusual one.[1] The annual failure rate for commercial banks from 1870 to 1913, before the establishment of the Federal Reserve System, averaged 0.78 percent compared to 1.01 percent for nonbanks. The annual volatility of the failure rate was greater for banks, however. The relatively low failure rate existed despite a banking structure that favored failures by restricting banks to one or at best only a few offices, thus preventing them from reducing risk through geographical and product diversification.. As a result, the country had thousands of independent banks; the number peaked at 30,000 in the early 1920s. The bank failures increased sharply in the 1920s to near 600 per year, but most of the failures were very small banks. Some 90 percent of the banks had loans and investments of less than $1 million, which adjusted for inflation would be equivalent to only about $10 million currently, and would rank them among te very smallest banks. Their failure had no visible effect on national economic activity. They were primarily located in small agricultural towns in the midwest. When a recession hit these towns from the rapid fall in farm prices after the post-World War I runup, the local automobile dealer failed, the local drugstore failed, and the local bank failed.

But things changed dramatically in the 1930s at the onset of the Great Depression. Between 1929 and 1933, the number of banks declined from 26,000 to 14,000, mostly by failure. Indeed, the very first act of newly elected President Franklin D. Roosevelt was to declare a "bank holiday" and close all banks in the country for at least one week in order to prevent depositors from cashing any more of their deposits into currency. The banks were permitted to reopen if the government found them solvent. Thereafter, banking became a relatively stable industry through the late 1970s. The number of bank failures averaged only near 10 per year and the number of S&L failures was not significantly greater. Then the picture changed again.

Before analyzing the 1980s, it should be noted that both the 1930s and 1980s debacles occurred after the creation of government institutions intended to correct failings in the system that were believed to have been at the root of the problem, and in order to reduce the likelihood of large numbers of simultaneous failures in the future. The Federal Reserve was established in 1913 in the aftermath of sharp jumps in the number of bank failures in 1894 and 1907 in order to increase flexibility in the system. The Fed was to facilitate the flow of bank reserves from capital surplus to capital deficient areas, to provide micro-liquidity through the discount window to individual solvent banks experiencing temporary liquidity problems, and to provide macro-liquidity to the banking system by offsetting outflows of currency and gold. For whatever reasons, not 20 years after it was established, the Fed failed to achieve these objectives sufficiently to prevent the banking crisis of the 1930s, which was far larger, longe, and costlier than any banking crisis before the establishment of the Fed. Indeed, the Fed appears to have introduced greater rigidities at the time of the Great Depression, e.g., prohibiting the issuance of clearing house certificates and making temporary bank suspensions more difficult, than existed before its establishment.[2]

In large part as a result of the Fed's failure to prevent a recurrence of large-scale bank failures, the FDIC was established in 1934. While the Fed's decisions to provide liquidity to the banking system in order to offset depositor runs into currency were discretionary, the FDIC operated by rules that effectively eliminated the need for bank runs by unconditionally guaranteeing the par value of insured deposits regardless of the bank's financial condition. This objective was quickly realized and, combined with a more cautious set of bankers and more restrictive regulations imposed by the Banking Act of 1933, the number of bank failures dropped equally quickly and remained low for the next 50 years. However, as was true of the Federal Reserve's structure, flaws eventually appeared in the FDIC that in time led to increases in bank failures that matched the conditions in the 1930s before the introduction of deposit insurance.

III. The S&L Debacle[3]

Savings and loan institutions are traditional residential mortgage lenders. Before the introduction of deposit insurance in 1934, S&Ls made primarily intermediate three-to-five-year renewable mortgage loans. These loans were effectively variable rate mortgages with sizeable down payments. They were financed by time deposits (legally labeled share capital), which were not necessarily redeemable on demand. As a result, neither the S&Ls' interest rate nor liquidity exposures were very great.

But things changed dramatically after 1934. Public policy encouraged S&Ls to make progressively longer-term (first 20, then 25, and finally 30-year) fixed-rate mortgages with progressively smaller down payments. At the same time, the new deposit insurance program effectively increased the liquidity and shortened the maturity of their deposits. These changes increased the institutions' exposure to interest rate and liquidity risk. Indeed, the large degree of maturity (duration) mismatch by the mid1970s made the industry a disaster waiting to happen.

When interest rates increased sharply in the late 1970s as a result of inflation, the disaster occurred. Between 1976 and 1980, interest rates on three-month Treasury bills jumped from 4 percent to 16 percent and those on long-term Treasury securities from 6 percent to 13 percent. By 1982, an estimated 85 percent of all S&Ls were losing money and two-thirds were economically or market value insolvent so that, ceteris paribus, they would be unable to pay their depositors in full and on time. The negative economic net worth of the industry and the corresponding loss to the FSLIC was generally estimated to be about $100 billion,[4] although some estimates placed it as high as $150 billion. This figure represents the difference between the par value of deposit accounts (the large majority of which were less than the maximum insured $100,000 per account) at insolvent institutions and the market value of the S&Ls' assets. But the FSLIC resolved only a very small number of the insolvencies for a number of reasons, incuding:[5]

• It was overwhelmed by the large number of insolvencies, and its staff was far too small and unprepared to deal with the crisis,

• It had insufficient reserves to cover the deficits at insolvent institutions and pay off depositors at par, whether the institutions were sold, merged or liquidated,

• Formal recognition of the large losses would be a black mark on the agency's record,

• Formal recognition of the large losses and number of insolvencies might spread. fear among the public and ignite a run on all institutions that would spill over to commercial banks and even beyond to the macro-economy. Further,

• Many of the losses were "only" unrecognized paper losses; and, because interest rates are cyclical and there was a high probability that they would decline again in the not very distant future, it was hoped that waiting would restore the associations to economic solvency.

Therefore, regulators publicly denied the magnitude of the problem, argued that the problem was a liquidity rather than a solvency problem, introduced creative accounting measures to make the industry's net worth appear higher even than the already overstated book value levels (i.e., they covered up the evidence), delayed imposing sanctions on insolvent and nearinsolvent institutions, and encouraged institutions to reduce their interest rate exposure by using newly permitted variable-rate mortgages and shorter-term loans to reduce their maturity mismatch. And the regulators and the industry lucked out. Interest rates declined sharply from 1982 through 1986. This reversal in rates caused the industry's net worth to rise and by 1985 its estimated negative net worth was only about $25 billion and was expected to improve further, ceteris paribus.

But ceteris did not remain paribus for many institutions. A substantial number incurred increases in credit risk that offset the decline in interest rate risk and either prevented their net worth from increasing greatly or actually caused it to decline further. The assumption of credit risk was either unintentional, arising from severe local and regional economic recessions, or intentional, arising from calculated gambles to regain solvency.

The first and most severe regional recessions started in the mid- 1980s in Texas and the neighboring energy-producing states in the Southwest following the collapse of world oil prices. This area had experienced a strong economic surge based on sharply rising oil prices and expectations of continued price increases. Employment, income, and real estate values all increased sharply and stimulated both a rapid immigration of people in search of employment and a building boom, particularly in commercial real estate. Much of this boom was financed by local S&Ls. When oil prices not only failed to increase further after 1981, but declined sharply from $30 a barrel in 1985 to near $10 in 1986, the bubble burst.[6] As incomes and real estate values dropped, borrowers defaulted on loans, and collateral values fell too fast for many lending S&Ls to protect the value of all their loans. As a result, many S&Ls became insolvent.

At the same time, a number of institutions, particularly those that had only recently converted from mutual ownership (which was the prevailing form of ownership) to stock ownership in order to raise additional capital more easily, became tempted to "gamble for resurrection." Because these institutions had little if any market value capital of their own to lose, this was a logical strategy. If the high-risk bets paid off, the institution won and possibly regained solvency. If the institution lost, the FSLIC bore the loss. That is, heads the institution won, tails the FSLIC lost! Some S&Ls placed progressively larger bets on the table by offering above market interest rates on deposits so that their deposit size grew rapidly. Such gambling was often accompanied by fraud, either ex-ante deliberate or ex-ante inadvertent through excessive carelessness in extending and monitoring loans. Particularly at the more rapidly growing associations, loan documentation was frequently incomplete or even nonexistent, record eeping casual at best, and loan collection was sporadic and done with little enthusiasm. Some of the new owners were land developers, who are gamblers almost by nature. They used greatly overinflated values of their personal properties as the base for their institution's capital, and the resources of the institution as their personal "piggy banks" to finance their ventures. Losses were often not recognized on the institutions' books on a complete or timely basis, so that the institutions gave false appearances of solvency.

The National Commission appointed in 1992 to identify and examine the origins and causes of the S&L debacle concluded that: "It is difficult to overstate the importance of accounting abuses in aggravating and obscuring the developing debacle. It would have been difficult for the process to continue for so long in the absence of an information structure that obscured the extent of the mounting losses."[7] The FSLIC economic deficit (computed as the difference between the par value of insured deposits at economically insolvent S&Ls and the market value of their assets), which had declined from some $100 billion in 1982 to near $25 billion in 1985, climbed back up to above $100 billion in 1989, almost entirely due to losses from credit risk exposure.

Commercial banks were not as badly hit by the interest rate increase in the late 1970s because the maturities on the two sides of their balance sheets were not as mismatched. But, like the S&Ls, they experienced large credit losses in the mid and late 1980s that resulted in the largest number of bank failures since the 1930s and the second largest number in U.S. history. These losses threatened to bankrupt the FDIC.

IV. Structured Early Intervention and Resolution and Deposit Insurance Reform

The S&L and bank problems were in large part caused by deposit insurance. The structure of deposit insurance adopted in 1933 had both good and bad aspects. The good aspect effectively prevented a systemwide run from deposits into currency by guaranteeing the par value of most deposits. Thus, it prevented the type of reserve drain experienced in the United States in the early 1930s.

The bad aspects were, first, that this guarantee reduced, if it did not eliminate, the incentive for many depositors to monitor the financial performances of their banks and thus encouraged both a moral hazard problem for banks and a principal-agent problem for regulators. Bank managers/ owners, knowing that few if any depositors were looking over their shoulders and that their insurance premiums were not scaled to their risk exposure, deliberately or inadvertently assumed greater risks either by increasing the credit and interest rate risk exposures in their portfolios and/or by decreasing their capital-asset ratios more than they would have in the absence of insurance. Bank regulators, knowing that most depositors had little if any incentive to flee financially troubled banks, were then able to delay imposing sanctions on troubled institutions and even resolving insolvent institutions, thereby keeping them in operation. To the extent that these institutions increased their losses, the regulators' principalshealthy, premium-paying institutions and taxpayers-were not well served.[8]

In an attempt to solve the problem, Congress at year-end 1991 enacted the FDIC Improvement Act (FDICIA), which focusses on structured early intervention and resolution (SEIR). SEIR reforms deposit insurance by attempting to impose on insured depository institutions the same conditions that the private market imposes on firms not covered by federal insurance whose financial condition is deteriorating, including conditions that the banks themselves impose on their borrowers. Moreover, it attempts to resolve troubled institutions before their own capital turns negative. Thus, losses would accrue only to shareholders, not to depositors, and deposit insurance would effectively be redundant.

SEIR's objective is also to reduce the discretion of regulators by imposing more specific rules, thus reducing the power of regulators. As such, it resembles the partial replacement of Federal Reserve discretion by FDIC insurance rules following the Fed's failure to prevent the banking crisis and economic depression of the early 1930s.[9] To protect their power, the regulators successfully fought to weaken many of the provisions reducing their discretionary authority during the legislative processing leading to the enactment of FDICIA and continued to weaken the potential effectiveness of the Act further by drafting weak regulations to implement it.[10]

V. The Lesson

An analysis of the experience of the U.S. banking debacle of the 1980s suggests that to minimize the moral hazard problem federally insured depository institutions should be subjected to the same conditions imposed by the private market on noninsured firms and that to minimize the regulators' principal-agent problem the insurer and other bank regulatory agencies should be required to operate in a transparent manner, be prohibited from providing forbearance, and be held fully accountable for their actions and inactions.

The major source of both the instability in the U.S. banking system in the 1980s that resulted in the exceptionally large number of bank and S&L failures and the associated large losses was not the private sector but the public or government sector. The government first created many of the underlying causes of the problem by forcing S&Ls to assume excessive interest rate risk exposure and preventing both S&Ls and banks from minimizing their credit risk exposure through optimal product and geographic diversification and then delayed in applying solutions to the problem by granting for-bearance to economically insolvent or near-insolvent institutions. That is, the banking debacle was primarily an example of government failure rather than market failure.


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1. A brief history and additional references appear in George J. Benston, Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane and George G. Kaufman, Perspectives of Safe and Sound Banking, Cambridge, Mass.: MIT Press, 1986, Chapter 2.

2. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960, Princeton, N.J.: Princeton University Press, 1963, Chapter 7.

3. Although savings banks have more in common with S&Ls than commercial banks, because they were insured by the FDIC rather than the FSLIC, data on them is included with that for commercial banks.

4. See Bert Ely, "Savings and Loan Crisis" in David R. Henderson, ed- Fortune Encyclopedia of Economics, New York: Warner Books, 1993, p. 72.

5. Edward J. Kane, The Gathering Crises in Federal Deposit Insurance, Cambridge, Mass.: MIT Press, 1985; The S&L Insurance Mess: How Did It Happen? Washington, D.C.: Urban Institute Press, 1989, James R. Barth, The Great Savings and Loan Debacle, Washington, D.C.: American Enterprise Institute, 1991; George G. Kaufman, "The Savings and Loan Rescue of 1989: Causes and Perspective" in George G. Kaufman, ed., Restructuring the American Financial System. Boston: Kluwer Academic, 1990; George J. Benston and George G. Kaufman, "Understanding the Savings and Loan Debacle," The Public Interest, Spring, 1990, pp. 79-95; National Commission on Financial Institution Reform, Recovery and Enforcement, Origins and Causes of the S&L Debacle: A Blueprint for Reform—Report to the President and Congress of the United States, Washington, D.C., July 1993; Martin Lowy, High Rollers: Inside the Savings and Loan Debacle, New York. Praeger, 1991; and Martin Mayer, The Greatest Ever Bank Robbery: The Collapse of the Savings and Loan Inustry. New York: Charles Scribner, 1990.

6. Paul M. Horvitz, "The Collapse of the Texas Thrift Industry" in George 0. Kaufman, ed., Restructuring the American Financial System, Kluwer, 1990, pp. 95-116.

7. National Commission, p. 9.

8. Edward J. Kane, "Changing Incentives Facing Financial-Services Regulators," Journal of Financial Services Research. September 1989, pp. 265-274 and Edward J. Kane, "How Market Forces Influence the Structure of Financial Regulation" in William S. Haraf and Rose Marie Kushmeider, eds., Restructuring Banking and Financial Services in America, Washington, D.C.: American Enterprise Institute, 1988, pp. 343-382.

9. The battle between rules and discretion in banking regulation resembles the more publicized and longer-run battle between rules and discretion in the conduct of monetary policy carried on in the U. S. at least since the 1930s.

10. George J. Benston and George G. Kaufman, "Improving the FDIC Improvement Act: What Was Done and What Still Needs to be Done to Fix the Deposit Insurance Problem" in George G. Kaufman, ed., Reforming Financial Institutions and Markets in the United States, Boston; Kluwer Academic, 1994, pp. 99-120; and Kenneth E. Scott and Barry R. Weingast, "Banking Reform: Economic Propellants, Political Impediments" in George G. Kaufman, ed., Reforming Financial Institutions and Markets in the United States, 1994, pp. 19-36.

 

[Spring Onion]

Can someone move this thread to appropriate section kindly.

I had posted it in the wrong section.

Thanks.