That is what the incredible
collapse of the savings and loan industry may cost U.S. taxpayers.
Recently, the public's attention and blame for this financial mess
has been focused on S&L managers who have misused federally
insured deposits for their own gain. Surely these people should
be identified and punished, but can this industry really be filled
with criminals? I think that the S&L industry has some, just
like every other industry. The majority in this industry, though,
are people just like the rest of us—people willing to take
a chance, especially if the government-created odds are in their
favor. In other words, bad people did not cause the S&L crisis,
bad governmental policy did.
The federal government set up the rules of the game—the federal
deposit insurance system—so that no one can lose but the taxpayers.
What we should do now is rewrite these rules so that those who can
benefit by taking chances are also the ones who can lose.
Federal deposit insurance has long been considered one of our
most successful government programs. Deposit insurance is something
all of us rely on to protect our hard-earned savings from the vagaries
of the marketplace. Regardless of the profitability (or lack of
profitability) of our depository institutions, as insured depositors,
we have a guarantee from our government that our funds are safe.
And deposit insurance has virtually eliminated bank runs, a recurring
problem in our banking system before 1933, when Congress established
the Federal Deposit Insurance Corporation (FDIC). How could such
a program be responsible for the S&L crisis?
The answer is found in a side effect of deposit insurance. Like
most insurance, deposit insurance creates incentives for the insured
to take on more risk than they would otherwise. In the insurance
literature, this is-known as moral hazard.
Deposit insurance, in its present form, creates an extreme type
of moral hazard. It enables insured banks to take high risk, high
expected-profit strategies with little or no risk to their owners.
Consider the following hypothetical example of such a bank. Suppose
you have $200,000 of your own money to invest in some business venture.
You decide to use half of your capital to go into the federally
insured depository business. After filling out the appropriate papers,
receiving a bank charter and becoming a member of the FDIC, you
raise $1 million in insured deposits by offering above-market interest
rates. You then proceed to invest the bank's assets at a Las Vegas
casino. Say you bet the $1.1 million at the roulette table on the
color black. At the same time, you bet your other personal funds,
$100,000, on red.
Assuming this roulette wheel has only numbers that are red or
black, you cannot lose. If red turns up, you break even: you lose
your $100,000 capital invested in the bank, but you win $200,000
at the roulette game. And depositors do not lose because their funds
are insured. The loser is the FDIC as it makes good on the $1 million
in deposits. And if it cannot, then the burden falls on the U.S.
But if black turns up, you become Banker of the Year. While you
lose the $100,000 bet you made on the color red, your bank's total
assets double to $2.2 million and your personal net worth increases
from $200,000 to $1.2 million.
This example is only meant to illustrate the nature of the problem.
Of course regulators prohibit banks from casino gambling, but there
are many permissible investments that are arguably just as risky.
Since riskier portfolios on average lead to higher profits and assuming
the risk can be diversified, we should expect insured institutions
to invest in the riskiest assets permitted.
Note, also, that by today's standards your bank would be highly
capitalized (with a 9.1 percent capital-to-asset ratio), yet that
would not reduce the moral hazard problem. You still had every incentive
to run a high-risk bank. By betting your personal funds on red while
betting the bank's on black, your own risk was perfectly hedged.
Not all types of risk can be so hedged, but most bank stockholders
should have little trouble diversifying their portfolios.
Today, virtually all deposits at banks and S&Ls are insured.
Deposits up to $100,000 per account are insured by law, and a person
can easily establish numerous insured accounts. Moreover, federal
regulators have made it clear that at least for large banks even
accounts holding more than $100,000 are insured because regulators
are unwilling to let large banks fail. Unless this deposit insurance
system is reformed or regulators find a better way to limit and
to supervise the activities of banks, moral hazard will continue
to be a serious problem. Limiting the activities of banks is probably
not feasible, as the industry is facing ever-increasing competition
at home and abroad. And, as a practical matter, I think supervision
can have only a limited effect on containing moral hazard. So deposit
insurance reform is critical.
But how, exactly, should we reform this system? After reviewing
various proposals with my colleague John Boyd in the Minneapolis
Fed's 1988 Annual Report, we concluded
that the best way to limit moral hazard in our federal deposit insurance
system is to adopt the proven techniques that private insurers use
to limit moral hazard: coinsurance. For deposit insurance, this
would mean that something less than 100 percent of accounts would
be insured; perhaps 90 percent. We also recommended that some
amount be fully insured to protect the small saver, but that each
saver be limited to one fully insured account. Consequently, beyond
the fully insured limit, depositors would have part of their savings
at risk. However, banks that choose to invest in risky portfolios
would have to compensate depositors. Depositors very risk averse
would shop for banks with safe portfolios, although these banks
would pay relatively low interest on their deposits. Depositors
less risk averse could earn higher interest rates, but only at the
riskier banks. Basically then, coinsurance is a way to make the
financial institutions and their depositors share in the costs and
the benefits of the risk they choose to incur.
Under a coinsurance system, regulators would still have to supervise
the behavior of insured institutions to protect the government's
interest. However, the market discipline that would result under
this system would contain moral hazard and protect taxpayers from
future billion-dollar bailouts.
The public's anger and energies, therefore, need to be refocused
on the real cause of the S&L crisis. Fraud has played its part;
but fraud was only a bit actor. The lead role was played by deposit
insurance. Until this character's part is rewritten, the costly
last act of this
long-running play is likely to be repeated.