Chairman 

L. William Seidman 

Division of Research 

and Statistics. 

Director 

Win. Roger Watson 

Editor 

Seorge F. French 

Editorial Committee 

Frederick S. Cams 

Arthur J Murton 

Lynn A. Nejenthleb 

Administrative 

Manager 

Detta Voesar 

Editorial Secretary 

Cathy Wright 

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Design and Printing 

Unit 

The views expressed arc 

those of the authors and 

do not necessarily reflect 

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if the FDIC Banking Re 

view and author(s) are 

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Federal Deposit Insurance Corporation 

FDIC 

Banking 

Review Fall 1990 

Vol. 3, No. 1 

Failure-Resolution Methods and Policy Considerations page 1 

by John F. Bovenzi and Maureen E. Muldoon 

The authors are, respectively, Deputy to the Chairman of the FDIC, and Financial Analyst in 

the FDlC's Division of Research and Statistics. In this paper the FDIC's methods for handling 

bank failures are examined and policy objectives and concerns are detailed. This is followed 

by a discussion of the difficult trade-offs that exist among sometimes competing policy goals, 

and how the various failure-resolution methods affect the achievement of these goals. The 

discussion is illustrated with a review of recent transactions involving large banks. 

An Overview of the U.S. Credit Union Industry page 12 

by Alane K. Moysich 

The author is a Financial Analyst in the FDIC's Division of Research and Statistics. This 

article provides information on the history, growth, regulation and insurance of credit unions 

in the United States. The current condition of the credit union industry, and its insurance 

fund, also are discussed. The author traces the evolution of the common bond requirement, 

and summarizes arguments for and against tax-exemption. She concludes that the financial 

condition of the industry generally appears good, but that recent events underscore the need 

for high-quality examination and supervision. 

Kisk-Based Capital Requirements: Reshaping the Thrift Industry page 27 

by Peter J. Elmer 

The author is a Financial Economist in the Office of Research and Statistics of the Resolution 

Trust Corporation. He estimates that almost half the assets of non-eonservatorship thrifts are 

in thrifts that do not meet their capital requirements, while almost three-fourths of the assets 

of non-conservatorship thrifts are in thrifts that do not now meet the standards that ul 

timately will be required. He points out that thrifts not meeting the requirements are not 

doomed to failure, but that absent a major improvement in performance, options available to 

many appear limited to some combination of shrinkage, mergers with healthier institutions or 

attracting outside capital. 

Recent Developments Affecting Depository Institutions page 36 

by Benjamin B. Christopher 

The author is a Financial Economist in the FDIC's Division of Research and Statistics, who 

contributes this regular section of the FDIC Banking Review. 
Failure-Resolution Methods 

Failure-Resolution Methods 

and Policy 

Considerations 

by John F. Bovenzi and Maureen E. Muldoon* 

In competitive markets, some 

institutions prosper while 

others do not. The evolution of 

the financial-services industry has 

forced banks and thrift institutions 

to operate in a highly competitive 

marketplace, one in which not 

every institution can survive. Prom 

a public-policy standpoint, the fail 

ure of an individual bank or thrift is 

not a great concern. It is the re 

sponsibility of the bank regulatory 

agencies, including the Federal De 

posit Insurance Corporation 

(FDIC), to maintain public con 

fidence and stability in the entire 

banking system, rather than in any 

individual bank or thrift within that 

system. The survival of the fittest 

produces a healthier, more efficient 

industry. Nevertheless, the manner 

in which individual institutions are 

handled as they approach, and then 

reach, the point of insolvency can 

have important implications for the 

stability of the entire banking sys 

tem, and for the long-term health 

and viability of the deposit insurer. 

These considerations warrant a 

careful review of the policies and 

procedures used by the FDIG to 

handle failing and failed insti 

tutions. In this article, the FDIC's 

traditional methods of handling 

bank failures are examined and pol 

icy objectives and concerns are de 

tailed. This is followed by a discus 

sion of the trade-offs that exist 

among the sometimes competing 

policy goals, and how the various 

failure-resolution methods affect 

the achievement of these objec 

tives. The discussion is illustrated 

with a review of recent large-bank 

transactions. These transactions 

highlight how the FDIC's recently 

acquired powers to establish bridge 

banks, to use pro rata payments 

more widely, and to impose liability 

on banks operating under common 

control (cross-guarantees) have 

given the FDIC greater flexibility to 

meet its policy objectives. 

Policy Consideratiotis' 

The FDIC has several primary ob 

jectives when determining the most 

appropriate failure-resolution 

method. First and foremost is the 

need to maintain public confidence 

and stability in the banking system. 

The deposit insurer must be aware 

that its handling of a particular fail 

ure may have adverse implications, 

and that failure-resolution methods 

that unnecessarily risk destabilizing 

the banking system should be 

avoided. Second, there is a need to 

encourage market discipline against 

risk-taking. The methods used to 

resolve bank failures have im 

plications for the amount of dis 

cipline exerted by market par 

ticipants against risk-taking by 

other banks. Failure-resolution 

policies influence the probability 

and size of toss that claimants may 

incur. In turn, these factors in 

fluence the degree to which any 

particular group of claimants will 

monitor and attempt to control a 

bank's risk-taking. Third, the 

failure-resolution method should be 

cost-effective. Unless the institution 

is considered essential to the com 

munity, the FDIC is required to 

meet a statutory "cost test" in 

which it must be reasonably sat 

isfied that the alternative pursued is 

not more costly than a deposit pay 

off. Fourth, the FDIC should be as 

equitable and consistent as possible 

in its failure-resolution policies. In 

recent years, the most prominent 

equity issue has been the treatment 

of uninsured depositors and other 

general creditors in large versus 

small banks. 

There are at least two secondary 

objectives of hank failure-resolution 

policies. The first of these objec 

tives is to minimize disruption to 

the community where the insolvent 

institution is located. This requires 

transactions that can be im 

plemented swiftly and smoothly. 

* John F. Bovenzi is Deputy to the Chairman 

of the Federal Deposit Insurance Corporation. 

Maureen E. Muldoon is a Financial Analyst in 

the Division of Research and Statistics. The 

authors would like to thank the many people 

who offered helpful comments and sugges 

tions, particularly George E. French and 

Arthur J. Murton. The authors are responsible 

for any remaining errors. 

1 For an additional discussion of policy ob 

jectives and failure-resolution methods, see 

John F. Bovenzi and Arthur J. Murton, "Resolu 

tion Costs of Bank Failures," FDIC Banking 

Review 1 (Pall 1988): 1-13. 
FDIC Banking Review 

The second goal is to minimize the 

government's role in owning, fi 

nancing, and managing financial in 

stitutions and financial assets. This 

is achieved by pursuing privatesector resolutions whenever pos 

sible. 

The objectives outlined above are 

not always mutually compatible, 

and the FDIG must decide how to 

balance these trade-offs in any 

given situation. The most basic 

trade-off exists between stability 

and market discipline. While mar 

ket discipline is necessary to pro 

mote stability, there is concern that 

too much market discipline can 

lead to greater instability by en 

couraging depositor runs. A second 

inherent conflict exists between 

equity and cost-effectiveness. Con 

sistency and equity considerations 

suggest that all bank failures should 

be handled in the same manner. 

However, this may reduce the 

FDIC's flexibility in obtaining the 

least costly or least disruptive 

transaction in any given situation. 

These and other possible conflicts 

among policy objectives make the 

selection of appropriate failureresolution policies a difficult process. 

Failure-Resolution Methods 

For most of its history, the FDIC 

has handled the majority of bank 

failures using one of three methods: 

the deposit payoff, the insureddeposit transfer, and the purchaseand-assumption (P&A) transaction. 

In addition, the FDIC has the au 

thority to provide financial assis 

tance to prevent the failure of an 

operating institution, and has done 

so on a number of occasions to re 

solve problem banks. In addition, in 

1987 the FDIC was granted the au 

thority to own and operate a newly 

chartered national bank until a 

more permanent solution can be 

arranged. The bridge bank, as it is 

called, provides a means of pre 

serving the going-concern value of 

an institution until an acquirer can 

be found, and has significantly 

broadened the FDIC's failureresolution alternatives. 

In a deposit payoff, as soon as the 

bank is closed by the chartering au 

thority, the FDIG is appointed re 

ceiver, pays all insured depositors 

the full amount of their claims, and 

liquidates the assets of the failed 

bank. Uninsured depositors and 

other general creditors of the bank 

generally do not receive either im 

mediate or full reimbursement on 

their claims. They obtain receiver 

ship certificates, which entitle their 

holders to their proportionate share 

of the collections on the failed 

bank's assets.2 The FDIC also is en 

titled to a share of these collections 

since it stands in the place of the 

insured depositors in the receiver 

ship. In the absence of a depositor 

preference statute,3 the FDIC, un 

insured depositors, and all other 

general creditors have equal stand 

ing and receive a proportionate re 

turn on their claims from the liqui 

dation of the receivership. 

An insured-deposit transfer is 

generally viewed as a variation of a 

deposit payoff, in part because un 

insured and unsecured depositors 

and creditors are not fully protected 

and usually suffer losses. In an 

insured-deposit transfer, only the 

insured deposits and secured and 

preferred4 liabilities are transferred 

to another institution. Uninsured 

and unsecured liabilities remain 

with the receivership. The FDIC 

makes a cash payment to the insti 

tution accepting these liabilities 

equal to the amount of the insured 

deposits and secured and preferred 

liabilities less any premium. 

A P&A transaction generally has 

been preferred by the FDIC to a 

payoff or an insured-deposit trans 

fer. Under this approach, an ac 

quirer "purchases" all or some of 

the failed bank's assets and "as 

sumes" its deposits and certain of 

1 At times in the past the FDIC has paid unin 

sured creditors a portion of their claims at the 

time of failure to minimize the disruption that 

can be caused by a deposit payoff. Cash outlays 

lo uninsured creditors have been based on con 

servative estimates of what they ultimately 

would have received after all the failed bank's 

assets were liquidated. This variation of a 

payoff is called a "modified payoff." 

3 Depositor preference statutes exist in 24 

states. These statutes elevate depositor claims 

over those of other general creditors in statechartered banks. State laws vary widely, and 

even those without a depositor preferenee 

statute may have other similar priorities 

established. The Federal Home Loan Bank 

Board adopted depositor preference for federal 

ly chartered thrifts in these states. However, 

the National Bank Act, which governs the li 

quidation of insolvent federally chartered 

banks, does not contain a depositor preference 

provision. 

* Claims for federal employment taxes at 

state-chartered banks. 
Failure-Resolution Methods 

its nondeposit liabilities.5 The usual 

procedure is for the FDIG to invite 

a number of potential acquirers to a 

bidders' meeting. A transaction is 

consummated with the highest ac 

ceptable bidder. In the past, an im 

portant distinction between a P&A 

transaction and a payoff or an 

insured-deposit transfer has been 

that typically in a P&A all deposi 

tors, uninsured as well as insured, 

have received full payment on their 

claims since these are "assumed" 

by the acquiring institution. Absent 

a depositor preference statute, gen 

eral creditors have sometimes also 

received full payment on their 

claims.6 

In addition to the more tradi 

tional approaches to handling bank expanded the FDIC's powers to failures, the FDIC has granted assis handle bank failures by granting tance to prevent the failure of an what is known as bridge bank au insured bank.7 In many respects, thority.s A failing bank is closed by "open-bank assistance" has the the chartering authority and certain same effects as a traditional P&A of its assets and liabilities^ are transaction. The primary difference transferred into a new, federally is that with open-bank assistance, a chartered institution owned by the transaction occurs before the failing FDIC. As the term bridge bank im bank is technically declared insol plies, this is simply meant to pro vent and closed, and the trans vide a temporary solution until a action may be structured as a re more permanent transaction can be capitalization rather than an arranged. The FDIC may operate acquisition. Generally, the FDIC failing institution as a bridge bank provides enough assistance to cover for up to two years, with the option the difference between the esti of three additional one-year exten mated market value of the bank's sions.10 Through year-end 1989, assets and its liabilities (the bank's the FDIC had exercised this author negative net worth). The PDIC re ity on six occasions. quires that private investors inject The bridge bank has several ad new capital into the firm. As in a vantages. First, it may be worth traditional P&A, all depositors and while to keep an insolvent bank op all general creditors have usually erating for a brief period until been protected against loss. How prospective acquirers can assess the ever, as a matter of FDIC policy, institution's condition in order to the bank's management is usually 

replaced and losses generally are 

imposed on the bank's sub s PScA transactions vary depending on the 

amount of assets purchased by the acquirer. ordinated debt holders and stock In a "clean bank1' P&A, the acquirer pur 

holders. In addition, if there is a chases only the highest-quality assets, 

whereas in a "whole bank" deal (also referred holding company, losses are gen to as a total-asset P&A or TAPA), the acquirer 

erally imposed on its creditors and purchases substantially all of the failed-bank's 

assets, good and bad alike In other P&A shareholders. transaetons, acquirers may purchase a spe 

cific pool of the failed hank's smaller in 

stallment loans. Bids received on P&A trans

Bridge Bank actions will reflect the expected loss on assets 

purchased, the perceived franchise value of In the Competitive Equality the bank, and the perceived value of the 

Banking Act of 1987, Congress FDIC's assistance. 

0 The FDIG has provided these creditors less 

than full payment in P&A transactions even in 

stales without a depositor preference statute. A 

more detailed discussion of this authority will 

be presented later in this article. 

' The FDIC was granted the authority to 

provide assistance to a failing bank in the 

Federal Deposit Insurance Act of 1950. Sec 

tion 13(c) permits such assistance when the 

banking services provided by the institution 

are deemed "essential" to the community. 

The FDIC did not use this authority until 

1971. Open-bank assistance became more 

common in the 1980s. In the Garn-St Ger 

main Depository Institutions Act of 1982, the 

FDIC was granted the authority to provide 

necessary assistance to prevent the failure of 

any insured bank. Only if the cost of such as 

sistance would exceed the cost of liquidaling 

the bank does the FDIC now have to make a 

finding of "essentiality." 

8 Section 214 of the Financial Institutions 

Reform, Recovery, and Enforcement Act of 

1989 (FIRREA) clarified and extended the 

FDIC's authority to transfer the assets and li 

abilities of a failed bank into a bridge bank. 

9 Upon the granting of a charter, a bridge 

bank is empowered to purchase the assets and 

assume the deposits (both insured and unin 

sured) of an insured institution in danger of 

default, as the FDIC in its discretion deems 

appropriate. The law specifies that if any in 

sured deposits are assumed, then all insured 

deposits must be assumed by the bridge bank 

or another insured depository institution. 

This is not necessarily the case for uninsured 

deposits and nondeposit liabilities. The bridge 

bank may assume uninsured deposits and 

nondeposit liabilities that the FDIC deems ap 

propriate. Such nondeposit liabilities would 

consist generally of those incurred for essen 

tial services that if not assumed by the bridge 

bank could adversely affect the going-concern 

value of the institution. Unassumed liabilities 

have a claim against the receivership and re 

ceive their pro raid share of the liquidation 

proceeds. 

10 Once it has been determined that a bridge 

bank is to be dissolved, the FDIC is appointed 

receiver and handles the affairs of the bridge 

bank in accordance with the laws relating to 

the liquidation of closed national banks. 

There is nothing in the law to preclude the 

FDIC from paying off ihe depositors of a 

bridge bank and liquidating the assets. 
FDIC Banking Review 

make a reasonable offer for the 

bank. If it continues to function, 

Che bank can retain much of its 

value, and there is likely to be less 

disruption to the local community. 

Secondly, the moral hazard prob 

lems11 that arise as a result of pro 

longing the operations of a failing 

bank are eliminated, because the 

institution is actually closed, man 

agement is replaced and holding 

company creditors and share 

holders lose their investment. In 

addition, the authority to create 

bridge banks has given the FDIC 

greater flexibility to handle the fail 

ure of banks within multibank 

holding companies. Because multibank holding companies are often 

very large banking organizations, 

completing a failed-bank trans 

action may require several months 

of analysis and negotiations. By 

creating a bridge bank, the FDIC is 

able to take control and stabilize 

the failing institution, reorganize it 

and prepare it to be sold. The abil 

ity to form bridge banks greatly 

expanded the FDIC's flexibility to 

handle the First RepublicBank Cor 

poration and the MCorp trans 

actions. These contrast with the 

open-bank assistance transaction 

involving First City Bancorporation, 

where obtaining voluntary con 

cessions from holding company 

shareholders and creditors was a 

difficult process and as a result, 

some bond holders received full 

payment on their claims.12 

Priority of Claims in 

a Bank Failure 

To understand the relationship 

between particular methods of han 

dling bank failures and the PDIC's 

policy objectives, it is important to 

distinguish between the treatment 

of the affected parties when a bank 

fails. In addition, the benefits of 

greater flexibility in handling bank 

failures are best illustrated by re 

viewing the priority of claims in a 

bank failure. For discussion pur 

poses, the relevant parties are di 

vided into the following eight 

groups: 

1. Insured depositors and se 

cured and preferred creditors 

2. Uninsured and unsecured de 

positors 

3. Unsecured, nondeposit credit 

ors (excluding subordinated 

debt holders] 

4. Holders of contingent claims 

5. FDIC 

6. Subordinated debt holders 

and bank stockholders 

7. Bank management, directors 

and officers 

S. Bank holding company credit 

ors and shareholders 

The FDIC's foremost respon 

sibility is to protect insured deposi 

tors. However, the FDIC also may 

protect other creditors against loss. 

Moreover, regardless of the failureresolution method chosen by the 

FDIC, some uninsured creditors 

may receive at least a partial reim 

bursement on their claims against 

the bank. The degree to which each 

group of creditors may or may not 

be protected against loss when a 

bank fails has important im 

plications regarding the FDIC's pol 

icy objectives. 

Insured depositors and secured 

creditors. The claims of insured 

depositors and secured and pre 

ferred creditors take priority over 

all other claimants. Regardless of 

the failure-resolution method pur 

sued by the FDIC, all insured de 

positors are completely protected 

against loss. Certain deposit li 

abilities and any nondeposit nonsubordinated liability may be se 

cured by assets on a bank's balance 

sheet. Because the assets pledged as 

collateral against a bank's debt gen 

erally consist of government securi 

ties or other high-quality assets, the 

holders of secured debt are gen 

erally fully protected against loss in 

the event the bank fails. 

Uninsured and unsecured deposi 

tors. The treatment of uninsured, 

unsecured depositors varies de 

pending on how a failure is 

handled. In a deposit payoff or an 

insured-deposit transfer, uninsured 

depositors generally share losses on 

a pro rate basis with the FDIC and 

other general creditors. If a deposi 

tor preference statute is applicable, 

the claims of the FDIC and the un 

insured depositors take priority 

over those of other general credit 

ors. In a P&A or open-bank assis 

tance transaction, uninsured and 

unsecured depositors typically have 

received treatment equal to that of 

insured depositors and secured debt 

holders; that is, depending on the 

structure of the transaction, they 

may be completely protected 

against loss. 

Because the treatment of unin 

sured and unsecured depositors 

generally depends on the failureresolution method pursued, the 

FDIC's policies often have been 

labeled inconsistent and in 

equitable. Depositors may be 

treated differently depending on the 

circumstances surrounding a bank's 

failure and especially, the market's 

perception of the franchise value of 

the failed institution. In addition, 

the FDIC is more likely to deter 

mine that the operations of a large 

bank, rather than a small bank, are 

essential to the community it ser 

vices. Because of these factors, 

there is a much greater likelihood 

that the FDIC would pay off a small 

bank as opposed to a large bank. 

Unsecured, nondeposit creditors. 

Unsecured, nondeposit creditors fall 

into the category of other general 

creditors. This group may include 

federal funds purchased and other 

similar borrowings. For national 

banks and state banks where a de 

positor preference statute is not ap

" [n a banking context, moral hazard refers 

to Che incentive which banks have to increase 

their portfolio risk in an attempt to capture 

greater returns. Under the current system of 

deposit insurance, when an institution is at or 

near insolvency, the risks of such activities 

are largely passed on to the insurer, while the 

reward if the gamble is successful accrues en 

tirely to the institution. 

"The FDIC had authority to use bridge 

banks at the time of the First City transaction. 

In that instance, however, it was determined 

that open-bank assistance was a less costly 

and more viable alternative. The First City 

transaction will be discussed in more detail 

later in this article. 
Failure-Resolution Methods 

plicable, these creditors generally 

have had the same status as unin 

sured, unsecured depositors. This 

means they have usually shared pro 

rata in losses with uninsured, un 

secured depositors and the PDIC if 

the failure was handled as a deposit 

payoff or an insured-deposit trans 

fer; or ordinarily they have incurred 

no loss if the failure was handled as 

a P&A or an open-bank assistance 

transaction. For state-chartered 

banks where a depositor preference 

statute is applicable, other general 

creditors follow depositors in order 

of priority, and generally stand to 

recover little, if anything, on their 

claims. Thus, in depositor prefer 

ence states, such creditors risk 

large losses if a state bank is near

ing the point of insolvency, depend 

ing on how the FDIG handles the 

situation. 

Holders of contingent claims. 

When a bank fails there may be a 

large number of outstanding con 

tingent claims against the insti 

tution. These claims include letters 

of credit and loan commitments, as 

well as lawsuits. Contingent claims 

are generally treated as any other 

unassumed claim in a failureresolution situation. 

Significant contingent claims 

against a failed or failing bank 

sometimes foreclose the possibility 

of open-bank assistance or a P&A 

transaction. While many creditors 

flee a failing institution, the number 

of contingent claims may increase 

rather than decrease as a bank ap 

proaches insolvency. A troubled in 

stitution is likely to attract lawsuits 

from a variety of disgruntled cus 

tomers and creditors. Hence, an 

outstanding lawsuit with a sizable 

potential judgment against a failed 

bank may render a P&A or openbank assistance more expensive 

than a payoff.13 Thus, contingent 

claims may be a significant factor 

for the FDIG to consider when 

evaluating failure-resolution alter 

natives. 

FDIC. The FDIC assumes the 

status of the depositors' or credit 

ors' claims it settles. Once the FDIG 

satisfies its obligation as insurer, its 

priority relative to all other claim 

ants depends on how the trans 

action is handled. The FDIC is al 

most always repaid less than 

insured depositors and secured 

creditors. Conversely, the FDIC 

usually recovers more than sub 

ordinated debt holders, bank stock 

holders and bank holding company 

creditors and shareholders. Prac 

tically speaking, the FDIC generally 

has received less payment on its 

claims than uninsured, unsecured 

depositors and other general credit 

ors, since these groups normally 

have been fully protected in P&As 

and open-bank assistance trans 

actions. If there is an applicable de 

positor preference statute the FDIC 

often protects only depositors in full 

and receives a greater proportional 

payment than nondeposit general 

creditors. If there is a payoff or 

insured-deposit transfer, only in 

sured depositors are protected in 

full and the FDIC stands in their 

place, having equal status with un 

insured, unsecured depositors. 

Subordinated debt holders and 

bank stockholders. In bank-failure 

transactions these two groups are 

treated much the same. Although 

subordinated debt holders have pri 

ority over stockholders, both 

groups' claims have a lower priority 

than those of depositors, general 

creditors and the FDIC. Therefore, 

subordinated debt holders and 

shareholders face the greatest risk 

to their investment, and generally 

recover nothing when a bank fails. 

This is true whether the failure is 

handled as a payoff, an insureddeposit transfer or a P&A trans 

action. In open-bank assistance 

transactions, shareholders and sub 

ordinated debt holders have slightly 

more leverage since they must 

agree to the transaction. Never 

theless, because the FDIC condi 

tions any assistance upon share 

holder and subordinated debt 

holder concessions, these groups 

rarely receive more than a few 

cents on the dollar from the assets 

of the failed banks in these trans 

actions.14 Because of their inferior 

status in bank-failure cases, the ex 

istence of subordinated debt and 

equity capital lowers the FDIC's 

failure -resolution costs and helps to 

impose market discipline on the 

banking system. 

Bank management, directors and 

officers. Bank managers' careers 

and reputations are closely tied to 

the performance of their bank. 

When a bank fails, senior managers 

usually lose their jobs. An acquiring 

institution may choose to keep 

some of the top executives of the 

failed bank, but generally most are 

replaced regardless of how the fail 

ure is resolved. These individuals 

may have a difficult time finding 

comparable employment elsewhere, 

particularly if it is perceived that 

the bank's problems were due to 

mismanagement rather than to 

general economic conditions. 

Legal liability extends to the di 

rectors and officers, who are ul 

timately responsible for approving 

the policies that bank managers 

implement. Regulatory agencies' 

powers to take strong enforcement 

actions and to impose civil and 

criminal penalties on bank direc 

tors and officers were greatly 

strengthened in FIRREA. Thus, the 

probable loss of employment, in 

come and status for managers, as 

well as the potential for legal liabil 

ity for directors and officers, pro 

vide strong incentives for these par 

ties to ensure that their bank 

" Some contingent claims are eliminated as 

a result of a bank closing. However such 

claims may not necessarily be eliminated if 

the bank remains open. FIRREA places cer 

tain requirements on the provability of con 

tingent claims. If these criteria are not met, 

such claims are nol recognized by the FDIC. 

" Subordinated debt holders and bank 

stockholders may receive additional valueh i/ 

there are non ban king assets in the holding 

company to which they are entitled. 
FDIG Banking Review 

operates in an acceptable 

manner.15 

Bank holding company creditors 

and shareholders. An additional in 

centive to curb excessive risktaking exists in the form of credit 

ors and shareholders of the parent 

holding company (if the institution 

is part of a holding company). 

When a bank becomes insolvent 

and is closed, holding company 

creditors and shareholders nor 

mally do not receive any value from 

the failed bank. The FDIC's han 

dling of large-bank failures in recent 

years has made it increasingly clear 

that the safety net of federal deposit 

insurance does not extend to hold 

ing companies. 

"Pro Rata" Treatment 

of Claimants 

As previously mentioned, an im 

portant distinction between a tradi 

tional P&A transaction and a payoff 

or an insured-deposit transfer, was 

that in a P&A all depositors and 

general creditors usually received 

full payment on their claims against 

the failed bank because these li 

abilities were assumed by the ac 

quiring institution. In 1973, the 

FDIC arranged for Crocker National 

Bank to purchase the assets and as 

sume the bulk of the liabilities of 

the failed United States National 

Bank of San Diego (USNB). Most of 

the creditors of the failed bank were 

paid in full; however, Crocker 

Table 3 

Bank-Failure Costs 

By Region, 1985-1989" 

Number" Assets 

(in billions) 

Costs**' 

(in hilhons) 

Cost As a 

Percentage 

of Assets 

"Data through September 30, 1989. 

"Includes failures through September 30, 1989 and only the major open-bank 

assistance transactions. 

"•Costs are based on FDIC reserves as of September 30, 1989. 

REGIONS: Southwest —Arkansas, Louisiana, New Mexico, Oklahoma, Texas 

Northwest —Connecticut, Delaware, District of Columbia, Maine, 

Maryland, Massachusetts, New Hampshire, New Jer 

sey, New York, Pennsylvania, Puerto Rico, Rhode 

Island, Vermont 

Southeast —Alabama, Florida, Georgia, Mississippi, North Car 

olina, South Carolina, Tennessee, Virginia, West Vir 

ginia 

Central —Illinois, Indiana, Kentucky, Michigan, Ohio, Wis 

consin 

Midwest —Iowa, Kansas, Minnesota, Missouri, Nebraska, North 

Dakota, South Dakota 

West —Alaska, Arizona, California, Colorado, Hawaii, Idaho, 

Montana, Nevada, Oregon, Pacific Islands, Utah, 

Washington, Wyoming 

National Bank did not assume cer 

tain standby letters of credit issued 

by USNB because of their perceived 

riskiness. First Empire Bank, one of 

the holders of the standby letters of 

credit, sued the FDIC, asserting 

that its claim against the failed 

bank should have been treated in 

the same manner as those that 

were assumed by Crocker National 

Bank. A federal district court in 

California held that the FDIC had 

properly exercised its discretion as 

receiver in deciding not to honor 

those claims. However, that deci 

sion was appealed and ultimately 

reversed in favor of First Empire 

Bank. In 1978, the Supreme Court 

declined to review the appellate 

court decision, and the FDIC was 

forced to pay the amount due on 

the letters of credit not assumed by 

Crocker National Bank. 

Because of this experience, when 

the FDIC subsequently effected 

P&A transactions, all general bank 

creditors' claims were usually sat 

isfied. In 1987 (in a case involving 

United American Bank, Knoxville), 

the Tennessee Supreme Court 

found that when the FDIC im 

plements a P&A transaction it is 

not required to pay all unassumed 

creditors in full, but need only pay 

the amount they would have re 

ceived in a straight liquidation. Ab 

sent specific codification, however, 

this approach was open to legal 

challenge.16 

In FIRREA, the FDIC was granted 

greater flexibility to settle the 

claims of uninsured depositors and 

general creditors of a failed bank. 

ls Offsetting these incentives to some extent 

are "golden parachutes," which are often part 

of executive compensation packages. Because 

such compensation is generally not tied to 

performance, managers may be generously 

rewarded when the institution they manage 

fails or requires FDIC assistance to prevent its 

failure. 

ls The FDIC chose to utilize the pro rata 

payment approach to certain classes of unin 

sured depositors in its handling of two major 

pre-FlRREA bank failures: First HepublicBank 

Corporation and MCorp. The FDIC faces a 

legal challenge in both of these cases as a re 

sult of this decision. The impact of pro rala 

payments on these transactions will be dis 

cussed later in this article. 
Failure-Resolution Methods 

This legislation specifically codified 

the ''pro rata" approach to handling 

bank failures. FIRREA states that 

the FDJC's maximum liability to 

any category of claimants is limited 

to the amount these parties would 

have received if the bank's assets 

had been liquidated. In addition, 

this legislation allows the FD1G 

complete discretion to use its own 

resources to make additional (full) 

payments to any claimant or cate 

gories of claimants in the interest of 

maintaining stability and con 

fidence in the banking system, 

without obligating itself to make 

similar payments to all other claim 

ants. According to FIRREA, both 

uninsured depositors and other 

general creditors are only legally 

entitled to receive their pro rata 

share of the liquidation proceeds in 

bank-failure situations, even if the 

FDIG chooses to fully protect cer 

tain claimants against loss. 

The use of pro rata payments af 

fects the priority of claims of unin 

sured depositors and general cred 

itors in P&A transactions. Instead 

of receiving treatment equal to that 

of insured depositors and secured 

debt holders, uninsured depositors 

and general creditors are only 

legally entitled to their pro rata 

share of the receivership proceeds, 

and therefore are exposed to poten 

tial loss.17 The FD1C has been uti 

lizing its pro rata authority in all 

P&A transactions since the en 

actment of FIRREA, absent an ap 

plicable depositor preference stat 

ute. While the statute permits the 

FDIG to provide pro rata payments 

to all uninsured or unsecured 

claimants or categories of claimants 

[including depositors), in recent 

P&A transactions the FDIC has 

chosen to fully protect ail deposi 

tors in a bank failure. 

In handling the failures of large 

banks such as Continental Illinois, 

the FDIG has been unwilling to im 

pose losses on uninsured deposi 

tors.18 The possibility that deposi 

tors would not be protected in the 

event the bank failed could 

heighten the threat of bank runs at 

large institutions facing financial 

difficulty. Thus, the decision to im 

pose losses on uninsured depositors 

has implications for the stability of 

the banking system. 

Pro rata payments also help to 

equalize the treatment of uninsured 

depositors at both large and small 

banks. The FDIC is often criticized 

for its handling of large-bank fail 

ures because traditionally these 

have been handled in a manner 

that extends de facto 100 percent 

deposit insurance to all depositors. 

It may be difficult for the FDIC to 

attract an acquirer interested in a 

P&A transaction for a small bank. 

Therefore, the FDIC may be forced 

to handle the failure of a small bank 

in a way that imposes losses on un 

insured depositors. With the use of 

pro rata payments, the FDIC may 

treat the liabilities of large and 

small failed banks more uniformly, 

and provide protection to all depos 

itors of small banks, even absent a 

depositor preference statute. Thus, 

there may be little difference be 

tween an insured-deposit transfer 

and a P&A transaction.19 In addi 

tion, the use of pro rata payments 

is more equitable than a depositor 

preference statute from the stand 

point of nondeposit creditors, since 

additional payments to uninsured 

depositors are made from FDIC re 

sources, not from receivership pro 

ceeds. 

The FDIC may also deem appro 

priate the full protection of certain 

nondeposit liabilities. In some in 

stances, failure to protect certain li 

abilities may adversely impact the 

going-concern value of an insti 

tution. These creditors are gen 

erally providing some essential ser 

vices, such as data processing or 

accounting services. Such claimants 

would receive the additional pay 

ment from FDIC resources, not 

from receivership proceeds. Unpro 

tected general creditors will obtain 

receivership certificates, which en 

title them to their pro rata share of 

the value of the assets of the failed 

institution. 

In essence, FIRREA has greatly 

expanded the FDIC's authority to 

handle the liabilities of a failed 

bank. This flexibility better enables 

the FDIC to balance its various pol 

icy objectives, such as maintaining 

equity, stability and market dis 

cipline in the banking system. For 

instance, the use of pro rata P&A 

transactions provides an effective 

means of limiting the federal de 

posit insurance safety net. Deposit 

insurance was never intended to 

provide protection to all bank cred 

itors. Indeed, insurance premiums 

are based on deposit liabilities only. 

Because bank creditors are subject 

to loss regardless of how the FDIC 

handles a bank failure, the level of 

market discipline imposed on bank 

risk-taking by creditors should in 

crease. 

Trade-offs among Policy 

Objectives 

The FDIC's foremost objective is 

to maintain public confidence and 

stability in the banking system. For 

any individual bank failure such a 

policy objective might suggest pro 

tecting as many creditor groups as 

possible. However, while this ap 

proach might satisfy the desired ob 

jective over a relatively short time 

frame, it would be self-defeating in 

the long run. Protecting all creditor 

groups at all times would remove 

any market discipline from the sys

17 As a matter of practice, general-creditor 

claims receiving pro rata payments include 

unsecured borrowing (including federal 

funds), accrued expenses, contingent li 

abilities and nonbook liabilities. 

18 In the MCorp and First Republic trans 

actions, intracompany loans and some unin 

sured deposits were treated differently than 

other uninsured deposits. Intracompany loans 

and certain uninsured deposits were dealt 

with on a pro rata basis, while other unin 

sured depositors received full protection. 

1V The same results could be achieved in an 

insured-deposit transfer or a P&A transaction 

by using pro rata payments, because the 

FDIG has the ability to treat uninsured depos 

itors and creditors in the same manner in 

both transactions if it chooses to do so. Other 

things being equal, the only difference be 

tween the two transactions would be the legal 

distinction between a paying agent in an 

insured-deposit transfer and an acquirer in a 

P&A transaction. 
FD1G Banltjng Review 

tem, leading to greater risk-taking 

by insured institutions and eventu 

ally to more insolvencies, higher 

failure-resolution costs and less, 

rather than more, stability. 

Any failure-resolution policy de 

signed for more than the shortest of 

time frames must address the crit 

ical issue of how much market dis 

cipline is appropriate. Clearly, some 

market discipline is necessary to 

control excessive risk-taking. How 

ever, too much market discipline 

could result in a return to the at 

mosphere of the 1930s, when bank 

runs posed a constant threat to the 

stability of the banking system. 

Of the eight different groups of 

creditors and other affected parties 

discussed previously, six groups al 

most always suffer losses when a 

bank fails; one group occasionally 

suffers losses; and one group, in 

sured depositors and fully secured 

creditors, never suffers a loss when 

a bank fails. The group of six that 

almost always will suffer losses now 

includes unsecured nondeposit 

creditors and holders of contingent 

claims, as a result of the pro rata 

treatment of claimants, in addition 

to the FDIG, subordinated debt 

holders and bank stockholders, 

bank management, and bank hold 

ing company creditors and share 

holders. Each of these groups has 

an incentive to control a bank's 

risk-taking. The only time that this 

incentive may become perverse is 

when the bank is nearing the point 

of insolvency and the incentive for 

self-preservation (moral hazard) 

may lead unprotected creditors and 

management to encourage the very 

risk-taking that is viewed as impru 

dent when the bank is healthy. The 

increased incentive to take risks as 

an institution nears insolvency was 

apparent in the savings and loan 

industry. The resulting crisis pro 

vides a mandate for stringent su 

pervision of problem banks and 

thrifts, and the timely closure of in 

solvent institutions. 

Equity in the handling of bank 

failures also is an important objec 

tive. However, it cannot be viewed 

in isolation. Any policy strides 

toward greater equity also must 

consider the effects on stability, 

market discipline and costeffectiveness before it can be de 

termined whether such a policy 

change is desirable. For example, a 

more uniform (i.e., equitable) 

treatment of all creditors reduces 

the FDIC's flexibility in handling 

bank failures. Limiting this flexibil 

ity could increase market dis 

ruption and failure-resolution costs. 

Illustrating the Policy 

Trade-offs— 

First City Bancorporation 

Transactkm 

The FDIC has continually sought 

the regulatory flexibility necessary 

to effect transactions that achieve a 

balance between its various policy 

considerations. The FDIC's han 

dling of bank failures evolved in the 

1980s, as the number of failures in 

creased, and as some of the nation's 

largest banks failed or required fi 

nancial assistance. This progress 

toward balancing policy objectives 

in the framework of failureresolution methods may be illus 

trated by reviewing the FDIC's ap 

proach to one of the major 

failing-bank transactions of the 

1980s. 

In 1987, the financial condition 

of First City Bancorporation of 

Texas had deteriorated to the point 

that the failure of the lead bank, 

First City National Bank, Houston, 

appeared imminent. With approxi 

mately 310 billion in assets and 62 

banking subsidiaries, the Texas 

banking firm was the fifth largest in 

the state and the 39th largest in the 

nation. Next to the 1984 near col 

lapse of Continental Illinois, First 

City was at that time the second 

largest potential bank failure in his 

tory. Because of the restrictions on 

branching in Texas, large bank 

holding companies comprised of 

one or two "lead" banks in the 

larger cities, and several small sub 

sidiary banks generally located out 

side the metropolitan areas, devel 

oped and functioned much like 

branch banking networks. The sub 

sidiary banks provided the neces 

sary funding, while the lead bank 

generated most of the lending. 

Though they were part of the same 

holding company and may have 

functioned as one unit, the sub 

sidiary banks were separate enti 

ties. As discussed more fully in the 

following section, this type of struc 

ture complicated the failureresolution process for the FDIC. 

Losses were concentrated in, but 

not confined to, the firm's lead 

bank. First City, Houston, had #2.8 

billion in deposits ($819 million of 

which were insured) in June of 

1987, and the task of completing a 

payoff or an insured-deposit trans 

fer on an institution of that size had 

never been attempted. In 1982, the 

FDIC paid off the depositors of 

Penn Square Bank, N.A., the largest 

bank ever to be handled in that 

manner. Total deposits (8470 mil 

lion, of which $250 million were in 

sured) in Penn Square prior to its 

failure were substantially less than 

in First City, Houston. As with 

other large banks, the FDIC was 

concerned about the implications 

for the stability of the banking sys 

tem in Texas and the nation if in 

sured depositors were paid off and 

losses were imposed on uninsured 

depositors and other general credit 

ors. 

Because of the holding company 

Structure, arranging a P&A of the 

lead bank would have meant that 

Che capital of the subsidiary banks 

would not have been available to 

offset losses in the lead bank. To 

the benefit of the holding company, 

much of the loss in the firm would 

have been effectively removed by 

the FDIC had a P&A of First City, 

Houston, been completed. In es 

sence, by effecting a traditional 

P&A transaction, the FDIC would 

have borne the burden of the losses 

in the lead bank, without the ability 
Failure-Resolution Methods 

to share them with the subsidiary 

banks.20 

Faced with the stability problems 

of a payoff and essentially enriching 

the holding company if it pursued a 

P&A, the FDIC opted to pursue an 

open-bank assistance. The agree 

ment with a private investor group 

led by A. Robert Abboud, which 

consisted of S970 million of FDIC 

assistance, was less costly than a 

payoff or a P&A, and it brought 

8500 million in private-sector capi 

tal into the banking firm. Signif 

icant concessions were required 

from holding company debt holders 

and shareholders before the trans 

action could be consummated. If an 

appropriate level of concessions 

could be obtained, an open-bank 

transaction would have an effect 

similar to that of using the capital of 

the affiliates to offset losses. How 

ever, because holding company 

creditors and shareholders must 

agree, obtaining these concessions 

is often a major obstacle to com 

pleting open-bank assistance. The 

First City transaction was no excep 

tion. 

Once a discount rate has been es 

tablished for the redemption of the 

outstanding holding company debt, 

the approval of the transaction de 

pends on the number of bond hold 

ers who tender their notes. In this 

transaction, it was determined that 

90 percent of the #226 million in 

affected holding company debt 

would have to be tendered at a dis 

count of between 65 and 75 percent 

of face value. Bond holders who 

agreed to these concessions would 

receive between 35 and 45 cents 

per dollar of investment; however, 

those who refused to tender their 

notes could potentially receive 100 

cents per dollar of investment. It 

was this aspect of the transaction 

that enticed arbitragers to purchase 

the holding company's bonds at 

discount prices with the hope that 

the FDIC would have to sweeten 

the transaction in order to obtain 

their concessions. The risk of this 

approach is that the transaction will 

not be approved and bond holders 

will receive nothing on their in 

vestment. 

The presence of the arbitragers 

made it significantly more difficult to 

obtain the necessary concessions. In 

an effort to preserve the transaction, 

the tender level was reduced to 70 

percent, and was finally consum 

mated with 67.5 percent of the bond 

holders tendering their notes. 

Because the tender level was less 

than 90 percent, the overall cost of 

the transaction was increased. In 

order to repay the 32.5 percent of the 

outstanding bonds at 100 percent of 

face value, an extra issue of senior 

notes had to be issued by the "col 

lecting bank" which was set up to sell 

the estimated $1.79 billion of bad 

assets of First City. The FDIC's share 

of the proceeds from the sale of these 

assets would be subordinate to these 

notes." 

The First City transaction illus 

trates the difficult decisions which 

must frequently be made in resolv 

ing bank failures. Neither a payoff 

nor a traditional P&A transaction 

was completely appropriate in this 

situation, and the open-bank assis 

tance that was ultimately agreed to 

was not without drawbacks. Since 

the First City transaction, the FDIC 

has attempted to reconcile these 

trade-offs by refining the traditional 

failure-resolution methods so that 

policy goals may be implemented 

more effectively. Provisions con 

tained in FIRREA have greatly fa 

cilitated this process. 

The Impact of FIRREA 

on the Treatment of 

Problem Banks within 

Multibank Holding 

Companies 

The FDIC encounters a unique 

set of problems when resolving the 

failure of a bank within a multibank 

holding company, as illustrated in 

the First City transaction and in 

subsequent large-bank failure situa 

tions. These problems arise because 

banks within a multibank holding 

company generally conduct busi 

ness as though they are a single 

corporate entity, which can make 

the FDIC's task of resolving bank 

failures more difficult and expen 

sive. FIRREA contains a number of 

important provisions that enhance 

the agency's ability to handle effec 

tively the failure of a bank that is a 

member of a multibank holding 

company. 

Because there are few restrictions 

on intracompany transactions in a 

multibank holding company, sub 

sidiary banks often behave as 

branches of a single bank.22 In 

many cases this means that the 

larger banks within the holding 

company generate most of the loan 

business, while drawing much of 

their funding from the smaller sub 

sidiary banks. 

In theory, this problem could 

arise whenever more than one bank 

is owned by a common parent. In 

states with unrestricted intrastate 

expansion, the branches of an indi 

vidual bank are actually part of one 

corporate entity. There may be 

good reasons why some institutions 

may prefer to operate in-state units 

as banks within multibank holding 

companies rather than as branches 

within a single bank, just as there 

may be valid reasons why banks 

within a multibank holding com

2" Had the pro rata approach to general 

creditors been a clear option at that time, the 

FDIC could have imposed losses on the sub 

sidiary banks that had claims against the lead 

bank because of intracompany funding ar 

rangements. However, the pro rata treatment 

of claimants in P&A transactions was in its 

early stages of development, and not com 

monly practiced by the FDIC in failureresolution situations at the time of this trans 

action. The effect of the pro rata provisions 

contained in P1R.REA on the failure-resolution 

treatment of banks within multibank holding 

companies will be discussed later in this arti 

cle. 

1] [n addition, the transaction could have 

been jeopardized by shareholder approval had 

it not fallen under Delaware law. In Texas, 

two-thirds of each class of stocltholders must 

approve the transaction, rather than twothirds of the aggregate, as is the case in Dela 

ware. 

s Sections 23A and 23B of the Federal Re 

serve Act limit transactions between member 

and nonmember banks and their nonbanking 

affiliates. Similar restrictions do not apply for 

transactions between subsidiary banks within 

a holding company. 
FDIC Banking Review 

pany should be able to transfer 

funds among themselves. Never 

theless, it would be inconsistent to 

allow banks to behave either as a 

single unit or as separate entities as 

it suits their benefit, because this 

allows banks to reap the rewards in 

prosperity and to burden the FDIG 

with potentially greater losses in in 

solvency. 

The FDIC has taken the view that 

if a multibank holding company 

functions as a branch banking sys 

tem when solvent, then it should be 

treated as such if it becomes insol 

vent. The pro rata treatment of 

claimants and the authority to en 

force cross-bank guarantees have 

broadened the FDIG's policy op 

tions in this area. 

Pro rata treatment of claimants 

in multibank holding companies. In 

recent large-bank transactions, the 

FDIC has effectively used the pro 

rata treatment of claimants to ease 

the problems associated with han 

dling failing banks in multibank 

holding companies. A review of the 

First RepublicBank and the MCorp 

transactions illustrates how the pro 

rata treatment of claimants facili 

tates the FDIC's policy objectives 

with respect to the treatment of 

problem banks within multibank 

holding companies. 

In the First RepublicBank Corpo 

ration transaction, the FDIC pro 

vided only pro rata coverage in set 

tling the claims of intracompany 

creditors (subsidiary banks), while 

fully protecting other categories of 

uninsured depositors and general 

creditors.23 The FDIC viewed the 

funding arrangement between the 

lead banks and the subsidiaries as 

the operations of a single entity, 

rather than as separate and distinct 

units. Had intracompany trans 

actions between the bank sub 

sidiaries been completely protected, 

some of the parties with direct re 

sponsibility for the insolvency of 

the lead bank would not have suf 

fered any loss as a result of their 

actions. Rather, the FDIC would 

have had to absorb the 

losses resulting from these intra 

company transactions. In turn, the 

pro rata treatment of intracompany 

transactions was a contributing fac 

tor to the insolvency of some of the 

other 39 banks and the credit card 

subsidiary.24 

In the MCorp transaction, the 

FDIC's pro rata policy yielded 

slightly different results. Since there 

were no prior assurances given to 

any categories of claimants, certain 

categories of general creditors were 

subjected to losses. The FDIC dis 

tinguished between claimants in 

side and outside the holding com 

pany. Intracompany federal funds 

claims received only a pro rata re 

covery, while similar claimants out 

side the holding company were fully 

protected against loss. As a result, 

20 of the 25 MCorp banking sub 

sidiaries were declared insolvent. 

The five surviving MCorp sub 

sidiaries were not rendered insol 

vent as a result of the pro rata 

treatment of intracompany trans 

actions, and remained part of the 

surviving holding company. 

Cross-Guarantees. Prior to FIR

REA, bank regulatory agencies 

lacked the explicit statutory author 

ity to force banks within holding 

companies to support their finan 

cially troubled bank affiliates. Un 

der FIRREA, however, the FDIC is 

permitted to impose liability on 

commonly controlled depository in 

stitutions to recoup any loss result 

ing from handling the failure of, or 

providing financial assistance to, an 

insured bank. The FDIC is required 

to estimate the amount of the loss it 

will incur, and inform each com 

monly controlled institution of its 

estimated share of the loss within 

two years of the date of failure or 

no liability may be imposed. For a 

period of five years, no bank will be 

held liable under the crossguarantee provisions for losses in 

curred as a result of the acquisition 

of a troubled thrift institution prior 

to the enactment of FIRREA, and 

vice versa. In addition, the FDIC 

may waive the collection of losses 

from commonly controlled deposi 

tory institutions if it determines 

that an exemption is in the best in 

terest of the deposit insurance 

funds. 

The general policy of the FDIC is 

to assess liability in all cases except: 

(1) where the acquirer held no di 

rect or indirect financial interest in 

the institution prior to insolvency; 

and (2) where the cumulative pro 

jected losses to the FDIC are 

greater than the cost of waiving the 

liability. The FDIC determines the 

applicability of the cross-guarantee 

provisions, and if they will be en 

forced, on a case-by-case basis. 

The cross-guarantee provisions of 

FIRREA enable the FDIC to address 

the problems multibank holding 

companies may pose in failureresolution situations. Cross-bank 

guarantees are designed to ensure 

that the deposit insurance fund 

does not suffer disproportionate 

losses in situations where assets 

that could be used to offset bankfailure costs are held in commonly 

controlled depository institutions. 

Since the FDIC's experience in im 

plementing cross-guarantees is very 

limited, it is difficult at this time to 

evaluate how successful this new 

tool will be in handling bank fail 

ures. At the very least, however, by 

enforcing cross-guarantees, the 

FDIC should be better able to pro 

tect the bank insurance fund from 

losses stemming from inter affiliate 

transactions by banks within a 

holding company. 

2i The FDIC provided assurances to fully 

protect the claims of certain creditors outside 

the holding company in an attempt to ease 

the liquidity problems experienced by the 

lead bank. As a result of these prior as 

surances, certain creditors to the lead bank 

that were not part of the holding company 

were completely protected from loss. 

24 The PDIC also provided a SI billion emer 

gency loan to halt a run on deposits. The loan 

was secured by the capital of the affiliate 

banks. Once the FDIC declared that the loan 

would not be renewed some of the affiliates 

were declared insolvent because of the pledge 

of their capital. The pro rata treatment of in 

tracompany transactions alone could have 

rendered a number of affiliates insolvent. 

However, the combination of these two con 

ditions precipitated the failure of the remain 

ing banks in the holding company. 

10 
Failure-Resolution Methods 

Concluding Comments 

This article discusses the various 

policy objectives the FDIG seeks to 

achieve when determining the most 

appropriate method for resolving 

bank failures. The FDIC's primary 

policy objective is to maintain pub 

lic confidence and stability in the 

banking system. However, the FDIC 

must also be concerned with issues 

such as maintaining market dis 

cipline against excessive risk-taking 

by banks, pursuing the least-costly 

failure-resolution method, limiting 

the deposit insurance safety net. 

and implementing policies that are 

both consistent and equitable. Un 

fortunately, these goals are not al 

ways compatible, and important 

trade-offs exist among the various 

public-policy objectives. 

In an effort to more satisfactorily 

achieve its policy objectives, the 

FDIC has significantly modified its 

handling of bank failures. This was 

facilitated by the legislative changes 

discussed in this article that have 

enabled the FDIC to refine and en 

hance its traditional failure-resolu 

tion methods. With greater flexibil 

ity to adapt resolution methods to 

the particular circumstances sur 

rounding each bank failure, policy 

goals are more easily achieved. The 

ability to effectively implement pol 

icy goals, in turn, should produce a 

stronger, more effective system of 

federal deposit insurance. 

11 
FD1C Banking Review 

An Overview 

of the U.S. Credit Union 

Industry 

by Alane K. Moysich* 

In recent years, credit unions 

have grown much faster than 

other types of federally insured 

financial institutions, in part as a 

result of expanded powers and lib 

eralized membership requirements. 

This rapid growth, and the corre 

sponding increased importance of 

credit unions in the financialservices marketplace, have led to 

vocal claims by commercial bank 

ers that credit unions have an un 

fair competitive advantage due to 

their tax-exempt status and other 

regulatory discrepancies. Further 

more, the failure of large numbers 

of commercial banks and thrift in 

stitutions, and the need for legis 

lation to restructure the thrift in 

dustry, have led many to question 

whether credit unions also pose 

substantial risks to the current sys 

tem of federal deposit insurance. 

As a result, two studies were 

mandated by Congress in the Fi 

nancial Institutions Reform, Recov 

ery, and Enforcement Act of 1989 

(FIRREA). The first study is a re 

view of the entire federal deposit 

insurance system, to be conducted 

by the Treasury Secretary in con 

sultation with other federal officials. 

One part of this review will be an 

examination of whether the insur 

ance of credit unions should be 

handled by an agency other than 

the National Credit Union Adminis 

tration (NCUA), which currently 

oversees the National Credit Union 

Share Insurance Fund (NCUSIF). 

The second study, to be prepared 

hy the General Accounting Office 

(GAO), will focus solely on the role 

credit unions play in the market 

place, the financial condition of the 

industry and its insurance fund, 

and whether any changes are 

needed in the current regulatory 

structure. These studies will be pre 

sented to Congress in early 1991. 

This article provides information 

on the history, growth, regulation, 

and insurance of credit unions in 

the United States. The current con 

dition of the credit union industry, 

and its insurance fund, also are dis 

cussed. Finally, this article presents 

information on the evolution of the 

common bond requirement as well 

as a summary of arguments for and 

against tax exemption. 

Origins and Growth of 

the Credit Union Industry 

Early European Credit 

Cooperatives 

The origins of the credit union 

industry in the U.S. can be traced 

to mid-19th century Germany 

where two men, Hermann SchulzeDelitzsch and Friedrich Wilhelm 

Raiffeisen, began organizing coop 

erative credit societies in response 

to the economic depression of the 

late 1940s. These men sought to 

combat usury and to improve the 

economic lot of the working class 

through mutual self-help and 

democratic organization. Credit co 

operatives rapidly spread through 

out Germany, where the social and 

economic structure was tradition 

ally centered around the com 

munity, and developed into a signif 

icant segment of the 20th century 

banking industry there. During the 

late 1800s, cooperative credit socie 

ties, or people's banks, similar to 

those in Germany, were formed in 

several other European countries. 

Credit Unions in 

North America 

Although some cooperative activ 

ities were organized in New York 

City among immigrant German 

craftsmen in the 1860s, credit 

unionism came to North America 

largely through the work of Cana 

dian journalist Alphonse Des

jardins, who established the first 

caisse popuktire in Levis, Quebec, 

in 1900. The United States' credit 

union movement claims Boston 

merchant and philanthropist Ed 

ward A. Filene as its founder. Filene 

and Pierre Jay, the first commis 

sioner of banks for Massachusetts, 

were interested in fighting usury 

and in finding alternative sources of 

consumer credit. With the help of 

Desjardins, they drafted the first 

credit union law, passed by Massa 

chusetts in 1909.1 This law defined 

* Alane K. Moysioh is a Financial Analyst in 

the FDIC's Division of Research and Statistics. 

1 That same year, St. Mary's Cooperative 

Credit Association in Manchester, New Hamp 

shire, actually became the first credit union 

to gain legal status in the U.S., through a special 

act of the State Legislature. 

12 
An Overview of the U.S. Credit Union Industry 

a credit union as "a cooperative as 

sociation formed for the purpose of 

promoting thrift among its mem 

bers,"2 and adopted the principle of 

member share capital to finance 

member loans. 

Unlike their European counter 

parts, credit unions in the U.S. 

were designed to be self-contained 

units, thereby eliminating much of 

the need for outside credit. The au 

thors of the first U.S. credit union 

law also incorporated the notion of 

membership limited to groups with 

a common bond. Finally, unlike the 

European cooperatives, which were 

designed to make production loans 

to farmers and small businessmen, 

U.S. credit unions were founded 

primarily to make consumer loans. 

Filene promoted the credit union 

concept vigorously during the early 

1900s, eventually spending over $1 

million of his own money to organ 

ize the credit union movement at 

the national level.3 By 1920, how 

ever, although nine states had en 

acted credit union laws there were 

still less than 200 credit unions in 

operation.4 The growth of credit 

unionism began in earnest during 

the 1920s, aided by the general 

economic prosperity that prevailed 

during the decade, and later, by 

passage of the Federal Credit Union 

Act in 1934. 

Credit Union Growth, 

1935-Present 

As shown in Table 1, the number 

of credit unions rose from 3,372 in 

1935 to over 9,000 in 1940. At the 

same time, credit union member 

ship grew by over 300 percent and 

savings by nearly 500 percent. Sav 

ings at credit unions continued to 

increase during the 1940s, but 

membership growth slowed greatly 

and the number of credit unions ac 

tually declined between 1940 and 

1945, as the country's attention 

was focused on World War II. 

Credit union growth began to ac 

celerate in 1950, and the number of 

credit unions doubled from 10,591 

to 20,456 over the next decade. 

During that same period, member 

ship rose from roughly 4.5 million to 

over 12 million and member savings 

increased fivefold, from $850 million 

to nearly $5 billion. Growth in the 

number of credit unions slowed 

dramatically during the 1960s, and 

the emphasis of the industry's trade 

organization shifted from organizing 

credit unions to developing those 

already in operation. The number of 

credit unions peaked sometime dur 

ing 1969 or 1970, at slightly less than 

24,000, then declined slowly over the 

course of the 1970s. Credit union 

membership and savings, however, 

continued to grow throughout the 

1960s and 1970s. Membership rose 

to over 22 million by 1970, and ex 

ceeded 44 million by 1980; while 

credit union savings, which exceed 

ed #15 billion in 1970, grew to $60 

billion by 1980. This latter trend was 

due, in part, to the introduction of 

federal share insurance in 1970. 

The 1980s was a decade of con 

solidation for the United States' 

credit union industry, which now 

consists of approximately 15,000 

institutions. During this time, credit 

union savings continued to grow, 

from $61.7 billion at year-end 1980 

to 8178.5 billion at year-end 1988, 

an increase of 189 percent. In con 

trast, deposit growth at commercial 

banks and savings and loans was 64 

percent and 93 percent, respec 

tively, during the 1980-1988 period. 

Total credit union assets, which 

were $69 billion in 1980, rose to 

nearly $200 billion by 1988. De 

spite the credit union industry's re

eent rapid growth, however, it is 

still small relative to the com 

mercial banking industry, which 

had assets of 83,131 billion at yearend 1988, and the savings and loan 

industry, which had assets of 

$1,352 billion. 

2J. Carroll Moody and Gilbert C. Kite, The 

Credit Union Mtnxment: Origins and Devel 

opment, 1850-1970 (Lincoln: University of 

Nebraska Press, 1971), 36. 

i Judy Weidman, "Are We Forgetting Who 

We Are?" Credit Union Magazine 54 (October 

1988): 37 

fl Donald J. Melvinh Raymond N. Davis and 

Gerald C. Fischer, Credit Union.-: and the 

Credit Union Industry: A Study of the 

Powers, Organisation, Regulation, and Com 

petition (New York Institute of Finance, 

1977), 12. 

5 This trend also has been observed among 

cooperative credit institutions in Europe. 

Table 1 

Selected Credit Union Statistics, 1935-1988 

($ in Millions) 

#of 

Credit #of 

Year Unions Members Assets Savings Loans 

1935 3,372 641,797 i 50 $ 38 J 36 

1940 9,023 2,826,612 253 222 190 

1945 8,683 2,842,989 435 369 127 

1950 10,591 4,610,278 1,005 850 680 

1955 16,201 8,153,641 2,743 2,447 1,934 

1960 20,456 12,037,533 5,653 4,975 4,377 

1965 22,219 16,753,106 .10,552 9,249 8,095 

1970 23,688 22,776,676 17,951 15,484 14,100 

1975 22,678 31,321,234 37,554 32,800 28,105 

1980 21,467 44,047,759 68,996 61,748 48,707 

1985 17,581 51,721,709 137,168 125,512 85,139 

1988 15,719 58,629,214 196,424 178,532 126,542 

Source: CUNA, Credit Union Report, 1988. 

13 
FDIG Banking Review 

Structure and Operation of 

the Credit Union Industry 

Credit unions are financial insti 

tutions organized by individuals 

having a "common bond," which 

serves to define the eligible field of 

membership. The common bond 

may be one of occupation or asso 

ciation; or it may be a well-defined 

neighborhood, community, or rural 

district. Like banks, credit unions 

may apply for federal or state char 

ters.6 Branch operations, though 

uncommon, may be established, 

and credit union charter con 

versions, mergers and liquidations 

are easier to facilitate than is the 

case with other financial insti 

tutions. 

Credit unions are democratic or 

ganizations; each member has one 

vote, and therefore, an equal say in 

how the organization is operated. 

Credit union members elect a 

board of directors, only one of 

whom can be compensated for his 

or her services, and other officers of 

the credit union, who volunteer 

their services. The board of direc 

tors is responsible for appointing a 

supervisory committee of between 

three and five credit union mem 

bers, whose function is to oversee 

the organization's financial oper 

ations through internal audits and 

reports to the board. Additionally. 

credit unions are required to have a 

three-person credit committee to 

pass judgment on all loan appli 

cations. The credit committee may 

be elected by the credit union's 

members, or it may be appointed 

by the credit union's board of direc 

tors. 

By definition, credit union mem 

bers own their credit unions coop 

eratively. Thus, savings deposits, 

called "shares," earn dividends in 

stead of interest, and are classified 

as equity, rather than liabilities, on 

financial statements.7 In the event 

of a liquidation, credit union mem 

bers are entitled to a pro rata dis 

tribution of assets in excess of li 

abilities. Credit unions are formed 

as nonprofit organizations, with the 

purpose of serving the financial 

needs of members by acting as an 

intermediary between member 

savers and member borrowers. 

Theoretically, the existence of a 

common bond among members 

lessens credit risk; the lack of pres 

sure to provide strong earnings to 

stockholders may also be a disin 

centive for excessive risk-taking by 

credit unions. 

Credit union capital is comprised 

of statutory reserves, voluntary re 

serves, and undivided earnings. 

There is no initial minimum capital 

requirement for new credit unions. 

but each credit union must set as 

ide a percentage of gross income 

annually until the minimum reserve 

requirement is met. Until 1978, 

federal credit unions were required 

by the Federal Credit Union Act to 

reserve ten percent of outstanding 

loans and risk assets against bad 

debt losses. In contrast, many state 

credit union statutes required re 

serves of seven percent or lower. 

The reserve requirement for federal 

credit unions in operation for more 

than four years and having assets in 

excess of §500,000, was lowered to 

six percent in the 1977 revision of 

the Federal Credit Union Act8 (re 

ferred to in the industry as the 

"Mini Bill"). The reserve require 

ment remains ten percent for 

smaller and newer institutions. 

The Credit Union 

System 

The U.S. credit union industry 

has evolved into a four-tier struc 

ture composed of individual credit 

unions, local chapters, state 

leagues, and the national trade as 

sociation. Local chapters provide 

credit unions with a means to co 

operatively offer programs and ser 

vices to their members. About 90 

percent of credit unions also belong 

to their state leagues, organizations 

which exist in each of the fifty 

states, as well as the District of 

Columbia and Puerto Rico.9 

State leagues, which are really 

trade associations, provide member 

credit unions with services ranging 

from technical help and education 

to public relations and legislative 

lobbying. Leagues are funded by 

member dues, and most associa 

tions work in conjunction with a 

statewide service corporation and a 

corporate central credit union. Ser 

vice corporations offer products and 

services for credit unions, such as 

office supplies and data processing. 

Corporate credit unions are essen 

tially credit unions for credit 

unions; they provide investment, 

liquidity, and transactionsettlement services for other credit 

unions. They also may loan funds 

to the officers of member credit 

unions who are restricted by law as 

to the amount that they may bor 

row from the institutions they con 

trol. In 1988, there were 41 cor 

porate credit unions, 30 of which 

were federally insured.1" 

Each state league is a member of 

the Credit Union National Associa 

tion (CUNA). CUNA, its affiliated 

service organizations, and the U.S. 

Central Credit Union provide the 

same types of services nationally 

that the state leagues provide 

locally. In particular, the U.S. Cen 

tral Credit Union acts as a credit 

union for the corporate centrals, 

and provides the main link to the 

6 According to The Comparative Digest of 

Credit Union Acts, three states (Delaware. 

South Dakota and Wyoming), and the Discriot 

of Columbia, do not charier credit unions; the 

Commonwealth of Poerto Rico does, however. 

' This practice was challenged by the Amer 

ican Institute of Certified Public Accountants 

in its 1986 guidebook. Audits of Credit 

Unions, which states that member shares 

should be classified as liabilities, rather than 

equity, on audited credit union financial 

statements. This ruling was reinforced by the 

Financial Accounting Standards Board's 

[PASB) Emerging Issues Task Force in Issue 

89-3. In practice, credit union share capital is 

not considered equity for purposes of calculat 

ing the capital-to-asset ratio required by reg 

ulators, but it is considered equity for certain 

investment regulations. 

8 Amendments to the federal credit union 

statute are contained in Title III of the Deposi 

tory Institutions Amendments of 1977 Acl, PL 

35-22. This Act was passed on April 19, 1977, 

to extend temporarily the flexible Regulation 

Q. authority of the financial regulatory agen 

cies to establish ceiling rates paid on time and 

savings deposits. 

'Judy Weidman, "Cooperation Works," 

Credit Union Magazine 55 (July 1989): 35 

">NCUSIP, Annual Report, 1988. 3. 
An Overview of the U.S. Credit Union Industry 

Federal Reserve System. Thus, even 

small credit unions or those lacking 

financial expertise have access to 

correspondent services such as 

share draft processing, wire trans 

fers and federal funds trading, as 

well as a vehicle to obtain com 

petitive rates on their investments. 

Credit Union Powers 

Until recently, credit union oper 

ations were limited by statute to 

serving the savings and short-term 

credit needs of consumers; invest 

ment options were limited to gov 

ernment securities and deposits in 

federally insured institutions. Over 

the last decade, credit unions have 

received expanded investment au 

thority and virtually the same 

powers as banks and thrifts in 

terms of retail financial services. 

Many of the services offered by 

credit unions today are extensions 

of their traditional activities, albeit 

set in a far more sophisticated and 

competitive financial marketplace. 

Traditional Services 

One of the stated purposes of 

credit unions has always been to 

improve the financial condition of 

members by encouraging thrift and 

by offering consumer financial ser 

vices in a convenient location, often 

the workplace, at a reasonable cost. 

Thus, credit unions were among the 

first financial institutions to offer 

payroll deduction and directdeposit plans, in the past, many 

credit unions provided, free of 

charge, some limited amount of 

credit life insurance, as well as fi 

nancial counseling and consumer 

education services. Other activities 

were developed according to the 

needs of a particular credit union 

and included services such as safe 

deposit boxes, automatic teller ma 

chines, and the sale of money or 

ders, travelers checks, savings 

bonds, food stamps, and even hunt 

ing and fishing licenses. 

The national trade association, 

GUNA, and the affiliated state 

leagues have always had an active 

role in the development of new ser 

vices for credit unions and their 

members. Over the years, CUNA 

has organized a number of profitmaking (and tax-paying) organiza 

tions whose services are marketed 

to credit unions and their mem 

bers. The earliest service affiliate, 

CUNA Mutual Insurance Society, 

formed in 1935 to provide health 

and life insurance to credit union 

members, is now only one of 

GUNA's affiliates providing 

consumer-related insurance prod 

ucts including property, casualty, 

automobile and credit life disability 

coverage. 

Expanded Powers 

Savings. The 1977 "Mini Bill" 

was the first legislation to alter sub 

stantially federal credit union 

powers since the original Federal 

Credit Union Act was passed in 

1934. Among other provisions, it 

gave credit unions savings-gathering 

authority extending far beyond the 

regular passbook-type share ac 

count. Thus, for the first time, 

credit unions could offer a wide va 

riety of savings instruments includ 

ing variable-rate share accounts, 

money-market certificates, jumbo 

CDs, and other time accounts. 

One of the most hotly contested 

new powers at that time, the ability 

to offer checking (share draft) ac 

counts, was not included in the 

1977 legislation, although an ex 

perimental share draft program had 

begun in 1974. Share draft author 

ity was challenged at the state level 

and in several lawsuits filed by the 

American Bankers Association be 

fore being made permanent in 1980 

with enactment of the Depository 

Institutions Deregulation and Mon 

etary Control Act (DIDMCA). 

Loans. Lending activities also 

were greatly enhanced by the "Mini 

Bill." Previously, credit unions were 

empowered to make loans to mem 

bers for "provident or productive 

purposes," with maturities not to 

exceed five years for unsecured 

loans and ten years for secured 

loans. Under that authority, credit 

unions could, for example, make 

ten-year real-estate loans to help 

members purchase homes; on the 

other hand, credit unions could not 

make line-of-credit loans where the 

ultimate use of the money could 

not be determined. 

Loan authority was substantially 

rewritten in the "Mini Bill," and 

credit unions were given the power 

to "make loans, the maturities of 

which shall not exceed twelve years 

except as otherwise provided," and 

were authorized to make line-of

credit loans, participation loans, 

loans to other credit unions, and 

government-insured or guaranteed 

loans.11 The ability to offer a selfreplenishing line of credit effec 

tively introduced credit unions to 

the credit card market and allowed 

them to offer members overdraft 

privileges on share draft accounts. 

Perhaps the most important au 

thority granted in this legislation 

was die provision permitting federal 

credit unions to make residential 

real-estate loans with maturities up 

to 30 years. Long-term lending (up 

to 15 years) also was granted to 

finance the purchase of a mobile 

home, if used by the member as a 

principal residence, and for homeimprovement loans. In 1978, the 

NCUA adopted a regulation per 

mitting federal credit unions to sell 

mortgage loans in the secondary 

market. Mortgage lending was fur 

ther deregulated by the Garn-St 

Germain Despository Institutions 

Act of 1982, which eliminated 

limits on the size and maturity of 

first-mortgage loans at credit unions 

(subject to NCUA regulations), 

permitted refinancing of mortgage 

loans, and extended the maturity 

limit to 15 years for all second 

mortgages, not just those used for 

home improvements. The Com 

petitive Equality Banking Act of 

1987 empowered the NCUA to ex 

tend the permissible maturity on 

second-mortgage, home-improvement 

11 Melvin, Davis and Fischer, 237-341. 

15 
FDIC Banking Review 

and mobile-home loans beyond 15 

years; as a result, in October 1989, the 

NGUA Board voted to extend the 

maturity limit on these loans to 20 

years.12 

Despite the deregulation of credit 

union lending powers, one tradi 

tional restriction on their activities 

remains: federal credit unions are 

the only financial institutions sub 

ject to a federally imposed ceiling 

on the rates that may be charged 

for consumer loans. Until 1980, the 

maximum amount that credit 

unions could charge members for 

loans was one percent per month 

simple interest, inclusive of fees, or 

12 percent annually. In 1980, when 

lending at federal credit unions had 

virtually stopped, DIDMCA 

amended the statute to allow a 15 

percent ceiling, with the provision 

that the NCUA Board could raise it 

higher for temporary periods if 

economic conditions warranted. In 

December 1980, the Board voted to 

raise the loan-rate ceiling to 21 per 

cent, where it remained until May 

1987, when the NGUA Board voted 

to lower the cap to 18 percent. The 

NGUA Board voted in January 

1990, to extend the 18 percent ceil 

ing until September 8, 1991.13 

Lobbying efforts through the years 

to abolish the loan-rate ceiling 

have, thus far, proved unsuccessful. 

Credit Union Service Organiza 

tions. Another specific lending au 

thority included in the 1977 

amendments to the Federal Credit 

Union Act permits credit unions to 

make loans to organizations which 

provide services associated with the 

routine operations of credit unions. 

As noted earlier, credit union ser 

vice organizations (CUSOs) were 

formed by the trade associations to 

provide services, such as data pro 

cessing, to credit unions lacking the 

size or expertise to develop intern 

ally. The maximum amount that 

may be loaned to GUSOs is one 

percent of the credit union's "paid

in and unimpaired capital and sur 

plus,"14 with an additional one per 

cent permitted to be invested in the 

stock of these organizations. 

During the 1980s, a wide variety 

of GUSOs were formed, prompting 

the NCUA to issue a list of per 

missible activities for GUSOs owned 

by federal credit unions. This list of 

approved activities, issued in 1986, 

is broader than that permitted bank 

holding companies or national 

banks and includes, for example, 

real-estate-brokerage activities. Also 

allowed are: insurance and discount 

brokers, credit card servicers, and 

firms providing financial planning, 

tax preparation, personal property 

leasing, and travel planning. 

Other Investment Powers- Fed 

eral credit union investment powers 

also were expanded by the NCUA in 

1984, when the agency authorized 

credit unions to invest in Yankee 

dollars, Eurodollars, bankers' ac 

ceptances, and cash-forward 

agreements. In 1988, the NGUA be 

gan permitting federal credit unions 

to invest in mortgage-related securi 

ties and to purchase real-estate 

loans, as long as they are bought for 

the purpose of completing a pool of 

loans to be sold or pledged on the 

secondary market. Finally, in 1989, 

the NGUA Board voted to permit 

federal credit unions to purchase 

put options on Government 

National Mortgage Association 

(GNMA), Federal National Mortgage 

Association (FNMA), and Federal 

Home Loan Mortgage Corporation 

securities, as a means to reduce 

interest-rate risk resulting from 

mortgage lending. 

Use of Expanded Powers 

and Current BakmeeSheet Trends 

Many of the expanded powers 

granted credit unions over the 

years were necessitated by the 

combined effects of several trends. 

These include, in particular, tech 

nological changes resulting in the 

development of new products in the 

financial-services industry and the 

deregulation of interest rates at de 

pository institutions. Additionally, 

consolidation within the credit 

union industry has permitted credit 

unions to offer more services, such 

as automatic teller machine net 

works, that may not have been 

cost-effective at smaller credit 

unions. Finally, competition from 

other institutions for traditional 

credit union business, particularly 

automobile financing, has led credit 

unions to expand into new markets. 

In recent years, the fastest 

growth in service offerings by credit 

unions has been for credit cards 

and first mortgages. CUNA reports 

that the number of credit unions of 

fering credit cards doubled from 

10.2 percent in 1985 to 22.4 per 

cent in 1988.15 In contrast, only 

two percent of credit unions offered 

credit cards to members in 1980. 

First mortgages were being offered 

by nearly 30 percent of credit 

unions surveyed in 1988, up from 

12 percent at the beginning of the 

decade. Among credit unions with 

more than $50 million in assets, the 

proportion offering first mortgages 

rose from 35 percent in 1980 to 

88.4 percent in 1988. 

The relative distribution of credit 

union assets, liabilities and equity 

at midyear 1989, is presented in 

Table 2. These data indicate that 

approximately two-thirds of credit 

union assets currently are in the 

form of loans to members,16 while 

investments now account for about 

30 percent of credit union assets. 

Fixed assets, such as land, build 

ings, furniture, etc., account for less 

than two percent of the total; other 

uBNA's Banking Report, Vol. 53, 23 OcLober 1989, 584. 

uBNA's Banking Repon, Vol. 54, 22 Janu 

ary 1990, 99. 

14 According to the statute, "paid-in and un 

impaired capital and surplus" means the bal 

ance of all member share accounts as of a 

given date, less any loss that may have been 

incurred for which there is no reserve, plus 

undivided earnings. Reserves are not con 

sidered part of surplus for purposes of this 

calculation. 

15 CUNA, Credit Union Report, 1988. and 

Credit Union Magazine, June, 1988. 

16 Credit unions generally have higher loanto-asset ratios than either commercial banks 

or savings and loans, which had loan-to-asset 

ratios of 62 percent and 60.7 percent, respec 

tively, at year-end 1988. The comparable fig 

ure for savings banks was 68.6 percent. 

16 
17 
FDIC Banking Review 

Table 4 

Distribution of Credit Union Investments. Midyear 1989 

(Items as Percent of Surplus Funds) 

Source: CLINA, Credit ('man Operating Antics and Spreiuls, Midyear 198'J. 

Regulatory Structure and 

Supervision of Credit 

Unions 

Overview 

The NCUA regulates and super 

vises all federally chartered credit 

unions, while state-chartered credit 

unions are regulated by various 

agencies within their states. Fortyseven states and the Com 

monwealth of Puerto Rico have 

statutes pertaining to the organiza 

tion and operation of credit unions; 

the majority of these statutes con 

tain a "wild card" provision which 

generally allows state-chartered 

credit unions to engage in the same 

activities as federally chartered 

credit unions.11 Additionally, there 

has been a tendency among state 

regulators to copy federal law and 

to ensure that state standards are 

not more lax than those of the 

NCUA. Thus, while most of the reg 

ulations discussed in this paper 

apply specifically to federal credit 

unions, they are true of a majority 

of state-chartered credit unions as 

well. 

Prior to the 1970s, credit unions 

operated under a far less detailed, 

albeit more restrictive, statute than 

those governing other financial in 

stitutions. Interpretation of the law 

tended toward paternalism: if the 

statute did not expressly permit an 

activity, then credit unions could 

not do it. The early credit union 

administrators also played a strong 

advocacy role, actively promoting 

the formation of new credit unions 

and in educating the public about 

the benefits and opportunities of 

credit union membership. 

Credit unions have become sub 

ject to increasing amounts of reg 

ulation as permissible activities 

have expanded and as a result of 

the number of consumer-related 

laws passed in recent years, e.g., 

the Truth in Lending Act, the Real 

Estate Settlement Procedures Act, 

and the Equal Credit Opportunity 

Act. In another sense, however, the 

Federal Credit Union Act has be 

come less restrictive. Recent NCUA 

Boards have tended to allow credit 

unions greater flexibility in manag 

ing their operations by simplifying 

rules and regulations. For example, 

in 1982, NCUA's regulation on 

share, share draft and share certifi 

cate accounts was reduced from six 

pages to two sentences. Essentially, 

it states that a credit union's board 

of directors shall determine rates, 

terms and conditions of accounts, 

and that all advertising and agree 

ments should be clear and accurate, 

In the late 1980s, credit union 

regulators focused on the safety and 

soundness of the credit union sys 

tem. Not surprisingly, a strong ef 

fort was made to improve the capa 

bilities of examiners, consistent 

with the increasing sophistication 

of credit unions. This effort in 

cluded expansion of the field staff, 

improvements in examiner-training 

programs, the use of on-site com 

puters, and better coordination 

with state supervisors. During 1987, 

NCUA adopted the CAMEL rating 

system, which had been used by 

bank examiners, as a supervisory 

tool to evaluate credit union per 

formance. 

National Credit Union 

Administration 

The NCUA was created as an in 

dependent agency in 1970. Previ 

ously, federal regulation of credit 

unions had been the responsibility 

of a number of agencies at different 

times, including the FDIC from 

1942-1948. In its early years, the 

NCUA was headed by a single Ad 

ministrator in conjunction with a 

seven-member advisory board. The 

agency was reorganized as a result 

of the Financial Institutions Regula 

tory and Interest Rate Control Act 

of 1978 (FIRA) which established a 

three-member board to manage 

NCUA. At the same time, the NCUA 

Board was given increased supervi 

sory powers and charged with re 

sponsibility for creating and manag 

ing the Central Liquidity Facility 

(CLF), which is discussed below. 

FIRA also created the Federal Fi 

nancial Institutions Examination 

Council with the newly designated 

Chairman of the NCUA Board as 

one of its five members. 

The NCUA is funded by charges 

17 CONA, Ctimparalive Digest of Credit 

Union Acts, 1986 edition. 13-14. 

18 
An Overview of the U.S. Credit Union Industry 

to the NCUSIF (referred to as the 

"overhead transfer"), to cover the 

agency's insurance-related activi 

ties, and by fees received from 

credit unions for NGUA's other ser 

vices. Prior to 1979, separate fees 

were assessed for examination, su 

pervision, and chartering of federal 

credit unions. The agency now col 

lects one annual operating fee from 

all federal credit unions, scaled ac 

cording to asset size. In 1986, the 

overhead transfer rate was raised 

from 33 percent to 50 percent of 

the agency's budget, reflecting the 

proportion of NGUA's costs which 

are insurance-related. Operating 

fees also have been raised in recent 

years to meet NGUA's expenses. 

The NGUA's powers are similar to 

those of the Federal Home Loan 

Bank Board, prior to enactment of 

FIRREA. NGUA is responsible for 

chartering, supervising, examining 

and insuring federal credit unions. 

State-chartered credit unions that 

elect federal share insurance are 

jointly supervised by NGUA and the 

respective state authorities. The 

NGUA Board has authority to issue 

cease-and-desist orders, to remove 

officers and directors for causes 

such as dishonesty or unfitness, 

and to suspend a federal credit 

union's charter or place the insti 

tution in involuntary liquidation in 

case of insolvency. 

During the 1980s, NCUA was 

given increased authority to deal 

with troubled credit unions. The 

agency first sought and received 

temporary powers of con

servatorship, which enable NGUA 

to take control of a failing credit 

union when it believes that the in 

stitution can be restored to health. 

Conservatorship also prevents dis 

sipation of a credit union's assets in 

cases where a cease-and-desist 

order has been willfully violated, or 

when a credit union's records have 

been concealed from examiners, 

NCSA's conservatorship authority 

was made permanent in the Com 

petitive Equality Banking Act of 

1987. 

The NGUSIF and NCUA also were 

granted increased supervisory and 

enforcement powers under Title IX, 

Regulatory Enforcement Authority 

and Criminal Enhancements, of 

FIRREA. In general, this section of 

the legislation grants federal bank 

ing agencies broader and more st 

ringent enforcement authorities, 

such as provisions to increase civil 

and criminal penalties, to expand 

the universe of persons subject to 

enforcement, and to shorten the 

required period for notice prior to 

termination of federal deposit in 

surance. 

Other enhanced supervisory 

powers included in FIRREA were 

directed to NCUA, in particular, as 

the result of the 1988 failure of 

Franklin Federal Credit Union of 

Omaha, Nebraska, the costliest credit 

union failure to date. The agency was 

given authority to investigate any 

substantive allegation of misconduct 

by a credit union or any institutionaffiliated party; previously, NCUA 

had been restricted to investigating 

only those irregularities that were 

discovered during the examination 

process. Additionally, FIRREA 

strengthened the existing require 

ment that all federally insured credit 

unions have an annual audit con 

ducted by the institution's super 

visory committee, or by an outside 

certified public accountant. 

As directed by FIRREA, NCUA 

adopted a regulation in late 1989, 

identifying the conditions under 

which an independent audit by a cer 

tified public accountant is required. 

These are: if the credit union's super 

visory committee has failed to con 

duct the required annual audit; or, if 

that audit was incomplete or un 

satisfactory; or, if the credit union has 

experienced serious and persistent 

recordkeeping deficiencies.18 More 

importantly, FIRREA gave NCUA 

power to enforce the annual audit 

regulation by stipulating that a credit 

union's failure to comply will con 

stitute an unsafe and unsound 

practice. 

National Credit Union 

Share Insurance Fund 

The NCUSIF was established in 

1970 as a fund in the U.S. Treasury 

under the management of NGUA. 

Legislation creating the NGUSIF di 

rected NGUA to insure member ac 

counts in all federal credit unions 

and in all qualifying state credit 

unions requesting insurance.19 No 

start-up capital from the U.S. 

Treasury or Federal Reserve was 

used to launch the NCUSIF, and in 

surance premiums (l/12th of one 

percent) were the fund's primary 

source of income during its first 

nine years. Low insurance losses 

and operating expenses, combined 

with generally favorable economic 

conditions, permitted the fund to 

put 74 percent of its revenues di 

rectly into equity capital. As a re 

sult, the ratio of equity to insured 

shares rose to 0.32 percent by 

1979. 

This ratio began to decline the 

following year as credit union losses 

increased due to sudden plant clos 

ings, poor investment decisions, 

and the adverse effects of inflation 

and recession on credit union 

finances. During the 1980-83 

period, fund equity stopped growing 

and contingent liabilities were used 

to conserve cash reserves.20 How 

ever, these liabilities soon grew to a 

level almost equal to the fund's en 

tire equity, forcing the NGUA to 

impose special assessments, which 

were permitted by statute. In 1982, 

the additional assessment was twothirds of the regular assessment and 

in 1983, the regular assessment was 

wBNA's Banking Report, Vol. 53, II 

December 1989, 880-881. 

19 NCUSIF insures approximately 96 percent 

of all credit union shares; the remaining four 

percent are insured by 11 state credit union 

or guaranty corporations, although six credit 

unions operated with no deposit insurance 

coverage in 1988. For a listing of the state laws 

governing credit union share insurance, see the 

NCUSIF's 1988 Annual Report, page 4. 

ao NCUSIF, Annual Report, 1984, 4-5. 
FDIC Banking Review 

effectively doubled. These ad 

ditional funds arrested the decline 

in the equity-to-share ratio but did 

not help move the NCUSIF toward 

its mandated goal of a one percent 

equity ratio. 

Legislation to capitalize the fund, 

approved by Congress in 1984, re 

quired credit unions to deposit one 

percent of insured shares in the 

fund. The amount of each credit 

union's deposit is carried as an as 

set on its books, and is adjusted 

annually in accordance with 

changes in the credit union's in 

sured shares. These deposits are to 

be returned to individual credit 

unions in the event the fund's oper 

ations are transferred from the 

NGUA, or in cases where a credit 

union converts to insurance cover 

age provided by another source or 

voluntarily liquidates. A credit 

union's deposit is not returned if 

the institution is declared insolvent. 

The NCUSIF is authorized to use 

the deposit funds to meet insurance 

expenses, if necessary, although 

any amount used must be expensed 

and replenished by insured credit 

unions. Therefore, the NCUSIF is 

designed to have a capitalization 

floor of one percent. 

The capitalization legislation also 

established a new "normal oper 

ating level," or level of fund equity 

to total insured shares of 1.3 per 

cent. The fund is required to con 

tribute sufficient amounts of net in 

come each year to obtain and 

maintain that goal. This figure 

serves as a ceiling; any excess 

amount of equity is returned to in 

sured credit unions as a dividend, 

as was done in 1985. The fund's 

equity-to-shares ratio stood at 1.26 

percent as of June 30, 1988.21 In 

the five years since capitalization, 

the NGUSIF has been able to pay all 

administrative and insurance costs 

from its investment income, 

thereby allowing NCUA to waive the 

annual insurance premium assess 

ment and saving credit unions $520 

million in expenses through 1989.22 

A recent proposal, contained in 

the original Bush Administration's 

plan for the savings and loan legis 

lation, would have required credit 

unions to write off their books the 

one percent deposit each is re 

quired to maintain in the NCUSIF, 

and to expense all future con 

tributions. The current NCUA reg 

ulation, which instructs credit 

unions to record the one percent 

deposit as an asset, is consistent 

with generally accepted accounting 

principles. 

The credit union industry argues 

that maintaining this deposit on 

their books as an asset is an impor 

tant hedge against the type of moral 

hazard present under the premiumtype of deposit insurance fund. 

That is, by maintaining an owner 

ship interest in the fund, credit 

unions are subject to a form of 

market discipline in that they bene 

fit from keeping industry losses to a 

minimum. Critics of this practice 

argue that the industry is over 

stating its capital by permitting this 

type of accounting. 

Central Liquidity Facility 

The Financial Institutions Reg 

ulatory and Interest Rate Control 

Act of 1978 authorized NCUA to es 

tablish the Central Liquidity Fa 

cility (CLF), and to oversee its on 

going operations. The CLF was 

designed to be a central bank and 

lender of last resort for the credit 

union industry which, at that time, 

had no access to a governmentsponsored liquidity facility such as 

the Federal Reserve System23 or 

the Federal Home Loan Bank Sys 

tem. In the absence of such a fa 

cility, the industry had developed a 

series of state-chartered central 

credit unions and, beginning in 

1975, federally chartered corporate 

central credit unions,24 to manage 

industry liquidity by pooling avail 

able credit union investment funds, 

and making these funds available 

for loans to other credit unions. 

The CLF was established to pro 

vide a back-up source of liquidity 

from outside the credit union in 

dustry, and hence, to provide fi 

nancial stability during an industry 

wide economic downturn. The CLF 

charges above-market rates for its 

short-term {30-90 days) adjustment 

credits, and for its seasonal credits, 

which are generally loans of 90-270 

days' duration. The CLF prices 

these loans by setting the rate just 

above the average rate charged by 

corporate central credit unions.25 

Income generated by the spread 

between its borrowing rate and that 

charged for its short-term and 

seasonal liquidity credits is used by 

the CLF to subsidize lending to 

troubled credit unions. These 

below-market-rate protracted ad 

justment credits (loans of one to 

four years), are collateralized loans 

granted to credit unions whose 

liquidity needs are expected to be 

of an extended duration, and which 

are the result of national, regional, 

or local difficulties. Unlike the Fed 

eral Home Loan Bank System, 

which may make advances for 

periods of up to twenty years for 

any purpose consistent with the 

promotion of home financing, the 

CLF makes no advances to credit 

unions for purposes of expansion. 

The CLF, which began operations 

on October 1, 1979, is owned by its 

member credit unions and managed 

by the NCUA Board in Washington, 

D.C.. Unlike the Federal Reserve 

System and the Federal Home Loan 

Bank System, the CLF has no re 

gional credit union liquidity facili 

ties. Regular membership in the 

2i NGUSIF, Annual Report, 1988, 14. 

*> BNA's Banking Report, Vol. 53, 11 

December 1989, 881. 

" Pearee notes that, although some large 

credit unions now have legal access to the 

Federal Reserve's discount window, they do 

not really have a choice between borrowing 

from the CLF or the discount window because 

the Federal Reserve requires that credit 

unions first approach the CLF1 (p. 10). 

-'Technically, "corporate central" credit 

unions restrict membership to other credit 

unions, while "central" credit unions raav, 

depending on state law, also accept certain 

individuals as members For a history of cen 

tral credit unions, see Donald J. Melvin, et. a!., 

pages 84-85. For a compilation of slate laws 

regarding central credit unions and corporate 

credit unions, see the Comparative Digest of 

Credit Union Acts. 

2S Pearee, 10. 

20 
An Overview of the U.S. Credit Union Industry 

CLF is open to federal or statechartered credit unions, insured or 

uninsured. Corporate central credit 

unions may join as agent members, 

thereby providing access to the CLF 

to their member credit unions. Dur 

ing 1988, the CLF had 266 direct 

credit union members and 42 agent 

members26 (generally one from 

each state), representing another 

15,500 credit unions.27 

Each credit union wishing to join 

the CLF is required to subscribe to 

the latter's capital stock in an 

amount equal to no less than onehalf of one percent of its paid-in 

and unimpaired capital and surplus; 

for agent members, the amount is 

based on the surplus of all member 

credit unions that are not them 

selves regular members of the CLF. 

Only one-half of the required sub 

scription amount is actually remit 

ted to the CLF; the remainder is 

required to be held in liquid assets 

by members, subject to call by the 

NCUA Board. Subscriptions are ad 

justed annually to reflect changes in 

the member credit unions' paid-in 

and unimpaired capital and surplus. 

Dividends are declared and paid 

quarterly on members' required 

capita) stock. Funds remitted by 

credit unions over and above the 

amount required for membership 

are called member deposits; these 

amounts receive interest payments 

equivalent to the dividend rate paid 

on capital stock. Members' equity 

in the CLF at the end of fiscal year 

1988 was 8408.4 million (excluding 

unremitted subscriptions) and 

members received S24.5 million in 

dividends and interest for the year. 

The NCUA reports that this figure 

represents a 6.4 percent return on 

members' capital and deposits.28 

The CLF invests all capital in U.S. 

government and agency obligations, 

and in deposits at member credit 

unions or at federally insured finan 

cial institutions. The CLF funds all of 

its lending activities by borrowing 

from the Federal Financing Bank 

(FFB).29 Unlike the Federal Home 

Loan Banks, which issue their own 

debt instruments which must ex 

plicitly state that they are not 

guaranteed by the U.S. government, 

obligations of the NCUA, incurred on 

behalf of the CLF, are supported by 

the full faith and credit of the U.S. 

government.30 Borrowing authority 

is limited each year to approximate 

ly twelve times equity and capital 

subscriptions on-call. Additionally, 

the CLF is authorized to borrow up 

to g500 million from the U.S. 

Treasury to meet the liquidity needs 

of credit unions in an emergency. 

The CLF had outstanding loans at 

fiscal year-end, September 30,1988, 

of $120.4 million and it also had pro 

vided lines of credit totaling S13.5 

million for four private share in 

surance funds.31 

Current Health 

of the Credit Union 

Industry 

Credit unions, like other thrift in 

stitutions, entered the 1980s under 

extremely unfavorable conditions. 

The effects of very high and volatile 

interest rates on the profitability of 

savings and loan associations and 

mutual savings banks at that time 

are well known. Credit unions also 

experienced disintermediation. 

liquidity pressures, and low earn 

ings in the early 1980s, but the in 

dustry was perhaps more affected 

by a different problem: many credit 

unions were organized around an 

occupational common bond in in 

dustries that were particularly hard 

hit by the economic conditions of 

the time. Increased loan de 

linquencies and decreased rates of 

saving compounded the liquidity 

and earnings pressures at credit 

unions. Loss of sponsorship, lack of 

economic viability, or actual insol 

vency led many hundreds of credit 

unions to be merged or liquidated 

in the late 1970s and early 1980s. 

Credit Union Failures 

in the 1980s 

As shown in Table 5, credit union 

failures peaked in 1981,32 when 

251 institutions were placed into 

involuntary liquidation and another 

98 were merged with financial as 

sistance from the NCUSIF; an ad 

ditional 114 credit unions, although 

not technical "failures," received fi 

nancial assistance to avoid liqui 

dation that year. In 1982, in 

voluntary credit union liquidations 

fell to 160, while assisted mergers 

rose to 167, and the numbers of ac 

tive assistance cases and problem 

credit unions peaked at 124 and 

1,192, respectively. By 1983, in 

voluntary liquidations bad dropped 

to 50, although assisted mergers hit 

a peak of 203 and the number of 

assistance cases was still high, at 

113. This trend reflects the previ 

ously noted decline in the insur 

ance fund's reserves during the 

early 1980s, which caused the 

NCUSIF to substitute alternative 

methods of credit union assistance 

for the more costly liquidation. 

Since 1983, the behavior of in 

terest rates has been more favor 

able for thrift institutions in gen 

eral, and severaJ regulatory changes 

have been favorable to credit 

unions, in particular. For example, 

several NCUA regulations governing 

M As noted on page 3 of the NGUSIF's 1988 

Annual Report, one of these was merged into 

another corporate credit union during the year, 

leaving a total of 41 corporate central credit 

unions. 

17 NCUA, Annual Report, 1988, 17. 

2B Ibid. 

"" The RRB, a corporation within the U.S. 

Treasury, was established in 1973 to coor 

dinate the financing activities of federal agen 

cies whose obligations are guaranteed by the 

federal government. The FFB borrows money 

at Treasury rates and lends the funds tc 

designated agencies at one-eighth of an interest 

point higher. 

a° A special memorandum opinion concern 

ing the full faith and credit status ot the CLF 

was issued by the Attorney General on May 

24, 1982. 

31 NCUA, Annual Report, 1988, 17 

35 Although previous years' data are not 

given in Table 5, the number of involuntary 

liquidations were 168 and 169 in 1978 and 

1979, respectively, according to the NGUSIF's 

1987 Annual Report. 

21 
FDIC Banking Review 

Table S 

Federally Insured Credit Union Failures and Problem Cases, 

Fiscal Years. 1980-1988 

Source: NCUSIF, Annual Report, 1988,24-27. 

'Assisted merger cases were not separately identified until calendar year 1981; 1982 figure 

is for nine months ending Sept. 30, 1982; figures thereafter coincide with fiscal year. 

"Number of active cases of credit unions receiving assistance to avoid liquidation. 

the common bond requirement for 

credit union charters were loos 

ened, giving many credit unions 

facing liquidation more flexibility to 

either merge with other credit 

unions, or to expand their member 

ship base. 

As a result, credit union failures 

dropped dramatically after 1983. 

An average of 35 credit unions per 

year were placed into involuntary 

liquidation during the 1984-1988 

period, while NCUSIF-assisted 

mergers, which declined steadily 

during that period, numbered 50 in 

1988. Cases of active credit unions 

receiving financial assistance to 

avoid liquidation fell from 72 in 

1984, to 16 in 1987, before rising to 

25 in 1988. 

A more disturbing trend is indi 

cated by the increase in die num 

ber of credit unions on NCUA's 

problem list (defined as those with 

CAMEL 4 and 5 ratings), from 742 

in 1985 to 1,022 in 1988. These 

credit unions have become the fo 

cus of increased supervisory over 

sight by NCUA examiners; the 

NCUA also has encouraged the in 

dustry's trade associations to offer 

assistance to troubled credit 

unions.33 In part as a result of these 

developments, the number of credit 

unions on the agency's problem list 

declined to approximately 900 in 

1989.34 

Recent Financial 

Performance of Credit 

Unions 

Selected performance measures 

for NCUSIF-insured credit unions 

are presented in Table 6. It is ap 

parent that growth in credit union 

assets and savings has slowed dra 

matically, beginning in 1987. Credit 

union savings, which increased 

24.3 percent during 1986, rose only 

3.1 percent in the twelve-month 

period ending June, 1989. In con 

trast, loan growth has remained 

strong; loans outstanding at feder 

ally insured credit unions increased 

nearly 14 percent in 1988. Other 

credit union investments, which 

grew by nearly 38 percent in 1986, 

declined in 1988 and 1989. 

The combination of slower share 

growth and brisk loan growth in re 

cent years has increased the loansto-savings ratio from 63.3 percent 

"Leigh Gregg, "Problem GUs Undergo 'In 

tensive Care,' " Credit Union Magazine 55 

;july 1989): 15. 

J'"Bank, S&L Failures Top Those of CUs," 

Credit Union Magazine 56 (January 1990): 

54. 

Table 6 

Selected Performance Measures, 1986-1989 

Federally Insured Credit Unions 

Source: Statement by Dr. Charles H. Bradford before the NCUA Board, Credit Union Per

farmancc. First Six Months of 1989, September 14, 1989. 

"Yearly growth is from June 1988, to June 1989; for ratios, income and expense items are 

22 
An Overview of the U.S. Credit Union Industry 

in 1986, to nearly 73 percent for 

the year ending June, 1989, This 

development has had a favorable ef 

fect on credit unions' net income, 

since loan yields tend to be higher 

than those of other traditional 

credit union investments, although 

this reflects their higher risk of de 

fault. Credit union net income 

(after dividend payments but before 

reserve transfers) has grown stead 

ily in the past few years, and the 

annual return on average assets 

rose from 0.94 in 1987 to 1.00 at 

midyear 1989. 

The remaining financial statistics 

also suggest that the credit union 

industry is generally healthy. Capi 

tal (reserves and undivided earn 

ings) rose at double-digit rates 

throughout the 1986-1989 period, 

and the capital-to-asset ratio for 

federally insured credit unions rose 

from 6.2 percent to 7.1 percent 

during this time. Credit quality ap 

pears good; loan delinquencies (two 

months or more overdue) declined 

from 2.2 percent of total credit 

union loans in 1986, to 1.7 percent 

in June, 1989. Finally, net chargeoffs remained steady at about 0.62 

percent during the last four years. 

In contrast, net charge-offs at 

commercial banks have increased 

during the last four years, with an 

average rate of about 0.94 during 

that time. 

Current Credit Union Issues 

Expansion of Common 

Bonds 

One of the primary areas of con 

tention between bankers and credit 

unions in recent years has been 

NCUA's increasingly liberal inter 

pretation of the common bond re 

quirement for credit union char 

ters. Although early credit unions 

were formed to serve small, closelyknit groups of individuals, many of 

these limited-membership insti 

tutions could not survive the chang 

ing economic structure of the last 

several decades, resulting in a 

number of voluntary and in 

voluntary credit union liquidations. 

In order to reverse the trend of 

credit union dissolutions, the NCUA 

Board amended its field of member 

ship chartering and expansion 

policies in order to allow credit 

unions to attract new members, 

and to facilitate mergers between 

credit unions. In 1982, when the 

NCUA Board began to make these 

changes, its operating philosophy 

was one of deregulation and, hence, 

the agency noted that it was "re 

turning to credit union boards the 

right and responsibility to deter 

mine whom the credit union would 

serve."35 

Thus, federal credit unions were 

permitted, with the regional direc 

tor's approval, to serve nearby em 

ployee and associational groups 

which requested credit union ser 

vice. In the past, multiple-group 

credit unions were restricted to 

either occupational or associational 

groups with a similar common 

bond. This restriction had forced 

occupational credit unions in de 

clining industries to either convert 

to community charters, or to liqui 

date. The multiple-group policy 

change allowed a number of 

financially-distressed credit unions 

Co merge with healthier institutions, 

and also helped diversify the eco 

nomic base of credit unions. Today, 

over one-half of all credit unions 

serve multiple employee groups.36 

Other changes were designed to 

expand membership at individual 

credit unions. For example, the 

Federal Credit Union Act is silent 

on the eligibility of other family 

members to join the credit union 

along with a member whose eligi 

bility is based on the common 

bond. Traditionally, credit union 

charters have contained "usual 

wording" clauses which provided el 

igibility to immediate family mem 

bers; these generally were inter 

preted by NCUA to be the primary 

member's spouse and any children 

living under the same roof.37 How 

ever, in 1983, the NCUA Board ap 

proved a standard bylaw amend 

ment allowing each credit union to 

define for itself the concept of fam 

ily member eligibility.38 Thus, some 

credit unions amended their bylaws 

to allow members to invite their 

parents, grandparents, stepchildren 

and other relatives to join the credit 

union, 

Similarly, NCUA also looked for 

ways to expand membership for 

senior citizens. In November 1984, 

NCUA adopted a policy permitting 

federal credit unions to sponsor or 

assist in the formation of senior cit 

izen and retiree organizations with 

the primary purpose of providing el 

igibility for joining a credit union.39 

Previously, organizations formed 

with the purpose of providing credit 

union eligibility were not defined as 

having a common bond. Although 

senior citizen groups, such as the 

American Association of Retired 

Persons (AARP), already were eli 

gible to join credit unions, this new 

policy eliminated much of the 

paperwork, and hence, delay in ex 

tending credit union membership 

to seniors. 

The AARP opened its own credit 

union in 1988; eligible members in 

clude the more than 28 million 

AARP members nationwide, and 

their spouses.40 This fact did not go 

unnoticed by banks and S&Ls, 

which, in the past, have benefitted 

from the large deposits often trans 

ferred to their institutions by re 

tirees, who find their credit unions 

inconvenient when they stop work 

ing. 

The formation of a credit union 

on the national level has prompted 

Ji NCUA, Annual Report, 1984, 11, 

30 Judy Weidman, "Members Still Deserve 

Personal Service," Credit Union Magazine 54 

(November 1988): 15. 

37 NCUA, Studies in Federal Credit Union 

Clwriering Policy, July 1979, 26. 

1(tNCUA, Letter No. 73 (February 2, 1983), 

Washington, D.G. 

39 Washington Financial Reports, 26 No 

vember 1984, 846. 

"' According to AARP offices in Washington, 

membership in the AARP Federal Credit 

Union had grown to only 85,000 by January 

1990, and the credit union's assets at yearend 1989 were about 8150 million. Sub 

sequently, in April 1990, the credit union's 

members voted to cease operations and the 

institution was closed barely two years after 

formation. 

23 
FDIC Banking Review 

many to accuse NGUA of taking 

field-of-membership expansion too 

far. Perhaps as a result of this criti 

cism, the NCUA Board voted in No 

vember 1988, to rescind plans to let 

well-run credit unions open their 

businesses to occupational groups 

of 300 or less without getting prior 

agency approval; at the same time, 

the agency voted to tighten charter 

ing procedures for large associa 

tions like the AARP. Previously, 

NCUA had allowed approval of a 

charter by the regional director in 

the region where a proposed credit 

union would be headquartered. The 

agency's new rule requires approval 

from a majority of directors in only 

the regions where the association 

has members, along with approval 

from the director of NGUA's Office 

of Examination and Insurance.41 

A more recent rule, passed by the 

NGUA Board on July 20, 1989, 

states that the agency's policy is to 

grant "associational charters at the 

lowest level which is economically 

feasible."42 Thus, a charter will only 

be issued at the national level after 

it is first determined that a local or 

regional credit union would not be 

economically viable. The ruling fur 

ther specifies that to form an asso 

ciational credit union, a group 

would have to: hold at least one an 

nual meeting, open to its members; 

sponsor other activities that would 

allow its members to meet and 

mingle; and specifically define who 

is eligible for membership. Associa 

tions based on a client or customer 

relationship are not considered to 

have a sufficient common bond. 

Thus, groups such as the American 

Automobile Association, which 

have more of a client base than a 

membership base, would be barred 

from forming a credit union. 

Tax-Exemptkm 

The federal income tax exemp 

tion for state-chartered credit 

unions dates to the Revenue Act of 

1916, which provided tax-exempt 

status to domestic building and loan 

associations and cooperatives. In 

1917, the U.S. Attorney General 

ruled that although credit unions 

were not explicitly mentioned in 

the Act, they were subsumed under 

that exemption, if found to be "or 

ganized and operated for mutual 

purposes and without profit."43 

Federal credit unions, which 

were not chartered until 1934, are 

exempt from federal income tax by 

a 1937 amendment to the Federal 

Credit Union Act. While the Senatepassed version of the original 1934 

bill contained a federal tax exemp 

tion, the House of Representatives 

not only eliminated this provision, 

but also voted to permit individual 

states to tax federal credit unions. 

In an effort to speed passage of fed 

eral credit union legislation, the 

Senate agreed to these provisions, 

"with the acquiescence of the credit 

union movement."44 However, the 

General Counsel of the Farm Credit 

Administration (then the chartering 

agency for federal credit unions) 

immediately requested an opinion 

on the tax-exempt status of federal 

credit unions from the Commis 

sioner of the Internal Revenue. 

Based on the tax-exempt status of 

state-chartered credit unions, the 

IRS ruled in June 1935, that federal 

credit unions also would be granted 

the exemption. 

Moreover, it soon was discovered 

that state income tax laws placed 

an unusually high tax burden on 

credit unions. At that time, states 

commonly taxed depository insti 

tutions on the basis of share capital; 

since credit union savings are 

defined as member shares and not 

deposits, their capital represents a 

much greater proportion of total as 

sets. As a result of this disparity, 

Congress amended the Federal 

Credit Union Act in 1937 to include 

exemptions for both state and fed 

eral income taxes. 

Congress reconsidered the taxexempt status of cooperatives and 

other tax-exempt financial insti 

tutions in 1951, and voted to re 

move the exemption for all but 

credit unions, which were given a 

separate Internal Revenue Code 

provision. The basis for this deci 

sion appears to have been the belief 

that credit unions remained true to 

their original purpose and charac 

teristics, while mutual savings 

banks were found to be "in active 

competition with commercial banks 

... for the public savings, and ... 

with many types of taxable insti 

tutions in the security and real es 

tate markets."45 Savings and loan 

associations, tax exempt since the 

Federal Home Loan Bank System 

was created in 1934, were declared 

"no longer self-contained cooper 

ative institutions as they were orig 

inally organized.1'46 

The tax-exempt status of credit 

unions has been challenged on a 

number of occasions since 1970, 

both by other financial institutions 

and those seeking to balance the 

federal budget. Banks and thrifts 

argue that relaxation of the com 

mon bond requirement and en 

hancements in credit union powers 

have eroded the traditional dis 

tinctions between their organiza 

tions and credit unions. The taxexempt status of credit unions is 

seen by bankers as a federal sub 

sidy, which permits them to price 

loans at 50 to 125 basis points 

below competing banks, and to of 

fer free checking and certificates of 

deposit at rates from 75 to 150 

basis points above area banks.47 

The American Bankers Association 

" BNA's Banking Report, Vol. 52, 14 No 

vember 1988,833. 

12 NGUA, "Final Rule and Final Interpretive 

Ruling and Policy Statement £9-1—Chartering 

and Field of Membership Policy," 54 Fed. Reg. 

31,165(1989). 

"J Op. Au"y Gen. 176 (1917). 

44 Statement of the Credit Union National 

Association, Inc. before the Committee of 

Finance, U.S. Senate, Taxation of Financial 

Services Industry: Hearing be/ore (he Com 

mittee on Finance, 98th Cong., 1st sess., 11 

March 1983, 221. 

iS U.S. Congress, Senate, Senate Report No. 

781, 82nd Cong., 1st sess., 18 September 

1951, reprinted in US. Code Cong. & Admin, 

News, 1993. 

"Ibid., 1996. 

" These figures were attributed to an inde 

pendent group of bankers known as the Bank 

ers Committee for Tax Equality. See Robert. 

M. Garsson, "Credit Unions Ready to Defend 

Tax-Exempt LStatus," American Banker, 13 

July 1987,3. 

24 
An Overview of the U.S. Credit Union Industry 

has estimated that the subsidy re

sulting from tax exemption 

amounts to an 81 basis-point reduc 

tion in the average loan rate that 

credit unions charge their mem

bers.48 

It should be noted that the credit 

union industry traditionally argues 

that its tax-exempt status plays 

only a small role in the ability to 

price loans and deposit products 

more favorably than banks. It ac 

knowledges the value of sponsor 

subsidies, typically rent-free office 

space and employees' time, but also 

stresses the large proportion of vol 

unteer staff. Although larger credit 

unions are usually staffed by sal 

aried employees, credit union offi 

cers and directors at these insti 

tutions are primarily still 

volunteers, saving the credit union 

industry over $1 billion annually, 

according to the National Associa 

tion of Federal Credit Unions.49 

The question whether credit 

unions "should" be taxed is beyond 

the scope of this paper. The answer 

will be determined, in part, by legal 

considerations, such as the degree 

to which credit unions fulfill their 

original purpose, and in part by 

whether credit unions are judged to 

pose a competitive threat to other 

taxable financial institutions. This 

determination is likely to be af 

fected, as well, by the amount of 

federal budgetary benefits that 

would accrue as a result of taxation 

of credit unions. 

In that regard, taxation of credit 

unions has been proposed in recent 

years by the Congressional Budget 

Office and by the Treasury De 

partment. Estimates of the ad 

ditional annual revenue that would 

be generated range from #200 mil 

lion to #400 million, depending on 

the formula used.50 Most of these 

proposals would limit taxation to 

larger credit unions in order to re 

duce the paperwork burden for 

small institutions. For example, 

taxing federal credit unions with 

over #10 million in assets would 

leave nearly 80 percent of the in 

dustry in number, but only 15 per 

cent of its assets, tax-exempt. 

Summary and Conclusions 

The U.S. credit union industry 

has evolved from serving simple, 

short-term consumer saving and 

lending needs, to being full-service 

consumer banks. Much of this 

change has occurred only in the 

last decade, and coincides with a 

period of rapid change and in 

creased competition for all financial 

institutions. However, important 

differences still remain between 

credit unions and commercial 

banks. Credit unions are limited to 

lending to their members and to 

other credit unions, and while loans 

are made for a greater variety of 

purposes, these do not include sec 

ond homes or loans for investment 

purposes. Although credit unions 

are empowered to make business 

loans, this activity accounts for 

only one percent of credit unions' 

lending. Finally, the majority of 

credit unions are still small, with 

less than $5 million in assets, and 

many continue to provide only the 

more traditional products and ser 

vices to their members. Even with 

the rapid growth in credit union 

savings during the 1980s, by the 

end of the decade, total credit 

union assets were still not as great 

as those of the largest U.S. bank 

holding company. 

Success has become a doubleedged sword for credit unions. As a 

result of their profitability and in 

creased market share, credit unions 

now face a variety of proposals de 

signed to alter the structure and or 

ganization of their industry. How 

ever, while other financial 

institutions have pointed to the 

changing characteristics of the 

largest credit unions, many of the 

small, traditional credit unions have 

not welcomed some of these 

changes. For example, liberalized 

regulations governing the common 

bond requirement exposed credit 

unions to competition with each 

other for the first time. De 

regulation of interest rates in the 

early 1980s eliminated another tra 

ditional advantage of credit unions, 

who were allowed to pay seven per 

cent on share accounts when banks 

and thrifts were limited to paying 

less than six percent. In addition, 

larger credit unions now are re 

quired to maintain reserves on 

transaction accounts. Finally, as 

previously noted, credit unions 

have been faced with increased 

competition for consumer lending 

from other financial institutions. 

Financial statistics suggest that, 

in genera], the credit union indus 

try currently is healthy. However, 

recent events in the savings and 

loan and commercial banking in 

dustries, as well as several promi 

nent credit union failures, under 

score the need for quality 

examination and supervision by 

regulators. In this regard, the credit 

union system may prove to be for 

tunate, since it was able to increase 

both the number and training of its 

examination staff during a period 

when the industry was experiencing 

few problems. All credit unions now 

receive annual on-site examina 

tions; those experiencing problems 

are visited more often. 

Credit unions will be facing a 

period of legislative scrutiny at both 

the state and the federal levels. 

Legislative action on issues such as 

common bond regulations, taxexemption, and the structure of 

their regulatory system and deposit 

insurance fund could alter sub 

stantially the economic and regula 

tory environment in which credit 

unions operate. 

8 Value of the Federa] Income Tax Exemp 

tion Subsidy to Credit Union Members," Hoo

sier Banker, February 1990, 9. 

A<> Rosenstein, 13. 

50 See, for example, Kevin J. Mullins and An 

thony Pennella, "Pressure to Share Tax Bur 

den Mounts for Credit Unions," American 

Banker, 14 February 1989, 8; Jay Rosenstein, 

"Tax Bite Getting Number-Crunched," .Ameri 

can Banker, 12 September 1989, 13; and 

"Budget Watchers Ponder Credit Union Tax 

ation," Savings Institutitms, April 1988, 21. 

25 
FDIC Banking Review 

SELECTED BIBLIOGRAPHY 

American Banker. 12 September 1989. 

Credit Union National Association. Comparative Digest of Credit Union 

Acts: A Comparative Study of the Credit Union Laws of the Several 

States, the United States and Puerto Rico as of December 1, 1985. 

Madison, Wisconsin, 1986 Edition. 

Credit Union National Association. Credit Union Report. Madison, Wis 

consin, 1988. 

Credit Union National Association. Introduction to Credit Unions. Dubu

que, Iowa: Kendall/Hunt Publishing Company for the Credit Union 

National Association, 1980. 

Credit Union National Association. Legislative History of the Federal 

Credit Union Act: A Study of the Historical Development From 1934 

to 1980 of the Statute Governing Federal Credit Unions. Madison, 

Wisconsin, 1981. 

Credit Union National Association. 1989 Operating Ratios and Spreads: 

Mid-Year Edition. Madison, Wisconsin, 1989. 

Flannery, Mark J., An Economic Evaluation of Credit Unions in the 

United States, Federal Reserve Bank of Boston, Research Report No. 

54, February 1974. 

Melvin, Donald J., Raymond N. Davis, and Gerald C. Fischer. Credit 

Unions and the Credit Union Industry: A Study of the Powers, Or 

ganization, Regulation and Competition. New York: The New York 

Institute of Finance, 1977. 

Moody, J. Carroll, and Gilbert C. Fite. The Credit Union Movement: Orig 

ins and Development, 1850-1970. Lincoln: University of Nebraska 

Press, 1971. 

Mullins, Kevin J., and Anthony Pennella. "Pressure to Share Tax Burden 

Mounts for Credit Unions."American Banker, 14 February 1989. 

National Credit Union Administration. Annual Reports. Washington, D.C., 

1978-1988. 

National Credit Union Administration. Studies in Federal Credit Union 

Chartering Policy. Washington, D.C., July 1979. 

National Credit Union Share Insurance Fund. Annual Reports. Washing 

ton, D.C., 1984-1988. 

U.S. Congress. House. Committee on Banking, Finance and Urban Affairs. 

State of the Bank and Credit Union Insurance Funds: Hearings be 

fore a subcommittee of the Committee on Banking, Finance and Ur 

ban Affairs. 101st Cong., 1st sess., 21 September 1989. 

U. S. Congress. Senate. Committee on Finance. Taxation of Financial 

Services Industry: Hearing before the Committee on Finance. 98th 

Cong., 1st sess., 11 March 1983. 

U. S. League of Savings Associations. Study of Credit Unions. Chicago, 

1979. 

26 
Risk-Based Capital Requirements 

Risk-Based Capital 

Requirements: Reshaping 

the Thrift Industry 

ecent legislation enacted in 

response to the failure 

.of hundreds of insolvent 

thrift institutions requires thrifts to 

hold substantially more capital. Es 

timates of thrifts' ability to meet the 

new capital requirements are pre 

sented in this paper. The estimates 

show that a substantial segment of 

the industry currently fails to meet 

the new standards. This group 

comprises 33 percent by number, 

and 44 percent by assets, of all 

thrifts not in conservatorship. 

Moreover, an even larger segment, 

comprising 46 percent of non

conservatorship thrifts by number, 

and 70 percent by assets, does not 

appear to meet the standards that 

ultimately will be required. 

Given their current earnings per 

formance, most thrifts estimated to 

fail the new standards will not be 

able to meet the standards in the 

near future solely through retained 

earnings. This suggests that policies 

soon will have to be developed to 

deal with large numbers of insti 

tutions that do not meet capital re 

quirements. These include supervi 

sory policies to limit high-risk 

behavior and inappropriate divi 

dend payments, programs for thrifts 

that do not have acceptable plans to 

increase capital, and policies on 

when, if ever, to use open-thrift as 

sistance. 

The long-term ability of thrifts to 

raise capital will be affected by eco 

nomic conditions, including the be 

by Peter J. Elmer" 

havior of interest rates, real-estate 

markets, and other factors influenc 

ing the value of the thrift charter. 

However, without substantial im 

provement in earnings, the options 

available to most thrifts failing to 

meet capital requirements appear 

limited to some combination of sh 

rinkage, raising capita! from exter 

nal sources, and mergers with 

healthy institutions. The activities 

of institutions actively seeking 

healthy merger partners and at 

tempting to sell high-risk assets 

would be, to some extent, in com 

petition with activities of the Reso 

lution Trust Corporation (RTC) and 

could make its responsibilities more 

difficult. 

Capital Requirements 

In compliance with the Financial 

Institutions Reform, Recovery, and 

Enforcement Act of 1989 (FIRREA), 

the Office of Thrift Supervision 

(OTS) set new capital standards for 

all federally and state-chartered sav 

ings associations insured by the 

Savings Association Insurance Fund 

(SAIF), effective December 7, 1989. 

These standards are based on stan 

dards developed in 1987 by an in 

ternational group of bank regula 

tors, the Basle Committee on 

Banking Regulations and Supervi 

sory Practices. The initial standards 

were subsequently revised and 

adopted by the major industrialized 

countries (the "Group of 10") as a 

framework for measuring bank 

capital adequacy. U.S. bank regula 

tors soon adopted regulations con 

sistent with the Basle standards. Al 

though thrift regulations have 

included various forms of risk-based 

capital standards for a number of 

years, P1RREA mandated stricter 

enforcement as well as a revision of 

the standards to ensure that they 

were no less stringent than the 

standards applicable to national 

banks. 

The requirements are considered 

"interim final" standards because 

they do not contain an interest-rate 

risk component that is currently 

under development. As such, they 

are almost entirely credit-based and 

are very similar to bank standards. 

The new requirements contain 

three component: 

• Tangible Capital Standard: Tan 

gible capital must be at least 1.5 

percent of adjusted total assets. 

• Leverage Ratio Standard: Core 

(Tier 1) capital must be at least 

three percent of adjusted total 

assets. 

• Risk-Based Capital Standard: 

Core plus supplementary (Tier 2) 

capital must be at least 6.4 per 

cent (80 percent of eight per 

cent) of risk-weighted assets and 

supplementary capital can not 

exceed core capital. 

Roughly speaking, the above terms 

are defined as follows: "tangible 

" Peter J. Elmer is a Financial Economist in 

the RTC's Office of Research and StacisEics. 

27 
FD1C Banking Review 

capital" is common equity less good 

will; "adjusted total assets" are total 

assets (net of specific reserves) 

less goodwill; "core capital" is tan 

gible capital plus qualifying goodwill 

up to 1.5 percent of tangible assets; 

"supplementary capital" is preferred 

stock, subordinated debt and gen 

eral loan- and lease-loss reserves; 

"risk-weighted assets" are the riskweighted sum of on-balance-sheet 

assets and off-balance-sheet com 

mitments.1 

The above standards will be 

tightened considerably over the 

next several years. For example, 

the risk-based 6.4 percent standard 

will be increased to eight percent 

by the end of 1992 and the ability 

to include qualifying intangibles in 

core capital will be eliminated by 

the end of 1994.2 

Impact of the New 

Requirements 

The impact of the new capital re 

quirements is estimated from De 

cember 31, 1989 Thrift Financial 

Reports (TFRs), based on De 

cember 7, 1989 standards, for all 

SAIF-insured thrifts. Since the 

TFRs are not designed to measure 

the new capital requirements, nu 

merous assumptions are needed to 

translate TFR data into capitalrequirement estimates. Estimating 

tangible capital, tangible assets, 

core, and supplementary capital is 

relatively straightforward. The pri 

mary problem is estimating riskweighted assets for risk-based capi 

tal purposes. In brief, TFR data are 

placed into one of five risk-weight 

classes (0, 20, 50, 100, and 200 

percent) and, where necessary, as 

sumptions are made regarding the 

distribution of line items among the 

risk-weight classes (see Box 2 in the 

Appendix for a more detailed dis 

cussion of the assumptions). 

The impact of the December 7, 

1989 requirements is shown in 

Table 1. Four points are of par 

ticular interest. First, a large num 

ber of thrifts fail to meet the new 

standards. In addition to the 290 

Table 1 

Financial Data for SAIF-lnsured Thrifts Failing December 7, 1989 

Capital Requirements 

(Data as of December 1989; $ Billions; % of Total Assets) 

Not In 

oiiservatorshi p 

But Fail Any All Thrifts 

In Capital Not In 

Con servatorship Requirement Conserva torsh i p 

(1) (2) (3) (4) on 

Note: The coiaservmoraliip lisi is m of March 20. 1990. Columns I and 2 allow' conservoloTship data by dollar amount 

aiul qb u ptrcenuuSu of total assets, respectively. Columns 3 and 4 shou- non-coracivaiorahip SM: -n:'nbii. .1 thrifts ihiii fall 

any of the December 7, WH9 uapiuil standards. Columns 5 ami t show ail thrifts nM in conservators hip. i.e., the remaining 

thrift industry Insured by SAIF. The regions shown in lines 9 through 12 are RTC regions lhai arc defined an follows! 

"Western Region1' contains California. Arizona. Ntiv.1 Mexieo. Colorado. Utah. Nevada, Oregon. Lilnhn, Wyoming. Montana. 

Washington, Alaska. Hawaii, and Guam- "Southwest Region" tonlntns Toms end OMahomn; "Central Regiun" contains 

Wisconsin, Minnesota. Korlh Dakota, Soutll llakotn. Nebraska, Kansas, Arkansas, Missouri. Iowa, Illinois, Indiana, and 

Michigan; "Ensiern Region" contains all remaining suites, the District of Columbia, Virgin Islands anil Pueno Rico. 

thrifts in conservatorship as of 

March 20, 1989, 845 thrifts, holding 

3497 billion in assets, are estimated 

to fail the new standards. These 

845 thrifts represent 33 percent in 

number, and 44 percent of the 

assets, of the 2,588 non-conser

vatorship thrifts. Total assets 

of all thrifts failing to meet the new 

standards plus conservatorships are 

estimated to be S628 billion, or 50 

percent of all thrift assets. The 

average thrift failing the new capital 

standards has 8589 million in as 

sets, which is considerably larger 

than either the average con 

servatorship (3449 million) or non

conservatorship (8433 million) 

thrift. 

Second, high-risk and problem 

assets held by RTC conserv 

atorships as of March 20, 1990, rep 

resent a small fraction of com 

parable assets held by all thrifts 

estimated to fail the new capital 

standards. For example, non-con

servatorship thrifts failing the stan 

dards hold 842.3 billion of the 

highest-risk assets (delinquent 

loans and real estate repossessed or 

held for development), which is al 

most twice the 822.7 billion held by 

conservatorships. They also hold 

about four times more construc 

tion, multi-family and commercial 

mortgages. 

The regional distribution of 

thrifts failing the new capital stan 

dards differs from the distribution 

of conservatorship thrifts. While the 

RTC's conservatorships are con 

centrated in the Southwest region, 

about 88 percent of the thrifts es 

timated to fail the capital standards 

are concentrated in the Eastern, 

Central and Western regions.3 

Table 2 provides more detail on the 

1 More precise capital definitions are given in 

Box 1 in the Appendix. A discussion of the riskweights is in Box 2 in the Appendix. 

2 Other transition rules affect the amount of 

maturing capital instruments inoludable in sup 

plementary capita], permissible equity invest 

ments, investments in subsidiaries, and general 

valuation loan and lease allowances. 

J See Table 1 for a listing of the slates in 

cluded in each RTC region. 

28 
Risk-Based Capital Requirements 

Table 2 

State Rankings of Thrifts Either in Conservatorship or 

Failing Any December 7, 1989 Capital Requirement 

regional distributions. Texas con 

tains the most conservatorships and 

all but three of the top ten con 

servatorship states are from the 

Southwest or Farm Belt. In con 

trast, the list of ten states with the 

most non-conservatorship thrifts 

estimated to fail the new standards 

is headed by California and in 

cludes only two states from the 

Southwest or Farm Belt. 

Finally, the striking number and 

size of thrifts estimated to fail the 

new capital standards are primarily 

due to risk-based capital standards, 

not the tangible capita] or leverage 

ratio standards. As shown in Figure 

1, the risk-based standards are by 

far the most restrictive of the three 

new capital standards. The riskbased standards cause 48 percent 

more thrift assets to fail capital re 

quirements than the next most 

stringent standard, the leverage ratio. 

Moreover, 98 percent of the assets 

of thrifts failing any capital re 

quirement are in thrifts that fail to 

meet the risk-based capital stan 

dards. 

Although the above statistics are 

unsettling, they nevertheless may 

understate significantly the ultimate 

(fully phased-in) impact of the new 

capital requirements. As an exam 

ple, consider the impact of phasingin only two of the scheduled re 

quirements: raising the 6.4 percent 

threshold to eight percent (required 

by the end of 1992) and eliminating 

the ability to use qualifying in 

tangibles in core capital (required 

by the end of 1994). Assuming that 

the December 1989, thrift balance 

sheets remain unchanged for five 

years, the number of thrifts esti 

mated to fail capital requirements 

rises 41 percent, from 845 to 1,190, 

and the amount of thrift assets af 

fected increases 57 percent, from 

8497 billion to S782 billion. The 

8782 billion of assets affected rep 

resent 70 percent of all non

conservatorship thrift assets. Other 

restrictions scheduled to be phasedin can only increase the number of 

thrifts failing to meet the new stan 

dards. 

It must be noted that institutions 

not currently meeting their capital 

requirements are not doomed to 

fail. Although some will fail, others 

will survive. Solvent thrifts not 

meeting the capital standards will 

doubtless come under considerable 

supervisory pressure to increase 

capital. However, a number of 

strategies may enable thrifts to im 

prove capital. Options available in 

clude shrinking balance sheets, se

curitizing assets, merging with 

healthier institutions, attracting 

outside capital, and, in some cases. 

Figure 1 

Non-Conservatorship Thrifts 

that Fail December 7, 1989 Capital Standards 

(Data as of December 1989: Billions) Assets 

29 
FD1C Banking Review 

Figure 2 

Distribution of Annualized Nee Income to Assets for ThrifLs Failing 

December 7, 1989 Capital Requirements 

(Data as of December 1989; Billions) Assets 

100 ! 

1.5 Above 

to 1.5% 

1.0% 

Nfti Income to Totel Assets (%) 

Mote: Nel income is total Income less tolal expenses. 

retaining earnings. This last possi 

bility is discussed below. 

Can Earnings Solve 

the Problem? 

Information on the earnings of 

thrifts estimated to fail the new 

capital standards are presented in 

Pigures 2 and 3. These data show 

two measures of annualized return 

on assets for fourth quarter, 1989, 

earnings.4 Although past earnings 

may not necessarily provide accu 

rate predictions of future earnings, 

the most recent data available are 

especially useful for this analysis 

because the new capital require 

ments took effect on December 7, 

1989, thus causing regulators to be 

1 The distribution of fourth-quarter earnings 

of thrifts failing to meet their capita) require 

ments is very similar to the distribution of 

third-quarter earnings described in an earlier 

draft of this paper. 

5 Net operating income is operating income 

plus interest income, less operating expense 

and less Interest expense. Operating income 

primarily includes servicing fees, loan orig 

ination fees, income from service corporations 

and income from real estate held for invest 

ment. Profits from the sale of foreclosed real 

estate, Investment securities and many other 

assets are considered nonoperating income. 

Operating expense includes employee com 

pensation, administrative expense and amor 

tization of goodwill. Nonoperating expenses are 

net provisions (reserves) for losses on assets, 

losses on the sale of assets and taxes. 

gin assessing viability in the first 

quarter, 1990. Moreover, it is un 

likely that the earnings trends of 

large numbers of institutions would 

change enough in the near term to 

alter the conclusions of this paper. 

Figure 2 shows the distribution of 

net income to assets. While net in 

come reflects the "bottom line" 

earnings available to be retained as 

capital, it can be heavily influenced 

by losses on, and reserves for, bad 

assets. In spite of this limitation, it 

is important to recognize that Fig 

ure 2 shows that over one-half (58 

percent) of the assets of all thrifts 

failing the new standards were in 

thrifts that had negative net in 

come. Twenty-nine percent lost at 

least 100 basis points on assets. 

While about 23 percent of the as 

sets were in thrifts that had modest 

positive earnings in the 0 to 50 

basis points range, only eight per 

cent were in thrifts that earned at 

least 100 basis points. 

Figure 3 shows the distribution of 

an optimistic measure of earnings, 

net operating income.5 Net oper 

ating income often overstates earn 

ings because it omits losses on, and 

reserves for, bad assets as well as 

taxes. In spite of the more opti 

mistic measure of earnings, the dis 

tribution of net operating income in 

Figure 3 tells largely the same story 

told by net income in Figure 2. 

Most important, over one-half (55 

percent) of the assets of all thrifts 

failing the new standards have 

negative net operating income 

while only nine percent earned at 

least 100 basis points. Thus, the 

measure of earnings does not alter 

the conclusion that a large portion 

of thrifts estimated to fail the new 

capital standards have significant 

earnings problems. 

The ability of thrifts to meet capi 

tal requirements through retained 

earnings can be estimated if we 

make a number of assumptions. In 

particular, the short-term impact of 

earnings can be estimated by as 

suming that the fourth quarter, 

1989, balance sheets and net in 

comes continue for the next year 

and that all earnings are retained. 

Given these assumptions, the 

results in Table 3 show that most 

thrifts wilt not be able to solve their 

capital problems with earnings in the 

Table 3 

Total 

Currently Fail Any Capital Standard 

Pass Standards if Retain One-Year Income 

Fail Standards if Losses Continue 

Fail Any Capital Standard if Income 826 S478.1 

Continues 

30 
Risk-Based Capital Requirements 

Figure 3 

Distribution of Annualized Net Operating Income 

to Assets for Thrifts Failing December 7, 1989 Capital Requirements 

(Data as of December 1989; Billions) Assets 

100 

Net Operating Income to Tolal Assets (%) 

Note: Nel operating Income is operating income plus interest Income less 

spejallng expense and less Inleresl expense 

near term. Specifically, retaining earn 

ings for one year would enable on 

ly 88 thrifts failing the new standards 

to meet their requirements, while 

losses at thrifts currently passing 

their capital requirements would 

cause an additional 69 to fail the stan 

dards. Thus, it is unlikely that retain 

ing earnings can change the basic 

impact of the new capital standards 

on the thrift industry over the short 

term. 

A different set of assumptions is 

needed to project the long-term 

impact of earnings. It is assumed 

that assets remain constant, that 

net income for the next five years is 

equal to the fourth quarter, 1989, 

net operating income, and that all 

net income is retained for five 

years. Given this scenario, Table 4 

shows that without substantial im 

provements in profitability and/or 

restructuring of balance sheets, 

long-term prospects for earnings to 

supply needed capital are not much 

better than short-term prospects. 

As noted earlier, 1,190 thrifts would 

fail the fully phased-in require 

ments if they were currently in ef 

fect. Table 4 shows that 386 of the 

1,190 thrifts could meet future 

capital standards by retaining earn 

ings. The remaining 804 thrifts 

would not meet the fully phased-in 

requirements, and most of these 

(599) would be over two percentage 

points below the required capital 

ratio of eight percent. Therefore, 

approximately one-third of the 

thrifts projected to fail the fully 

phased-in requirements may be 

able to retain sufficient earnings to 

meet future capital requirements, 

while two-thirds currently seem un 

likely to do so, 

Implications 

The existence of large numbers of 

undercapitalized thrifts over the 

next several years could have inter 

esting implications for the thrift in 

dustry, its regulatory system, and 

the RTC. First, given that riskbased standards are the driving 

force behind capital deficiency, 

large numbers of thrifts may at 

tempt to raise their regulatory capi 

tal ratios by either selling high-risk 

assets or reducing risk exposure 

through securitization. Since thrifts 

failing the new capital standards 

have a much larger volume of these 

assets than all RTC conservatorships combined, competition be 

tween the RTG and thrifts attempt 

ing to sell or securitize assets could 

make the RTC's job of selling assets 

more difficult. 

Competition between the RTC 

and thrifts could extend to the 

market for whole institutions as 

Table 4 

Impact of Retaining Five Years of Earnings for Thrifts Projected 

to Fail Fully Phased-in Capital Requirements 

(8 Billions) 

Projected Capital/Tangible Assets Number of Value of 

Ratio Shortfall Thrifts Assets 

Over Two Percent Below Required Capital 599 R378.5 

Zero to Two Percent Below Required Capital 205 139.4 

Meet Required Capital 386 264.3 

Total Failing Fully Phased-in 

Requirements if Currently in Effect 1,190 8782.2 

Note: Kiilly phased-in required capital is assumed lo equal eight percent of risk-weighted 

assets and permits no qualifying intangible assets in capital. Other fully phased-in require 

ments, such as those concerning permissible equity investment!! and maturing capital in 

struments, are not considered. The total (1,190 thrifts and :S7.S2.2 billion in assets) reflects 

thrifts that fail fully phastd-in requirements if they were currently in effect. The first three 

lines show the potential impact (if retaining earnings on thrifts that would otherwise fail the 

fully phased-in requirements. Specifically, artnualized fourth quarter, 1989, net operating 

income is used as a proxy for long-term annual earnings, then five years of annualized net 

opratinfi income are added to the fourth quarter, 198'). balance sheet as retained earnings. 

The additional retained earnings enable 386 thrifts to meet the fully phased-in 

requirements. 
FDIC Banking Review 

well. Although the restructuring of 

assets may help some thrifts, others 

may nevertheless be seeking buyers 

and/or merger partners. Thus, po 

tential purchasers of thrifts may 

have many options other than insti 

tutions in conservatorship, again 

making the RTC's job more diffi 

cult. 

The RTG's activities may be af 

fected in other ways. As discussed 

earlier, to the extent some thrifts 

not meeting capital requirements 

become insolvent, the resolution of 

insolvent thrifts could shift from the 

Southwest to other parts of the 

country. In situations where a thrift 

not meeting capital requirements 

appears headed for insolvency, 

there is likely to be debate over 

whether it should be put into RTG 

conservatorship or handled early in 

some way such as open-thrift assis 

tance ("early intervention"). 

Certain provisions of FIRREA are 

designed to encourage thrifts to re 

turn to their traditional lending ac 

tivities.6 FIRREA's impact on lend 

ing activity could be reinforced by 

the new risk-based capital stan 

dards, which could tend to en 

courage thrifts to hold single- and 

multi-family mortgages, rather than 

commercial and construction mort 

gages, due to differences in risk

weightings.7 In addition, the avail 

ability of securitization for singleand multi-family mortgages could 

encourage thrifts attempting to re 

duce assets to originate these types 

of mortgages rather than com 

mercial and construction mort 

gages. 

Finally, the existence of large 

numbers of thrifts that fail capital 

requirements, but are formally sol 

vent, will put great pressure on the 

thrift industry supervisory system. 

If not restrained by supervision, 

there is a danger that some insti 

tutions might attempt to earn their 

way out of their problems by en 

gaging in aggressive lending, 

interest-rate speculation and direct 

investments. In some instances 

there may be great temptation for 

insiders to extract whatever value 

they can from the institution before 

it is taken by the regulators. Thus, 

regulators may find that thrifts fail 

ing the new capital standards re 

quire substantial supervisory re 

sources. 

"The following is a partial listing of many 

changes mandated by FIRREA: raised the 

percentage of portfolio assets held as qualified 

thrift investments (the "QTL" test) from 60 to 

70 percent: limited nonresident]al real-estate 

loans of federal associations to four times 

capital; prohibited many loan and investment 

activities of state associations if they are not 

permitted for federal associations; prohibited 

troubled thrifts from accepting brokered 

deposits; limited loans and investments with 

affiliates; disqualified low rated (junk) bonds 

as permissible investments. 

'Single and some multi-family mortgages 

receive a 50 percent risk-weight whereas other 

mortgages are in the 100 percent bucket. 

32 
Risk-Based Capital Requirements 

.\PPENDIX 

Boxl 

Capital-Requirement 

Definitions 

The formal capital-requirement 

definitions are very complex and 

too lengthy to fully list here. The 

following are the primary com 

ponents of the capital definitions. 

Tangible Capital: Add common 

stockholders' equity (including re 

tained earnings), noncumulative 

perpetual preferred stock and re 

lated earnings, minority interests in 

the equity accounts of fully con 

solidated subsidiaries, and non

withdrawable accounts and pledged 

deposits of mutual savings associa 

tions that have no fixed maturity, 

do not earn interest that can be 

carried to future periods, and can 

not be withdrawn at the option of 

the accountholder. Deduct goodwill 

and other intangible assets except 

purchased mortgage servicing val 

ued at the lower of 90 percent of 

fair market value or original cost, 

and investments (both equity and 

debt) in "ineludable" subsidiaries, 

i.e., subsidiaries engaged in activi 

ties not permissible for a national 

bank.8 

Adjusted Total Assets: Adjusted 

total assets are total assets reported 

under generally accepted account 

ing principles (GAAP);[plus the pro 

rated assets of ineludable sub 

sidiaries for which a minority 

interest is held that is uncon

solidated under GAAP, the prorated 

assets of non-includable sub 

sidiaries acquired prior to April 12, 

1989, qualifying goodwill resulting 

from prior regulatory accounting 

practices, and for risk-based stan 

dards, general valuation loan- and 

lease-loss allowances up to 1.5 per 

cent of risk-weighted assets (re 

duced to 1.25 percent starting De 

cember 31, 1992); minus assets not 

included in the applicable capital 

standard, minority interests in in 

eludable subsidiaries, investments 

in subsidiaries that are subject to 

consolidation, and, for purposes of 

determining core capital standards, 

supervisory goodwill. 

Core (Tier 1) Capital: Add com 

mon stockholders' equity (including 

retained earnings), noncumulative 

perpetual preferred stock and re 

lated surplus, minority interests in 

the equity accounts of fully con 

solidated subsidiaries, non

withdrawable accounts and pledged 

deposits of mutual savings associa 

tions that have no fixed maturity, 

do not earn interest that can be 

carried to future periods, and can 

not be withdrawn at the option of 

the accountholder, and the remain 

ing goodwill resulting from prior 

regulatory accounting practices 

(FSLIC capital contributions). De 

duct and/or phase-out a number of 

investments (both equity and debt) 

in subsidiaries, and intangible as 

sets over 25 percent of core capital 

except qualifying supervisory good 

will up to 1.5 percent of adjusted 

total assets (phased-out to zero 

through December 31, 1994), and 

purchased mortgage servicing val 

ued at the lower of 90 percent of 

fair market value or original cost. 

Supplementary (Tier 2) Capital: 

Up to 100 percent of an institution's 

core capital, add cumulative per 

petual preferred stock, mutual capi 

tal certificates, nonwithdrawable 

accounts and pledged deposits not 

included in core capital, general 

loan- and lease-loss allowances up 

to a maximum of 1.5 percent of 

risk-weighted assets (reduced to 

1.25 percent after December 31, 

1992), and most net worth certifi 

cates, income capital certificates, 

perpetual subordinated debt, man 

datory convertible subordinated 

debt, and a number of maturing 

capital instruments such as 

intermediate-term preferred stock.9 

Risk-Weighted Assets: The 

weighted sum of all assets plus con 

solidated off-balance-sheet items 

where each asset or item is multi 

plied by the appropriate riskweight. Off-balance-sheet items 

must be converted to on-balance

sheet credit equivalent amounts be 

fore a risk-weight is assigned. Assets 

deleted from capital for capitalrequirement purposes are also not 

included in risk-weighted assets. 

Box2 

Estimating Risk-Based 

Capital Requirements 

from Thrift Financial 

Reports 

Estimating required capital is of 

ten very difficult for analysts be 

cause they are limited to examining 

standard Thrift Financial Reports 

(TFRs) that have not been designed 

to meet the needs of risk-based 

capital analysis. In particular, por 

tions of many line items fall into 

two or more risk classes, making it 

necessary to make assumptions re 

garding the line-item components.10 

Table A provides a summary of 

the risk-weights applied to TFR line 

items used to estimate risk-based 

capital in this paper.11 Many of the 

risk-weights can be calculated di 

rectly from TFRs without any need 

for assumptions. This is true of one

to-four family mortgages ("l-4s") 

except FHA/VA insured loans, be 

cause l-4s and FHA/VA loans ap 

pear as separate TFR line items. 

In three cases, line items that 

contain more than one risk class of 

assets are broken apart based on 

reasonable assumptions regarding 

the distribution of assets in the line 

item. 

• Mortgage pool securities guaran 

teed by Ginnie Mae are classified 

8 The subsidiary investment restrictions in 

clude a number of exceptions and special cases 

such as permissibility of certain mortgage 

banker subsidiaries and the phase-in of capital 

requirements for subsidiaries engaged be/ore 

April 12, 1989 in activities thai are not per 

missible for a national bank. 

'' Separate restrictions apply to the amortiza 

tion of maturing capital instruments issued be 

fore -versus afler November 7, 1989. 

1 Assumptions will no longer be needed as 

thrifts begin reporting required capital on a 

separate section of the TFR, schedule GCR 

(Consolidated Capital Requirement), in March 

1990. 

" As a technical point, off-balance-sheet 

items must be converted to on -balance -sheet 

credit equivalent amounts before being assigned 

a risk-weight. The risk-weights shown in Table 

A include the impact of credit conversion for 

off-balance-sheet items. 
FDIG Banking Review 

with Freddie Mac and Fannie 

Mae securities. Given that Ginnie 

Maes are about one-third of the 

mortgage security market, a con 

servative 25 percent of all mort 

gage pool securities are assumed 

to be Ginnie Maes (zero percent 

weight). 

• Since the majority of col

lateralized mortgage obligations 

(GMOs) do not have residual 

characteristics, one-half of all 

GMOs are assumed to have resi 

dual characteristics (100 percent 

weight) and one-half not to have 

them (20 percent weight). 

• Stock in Federal Home Loan 

Banks is assumed to be 0.3 per 

cent of assets due to statutory 

ownership restrictions. 

While some line items can be 

broken apart, assumptions must be 

made regarding others. The fol 

lowing is a list of the more impor 

tant assumptions made to complete 

the analysis. 

No assets are guaranteed by the 

FSLIC Resolution Fund, formerly 

the FSLIG, (guaranteed assets 

require a zero percent weight, 

whereas either a 100 or 200 per 

cent weight would typically 

otherwise apply). 

No multi-family mortgages qual 

ify for the 50 percent weight 

(non-qualifying multi-family 

mortgages receive a 100 percent 

weight instead of the 50 percent 

weight applied to qualifying 

multi-family). 

All preferred stock is cumulative 

(cumulative preferred stock does 

not qualify as core capital, 

whereas non-cumulative pre 

ferred stock is permitted in core 

capital). 

No l-4s are held with loan-to

value ratios in excess of 80 per 

cent (l-4s above 80 percent re 

quire a 100 percent risk-weight 

instead of the 50 percent weight 

applied to l-4s below 80 per 

cent). 

• Subsidiaries do not hold sub 

stantial amounts of risk assets 

(while the net equity in service 

corporation subsidiaries is 

counted at 100 percent, sub 

sidiaries that contain significant 

amounts of risk assets could eas 

ily require much higher capital if 

consolidated). 

• All goodwill is supervisory good 

will (supervisory goodwill is per 

mitted in core capital up to 1.5 

percent of tangible assets). 

The first three of the above six 

assumptions tend to overestimate 

required capital; the last three to 

underestimate it. On balance, it is 

not clear whether the overall net ef 

fect is to overstate or understate 

required capital. More accurate es 

timates of risk-based capital will be 

possible as more extensive 1990 

TFRs become available showing 

thrifts on a consolidated basis. 

34 
Risk-Based Capital Requirements 

Table A 

Summary of Risk-Weights and Assumptions for Estimating 

December 7, 1989 Capital Requirements 

RiskWeigh^ 

0% 1 

On-Balance-Sheet 

Cash and noninterest-earning assets. 

1 U.S. government and agency securities. 

30% 

Losses unrecognized pursuant to 561.12 (a)(3) and 

deferrals pursuant to 563c.l4. 

Ginnie Mae securities (assumed 25% of federally insured 

mortgage pool securities). 

FHA/VA insured loans. 

50% 

Non-Ginnie Mae securities (assumed 75% of federally 

insured mortgage pool securities) and non-residual 

CMOs (assumed 50% of CMOs). 

Consumer closed-end loans on deposits. 

FHLB stock (assumed 0.3% of total assets). 

1-4 family mortgages except FHA/VA insured loans and 

delinquent l-4s (assumed all l-4s qualify for this risk 

class). 

00% 1 Construction, land, and commercial mortgages net of 

reserves, other contra assets except loans in process, 

and delinquencies. 

200% 

1 Multi-family mortgages (assumed none qualify for 50% 

risk-weight). 

1 Loans in process. 

Non-mortgage loans, except consumer loans on deposits, 

net of reserves, other contra assets except loans in 

process, and delinquencies. 

Real estate held for development, net of reserves 

(assumed none are guaranteed by FSLIC Resolution 

Fund). 

Equity securities, except FHLB stock, and net equity in 

service corporations. 

IOs, POs, and residual CMOs (assumed 50% of CMOs). 

FSLIC capital contributions up to 1.5% of tangible assets. 

Other assets, including goodwill (assumed all 

supervisory), loan servicing, and fixed assets, net of 

valuation allowances. FHLB stock (assumed 0.3% of total 

assets) deleted from "other" assets. 

Repossessed real estate (assumed none are guaranteed 

by FSLIC Resolution Fund), net of reserves. 

Off-Balance-Sheet 

All commitments to originate 

or sell loans. 

Underlying principal of 

interest-rate swaps. 

All options and futures 

positions outstanding. 

Mortgage loans held for sale 

or serviced for others. 

Letters of credit 

collateralized by deposits. 

Letters of credit 

collateralized by cash. 

Principal amount of loans 

sold with recourse (assumed 

all recourse commitments 

are for l-4s). 

Delinquent 1-4 family 

mortgages (assumed none 

are guaranteed by FSLIC 

Resolution Fund). 

All delinquent loans except 

1-4 delinquents (assumed 

none are guaranteed by 

FSLIC Resolution Fund). 

35 
FDIC Banking Review 

Recent Developments 

Affecting Depository 

Institutions 

by Benjamin B. Christopher* 

Federal Legislation 

Financial Institutions 

Reform, Recovery, And 

Enforcement Act 

Of 1989 

President Bush on August 9, 1989 

signed the Financial Institutions Re 

form, Recovery, and Enforcement 

Act of 1989 (FIRREA). The Act 

abolishes the Federal Home Loan 

Bank Board (FHLBB) and merges 

the Federal Savings and Loan In 

surance Corporation (FSLIC) into 

the PDIC. It establishes a Bank In 

surance Fund (BIF) and a Savings 

Association Insurance Fund (SAIF), 

both to be administered by the 

FDIC. The Act creates in the 

Treasury Department, The Office of 

Thrift Supervision (OTSJ, which 

succeeds the FHLBB as the primary 

federal regulator of thrift insti 

tutions. The Federal Housing 

Finance Board (FHFB) will oversee 

the Federal Home Loan Bank 

System. 

The Act creates the Resolution 

Trust Corporation (RTG) which will 

manage the assets and liabilities of 

insolvent savings and loan associa 

tions that are closed between Janu 

ary 1, 1989 and August 9, 1992, 

and will terminate on December 31, 

1996. The FDIC will direct the day

to-day activities of the RTC. The 

Oversight Board (OB) will be re 

sponsible for setting broad policies 

for RTC. The OB consists of the 

Secretary of the Treasury (Chair 

man), the Chairman of the Federal 

Reserve Board, the Secretary of the 

Department of Housing and Urban 

Development, and two independent 

members (of different political par 

ties) to be appointed by the 

President. 

The Resolution Funding Corpora 

tion (REFCORP) is established to 

provide funds for the RTC through 

the issuance of debt obligations, 

and is subject to the authority of 

the OB. 

Among the many provisions of 

FIRREA are those providing capital 

standards for insured thrift insti 

tutions, phased-in increases in as 

sessments for banks and thrifts, and 

stronger enforcement powers for 

bank and thrift regulators. 

The Act requires that reports on 

several matters related to deposit 

insurance be provided to the Con 

gress. Among these are reports by 

the FDIC on pass-through of deposit 

insurance, availability of directors' 

and officers' liability insurance, and 

risk-based assessments, and a re 

port by the Treasury Department 

on reforms needed in the deposit 

insurance system. 

Regulatory Agency Actions 

Federal Deposit 

Insurance Corporation 

Capital Requirements 

The FDIC adopted capital re 

quirements for newly formed statechartered nonmember banks and 

thrifts created as a result of RTC 

transactions. The FDIC will require 

a 4J/2 percent tangible capital-to

assets ratio for new applications for 

deposit insurance by such insti 

tutions. Capital in these cases 

would be defined by risk-based 

guidelines. It would include at least 

three percent Tier 1 capital and no 

more than W2 percent from Tier 2, 

Loan-loss reserves would be 

excluded. 

The FDIC Board emphasized that 

the policy is designed to expedite 

the thrift resolution process and 

does not affect long-term capital 

standards. Directors Robert L. 

Clarke and M. Danny Wall stressed 

that their votes approving the pol 

icy were intended to permit the 

RTC to go forward with case resolu 

tions but did not indicate endorse 

ment of the specific ratio set forth 

in the policy for institutions under 

their Supervision. Joint News Release, 

FDIC, RTC PR-18S-89 (FDIC), 9/27. 

" Benjamin B. Christopher is a Financial 

Economist in the PDIG's Division of Research 

and Statistics. 

Reference sources: American Banker (AB); 

Wall Street Journal (WSJ); Bffl's Bankhig Keport (BBR); Federal Register (FR); Commerce 

Clearing House, Inc., Electronic Legislative 

Search System (ELSS). All ELSS items have 

been enacted into law when included in [his 

report. 
Recent Developments 

Cooperative Agreement 

With Office Of Thrift 

Supervision 

The FDIC and the OTS have 

formed an agreement to coordinate 

and cooperate on regulatory mat 

ters. FDIG Chairman L. William Seid

man said the agreement, aimed at 

avoiding duplicate efforts by the 

two regulators, "recognizes the OTS 

is the primary federal supervisor of 

both federal and state thrifts. At the 

same time, it provides the FDIG 

with the flexibility necessary to ad 

dress our mandated backup super 

visory role." 

Under the agreement, the two 

agencies will exchange databases, 

provide copies of reports of exami 

nation and relevant documents to 

the other agency, and notify each 

other of the receipt of applications 

in which both agencies have an in 

terest. The agencies will cooperate 

in administrative hearings proce 

dures by providing documents and 

personnel as necessary; also, they 

will exchange information about en 

forcement actions, and proposed 

changes in control and examination 

schedules involving thrift insti 

tutions. PR-199-89 (FDIC), 10/13. 

Brokered Deposits 

The FDIG issued an interim rule 

and request for comments under a 

section of FIRREA which prohibits 

the acceptance or renewal of bro 

kered deposits by any under 

capitalized insured depository insti 

tution (bank or thrift) after 

December 7, 1989 except on spe 

cific application to and waiver of 

the prohibition by the FDIG. The 

interim rule provides guidance and 

further detail on when an insti 

tution is considered under 

capitalized, when certain deposits 

are considered "brokered" for pur 

poses of the prohibition, and the 

circumstances under which a wai 

ver from the prohibition may be 

granted. The rule specifically per 

mits an undercapitalized insured 

depository institution to accept, re 

new or rollover brokered deposits 

during a 60-day period from De 

cember 8, 1989 to February 5, 

1990, if certain requirements are 

met. 

The interim rule, effective upon 

publication in the Federal Register, 

will "sunset" in six months unless 

modified or replaced by a final rule 

prior to that time. FR, 12/12/89, p. 

51012. 

Definition Of Highly 

Leveraged Transactions 

The FDIC, Federal Reserve Board 

(FRB), and Office of the Comptrol 

ler of the Currency (OGG) jointly 

adopted a common definition of 

highly leveraged transactions 

(HLTs) to be used by examiners in 

supervising HLT activities at all in 

sured banks. 

For supervisory purposes, a bank 

or bank holding company is con 

sidered to be involved in an HLT 

when credit is extended or invest 

ment is made in a business where 

the financing transaction involves 

the buyout, acquisition, or recap 

italization of an existing business. 

In addition to this purpose test, to 

be considered an HLT the trans 

action must at least double the sub 

ject company's liabilities and result 

in a leverage ratio (total assets di 

vided by total liabilities) higher 

than 50 percent, or must result in a 

leverage ratio higher than 75 per 

cent, or must be designated an HLT 

by a syndication agent. 

Where a credit meets the purpose 

test but is not covered by any of the 

above criteria, the bank supervisory 

agencies may nevertheless desig 

nate the credit as an HLT. It is an 

ticipated that this would be done 

infrequently and only in material 

cases. FIL-18-89 (FDIC), 11/20; FIL14-90, 

2/9. 

Notice Of Rapid Growth 

The FDIC adopted a final rule 

which requires insured banks to 

give the agency 30 days' advance 

notice when planning to increase 

their assets 7.5 percent or more 

over any three-month period 

through the solicitation, in any 

combination, of fully insured bro 

kered deposits, fully insured out-of

territory deposits, or secured bor 

rowings, including repurchase 

agreements. The final rule elimi 

nates after-the-fact reporting of 

rapid growth, as originally pro 

posed. PR-61-90, 4/4. 

Changes In Officials Of 

Nanmember Banks 

The FDIC issued an interim rule 

and request for comments under 

FIRREA which requires certain in 

sured nonmember banks to notify 

the FDIG before adding or replacing 

a member of the board of directors 

or employing or changing the re 

sponsibilities of an individual to a 

position as a senior executive offi 

cer. The FDIC may disapprove any 

proposed board member or senior 

executive officer whose service is 

not considered to be in the best in 

terest of the depositors of the in 

sured nonmember bank or the 

public. 

An insured nonmember bank 

which is covered by the require 

ment must notify the FDIG within 

30 days before adding a director or 

employing any individual as a se 

nior executive officer. A bank is 

covered if it (1) has been chartered 

less than two years; (2) has under 

gone a change in control within the 

preceding two years; or (3) is not in 

compliance with the minimum 

capital requirements applicable to it 

or is otherwise in a "troubled condi 

tion," as determined on the basis of 

the bank's most recent Report of 

Condition or Report of Examination 

or inspection. Effective December 

27, 1989. FR, 12/27/89, p. 53040. 

Applications For Mergers 

The FDIG adopted a policy 

statement that redefines and clari 

fies product and geographic mar 

kets and the standards to be applied 

in assessing both the competitive 

effects and prudential concerns in 

volved in proposed bank merger 

37 
FDIC Banking Review 

transactions. The final statement is 

fundamentally the same as the pro 

posal issued in October 1988 for 

revising the Corporation's policy on 

the approval of mergers. 

The Federal Deposit Insurance 

Act requires the prior written ap 

proval of the FDIC before any in 

sured bank may merge, consolidate 

with or purchase the assets and as 

sume the deposit liabilities of a noninsured bank, or in any merger or 

consolidation of two or more in 

sured banks if the acquiring, assum 

ing or resulting institution is to be 

an insured nonmember bank. The 

new policy statement was effective 

September 22, 1989. FR, 9/22/89, p. 

39043. 

Loan-Review Systems 

In a letter to FDIC-supervised 

banks, the FDIC strongly endorsed 

institutions' internal loan-review 

and grading systems that are de 

signed to highlight for management 

and the board of directors those 

loans which warrant special atten 

tion for reasons bearing on ultimate 

collectibility. The FDIC believes 

that every bank it supervises should 

have a loan-review system which, at 

a minimum, provides for: an identi 

fication or grouping of loans that 

warrant the special attention of 

management; for each loan identi 

fied, an indication of the reason(s) 

why the particular loan merits spe 

cial attention; and a mechanism for 

reporting periodically to the board 

on the status of each loan identified 

and action(s) taken by 

management. 

Examiners will encourage banks 

to establish and maintain systems 

that meet the minimum standards. 

BL-27-89, 6/29. 

Guidance On External 

Auditing Procedures 

The FDIC adopted a new policy 

statement recommending minimum 

procedures for annual external au 

diting programs of FDIC-supervised 

banks. The new guidance is in addi 

tion to an FDIC policy statement 

that became effective December 28, 

1988, which strongly urges banks to 

have an audit by an "independent 

public accountant" but also identi 

fies acceptable alternatives. Gui 

dance is provided on specific audit 

ing procedures, especially for banks 

that forgo an annual audit of their 

financial statements by an inde 

pendent public accountant, in areas 

common to all banks that may 

prove to be high-risk. These areas 

include loans, the allowance for 

loan losses, securities investments, 

transactions involving bank officers, 

directors and other "insiders," and 

internal controls. 

The new policy statement will 

become effective when it is pub 

lished in the Federal Register. 

PR-8-90:1/19. 

Independent Audit 

Requirement For Publicly 

Held Banks 

The FDIC amended its securities 

disclosure regulations issued under 

the Securities Exchange Act of 

1934 to bring them into substantial 

similarity with those of the Securi 

ties and Exchange Commission 

(SEC). One of the amendments 

eliminates the use of verification 

statements and will require that fi 

nancial statements of publicly held 

banks be audited by independent 

public accountants. Since 1964 

most banks have generally had the 

option of using verification state 

ments which express the opinion of 

a bank's principal accounting offi 

cer or internal auditor. Currently, 

only eight banks reporting under 

this regulation do not file certified 

financial statements. The amend 

ment is effective for periods ending 

after December 15, 1990. FR, 

12/29/89, p. 53571. 

Appraisal Standards 

The FDIC is seeking public com 

ment on a proposal on uniform ap 

praisal standards. A similar pro 

posal was approved by the RTC. 

The federal financial institution 

regulators and the RTC are re 

quired to develop uniform appraisal 

standards by PIRREA. 

The proposed regulation, drafted 

by an interagency committee, iden 

tifies which transactions require an 

appraiser, sets forth minimum 

standards for performing appraisals, 

and distinguishes appraisals requir 

ing the services of a state-certified 

appraiser from those requiring a 

state-licensed appraiser. The agen 

cies specifically seek comments on 

definitions, the transaction amount 

below which a state-certified or li 

censed appraiser would not be re 

quired, the criteria that determine 

when a state-certified appraiser is 

required and when a state-licensed 

appraiser is required, and ad 

ditional appraisal standards con 

tained in the proposed regulation. 

PR-21-90, 2/13; FR, 2/22, p. 6285 (RTC). 

Savings Institutions' 

Activities And 

Investments 

The FDIC adopted an interim 

rule to implement provisions of 

FIRREA which (a) seek to establish 

parallel regulation of state- and fed 

erally chartered savings associa 

tions, and (b) would prevent state 

associations from exercising powers 

not authorized to federal associa 

tions or which the FDIC deems too 

risky. The interim rule also requires 

that savings associations provide 

the FDIC and the OTS with a notice 

of intent to establish or acquire a 

subsidiary, or to conduct a new ac 

tivity through a subsidiary. In addi 

tion, it requires state-chartered sav 

ings associations to obtain FDIC 

approval before engaging, either di 

rectly or through service corpora 

tions, in activities not permissible 

for a federal association or at levels 

beyond what is permitted a federal 

association. The rule became effec 

tive on December 29, 1989. 

FIL-2-90, 1/10, FDIC; FR, 12/29/89, p. 

53540. 

38 
Recent Developments 

Real-Estate Lending 

Problems 

FDIG Chairman L. William Seid

man expressed concern over realestate lending problems developing 

around the country, citing in par 

ticular the emerging trends in 

Arizona, parts of Florida and certain 

Northeastern areas. 

Over a 12-month period to the 

fall of 1989, real-estate loan growth 

accounted for nearly two-thirds of 

all bank asset growth across the 

nation, and comprised almost onefourth of all commercial bank as 

sets. Nonperforming real-estate as 

sets constitute almost half of all 

nonperforming assets in the bank 

ing system, Mr. Seidman said. In 

the Northeast, the percentage of 

real-estate loans in nonaccrual 

status has almost doubled over the 

past year. Also, net charge-offs of 

real-estate loans, on average, were 

running 47 percent higher than the 

same period in 1988, and were ex 

pected to accelerate in the fourth 

quarter. 

Industry indicators would be 

even less favorable were it not for 

the FDIC's assistance in removing 

billions of dollars in bad real-estate 

assets from the commercial banking 

sector, the Chairman noted, 

PR-23-89, 12/5. 

Insured Foreign-Currency 

Deposits 

The FDIC proposed amendments 

including a specific provision that 

would recognize that foreign

currency-denominated deposits are 

entided to deposit insurance. Such 

deposits are foreign currency main 

tained in an account at a domestic 

office of a U.S. bank. 

The Federal Deposit Insurance 

Act does not prohibit the mainte 

nance of deposits in foreign cur 

rencies, and some banks have been 

accepting these deposits, and the 

FDIC has been insuring them, for 

years. 

The FRB announced that, as of 

January 1, 1990, it would no longer 

object to banks' holding deposits 

denominated in foreign currencies. 

This reverses the FRB's long 

standing policy of discouraging 

banks from engaging in this activ 

ity. Statement by FDIG official, AB, 2/13/90, 

p. 6. 

Studies Required By 

FIRREA 

"Pass-Through" Of Deposit Insur 

ance: The FDIC submitted to Con 

gress a report containing its find 

ings and recommendations 

concerning "pass-through" deposit 

insurance. The report addresses 

such deposit insurance provided to 

individual participants in pension 

and profit-sharing plans qualified 

under section 401 of the Internal 

Revenue Code and to individual in 

vestors in unit investment trusts. In 

addition, the report includes the 

FDIC's assessment of the potential 

effects of broadening deposit insur 

ance coverage on the safety of the 

insurance funds and the operation 

of capital markets. Findings and Rec 

ommendations Concerning "Pass-Through" 

Deposit Insurance, FDIC, 2/90. 

Directors' And Officers' Liability 

Insurance: The FDIC requested 

public comments on a study of di 

rectors' and officers' liability insur 

ance and depository institution 

bonds, and the availability and 

terms of such insurance for direc 

tors and officers of insured deposi 

tory institutions. FR, 12/29/89, p. 53719; 

1/30/90, p. 3102. 

Federal Reserve Board 

Capital Adequacy 

Guidelines 

The FRB proposed transition 

capital standards for state member 

banks and bank holding companies 

through the end of 1990, and set 

forth its preliminary views on the 

appropriate leverage standard to be 

applied to banking organizations in 

conjunction with the risk-based 

capital framework after year-end 

1990. 

Under the proposal, a banking 

organization may choose until yearend 1990 to conform to either the 

existing minimum capital adequacy 

ratios (5.5 percent primary capital 

and six percent total capital to total 

assets) or to the 7.25 percent yearend 1990 risk-based capital stan 

dard. In addition, the FRB is pro 

posing to establish and apply during 

this period a minimum ratio of 

diree percent Tier 1 capital to total 

assets (leverage ratio). For leverage 

purposes, Tier 1 would be defined 

consistent with the year-end 1992 

risk-based capital guidelines. At the 

end of 1992, Tier 1 capital for state 

member banks will include com 

mon equity, minority interests in 

equity accounts of consolidated 

subsidiaries, and qualifying non

cumulative perpetual preferred 

stock, less goodwill. It excludes 

other intangibles and investments 

in subsidiaries as determined by the 

FRB on a case-by-case basis. 

The proposed standards are min 

imum requirements, applicable to 

sound institutions rated composite 

1 under the appropriate bank hold 

ing company rating system. Organi 

zations experiencing growth, 

whether internally or by acquisi 

tion, are expected to maintain 

strong capital positions sub 

stantially above minimum supervi 

sory levels, without significant reli 

ance on intangible assets. Federal 

Reserve Press Release, 12/29/89. 

BHC Acquisitions Of 

Savings Associations 

The FRB, as authorized by FIR 

REA, amended its Regulation Y to 

permit bank holding companies to 

acquire healthy as well as failed or 

failing savings associations, in any 

state, regardless of whether the 

holding company can operate a 

bank in that state. No operational 

or branching conditions are im 

posed on the savings associations 

except that they must conform 

their activities to those permissible 

for bank holding companies. Effec 

tive October 10, 1989. Federal Reserve 

Press Release, 9/5/89. 

39 
FDIC Banking Review 

Court Upholds Approval Of 

Powers For State Banks 

In Holding Companies 

Under a decision by a U.S. Court 

of Appeals, two Indiana state banks 

acquired by Merchants National 

Corp., Indianapolis, may resume 

insurance activities that are per 

mitted by the state's law but are 

barred by federal law. The Court, 

accepting the FRB's interpretation 

of section 4 of the Bank Holding 

Company Act, ruled that the limi 

tations on bank holding company 

activities, including the restrictions 

on insurance activities imposed by 

the Garn-St Germain Depository 

Institutions Act of 1982, do not 

apply to activities conducted di 

rectly by state banks owned by 

bank holding companies. 

The FRB, in October 1986, ap 

proved Merchant National's pur 

chase of the two state banks— 

Anderson Banking Co., of 

Anderson, and Mid State Bank of 

Hendricks County, Danville—and 

about a year later allowed the banks 

to resume their insurance activities. 

The Independent Insurance Agents 

of America sued the FRB to over 

turn the decision, arguing that al 

lowing the banks to sell insurance 

violated the BHC Act. BBR, 12/4/89, p. 

845; AB, 11130, p. 1; 12/1, p. 2. 

Thrift's Merger Into Bank 

Approved 

The FRB granted approval for 

Southeast Banking Corp. to merge 

Southeast Bank for Savings—the 

former First Federal Savings and 

Loan, Jacksonville—into Southeast 

Bank, Miami. Southeast Banking 

acquired First Federal in 1988. 

Through the merger the thrift 

would be effectively converted into 

a bank. A provision of FIRREA 

permits such mergers if the resul 

tant institution continues to pay 

premiums into SAIF. 

As of late December, the FRB had 

approved four thrift-to-bank con 

versions under the SAIF 

continuing-premium provision of 

FIRREA. AB, 12/28/89, p. 2. 

Citicorp Allowed To Keep 

Insurance Subsidiaries 

The FRB permitted Citicorp to 

retain ownership of two nonbank 

subsidiaries in Arizona that sell in 

surance. The Garn-St Germain Act 

of 1982, which generally prohibits 

bank holding companies from sell 

ing insurance, provides for excep 

tions, including any insurance 

agency activity that a bank holding 

company or its subsidiaries engaged 

in on May 1, 1982. The FRB re 

jected the argument of insurance 

industry groups that the exception 

did not transfer when Citicorp pur 

chased GWB Holding Co., parent 

firm of Great Western Bank and 

Trust, Phoenix, and two other firms 

that engage in insurance activities. 

AB, 12119189, p. 2. 

BankAmerica Can Acquire 

Bank Sellers Of 

Insurance 

The FRB granted approval for 

BankAmerica Corp. to acquire 

Bank of America State Bank, Con 

cord, California, a newly chartered 

state bank that will engage in spe 

cialized community lending activi 

ties, cash management services for 

California corporate customers and 

public agencies, and insurance 

agency/brokerage activities. The 

application appears to be the first 

for a charter to take advantage of 

provisions of the state's Proposition 

103 which removed prohibitions on 

the conduct of insurance activities 

by banks and bank holding compa 

nies. 

The FRB also allowed Bank 

America to acquire a state bank in 

Oregon through which Bank 

America can conduct general insur 

ance agency activities in the state. 

BBR, 2/26/90, p. 326; 3/5, p. 366. 

Dealing In Bank-Ineligible 

Securities 

The FRB modified its author 

ization for bank holding company 

subsidiaries to underwrite and deal 

in securities that member banks 

may not underwrite and deal in un 

der the Glass-Steagall Act. The limit 

on revenue which a subsidiary may 

derive from underwriting and deal 

ing in ineligible securities is raised 

from five to ten percent of its total 

revenues. In addition, a subsidiary 

is permitted to underwrite and deal 

in securities held by affiliates if the 

securities are rated by a nonaffiliated nationally recognized rat 

ing organization; or are issued or 

guaranteed by the Federal National 

Mortgage Association, the Federal 

Home Loan Mortgage Corporation, 

or the Government National Mort 

gage Association, or represent in 

terests in such obligations. Effective 

immediately. Federal Reserve Press Re 

lease, 9/21/89. 

Approval To Underwrite 

Corporate Debt 

The FRB granted final approval 

for J.P. Morgan & Co. to underwrite 

and deal in corporate debt in the 

U.S. through its securities sub 

sidiary. The bank holding company 

was the first to receive the FRB's 

final approval to engage in these ac 

tivities. In January 1989 the FRB 

granted several major banking firms 

initial approval to underwrite and 

deal in corporate debt. Final ap 

provals were delayed until the firms 

could show that they had enough 

capital to support the securities 

subsidiary and undergo an audit to 

indicate adequate management and 

systems to support the new under 

writing activities. 

The FRB also said it will consider 

giving bank holding companies 

permission to underwrite corporate 

equities in 1990. The Securities In 

dustry Association has challenged 

in a pending lawsuit the FRB's 

January action. WSJ, 6/20/89, p. ci;ab, 

6/20, p. 1. 

The FRB gave final approval to 

Bankers Trust New York Corp. and 

Chase Manhattan Corp. to under 

write corporate debt through their 

government securities subsidiaries. 

The FRB's decision required the 

BHCs to raise additional capital 

within 60 days by issuing preferred 

Stock. BBR, 7/31/89, p. 160. 

40 
Recent Developments 

Bank Loans To SecuritiesUnit Clients 

A ruling by the FRB allows Mor 

gan Guaranty Trust Company of 

New York, or its parent company, 

to extend credit to customers pri 

vately placing debt securities 

through Morgan's securities affiliate 

even if the loan is used by the cus 

tomer to repay principal on its 

debt. A three-year period is re 

quired between the time the secu 

rity was placed to the time the 

credit is extended. Previously, 

banks were permitted to extend 

credit to a company involved in a 

private placement managed by a 

bank's securities unit only if the 

loan was for another purpose. The 

decision is seen as a significant de 

parture from the FRB's long-held 

policy requiring banks' securities af 

filiates to operate entirely sepa 

rately from the banking affiliates, 

and is expected to enable banks to 

be more competitive with Wall 

Street firms. 

The FRB's ruling follows its Oc 

tober 30 decision permitting Bank 

ers Trust New York Corp. to trans 

fer its private-placement business 

from its subsidiary bank to its sub 

sidiary securities company. Also, 

lending to securities-unit clients 

was ruled an "eligible" activity, not 

included within the ten percent 

limitation on limited securities ac 

tivities, and may be counted in the 

base for calculating that limitation. 

AB, 11/27/89, p. 1. 

Foreign Banks Permitted To 

Operate Securities Units 

The FRB granted approval for 

Canadian Imperial Bank of Com 

merce, Royal Bank of Canada, and 

Barclays Bank PLC to own and fund 

companies that will underwrite 

corporate debt, commercial paper 

and other securities which U.S. 

banks are not allowed to under 

write. The FRB would approve such 

activities for U.S. banks only if they 

were conducted by units of hank 

holding companies. Foreign banks, 

however, do not generally have 

holding companies. Restrictions 

placed on the new powers are ex 

pected to prevent the foreign insti 

tutions from gaining a competitive 

edge over U.S. banks. The FRB re 

jected a request from the two Ca 

nadian banks for authority to un 

derwrite corporate equity 

securities. AB, 1/8/90, p. i, wsj, 1/5, p. 

A2. 

West German Bank's 

Subsidiaries Approved As 

Investment Adviser, 

Broker 

The FRB granted approval for an 

asset management subsidiary of 

Dresdner Bank AG, Frankfurt, to 

acquire an interest in a Boston firm 

that provides portfolio investment 

advice and investment management 

services to institutions and indi 

viduals. Dresdner also owns a regis 

tered broker-dealer subsidiary 

which acts as a broker and special 

ist on the floor of the New York 

Stock Exchange—an activity not 

permitted for subsidiaries of 

U.S.-based bank holding compa 

nies. To forestall any unfair com 

petitive advantage, or possible con 

flicts of interest, Dresdner agreed to 

separate completely the operations 

of the two subsidiaries. BBR, 8/7/89, p. 

200. 

Japanese BHC May Broker 

Interest-Rate Swaps 

The FRB granted approval for a 

U.S. subsidiary of the Sumitomo 

Bank Ltd., Osaka, Japan, to act as 

originator, principal or broker in 

interest-rate and currency swaps 

and swap-derivative products. It 

was the FRB's first approval for a 

bank holding company to act in 

these capacities in such trans 

actions. Previously it had approved 

similar activities for bank holding 

companies in foreign-exchange for 

ward transactions. 

Approval also was granted for the 

subsidiary to advise institutional 

customers about interest-rate and 

currency swaps and swap-derivative 

products. BBR, 7/3/89, p. 7. 

Approval For French Bank 

As Specialist On Stock 

Exchange 

The FRB granted approval for a 

subsidiary of Societe Generale. 

Paris, to become a specialist in deu

tsehe mark options on the Philadel 

phia Stock Exchange. It will be the 

first bank to be a specialist on a 

registered securities exchange. 

In 1986 the FRB denied a request 

from a French bank to become a 

specialist in French franc options. 

Reportedly the FRB has been con 

cerned about conflicts involved in a 

major bank acting as a market 

maker in its own country's cur 

rency. The FRB noted that the deu

tsche mark market is more liquid 

than was the French franc market 

at the time of the earlier request, 

and that the market for foreigncurrency options has broadened 

significantly on the Philadelphia 

Exchange. AB, 6/38/89, p. m 

Community Reinvestment 

Records Influence 

Regulators' Decisions 

On Applications 

The FRB granted approval for 

First Union Corp., Charlotte, North 

Carolina, to acquire Florida 

National Banks of Florida, Inc., 

Jacksonville, despite a less than 

fully satisfactory record of First 

Union's subsidiary banks in several 

states in meeting Community Re 

investment Act (CRA) require 

ments. Influencing the FRB's deci 

sion was Florida National's 

deteriorating financial condition. 

First Union agreed to improve its 

CRA performance. The FRB said 

First Union should not plan further 

expansion until it demonstrates a 

fully acceptable CRA record. 

A provision of FIRREA requires 

public disclosure of CRA examina 

tions and ratings for the first time. 

AB, 7/24/89, p. 3; 1111, p. 1. 

Fees On Daylight 

Overdrafts 

The FRB proposed that beginning 

in 1991, banks pay a fee on their 

41 
FDIG Banking Review 

daily intraday average of Fed Wire 

overdrafts above a deductible of ten 

percent of their risk-based capital. 

When fully phased in, the fees 

would be equivalent to 86.85 per 

day per Si million of average over 

drafts beyond the deductible. This 

is one of the proposed rules on 

overdrafts that, if adopted, will be 

phased in between 1990 and 1993. 

Most banks will be able to incur 

small overdrafts free of charge be 

cause of the deductible. While an 

estimated 200 to 250 financial insti 

tutions would pay for overdrafts, 

about 90 percent of the fees would 

be paid by 15 banks. 

The FRB proposed also to include 

government securities transactions 

in the calculation of daylight over 

drafts. These so-called "book-entry" 

overdrafts account for 60 percent of 

all Fed Wire overdrafts. 

In its previous efforts to control 

risk to the banking system from 

daylight overdrafts, in 1986 the 

FRB established debit caps limiting 

the daylight overdrafts banks may 

incur, and since then the caps have 

been tightened. The new proposals 

would require banks that regularly 

exceed their Fed Wire overdraft 

caps solely due to book-entry trans 

fers to collateralize all of their Fed 

Wire overdrafts, ab, 6/1/89, p. i; 6/2, p. 

3; FR, 6/21, pp. 26090, 26094, 26108. 

Office Of T/ie Comptroller 

Of The Currency 

Minimum Capital Ratio 

The OGG proposed to adopt a 

three percent minimum capital-to

assets ratio to supplement riskbased capital standards for national 

banks. Banks would be required, ef 

fective December 31, 1990, to meet 

both the minimum leverage ratio, 

and interim risk-based capital stan 

dards. Capital would be defined, for 

purposes of the leverage ratio, as 

Tier 1 capital, which includes 

common equity, noncumulative 

perpetual preferred stock (exclud 

ing auction rate issues), and mi 

nority interests that are held by 

others in a bank's consolidated sub 

sidiaries. The agency specifically 

asked for comments on whether an 

overall six percent leverage ratio to 

include some Tier 2 capital would 

be more effective. 

Risk-based capital standards are 

scheduled to be fully effective at 

year-end 1992. Between 1990 and 

year-end 1992, banks would be re 

quired to hold at least 7.25 percent 

capital to risk-adjusted assets, rising 

to eight percent at the end of 1992. 

Of the eight percent, four percent 

must be in Tier 1, and the other 

half in Tier 2, which consists of 

loan-loss reserves, cumulative and 

limited-life preferred stock, man 

datory convertible securities, sub 

ordinated debt, and other forms of 

capital. BBR, 11/13/89, p. 687; FR, 11/3, p. 

46394. 

Procedures For 

Receiverships 

The OCG specified certain fac 

tors which the agency may consider 

in determining whether to appoint 

a receiver for a national bank. A 

major change is the use of equity 

capital, radier than primary capital, 

in measuring a bank's net worth. 

The allowance for loan and lease 

losses (loan-loss reserve) is ex 

cluded from the calculation of net 

worth. This change is intended to 

bring the measurement of net 

worth more closely in line with 

generally accepted accounting prin 

ciples (GAAP). The final rule does 

not alter the method of determining 

insolvency on a liquidity basis. 

Also, it does not limit the OGG's 

discretion to consider other factors 

in assessing the solvency of a 

national bank on a case-by-case 

basis. FR, 11/28/89, p. 48851. 

Highly Leveraged 

Transactions 

The OGG announced a policy 

starting late in 1989 for periodic 

monitoring of HLTs in all national 

banks with exposure to such trans 

actions greater dian two percent of 

assets. 

Comptroller of the Currency 

Robert L. Clarke on November 14 

said the agency had conducted re 

cent detailed examinations of HLTs 

in 11 multinational banks. Much of 

the U.S. banking industry's ex 

posure to HLTs is at 17 multi 

national banks, which have an ag 

gregate $79 billion in exposure. Mr. 

Clarke said that 12 of these compa 

nies had more than 100 percent 

equity exposure to HLTs, and nine 

had more than 150 percent equity 

exposure. At the 11 institutions 

given detailed examinations, criti 

cized HLTs relative to total out 

standing HLTs almost doubled from 

year-end 1988 to mid-1989, rising 

from nine percent to 17 percent. 

Statement by Robert L. Clarke, 11114/89. 

Banks Can Sell Fixed-Rate 

Annuities 

The OCC gave approval for 

national banks to sell fixed-rate an 

nuities for insurance companies. 

Brokering fixed-rate annuities is not 

an insurance activity, the OCC 

said, but is more similar to the sale 

of a financial instrument like a cer 

tificate of deposit. National banks 

have been allowed to market 

variable-rate annuities since 1985. 

AB, 2/26/90, p. 1. 

Broader Powers For Bank 

Subsidiary Approved 

The OCC granted approval to Se 

curity Pacific National Bank, Los 

Angeles, for its subsidiary, Security 

Pacific Futures Inc., to buy and sell 

agricultural, petroleum, metal, and 

other commodity futures, and their 

related options. Previously, federal 

regulators permitted subsidiaries of 

banks to broker futures and options 

contracts only when the underlying 

items were financial instruments 

that are traded on financial ex 

changes, and not used as a way to 

buy and sell the underlying com 

modity. 

The OCC's order specifically 

prohibits the bank from guarantee 

ing the futures subsidiary's ob 

ligations. It also limits the bank's 

investment in, or unsecured loans 

to the subsidiary, to 15 percent of 

42 
Recent Developments 

the bank's capital, and limits the 

total of secured and unsecured 

loans and investments to 25 per 

cent. AB, 112190, p. 1. 

Banks' Payment Of 

Dividends 

The OCC proposed regulatory 

amendments and clarifications 

which are intended to make the 

calculation of national banks' 

dividend-paying capacity consistent 

with GAAP. In this regard, the al 

lowance for loan and lease losses 

would not be a part of either "un 

divided profits then on hand" or 

"net profits." A national bank may 

be able to use a portion of its capi 

tal surplus account as undivided 

profits, depending on the com 

position of that account. Also, some 

banks may be able to restore their 

ability to pay a dividend either 

through a quasi-reorganization or 

issuing preferred stock not subject 

to the dividend limitation, the OCC 

said. 

Industry sources believe that the 

amendment could discourage 

banks' reserving for losses, includ 

ing losses on less-developed

country (LDC) debt. However, re 

serves provisioned in 1987 would 

not be affected by the change if the 

final rule is adopted in 1990 as is 

expected. Under the rule, dividendpaying capacity would be based on 

profits for three years. FR, 8/16/89, p. 

33711; AS, 8/29, j>. 1. 

Disclosure Of CRA 

Decisions 

The OCC notified national banks 

that it will publish letters to appli 

cants reporting on decisions for all 

cases in which applications from 

national banks have been condi 

tionally approved or denied on CRA 

grounds. The decision letters will be 

disclosed, beginning with cases de 

cided in July, 1989, in the OCC's 

monthly Interpretations publica 

tion and the decisions will be sum 

marized in the OCC's Quarterly 

Journal. Decision letters for pro 

tested applications that have been 

approved without conditions are 

available to the public upon re 

quest. Banking Circular 238, OCC, 

6/15/89. 

National Bank Lending 

Limits To Foreign 

Governments 

The OCC amended its regulation 

to establish a noncombination rule 

when the central government or 

another central facility becomes the 

obligor for loans to a foreign gov 

ernment, its agencies, and instru 

mentalities, as a result of debt re 

structuring. Under the amendment, 

the loans will continue to be in 

cluded under the lending limit for 

the original obligor on each loan 

and will not be attributed to the 

named central obligor in the re 

structuring. The amendment also 

imposes, in such cases, an overall 

limitation equal to 50 percent of a 

bank's unimpaired capital and sur 

plus with respect to all loans, in the 

aggregate, to the foreign govern 

ment, its agencies, and instrumen 

talities, including restructured 

loans. Effective January 10, 1990. 

FR, 1/10/90, p. 854. 

Resolution Trust 

Corporation And 

Oversight Board 

Status Of The RTG 

L. William Seidman, Chairman, 

and David C. Cooke, Executive Di 

rector, of the RTC, said that as of 

January 16, 1990 the RTC had re 

solved 40 failed cases of savings in 

stitutions, and had 293 institutions 

under conservatorship. Collectively, 

these 333 institutions reported 

8136 billion in gross assets and 

8148 billion in liabilities as of Sep 

tember 30, 1989. The estimated 

present-value cost of resolving these 

cases, based on FDIC loss experi 

ence, is approximately 842 billion. 

There were 225 to 295 more in 

stitutions with 8160 billion to S200 

billion in assets that may be cat 

egorized as "likely failures," accord 

ing to preliminary estimates of the 

OTS. In addition, there were 295 to 

325 seriously undercapitalized in 

stitutions with assets of S185 billion 

to S205 billion that OTS expects to 

categorize as "distressed," and 

which it expected to resolve with 

out government assistance. 

OB staff have completed a Strate 

gic Plan concerning the policies and 

activities of the RTC. According to 

the Plan, the RTC's mission is to 

manage and resolve institutions 

that come under its jurisdiction and 

to dispose of any residual assets in 

a manner that (a) maximizes return 

and minimizes loss, (b) minimizes 

the impact on local real-estate and 

financial markets, and (c) maxi 

mizes the preservation of the avail 

ability and affordability of residen 

tial property for low- and 

moderate-income individuals. 

L. William Seidman and David C. Cooke, 

Testimony, US. House Committee on Bank 

ing, Finance and Urban Affairs, 1/24/90. 

Ethical Standards Relating 

To Independent 

Contractors 

The OB and RTG adopted ethics 

rules for independent contractors 

who seek to perform services for 

the RTC. The regulation addresses 

conflicts of interest, ethical respon 

sibilities and use of confidential 

information. It establishes qual 

ification standards, conflict-of

interest restrictions, certification 

requirements and other standards 

applicable to law firms, accounting 

firms, investment banking firms, 

real-estate brokers, appraisers, 

property managers and others who 

provide similar services under 

agreements with the RTC. 

In part, contractors will need to 

certify that they and their related 

entities have not caused a sub 

stantial loss, denned as 850,000 or 

more, to the federal deposit insur 

ance funds. In addition, a con 

tractor currently in default on an 

obligation to the FDIC, the RTC, or 

an insured depository institution 

under the jurisdiction of the RTC 

would also be deemed ineligible to 

contract with the RTC. 

43 
FDIC Banking Review 

The RTC will establish a process 

for reviewing the disqualification of 

contractors to ensure that imple 

mentation of the regulation is equi 

table and consistent. PR-46-90,2/6, OB, 

RTC. 

Asset Inventory 

The initial inventory of realestate assets that will be available 

for sale from the RTG was released. 

The comprehensive inventory in 

cludes about 30,000 real-estate as 

sets that the RTC was managing on 

September 30, 1989. It includes 

commercial properties, land, and 

residential properties. FIRREA re 

quires that an inventory of record 

be published every six months. 

However, the RTC soon will begin 

making asset information available 

on a more frequent basis. News Retease, RTC, 1/2/90. 

Buyer's Guide 

The RTC released A Buyer's 

Guide, a 20-page booklet con 

taining information about doing 

business with the agency. The 

Guide will be updated as necessary 

to reflect any changes that might 

occur in the programs of the RTC. 

RTC, 11115/89. 

Office Of Thrift 

Supervision 

Capital Standards 

The OTS issued new standards 

requiring savings and loan associa 

tions to have tangible capital total 

ing at least 1.5 percent of assets, 

core capital of three percent, and 

additional risk-based capital by De 

cember 7, 1989. The action con 

formed to provisions of FIRREA. 

See "Risk-Based Capital Require 

ments: Reshaping the Thrift Indus 

try," FDIC Banking Review, this 

issue. 

Institutions that fall below the 

new standards on December 7 must 

submit an acceptable capital plan to 

raise their capital levels or be sub 

jected to operating restrictions in 

cluding growth and capital distribu 

tion limitations and regulatory 

approvals of changes in manage 

ment and board of directors. The 

capital plan must be submitted to 

the OTS within 60 days after No 

vember 7, the date on which the 

capital regulation was adopted, or 

the date on which the institution 

fails to comply with the capital 

standards. NEWS, OTS, 11/6/89; n/8; 

12/15. 

Capital Forbearances 

Ended; Some Thrifts' 

Growth Is Limited 

OTS reminded thrifts that FIR 

REA eliminates capital and ac 

counting forbearances previously 

granted by the Federal Home Loan 

Bank Board. The institutions were 

advised to eliminate such for 

bearances in calculating whether 

they comply with the new min 

imum capital standards. 

Certain thrifts were advised that 

they may not increase deposits be 

yond the amount of net interest 

credited to the accounts, or may 

not increase deposits or borrowings 

more than needed to fund legallybinding loan commitments and 

loans in process. This applies to all 

thrifts that fail to meet their min 

imum regulatory capital require 

ments, and that are not operating 

under a capital restoration plan ap 

proved by OTS, as well as to insti 

tutions that receive a low composite 

rating from federal examiners 

(MACRO 4 or 5) or require more 

than normal government super 

vision. Some associations, defined 

in OTS' statement, are subject to 

greater restrictions and may not 

make any new loans or investments 

without prior approval from an OTS 

District Director. NEWS, OTS, 1/12/90. 

Single-Borrower Loan 

Limits 

Under new guidelines issued by 

the OTS, savings and loan associa 

tions have the same limits as 

national banks on loans to one bor 

rower. The limitations were man 

dated by FIRREA. 

A thrift, with certain exceptions, 

cannot have total loans to any one 

borrower of more than 15 percent 

of the institution's unimpaired capi 

tal and surplus. An additional ten 

percent of unimpaired capital and 

surplus can be lent to a single bor 

rower if the loan is fully secured by 

readily marketable collateral. Prior 

to FIRREA the lending limit for 

thrifts and their subsidiaries was 

ten percent of withdrawable ac 

counts, or regulatory capital, 

whichever was less. 

FIRREA also provides that a sav 

ings institution can lend up to 

$500,000 to any borrower for any 

purpose. If the loan is to be used to 

develop residential housing units, 

the aggregate lending limit is the 

lesser of $30 million, or 30 percent 

of the association's unimpaired 

capital and surplus, provided the 

lender meets certain requirements. 

Up to 50 percent of an institution's 

unimpaired capital and surplus may 

he lent if the loan is to be used to 

facilitate the sale of repossessed 

property. 

At any time, the OTS Director 

may impose more stringent restric 

tions on an institution's loans to 

one borrower if necessary to pro 

tect the safety and soundness of the 

association. NEWS, OTS, 9/29/89. 

Agency Offices 

The OTS will remove the current 

restriction banning federal savings 

associations from establishing of 

fices to originate and service loans 

outside the same state as the home 

office of the savings association or 

the same state of any association's 

branch office. Additionally, the 

OTS will require notification in 

writing of openings and closings of 

these offices. The change in regula 

tions is effective January 8, 1990. 

Previously, a thrift would have to 

create a service corporation in 

order to operate loan production 

facilities in states where the firm 

did not already have a presence. FR, 

12/8/89, p. 50613; AB, 12/14, p. 2. 

44 
Recent Developments 

Equity-Risk Investments 

The OTS has delayed the termi 

nation of its equity-risk investment 

regulation until July 13, 1990. The 

regulation requires savings associa 

tions to obtain prior approval of 

their Principal Supervisory Agents 

(now District Directors), before 

making investments in equity se 

curities, real estate, service corpo 

rations and operating subsidiaries 

above certain thresholds. These 

thresholds are tied to the regulatory 

and tangible capital levels of the 

savings association. 

The OTS noted that FIRREA conCains a number of provisions that 

will have a significant effect on in 

vestments covered by the current 

equity-risk investment regulation. 

Thus the OTS believed it prudent 

to again delay the termination date. 

FR, 11/15/89, p. 47510. 

Federal Thrift Regulator 

Accreditation Program 

Beginning September 1,1989, on 

ly accredited individuals, designated 

by OTS as "federal thrift regulators," 

can conduct complete examinations 

and/or manage a supervisory 

caseload, conduct meetings with 

thrift institutions' directors, set the 

scope of an examination and recom 

mend corrective action for thrift in 

stitutions. A regulator who has not 

yet been accredited can still perform 

examination and supervisory func 

tions, but must do so in an "acting 

capacity" under the close supervision 

of a federal thrift regulator. 

OTS had accredited about 1,100 

examiners and supervisors by early 

September, 1989. To be accredited, 

a regulator must meet specific edu 

cation and course-work require 

ments, and demonstrate proficiency 

over a two- to five-year period in 

certain designated capacities. This 

is an on-going program with con 

tinuing requirements for maintain 

ing active status as a federal thrift 

regulator. NEWS, OTS, 9/7/89. 

Federal Financial 

Institutions Examination 

Council 

Call Report Changes 

The Federal Financial Insti 

tutions Examination Council 

(FFIEG) adopted changes to the 

Reports of Condition and Income 

(Call Reports) filed quarterly by 

commercial banks and FDICsupervised savings banks. The 

changes will (1) provide the bank 

ing agencies with sufficient data to 

permit the monitoring of banks1 

risk-based capital levels, while bas 

ing the amount of information re 

ported by individual banks on their 

size and capital level, and (2) pro 

vide other data considered neces 

sary for bank supervisory purposes, 

particularly with respect to the 

nature and extent of banks' offbalance-sheet activities. There is a 

new risk-based capital schedule, a 

revised version of the current offbalance-sheet schedule, and modi 

fications or new items in other 

schedules. 

Pending approval by the Office of 

Management and Budget, these 

changes will become effective on 

the March 31, 1990, report date, 

except for one new item that would 

be added as of June 30, 1990. 

F1L-4-89, 8/28, FFIEC, and information 

from FFIEG, 1/30/90. 

States' Licensing Of 

Real-Estate Appraisers 

The FFIEC released guidelines for 

state certification and licensing of 

real-estate appraisers. Authorized 

under Title XI of FIRREA, the 

guidelines are intended to help 

states establish certification and li 

censing procedures for appraisers 

involved in federally related trans 

actions. 

The certification and licensing 

function, the FFIRC said, should be 

established as an independent reg 

ulatory agency answerable to the 

governor or a cabinet-level officer 

who has no regulatory respon 

sibility for realty-related activities. 

Those who appoint an agency head 

or appraisal board members should 

not be associated with an affected 

industry. Agency heads should not 

be actively engaged in the appraisal 

business or any other affected in 

dustry. 

Among other guidelines are that 

all appraisers subject to the li 

censing or certification provisions 

must be qualified through appropri 

ate testing and experience require 

ments established by state law. 

Also, no persons are to be exempt 

from meeting the requirements, or 

be otherwise "grandfathered" into 

the system. FILU-90, ma, FFIEG. 

Department Of The Treasury 

Study Of Deposit Insurance 

The Department requested public 

comments on a study the Depart 

ment is conducting of the federal 

deposit insurance system. The De 

partment intends to complete its 

study, which was mandated by 

FIRREA, by early 1991, and submit 

a final report of its conclusions and 

recommendations to Congress by 

early 1991. FR, 12/6/89, p. 50469. 

State Legislation And 

Regulations 

Investment In Real Estate 

Iowa: A new law allows statechartered banks to invest directly 

in certain real estate after obtaining 

the approval of the Superintendent 

of Banking. A state bank's invest 

ment in real estate is limited to a 

total of 20 percent of capital and 

surplus. Effective July 1, 1989. ELSS, 

9/29/89. 

Real-Estate Appraisals 

Maryland: New legislation re 

quires the Bank Commissioner, Di 

rector of the Division of Savings and 

Loan Associations, and Commis 

sioner of Consumer Credit to de 

velop and implement minimum 

safety-and-soundness standards for 

real-estate appraisals and apprais 

ers. ELSS, 9129/89. 

45 
FDIG Banking Review 

lntrastate Branching 

Colorado: A federal judge ruled 

that the RTC is prohibited under 

Colorado's branching law from con 

verting failed thrifts in the state into 

branches of national banks. As a re 

sult of the decision, Mesa National 

Bank, Grand Junction, agreed to 

acquire Valley Federal Savings and 

Loan Association, and Mesa Federal 

Savings and Loan Association, both 

of Grand Junction, as affiliates 

rather than branches. BBR, 2/19190, p, 

30. 

Georgia: An appeals court ruled 

against a decision of the state De 

partment of Banking and Finance 

allowing Bank Corp. of Georgia, 

Macon, to acquire four branches 

from two savings and loan associa 

tions. Under Georgia's law, to enter 

another county a bank must pur 

chase another bank or an entire 

S&L. Excepted from this restriction 

are the state's two largest counties, 

Fulton and DeKalb, between which 

banks are permitted to branch. AB, 

11/14/89, p. 2. 

Illinois: A new law allows banks 

to buy failed or failing thrifts irre 

spective of previous restrictions on 

acquisitions. The law brings the 

state into compliance with the re 

quirements of F1RREA. Effective 

November 30, 1989. ABA Bankers 

Weekly, 11/14/89, p. 7. 

Wisconsin: The Governor signed 

legislation which, for one year be 

ginning August 5, 1989, allows 

state-chartered banks to branch 

anywhere in Wisconsin. Existing 

law permits state banks to branch 

only countywide, with few excep 

tions, and forbids them from open 

ing a branch within three-quarters 

of a mile of a branch, or 1.5 miles 

of the home office, of another bank. 

The OCC has given national banks 

unrestricted branching rights in the 

state. The OCC cited the authority 

of savings and loan associations to 

branch statewide in Wisconsin. AB, 

7/5/89, p. 2; Office of Commissioner of 

Banking, Wisconsin, 1/30/90. 

Interstate Banking 

Iowa: A new law, to become ef 

fective January 1, 1991, allows 

bank holding companies based in 

six bordering states to purchase 

banks in Iowa, if the other state al 

lows entry to Iowa banks on a re 

ciprocal basis. The states are Min 

nesota, Nebraska, South Dakota, 

Illinois, Missouri and Wisconsin. 

The new law provides that not 

more than 35 percent of Iowa's 

bank deposits may be controlled by 

out-of-state holding companies. 

An Iowa bank is permitted, by 

adopting an appropriate resolution 

prior to January 1, to remove itself 

from consideration by an out-of

state holding company with respect 

to the purchase of more than 25 

percent of its stock. AB, 2/5/90, p. i; 

BBR, 2/19, p. 292. 

New Jersey: Effective August 2, 

1989, under the state's reciprocal 

interstate banking law that initially 

took effect on January 1, 1988, 

eleven states and Puerto Rico were 

added to those whose banking firms 

can acquire New Jersey's banks, 

and vice versa. The states are Co 

lorado, Idaho, Illinois, Indiana, 

Louisiana, Nebraska, Nevada, New 

Mexico, Oregon, South Dakota and 

Vermont. AB, 8/10/89, p. 12. 

Bank Subsidiaries' 

Activities 

New Jersey: Under a new law ef 

fective January 2, 1990, banks 

owned by the same holding com 

pany may accept deposits and con 

duct other activities for each other. 

ELSS, 1/17/90. 

State Prohibits Sale 

Of Uninsured 

Bonds At S&Ls 

California: Thrift regulators are 

banning California's 108 statechartered thrifts from sales in their 

branches of subordinated deben 

tures, which have low payment pri 

ority in event of bankruptcy. Re 

portedly the state's savings and loan 

department also is considering a 

rule to prohibit the sale of all unin 

sured securities in retail offices. 

The action comes in the after 

math of the failure of Lincoln Sav 

ings and Loan Association, which 

sold retail customers the uninsured 

bonds issued by the parent com 

pany, American Continental Corp., 

bonds that became almost worth 

less. AB, 12/29189, p. 3. 

Bank And Thrift 

Performance 

Banks' Earnings Down 

In 1989 

Commercial banks in the U.S. 

had net income in 1989 of #16.3 

billion, down by more than 35 per 

cent from the level of 1988. Net 

earnings in the first two quarters of 

1989 totaled over #14 billion, but 

were followed in the third quarter 

by a loss of 8740 million, the de 

cline resulting mainly from in 

creases in provisioning for interna 

tional loan losses. In the last 

quarter larger allowances for do 

mestic credit losses held down the 

results, as earnings recovered to 

$2.7 billion. 

Five of the ten largest banks in 

the U.S. reported full-year losses 

due mainly to higher reserving for 

losses on loans to LDGs. Onequarter of all U.S. banks with assets 

over #10 billion also had net losses 

for the year, as many regional 

banks experienced problems in 

their real-estate loan portfolios. 

Smaller banks, particularly those in 

the Southwestern U.S., continued 

to show a recovery in profitability. 

In 1990, money-center insti 

tutions generally are likely to re 

duce their reserving for loan losses 

and their earnings should improve. 

Regional banks in various sections 

of the U.S. are expected to experi 

ence higher losses on real-estate 

loans. The outlook for the smaller 

banks is for improved earnings. The 

FDIC Quarterly Banking Prqfile, Fourth 

Quarter, 1989. 

Bank Failures In 1989 

A total of 206 FDIC-insured 

banks failed in 1989, six more than 

in 1988. Texas accounted for nearly 

two-thirds of all bank failures in the 

46 
Recent Developments 

U.S. in 1989. It had 133 cases, up 

from 120 in 1988. In Louisiana 

there were 21 failures in 1989, 

compared to 11 in 1988, while in 

Oklahoma the number declined by 

11, to 12 failures in 1989. 

Most insured-bank failures are 

handled by the purchase-and

assumption method, in which a 

healthy institution assumes the de 

posits and other liabilities and pur 

chases a portion of the assets of the 

failed bank. .There were 174 P&As 

in 1989. In addition, insureddeposit transfers were used to re 

solve 23 failed-bank cases in 1989, 

and there were nine deposit pay 

offs. 

Most Thrifts Were 

Profitable While Industry 

Losses Increased In 1989 

Seventy percent of the 2,597 sav 

ings and loan associations not in 

conservators hip at year-end 1989 

had net earnings of 21.3 billion in 

the fourth quarter of 1989, accord 

ing to the OTS. However, losses of 

$3.4 billion-by the other 30 percent 

caused a net loss of 82.1 billion. 

Also in the fourth quarter, the 281 

thrifts in conservatorship at yearend lost S4.4 billion, and 84 thrifts 

transferred to the RTC since Janu 

ary 1, 1990, lost 81.8 billion. 

For the year 1989, the profitable 

portion of the non-conservatorship 

group earned g5.1 billion, while the 

remainder of the group lost 810.3 

billion. The consolidated industry 

lost 819.2 billion, compared with 

813.4 billion a year ago. Most of the 

losses in the fourth quarter and for 

the full year reflected non-operating 

losses, an official said, as insti 

tutions sold assets at a loss or made 

provisions for losses. NEWS, OTS, 

3/26/90. 

Banks' Purchases Of SSiLs 

Banks have agreed to buy 55 

thrifts under the provisions of FIR

REA, enacted in August 1989. 

These thrifts have assets of around 

billion, or 1.6 percent of the 

industry's total assets. The largest 

of the S&Ls, First Federal Savings 

and Loan Association, Pittsburgh, 

has assets of 83.1 billion, and five 

others are in the 81 billion-or-over 

□lass. 

Almost half of the deals have in 

volved banks' agreeing to buy 

healthy thrifts. Most of these trans 

actions are still pending. Reportedly 

most banks have not decided 

whether to continue the acquired 

institution as a thrift or merge it 

into the banking operation. 

It is expected that acquisitions 

will speed up as banks become 

more familiar with thrifts, and the 

OTS completes its guidelines for 

banks' purchases of mutual thrifts. 

AB, 1/16/90. 

S&Ls Edge Ahead Of Banks 

In Home-Loan 

Originations 

Savings and loan associations had 

36 percent, and commercial banks 

33 percent, of home-mortgage orig 

inations nationally in December 

1989, according to the U.S. De 

partment of Housing and Urban De 

velopment (HUD). Banks led S&Ls 

in such originations in June for the 

first time in the 19 years that HUD 

has collected these data. 

Growing numbers of commercial 

banks in many sections of the U.S. 

are emphasizing home mortgages as 

part of their consumer-services 

strategy. Analysts say also that 

banks were especially aggressive in 

1988 in originations of longer-term 

loans, and fixed-rate loans which 

increased in popularity when inter 

est rates declined. At the same 

time, many thrifts have had to slow 

their growth—or even become 

smaller—to meet regulatory capital 

requirements. Some thrifts, how 

ever, may be planning to increase 

their mortgage lending to meet the 

70 percent (up from 60 percent) 

qualified-asset guidelines for dirifts 

contained in FIRREA. AB, 9/29/89, p. 

1; 11/6, p. J; 12122, p. 6; 2/2/90, p. 8; 4/9, p. 

9. 

ATM Systems In Southeast 

To Merge 

Three southeastern electronic 

banking systems—Avail in Georgia, 

Honor in Florida, and Relay in the 

Carolinas—agreed to merge. The 

merger would link about 7,000 au 

tomated teller machines and 4,400 

point of sale terminals in five states 

and the District of Columbia, cre 

ating the nation's third-largest net 

work of ATMs. The largest ATM sys 

tem, New York Cash Exchange, has 

8,800 ATMs, and the second 

largest, Star System in California, 

has 8,600. The merging networks 

are expected to sign a definitive 

agreement in early 1990. AB, 

12/19/89, p. J. 

Recent Articles And 

Studies 

Deposit Insurance Reform 

A study ("Can the Market Evalu 

ate Asset Quality Exposure in 

Banks?", Richard E. Randall) of the 

effectiveness of market discipline 

evaluates the success of investors 

and security analysts in identifying 

and evaluating the problems of 

large bank holding companies. The 

study includes 40 BHCs, each with 

assets exceeding 82 billion, that de 

veloped serious problems in the 

1980s through mid-1987. It is con 

cluded that market discipline can 

not be relied on to limit banks' 

credit risk. The evidence from this 

study is that the underperformance 

of stock prices and downgrading of 

bond ratings came at a late stage, 

only after excessive damage had 

occurred. This is not unexpected, 

because market analysts do not 

currently have, and are unlikely to 

ever have, the means to accurately 

identify and evaluate changes in as 

set quality at an early stage. 

The author does not favor a re 

duction in deposit insurance cover 

age because there would be little or 

no benefit from market discipline 

while the greater depositor sensitiv 

ity could make banks much more 

vulnerable to runs. New England Eco

47 
FD1C Banking Review 

nomie Review, Federal Reserve Bank of 

Boston, July/August. 1989, pp. 3-24. 

This article ("A Plan for Reducing 

Future Deposit Insurance Losses: 

Puttable Subordinated Debt," Larry 

D. Wall) presents a plan for a no

deposit-insurance environment for 

banks without reducing insurance 

coverage for depositors. A new 

mechanism, puttable subordinated 

bonds, would both discipline ex 

cessive risk-taking and identify failing 

banks. The bonds under the plan 

would be subordinated to all other 

liabilities. However, bondowners 

could request redemption. 

It is suggested that large banks be 

required to issue the debt and that 

small banks have this as an option. 

Banks operating under the plan 

would not be permitted to redeem 

the puttable bonds if redemption 

would violate regulatory standards. A 

bank would have 90 days to meet a 

redemption request by issuing new 

debt, or reducing its subordinated 

debt needs, for example, by selling 

assets. Any bank that could not 

honor the redemption requests on its 

puttable subordinated debt at the 

end of 90 days without violating the 

regulatory requirements would be 

deemed insolvent and would be 

closed. 

Holders of the subordinated debt 

would have a strong incentive to 

have a bank closed before its capital 

became negative. The system would 

discourage bank risk-taking because 

the subordinated debtholders would 

bear most of the consequences of 

failure, and would demand com 

pensation to reflect the degree of 

riskiness. 

A risk that the put option may be 

exercised on solvent institutions 

could be reduced by issuing bonds 

with rates that vary with the mar 

ket and the bank's riskiness, and by 

pricing the bonds to sell above par. 

The role of the regulators under 

the plan, while substantially re 

duced, would not be eliminated be 

cause (a) of a continuing potential 

risk to the deposit insurance sys 

tem, and (b) the existence of small 

banks that could not join the plan 

because of the lack of a satisfactory 

market for their subordinated debt. 

Economic Review, Federal Reserve Bank of 

Atlanta, July/August, 1989, pp. 2-17. 

Based on the experience of statelevel deposit insurance programs, 

several of which are reviewed in de 

tail, this article ("Deposit Insur 

ance: Lessons From the Record," 

Charles W. Galomiris) suggests a 

system in which banking industry 

self-regulation would perform an es 

sential role. Banker participation in 

the enforcement of regulations was 

successful in state programs in the 

past. One reason is that bankers 

were adept at restricting risktaking. Also, they were more skillful 

than the regulators in identifying 

"the least-cost regulatory struc 

ture," which involves the "optimal 

combination of reserve require 

ments, risk-based insurance pre 

miums, capital and subordinated 

debt requirements, etc." 

There could be a two-tier regula 

tory system of deposit insurance in 

which the government provides 

national protection, but relies on 

local incentives to monitor risk. By 

making insurance premiums for 

banks in any region depend on the 

failure experience of their neigh 

bors, for example, the government 

can make monitoring incentivecompatible. Some regulations gov 

erning banks (including the geo 

graphic limits on bank groups) 

could be determined at the national 

level, while other regulations might 

be allowed to vary at the level of the 

individual groups. Economic Per 

spectives, Federal Reserve Bank of Chicago, 

May/June, 1989, pp. 10-30. 

International Debt 

Insurance Proposal 

FDIG Chairman William Seidman 

proposed the creation of an Inter 

national Debt Insurer (ID1) to pro 

vide a flexible coinsurance system 

of debt guarantees for commercial 

bank loans to heavily-indebted de 

veloping countries. It would be 

managed by a multinational board 

appointed by capital contributors, 

or the International Monetary Fund 

and World Bank. 

The IDI would be funded with 

initial contributions from creditor 

banks, and callable capital from 

multilateral development agencies 

(IMF, World Bank), premiums paid 

by banks, and possibly con 

tributions from creditor govern 

ments. Capital contributions and 

accumulated premiums would be 

refunded as covered debt is retired. 

IDI would coinsure new loans 

only if the developing country had 

made certifiable economic progress 

entitling the country to insurance 

coverage for the year involved. To 

be insured, new loans would re 

quire additional capital con 

tributions, and only certain types of 

new loans, for example, project fi 

nancing, could be insured. 

In return for insurance coverage, 

commercial banks would agree to 

debt-reduction plans that would fo 

cus on reducing annual debt-service 

burdens, setting the amount and 

timing of debt-service reductions at 

reasonable levels given the situation 

in each debtor country. Generally, 

debt would be restructured with 

lengthened maturities and reduced 

payments. IDI insurance would 

cover only a portion of the re 

structured debt-service payments. 

The greater the reduction in claims 

that banks are willing to accept, the 

greater the percentage of re 

structured payments that would be 

insured. 

Debtor countries, if they are to 

qualify for the insurance program, 

must agree to undertake economic 

reforms that will lead to the restora 

tion of their creditworthiness. State 

ment by Chairman Seidman, July, 1989. 

48 
Recent Developments 

Multiproduct Costs In 

Large Banks 

Deregulation of bank products is 

often justified based on the con 

tention that cost savings can result 

from joint production of a variety of 

financial services. This study is 

concerned with whether multiproduct production in large banks 

does in fact reduce their costs. It 

attempts to measure the costs of a 

single bank against the sum of the 

costs of two "competing" banks in 

producing a given output mix. The 

data are taken from Reports of 

Condition and Income submitted to 

the Federal Reserve during 1986 by 

a sample of over 300 of the largest 

banks in the U.S.. The study con 

cludes that for large banks generally 

no appreciable cost savings seem to 

result from multiproduct produc 

tion. 

The model does not, however, 

explicitly incorporate convenience 

to customers, and banks may be 

reducing consumers' transactions 

costs through the array of services 

offered. Banks also may engage in 

multiproduct production as a 

means of diversification to reduce 

risk even though the resulting scale 

of output or product mix is not op 

timal when viewed strictly from a 

production perspective. Economic Re 

view, Federal Reserve Bank of Atlanta, May/ 

June, 1989, pp. 2-11. 

49