Academic journal article International Advances in Economic Research

Regulatory Forbearance: A Reconsideration

Academic journal article International Advances in Economic Research

Regulatory Forbearance: A Reconsideration

Article excerpt

WILLIAM G. GISSY [*]

Critics of regulatory forbearance argue that the resulting moral hazard produces higher costs when a depository institution is ultimately resolved. This paper derives a formula for the minimal survival rate necessary to make forbearance the least cost policy. When applied to the empirical results produced by critics of the policy, it appears that the forbearance practice of the 1980s was a cost saver to taxpayers. (JEL G28)

Introduction

As Benston and Kaufman [1997] note, the end of 1990 saw the American banking industry in its worse shape since 1933. From 1984 through 1990, 8 percent of commercial banks and 25 percent of savings and loan (S&L) associations were either resolved or placed in conservatorship. The absolute number of failures was double the amount from 1934 through 1983. The debacle of the 1980s has been examined extensively (see Barth [1991], Benston [1985, 1995], Jaffe [1989], Kane [1985, 1989a, 1989b], Pizzo et al. [1989], and White [1989, 1991]). The S&L collapse was due to a myriad of factors, including economic decline in certain markets, moral hazard costs of deposit insurance, imprudent risk taking resulting from broadened asset powers, and asset growth fueled by brokered deposits. Add to this mixture varying degrees of political interference, inadequate monitoring, and out-and-out fraud, and you have a recipe for financial disaster. [1]

As is often the case, the crisis of the 1980s was due in part to the economic conditions of the previous decade. Since S&Ls were restricted by Regulation Q which set limits on the rates they could pay on their deposits, sudden increases in interest rates stimulated an outflow of funds from the industry. In addition, interest rate increases reduced the present discounted value of their mortgage portfolios. Despite last-gap efforts at deregulation, most S&Ls were economically insolvent by 1982.

Overwhelmed by the sudden influx of troubled institutions and burdened with an economically insolvent insurance fund, the Federal Home Loan Bank Board (FHLBB) reduced the number of insolvent S&Ls by lowering the requirements for legal insolvency. As noted by Leggett [1994] and Benston and Kaufman [1997], this policy of forbearance [2] was motivated by necessity in that the Federal Savings and Loan Insurance Corporation (FSLIC) lacked the capitalization to cover all insured deposits at all legally insolvent institutions. Nevertheless, these authors belong to the chorus of critics that have labeled the practice of forbearance as a dismal failure. The practice of regulatory forbearance fails to weed out institutions suffering from incompetent or corrupt management and creates a new moral hazard by placing institutions in a go-for-broke position. [3] The failure to engage in the timely resolution of insolvent institutions resulted in dramatically higher closure costs, with much of the burden falling to the U.S. taxpayer (see Barth et al. [1990], DeGennaro and Thompson [1996], Kane [1989b, 1993], and Kane and Yu [1995]). [4]

This paper challenges conventional wisdom by arguing that the practice of forbearance was a cost-saving action. Although the incremental cost of resolving an institution that was granted a period of forbearance was positive, critics fail to account for foregone costs. Not all institutions operating under the veil of forbearance had closed. The question centers on the necessary survival rate to justify the policy of delayed closure.

The second section provides a brief overview of the reregulation that resulted in response to the crisis of the 1980s. The third section derives the formula for the minimum survival rate and the fourth section applies this formula to the empirical results produced by the various critics of forbearance. The fifth section provides a summary discussion.

Farewell Forbearance?

In response to the fiasco of the 1980s, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, which replaced the FHLBB with the Office of Thrift Supervision, which was placed under the direction of the Treasury Department. …

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