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The S & L Debacle: Public Policy Lessons for Bank and Thrift Regulation.

The savings and loan crisis is one of the most poorly understood economic problems that we face today. It has been misconstrued by economists, by politicians, and by the general public. Economists with a conservative bent have tended to blame the problem on a deposit insurance system providing risk-free funds for S&L owners to speculate with. More liberal economists have faulted economic deregulation and the laissez-faire philosophy of Reaganomics for the excesses that led to the S&L debacle. Politicians have held the thrift industry responsible for the crisis, and as a result, have imposed financial penalties on solvent S&Ls. Finally, the general public has been misled into believing that fraud and mismanagement caused the S&L debacle, and that taxpayers must now bail out the industry.

Into this intellectual wasteland come two books which correctly pinpoint the causes of the S&L crisis, and which also make a number of effective policy recommendations.

On most substantive issues Barth and White are in accord. They agree that deregulation did not cause the savings and loan debacle. Rather, problems stemmed from requirements that savings and loans take in short-term liabilities (deposits) and make long-term investments at fixed interest rates. Barth and White also agree that adequate capitalization is the key to a healthy thrift industry. They both fault accounting procedures which hide rather than illuminate the problems of individual S&Ls. Both authors also blame the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) for not providing the necessary funds to clean up S&Ls, and for imposing excessive financial penalties on the industry. Such penalties in effect reduce the profitability of S&Ls that did not engage in any excesses during the 1980s and that remain profitable.

Despite these points of agreement, the two books part company in several ways. Barth provides a wonderful historical account of savings and loan institutions, starting from the 1800s when the first S&L--the Oxford Provident Building Association--was formed in Pennsylvania by a pool of Investors to provide a source of funds for a subset of its members to purchase homes.

Rejecting deregulation and fraud as causes of the S&L fiasco, Barth identifies several different factors which jointly contributed to the demise of S&Ls. First, the institutional fact that S&Ls traditionally relied on savings account deposits of short maturity to finance home mortgages of longer maturities in one local geographic region. This made S&Ls vulnerable to sharply increasing interest rates during the late 1970s and early 1980s, and to deteriorating real estate values in regional markets during the late 1980s. Making matters worse, financial deregulation resulted in greater competition from other financial service industries as well as greater competition among S&Ls. This exerted a downward pressure on profits in the entire thrift industry. Finally, the moral hazards associated with Federal deposit insurance allowed those S&Ls in financial difficulty to gamble with taxpayer assurances that deposits were protected.

Barth makes three main policy recommendations. First, S&Ls must be allowed greater flexibility to respond to changes in the marketplace. They must not be hindered by regulations limiting the products they can offer, the geographic area they can operate in, or who can own them. Second, to reduce the moral hazard problem and protect the taxpayer as much as possible, depository institutions must be adequately capitalized. This means that the capital of depository institutions must be accurately measured, and that undercapitalized institutions be quickly closed or reorganized. Finally, and perhaps most important, a healthy and prosperous economy is required for a healthy and prosperous thrift industry.

Inexplicably, Barth concludes that deposit insurance is the single unifying cause of the S&L crisis. Such a conclusion is unwarranted under Barth's own analysis, which puts responsibility elsewhere. Blaming deposit insurance also conflicts with Barth's policy prescriptions, which suggest raising capital requirements rather than reducing or eliminating deposit insurance.

White provides additional arguments that deposit insurance did not cause the S&L crisis. He notes that deposit insurance problems for savings and loans did not develop until the 1980s, and so insurance is not likely to be the real problem. In addition, deposit insurance was not a problem in the 1980s for other depository institutions. Consequently, White strongly opposes any reduction in deposit insurance as likely to lead to runs on banks, and therefore resulting in more harm than good.

For White, the central causes of the savings and loans crisis were inadequate regulation and insufficient capital requirements. White distinguishes economic regulation, which he opposes, from safety regulation, which is necessary to protect the taxpayers who ultimately insure the deposits in savings and loans. Between 1981 and 1984 the number of thrift examiners and thrift supervisors was reduced, as was the number of examiners and supervisors per $1 billion of thrift assets. Compounding matters, in 1983 the headquarters of the 9th district Federal Home Loan Bank System moved from Little Rock to Dallas. Besides the disruption of moving, which led to a one-third reduction in the number of examinations in the district, less than one-quarter of 9th district supervisory personnel made the move. Thus, the Dallas office had to be restaffed with inexperienced regulators. White thinks it is no coincidence that the largest and most serious S&L problems occurred in the 9th district.

An additional problem is that S&L regulators possess inadequate information about the financial status of these institutions. Generally accepted accounting principles (GAAP), which employ historical asset valuation, create the following problem. Those assets which have increased in value get sold, with the gain reported as profits; but those assets which have declined in value are kept and their value reported at cost. With such an accounting system it is impossible for regulators to determine the true value of any S&L.

But White goes even further than this, and holds that regulators need more information than the current value of S&L assets. Financial solvency is also a function of S&L exposure to various risks. Regulators thus need to receive dynamic accounting information, the results of "what if" simulations, which would allow them to assess the exposure of banks to changes in economic activity and interest rates. Those S&Ls likely to become insolvent due to changes in interest rates, real estate values, or regional economic circumstances should be assessed higher deposit insurance premiums in order to protect the taxpayer from having to assume all the risks of insolvency.

As important as accurate accounting information is, adequate capital standards for savings and loans is even more important according to White. Prior to 1980, the minimum net worth standard for thrifts was set at 6 percent. The Depository Deregulation and Monetary Act of 1980 let the Federal Home Loan Bank Board set minimum net worth standards anywhere between 3 percent and 6 percent. The Bank Board proceeded to reduce the net worth requirement to 4 percent in 1980 and to 3 percent in 1982. In addition, net worth standards involved five-year averages; therefore rapidly growing thrifts would have net worth standards significantly lower than 3 percent. Since thrift owners risk only their own capital, and since they receive all the gains of risky activities, it is no wonder that more risky loans were made by S&Ls during the 1980s. To prevent such behavior, White proposes a return to the higher capital standards in existence before 1980s. This, according to White, is the only way to prevent further S&L debacles.

Current estimates of the cost of paying depositors of failed thrifts run into the hundreds of billions of dollars. Added to this are the real resources wasted on having to clean up the S&L mess. To prevent such crises in the future it is important that we learn more about what happened to thrift institutions in the 1980s, draw the appropriate conclusions, and implement the correct policy remedies. For those wanting to learn more about the savings and loan crisis--its causes, its consequences, and its potential cures--these two books are excellent places to turn.
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Author:Pressman, S teven
Publication:American Economist
Article Type:Book Review
Date:Sep 22, 1992
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