DIDMCA - Deregulation and its Significance

During the late 1970s people who saved their money at mortgage lending institutions began withdrawing their deposits from these institutions. The disadvantages of saving in the mortgage lending institutions were hurting the investor’s returns. In order to achieve more profitable returns, these traditional savers started investing in high-yield money market mutual funds and other various markets (Brewer III, 1980). With money leaving the mortgage lending institutions, the housing markets were being squeezed. This squeeze on banks, felt in some states, caused banks to cut off credit to households, farmers, and small businesses. Also, during this time only depository institutions were required to maintain non-interest bearing reserves with the Federal Reserve Bank (Allen & Wilhelm, 1988). This caused a record number of banks giving notice of leaving the Federal Reserve in order to be more competitive in the markets. Toward the end of the 1970s inflation was at a high level along with the interest rates. The culmination of these events along with other events called for new legislation to be written.

The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) was signed into law by President Jimmy Carter on March 31, 1980. DIDMCA was considered, by many, as the largest change in the financial industry since the Federal Reserve Act in 1913. Two of the major sections of DIDMCA are Titles I and II. Title I, known as the Monetary Control Act of 1980, sets new standards in reporting requirements, reserve requirements, pricing for services, and sets effective dates. Title II, known as the Depository Institutions Deregulation Act of 1980, sets to create establishment and authority of committee, give directive to the committee, establish targets, reports, and termination of deposit interest rate ceilings (Federal Reserve Bank of Boston, 1980). DIDMCA also allowed the Savings and Loans Institutions to invest up to 20 percent of their assets in consumer loans, commercial paper, and corporate debt securities (Allen & Wilhelm, 1988) (Visser & Wu, 1989) (Moysich, 1997).

Empirical research conducted by Allen and Wilhelm (1988) assesses the impact of DIDMCA within three different types of depository institutions. Allen and Wilhelm used intervention analysis on each portfolio, FRS banks, non-FRS banks, and Savings & Loans (S&Ls). The study concluded that the FRS banks exhibited a gain of 3.9 percent and the non-FRS and S&L’s portfolios lost 4.3 percent and 4.4 percent, respectively. This research indicates that the passage of the DIDMCA, in one respect, was a way to redistribute wealth back into the FRS banks at the expense of S&Ls and non-FRS banks. However Allen and Wilhelm’s research only focused on weekly returns for 179 weeks before and only 30 weeks after the enactment of DIDMCA on March 31, 1980. A better example may come from a long term study of the industry.

Other research, such as Visser and Wu’s (1989) study on the effects of deregulation on bank stock price-earnings ratios (P/Es), set to determine the price-earnings ratios within the banking industry after a major legislative event, like DIDMCA. The study was run over a 10-year period, from 1976 to 1985. The study highlights the variables known to influence P/Es and of the nine titles of DIDMCA only Title IV appeared to have unambiguously negative effects on the P/Es of large banks. Title IV increased the powers of thrifts, which potentially can lower expected earnings for banks as thrifts penetrate their markets. Visser and Wu concluded that the DIDMCA significantly raised the P/Es of large banks, caused them to fluctuate more, and fundamentally changed the way in which they are determined. With P/Es raising investors are left paying more for each unit of stock.

DIDMCA increased the amount of deposit insurance covered by the FDIC from $40,000 to $100,000. This increase in insurance allow for an increase of risk and “moral-hazard.” This increase of the FDIC insurance and deposits interest rates were established to alleviate disintermediation, or the flow of deposits out of financial institutions into money market mutual funds and other investments (Moysich, 1997). The deregulation and increase of “moral hazard” lead to a growth in the S&L industry. From 1980-86 the S&L industry saw a rise of nearly 500 new charters, and the S&L stock contributed to 21 percent of the industry. The percentage of S&L assets in mortgage loans, from 1981-1986, dropped from 78 percent to 56 percent. S&L assets were insolvent and a bailout was not too far away.

Summary

With the onset of increasing competitions between the different financial institutions, investors pulling deposits out of deposit institutions for more lucrative returns, banks pulling out of the Federal Reserve, and decades without financial reform, the need for a financial overhaul was inevitable. Starting from the beginning of the 1980’s, deregulation and moral hazard lead to S&L crisis. As congress fights on to create a new set of financial reform, I hope they have all learned that deregulation is not reform. I believe banks need to be able to fail; this will separate the strong from the weak. If people wish to gamble their money in risky stocks then they should be able to lose, after all it’s a gamble not certainty.

References

Allen, P. R., & Wilhelm, W. J. (1988). The Impact of the 1980 Depository Deregulation and Monetary Control Act on Market Value and Risk: Evidence from the Capital Markets. Jorunal of Money, Credit, and Banking , 364 - 380.

Brewer III, E. (1980, September 11). The Depository Institutions Deregulation and Monetary Control Act of 1980. Retrieved June 22, 2010, from ChicageFed.org: http://www.chicagofed.org/digital_assets/publications/economic_perspectives/1980/ep_sep_oct1980_part1_brewer.pdf

Federal Reserve Bank of Boston. (1980). Depository Institutions Deregulation And Monetary Control Act of 1980. Retrieved June 22, 2010, from Bos.FRB.org: http://www.bos.frb.org/about/pubs/deposito.pdf

Moysich, A. (1997). The Savings and Loan Crisis and Its Relationship to Banking. Retrieved June 22, 2010, from FDIC.gov: http://fdic.gov/bank/historical/history/167_188.pdf

Visser, J. R., & Wu, H.-K. (1989). The Effects of Deregulation on Bank Stock Price-Earnings Ratios. Financial Analysts Journal , 62 -67.

By: Joseph Dustin

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The U.S. Financial Meltdowns: Then and Now

Bank Failures created in the 1930’s

Banks during the 1930s were vastly embarking into an unforeseen calamity; causation leading to the bank failures is still open to interpretation. At the turn of the 20th century, banks began to “boom.” The next two decades saw an increase in the numbers of banks that peaked in 1921 with roughly 31,000 banks in operation (Walter, 2005). So, what caused the catastrophic ripples, throughout the banking industry, that ended with the onset of the Great Depression?

Did the Bank of the United States (BUS) lead to the economic downswing during the early 1930s; thus becoming the catastrophic ripple? BUS, prior to its failure in December, 1930, was the twenty-eight largest commercial bank in the country (Trescott, 1992). To better understand the causation of bank failures during the 1930s, I will explore previous literature that attempt to scrutinize the Bank of the United States.

Milton Friedman and Anna J. Schwartz’s research, A Monetary History of the United States, has been said to be “the leading and most persuasive explanation of the worst economic disaster in American history,” by Ben S. Bernanke (Bernanke, 2002). Friedman and Schwartz’s research advocates that bank failures, during the “Great Contraction of 1929-33,” arise from monetary issues and view bank failures as a result of unwarranted “panic” and that failing banks were in large measure illiquid rather than insolvent (Calomiris, 2007). Others, including Paul B. Trescott, “argue that the bank’s closing was a response to actual and threatened insolvency, not illiquidity (Trescott, 1992).”

It is important to understand if banks at the time were failing due to becoming illiquid or insolvent. If banks, during the Great Contraction, were illiquid at the time then one could be lead to believe that contagion and/or bank runs might be at fault. On the contrary, if banks at the time were insolvent then we might need to look into other reasons as to why banks were failing.

One could easily come to the conclusion that banks, during the Great Contraction, were indeed illiquid. This conclusion could be explained through the creation of the Federal Deposit Insurance Corporation (FDIC). The creation of the FDIC in 1934 and the simultaneous halt of bank failures are both valid points that insinuate strong evidence that contagion may have played a factor. The FDIC insured deposits to prevent unfounded bank failures caused by contagion (Walter, 2005). The creation of the FDIC may have calmed the ripples moving throughout the banking industry, but could there be any other reason besides contagion that stopped the ripples?

There are a few explanations that might lead us to believe that the FDIC’s halt of bank failures was not caused by contagion. First, deposit insurance augmented the profits of risky banks, protecting them from failure. Second, the creation of deposit insurance undercut a market process that caused supervisors to close troubled banks quickly (Walter, 2005). So, if contagion was not a factor then maybe banks were not illiquid but rather insolvent.

Paul B. Trescott, professor of economics at Southern Illinois University, states that BUS was fairly liquid in the few months prior to its close in December, 1930. Trescott, also elaborates on the Bank of United State’s management strategy. These three elements are expansion through mergers and bank purchases, involvement with a series of securities affiliates and a syndicate for stock trading, and extensively investing in real estate development projects (Trescott, 1992). BUS was heavily into real estate lending, as were other banks in the New York area, but the loans lacked the usual safeguards relating to borrowers’ equity and collateral. Combine the risky lending with the heavy investing in BUS stocks and you have a recipe for disaster. The FDIC insurance allowed banks, which might have operated like the Bank of United States, to gain significant profits in subsidy by allowing them to take more risks. In this case the FDIC ended bank failures by providing insolvent banks a way to stay afloat. In either case, banks being illiquid or insolvent, the creation of the FDIC terminated bank failures during the Great Contraction.

Bank Failures during the Financial Crisis of 2007

During the 1980s the United States was going through a Savings & Loans (S&L) Crisis. The S&L crisis, brought on by years of deregulation and moral hazard (Degen, 2009), was bringing down the public’s confidence in the thrifts markets. Runs began to hit the S&L industry as values started to drop. Much like the FDIC, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), in an effort to restore confidence, this time in the thrift industry.

The purpose of FIRREA, as set forth in Section 101 of the bill, was to promote a safe and stable system of affordable housing finance; improve supervision; establish a general oversight by the Treasury Department over the director of the Office of Thrift Supervision; establish an independent insurance agency to provide deposit insurance for savers; place the Federal Deposit Insurance System on sound financial footing; create the Resolution Trust Corporation; provide the necessary private and public financing to resolve failed institutions in an expeditious manner; and improve supervision, enhance enforcement powers, and increase criminal and civil penalties for crimes of fraud against financial institutions and their depositors (Law Brain, 2010).

FIRREA gives the FDIC the duty of insuring the deposits of savings associations as well as banks. In addition, FIRREA created a separate fund under the management of the FDIC called the FSLIC Resolution Fund. The FSLIC Resolution Fund generally assumed all of the "assets and liabilities" of FSLIC as of the day before its abolition (Moss, Randolph D., 1998).

Did the creation of FIRREA settle the S&L industry by providing these institutes with relief from contagion or did it allow for more risky behavior? The next two decades are again cast with troubles. First, with the “dot com” bust in the 1990s, then the housing bubble bursting in 2006, and followed by the “shadow banking” industry in 2008. This rapid growth followed by rapid burst is starting to become the norm within our economy. A norm, if left unchecked, could devastate the United States.

Summery

The FDIC and FIRREA were two pieces of legislation that were created out crisis. We may not all agree as to the exact causes of the crisis but we can agree that something needed to be done. Determining if the banking industry was illiquid or insolvent during these crises may be hard to discover and I believe that both played their part. As legislators rush to fix one part of our broken financial system the industry will leap to invest in another profiteering idea until it bursts. This herd mentality, which the financial industry’s management must refrain from, is the only way to slow down the crises. As long as the banking industry is allowed to take risks, speculate values, and use loopholes, we should all prepare ourselves for another bailout.

References

Bernanke, B. S. (2002, November 8). On Milton Friedman's Ninetieth Birthday. Retrieved April 5, 2010, from Federal Reserve: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/default.htm

Calomiris, C. W. (2007). Bank Failures in Theory and History: The Great Depression and Other "Contagious" Events.

Cecchetti, S. G. (2008). Monetary Policy and the Financial Crisis of 2007-2008.

Degen, R. J. (2009). Moral hazard and the financial crisis of 2007-9: An Explanation for why the subprime mortgage defaults and the housing market collapse produced a financial crisis that was more severe then any previous crashes (with exception of the Great Depression of 1929). Glob Advantage.

Law Brain. (2010, March 16). Savings and Loan Association. Retrieved April 6, 2010, from Law Brain: http://lawbrain.com/wiki/Savings_And_Loan_Association

Moss, Randolph D. (1998, July 22). APPROPRIATE SOURCE FOR PAYMENT OF JUDGMENTS AND SETTLEMENTS IN UNITED STATES v. WINSTAR CORP. AND RELATED CASES. Retrieved April 6, 2010, from Justice.gov: http://www.justice.gov/olc/winstarfinal.htm

Trescott, P. B. (1992). The Failure of the Bank of United States, 1930. Journal of Money, Credit, and Banking, Vol. 24, No. 3 (August 1992) , 384-399.

Walter, J. R. (2005). Depression-Era Bank Failures: The Great Contagion or the Great Shakeout? Federal Reserve Bank of Richmond Economic Quarterly Volume 91/1 Winter 2005 , pp. 39-54.

By: Joseph Dustin

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