What economic principles should policymakers in other countries have learned from the S&L mess? Appropriate incentives for government supervisors are critical for avoidance of financial crises - savings and loan

Business Economics, Jan, 2003 by Edward J. Kane

For individual institutions' insolvencies to trigger a national financial crisis, cumulative losses across an important industry sector must exceed the safety-net support that creditors expect the government to provide. This happens when official supervisors acquiesce to pressure of threatened institutions to engage in risky lending in an effort to stay afloat. Such regulatory risk-taking takes the form of insurance against failure and concealment of the magnitude of the risks to which the insured institutions and their insuring governmental institutions are exposed. The source of such regulatory dereliction is rooted in conflicting incentives for regulators that must be resolved if future crises are to be avoided. The paper describes and analyzes the U.S. savings and loan crisis and financial crises in developing countries to illustrate these points.

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An important contributor to the depth of most modern financial crises is the degree to which healthy market discipline was displaced by inefficiently managed systems of government supervision. Taxpayers and public servants around the world need to understand that the extent of a financial system's exposure to bad luck, aggressive management, and looting is an endogenous consequence of the economic principles public policies embody.

Economic insolvency strikes an individual financial enterprise when it suffers losses that destroy its capacity to repay depositors and other creditors without outside assistance. Destructive losses are rooted in poor or dishonest management, bad luck, defective information systems, and superior competitors.

For individual economic insolvencies to trigger a national crisis, cumulative losses across an important industry sector must exceed the safety-net support that creditors expect the government to provide. Entry pressure from more-efficient and better-capitalized competitors can create such losses if implicit and explicit governmental guarantees degenerate into a mechanism for retarding the recapitalization of insolvent deposit-institution competitors. Although no two financial crises unfold in exactly the same way, events are driven by the interaction of (a) risky lending and funding strategies that lead to the economic insolvency of individual institutions and (b) risky regulatory strategies that government supervisors and regulators use to handle individual insolvencies when they develop.

The major lesson of the U.S. savings and loans (S&L) mess is how dangerously regulatory and bank risk-taking can reinforce each other. For individual insolvencies to persist for years on end requires that--at some level of government--officials sell insolvent institutions protection against failure and conspire at least implicitly with internal and external auditors to conceal gaping holes in individual balance sheets. As long as the cover-up succeeds, the lending policies of troubled institutions escape the ordinary weight of depositor discipline.

Around the world, the valuation and itemization principles that deposit-institution accountants and regulators use to measure banking profits and net worth contain options that make it possible for large opportunity losses to be hidden from public view. Until and unless challenged by economic analysis, using these options can generate phantom and nonrecurring profits that overstate profits and net worths for years on end. Cooked books and earnings projections based upon them resemble the digital readouts from a scale rigged by a dishonest butcher. With a show of irrelevant precision, authorities can systematically and repeatedly mismeasure the obligations that deposit insurance is putting on the taxpayers' bill.

Accounting and regulatory dereliction is rooted in incentive conflict experienced by a country's designated watchdog institutions. The solution to incentive conflict lies in reworking the watchdogs' incentives in the social contracts that are breaking down. The conflict at issue is the tradeoff between regulators' and accountants' social missions and the personal and bureaucratic costs of resisting client pressure for relief. Ironically, the accounting and regulatory strategies that ruined the Federal Savings and Loan Insurance Corporation (FSLIC) and the U.S. S&L industry were of the industry's own making. Even more ironically, these discredited strategies closely resemble the policies that multinational firms and the IMF have implicitly urged on crisis countries in Asia and Latin America (e.g., Fischer, 2001).

Guaranteeing the debt of insolvent institutions and covering up the loss exposures this creates for a country's taxpayers is costly in three ways. First, by allowing important institutions to operate in an insolvent condition, authorities leave poorly performing assets and franchises in the hands of managers whose lending and funding incentives are distorted by capital weaknesses. Because the downside of future returns belongs to the guarantor, insolvent firms are tempted to invest the savings entrusted to them in lottery-like projects that combine a negative present value with a small chance of a very large payoff. Second, until the coverup begins to unravel, accounting disinformation insulates the guidance and forbearance decisions that government officials are making from financial and political review. Finally, any cover-up is likely to be accompanied by microeconomically inefficient pricing and entry restrictions intended to protect the markets of troubled firms from close competitors. However, because o f their inefficiency, these restrictions are apt to boomerang against the industry in the long run.