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Savings & Loan Regulations Create 'Win-Win' Situation for Risk-Takers

February 05, 1989|Jonathan R. Macey | Jonathan R. Macey is a law professor at Cornell University

ITHACA, N.Y. — In the midst of unprecedented economic growth, it is bewildering that so many U.S. savings-and-loans are in such dire straits. Everyone is pointing fingers at everyone else. Regulators blame bankers, bankers blame Congress and Congress blames the economy.

Recently some of President Bush's advisers seemed to blame innocent depositors. Key officials, such as Treasury Secretary Nicholas F. Brady, advocated a direct charge of 25 cents for each $100 held in federally insured commercial banks, thrifts and credit unions.

There is a clear answer to the question: "Who's to blame for the banking crisis?" Federal regulators--particularly the Federal Savings and Loan Insurance Corp.--are to blame for creating an environment where taking huge risks is the only sensible strategy for the nation's federally insured depository institutions.

S&Ls are failing in record numbers because they operate under a set of regulations that provide huge incentives to take excessive risks. When an entire industry is taking huge risks, many participants are going to come up losers.

The administration of federally insured deposit insurance is the cornerstone of the current regulatory structure. All FSLIC-insured S&Ls pay an annual premium for the privilege of offering deposit insurance. That insurance on deposits is different from all other forms of insurance: The fee bears no relationship to the underlying riskiness of an institution's activities. It is fixed at a flat percentage of deposits.

The insurance-pricing system has led to a disastrous situation because it creates a "heads I win, tails the government insurers lose" environment. S&L managers can invest federally insured money on high-risk, high-return projects. If these turn out well, the managers reap the reward. If they fail, the FSLIC is left holding the bag. If the federal insurers were acting rationally they would demand compensation for the risks they are bearing--higher insurance premiums for the less prudent S&Ls.

No private auto insurance firm would survive if it charged the same premiums to drunk drivers as safe drivers. Drunk drivers would flock to the company while safe drivers would seek firms offering them the reduced rates they deserve.

Under the current system, S&Ls on the edge of insolvency can attract massive amounts of additional money for a last-ditch gamble because of deposit insurance. Inspection of records of failed institutions shows many did indeed have a last fling with depositors' money in the hopes of hitting the jackpot.

Just as having a single price for car insurance would punish safe drivers, our system of fixed-price deposit insurance punishes safe S&Ls. Not long ago, the FSLIC increased its premiums--an inappropriate gesture, since it signals those trying to operate safely that their prudence offers no advantages.

Logic demands a deposit insurance system where premiums are based on the riskiness of the S&Ls insured. This could be done by requiring federally insured S&Ls to obtain private insurance as well, and then basing government premiums on the rate charged by the private insurer. That way, S&Ls would begin bearing the cost of excessively risky activities.

Current insurance pricing policy is nothing short of scandalous, yet it pales in comparison to the policies used to administer failed S&Ls.

Regulators have two options when confronted with an insolvent financial institution. The deposit payoff is the old-fashioned approach--envisioned by Congress when it began insuring deposits in 1934. In a deposit payoff, the federal insurer closes the failed S&L and makes payments to insured depositors up to the $100,000 insurance limit. The FSLIC then sells the S&L's assets. Creditors, including uninsured depositors, receive their share as assets are sold. The advantage of this option is that large uninsured depositors--sophisticated investors--have an incentive to make sure their funds are not subjected to unnecessary risks.

Unfortunately, large depositors are also politically sophisticated, and they have convinced regulators to refrain from closing failed S&Ls. Consequently, almost no depositor has to worry about losing money. Deposit insurance protection has been extended to all depositors in U.S. institutions, deserving and undeserving.

The FSLIC manages to bail out all the creditors of failed S&Ls by merging the assets and deposits into other institutions. All of the uninsured deposits simply become liabilities of the merged firm.

The FSLIC claims it uses mergers rather than liquidations to handle failures because mergers are cheaper. This is not true. Mergers contain promises requiring the FSLIC to repurchase assets acquired in the merger that later go into default. For other assets, the FSLIC has guaranteed a certain rate of return to the acquirer under so-called yield-maintainance agreements. These agreements are set to insure a substantial rate of return on any assets not resold to the FSLIC.

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