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Regulatory Forbearance: A Reconsideration.

WILLIAM G. GISSY [*]

Critics of regulatory forbearance argue that the resulting moral hazard produces higher costs when a depository institution is ultimately resolved. This paper derives a formula for the minimal survival rate necessary to make forbearance the least cost policy. When applied to the empirical results produced by critics of the policy, it appears that the forbearance practice of the 1980s was a cost saver to taxpayers. (JEL G28)

Introduction

As Benston and Kaufman [1997] note, the end of 1990 saw the American banking industry in its worse shape since 1933. From 1984 through 1990, 8 percent of commercial banks and 25 percent of savings and loan (S&L) associations were either resolved or placed in conservatorship. The absolute number of failures was double the amount from 1934 through 1983. The debacle of the 1980s has been examined extensively (see Barth [1991], Benston [1985, 1995], Jaffe [1989], Kane [1985, 1989a, 1989b], Pizzo et al. [1989], and White [1989, 1991]). The S&L collapse was due to a myriad of factors, including economic decline in certain markets, moral hazard costs of deposit insurance, imprudent risk taking resulting from broadened asset powers, and asset growth fueled by brokered deposits. Add to this mixture varying degrees of political interference, inadequate monitoring, and out-and-out fraud, and you have a recipe for financial disaster. [1]

As is often the case, the crisis of the 1980s was due in part to the economic conditions of the previous decade. Since S&Ls were restricted by Regulation Q which set limits on the rates they could pay on their deposits, sudden increases in interest rates stimulated an outflow of funds from the industry. In addition, interest rate increases reduced the present discounted value of their mortgage portfolios. Despite last-gap efforts at deregulation, most S&Ls were economically insolvent by 1982.

Overwhelmed by the sudden influx of troubled institutions and burdened with an economically insolvent insurance fund, the Federal Home Loan Bank Board (FHLBB) reduced the number of insolvent S&Ls by lowering the requirements for legal insolvency. As noted by Leggett [1994] and Benston and Kaufman [1997], this policy of forbearance [2] was motivated by necessity in that the Federal Savings and Loan Insurance Corporation (FSLIC) lacked the capitalization to cover all insured deposits at all legally insolvent institutions. Nevertheless, these authors belong to the chorus of critics that have labeled the practice of forbearance as a dismal failure. The practice of regulatory forbearance fails to weed out institutions suffering from incompetent or corrupt management and creates a new moral hazard by placing institutions in a go-for-broke position. [3] The failure to engage in the timely resolution of insolvent institutions resulted in dramatically higher closure costs, with much of the burden falling to the U.S. taxpayer (see Barth et al. [1990], DeGennaro and Thompson [1996], Kane [1989b, 1993], and Kane and Yu [1995]). [4]

This paper challenges conventional wisdom by arguing that the practice of forbearance was a cost-saving action. Although the incremental cost of resolving an institution that was granted a period of forbearance was positive, critics fail to account for foregone costs. Not all institutions operating under the veil of forbearance had closed. The question centers on the necessary survival rate to justify the policy of delayed closure.

The second section provides a brief overview of the reregulation that resulted in response to the crisis of the 1980s. The third section derives the formula for the minimum survival rate and the fourth section applies this formula to the empirical results produced by the various critics of forbearance. The fifth section provides a summary discussion.

Farewell Forbearance?

In response to the fiasco of the 1980s, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, which replaced the FHLBB with the Office of Thrift Supervision, which was placed under the direction of the Treasury Department. Additionally, the FSLIC was replaced by the Savings Association Insurance Fund, administered by the Federal Deposit Insurance Corporation (FDIC). The responsibilities of resolving insolvent S&Ls and raising the funds to cover the costs were extended to the Resolution Trust Corporation and the Resolution Finance Corporation. However, as Benston and Kaufman [1997] note, the Financial Institutions Reform, Recovery, and Enforcement Act provided minimal changes in regulation, with most FHLBB and FSLIC personnel transferring to the Office of Thrift Supervision and the Savings Association Insurance Fund.

The problems with S&Ls coupled with the failures of some of the largest banks in Texas, New England, New York, and Illinois resulted in significant public pressure to reform the regulatory environment. The debate in political and academic circles resulted in numerous suggestions, including the elimination of deposit insurance, rolling back the deregulation of the 1980s, and the creation of narrow banks and risk-based insurance premiums. The response adopted by Congress was to reduce the discretionary power of regulators by requiring a policy of structured early intervention and resolution (SEIR). [5] The goal of SEIR is to require specific forms of intervention on a timely basis. SEIR establishes trip-wire levels for an institution's capital to assets ratio that warrant a series of mandatory and discretionary provisions. As an institution's capital to assets ratio continues to fall, the degree of regulatory intervention increases, including mandatory resolution at some specified level.

Toward the end of 1991, Congress passed the FDIC Improvement Act (FDICIA). The FDICIA established five capital to assets zones, each with a mix of mandatory and discretionary provisions. [6] The values for each zone were established by the very regulators who lobbied extensively against the legislation, claiming that it was an infringement on their discretionary authority. Because they believe the capital to assets values for each zone are too low, Benston and Kaufman [1997] view the FDICIA as limited SEIR. [7]

As presently constituted, the FDICIA still allows for substantial forbearance with respect to resolution. Only institutions in the lowest zone for five quarters are mandated to be placed in receivership, although they must be placed in conservatorship within 90 days of falling into Zone 5. Zone 3 and Zone 4 institutions are not mandated to be resolved although they are classified as undercapitalized or significantly undercapitalized. Benston and Kaufman [1997] point to this as the one central weakness of the FDICIA. Indeed, their support of rapid resolution has support in recent research by Lai [1996], Strich [1997], and Helwege [1996], although Nagarajan and Sealey [1995] produce a model with contrary results. According to the latter paper, when a bank's asset returns are influenced by market risk, a state-contingent forbearance policy can be part of a rational regulatory mechanism where risk-shifting behavior can be alleviated. These results hold in the absence of risk-adjusted deposit insurance. In essenc e, Nagarajan and Sealey produce a model that argues against the necessity of the FDICIA.

The critics of delayed resolution point to the higher costs associated with the policy. Unfortunately, the critics fail to consider the correct cost measure, net incremental cost, which would be the incremental cost of resolving institutions granted forbearance less the foregone cost of not resolving surviving institutions. In the next section, we will derive the formula for the minimum survival rate.

Minimum Survival Rate

Regulators faced with financially troubled depository institutions must make a decision to either resolve the institution now or delay closure for a specified period in hopes that the institution can improve its position. Let q be the cost of resolving the institution in period t = 0. Discounted costs increase by rate s each period and institutions are given n periods to improve their financial situation.

Let p be the overall proportion of depository institutions that will need to be resolved. We seek to solve for a survival rate v = 1 - p, where a policy of forbearance generates lower resolution costs than immediate resolution. There are two basic approaches to forbearance. The first is to wait until the end of the stated forbearance term to review the performance of the institution and make the subsequent resolution decision. The decision to extend forbearance is determined by the solution:

min([theta];p[theta][(1 + [sigma]).sup.n]). (1)

Letting [lambda] = [(1 + [sigma]).sup.n], forbearance represents the cost-minimizing strategy if p [less than] 1/[lambda]. The corresponding survival rate is given as:

v = ([lambda] - 1)/[lambda]. (2)

The alternative approach is to engage in periodic review, with resolutions occurring periodically throughout the forbearance term. Let k be the number of review periods during the term so that p/k is the proportion of institutions resolved at the end of the review period. [8] The decision to extend a period of forbearance is determined by the solution:

min([theta];(p/k)[theta][[[sigma].sup.k].sub.t=1][(1 + [sigma]).sup.nt/k]). (3)

Letting [lambda] = [[[sigma].sup.k].sub.t=1][(1 + [sigma]).sup.nt/k], forbearance provides the least cost approach if p [less than] k/[lambda]. The minimum survival rate is given by:

v = ([lambda] - k)/[lambda]. (4)

Equations (3) and (4) may be viewed as the general form while (1) and (2) represent the special case of k = 1. [9] Although l is increasing in k, v is decreasing ink. This intuitively follows since an increase in the frequency of resolution reduces the number of resolved institutions, accumulating incremental costs throughout the entire forbearance term. Although forbearance critics might argue that this result is consistent with their argument for increased supervision, it runs counter to their attacks on delayed resolutions.

How Much Survival Is Successful?

Here, the formulas for minimum survival rate will be applied to the empirical results of Kane [1989b] and DeGennaro and Thompson [1996]. This latter study examined all 952 institutions that were granted foreclosure. The former study is considered to compare the results of competing cost estimation techniques. [10] According to Leggett [1994], forbearance became a formal policy on February 21, 1986 and lasted until December 31, 1989. Critics of forbearance, however, generally argue that it was a de facto policy well before the date cited by Leggett.

Kane estimated the incremental discounted cost over the period 1982 through 1989 and concluded that forbearance resulted in costs that were 40 percent higher for an annual average increase of 5.77 percent. DeGennaro and Thompson argue that the process of resolution should have begun in 1979. They estimate incremental discounted costs from 1980 through 1994 and conclude that forbearance caused resolution costs to be 460 percent greater. However, spread over a 15-year period, this becomes a 12.19 percent annual increase.

Table 1 shows the minimum survival rates using both the Kane and the DeGennaro and Thompson estimates. The table considers five possible forbearance terms ranging from three to eight years. For each term, there are several possible values for the number of review and resolution periods. These review and resolution periods are uniformly distributed across the forbearance term.

According to DeGennaro and Thompson, of the 952 institutions granted forbearance, only 133 were operating as independent institutions by August 1994. This survival rate of 13.97 percent would seem to imply that forbearance was a failed policy as its critics contend. However, to survive forbearance means that the insurance fund is spared resolution costs that would have been incurred under immediate resolution. According to DeGennaro and Thompson, 252 institutions improved to the point where they could be successfully merged with other viable institutions at no cost to the insurance fund. If we consider this to be a form of survival, then the survival rate becomes 40.44 percent. A forbearance term of six years with two-year reviews or seven years with annual reviews would require survival rates that are less than what we experienced. If we consider any institution that is not resolved at a cost to the insurance fund, a survivor then delaying closure in order to improve an institution so that a successful merg er can occur at a future date, then that institution can be said to have survived the forbearance process.

Summary

Critics of forbearance argue that delayed resolution increases the cost of closures. What they tend to overlook are the foregone costs generated by those institutions that survive the forbearance term either by improving sufficiently to continue operations or becoming attractive to potential buyers. According to the results of DeGennaro and Thompson [1996], 40.44 percent of the institutions granted forbearance did not impose any costs on insurers. Using their cost estimates, this survival rate is sufficient to make forbearance a cost-minimizing strategy.

Although forbearance critics complain about the burden imposed on taxpayers, this burden was due to an undercapitalized insurance fund. The practice of delayed resolution produced a significant number of survivors who would have been a cost under immediate resolution. Although Benston and Kaufman [1997] are critical of loopholes in the FDICIA that allow regulators to continue with some discretion with respect to resolution, the results in this paper indicate that such discretion is justifiable.

(*.) Morehouse College--U.S.A.

Footnotes

(1.) Hunter et al. [1996] observe similar patterns for de novo S&Ls established after 1980.

(2.) According to Lai [1996], there is a technical difference between closure and forbearance. Literature often uses the former to imply the latter. DeGennaro and Thompson [1996] use the term "capital forbearance."

(3.) As Benston and Cahill [1994] note, the interest rate decline after 1982 did help in the recovery of several institutions. However, sharp economic downturns and high-risk gambles resulted in substantial new losses.

(4.) Barth et al. [1992] examine the cost implications for the commercial banking industry.

(5.) For more discussion on the development of SEIR, see Benston and Kaufman [1988, 1994a, 1994b].

(6.) The FDICIA also established risk-based insurance premiums, prohibited coverage of uninsured deposits, and significantly limited the "too big to fail" policy.

(7.) The FDICIA refers to the SEIR principles as prompt corrective action and least cost resolution.

(8.) This assumption is close to the observation in Leggett [1994].

(9.) For k = 1, (3), the general form, reduces to (1), the special case.

(10.) DeGennaro and Thompson employ the synthetic net worth method developed by Kane and Yu [1995]. The alternative estimation is the tangible net worth method.

References

Barth, J. R. The Great Savings and Loan Debacle, Washington, DC: American Enterprise Institute, 1991.

Barth, J. R.; Bartholomew, P. F.; Bradley, M. C. "Determinants of Thrift Resolution Costs," Journal of Finance, July 1990, pp. 731-54.

Barth, J. R.; Brumbaugh, R. D.; Litan, R. E. The Future of American Banking, Armonk, NY: M. E. Sharpe, 1992.

Benston, G. J. An Analysis of the Causes of Savings and Loan Failures, New York, NY: New York University Press, 1985.

___. "Society Nets and Moral Hazard in Banking," in Kuniho Sawamoto; Zenta Nakajima; Hiroo Taguchi, eds., Financial Stability in a Changing Environment, New York, NY: St. Martin's Press, 1995, pp. 329-77.

Benston, G. J.; Cahill, M. "The Causes and Consequences of the Thrift Disaster," in G. F. Kaufman, ed., Research in Financial Services, Greenwich, CT: JAZ Press, 1994, pp. 103-69.

Benston, G. J.; Kaufman G. G. Risk and Solvency Regulation of Depository Institutions: Past Policies and Current Options, New York, NY: New York University Press, 1988.

___. "The Intellectual History of the Federal Deposit Insurance Corporation Improvement Act of 1991," in G. G. Kaufman, ed., Reforming Financial Institutions and Markets in the United States, Boston, MA: Kluwer, 1994a, pp. 1-18.

___. "Improving the FDIC Improvement Act: What Was Done and What Still Needs to be Done to Fix the Deposit Insurance Problem." in G. G. Kaufman, ed., Reforming Financial Institutions and Markets in the United States, Boston, MA: Kluwer, 1994b, pp. 99-120.

___. "FDICIA After Five Years," Journal of Economic Perspectives, 11, 3, Summer 1997, pp. 139-58.

DeGennaro, R. P.; Thompson, J. B. "Capital Forbearance and Thrifts: Examining the Costs of Regulatory Gambling," Journal of Financial Services Research, 10, 3, September 1996, pp. 199-212.

Helwege, J. "Determinants of Savings and Loan Failures: Estimates of a Time-Varying Proportional Hazard Function," Journal of Financial Services, 10, 4, December 1996, pp. 373-92.

Hunter, W. C.; Verbrugge, J. A.; Whidbee, D. A. "Risk Taking and Failure in De Novo Savings and Loans," Journal of Financial Services Research, 10, 3, October 1996, pp. 235-71.

Jaffee, D. M. "Symposium on Federal Deposit Insurance for S&L Institutions," Journal of Economic Perspectives, 3, 4, Fall 1989, pp. 3-9.

Kane, E. J. The Gathering Crisis in Federal Deposit Insurance, Cambridge, MA: MIT Press, 1985.

___. The S&L Insurance Mess, Washington DC: Urban Institute Press, 1989a.

___. "The High Cost of Incompletely Funding the FSLIC Shortage of Explicit Capital," Journal of Economic Perspectives, 3, 4, Fall 1989b, pp. 31-47.

___. "Taxpayer Loss Exposure in the Bank Insurance Fund," Challenge, 36, 2, March/April 1993, pp. 43-9.

Kane, E. J.; Yu, M. "Measuring the True Profile of Taxpayer Losses in the S&L Insurance Mess," Journal of Banking and Finance, 19, 8, November 1995, pp. 1327-1502.

Lai, V. S. "The Effects of Variations in Laxity (or Strictness) of Closure Rules on the Valuation of Deposit Insurance," The Financial Review, 31, 4, November 1996, pp. 721-46.

Leggett, K. "The Consequences of a Policy of Necessity: Bank Regulatory Forbearance, 1986-1989," Journal of Economics and Finance, 18, 1, Spring 1994, pp. 1-12.

Nagarajan, S; Sealey, C. W. "Forbearance, Deposit Insurance Pricing and Incentive-Compatible Bank Regulation," Journal of Banking and Finance, 19, 6, September 1995, pp. 1109-30.

Pizzo, S.; Fricher, M.; Muolo, P. Inside Job: The Locating of America's Savings and Loans, New York, NY: McGraw-Hill, 1989.

Strich, K. J. "The Evolution of an Industry: U.S. Thrifts in the 1990s," Journal of Banking and Finance, 21, 7, October 1997, pp. 1375-94.

White, L. J. "The Reform of Federal Deposit Insurance," Journal of Economic Perspectives, 3, 4, Fall 1989, pp. 11-29.

___. The S&L Debacle: Public Policy Lessons for Banks and Thrift Regulation, New York, NY: Oxford University Press, 1991.
                          Minimum Survival Rates
n k [sigma] = .0577 [sigma] = .1219
3 1      .1548           .2918
  2      .1193           .2309
  3      .1070           .2090
4 1      .2010           .3688
  2      .1562           .2965
  4      .1325           .2561
5 1      .2446           .4373
  2      .1917           .3570
  4      .1627           .3109
  5      .1575           .3011
6 1      .2857           .4985
  2      .2298           .4128
  3      .2043           .3798
  4      .1932           .3623
  6      .1820           .3441
7 1      .3247           .5530
  2      .2586           .4642
  4      .2223           .4105
  7      .2060           .3852
8 1 .3616 .6016
  2 .2903 .5115
  4 .2504 .4555
  8 .2294 .4242
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Author:GISSY, WILLIAM G.
Publication:International Advances in Economic Research
Date:Nov 1, 2000
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