Academic journal article The Cato Journal

Incentive-Robust Financial Reform

Academic journal article The Cato Journal

Incentive-Robust Financial Reform

Article excerpt

"Will Rogers, commenting on the Depression, famously quipped: "If stupidity got us into this mess, why can't it get us out?" Rogers's rhetorical question has an obvious answer: persistent stupidity fails to recognize prior errors and, therefore, does not correct them. For three decades, many financial economists have been arguing that there are deep flaws in the financial policies of the U.S. government that account for the systemic fragility of our financial system, especially the government's subsidization of risk in housing finance and its ineffective approach to prudential banking regulation. To avoid continuing to make the same mistakes, it would be helpful to reflect on the history of crises and government policy over the past three decades.

The U.S. banking crises of the 1980s--which included the nationwide S&L crisis of 1979-91, the 1986-91 commercial real estate banking crisis (Boyd and Gertler 1993), the LDC debt crisis primarily afflicting money-center banks from 1979 to 1991, the farm credit crisis of the mid-1980s (Calomiris, Hubbard, and Stock 1986; Carey 1990), and the post-1982 Texas and Oklahoma banking crisis (Horvitz 1992)--were disruptive and pervasive. The resolution costs of the thrift failures alone amounted to about 3 percent of U.S. GDP. And, "large" troubled financial institutions (e.g., Continental Illinois Bank--actually a bank of moderate size and insignificant affairs--Citibank, and Fannie Mae) were either explicitly bailed out by the government or allowed to survive despite their apparent fundamental insolvency.

The underlying policy failures that had contributed to these crises were discussed and reasonably well understood by 1990. Clearly, the monetary policy changes of 1979-82, which caused interest rates to skyrocket and later decline, and which were associated with dramatic changes in inflation, term spreads, exchange rates, and energy prices, were the most important shocks driving events in the U.S. banking system during the 1980s. Changes in tax law in 1986 that eliminated accelerated depreciation were also important for promoting commercial real estate distress. But the U,S. banking crises of the 1980s were not primarily attributable to those shocks; three microeconomic policies substantially magnified the severity of the losses experienced by banks. (1)

First, at the heart of the real estate disaster was a raft of government subsidies for real estate finance that proved destabilizing, especially to real estate markets and to financial institutions operating in those markets. These distorting subsidies included special advantages of the thrift charter, subsidized lending from the Federal Home Loan Banks, "regulatory accounting" rules that purposely masked thrift losses, the absorption of interest rate risk in the mortgage market by the inadequately capitalized government-sponsored enterprises (GSEs), Fannie Mac and Freddie Mac, and the lending policies of the Farm Credit System that promoted the farm land bubble of the 1970s and early 1980s.

Second, the increased protection of banks removed deposit market discipline as a source of control over the risk-taking of banks and thrifts. Protection from deposit insurance increased dramatically in 1980 and has been further expanded subsequently, which substantially reduced the possibility that higher risk-taking by banks would lead depositors to withdraw their funds. (2)

Third, ineffective prudential regulation failed to substitute for the market discipline that deposit insurance and other government protection of banks removed. That was especially visible in the failure of supervisors to identify losses in failing banks and prevent those losses from growing larger as the result of increased risk-taking by "zombie" banks and thrifts.

In the wake of the banking crises of the 1980s, the U.S. promulgated an ambitious program of reform to prudential banking regulation and regulatory accounting practices, implemented through the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) in 1989 and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. …

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