Implications of the Savings and Loan Debacle: Lessons for the Banking Industry
Reinstein, Alan, Steih, Paul W., Review of Business
Congress and the White House enacted the Federal Deposit Insurance Company (FDIC) Improvement Act of 1991 to overhaul the banking industry. Key provisions of this Act include having federal regulatory agencies establish managerial, operational and financial standards for insured depository institutions. The managerial and operational standards require that all federally insured banks have adequate internal accounting controls (i.e. to prevent, detect and minimize the potential for fraudulent transactions); appropriate underwriting standards for issuing and monitoring loan portfolios; and reasonable compensation (banning them from overpaying their officers and directors).
Financial standards require certain minimum capital ratios; earnings levels sufficient to absorb losses without impairing capital; and minimum market to book value ratios for the institutions capital stock. Based upon these financial standards, regulatory agencies will classify FDIC-insured financial institutions into five categories:
a. Well capitalized (where few problems seem to exist);
b. Adequately capitalized (where regulatory approval is needed to obtain brokered deposits);
c. Undercapitalized (where regulators must approve a capital restoration plan);
d. Significantly undercapitalized (where regulators can restrict financial operations, replace officers and directors and require divestiture of the institution, affiliate or subsidiary); and
e. Critically undercapitalized defined by law as tangible equity ratio below 2%) (where regulators must require the institution to prepare for conservatorship within 90 days of it becoming critically undercapitalized).
With the initial implementation now complete, we have seen that these laudable concepts may be too restrictive in some areas and yet not go far enough to avert a banking industry debacle similar to that in the thrift industry, where U.S. taxpayers are projected to have lost almost half a trillion dollars. Management, depositors and United States taxpayers must act to ensure that the problems of the thrift industry do not recur in the banking industry. The purpose of this study is to outline the thrift industry crisis, the resulting government regulation and discuss how to avert its recurrence in the banking industry.
Background of the Thrift industry Crisis
Many thrift executives, accountants and attorneys facing severe civil and criminal penalties for not adhering to their professions' standards have assumed much of the blame for the thrift industry debacle [e.g., Wayne, 1989]. However, the U.S. government, which deregulated the thrift industry, increased the insurance levels provided on thrift deposits and "encouraged" thrifts to make risky, high yield investments with depositors' money, is at least as culpable for this recent crisis. Through deregulation, the government significantly reduced the thrifts minimum capital requirements, expanded the types of assets allowed to comprise the institution's equity structure, allowed nonresidential real estate and consumer loans to comprise up to 70 percent of thrifts loan portfolios -- where they had been restricted previously to the less volatile residential home mortgage market, and permitted accounting rules to not portray accurately this vast erosion of value.
Deregulation and the Emerging Fairy Tale -- In 1980 and 1982, Congress deregulated the thrift industry [Cairs, 19911. Interest rate caps were lifted, deposit insurance levels increased, and accordingly, thrift institutions became more aggressive in their investments. This partial deregulation of the thrift industry encouraged higher risk investments with potentially higher rewards. Real estate and business investors capitalized on the newly deregulated industry to make business investments using only three percent of their own capital; the government provided the other 97 percent and guaranteed depositors the return of their money. …