Outlook
 

FALL 2005 

A Message to Our Readers 

The FDIC community extends its deepest sympathy to the victims of Hurricane 

Katrina and Hurricane Rita. The articles in this edition of the FDIC Outlook were 

prepared before the hurricanes struck the Gulf Coast. We will assess the economic 

implications of these tragic events in future editions of the Outlook. The public can 

rest assured that their federally insured deposits are fully protected—their money is 

safe in FDIC-insured institutions. 

In Focus This Quarter: 

Stroke-of-the-Pen Risk 

This issue of FDIC Outlook focuses on a special class of risks related to policy changes that arise outside the realm of banks and 

their regulation. Termed “stroke-of-the-pen” risks, these policy changes may have significant, unintended, and unexpected negative 

consequences for the U.S. banking industry. FDIC analysts explore the spillover effects that changes in monetary policy, the tax 

code, accounting rules, and other policies can sometimes impose on insured depository institutions. 

The Stroke of the Pen: A Unique Class of Risks to Insured Financial Institutions 

Risk assessment that focuses on market, credit, and operational risk may overlook stroke-of-the-pen risks that expose FDIC-insured 

institutions to a wide range of events that originate outside the financial services sector. This article introduces the concept of 

stroke-of-the-pen risk and looks at its unique applicability to the banking industry. See page 3. 

Stroke-of-the-Pen Risk: An Historical Perspective 

Risks to the banking industry have sometimes emerged from unexpected sources. This article focuses on three historic policy shifts 

that significantly affected FDIC-insured institutions: a 1979 shift in Federal Reserve monetary policy that led to dramatic increases 

in interest rates, enactment of the Tax Reform Act of 1986, and implementation of Financial Accounting Statement 125 during 

the mid- to late 1990s. The authors argue that while each of these policy changes served a clear and important purpose, each also 

contributed to a more challenging operating environment for banks that ultimately led to financial losses for a segment of the 

industry. See page 4. 

Implications of the Sarbanes-Oxley Act for Public Companies and the U.S. Banking Industry 

The unanticipated collapse of several large, high-profile corporations—including Enron, Tyco, and WorldCom—in 2001 and 2002 

contributed to a crisis of investor confidence and prompted far-reaching legislative and regulatory reform. The Sarbanes-Oxley Act 

of 2002 (SOX) represents a cornerstone of this reform effort. However, its impact on corporate America is only beginning to be 

understood. Could this monumental stroke of the pen pose risks to depository institutions? This article surveys the effects of SOX 

on public companies, including FDIC-insured institutions. See page 11. 

What Does the Future Hold for U.S. Agricultural Subsidies? 

The strong recent financial performance of the U.S. agricultural sector and FDIC-insured farm banks rests somewhat precariously 

on federal policies that heavily subsidize farm producers. This tends to make both farmers and their bankers vulnerable to a legislative stroke of the pen that might alter these policies. Pressure to cut U.S. farm subsidies has been building as a result of both the 

ongoing World Trade Organization negotiations and the presence of a large federal budget deficit. This article examines how farm 

program cutbacks might affect farmers and their lenders. See page 20. 

FEDERAL DEPOSIT INSURANCE CORPORATION 
The FDIC Outlook is published quarterly by the Division of Insurance and Research of the Federal Deposit 

Insurance Corporation as an information source on banking and economic issues for insured financial 

institutions and financial institution regulators. 

The FDIC Outlook provides an overview of economic and banking risks and discusses how these risks relate 

to insured institutions nationally and in each FDIC region. 

Single copy subscriptions of the FDIC Outlook can be obtained by sending the subscription form found on 

the back cover to the FDIC Public Information Center. 

The FDIC Outlook is available online by visiting the FDIC’s Web site at www.fdic.gov. For more information 

or to provide comments or suggestions about FDIC Outlook, please call Barbara A. Ryan at 202-898-3841 or 

send an e-mail to baryan@fdic.gov. 

The views expressed in the FDIC Outlook are those of the authors and do not necessarily reflect official 

positions of the Federal Deposit Insurance Corporation. Some of the information used in the preparation 

of this publication was obtained from publicly available sources that are considered reliable. However, the 

use of this information does not constitute an endorsement of its accuracy by the Federal Deposit Insurance 

Corporation. 

Chairman Donald E. Powell 

Director, Division of Insurance 

and Research 

Arthur J. Murton 

Executive Editor Maureen E. Sweeney 

Managing Editor Kim E. Lowry 

Editors Richard A. Brown 

Christopher J. Newbury 

Barbara A. Ryan 

Ronald L. Spieker 

Norman Williams 

Publications Managers Elena Johnson 

Geri Bonebrake 

Contact information for the FDIC’s six geographic regions: 

Atlanta Region (AL, FL, GA, NC, SC, VA, WV) 

Jack M. Phelps, Regional Manager, 678-916-2295 

Chicago Region (IL, IN, KY, MI, OH, WI) 

David Van Vickle, Regional Manager, 312-382-7551 

Dallas Region 

Midsouth (AR, LA, MS, TN): Gary Beasley, Regional Manager, 901-821-5234 

Southwest (CO, NM, OK, TX): Alan Bush, Regional Manager, 972-761-2072 

Kansas City Region (IA, KS, MN, MO, ND, NE, SD) 

John Anderlik, Regional Manager, 816-234-8198 

New York Region 

Mid-Atlantic (DC, DE, MD, NJ, NY, PA, PR, VI): Kathy Kalser, Regional Manager, 917-320-2650 

New England (CT, MA, ME, NH, RI, VT): Paul Driscoll, Regional Manager, 781-794-5502 

San Francisco Region (AK, AS, AZ, CA, FM, GU, HI, ID, MT, NV, OR, UT, WA, WY) 

Catherine Phillips-Olsen, Regional Manager, 415-808-8158 

FDIC OUTLOOK 2 FALL 2005 
The Stroke of the Pen: A Unique Class of Risks to 

Insured Financial Institutions 

Financial risk management, as practiced by depository 

institutions and many other classes of enterprises, tends 

to be based on a familiar taxonomy of risk classes. The 

three broadest and most commonly cited classes are 

credit, market, and operational risk.1 In addition to 

these categories, liquidity and solvency risks represent 

bottom-line measures of an institution’s vulnerability to 

adverse situations. Beyond this basic taxonomy, the 

recognized categories of risk tend to differ according to 

where they are applied. Reputational risk is generally of 

utmost importance to financial institutions because of 

the central role public confidence plays in their success. 

Regulatory risk assumes a prominent role for financial 

institutions because they tend to be heavily regulated. 

This issue of FDIC Outlook is devoted to a special 

class of risks that may slip between the cracks of these 

standard taxonomies. What we will call stroke-of-thepen risks share elements with regulatory risk, or the risk 

that a change in the rules governing the industry could 

impair an institution’s financial performance. However, 

our understanding of stroke-of-the-pen risks extends 

beyond changes in the regulatory rules governing banks 

and thrifts. After all, these rules are targeted to the 

concerns specific to the institutions themselves as well 

as their customers, regulators, and other major stakeholders. While changes in bank regulation usually have 

systematic effects on the banking industry, the outcomes are presumably deliberate and can be anticipated. By contrast, our conception of stroke-of-the-pen 

risks focuses on changes in policy, regulation, and 

accounting that address issues arising outside the financial services industry, but that can result in systematic 

risks to banks and thrifts. Such changes often arise in 

the political process, making them difficult to anticipate. A prime example (one that is addressed in the 

next article) is a change in the U.S. tax code. Tax 

reform has unique policy goals, related primarily to 

efficiency and fairness. Changes in the tax code may 

have implications for virtually any sector of the economy. But these implications are of particular interest to 

1 For two examples of risk taxonomies as applied to depository institutions, see Cornett, Marcia, and Anthony Saunders. Fundamentals of 

Financial Institutions Management. New York: McGraw-Hill 1999, 180, 

and Cade, Eddie. Managing Banking Risks. Chicago: FitzroyDearborn 

Publishers, 1999, 16. 

bank risk managers for two 

reasons: (1) they may have 

adverse effects that are difficult 

to minimize through geographic 

or product diversification, and 

(2) negative effects on banks or 

their borrowers may result from 

unintended or unanticipated 

consequences. 

The very term “stroke of the pen” traditionally has 

referred to policy choices or significant actions made 

unilaterally—decrees that could carry profound positive 

as well as negative consequences for certain groups or 

constituencies. U.S. presidential executive orders sometimes are referred to as stroke-of-the-pen actions 

because they are directives made by one person that 

may carry momentous implications. What our definition emphasizes is that the risk arises not so much from 

the fact that the consequences of a policy change have 

not been evaluated by the person or group that initiated it, but that these consequences have not been 

evaluated primarily in terms of their effects on insured 

financial institutions. 

In this vein, this issue examines policy changes—past 

and prospective—arising outside the realm of bank 

regulation that have led to (or may lead to) significant 

negative consequences for banks and thrifts. The first 

article is a historical look at the effects of three such 

changes: the 1979 change in Federal Reserve monetary policy targets, the 1986 Tax Reform Act, and the 

1996 implementation of Financial Accounting Statement 125 by the Financial Accounting Standards 

Board. The second article considers the more recent 

and much-discussed effects of the 2002 Sarbanes-Oxley 

legislation on U.S. corporations and financial institutions. A final article looks prospectively at risks associated with possible changes in U.S. farm subsidies that 

could result from the ongoing World Trade Organization negotiations and the U.S. budget process. While 

it is difficult to predict the types of changes that may 

come about as a result of an ongoing policy process, it 

makes sense for policymakers—and bank managers— 

to consider in advance the implications such changes 

may have for the financial condition of FDIC-insured 

institutions. 

FDIC OUTLOOK 3 FALL 2005 
Stroke-of-the-Pen Risk: An Historical Perspective
 

Insured financial institutions are vulnerable to a variety 

of risks, including credit, operational, and interest rate 

risk. For the most part, bank managers and regulators 

understand the factors and scenarios that may heighten 

these risks and therefore can develop prudent strategies 

for minimizing or mitigating a particular institution’s 

vulnerability. However, risk also may emerge from 

unexpected sources, such as changes in accounting 

standards, congressional appropriations, macroeconomic developments and enactment of federal and 

state laws and regulations. As described in the FDIC 

Outlook introduction, this exposure can collectively be 

described as “stroke-of-the-pen” risk, as a single change 

in policies relating to one area of the economy may 

bring unanticipated negative consequences for other 

sectors—including banks and savings institutions. 

This article focuses on three historical events that had 

significant implications for FDIC-insured financial 

institutions: a 1979 shift in Federal Reserve monetary 

policy that led to dramatic increases in interest rates; 

enactment of the Tax Reform Act of 1986; and implementation of Statement of Financial Accounting Standards No. 125, Accounting for Transfers and Servicing of 

Financial Assets and Extinguishments of Liabilities. 

Although significant debate and deliberation occurred 

before these changes were enacted, their implications 

for insured institutions may not have been fully understood at the time. Overall, the effects of these regulatory, legislative, and accounting changes have been 

positive; however, some specific provisions complicated 

the operating environment for banks and thrifts. 

A Shift in U.S. Monetary Policy 

During the late 1970s, the U.S. economy was characterized by high levels of inflation, interest rates, and 

unemployment, a condition referred to by economists 

as “stagflation.” While a series of energy price shocks 

had contributed to rising inflation during the 1970s, by 

the end of the decade there was also recognition that 

reforms were needed in the way the Federal Reserve 

conducted monetary policy.1 The Federal Reserve’s 

policy had been to target—or to seek to preserve 

stability in—the level of short-term interest rates, 

1 See Black, Robert P. March/April 2005. Reflections on the October 6, 

1979, Meeting of the FOMC. Review—Federal Reserve Bank of 

St. Louis, vol. 87, no. 2, 307. 

with the expectation that doing so 

would stabilize 

economic activity. 

However, prices 

rose and inflationary expectations 

began to become 

firmly entrenched 

in household, business, and investor 

decisions. The high inflation rate tended to distort the 

economic decisions made by all of these groups, 

impairing the overall performance of the economy. 

Because of this economic scenario, the Federal Open 

Market Committee (FOMC), in an historic session 

held on October 6, 1979, approved a fundamental shift 

in its monetary policy strategy. The new strategy 

switched the Federal Reserve’s immediate focus from 

targeting short-term interest rates to achieving stability 

in the growth of monetary reserves and, hence, the 

supply of money. This shift in operating procedure 

effectively meant that monetary policy would no longer 

attempt to cushion the blow of economic shocks, such as 

a sharp rise in oil prices, at the cost of allowing inflation 

to rise. Instead, the Federal Reserve pursued a longerterm goal of price stability by emphasizing controlled 

growth in monetary reserves and the money supply. 

The shift in policy necessitated an immediate and 

dramatic rise in U.S. short-term interest rates. The 

federal funds rate quickly rose from an already high 11.4 

percent in September 1979 to 13.8 percent in October, 

and to 17.2 percent by March 1980.2 This change in 

interest rates was deemed necessary in part to curtail 

expectations of ever-rising consumer prices, which 

increased at a year-over-year rate of 11.7 percent in 

the third quarter of 1979. 

In terms of containing inflation, the policy change was 

considered an unqualified success. The inflation rate 

peaked at 12.9 percent in the third quarter of 1980. 

Within three years, consumer price inflation fell to just 

2.5 percent.3 But the impact on the U.S. economy was 

severe. Back-to-back recessions in 1980 and 1981–82 

2 Source: Federal Reserve Board, calculated as a monthly average of
 

rates on trades through New York brokers.
 

3 U.S. Bureau of Labor Statistics, as of third quarter 1983.
 

FDIC OUTLOOK 4 FALL 2005 
Stroke-of-the-Pen Risk: An Historical Perspective 

Chart 1 Chart 2 

A Period of Low and Volatile Thrift Earnings Followed 

Immediately After the Interest-Rate Shock of 1979 

Annual Return on Assets, FSLIC-Insured Thrift Institutions 

0.8% 

0.6% 

0.4% 

0.2% 

0.0% 

-0.2% 

-0.4% 

-0.6% 

-0.8% 

1970 1972 1974 1976 1978 1980 1982 1984 1986 

Source: FHLBB, “Information for Senate Committee on Banking, Housing, and Urban Affairs,’’ 

April 1988. 

The Capitalization of the Thrift Industry Declined 

Sharply Between 1979 and 1982 

GAAP Net Worth as Percent of Total Assets, Year-End, FSLIC-Insured Thrift Institutions 

7.0% 

6.0% 

5.0% 

4.0% 

3.0% 

2.0% 

1.0% 

0.0% 

1970 1972 1974 1976 1978 1980 1982 1984 1986 

Source: FHLBB, ”Information for Senate Committee on Banking, Housing, and Urban Affairs,” 

April 1988. 

drove the U.S. unemployment rate to a post-Depression 

high of 10.8 percent by the end of 1982. It was not 

until September 1987 that the unemployment rate fell 

to where it had been when the FOMC instituted its 

October 1979 policy change. 

Perhaps less widely appreciated at the time was the 

effect that high and volatile short-term interest rates 

would have on financial institutions, particularly thrift 

institutions insured by the Federal Savings and Loan 

Insurance Corporation (FSLIC). The predominant 

business model for thrifts up to that time was to originate and hold long-term, fixed-rate mortgage loans, 

funding them primarily with savings deposits of somewhat shorter duration. Through most of their history, 

this basic strategy had produced steady, if unspectacular, 

earnings results (see Chart 1). The industry’s return on 

assets averaged 0.62 percent during the 1970s and 

measured 0.64 percent in 1979. However, by this measure, industry profitability in 1980 declined by fourfifths, to just 13 basis points. The thrift industry as a 

whole lost $4.6 billion in 1981 and $4.3 billion in 

1982.4 On a before-tax basis, an additional $1.5 billion 

a year in losses would have occurred during this period.5 

The financial problems that began for the thrift industry in 1980 coincided with the sudden spike in interest 

rates associated with the change in Federal Reserve 

policy. While the long-term mortgage assets held by 

thrifts continued to pay steady streams of interest, their 

4 Federal Home Loan Bank Board, April-May 1988. Staff Report to the 

Senate Committee on Banking, Housing, and Urban Affairs, 37. 

5 Eichler, Ned. 1989. The Thrift Debacle. Los Angeles, CA: University of 

California Press, 71. 

market value deteriorated as interest rates rose. Meanwhile, the shorter maturity deposit liabilities used to 

fund thrift balance sheets were quickly becoming much 

more expensive. As short-term deposits matured, thrift 

managers were left with an unenviable choice: to 

either liquidate their mortgage holdings and realize a 

capital loss, or fund them with market-rate deposits 

and incur operating losses as long as rates remained 

high.6 Given its relatively monolithic business model 

at the time, with its built-in vulnerability to spikes in 

interest rates, the thrift industry continued to incur 

losses as long as high interest rates persisted. Chart 2 

shows that the average net worth of the thrift industry 

declined for six consecutive years after 1979, falling by 

more than half to just 2.7 percent. By 1981 the gap 

between book value and market value of the thrift 

industry’s net worth exceeded $86 billion, making the 

industry as a whole insolvent on a market-value basis.7 

Legislators, regulators, and thrifts initiated actions in the 

early 1980s intended to limit or in some cases recoup 

the losses resulting from the interest rate spike. Congress 

passed legislation in 1980 to gradually relax the Regulation Q ceilings on deposit interest rates, so that thrifts 

could offer competitive market rates to attract and 

retain deposit funding. This move helped to solve one 

problem for the industry: disintermediation, or the 

outflow of deposits as savers found higher returns in new 

instruments (such as money market mutual funds) that 

paid market rates of return. It did not, however, solve 

6 White, Lawrence J. The S&L Debacle: Public Policy Lessons for 

Bank and Thrift Regulation. New York: Oxford University Press, 70. 7 Carron, Andrew S. 1982. The Plight of the Thrift Institutions, 

Washington, DC: The Brookings Institution, 19. 

FDIC OUTLOOK 5 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

the earnings problems resulting from rising deposit costs 

and shrinking net interest margins. The thrift industry’s 

net interest income for 1981 was a negative $1.8 billion 

(–0.28 percent of assets), which deteriorated to a negative $4.2 billion (–0.61 percent) in 1982.8 

Although the thrift industry was losing money rapidly, 

there was the possibility that a decline in interest rates 

and a steepening of the yield curve could help thrifts 

become profitable if they occurred soon. A range of 

forbearance policies enacted by federal bank and thrift 

regulators in the early 1980s were designed to give the 

industry extra time to address its financial problems. 

These policies included a lowering of regulatory net 

worth requirements, a net worth certificate program 

that helped undercapitalized financial institutions 

meet their capital requirements, and adjustments to 

accounting policies to allow institutions to defer losses 

into the future.9 

Legislation enacted in 1982 also allowed thrifts to 

engage in new types of lending activities that promised 

to boost asset yields and limit exposures to future 

interest rate spikes. These new powers included, most 

notably, the ability to fund commercial real estate 

(CRE) loans and, under certain conditions, to make 

equity investments in CRE enterprises. In the generally 

adverse financial climate facing the thrift industry at 

that time, a number of institutions significantly 

expanded their activities in these nontraditional areas. 

Nonmortgage loans held by FSLIC-insured institutions 

more than doubled as a percentage of assets between 

1982 and 1986, from 3.0 percent to 6.5 percent. But 

these new investment powers were not a panacea for 

the industry. While they helped to mitigate the interestrate risk exposures that had produced the losses of 

1980–81, they significantly raised the credit risk profile 

of many thrifts, leading to even larger problems in the 

mid- to late 1980s. 

A number of studies have documented the roles played 

by regulatory forbearance and deregulation in contributing to the eventual failure of hundreds of insolvent 

thrift institutions in the 1980s and early 1990s and the 

insolvency of the FSLIC itself in 1989.10 Some studies 

also emphasize the interest rate squeeze of 1979–1981 as 

8 Federal Home Loan Bank Board. Staff Report to the Senate Committee on Banking, Housing, and Urban Affairs, 32a.
 

9 See White. 82-83.
 

10 See Federal Deposit Insurance Corporation. 1997. Chapter 4: The
 

Savings and Loan Crisis and Its Relationship to Banking. In History of
 

the Eighties, Lessons for the Future. Washington, DC: FDIC.
 

the prime mover of the ultimate thrift industry debacle.11 A prominent role was also played by the economic 

adversity associated with the energy industry in the 

Southwest, the defense industry in New England, and 

the “rolling regional recession” that depressed commercial real estate markets and imposed large losses on 

banks and thrifts in both regions. Perhaps it is in part 

the sheer magnitude of these later losses—2,420 federally insured banks and thrifts failed between 1985 and 

1993—that tends to overshadow the role played by the 

initial interest rate shock in pushing the thrift industry 

toward its later financial problems. 

The Tax Reform Act of 1986 (Tax Act) 

The 1986 amendment to federal tax laws on real estate 

investments represents a prime example of how a policy 

change can affect financial institutions. With the 

stroke of a pen, this legislation eliminated the ability to 

offset passive losses with nonpassive income; increased 

the capital gains tax rate from 20 to 28 percent; and 

reinstated straight-line depreciation, dampening 

demand for CRE investment and putting downward 

pressure on real estate prices. Ultimately, this legislation tended to depress real estate market values in the 

late 1980s, which in turn contributed to the subsequent 

failures of financial institutions with relatively large 

concentrations in real estate development loans. 

In some sense, the Economic Recovery Act of 1981 set 

the stage for enactment of the Tax Act of 1986, as it 

lowered marginal tax rates and changed the capital 

gains rules and depreciation schedules for real estate 

investments. The 1981 Act allowed investors to recoup 

their initial investment quickly through tax losses 

alone, which resulted in real estate investments 

becoming a favored federal tax shelter. The growing 

popularity of real estate was reflected on financial 

institutions’ balance sheets. For example, in 1980, 

commercial bank real estate loans as a percentage of 

total loans was 18 percent. Five years later, this 

amount had jumped to 27 percent. 

The Tax Act of 1986 wiped out the 1981 tax advantages 

and made sweeping changes in the treatment of personal 

and corporate income. (See Table 1 for a comparison of 

11 See Benston, George J. 1985. An Analysis of the Causes of Savings 

and Loan Association Failures. Salomon Brothers Center for the Study 

of Financial Institutions Monograph Series in Finance and Economics, 

4/5, 171. 

FDIC OUTLOOK 6 FALL 2005 
Stroke-of-the-Pen Risk: An Historical Perspective 

Table 1 

Major Tax Law Provisions Affecting Returns on Commercial Real Estate Investment 

After the Economic After the Tax 

Before 1981 Recovery Tax Act of 1981 Reform Act of 1986 

Allowable depreciation life, 40 years 15 years 31.5 years 

commercial real estate 

Allowable depreciation method Straight-line 175% Declining balance Straight-line 

Passive losses deductible? Yes Yes No 

Max. ordinary income tax rate 70% 50% 38.50% 

Capital gains tax rate 28% 20% 28% 

Source: FDIC, History of the Eighties, Lessons for the Future. 

the tax changes made throughout the 1980s.) The legislation eliminated many tax deductions and tax preferences and changed the tax treatment of bad debt 

reserves and tax-exempt securities. Previously, taxpayers 

generally could use losses and credits from one activity 

to offset income from another activity. Following enactment of the Tax Act, taxpayers could not use losses and 

credits to offset income from another activity; instead, 

passive losses and credits had to apply to other passive 

income.12 CRE now became a relatively higher risk 

investment because the federal government would no 

longer share the losses of unsuccessful investments.13 

Rental real estate income earned by proprietors and 

partnerships would be treated as corporate income, and 

be fully taxed if positive. As a result, investors began to 

ask higher rents on real estate investments to compensate for higher taxes. The after-tax internal rate of return 

declined under the Tax Act; much of the difference can 

be attributed to the elimination of depreciation deductions that had been allowed under the 1981 tax bill. 

Overall, the 1986 tax legislation tended to depress real 

estate values because of changes in the depreciation 

schedule. Under the depreciation provisions in the 

1981 tax law, the after-tax return of CRE investments 

had increased relative to other assets. The Tax Act of 

1986 eliminated this favorable depreciation schedule. 

As a result, demand for real estate declined and the 

value of real estate fell. According to the FDIC’s 

History of the Eighties, Lessons for the Future, 

$16 billion was invested in real estate limited partnerships in 1985; by 1989, this amount had declined to 

12 Nixon, Hargrave, Devans, and Doyle. 1986. The Tax Reform Act of 

1986. Philadelphia: American Law Institute—American Bar Association, F-5. 

13 Passive activity is defined as any business, rental, or trade activity 

in which the taxpayer does not materially participate. 

$1.5 billion. In addition, the quality of banks’ real 

estate loans deteriorated, with nonperforming loans 

rising from 3.1 percent in 1984 to 4.8 percent in 1990 

(see Table 2). The 1980s ended with a two-year total of 

406 failed banks that held $64.9 billion in assets.14 Real 

estate losses contributed significantly to these bank failures, costing the FDIC billions of dollars in resolution 

costs and leading to the FDIC’s first annual operating 

loss. The FDIC and the Resolution Trust Corporation 

eventually became the nation’s largest real estate sales 

organizations because of the inventories acquired from 

failed banks and thrifts in areas where real estate values 

fell precipitously.15 To be sure, changes in the tax laws 

Table 2 

Nonperforming Real Estate Loans Rose 

as a Percent of Total Loans 

After 1986, As Did Net Charge-Offs. 

Nonperforming Net Charge-Offs/ 

Year Loans/Total Loans* Total Loans 

1984 3.1% 0.7% 

1985 2.9 0.8 

1986 3.1 0.9 

1987 3.7 0.8 

1988 3.3 0.9 

1989 3.6 1.1 

1990 4.8 1.4 

Note: Data are not available for years before 1984. 

*Nonperforming loans include loans 90 days past due, non-accruing loans, and repossessed real estate. 

Source: FDIC, History of the Eighties, Lessons for the Future. 

14 Annual Report of the FDIC for the Year Ended December 31, 1990, 77. 

15 The Resolution Trust Corporation was created to handle former 

Federal Savings and Loan Insurance Corporation institutions that 

became insolvent. 

FDIC OUTLOOK 7 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

were not the only—and were perhaps not the 

primary—cause of the bank and thrift losses in CRE 

loans in the late 1980s and early 1990s. However, the 

changes were a well documented contributing factor. 

This situation shows clearly the effects of a stroke-ofthe-pen legislative policy change, and reinforces the 

need for bank management to closely monitor all implications of key tax legislation. 

Statement of Financial Accounting Standards No. 

125—Accounting for Transfers and Servicing of 

Financial Assets and Extinguishments of Liabilities 16 

In 1996, the Financial Accounting Standards Board 

(FASB) issued Statement of Financial Accounting 

Standards No. 125 (FAS 125) to provide guidance for 

distinguishing between the transfers of financial assets 

that should be reported as sales and transfers that should 

be reported as borrowings. During the early 1990s, the 

FASB acknowledged that the market’s increasingly 

complicated financial assets made it difficult to determine when transferred financial assets should be 

removed from the balance sheet and a related gain or 

loss recognized, and announced efforts to develop plans 

for an approach that would achieve consistent, credible, 

and understandable financial statements. 

The FASB recognized that financial assets and liabilities can be divided into several categories, such as servicing rights, residual interests, recourse obligations, 

and pledges of collateral. When accounting for transfers 

of financial assets, particularly those related to securitizations of assets, concerns arose about whether transactions represented a sale, which would result in the 

reporting of a gain or loss on sale, or a secured borrowing. Unless accounted for correctly, securitizing assets 

can make companies appear more profitable than they 

are and overstate capital levels, while the risks that are 

often concentrated in the interests that an entity 

retains in the securitized assets may not have been 

properly considered in the measurement process. In 

another stroke-of-the-pen policy change, FAS 125 

16 In general, FAS 125 applied to transfers of financial assets occurring 

after December 31, 1996, through the end of the first quarter of 2001, 

when it was replaced by Statement of Financial Accounting Standards No. 140 (FAS 140), which applies to transactions occurring after 

March 31, 2001. FAS 140 revised certain aspects of the accounting for 

securitizations and other financial asset transfers in FAS 125 and 

required additional disclosures, but it carried over most of the provisions of FAS 125. 

required that the fair values of retained interests enter 

into the accounting for securitizations that qualified as 

sales, thereby affecting the size of the gain or loss on 

the sale. In the absence of quoted market prices, which 

was typically the case with retained interests, companies had to estimate the fair value of these interests and 

support the estimated fair value with documentation 

using reasonable and supportable assumptions. 

FAS 125 proved to be quite complicated, and it became 

clear that more guidance was needed. In September 

1998, December 1998, and July 1999, the FASB issued 

“Question and Answer” implementation guidance on 

FAS 125. In addition, in December 1999, the federal 

bank regulatory agencies issued the Interagency Guidance on Asset Securitization Activities, which included 

discussion of valuations of retained interests in securitizations accounted for in accordance with FAS 125. The 

interagency guidance emphasized the agencies’ expectation that retained interests held as assets would be 

supported by documentation of the interests’ fair values, 

using reasonable, conservative valuation assumptions 

that could be objectively verified. 

The pitfalls of inaccurately accounting for securitized 

assets were obvious in the situation of Superior Bank 

FSB.17 Starting in 1993, Superior Bank originated 

and securitized large volumes of subprime residential 

mortgages and retained residual assets that were a byproduct of the securitizations. Residual interests represent claims on the cash flows that remain after all 

obligations to investors and any related expenses have 

been satisfied.18 In 1994, Superior expanded its securitizations activities to incorporate subprime automobile 

lending. Superior’s concentrations of residual assets to 

tangible capital rose from 122 percent at year-end 

1995 to 268 percent at year-end 1999. 

Because there was not a ready market for these assets, 

Superior valued its residual interests using a model. The 

model was based on the thrift’s assumptions of default 

rates and prepayment rates on the portfolio of loans 

underlying the securitizations and discount rates.19 

According to the FDIC Office of Inspector General’s 

17 Superior Bank FSB, Hinsdale, Illinois. Superior Bank was a federally 

chartered savings bank outside of Chicago that was regulated by the 

Office of Thrift Supervision, with deposits insured by the Savings 

Association Insurance Fund. Superior Bank failed in July 2001. 

18 FDIC Office of Inspector General. Issues Related to the Failure of 

Superior Bank, FSB, Hinsdale, Illinois. Audit Report No. 02-005, 18. 

19 Ibid. 

FDIC OUTLOOK 8 FALL 2005 
Stroke-of-the-Pen Risk: An Historical Perspective 

report on the failure of Superior, the thrift booked large 

imputed gains based on liberal interpretations of FAS 

125.20 For example, the thrift used unsupported 

discount rates, and at one point lowered the discount 

rate by 400 basis points, resulting in a substantial gain. 

Superior also chose a method of accounting that did 

not require discounting of funds providing credit 

enhancement to securitizations, even though those 

funds were not immediately available to the thrift.21 

The large imputed gains augmented capital and allowed 

the thrift to continue to lend and securitize. 

In 2000, regulators noticed that, although some institutions had shown downward adjustments to reflect the 

application of the guidance in the 1998 FASB Questions and Answers, Superior’s financial data did not 

have such adjustments.22 The Office of Thrift Supervision, with FDIC participation, scheduled an on-site 

visitation in October 2000 to review residual assumptions, and the agencies focused on residuals at a subsequent examination in March 2001. After examiners 

found the thrift had not properly discounted cash flows 

and had used other unsupported assumptions, they 

determined that the thrift’s assets were overvalued by at 

least $420 million as of December 31, 2000.23 

When federal regulators required Superior Bank to 

restate its financial data, the institution was deemed 

significantly undercapitalized and failed shortly thereafter. At the time of its failure, Superior had $1.7 

billion in total assets, of which $842 million were residual assets. The failure cost to the FDIC was an estimated $426 million. 

Lessons Learned 

The business strategies, investment choices, and risk 

management decisions of financial institutions are 

necessarily based on the current economic, accounting, 

legislative, and regulatory situation, as well as the possibility that this situation may change. However, 

management can never anticipate all scenarios or the 

unintended negative consequences that could arise 

from sweeping policy changes. 

20 FDIC Office of Inspector General. Audit Report No. 02-005. 4.
 21 FDIC Office of Inspector General. Audit Report No. 02-005. 15-16.
 

22 Department of the Treasury, Office of Inspector General. February 6,
 

2002. Material Loss Review of Superior Bank, FSB. Audit Report OIG02-040, 28.
 

23 FDIC Office of Inspector General. Audit Report No. 02-005. 24-25.
 

The three historical “stroke-of-the-pen” events 

addressed in this article show the dramatic effects 

policy changes can sometimes exert on the operating 

environment of financial institutions. The 1979 shift 

in U.S. monetary policy was successful in containing 

inflation and contributed to much improved U.S. 

economic performance in the 1980s and 1990s. But at 

the time it was introduced, the full effects of this 

policy change, in tandem with other domestic and 

international economic events, were difficult, if not 

impossible, for financial institution managers and 

regulators to anticipate. Similarly, the changes 

mandated by the Tax Reform Act of 1986 brought 

about significant adverse consequences for insured 

financial institutions with exposure to CRE loans. 

The elimination or tightening of real estate tax 

deductions and preferences contributed to a serious 

downturn in the CRE market and eventually to failures of insured financial institutions with relatively 

high CRE portfolio concentrations. Finally, the 

accounting changes of FAS 125, although developed 

and implemented to improve the clarity, consistency, 

and transparency of financial statements, had the 

unintended effect of potentially complicating 

accounting procedures for securitized assets, as the 

example of Superior Bank demonstrates. 

The point of emphasizing these episodes of systemic, 

“stroke-of-the-pen” risk is not to portray them as 

unmanageable, catastrophic events. As with any other 

class of risks, bank managers assume ultimate responsibility for monitoring changes in the policy environment and managing their institutions’ exposure to these 

changes. The point is for risk managers to attempt to 

anticipate the possible consequences of policy changes 

as early as possible, and to recognize the possibility that 

such changes may have sweeping effects on their institutions. These episodes show that, despite substantial 

debate and discussion before the fact, the enactment of 

policy changes may have unforeseen effects on financial 

operations, and their negative results can be considerable. While every implication of a policy change 

cannot be known in advance, management is best 

served by a business strategy that is watchful for and 

responsive to such changes. 

Suggested Readings 

Axilrod, Stephen H. 1985. U.S. Monetary Policy in 

Recent Years: An Overview. Federal Reserve Bulletin, 

71:14-24. 

FDIC OUTLOOK 9 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

Benston, George J. 1985. An Analysis of the Causes of 

Savings and Loan Association Failures. Salomon 

Brothers Center for the Study of Financial Institutions Monograph Series in Finance and Economics, 4/5. 

Federal Deposit Insurance Corporation (FDIC). 1982. 

Annual Report of the FDIC for the Year Ended December 31, 1982. FDIC. 

Federal Reserve Bank of St. Louis. 2005. Conference 

Proceedings: Reflections on Monetary Policy 25 

Years After October 1979. FRBSTL Review 87. 

March/April 2:137-358. 

Follain, James R., Patric H. Hendershott, and David C. 

Ling. 1987. Understanding the Real Estate Provisions of Tax Reform: Motivation and Impact. 

National Tax Journal 40, 3:363-372. 

Johnson, Christian A. 2004. The Failure of Superior 

Bank FSB: Regulatory Lessons Learned. Banking Law 

Journal 121, 47:1-13. 

Neuberger, Jonathan A. 1988. Tax Reform and Bank 

Behavior. Federal Reserve Bank of San Francisco 

Weekly Letter December 16, 1-3. 

Seballows, Lynn D., and James B. Thomson. 1990. 

Underlying Causes of Commercial Bank Failures in 

the 1980s. Federal Reserve Bank of Cleveland 

Economic Commentary September 1, 1-4. 

U.S. General Accounting Office. 	Bank Regulation: 

Analysis of the Failure of Superior Bank, FSB, Hinsdale, 

Illinois. GAO/02-419T. February 7, 2002. 

Volcker, Paul A. 1981. Statement before the Committee on Banking, Housing, and Urban Affairs. Federal 

Reserve Bulletin, 67:237-241. 

Richard A. Brown, Chief Economist 

Jane F. Coburn, Senior Financial Analyst 

Christopher J. Newbury, Chief, Financial Analysis Section 

FDIC OUTLOOK 10	 FALL 2005 
Implications of the Sarbanes-Oxley Act for 

Public Companies and the U.S. Banking Industry 

The fall of several high-flying corporations, such as 

Enron, Tyco, and WorldCom in 2001 and 2002, 

resulted in the collapse of employee pension plans, a 

drastic devaluation of corporate stock, a decline in 

investor confidence, and a scrambling by legislators and 

regulators to restore the public’s confidence. These 

events prompted many to ask how these corporate 

abuses could happen. The mid-1990s had been characterized by strong corporate growth, more aggressive risk 

taking by some managers, and a generally profitable 

corporate sector, with only 70 public company bankruptcy filings in 1994. However, by the early 2000s, the 

tide had turned, and public company bankruptcies 

peaked at 257 in 2001.1 

Corporate governance generally can be defined as the 

process of managing an organization’s affairs or ensuring 

accountability. It can include a range of activities, such 

as setting business strategies and objectives, determining risk appetite, establishing culture and values, developing internal policies, and monitoring performance. 

Corporate fairness, transparency, and accountability 

commonly are viewed as goals of corporate governance. 

To some, corporate governance simply means more 

active and involved participation by the board of directors; others emphasize corporate “democracy” or 

broader shareholder participation. 

In the wake of widespread abuse and corporate scandal, 

corporate governance issues emerged as the focal point 

for reform. Lawmakers and the administration moved 

quickly to stem the damage to investor confidence with 

the enactment of the Sarbanes-Oxley Act of 2002 

(SOX). The rationale behind enactment of SOX was to 

strengthen public financial reporting, improve internal 

control processes, ensure auditor independence, and 

make corporate decision makers responsible for their 

actions. This article provides an overview of the 

SOX legislation, reviews key areas of study that have 

emerged since the legislation was enacted, assesses the 

implications and costs of SOX for public companies and 

FDIC-insured institutions, and summarizes new regulations and standards implemented as part of other corporate governance reform initiatives (see the box on page 

19, “Other Recent Corporate Governance Reforms”). 

1 Bankruptcy Week. January 10, 2005. www.BankruptcyData.com. 

Overview of the Sarbanes-Oxley Act of 2002 

Following the recent 

corporate scandals 

and the resulting 

demand for greater 

transparency and 

increased integrity 

in financial reporting, Congress and 

the administration 

wanted to help assure 

stakeholders that 

public companies were operating in a sound manner. 

Therefore, SOX provisions focus on the implementation of sound corporate governance practices. Two of 

the more frequently cited sections of SOX are Section 

404, which addresses management’s responsibility for 

establishing sound internal controls and assessing the 

effectiveness of these controls, and Section 302, which 

requires company chief executive officers (CEOs) and 

chief financial officers (CFOs) to certify the accuracy 

of company financial statements. Key provisions of the 

SOX legislation are summarized below. 

Impact of SOX on the Corporate Sector 

Three distinct areas of analysis and study have emerged 

since enactment of the SOX legislation: 1) the effect 

on compliance costs, 2) the effect on the quality of 

corporate earnings and the level of earnings management, and 3) the effect on firm and managerial behavior. Even though the research on SOX is preliminary, 

the historical impact of SOX and the effects of several 

large corporate scandals can be assessed by looking at 

changes in stock prices following certain significant 

events (see Chart 1 on page 12). 

Recent reports suggest that compliance costs for public 

companies are ratcheting upward. Financial Executives 

International (FEI), a research firm focusing on the 

business community, surveyed 217 public companies 

with average revenues of $5 billion. The survey results 

show spending on SOX-related services averaged 

$4.4 million during 2004, eclipsing the $3.1 million 

these firms expected to spend on compliance-related 

FDIC OUTLOOK 11 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

Chart 1 

Congress Passed the SOX Legislation during a Period of Corporate Scandals 

Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 

Source: Bloomberg. 

S&P 500 Index 

WorldCom 

announces it 

understated 

expenses by $3.8 billion. 

SOX passes Senate. 

SOX passes House. 

SOX signed into law. 

Enron CEO Jeff Skilling resigns. 

Market peak. 

Tyco CEO Dennis Kozlowski resigns 

and is indicted by SEC. 

700 

800 

900 

1000 

1100 

1200 

1300 

1400 

1500 

1600 

9/11 

issues.2 In addition, the results indicate that compliance 

with Section 404 of SOX has spurred most of the 

increase. About 39 percent of compliance costs are for 

external services such as consulting, while 30 percent 

are earmarked for auditing fees. A separate survey of 

Fortune 1000 firms found that these companies spent 

an average of $7.8 million on SOX compliance in 

2004.3 About a quarter of these costs were related to 

audit fees, consistent with the results of the FEI survey. 

In a widely cited research paper on the economic 

implications of SOX, Ivy Xiying Zhang of the University of Rochester measured returns to stock prices on 

key legislative dates, ranging from the introduction of 

SOX in congressional committee to enactment of the 

bill, and found a large abnormal loss for companies on 

these dates.4 Tallying the losses, Zhang’s research 

showed the net private costs of compliance with 

Section 404 were about $1.4 trillion and concluded 

that investors perceived the purchase of nonaudit 

services and investment in internal controls as costly. 

Executives have expressed mixed feelings about the 

costs and benefits of compliance with SOX. A survey 

conducted during first quarter 2005 by Foley & Lardner, 

a national law firm providing interdisciplinary services 

2 FEI Survey on SOX Section 404 Implementation. March 2005. 

www.fei.org/news/press.cfm. 3 Charles River Associates. April 2005. Sarbanes-Oxley Section 404 

Costs and Remediation of Deficiencies: Estimates from a Sample of 

Fortune 1000 Companies. www.sec.gov/spotlight/soxcomp/soxcompall-attach.pdf. 

4 Zhang, Ivy Xiying. June 2005. Economic Consequences of the 

Sarbanes-Oxley Act of 2002. AEI-Brookings Joint Center for Policy 

Research. www.aei.brookings.org/admin/authorpdfs/page.php?id=1154. 

to global corporations, shows that 38 percent of private 

company executives believe the costs equal the benefits.5 

Interestingly, 29 percent responded that the benefits 

outweigh the costs, while almost the same share (28 

percent) believe the costs exceed the benefits. Mixed 

results were also found in the FEI study cited above. 

Although 55 percent of respondents to the FEI survey 

believe SOX increased investors’ confidence with 

financial statements, the vast majority (94 percent) also 

believe the costs of complying with SOX exceed the 

benefits. Finally, a survey by the Risk Management 

Association found that 59 percent of financial services 

firms believe SOX has “greatly” or “somewhat” helped 

management to implement an operational risk program 

that would minimize the risk of losses from inadequate 

internal processes and systems or from external events.6 

Although survey results suggest that the enactment of 

SOX is beginning to boost investor confidence, opportunity costs also must be considered. The SOX legislation contains numerous compliance requirements that 

force corporate management to shift resources away 

from product development or customer service activities. Costs also are attributed to learning new systems 

and internal controls, complying with strict timelines, 

and overseeing the work of others to deter fraud. 

Company executives are responsible for certifying the 

accuracy of company financial reports and may face 

penalties and fines for issuing misleading statements. 

5 Foley & Lardner LLP. March 10, 2005. The Impact of Sarbanes-Oxley
 

on Private and Nonprofit Companies. www.fei.org/advocacy/
 

sarbanesoxley.cfm.
 

6 Risk Management Association survey on Sarbanes-Oxley. May 2005.
 

www.rmahq.org/RMA. 


FDIC OUTLOOK 12 FALL 2005 
Implications of the Sarbanes-Oxley Act 

This environment could prompt management to 

become more risk averse and, as a result, constrain 

product development and innovation.7 

Earnings management is a term commonly used to 

describe the use of generally accepted accounting principles (GAAP) to control how a company’s financial 

statements are reported. For example, managers can use 

various methods for recording inventories and depreciation that can have the effect of smoothing reported 

earnings across time. Researchers have tried to determine if SOX has improved the reliability of financial 

statements. Gerald Lobo of the University of Houston 

and Jian Zhou of the State University of New York– 

Binghamton found that earnings management declined 

during the year when CEOs and CFOs certified the 

accuracy of their company’s financial statements.8 Firms 

most likely to certify early fell into a larger asset size 

category, reported higher quality earnings, and had a 

higher percentage of institutional shareholders. 

However, other research concludes that CEO and CFO 

certification did not affect stock prices, suggesting that 

7 Powell, Scott S. May 2, 2005. Seeking a Cure for Sarbox. Barron’s. 8 Lobo, Gerald J., and Jian Zhou. Forthcoming. To Swear Early or 

Not to Swear Early? An Empirical Investigation of Factors Affecting 

CEOs’ Decisions. Journal of Accounting and Public Policy. 

http://ssrn.com/abstract=651423. 

investors perceived no benefit from the certification 

process. Uptal Bhattacharya, Peter Groznik, and Bruce 

Haslem of Indiana University studied the market 

reaction of firms that began to certify their results and 

found the market did not react to the news of financial 

statement certification.9 

In a separate study, Northwestern University professors 

Daniel Cohen, Aiyesha Dey, and Thomas Z. Lys examined 

earnings management behavior, measured by accruals, for 

more than 6,000 firms. They determined that earnings 

management increased through the 1990s but declined 

after the enactment of SOX.10 However, these researchers 

stop short of concluding that earnings management 

declined only because of the enactment of SOX. Rather, 

other events, such as the corporate scandals of the early 

2000s, also are contributing factors. To date, a paucity of 

data clouds the impact of SOX on earnings management, 

and this area will benefit from additional research. 

9 Bhattacharya, Uptal, Peter Groznik, and Bruce Haslem. September
 

2002. Is CEO Certification of Earnings Numbers Value-Relevant?
 

http://ssrn.com/abstract=332621.
 10 Cohen, Daniel A., Aiyesha Dey, and Thomas Lys. February 1, 2005.
 

Trends in Earnings Management and Informativeness of Earnings 

Announcements in the Pre- and Post-Sarbanes Oxley Periods. 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=658782. 

Key SOX Provisions 

•	 Created the Public Company Accounting Oversight propriate actions by officers and directors, bars 

Board (PCAOB) with responsibility for overseeing persons who violated certain Securities and Exchange 

the actions of public accounting firms. The PCAOB Commission (SEC) regulations from serving as 

oversees the auditors of public companies; protects corporate officers or directors, and prohibits insiderthe interests of investors; and supports the prepara- trading violations. 

tion of informative, accurate, and independent audit 

• Mandates appropriate disclosures—requires accu­ reports. rate material disclosures in reports, restricts personal 

•	 Establishes auditor standards—requires audit part- loans to executives, requires internal control discloner rotation, provides guidance on audit committee sures in annual reports, provides for timely disclosure 

reporting responsibilities, places restrictions on based on material changes in a company’s financial 

hiring external audit staff to avoid auditor/client position, and details the extent of financial expertise 

conflicts of interest, and permits state regulators to on the audit committee.11 

determine whether PCAOB standards should apply 

to smaller accounting firms. 11 The full text of the Sarbanes-Oxley Act of 2002 may be found at 

www.loc.gov/law/guide/pl107204.pdf. Other summaries of SOX may • Establishes management standards—outlines audit be found at www.aicpa.org/info/sarbanes_oxley_summary.htm; committee standards, requires CEOs and CFOs to Executive Summary of the Sarbanes-Oxley Act of 2002,

certify the accuracy of financial statements, prohibits www.csbs.org/government/legislative/misc/2002_sarbanes-oxley_ 

management from attempting to influence an audit, summary.htm; and the Public Company Accounting Oversight 

establishes guidelines and penalties for certain inap- Board, www.pcaobus.org. 

FDIC OUTLOOK 13	 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

Another line of study has examined managerial behavior and executive compensation contracts. The results 

of some of the analysis suggest a direct relationship 

between managerial contracts and the incidence of 

corporate fraud.12 Firms whose executives had contracts 

with higher equity-based compensation relative to total 

compensation were more likely to experience fraud. 

However, the adjustment in managerial compensation 

following the enactment of SOX may have influenced 

how corporations make investment decisions. A paper 

by researchers at Northwestern University indicates 

that incentive compensation relative to total compensation declined following implementation of the SOX 

provisions.13 Furthermore, after controlling for macroeconomic effects such as gross domestic product (GDP) 

growth, the data show that expenditures on research 

and development, as well as capital expenditures, 

also declined. 

SOX also has influenced company decisions about 

whether to issue equity shares to the public or to remain 

privately held. Researchers at the University of Chicago 

found that the frequency of firms going private increased 

following passage of SOX.14 However, firms most likely 

to go private were smaller and characterized by a greater 

percentage of insider ownership. For firms that go public, 

registration and compliance costs have risen in recent 

years. Foley & Lardner estimate that SOX requirements 

and the costs of listing on stock exchanges have doubled 

since 2002 to an average of $2.3 million for firms with 

market capitalization less than $900 million.15 

In addition, the SOX legislation is affecting merger and 

acquisition (M&A) activity. For some companies, selling to a larger company has been easier and less costly 

than trying to take the company public, either because 

of compliance costs or the inability to receive analyst 

attention.16 In a roundtable sponsored by PricewaterhouseCoopers in spring 2004, leading M&A executives 

12 Johnson, Shane A., Harley E. Ryan, and Yisong Sam Tian. 


April 16, 2003. Executive Compensation and Corporate Fraud.
 

http://ssrn.com/abstract=395960. 
 13 Cohen, Daniel A., Aiyesha Dey, and Thomas Lys. July 23, 2004. The
 

Sarbanes-Oxley Act of 2002: Implications for Compensation Structure
 

and Risk-Taking Incentives of CEOs. http://ssrn.com/abstract=568483.
 14 Engel, Ellen, Rachel M. Hayes, and Xue Wang. May 6, 2004. 


The Sarbanes-Oxley Act and Firms’ Going-Private Decisions. 

http://ssrn.com/abstract=546626. 
 15 Thornton, Emily. May 24, 2004. Why Small Companies Want a Little
 

Privacy. Business Week.
 16 Quittner, Jeremy. November 1, 2004. Private Matters. Business
 

Week, 50. 


said SOX-related issues are emerging in merger negotiations.17 For example, targets that have been slow to 

comply with Sections 302 and 404 have led to postponement of deals that otherwise would have been 

considered acceptable. Panelists also noted that due 

diligence was becoming more complicated and was 

lengthening the process of closing deals. 

The Cost of SOX Compliance for 

FDIC-Insured Institutions 

In the case of FDIC-insured depository institutions that 

issue equity shares to the public, SOX compliance costs 

vary with institution asset size, operating controls, 

management experience and staffing levels, financial 

condition, local economic conditions, and the institution’s product offerings. However, regardless of the size 

and type of institution, some published studies show 

that overall compliance costs have increased since the 

enactment of SOX. 

An article in the May 2005 issue of US Banker states 

that the costs of complying with SOX can reach as 

high as $2 million for publicly traded community 

banks. The article concludes that these costs are 

becoming a significant factor in some banks’ decisions 

to go private and avoid SEC reporting requirements. 

“To add $1 million to $2 million in costs—with no 

income to show for it—makes a huge difference. 

Community banks are having a hard enough time with 

compliance anyway,” observes Patrick D. Daugherty, a 

partner with Foley & Lardner, who was interviewed for 

the US Banker article.18 A May 2005 ABA Banking 

Journal article estimates that compliance costs specifically related to legal, audit, Section 404 consulting, and 

administrative activities may exceed $500,000 annually 

for a community bank.19 

The American Bankers Association (ABA) estimates 

that auditing expenses of community banks in the 

17 Corporate Development Roundtable: The Impact of Sarbanes-Oxley 

on M&A Transactions. July 2004. PricewaterhouseCoopers. 18 Patrick Daughtery participated on a panel on “Why and How to ‘Go 

Private’” during the 2004 National Directors Institute held May 19, 

2004, in Chicago. The theme of this year’s conference was “Corporate 

Governance Reform: What’s Working and What Isn’t.” Daughtery 

noted that “by delisting, small (public) companies can save up to 

$2 million annually.” 

19 Baran, Mark R., and Katherine M. Koops. May 2005. Escaping SOX. 

ABA Banking Journal. 

FDIC OUTLOOK 14 FALL 2005 
Implications of the Sarbanes-Oxley Act 

mid-Atlantic states tripled from $193,000 in 2003 to Chart 2 

$600,000 in 2004.20 Finally, the results of a survey Total Overhead Costs Have Consistently Been conducted by the Independent Community Bankers of Higher at Smaller Institutions America (ICBA) from December 1, 2004, to February 

25, 2005, show that the average outside Section 404 

compliance costs of publicly traded community banks 

total slightly more than $202,000.21 

Although Call Report data do not specifically break 

out SOX-related compliance costs, such expenses are 

included as part of commercial bank noninterest or 

overhead expense. Total overhead expenses have been 

increasing at large and small commercial banks, a trend 

that may offer some insight into the impact of complyOverhead Expense to Average Assets

(Avg. %) 

Banks Under $500 Million 4.25 

4.00 

3.75 

3.50 

3.25 

Banks Over $500 Million 

3.00 

2.75 

2.50 

ing with provisions of the SOX legislation.22 For larger 

commercial banks (holding assets greater than $500 

million), total overhead expenses doubled from $122 

billion in 1995 to an annualized $246 billion by the 

first half of 2005. 

Although the dollar volume of overhead expenses 

increased among large commercial banks, the ratio of 

overhead expenses to average assets tells a different 

story. This ratio reflects how well a bank is managing 

overhead expenses as a percentage of average assets, 

and it actually dropped 52 basis points from June 30, 

1995, through June 30, 2005. Much of this improvement occurred during the past three years and is attributed to the “other noninterest expense” component of 

total noninterest expense.23 A closer look at the 

components of this ratio sheds light on trends in 

expense and asset growth for large banks. During the 

past ten years, overhead expenses grew at an average 

annual rate of 7.33 percent, possibly a reflection of 

higher SOX-related compliance costs, while the growth 

in average assets averaged 8.65 percent. This more 

rapid growth rate may be masking the potential effects 

of higher expenses for these institutions. 

20 Abernathy, Wayne. March 31, 2005. ABA Letter to SEC Proposes 

Regulatory Relief for U.S. Businesses. www.aba.com. 21 ICBA surveyed ICBA-member publicly held community banks. The 

response rate was 13 percent, with 91 banks responding. The survey 

included costs for 2004 or 2005, depending on the year in which each 

institution complied or is required to comply with Section 404. 

22 FFIEC (Federal Financial Institutions Examination Council) Reports of 

Condition and Income—Call Reports. 23 Per Call Report instructions, noninterest expense equals the sum of 

salaries and employee benefits, expenses of premises and fixed 

assets, amortization expense of intangible assets, and other noninterest expense. Other noninterest expense includes expenses such as 

postage, legal fees, advertising, insurance premiums, sales tax, and 

auditing fees. 

1990 1992 1994 1996 1998 2000 2002 2004 

Source: FDIC (Commercial Banks; June 30 of each year). 

Smaller commercial banks also are reporting lower 

overhead expense ratios. However, the improvement 

in this ratio during the past decade was less than that 

of larger commercial banks, largely because of a slower 

growth rate in average assets (see Chart 2). Again, 

most of the improvement occurred in recent years and 

was attributed to other noninterest expenses. During 

the past ten years, total overhead expenses have 

remained relatively stable for smaller institutions— 

around $27 billion. However, average assets have 

grown more dramatically—from $775 billion in 1995 

to slightly more than $800 billion in 2003, totaling 

$840 billion by the first half of 2005. The growth in 

average assets has outpaced the growth in noninterest 

expenses, helping to explain the decline in the overhead expense to average assets ratio, despite the added 

compliance costs that may be attributed to the enactment of SOX. 

Although commercial banks are reporting improvement 

in their overhead ratios, some banks, particularly smaller 

publicly traded banks, are considering strategies that 

would exempt them from complying with SOX, such as 

going private.24 Since January 2003, banking institutions 

have filed more than 40 “going-private” transactions.25 

An article published by the Federal Reserve Bank of 

Richmond discusses SOX compliance costs and previews 

the challenges one bank, Darlington County Bancshares, 

24 Sisk, Michael. June 2005. Going Private. US Banker, and Krebsbach, 

Karen. May 2005. SOX Costs Prompt Switch From Public to Private. 

US Banker. 

25 Baran, Mark R., and Katherine M. Koops. May 2005. Escaping SOX. 

ABA Banking Journal. 

FDIC OUTLOOK 15 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

Corporate Governance for FDIC-Insured Institutions
 

Among FDIC-insured institutions, corporate governance 

determines how management and boards of directors set 

corporate objectives, run daily operations, consider 

stakeholder or shareholder interests, ensure safe and 

sound operations, comply with applicable laws and regulations, and protect the interests of depositors. Insured 

financial institutions are operating in an increasingly 

complex and rapidly changing environment. Bank 

management and directors must know how to fulfill their 

fiduciary responsibilities in a manner that will ensure the 

institution’s stability and soundness. Although not 

specifically developed in response to the SOX legislation, 

the FDIC’s Pocket Guide for Directors offers timely 

guidance and suggestions for an institution’s board of 

directors:27 

•	 Select and retain competent management. 

•	 Establish, with management, the institution’s longand short-term business objectives, and adopt operating policies to achieve these objectives in a legal and 

sound manner. 

27 The FDIC’s Pocket Guide for Directors is available at 

www.fdic.gov/regulations/resources/directors/index.html. 

faced with the going-private decision.26 The advantages 

of going private include greater management flexibility, 

fewer reporting requirements, fewer resources devoted to 

compliance, and more efficient use of capital. This strategy has its disadvantages, however, such as limited access 

to the capital markets; costs of going private, such as 

legal fees; greater exposure to unsolicited takeover offers; 

and fewer control procedures, which could expose an 

institution to resource mismanagement. 

Looking Ahead ... 

Discussion continues among policymakers and legislators 

about the effectiveness and costs of SOX. Comments 

that appear in the text box on the following page show 

that the effects of this legislation continue to be hotly 

debated, raising the possibility of future legislative 

changes to the provisions of the Act. In fact, in late 

26 Campbell, Doug. Summer 2005. Lights Out. Region Focus. Federal 

Reserve Bank of Richmond. 

•	 Monitor operations to ensure they are controlled adequately and are in compliance with laws and policies. 

•	 Oversee the institution’s business performance. 

•	 Ensure the institution helps to meet its community’s 

credit needs. 

•	 Maintain independence when overseeing and evaluating management’s actions and competence. 

•	 Keep informed about the activities and condition of 

the institution and the economic and business environment in which it operates. 

•	 Ensure the daily operations of the institution are in 

the hands of qualified management. 

•	 Supervise management by establishing clearly 

communicated written policies that address all significant activities, monitoring the development and 

implementation of management reports, providing 

for independent reviews and testing of compliance 

with board policies and procedures, and heeding 

supervisory reports. 

•	 Avoid preferential transactions involving insiders. 

March 2005 the ABA proposed some degree of regulatory relief for corporations, including small banks and 

businesses. The two-part proposal, submitted to the SEC, 

recommends increasing the shareholder threshold for 

companies governed by SEC reporting requirements, as 

well as reexamining the audit of internal control testing 

required by SOX.28 Also in March, the ICBA urged the 

SEC and PCAOB to exempt community banks with 

total assets less than $1 billion from compliance with 

Section 404.29 In addition, Representative Jeff Flake (RArizona) introduced a proposal in mid-April 2005 that 

would make compliance with Section 404 of SOX voluntary.30 Overall, the enactment of the SOX legislation has 

pushed the corporate governance debate to the fore, and 

this debate is unlikely to be resolved in the near term. 

28 ABA. March 31, 2005. 


29 Letters to regulators. March 31, 2005. Implementation of Internal Control
 

Reporting Provisions of the Sarbanes-Oxley Act of 2002. www.icba.org.
 30 Flake, Jeff. Congressman Flake Introduces Legislation Reforming
 

the Sarbanes-Oxley Act, United States Congress, April 15, 2005.
 

www.house.gov/apps/list/press/az06_flake/050415SARBOX.html. See
 

also Congressional Record, 109th Congress, H2100.
 

FDIC OUTLOOK 16	 FALL 2005 
Implications of the Sarbanes-Oxley Act 

SOX Dissenters
 

Several prominent policymakers have criticized SOX 

and are calling attention to possible negative consequences. The views of two dissenters, in their own 

words, appear below. 

Alex Pollock, Resident Fellow at the American Enterprise Institute and former President and Chief Executive Officer of the Federal Home Loan Bank of 

Chicago, believes “there’s no doubt that this [SOX] is 

tremendously costly. We don’t know exactly how much. 

Estimates range from millions of dollars per firm for large 

firms and many billions of dollars in the aggregate. The 

implicit costs of diversion of employee and management 

behavior are high. The accounting and legal costs are 

high. Virtually every audit committee around the country is watching its audit fees escalate by huge amounts, 

going up as much as 50 to 100 percent. And, as we’ll get 

to later, the opportunity costs are also very high, 

although it is very hard to know exactly how high. 

Whatever these costs are, in general we know they are 

disproportionately higher for smaller companies.” 

Mr. Pollock suggests three reforms to “reduce the net 

economic cost, the cost in excess of the benefits, of 

Sarbanes-Oxley. With regard to governance by boards of 

directors, there is only one reform that I think is really 

meaningful. That is ensuring significant stock ownership 

by all directors. Second, regulatory reform. The SEC and 

the PCAOB have to acknowledge their own role in 

creating the morass of Sarbanes-Oxley cost and bureaucracy, not just blame it on the accountants, and then try 

to write more sensible, balanced rules. And thirdly, 

Congress should acknowledge its own role in creating 

Sarbanes-Oxley. They did something in a hurry, subject 

to a lot of political fear. The best effort that I’m aware of 

to fix Sarbanes-Oxley is a two-page bill introduced by 

Congressman Jeff Flake, a Republican of Arizona, which 

I recommend to everybody.”31 

31 Pollock, Alex J. May 18, 2005. Economic Consequences of 

Sarbanes-Oxley. AEI. http://aei.org/publications/pubID.22625, 

filter.all/pub_detail.asp. 

Peter J. Wallison, a Resident Fellow at the American 

Enterprise Institute and former Counsel to President 

Ronald Reagan and General Counsel to the U.S. Treasury Department, believes SOX stresses the wrong 

aspects of financial profiling. He states, “In adopting the 

act, Congress acted hastily, without adequate thought, 

and apparently without an understanding of the problem 

it was seeking to address. 

“In reality, the underlying cause of the collapse of 

investor confidence was the recognition that audited 

financial statements prepared under GAAP or any other 

system of financial statement preparation currently in 

use could never give a completely accurate picture of the 

prospects of public companies. As a result, the appropriate policy for Congress would have been to diminish the 

importance of audited financial statements by encouraging the disclosure of information that is more useful to 

investors and less subject to manipulation by corporate 

management. 

“There is a consensus among financial experts that 

companies are valued, not on the basis of their audited 

earnings, but on the basis of their current and estimated 

future cash flows. 

“For this reason, Sarbanes-Oxley’s sole focus on audited 

earnings as the key to corporate financial disclosure 

was wholly misplaced. After Enron, WorldCom and 

others, Congress and many investors were concerned 

about the accuracy of financial statements. The correct 

solution was not to create a massive regulatory structure to improve the auditing process but to encourage 

companies and the SEC to develop methods that will 

provide investors with information on company cash 

flows, making it easier for analysts and investors to 

understand how effectively and efficiently the 

company is able to generate cash.”32 

32 Wallison, Peter J. January 23, 2003. Poor Diagnosis, Poor 

Prescription: The Error at the Heart of the Sarbanes-Oxley Act. 

AEI American Enterprise Institute. http://aei.org/publications/ 

pubID.15714,filter.all/pub_detail.asp. 

FDIC OUTLOOK 17 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

SOX Supporters
 

SOX also has its ardent advocates. Views of several 

prominent SOX supporters, also in their own words, 

appear below. 

Former Federal Reserve Board Chairman Paul 

Volcker and former SEC Chairman Arthur Levitt Jr. 

state in a policy paper that appeared June 14, 2004, in 

the Wall Street Journal, “measures to reform the auditing profession and to assure its independence were 

central elements of the new legislation. Complementing 

them were strong new corporate governance rules 

ranging from who can sit on their boards and audit 

committees to new and clear responsibilities for internal 

controls and the accuracy of financial reports. These 

reforms were long overdue, and have made companies 

more transparent and accountable to shareholders. We 

are under no illusion that complying with SarbanesOxley and other new regulations will come for free; 

financial and managerial effort as well as money is 

required. But we believe that those costs are justified in 

light of the benefits—the price necessary to pay for more 

reliability in accounting, clear accountability to shareholders, and more robust and trusted markets. We 

should not let the relatively quick rebound of the 

markets induce a collective amnesia toward the real pain 

and loss that investors suffered, or blind us to the critical 

role that Sarbanes-Oxley has played in restoring 

investor confidence and strengthening our free market 

system. While there are direct money costs involved in 

compliance, we believe that an investment in good 

corporate governance, professional integrity, and transparency will pay dividends in the form of investor confidence, more efficient markets, and more market 

participation for years to come.”33 

William H. Donaldson, who recently stepped down as 

Chairman of the SEC, believes SOX restores consumer 

confidence in the stock market and creates healthy 

business practices. He states, “It is already clear that 

Section 404 is helping to strengthen the business opera33 Levitt, Arthur Jr., and Paul Volcker. June 2004. In Defense of 

Sarbanes-Oxley. AEI-Brookings Joint Center. www.aeibrookings.org/policy/page.php?id=188. 

tions of these U.S. and foreign issues who have seized 

the opportunity to use the internal controls assessment 

as a managerial opportunity and not simply a compliance exercise.”34 

Treasury Secretary John W. Snow, when asked if 

Congress should modify SOX, responded that 

“Sarbanes-Oxley was critically important legislation 

that met a real need for the country at the time of those 

scandals. Sarbanes-Oxley played a very important role in 

reaffirming the norms of good corporate behavior, and, 

in some ways, I think [it] was absolutely essential. 

Corporate capitalism depends on trust.” Treasury Secretary Snow concedes aggressive politicians and investors 

may rush to “criminalize innocent mistakes,” leaving 

little room for companies to feel assured they can make 

such mistakes. “The nature of business is that you aren’t 

always going to be right.”35 

George David, United Technologies Chairman and 

CEO, states, “Sarbanes-Oxley is not bad. We redid 

30,000 financial processes in the company to meet the 

regulations. We spent $40 million on it last year, though 

we’ll spend less in 2005. Ultimately, it makes the 

company better. There’s no silver bullet here. People 

think you can write a new regulation, and there will be 

no WorldCom, Enron, or Tyco. That’s not true. How 

long has the criminal justice system been in place? We 

can improve regulations, but problems will still come up. 

We have a very good system of governance in the 

[average] American company. We have better governance than in most parts of the world. Everybody is 

anxious about [getting rid of] problems. It’s a hazard that 

won’t go away.”36 

34 From a speech by William Donaldson in London. January 25,
 

2005. U.S. May Ease Corporate Accounting Deadlines for Foreign
 

Firms. www.usembassy.org.uk/gb007.html.
 35 An interview with Business Week senior writer Rich Miller.
 

January 4, 2005. Sarbanes-Oxley: A Sense of “Siege.” A Q&A 


with Treasury Secretary John Snow on Corporate Reform.
 

http://msnbc.msn.com/id/6798606/.
 36 Brady, Diane. April 25, 2005. Sarbanes-Oxley Is Not Bad.
 

BusinessWeek Online. www.businessweek.com/magazine/
 

content/05_17/b3930023_mz001.htm.
 

FDIC OUTLOOK 18 FALL 2005 
Implications of the Sarbanes-Oxley Act 

Other Recent Corporate Governance Reforms
 

The breakdown in corporate governance systems in the 

early 2000s precipitated the enactment of the 

Sarbanes-Oxley Act, but this piece of legislation was 

not debated and implemented in a vacuum. At the 

same time SOX was being implemented, other corporate governance changes were in the making, as many 

policymakers and industry leaders recognized the need 

for a concerted reform effort that would strengthen 

corporate governance and restore the public’s confidence. These reform initiatives are far-reaching and 

extend to some highly visible organizations in the 

nation’s financial services sector—the NASDAQ 

Stock Market Inc. (NASDAQ) and the New York 

Stock Exchange (NYSE), the American Institute of 

Certified Public Accountants (AICPA), the Financial 

Accounting Foundation (FAF), and the Financial 

Accounting Standards Board (FASB). Key corporate 

governance rules and standards implemented by these 

groups are summarized below. 

The NYSE standards require that independent directors 

comprise a majority of a company’s board of directors; 

the audit, compensation, and nominating committees 

remain independent; companies develop an internal 

audit function; members adopt a code of business 

conduct and ethics; and stockholders vote on stock 

option plans and any material changes to these plans. 

The NASDAQ standards mandate that the majority of 

corporate board members be independent, the authority 

of audit committees be expanded, the role of independent directors in compensation and nomination 

decisions be strengthened, shareholders approve all 

Robert E. Basinger, Senior Financial Analyst 

Daniel F. Benton, Intern 

Mary L. Garner, Senior Financial Analyst 

Lynne S. Montgomery, Senior Financial Analyst 

Nathan H. Powell, Financial Economist 

stock option plans, companies develop codes of conduct, 

and companies promptly disclose insider stock deals for 

transactions exceeding $100,000. 

The AICPA issued guidance to help auditors detect 

misstatements resulting from fraud. In addition, the 

AICPA implemented standards to enhance the quality 

control processes and procedures of U.S. audit firms. 

These standards were issued following the collapse of 

Enron—during a time when many public companies were 

seeking new audit firms. AICPA members also granted 

the professional association greater flexibility to ensure 

that it can act in the public interest should a member 

violate the accounting profession’s code of ethics. 

Changes implemented by the FAF, which oversees the 

FASB, attempt to improve the efficiency of the FASB 

rulemaking process, as the FASB had been criticized for 

delays in issuing new accounting standards. Under these 

new operating procedures, the voting requirement of the 

seven-member FASB board was streamlined from a supermajority to a simple majority. In addition, FASB shortened the proposed rule comment period as a means of 

expediting the issuance of new accounting guidance and 

standards. The failure of Enron, which had several offbalance-sheet partnerships with guarantee provisions, 

prompted the FASB to issue guidance for variable-interest 

entities and guarantees. This guidance addresses accounting requirements for a variety of investment and financial 

enterprises and requires a company entering into a guarantee agreement to record an upfront liability. 

FDIC OUTLOOK 19 FALL 2005 
What Does the Future Hold for 

U.S. Agricultural Subsidies? 

The banking industry’s vulnerability to “stroke-of-thepen” risk extends into the nation’s farm sector. Strong 

performance in the agricultural sector and among farm 

banks would be seriously challenged if an underpinning 

of this success, high levels of domestic government 

support payments, were to be scaled back because of the 

results of international trade negotiations or U.S. 

congressional budget debates. Should agricultural subsidies be lowered or phased out altogether, not only 

would farm income be hurt, but the value of farm land 

also could decline, and the financial condition of the 

nation’s farm banks could weaken. The effects of these 

policy changes would be significant and far-reaching 

and therefore warrant close scrutiny. 

Performance of U.S. Agricultural Sector 

Remains Strong: Effect of Subsidies Is Clear 

The U.S. agricultural sector is riding a wave of positive 

numbers. Net farm income of almost $74 billion set a 

record in 2004; this strong performance is expected to 

continue into 2005 with forecasted income of more 

than $64 billion.1 Relatively high livestock prices and 

substantial government support payments to farmers are 

compensating for low commodity prices (see Chart 1). 

In addition, farm real estate values have climbed rapidly 

in many areas, bolstering farmers’ balance sheets. 

A key contributor to net farm income, government 

payments to farmers have exceeded $10 billion each 

year since 1997 (see Chart 1). Before 2002, these 

payments largely took the form of emergency assistance 

to help farmers through periods of low commodity 

prices. Since the enactment of the Farm Security and 

Rural Investment Act of 2002 (Farm Bill), the level of 

government support has been tied to commodity prices. 

As strong harvests for corn, soybeans, wheat, and 

cotton have dramatically lowered prices for these crops, 

government payments have helped fill the gap. 

Pressures are building in Congress to scale back farm 

subsidies. In the longer term, the outcome of international trade negotiations may result in the U.S. 

1 Economic Research Service, U.S. Department of Agriculture (USDA). 

Figures for 2004 and 2005 are forecasts. 

government cutting 

or discontinuing 

many subsidy 

programs, possibly as 

soon as 2007, when 

the next farm bill 

will be negotiated. 

In the short term, 

Congress could cut farm subsidies to help close federal 

budget shortfalls. Any such reductions would be a blow 

to farmers’ cash flows and incomes and could affect 

farmland prices, as the expectation of continuing subsidies has been capitalized into land values. This article 

explores the events and pressures that could scale back 

farm subsidies and examines the implications for farmers, their lenders, and farmland values. 

The World Trade Organization and 

U.S. Agricultural Subsidies 

The United States is a member of the World Trade 

Organization (WTO), a forum for the negotiation of 

international trade rules that help lower trade barriers 

and improve the flow of goods.2 International trade 

negotiations from 1948 to 1994 reduced tariffs on 

manufactured goods from 38 percent to 4 percent, 

while total merchandise trade expanded an impressive 

18-fold.3 Economic data show a strong link between 

free trade and economic growth, and liberal trade 

policies—those with fewer restrictions on the trade 

of goods and services—enhance competition and 

drive innovation.4 

2 The WTO was created January 1, 1995, as the successor of the 

General Agreement on Tariffs and Trade (GATT). International trade 

negotiations have been ongoing since the GATT was formed in 1948. 

In response to protectionist strategies pursued by several countries 

in the 1930s, which many believed contributed to the severity of the 

Great Depression, 32 countries formed the GATT in the postwar 

period as a forum for multilateral negotiations, initially to reduce 

tariffs on manufacturing goods. The WTO has similar goals but is 

wider in scope, with a stronger institutional base. 

3 Ingco, Merlinda, and John Nash. 2004. What’s at Stake? DevelopingCountry Interests in the Doha Development Round. In Agriculture and 

the WTO: Creating a Trading System for Development. Washington, 

DC: The World Bank, 7. 

4 World Trade Organization. 2005. Understanding the WTO. Geneva, 

Switzerland: WTO, 13. www.wto.org/english/thewto_e/whatis_e/ 

tif_e/understanding_e.pdf. 

FDIC OUTLOOK 20 FALL 2005 
What Does the Future Hold for U.S. Agricultural Subsidies? 

Chart 1 

U.S. Net Farm Income and Government 

Payments Remain High 

80
 

70
 

60
 

50
 

40
 

30
 

20
 

10
 

0
 

Source: Economic Research Service, United States Department of Agriculture. 

Government Payments 

U.S. Net Farm Income 

Net Farm Income before 

Government Payments 

96 97 98 99 00 01 02 03 04F 05F 

$ Billions 

However, while most economists agree that a policy of 

free trade will maximize wealth and output globally, 

individual country leaders face political pressure at 

home to maintain policies that benefit particular interest groups. The agricultural sector, in particular, is 

characterized by strong special interests and has been 

governed by few trade rules until relatively recently. 

During the 1970s, the United States strongly supported 

liberalizing farm trade because it faced increasing 

competition in world markets. Consequently, during 

the trade negotiations that began in 1986, agricultural 

issues ranked high on the agenda.5 That round of negotiations, which concluded in 1994, resulted in the 

Agreement on Agriculture, the first significant multilateral treatment of farm sector issues. 

Despite the 1994 agreement, however, tariff levels 

remain significantly higher on agricultural products 

than on nonagricultural products, and trade continues 

to be somewhat restricted. Similarly, export subsidies, 

which countries use to reduce the prices of their 

commodities and strengthen their competitiveness 

worldwide, remain widespread. Overall, though levels 

of agricultural subsidies declined shortly after the 

agreement’s implementation, low commodity prices 

since 1998 (attributed to strong crop harvests worldwide) have prompted an increase in domestic support 

payments in most industrialized countries, including 

the United States.6 

5 Sheingate, Adam. 2001. The Rise of the Agricultural Welfare State.
 

Princeton, NJ: Princeton University Press, 183.
 

6 Ingco, Merlinda, and John Croome. 2004. Trade Agreements:
 

Achievements and Issues Ahead. In Agriculture and the WTO:
 

Creating a Trading System for Development, 36.
 

The Doha Round: Developing versus industrialized 

countries and a pledge to reduce subsidies. 

A new round of WTO negotiations was launched in 

Doha, Qatar, in November 2001. This series of negotiations, known as the Doha Round, is intended to 

reduce trade barriers, export subsidies, and domestic 

support for many goods, with agricultural subsidies a 

key agenda item. 

The Doha Round has sharpened the philosophical 

differences between developing and industrialized 

countries. International trade policies are hindering the 

ability of developing countries to realize the full benefit 

from their comparative advantages in the agricultural 

sector—low costs for farmland and labor. Industrialized 

countries, such as the United States and nations in the 

European Union, seek to support their agricultural 

producers through continued subsidy programs. Many 

economists maintain that agricultural subsidies in industrialized countries contribute to the overproduction of 

supported commodities and, in turn, depress world 

prices, hurting producers in developing countries.7 

A turning point in the Doha Round occurred in August 

2004, when industrialized countries agreed to “make 

substantial reductions in distorting supports, and those 

with higher levels are to make deeper cuts ...”8 This 

statement reflects the first time the United States and 

the European Union committed to reduce domestic 

support levels. While no timetable has been set to 

curtail U.S. subsidy programs, the negotiation of the 

next Farm Bill will be an opportunity for this country 

to address farm subsidy payments. 

Brazil’s challenge may strengthen the hand of 

developing countries. 

In September 2002, the Brazilian government sued the 

United States in the WTO, challenging more than 

$3 billion in subsidies paid by the U.S. government to 

its cotton farmers. Brazil argued that the subsidies 

contributed to increased U.S. cotton output that 

depressed world cotton prices and undermined Brazilian 

farmers’ livelihoods. Brazil estimated that if U.S. cotton 

subsidies were eliminated, U.S. cotton exports would 

decline 41 percent, and worldwide production would fall 

7 Johnson, D. Gale. 1991. World Agriculture in Disarray. New York: 


St. Martin’s Press, 9.
 

8 World Trade Organization. December 2004. WTO Agriculture
 

Negotiations: The Issues and Where We Are Now. Geneva,
 

Switzerland: WTO, 58. www.wto.org/english/tratop_e/agric_e/
 

agnegs_bkgrnd_e.pdf.
 

FDIC OUTLOOK 21 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

29 percent. This would boost world cotton prices more 

than 12 percent, benefiting cotton farmers in developing countries such as Brazil and West African nations.9 

The WTO ruled in favor of Brazil in June 2004. The 

United States appealed the decision, but the WTO’s 

Appellate Body upheld most of the original ruling in 

May 2005. The decision marked the first time the 

WTO had ruled against any domestic agricultural 

support program. In another challenge, the WTO ruled 

in favor of Brazil against the European Union’s sugar 

subsidy program. Some observers believe the WTO’s 

cotton and sugar decisions could encourage Brazil or 

other developing countries to file similar complaints 

against other subsidy programs. 

Although progress on international agricultural trade 

policy is typically very slow, the U.S. farm subsidy 

program appears to be vulnerable over the longer term. 

The outcome of the Doha Round negotiations, especially industrialized countries’ pledge to reduce domestic 

support payments to farmers, certainly is problematic. 

And the WTO cotton and sugar rulings fuel calls for 

scaling back government payments to farmers. These 

policy changes indeed have far-reaching consequences 

and will be carefully monitored by agricultural economists and policymakers. 

U.S. Budget Pressures Could Prompt Cuts in 

Agricultural Subsidies 

The 2002 Farm Bill was enacted during a time of 

federal budget surpluses. However, several key developments have occurred since that time: the extended war 

on terror, a weakening stock market, and growing 

budget deficits. Today we face a much different 

economic scenario, one that requires close scrutiny of 

all federal spending. In fact, as part of the 2006 budget 

reconciliation process, Congress must cut $70 billion by 

September 16, 2005. Of that amount, the House and 

Senate agricultural committees are tasked with trimming $3 billion in mandatory spending, most of which 

is for crop subsidies, food stamps, and other nutrition 

programs. Because the latter two are considered critical 

social programs, many observers believe crop subsidies 

will be targeted for cuts. In fact, the administration has 

proposed the following legislative changes to reduce 

9 Benson, Todd. WTO Rules Against U.S. Cotton Subsidies. New York 

Times, June 19, 2004. 

agricultural subsidies or promote more efficient production decisions: 

•	 Reduce crop and dairy payments to farmers by 

5 percent. 

•	 Scale back the commodity payment cap for individuals from the current $360,000 to $250,000. 

•	 Require the dairy price support program to curtail 

expenditures. 

•	 Base subsidies on historical production, allowing 

farmers to update their acreage according to what 

they actually grow.10 

By far the most serious, the 5 percent across-the-board 

cut would affect many farmers and potentially strap 

highly leveraged farmers. The payment cap would be 

particularly problematic for larger farmers. The five 

states that stand to lose the most in agricultural subsidies are California, Texas, Kansas, Arkansas, and 

Nebraska; these states represent 51 percent of U.S. 

total reductions under the proposed cap.11 It is not 

certain that Congress will adopt these proposals; 

Congress traditionally has shown a bias against cutting 

agricultural subsidies. However, the potential fallout 

from these cuts should be anticipated and analyzed. 

Reductions in Farm Subsidies Would Pose Significant 

Challenges for Farmers and Their Lenders 

Since 1997, government subsidies of $120 billion have 

represented about one-third of the nation’s net farm 

income. About 40 percent of the nation’s farms receive 

government payments for one or more of these crops: 

wheat, corn, soybeans, cotton, sorghum, rice, barley, 

and oats. States that specialize in these crops would be 

disproportionately affected by subsidy cuts. For example, 

North Dakota, which is by far the most heavily subsidized state because of its concentration in wheat 

production, derived more than 71 percent of its net 

farm income from government payments from 1990 

through 2003.12 

10 USDA. 2005. 2006 Budget Summary. www.usda.gov/agency/obpa/
 

Budget-Summary/2006/FY06budsum.htm.
 

11 Report of the Commission on the Application of Payment Limitations
 

for Agriculture, USDA, August 2003.
 

12 Economic Research Service, USDA. 2003 is the most recent year for
 

which state data are available.
 

FDIC OUTLOOK 22	 FALL 2005 
What Does the Future Hold for U.S. Agricultural Subsidies? 

In a related development, reductions in federal farm 

subsidies could depress farmland values. U.S. farm and 

ranch values have climbed in recent years because of 

strong farm income, increased demand for land for 

nonfarm uses, low interest rates, and tax advantages. 

According to Federal Reserve Agricultural Lender 

Surveys, land prices for good-quality (nonirrigated) 

farmland rose between 8.7 percent and 15.4 percent 

from 2003 to 2004. Ranchland values posted doubledigit gains, primarily because of record cattle prices. 

The Real Estate Center at Texas A&M University 

reported that Texas land prices jumped 16 percent on 

average from 2003 to 2004, with some areas posting 

gains of more than 35 percent.13 

Where the expectation of continued high government 

payments has been capitalized into real estate values, a 

scaling back of payments undoubtedly would place 

some downward pressure on land prices. Several studies 

indicate that government payments in recent years 

have contributed to higher U.S. farmland values; in 

fact, a study by economists at the University of Florida 

estimates that farmland values have increased 15 to 

25 percent across the nation because of government 

payments.14 Although the impact on farmland values 

of lower payment levels would be widespread, the 

effects would not be felt uniformly across the country. 

Farmland values in areas that rely more heavily on 

subsidies slated for reduction would be expected to fall 

the most. An analysis by the U.S. Department of 

Agriculture estimated severe effects in the most 

heavily subsidized states. For example, in North 

Dakota, farmland values would decline 69 percent if 

government payments were removed altogether.15 

While the elimination of government payments is 

highly unlikely, the study shows how closely farmland 

values and government payments are tied. 

Among the nation’s farm banks, the use of farmland 

real estate as collateral has increased in tandem with 

higher farmland values.16 At year-end 2004, loans 

13 Novack, Nancy. June 2005. Agricultural Credit Conditions: Booming 

Farmland Values. The Main Street Economist. 14 Moss, Charles B., and Andrew Schmitz. 2003. Government Policy 

and Farmland Markets: The Maintenance of Farmer Wealth. Ames, 

Iowa: Iowa State Press. 

15 Barnard, Charles, et al. 1997. Evidence of Capitalization of Direct 

Government Payments into U.S. Cropland Values. American Journal 

of Agricultural Economics 79:1646. 16 A farm bank is defined by the Federal Deposit Insurance Corporation as having at least 25 percent of its loans to farm operations or 

secured by farmland. 

secured by farmland represented 18.6 percent of total 

loans, a significant rise from 16.4 percent at year-end 

2000. Much of this growth was reported among farm 

banks based in states where farmland prices have appreciated rapidly, such as Minnesota, Wisconsin, and 

Missouri.17 In these states, loans secured by farmland 

grew 69 percent from 1997 through 2002. By contrast, 

farm banks in areas characterized by less rapid price 

appreciation reported only a 10 percent hike in farmland loans. 

However, heavy reliance on government payments 

would not necessarily contribute to declining farmland 

values in all cases. Certain mitigating factors, such as 

those described below, exist. 

Vibrant economies: While many rural counties, particularly in the middle of the country, are losing 

population, some counties with strong employment 

opportunities are attracting more residents. Many of 

these counties also have strong retail bases. Farmland 

values in such counties likely would better withstand 

the adverse effects of subsidy cuts than counties with 

declining populations. 

Natural amenities: Agricultural areas characterized by 

natural amenities, such as lakes, forests, or mountains, 

likely will fare better than other areas. As people 

consider relocating away from urban areas, anecdotal 

evidence suggests they are looking for land suitable for 

hunting, fishing, hiking, and camping. These areas are 

also popular for nonresidential purchases. In the past 

few years, the value of land used for recreational 

purposes has contributed significantly to the increase in 

farmland values. 

Proximity to metropolitan areas: Approximately 17 

percent of the nation’s farms are located near a major 

urban center, and many of these farms have benefited 

from higher farmland values because of residential and 

commercial development. Growing population in many 

urban centers has driven demand for residential housing, pushing rural land values higher. 

Each of these factors could be spurring the appreciation 

in farmland prices that has occurred to date, reflecting 

the influence of nonagricultural uses on farmland value. 

These factors could mitigate the downside effects of 

17 Areas of rapid farmland appreciation are defined as the top quintile 

of counties based on farmland price appreciation from 1997 through 

2002. 

FDIC OUTLOOK 23 FALL 2005 
In Focus This Quarter: Stroke-of-the-Pen Risk 

Map 1 

Impact of Reductions in Subsidies on Farmland Values Is Determined by These Factors 

Dependence on Government Subsidies Population Trends 

Source: USDA/ERS.* Source: U.S. Census Bureau. 

Natural Amenities Proximity to Metro Areas 

Source: USDA/ERS.* 

*United States Department of Agriculture/Economic Research Service 

future subsidy cuts. However, the absence of these 

factors also could exacerbate the effects of lower levels 

of government payments. In summary, where would we 

expect to find the greatest adverse impact on farmland 

values? Based on our analysis of the downside potential 

of these factors, we mapped the results, and Map 1 

clearly shows the more vulnerable areas. Of particular 

concern are areas where government payments are 

“institutionalized,” meaning that during the past 35 

years, high farm subsidies have been the norm.18 As the 

map shows, the middle of the nation, where heavily 

subsidized crops are typically grown, depends signifi18 The analysis of dependence on farm subsidies is based on Bureau 

of Economic Analysis county-level data for 1969 through 2003 for 

government payments and net farm income (NFI). If a county’s ratio of 

government payments to NFI ranked in the top quartile in at least half 

the years covered in our study, or if the ratio never fell into the bottom 

quartile during that period, the county’s reliance on government 

payments was considered “institutionalized.” 

Source: USDA/ERS.* 

cantly on government support, as do the Mississippi 

Delta and the South. If payments are reduced, these 

areas would experience the greatest impact, both to 

farmers’ incomes and farmland values. 

The map also shows the Great Plains, Corn Belt, and 

Mississippi Delta are being hurt by depopulation.19 

These areas likely do not have vibrant economies that 

could help sustain farmland values should government 

payments be reduced. In addition, many areas in the 

northern Great Plains and Midwest do not have natural 

amenities to support recreational demand for farmland. 

And finally, many counties are in remote, rural areas 

19 For definitions of the geographic terms and a detailed discussion of 

rural depopulation across the nation, refer to Walser, Jeffrey, and 

John M. Anderlik. 2004. Rural Depopulation: What Does It Mean for 

the Future Economic Health of Rural Areas and the Community Banks 

That Support Them? FDIC Banking Review 16:57. 

FDIC OUTLOOK 24 FALL 2005 
What Does the Future Hold for U.S. Agricultural Subsidies? 

Map 2 

Sources: United States Department of Agriculture/Economic Research Service; 

U.S. Census Bureau; and authors’ geospatial calculations. 

Confluence of Factors Shows 

Areas of Greatest Impact 

that are not close enough to urban areas for farmland 

values to benefit from development. These areas also 

may lack the employment opportunities benefiting 

areas closer to metropolitan areas. 

Although the absence of or weakness in any factor 

indicates some vulnerability to reductions in government payments, the confluence of shortcomings across 

all factors represents the areas of greatest concern (see 

Map 2).20 Our analysis highlights 666 counties characterized by a relatively high dependence on government 

payments, adverse demographic trends, poor natural 

amenities, and distance from metropolitan areas. As a 

result, we would expect farmland values in these counties to be hurt the most should government payments 

be significantly curtailed. 

The most vulnerable counties are in the nation’s 

midsection—the Great Plains states of North Dakota, 

Montana, South Dakota, Nebraska, and Kansas; Corn 

Belt states of Iowa, Minnesota, and Missouri; and the 

Mississippi Delta, stretching up the Mississippi River 

from Louisiana to Illinois. The crops produced in these 

20 This analysis is based on geographic information system software 

that allows for the comparison among factors. Each factor is given 

equal weight. 

areas (wheat, cotton, corn, and soybeans) are the most 

heavily subsidized, and as a result, farmers’ reliance on 

government payments is the greatest. These areas also 

do not benefit from positive demographic trends, natural amenities, or proximity to metropolitan areas. 

A significant number of the nation’s farm banks (979 

of 1,730 nationwide as of year-end 2004) are headquartered in these areas. Almost two-thirds of these 

institutions are in five states: Nebraska, Iowa, Kansas, 

Minnesota, and North Dakota. These farm banks 

(holding $71 billion in total assets) have performed 

well in recent years because of historically high levels 

of net farm income and government subsidies. In addition, these banks have increased farmland lending 

during the past few years; loans secured by agricultural 

real estate constituted 19.4 percent of total loans at 

year-end 2004, up from 16.9 percent four years earlier. 

Although farmland tends to be a strong form of collateral, these collateral positions could weaken should 

lower levels of farm subsidies depress real estate values. 

Conclusion 

Reductions in federal farm subsidy programs are becoming more likely as international trade negotiations and 

budget shortfalls pressure Congress to modify existing 

farm programs. If cuts do occur, farmers’ cash flows and 

profits would be hurt. In addition, farm real estate 

values, particularly in the middle of the country, could 

decline substantially. As farmland tends to be farmers’ 

most significant asset as well as valuable loan collateral, 

farmers and their lenders must continue to monitor the 

potential for payments to be scaled back through budget 

cuts or the outcome of international trade agreements. 

John M. Anderlik, CFA, Regional Manager 

Stephen L. Kiser, Regional Economist 

Jeffrey Walser, Regional Economist 

The authors acknowledge Jeffrey A. Ayres, Senior Financial Analyst, for his work with the geographic information 

system analysis. 

FDIC OUTLOOK 25 FALL 2005 

In Focus This Quarter

FDIC OUTLOOK 27 SUMMER 2005

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