Academic journal article New England Economic Review

Resolving a Banking Crisis: What Worked in New England

Academic journal article New England Economic Review

Resolving a Banking Crisis: What Worked in New England

Article excerpt

Many Asian economies are now experiencing economic hardship, their troubles stemming in part from crises in their banking sectors. Given the important role the banking sector plays in these economies, resolution of their banking crises is a vital first step toward resuming economic growth. Unfortunately, the steps taken so far to resolve their banking problems appear inadequate. Many observers compare current attempts to those of U.S. regulators during our initial efforts to resolve the S&L crisis. Given the lengthy time it took to resolve the S&L crisis and the high cost of a taxpayer-supported resolution, this is not a comparison the Asian countries should welcome.

The S&L crisis, however, was not the only U.S. banking crisis resolved in recent years. The six New England states also experienced a severe banking crisis, losing more than 15 percent of their banks in the early 1990s. Unlike the S&L crisis, however, the New England crisis was resolved at far less cost and in a much more timely manner. In fact, just a few years after the crisis, the banking sector was healthy and profitable again and the region enjoyed a vibrant economic recovery. This paper examines the behavior and interactions of bankers, regulators, and market participants during the New England banking crisis, in order to determine what factors led to the relatively successful resolution of this banking crisis.(1)

While the S&L crisis has been widely analyzed (for example, see Kane 1989b, Barth 1991, and White 1991), only sparse evidence is available on the resolution of New England's banking crisis. Studies of the S&L crisis examine the role that deposit insurance and regulatory forbearance played in that crisis, contending these policies contributed greatly to the cost of its resolution. Many argue that these policies allowed economically insolvent institutions to conceal the true extent of their weakness and to undertake a "go for broke" strategy in a last-ditch effort to salvage their institution. Did managers of failing New England banks undertake similar "go for broke" strategies in the years prior to their failures? If not, what made managers of New England banks choose an alternative path? This article examines these two questions.

The primary finding of this study is that failing New England banks, in their final years, did not increase the riskiness of their operations in a last-chance effort to salvage their firms. This lack of excessive risk-taking was likely the basis for the relatively efficient resolution of the crisis. The data also suggest that strict regulatory oversight, public disclosure of banking problems, and market discipline all contributed to the success of the resolution?

I. The New England Banking Crisis

Starting in 1989 and continuing through the early 1990s, the New England banking industry experienced tremendous hardship. Amid a slowdown in the region's economy and the collapse of the region's real estate market, banks faced an increasing number of delinquent loan customers. Profitability deteriorated as loan defaults rose, and many of the region's banks did not survive. Table 1 shows the extent of these problems.(3) More than 15 percent of the region's banks operating in early 1989 had failed by the end of 1994.(4) These failing banks held approximately 20 percent of the region's banking assets as of the beginning of 1989.

Most of the failures were due to loan losses resulting from the region's slumping real estate market (Randall 1993). Table 1 shows that the average bank had 5.87 percent of its assets classified as nonperforming loans by the end of 1991, an increase of more than 5 percentage points from levels at the end of 1987. Given that this figure does not take into account loans already charged off by banks, it understates the true extent of the industry's loan problems. Eventually, these problems affected banks' earnings and capital positions. …

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