October 1,1994 eCONOMIG COMMeNTORY Federal Reserve of Cleveland

Bank and

by Walker F.Todd

"efining physiological life and death Confining the analysis to commercial used to be comparatively easy. Under , the standard definition of the term In the past quarter century, legal and broad definitions, living mammals were "banks" contemplates a set of institu- economic distinctions surrounding the considered capable of growth and repro- tions authorized both to accept demand 1 viability of depository institutions duction and exhibited a variety of vital deposits and to make commercial loans. have become increasingly blurred. signs such as positive blood pressure and Following this standard legal definition, Changes enacted since 1987 have respiration. Dead mammals lacked these failed or failing banks that are no longer made U particularly difficult for the capacities and gradually lost vital signs viable as going concerns should lack casual observer to detect differences as death progressed. either or both of the deposit-taking and loan-making powers. Before 1933, this among the three forms of resolution: , conservator- In this century, however, such simple generally was true. But the standard ships, and bridge banks. This article distinctions have become vastly more forms of supervisory intervention that provides a history of regulatory and complicated. In some systems of moral have evolved since then have increas- statutory responses to failing banks, philosophy, human life has been held to ingly blurred this distinction between with special focus on recent changes, begin long before live birth. At the other living and dead banks. including depositor preference legisla- extreme, the prolonging of life by artifi- tion, that have had unintended and cial means has led to new concepts like This Economic Commentary examines still-uncertain consequences. "brain death" to replace prior definitions the changing treatment of troubled insti- of death. An organic structure can tutions in the U.S. banking structure, with endure now, for a time at least, even particular focus on changes since 1987 after vital functions have ceased. affecting receiverships, , and bridge banks. Some of those changes, Legal and economic distinctions regard- including depositor preference legislation ing the viability of depository institu- enacted in 1993, have had unintended consequences whose overall effects are tions also have become increasingly still somewhat uncertain.2 complicated in this century, with most of the relevant changes concentrated in the last 25 years. It is now difficult to • Background before 1933 describe with sufficient precision how to The concept of a receiver for failing characterize a depository institution as a banks is derived from practices in bank- going concern—mat is, one capable of ruptcy or other insolvency proceedings satisfying its obligations as they mature. even before the advent of a permanent Commercial bank supervisors have been code in the United States in faced with the blending of legal and eco- 1898. A receiver is appointed to take nomic concepts regarding failure resolu- over the assets and liabilities of an insti- tion into new, hybrid forms. tution that has failed or has lost its bank- ing charter in order to quickly and effi- ciently dispose of that institution—in essence, to wind up its affairs. In pre-Civil War banking, bank charters Thus, under applicable federal , the for our purposes is that it estab- had limited terms (usually 20 years), so potentially incomplete repayment of lished a new regime allowing a receiver- states would appoint a receiver to wind depositors' and other general ' like entity to take control of a national up the affairs of a bank whose charter claims was a concept embedded within bank's affairs involuntarily and for the was not renewed,o r which had forfeited the appointment of a receiver for a explicit purpose of protecting depositors its charter prior to expiration. Judicially national bank.5 and general creditors. accountable receivers were created vol- untarily by a vote of the partners, share- Prior to 1933, receiverships under state Jesse Jones, the chairman of the former holders, or other owners of a bank to ter- law, for state-chartered banks, were by Reconstruction Finance Corporation, minate their responsibility for the bank's no means administered in accordance wrote that in drafting me conservator- liabilities or to make an equitable distri- with national bank receivership princi- ship statute, the Hoover bution of its remaining assets. Bank in- ples. As late as 189S, for example, the and involved Federal Reserve officials solvencies generally were treated no Comptroller of the Currency reported to believed that the title conservator was differently under state law than the insol- Congress, "In nearly all of the states "akin to receiver but less harsh on the vencies of commercial enterprises, with insolvent banks are managed in the same public ear," adding that the original the exception of particular protections manner as other insolvent concerns."6 object of conservatorship was "to stave for holders of failed banks' circulating Only California provided for supervision off creditors long enough to rehabilitate currency notes. Unpaid depositors usu- of the of insolvent state a bank rather than let it go into receiver- ally had no better rights in the liquida- banks by the state bank supervisory ship."9 Thus, the first blurring of the tion of a failed bank man did other gen- authority. Thus, insolvency, a concept distinctions between living and dead or eral creditors, and banks usually were that included but was more than mere dying banks was introduced into federal prohibited from giving security for de- failure to repay depositors or general banking law in 1933. posits, other man deposits of public creditors, was the principal determinant 3 funds. of the fate of a failing bank or other busi- An important provision of this statute ness, whose owners turned to voluntary required conservators to segregate new Later, involuntary receivership for banks receivership to limit their liability to deposits (those received after appoint- became embodied in federal law in Sec- depositors and general creditors. ment) from previously existing deposits, tion SO of the National Bank Act of to make such prior deposits available for 1864, which provided as follows: Between the Civil War and the end of withdrawal only on a ratable basis World War I, many new banks were cre- (which could be estimated), and not to [O]n becoming satisfied... that any ated. Active U.S. banks numbered 8,030 use new deposits to liquidate any indebt- association [national bank] has re- in 1897 and 29,417 by 1921, but more edness of the bank existing prior to fused to pay its circulating notes..., than 12,000 of them failed between 1921 appointment10 This provision enabled and is in , the Comptroller of and year-end 1933, focusing renewed the conservator to satisfy old claims only the Currency may forthwith appoint attention on the legal and institutional insofar as they would have been satisfied a receiver... who, under the direc- structures of bank receiverships.7 In in receivership, while still preserving the tion of the Comptroller, shall take 1933, as an alternative to receiverships, option of handing over the entire bank to possession of the books, records, and conservatorships for national banks were new ownership (or even returning the assets of every description of such created under Title II of the Emergency bank to the former management) with a association, collect all debts, dues, Banking Act of March 9,1933.8 The body of protected new deposits intact and claims belonging to such associ- condition then provided for appointment ation, and, upon the order of a court of a conservator "whenever the Comp- The investments for which a conservator of record of competent jurisdiction, troller shall deem it necessary in order to could use new deposits were limited to may sell or compound all bad or conserve the assets of any bank for the safe assets like government securities. In doubtful debts, and ... sell all the benefit of the depositors and other credi- the low-interest-rate environment of real and personal of such tors thereof..." (former 12 U.S.C. Section 1933, the asset values backing new association... [and pay over the pro- 203). In other words, no explicit finding deposits in conservatorships were not ceeds to the Comptroller's order]. of actual or potential insolvency or exist- expected to fall below par, while the rat- And from time to time the Comptrol- ing violation of the National Bank Act able distributions to prior depositors ler... shall make a ratable dividend was required—findingstha t would have could have required substantial dis- of the money so paid over to him by been required for the appointment of a counts from par values due to impaired such receiver on all such claims as receiver. However, that former version creditworthiness." In any case, while may have been proved to his satisfac- of the national bank conservatorship about 1,100 conservatorships were cre- tion or adjudicated in a court of com- statute provided explicitly that a conser- ated for national banks during 1933, they petent jurisdiction 4 vator was to have all the powers of a were rare afterward until the 1980s.12 receiver, in addition to powers necessary to operate the failing bank. The principal significance of the 1933 conservatorship • Regulatory and Statutory In effect, a bridge bank is a hybrid cre- Act of 1989 (FIRREA). The most im- Responses to the 1980s Crises ation that enables the FDIC to take over portant change for the purposes of this The decline of federal deposit insurance and maintain ongoing banking services article was that the formerly explicit funds for the thrift and commercial at failing banks, including the commin- statutory requirement that new deposits banking industries in the 1980s was the gling of post-organization with pre- be segregated from pre-appointment de- first occasion since the 1930s for a crisis- organization deposits, even though the posits was dropped in favor of new lan- 15 related review of receivership and con- FDIC does not issue bank charters. guage providing that the Comptroller of servatorship structures. Confronting This additional power is important to the Currency may require any conser- large-scale but officially unrecognized the FDIC because before 1987, it had vator to set aside amounts that can be insolvency in the thrift industry in the no statutory way to induce state regula- withdrawn safely by all depositors and tors to close failing state-chartered creditors similarly situated.19 While Congress initially attempted to avoid banks while ensuring that their banking the Comptroller still might require a 16 creating large numbers of conservator- services would continue. Large conservator to segregate new from old ships and receiverships. Instead, they bridge banks created since 1987 include deposits, in the conservatorships cre- responded by allowing regulatory First Republic (1988) and M Corp ated for banks and thrifts since enact- accounting principles that diverged (1989), both in Texas, and Bank of New ment of FIRREA, new deposits have widely from generally accepted account- England (1991). not been so divided. ing principles and by issuing Federal Savings and Loan Insurance Corporation Bridge banks may create moral dilem- As with bridge banks, post-FIRREA certificates that generated positive net mas regarding the distinctions between conservatorships create moral dilemmas worth under regulatory accounting.13 living and dead banks because a bridge regarding the status of a conservatorship After the failure of Continental Illinois bank has many of the attributes of a liv- as a living or dead institution: The Corporation and its banking subsidiary ing institution: It may accept new depos- absence of the segregation of deposits in 1984 and the demise of several large its and make new loans, commingling (formerly a hallmark of conservator- southwestern banks after 1986, federal them with existing accounts; it is deemed ships) and the indefiniteness of the dura- bank regulators began to explore ways to a new, insured national bank from the tion of a conservatorship may convey enable failing banks to continue to offer time it is chartered; it may exercise all the impression mat no useful distinction banking services without having to the corporate powers of a national bank; can be drawn between conservatorships reduce the ultimate payouts to prior it may exist for up to two years, subject and ordinary banks. At the same time, uninsured depositors.14 For commercial to renewals for up to three additional this blurring of distinctions may serve to banks and, after 1987, mutual savings one-year terms; and it is explicitly en- maintain public confidence in the viabil- banks, the first new device for this pur- couraged to accommodate existing bor- ity of the overall banking system in 17 pose was bridge banks. rowers and depositors. However, it regions where a comparatively large also shares many characteristics with share of the banks are failing.20 Bridge banks share many common dying or dead institutions: It is created in attributes with and serve many of the a manner analogous to that of a conser- • Insolvency Resolutions same economic objectives as national vatorship or receivership; it is in default after FDICIA bank conservatorships, but are more for the legal purpose of abridging certain The enactment of the Federal Deposit amorphous. Because bridge banks pro- contractual obligations of the former Insurance Corporation Improvement vide no segregation of post-organization bank; it operates without capital and Act of 1991 (FDICIA) and one subse- deposits or "safe bank" restrictions on need not observe normal capital ade- quent statutory revision have made some the investment of those deposits, an quacy requirements; the FDIC exercises potentially significant changes in bank accounting and legal nightmare can close control over its asset and liability insolvency resolution procedures. Criti- ensue if these banks are not sold or powers; and it exists only for a limited cally undercapitalized institutions must recapitalized as going concerns. The term, with the appointment of a receiver be placed into conservatorship or re- principal difference in legal authority is required if the bank is not merged, sold, ceivership within 90 days, unless the that bridge banks are organized and or otherwise disposed of during that appropriate supervisory agency grants 18 administered by the Federal Deposit term. Legally, a bridge bank is like an extension that may be renewed only Insurance Corporation (FDIC), while the a new national bank, but it serves the once.21 In that sense, the moral dilemma Comptroller of the Currency appoints economic function of an improperly of distinguishing between living and dy- national bank conservators. operated conservatorship because of the ing banks should eventually be resolved. commingling of deposits.

Some significant revisions of the na- tional bank conservatorship statute were enacted by the Financial Institutions Reform, Recovery, and Enforcement Under FDICIA, the standards for ap- depositors time to flee but also, together The principal change from the previous pointment of conservators of national with the new depositor preference legis- list of priorities is that depositors' banks were unified with those for ap- lation, reduces their incentives to flee. claims (to which the FDIC as receiver pointment of the FDIC as conservator The failure to segregate deposits effec- would succeed) were advanced from the of insured state-chartered banks; previ- tively creates an accounting pyramid same level as general and senior liabili- ously, appointment of the FDIC as con- scheme in which the existing shortfall ties to a preferential class of their own, servator of state banks was a matter between historic cost (book value) and following only the receiver's adminis- entirely governed by state (not federal) current market values of assets is trative expenses. In order to prevent the law. The principal new feature of the merely rolled forward into the new asset FDIC from increasing its share of the revised standards is an explicit recog- pool supporting the mixture of bom old receivership estate, general creditors nition of a balance-sheet test (an excess and new deposits. probably will attempt to take increased of noncapital liabilities over assets) as amounts of collateral from failing insti- sufficient grounds; previously, only a The original federal policy intention tutions in order to become secured going-concern (ability to satisfy matur- regarding receiverships and conservator- claimants and (hereby avoid subordina- ing claims) test was used.22 ships could be restored without modifi- tion to the new depositors' preference.23 cation of the new depositor preference The probable effect of federal depositor statute if the relevant sections of the FDICIA also modified the receivership preference legislation should be to FDIC Act and the National Bank Act section of the National Bank Act (now reduce depositors' confusion about the were amended to provide for the manda- 12 U.S.C. Section 191) to provide for status of their claims (it appears that tory segregation of pre-appointment appointment of the FDIC as receiver of many of them believed that they already from post-appointment accounts and to national banks without prior notice or had such a preference under federal law, prohibit the use of post-appointment hearings on the same unified grounds even though that was not so before deposits to satisfy pre-appointment as for its appointment as conservator, 1993), at the expense of the possibly claims in conservatorships and bridge including explicit recognition of a increased confusion of general creditors. balance-sheet test of insolvency. The banks. The pre-1989 language of 12 Comptroller of the Currency is now • Conclusion U.S.C. Section 206 would be adequate authorized to appoint a receiver even Since 1989, it has become increasingly for such a purpose. without a prior examination of the difficult for casual observers to make failed bank. These changes should useful functional distinctions among • Footnotes have the effect of reducing any public receiverships, conservatorships, and 1. This definition is a paraphrase of the confusion about the status of banks not bridge bank administrations for failing statutory definition of the term "bank" in yet in receivership: If a bank is really or failed banks and thrifts. Also, legal Section 2 (cXl) of the Bank Holding Com- pany Act of 1956, as amended, 12 U.S.C. dead on a balance-sheet basis, there is distinctions among those three forms Section 1841. For purposes of the analysis no longer any reason for supervisory of insolvency resolution that were here, the "nonbank banks" issue is ignored. forbearance based on its lingering fairly sharp before 1987 have become See Board of Governors v. Dimension Finan- capacity to satisfy maturing claims. blurred. Under federal law, since 1991, cial Corporation, 474 U.S. 361 (1986). the standards for appointment of a Finally, on August 10 of last year, the receiver or a conservator have been 2. See 12 U.S.C. Section 1821 (cX5), amended by the Omnibus Budget Reconcili- unified, and since 1987 (bridge banks) Omnibus Budget Reconciliation Act of ation Act of 1993. See also James B. Thom- 1993 was enacted. Among other and 1989 (conservatorships), previous son, "The National Depositor Preference things, it amended Section 11 (dXl 1) legal barriers to the commingling of Law," Federal Reserve Bank of Cleveland, of the FDIC Act (12 U.S.C. Section pre-insolvency and post-insolvency Economic Commentary, February 15,1994. 1821 [d][ 11 ]) to establish a revised set deposits have been removed. of priorities for payment of claims 3. See generally Bray Hammond, Banks and Politics in America, from the Revolution to (other than secured claims) by The economic effect of failure to segre- the Civil War, Princeton, N.J.: Princeton Uni- receivers of failed depository institu- gate deposits in an insolvent or prospec- versity Press, 19S7. On the general prohibi- tions. The new priorities are (a) admin- tively insolvent institution is to spread tion of pledging security for deposits, other istrative expenses of the receiver, (b) the cost of repaying uninsured claims than municipal and other public entity any deposit liability of the institution; across all flinders of the federal safety deposits, see cases cited under New York Banking Law Section 96 (7). (c) general or senior liabilities of the net instead of limiting these recoveries institution; (d) subordinated obliga- to the estimated amounts to be realized tions; and (e) shareholder claims. from the eventual liquidation of conser- vatorship or bridge bank assets. In effect, this condition gives uninsured 4. Herman E. Krooss and Paul A. Samuel- 11. Upham and Lamke (1934, footnote 4% 20. One may infer support for this view, son, eds.. Documentary History of Banking pp. 248-49, present tables showing that which is akin to a "systemic risk" argument, and Currency in the United States, vol. 2, recoveries by unsecured depositors of failed in Richard F. Syron, "The Fed Must Contin- New York: Chelsea House Publishers, 1977, banks, 1921-1930, inclusive of offsets, were ue to Supervise Banks," Federal Reserve pp. 1405-06. In 1876, new grounds were only 55.7 percent of par for 267 national Bank of Boston, New England Economic Re- added to the statute for appointment of a re- banks studied and 62.0 percent of par for 988 view (January/February 1994), pp. 3-8; and ceiver, including failuret o satisfy a judgment state banks studied. in Larry D. Wall, "Too-Big-to-Fail after within 30 days "or whenever the Comptroller FD1CIA," Federal Reserve Bank of Atlanta, should become satisfied of me bank's insol- 12. Ibid., pp. 48-56. Economic Review, vol. 78, no. 1 (January/ vency," and afterward other grounds were February 1993), pp. 1-14. added that involved violations of the National 13. See descriptions of thrift institution res- Bank Act and "false certification of checks by cue devices used in Edward J. Kane, The 21. Critically undercapitalized institutions any officer, clerk, or agent" By 1930, a new S&L Insurance Mess: How Did It Happen? have Tier 1 leverage ratios of 2 percent or ground for appointment of a receiver was Washington, D.C.: Urban Institute Press, less. The closing rule for these institutions enacted: discontinuation of banking opera- 1989, pp. 1-18,95-104. See also Ned Eich- does not apply to conservatorships and tions for a period of 60 days. See Cyril B. ler. The Thrift Debacle. Berkeley, Calif.: Uni- bridge banks, which are permitted to operate Upham and Edwin Lamke, Closed and Dis- versity of California Press, 1989, pp. 139-44. without capital tressed Banks: A Study in Public Administra- tion, Washington, D.C.: Brookings Institution, 22. See 12 U.S.C. Section 1821 (c)(5). 1934, p. 19. Also, receivers of national banks 14. See Irvine H. Sprague, : An Regarding the introduction of alternative were not supposed to confront problems re- Insider s Account of Bank Failures and Res- means to accelerate the appointment of a garding the commingling of pre-appointment cues, New York: Basic Books, 1986, pp. 149-264. See also Edward J. Kane," Long- receiver or conservator for failing institutions with post-appointment accounts, a principle Run Benefits in Financial Regulation from in FDICIA, Richard S. Camell notes that the that was carried over into the conservatorship Increased Accountability and Privatization,'1 intention originally was to "safeguard against statute in 1933 but was lost in the bridge bank in Rebuilding Public Confidence through forbearance," but that Congress "ultimately statute in 1987. Knowing violations of the Financial Reform, Columbus: Ohio State adopted a weakened time limit" for forbear- National Bank Act prohibited under 12 University, College of Business, Conference ance with respect to critically undercapital- U.S.C. Section 93 included the acceptance of Proceedings, June 25,1992, pp. 67-77; and ized institutions." See Camell, "A Partial deposits after the commission of an act of James R. Barth and R. Dan Brumbaugh, Jr., Antidote to Perverse Incentives: The FDIC insolvency, or in contemplation of such an "Depository Institution Failures and Failure Improvement Act of 1991," Boston Univer- act See 12 U.S.C. Section 91. Costs: The Role of Moral-Hazard and sity School of Law, Annual Review of Bank- Agency Problems," ibid., pp. 3-19. ing Law, vol. 12, Boston: Butterworth Legal 5. New York Banking Law, Section 606, Publishers, 1993, p. 348. He adds, "the contains analogous but different provisions [supervisors' viability] certification require- 15. See Todd (1993, footnote 10), pp. 17-19. for possession of banks by the superintendent ment will constrain extensions [of forbear- Bridge banks were authorized under Section of banks. Notably, the superintendent is not ance] beyond one year, as regulators will 503 of the Competitive Equality Banking Act required to segregate post-possession from have difficulty—even under the best of cir- pre-possession deposits or other claims and of 1987 (now 12 U.S.C. Section 1821 [n]). cumstances—averring that a critically under- may surrender possession and permit a capitalized institution is viable and not seized bank to resume business. 16. Since 1989, the FDIC has been author- expected to fail." ized to organize bridge banks even without awaiting approval by state bank regulators 6. New York Banking Law, Section 663, whenever appropriate findings can be made 23. See Thomson (1994, footnote 2). Several p. 30. that one or more insured institutions are states previously had similar depositor pref- either "in default" or "in danger of default," erence , but they were binding on the 7. See Upham and Lamke (1934, footnote statutory terms meaning generally either that FDIC as receiver only with respect to failed 4), pp. 245-50. a conservator, receiver, or other legal custo- state-chartered banks. dian is actually appointed or that they have 8. See 12 U.S.C. Sections 201-211. exhausted or are likely to exhaust remaining capital or net worth without federal assis- 9. Jesse H. Jones with Edward An&y, Fifty tance. See Sections 204 and 214 of the Fi- Walker F. Todd, an attorney at the law firm of Billion Dollars: My Thirteen Years with the nancial Institutions Reform, Recovery, and Buckingham, Doolittle, and Burroughs, RFC (1932-1945). New York: Macmillan Enforcement Act of 1989; 12 U.S.C. Sec- Cleveland, is a former assistant general Company, 1951, pp. 21-22. The conservator- tions 1813 (x) and 1821 (n). counsel and research officer at the Federal ship statute was more than a mere public Reserve Bank of Cleveland. For helpful com- relations maneuver, however. During 1933, it 17. See 12 U.S.C. Section 1821 (nX3)(B). ments, the author thanks Mark Sniderman, was unclear for several months how many E.J. Stevens, and James Thomson. The views stated herein are those of the gravely damaged banks eventually would 18. See Todd (1993, footnote 10), pp. 18-19. have to be closed, and conservatorship author and not necessarily those of the Fed- offered a vehicle for postponing some of eral Reserve Bank of Cleveland or of the 19. See 12 U.S.C. Section 206 (c). those decisions to enable supervisors to see Board of Governors of the Federal Reserve how matters turned out. System.

10. See former 12 U.S.C. Section 206, sub- stantially revised in 1989. See also Walker F. Todd, "The Evolving Legal Framework for Financial Services," Federal Reserve Bank of Cleveland, Working Paper 9306, October 1993. Federal Credit Allocation Conference Proceedings Now Available

The papers in the August 1994 issue of the Journal of Money, Credit, and Banking (part 2) were presented at a conference on "Federal Credit Allocation" held at the Federal Reserve Bank of Cleveland on October 18-19,1993. The purpose of this conference was to stim- ulate research and discussion of credit allocation and the associated regulations. To order a copy of the conference proceedings, please send $8.00 (U.S.) in a check or money order drawn on a U.S. bank to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, Ohio 44101. Make checks payable to the Federal Reserve Bank of Cleveland.

Do Informational Frictions Justify Did Risk-Based Capital Allocate Public Policies and Private Federal Credit Programs? Bank Credit and Cause a "Credit Pension Contributions by Stephen D. Williamson Crunch" in the US.? by William G. Gale Comments: Paul Davidson by Allen N. Berger and Gregory F. Udell Comments: Joseph A. Ritter Comments: Merwan Engineer An End to Private Banking: The Value of Pension Benefit Early New Deal Proposals to Housing-Finance Intervention Guaranty Corporation Insurance Alter the Role of the Federal and Private Incentives: Helping by George C. Pennacchi and Government in Credit Allocation Minorities and the Poor Christopher M. Lewis by Ronnie J. Phillips by Charles W. Calomiris, Comments: Andrew H. Chen Comments: Walker F. Todd Charles M. Kahn, and Stanley D. Longhofer Why We Need an "Accord" Comments: Robert Van Order for Federal Reserve Credit Policy: A Note A "Barter" Theory of Bank by Marvin Goodfriend Regulation and Credit Allocation Comments: E.J. Stevens by Anjan V. Thakor and Jess Beltz Comments: Deborah J. Lucas

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