Economic Principles and Deposit-Insurance Reform - May 15, 1989

Sep 21, 2026

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Economic analysis of the U.S. thrift crisis highlights how rising interest rates destabilized savings and loan institutions and triggered insolvencies. It explains how Congress and regulators responded with capital forbearance, then evaluates the later Bush administration plan to recapitalize and close failing thrifts while strengthening the FDIC. The commentary then develops core principles for deposit-insurance reform, focusing on policy objectives and economic consequences.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages5

Reading Time13 min

AccessFree to download

Economic Principles and Deposit-Insurance Reform

The Purpose of Deposit Insurance

Policy Objectives and Implementation

Bank Runs and Market Discipline

by James B.Thomson T he dramatic rise in interest ratesduring the late 1970s and early 1980swreaked havoc on the balance sheets ofsavings and loan(thrift)institutions.Astheir cost of funds rose above what theycould eam on their asset portfolios,thrift institutions began to lose billionsof dollars.By the end of 1982,237thrifts(with S67.8 billion in assets)in-sured by the Federal Savings and LoanInsurance Corporation(FSLIC)were insolvent by generally accepted account-ing principles(GAAP). The initial response of Congress andthe Federal Home Loan Bank Board tothe thrift crisis was a policy of capitalforbearance.Capital requirements wererelaxed for the industry as a whole,andinsolvent and capital-deficient thriftswere allowed to operate because if in-terest rates declined,the institutionsstood a chance of recovering. This policy of capital forbearance en-tailed a high degree of risk.By buyingtime to deal with the insolvency prob-lem,the ultimate cost of resolving theproblem could have become smaller.Unfortunately,the outcome was disap-pointing,as both the number of insol-vent institutions and the cost of resolv-ing these insolvencies rose through theend of 1987(see table 1). By late 1988,nearly 500 thrifts wereeither GAAP-insolvent or in danger offailing.The cost of closing,reorganiz-ing,or recapitalizing these institutions # Economic Principles andDeposit-Insurance Reform is estimated at more than $124 bil-lion.²Furthermore,approximately 500additional thrifts are above normal risksfor failure.The expected future cost as-sociated with these failures is not in-cluded in the FSLIC loss estimates. In contrast,the fund of the FederalDeposit Insurance Corporation(FDIC)remains solvent,despite havingerodedin this decade under the pressure ofrecord bank failures and an increase infailure-resolution costs.In 1988,theFDIC experienced its first loss in thepost-Depression era,as the book valueof its fund balance shrank from $18.3billion to $14.1 billion.Academiceconomists and private bankinganalysts estimate the real value of thefund as being significantly less.In factthe private group known as the ShadowFinancial Regulatory Committee esti-mates that the true reserve balance ofthe FDIC fund,net of estimated un-booked losses,is only $400 million. On February 6,1989,the Bush ad-ministration announced a plan forresolving the thrift crisis that includesprovisions to recapitalize the insolventFSLIC and to close nearly 500 savingsand loan institutions that are currentlyinsolvent or in danger of failing.TheBush plan also contains provisions forstrengthening the FDIC's fund. Conspicuously absent from thisproposal are fundamental reforms to May 15,1989 The current system of federal depositinsurance subsidizes risk-taking bydepository institutions,resulting inincreased failure-resolution costs anddecreased efficiency for the entirefinancial system.Reforms to thedeposit-insurance system should con-sider both the policy objectives andthe attendant economic consequencesand costs of deposit guarantees. the federal deposit-insurance systemthat would help prevent another suchcrisis.Numerous proposals fordeposit-insurance reform have been ad-vanced.The purpose of this EconomicCommentary is to examine the fun-damental economic principles thatshould be used in evaluating thesereform proposals. ■ The Purpose of Deposit InsuranceWhat are the policy objectives ofdeposit insurance?Are depository in-stitutions special in some way that re-quires that they have access to federaldeposit guarantees,or are they simplyspecial because they have access tothese guarantees?While often ignored,these fundamental questions are impor-tant because different objectives fordeposit insurance could correspond todifferent methods of implementing adeposit-insurance system.⁴ One widely cited justification forfederal deposit guarantees is the need toprotect the savings and transactions bal-ances of small savers.If small deposi-tors lack the sophistication and

FAQs

What economic problem drove the thrift crisis discussed in the commentary?

Late-1970s and early-1980s interest rate increases raised the cost of funds for thrift institutions above what they could earn on their asset portfolios. This led thrifts to lose billions and, by the early 1980s, to become insolvent under GAAP.

What was the initial policy response to the thrift crisis?

Congress and the Federal Home Loan Bank Board adopted capital forbearance by relaxing capital requirements and allowing insolvent, capital-deficient thrifts to operate in the hope that interest rates would decline and recovery would become possible.

Why does the document argue deposit insurance should not guarantee indiscriminately?

It distinguishes rational bank runs (based on good information) from irrational ones (driven by poor information). Since deposit-insurance systems cannot reliably tell the difference, reform should consider how to target insurance in a way that preserves desirable market discipline.

Sep 21, 2026

Uploaded by Aurelia