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Banks in distress: depositors must act like investors.

To the dulcet tones of Rod Serling announcing that we have just entered into the "Twilight Zone" comes the news that the nation's banking system is facing problems akin to those experienced by the savings & loan industry. In view of the fact that estimates of the total cost of the S&L bailout range from $130 billion to $500 billion|1~, this weakening of the banking system is a frightening economic prospect.

Upon close examination it is true that the thrift industry collapse and the present financial strain on the nation's commercial banking industry do possess some congruent causes. In reality, however, the two phenomena are more unalike than similar. Problems in the banking industry can be corrected without causing the enormous taxpayer cost that has already been incurred in setting the thrift industry straight. It will take the right set of policies to accomplish this more favorable outcome.

It is overly simplistic to assign total blame for the thrift industry debacle on the deregulation of the financial system that began in the early 1980s. The fact is that financial deregulation, viewed in isolation, was insufficient to cause the thrift industry failure.|2~ Deregulation did provide an important catalyst, however, in that it gave the thrift industry newfound freedom to do business in far-reaching arenas. The basic problems, then, can be attributed to a combination of three factors that surfaced as a result of this new mobility.

Multiple Factors

First, there was an erosion of management ability and integrity within the thrift industry that contradicted the more prudent standards that had previously been evidenced. Part of the present emphasis on "business ethics" that appears in the popular press and extends into the curricula of the country's business schools stems from this erosion. A specific example is that of a savings and loan institution paying rates of return significantly above that available on U.S. Treasury securities of like maturity in order to attract deposits. This practice actively sought to exploit both savers and the deposit insurance system (then the FSLIC).

Second, the exercise of corporate democracy was passive when it should have been active. Thrift institution boards of directors acted more like "boards of the directed" than the mechanism through which investors controlled management. The example here is the presence of an excessive number of "friends" on the boards of thrift institutions. These individuals occupied seats because they were big customers (depositors, borrowers, or both) of the given institution and not because of their financial acumen. When management and the board are, in effect, the same group, a central control mechanism is lost. The result for the thrift industry was that incompetent or unethical managers were not replaced and shoddy management practices continued--all to the detriment of the system.

The third factor is related to the financial regulatory system. Sadly, because of undue influence by congress, political action committees and trade associations, the regulatory agencies charged with the responsibility to monitor thrift industry practices frequently "looked the other way" from poor management decisions. As a result, weak institutions remained open and a systematic weakening that grew over the years went unchecked. The combined results of these factors were largely responsible for the failure of the industry; the cost is now being socialized across the nation's taxpayers.

These factors noted could potentially affect the commercial banking industry. Fortunately, however, the socio-political mentality of the country has changed. The present emphasis is on averting an immense taxpayer bailout of the significantly larger banking industry. Both legislators and regulators realize the enormous risks to economic stability that a financially shaky banking system implies.|3~ The result has been a much-needed and extended debate on bank reform that is reviewed later in this article.

More is required, though, than is covered within the context of the present debate. To help control the costs to other banks and society of both inefficient managements and passive boards of directors, it is necessary to inject a heavy dose of market discipline into banking markets. This requires that depositors act like bank investors. The mechanism for generating such an outcome is the focus of this article.

The Role of Banks

The traditional role of banks has been to intermediate between borrowers and depositors by converting short-term liabilities to the banks into longer term loans (their assets). Based upon an unwillingness to rely upon the forces at work in a free market environment, a series of regulatory acts were passed during the 1930s that protected banks from competitive pressures. Deposit insurance was introduced to protect depository institutions and the public from the damaging effects of bank panics. It was felt that such panics would result in depositors indiscriminately withdrawing funds from the banking system by converting bank deposits into currency.

In the post-World War II period, banks have generally prospered. Separations in product and geographic markets protected banks from competitive pressures; all the while deposit insurance increases (to the customer) raised the market value of the banking entities.

Bank deregulation instituted during the early 1980s changed that by permitting the creation of new interest-bearing consumer checking accounts and eliminated ceilings on time and savings deposit interest rates. The effect was to remove banks' virtual monopoly control over zero-interest bearing checking accounts and low-interest consumer savings deposits.

Figure One shows the shift away from banks to non-bank products that took place during the 1980s. Commercial banking assets accounted for 32 percent of the total assets of major types of financial intermediaries in 1990, compared with 37 percent in 1980. The market share of pension funds, mutual funds and money market funds also rose over the decade.|4~

Trends in Commercial Banking

The stability of the commercial banking environment has changed. During the depression era, for example, 84 banks were closed in 1937 and 81 in 1938. The decade of the 1970s, which included two recessions totaling 26 months, had an average of 8 banks failing annually. Only 10 banks failed in each of the years 1980 and 1981. By contrast, bank failures over the last five years (1987-1991) have totaled 184, 200, 206, 168 and 124, respectively. Figure Two shows the trend in bank failures for the period 1980-1991. These data suggest that current risk exposures are greater for banks and their depositors than in past decades. Of further concern is the fact that the pattern in the absolute number of failed banks is only one issue. Figure Three depicts the total assets of failed banks for the 1984-1991 period. As shown, the total assets of the 184 failed institutions in 1987 amounted to $6.9 billion. In 1988 and 1989, the assets of failed banks amounted to $35.7 billion and $29.2 billion, respectively. In 1991 the figure reached an astounding $64.3 billion. Not only are the total number of bank failures increasing at an alarming rate, but the banks that are failing are the larger institutions.

Clearly, this has placed tremendous strain on the Bank Insurance Fund (BIF). L. William Seidman, head of the Federal Deposit Insurance Corporation (FDIC) until late 1991, suggested that as many as 440 banks may fail during 1991 and 1992.|5~ The impact of such projected bank failures is estimated to cost the insurance fund $23 billion, leaving it with a deficit of approximately $6 billion at the end of 1992.|6~ Thus, the U.S. Congress in November, 1991 had no true choice except to replenish the BIF.

Bank Reform Proposals

Growing awareness of the potential for financial disaster within the banking community produced a flurry of congressional and presidential administration activity addressing the problems. There were and remain three basic issues. The first issue centers on how best to finance the deposit-insurance protection requirements in light of recent developments. This problem is the most immediate and basic. It triggered debate on all of the problems.

The second issue is whether banks can be kept more solvent by letting them participate in different lines of business (e.g., underwriting securities, selling insurance, and branching across state lines) and allowing them to become better capitalized by permitting other types of businesses to own them. The third issue concerns optimal means to guide and direct a bewildering batch of bank regulators.

Recently, there has been considerable activity looking at the whole concept of bank reform. Initially, the Treasury Department released a proposed banking reform plan on February 5, 1991. This study, some 18 months in preparation, suggested scaling back deposit insurance coverage, consolidating and realigning oversight responsibilities for the prominent banking regulators, toughening supervision and granting well-capitalized institutions the permission to enter new lines of business.|7~

On February 28, 1991, L. William Seidman, then-Chairman of the FDIC, unveiled a strategy for bolstering the Bank Insurance Fund that included the following proposals:|8~

a. Borrow $10 billion, to be repaid through a 3.5 cent premium charge per $100 of deposits.

b. Quadruple the Treasury Department's credit line to the FDIC to a maximum of $20 billion.

c. Permit the FDIC to borrow from the Federal Reserve and commercial banks.

d. Set insurance premiums according to an assets minus capital formula and build reserves to 1.5 percent of the total.

e. Allow the FDIC to issue preferred and possibly other types of stock to the public or to other agencies.

Mr. Seidman did not specify whether borrowed funds would come from the Federal Reserve or the banking industry. The Treasury's next proposal of March 21, 1991 did, however, address this "source of funds" question and immediately became the subject of controversy.

This later plan asked for a full $70 billion in borrowing authority on behalf of the FDIC. In this arrangement a $25 billion credit line would come from the Federal Reserve and another $45 billion from the Federal Financing Bank. The latter organization coordinates financing activities of Federal agencies whose financial claims are guaranteed by the federal government.|9~

More Ideas

The Bush administration attempted to initiate legislation that would permit banks to sell insurance and stocks, underwrite bonds, and allow banks to be acquired by non-banking companies. Their argument was that such measures would allow banks to diversify, attract more capital, and ultimately become more profitable. Enhanced bank profitability is a cornerstone of the "new lines of business" angle.

Congressional reaction to these proposals was mixed. It was obvious that many

politicians feared a repeat of the kind of botched deregulation that is cited as a primary cause behind the thrift industry debacle. A summary of the diversity within the congressional stance on bank reform is provided in Figure Four.

As the reform bill passed through Congress, the provisions which would have allowed banks new powers were progressively eliminated. It became apparent that the legislators were unable or unwilling to agree on the substance that bank reform should take.|10~ On November 4, 1991, the House voted 324-89 to send the legislation back to the House Banking Committee, effectively killing any hope of major bank reform prior to the 1992 general elections. Rarely do programs of this import get seriously discussed in Congress during a presidential election year.

Despite their failure to pass any significant bank reform legislation, Congress could not ignore the immediacy of the need to recapitalize the BIF. On November 27, 1991, Congress passed the FDIC Improvement Act which provided an additional $70 billion for the BIF. Rejecting most of the administration's proposals to expand banks' business horizons, the new legislation instead called for a much more stringent regulatory system. Regulators are now called upon to move more quickly to correct bank administration problems and to close banks before they become insolvent. The act limits the Federal Reserve's ability to keep sick banks alive and terminated the FDIC's authority to reimburse uninsured deposits in excess of $100,000 and foreign accounts.

It has been argued that the tougher regulatory provisions of the new bill are a political quid pro quo for the $70 billion designated to recapitalize the insurance fund.|11~ Whatever the political ramifications of the latest legislation, it is obvious that the major issues to be considered in bank reform have yet to be resolved. They will resurface, most likely, after the 1992 presidential election.

Market Discipline

In reviewing all the proposed changes to bank regulations, it is meaningful to note that any consideration of lowering the level of deposit insurance coverage below the current $100,000 ceiling per account was almost completely ignored. Between multiple account coverage and the ill-defined "too-big-to-fail" doctrine, the existing law protects virtually all deposits, regardless of size, from loss when banks fail.

Federal deposit insurance, by guaranteeing the full value of deposits, greatly reduces the threat of bank runs. By so doing, however, a very important market mechanism has been removed. Without deposit guarantees, the threat of withdrawal by uninsured depositors concerned about the safety of their deposits provides a disciplinary role by forcing banks to maintain sufficient capital and limit their risk taking.

This lack of market discipline actually encourages some banks to reduce their capital-to-asset ratios and pursue high-risk investments. Increased competition has reduced the value of bank charters in recent years, so the tendency to take more risk has increased. This failure to impose adequate regulatory discipline is reflected in the unprecedented losses and FDIC assistance stemming from recent bank failures.

If market discipline is to be restored, it must be fueled by two factors. The first is that depositors be provided with sufficient information to enable them to evaluate the performance of their banking institutions. In the current environment, there are few public sources of bank-status information and they are not readily available. For a fee, interested parties may obtain bank ratings from the Sheshunoff Group in Austin, Texas. Additionally, USA Today once a year publishes a special section which lists troubled banks by state. While the existence of these reports, both compiled from public records, suggests that some information is available, it is unlikely that the average depositor will willingly go to the effort required to obtain meaningful data.

Probe Results Are Secret

Periodically, the regulatory agencies conduct safety and soundness examinations on banks. It is an indefensible anomaly that the results of their examinations, which give rise to a system of commercial bank ratings, are kept secret from the public.|12~ Worse yet, the cost of these efforts is partially funded by U.S. taxpayers. Making these data visible would aid depositors and investors in assessing the overall stability and strength of specific banks.|13~ While both regulators and bank officers and directors are fully aware of the importance of these ratings, they are purposely kept from the public.

The aversion to publishing bank ratings rests on several positions. First, regulators fear a run by depositors who might react to a poor rating by withdrawing their funds. Over the long-term, this is exactly what should occur--bad managements should be confronted with a dearth of deposits while good managements should be rewarded with heavy (plentiful) deposits.

A second reason for not publishing bank ratings is a function of some bank officers' positions that the rating is "examiner sensitive". If this problem were pervasive, the regulatory agencies would have ceased generating the ratings long ago. A third reason cited for not publishing these ratings is the fear that such disclosure could weaken public confidence in banks that are trying to rebuild. Despite the fact that the number of American banking firms fell from almost 15,000 in 1984 to about 12,250 at present|14~, these figures, when compared to our international competitors|15~, suggest that market forces are not working effectively and that this country has far too many commercial banks. Deliberate failure to disclose bank ratings can only help to perpetuate those circumstances which circumvent normal market forces.

The idea of disclosure of these ratings is not unfamiliar to practicing bankers. In late 1991, we sent a questionnaire on regulation to a group of community and large banks. As shown in Figure Five, 52.2% of the 115 respondents favored full, public disclosure of their bank rating.|16~

Depositors Need to Get Involved

The second factor needed to restore market discipline requires that depositors have sufficient motivation to want to evaluate the management and financial strength of their banks. Proposed legislation looked at insurance on multiple accounts and the "too-big-to-fail doctrine" while failing to address the $100,000 insurance limit. It is almost as if this limit, expanded repeatedly since its inception in 1934, has become ingrained as an inalienable right in the public psyche. It now resembles an "entitlement."

Although the outcome of the various forces trying to bring about bank reform is uncertain, the general trend seems to favor relaxation of geographic and product restrictions. Key to the perceived benefit of these changes is the belief that they will allow market forces to play a much larger role in guiding bank policy and actions. Without arguing about the benefit of the self-correcting mechanism provided by the market, a central question appears to have been missed. What will be the result of a less restrictive bank regulatory environment in the absence of increased market discipline?

Nowhere in the current plethora of bank reform proposals is a vehicle that would cause the market to want to take a direct interest in the running and continual monitoring of the various institutions. Depositors have had decades to become accustomed to ignoring this factor. A deposit insurance cap of $100,000 virtually guarantees this for the majority of depositors. In the absence of a vehicle which would cause bank investors/depositors to take an active interest in the running of their banks, it is conceivable that lessening current regulatory restrictions could actually worsen the problem. The result is taxpayers are at risk.

A distrust of pure market forces has been the cornerstone of U.S. banking policy since the 1930s.|17~ Likely, this has been an error. Present public policy has proved too costly to American taxpayers and all consumers. If, however, it is now to be left to the market to produce a safer and more efficient banking industry, then all of the factors relating to the previous protective regulatory environment must be removed or altered. Heading the list of changes should be lowering the level of deposit insurance per account, thereby causing bank depositors to want to evaluate the performance of their lending institutions. Bank depositors must think like bank equity investors. Such an outcome will reduce the direct loss to taxpayers from bank failures and improve the allocation of financial capital. A less complacent bank consumer motivates a more efficient banking system.

WILLIAM G. JENS, JR., CPA, MBA, is an assistant professor of accounting at Stetson University in DeLand, Florida. Prior to teaching at the college level, he held corporate positions with Arthur Andersen & Co., Essex Chemical Corporation, and A. Duda & Sons. He is presently working on a Ph.D. in finance.

DAVID F. SCOTT, JR., Ph.D., is holder of the Phillips-Schenck Chair in American Private Enterprise, executive director of the Dr. Phillips Institute for the Study of American Business Activity, and professor of finance at the University of Central Florida. His articles have appeared in numerous publications and he has co-authored several textbooks. He is past founding co-editor of the Journal of Financial Research, associate editor for the Akron Business and Economic Review, and past associate editor for Financial Management.

1 Stephen Labaton, "Are Banks Going Down the Same Path As S&L's?," The New York Times, June 16, 1991, 1,5.

2 A useful and comprehensive review of the thrift industry's unique problems is presented by a former member of the Federal Home Loan Bank Board. See Lawrence J. White, The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation, New York: Oxford University Press, 1991.

3 Some analysts remain skeptical that a taxpayer-funded bailout of the commercial banking system can be averted. Refer to Barbara A. Rehm, "Shadow Panel of Economists Calls Bank Bailout Inevitable," Banking Week, June 8, 1992, 6.

4 Genie D. Short, Jeffery Gunther and Kelly Klemme, "A Perspective on Banking Reform," Federal Reserve Bank of Dallas, Third Quarter, 1991, 1-4.

5 Labaton, "Are Banks Going Down the Same Path...," Ibid, 1.

6 The GAO's latest projections on bank failures are in line with what Mr. Seidman originally outlined as a "pessimistic scenario" as noted by Jerry Knight, "Back to the Shoebox Under the Bed," The Washington Post National Weekly Edition, September 2-8, 1991, 19, 20.

7 Complete overviews of the Treasury's 649-page banking reform package can be found in the Wall Street Journal, February 6, 1991, A1, A6; The New York Times, February 6, 1991, A1, C6; and Investor's Dairy, February 6, 1991, 1, 34.

8 Barbara A. Rehm, "FDIC Proposes Borrowing Up To $30 Billion For Fund," Banking Week, March 4, 1991, 1, 11.

9 Kenneth H. Bacon, "The New Banking Law Toughens Regulation, Some Say Too Much," The Wall Street Journal, November 29, 1991, A1.

10 David E. Rosenbaum, "Banking Overhaul's Fate," Times, November 6, 1991, A-1, C-5.

11 Bacon, "The New Banking Law Toughens...," Ibid, A1.

12 These are known as "CAMEL" ratings. CAMEL is an acronym taken from the key components of the safety and soundness examination process. Specifically, the categories are Capital Adequacy, Asset Quality, Management, Earnings and Liquidity.

13 Analyses concerning the public release of bank ratings are found in D.F. Scott, Jr., R.E. Spudeck, and W.G. Jens, Jr., "The Secrecy of CAMELS," The Bankers Magazine, September-October 1991, 47-51; and "Give Public Access to Taxpayer-Funded Secret Bank Rating System," Challenge: The Magazine of Economic Affairs, November-December 1991, 58-60, by the same authors.

14 L.J. Davis, "The Great Bank Holdup", Investment Vision, April/May 1991, 35-41.

15 Nicholas F. Brady, Secretary of the Treasury, in a speech at the annual convention of the Securities Industry Association on November 30, 1990, compared the 12,300 commercial banks in the United States to Japan's 150, the United Kingdom's 550, Canada's 65 and Germany's 900. L.J. Davis (see Endnote 12 above) corroborated this by noting that there are 63,00 people for every bank in France, 86,000 in Great Britain, and 18,000 in Japan. The United States, by comparison, has 7,300 citizens per bank and Citicorp, the largest banking company in the country, claims less than 1% of the total depositors. See Nicholas F. Brady, "The Need for Reform in the Financial Markets," Treasury Bulletin, Winter Issue, March, 1991, 3-6.

16 The complete questionnaire can be obtained by writing the authors.

17 See Short, Gunther, and Klemme, "A Perspective on Banking Reform," Ibid, 4.
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Author:Jens, William G., Jr.; Scott, David F., Jr.
Publication:Business Forum
Date:Sep 22, 1992
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