A History of the Federal Reserve, Volume 2 (90 page)

The source of the problem lies in the choice that a regulator has to make under uncertainty at a time of banking crisis. One option is to let the bank fail but lend freely to the market at a penalty rate to protect solvent banks from a possible run. This is the Bagehot rule. Let the stockholders bear the loss and replace the management, but allow the bank to continue operating. The other option is to bail out the failing bank. The second course always gains from fear that the crisis will spread and become a large panic with many failures. Faced with the choice under these conditions, few regulators choose the first course.
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Knowing that large banks will not fail encourages mergers and acquisitions to become sufficiently large to be too big to fail. And it encourages excessive risk taking. At hearings on the Continental Illinois failure, the Comptroller of the Currency announced that “too big to fail” applied to eleven U.S. national banks. Many observers concluded that the list was longer or would be enlarged in a crisis (ibid., 155).

Congress responded to “too big to fail” and regulatory decisions in the 1980s by passing the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The act tried to restrict discretion and limit bailout of uninsured depositors. It required regulators to choose the least costly means of resolving banking problems while showing concern for adverse effects on the financial system.
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It made clear that Congress had a continuing oversight interest and would require ex post explanations of actions. This was not new, but there is some evidence that FDICIA worked to reduce bailouts to uninsured depositors (Stern and Feldman, 2004, 153).
²⁵
In FDICIA Congress acted to restrict the Federal Reserve and the FDIC from protecting bankers and uninsured depositors. The act prohib
ited the FDIC from paying off more than the insured depositors, but other sections of the act weakened the prohibition. And FDICIA restricted the Federal Reserve from lending large sums to failing banks, thereby shifting the cost to the FDIC.

23. Stern and Feldman (2004, 48) cite studies showing that failure of Continental Illinois “would not have wiped out the entire financial capital of any respondent banks . . . and therefore would not have led many of them to fail.”

24. FDICIA shifted the cost of bank failures from taxpayers to banks by requiring FDIC to maintain a minimum ratio of reserves to insured deposits (1.25 percent). If the ratio fell below the target, FDIC had to increase premiums paid by solvent banks. FDICIA also introduced “structured early intervention,” a requirement that regulators act promptly to restrict a failing bank’s actions before it became insolvent.

25. Large borrowing by Continental Illinois contributed to slower growth of the monetary base and money. The Federal Reserve chose to target nonborrowed reserves but included large borrowing with nonborrowed reserves, so it supplied fewer reserves through open market operations.

The July assistance to Continental did not end its borrowing. A month later, Peter Sternlight reported that Continental’s borrowing increased to around $7.5 billion from $5 billion in mid-July (FOMC Minutes, August 21, 1984, 2). A month later, Sternlight appended a report from his staff showing additional problems; large money center banks became more reluctant to borrow from the Federal Reserve and held larger excess reserves. He said this increased the federal funds rate for any level of borrowing (ibid., September 28, 1984).

Volcker conducted monetary policy forcefully, but he was less forceful and less successful as a bank supervisor. He told a Senate committee that he urged Continental to take drastic action in 1982 after Penn Square failed, but he did not require them to do so. The bank continued to pay dividends to shareholders. With hindsight he recognized his mistake (Grieder, 1987, 626).

Continental was the largest failure but far from the only one. During the first half of 1984, forty-three banks failed. Most suffered from falling crop and land prices, an event with many precedents. The FDIC paid off the insured depositors and usually merged the failing bank with another local bank.

Large banks experienced losses especially on agriculture, energy, and real estate lending. Bank of America and Manufacturers Hanover had to pay a premium to borrow on CDs after the collapse of Continental Illinois.

The Financial Corporation of America, a holding company, was the largest operator of thrift associations in the country. Its principal holding, American Savings and Loan Association (Los Angeles) experienced deposit losses. These increased following a decision by the Securities and Exchange Commission requiring American Savings to restate its earnings using generally accepted accounting in place of regulatory accounting permitted by the Home Loan banks. The ruling converted a reported profit into a loss.
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The Board of Governors could approve collateralized loans to American if requested by the Federal Home Loan Bank. The Board discussed the loan and collateral available. It decided to authorize long-term loans at an
above-market rate. The holding company had only $6 billion dollars in collateral and was unlikely to get more. Deposit losses increased as rumors spread that the Federal Savings and Loan Insurance Corporation (FSLIC), the government’s deposit insurance company for thrift institutions, was unlikely to be able to meet all of the claims from failing savings and loan associations (Board Minutes, August 17, 1984, 7).

26. Barth, Bartholomew, and Labich (1989, 41) examined the available evidence on failures of thrift institutions to conclude that “insufficient capital and the lack of a timely closure rule were major causes of the thrift crisis.” Moral hazard and regulators’ forbearance made serious contributions to the losses.

Ohio had several problems with savings and loans that were not members of FSLIC. The Federal Reserve helped to close the failing associations. At the May FOMC meeting, President Horn (Cleveland) commented on the moral hazard problem. The position of some failing thrifts is so bad that “there is nothing to keep them from trying to take a big bet and trying to hit a home run in real estate development kinds of projects. Because if they fail to hit the home run, have they really worsened their condition?” (FOMC Minutes, May 21–22, 1984, 10). The moral hazard problem, recognized when deposit insurance started, had finally become a major problem.
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Regulatory forbearance aggravated the problem.

The Board took an important step in January, when it approved the sale of two failing thrifts in Florida to a major New York bank, Citicorp. The Board fully discussed its concerns about allowing Citicorp to expand when it had large holdings of foreign debt in countries such as Mexico and Brazil that had defaulted. Unwilling to permit the failures in Florida, the Board permitted the acquisitions, thereby introducing interstate banking in Florida. The vote was four to two with Governor Wallich abstaining and Governors Rice and Teeters dissenting mainly out of concern for problems in Citicorp’s portfolio (Board Minutes, January 19 and 20, 1984).

During the year, the Board considered major mergers and acquisitions to prevent failures by banks and thrifts. Out-of-state banks acquired most of the large Texas banks. Chase Manhattan acquired Lincoln First Bank in New York State, permitting it to expand out of New York City for the first time. Selin Corporation, a one-bank holding company in Chicago, acquired four banks in Illinois, a major break in the Illinois unit banking law that did not permit branching until that time.

These actions changed the nature of the financial system. They could occur because legislation permitted acquisition of a failing thrift association by an out-of-state bank holding company as a last resort.
²⁸
After 195
years, the United States had interstate banking. Banks could now diversify more readily, a step that particularly helped smaller, rural banks.
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27. In the midst of the series of problems in summer 1984, Volcker recognized lax regulation and supervision, noting that he was not proud of regulatory policy in general and by the Federal Reserve. He announced that the Federal Reserve would soon require members to increase capital (FOMC Minutes, July 16–17, 1984, 56).

28. In June, the Board rejected acquisition of a solvent North Carolina thrift by a Rhode
Island bank. It had
previously permitted the Rhode Island bank to acquire a failing North Carolina thrift (Board Minutes, June 4, 1984, 7).

Regulatory
Changes

The large number of failures and losses to the deposit insurance funds and regulatory forbearance stimulated interest in reform of the deposit insurance system. The public became aware of political pressures to avoid closing failing banks and the difference in treatment of small and medium banks versus “too big to fail” for large banks. The Treasury Department proposed to adjust deposit insurance premiums for the risk undertaken by the bank. In principle, this would increase incentives for reducing risk and penalize high risk. The Treasury also proposed to permit the FDIC to withdraw insurance for certain classes of risky depositors.

The Board recognized the need for change, but it did not endorse the Treasury proposal. It argued that the proposals were inadequate in part because insurance premiums were too small to affect the desired outcome. Also, the Board wanted to require banks to increase capital (letter, Volcker to Thomas J. Healey, Board Minutes, May 4, 1984).

To its discredit, Congress concentrated most of its attention on finding malefactors and charging them in public. It largely ignored structural problems in financial regulation, lax regulation, the pressures it put on regulators, and flaws in the deposit insurance system. This delayed reform for several years. In 1991, it corrected these errors by passing FDICIA, as noted earlier.

When foreign banks began to purchase domestic banks, the Board considered the capital requirements of the foreign banks. At the time, the requirement for domestic banks was 5 percent of assets. The Board could not agree on how this standard could be applied to foreign banks that used different accounting and regulatory conventions. It did not set a standard for foreign banks.

As Japanese banks became active in the domestic financial system, the Board decided to consider each acquisition on its merits. For example, although the Board members believed that the capital ratio of Mitsubishi Banks was inadequate, the Board voted five to two to permit Mitsubishi to acquire a California bank. Governors Martin and Rice dissented on grounds that foreign banks should meet the same standards as domestic banks.

29. The first and second banks of the United States had branch banking systems in the years that these banks operated, 1791 to 1811 and 1816 to 1836.

The Board set or recommended bank capital requirements, but it was slow to change them. In July, the FDIC and the Comptroller proposed new capital standards. The Board’s concern was that the proposed standards raised the standards for most banks, but the proposed level was lower than the standards at smaller community banks. Although the Board was reluctant to lower any standards, it joined in the proposal but issued the standards as guidelines for banks and not as a regulation. All member banks and holding companies were asked to have minimum primary capital equal to 5.5 percent of total assets and total capital equal to 6 percent of adjusted assets.
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The Board continued to use “zones” for capital. Institutions with a 7 percent capital-to-asset ratio were considered “adequately capitalized.” Below 6 percent, the bank was “undercapitalized” (press release, Board Minutes, July 26, 1984).
³¹

Other
Regulations

The Board in January also adjusted reserve requirements as required by the Monetary Control Act of 1980. In January, it reset to $29.8 million the amount of transaction balances subject to the 3 percent reserve requirement. Under the Garn-St. Germain Depository Institutions Act, it reset the aggregate amount of deposits subject to zero percent reserve requirement from $2.2 to $2.4 million.

In February, the Board issued a statement opposing the growing practice of making payments from accounts at banks located far from the payee to capture additional days of float. The Board objected that the practice reduced the efficiency of the payments system.

Litigation

Several court cases approved Board actions extending opportunities for bank holding companies to own and operate brokerages, insurance agencies, and industrial banks, and to expand across state lines. Affected parties often sued to challenge the expansion of banking powers. The relative positions of banks, investment banks, and insurance companies had been limited by rules and legislation adopted in the 1930s. Another decade passed before Congress could agree to change these rules and increase competition in financial services. Some examples of the 1984 cases follow (Annual Report, 1984, 161–88).

30. The Board excluded intangible assets from primary capital. Reserves for loans and leases were included as primary capital.

31. In May, the New York bank announced capital adequacy guidelines for dealers in the government securities market. The guidelines were voluntary and proposed after a number of defaults (statement of Edward J. Ging, Board Records, May 31, 1984).

In 1983, the Board approved Bank of America’s acquisition of a discount brokerage, Charles Schwab, for its holding company. The Securities Industry Association sued to reverse the acquisition. The Supreme Court upheld the order.

Also in 1983, the Board approved an application by three Missouri banks to sell property and casualty insurance directly related to financial services. On June 13, 1984, the court upheld the Board’s decision.

First Tennessee National Corporation sued to require the Board to reverse its decision permitting Citicorp to acquire an industrial bank in Tennessee. The case was dismissed.

The Board amended its regulation of bank holding companies to permit new powers. These included commodity trading services, check guaranty services, financial counseling, armored car services, tax planning and preparation, and operating a credit agency (ibid., 189).

INTERNATIONAL DEBT AND EXCHANGE RATES

During the spring and summer of 1982, Mexico had borrowed overnight from Treasury and Federal Reserve swap lines to show more reserves on its monthly statement in the hope that holders of Mexican dollar securities would roll over their loans. This made it difficult for lenders to know the extent of Mexico’s problem, but they knew there was a problem. Mexicans had more dollar liabilities than it was likely to repay and service. Wary foreign lenders withdrew their loans, and informed Mexicans sent money abroad, draining foreign reserves. The games played by the Bank of Mexico and the Federal Reserve made it difficult to know the magnitude of the problem, but that did not stop the capital outflow.

Mexico would not act before its July election, and outgoing president López Portillo would not act after the election during his last months. He left the problem to two able officials, Jesús Silva Herzog and Ángel Gurría, assisted by Miguel Mancera, president of the Bank of Mexico. López Portillo would not permit negotiations with the IMF, so Silva Herzog and Gurría had to find an interim solution that would keep Mexico from defaulting before the new administration took control in December.

By mid-August Mexico’s foreign exchange reserve had fallen to about $200 million. It lost $100 million a day in capital outflow. Without support from abroad, Mexico could not avoid default. Whatever concern the United States had for Mexico, its first concern was the effect of a default on domestic banks and financial institutions with loans to Mexico. Other debtor countries would soon follow Mexico, adding to the financial problem. British, Swiss, and Japanese banks also faced substantial losses, so the governments of these countries participated in the lending program.
The central banks agreed to provide $1.85 billion in swap credits, half from the United States. Also, agricultural credit and advance payment for oil shipments added about $2 billion. The private sector banks agreed to a “standstill,” i.e., a “hidden” default; Mexico would not pay and the banks would not declare a default (Volcker and Gyohten, 1992, 200–202). The banks agreed also to advance more loans.