There are many similarities between today's insider-abuse headlines and those from the banking crisis of the late 1980s. Policymakers and regulators struggling with how to confront the spasm of greed and mismanagement in corporate America and restore public confidence in Wall Street should look to the Federal Deposit Insurance Corp. for advice.
Before Enron Corp. and WorldCom Inc., the FDIC was tasked with rebuilding a strong and durable system of corporate governance in the banking industry. The system that emerged is strong and successful, and offers important lessons for policymakers, industry, and consumers.
The banking industry today is healthy and stable. Profits, revenue growth, investment in Internet and information technologies, and product diversification have led to a generally optimistic outlook for the industry. Although bank failures are up this year, widespread mismanagement, pervasive insider abuse, and rubber-stamp boards of directors are a rare exception.
Back in the 1980s the industry experienced its own version of "irrational exuberance," primarily in real estate lending. Soaring interest rates curtailed traditional revenue sources. Lenders desperately sought fee income from alternative products authorized by the Competitive Equality Banking Act of 1980, which gave historic new authority for S&L owners and managers to invest depositors' funds.
The search for new income streams was accompanied by hyper-liberal lending policies at savings and loans across the nation. Meanwhile the Reagan administration slashed regulatory budgets, fired large numbers of examiners, and frustrated the enforcement efforts of experienced regulators.
Those with a long view of history will recall the extensive bank and thrift speculation in raw land; ill-conceived acquisition, development and construction lending; and other investments pursued without meaningful underwriting. Banks and thrifts were plagued with insider profiteering and supported by a fee-driven, client-knows-best culture in the accounting industry.
The Competitive Equality Banking Act's results were quickly apparent. The reckless and criminal conduct of executives of the failed banks and thrifts resulted in enormous industry losses. Casualties included thousands of insolvent banks and thrifts, an insolvent federal deposit insurance fund, several bankrupt state and private bank insurance funds, and a fatally weakened Federal Home Loan Bank Board.
Congress and the regulators recognized the crucial need for increased oversight of and limits on boards of directors, outside accounting and auditing firms and appraisers, as well as the need for enhanced enforcement authority. Out of the policy debates came the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.
The thrust of this law was to stop insider abuse in the thrift industry. It authorized federal bank regulators to increase the scrutiny of banks' outside auditors and accountants and to curtail management and board activities that pose risks to the deposit insurance funds. Moreover, it created two federal agencies, the Office of Thrift Supervision and the Resolution Trust Corp.
The FDIC, however, was the major regulatory beneficiary of the law. It was responsible for liquidating the assets and liabilities of failed federally insured banks and thrifts.
To attack the corporate governance crisis, the FDIC used enhanced examination tools and litigation strategies to clarify the legal duties of bank directors and officers, purge the industry of insider abuse, and enforce compliance by third-party service providers, most notably outside auditors and attorneys.
Contrary to common belief, neither Congress nor the FDIC created the laws FDIC sought to enforce against bank insiders, accountants, and other professionals - with the exception of Regulation O [which implements provisions of the Federal Reserve Act]. In most of these lawsuits, the FDIC was required to apply the fiduciary duty and other substantive laws of a particular state - not federal law. This is important and often overlooked. In nearly all states the FDIC had to enforce existing state laws, which often differ in significant ways.
The application of these state laws became one component of the FDIC's efforts to reestablish a strong corporate governance ethic among bank directors and senior executives. In many instances, state laws were incomplete or unclear, and the FDIC argued that an expansive application of these laws was in the best interest of the public and essential to protecting the deposit insurance funds.
Courts largely agreed with the FDIC, and their opinions now form a significant portion of each state's laws on corporate governance and fiduciary duties. The FDIC's efforts to clarify and enforce the fiduciary duties of loyalty and care that directors and senior officers owe to their employers created the backbone of most states' corporate governance jurisprudence.
The combined effect of the FDIC's decade-long quest to establish clear legal standards for the conduct of senior bank management and outside professionals dramatically reduced insider abuse and self-dealing, strengthened the industry as a whole, and ensured its long-term survival. Bank insiders now better understand the scope of their fiduciary duties; the FDIC and other federal and state regulators have adopted examination strategies that more directly test the safety and soundness of management and board conduct; and all industry stakeholders have learned to work together for a common goal in this new environment.
Bank directors and senior executives are now more aware of the risks of insider transactions and less likely to initiate transactions that lack economic substance. Most significantly, bank management and directors expect outside auditors to truly be independent and to fully comply with all accounting industry auditing standards, rather than kowtow to management's results-oriented balance sheet demands.
Since the FDIC's creation in 1933, the agency and the banking industry have traveled a long, arduous, and sometimes combative road together. While some have called it a love-hate relationship, it is permanent and imbued with understanding and respect for each others' objectives.
Disagreements will still arise over regulatory strategies, but a strong, well-regulated banking sector is a cornerstone of our national economy and a pillar of the global financial regime. When regulators and bankers work together for the common good, the confidence of depositors, borrowers, and investors is renewed.
The FDIC's vision of corporate governance has largely been achieved. Its legacy is a heightened scrutiny of board members' and senior executives' conduct; the establishment of clear legal standards of the fiduciary duties of bank directors and officers; and the trust and confidence of the public in our financial industry and regulators.
We haven't seen the last of problem banks, or bankers; the failures this year alone remind us that corporate governance must continue to be a priority for the banking industry and the regulators. But the FDIC proved that it is possible to reform the ethics of the corporate boardroom. Why hasn't anyone noticed?
