The Banking Crises of the 1980s and Early 1990s

FDIC
 

Banking


Review
 

1998
 

Volume 11, No. 1
 

Chairman

Andrew C. Hove, Jr.

Division of Research

and Statistics,

Director

Wm. Roger Watson

Deputy Directors

Barry Kolatch
 

Steven A. Seelig
 

Editor

Steven A. Seelig

Editorial Committee

Jack T. Reidhill
 

Detta Voesar
 

Managing Editor

Detta Voesar

Editorial Secretary

Cathy Wright

Design and Production

Geri Bonebrake 

The views expressed are

those of the authors and do

not necessarily reflect official positions of the Federal

Deposit Insurance Corporation. Articles may be reprinted or abstracted if the

FDIC Banking Review and

author(s) are credited.

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Statistics with a copy of any

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Page

Introduction 1

The Rise in the Number of Bank Failures in the 1980s: 

The Economic, Legislative, and Regulatory Background 1

Regulatory and Supervisory Issues Raised by the 

Experience of the 1980s 22

Open Questions 45

Concluding Comments 49

References 52
The Banking Crises of the 1980s and Early 1990s

A Letter to Our Readers

This special issue of the FDIC Banking Review contains the introductory chapter from the recently published book Histfry ff the Eighties-Lessfns ffr the Future:

An Examinatifn ff the Banking Crisis ff the 1980s and Early 1990s, which was researched and written by staff of the Division of Research and Statistics of the

Federal Deposit Insurance Corporation. The four sections of the analysis presented in this issue deal with (1) the factors underlying the rapid rise in the number of bank failures; (2) the regulatory issues raised by this experience; (3)

questions that remain open despite the legislative and regulatory remedies

adopted between 1980 and 1994; and (4) concluding comments.

The study was initiated in 1995 in the belief that with the banking industry recovering, it was important to look back at the crises that had just passed and to

assess what had taken place. The study would serve to identify areas where the

agency's mission could be better accomplished in the future, and to learn from

the unique experience that the 1980s and early 1990s provided to the regulators

and bankers alike. Although the problems of the past are unlikely to be precisely repeated in the future, the study of these recent crises is nevertheless instructive. As FDIC Chairman Andrew C. Hove, Jr. noted in the foreword to the study:

"At the very least, the history of the turbulent time in banking should teach us

that we cannot afford to be complacent, and the FDIC hopes this study that

glances backward will be helpful as we look forward."

Wm. Roger Watson
 Director,
 

Division of Research
 

and Statistics
 

iii
The Banking Crises of the 1980s and Early 1990s

Acknowledgments
 

The introductory chapter to the Histfry ff the Eighties was written by George Hanc,

Associate Director, Division of Research and Statistics, who directed preparation of

the study. This chapter summarizes the findings of FDIC staff who participated in

the study. The primary authors of the study and the topics they researched included:

The Banking Crises of the 1980s and Early 1990s:

Summary and Implications George Hanc

Banking Legislation and Regulation Lee Davison

Commercial Real Estate and the Banking Crises of the 

1980s and Early 1990s James Freund,

Timothy Curry,

Peter Hirsch, and

Theodore Kelly

The Savings and Loan Crisis and Its Relationship 

to Banking Alane Moysich

The LDC Debt Crisis Timothy Curry

The Mutual Savings Bank Crisis Alane Moysich

Continental Illinois and "Too Big to Fail" Lee Davison

Banking and the Agricultural Problems of the 1980s Brian Lamm

Banking Problems in the Southwest Brian Lamm and

John O'Keefe

Banking Problems in the Northeast Brian Lamm and

John O'Keefe

Banking Problems in California Victor Saulsbury

and Timothy Curry

Bank Examination and Enforcement Timothy Curry,

With contributions by George Hanc,
 

John O'Keefe,
 

Lee Davison, and
 

Jack Reidhill
 

Off­Site Surveillance Systems Jack Reidhill and

John O'Keefe

v
The Banking Crises of the 1980s and Early 1990s

The Banking Crises of the
 

1980s and Early 1990s:
 

Summary and Implications
 

by George Hanc*
 

The distinguishing feature of the history of

banking in the 1980s was the extraordinary

upsurge in the number of bank failures. Between 1980 and 1994 more than 1,600 banks insured

by the Federal Deposit Insurance Corporation

(FDIC) were closed or received FDIC financial assistance-far more than in any other period since the

advent of federal deposit insurance in the 1930s (see

figure 1.1). The magnitude of bank failures during

the 1980s put severe, though temporary, strains on

the FDIC insurance fund; raised basic questions

about the effectiveness of the bank regulatory and

deposit insurance systems; and led to far­reaching

legislative and regulatory actions.1

Figure 1.1

Number of Bank Failures, 1934–1995

Number

300

250

200

150

100

50

0

Note: Data refer to FDIC-insured commercial and savings banks that were
 

closed or received FDIC assistance.
 

1935 1945 1955 1965 1975 1985 1995

This article summarizes the findings and implications of History of the Eighties-Lessons for the Future: An

Examination of the Banking Crises of the 1980s and Early

1990s, a study conducted by the FDIC's Division of

Research and Statistics to analyze various aspects of the

1980-94 experience. The four sections of this summary deal with (1) the factors underlying the rapid rise in

the number of bank failures; (2) the regulatory issues

raised by this experience; (3) questions that remain

open despite the legislative and regulatory remedies

adopted between 1980 and 1994; and (4) concluding

comments.

The Rise in the Number of Bank Failures

in the 1980s: The Economic, Legislative,

and Regulatory Background

The rise in the number of bank failures in the 1980s

had no single cause or short list of causes. Rather, it resulted from a concurrence of various forces working together to produce a decade of banking crises. First,

broad national forces-economic, financial, legislative,

and regulatory-established the preconditions for the

'George Hanc is Associate Director, Research Branch, Division of Research and Statistics, Federal Deposit Insurance Corporation.

1 Although the FDIC's study is devoted to banking, it is appropriate to

recall that the thrift industry suffered an even greater catastrophe. In

1980 there were 4,039 savings institutions; approximately 1,300 savings

institutions failed during the 1980­94 period. This high proportion of

failures led to the demise of the fund that insured savings institution

deposits, and imposed heavy costs on surviving institutions and on taxpayers.

1
FDIC Banking Review

increased number of bank failures. Second, a series of

severe regional and sectoral recessions hit banks in a

number of banking markets and led to a majority of the

failures. Third, some of the banks in these markets

assumed excessive risks and were insufficiently restrained by supervisory authorities, with the result that

they failed in disproportionate numbers. 

Economic and Financial Market
 

Environment
 

During most of the 1980s, the performance of the

national economy, as measured by broad economic aggregates, seemed favorable for banking. After the

1980-82 recession the national economy continued to

grow, the rate of inflation slowed, and unemployment

and interest rates declined. However, in the 1970s a

number of factors, both national and international, had

injected greater instability into the environment for

banking, and these earlier developments were directly or indirectly generating challenges to which not all

banks would be able to adapt successfully. In the

1970s, exchange rates among the world's major currencies became volatile after they were allowed to

float; price levels underwent major increases in response to oil embargoes and other external shocks; and

interest rates varied widely in response to inflation, inflationary expectations, and anti­inflationary Federal

Reserve monetary policy actions.

Developments in the financial markets in the late

1970s and 1980s also tested the banking industry. Intrastate banking restrictions were lifted, allowing new

players to enter once­sheltered markets; regional banking compacts were established; and direct credit markets expanded.2 In an environment of high market

rates, the development of money market funds and the

deregulation of deposit interest rates exerted upward

pressures on interest expenses-particularly for smaller institutions that were heavily dependent on deposit

funding. Competition increased from several directions: within the U.S. banking industry itself and from

thrift institutions, foreign banks, and the commercial

paper and junk bond markets. The banking industry's

share of the market for loans to large business borrowers declined, partly because of technological innovations and innovations in financial products.3 As a

result, many banks shifted funds to commercial real estate lending-an area involving greater risk. Some

large banks also shifted funds to less­developed countries and leveraged buyouts, and increased their offbalance­sheet activities.

Condition of Banking on the Eve 

of the 1980s
 

Yet on the eve of the 1980s most banks gave few obvious signs that the competitive environment was becoming more demanding or that serious troubles lay

ahead. At banks with less than $100 million in assets

(the vast majority of banks), net returns on assets

(ROA) rose during the late 1970s and averaged approximately 1.1 percent in 1980-a level that would not be

reached again until 1993, after the wave of bank failures had receded (see figure 1.2).4 For this group of

banks, net returns on equity (ROE) in 1980 were also

high by historical standards, equity/asset ratios were

moving gradually upward, and charge­offs on loans averaged approximately what they would again in the

early 1990s. The fact that key performance ratios in

1980 compared favorably with those in 1993-94-a period of extraordinary health and profitability in banking

that has continued to the present (mid­1997)-emphasizes the absence of obvious problems at most banks at

the beginning of the eighties.

Large banks, however, showed clearer signs of

weakness. In 1980 ROA and equity/assets ratios were

much lower for banks with more than $1 billion in assets than for small banks and were also well below the

large­bank levels they would reach in the early 1990s.

Market data for large, publicly traded banking organizations suggest that investors were valuing these institutions with reduced favor. During the 1960s and

1970s price­earnings ratios for money­center banks

trended generally downward relative to S&P 500 priceearnings ratios, although for regional banks the decline

was much less pronounced (see figure 1.3). For the 25

largest bank holding companies in the late 1970s and

2	 Many of these developments are discussed in Allen N. Berger, Anil K.

Kashyap, and Joseph M. Scalise, "The Transformation of the U.S.

Banking Industry: What a Long, Strange Trip It's Been " Brookings Papers on Economic Activity 2 (1995).

3	 Between 1980 and 1990, commercial paper outstanding increased from

7 percent of bank commercial and industrial loans (C&I) to 19 percent.

4	 Data in figure 1.2 are unweighted averages of individual bank ratios.

Use of median values or averages weighted by assets reveals broadly

similar trends, except that medians are less affected by extreme values

and tend to be less volatile than unweighted averages, while weighted

averages are dominated by larger banks in each size group. The data in

figure 1.2 are for banks with assets greater than $1 billion (large banks)

or less than $100 million (small banks) in each year; thus, the number

of banks included in the two size groups varies from year to year. In

1980, there were 192 banks with assets greater than $1 billion and

12,735 banks with assets less than $100 million. In 1994, the comparable figures were 392 banks and 7,259 banks. Asset data are not adjusted for inflation.

2
The Banking Crises of the 1980s and Early 1990s

Figure 1.2

Bank Performance Ratios, 1973–1994

Percent ROA Percent ROE

1.4 20

15

1.0

10

5

0.6

0

0.2 -5

1974 1978 1982 1986 1990 1994 1974 1978 1982 1986 1990 1994

Percent Equity/Assets Percent Net Loan Charge-Offs/Loans

12

1.6
 

10
 

1.2
 

8
 0.8
 

6 0.4

4 0

1974 1978 1982 1986 1990 1994 1974 1978 1982 1986 1990 1994

Percent Loans and Leases/Assets

1974 1978 1982 1986 1990 1994

45

50

55

60

65

70

All Banks Large Banks Small Banks

Note: Data are unweighted averages of individual FDIC-insured commercial and savings bank ratios. Large banks are those

with assets greaterthan $1 billion in any given year. Small banks are those with assetslessthan $100million in any given year.

early 1980s, the market value of capital decreased relative to-and fell below-its book value, suggesting

that to investors, the franchise value of large banks was

declining.5

Differences in performance between large and small

banks in 1980 are not surprising. At that time, because

of branching restrictions and deposit interest­rate controls, many small institutions operated in still­protected

markets. Accordingly, they were affected more slowly

by external forces such as increased competition and

increased market volatility. During the 1980s, of

course, performance ratios of banks of all sizes weakened and exhibited increased risk. Profitability declined and became more volatile, while loan

5 Michael C. Keeley, "Deposit Insurance, Risk, and Market Power in

Banking," American Economic Review (December 1990): 1185. Data are

for the 25 largest bank holding companies as of 1985.

3
FDIC Banking Review

Figure 1.3

Bank Price-Earnings Ratios as a Percentage

of S&P 500 Price-Earnings Ratios,

1964–1995 Percent

100

90

80

70

60

50

40

1964 1970 1975 1980 1985 1990 1995

Banks

Money-Center Regional Superregional

Source: Salomon Brothers, Bank Annual, 1992 and 1996 editions.
 

Note: Data for superregional bank price-earnings ratios begin in 1982.
 

charge­offs rose dramatically.6 Large banks assumed

greater risk in order to boost profits, as is indicated by

the sharp rise in the ratio of loans and leases to total assets for these banks. In contrast, equity ratios increased over the period, particularly for large banks, in

line with increased regulatory capital requirements and

perhaps also in response to market concerns about distress in the banking system.

Then in the 1990s the performance of banking improved markedly. This is apparent not only from the

accounting data presented in figure 1.2 but also from

the market data presented in figures 1.3 and 1.4, which

suggest that to investors, the value of publicly traded

banks improved greatly in the 1990s. From 1993 to

1995, bank price­earnings ratios rose relative to S&P

500 price­earnings ratios, although the movements in

this measure were extremely volatile. After the early

1980s market prices per share of money­center and regional banks increased from below book value per

share to well above book value, except for a sharp and

temporary drop in 1990 (figure 1.4). The major improvement in the performance and investor perceptions of banking in the 1990s, albeit of limited duration

so far, does not support earlier concerns that banking

was a declining industry or the view that banking was

characterized by widespread and persistent overcapacity that would lead to increased failures.7

Although the overall performance of the banking industry varied greatly during the 1980-94 period, in its

structure the industry showed a strong trend in one

direction-toward consolidation into fewer banking

organizations. This trend was partly due to the relaxation of branching restrictions.8 From the end of 1983

through the end of 1994, the number of insured commercial banks declined by 28 percent, from 14,461 to

10,451. The number of separate corporate unitsbank holding companies plus independent commercial

banks-decreased somewhat more, by 31 percent.

The 4,010 reduction in the number of insured commercial banks was due primarily to the consolidation of

bank affiliates of multibank holding companies and to

Figure 1.4

Price-to-Book Value per Share,

1982–1995

Percent

175

150

125

100

75

50

1982 1984 1986 1988 1990 1992 1995

Banks

Money-Center Regional Superregional

Source: Salomon Brothers, Bank Annual, 1992 and 1996 editions.

Note: Values are industry composite medians. Data for superregional bank

price-to-book ratios begin in 1987.

6 The 1986 peak in net loan charge­offs for small banks was associated

with the agricultural, energy, and real estate problems of the Southwest; the 1991 peak for large banks was associated with the real estate

problems in the Northeast.

7 The issue of whether banking is a declining industry and the related

question of overcapacity in banking are explored in Federal Reserve

Bank of Chicago, The (Declining.) Role of Banking Proceedings of the 30th

Annual Conference on Bank Structure and Competition (May 1994). In the

Proceedings, see particularly Alan Greenspan, "Optimal Bank Supervision in a Changing World," 1-8; John H. Boyd and Mark Gertler, "Are

Banks Dead? Or, Are the Reports Greatly Exaggerated?" 85-117; and

Sherrill Shaffer, "Inferring Viability of the U.S. Banking Industry from

Shifts in Conduct and Excess Capacity," 130-144. Shaffer concludes

that a small amount of excess capacity in bank loans was eliminated in

the mid­1980s.

8 Some observers have argued that bank failures in the 1980s were partly due to restrictions on bank ownership (geographic restrictions within the banking industry, and prohibition of acquisitions by nonbank

organizations), which prevented weak or inefficient banks from being

taken over before they failed. Although such restrictions on ownership

probably contributed to the rise in the number of bank failures, particularly in the early 1980s, the large number of voluntary mergers and

consolidations within the industry may have averted some other failures by eliminating weaker institutions while they still had some value.

4
The Banking Crises of the 1980s and Early 1990s

unassisted mergers of unaffiliated banks (4,803). The

net effect of failures, new charters, conversions, and

other changes was an addition of 793 banks.

Legislative Developments

Banking legislation also played a large role in the

bank­failure experience of the 1980s and early

1990s.9 This legislation was largely shaped by two

broad factors: widespread recognition that banking

statutes should be modernized and adapted to new

marketplace realities, and the need to respond to the

outbreak of bank and thrift failures. In the early

1980s the focus was on the attempt to modernize, and

congressional activity was dominated by actions to

deregulate the product and service powers of thrifts

and to a lesser extent of banks. These deregulatory

actions were generally unaccompanied by actions to restrict the increased risk taking they made possible, and

so they contributed to bank and thrift failures. As the

number of failures mounted, the legislative emphasis

then shifted to recapitalizing the depleted deposit insurance funds and providing regulators with stronger

tools, while at the same time restricting their discretion. As a group, the various legislative actions addressed a variety of issues, but only the provisions most

relevant to the increased number of bank failures are

discussed here. 

The Depository Institutions Deregulation and

Monetary Control Act of 1980 (DIDMCA)

phased out deposit interest­rate ceilings, broadened

the powers of thrift institutions, and raised the deposit

insurance limit from $40,000 to $100,000. Two years

later the most pressing problem was the crisis of thrift

institutions in an environment of high interest rates.

Accordingly, the Garn-St Germain Depository Institutions Act of 1982 (1) authorized money market

deposit accounts for banks and thrifts to stem disintermediation, (2) authorized net worth certificates to implement capital forbearance for thrifts facing

insolvency in the short term, and (3) increased the authority of thrifts to invest in commercial loans to

strengthen the institutions' viability over the long

term. In the case of national banks, Garn-St Germain

removed statutory restrictions on real estate lending,

and relaxed loans­to­one­borrower limits. With respect

to commercial mortgage markets, this legislation set

the stage for a rapid expansion of lending, an increase

in competition between thrifts and banks, overbuilding, and the subsequent commercial real estate market

collapse in many regions.

As the thrift crisis deepened and commercial bank

problems were developing, Congress passed the Competitive Equality Banking Act of 1987 (CEBA). It

provided for recapitalizing the fund of the Federal Savings and Loan Insurance Corporation (FSLIC) through

the Financing Corporation (FICO), authorized a forbearance program for farm banks, extended the fullfaith­and­credit protection of the U.S. government to

federally insured deposits, and authorized bridge

banks. Two years later, again grappling with the thrift

debacle, Congress passed the Financial Institutions

Reform, Recovery, and Enforcement Act of 1989

(FIRREA), which authorized the use of taxpayer

funds to resolve failed thrifts. Other provisions reflected congressional dissatisfaction with the regulation of

thrifts: the act abolished the existing thrift regulatory

structure, moved thrift deposit insurance to the FDIC,

and mandated that bank and thrift insurance fund reserves be increased to 1.25 percent of insured deposits. 

The belief that regulators had not acted promptly to

head off problems was again evident in the Federal

Deposit Insurance Corporation Improvement Act

of 1991 (FDICIA). This act was aimed largely at

limiting regulatory discretion in monitoring and resolving industry problems. It prescribed a series of specific "prompt corrective actions" to be taken as capital

ratios of banks and thrifts declined to certain levels;

mandated annual examinations and audits; prohibited

the use of brokered deposits by undercapitalized institutions; restricted state bank activities; tightened leastcost standards for failure resolutions; and mandated a

risk­based deposit insurance assessment system.

Two years after the enactment of FDICIA, the Omnibus Budget Reconciliation Act of 1993 included a

national depositor preference provision, which provided that a failed bank's depositors (and the FDIC standing in the place of insured depositors it has already

paid) have priority over nondepositors' claims. It was

believed that national depositor preference would

make failure transactions simpler and less expensive to

the insurance fund and would encourage nondeposit

creditors to monitor bank risk more closely.

The final chapter of the savings and loan emergency

legislation was completed in October 1996 with the

enactment of the Deposit Insurance Funds Act,

which provided for the capitalization of the Savings

Association Insurance Fund, phased in pro rata bank

and thrift payments of interest on FICO bonds, and

required merger of the bank and thrift insurance

9 Tax legislation was also a significant influence. After­tax yields on real

estate investment were enhanced by the Economic Recovery Act of

1981 and then reduced by the Tax Reform Act of 1986.

5
FDIC Banking Review

funds in 1999 if no savings associations are in existence at that time. Given Congress's past reluctance

to address promptly the need to fund thrift deposit insurance, enactment of this legislation at a time when

no major thrift failure was on the horizon suggests the

extent to which safety­and­soundness considerations

had come to dominate banking legislation.10

Legislation addressed not only the thrift and banking crises of the 1980s but also, after those crises had

ended, the question of interstate banking. By the end

of the 1980s the risks posed by geographic lending concentrations were well understood, so attempts were

made to eliminate the remaining legal impediments to

full interstate banking. Already state action had enabled many banking firms to use bank holding company affiliations to circumvent geographic restrictions.

Interstate banking was enacted in the Riegle­Neal Interstate Banking and Branching Efficiency Act of

1994, which enables banks to diversify loan portfolios

more effectively. (As noted below, it also requires existing regulatory risk­monitoring systems to adapt to

the changing nature of individual bank loan portfolios.)

Regulation

The tension between the two objectives of deregulating depository institutions and preventing or containing failures was manifest not only in legislative

activity but also in policy differences among the federal bank regulators. Of course, all three agencies were

sensitive to issues of safety and soundness as well as to

the importance of modernizing bank powers. On specific issues, however, the Office of the Comptroller of

the Currency (OCC) tended to emphasize the need to

allow banks more freedom to compete and seek profit

opportunities, the FDIC leaned toward protecting the

deposit insurance fund, and the Federal Reserve often

took a middle­of­the­road position.

Differences between the FDIC and the OCC reflected the different responsibilities of an insurer and a

chartering agency. They also reflected a problem that

may potentially arise in bank regulation regardless of

the agency involved: how to strike the correct balance

between encouraging increased competition and preserving stability and safety. To be sure, no such conflict

is likely to exist in the long run: depository institutions

must be able to compete and to participate in market

innovations if they are to be viable in the long term. At

any particular time, however, a short­term conflict may

arise. The classic case is that of the savings and loan industry. Broadened nonmortgage powers were deemed

essential to the long­term viability of thrift institutions,

but the very act of providing these powers (without appropriate safeguards and at a time when thrifts were

undercapitalized) contributed to the collapse of many

thrift institutions and the weakening of many banks in

the 1980s.11

In varying degree, differences among regulators

were evident in the development of policies relating to

chartering new banks, the use of brokered funds, and

capital requirements. With respect to the entry of new

banks, both the OCC and the states sharply increased

chartering in the 1980s. (Texas-where branching was

restricted-accounted for particularly large shares of total new state and national bank charters.) In 1980,

when the OCC sought to foster increased competition

by allowing new entrants into banking markets, the

agency revised its requirements for approving new

charters. But when a disproportionate number of new

banks became troubled and failed, the FDIC expressed its concern about the OCC's policy. A basic issue was the FDIC's ability to deny insurance coverage

to newly chartered institutions. FDIC approval of insurance was, for all practical purposes, necessary before

a state would grant a new charter, but national banks

and Federal Reserve member banks received insurance upon being chartered as a matter of law. Congress

settled this issue in FDICIA by requiring that all institutions seeking insurance formally apply to the FDIC,

thereby assuring the deposit insurer a role in new bank

chartering. Meanwhile, the number of new commercial bank charters reached a peak in 1984, then gradually declined until 1994.12

The regulators also differed on the appropriate treatment of brokered deposits. (Brokered deposits had a

largely indirect influence on bank failures in that many

weak savings institutions used them to fund rapid loan

10	 Passage of the Deposit Insurance Funds Act was helped along by (1)

the possibility of a FICO default if deposits were to shift from the Savings Association Insurance Fund, with higher assessment rates, to the

Bank Insurance Fund, with lower assessment rates, and (2) the budgetary treatment of deposit insurance assessments, $3 billion of which

was to be counted as revenue to "pay" for nonbanking spending programs.

11	 With respect to the potential short­term conflict between pro­competitive and safety­and­soundness objectives, the following statement on

S&L deregulation, made by the National Commission on Financial Institution Reform, Recovery and Enforcement, is instructive: "[C]ommon sense and prudence should have dictated that the industry be

required to wait out the high interest rates, regain net worth, and then

gradually shift into new activities. This is what well­managed and responsible S&Ls did on their own, and they were largely successful"

(Origins and Causes of the S&L Debacle: A Blueprint for Reform [1993], 32).

12	 In 1984, 356 new commercial banks were chartered. By 1994 the number had declined to 47, but it then increased to 97 in 1995 and 140 in

1996.

6
The Banking Crises of the 1980s and Early 1990s

expansion in competition with healthier banks and

thrift institutions.) In 1984, the FDIC and the Federal

Home Loan Bank Board proposed that brokered deposits be insured only up to $100,000 per broker per

bank, whereas the OCC favored a less­stringent approach. Safety­and­soundness considerations seemed

to be pitted against the objective of permitting evolution to proceed in the financial markets. In the end

Congress stepped in, and both FIRREA and FDICIA

limited the use of brokered deposits by troubled institutions.

A third instance of regulatory disagreement concerned the adoption of formal capital requirements

with uniform standards for minimum capital levels. In

view of the relatively low capital ratios at many large

banks and the rise in the number of failures, all of the

agencies favored the objective of explicit capital standards, but initially they differed on the specifics; the

FDIC generally favored higher capital requirements

than the OCC, and the Federal Reserve offered a compromise in at least one instance. In 1985, with congressional encouragement, the regulators agreed on a

uniform system covering all banks. In 1990 a further,

major change came with the adoption of interim riskbased capital requirements, supplemented by leverage

requirements. Capital standards became part of the

triggering mechanism for the Prompt Corrective Action (PCA) prescribed by FDICIA in 1991. Final riskbased requirements took effect in 1992.

Geographic Pattern of Bank Failures

The national economic, legislative, and regulatory

factors discussed above affected potentially all banks.

A variety of other factors affected banks differently in

particular regions of the country, as indicated by the geographic pattern of bank failures. During the 1980-94

period, 1,617 FDIC­insured commercial and savings

banks were closed or received FDIC financial assistance (see table 1.1). This number was 9.14 percent of

the sum of all banks existing at the end of 1979 plus all

banks chartered during the subsequent 15 years. The

comparable figure for the preceding 15­year period

(1965-79) was 0.3 percent.

The geographic pattern of bank failures can be expressed in a number of ways-by number of failed

banks, amount of failed­bank assets, proportion of

failed banks and failed­bank assets relative to all banks

in individual states, or particular states' shares in national totals for bank failures and failed­bank assets.

But by any of these measures, it is evident that bank

failures during the 1980-94 period were highly concentrated in relatively few regions-which, however,

included some of the country's largest banking markets

in terms of number of institutions and dollar resources.

Thus, geographically confined crises were translated

into a national problem. At one end of the scale, in 7

states the number of bank failures constituted at least

20 percent of the total number of existing and new

banks (Alaska, Arizona, Hawaii, Louisiana, Oklahoma,

Puerto Rico, and Texas). At the other end of the scale,

in 24 states bank failures represented less than 5 percent of the total number of existing and new banks. Of

the total 1,617 failures during the entire 1980-94 period, nearly 60 percent were in only 5 states: California,

Kansas, Louisiana, Oklahoma, and Texas. Included in

these numbers are failures of bank holding company

subsidiaries; in Texas and other states with branching

restrictions, these were more like branches than independent institutions. 

An alternative measure of the severity of bank failures is based on assets. Assets of banks failing in

1980-94 constituted 8.98 percent of the sum of total

bank assets at the end of 1979 plus the assets of banks

chartered during the 1980-94 period.13 In 6 states

(Alaska, Connecticut, Illinois, New Hampshire, Oklahoma, and Texas), failed­bank assets constituted at

least 20 percent of total assets at year­end 1979 plus

new­bank assets. On the other hand, in 33 states the

failed­bank share was less than 5 percent. Of all banks

that failed during the 1980-94 period, 59 percent of assets at the quarter before failure were accounted for by

3 states: Illinois, New York, and Texas. (See table

1.2.)14

Although widespread bank failures were limited to a

few areas of the country, even a relatively "small"

number of failures could cause serious strains on the

deposit insurance fund. In 1988, for example, the

number of failures and the amount of failed­bank assets reached post­Depression records of 279 and $54

billion (nominal dollars), respectively, but still represented in each case less than 2 percent of the total

number of banks and total bank assets at the beginning

of the year. Nevertheless, in that year the FDIC sustained the first operating loss in its history, and operat13	 The 8.98 percent figure refers to the failed­bank portion of the following: assets of all banks existing as of December 31, 1979, plus assets of

banks chartered in 1980-94 as of the date of merger, failure, or December 31, 1994, whichever is applicable, and first available assets for

Massachusetts banks that became FDIC­insured in the mid­1980s.

Data are not adjusted for inflation.

14	 Comparisons based on assets of failed banks are subject to distortion

because of the effect of inflation, differences in the timing of failures

among the states, and differences in asset dates between new banks

and banks existing at year­end 1979.

7
FDIC Banking Review

Table 1.1

Bank Failures by State, 1980-1994

Number of Bank Percent of Total Assets of Failed Banks Percent of Total

Failures Number of Banks ($Thousands) Bank Assets

Alabama 9 2.47 $ 215,589 1.18

Alaska 8 44.44 1,083,417 41.58

Arizona 17 26.15 331,059 1.66

Arkansas 11 4.03 160,797 1.47

California 87 15.26 4,222,302 1.69

Colorado 59 12.39 1,035,553 5.24

Connecticut 32 18.39 6,818,223 22.17

Delaware 1 1.61 582,350 0.74

District of Columbia 5 17.86 1,135,066 13.39

Florida 39 4.56 4,524,461 4.30

Georgia 3 0.53 60,922 0.17

Hawaii 2 20.00 13,941 0.29

Idaho 1 3.13 42,931 0.84

Illinois 33 2.52 35,031,196 25.75

Indiana 10 2.40 241,463 0.76

Iowa 40 6.07 652,681 3.25

Kansas 69 10.71 1,233,874 7.26

Kentucky 7 1.91 97,742 0.48

Louisiana 70 22.44 4,105,621 17.39

Maine 2 2.63 875,303 13.51

Maryland 2 1.45 43,827 0.06

Massachusetts 44 10.63 10,240,719 12.90

Michigan 3 0.75 159,917 0.29

Minnesota 38 4.87 1,491,250 4.95

Mississippi 3 1.63 338,680 3.18

Missouri 41 5.24 1,043,379 2.25

Montana 10 5.75 172,739 3.32

Nebraska 33 6.88 323,646 2.91

Nevada 1 4.17 18,036 0.10

New Hampshire 16 12.60 3,320,916 31.98

New Jersey 14 5.71 4,695,156 9.49

New Mexico 11 11.00 568,326 9.47

New York 34 8.79 31,701,442 6.22

North Carolina 2 1.59 74,553 0.27

North Dakota 9 5.00 77,565 1.76

Ohio 5 1.14 171,765 0.29

Oklahoma 122 22.02 5,838,273 23.85

Oregon 17 17.00 599,703 4.34

Pennsylvania 5 1.19 17,454,150 16.99

Puerto Rico 5 33.33 527,375 8.94

Rhode Island 2 8.33 323,861 3.29

South Carolina 1 0.87 64,629 0.67

South Dakota 8 4.73 711,345 4.04

Tennessee 36 9.05 1,730,076 6.34

Texas 599 29.41 60,192,424 43.84

Utah 11 11.58 339,237 4.04

Vermont 2 5.41 93,802 2.94

Virginia 7 2.45 133,529 0.47

Washington 4 2.63 713,803 2.42

West Virginia 5 1.98 123,829 1.25

Wisconsin 2 0.30 50,882 0.19

Wyoming 20 16.67 375,332 10.30

U.S. 1,617 9.14% $206,178,657 8.98%

Note: Data refer to FDIC­insured commercial and savings banks that were closed or received FDIC assistance. Total

number of banks is the number of banks on December 31, 1979, plus banks newly chartered in 1980-94. Asset data are

assets of banks existing on December 31, 1979, plus assets of newly chartered banks as of date of failure, merger, or December 31, 1994, whichever is applicable, and first available assets for Massachusetts banks that became FDIC­insured

in the mid­1980s. Data exclude 13 newly chartered banks that reported no asset figures and 4 banks in U.S. territories.

8
The Banking Crises of the 1980s and Early 1990s

Table 1.2
 

Assets of Failed Banks at the Quarter before
 

Failure, by State, 1980-1994
 

Assets of Failed Banks

State ($Thousands) Percent Distribution

Alabama $ 266,443 0.08

Alaska 3,049,573 0.96

Arizona 453,522 0.14

Arkansas 229,700 0.07

California 6,018,036 1.90

Colorado 1,072,556 0.34

Connecticut 17,717,959 5.59

Delaware 582,350 0.18

District of Columbia 2,189,658 0.69

Florida 15,471,515 4.88

Georgia 104,607 0.03

Hawaii 11,486 0.00

Idaho 55,867 0.02

Illinois 40,765,430 12.87

Indiana 311,825 0.10

Iowa 809,089 0.26

Kansas 1,697,588 0.54

Kentucky 114,931 0.04

Louisiana 4,616,370 1.46

Maine 2,228,177 0.70

Maryland 57,000 0.02

Massachusetts 26,632,401 8.41

Michigan 160,300 0.05

Minnesota 1,669,974 0.53

Mississippi 288,949 0.09

Missouri 3,096,719 0.98

Montana 212,896 0.07

Nebraska 402,185 0.13

Nevada 18,036 0.01

New Hampshire 5,393,842 1.70

New Jersey 6,919,198 2.18

New Mexico 723,576 0.23

New York 51,577,291 16.28

North Carolina 74,553 0.02

North Dakota 120,109 0.04

Ohio 152,254 0.05

Oklahoma 6,712,651 2.12

Oregon 622,091 0.20

Pennsylvania 14,265,742 4.50

Puerto Rico 543,748 0.17

Rhode Island 600,706 0.19

South Carolina 64,629 0.02

South Dakota 743,698 0.23

Tennessee 2,446,083 0.77

Texas 93,061,510 29.37

Utah 469,637 0.15

Vermont 329,478 0.10

Virginia 296,368 0.09

Washington 769,109 0.24

West Virginia 123,139 0.04

Wisconsin 70,757 0.02

Wyoming 428,606 0.14

U.S. $316,813,917 100.00%

Note: Failed­bank assets are assets as of the quarter before failure or assistance, or assets as of the last available Call Report before failure or assistance.

ing losses continued through 1991, after which, provisions for insurance losses were sharply reduced. And

even the smaller number of failures before 1988 had an

evident effect on the FDIC's income and expense position. Beginning in 1984, provisions for insurance losses exceeded annual deposit insurance assessments, and

this shortfall continued through 1990.15

The figures by state illustrate some of the factors associated with bank failures. The incidence of failure

was particularly high in states characterized by

•	 severe economic downturns related to the collapse in energy prices (Alaska, Louisiana, Oklahoma, Texas, and Wyoming);

•	 real estate-related downturns (California, the

Northeast, and the Southwest);

•	 the agricultural recession of the early 1980s

(Iowa, Kansas, Nebraska, Oklahoma, and

Texas);

•	 an influx of banks chartered in the 1980s

(California and Texas) and the parallel phenomenon of mutual­to­stock conversions

(Massachusetts);

•	 prohibitions against branching that limited

banks' ability to diversify their loan portfolios

geographically and to fund growth through

core deposits (Colorado, Illinois, Kansas,

Texas, and Wyoming);16

•	 the failure of a single large bank (Illinois) or of

a small number of relatively large banks (New

York and Pennsylvania).

In some states bank failures were affected by more

than one of these factors. For example, the particularly high incidence of failures in Texas reflected the

rapid rise and subsequent collapse in oil prices, the

commercial real estate boom and bust, the effects of

the agricultural recession, the large number of new

banks chartered in the state during the 1980s, and state

prohibitions against branching. (The high proportion

of bank failures in Texas also reflected supervisory developments. As noted below, declines in the number

and frequency of on­site examinations in the 1983-86

period were particularly pronounced in Texas; earlier

15	 Beginning in 1989, data refer to the Bank Insurance Fund (FDIC, Annual Report, various years).

16	 Information on state branching provisions is as of September 30, 1985,

as compiled by the Conference of State Bank Supervisors. CSBS listed 7 states as having unit banking as of September 30, 1985, 6 as a result of legal prohibitions (Colorado, Illinois, Kansas, Montana, North

Dakota, and Texas). One (Wyoming) had no statute, but unit banking

was prevalent. 

9
FDIC Banking Review

identification of troubled banks might have prevented

some failures.)17 By the same token, some states that

exhibited only one or two of the factors associated with

bank failures had relatively few failures. Montana and

North Dakota, for example, had prohibitions against

branching, but their failure rates were below the national average, whether measured by number of institutions or by assets. Differences among the states in

failure rates and in the presence or absence of factors

associated with failures illustrate the conclusion that

the rise in the number of bank failures cannot be ascribed to any single cause.

Regional and Sectoral Recessions

Although the interplay of broad economic, legislative, and regulatory forces helped make the environment for banking increasingly demanding, the more

immediate cause of bank failures was a series of regional and sectoral recessions. Because most U.S.

banks served relatively narrow geographic markets,

these regional and sectoral recessions had a severe impact on local banks. It should be noted, however, that

not all regional recessions of the magnitude experienced during the 1980-94 period resulted in a major increase in the number of bank failures. Rather, bank

failures were generally associated with regional recessions that had been preceded by rapid regional expansions-that is, they were associated with "boom­andbust" patterns of economic activity. Bank loans helped

to fuel the boom phase of the cycle, and when economic activity turned down, some of these loans went

sour, with the result that banks holding these loans

were weakened. By contrast, recessions that were preceded by relatively slow economic activity, such as

those in the Rust Belt, generally did not lead to widespread bank failures.

This relationship between the number of bank failures and regional boom­and­bust patterns of economic

activity is illustrated by the data in tables 1.3 and 1.4,

which show that bank failure rates were generally high

in states where, in the five years preceding state recessions, real personal income grew faster than it did for

the nation as a whole. Conversely, bank failure rates

were relatively low in states where, in the five years

preceding state recessions, real personal income grew

more slowly than it did for the nation as a whole.18

There were four major regional and sectoral economic recessions that were associated with widespread

bank failures during the 1980-94 period. The first accompanied the downturn in farm prices in the early

and middle 1980s after years of rapid increases during

the late 1970s (see figure 1.5). The downturn in prices

led to reductions in net farm income and farm real estate values and a rise in the number of failures of banks

with heavy concentrations of agricultural loans. The

second recession occurred in Texas and other energyproducing southwestern states, where gross state product dropped after oil prices turned down in 1981 and

again in 1985 (see figure 1.6). The 1981 oil price reduction was followed by a regional boom and bust in

commercial real estate activity. The third recession

was in the northeastern states, which experienced negative growth in gross state product in 1990-91. The final episode was a recession in California, as growth in

gross state product turned negative in 1991-92. 

Of the 1,617 bank failure and assistance cases from

1980 to 1994, 78 percent were located in the regions

suffering these economic downturns-the Southwest,

the Northeast, and California-or were agricultural

banks outside of these three regions.19 These failures

accounted for 71 percent of the assets of failed banks

over the period. Although all four of the recessions associated with bank failures were partly shaped by their

own distinct circumstances, certain common elements

were present:

1. Each followed a period of rapid expansion;

in most cases, cyclical forces were accentuated by external factors.

2. In all four recessions, speculative activity

was evident. "Expert" opinion often gave

support to overly optimistic expectations. 

3. In all four cases there were wide swings in

real estate activity, and these contributed to

the severity of the regional recessions.

17	 Texas was also a leading state for S&L failures. Texas S&Ls accounted for 18 percent of all of the failures resolved by the Resolution Trust

Corporation (RTC), 14 percent of S&L assets at time of takeover, and

29 percent of total estimated RTC resolution costs. See RTC, Statistical Abstract (August 1989/September 1995).

18	 In some high­growth states the number of bank failures rose sharply

after the states' recessions, but the increase fell outside the three­year

periods shown in table 1.3. For example, Arizona experienced especially rapid growth before the state's 1982 recession and also saw a high

rate of bank failures (tables 1.1 and 1.2), but most of them occurred in

1989-90.

19	 Agricultural banks are defined as banks with 25 percent or more of total loans in agricultural loans. Data on assets of failed banks are as of

the quarter before the date of failure. The Southwest includes

Arkansas, Louisiana, New Mexico, Oklahoma, and Texas. The Northeast includes New Jersey, New York, and the six New England states

(Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island,

and Vermont). The bulk of the agricultural bank failures, other than

those in the two southwestern states of Oklahoma and Texas, were in

Iowa, Kansas, Minnesota, Missouri, and Nebraska.

10
The Banking Crises of the 1980s and Early 1990s

Table 1.3
 

Bank Failures and Growth Rates of Real Personal Income, by State,
 

1980-1994 (Percent)
 

Growth Rates of Real Personal Income

Five Years before Recession

State Minus Percent of Banks Failing

Recession State Growth Rate, State Growth U.S. Growth in Recession and Next 2

State* Yearst Recession Years Rate Rate Years:

Wyoming 1982-87 −3.03 8.26 5.05 18.52

Nevada 1982 −0.17 7.83 4.62 8.33

Oklahoma 1983-87 −1.42 6.05 3.78 20.83

Alaska 1986-87 −5.46 6.63 3.75 50.00

Arizona 1982 −0.18 6.69 3.49 0.00

New Hampshire 1990-91 −0.43 5.69 2.50 19.51

Louisiana 1983-87 −0.75 4.69 2.41 21.22

Washington 1982 −0.24 4.97 1.76 0.93

Maryland 1991 −0.33 4.49 1.61 1.92

Texas 1986-87 −0.98 4.43 1.55 20.45

Maine 1991 −2.15 4.42 1.54 5.13

Vermont 1991 −1.45 4.32 1.44 6.25

Connecticut 1991 −1.94 4.30 1.42 22.05

California 1991 −1.04 4.20 1.32 7.26

Oregon 1981-82 −2.40 5.03 1.21 14.63

New Jersey 1991 −1.13 3.89 1.01 6.00

Rhode Island 1991 −1.82 3.79 0.91 13.33

Massachusetts 1991 −1.87 3.79 0.91 9.77

New York 1991 −0.88 3.71 0.83 3.86

Mississippi 1980 −1.09 4.15 0.42 0.00

Arkansas 1980-82 0.27 4.14 0.42 2.33

Kentucky 1980-83 0.17 4.08 0.36 0.58

Tennessee 1982 −0.05 3.12 −0.09 7.41

West Virginia 1981-83 −0.73 3.63 −0.19 0.84

Illinois 1991 −0.09 2.64 −0.24 0.55

Missouri 1980-82 0.55 3.41 −0.32 0.69

Wisconsin 1981-82 −0.22 3.49 −0.33 0.00

North Dakota 1985-88 −3.54 2.28 −0.38 4.52

Kansas 1980 −0.30 3.32 −0.41 0.49

Idaho 1982 −1.91 2.79 −0.41 0.00

Michigan 1991 −0.58 2.41 −0.47 0.00

Alabama 1982 −0.24 2.72 −0.48 0.97

Michigan 1980-82 −2.73 3.12 −0.60 0.54

Hawaii 1981 −0.63 3.20 −0.62 0.00

Indiana 1980-82 −1.39 3.03 −0.69 0.49

Iowa 1979-85 −0.31 1.83 −0.79 4.92

Iowa 1991 −0.39 2.04 −0.84 0.18

Montana 1980-82 1.21 2.87 −0.86 0.62

Nebraska 1979-83 0.24 1.67 −0.96 4.20

Montana 1985-88 −0.17 1.39 −1.28 4.79

Ohio 1980-82 −0.73 2.41 −1.31 0.00

Illinois 1980-82 −0.28 2.34 −1.38 1.60

South Dakota 1980-82 −1.38 2.09 −1.63 1.30

West Virginia 1987 −1.33 0.51 −2.65 0.47

North Dakota 1991 −2.50 0.08 −2.80 0.00

Iowa 1988 −1.11 1.01 −3.09 1.17

District of Columbia 1980 −2.94 −0.08 −3.80 0.00

North Dakota 1979-80 −3.54 −1.59 −4.21 0.58

Note: Data refer to all states that experienced a decrease in real personal income in any year from 1980 to 1992. 

'States are ranked according to the magnitude of the difference between state growth rates and the U.S. growth rate in

real personal income during the five years before state recessions. 

tRecessions are defined as years in which personal income deflated by GDP deflator decreased. Recoveries are counted

as having at least two consecutive years of growth in real personal income. In some states, therefore, personal income increased during a single year sufficiently to produce positive growth for the recession as a whole. 

:Percent of banks failing is based on the number of banks existing as of December of the year preceding the recession.

11
FDIC Banking Review

Table 1.4

Bank Failures and Growth Rates of Real Personal Income,
 

by State Recession Quartile
 

(Percent)
 

Average Difference between State Average State Bank Failure

State Recession Growth Rate and U.S. Growth Rate, Rate in Recession

Quartile* 5 Years before Recessiont and Next 2 Years

1 2.79 14.42

2 0.71 7.34

3 −0.48 1.06

4 −2.07 1.28

'State recessions are grouped in quartiles according to the magnitude of the difference between state growth rate and U.S.

growth rate in real personal income from table 1.3. 

tData are unweighted averages of individual state data.

4. Commercial real estate markets in particular deserve attention because boom and

bust activity in these markets was one of

the main causes of losses at both failed and

surviving banks.

Rapid expansion. In the agricultural belt, increased

farm production and purchases of farmland were stimulated by rapid inflation during the 1970s in the prices

of farm products, a sharp run­up in farm exports, and

widespread expectations of strong worldwide demand

in the 1980s. But as farm exports declined and higher

interest rates increased farm costs, the expansion gave

way to a downturn. Similarly, in the Southwest (as well

as other oil­producing areas around the world) strong

worldwide demand for oil plus OPEC restrictions on

supply led to a major rise in oil prices and strong economic expansion-but the weakening in oil prices after 1981 and their rapid drop in 1985 (brought on partly

by the collapse of discipline in the international oil cartel) resulted in two economic downturns during the

1980s in the Southwest.20 California enjoyed a rate of

economic growth above the national average during

the 1980s but was hit particularly hard during the

1991-92 national recession, partly because of cutbacks

in defense spending. In the Northeast, growth rates in

overall production were above the national average

during 1982-88; the subsequent decline came about

mainly because a local economic slowdown was followed-and aggravated-by the 1991-92 national economic recession and by a boom and bust in

northeastern residential and commercial real estate activity.

Speculative activity with "expert" support. Speculative

activity was reflected in a number of developments.

Farm real estate values showed an uninterrupted rise

in the late 1970s and early 1980s, even though gross returns per acre for major crops were tracing a highly variable and generally downward trend.21 In the

Southwest, commercial construction and lending activity continued in major markets after vacancy rates began to soar. In many commercial real estate mortgage

markets, underwriting standards were relaxed.22 The

presence of speculative activity was frequently mentioned in interviews conducted in 1995 by staff of the

FDIC's Division of Research and Statistics as part of

the research for this study.23 (In all, approximately 150

bankers and regulators were interviewed in Atlanta,

Boston, Dallas, Kansas City, New York, San Francisco,

and Washington.) Numerous interviewees cited a belief common in the 1980s that the boom economies of

this period had unlimited viability. They also noted

that in many cases bankers were engaged in assetbased lending, relying on collateral values supported

by inflationary expectations rather than by cash flows.

Examples of "expert" opinion that supported optimism included statements attributed to two secretaries

20	 See John O'Keefe, "The Texas Banking Crisis: Causes and Consequences, 1980-1989," FDIC Banking Review 3, no. 2 (1990).

21	 In 1982, when land values reached their zenith, gross rates of return for

corn and soybeans were less than two­thirds their 1970 levels and approximately one­third their 1973 levels. 

22 See O'Keefe, "The Texas Banking Crisis."

23	 "Speculative activity" in this context is synonymous with economic

"bubbles" defined as follows: "if the reason that the price is high today is only because investors believe that the selling price will be high

tomorrow-when "fundamental" factors do not seem to justify such a

price-then a bubble exists." See Joseph E. Stiglitz, "Symposium on

Bubbles," Journal of Economic Perspectives 4, no. 2 (spring 1990): 13.

12
The Banking Crises of the 1980s and Early 1990s

Figure 1.5

Farm Prices, Exports, Income, Debt, and Real Estate Value, 1975–1994

Prices Received by Farmers Farm Exports Index 1990–1992 = 100 $Billions

25

35

45

80

90

100

1975 1980 1985 1990 1994 1975 1980 1985 1990 1994

$Billions Net Farm Income	 Farm Debt $Billions

20

30

40

90

120

150

180

1975 1980 1985 1990 1994 1975 1980 1985 1990 1994

Average Farm Real Estate Value per Acre

Dollars

800

600

400

1975 1980

Source: EconomicReport of thePresident, 1986, 1996.

of agriculture24 and comments by many observers in

the Northeast that the area's economy was diversified,

mature, and largely immune to Texas­style real estate

problems.25 Another example is provided by economists and other analysts, who as late as 1990 and 1991

were discounting the prospect of a bust in California

home prices.

�ide swings in real estate activity. In the agricultural

belt, prices of farmland were bid up during the 1970s

by farmers and investors, who were responding to in1985 1990 1994

creases in the prices of farm products as well as expectations of continued strong foreign demand. Farmland

values continued to rise until 1982, remained at high

levels until 1984, and then collapsed (figure 1.5). In

24	 Robert Bergland, secretary of agriculture in 1980, said, "The era of

chronic overproduction...is over." In 1972, then­Secretary of Agriculture Earl Butz is said to have advised farmers to plant "from fencerow

to fencerow." (Both quotations are from Gregg Easterbrook, "Making

Sense of Agriculture: A Revisionist Look at Farm Policy," The Atlantic

256 (July 1985): 63.

25 Interviews with regulators and bankers.

13
FDIC Banking Review

Figure 1.6

Changes in Gross State Product and Gross Domestic Product, 1980–1994

Southwest Northeast Percent Percent

9 9

6 6

3 3

0 0

-3 -3

U.S.

Southwest

1980 1982 1984 1986 1988 1990 1992 1994

U.S.

Northeast

1980 1982 1984 1986 1988 1990 1992 1994

Peak Number

of Failures

Percent

9

6

3

0

-3

Peak Number

of Failures

California

U.S.

California

1980 1982 1984 1986 1988 1990 1992
 1994
 

Peak Number

of Failures

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

the Southwest, both residential and nonresidential

construction rose sharply during the early 1980s before

falling precipitously later in the decade; these wide real

estate swings followed the earlier oil­generated cycle

and contributed to the second Southwest recession in

the 1980s. In both the northeastern states and California, boom­and­bust real estate activity aggravated general state recessions in the early 1990s.

Commercial real estate markets and bank losses. Commercial real estate development is inherently risky,

partly because of the long gestation period of many

commercial construction projects. When completed

projects finally come to market, demand conditions

may have changed considerably from what they were

at the time of conception. Another cause of risk is that

many firms seeking commercial floor space are geographically mobile, so developers are affected by economic events not only in the project's proximity but in

far­distant areas as well. In addition, commercial real

estate projects tend to be highly leveraged, a condition

that increases the volatility of returns. Relevant data

on commercial real estate are often difficult to obtain

because these markets are not highly organized and because transactions are often "private deals" whose crucial elements may not be publicly available. Finally,

commercial loan contracts usually have nonrecourse

provisions prohibiting lenders from satisfying losses

from other borrower assets.

In the early 1980s, booming activity in commercial

construction was supported by rapidly increased bank

and thrift commercial mortgage lending. A major stimulus for this activity was provided by public policy ac14
The Banking Crises of the 1980s and Early 1990s

tions: tax breaks enacted as part of the Economic Recovery Act of 1981 greatly enhanced the after­tax returns on real estate investment, and the Garn-St

Germain Act expanded the nonresidential lending

powers of savings associations. Competitive pressures,

including those reflected in the reduced bank share of

the market for business loans to large companies, also

provided an important stimulus.

Many banks and thrifts moved aggressively into

commercial real estate lending. During the 1980s,

when total real estate loans of banks more than tripled,

commercial real estate loans nearly quadrupled. As a

percentage of total bank assets, total real estate loans

rose from 18 to 27 percent between 1980 and 1990,

while the ratio for nonresidential and construction

loans nearly doubled, from 6 to 11 percent. A pervasive

relaxation of underwriting standards took place,

unchecked either by the real estate appraisal system or

by supervisory restraints. Overly optimistic appraisals,

together with the relaxation of debt coverage, of maximum loan­to­value ratios, and of other underwriting

constraints, meant that borrowers frequently had no

equity at stake, and lenders bore all of the risk.26

Overbuilding occurred in many markets, and when

the bubble burst, real estate values collapsed. (The

downturn was aggravated by the Tax Reform Act of

1986, which removed tax breaks for real estate investment and caused a reduction in after­tax returns on

such investment.) At many financial institutions loan

quality deteriorated significantly, and the deterioration

caused serious problems. As discussed in detail below,

banks that failed in the 1980s had higher ratios of commercial real estate loans to total assets than surviving

banks. Failing banks also had higher ratios of commercial real estate loans to total real estate loans, of

real estate charge­offs to total charge­offs, and of nonperforming real estate assets to total nonperforming assets.

Bank Performance in Regional and Sectoral

Recessions

The behavior of banks in the regions and sectors

that suffered recessions during the 1980s also exhibited some common elements:

1. In the economic expansions that preceded

these recessions, banks generally responded

aggressively to rising credit demands.

2. Banks that failed during the regional recessions

generally had assumed greater risks, on average, than those that survived, as measured by

ratios of total loans and commercial real estate

loans to total assets. Banks that failed had generally not been in a seriously weak condition

(as measured by equity­to­assets ratios) in the

years preceding the regional recessions.

3. Banks chartered in the 1980s and mutual institutions converting to the stock form of ownership failed with greater frequency than

comparable banks.

Aggressive response. In the case of agricultural banks,

aggressive response is evident in the growth of farm

loans, which increased rapidly and reached a peak in

1984, after the 1981 highs in prices received by farmers

and net farm income and the 1982 high in farmland values. In Texas, banks responded to the rise in oil prices

by rapidly increasing not only their commercial and industrial loans (including loans to oil and gas producers)

but also the share of commercial and industrial loans in

total bank assets. In most of the regions that underwent recessions, the aggressiveness of bank lending is

evident as well in the rapid expansion in nonresidential

mortgage lending and in the increased share of commercial mortgages in total bank assets.

Risk taking and failure. Banks that would fail during

the 1980-94 period generally had higher ratios of total loans to assets and commercial real estate loans to

assets throughout most of the period (see figures 1.7

and 1.8). (In this context, commercial real estate

loans include construction loans, nonfarm nonresidential loans, and multifamily mortgages.) This was

true for banks in the agricultural belt, the Southwest,

the Northeast, California, and the total United States.

In the agricultural belt, the Southwest, and the

Northeast, banks that would fail during the regional

recessions had significantly higher loans­to­assets ratios in the year before the recessions began (see table

1.5).27 In the Northeast and Southwest, commercial

mortgages were higher relative to total assets for failed

banks. Banks that would fail also had lower equity­to26	 These observations on underwriting practices reflect the comments of,

and have been reviewed by, a number of FDIC examiners and supervisory personnel who were actively engaged in bank examination and

supervision during the 1980s.

27	 Regional recessions are considered to have begun in the agricultural

belt in 1982 (following the 1981 high in prices received by farmers), in

the Southwest in 1982 (after oil prices reached a peak in 1981), and in

the Northeast and California in the first year of negative gross state

product (figure 1.6).

15
FDIC Banking Review

Figure 1.7

Ratio of Gross Loans to Total Assets, Failed and Nonfailed Banks, 1980–1994

Agricultural Banks* Southwest Percent Percent

45

50

55

60

45

55

65

1980 1982 1984 1986 1988 1990 1992 1994 1980 1982 1984 1986 1988 1990 1992 1994

*Agricultural banks are banks where agricultural loans are at least

25% of total loans.

Percent Northeast Percent California

55

65

75

55

65

75

1980 1982 1984 1986 1988 1990 1992 1994 1980 1982 1984 1986 1988 1990 1992 1994

Percent Total U.S.

50

60

70

1980 1982 1984 1986 1988 1990 1992 1994

Banks That Subsequently Failed Banks That Did Not Fail

Note: Data are unweighted averages of individual bank ratios. Data for banks that subsequently failed are not shown for years when

there were fewerthan ten banksthat would fail in subsequent years. Open-bank assistance cases are not counted asfailures.

assets ratios than survivors in the year before the recession.28 Three years before the onset of the regional recessions, banks that would fail likewise had

significantly higher ratios of loans to assets, but these

banks' equity­to­assets ratios-although somewhat

lower than those of banks that would survive-were in

the generally healthy range of nearly 7 percent to nearly 8 percent (table 1.5).

These results are generally consistent with the findings on measures of risk and condition summarized below in the section on off­site surveillance. As noted in

that section, five years before their failure, banks that

would subsequently fail differed little from banks that

would survive in terms of equity­to­assets ratios and

other measures of current condition. On the other

hand, banks that would fail had higher loans­to­assets

28 The comparison in California is between failing and surviving banks

with assets below $300 million. All but one of the state's bank failures

were in that asset­size group, while the total state data are dominated

by California's four megabanks.

16
The Banking Crises of the 1980s and Early 1990s

Figure 1.8

Ratio of Commercial Real Estate Loans to Total Assets, Failed

and Nonfailed Banks, 1980–1994

Agricultural Banks* Southwest Percent Percent

14

5

4 10

3

6

1980 1982 1984 1986 1988 1990 1992 1994 1980 1982 1984 1986 1988 1990 1992 1994

*Agricultural banks are banks where agricultural loans are at least
 

25% of total loans.
 

Percent Northeast Percent California

25 30

20

20

15

10 10

1980 1982 1984 1986 1988 1990 1992 1994 1980 1982 1984 1986 1988 1990 1992 1994

Total U.S. Percent

1980 1982 1984 1986 1988 1990 1992 1994

0

10

20

30

Banks That Subsequently Failed Banks That Did Not Fail

Note: Commercial real estate loans = construction loans + multifamily loans + nonfarm, nonresidential loans. Data are unweighted averages of individual bank ratios of commercial real estate loansto total assets. Data for banksthatsubsequently

failed are notshown for years when there were fewer than ten banksthat would fail in subsequent years. Open-bank assistance cases are not counted asfailures.

ratios than survivors, and high loans­to­assets ratios

were the risk factor with the strongest statistical relationship to incidence of failure five years later.

Although high loan volumes were a prominent feature of failing banks from 1980 to 1994, they obviously

were not an automatic route to failure. Banks earn income by managing risk, including risk of loan defaults.

The averages of individual bank ratios discussed above

obscure the fact that some banks that survived also had

high concentrations of assets in total loans and/or commercial mortgages. Similarly, as noted below in the section on off­site surveillance, only a fraction of the banks

with high loans­to­assets ratios would fail five years later. The conditions enabling many banks with high­risk

financial characteristics to survive the recessions and

avoid failure may include the following, among others:

strong equity and reserve positions to absorb losses,

more­favorable risk/return trade­offs, superior lending

and risk­management skills, changes in policies before

high risk was translated into severe losses, improve17
FDIC Banking Review

Table 1.5

Selected Financial Ratios

A. Failed and Nonfailed Banks 1 Year before Regional Recession

1981 1989 1990

Agricultural Banks Southwest Banks Northeast Banks California Banks

Ratio Failed Nonfailed Failed Nonfailed Failed Nonfailed Failed Nonfailed

Equity/Assets 7.91% 8.30%' 7.00% 7.63%' 6.67% 9.21%' 5.71% 10.47%'

Eq.+Loss Res./Assets 9.11 9.77' 8.64 9.25' 8.34 9.93 7.20 11.46'

Nonprfm Lns/Tot Lns NA NA NA NA 8.60 2.95' 6.23 2.39'

ROA 1.26 1.33 1.22 1.38' ­1.68 0.67' ­0.63 0.36

ROE 16.90 16.44 18.98 18.99 ­23.65 6.73' ­7.78 9.88'

Loans/Assets 56.30 48.48' 53.94 47.72' 75.16 68.05' 73.12 69.63

Comm. Mtgs/Assets 2.08 2.19 3.92 3.42' 13.91 9.44' 10.79 11.91

B. Failed and Nonfailed Banks 3 Years before Regional Recession

1979 1987 1988

Agricultural Banks Southwest Banks Northeast Banks California Banks

Ratio Failed Nonfailed Failed Nonfailed Failed Nonfailed Failed Nonfailed

Equity/Assets 7.39% 7.87%' 6.94% 7.45%' 7.96% 8.86%' 6.95% 9.58%

Eq.+Loss Res./Assets 8.85 9.45' 8.45 9.08' 8.53 9.37 8.02 10.52

Nonprfm Lns/Tot Lns NA NA NA NA 1.70 1.14' 4.86 2.28'

ROA 1.15 1.28' 1.00 1.28' 0.62 1.04' 0.08 0.78'

ROE 16.10 16.64 15.55 17.80' 11.66 14.32 2.29 10.85

Loans/Assets 58.40 55.56' 53.42 50.02' 74.31 66.33' 68.72 63.01'

Comm. Mtgs/Assets 2.13 2.42' 3.99 3.71 13.08 8.25' 7.78 8.76

Note: Data are unweighted averages of individual bank ratios. Asset and loan figures are year­end values of the given

year, and equity figures are year­end of the previous year. Excluded were banks chartered within the specified year,

banks that failed before the recession, and banks participating in the Net Worth Certificate Program. Nonperforming

loans were not reported before 1982.

'Significant at 95 percent level

ments in local economic conditions, and timely supervisory actions. High lending volumes may lead to trouble

if a bank achieves them by relaxing credit standards, entering markets where management lacks expertise, or

making large loans to single borrowers, or if loan growth

strains the bank's internal control systems or back­office

operations. That such factors were present at many

banks that failed from 1980 to 1994 has been suggested

by numerous observers, including those interviewed

during the research for this study.

New and converted banks. Approximately 2,800 new

banks were chartered in the period covered by this

study, 39 percent of them in the Southwest (notably

Texas) and California. Of all the institutions chartered

in 1980-90,29 16.2 percent failed through 1994, compared with a 7.6 percent failure rate for banks that were

already in existence on December 31, 1979 (see table

1.6).30 Although the data are dominated by the Texas

experience, in most areas banks chartered in the 1980s

generally had a higher failure rate than banks existing

at the beginning of the 1980s.31

In the Northeast, mutual savings banks that converted to the stock form of ownership represented a

somewhat comparable phenomenon.32 Of the mutuals

that converted in the middle and late 1980s after state

legislation permitted such action, 21 percent of the institutions existing at the end of 1989 failed in 1990-94.

29	 The 1980-90 period was selected in this comparison to compensate

roughly for the fact that banks chartered between 1991 and 1994 did

not have as much chance to fail during the period through 1994.

30	 A study of the Texas experience concluded that "the relatively high

failure rate for newly established Texas banks can be explained by

high­risk financial policies" (Jeffery W. Gunther, "Financial Strategies

and Performance of Newly Established Texas Banks," Federal Reserve Bank of Dallas Financial Industry Studies [December 1990]: 13).

31	 In the Southwest and Northeast, newly chartered banks failed with

greater frequency than preexisting banks, whether "newly chartered"

includes all banks chartered during the 1980-90 period or only those

that were in existence for five years or less. In Southern California,

however, failure rates for banks in existence for five years or less were

lower than those for preexisting banks, whereas failure rates for all

banks chartered in the entire 1980-90 period were higher.

32	 Jennifer L. Eccles and John P. O'Keefe, "Understanding the Experience of Converted New England Savings Banks," FDIC Banking Review 8, no. 1 (1995): 1-18.

18
The Banking Crises of the 1980s and Early 1990s

Table 1.6

Failure Rates, Newly Chartered and Existing Banks

Banks Chartered, 1980-1990

Number Failed Percent Failed

Region 1980-1994 1980-1994

Southwest 248 33.3

Southeast 26 4.3

Northeast 38 19.3

California 41 13.1

U.S. 420 16.2

Banks Existing on December 31, 1979

Number Failed Percent Failed

Region 1980-1994 1980-1994

Southwest 538 21.4

Southeast 77 3.1

Northeast 89 8.5

California 31 12.8

U.S. 1,114 7.6

This compared with 8 percent of the mutuals that existed as of the end of 1989 and had not converted, and

11 percent of the region's commercial banks (see table

1.7). New banks and converted mutuals highlighted in

extreme fashion the problems confronting many other

banks in the 1980s. These institutions had strong incentives to expand loan portfolios rapidly in order to

leverage high initial capital positions, increase earnings

per share, and meet stockholder expectations.33 In so

doing, these institutions rapidly increased their lending

in markets already experiencing vigorous competition

and deteriorating credit standards. They combined

powerful competitive pressures to assume greater risk

with relative inexperience in a demanding new environment. Newly chartered banks began operations at

a time when inexperience was a distinct liability, while

many converted mutuals responded to internal and external pressures by entering unfamiliar markets or geographic areas. As a result, a disproportionate number of

new and converted banks failed. 

Fraud and Financial Misconduct

The precise role of fraud and financial misconduct

as a cause of bank failures is difficult to assess. The

consensus of a number of studies is that fraud and financial misconduct (1) were present in a large proportion of bank and thrift failures in the 1980-94 period,

(2) contributed significantly to some of these failures,

and (3) were able to take root because of the same man33 Managers of savings banks that converted may also have been willing

to take greater risks with their personal compensation than managers

of banks that retained the mutual form.

Table 1.7
 

Failure Rates of Converted Mutual Savings Banks and Other Banks,
 

Northeastern States
 

Savings Banks Commercial Cooperative

Banks Stock Mutual Banks* Total

Number Existing 12/31/89 588 149 211 101 1,049

Number of Failures, 1990-94 65 32 16 5 118

Percent Failed 11 21 8 5 11

Note: Data are for Connecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont.

' "Cooperative banks" is the term used for state­chartered savings and loan associations in Massachusetts.

19
FDIC Banking Review

agerial deficiencies and inadequate internal controls

that contributed to the financial problems of many

failed and problem institutions (apparently internal

weaknesses left some institutions vulnerable not only

to adverse economic developments but also to abuse

and fraud). The studies also agree that the dollar impact of such activity is extremely difficult to estimate. 

A 1988 OCC study of 162 national bank failures between 1979 and 1987 concluded that insider abuse was

a significant contributing factor in 35 percent of the

failures, and fraud in 11 percent.34 As for problem

banks that recovered and survived, the OCC found

that 24 percent of these banks had suffered from significant insider abuse, while none had significant problems with fraud. Another study, which drew on a

number of analyses and reports prepared by Congress

and the regulators, concluded that fraud and insider

abuse contributed to between 33 and 50 percent of

commercial bank failures and from 25 to 75 percent of

thrift failures in 1980-88.35 A 1993 U.S. General Accounting Office (GAO) report pointed to the difficulties of quantifying the effects of fraud and to the wide

variations in estimates of its impact.36 Whereas the

OCC study found that fraud played a significant role in

11 percent of national bank failures, the FDIC found

that fraud and insider abuse were present in 25 percent

of 1989 bank failures; and the Resolution Trust Corporation (RTC) reported in 1992 that potential criminal

abuses by insiders contributed to 33 percent of RTC

failed thrift cases. Finally, a 1994 GAO report indicated that FDIC investigators had found insider fraud to

be a major cause of failure in 26 percent of a sample of

286 banks that failed in 1990-91 and insider "problems" (fraud, noncriminal abuses, and loan losses on insider loans) to be present in 61 percent.37

A number of factors make it difficult to measure the

effect of fraud and abuse. First, some cases of fraud go

undetected. Second, sometimes the line between poor

business judgment and fraud is difficult to draw, as is

the line between criminal and noncriminal activities.

Third, the regulators and the Federal Bureau of Investigation do not maintain complete or consistent records

on fraud convictions, reported incidents of fraud, and

financial misconduct. Fourth, new legislation had effectsthat make comparisons over time difficult to draw:

FIRREA and the Crime Control Act of 1990 increased

the resources for detecting and reporting fraud and

broadened the agencies' powers to deal with bank and

thrift fraud. For all of these reasons, any attempt at precision would be unwarranted. However, it seems

reasonable to infer that fraud and abuse not only were

present in a large number of bank and thrift failures in

the 1980-94 period but also contributed to some of

them.

Factors Associated with Bank Failures:
 

Conclusion
 

The preceding discussion points to a variety of factors-economic, financial, legislative, regulatory, supervisory, managerial-that contributed to bank failures

during the 1980s. Not all observers subscribe to a multiple­cause interpretation of bank­failure history or to

the particular set of multiple causes described in this

study. Some place particular emphasis on one or two

specific causes that they believe were especially influential. For example, bank regulators tend to place

heavy weight on deficiencies in bank management.38

Bankers tend to blame government policy and adverse

changes in the economy. Journalists point to cases of

malfeasance. Academic writers have placed special

emphasis on the financial incentives facing bank owners and managers.

With respect to these last, a considerable body of

academic literature has stressed the effect that flatrate deposit insurance (whose cost is unrelated to the

level of risk assumed by individual institutions) had

in encouraging moral­hazard risk taking and leading

to depository­institution failures.39 There seems little

question that excessive risk taking by then­solvent

banks contributed to bank failures and that flat­rate

deposit insurance contributed to risk taking. However, singling out deposit insurance pricing as the principal explanation of bank failures seems unwarranted.

Deposit insurance was available at fixed rates

throughout most of the FDIC's history, but before the

1980s bank failures were few in number and were of34	 Office of the Comptroller of the Currency, Bank Failure: An Evaluation

of the Factors Contributing to the Failure of National Banks (1988).

35	 Benton E. Gup, Bank Fraud: Exposing the Hidden Threat to Financial Institutions (1990).

36	 U.S. General Accounting Office, Bank and Thrift Criminal Fraud: The

Federal Commitment Could Be Broadened (GAO/GGD­93­48, January

1993).

37	 U.S. General Accounting Office, Bank Insider Activities: Insider Problems

and Violations Indicate Broader Management Deficiencies (GAO/GGD­94­

88, March 1994).

38	 See OCC, Bank Failure 5, 10: "The study showed that deficiencies

within boards of directors and management were the primary internal

problems of problem and failed banks . . . The evidence from healthy

and rehabilitated banks also supports our hypothesis that economic

conditions are rarely the primary factor in determining a bank's condition." See also Richard Duwe and James Harvey, "Problem Banks:

Their Characteristics and Possible Causes of Deterioration," Federal

Reserve Bank of Kansas City Banking Studies (1988): 3-11.

39 See discussion below of moral hazard ("Role of Deposit Insurance").

20
The Banking Crises of the 1980s and Early 1990s

ten caused by fraud rather than by financial risk taking. It was changes in the marketplace (increased

competition, downward pressure on profits, lifting of

legal restraints, and so forth) that created the environment in which increased risk taking (including exploitation of flat­rate deposit insurance) became

advantageous or necessary for many banks.

Furthermore, as mentioned above, although banks

that failed had generally assumed greater risk before

their failure, many other banks with similar risk profiles

did not fail. In the case of these surviving banks, the

effects of risk taking, including risk taking stimulated

by underpriced deposit insurance, were apparently offset by other factors, including superior risk­management skills. The absence of these offsetting factors

should therefore be considered more important causes

of bank failures. Moral­hazard risks appear to have had

greater significance in the savings and loan industry

than in the banking industry; this was mainly because

thrift regulators permitted (or were forced by a depleted insurance fund to permit) a large number of thrifts

to operate for lengthy periods with little or no equity, a

situation that produced extraordinary incentives for

risk taking.

The academic literature has also produced a second,

alternative explanation of the incentives facing solvent

banks, focusing on issues related to the control of

banks exercised by owners and managers.40 According

to this view, managers rather than owners make lending decisions. If managers are entrenched (imperfectly controlled by owners), they may make decisions that

are at odds with the interests of stockholders. According to this view, in periods (such as the 1980s) when the

lending opportunities for banks were reduced as a result of the loss of market share in financing large businesses, some managers sought to preserve their

perquisites by shifting lending to risky loans-a shift

that led to loan losses and reductions in capital. Focusing on the sometimes different incentives of managers and owners is useful for understanding variations

in the behavior of different institutions. However, it is

not clear that such differences played a leading role in

the increased number of bank failures. Many managers may have believed that maintaining their reputations and future employment prospects would best be

served by risk­averse policies that avoided the failure

of their institution. Furthermore, some "entrenched"

managers of solvent institutions (for example, managers of savings banks that retained the mutual form)

seem to have operated their institutions relatively conservatively in the late 1980s.41

A third view of the role of incentives in explaining

risk taking by banks draws an analogy between federal

deposit insurance and a trilateral performance bond in

which the insurance agency provides a bond that protects depositors against poor performance by the

bank.42 This view emphasizes incentive conflicts between various parties: for example, bank owners and

managers, stakeholders in insured institutions and

managers of the insurance agency, insurance agency

managers and elected government officials, elected

government officials and taxpayers. In this setting, regulators lack the incentives to enforce effective loss­control measures (capital requirements, monitoring, etc.)

that are opposed by the regulated industry or "threaten a regulator's ability to mask poor performance."43

These academic views share an emphasis on the

sometimes conflicting incentives of bank owners, managers, regulators, and others as the principal explanation of insufficiently restrained bank risk taking. They

also share the view that bank risk is essentially endogenous, arising from factors internal to the banking

and regulatory systems, including mispriced deposit insurance, inadequate owner­control of bank managers,

or more general principal­agent problems among various parties involved in or affected by deposit insurance

and bank regulation. The importance of exogenous

factors (the economy, financial markets, etc.) is correspondingly diminished in explaining bank risk taking

and failures.

40	 Gary Gorton and Richard Rosen, "Corporate Control, Portfolio Choice,

and the Decline of Banking," Journal of Finance (December 1995):

1377-410. Gorton and Rosen conclude that issues of corporate control

are more important than moral hazard in determining the behavior of

solvent institutions. In the case of insolvent institutions, managers and

owners have identical interests and behave in the manner suggested

by the moral­hazard principle. Another study, based on experience in

the 1990s, concluded that the relationship between corporate structure

and risk is significant only at low­franchise­value banks where moralhazard problems are most severe and conflicts between owner and

manager risk preferences are therefore the strongest. See Rebecca S.

Demsetz, Marc R. Saidenberg, and Philip E. Strahan, "Agency Problems and Risk Taking at Banks," Staff Report, Federal Reserve Bank

of New York, September 1997.

41	 As noted before, mutual savings banks that converted to the stock

form failed with greater frequency in the late 1980s and early 1990s

than mutuals that retained the mutual form. Mutual savings banks had

no stockholders and were governed by self­perpetuating boards of

trustees or directors, which in some cases were dominated by their

chief executive officers; managers of such institutions might reasonably be considered entrenched in the sense of being imperfectly controlled.

42	 Edward J. Kane, "Three Paradigms for the Role of Capitalization Requirements in Insured Financial Institutions," Journal of Banking and

Finance 19 (1995): 431-59.

43 Ibid., 447. 

21
FDIC Banking Review

Ultimately, the role of financial incentives in bank

failures is inseparable from the role of broader economic, financial, legislative, and regulatory factors; the

extent to which flat­rate deposit insurance pricing, for

example, led to excessive risk taking and widespread

failures apparently depended on the circumstances.

The multiple­cause explanation appears to be a more

plausible reading of the history of the 1980s. According to this view, the rise in the number of bank failures

was caused by a variety of factors internal and external

to the industry.44 This is not to say that failures were

due merely to "bad luck," with everything going wrong

at the same time. More realistically, the preconditions

for a rise in the number of bank failures were present

well before the 1980s. These preconditions included,

among others, a structure of banking laws that inhibited competition, geographic diversification of risks, and

consolidation of units. They also included managerial

attitudes and regulatory provisions that reflected the

relatively benign pre­1980 environment for banking

when failures were rare, and a system of flat­rate deposit insurance premiums that was tenable when other

incentives and opportunities for risk taking were weak.

The localized nature of many banks and a lack of experience with hard times left them vulnerable to external shocks and regional and sectoral recessions. Under

the pressure of increased competition, many banks assumed greater risks, and as long as they remained solvent and profitable they were insufficiently restrained

by the supervisory authorities. When the economic, financial­market, and competitive environment turned

markedly less favorable for banks and some government policy actions (principally ill­timed deregulation

and tax changes) exacerbated the situation, the preconditions were translated into increased numbers of

bank failures. Which banks failed and which banks

survived in an increasingly demanding environment

was largely determined by an individual bank's circumstances, particularly variations in the levels of risk

it assumed, its success (or lack thereof) in operating

with high risk levels, the overall strength of its management, good or bad fortune, and (in some cases) the

presence or absence of fraud and misconduct.

Regulatory and Supervisory Issues 

Raised by the Experience 

of the 1980s

The principal regulatory and supervisory issues arising from the experience of the 1980s include the role

of deposit insurance, the treatment of large­bank failures, the use of forbearance, the impact of Prompt Corrective Action, and the effectiveness of supervisory

tools-examination, enforcement, and off­site surveillance.

Role of Deposit Insurance

Deposit insurance has often been described as involving a trade­off between stability and moral hazard.45 On the one hand, by protecting depositors

against loss, deposit insurance virtually eliminates the

risk of bank runs and disruptive breakdowns in bank

lending. On the other hand, by assuming the risk of

losses that would otherwise be borne by depositors, deposit insurance eliminates any incentive for insured depositors to monitor bank risk and permits bank

managements to take increased risks. Because of deposit insurance, banks are able to raise funds for risky

projects at costs that are not commensurate with the

risk of the projects, a situation that may lead to the misallocation of resources and to failures.46 Moral hazard is

a particularly serious concern if the bank is insolvent or

close to insolvency, in which case the owners have

strong incentives to make risky investments because

profits accrue to the owners, whereas losses fall on the

insurer. (On the other hand, risk taking may be restricted if the bank has sufficient franchise value, defined as the present value of future income expected to

be earned by the bank as a going concern.) In principle,

the insuring agency can protect itself by requiring deductibles (equity positions) so that owners have their

own funds at risk and by charging premiums commensurate with the risk assumed by the various banks.

However, because it is difficult to identify indicators

that give accurate advance warning of future distress,

moral­hazard problems are inherent in deposit insurance, as in other types of insurance.47 Deposit insurance suffers from the additional problem that it insures

44	 A study by the FDIC Office of Inspector General (OIG) of the 13 bank

failures in 1994, when conditions for banking were much different

from in the 1980s, concluded that in a majority of cases problems were

evident in loan underwriting, credit concentrations, high overhead, imprudent management, and external economic factors. Less common or

critical factors were financial derivatives, volatile deposits, cross­guarantee assessments, and newly chartered banks. See FDIC Office of Inspector General, 1994 Failed Banks Trend Analysis (1995), 2. Similar

results were found for 6 failures in the OIG's 1995 Failed Banks Trend

Analysis (1996).

45	 Arthur J. Murton, "Bank Intermediation, Bank Runs, and Deposit Insurance," FDIC Banking Review 2, no. 1 (1989): 1-10. The term "moral

hazard" has been defined as "a description of the incentive created by

insurance that induces those insured to undertake greater risk than if

they were uninsured because the negative consequences are passed

through to the insurer" (Congressional Budget Office, Reforming Federal Deposit Insurance [September 1990], 163).

46	 In principle, owners of marginally solvent nonbank firms may also

have incentives to take greater risk, but they are generally constrained

by uninsured creditors.

47	 The unreliability of ex ante risk measures has been attributed to information asymmetries between the insured and the insurer, whereby the

former is seen to be better informed about his or her risky behavior.

22
The Banking Crises of the 1980s and Early 1990s

against losses that are not independent but are interrelated through the effects of cyclical economic activity

and the possibility of contagious bank runs.

During the 1980s, the balance in this trade­off was

generally tipped in favor of stability. In this respect,

regulatory policy was eminently successful; despite an

unprecedented number of bank and thrift failures,

there was no evidence of serious runs or credit­flow

disruption at federally insured institutions. Stability

was achieved, it should be noted, at substantial cost to

surviving institutions and to their customers (assuming

the institutions passed on at least part of the burden

of increased assessments). In the case of thriftinstitution failures, some of the costs were borne by

taxpayers as well. The estimated total cost of FDIC

failed­bank resolutions in 1980-94 is $36.3 billion.

The estimated cost of the savings and loan debacle is

$160.1 billion, of which an estimated $132.1 billion

was borne by taxpayers.48

In contrast, the record of regulators with respect to

controlling risk taking was mixed-and in the case of

still­profitable and solvent banks, often unfavorable.

Here a distinction must be made between controlling

the risky behavior of profitable, solvent banks and

controlling risk taking by problem banks that already

face the near­term prospect of insolvency and failure.

The record of the 1980s seems clear on this point.

The regulators were reasonably successful in modifying the behavior of officially designated problem

banks so as to reduce the prospects of their failure or

the cost to the insurance fund if failure occurred. The

regulators were less successful in constraining risk taking by still­profitable and healthy banks, partly because there were no reliable, generally accepted,

forward­looking measures of risk.

There are three traditional means of controlling

moral hazard: (1) examination and supervision; (2) regulatory capital requirements and risk­based deposit insurance premiums; and (3) uninsured depositor and

creditor discipline.49 In varying degrees and at various

times, all three of these means were operating imperfectly in the 1980s. As discussed below, examination of

many banks was infrequent in the early and middle

1980s, with the result that the consequences of risky

behavior and other problems were not always identified on a timely basis. Although for some time regulators had been using capital standards to assess the

condition of banks, uniform minimum capital requirements covering all banks were not adopted until 1985,

and risk­based capital requirements not until 1990.

Most bank failures were resolved through purchaseand­assumption transactions or open­bank assistance

agreements that protected uninsured depositors and

nondeposit creditors and therefore fostered the belief

that all deposits of large banks were 100 percent insured. This belief severely limited the discipline that

depositors might otherwise have exerted on the behavior of banks.

More specifically, supervisory restraints did not prevent the speculative binge of commercial real estate

and other risky lending by solvent banks in many regions of the country in the 1980s. Regulators apparently believed that as long as risky behavior was

profitable, they had limited leverage to restrain such

behavior. Examiners interviewed for this study stated

that as long as the banks were profitable, it was difficult

to persuade bank managements or their own superiors

in the regulatory agencies that problems could lie

ahead. When risky behavior resulted in actual losses,

regulators were more effective, but often by that time

the damage had been done. 

Part of the problem was the absence of explicit

penalties or costs to make risky behavior less attractive-penalties and costs such as risk­based premiums

and capital requirements that, as stated, were not

adopted until late in the period. Earlier adoption of

uniform capital requirements and risk­based premiums

would have improved the position of the bank regulators but might still have been insufficient to curb the

excessive risk taking in the 1980s. As noted, capital

regulation is a principal means of restraining risky behavior, but equity­to­assets positions are lagging indicators of a bank's risk profile and therefore poor

indicators of the risk of failure several years before the

fact. Current risk­based capital standards, which differentiate among broad asset categories, permit considerable shifting toward riskier lending within categories

without requiring additional capital, while higher risk48	 The savings and loan cost figure includes the costs of the FSLIC and

the RTC plus tax benefits under FSLIC assistance agreements, but

excludes potential costs from supervisory goodwill claims. See U.S.

General Accounting Office, Resolution Trust Corporation�s 1995 and

1994 Financial Statements (July 1996), 13.

49	 See Murton, "Bank Intermediation." A study of Texas banks concluded that "the propensity to engage in risky activities depends on

more than just changes in capital. A bank's current risk influences the

response of bank lending to changes in capital. As long as banks possessed the ability to expand their lending, lower growth rates of capital were associated with larger increases in lending, as moral hazard

would suggest. However, once banks were more exposed to risk, those

institutions with lower capital growth recorded statistically insignificant differences in lending compared to those banks with greater increases in capital. While this latter finding is inconsistent with moral

hazard, it points out the potential importance of both regulatory and

liquidity constraints at work" (Jeffery W. Gunther and Kenneth J.

Robinson, "Moral Hazard and Texas Banking in the 1980s," Federal

Reserve Bank of Dallas Financial Industry Studies [December 1990]: 6).

23
FDIC Banking Review

based premiums are charged to banks whose condition

has already deteriorated.50 In short, regulators' ability

to restrain the risky behavior of currently profitable

banks was limited by the absence of penalties or costs

based on reliable and generally accepted early­warning

signals.51

The problems faced by regulators in controlling the

risky behavior of profitable banks as compared with

troubled banks illustrate differences between ex ante

and ex post measures of risk. Common measures of ex

ante risk (for example, loans­to­assets and other assetcomposition ratios) measure risk taking independent of

the current condition of the bank. They tend to be

limited in their reliability-for example, many banks

with high­risk profiles were able to avoid failure in the

1980s. Thus, regulators may be reluctant to apply

stringent restraints and penalties on the basis of ex ante

risk measures. On the other hand, ex post measures of

risk (for example, capital­to­assets ratios) are the most

proximate measures of risk to the insurance fund and

measure the consequences of risk taking after it has

materially weakened the condition of the bank. Supervisory restraints and penalties can be more confidently applied on the basis of ex post risk measures,

but they may be less effective than those based on reliable ex ante measures in curbing risk taking before it

weakens the condition of the bank. Moreover, the

weakened condition of banks identified on the basis of

ex post risk limits the magnitude of penalties that can

actually be applied.52

Whereas bank regulators may have lacked the tools

to restrain solvent banks from excessive risk taking,

thrift regulators were in a far different position. The

Federal Home Loan Bank Board was not confronted

by the problem of limiting risk taking by healthy institutions but by a large number of savings and loan associations that were insolvent or barely solvent in the

early 1980s. The course that thrift regulators followed

may in retrospect be termed high risk, featuring reduced capital standards, liberalized ownership restrictions for stockholder­owned thrifts, and capital and

accounting forbearance that allowed savings and loan

associations to operate with minimal or no equity while

their true condition was obscured. This course was followed partly because the financial resources of the

FSLIC fund were inadequate. It was apparently motivated by the belief (or hope) that thrifts could grow out

of their problems by acquiring new assets, that external

capital could be attracted to shore up the industry, and

that thrift institutions should be permitted to operate

with minimal capital until they were able to improve

earnings by using new asset powers. In contrast to

banks, in the first half of the 1980s undercapitalized

thrifts were allowed and even encouraged to grow.53

Apart from differences in regulatory philosophy,

FHLBB policies reflected the depleted state of the

FSLIC insurance fund. The closure of all thrifts as

they reached or approached insolvency was not a viable

option. One obvious conclusion from the experience

of the 1980s is that an adequate insurance fund is a prerequisite for any attempt to control moral hazard. 

Treatment of Large Banks

Regulators' preference for solutions that promoted

stability rather than market discipline is apparent in the

treatment of large banks (mutual savings banks, money­center banks, and Continental Illinois). At various

times and for various reasons, regulators generally concluded that good public policy required that big banks

in trouble be shielded from the full impact of market

forces and that their uninsured depositors be protected.

This policy contributed to the overall record of stability achieved by the deposit insurance system in the

1980s. At the same time, however, it weakened any incentive for uninsured depositors to monitor and restrain risk taking by the banks. The first big bank to

fail in the 1980s was First Pennsylvania Bank, N.A., of

Philadelphia, with $8 billion in assets in early 1980.54

In this case the FDIC provided open­bank assistance,

and the agency's determination of the bank's "essentiality" was based mainly on First Pennsylvania's size

as the city's largest bank and on the possibility that its

failure would have local and national repercussions.

Large mutual savings banks. The issue of systemic

risk was raised more explicitly by the threatened insolvency of mutual savings banks. Located mainly in

New York and other northeastern states, these institutions suffered a severe earnings squeeze because of the

rapid rise in interest rates in the late 1970s and early

1980s, pushing interest costs on short­term deposits

50	 The shift in bank lending from business loans to commercial mortgages during the 1980s would not have required increased capital under present risk­based capital standards. Risk­based premiums vary

according to capital positions and supervisory ratings.

51	 Some would argue that problems of controlling risky behavior would

be solved by the adoption of market value accounting. This argument

assumes that market participants, utilizing publicly available data,

would be better able than regulators to correctly recognize advance

warning signs of risk, even though regulators have access to information developed through on­site examinations. This assumption remains unproven. See section below on "Treatment of Big Banks:

Systemic Risk and Market Discipline."

52 For discussions of this topic, see two FDIC studies: Deposit Insurance

for the Nineties: Meeting the Challenge (1989) and A Study of the Desirability

and Feasibility of a Risk­Based Deposit Insurance System (1990).

53 See "Use of Forbearance" below.

54 FDIC, The First Fifty Years: A History of the FDIC 1933-1983 (1984), 95.

24
The Banking Crises of the 1980s and Early 1990s

above interest rates on the institutions' long­term,

fixed­rate mortgage loans and bond holdings. Earnings were also held down by usury ceilings applicable

to residential mortgage loans in New York. Although

asset quality was not generally a problem at this time,

the net worth shortfall at market values was so large,

according to one estimate, that if the banks had failed,

the liability facing the FDIC would have exceeded the

size of the insurance fund.

The first savings bank to fail was the Greenwich

Savings Bank with $2.5 billion in assets-at the time,

the third­largest bank failure in the FDIC's history.

The initial estimated cost of the Greenwich failure was

more than the recorded total cost of all previous failures

of insured banks. Federal action was precipitated by

the bank's inability to roll over foreign borrowings.

Among the FDIC's first acts was to announce that no

depositors, insured or uninsured, would lose any principal or interest, a move designed to preserve confidence in other savings banks that were also suffering

severe interest­rate pressures. The bank was resolved

through an FDIC­assisted merger transaction with another savings bank, a transaction assisted through an

Income Maintenance Agreement, and this became the

prototype for other savings bank transactions. In all, 17

mutual savings banks with $24 billion in assets were resolved through assisted mergers during 1981-85.55

Money­center banks with LDC (less­developed­country)

loans. The case of money­center banks with large concentrations of loans to developing countries also illustrates the regulators' preference for stability (as well as

other public policy objectives) over market discipline.

Between year­end 1978 and year­end 1982, total LDC

debt held by the eight largest money­center banks expanded from $36 billion to $55 billion. Total LDC

portfolios held by these banks averaged more than

double the banks' aggregate capital and reserves at the

end of 1982, a ratio that put some of the largest banks

at risk. Bank regulators made some attempt to curtail

LDC lending activity and ensure diversification of

foreign lending risk, doing this partly through the Interagency Country Exposure Review Committee,

composed of officials of the OCC, the FDIC, and the

Federal Reserve. These efforts apparently had little

effect on the growth of LDC loans. Conversely, LDC

lending may have been encouraged by the OCC's 1979

interpretation of the loans­to­one­borrower rule, an interpretation according to which public sector borrowers

that met certain conditions did not have to be counted

as parts of a single entity. On balance, it may be said

that government policy supported LDC lending activity by the banks.

In August 1982, the government of Mexico announced it could no longer meet interest payments,

and by the end of the year 40 nations were in arrears.

By the end of 1983, 27 countries were in negotiations

to restructure their existing loans. Following the Mexican default, U.S. banking officials did not require that

large reserves be immediately set aside for the restructured LDC loans, apparently believing that some large

banks might have been deemed insolvent and that an

economic and political crisis might have been precipitated.56 Although loss reserves did increase, at the end

of 1986 they still averaged only approximately 13 percent of the total LDC exposure of the money­center

banks. Starting in 1987, however, the money­center

banks began to recognize massive losses on LDC loans

that in some instances had been carried on the banks'

books at par for more than a decade. By the end of

1989, total reserves at the money­center banks were

nearly 50 percent of total LDC loans.

The LDC experience illustrates the high priority

given to maintaining financial market stability in the

treatment of large banks. It also represents a case of

regulatory forbearance. The OCC's 1979 interpretation of the loans­to­one­borrower rule permitted banks

to continue lending in the face of signs that Latin

American nations were having increasing difficulty

meeting their obligations. Regulatory forbearance also

enabled money­center banks to delay recognizing the

losses and thereby avoid repercussions that might have

threatened their solvency. In time, loss reserves and

charge­offs were greatly increased, and no money­center bank failed because of LDC loans.57 The creation

of the Brady Plan in 1989 reflected recognition that

55	 The assisted merger transaction was chosen over a purchase and assumption or a deposit payoff so that the FDIC could avoid the immediate outlays necessary to offset the full amount of asset depreciation

and because these institutions had no stockholders to benefit from the

transactions (and, in most cases, few uninsured depositors to share the

cost with the FDIC). Most of the transactions were accomplished before the Net Worth Certificate Program was adopted as part of the

Garn-St Germain Act (see the section below on forbearance).

56	 L. William Seidman, Full Faith and Credit: The �reat S&L Debacle and

Other �ashington Sagas (1993), 127. According to former FDIC Chairman Seidman, "U.S. bank regulators, given the choice between creating panic in the banking system or going easy on requiring our banks

to set aside reserves for Latin American debt, had chosen the latter

course. It would appear that the regulators made the right choice."

57	 One analysis concluded that "had these institutions been required to

mark their sometimes substantial holdings of underwater debt to market or to increase loan­loss reserves to levels close to the expected losses on this debt (as measured by secondary market prices), then

institutions such as Manufacturers Hanover, Bank of America, and perhaps Citicorp would have been insolvent" (Robert A. Eisenbeis and

Paul M. Horvitz, "The Role of Forbearance and Its Costs in Handling

Troubled and Failed Depository Institutions," in Reforming Financial

Institutions in the �nited States ed. George G. Kaufman [1993], 60).

25
FDIC Banking Review

banks would not recover the full principal value of existing loans and turned international efforts from debt

rescheduling to debt relief. As part of the process, substantial funds were raised from the International Monetary Fund and the World Bank to facilitate debt

reduction. Ultimately, the shareholders of the world's

largest banks assumed the losses under the Brady Plan,

which brought the crisis to an end.

Continental Illinois. The failure of Continental Illinois-a bank with $45 billion in assets in 1981 and one

of the ten largest in the nation-was the large­bank

transaction that set the terms for the ensuing "too­bigto­fail" debate. The $4.5 billion rescue package devised by the regulators in May 1984 was prompted by

a high­speed electronic bank run that followed a period of deteriorating performance. Problems in Continental's loan portfolio had been highlighted in July

1982, when Penn Square Bank failed; Continental Illinois had had a heavy concentration of loan participations with Penn Square. The rescue package included

the promise to protect uninsured depositors fully, and

it brought to an end the FDIC's modified payoff program, in which only a portion of the amount owed to

uninsured depositors was paid; that portion was based

on the estimated recovery value of the failed institution's assets. The reversal in FDIC policy reflected

concerns that other large banks might be subject to

bank runs and that Continental's correspondent banks

would suffer losses if the FDIC resolved the bank

through a deposit payoff or otherwise failed to protect

uninsured deposits.

The justification for the Continental Illinois transaction has been debated at length. For example, a 1993

article criticizing the transaction and its rationale concluded that in most cases losses on deposits held by

correspondent banks at Continental would have been

relatively small and that these banks probably would

have been able to meet any liquidity strains through

the Federal Reserve's discount window.58 As for the

possibility that problems at Continental Illinois might

have caused contagious runs on otherwise viable

banks, the essential question is whether the market

would have been able to distinguish between viable

and nonviable banks (so that it would be able to end

quickly any run on the former). Uncertainties on this

point have made decisions on the resolution of largebank failures difficult and will continue to make them

difficult in the future. (See "Open Questions" below.)

* * *

These transactions in the early 1980s involving mutual savings banks, money­center banks, and Continental Illinois generally set the pattern for the treatment of large banks throughout the rest of the decade.

In large­bank resolutions in the Southwest and Northeast as well as in other regions, the FDIC used purchase­and­assumption transactions, bridge banks, and

open­bank assistance agreements that provided full

protection for uninsured depositors. These methods

eliminated the need for uninsured depositors to monitor the performance of large banks and raised questions

of fairness, since numerous small­bank failures were resolved through deposit payoffs, in which uninsured depositors suffered losses.59

The treatment of some large­bank failures has also

been criticized on the ground that regulators were not

assertive or prompt enough in curbing the risky behavior that led to the failures. It is clear that some years

before its failure in May 1984, Continental Illinois had

embarked on a rapid­growth strategy built on decentralized loan management that was unconstrained by

an adequate system of internal controls and was heavily reliant on volatile funds. It is also clear that supervisory restraints were insufficient to modify the bank's

behavior. A House subcommittee report in 1985 criticized a lack of "decisive action" on the part of the OCC

and also found fault with the Federal Reserve's supervision of the parent holding company. Some of the regulators who participated in the Continental Illinois

transaction have indicated that while the bank was

profitable, regulators were reluctant to take early action

in opposition to the bank's board of directors.

Criticism has also been leveled against the supervisory treatment of the Bank of New England in the

years before its failure in January 1991. According to

the General Accounting Office, problems in the bank's

operations were identified through the examination

process several years before its failure. The firm grew

rapidly from 1985 to 1989, primarily through acquisitions and aggressive real estate lending. During this

high­growth period, OCC examiners repeatedly identified and reported problems with the bank's controls

58	 Larry D. Wall, "Too­Big­to­Fail after FDICIA," Federal Reserve

Bank of Atlanta Economic Review (January/February 1993): 1-14.

59	 It is likely that even without the too­big­to­fail policy, large banks

would have been resolved less frequently through deposit payoffs because they tended to have greater franchise value and marketability.

The greater marketability of large banks may have been due to their

greater flexibility in seeking new markets and offering new product

lines, their location in states where the absence of restrictions on geographic expansion meant a greater number of qualified bidders, and

the earlier resolution action (to the extent that disclosure requirements applicable to publicly traded companies alerted regulators to

problems at an earlier stage).

26
The Banking Crises of the 1980s and Early 1990s

over lending operations and strategies. However, not

until 1989 were any enforcement actions taken against

the bank to compel corrective measures. The GAO

concluded that the OCC relied on management's assurances that it would address the problems; it also

concluded that more vigilant supervision could have

reduced losses.

Use of Forbearance

Forbearance has taken on such pejorative connotations that various uses of the term need to be distinguished.60 At one extreme, forbearance may be said to

occur when supervisory authorities permit an insured

depository institution to operate without meeting established safety­and­soundness standards for a limited

period of time while taking remedial actions to reduce

risk exposure and correct other weaknesses. Forbearance in this sense has often been applied by bank regulators on a case­by­case basis. As an example,

problem banks that face near­term insolvency and closure frequently attempt, under pressure from regulators, to acquire additional capital. The success or

failure of such efforts often determines whether the

bank survives or is closed. Decisions as to whether, and

for how long, to allow these efforts to continue are in

fact decisions as to whether, and for how long, forbearance of this limited type should be granted. Whether

regulators make the correct decisions in these situations cannot be tested with any precision. However,

such limited, case­by­case forbearance seems to be an

integral part of the overall supervision of problem

banks, and its usefulness is best judged by the degree

of success of such supervisory efforts.61

At the other extreme is the type of forbearance practiced by the FSLIC, as a result of which a large number of insolvent or marginally solvent savings and loan

associations were permitted to operate as open institutions for lengthy periods.62 The difference between

the extremes is more than a difference of degree. Limited, case­by­case forbearance is designed to provide an

opportunity to reduce risk exposure and correct weaknesses. Longer­term, wholesale forbearance as practiced by the FSLIC was a high­risk regulatory policy

whose main chances of success were that the economic environment for thrifts would improve before their

condition deteriorated beyond repair or that the new,

riskier investment powers they had been granted

would pay off. The latter type of forbearance, which

the FSLIC adopted against the background of a depleted insurance fund, is widely judged to have increased the cost of thrift failures.63 Because of the state

of the FSLIC fund, forbearance became a necessity for

the thrift regulators rather than a matter of choice64 and

continued to be widely granted after interest­rate reductions in the early and middle 1980s had alleviated

maturity mismatches in thrift portfolios, and poor­quality assets had become the chief problem of S&Ls.

Generally, the bank regulators did not practice such

wholesale, protracted, and risky forbearance.

The bank regulators did, however, allow several

large banks that subsequently failed to operate for long

periods with minimal capital (see "Impact of Prompt

Corrective Action" below). As noted above, bank regulators also eased the problems of money­center banks

with large holdings of LDC loans by not requiring

prompt establishment of reserves against such loans.

This was a form of temporary forbearance; eventually

money­center banks substantially increased their reserves.65 Finally, bank regulators administered three

forbearance programs that were applied to classes of

banks rather than to individual institutions (see table

1.8). These programs were initiated or inspired by

Congress rather than by the bank regulators. 

60	 Bank forbearance programs are discussed by Dean Forrester Cobos,

"Forbearance: Practices and Proposed Standards," FDIC Banking Review 2, no. 1 (1989): 20-28.

61	 See "Effectiveness of Supervisory Tools: Examination and Enforcement" below.

62	 In 1984, 687 FSLIC­insured thrifts with $358 billion in assets, constituting 22 percent of the number of thrifts and 37 percent of total industry assets, were insolvent on the basis of tangible net worth. See

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

Thrift Regulation (1991), 114. 

63	 See, for example, Edward J. Kane, The S&L Insurance Mess: How Did It

Happen. (1989); Eisenbeis and Horvitz, "Forbearance and Its Costs,"

49-68; Edward J. Kane and Min­Teh Yu, "Opportunity Cost of Capital

Forbearance during the Final Years of the FSLIC Mess," Quarterly Review of Economics and Finance 36, no. 3 (fall 1996): 271-90; and Ramon

P. DeGennaro and James B. Thompson, "Capital Forbearance and

Thrifts: An Ex Post Examination of Regulatory Gambling," in Proceedings of the 29th Conference on Bank Structure and Competition, Federal

Reserve Bank of Chicago, May 1993, 406-20. However, one analysis

concluded that "[F]orbearance was not a major culprit in the taxpayer

bill for the thrift crisis." See George J. Benston and Mike Carhill, "FSLIC Forbearance and the Thrift Debacle" in Credit Markets in Transition Proceedings of the 28th Annual Conference on Bank Structure and

Competition Federal Reserve Bank of Chicago, 1992: 131.

64	 One analysis concluded that the FSLIC's ability to dispose of insolvent thrifts was constrained by S&L industry pressures, by the extent

of past cover­ups of thrift insolvencies, and by the actions of elected officials (Kane, The S&L Mess 97, 98).

65	 According to some authors, the case for forbearance rests on the existence of market imperfections (such as legal impediments to diversification), deadweight bankruptcy costs, inefficient markets for bank

assets, information asymmetries whereby assets have greater value

when managed by the banks that originated them than when managed

by FDIC liquidators, and macroeconomic considerations (Eisenbeis

and Horvitz, "Forbearance and Its Costs," 52, 64, 65).

27
FDIC Banking Review

Table 1.8

Results of Bank Forbearance Programs

Mutual Savings Banks,

Net Worth Certificates

Agricultural and

Energy Sector Banks

Number of banks in program

Assets of banks in program ($billions)

Number of banks that survived

29

40

22

301

13

236

Number of banks that failed 7 65

Losses as percent of assets at failure

Banks in forbearance program

Comparable banks not in program

4

12

21'

22'

' Data refer to banks with less than $100 million in assets.

The first such program was the Net Worth Certificate Program for thrifts that was adopted, despite

FDIC reservations, as part of the Garn-St Germain

Act.66 This program was applied mainly to FDIC­insured mutual savings banks in New York and other

northeastern states that were suffering extreme earnings pressures in a period of high and rising interest

rates. Between 1982 and 1986, 29 mutual savings

banks with approximately $40 billion in assets participated. Of these, 22 banks were restored to profitability as falling interest rates in the early and middle 1980s

enabled these institutions to improve equity positions

and retire their net worth certificates. Seven savings

banks that participated in the program failed as a result

of interest­rate pressures and were resolved at a cost of

$420 million, or approximately 4 percent of total assets

at the time they entered the program.67 This loss rate

was substantially less than the average loss rate of 12

percent for savings banks resolved before the Net

Worth Certificate Program was adopted.68

The effectiveness of the Net Worth Certificate Program was due largely to the drop in interest rates after

1981. In effect, Congress required that action against

insolvent savings banks be deferred until after interest

rates had come down, by which time, it was thought,

profitability and equity positions would be restored,

and in fact in most cases they were.69 Also important

was the fact that the FDIC was generally able to contain moral­hazard risks associated with the continued

operation of banks having little or no equity. Most of

the savings banks were free of serious credit­quality

problems (as mutual institutions, they might have had

less incentive than stockholder­owned institutions to

make risky investments), and the relatively small number of savings banks in the program simplified supervision and facilitated control of risky behavior.

The second instance of class­of­bank forbearance

was the 1986 temporary capital forbearance program for

banks that were weakened as a result of lending to the

troubled agricultural and energy sectors; this program

was later extended to all banks that were experiencing

difficulties because of economic factors beyond their

control. Bank regulators developed the program at a

time when support for forbearance was building in

Congress. By developing their own program, bank regulators sought to include a strong safety­and­soundness

focus and to avoid being required to use measures like

the Net Worth Certificate Program or those the thrift

regulators employed.70 Of the 301 banks in the capital

forbearance program, 201 were operating as independent institutions one year after leaving the program,

another 35 had been merged without FDIC assistance,

while 65 had failed. As these results indicate, after a

period of forbearance a large majority of the institutions

in the program either were able to recover as independent institutions or had sufficient value to be acquired

by merger partners without FDIC assistance. Losses

of the 65 banks that failed were similar to those of comparable failed banks, a fact suggesting that the period

66 FDIC, The First Fifty Years, 102.

67	 Two of the 22 savings banks failed subsequently, four to six years after

having retired their net worth certificates. These failures were probably the result of actions taken after the two banks left the program.

68 The lower loss rate of banks that failed while in the Net Worth Certificate Program was probably due in part to the fact that after the program was introduced, interest rates were generally declining. In

addition, the first savings banks to fail might have been in a more serious condition than those that failed later.

69	 By comparison, many insolvent savings and loan associations did not

recover as a result of the drop in interest rates. At the end of 1982,

there were 222 GAAP­insolvent FSLIC­insured thrifts. In September

1986, despite a nearly 500 basis­point drop in 90­day Treasury bill rates

from 1982 to 1986, only 29 percent of these institutions were now

GAAP­solvent, whereas 36 percent were still GAAP­insolvent and 35

percent had ceased to exist. See U.S. General Accounting Office, Thrift

Industry: Forbearance for Troubled Institutions, 1982-1986 (GAO/GGD87­78BR, May 1987), appendix 1.

70 See Cobos, "Forbearance: Practices and Proposed Standards," 23.

28
The Banking Crises of the 1980s and Early 1990s

of forbearance did not result in serious deterioration.

Of the 65 failed banks in the program, 59 were under

$100 million in assets and had losses of 21 percent of

assets. In comparison, 965 banks with assets less than

$100 million that were not in the forbearance program

and failed during 1986-94 had a 22 percent loss rate.

As in the case of the Net Worth Certificate Program,

the effectiveness of the 1986 regulators' program was

largely due to its temporary nature and to cyclical economic forces, in this case, a recovery in the agricultural

sector.

A third instance of class­of­bank forbearance was the

Agricultural Loan­Loss Amortization Program adopted

by Congress in 1987 as part of CEBA, apparently because Congress concluded that the regulators' program

was inadequate. Of 33 banks in the program, 27 survived as independent institutions one year after leaving it, another 2 had merged, while 4 had failed.71

Essentially the same conclusions apply to this program

as to the 1986 regulators' agricultural and energy forbearance program.

In assessing the effectiveness of class­of­bank forbearance programs, one needs to consider how banks

are chosen to participate when the regulators are allowed to exercise discretion. Ideally, the regulators

must be able to distinguish between institutions that

will recover after a period of forbearance and those that

will not recover and should therefore not be granted

forbearance. The ability to make such distinctions accurately is important for reasons of fairness and because

of moral hazard. In making such distinctions, the regulators have the benefit of information derived from

examination reports-information that is not available

in financial reports or other public records. Nevertheless, picking winners and losers is difficult, and some

writers have concluded that regulators were unsuccessful in their attempts.72

Furthermore, applying forbearance to a group of

banks may have adverse competitive effects on institutions outside the program. Unless restrained by the supervisory authorities, insolvent banks may offer

above­market deposit rates and submarket loan rates,

thereby weakening healthy competitors. Such behavior by many thrift institutions during the 1980s generated frequent complaints, but it was apparently less of

a problem in the bank forbearance programs because a

smaller number of institutions were involved and the

participants were closely monitored and supervised. In

other words, while forbearance may provide an opportunity to correct weaknesses, without effective oversight it may also permit further deterioration. As noted

below ("The Impact of Prompt Corrective Action"), allowing unprofitable banks to continue operating can

increase resolution costs as operating losses accumulate. Even if it is successfully applied to some banks,

forbearance may have undesirable effects if it encourages other banks to expect similar treatment. Moreover, if forbearance is granted to a large number of

institutions, it may have adverse effects on the economy.73

Thus, forbearance programs may have a number of

disadvantages-and, when practiced on the scale and

with the purposes of the FSLIC program, they can be

a disaster. While survival of the institution is not the

only criterion for the success of forbearance programs,

it remains significant that most of the banks in class­ofbank forbearance programs survived,74 and the minority that failed had losses comparable to, or lower than,

those of failed banks not included in the programs.

The more favorable results of bank forbearance programs as compared with the FSLIC strategy reflect the

smaller number of banks involved, the closer monitoring of banks, the fact that the problems addressed by

bank forbearance programs were temporary and cyclical in nature,75 and (most important) the fact that bank

regulators sought to control risk taking by participating

institutions rather than encourage it.76 In the absence

of the class­of­bank forbearance programs, more of the

banks that actually survived might have been closed:

71	 Data exclude banks that were in both the CEBA and the 1986 regulators' programs. These banks are included only in data for the latter program.

72	 See, for example, Emile J. Brinkmann, Paul M. Horvitz, and Ying­Lin

Huang, "Forbearance: An Empirical Analysis," Journal of Financial

Services Research (1996): 39-40.

73	 See the discussion in Congressional Budget Office, The Economic Effects of the Savings and Loan Crisis (1992).

74	 One analysis states that "the cost to taxpayers of FDIC gambling lies

in offering the equivalent of dividend­free equity capital to undercapitalized banks. The success of these gambles must not be measured by

whether assisted banks recovered, but by whether societal returns on

taxpayer funding proved high enough to justify the waiver of dividends." See Kane, "Three Paradigms," 444.

75	 One view of S&L forbearance programs is that as a result of deregulation, these institutions were undergoing a permanent change that

could not be addressed by an essentially temporary measure. See Congressional Budget Office, Reforming Federal Deposit Insurance, xiv. 

76	 The difference between the FDIC forbearance program for mutual

savings banks and the FSLIC program for savings and loan associations

has been described as follows: "[A]ccounting gimmicks were limitedand the mutual savings banks were not allowed to grow. With a conservative policy of temporary forbearance in place, many mutual

savings banks recovered, and those ultimately shut down or merged

did not put an intolerable burden on the FDIC . . . the S&Ls that followed the incentives and implicit advice of government policy to enter new areas rapidly and grow their way out of the problems became

part of the S&L debacle" (National Commission on Financial Institution Reform, Recovery and Enforcement, Origins and Causes 32-33).

29
FDIC Banking Review

for example, as shown in the next section, if the provisions of Prompt Corrective Action had been in effect

throughout the 1980s, 12 of the 22 mutual savings

banks that participated in the Net Worth Certificate

Program and recovered would have faced the prospect

of closure, while 50 of the 236 surviving farm and energy banks in the regulators' 1986 temporary program

might also have been closed.

Impact of Prompt Corrective Action

The Prompt Corrective Action (PCA) provisions of

FDICIA were designed to limit regulatory forbearance

by requiring more­timely and less­discretionary intervention, with the objective of reducing failure costs.

FDICIA mandated that the regulatory authorities

adopt five capitalization categories, ranging from "well

capitalized" to "critically undercapitalized," to serve as

the basis for Prompt Corrective Action. As an institution's capital position declines, the appropriate regulator is required to increase the severity of its actions.

These actions range from restricting asset growth (for

undercapitalized institutions) to closing banks (those

that are critically undercapitalized for a prescribed period). The top four capital categories are defined in

terms of risk­based capital and leverage ratios. Critically undercapitalized institutions are those with tangible capital ratios of 2 percent or less. In general, a

receiver must be appointed for any institution that is

critically undercapitalized for up to 270 days.77

It is difficult to judge what would have happened if

PCA had been in effect during the 1980s, for the behavior of both banks and bank regulators would have

been altered. However, it appears that some banks

that failed might have been closed earlier than they actually were, whereas some banks that survived might

have faced the prospect of being unnecessarily or erroneously closed. Alternatively, banks in the latter group

might have been compelled to try either to recapitalize

earlier than they actually did or to merge with healthier banks. A large majority of banks that failed were

closed within the time frame specified by FDICIA for

critically undercapitalized banks. However, 343 banks

that failed (21 percent of all failures from 1980 to 1992)

with $88 billion in assets would have faced earlier closure because they were critically undercapitalized for

more than 270 days.78 For the same reason, 143 problem banks (those with CAMEL ratings of 4 or 5) with

$11 billion in assets that did not fail would have faced

the possibility of unnecessary closure because of the 2

percent rule.

Of the 343 failed banks that would have been closed

earlier under the PCA rule, 201 (59 percent) were national banks, 131 (38 percent) were state nonmember

banks, and 11 (3 percent) were state member banks. In

the case of national banks, closure is the responsibility

of the OCC; in the case of state­chartered institutions,

of state banking departments. In the states that had

the most closings and the most late closings, the state

authorities closed problem banks more quickly than

the OCC did.79 The difference was especially apparent in Texas and Oklahoma, which accounted for a disproportionate number of bank failures. Part of the

difference was due to the fact that state banking authorities had greater flexibility under applicable law.

The OCC had statutory authority to close a national

bank "whenever the Comptroller shall become satisfied of the insolvency of the bank" (12 U.S.C. 191).

Thus, the OCC had to wait until the bank was insolvent before being able to close it. On the other hand,

the six states had the authority to close banks when

capital was "impaired," when the bank faced "imminent insolvency" or was in an "unsafe" or "unsound"

condition. These more flexible standards made it possible for the states to close banks earlier.80 However,

although the OCC's closing policy was constrained by

the statutory­insolvency rule, the agency had wide latitude to define insolvency and presumably could have

adopted a more flexible standard than was actually in

effect during most of the 1980s. Until December 1989,

the OCC's definition of insolvency was the exhaustion

of primary capital (equity plus loan­loss reserves). In

December 1989, after approximately a year of study,

the OCC shifted to equity capital alone, without loss

77	 Under FDICIA, when an institution is critically undercapitalized for

90 days a receiver or conservator must be appointed or some other action must be taken to achieve the purpose of the provision. The 90­day

delay may be extended, provided that the regulator and the FDIC

concur and document why extension would better serve the purposes

of the provision. After the institution has been critically undercapitalized for 270 days, a receiver or conservator must be appointed unless

the regulator and the FDIC certify that the institution is viable and not

expected to fail. Under the conditions existing in the 1980s when failures were bunched and the market for failed institutions was often saturated, it seems reasonable to suppose that taking more than 90 days

to spread out marketing efforts for failed banks would have been an acceptable reason for delay up to the 270­day limit.

78	 Excluded from this analysis are banks that participated in forbearance

programs mandated or inspired by Congress.

79	 In six states (California, Colorado, Louisiana, New York, Oklahoma,

and Texas) the OCC closed 473 banks during the 1980-92 period, 38

percent of which were closed later than would have been required under PCA. The state authorities closed 459 banks, 17 percent of which

were closed later than would have been required under PCA.

80	 Information on the statutory authority of the six state banking departments is based on conversations with representatives of each of the six

departments.

30
The Banking Crises of the 1980s and Early 1990s

reserves, and the new definition permitted more expeditious closing of national banks.81 This change was

made after most of the failures of the 1980s had already

been resolved.

Estimates of the cost savings that would have resulted from the earlier closure of failed institutions are necessarily very rough.82 For most of the 343 banks that

would have faced earlier closure if PCA had been in effect, the interval between the date that closure would

have been required by PCA and the actual closure date

was approximately two quarters.83 During this interval, these banks experienced a reduction in equity

from $220 million to a negative $1.6 billion. But a large

part of this reduction was due to the recognition of losses that were already embedded in loan portfolios and

would not have been affected by more­timely closure.

Another portion-chiefly operating losses associated

with higher private­sector funding costs and the cost of

operating retail bank branch systems-could have

been avoided by earlier closure. This avoidable cost

for the 343 banks is estimated to be on the order of

$825 million and constituted 8 percent of the actual estimated resolution costs of the 343 banks and approximately 2 percent of the cost of all bank failures during

the 1980-92 period.84 Approximately 60 percent of the

$825 million estimated cost savings is attributable to six

large banks.

An alternative estimate of the avoidable cost, based

on net operating losses, produced essentially the same

aggregate result. For the 343 banks, net operating losses before loan­loss provisions, gains/losses on asset

transactions, taxes, and extraordinary items totaled

$815 million for the intervals between closure dates required by PCA and actual closure dates. As with the

previous estimate, these losses were concentrated in a

few large banks.

A number of caveats are in order when one considers these estimates. Regulators' bank closure policies

would have been different if PCA had been in effect in

the 1980s, and such policy changes might have reduced

projected cost savings. For example, for the large number of banks that were allowed to operate with tangible

capital below the 2 percent level for only a few months

beyond the interval allowed by PCA, earlier closure

might have meant that, because of insufficient time to

market the institutions among potential acquirers,

more institutions would have been resolved through

insured­deposit payoffs.85 This likelihood would have

been greatest in periods when failures were bunched,

temporarily saturating the market for failed bank and

thrift deposit franchises and assets. Spreading closings

over a longer period of time might have attracted better bids and offset some of the additional costs resulting from delayed closings. Thus for many of the 343

banks, the cost savings resulting from earlier implementation of PCA might have been smaller than the

estimates set forth above suggest. For the six large

banks that operated for extended periods of time with

minimal capital, earlier closure would probably have

achieved cost savings. For some of these banks, fairly

lengthy marketing periods might have been needed

and, because of PCA, regulators might have had to start

the marketing process while the banks had capital

above the 2 percent tangible level. In any event, whatever savings might have been achieved through earlier

closure would apparently have been concentrated

largely in a few large banks that were permitted to operate with little or no equity for relatively long periods

of time.

During the interval between the actual and the

PCA­required closure dates, problem institutions were

generally under close supervision and many of them

were subjects of enforcement actions aimed at reducing losses to the insurance fund. Of the 343 failed

banks that would have faced earlier closure under

PCA, 127 were FDIC­supervised state nonmember

81 OCC, Bulletin BB­89­39 (December 13, 1989).

82	 The calculations are described in note 84. R. Alton Gilbert concluded,

contrary to the implications of this study, that FDIC resolution costs

were not positively related to the length of time that banks operated

with relatively low capital ratios before their failure. See "The Effects

of Legislating Prompt Corrective Action on the Bank Insurance

Fund," Federal Reserve Bank of St. Louis Review 74, no. 4 (July/August 1992): 3-22.

83	 The unweighted average interval was two quarters. Weighted by assets, the average interval was three quarters, reflecting the especially

long intervals for a few large banks.

84	 The avoidable cost is estimated as the sum of (1) the actual funding

costs of these banks minus the one­year Treasury rate and (2) the operating expenses of transactions and nontransactions deposit accounts

as estimated by the 1990 Functional Cost Analysis of the Federal Reserve Board. The avoidable cost was computed for the period of time

beyond 270 days that the bank's tangible capital ratio was below 2 percent. In cases where the tangible capital ratio fluctuated below and

above 2 percent, the bank was considered to be critically undercapitalized for the entire period after the ratio first fell below 2 percent, except when the ratio subsequently rose above 3 percent. In the latter

case, that bank was counted as critically undercapitalized only for the

period it was below 2 percent subsequent to having reached the 3 percent level. Two large savings banks that had entered into Income

Maintenance Agreements with the FDIC in connection with the acquisition of other failed institutions were counted as critically undercapitalized from the time the bank's agreement was terminated (in one

case) and (in the other case) from the date the FDIC formally permitted the bank to miss capital targets prescribed in its agreement.

85	 This possibility was pointed out by R. Alton Gilbert. See his comments in volume 2 of the FDIC's study, History of the Eighties-Lessons

for the Future: An Examination of the Banking Crises of the 1980s and Early 1990s (1997).

31
FDIC Banking Review

banks for which enforcement data are available. Of the

127 banks, 101 (approximately 80 percent) had been issued formal enforcement actions before the closure

date required by PCA-in fact, an average of 14

months before-and the remaining 26 banks might

have had informal enforcement actions.86 

The consequences of unnecessarily closing some of

the 143 problem banks that were below the 2 percent

level but did not fail must be weighed against the cost

savings of closing failed banks earlier. As noted above,

some of these banks would have recapitalized or would

have merged sooner to avoid closure.87 However, any

unnecessary or erroneous closure of these institutions

would be difficult to justify and might have involved

unnecessary deadweight bankruptcy costs. In any future period of widespread failures, balancing the benefits of earlier closure against the consequences of

closing some banks that otherwise would have survived may be difficult. Presumably banks will strive to

avoid becoming subject to the 2 percent rule, or to any

other similarly binding rule, by maintaining capital levels higher than they otherwise would or by seeking

merger partners while they still have value. However,

the history of the 1980s shows that capital levels may

decline quickly in the face of external shocks or other

unforeseen events. Or at times the market may temporarily undervalue a bank franchise, making it difficult for some banks to secure external capital when

they are in danger of failing the 2 percent rule. Thus,

in some future period of widespread depository­institution failures, the issue of erroneously closing salvageable institutions may be unavoidable and critical in

implementing statutory closure rules.

The computations that produced the estimates that

343 failing banks would have been closed earlier and

143 banks might have been unnecessarily closed as a

result of the application of PCA in the 1980s did not include banks in the class­of­bank forbearance programs,

because the assumptions underlying these programs

were obviously at variance with the later views of Congress as expressed by the PCA provision of FDICIA.

However, for the sake of completeness, separate calculations using the same methodology were made for the

banks that participated in these forbearance programs.

The results show that (1) 48 banks with $11 billion in

assets that actually failed would have been closed earlier as a result of PCA, and (2) 66 banks with $16 billion

in assets that actually survived would have been closed.

In addition to the closure of critically undercapitalized banks, FDICIA requires specific regulatory

intervention geared to capital positions of open

banks. For example, in the case of undercapitalized

banks, FDICIA requires regulators to have the bank

submit a capital restoration plan, restrict asset growth,

and get prior approval for expansion. For significantly

undercapitalized banks, more­stringent actions are prescribed. In this regard, a study of the New England

banking crisis, which occurred before the adoption of

FDICIA in 1991, found that regulators were already

imposing formal actions on banks before they became

undercapitalized as defined by PCA. Moreover, according to the study, the regulators imposed restrictions

more comprehensive than those prescribed in the PCA

legislation.88 The reason given for this result is that

capital ratios prescribed in PCA are lagging indicators

of the health of the institution and will trigger enforcement action well after problems are identified in examinations. Examiners analyze considerably more

information than capital ratios to determine a bank's

likelihood of failure. Therefore, more­timely intervention would result from triggers that mimic the timing of

problem­bank identification by examiners. This view

of the lagging nature of capital ratios is consistent with

the findings summarized below in the section on offsite monitoring.

Effectiveness of Supervisory Tools:
 

Examination and Enforcement
 

The increased number of bank failures in the 1980s

raised questions about the effectiveness of bank regulators' systems of identifying problem banks and then

influencing their behavior in order to prevent failures

and reduce insurance losses. The evidence suggests

that bank examination ratings provided a reasonably

accurate indication of the prospect of failure if the ratings were based on recent examinations. But in the

86	 Data on formal enforcement actions (such as cease­and­desist orders

and terminations of insurance) are presented here only for FDIC­supervised state nonmember banks. Comparable data are not available

for OCC­supervised banks; relatively few banks were supervised by

the Federal Reserve. Systematic data on informal enforcement actions

are unavailable for the FDIC and the OCC.

87	 The cost of unnecessary or erroneous closure of banks that would otherwise have survived is likely to be large if bankruptcy costs are high

and if investors undervalue the assets of the banks. As noted by Stanley C. Silverberg in volume 2 of History of the Eighties, "Early resolution

works very well when the market places reasonable or high valuations

on bank franchises. However, in, say, 1990, the stock prices of several

of the most conservatively run banks were well below book value. Investors and other banks were reluctant to pay positive prices for troubled banks without FDIC assistance. That has changed considerably

during the past several years."

88	 Joe Peek and Eric S. Rosengren, "The Use of Capital Ratios to Trigger Intervention in Problem Banks: Too Little, Too Late," Federal

Reserve Bank of Boston New England Economic Review (September/

October 1996). See also Peek and Rosengren, "Will Legislated Early

Intervention Prevent the Next Banking Crisis?" working paper series

no. 96­5, Federal Reserve Bank of Boston, September 1996.

32
The Banking Crises of the 1980s and Early 1990s

early and middle 1980s many banks were not examined frequently, and the ratings available for them at

any point tended to be obsolete. Troubled banks that

were properly identified, however, were generally subject to enforcement actions that appear to have been

effective in reducing insurance losses. The critical issues, therefore, are the frequency and use of examinations, the effectiveness and limitations of CAMEL

ratings, and the effectiveness of follow­up enforcement

actions.

Evolution in the fre�uency and use of examinations. In

the late 1970s and early 1980s, the bank examination

process was affected by two key policy changes embraced particularly by the OCC and the FDIC: (1) relatively more reliance was placed on off­site monitoring

and relatively less on on­site examination, and (2) examination resources were concentrated on those institutions that posed the greatest threat to the insurance

fund and to the stability of the financial system. These

changes were made partly because it was believed that

comprehensive Call Report data and the use of computer technology would enhance off­site surveillance

and enable the agencies to reduce the examination

burdens on banks and on their own staffs. Further, the

decision to concentrate resources on the larger and the

more­troubled banks was seen as an efficient allocation

of resources. (Both the FDIC and the Federal Reserve

also made increasing use of state bank examinations for

nonproblem institutions.) Another important change

took place at the OCC, where the traditional emphasis

on a detailed audit and verification system was replaced by a focus on the quality of management and internal policies. The OCC also placed increased weight

on targeted examinations, which focused on a particular aspect of a bank's operations, rather than full­scope

examinations. 

These policy changes implied that fewer examiners

would be needed. In addition, both the Carter and

Reagan administrations restricted federal hiring in an

attempt to reduce the size of the federal government.

In this climate, the FDIC and the OCC froze examiner staffing levels in 1981. As a result, between 1979 and

1984 the total number of examiners in federal and state

banking agencies declined by 14 percent (see table

1.9). Among the agencies, the reductions varied in size:

examiner staffing at the FDIC declined by 19 percent,

at the OCC by 20 percent, and at state agencies by 12

percent. At the Federal Reserve, examiner staffing

was largely unchanged. While examination forces were

being reduced, the total number of troubled banks was

increasing from 217 in 1980 to 1,140 in 1985. In the

mid­1980s, therefore, the FDIC and the OCC began to

rebuild examiner staffs-but several years of training

are required to produce qualified examiners, so it was

not until the late 1980s that the examiner forces at

those two agencies were restored to 1980 levels in

number and experience.89

These trends in examiner staffing contributed to

marked changes in the number and frequency of examinations. Between 1981 and the low point of 1985,

the number of examinations declined from approximately 12,300 to 8,300. The decline was particularly

sharp for state nonmember banks; for national banks

and state member banks it was less severe. In 1979,

the average length of time between examinations was

379 days, or 13 months (see table 1.10). By 1986, the

average interval had increased to 609 days, or 20

89 The demands on the shrunken examiner staffs extended to training

new hires and taking on duties related to settlement and asset liquidation for failed banks.

Table 1.9
 

Number of Bank Examiners, Federal and State Banking Agencies,
 

1979-1994
 

Year FDIC FRS OCC States Total

1979 1,713 805 2,151 2,496 7,165

1984' 1,389 820 1,722 2,201 6,132

1990 2,645 1,025 1,907 2,470 8,047

1994 2,547 1,529 2,376 2,564 9,016

Source: Compiled by FDIC on the basis of information from FRS, OCC, and Conference of State Bank Supervisors.

'Trough in total number of examiners.

33
FDIC Banking Review

Table 1.10

Mean Examination Interval, by Initial Composite CAMEL Rating (in days)

Year 1 2 3 4 5 All Banks

1979

1986'

1990

1994

392

845

463

380

396

656

436

357

338

407

331

296

285

363

303

279

257

313

270

245

379

609

411

354

Source: FDIC, FRS, and OCC.

'Peak of mean intervals.

months. The greatest change was for CAMEL 1­rated

banks, whose average interval increased from 392 days

to 845, or from 13 to 28 months. The increase in examination intervals was greatest at the OCC and the

FDIC and smallest at the Federal Reserve. As the

agencies built up their examination staffs in the late

1980s, intervals between examinations shortened once

again, and by 1990, the average interval was 411 days

(14 months) for all banks; for all banks with CAMEL

ratings below 2, it was one year or less. In 1991 FDICIA

reinforced the return to greater frequency of examinations by requiring annual full­scope examinations for

all banks, except that for small banks with satisfactory

ratings an 18­month interval could be substituted.90

For some banks during the mid­1980s, these

changes meant that CAMEL ratings and other information derived from examinations were sometimes obsolete and unrepresentative. CAMEL ratings are a

measure of the condition of a bank essentially at the

time it is examined; as a bank's condition changes, old

ratings become increasingly inaccurate as indicators of

its current health.91 Problems developing at some

banks in the 1980s were not identified on a timely basis; this view is supported by examiners interviewed for

this study, who indicated that extended examination

intervals and increased demands on staff resources

meant that some banks received insufficient attention.

For example, banks that were well rated but deteriorating might not receive attention until it was too late

to prevent serious losses. In Texas, which had the

largest concentration of bank failures and losses to the

insurance fund, the problem of extended examination

intervals was particularly acute. The severe problems

of some Texas banks might have been recognized

sooner if examinations had been more frequent.92

The reduced frequency of examinations limited the

usefulness not only of information derived from the examinations but also of the financial reports used in offsite monitoring. On­site examiners are able to evaluate

the quality of the loan portfolio and verify the data on

nonperforming loans and loan charge­offs that banks

report in Call Reports.93 In other words, on­site examinations are needed to ensure the accuracy of bank financial reports. If examinations are less frequent, the

accuracy of off­site monitoring systems using Call Report data suffers.

Effectiveness of CAMEL ratings. When examination

ratings were up­to­date, they generally identified most

of the banks that required increased supervisory attention well before the banks actually failed. As shown in

figure 1.9, of the more than 1,600 banks that failed in

1980-94, 36 percent had CAMEL 1 and 2 ratings two

years before failure; 25 percent had ratings of 3, 31 percent had ratings of 4, and 8 percent had ratings of 5.

But these data refer to examination ratings available

two years before failure, whereas some of the examinations had actually been conducted considerably more

than two years before failure. Also included in these

data are banks that failed for types of reasons that cannot be anticipated well in advance by safety­andsoundness examinations: cross­guarantee failures;

failures due to fraud; and failures of affiliates of certain

Texas holding companies that were essentially operating as branches of the parent institution, were tracked

outside the CAMEL system, and were resolved

through procedures that had much the same effect as

90	 John O'Keefe and Drew Dahl, "The Scheduling and Reliability of

Bank Examinations: The Effects of FDICIA" (unpublished paper presented at the Financial Management Association conference, October

1995).

91	 Rebel A. Cole and Jeffery W. Gunther, "A CAMEL Rating's Shelf

Life," Federal Reserve Bank of Dallas Financial Industry Studies (December 1995). Cole and Gunther concluded that the information content of CAMEL ratings decays rapidly; examination ratings indicate

bank survivability more accurately than off­site monitoring does for

two quarters after examinations; for periods longer than two quarters,

examinations are less accurate than off­site monitoring. 

92 O'Keefe, "The Texas Banking Crisis."

93	 R. Alton Gilbert, "Implications of Annual Examinations for the Bank

Insurance Fund," Federal Reserve Bank of St. Louis Review 75, no. 1

(January/February 1993); and Drew Dahl, Gerald A. Hanweck, and

John O'Keefe, "The Influence of Auditors and Examiners on Accounting Discretion in the Banking Industry," unpublished paper presented at Academy of Financial Services conference (October 1995).

34
The Banking Crises of the 1980s and Early 1990s

Figure 1.9

Composite CAMEL Ratings Two Years before
 

Failure for Banks Failing between 1980 and 1994
 

CAMEL Rating

1 and 2

3

4

5

0 10 20 30 40

36%

25%

8%

26%

28%

10%

As a Percentage of Failing Banks

31%

36%

All Available Ratings Ratings Less Than One Year Old*

*Ratingsthat were lessthan one year old as ofthe two-years-before-failure date;

that is, ratings based on examinations dated between two and three years

before failure.

cross­guarantees.94 If we exclude examinations for

these banks as well as examinations that are more than

one year old,95 the percentage of failed banks that had

CAMEL 1 and 2 ratings two years before failure drops

to 16 percent of the total number of failures (see table

1.11).96 In other words, the proportion of failed banks

that were not identified as requiring increased scrutiny

two years before their failure was 16 percent.97

Over the course of the 1980-94 period, the record of

CAMEL ratings in anticipating failures improved as

the frequency of examinations increased and problems

were apparently better identified. From the period

1980-86 to the period 1987-94, the proportion of failed

banks that had CAMEL 1 and 2 ratings two years before failure declined from 28 to 12 percent. Similarly,

94 In the case of First RepublicBank Corporation, the FDIC's demand

that affiliate banks honor their pledge to back the agency's assistance

to the lead bank caused the affiliates to fail. In the case of First City

Bancorporation, the FDIC provided assistance to the holding company

and required that it be downstreamed to the affiliates. One may argue

that examiners should consider what the condition of the lead bank implies for the condition of affiliated banks in the holding company. However, examiners could not have known two years in advance the nature

of the resolution arrangements that would be adopted in these two cases and in post­FIRREA cross­guarantee cases and their effects on other banks in the company.

95 Exclusion of banks with ratings that were more than one year old two

years before failure means, in effect, that the data refer to examinations conducted between two and three years before failure.

96 Banks with CAMEL 1 and 2 ratings are treated here as a separate catthe proportion of failed banks that had CAMEL 4 and

5 ratings two years before failure rose from 25 to 46 percent.98

Limitations of examination ratings. Although CAMEL

ratings were reasonably successful in identifying banks

that required greater supervisory attention, they also

had limitations. First, they did not necessarily capture

the severity of the situation of the banks that subsequently failed. Second, they are based on the internal

operations of the bank and therefore do not take into

account local economic developments that may pose

future problems and are not yet reflected in the bank's

condition. Third, as noted above, they are generally a

measure of the condition of the bank at the time it is

examined. They do not systematically track risk facegory from banks with worse ratings. CAMEL 1­ and 2­rated banks are

defined as "basically sound in every respect" or "fundamentally

sound, but may reflect modest weaknesses correctable in the normal

course of business." Banks with a CAMEL 3 rating "give cause for supervisory concern and require more than normal supervision," while

CAMEL 4 and 5 ratings are reserved for progressively weaker banks.

97 For banks with assets of more than $250 million, the proportion was 15

percent. This suggests that the effectiveness of CAMEL ratings in anticipating failures was about the same for large and small banks.

98 Data are the numbers of failed banks that had the indicated CAMEL

ratings two years before failure in each year, weighted by the total

number of failures in that year. The data are based on 260 banks after

exclusion of examinations more than one year old, failures due to

fraud, cross­guarantees, and the subsidiaries of two Texas bank holding companies (table 1.11).

35
FDIC Banking Review

Table 1.11
 

Failing Banks with CAMEL Ratings of 1 or 2 Two Years before Failure,
 

1980-1994
 

Number Percent of Total Failures

Total 1­ and 2­rated future failures 565 35%

Specific types:

Cross­guarantee cases

Failures associated with fraud

25

24

First City Bancorporation affiliates

First RepublicBank Corporation affiliates

CAMEL ratings more than one year old'

Total of above

36

26

194

305 19

Remaining 1­ and 2­rated future failures 260 16

' Failures of banks with ratings more than one year old (two years before failure) do not include cross­guarantee cases,

failures associated with fraud, First City Bancorporation affiliates, or First RepublicBank Corporation affiliates.

tors that may produce future losses.99 Fourth, frequent

use of on­site examinations imposes a burden on depository institutions. Examinations may seem particularly burdensome during good economic times, when

the condition of most banks is healthy and examination

ratings change relatively little. An average of 85 percent of all banks examined each year during the

1980-94 period experienced either no change or an improvement in ratings; only 15 percent, on average, experienced ratings downgrades. However, examination

ratings changed considerably more often in particular

regions of the country and during periods of regional

recessions.

Most banks that are designated as troubled banks

(rated CAMEL 4 and 5) do not fail. This may be regarded as a deficiency of CAMEL ratings. On the other hand, examination ratings trigger the supervisory

responses that may prevent troubled banks from failing

or may reduce failure costs when the banks have to be

closed. From this perspective, when supervisory efforts to cure bank problems as revealed by examinations have been successful, the failure forecasts based

on these examinations will necessarily prove to have

been inaccurate. Either way, the large number of troubled banks that do not fail and the large number of

banks whose ratings do not change through repeated

examinations are unavoidable consequences of frequent use of on­site examinations. However, on­site

examinations provide information to the regulators that

is otherwise unavailable,100 and they also help ensure

the accuracy of financial reports issued by the

banks.101 As a result, the burdens of frequent examinations must be borne if the condition of insured banks is

to be monitored effectively. Recognizing these burdens, the FDIC has sought to reduce the time examiners spend in banks and is developing a program

designed to allow individual loan files to be examined

off­site.

Number kinds and effectiveness of enforcement actions.

After troubled institutions were identified during the

1980-94 period, they were subject to supervisory and

enforcement actions that appear to have been effective

in reducing failures and losses to the insurance fund.

This conclusion is based on evidence concerning the

behavior of banks with respect to asset growth rates,

dividend payouts, and equity infusions when the banks

had been designated as problem institutions and been

made subject to informal and formal enforcement actions.102

The FDIC used formal enforcement actions (for example, cease­and­desist orders) sparingly in the 1970s

but more frequently in the early 1980s, as the number

of troubled banks increased. Formal enforcement actions are legally enforceable in court, and noncompliance with such actions may lead to heavy fines. Most

99	 A possible exception is the management rating, which encompasses

technical competence, leadership qualities, adequacy of internal controls, and other factors that may determine the bank's ability to weather future adversity. However, examiners appear to be reluctant to rate

management much below capital, asset quality, and other CAMEL

components. In this regard, in only 6 percent of failed banks were the

management ratings of two years before failure one full number worse

than the average of other components.

100	 The view that examinations yield unique information is largely based

on the belief that banks specialize in evaluating and monitoring idiosyncratic borrowers who do not have practical access to the capital

markets. This view suggests that the best way to secure the private information banks have gathered about borrowers is by examining individual loan files.

101	 See Drew Dahl, Gerald A. Hanweck, and John O'Keefe, "The Influence of Auditors and Examiners on Accounting Discretion in the

Banking Industry," and Gilbert, "Implications of Annual Examinations." 

102 Data on enforcement actions are available for FDIC­ and Federal Reserve-supervised banks only.

36
The Banking Crises of the 1980s and Early 1990s

FDIC formal enforcement actions in the 1980s were issued against 4­rated banks, which are troubled but salvageable; most of the remainder were issued against

5­rated banks, which face a high probability of imminent or near­term failure. About one­half of all banks

rated 4 and 5 by the FDIC in the 1980s were the subject of formal enforcement actions; many of the remaining banks received informal enforcement actions

(for example, memoranda of understanding).103 Enforcement actions require banks to take corrective actions in various areas: compliance with regulations,

improvement in operating procedures, the raising of

new capital, the cutting of dividend payments, replacement of managers, and so forth.

That supervisory and enforcement actions were effective in reducing failures and losses to the insurance

fund is suggested by the following:

•	 Of all banks that were rated 4 and 5 sometime

during the 1980-94 period, 73 percent recovered, while 27 percent failed. As noted above,

one­half of the FDIC­supervised problem

banks were the subject of formal enforcement

actions, and many others received informal

actions.

•	 For all insured banks rated 4 and 5, in the three

years before failure or recovery their asset

growth and dividend payout rates declined

(see table 1.12).104 (Recovery was defined as

either a CAMEL rating upgrade to 1, 2, or 3 or

merger without FDIC financial assistance.)

Capital injections generally increased over the

three years before recovery for the banks that

recovered, and from the third to the second

year before failure for the banks that failed. 

•	 The data in table 1.12 suggest that in the later

years of the banking crisis, supervisory efforts

to reduce risk taking and insurance losses became increasingly aggressive. During 1992-94,

for both failed banks and survivors, the levels

to which asset growth rates and dividend payouts dropped in the final year before failure or

Table 1.12
 

Asset Growth Rates, Dividend Payments, and Capital In�ections,
 

All Banks with CAMEL Ratings of 4 and 5, 1980-1994
 

Total Banks

Years before Failed Banks Surviving Banks (Failed and Surviving)

Failure, Years Years of Recovery' Years of Failure, Recovery,'

Recovery, of Failure or Merger or Merger

or Merger 1980-85 1986-91 1992-94 1980-85 1986-91 1992-94 1980-85 1986-91 1992-94

Asset Growth Rate (Percent)

3 14.60 15.65 18.77 10.39 13.38 4.42 11.91 14.09 5.93

2 10.72 1.71 −3.53 3.67 1.25 −0.61 6.21 1.40 −0.92

1 0.91 −10.17 −13.39 1.96 0.96 −0.64 1.58 −2.51 −1.98

Dividends to Average Assets (Percent)

3 0.34 0.42 0.09 0.20 0.21 0.13 0.25 0.21 0.13

2 0.32 0.52 0.06 0.16 0.14 0.09 0.22 0.15 0.09

1 0.16 0.39 0.02 0.13 0.13 0.08 0.14 0.11 0.07

Capital In�ections to Average Assets (Percent)

3 0.18 0.42 0.45 0.19 0.46 0.42 0.19 0.45 0.42

2 0.22 0.52 0.54 0.39 0.56 0.42 0.33 0.55 0.43

1 0.65 0.39 0.40 0.44 0.45 0.49 0.51 0.43 0.48

Note: Data are unweighted averages of individual bank percentages.

'Recovery is either the date of a bank's unassisted merger, or if the bank survived as an independent institution, the

date it received a CAMEL rating of 1, 2, or 3.

103 In a sample of 307 FDIC­supervised problem banks there were 209 pressed as a percentage of net income or as a percentage of assets.

with formal actions, 83 with informal actions only, and merely 15 with Capital injections include stock transactions, capital contributed

neither formal nor informal actions. through merger, and capital transactions with parent holding companies. 104 For dividends, similar results are produced whether dividends are ex37
FDIC Banking Review

recovery were considerably lower than had

been the case during the 1980-85 period.105

Table 1.12 and the preceding pages summarize an

analysis of the behavior of problem banks in relation to

the dates of their failure or recovery. Problem­bank behavior was also analyzed in relation to the dates of regulatory intervention. For purposes of this second

analysis, the dates of regulatory intervention were taken to be the dates of on­site examinations that led to either formal enforcement actions or downgrades in

CAMEL ratings without such actions.106 The purpose

was to test more directly the effects of formal and informal enforcement actions on problem­bank behavior.

(As noted before, most problem banks that did not receive formal enforcement actions received informal

ones.) As shown in figure 1.10, at FDIC­ and Federal

Reserve-supervised banks with CAMEL ratings of 4,

median quarterly asset growth rates declined before

the date of regulatory intervention and generally remained negative in the four quarters immediately following the intervention.107 This was true both for

banks that were downgraded to a CAMEL 4 rating and

had no formal enforcement action taken against them

and for 4­rated banks that eventually did receive formal actions. Growth rates of banks with formal enforcement actions showed greater changes, on average,

from before intervention to after intervention than

growth rates of banks without such actions.108 Similar

results were produced by other measures of bank behavior (see figure 1.11). Dividend rate reductions and

increases in external capital injections began before

regulatory intervention and generally continued in the

first year after intervention, and banks that became the

subject of formal enforcement actions showed the

greatest dividend cuts and capital injections.109 Comparable behavior was also exhibited by loan­loss provisions (not shown in figure 1.11).

The foregoing analysis indicates that bank managements took remedial actions even before the examinations that triggered reductions in CAMEL ratings or

led to formal enforcement actions. Whether these remedial actions were driven by market forces, by management's own objectives, or by expectations of future

regulatory action cannot be readily ascertained. In any

event, regulatory intervention apparently had the effect of reinforcing and accelerating these remedial actions. Changes in the behavior of problem banks were

greater for banks that later received formal enforcement actions as compared with banks subject only to

informal actions. However, it is not clear whether

these differences in behavioral change were due primarily to the more demanding nature of formal actions

or to the condition and behavior of the banks that received them. Formal actions are frequently taken

when banks fail to comply with informal ones. Such

failure may be due to the existence of more severe

problems at the banks receiving formal actions or to

less willingness on the part of their management to

cure them.110

In general, the reduction in asset growth was an indication that moral hazard was being contained-that

troubled banks were not attempting, or were not being

allowed, to "grow out of their problems"; indeed, in

many cases their assets were shrinking. In the case of

the surviving banks, reduced dividend payouts and increased capital injections helped restore equity positions and were instrumental in facilitating recovery. In

the case of the failing banks, dividend cuts and new

capital had the direct effect of reducing failure costs.111

105	 R. Alton Gilbert found that undercapitalized banks during the

1985-89 period generally did not grow rapidly, pay dividends, or

make loans to insiders. See his "Supervision of Under­Capitalized

Banks: Is There a Case for Change," Federal Reserve Bank of St.

Louis Review 74, no. 4 (1992): 3-20.

106	 Enforcement data in this analysis are based on 2,398 formal actions issued by the FDIC and 362 by the Federal Reserve. Comparable data

are not available for the OCC. Intervention dates are (1) the date of

the examination that resulted in a downgrading of the bank to a

CAMEL 3, 4, or 5 rating for the first time without a formal enforcement action or (2) the date of the last examination before the issuance

of a formal enforcement action for banks receiving such actions. At

the end of the examination the bank would normally be informed of

conditions that were likely to result in such downgrades or of the likelihood of formal enforcement actions. Actual issuance of the formal

enforcement actions would not take place until six to nine months after the examination. For FDIC­supervised banks, the median interval between the date of formal enforcement actions and the last

examination before such actions was 261 days for 4­rated banks and

176 days for 5­rated banks.

107	 It is not clear that the remedial actions taken by management before

regulatory intervention were purely voluntary and would have been

undertaken even if such intervention had not been expected. See

also George E. French, "Early Action for Troubled Banks," FDIC

Banking Review 4, no. 2 (1991): 1-12.

108	 Similar patterns in growth rates were found for banks with CAMEL

5 ratings. For banks with CAMEL ratings of 3 that were subject to

formal enforcement actions, however, growth rates were highly variable, perhaps because for these banks the number of such actions was

relatively small.

109	 Data for capital injections are annual in figure 1.11 because small

banks do not report capital injections quarterly. The analysis was confined to 4­rated banks in order to have large samples of banks with

similar conditions.

110	 Seventy­one percent of problem banks that failed had received formal enforcement actions, compared with 41 percent of problem

banks that survived. This is consistent with the view that formal actions were taken against the most unhealthy banks.

111	 Although dividend payout ratios declined for troubled banks, a significant number of undercapitalized banks did pay dividends. See

David K. Horne, "Bank Dividend Patterns," FDIC Banking Review 4,

no. 2 (1991): 13-24.

38
The Banking Crises of the 1980s and Early 1990s

Figure 1.10

Median Asset Growth Rates of CAMEL 4-Rated Banks before and
 

after Regulatory Intervention
 

(Annualized)
 

Percent 1979–1985	 Percent 1985–1990

-4 -3 -2 -1 0 1 2 3 4

-8

-4

0

4

8

12

-4 -3 -2 -1 0 1 2 3 4

-8

-4

0

4

8

Quarter Relative to Intervention Quarter Relative to Intervention

Percent 1990–1995

-4 -3 -2 -1 0 1 2 3 4

Quarter Relative to Intervention

-12

-8

-4

0

4

8

Banks Downgraded to CAMEL 4 Rating That Received No Formal Action

4-Rated Banks That Did Receive Formal Action

Note: Data are median asset growth rates of FDIC- and Federal Reserve–supervised banks before and after regulatory

intervention. Forthis analysis, the intervention dates were dates of:

(1) examinations that resulted in the downgrading of the bank's CAMEL rating to 4 but did not result in a formal

enforcement action, or

(2) the last examination before the issuance of a formal enforcement action against a bank with a CAMEL 4 rating.

Normally, a bank is informed at the time of the examination of the prospect of a CAMEL rating downgrade or a formal

enforcement action. Data were run on a constant population sample for each period. The number of observationsranged from

200 to almost 500 for the different periods for banks downgraded to CAMEL 4 rating that did not receive formal enforcement

actions, and from200 to 300 for 4-rated banksthat did receive formal enforcement actions.

These favorable results, no matter what the immediate	 banks of attractive investment opportunities and restimulus, were consistent with the regulators' objec­ quired them to sell high­quality assets they already

tives of preventing the failure of troubled banks and re­ owned.112 Similarly, it is sometimes argued that cuts

ducing the insurance costs of banks that did fail.	 in dividends may have retarded the growth of exterThe policy of encouraging or for nal capital infusions. It should be remembered, how­ cing problem banks

ever, that the range of choices available to regulators to retrench and shrink has been criticized by some ob­ in dealing with problem banks was limited and per­ servers for inhibiting the banks' recovery and, in the

context of the 1990s, for contributing to the "credit

crunch." For example, it is sometimes argued that restrictions on asset growth may have deprived problem 112 See comments by Joe Peek in volume 2 of History of the Eighties.

39
FDIC Banking Review

Figure 1.11

Dividend Rates and Capital Infusions of CAMEL 4-Rated Banks

before and after Regulatory Intervention

Dividends Capital Infusions

1979–1985 1979–1985 Percent of Assets Percent of Assets

0.25 2.0

0.20 1.6

0.15 1.2

0.10 0.8

0.05 0.4

0 0

1985–1990 1985–1990

0.8

0.3

0.6

0.2

0.4

0.1

0.2

0

1990–1995 1990–1995

2.0 1.0

0.8 1.5

0.6
 

1.0
 

0.4
 

0.5 0.2

0 0

-1 0 1 2 3 -1 0 1 2 3

Year Relative to Intervention Year Relative to Intervention

Banks Downgraded to CAMEL 4 Rating That Received No Formal Action

4-Rated Banks That Did Receive Formal Action

Note: Data are averages of individual bank ratios. See note to figure 1.10.

meated by uncertainty. Many problem banks had exhibited a tendency toward excessive risk taking

and/or managerial and other weaknesses. A more relaxed supervisory posture might have resulted in the

resumption of risk taking and an increase in losses

when an institution failed. Continued dividend payments would also have increased insurance losses if

failure occurred. It is not surprising that bank regulators generally chose the surer course of reducing risktaking opportunities and insurance losses by seeking

the retrenchment and shrinkage of problem banks.

Effectiveness of Supervisory Tools: 

Off-Site Surveillance
 

Off­site monitoring based on financial reports submitted by banks evolved during the 1980s in response

to earlier developments in computer technology and to

fundamental changes in the OCC's examination poli40
The Banking Crises of the 1980s and Early 1990s

cies after two large national banks failed in the

1970s.113 The evolution of off­site monitoring appeared to justify reductions in examination staffing and

frequency. As the number of failures mounted during

the 1980s, however, it became clear that off­site monitoring was not a substitute for, but potentially a useful

complement to, on­site examinations. Compared with

on­site examinations, off­site monitoring systems have

a number of advantages: they are less intrusive and

costly, they can be updated frequently when new information is received through quarterly Call Reports,

they can provide the basis for a financial evaluation of

the bank between examinations, and they are potentially able to isolate risk factors that may lead to future

problems, whereas examinations are essentially a measure of the bank's current condition. Furthermore, Call

Report data on which off­site monitoring systems are

based are largely available to the public and can be

used by investors and others as the basis for imposing

market discipline on the banks. By identifying those

banks that appear to have deteriorated since their last

examinations, the systems can help regulators allocate

examiner resources. 

The disadvantages of off­site monitoring systems

are that they provide no direct evaluation of management, of individual loan characteristics, of underwriting

practices, or of internal controls and procedures. Moreover, the accuracy of the financial reports on which

they are based, particularly the quality of loan portfolios, is dependent on periodic on­site examinations. 

Off­site surveillance systems, despite their distinct

advantages, did not play a very helpful role in the

1980s. On the contrary, belief in their usefulness and

their potential helped reinforce the idea that fewer onsite examinations were necessary. In addition, with the

large number of failed and troubled banks already

straining supervisory resources, targeting banks for additional examinations was not a high priority (staff limitations meant that resources were unavailable to

examine any additional banks targeted by off­site systems). Off­site systems appear to have worked best

when the number of problem institutions and failures

was not large and when examination resources were

sufficient for identified banks to be examined.

Condition and risk factors. Call Report data can be

used to provide an indication of the condition of a bank

and the level of risk it has undertaken. In this context,

condition variables are indicators of the current

strength or weakness of a bank. A bank in a weak condition would typically have low capital and net­income

ratios and high nonperforming­loan ratios. Such a bank

would face insolvency and failure in the near term.

Risk factors, on the other hand, are indicators of a

longer­term problem. A bank may be pursuing risky

policies but still be in a currently healthy condition,

with strong earnings and capital. In time, however, the

risky policies could result in loan losses, reduced income, deterioration in capital, and eventual failure.

(The distinction between condition and risk in this

context is essentially the same as the distinction between ex post and ex ante risk measures discussed

above.)

The possibilities of isolating condition and risk factors by analyzing banks' financial data are illustrated in

figures 1.12 and 1.13. Figure 1.12 shows various measures of the current condition of banks-ratios to assets

of equity, of equity plus reserves minus nonperforming

loans (coverage), of net income, and of nonperforming

loans-as of l982 for banks that failed four to five years

later (in 1986-87) and for banks that existed throughout the period and never failed. On the basis solely of

these condition variables, there was little as of 1982 to

distinguish banks that subsequently failed from those

that did not.114 Although the condition ratios for the

future failures were slightly below those for the future

survivors, they were nonetheless at levels that would

normally be considered healthy; for example, in 1982

the average equity/assets ratio of banks that failed in

1986-87 was over 8 percent. As the banks that failed

approached their dates of failure, their condition ratios

deteriorated markedly compared with those of the

nonfailures. 

Comparisons of long­run risk factors show a considerably different picture (figure 1.13). In 1982 and

throughout the subsequent four to five years, the risk

profile of banks that failed in 1986-87 was distinctly

higher than that of banks that did not fail. Banks that

would fail had substantially higher loans­to­assets ratios than survivors did. They also had substantially

higher ratios of interest and fee income on their loan

and lease portfolios, which suggests that their loans

were riskier. Finally, banks that subsequently failed

113	 See also Jesse Stiller, OCC Bank Examination: A Historical Overview,

(1995).

114	 The data in figures 1.12 and 1.13 include, for 1982, all banks that existed in 1982 and failed in 1986-87 and all banks that existed throughout the 1982-87 period and did not fail after 1987. Certain failures are

excluded: those due primarily to fraud, cross­guarantee failures subsequent to FIRREA, and bank affiliates of two Texas bank holding

companies with CAMEL ratings of 1 and 2 that were essentially

branches of the lead bank and were resolved through transactions

whose effects were similar to cross­guarantees.

41
FDIC Banking Review

Figure 1.12

Bank Condition Ratios for Failed and Nonfailed Banks

1982–1986

A. Equity Ratio* B. Coverage Ratio* Percent Percent

10 10

8
 5
 

6

0

4

-5
 2
 

0 -10

1982 1983 1984 1985 1986 1982 1983 1984 1985 1986

*Equity/assets *(Equity + reserves – nonperforming loans) /assets

C. Return on Assets* D. Nonperforming Loans*

Percent Percent

2

12

0

8

-2

4 -4

0
 

1982 1983 1984 1985 1986
 

-6

1982 1983 1984 1985 1986

*Net income/assets *As a percentage of assets

Banks That Subsequently Failed Banks That Did Not Fail

Note: “Failed” means banks that existed in 1982 and failed in 1986 or 1987; “nonfailed” means banks that existed during

the entire period and never failed.

had higher growth rates in 1982 than the banks that did

not fail, but as the banks approached failure these

growth rates were sharply cut back in a manner consistent with the findings cited above on FDIC enforcement actions.

Many prediction models constructed for the purpose

of predicting bank failures use measures of current

condition (or ex post risk) as independent variables.

Thus, the accuracy of failure predictions falls off considerably for predictions of failures more than one year

ahead. As part of the research for the History of the

Eighties, an attempt was made to use ex ante risk measurements to identify groups of banks that had a high

long­term risk of failure. For this purpose, nine risk ratios were tested: loans to assets, deposits over $100,000

to liabilities, ROA, asset growth rate, loan growth rate,

operating expenses to total expenses, salary expenses

per employee, interest yield on loans and leases, interest and fee income on loans and leases. The banks

were divided into quintiles according to these ratios.

The periods of analysis were four and five years from

1980, 1982, 1984, 1986, and l988. In each period the

42
The Banking Crises of the 1980s and Early 1990s

Figure 1.13

Bank Risk Ratios for Failed and Nonfailed Banks

1982–1986

A. Loans to Assets B. Asset Growth Rate

Percent Percent

60

10

40

0

20

0 -10

1982 1983 1984 1985 1986 1982 1983 1984 1985 1986

C. Interest Income and Fees Ratio* D. Average Employee Salary

Percent $Thousands

8 20

4 10

0 0

1982 1983 1984 1985 1986 1982 1983 1984 1985 1986

*Total interest and fees on loans and leases/total loans and leases

Banks That Subsequently Failed Banks That Did Not Fail

Note: “Failed” means banks that existed in 1982 and failed in 1986 or 1987; “nonfailed” means banks that existed during

the entire period and never failed.

risk ratio with the strongest statistical relationship to

failures turned out to be the ratio of loans to assets.115

For example, 8.20 percent of the banks that were in the

highest loans­to­assets ratio quintile in 1984 failed in

1988-89, compared with 2.89 percent of all banks in

the sample, for an increase of 184 percent in the incidence of failure (see table 1.13).116

The same statistical procedure was applied to the

"low­risk" group (the lowest four quintiles) as measured by the loans­to­assets ratio, and different risk factors proved to be the best predictors of failure in four to

115 Logit regressions were performed on each of the risk variables

where the dependent variable was whether the bank failed or not.

The risk variable with the highest predictive power for failure was

determined by a Chi­Square test score for each regression. The coefficients for each quintile of the variable were then compared, and

a Chi­Square test was performed to determine which quintile or

group of quintiles was the best predictor of failure. The analysis was

then repeated on the high­ and low­risk quintiles to determine

which was the next­best predictor of failure in both groups.

116 In an initial inquiry, the ratio of large deposits to total liabilities was

found to be the best predictor of failures in 1984 and 1986. However, this ratio was found to be essentially a proxy for location in

Texas, where large­scale use of large deposits occurred in part because of restrictions on branching. Once the large­deposit ratio was

excluded, the loans­to­assets ratio was the best predictor of failure

in all years.

43
FDIC Banking Review

Table 1.13
 

Probability of Failure
 

Banks in the Highest Loans­to­Assets Quintile
 

All Sample Banks Highest Loans­to­Assets Quintile

Increase in

Beginning Probability of Number of Probability Number of Percent of Probability

Year of Failure Failures of Failure Failures Total Failures of Failure

1980 1.51% 184 3.62% 88 47.8% 140%

1982 2.45 291 6.75 160 55.0 175

1984 2.89 332 8.20 188 56.6 184

1986 2.25 253 6.46 145 57.3 187

1988 1.24 133 3.36 72 54.1 171

five years (see table 1.14). ROA was the best predictor

of failure for the "low­risk" group in 1984; of the "lowrisk" loans­to­assets group in 1984, 3.96 percent of the

banks in the highest­risk ROA quintile failed in

1988-89.

A number of observations are in order. First, the risk

factors do not predict which individual banks will fail;

rather, they identify a group of banks with the highest

incidence of failure. Second, the risk group encompassing the highest loans­to­assets ratio quintile plus

the high­risk ROA group in the remainder of the banks

in 1984 accounted for 76 percent of all failures in the

entire sample.117 Third, to capture 76 percent of the

total number of failures in 1988-89, the two risk groups

"flagged" a large proportion (34 percent) of the total

number of banks in the sample.118 Fourth, most banks

in the high­risk groups did not fail. For example, nearly 92 percent of the banks in the high­risk loans­to­assets ratio quintile in 1984 did not fail four to five years

later, in 1988-89.

These findings suggest that failing banks shared a

common characteristic: they followed a relatively highrisk strategy, as indicated particularly by the ratio of

loans to assets, and could be identified well in advance

of their failure dates. The findings also indicate that

many other banks had similar risk characteristics but

were able to avoid failure. As indicated above, the success or failure of banks depends on many factors, so

predicting failures far in advance on the basis of the institutions' risk characteristics is difficult.

Specific off­site surveillance systems. The original offsite surveillance systems used in the 1970s were a col117	 The 76 percent was derived as follows: 188 failures in the high­risk

loans­to­assets ratio quintile plus 65 failures in the high­risk ROA

group in the four "low­risk" loans­to­assets quintiles, for a total of

253, or 76 percent of all the 332 failures in the sample.

118	 The 34 percent figure refers to the highest loans­to­assets quintile

plus the highest ROA group of the "low­risk" loans­to­assets quintiles, or 3,935 (2,292 + 1,643) banks. This was 34 percent of the 11,479

banks in the sample. 

Table 1.14

Probability of Failure for "Low­Risk" Banks

(Banks Not in the Highest Loans­to­Assets Quintile)

Failures in Highest­Risk Group of "Low­Risk" Banks

Beginning Highest­Risk Indicator for Probability of Number of Percent of Total Failures in
 

Year "Low­Risk" Group Failure' Failures "Low­Risk" Groupt
 

1980 Loan Growth 2.32% 40 41.7%

1982 Interest Yield 3.76 53 40.4

1984 ROA 3.96 65 45.1

1986 ROA 3.74 62 57.4

1988 ROA 2.12 35 57.4

' This is the probability of failure in the 80 percent of banks that are not in the high­risk loans­to­assets quintile.

t Excludes failures in the high­risk loans­to­assets quintile.

44
The Banking Crises of the 1980s and Early 1990s

lection of commonly used financial ratios. The OCC's

system eventually evolved into the Uniform Bank Surveillance System, whose best­known product is the

Uniform Bank Performance Report (UBPR). The

UBPR is a bank­specific report that allows an analyst to

compare the financial characteristics of an individual

bank with the characteristics of comparable (peer)

banks. The Federal Reserve and the FDIC developed

similar systems. In 1985 the FDIC developed the

CAEL system (Capital, Assets, Earnings, LiquidityManagement is not modeled). This was designed to

replicate the examination rating that an "expert examiner" would give an institution solely on the basis of

Call Report data. Banks were flagged for attention if

their CAMEL rating was 2 or worse and their CAEL

rating was more than one rating worse than their current CAMEL rating.

The CAEL system was adopted in the mid­1980s

and has been used to help achieve and maintain efficient allocation of supervisory resources, primarily by

detecting at an early date banks that appear to have a

high probability of receiving a CAMEL downgrade at

their next on­site examination. CAEL uses 19 financial ratios by which a bank is matched against its peer

group. From 1987 to 1994, the CAEL system was reasonably correct in its predictions; approximately onehalf of all CAMEL downgrades predicted by the

system actually occurred within six months. The

CAEL system identified approximately 25 percent of

total rating downgrades in the relevant group (banks

downgraded from CAMEL 2 or worse). By design,

CAEL misses a large number of actual downgrades in

order to avoid targeting many banks that are in fact in a

stable condition. This appears to be appropriate in a

regime of frequent on­site examinations, for banks

whose conditions have deteriorated since their last examinations but that were not identified by the CAEL

system will in any event be examined without too

much delay.

In the mid­1980s the FDIC also developed the

Growth Monitoring System (GMS). Banks flagged by

GMS as rapid­growth institutions are identified for

off­site review and may receive increased supervisory

attention. The system is based on the levels and

quarterly trends of five summary measures: asset

growth rate, growth rate of loans and leases, and ratios

to assets of equity capital, volatile liabilities, and loans

and leases plus securities with maturities of five years

or more. The system's premise is that rapid growth in

total assets or loans represents a risky activity.

Through the 1980s banks that generated high growth

scores in the model had a higher­than­average incidence of failure up to four years later. 

In the years since the CAEL and GMS systems

were developed, there has been a substantial body of

economic research related to modeling bank failures

and financial distress. The Federal Reserve has based

its off­site surveillance methods on statistical modeling

techniques, beginning with the Financial Institutions

Monitoring System (FIMS), which was adopted in

1993 and predicted CAEL­like ratings and bank failures. As of mid­1997 the FDIC was considering substantial modifications in GMS and adoption of a

statistical model for predicting CAMEL rating downgrades for banks and thrifts.

Open �uestions

Many of the weaknesses revealed in bank statutes,

regulations, and supervisory practices in the 1980s

were subsequently addressed and corrected. However, some issues remain open-two in particular: the

potential impact of resolving large­bank failures in accordance with FDICIA, and the adequacy of present

systems of identifying and pricing risk.

Treatment of Large Banks: 

Systemic Risk and Market Discipline
 

FDICIA shifted the balance between stability and

market discipline toward market discipline. It accomplished this by requiring that the methods used to resolve bank failures produce the least cost to the FDIC

and by prohibiting the protection of uninsured deposits

when such action would increase the cost to the insurance fund. Under the pre­FDICIA cost test, either the

FDIC could choose to sell the failed bank if the estimated resolution cost was less than that of a deposit

payoff or the FDIC could provide open­bank assistance, regardless of cost considerations, if the bank's

services were determined to be "essential" to the community. Failures of big banks were generally resolved

in ways that protected all deposits against loss because

of fears of depositor runs on other banks, systemwide

crises through correspondent accounts, or disruption of

the payments system.

FDICIA also limits the ability of the Federal Reserve to provide liquidity to problem banks (defined in

terms of capital position) through its discount window.

For critically undercapitalized banks, repayment must

be demanded within no more than 5 days, and if that

limit is violated, the Federal Reserve is liable to the

FDIC for any additional cost. In the case of undercap45
FDIC Banking Review

italized banks, Federal Reserve advances can remain

outstanding for no more than 60 days in any 120­day

period.119

FDICIA increases the likelihood that large banks

will be resolved with losses to uninsured depositors

and reduces the likelihood that open­bank assistance

will be used to deal with large troubled banks. An exception to the least­cost test is allowed in cases of systemic risk: two­thirds of the FDIC Board and

two­thirds of the Federal Reserve Board would have to

recommend that an exception be made, with the final

decision in the hands of the secretary of the treasury in

consultation with the president. Any loss incurred by

the FDIC as a result of using the systemic­risk exception would have to be made up by a special assessment

on all institutions insured by the same fund. These

provisions were designed to discourage use of the exception and to increase accountability.

The 1980-94 experience provides only limited guidance as to how the rules prescribed by FDICIA will affect future large­bank resolutions. On the one hand,

there are the well­known troubles of Continental Illinois, which in 1984 sustained enormous withdrawals of

foreign deposits through high­speed electronic transfers. At the time there was concern that if uninsured

deposits were not protected, Continental's correspondent banks would sustain serious losses, possibly with

"ripple" effects on other major banks that were perceived to be vulnerable. Action by the regulators in assisting Continental Illinois forestalled the possibility of

such effects on other major banks. 

On the other hand, in numerous cases the FDIC

resolved banks through methods that left uninsured

depositors unprotected yet had no serious repercussions.120 These were generally smaller banks that

did not pose problems of systemic risk.121 Another instance was the modified payoff method used to resolve

13 banks in 1983-84, a method that caused uninsured

depositors to suffer losses: at closure uninsured depositors were paid a portion of their money based on the

value of the bank's assets that it was estimated would

be recovered in liquidation. At the time of these resolutions there were no flights of deposits from other institutions. Similarly, in the period since FDICIA,

resolutions with losses to uninsured depositors have

not produced large­scale withdrawals at other institutions. From 1992 to 1995, uninsured depositors were

unprotected in 63 percent of all failures, compared with

19 percent in 1986-91. The experience since the adoption of FDICIA is, of course, hardly a rigorous test. In

this period bank profits have increased to record levels,

failures have slowed to a trickle, and no major bank has

been threatened. 

Some studies, published mostly in the post­FDICIA

period, present evidence suggesting that investors recognize the risk of loss on uninsured deposits and that

the market responds appropriately to new information

about risk in banking firms. For example, one study

found that when banks' subordinated debt claims were

downgraded by Moody's rating service, the stock prices

of banks with larger proportions of insured deposits declined less, and downgraded banks then increased their

reliance on insured deposits.122 Another study found

that stock prices reacted negatively after a downgrade

in a bank's CAMEL rating, and suggested that such information may be transmitted to the market through

the bank's Call Reports.123 A study of subordinated

debt concluded that yields on such instruments rationally reflected changes in the government's policy toward protecting large bank holding company

creditors.124 Still another concluded that bond rating

agencies convey new information to the market and

thereby enhance market discipline, since banks that

experience downgrades suffer negative stock returns.125

Studies have also been done to compare the accuracy of "inside" information developed through on­site

examinations with that of "outside" information avail119	 A decision by the FDIC to act in the Federal Reserve's stead by providing open­bank assistance might have rendered this provision less

substantial. However, this avenue was essentially closed by the Resolution Trust Corporation Completion Act of 1993, which effectively

prohibited-unless the systemic­risk exception had been invokedthe use of BIF or SAIF funds to benefit the shareholders of insured

depository institutions, a likely outcome of FDIC open­bank assistance.

120	 From 1986 through 1991, 199 banks (representing 19 percent of all

bank failures) were resolved through means that did not protect uninsured depositors. Average assets of these banks amounted to $57 million. See FDIC, Failed Bank Cost Analysis, 1986-1995.

121	 A possible exception was Penn Square Bank, which was closed

through a deposit payoff in 1982. Because of Penn Square, "Some

banks had difficulty rolling over large CDs. The business of brokers,

who divide up large deposits and participate them to several banks,

was significantly boosted. Depositors generally became more selective in their choice of banks" (FDIC, The First Fifty Years 98).

122	 Matthew T. Billet, Jon A. Garfinkel, and Edward S. O'Neill, "Insured

Deposits, Market Discipline, and the Price of Risk in Banking," unpublished paper (November 28, 1995).

123	 Allen N. Berger and Sally M. Davies, "The Information Content of

Bank Examinations," working paper 94­24, Wharton Financial Institutions Center, 1994.

124	 Mark J. Flannery and Sorin M. Sorescu, "Evidence of Bank Market

Discipline in Subordinated Debenture Yields: 1983-1991," Journal of

Finance 51, no. 4 (September 1996): 1347-77.

125	 Robert Schweitzer, Samuel H. Szewczyk, and Raj Varma, "Bond Rating Agencies and Their Role in Bank Market Discipline," Journal of

Financial Services Research 6 (1992): 249-63.

46
The Banking Crises of the 1980s and Early 1990s

able to market participants. For example, one study of

problem banks concluded that stock returns had failed

to anticipate downgrades in CAMEL ratings; neither

the market nor the banks' managements seemed to

have been aware of the banks' problems before the examinations took place.126 Another study concluded

that both regulators and market participants price credit risk, but only regulators price capital strength; the results seem to reflect, on the one hand, the supervisors'

concern with preventing bank failures and protecting

the deposit insurance fund and, on the other hand, the

market's emphasis on risk/return trade­offs.127 But a

third study concluded that CAMEL ratings are primarily proxies for available market information about the

condition of banks; the additional informational content of CAMEL ratings did not appear large.128

These studies often address the issue of whether, in

monitoring large, publicly traded banks, market discipline and supervision are interchangeable. However,

their results also have a bearing on the issue of the future treatment of large problem banks. If it appears

that the market exercises appropriate discipline and

readily obtains relevant information, then there are

grounds for optimism that, in the future, major surprises at large banks may be avoided because weaknesses

will become public knowledge at an early stage, the

market will have sufficient information to make realistic assessments of bank risk, and investors will be able

to distinguish accurately between viable and nonviable

banks. Under these conditions, the likelihood that

contagious runs will cause systemic problems would be

reduced. There would be fewer grounds for optimism

if it appeared that the market had inadequate or obsolete information (as compared, for example, with information produced by examinations) about a bank's

condition.

With respect to contagious runs, the evidence is not

clear; some failures apparently have not affected other

banks, whereas others seemingly have.129 Testing for

contagious runs on large banks is obviously problematic: federal deposit insurance and the practice of protecting uninsured depositors of large banks eliminated

the possibility of such runs during the 1980s, and an

environment highly favorable to banking has minimized their likelihood in the 1990s. Experience from

the pre­FDIC era or from countries that have no formal

deposit insurance system is not always consistent or

clearly applicable to present­day U.S. conditions.130

The most likely scenario in the event of a future

large­bank problem is that the FDIC, the Federal Reserve, and the administration will have to make difficult judgment calls on whether use of the systemic­risk

exception is justified. Such decisions will probably

have to be made more quickly than were decisions relating to large­bank failures in the 1980s. In any event,

the combination of least­cost resolutions, PCA, and

limitations on Federal Reserve advances will no doubt

increase market discipline and reduce regulatory discretion. These, of course, are what the supporters of

these measures sought to achieve. Additional and unintended effects of the new requirements may be that

some regulatory decisions will have to be made in haste

and that the range of potential solutions to large­bank

problems will be narrowed.

Ade�uacy of Present Systems for Identifying

and Pricing Risk

Banking operations became more complex during

the 1980s and deviated increasingly from the traditional loan and deposit­taking model (the increase in various types of off­balance­sheet activity is one example).

These developments pose new risks and have required

adaptations in capital standards and reporting requirements to ensure that major types of risk are addressed.131

126	 Katerina Simons and Stephen Cross, "Do Capital Markets Predict

Problems in Large Commercial Banks?" Federal Reserve Bank of

Boston New England Economic Review (May/June 1991): 51-56.

127	 John R. Hall, Andrew P. Meyer, and Mark D. Vaughan, "Do Markets

and Regulators View Bank Risk Similarly?" Federal Reserve Bank of

St. Louis, supervisory policy analysis working paper no. 1­97, February 1997.

128	 Thomas F. Cargill, "CAMEL Ratings and the CD Market," Journal of

Financial Services Research 3, no. 4 (September 1989): 347-58.

129 However, one study concluded that "analysis suggests that bank contagion is largely firm­specific and rational, as it appears to be in other

industries, and that the costs are not as great as they are perceived to

be" (George G. Kaufman, "Bank Contagion: A Review of the Theory

and Evidence," Journal of Financial Services Research 8, no. 2 [April

1994]: 123-50).

130 Among the studies of this issue are Charles W. Calomiris and Joseph

R. Mason, "Contagion and Bank Failures during the Great Depression: The June 1932 Chicago Banking Panic," 110-22; and Fred R.

Kaen and Dag Michalsen, "The Effects of the Norwegian Banking

Crisis on Norwegian Bank and Nonbank Stocks," both in Proceedings

of the 31st Conference on Bank Structure and Competition Federal Reserve

Bank of Chicago, May 1995, 123-61; Gerald D. Gay, Stephen G.

Timme, and Kenneth Yung, "Bank Failure and Contagion Effects:

Evidence from Hong Kong," Journal of Financial Research (summer

1991): 153-65; George G. Kaufman, "Bank Contagion: A Review of

the Theory and the Evidence," Journal of Financial Services Research

8, no. 2 (April 1994): 123-50; Charles W. Calomiris and Gary Gorton,

"The Origin of Banking Panics: Models, Facts and Bank Regulation,"

in Financial Markets and Financial Crises ed. R. Glenn Hubbard

(1991), 109-74; and Wall, "Too­Big­to­Fail after FDICIA," 7-9.

131	 The revisions in risk­based capital rules are discussed and evaluated

in U.S. General Accounting Office, Financial Derivatives: Actions Taken or Proposed since May 1994 (November 1996).

47
FDIC Banking Review

Another development that has important implications for assessing risk is the continued geographic diversification of the banking industry through

consolidation. As more banks spread their activities

across state boundaries, they will have increased opportunities to diversify their loan portfolios. But as a

result of consolidation of multibank holding companies

into out­of­state branch systems, financial reports under current reporting procedures will provide increasingly uncertain indications of the geographic

concentrations of credit risk.132 For example, if multibank holding companies were to consolidate all their

bank and thrift affiliates into a single lead bank, 38

states would show an apparent decline in bank loans

outstanding, whereas a few states would show substantial gains.133 A number of efforts are being made to

ensure that meaningful data on geographic concentrations of lending risk are available.

As these remarks suggest, bank regulators are attempting to adapt systems for identifying and pricing

risk in order to keep up with developments in the

banking industry, and one of the principal tools for restraining risk is capital requirements that also serve to

trigger increasingly severe regulatory action under

PCA. As emphasized repeatedly in this article, however, bank capital positions are poor predictors of failure several years before the fact. If regulatory action

were based solely on capital positions, in many cases

such action might come too late to do much good. Yet

a policy of basing costs or penalties on more­forwardlooking measures would have its own problems. Although ex ante measures of risk-such as the ratio of

loans to assets-correctly flagged a large majority of

the institutions that failed several years later, they also

flagged a much larger number of banks that did not

fail. The latter group of banks was presumably being

compensated-by earning higher returns, at least for

a time-for the greater risk it was assuming. Imposing restrictions on this group of banks might unnecessarily restrain potentially profitable activities. Basing

penalties on ex ante measures of long­term risk might

also expose the regulators to charges of credit allocation, since they might be restraining banks' efforts to

meet rising credit demands in particular regions or

sectors of the economy. And basing regulatory restraints on unreliable ex ante risk measures might increase the prospect of a regulator­induced "credit

crunch." All these difficulties may make regulators

loath to base supervisory restraints on, or levy penalties on the basis of, ex ante risk measures, a situation

raising the possibility that some future episode of

high­risk activity will go unrestrained until the risky

behavior is translated into actual losses and erosion of

capital positions. In other words, identifying and restraining risky bank behavior on a timely basis will

continue to be a difficult task for bank regulators.

Some observers would address the issue by placing

greater reliance on bank owners and the marketplace,

and less on regulators, to monitor and restrain risky

behavior. Thus, raising regulatory capital requirements

considerably above present standards would increase

stockholders' stake in the banks, increase their incentive to enforce conservative policies, and provide greater

protection for the deposit insurance fund, taxpayers,

and the economy against the risk of bank failures.

However, if capital requirements are set too high, entry

into the industry will be discouraged, competition

within the industry will be weakened, and credit flows

through bank and thrift intermediation will be reduced. A trade­off exists between the objective of restraining risk through regulatory capital requirements

and the consequences of reduced competition among,

and credit flows through, depository institutions.

Market value accounting has been proposed as a

means of substituting the judgment of the marketplace

for that of regulators in assessing bank risk. This assumes that market participants are better able (or willing) to evaluate the risk characteristics of depository

institutions on the basis of publicly available data than

regulators who have access to internal information

gained through examination of loan files. As has been

frequently pointed out, there are serious problems in

assigning market values to bank loans that have no secondary markets and have little or no inherent marketability because of the difficulty of assessing

information developed by the banks on the characteristics and behavior of their borrowers. Aside from implementation problems, market value accounting may

reduce longer­term bank lending, restrict credit flows

during periods of falling asset prices, and inject greater

instability in the banking system as a result of fluctuations in net worth positions of depository institutions.

In short, whether risky behavior is monitored by regulators, bank owners, or the market, the objective of

132 "Minimum Data Needs in an Interstate Banking Environment,"

FDIC staff analysis, September 16, 1996.

133 To the extent that out­of­state affiliates were consolidated into a local

lead bank, a particular state would show an increase in loans. To the

extent that locally based affiliates were consolidated into an out­ofstate lead bank, a particular state would show a decrease in loans.

48
The Banking Crises of the 1980s and Early 1990s

greater ex ante restraints on risky behavior may conflict

with other public policy objectives.134

Concluding Comments

An eminent philosopher once offered this discouraging view of the lessons policymakers learn from history: "[P]eople and governments never have learned

anything from history, or acted on principles deduced

from it."135 The present study is based on the view that

history can be used constructively by policymakers.

The lessons to be learned from this history concern the

effectiveness of the federal bank regulatory and deposit insurance systems during a period of extraordinary stress. How well did they perform in the 1980s,

and how can a study of their performance benefit future policymakers? 

Despite bank and thrift failures in numbers not seen

since the Great Depression, the government's promise

to protect insured depositors was fully honored: no depositor lost a penny on federally insured deposits, there

was no significant disruption of the financial intermediation process, and a high degree of financial market

stability was maintained. These results did not come

cheap, but the financial cost for the banking industry

was borne by the banks themselves and by their customers rather than by taxpayers, who ended up bearing

most of the much greater cost of the S&L debacle.

There were also other, less­quantifiable costs, particularly those associated with the moral­hazard risk taking

inherent in deposit insurance. A chief example was the

misallocation of resources when banks and thrifts

poured funds into high­risk commercial real estate

lending, although other factors besides moral hazard

contributed to this outcome, including poorly conceived deregulation and disruptive tax­law changes. In

view of these overall results, several lessons can be

drawn about the performance of bank regulators in the

1980s.

1. Problems in the operations of depository institutions must be identified at an early stage if serious deterioration in the institutions' condition is to

be prevented, and early identification requires continuous and sometimes burdensome monitoring of

the institutions' activities. Partly to support the objective of reducing the federal work force and partly

because of presumed efficacy of off­site monitoring,

the number of bank examiners and the frequency of

on­site examinations were reduced in the first half of

the 1980s, at the very time when the number of troubled banks and bank failures began to rise rapidly. As

a result, emerging problems were not always identified

on a timely basis, some failures occurred that might

have been averted, and losses to the insurance fund

were probably increased. Examination forces were rebuilt and the frequency of examinations was increased

in the second half of the 1980s, even before legislation

requiring such action was passed by Congress in 1991.

Up­to­date, on­site examination results appear to yield

information on banks not available through other

means, and they help maintain the integrity of Call

Report and other publicly available bank data. In the

1980s, they provided reasonably accurate advance

warning of future banking problems, and their accuracy increased during the period.

2. Adequate funding of the deposit insurance

agency is essential to effective regulatory control of

risk taking by insured institutions. The FSLIC suffered from a number of defects, but among the most

serious was the lack of funding (and the reluctance of

the S&L industry and Congress to provide it). As a result, the FSLIC was unable to close large numbers of

insolvent S&Ls, which were allowed to continue operating in the hope that higher­risk investments would

pay off. FDIC resources, although strained during the

late 1980s, were sufficient to close failed banks. Bank

regulators generally forced or encouraged problem

banks to cut asset growth, reduce dividend payments,

and attract external capital. Problem banks were generally not permitted to "throw the long bomb," and

most of them survived as independent institutions or

were merged without FDIC financial assistance. With

some significant exceptions, most problem banks that

failed were closed within the time frame later prescribed by the PCA provisions of FDICIA for critically

undercapitalized banks. Forbearance programs mandated or inspired by Congress were administered in a

generally effective manner by the bank regulators, in

contrast to the unfavorable S&L experience with forbearance. Although other factors obviously affected

the quality of regulation, the availability of the financial

resources needed to close insolvent institutions was

central to the bank regulators' ability to control bank

134	 See Allen N. Berger, Kathleen Kuester King, and James M. O'Brien,

"The Limitations of Market Value Accounting and a More Realistic

Alternative," Journal of Banking and Finance 15 (1991): 753-83; and

Allen N. Berger, Richard J. Herring, and Giorgio P. Szego, "The Role

of Capital in Financial Institutions " Journal of Banking and Finance 19

(1995): 393­430.

135	 Georg Wilhelm Friedrich Hegel, Philosophy of History (1832), quoted

in John Bartlett, Familiar Quotations, 14th edition.

49
FDIC Banking Review

risk and moral­hazard problems and reduce losses to

the insurance fund when failure occurred.

3. The treatment of large­bank failures had undesirable side effects, but it is unclear whether alternative resolution methods would have been

successful in the environment of the 1980s. Protecting uninsured depositors of large failed banks

weakened market discipline and exposed regulators to

charges of treating small banks unfairly. Imposing losses on uninsured depositors and liquidating a few large

banks might have had salutary effects on market discipline, and some observers suggest that the regulators

should have been more willing to take the risk involved in such actions. However, no such experiment

was undertaken, and therefore the experience of the

1980s provides little guidance on whether these actions

would have led to runs on other large banks and to

more­general financial market instability. 

In other respects, it is clear that the treatment of

large banks could have been improved. While still

profitable and solvent, some large banks that eventually failed were engaging in risky behavior that was not

sufficiently restrained by bank regulators. In addition,

a few large banks continued to operate with little equity for extended periods before being closed; these

banks generated avoidable losses that increased total

resolution costs. In these instances, more­effective

regulatory action was feasible and could have reduced

losses to the insurance fund. 

4. Statutory rules limiting regulatory discretion

may help prevent a repetition of the regulatory

lapses that occurred in the 1980s, but it remains to

be seen whether such rules will be maintained in a

future period of widespread banking distress. Limits on the discretionary authority of bank regulators

were adopted as part of FDICIA after the banking crisis had largely passed, and they have raised few problems in the benign banking climate that has since

prevailed. However, the tension between rules and

discretion in bank regulation may reappear in some future period of widespread banking problems. In the

early 1980s, Congress responded to the concerns of the

banking and thrift industries and limited the ability of

regulators to close weakened institutions. In that instance, Congress mandated forbearance for thrifts and

some banks, delayed recapitalization of the FSLIC's

insurance fund, and then declined to provide the

amount requested by the Reagan administration.136

Given this experience, it is difficult to predict the effect of current statutory rules in some future banking

crisis, or the willingness of legislators to retain them. In

such a crisis, numerous banks might be suffering substantial operating losses and capital reductions resulting from external shocks and other unforeseen

developments. Will it then be politically feasible, for

example, to liquidate a significant number of large

banks in accordance with least­cost resolution requirements or to close many small and large banks because

they fail a statutory solvency test? If so, will such actions be compatible with the objective of maintaining

financial market stability? Experience in the 1980s provides little basis for confident answers to these questions.

5. Bank regulation can limit the scope and cost

of bank failures but is unlikely to prevent failures

that have systemic causes. The rise in the number

of bank failures in the 1980s had many causes that were

beyond the regulators' power to influence or offset.

These included broad economic and financial market

changes, ill­considered government policy actions, and

structural weaknesses that inhibited geographic diversification and made many banks vulnerable to regional

and sectoral recessions. Earlier implementation of uniform capital standards and other improvements in regulation might have reduced the number of failures in

the 1980s, but it could not have prevented a great many

of them. Legislation permitting geographic consolidation was a major step toward correcting existing structural weaknesses in the banking system. However, if

significant new structural weaknesses or serious economic problems are allowed to develop in the future,

bank regulation alone will not be able to prevent a major increase in the number of bank failures. 

6. The ability of regulators to curb excessive risk

taking on the part of currently healthy banks was

(and continues to be) limited by the problem of

identifying risky activities before they produce serious losses and by competing public policy ob�ectives. As noted, bank regulators were reasonably

successful in curbing risk taking on the part of officially designated problem banks whose condition had

already deteriorated. However, in dealing with ostensibly healthy banks, regulators had difficulty restricting

risky behavior before the fact, while the banks were

still solvent and the risky behavior was widely practiced and currently profitable. It was (and remains)

hard to distinguish such behavior from acceptable

risk/return trade­offs, innovation, and other appropriate

136	 National Commission on Financial Institution Reform, Recovery and

Enforcement, Origins and Causes 73.

50
The Banking Crises of the 1980s and Early 1990s

activity, or to modify the behavior of banks while they

were (and are) still apparently healthy. Current riskbased capital requirements are forward­looking in the

sense that they apply different weights to different asset categories, but the categories are so broad that they

permit major increases in high­risk loans without requiring more capital. On the other hand, current riskbased premium schedules penalize banks after the

fact, when losses have already weakened their condition. In addition to problems of identification, conflicting public policy objectives are also a limiting

factor; this was evident during the "credit crunch" of

the early 1990s, when bank regulators were criticized

by legislators and administration officials for retarding

economic recovery through their excessive zeal in applying the very supervisory restraints they had previously been urged to implement. 

An alternative approach, proposed mainly by academic writers, would be to rely more heavily on bank

owners and investors, rather than on regulators, to restrain risky behavior on the part of profitable banks;

this would be done by raising overall capital standards

to considerably higher levels than at present in order to

increase shareholders' stake or by adopting market value accounting. Aside from problems of implementation, the potential efficacy of this alternative is also

limited by conflicts with other public policy objectives,

such as maintaining financial stability and meeting private sector credit demands.

7. Differences in perspective among federal

bank regulators may have delayed recognition of

the nature of the problems of the 1980s. Differences among the regulators are to be expected, given

their various primary responsibilities, and the resulting

checks and balances are frequently cited as one of the

main advantages of the present regulatory structure.

However, conflicts among regulators on the issue of

brokered funds persisted until 1985, and on new bank

charters until 1989. Arguably, it should have been clear

before then that bank failures were the most pressing

problem, outweighing such considerations as encouraging innovations in deposit gathering and easing the

entry of new institutions into banking markets. While

the present system of divided regulatory responsibilities is believed to have important advantages, in the

early 1980s it may have delayed recognition of the seriousness of a new crisis.

* * *

Finally, it is appropriate to emphasize that the

lessons of the 1980s need to be applied to future problems judiciously. As noted by one of the participants in

the FDIC's symposium at which an earlier version of

this article was presented, the problems of the past may

bear little or no resemblance to those of the future.137

Therefore, it is important to keep in mind those

lessons of the 1980s that appear to be relevant while remaining alert to emerging problems that have few or no

precedents in the past.

137 See comments by Carter H. Golembe in volume 2 of History of the

Eighties.

51
FDIC Banking Review

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