V. The Lesson
An analysis of the experience of the U.S. banking debacle of the 1980s suggests that to minimize the moral hazard problem federally insured depository institutions should be subjected to the same conditions imposed by the private market on noninsured firms and that to minimize the regulators’ principal-agent problem the insurer and other bank regulatory agencies should be required to operate in a transparent manner, be prohibited from providing forbearance, and be held fully accountable for their actions and inactions. The major source of both the instability in the U.S. banking system in the 1980s that resulted in the exceptionally large number of bank and S&L failures and the associated large losses was not the private sector but the public or government sector. The gov- ernment first created many of the underlying causes of the problem by forcing S & Ls to assume excessive interest rate risk exposure and preventing both S & Ls and banks from minimizing their credit risk exposure through optimal product and geographic diversification and then delayed in applying solutions to the problem by granting for- bearance to economically insolvent or near- insolvent institutions. That is, the banking debacle was primarily an example of government failure rather than market failure.
At the time of the original publication, Dr. Kaufman was the John Smith Professor of Banking and Finance at Loyola University Of Chicago, and was Co-Chair of the Shadow Financial Regulatory Committee. This paper is a shortened version of a longer paper presented at the International Conference on Bad Enterprise Debts in Central and Eastern Europe in Budapest, Hungary on June 6-8, 1994. The author is indebted to Herbert Baer (World Bank) and Larry Mote (Comptroller of the Currency) for helpful comments and suggestions.
1. A brief history and additional references appear in George J. Benston, Robert A, Eisenbeis, Paul M. Horvitz, Edward J. Kane and George G. Kaufman, Perspectives of Safe and Sound Banking, Cambridge, Mass.: MIT Press, 1986, Chapter 2.
2. Milton Friedman and Anna J. Schwartz