FROM THE OFFICE OF PUBLIC AFFAIRS

The initial response to the FDIC Improvement Act of 1991 was chilly, to say the least. Treasury Secretary Brady called FDICIA a "pale shadow of the fundamental reforms . . . that the nation's banking system so badly needs." The Wall Street Journal reported the widely held view that FDICIA "may undermine banks further." President Bush criticized the legislation as "do[ing] little more than provide critical funding to the Bank Insurance Fund," and he warned that "[t]his shortsighted congressional response to the problems we face increases taxpayer exposure to bank losses." The December 19 enactment date -- three weeks after Congress adjourned -- in part reflected the President's decision to sign the bill privately, with no media event and no champagne. History does not record whether he held his nose.

Many bankers denounced FDICIA as the epitome of regulatory burden. Banking lawyers and consultants characterized it as gratuitously punitive. Asked about FDICIA, Federal Reserve Governor John LaWare "could only shake his head," saying "How they had the audacity to call it an 'improvement act' I'll never understand." And my good friend Karen Shaw declared: "This legislation creates a system of arbitrary, Draconian and inflexible regulatory criteria designed to ensure that no bank will ever again fail. In pursuit of this Quixotic goal, the legislation will ensure that while few banks will ever fail, none will ever prosper."

Well, a funny thing happened on the way to the fiasco.

Depository institutions have prospered since FDICIA's enactment. For example, commercial banks' return on assets has more than doubled. It was 0.53 percent in 1991 and 0.93 percent in 1992, and has ranged between 1.15 percent and 1.20 percent since then. Banks' return on equity rose from 7.94 percent in 1991 to 14.4 percent this year. Banks' ratio of core capital to tangible assets increased more than 20 percent, from 6.48 percent in 1991 to the current level of 7.79 percent. The percentage of commercial banks reporting net losses plummeted by two-thirds, from 11.6 percent in 1991 to 3.75 percent now. Aggregate commercial bank net income rose to a record $32.0 billion in 1992 (surpassing the previous high of $24.8 billion set in 1988) and went on to set new records in each successive year: $43.1 billion in 1993; $44.6 billion in 1994; and $48.8 billion in 1995.

Not only has bank profitability increased but failures and problem cases have fallen to a tiny fraction of prior levels. In 1991, the FDIC closed or bailed out 127 institutions insured by the Bank Insurance Fund, with $63 billion in assets. In 1992, the agency resolved another 122 failed BIF members, with $44 billion in assets. By contrast, so far this year, failure has claimed 5 BIF-member institutions, with $190 million in assets. Likewise, the FDIC's 1991 problem list included 1,089 BIF-member institutions, with over $600 billion in assets -- one-sixth of the assets of all BIF members. Today, that list has shrunk to 93 institutions, with $8 billion in assets -- less than 0.2 percent of the assets of all BIF members. BIF's fund balance rose from negative $7 billion at the end of 1991 (negative 0.36 percent of insured deposits) to over $26 billion this past September (1.32 percent of insured deposits).

As George Kaufman declared here four years ago, AIf this be death by regulation, what a way to go!@

Now I'm certainly not suggesting a simple one-to-one correlation between this turn-around and FDICIA's reforms. Depository institutions benefited greatly from a favorable interest-rate environment during 1992 and 1993, and from the economic recovery of the past four years. Moreover, we should see FDICIA itself as part of a process that began with the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and included the tightening of bank supervision in 1989-91. That tightening reduced losses and increased profits in the ensuing years. Depository institutions also benefited from the closure of hundreds of insolvent thrift institutions that had bid up rates paid on deposits, bid down rates charged on loans, and undercut credit standards.

FDICIA: What Is Important and What Is Not

FDICIA differed from most previous U.S. banking legislation in that it consciously sought to change the incentives confronting depository institutions' owners, managers, and regulators. Specifically, it sought to align those incentives more closely with the interests of the federal deposit insurance funds and the taxpayers.

As I and others have explained on previous occasions,1 the pre-FDICIA system of federal deposit insurance and depository institution regulation inadvertently encouraged depository institutions' owners, managers, and regulators to act in ways that harmed the insurance funds. It created perverse incentives for owners and managers to take excessive risks and for regulators to forbear and overextend the federal safety net. FDICIA's most important reforms -- such as prompt corrective action, risk-based premiums, and least-cost resolution -- represent a coherent effort to correct those perverse incentives.

These incentive-oriented reforms constitute the heart of FDICIA. They are what is important in the Act. And, to the extent that they have been implemented, I believe that they have worked. They have helped create a better set of incentives. They have reduced the potential for moral hazard. And they have helped regulators be more faithful agents of the taxpayers.

Regulators' Implementation of FDICIA's Key Reforms

One of the challenges of our topic this morning -- what in FDICIA has worked and what has not -- is that we have not gone through a full economic cycle with FDICIA in effect. FDICIA became law as the economy was touching bottom during the last recession. The two years preceding its enactment also saw significant tightening of bank supervision. Moreover, prompt corrective action took effect one year after enactment, when the economy was already beginning to recover. So we don't know for certain how things will work. We can't know for certain -- that's why we call it the future. So far, so good.

But I'm troubled by the argument that FDICIA's limits on regulatory discretion will have draconian consequences -- and pose an acute risk of a meltdown-- the next time that the financial system comes under stress.

Let's look at the argument more closely. It has two fundamental assumptions. First, that provisions like prompt corrective action and least-cost resolution impose such severe constraints on regulatory discretion that they will, all too often, force regulators to take actions that are self-defeating. And second, that regulators can do nothing to avoid getting caught in such a bind. In my view, neither assumption is true.

I'll focus here on the first assumption, as applied to prompt corrective action. FDICIA's prompt corrective provisions impose relatively modest constraints on regulatory discretion.2 Only a few of the rules are categorical. For example, an undercapitalized institution cannot pay dividends. Most of the rules involve some degree of regulatory discretion -- generally involving authority to make exceptions if following the rule would not help avoid or minimize loss to the insurance fund. Quite a few rules are purely discretionary. So critics err in characterizing FDICIA as a mechanistic attempt to eliminate regulatory discretion.

The fact is that prompt corrective action, like FDICIA's other key reforms, relies heavily on regulators and regulatory discretion. That reliance follows naturally, and in some ways unavoidably, from the use of conventional historical-cost accounting data to define depository institutions' capital for purposes of prompt corrective action. Capital is intrinsically a lagging indicator of problems. Traditional historical-cost accounting principles accentuate the lag. The upshot is uncertainty about a troubled institution's market value. Because of that uncertainty, prompt corrective action provisions generally give regulators some leeway to make a judgment about the institution's condition and prospects and take actions sooner, or later, than accounting numbers might suggest. By the same token, the statute did contemplate that regulators, in the course of implementation, would develop some limits on their own discretion beyond the minimum prescribed by the statute.

Perhaps the most striking common thread in the regulations implementing FDICIA's key reforms is their minimalism. They generally do the minimum that the statute requires, and no more. In many ways, this minimalism is not surprising. To begin with, there is still remarkably little appreciation of the ways in which unconstrained discretion, coupled with the federal safety net, tended to create perverse incentives for regulators to forbear and overextend the safety net. Thus it's natural for regulators, like other people, to resist limits on their discretion.

Second, FDICIA became law also during a crisis in the financial system and (as previously noted) during a recession. It took a crisis to overcome normal complacency -- and the normal inertia of the legislative process. But regulators naturally wanted to take care not to exacerbate the financial crisis or credit-availability problems. Hence a reinforced interest in keeping their options open.

Third, regulators accorded great weight to bankers' complaints about regulatory burden. These complaints in part reflected a reaction to FIRREA and the heightened stringency of bank supervision. They also reflected bankers' perception that they were, in effect, being penalized for the excesses of the thrift industry. As a result, regulators tended to be cautious and sparing in implementing FDICIA's key reforms.

As a matter of history, the minimalist implementation of those reforms is understandable enough. But what of the future? FDICIA contemplated that regulators would continually strive to strike a better balance between the costs and benefits of safety-and-soundness regulation. I believe that we need to be careful to make sure that we do not squander the beneficial incentive-effects of FDICIA's key reforms by succumbing to complacency -- and thereby leaving depository institutions needlessly vulnerable to future stress.