The 1980s: Booms, Busts, and Bailouts

Financial crises often are described as something akin to a “perfect storm,” in which the simultaneous occurrence of so many unforeseen and unpredictable events can only happen once every 100 years.

But that is far from the truth. Booms, busts, and financial crises have occurred throughout U.S. history, for the most part every 20 years or so. However, only during the last two financial crises—the banking and savings-and-loan (S&L) crisis of the 1980s and early 1990s, and the financial crisis of 2008—have we experienced the additional phenomena of “too big to fail” and the widespread use of taxpayer bailouts.

Perhaps the 100-year flood explanation is a way to justify unpopular taxpayer bailouts, with the follow-on statement, “Don't worry, it won't happen again, at least anytime soon.” But financial markets are becoming progressively more integrated, which means that financial volatility spreads much faster. Unless we learn from history and better prepare ourselves for new challenges, in the years ahead we risk facing larger, more sudden, and more frequent storms, more taxpayer bailouts, continued economic hardship, and social unrest.

The history that remains critically important to understand is the boom-and-bust period encompassing the 1920s and the Great Depression that followed. From 1921 to 1929, the stock market experienced a sixfold increase. Almost everyone wanted to share in the gains, and an article in the Ladies Home Journal headlined “Everyone Ought to Be Rich” captured the spirit of the era. People borrowed more so they could invest more. Debt levels steadily rose. Bank lending standards steadily eroded.

Then the bubble burst. The Dow Jones Industrial Average fell 39 percent from October 23 to November 13, 1929. There was a small recovery over the next few months, but then the decline resumed. When the market bottomed out in July 1932, stock prices were 85 to 90 percent lower than their peak in 1929.

Once the selling started, it turned into a vicious downward cycle. Panic ensued and there were bank runs. But the banks didn't have enough cash on hand to meet the demand. They had to sell good assets at fire-sale prices, further exacerbating the downward cycle. Half of all U.S. banks either closed or merged with other institutions. There were no taxpayer bailouts. Instead, there were suicides, bankruptcies, and massive levels of poverty and unemployment.

The experience was forever etched into the memories of all who were touched by it, and it was something no one ever wants to repeat. It took decades for the country to recover. The most significant financial reform legislation in the history of the United States was enacted during the early to mid-1930s, calling for the creation of the Social Security System, unemployment compensation, and a number of new government agencies, including the Federal Deposit Insurance Corporation (FDIC).

The FDIC was created to help maintain public confidence in the banking system and reduce the likelihood of bank runs. Individuals could be assured that their money was safe, up to the deposit insurance limit of $2,500, regardless of which bank was holding the deposits. In the decades that followed, the pendulum swung full circle from the “anything goes” days prior to the 1930s. The banking system was heavily regulated and tightly controlled. There was little risk in the system. Few banks failed, but this stability was offset by a dearth of competition or innovation.

As memories of the Great Depression dimmed, the financial markets gradually evolved. Inflation accelerated during the 1970s, as did market interest rates. But there were strict limits on the interest rates that banks and S&Ls were allowed to pay for deposits. Bank customers began to look for better places to invest their money. Money started to move out of the heavily regulated banking system into far less regulated money market mutual funds, part of what later became known as the “shadow banking system.”

Businesses and consumers found that loans were harder to obtain and more expensive. Economic growth slowed. The interest rate caps at banks and S&Ls had to be eliminated in order to encourage people to deposit money back into the banking system.

In 1980, President Carter signed legislation that would begin the deregulation of interest rates. Over the next several years, interest rate controls at banks and thrifts were gradually removed. That law also raised the deposit insurance coverage limit from $40,000 to $100,000.

I joined the FDIC in 1981 thinking that I would be there for only a couple of years to experience what it was like to work in Washington, D.C. But by the early 1980s financial markets were starting to operate very differently than they had for the prior few decades. The FDIC was about to find itself right in the middle of the developing turmoil. From a quiet little agency with somewhat of an inferiority complex, the FDIC would be transformed into an independent-minded organization operating in a challenging and fast-paced environment.

During the 1980s, the rapid evolution of the financial environment, coupled with reckless lending, reckless borrowing, weak oversight, careless policies, and boom-to-bust markets, led to the failure of over 2,000 banks and S&Ls. In the first half of the 1990s, another 900 became insolvent. These failures were more than enough to render the S&L deposit insurance fund insolvent, while also costing the FDIC's deposit insurance fund over $30 billion. The total cost to taxpayers was $125 billion.

But none of that was easy to see in 1981. I was 28 years old, newly arrived from Massachusetts, and impressed with my new world. The solid structure that housed the FDIC headquarters was just one block away from the White House. The photographs on the inside walls showed lines of depositors waiting to take their money out of banks during the Great Depression. They were a constant reminder of the importance of the FDIC's mission.

But not everyone in Washington was impressed with the FDIC. The Federal Reserve, which also had regulatory authority over banks, looked at the FDIC as a younger sibling that mostly could be ignored, but occasionally had to be told what to do.

At the FDIC, we looked upon the Federal Reserve with a combination of respect and suspicion. It was the top dog in the financial regulatory community, and staffers there liked having the rest of us know they were the top dogs. They supervised big banks, while the FDIC supervised small banks. They were the bank regulatory equivalent of Wall Street, while we were more Main Street. Their male bank examiners wore starched shirts with ties and suits. The FDIC's bank examiners wore ties, too, although occasionally one might detect the slightest hint of food stains. The short-sleeved shirts were easier to notice.

My early impression was that the Federal Reserve staff was arrogant. When I went to a meeting with a couple of their economists and introduced myself as being from the FDIC, one of them said: “Oh yes, you supervise small banks, don't you?”

The Federal Reserve also appeared to be ready to bail out any big bank regardless of the situation. “Regulatory capture” is the phrase that came to mind. At the FDIC, we sometimes referred to the Fed as the “Evil Empire,” a Star Wars analogy bestowed upon them by Roger Watson, then the FDIC's deputy director of research.

In 1981, Paul Volcker was the chairman of the Federal Reserve. Despite being the leader of the Evil Empire, Volcker was no Darth Vader, even if many people probably thought of him that way. Volcker was determined to bring inflation under control. To do this, the Federal Reserve drastically reduced the supply of money in the economy, which had the intended effect of dramatically increasing interest rates. They peaked at over 20 percent. Needless to say, this greatly depressed economic activity, since neither businesses nor consumers could afford to borrow money at those rates of interest.

Volcker was not a very popular person, but he persisted and achieved his objective. By bringing inflation under control, he set the stage for many years of economic prosperity. He had the courage to take a position that was in the best long-term interest of the country despite the personal attacks that he endured from those with a much shorter-term point of view.

This is not to say that some of Volcker's critics didn't have legitimate concerns. The Federal Reserve's monetary policy had some nasty side effects. Many people had made financial decisions based on a certain view on where the economy was headed. Volcker changed those expectations so dramatically that it was hard to adjust. Many small businesses no longer could afford the loans they needed to stay in business. Events didn't turn out as they had planned, and no one was going to bail them out of their problems. Countless individuals and institutions no doubt felt there was some unfairness in the size and speed of the Fed's interest rate pivot, and their concerns were legitimate.

Some of the businesses that were overwhelmed by the changing economy were more fortunate than others. Many savings-and-loan institutions also had trouble adjusting to the new economic environment, but they were bailed out. The increase in interest rates had left them in a hopeless financial position. Their customers were demanding much higher interest rates on their deposits. That would have been fine if these S&Ls could have lent that money out at higher interest rates, but their ability to do so was limited.

Because savings-and-loan institutions primarily lent to home buyers, in the early 1980s that meant their loans were 30-year fixed-rate mortgages. S&Ls already had plenty of 30-year mortgages that they had made when interest rates were much lower. Those low interest rates were locked in place for up to 30 more years. So while S&Ls had to pay depositors higher and higher interest rates, their income from mortgage holders did not change much. They were steadily losing money. The reality was that they had no way to save themselves.

The Federal Home Loan Bank Board (FHLBB) regulated the savings-and-loan industry, but it didn't have enough money to close insolvent S&Ls. Instead, it decided to prop them up, creating zombie S&Ls.

The FHLBB engaged in policies that were designed to buy time. Capital requirements (the amount of money required to be put into a financial institution by its owners) were reduced, accounting rules were weakened, and other regulatory requirements were relaxed. The FHLBB hoped that these types of “forbearance” policies would buy enough time to allow the interest rate environment to improve so the weakened S&L industry could regain its financial strength.

This regulatory strategy might have worked out if there were stronger supervisory controls on weak and insolvent S&Ls. As their capital became depleted, the owners of these S&Ls saw that they had nothing left to lose by taking extravagant risks. If those risks worked out, they might get all of their money back, perhaps even more. If those bets did not work out, their S&Ls would be that much more insolvent. But so what? They had already lost all of the money they had invested. It was worth the gamble. Heads, they'd win; tails, the federal government would lose.

The incentives were all wrong. Insolvent S&Ls tried to grow their way out of their problems. By paying extremely high interest rates for deposits, they could attract as much money as they wanted. They invested that money in speculative new real estate development projects. When the real estate market crashed in the mid-1980s, the losses at these now much larger institutions had grown enormously.

These S&Ls had been given a second chance, but many wound up failing anyway. The Federal Savings and Loan Insurance Corporation (FSLIC), the industry's deposit insurance fund, now was broke. It was the responsibility of the S&L industry to replenish the FSLIC, but the amount needed far exceeded what the industry had the capacity to pay. Most of the cost would have to be borne by taxpayers, and that cost was much higher than it would have been if these S&Ls had been closed earlier or if their activities had been placed under tighter supervisory controls.

At the time, my focus was on what was happening within the FDIC. The FDIC did not supervise S&Ls, but it did supervise commercial banks and mutual savings banks. The term mutual means that there are no shareholders, this type of bank is “owned” by its depositors and other creditors. Mutual savings banks were a lot like S&Ls. They also lent money to home buyers for 30 years at fixed rates of interest. This meant that they were experiencing the same type of financial problems as S&Ls, but there were significant differences in how the FDIC and the FHLBB handled their otherwise very similar problems.

The financial problems affecting savings banks in the early 1980s were the most serious problem the FDIC had ever faced. Because of the significant rise in interest rates, the market value of the assets owned by FDIC-supervised savings banks was far below what they in turn owed to their depositors and other customers. If all of the weak savings banks were closed, the cost could have been over $10 billion—an amount that far exceeded what was in the FDIC's deposit insurance fund.

These problems had their first financial impact on the FDIC in November 1981, when the FDIC arranged for a healthier institution to purchase the $2.5 billion, 148-year-old Greenwich Savings Bank. This was an “Open Bank Assistance Transaction,” which meant that the failing institution was not closed before it was sold, and that the buyer received financial assistance from the FDIC. That assistance cost the FDIC $465 million, an amount higher than the combined cost of all previous bank failures in the FDIC's history.

The FDIC offered to provide financial assistance to other buyers of insolvent mutual savings banks through a voluntary merger program. Under this program, the FDIC offered to cover the cost being incurred by failing savings banks (the difference came from what they had to pay in interest on their deposits compared to the interest they were receiving on their loans and other assets). Thus, buyers were protected against any further losses due to fluctuations in interest rates. By structuring its financial assistance in this manner, the FDIC was taking a calculated risk that interest rates would decline from their historically high levels rather than increase even further.

In 1982, Congress further encouraged the FDIC to provide financial assistance to weak or insolvent banks by giving the agency broader open bank assistance authority. The FDIC was also given the authority to create a program that would allow weak savings banks to remain open even if they did not have the minimum amounts of capital generally required by bank regulators.

Importantly, the FDIC closely monitored and controlled the activities of banks that were allowed to stay open despite their lack of capital. They were not allowed to try to grow their way out of their problems. This helped ensure that if some of these banks still failed, the government's costs wouldn't be any higher because the FDIC had deferred their closings. This oversight was a clear difference from what the FHLBB was doing at that time. Twenty-nine savings banks were allowed into this new program, six of which ultimately failed.

Altogether, the FDIC also arranged 17 open bank assistance transactions under its voluntary merger program. The healthy savings banks that merged with weak or insolvent banks received a combined amount of financial assistance from the FDIC of just over $2 billion. This was a very positive financial result for the FDIC, given what the cost could have been if these banks had been handled in a different manner.

The voluntary merger program helped ensure that there was no run on these or other banks, and there was no public panic. Everyone was protected against any losses. Deposit insurance was there to protect insured depositors, and the structure of the transactions meant that no other creditors were exposed to losses either. Since these were mutual savings banks that were “owned” by their depositors and other creditors, there were no shareholders to absorb losses either.

The FDIC viewed these open bank assistance transactions as being much better than the alternatives. There wasn't that much uninsured money in these banks, so protecting uninsured depositors didn't cost the FDIC very much, and that expense was far outweighed by how much less these transactions cost compared to the alternatives. Nor was there any need to dictate changes in management in most of these situations, since the problems facing these savings banks stemmed from the dramatic change in interest rates that had affected the entire industry. For the most part, they had been conservatively managed and had made high-quality loans.

However, the next problem the FDIC faced was very different. The Oklahoma City–based Penn Square National Bank was terribly mismanaged. It had very loose lending policies, which were used to attract borrowers who could not obtain loans from other more conservative lenders. Nevertheless, these borrowers generally were given very favorable interest rates and loan terms.

Penn Square's business was based on lending money to oil and gas producers. The high rates it paid to attract deposits and its relaxed lending policies allowed it to grow very rapidly. However, much of that growth came just as oil prices were peaking. Prices had risen from under $3 a barrel in the early 1970s to $36 a barrel in 1981. Then they started their descent. The forecasts for a continued upward growth in future oil prices that Penn Square had based its loans on were no longer valid.

Oil prices dropped sharply in 1986, affecting most oil and gas producers at that time. But Penn Square's borrowers were among the first to run into financial difficulty, and Penn Square National Bank was one of the first energy banks that became insolvent.

The FDIC did not want to bail out the uninsured creditors in Penn Square. A bailout in this situation would have been enormously expensive and would have sent a message that no one in the private sector needed to worry about the risks they took in supporting a poorly managed bank.

The Federal Reserve and the Office of the Comptroller of the Currency (OCC), the federal bank regulatory agency that was responsible for supervising Penn Square and other nationally chartered banks, felt differently. Senior officials at these two agencies wanted to see Penn Square get bailed out despite its obvious mismanagement and the far higher cost to the FDIC associated with a bailout. They argued that Penn Square was too connected to other banks to allow its uninsured creditors to suffer losses.

Penn Square had sold shares or so-called participations in its energy loans to other, larger banks. If uninsured creditors lost money at Penn Square because of its bad energy loans, argued the Federal Reserve and the OCC, what was going to prevent uninsured creditors at these other banks from thinking that the same fate could await them? After all, wouldn't these other banks be exposed to the same risks? This could lead to a run of uninsured creditors from these banks. And if those banks ran out of cash, they would have to be closed. And what other banks did they have business dealings with?

The Federal Reserve and the OCC were more worried about these spillover effects and their impact on the broader U.S. economy than they were about what happened to Penn Square itself. They made their views very clear to the FDIC, and they were accustomed to getting their way.

Their arguments had some merit. Bank failures can have spillover effects that damage the entire economy. Some of these spillover effects stem from direct business interactions, such as Penn Square's energy loan participations. Some may stem from a heavy reliance on the same markets, such as subprime mortgages in 2008. And some may stem from the opacity or complexity of a bank's business operations, which make it hard for investors to discern the true financial condition of individual banks.

These spillover effects can be felt suddenly because depositors or other bank investors generally can withdraw their money on a moment's notice. If this happens, a bank can run out of cash and be subject to a liquidity failure. This is a big difference between banks and commercial firms. Commercial firms go through the bankruptcy process, and no one worries too much about creditors losing some money or having the same problems quickly spill over into other commercial businesses. Thus, bailouts of commercial firms, while not unheard of, have been less frequent than what has happened in banking.

If the FDIC wanted to impose losses on the uninsured creditors at Penn Square, it would have had to stand up to the Fed and the OCC and take the risk that there would be spillover effects on other banks. William Isaac was the person on the hot seat. The newly elected president, Ronald Reagan, appointed him chairman of the FDIC in 1981. Isaac was young, confident, and independent-minded and appeared to have been born with an extra portion of attitude.

Isaac was a proponent of market discipline. He did not want to bail out Penn Square's uninsured depositors. Isaac knew there were risks, but felt that if spillover effects posing a threat to the broader economy started to appear at other, larger banks, then that's where the FDIC could draw the line and calm the situation by announcing that it would protect all uninsured creditors. But if the government had to bail out even a $500 million bank, would it be possible to impose enough discipline on the banking system to prevent excessive risk taking and future banking crises?

Isaac held firm and Penn Square was shut down in July 1982, and no uninsured creditors were protected. The FDIC reopened the bank for a short time in order to pay insured depositors their money. Uninsured depositors, of which there were many, were given half of the uninsured portion of their money back. The other half was at risk, depending on what could ultimately be recovered from the bank's poor-quality loans.

Needless to say, people who had invested uninsured money in the bank were furious. No one had expected to lose any money. Since the Great Depression, the few banks that had failed in the past were handled in such a way that all depositors were protected against losses whether they were insured or not. The local community and their congressmen took their anger out on the FDIC.

This seemed to mark the start of a new era, in which uninsured creditors would not be bailed out if their bank became insolvent. Over the course of the next year, there were several more failures of small banks. In each case, the FDIC protected only the insured depositors, providing uninsured depositors and other uninsured creditors with no more than what they were entitled to from the bankruptcy or receivership process. There weren't a lot of uninsured creditors in these banks, and they weren't in much of a position to exert any real discipline on their bank's behavior. Nevertheless, these actions were a positive step forward in creating greater market discipline within the banking system.

All this was happening during my first year at the FDIC. I was learning that first and foremost, the FDIC thought of itself as a bank supervisory agency. Of the roughly 14,000 banks in the country, the FDIC was the federal supervisor for nearly 9,000 of them. Most of these were small banks operating in a single town or in a single state due to the restrictions on interstate and intrastate banking. Most of the people who worked at the FDIC either were bank examiners or had other responsibilities related to bank supervision.

The culture was like that of a military organization. There was a clear chain of command. Bank examiners were the FDIC's foot soldiers. They were located in about 90 field offices spread throughout the country. This enabled them to be within driving distance of the thousands of banks that they examined. The senior officials in these field offices reported to regional offices located in several of the larger cities. Their senior officials reported to Washington, D.C. At headquarters, the division's most senior official had an office near that of the FDIC's chairman. Within the FDIC, next to the chairman, it was the voice of the bank supervisors that mattered most.

Bank supervisory operations were, and still are, highly confidential. In the FDIC's early years, internal communication related to the supervisory assessment of a bank's financial condition often was communicated by code. Each new bank examiner received a copy of the codebook. Those days were gone, but secrecy and careful controls remained paramount.

It took years to work your way up the supervisory hierarchy. One senior official told me he believed that for a regional director to be effective, he (women were rare in the senior ranks) needed to have worked in that region for 20 years. If you had less seniority, you were a newcomer. If you left for another job, either within or outside the FDIC, the unspoken rule was that if you were allowed to return to the division at all, it had to be at a pay level no higher than where you were when you left.

Bank supervision was serious business. Change came slowly. The FDIC wasn't known as a dynamic or creative environment. Many bankers felt that the initials FDIC stood for “Forever Demanding Increased Capital,” given how conservative the agency was and the emphasis it placed on bank safety and soundness. Within the FDIC, this was a source of pride, given that there were always plenty of voices arguing to reduce bank capital requirements. Over the years, as you will see, the FDIC's emphasis on higher levels of bank capital than what other bank regulators or bankers saw as sufficient never changed.

In contrast to the internal clout of bank supervisors, a relatively small staff in the Division of Liquidation was quietly situated in a building down the street from headquarters. These “liquidation specialists” were the employees responsible for closing insolvent banks, paying insured depositors their money, and winding up the affairs of the failed institution. There were few employees in this division because over the past few decades there had not been very many bank failures. Prior to the 1980s, their activities did not draw a lot of attention. But as the number of bank failures started to increase, they were hiring new employees and opening up new offices around the country.

I worked in the Division of Research, and if there was a pecking order, we were probably near the bottom. I was one of a small group of economists and financial analysts hired in the early to mid-1980s. We did not focus on supervising or closing individual banks. We focused more on the broader policy issues facing the organization.

When the Division of Liquidation wanted an economist to speak at their annual national conference in Monterey, California, they didn't invite any of us newcomers. Instead, they invited the Nobel laureate economist Milton Friedman. When he declined their invitation, they tried the Harvard professor Martin Feldstein. He, too, declined. So the Division of Liquidation settled on asking Stanley Silverberg to speak. Stan was not a household name, but he was the very talented director of the FDIC's Division of Research, and he willingly accepted the invitation.

However, a couple of days before the start of the conference, Bill Isaac asked Stan to go to Chicago, where a bank named Continental Illinois was in trouble. This left the Division of Liquidation without an economist to speak at its conference. Stan asked me to fill in for him. I gladly accepted the opportunity to make a trip to Monterey.

When my plane landed in California, there still was a long ride to the conference hotel. This seemed to be a feature of FDIC conferences. They were never anywhere convenient. A large van showed up to drive a dozen or so other attendees and me to the conference. We had an hour's drive ahead of us and had only gone about a mile down the road when the van pulled up at a liquor store, a couple of people jumped out, went into the store, and soon arrived back with a couple of cases of beer for the ride. I would find that my colleagues in the Division of Liquidation did not like to let beer-drinking opportunities pass them by.

My talk at the conference was uneventful—a striking contrast to the events unfolding in Chicago. Continental Illinois was the seventh-largest bank in the country, with about $34 billion in total assets. It was in real trouble, as it had significant exposure to Penn Square, having bought many of its energy loans. Those loans were going bad, and uninsured creditors at Continental were losing confidence in the bank.

At that time, banks weren't allowed to open branches in more than one state, and Illinois also was a unit banking state, which meant that banks couldn't even open branches in more than one location. Therefore, Continental had been unable to attract very many retail deposits (money deposited by individuals). Instead, it had borrowed large sums of wholesale deposits (money deposited by large businesses, other banks, or institutional investors, such as insurance companies, investment companies, mutual funds, or pension funds). As a result, the bank had few insured deposits, but many uninsured deposits. Of Continental's roughly $33 billion in total deposits, our estimate was that only about $3 billion was insured. The uninsured money was starting to leave the bank. Something would have to be done. Isaac asked Silverberg to take the lead in developing a plan. Stan worked closely with Roger Watson, Jim Marino, Jack Murphy, Doug Jones, and others at the FDIC and at the other bank regulatory agencies.

In May 1984, an open-bank assistance transaction was arranged for Continental Illinois. The bank's top-level management and board of directors were replaced. The shareholders' investment was wiped out, but all depositors and other creditors were protected against any losses. Continental was not merged into a healthier bank, as had been done with a number of troubled mutual savings banks; instead, the FDIC temporarily took over ownership of the bank. Put differently, Continental Illinois was nationalized. Over time, the FDIC sold its ownership position, placing the bank back into the private sector. The final cost to the FDIC was a little over $1 billion.

The protection offered to uninsured depositors and bondholders at Continental Illinois marked the end of the short era in which regulators imposed greater market discipline on the banking system. Community bankers around the country were outraged at this inequity. Uninsured depositors in small banks that failed over the past year had suffered losses, while this bailout showed that uninsured depositors and other creditors in large banks that became insolvent did not have to suffer losses. “Too big to fail” became a new part of our financial lexicon.

Despite Isaac's belief in market discipline, there was never any serious consideration within the FDIC of allowing Continental Illinois to be shut down. No one in a position of authority within the financial regulatory agencies was willing to take the chance to see what would happen if uninsured depositors at Continental were exposed to losses. I believe that it was the right decision. This is where the FDIC had to draw the line.

U.S. and non-U.S. depositors were likely to have withdrawn their money from other large banks if they lost money at Continental. Some of these larger banks already were in a relatively weak condition. There were also hundreds of small banks that had invested significant amounts of money in Continental. Many of the smaller banks might have failed as well. The spillover effects on the banking system and the U.S. economy from imposing losses on so many uninsured depositors were too uncertain and potentially too damaging to take the chance.

Segregating insured from uninsured deposits at Continental Illinois also would have presented the FDIC with an enormous operational challenge, which could have taken months to complete. Such a delay in returning money to insured depositors would only have added to public alarm and increased the potential for harmful spillover or systemic effects.

The too-big-to-fail dilemma highlighted by the bailout of Continental Illinois raised what is perhaps the key issue for the FDIC and other financial-market regulators. How can a single large financial institution be shut down in a manner that effectively imposes losses on uninsured creditors without creating a system-wide meltdown? Resolving this dilemma is at the crux of debates over how to regulate the financial sector in a manner that is both fair and effective.

Protecting uninsured and unsecured creditors against losses when a large bank becomes insolvent generally raises the government's cost, creates inequities between how creditors are treated in large bank failures compared to other types of business insolvencies, and increases the likelihood of future banking crises by reducing any incentive these creditors have to control excessive risk taking at large banks. Yet because most bank depositors and other creditors can withdraw their money whenever they want, other banks viewed to be at risk are likely to experience significant deposit outflows. And that can lead to a chain reaction of insolvencies if uninsured depositors and creditors believe that they are exposed to losses.

The too-big-to-fail problem went unaddressed during the 1980s. The banking system began experiencing so many more problems during the 1980s and early 1990s that maintaining public confidence in the financial system became the overriding objective. Finding effective ways to impose greater market discipline and eliminating “too big to fail” would have to wait. However, for reasons to be described later, there are less understandable reasons why the problem also went unaddressed in the late 1990s and early 2000s. It returned with a vengeance in 2008.

During the mid to late 1980s, the U.S. economy began to experience the effects of boom-to-bust cycles in various business sectors of the economy. These cycles resulted in a rolling recession that engulfed different parts of the country at different times. Because banks were geographically restricted in where they could do business, they were highly dependent on the businesses that operated in their geographic area. Thus, they were vulnerable.

The first of these boom-to-bust cycles occurred in the farm belt. During the 1970s, most agricultural experts believed that agriculture was set to prosper for many more years. Farm exports were growing at record rates as the world's population grew at a fast pace. Farm income levels were at historic highs. Farmers borrowed increasing amounts of money to invest in farmland so they could produce even more. Debt levels and real estate prices rose ever higher.

But the agricultural market shifted significantly in the early 1980s, and with rising interest rates, it became much harder for many farmers to keep up with the payments on their record high debt levels. Land prices, which had peaked in 1981, dropped precipitously. Many farmers couldn't afford to repay their loans.

At the time, there were about 4,000 “agricultural banks” in the United States, and many of them faced financial difficulty due to the financial problems of their customers. By 1984, a large number of them were becoming insolvent.

Some in Congress viewed the problems in the agricultural sector as beyond the control of individual banks. Many believed that bank regulators should temporarily relax their standards so these banks could have a chance to work their way out of their problems rather than being shut down.

Bank regulators were not inclined to support this point of view. Nevertheless, supervisory standards for many agricultural banks were temporarily lowered to preclude Congress from enacting legislation that might have been even more lenient. Still, if a bank looked like it was in hopeless financial condition, it was shut down. This was to ensure that bank failure costs did not spiral out of control, as they had in the S&L industry.

Most agricultural banks eventually did recover. Nevertheless, slightly more than 200 insolvent agricultural banks were closed between 1984 and 1987.

Responsibility for closing insolvent banks rested with the FDIC's Division of Liquidation. Some of the banks' owners and managers weren't overly receptive to government employees coming into their towns to shut down their banks. One bank president sat at his desk with a shotgun in full view of the FDIC employee who had come to close his bank. “You aren't here to take my bank, are you?” he asked.

Adverse weather conditions could impact the FDIC's work. During one particularly bad blizzard in the Midwest, an FDIC employee, Bob Longworth, on his way to a bank closing, was involved in an automobile accident. When he got out of his car to look at the damage, an out-of-control 18-wheel truck ran over him. It took his colleagues 15 minutes to find him, buried under a pile of snow, bruised and cold, but not seriously hurt. Despite the near tragedy, he went to the closing, courtesy of a ride from the truck driver.

Other problems arose once inside the banks. In one case, the only bank employee who knew the combination of the bank's vault couldn't remember it. The woman agreed to allow herself to be hypnotized to see if that worked. It did.

That episode was a reminder that while most bank closures were fairly routine procedures, some of them involved issues never encountered before. One example was Golden Pacific National Bank of New York, which was closed in June 1985. There had been a run on the bank, amid rumors that the bank's president was skimming funds and transferring them out of the country.

Located on Canal Street in Chinatown, Golden Pacific catered to immigrant Chinese customers. For a number of years, when the bank's customers made deposits, they were given the option of receiving higher rates of deposit, and in return they would be given a receipt on a yellow piece of paper. There were about $15 million of these so-called “yellow certificates,” which were not recorded on the bank's books. As a result, it was unclear whether they were truly deposits and thus whether they were FDIC-insured deposits.

The bank closing sparked an angry protest by more than 100 of the bank's customers. New York newspapers gave extensive coverage to the bank closing, and the city's mayor, Ed Koch, made an appearance at the bank.

For the FDIC staff who were on site, sorting through the bank's paperwork was a logistical nightmare. Most of the documents were in Chinese, and most of the bank's employees and customers spoke only Chinese. And many of them did not want to speak to government officials, fearing that they might be identified as an illegal immigrant and deported. (To help the FDIC work through these challenges, Chinese-speaking bank examiners were brought to the bank, and interpreters were hired.)

A federal judge ultimately ruled that the “yellow certificates” deserved federal insurance protection, and depositors were reimbursed up to $100,000. And the bank's president was sentenced to five years in prison for defrauding bank customers of $15 million.

By 1985, Bill Isaac's term as FDIC chairman ended. Bill had helped the FDIC find its voice and become more of an equal partner with the other two bank regulatory agencies. More importantly, he had successfully guided the FDIC through the most significant challenges it had ever faced. But it looked like the challenges on the horizon would be as great, if not even more daunting. The FDIC would need a very capable new chairman.

L. William Seidman was that person. An accountant, lawyer, and economist, he had run Seidman & Seidman, the family's firm and one of the largest accounting firms in the country. Bill had also been vice chairman and chief financial officer at Phelps Dodge Corporation, and he was very experienced in the ways of Washington, D.C., having worked in a senior position at the White House during the Ford administration.

Bill had the background and capability to hit the ground running, which was particularly important once the rolling recession hit the energy and real estate markets in the Southwest. No part of the country was harder hit, and no state more so than Texas. Nearly 30 percent of all of the banks and S&Ls that failed during the 1980s and early 1990s were located in Texas. Most of these failures occurred in the latter part of the 1980s. Nine of the state's 10 largest bank holding companies failed. Four of these bank holding companies (First City, First Republic, MCorp, and Texas American) owned over 120 banks, with $60 billion in total assets. Their failures cost the FDIC over $8 billion.

First City Bancorporation of Texas was the first to go. The $11 billion bank holding company owned 60 banks that had grown along with the oil industry during the early 1980s. But the decline in oil prices, agricultural markets, and real estate markets that followed were too much for it to overcome. Given the weak economy and all of the problems in Texas at that time, the FDIC decided to arrange for an open-bank assistance transaction rather than attempting to close and then quickly sell 60 banks.

Open-bank assistance is a lot less disruptive than closing banks since banking services remain uninterrupted. The problem with these transactions is that even though the FDIC is contributing money to recapitalize insolvent banks, the agency still needs to negotiate with the banks' owners and bondholders over an appropriate settlement for their claims. And many bondholders will hold out for more money than what their claims are worth.

In the Continental Illinois open-bank assistance transaction, the shareholders had agreed to a deal that completely wiped out their claims, which was the same fate that would have awaited them if the bank had been closed. But bondholders and uninsured depositors didn't have to accept any losses.

In the First City deal, the FDIC was willing to give the shareholders two cents on the dollar in order to complete the deal, but expected at least 90 percent of the bondholders to accept only 35 to 45 cents on the dollar. It took seven months to negotiate, after which only two thirds of the bondholders had agreed to accept the FDIC's offer. The other third received a full 100 cents on the dollar.

The deal was highly unsatisfactory. The FDIC had contributed financial assistance to complete a deal, where once again many of the bondholders were bailed out. Adding insult to injury, a few years later the bank failed again. The FDIC decided to handle the next large insolvent Texas bank holding company differently.

In 1987, Congress gave the FDIC authority to establish bridge banks, which are temporary banks that can be established and operated on an interim basis in order to preserve critical banking services without having to bail out anyone. When a bank becomes insolvent, the FDIC can close it after business hours on a Friday and then reopen it as a new FDIC-owned bank the following Monday morning. There are no negotiations with shareholders and bondholders. They simply get the amount they are entitled to once the bridge bank is sold.

First Republic Bank Corporation was the largest bank holding company in Texas, owning 40 banks with $33 billion in assets. The FDIC closed these banks and reopened them as bridge banks. Later, they were sold to NCNB, which eventually merged with Bank of America.

Stockholders and bondholders at First Republic were wiped out, a major step forward from the Continental Illinois transaction, where all bondholders were completely protected against any losses, and from the First City transaction, where some bondholders were protected.

But the FDIC still protected uninsured depositors. Before the First Republic banks were closed, the FDIC explicitly guaranteed all of their depositors that they would be protected against any losses in order to prevent a run on the banks by the uninsured depositors. A similar announcement was made prior to the Continental Illinois transaction.

The FDIC's problems in Texas were significant, but they paled in comparison to the problems the FHLBB was having with S&Ls in Texas. The FHLBB arranged numerous sales of insolvent S&Ls under its Southwest Plan. Since that agency still didn't have much money, it gave purchasers of insolvent S&Ls a number of other types of financial incentives, including generous tax breaks. These transactions cost the government enormous amounts of money.

The director of the FHLBB, Danny Wall, had made numerous predictions on what the total cost to the government would be for cleaning up the problems in the S&L industry. Each prediction had been well off the mark, as his estimates only grew higher. His credibility, and that of the FHLBB, steadily eroded.

By contrast, Bill Seidman's credibility, and with it the FDIC's, only grew stronger. Seidman was a no-nonsense, tell-it-like-it-is kind of leader. More and more people in Congress and in the new administration began to think about transferring authority for the S&L clean-up from the FHLBB to the FDIC.

In 1988, both presidential candidates and the media devoted little attention to the looming S&L crisis and the impending costs facing taxpayers. But in August 1989, President Bush signed into law the most significant financial industry reform legislation since the 1930s. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) contained a number of major new initiatives.

The law created the Resolution Trust Corporation (RTC), which was focused on cleaning up the problems in the S&L industry. The RTC was responsible for taking over insolvent S&Ls, selling their assets, and reimbursing insured depositors until its projected sunset in 1996. The FDIC was responsible for managing the RTC, but the federal government would fund it.

The Office of Thrift Supervision (OTS) was created to replace the FHLBB as the regulator of the S&L industry. The staff was essentially the same as before, but organizationally the new agency was separated from the Federal Home Loan Bank System. This separation ended a significant conflict of interest, since their member institutions, the S&Ls that they regulated, owned the Federal Home Loan Banks.

The Savings Association Insurance Fund (SAIF) was created to replace the insolvent Federal Savings and Loan Insurance Corporation (FSLIC). The new deposit insurance fund for the S&L industry was placed under the FDIC's control. It took over responsibility for protecting insured depositors at S&Ls once the RTC went out of business.

The legislation also expanded the FDIC board of directors from three to five members. Danny Wall, the director of the newly formed OTS, and Andrew “Skip” Hove, a community banker from Nebraska, were the two new board members joining Bill Seidman, C. C. Hope Jr., and Robert Clarke, the comptroller of the currency.

In 1986, I had left the Division of Research for a year to work as special assistant to C. C. Hope Jr. C. C. was a former vice chairman at First Union Bank in North Carolina and had traveled around the state arranging mergers between First Union and other, smaller banks. The bank continued to grow, eventually merging with Wachovia Bank to form one of the largest banks in the country. C. C. was a southern gentleman who made a point of remembering the names of everyone he met. I enjoyed working for him. However, a year later, Stan Silverberg retired as the FDIC's director of research. Roger Watson replaced him, and I returned to the division as its deputy director.

At the start of the decade, I had been given the opportunity to play a part in helping the FDIC address the most significant banking problems in the United States since the Great Depression. As the decade came to a close, I was offered another tremendous opportunity when Bill Seidman asked me to be his deputy. I was excited yet apprehensive. In addition to the problems in the S&L industry, new concerns were arising at banks in the Northeast. The rolling recession was heading their way. At the time, I was 36 years old—an adolescent when measured in FDIC years.

What is a bailout? My definition is when an individual or a business in financial distress receives a benefit they are not entitled to. When are bailouts warranted? When it is clear in advance that no one will be made worse off as a result. If a bailout is justified, does that mean it is fair? No. Sometimes there are operational or other constraints that make all of the available options undesirable and unfair, such as when we are faced with a failing institution deemed to be too big to fail.

Bailouts were common in the 1980s. Some were warranted; some were even fair: others were neither. In the most egregious situations, insolvent S&Ls were left open and unattended. Their owners, managers, and other uninsured creditors were given a second chance that their counterparts in other failing businesses don't get. They badly abused that opportunity.

Not only did the costs connected with these failures break the industry's deposit insurance fund, they far exceeded what the entire S&L industry was capable of paying to fulfill its commitment to replenish that fund. As a result, taxpayers paid $125 billion to bail out the S&L industry, much more than what would have been the cost if these insolvencies were addressed in a timely manner. These weren't unavoidable bailouts because the institutions were too big to fail; they were simply the result of misguided policies and ineffective actions by the S&L industry, its regulators, and Congress. They were unjustified and they were unfair.

In response, Congress enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The 1991 law included a provision called “Prompt Corrective Action” (PCA), which was designed to force more timely action on the part of bank regulators when problems appear at banks and S&Ls. Progressively stronger supervisory actions are required as an institution's capital slips below certain thresholds. If an institution's capital drops below 2 percent, it has to be closed within 90 days.

There were some financial industry observers who believed these PCA requirements would eliminate bank failures altogether, believing it would force management to find a solution before a closing wiped out all of the owners' capital. Things did not turn out that way. While helpful in many respects, PCA had a number of shortcomings—a notable one being that it did not envision the kind of liquidity crisis that unfolded in 2008, even at banks that presumably still had relatively high levels of capital.

The law also granted the FDIC backup supervisory and enforcement authority over banks and S&Ls. The FDIC had been frustrated by the actions of the other bank regulators to keep it out of problem institutions that they regulated and supervised. This hindered the FDIC's ability to effectively plan for bank closings and, from the FDIC's viewpoint, contributed to delayed closings and higher failure resolution costs. Since the FDIC has to pay those costs, it is the agency with the greatest incentive to see that insolvent banks and S&Ls are closed in a timely manner. This legislative authority was helpful, but it would not be the final word in the ongoing tension on this subject between the FDIC and the other bank regulators.

The need for strong and timely supervision of the banking industry was better recognized in the aftermath of the 1980s' banking crisis. In the early 1980s, the Reagan administration made a critical mistake. While it recognized that rolling back certain regulations would help create a safer and more effective banking system (deregulation allowed banks to diversify their risks, innovate, and compete for funds), rolling back bank supervision had the opposite effect. Because of deposit insurance and the tendency to protect uninsured creditors from losses, the private sector has insufficient incentive to control excessive bank risk taking. These factors and the fact that a bank's short-term creditors can run at a moment's notice differentiate banks from most other types of businesses, making it essential that the government step in to provide an extra level of oversight and control. In the early 1980s, the FHLBB was severely understaffed due to hiring restrictions imposed by the administration. That contributed to ineffective supervision over the S&L industry.

This is not to say that the regulators of commercial banks were without fault during the 1980s. As the rolling recession moved from one part of the country to another, so did bank supervisors. This constant focus on the individual problem institutions of the moment kept the agencies from recognizing and trying to address the bigger picture as it was developing. After the 2008 financial crisis, the bank regulatory agencies again would be criticized for not paying sufficient attention to the broader systemic effects that had developed.

The 1991 law also did not specify the appropriate amount of capital that should be held by banks and S&Ls. Having more of their own money at risk gives owners a greater incentive to manage banks and S&Ls well. Capital also is the buffer that protects the deposit insurance fund and the taxpayers against losses. The capital forbearance policies that allowed weak S&Ls to remain open when they held little to no capital showed what could happen without appropriate capital levels. In the aftermath of the S&L crisis, regulators required higher levels of capital at banks. But over time these controls were gradually weakened, which contributed to the problems that manifested themselves in 2008.

The commercial banking industry did not need a taxpayer bailout. The industry was able to provide the FDIC with enough money to get it through the crisis. Nevertheless, there were some bailouts, which were paid for by the deposit insurance fund rather than by taxpayers. Continental Illinois was the most notable example. The bank's shareholders were wiped out, and senior managers lost their jobs, but the bank's bondholders were bailed out.

Bondholders tend to be sophisticated Wall Street investors who know the risks they are taking, and are well compensated for those risks. Yet, all of Continental's bondholders, and some of First City's, were protected against losses. This was unfortunate, but at the time the FDIC did not have a viable mechanism for protecting uninsured depositors, who were the greater systemic concern, without also protecting bondholders. The results here weren't fair even if they were justified under the circumstances.

Uninsured depositors also were bailed out at most of the banks (big and small) that failed during the 1980s and early 1990s. The FDIC was far less concerned about these bailouts. In many cases, like with the mutual savings bank transactions in the early 1980s, the transactions were viewed to be the least-cost alternative, thus they were justified, since no one was made worse off as a result.

There was also a fairness element involved in the FDIC's treatment of uninsured depositors. If some banks were too big to fail, why should their uninsured depositors be protected if the same protection wasn't extended to uninsured depositors at smaller institutions? After Continental Illinois, the FDIC was much more sensitive to the complaint from smaller banks that the differential treatment of uninsured depositors between small and large banks created a competitive inequity.

But the main reason why the FDIC protected uninsured depositors at banks of all sizes was to maintain public confidence in the banking system throughout the crisis.

The majority of banks that failed were small institutions. Their customers weren't sophisticated Wall Street businesses; they were small Main Street businesses and local residents. Very few of these customers had money deposited in their banks or S&Ls that exceeded the deposit insurance limits. For those that did, the money often was in accounts used to meet payrolls at small businesses, or it was money held by an elderly individual or couple for retirement expenses. On occasion, there were escrow accounts that had been deposited for a brief period after the sale of one home and before the purchase of another. Perhaps a local church had deposited money that exceeded the deposit insurance limits. These weren't customers who could reasonably be expected to understand the financial condition of the bank they did business with and exert much market discipline on their bank's behavior.

If the FDIC had taken the time to segregate insured deposits from uninsured deposits at all of these small failed institutions during the 1980s, there likely would have been significant delays in getting money back to insured depositors. Depositors generally had access to their money the following Monday morning after a Friday closing. If insured depositors began to worry about having to wait for their money, there likely would have been far less confidence in the banking system as a whole.

There were simply too many small-bank failures during the 1980s for the FDIC not to protect all depositors. Together, the hundreds of small-bank failures created a systemic threat not dissimilar to that posed by a too-big-to-fail institution. Protecting all of these uninsured depositors at small banks also didn't cost much; in fact, it likely saved money. This is not to say that the FDIC didn't care about ending too big to fail or other types of bailouts that were unfair. However, maintaining public confidence and protecting the overall financial system came first.

Thereafter, members of Congress saw things differently than they had earlier in the decade. In 1991, they put greater controls over the FDIC's flexibility in handling such matters. Included in the FDICIA was a provision for a least-cost test, which required that the FDIC handle all future bank and S&L failures in a way that was less costly to the deposit insurance funds than any of the alternatives. This meant that uninsured depositors and other creditors could no longer be protected against losses when their bank failed, unless a decision was made that by protecting uninsured depositors the transaction was the lowest-cost alternative for that particular institution, and hence was justified because it wasn't taking money out of the deposit insurance fund to give uninsured depositors added protection.

There is one possible exception to the least-cost test and that was if the least costly transaction could lead to a system-wide financial crisis. The bar for such a systemic-risk determination was set very high. It requires a two-thirds vote of the FDIC's board of directors, a two-thirds vote of the Federal Reserve's Board of Governors, and approval by the secretary of the Treasury, after consultation with the president.

Congress also put strict restrictions on the FDIC's ability to conduct open-bank assistance transactions, since that was another means by which shareholders and uninsured creditors might receive some government financial assistance without being forced to pay their full share of any insolvency-related costs.

By limiting the FDIC's discretion, Congress was saying that there should be no more bailouts of uninsured creditors at failed banks and S&Ls, unless it saved money compared to the alternatives, or unless there was broader agreement across the key government agencies that imposing losses on failed-bank creditors would create a system-wide financial crisis.

During the 2008 financial crisis, the systemic-risk exception was invoked several times, leading to bailouts by the deposit insurance fund. However, the 2008 taxpayer bailouts of Bear Stearns, Fannie Mae, Freddie Mac, AIG, and money market mutual funds, and the other emergency programs enacted by Treasury and the Federal Reserve were different. They did not require systemic risk exceptions. In 1991, Congress was focused exclusively on commercial banks and S&Ls, the source of problems during the 1980s. FDICIA wasn't designed for the large investment banks and other parts of the shadow banking system that contributed significantly to the 2008 financial crisis. Most of these institutions were outside the traditional and more heavily regulated commercial banking system. Just as importantly, they also were outside of the FDIC's authority and the carefully constructed legislative framework for resolving insolvent commercial banks and S&Ls. Nevertheless, most of these financial institutions also had short-term creditors who could run (and did) at the first sign of trouble. Afterwards, Congress enacted the Dodd-Frank Act, putting additional controls on these other parts of the financial system.