Financial Institutions Reform, Recovery, Enforcement Act of 1989 ; Deposit insurance

Jonathan A. Neuberger

English

Research Papers in Economics

FRBSF WEEKLY LETTER
December 1, 1989
FIRREA and Deposit Insurance Reform
In August 1989, the Financial Institutions Reform,
Recovery, and Enforcement Act (FI RREA) was
passed to protect the federal deposit insurance
funds from the escalating claims of insolvent
thrift institutions. To achieve this goal, the bill
enhances the powers of thrift regulators to restrict
risky activities and close insolvent institutions
promptly. The new law also strengthens super-
visory and regulatory oversight and imposes
more stringent capital requirements on thrift
institutions. These measures are features of a
number of proposals for permanent reform of
deposit insurance.
This Letter analyzes key provisions of FIRREA
and finds that although the law takes a number of
positive steps to deal with the current thrift crisis,
it contains elements of forbearance that risk fur-
ther growth in claims on the deposit insurance
funds. Perhaps more important, FIRREA does not
address the flawed incentive structure of the
deposit insurance system. Additional reforms,
therefore, will be necessary iffuture problems
are to be avoided.
Objectives of FIRREA
The crisis in the savings and loan industry is the
resuIt of serious deterioration in the net worth of
insured institutions. As of August this year, in-
sured liabilities at insolvent institutions exceeded
the value of assets by an estimated $100 billion
or more. Moreover, the potential liabilities of the
insurance fund were increasing at a rapid rate.
Lacking even a tenth of the resources to cover
this enormous shortfall, the Federal Savings and
Loan Insurance Corporation ultimately was
declared insolvent.
There is much debate over the proximate causes
of this deterioration, but it is widely agreed that
the deposit insurance system itself is fundamen-
tally at fault. With fixed-rate premiums unrelated
to the riskiness of insured institutions' portfolios,
there exists an incentive, or "moral hazard:' for
excessive risk taking. This' perverse incentive for
risk taking increases, moreover, as the net worth
of insured institutions approaches zero.
The legislative responseto the S&L crisis was
passage of FIRREA. The bill has a number of
stated objectives. Among these are: 1) to
strengthen the enforcement powers of thrift
regulators, enabling them to deal promptly with
insolvent and weak thrifts; 2) to protect the
integrity of the deposit insurance funds by cur-
tailing activities at insured institutions that pose
unacceptable risks; 3) to strengthen the financial
condition of the industry by imposing more strin-
gent capital and other supervisory standards;
and 4) to promote through regulatory reform a
safe and stable system of affordable housing
finance.
Strengthening supervision and regulation
Since the incentive for excessive risk taking rises
as the net worth of an institution approaches
zero, currently insolvent institutions pose the
greatest risks to the deposit insurance fund and
must be closed immediately. Previous regulatory
forbearance enabled these insolvent thrifts to
continue to operate, thereby increasing risk tak-
ing and the potential liabilities of the insurer.
Many have suggested that the Federal Home
Loan Bank Board's dual roles as thrift chartering
agent and overseer ofthe deposit insurance fund
created conflicts of interest that led to this for-
bearance policy and increased the size of the
insurance crisis. In response to these concerns,
FIRREA includes a number of organizational re-
forms of thrift industry regulators. It consolidates
management of the bank and thrift deposit insur-
ance funds under the Federal Deposit Insurance
Corporation (FDIC) and creates a new thrift regu-
latory agency, the Office of Thrift Supervision
(OTS). FDIC and OTS are endowed with en-
hanced powers to enforce bank and thrift
regulations.
FIRREA facilitates the closure process by broad-
ening the powers of the FDIC to close insolvent
thrift institutions as well as insolvent banks in a
prompt manner. The bill authorizes the FDIC to
step in as conservator or receiver for any insured
bank or S&L chartered under federal or state law.FABSF
(As conservator, the FDIC operates or disposes of
an institution as a going concern, while a re-
ceiver has th~ power to terminate activities and
liquidate assets.)
The Act also gives FDIC authority to suspend
or terminate deposit insurance coverage more
expeditiously. Prior toFIRREA, the minimum
legal period required to terminate coverage was
significantly more than two years. Underthe new
bill, this process has been "accelerated" to as
little as six to seven months. Since most weak or
insolventinstitutions cannot survive without
deposit insurance, the power to terminate cover-
age promptly is, in effect, a prompt closure
policy.
FI RREA also gives OTS greater authority to
restrict activities at undercapitalized thrifts, the
ones that face the strongest incentives to exploit
the deposit insurance guarantee by pursuing
high-risk activities. For example, OTS can
prohibit undercapitalized thrifts from accepting
brokered deposits and it can restrict the growth
rate of assets at such thrifts. These restrictions
limit the extent to which an ailing institution can
add to the potential liability of the deposit
insurance fund.
Enhancing capital
Another objective of FIRREA is to reinforce the
financial position of thrifts and ensure a safe and
sound housing finance industry. The primary tool
is stricter capital requirements. In the past,
regulatory accounting techniques and other
means of capital forbearance enabled zero or
negative-net-worth institutions to continue to
operate. In contrast, FIRREA sets new capital
standards that are to be strictly applied to all
institutions.
Thus, thrifts must hold core capital equal to three
percent of their assets and tangible capital equal
to 1V2 percent of assets. Core capital is the sum
of common equity, noncumulative preferred
stock, minority interests in consolidated subsidi-
aries, and supervisory goodwill, less most intan-
gible assets. Tangible capital is core capital
minus all intangibles (except mortgage servicing
rights) and supervisory goodwill.
FIRREA's more stringent capital regulations
should give thrift owners and managers greater
j
incentives to control risk-taking. With more of
their own money at stake, thrift owners will be
less likely to exploit the deposit insurance
guarantee by pursuing high-risk strategies.
In an additional effort to limit the risk and
enhance the financial stability of thrifts, FIRREA
contains some new restrictions for all savings and
loan institutions, including those that are not
federally chartered. For example, the new legisla-
tion prohibits thrifts from investing in less-than-
investment grade debt instruments, that is, junk
bonds. Thus, it supercedes certain states' laws
that have granted thrift institutions considerable
latitude in investment powers.
FIRREA also raises the proportion of assets that
depositories must hold in residential mortgage-
related assets in order to be considered thrifts.
The "Qualified Thrift Lender" (QTL) test requires
an insured institution to hold at least 70 percent
of its assets in so-called "qualified thrift invest-
ments:' S&Ls that satisfy the QTL test benefit
from low interest rate advances from the Federal
Home Loan Banks. Those that do not meet the
new QTL guidelines must convert to a bank
charter.
Where FIRREA falls short
Although FIRREA enhances closure powers,
strengthens capital standards, and limits for-
bearance, it does not go far enough to provide for
lasting reform of the deposit insurance system.
One important problem is that the new capital
requirements are based on book-value ratios.
Although a book-value standard has the advan-
tage that it is relatively easy to administer, in a
liquidation or reorganization, book accounting
values are irrelevant. The cost to the insurance
fund in a liquidation is the difference between
the prices the institution's assets and liabilities
can be sold for on the open market. The incen-
tive to take on risk, moreover, relates to the
market value of capital. Thus, emphasis on book
values raises the likelihood that thrift portfolios
may look good on paper while concealing weak
market-value net worth and large potential
claims on the deposit insurance fund.
The failure to incorporate market-value account-
ing in FIRREA also presents problems for the
closure of insolvent institutions. Although the
new law makes it easier for the OTS and FDIC toclose book-value insolvent institutions, clever
accounting at troubled thrifts may make it pos-
sible for market-value insolvent institutions to
continue to operate under the new law, pursuing
high-risk strategies that entail growing liabilities
for the deposit insurer. In addition, the growth
limits, asset restrictions, and other sanctions
contained in the bill are all based on book value
measures of capital deficiency and thus suffer the
same weakness as the closure rules.
Also, it is difficult under FIRREA's capital provi-
sions to distinguish risky from relatively safe
institutions. The bill calls for risk-based capital
standards that are "no less stringent" than those
applied to national banks. Even the bank stan-
dards, however, do not employ market valuations
and focus primarily on credit risk. These meas-
ures thus do not provide an accurate valuation of
institutions' risk-adjusted market-value net
worth, particularly as regards interest rate risk.
Thus, two 5&Ls could maintain the same book-
value capital ratio, but pose very different risks to
the insurance fund.
These problems with book valuation implicitly
allow capital forbearance to continue. Another
problem with FIRREA is that it still explicitly
allows room for forbearance that would permit
even book-value insolvent institutions to con-
tinue to operate. At the discretion of the Director
of OT5, an institution that violates the new capi-
tal standards can be granted an exemption from
FIRREA's asset growth and activity restrictions by
filing an acceptable "capital plan!' Although this
plan must address the need for additional capital
at the institution and describe the methods that
the insured thrift will use to raise the new funds,
this provision leaves the door open to continued
capital forbearance.
There is also an implicit form of forbearance in
the relatively long delays required to terminate
insurance coverage (though these delays are
shorter than in the past). Claims against the
deposit insurance fund could grow significantly
while the FDIC moves to terminate coverage.
Another potential problem with FIRREA is that it
requires thrifts to concentrate a large majority of
their portfolios on residential mortgage assets.
These QTL restrictions prevent thrifts from em-
ploying diversification strategies that actually
might reduce the risk oftheir portfolios. In fact,
it can be argued that a lack of diversification
contributed to the problems at many failed thrift
institutions. The wisdom of these restrictions is
thus questionable.
Long-term reform
FIRREA was intended primarily as a short-term
reorganization and recapitalization of the thrift
industry and its deposit insurance fund. The bill,
however, comes surprisingly close to true, long-
term reform of the deposit insurance system.
Long-term reform requires that the perverse in-
centives for risk taking embedded in the existing
insurance system be eliminated.
FIRREA falls short of this standard by continuing
to emphasize book-value net worth. It is possible
under the new law for a book-value solvent, but
market-value insolvent, institution to manipulate
the recorded value of its net worth and continue
to operate in a high-risk fashion. The deposit
insurance fund will thus continue to be in dan-
ger until long-term reform eliminates the
incentives for such behavior.
Two provisions of FIRREA, namely, enhanced
capital requirements and prompt closure could
be sufficient to eliminate the perverse incentives
if these provisions were geared to market values.
In fact, risk-based capital standards and a policy
of closing depository institutions that fail to meet
these standards on a market-value basis effec-
tively would eliminate the need for deposit
insurance.
FIRREA recognizes the importance of more
fundamental deposit insurance reform. It com-
missions a number of special studies on long-
term issues, including market-value accounting
and a risk-based insurance premium system.
True reform likely will have to wait for the
findings of these studies in 1991.
Jonathan A. Neuberger
Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors ofthe Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author..•. Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
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FIRREA and deposit insurance reform

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