Policy Analysis No. 149

Judging the 1991 Reform Effort: Do U.S. Banks Have a Future?

By Catherine England
February 12, 1991

Executive Summary

When President Bush signed into law the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) on August 9, 1989, he promised that the bailout legislation for savings and loans would “safeguard and stabilize America’s financial system and put in place permanent reforms so these problems will never happen again.” Less than 18 months later, disturbing predictions of a possible crisis among U.S. banks have raised doubts about the administration’s ability to deliver on its promise of “never again.”

Although there is considerable disagreement about the state of the banking industry’s health, there is enough unsettling news to cause many taxpayers to take notice. Bank failures increased dramatically during the 1980s. Between 1945 and 1980, bank failures averaged fewer than five per year. In only four of those years (1975, 1976, 1979, and 1980) did 10 or more banks fail. Between 1981 and 1989, however, the average annual number of bank failures jumped to 114.(1) The changes in the bank failure rate between 1955 and 1990 are illustrated in Figure 1. Credit quality represents a serious problem for a significant number of banks. Those industry trends become even more disturbing when they are coupled with newsmaking events such as the failure of the Bank of New England, Chase Manhattan’s recent decision to cut 5,000 jobs while setting aside $850 million to cover bad loans, or the recent prediction by the Congressional Budget Office that the Bank Insurance Fund will become insolvent sometime in 1992. Year-end financial statements from the nation’s banks will be examined with uncommon interest in the coming months, and the Federal Deposit Insurance Corporation’s reserve position will be watched closely in an effort to ascertain the insurance fund’s financial health.

The bad news coming from the banking industry will also draw attention to the Treasury Department’s recently released report on deposit insurance reform. Mandated by FIRREA, the report offers a blueprint for broad reform of the regulatory structure of the financial services sector, and alternative proposals from both Congress and the industries affected have already begun to appear. All such suggestions for reform must be carefully evaluated, however. If policymakers are to prevent the deteriorating condition of the banking industry from developing into a sequel to the S&L crisis, reform must address the fundamental problems facing the nation’s banks. Taxpayers must not be satisfied with halfway, patch-up measures.

This paper describes four broad criteria against which alternative reform proposals should be judged. But first, the fundamental sources of the banking industry’s malaise are identified.

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Catherine England is director of regulatory studies and senior editor of Regulation magazine at the Cato Institute.