Trip Wire for |Early Intervention' Could Trigger Chaos

"Early intervention" when a bank's capital declines to a low level makes sense when the regulator can see that the balance sheet won't permit a turn-around. Certainly, regulators should have authority to intervene when they reach that conclusion.

The real questions are:

* Should Congress force regulators to intervene at a specified capital percentage?

* If so, is a phase-in period necessary?

The answer to the second question is clear: If statute forces regulators to take over banks when capital sinks to a specified level, we need some sort of phase-in period. Otherwise - because of the dynamics of banks on the slippery slope to insolvency - we would increase losses, not reduce them.

True, such banks usually lose more money than it would cost to fund their market-value deficit at rates for long-term government bonds. But the difference is smaller than most analyses suggest.

It is smaller because the bank loses more money only to the extent it makes additional bad loans, pays dividends, or pays more than the government bond rate for funds.

Banks with weak capital can be prohibited from making speculative loans or paying dividends - and in fact, they are routinely prohibited from doing so. And they can be prevented from growing, so their cost of funds rises less than did those of weak S&Ls that kept growing long after their capital was exhausted.

Therefore, the actual cost of delay may be small, even though the gross amount of periodic loss reported by the failing bank may be large.

For example, if a bank would cost the Federal Deposit Insurance Corp. $100 million to deal with and the long-term government bond rate were 8%, $8 million would have to be deducted from the annual operating loss to derive the true cost of a year's delay.

In addition, we have to deduct loan losses that are taken currently - because they already are reflected in the $100 million hypothetical cost.

Once these adjustments are made, in many cases the cost of a year's delay is small.

If the hypothetical weak bank is taken over and sold immediately, the insurance fund saves money because of the cost-of-funds differential and the immediate realization of the franchise value.

However, if the bank is taken over and not sold immediately, several costly things happen during the receivership:

* The franchise value depreciates rapidly.

* In the early stages of a receivership, workouts of troubled loans are significantly delayed.

* Costs rise and decision-making suffers, because protection of the liquidator from criticism replaces profit as the prime motive in dealing with the assets.

Haste Makes Waste

Moreover, the more assets in receiverships nationwide, the more this market overhang depreciates all other assets held in receivership (and in the private sector as well). These are clear lessons of the thrift debacle.

Putting dying banks under government control increases rather than decreases the cost of liquidation - unless looting would otherwise occur.

For this reason, a law that required the FDIC to immediately take over all banks with less than a specified percentage of capital would be another multibillion-dollar mistake in the long line of such mistakes by policymakers.

An article in the June 4 issue of American Banker reports that if the threshold were set at 2% equity, then 366 banks and S&Ls with $196 billion of assets would be put into receivership immediately.

It would probably take the FDIC and the Resolution Trust Corp. years to deal with all of these failed banks. In the meantime, the assets would depreciate and drag down the market.

Therefore, any mandatory early intervention should be either delayed for at least three years or phased in over such a period.

A Bad Idea

As to whether there should be mandatory intervention at all, I vote no.

Most economists argue that if we don't have it, the regulators will always over-forbear - and that this forbearance will be costly. They point to the S&L experience and several recent bank cases.

I would argue that the S&L experience is not relevant, for two reasons:

* The Federal Savings and Loan Insurance Corp. didn't have any money, so it couldn't have liquidated insolvent institutions.

* The Federal Home Loan Bank Board was too close to its industry to be a good indicator of what the FDIC will do.

I would point to the farm banks that almost failed in the mid-1980s and that have returned to a fairly sound condition today, and to the money-center banks (and Bank of America, if it is not a money-center bank) that would have failed if we had marked their lesser-developed-country loans to market in the early 1980s.

Forbearance worked in those cases, and I believe the American economy is the better for it.

Mr. Lowy is counsel to the law firm of Rosenman & Colin and former vice chairman of Dollar Dry Dock Bank, both in New York. His book, "High Rollers: Inside the savings and Loan Debacle," is to be published this fall.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.