The S&L crisis: bad people or bad policy?
Published September 1, 1990 | September 1990 issue
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. taxpayer.
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.