Federal Deposit Insurance Corporation
at the FDIC Symposium
History of the Eighties: Lessons for the Future
January 16, 1997
It has been said that experience is a tough teacher -- first
you get the test, then you learn the lesson. In the banking crisis of
the 1980s and early 1990s, banking regulators were tested, and
from their experience they learned lessons. Did we learn the
When I became FDIC Chairman, I initiated a project to find
the answer to that question, an answer based on objective analysis.
The result is a series of 14 papers we will publish over the coming
year. The purpose of this symposium is to discuss the first three
papers in this series, which focus on supervisory issues.
This afternoon, I want to focus my remarks on the role of
Federal deposit insurance in our banking and financial system.
One of the lessons of the 1980s and early 1990s is that deposit
insurance was eminently successful in maintaining stability in the
banking system during the crisis. A second lesson is that this
success came at enormous cost to the insurance funds, to the
taxpayer, to the surviving institutions, and to their customers.
Our experience in the crisis reminded us that guaranteeing
savings can be a costly business, although it may be necessary to
stabilize the banking system in times of stress to prevent runs on
individual banks from spreading to become banking panics.
One event toward the end of the most recent banking crisis
underscored how quickly public confidence can evaporate -- and
the importance of deposit insurance in maintaining public
confidence in the banking system.
In early 1991 -- just six years ago -- the New York Times
described recent events at the Bank of New England in this way:
"Frantic depositors pulled nearly $1 billion out of the bank
in two days; small savers trooped through the lobbies with their
money in wallets, bulging envelopes and briefcases, and money
managers yanked out multimillion-dollar deposits by remote
control with computer and telex orders.
"Some local crooks even tried to get in on the action. The
Federal Bureau of Investigation said it foiled a plan by six men
who had hoped to rob an armored car they figured would be loaded
with cash for all the withdrawals."
The New York Times story concluded: "Yet as soon as
Washington stepped in, with the Federal Deposit Insurance
Corporation taking over the bank on Sunday, the panic subsided."
Bank of New England customers may have had doubts
about their bank -- but their doubts were not contagious. Because
Federal deposit insurance maintained public confidence in the
banking system, a run on the Bank of New England did not spread
to other banks or into a general banking panic, with depositors at
other banks demanding their funds, too.
How costly was this protection?
From 1980 to 1994 -- 1,617 banks failed or received
financial assistance from the FDIC. These failures severely tested
the FDIC insurance fund. During the same period, nearly 1,300
savings and loans failed. These failures more than bankrupted the
old savings and loan insurance fund and directly cost the taxpayers
of America $125 billion, and billions more in indirect costs.
As a result of the experience of the 1980s and early 1990s,
deposit insurance has become part of the continuing debate on how
the banking industry should be modernized -- and at the center of
the discussion of deposit insurance is the problem of moral hazard.
The problem of moral hazard occurs when insurance
induces the insured to take more risk than they would take if they
were not insured. Any deposit insurance fund -- any form of
insurance, in fact -- faces the problem of moral hazard. With
deposit insurance, the insured party is the depositor. Insurance
permits insured depositors to ignore the condition of their
institutions. Even fundamentally unsound institutions may have
little difficulty obtaining funds. Because insured depositors may
no longer have an incentive to monitor and discipline their
institutions, the managers of those institutions may take more risks
than they otherwise would. In short, deposit insurance can create
opportunities for managers to make high risk/high return
investments, without the market discipline of having to pay
creditors to take that risk.
Moreover, as the paper that is the subject of the next panel
states: "with respect to the basic trade-off between promoting
stability and controlling moral hazard, bank regulators (in the
1980s) showed a preference for solutions that tipped the balance
toward stability, a policy that was apparent in the treatment of
"This contributed to the success of the deposit insurance
system in avoiding bank runs and disruptive interruptions in credit
flows. . . . (But) By protecting uninsured depositors, the methods
used to resolve large-bank failures removed a source of market
discipline that could have reinforced supervisory efforts to
To inform the debate over deposit insurance in the context
of modernizing the banking charter, today I want to ask a number
of fundamental questions, beginning with a question based on our
experience in the 1980s and 1990s.
Did the problem of moral hazard created by Federal deposit
insurance lead to a large number of failures of insured institutions
in the 1980s and early 1990s, causing massive losses in the
To answer that question, moral hazard has to be broken into
two components. First, in the case of a solvent institution, deposit
insurance may lessen -- or may eliminate -- the incentive for
insured creditors to monitor the activities of management and
owners. Second, where a banking organization is insolvent or is
approaching insolvency, deposit insurance may provide an
incentive to bank management to take abnormal risks, thus
magnifying losses to the insurance fund.
For the thrift industry in the 1980s, moral hazard
contributed to huge losses in the savings and loan insurance fund,
to its ultimate failure, and to substantial costs to the taxpayer.
What began as an asset/liability mismatch problem, aggravated by
rapidly rising interest rates in the beginning of the decade, became
an enormous credit problem as real estate markets collapsed.
Weak regulatory oversight and the lack of resources to
close insolvent thrifts encouraged some institutions to speculate
widely in real estate and other ill-conceived efforts to "grow" out
of their problems.
For banks in the 1980s and early 1990s, the role that moral
hazard played in the significant losses to the insurance fund is not
as clear. Certainly, deposit insurance did remove the incentive for
insured creditors to monitor a bank's activities, but its effect is
difficult to measure.
Moreover, the moral hazard that arises when banks
approached insolvency and owners had less and less at stake was
effectively restrained to a much greater extent than was the case
with savings and loans by supervision of problem institutions. As
will be detailed this afternoon, this restraint is indicated by the
dividend, capital, and asset growth behavior of problem banks at
Higher prudential standards for banks and more immediate
regulatory attention to serious problems -- as well as a solvent bank
insurance fund with the resources to solve problems as they were
identified -- accounted for the difference in the experience of banks
and thrifts. This difference should inform the debate over the role
of deposit insurance in banking's future.
As this debate has developed, two alternatives to the
current system have been offered: The first is to privatize the
deposit insurance system. The second is to reduce the scope of the
current system, and thus rely more on the markets to discipline the
banking system. The two alternatives are, of course, not mutually
Let's briefly analyze these proposals by seeking answers to
four questions: One, what led Congress to make deposit insurance
the responsibility of the Federal government? Two, can deposit
insurance effectively be provided by another supplier? Three, how
much less than the equivalent of a "full faith and credit" pledge by
the Federal government will the public accept? Four, would
reducing the scope of the deposit insurance system bring positive
First, what led Congress to make deposit insurance the
responsibility of the Federal government?
Recurring and worsening banking panics marked the
history of banking in the United States until the creation of the
Federal Deposit Insurance Corporation in 1933. Nine thousand
banks suspended operations from 1930 through 1933. The year
after the FDIC was created, nine insured banks failed.
Even though the banking crisis of the 1980s and early
1990s resulted in a dramatically high number of bank failures,
there was no banking panic -- no contagion that could have
threatened sound banks -- and public confidence in the banking
system held steady.
Today the banking industry is healthy and the economy is
strong. Because the memories in good times can be short, it is
important to remember the lessons of history.
It was the historical experience in the 1930s that has led a
broad range of economists to conclude that Federal deposit
insurance solved a problem that had plagued the banking system --
and the economy -- for more than a century, the problem of
maintaining public confidence in a banking system marked by
liabilities that were liquid and assets that were illiquid.
For example, in his The Great Crash, 1929, John Kenneth
Galbraith observed: "Federal insurance of bank deposits, even to
this day, has not been given full credit for the revolution that it has
worked in the nation's banking structure. With this one piece of
legislation, the fear which operated so efficiently to transmit
weakness was dissolved. As a result one grievous defect of the old
system, by which failure begot failure, was cured. Rarely has so
much been accomplished by a single law."
In their A Monetary History of the United States, 1867-1960,
Milton Friedman and Anna J. Schwartz similarly laud the
role of deposit insurance in stabilizing the banking system:
"Federal insurance of bank deposits was the most important
structural change in the banking system to result from the 1933
panic and, indeed in our view, the structural change most
conducive to monetary stability since state banknote issues were
taxed out of existence immediately after the Civil War."
More recently, Federal Reserve Board Governor Janet
Yellen, who has been nominated to become Chairwoman of the
Council of Economic Advisors, addressed the issue also by
reminding us of history. She said: "Deposit insurance was
introduced both to protect individual depositors and to prevent
panics surrounding individual banks from spreading throughout the
"Would we be better off as a country giving that up?"
Governor Yellen asked rhetorically. "I don't think it is obvious
that we would be. We would have to think through very carefully
what implications the reduction or elimination of deposit insurance
would have for systemic risk. The Depression taught us a lesson."
These tributes to Federal deposit insurance, however, do
not address the question of whether a supplier other than the
Federal government can provide essential depositor protection. In
answering that question, the experience of private and state
insurance providers in the banking crisis of the 1980s and early
1990s should give us some guidance.
As recently as 1982, there were 32 deposit insurance funds
in operation. Only eight survived the crisis. Six operate today,
three cover state credit unions and three are very limited in scope
or are being phased out. Almost all the other funds collapsed
because of the failure of one or more institutions. Most of the
funds were state-sponsored, although the state did not usually
provide any financial guarantees to the fund. These funds typically
were mutual insurance funds with a board of directors drawn from
the insured institutions.
In response to the failure of state deposit insurance plans in
Ohio and Maryland, those states required state-chartered
institutions to obtain Federal deposit insurance. Approximately
150 institutions were added to FDIC coverage in 1985 as a result.
Federal Reserve Chairman Alan Greenspan has observed:
"Confidence in the stability of the banking and payments system
has been the major reason why the United States has not suffered a
financial panic or systemic bank run in the last half century."
It is my belief that deposit insurance can help maintain
stability in the banking system only if depositors have confidence
in the insurance plan. To inspire confidence during a period of
turmoil, deposit insurance must be a certainty for the insured
The experience with private and state-sponsored insurance
plans in the 1980s and early 1990s suggests that the limited pool of
resources on which they can draw inspires less confidence than
does the unlimited pool of resources of the Federal government.
Bank failures may come in waves, because the performance of the
industry is closely tied to the performance of the economy.
While it may be possible to design private insurance funds
that could handle isolated failures successfully, our experience in
the 1980s in Ohio and in Maryland suggests that limited plans have
difficulty handling failures in waves.
Further, if private insurance is substituted for Federal
deposit insurance, a private insurance plan facing depletion of its
fund during a crisis would likely have to seek financing from the
banking industry or other private sources of funds at the same time
that the economy may be weak and the banking industry is having
difficulties. Moreover, if the private insurance supplier fails, the
Congress may have to act to restore public confidence. That would
take time, and based upon the experience during the savings and
loan crisis, Congressional action might occur only after serious
damage has been done and costs have been significantly increased.
In considering privatizing Federal deposit insurance,
therefore, the serious question becomes: How much less than the
equivalent of a "full faith and credit" pledge by the Federal
government will the public accept -- in other words, how much less
would fully protect the banking system in times of crisis? We do
not know the answer, but history suggests that we cannot predict
the depth or duration of a crisis, and that should make us wary.
The final question I want to ask today is: Would reducing
the scope of deposit insurance bring positive results?
In this regard, one observer, former FDIC Chairman Bill
Isaac, recently wrote in the American Banker: "What's needed is
more private-sector discipline. This will come about once the
scope of depositor protection is curtailed sharply, including
abandonment of the too big to fail' doctrine. Millions of
organizations and sophisticated individuals must be given the
incentive to understand, monitor, and control the risks in the
I agree that market discipline is an important element of a
sound deposit insurance system. Our goal is to assure the stability
of the banking system in times of great stress, not to eliminate all
bank failures. An effort to eliminate all bank failures would
involve over-regulation of banks that would lessen their
effectiveness in providing financial intermediation in the economy.
The question remains: What has been done to encourage
market discipline and what more can be done? I will discuss these
issues more in a moment, but first let's consider the issue of the
scope of deposit insurance.
In terms of insuring individual deposits, the scope of
coverage increased until 1980 and then declined, in terms of
today's dollars. Let me explain.
As of January 1, 1934, the FDIC insured deposits up to
$2,500. In 1996 dollars, however, that $2,500 is the equivalent of
$30,000 today. Six months later, the insurance limit was raised to
$5,000, which is almost $60,000 in today's dollars. In 1969, the
limit was raised to $20,000, which is about $85,000 in today's
dollars. When the limit was raised to $40,000 in 1974, that was the
equivalent of $127,000 today.
From its very beginning, deposit insurance covered more
than just the average American's "food and rent" money -- is was
sufficient to cover some savings.
Moreover, depositors today are insured up to $100,000 -- a
limit that has been in place since 1980. The dollars of 1980 are not
the dollars of 1996, however -- $100,000 in 1980 was the
equivalent of $190,000 today. In this sense, for the individual
depositor, the scope of deposit insurance coverage has declined by
almost half since 1980.
I am not advocating any change in the level of today's
coverage for deposits -- the marketplace has already done that. Of
course, the other side of the scope of insurance coverage is
uninsured depositors and the so-called too big to fail' doctrine, as
Bill Isaac points out. The Federal Deposit Insurance Corporation
Improvement Act, however, significantly reduced the authority
regulators have to deal with large institutions that are failing. It
leaves us with enough flexibility, with appropriate oversight by
Congress, to achieve a solution where the failure would present a
genuine risk to the system. This can occur, however, only if the
Secretary of the Treasury -- in consultation with the President --
determines that there would be "serious adverse effects on
economic conditions or financial stability." Such a decision would
be undertaken only after written favorable recommendations from
both the FDIC Board of Directors and the Board of Governors of
the Federal Reserve System, with at least two-thirds of the
members of each body voting in favor of the recommendation.
That is a high standard, particularly when one considers that the
recommendation would have to be defended to the Congress.
Moreover, the FDIC has been required by law since 1991 to
accept the proposal from a potential purchaser that is the least
costly to the insurance fund of all the proposals we receive. In
more than half of the failures in 1992 -- 66 out of 120 -- uninsured
depositors received less than 100 cents on each dollar above the
$100,000. That was a significant increase in uninsured depositors
experiencing losses from 1991, when fewer than 20 percent of the
failures involved a loss for uninsured depositors. While the
number of bank failures in 1992 was lower than in previous years,
the number of uninsured depositors experiencing a loss was
significantly greater. Moreover, as the paper that is the subject of
the next panel points out, resolution with losses to uninsured
depositors have not produced large-scale withdrawals at other
institutions -- though, in the years since 1992, with record levels of
bank profits, failures slowing to a trickle, and no major bank
threatened with failure, the system has not come under stress.
Further, I would ask, can depositors be expected to impose
market discipline on banks? After all, it was this approach that led
to the recurring banking panics that marked most of our history
until 1933. A number of years ago, banking analyst Karen Shaw
Petrou concisely described why the Congress created the FDIC to
benefit individual Americans: "After the collapse of the early
1930s, it was agreed that individual savers should have a protected
right to place a limited amount of money in a financial institution
without having to worry that it could be lost. Individual depositors
should not have to read a detailed report of a bank's condition
before deciding where to deposit their retirement or other savings,
since most depositors would be hard pressed to interpret such
information. To solve the problem, the government took upon
itself the obligation to interpret the financial condition of banks for
depositors, and to back up its judgments with limited federal
In standing in the place of the depositor, banking
supervisors seek to mitigate the problem of moral hazard created
by Federal deposit insurance through examinations and safety-and-
The challenge to the regulators is to develop safety-and-
soundness regulation that comes as close as possible to market
discipline, without imposing inefficient, ineffective regulations on
banks, regulations that unduly inhibit the important function of
financial intermediation that they perform for the economy.
Market discipline, however, does have a critical role in addressing
the problem of moral hazard that deposit insurance creates -- that
discipline, however, can perhaps more effectively be imposed by
large creditors and shareholders of banks.
At least since the least cost test has been imposed on the
FDIC, large creditors should understand the potential for losses on
their exposures to banks. That was perhaps less true with respect
to earlier large-bank resolutions. In addition, over the past few
years, we have undertaken two reforms in deposit insurance that
give shareholders a greater incentive to curb excessive risk taking
at their institutions: one is higher, risk-based, capital standards; the
second is risk-related insurance premiums.
Higher risk-based capital standards expose shareholders of
an institution to greater loss, and risk-based standards expose
shareholders to greater loss as the institution's risks increase. Not
incidentally, the regulations that put higher minimum capital
standards into effect impose restrictions on dividend payments and
other capital distributions if an institution falls below the
Similarly, risk-based premiums are designed to reduce
income in institutions that take on excessive risk, and that
reduction in income is aimed at giving shareholders reason to curb
the excesses. As you know, in 1993, the FDIC established risk-based
deposit insurance premiums. Banks and thrift institutions
were divided into nine groups, depending upon the risks they
present to their insurance fund.
Part of that risk calculation is based on capital and part on
supervisory factors such as asset quality, loan underwriting
standards, and management. We are now analyzing whether other
factors are relevant to risk -- and whether our current 27-basis
point spread is sufficient to price the risks to the insurance fund
posed by individual institutions. Making it more costly for banks
to take on excessive risk will impose more economic discipline on
In conclusion, in the 1980s and early 1990s, deposit
insurance helped maintain financial stability, but at great cost,
particularly with respect to the savings and loan industry.
We should learn from that experience.
Those lessons could lead us to continue to improve our
current Federal deposit insurance system -- as we have begun to do
-- to make it more sensitive and responsive to the marketplace --
finding even better regulatory surrogates and incentives for
Some say that those lessons should lead us to replace the
current system with a privatized approach. But before we take that
course, we should agree on the answers to the questions: What
would happen if there were no Federal deposit insurance program?
Can a supplier other than the Federal government bear the costs
necessary to provide deposit insurance coverage sufficient to
maintain stability in the banking system in times of extreme stress?
How much less than the equivalent of a "full faith and credit"
pledge by the Federal government will the public accept?
Without firm answers to those questions, in privatizing
Federal deposit insurance we may be putting the banking system at
risk. We know Federal deposit insurance works to stabilize the
banking system in times of great stress. Can we be sure that
another approach will work as well?