FRBSF Economic Letter
2006-26; October 6, 2006
Safe and Sound Banking, 20 Years Later
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The U.S. banking industry has enjoyed record
profitability and very low failure rates in recent years. This
scenario is a welcome contrast to the 1980s, when turbulent economic
conditions, the crisis in the savings and loan industry, and
a highly volatile interest rate environment put the banking industry
under severe stress.
In those dark days, analysts and policymakers
debated a variety of ways to address the factors that arguably
precipitated the dire situation. Among the most comprehensive
and influential sets of proposals was one developed by a task
force of five academic researchers that was organized and sponsored
by the American Bankers Association in 1986. In their Report
(published as Perspectives on Safe and Sound Banking: Past,
Present, and Future Benston et al. 1986), they identified
the underlying problem as follows: the administration of the
federal safety net at that time, especially deposit insurance,
provided incentives for excessive risk-taking by insured depository
institutions. The Report also recommended measures that could
reduce the overall risk exposure of the deposit insurance system,
align accountabilities for the administration of deposit insurance
with those for prudential supervision and regulation, and help
ensure that the deposit insurance system would be compensated
for its risk exposure. To this end, the Report focused on changes
in regulatory policies dealing with a wide range of issues including
deposit insurance, lender-of-last-resort, market discipline,
bank examinations and supervision, and expansion of banking powers.
On the twentieth anniversary of this Report,
the Federal Reserve Banks of San Francisco and Atlanta, along
with the founding editors of the Journal of Financial Services
Research, held a conference named
after the Report. This Economic Letter (based on Furlong
and Kwan 2006) highlights
four major areas of banking reform during the period, reviewing
both the analysis and recommendations in the Report and comparing
them to the actual outcomes.
Deposit insurance
Deposit insurance reform was viewed as an especially
critical area for ensuring the safety and soundness of the U.S.
banking system. A key shortcoming was the so-called moral hazard
problem, in which the pricing and administration of deposit insurance
distort depository institutions’ incentive for taking risk. To
remove the distortions and ensure that the deposit insurance
system would be appropriately compensated for its risk exposure,
the Report recommended using risk-related charges for coverage,
including risk-related deposit insurance premiums and risk-adjusted
capital standards. In addition, the Report argued that the risk
assessment should be based on the consolidated banking organization—not
just the bank subsidiaries; furthermore, it should also include
off-balance-sheet risks.
Consistent with these recommendations, the Federal
Deposit Insurance Corporation Improvement Act (FDICIA) of 1991
required the FDIC to establish a risk-based assessment system.
However, the Deposit Insurance Funds
Act of 1996 prohibited the FDIC from charging well-managed
and well-capitalized institutions deposit insurance premiums
when the deposit insurance fund is at or above the Designated
Reserve Ratio (DRR). As a result, the risk-based assessment system,
bounded by the DRR requirement, did not have a meaningful sensitivity
to risks. Indeed, in 2005, only about 6% of the almost 8,000
commercial banks paid deposit insurance premiums. The Federal
Deposit Insurance Reform Act of 2005 (FDIRA) grants the FDIC
more discretion to price deposit insurance according to risk
by replacing the fixed DRR with a range.
In keeping with the Report's recommendations
on risk-based capital requirements, the first Basel Capital Accord
(1988) formally introduced them and included extending them to
off-balance-sheet activities. The Accord has since been found
to be vulnerable to capital arbitrage, which has been addressed
in part by several supervisory initiatives, but its shortcomings
have prompted changes that have been proposed in the new Basel
II framework.
The Report also recommended keeping the insurance
coverage at $100,000 and letting it decline in real terms with
inflation. The rationale was to increase market discipline by
gradually exposing more depositors to the risk of default. In
real terms, the $100,000 coverage limit that was established
in 1980 has been roughly halved by inflation since then. Recently,
FDIRA raised the retirement account insurance coverage from $100,000
to $250,000, and it allowed the FDIC to adjust the general account
coverage levels to keep pace with inflation starting in 2010.
To protect the insurance fund and uninsured creditors,
the Report recommended closing a failing depository institution
when its market-value net worth falls below some low, but still
positive, number such as 1% or 2% of assets. While FDICIA
embodied the concept of early intervention with the Prompt Corrective
Action provision, the triggers for regulatory intervention are
based on book-value capital ratios. Relying on book-value capital
ratios may undermine the usefulness of early intervention when
they lag their true economic values. However, in the absence
of full market-value accounting (which the Report also recommended),
using the book value ratios is necessary for implementation purposes.
Going beyond early intervention, FDICIA's Least Cost Resolution
provision requires the FDIC to resolve bank failures using the
method that is least costly to the insurance fund. Furthermore, the act also clarified and formalized the conditions
for protecting uninsured depositors or creditors at large banking
organizations whose failure would have serious adverse effects
on economic conditions or financial stability.
Market discipline
Under market discipline, a firm has private sector
stakeholders, including management, shareholders, and uninsured
depositors and other creditors, who are at risk of financial
loss from the firm's decisions and who can take actions to "discipline"
the firm or influence its behavior. The Report recommended increasing
the reliance on market discipline by imposing costs on stakeholders
as disincentives for taking risk. More specific recommendations
included those for greater reliance on subordinated debt. The
Report also recommended expanding the use of current-value measures
for internal use by depository institutions, for deposit insurance
purposes, and for public disclosures. The Report argued that
one benefit of increased market discipline is that it can supplement
supervision and thus lower the agencies' expenses. One recommendation
also calls for examination reports to be shared with bank management.
Some of these recommendations for increasing
reliance on market discipline are embodied in the collection
of changes that have increased regulatory emphasis on bank capital,
starting from the first Basel Capital Accord to the newly proposed
Basel II capital regulation framework. Coincident with this has
been the substantial turnaround in book-value capitalization
in the banking industry, with nearly all U.S. banks being classified
as well-capitalized by their regulators.
In addition, subordinated debt has become part
of Tier 2 capital, which is counted towards meeting regulatory
capital requirements. Contrary to the Report's recommendations,
the debt can have restrictive covenants and its issuance need
not be staggered. The current environment is more conducive to
the use of such debt in meeting capital requirements. In fact,
as part of the recapitalization of the banking industry in the
early 1990s, banking organizations as a group did increase their
reliance on subordinated debt. More recently, policymakers also
have allowed trust preferred securities to meet part of Tier
I capital requirements.
Several steps have been taken to improve public
disclosure by financial institutions. At the policy level, improved
disclosure is one of the three pillars in the Basel II proposal.
Banking agencies also have improved disclosure by expanding the
scope of regulatory reports, accelerating the release of the
reports, and making the information more readily available.
Prudential supervision
The Report recommended several revisions to the
bank examination process. It argued that, because fraud and insider
abuse were major problems, the examination process should focus
on uncovering them. Other recommendations included: directing
examinations at verifying accounting and estimates of the current
value of assets and liabilities; using existing data, statistical
methods, and computer models to monitor risk, to predict risk,
and to identify problems; increasing the reporting of significant
information using computer technology.
Over time, the agencies have, indeed, taken advantage
of advances in computer technology. A notable change directly
affecting the examination process has been the adoption of the
so-called risk-focused approach. This approach was formally announced
by the Federal Reserve in 1997 and was supplemented with traditional
transactions-testing of a sample of a banking organization's
assets.
While improved risk management in banking could
help protect the insurance fund, that was not the motivation
for adopting risk-focused supervision. The motivation instead
rested on the assumption that banks have incentives to measure
risk accurately and to manage it. In fact, the risk-focused approach
can be seen as arising out of financial institutions' own innovations
in risk management.
The risk-focused approach, which emphasizes internal
controls at banking organizations, is consistent with the Report's
attention on fraud detection, as is the move toward more continuous
supervision for larger banking organizations. Aside from having
staff on-site at the very largest banking organizations and regular
off-site monitoring for other banks, supervision involves a series
of targeted examinations leading up to full examinations. The
targeted examinations can focus on particular areas of risk,
including credit risk, market risk, compliance risk, and operational
risk.
At the same time, off-site monitoring among the
federal banking agencies has been expanded and improved substantially,
as the agencies have taken advantage of statistical models and
advances in information technology. At the Federal Reserve, for
example, off-site monitoring models are used to estimate probabilities
of failures and to predict supervisory ratings, and new models
that incorporate market-based variables are currently being developed.
Expansion of banking powers
The Report recommended that the main criterion
for authorizing new activities should be the insurance agency's
ability to monitor and to assess the total risk implications
of the new activity for the consolidated entity as well as to
price the risk to the consolidated entity. It viewed the legal
separation of commercial and investment banking, and the separation
of banking and insurance, as neither necessary nor desirable
for reducing conflicts of interest. It also rejected the idea
of housing the new activities in nonbank subsidiaries or affiliates
because doing so would not protect the insurance agency from
the risk of the new activities so long as the holding company
can shift risk to insured bank subsidiaries.
Regulatory and legislative actions over the past
20 years have allowed greater affiliation of banking and other
financial services. Even under the Glass-Steagall Act of 1933,
bank holding companies were permitted to engage in securities
underwriting and dealing on a limited basis through their so-called
Section 20 subsidiaries approved by the Federal Reserve. On the
insurance side, national banks exploited loopholes in the law
by conducting insurance agency activities in small towns.
In 1999, the Gramm-Leach-Bliley Act formally
repealed provisions of Glass-Steagall, allowing banking firms
to be affiliated with securities firms and insurance companies.
However, the new securities activities and the insurance activities
of the banking organization must be conducted outside of the
bank subsidiaries in nonbank affiliates. These measures allowing
greater affiliation of banking with other financial activities
are consistent with the views in the Report that such affiliation
should not lead to conflicts of interests that are harmful to
consumers. Even the continued restrictions on mixing banking
and commerce could be seen as consistent with the Report's views,
to the extent that the ban could be motivated by concerns over
the ability of the supervisory agencies to assess and monitor
the associated risks. Nevertheless, the use of the holding company
framework for expanding banking powers is clearly at odds with
the Report.
Conclusions
The task force Report, written 20 years ago when
the nation's banking and thrift sectors were in serious distress,
took a broad and deep look at the underlying contributory causes.
Its recommendations were based on sound economic principles,
including the theory underlying options pricing models and agency
theory in finance. Today, we have much healthier banking and
thrift sectors, and there seems to be little question that the
safety and soundness of the banking system has improved substantially—at
least for now. Looking back, one can point to several major developments
that have shaped the U.S. banking system during the last two
decades, including the recapitalization of the banking industry,
the greater reliance on market discipline, and increased sophistication
of risk management. These developments are broadly consistent
with, and to some extent connected to, public policy measures
recommended by the task force, whose primary thesis was to align
risk-taking incentives among depository institutions more appropriately
and to limit the scope of the bank safety net.
Simon Kwan
Vice President
References
[URLs accessed October 2006.]
Benston, George J., Robert A. Eisenbeis, Paul
M. Horvitz, Edward J. Kane, and George G. Kaufman. 1986. Perspectives
on Safe and Sound Banking: Past, Present, and Future. Cambridge,
MA: MIT Press.
Furlong, Fred, and Simon Kwan. 2006. "Safe
and Sound Banking, 20 Years Later: What Was Proposed and What
Has
Been Adopted." Mimeo. Federal Reserve Bank of San Francisco.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
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