The crash of 1988 - problems looming in American depository institutions

National Review, April 29, 1988 by David Glasner

THE CRASH OF 1988

JUST AS the financial community has begun to recover from last fall's nerve-wracking stock-market crash, a new danger looms: American depository institutions (banks and savings & loans) are failing at a greater rate than at any time since the Depression. If you liked Black Monday, you'll love the Great Banking Collapse of '88.

An exaggeration? Perhaps, but the current state of our banking system is anything but reassuring. In 1986 over 140 banks failed. Last year more than 180 closed their doors. In comparison, the average number of bank closings between 1940 and 1970 was less than ten per year.

Savings & loans are having even more trouble. The official statistics (229 S&L failures between 1981 and 1985) do not begin to reflect the wreckage in the thrift industry; regulators have been covering up for bankrupt thrifts on a massive scale. A more telling indicator is the fact that, at the end of 1985, some 450 thrift institutions (with combined assets of over $100 billion) had negative net worth when net worth is calculated using generally accepted accounting principles instead of regulatory accounting principles. On that basis, another 730 shaky institutions (with assets of $290 billion) had net worth between 0 and 3 per cent of assets.

What's to prevent a crisis in our banking system? Not the Federal Savings & Loan Insurance Corporation (FSLIC), whose claimed reserves totaled only $4.6 billion at the end of 1985. In contrast, the unrecognized claims against the fund totaled over $29 billion. Nor is there any sign of improvement; FSLIC reserves have since dwindled to less than $2 billion.

In short, not only is 15 to 20 per cent of the savings & loan industry at or over the brink of economic, if not legal, insolvency, but the insurance fund that supposedly safeguards depositors and thus the stability of the industry is itself economically insolvent. If a renewed burst of inflation drives up interest rates or a recession impairs the ability of borrowers to repay debts, it will not be possible to continue pretending that these zombie institutions are still viable.

The current expansion is already one of the longest on record. It would be foolish to assume that Reaganomics, however successful it has been, has permanently eliminated the business cycle. So a massive shakeout of the thrift industry is hardly an implausible scenario.

When the next recession hits, we may be left with only three choices: use general revenues to compensate depositors; nationalize defunct institutions; or allow a default by federal deposit insurance. The financial panic that the latter course would cause is too frightening to risk. Yet the first two options are scarcely more appealing. Financing FSLIC through general revenues would lead to either a major tax increase or an inflationary spiral; whereas nationalizing failed institutions would constitute one of the most breathtaking shifts of economic power from the private to the public sector in American history.

So far, politicians and regulators have simply looked the other way, hoping that the financial time bomb would somehow defuse itself, or at least wait until after they left office to explode. The legislation passed by Congress last year injecting $7.5 billion into the FSLIC kitty left FSLIC still insolvent without addressing any of its underlying structural problems. (One observer described the Administration's stronger version of the measure as "nothing more than a thirty-month punt of the FSLIC mess into the next Administration.")

There is a school of thought, represented by Wall Street economist Henry Kaufman among others, that blames the current crisis on financial deregulation. According to this view, deregulation, by forcing banks and S&Ls to pay competitive interest on deposits, encouraged them to take excessive risks. The risks produced handsome payoffs for some institutions, but they also led others to insolvency. The solution critics of competitive banking propose is simple: re-regulate banks and thrifts, prohibit payment of interest on demand deposits, and sharply limit the kinds of activities banks and thrifts may engage in.

Betting the Bank

PART OF THIS diagnosis surely is correct. Excessive risk-taking is indeed the principal threat to the banking and thrift industries. But it is not deregulation that leads depository institutions to take excessive risks: rather, deposit insurance is at fault. If their gambles pay off, managers and stockholders revel in the rewards; if not, they shift the loss to FSLIC and ultimately to the taxpayer. What is worse, the temptation to shift losses to the insurer increases rapidly as the net worth of an institution shrinks. With your equity gone, and deposit insurance there to guarantee your liabilities, why not bet the bank? So the incentive for risk-taking is greatest for the shakiest institutions.

Ironically, the system of deposit insurance that now threatens our financial system was instituted in 1933 precisely to prevent a recurrence of the banking collapse of the Great Depression. And by giving the public confidence in the safety of their deposits, FSLIC and the Federal Deposit Insurance Corporation (FDIC) certainly have prevented contagious runs on the banks and thrifts they insure. (The recent runs on S&Ls in Ohio and Maryland were on institutions insured under state-operated plans.)