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Farm Credit System Safety Àhâ Soundness ^'^SKv Unitedunnea Statesaiaies An Economic Research Service Report (CÛOSl Department of wßSifJ AgricultureAariculture D^ Farm Credit System Agriculture Information Safety àhâ Soundness Bulletin Number 722 Robert N. Collender Audrae Erickson It's Easy To Order Another Copy! Just dial 1-800-999-6779. Toll free in the United States and Canada. Other areas, please call 1-703-834-0125. Ask for Farm Credit System Safety and Soundness (AIB-722). The cost is $9.00 per copy. For non-U.S. addresses (including Canada), add 25 percent. Charge your purchase to your VISA or MasterCard. Or send a check (made payable to ERS-NASS) to: ERS-NASS 341 Victory Drive Herndon, VA 22070 We'll fill your order by first-class mail. The United States Department of Agriculture (USDA) prohibits discrimination in its programs on the basis of race, color, national origin, sex, religion, age, disability, political beliefs, and marital or familial status. (Not all prohibited bases apply to all programs.) Persons with disabilities who require aiternative means for communication of pro- gram Information (braille, large print, audiotape, etc.) should contact the USDA Office of Communications at (202)720-2791. To file a complaint, write the Secretary of Agriculture, U.S. Department of Agriculture, Washington, DC 20250, or call (202) 720-7327 (voice) or (202) 720-1127 (TDD). USDA is an equal employment opportunity employer. Farm Credit System Safety and Soundness. By Robert N. CoUender and Audrae Erickson, Rural Economy Division, Economic Research Service, U.S. Department of Agriculture. Agriculture Information Bulletin No. 722. Abstract The Farm Credit System (PCS) is safer and sounder than it was before the farm financial crisis of the mid-1980's, but important issues related to the safety, soundness, and viability of the system warrant continuous attention. These issues involve finding a balance between regulation and regulatory bur- den, resolving the relationships among capital and accounting standards and risk exposure, and finding policies that expose PCS institutions to efficiency- enhancing market forces. TTiis report explores issues related to PCS safety and soundness, particularly the role of Parm Credit System Insurance Corporation (PCSIC), Parm Credit Administration (PCA), and voluntary mechanisms. The report also compares PCS safety and soundness mechanisms to those of other financial institutions. Keywords: Parm Credit System, Parm Credit System Insurance Corporation, Parm Credit Administration, prudential regulation, safety and soundness, gov- ernment-sponsored enterprises Acknowledgments The authors wish to thank officers of the Parm Credit System Insurance Corpo- ration, the Parm Credit Administration, the Pederal Parm Credit Banks Punding Corporation, the Pederal Deposit Insurance Corporation, and the National Credit Union Administration for their helpfulness and thoughtful suggestions. Washington, DC 20005-4788 January 1996 Contents Page Summary iii List of Acronyms . , iv Introduction 1 FCSIC Protects Bondholders and Taxpayers, Helps Distressed FCS Institutions 3 Managing Fund Assets 6 Changes Were Needed Within FCS To Limit Risk 6 FCS History and Cooperative Structure Led to Inherent Riskiness and Inefficiency 7 Failure of Existing Protections, Fear of Contagion in Agency Bond Market Spurred Creation of FCSIC . 8 Many Other Mechanisms Now Protect FCS Bondholders and Taxpayers . 10 Farm Credit Administration as an Arm's-Length Regulator 10 Contractual Interbank Performance Agreement (CIPA) . 13 Market Access Agreement (MAA) 14 FCSIC Inspired by Bank and Thrift Deposit Insurance 14 How Deposit Insurance Works 14 Problems With Insurance Systems 15 The Savings and Loan Crisis: A Worst-Case Scenario 18 Many FCS Safety and Soundness Issues Require Continuous Attention 20 Striking a Balance Between Regulation and Regulatory Burden 20 Strengthening Policies 21 Control and Capitalization Policies May Aggravate Agency Problems . 24 Conclusions 25 References 26 Glossary 27 Farm Credit System Safety and Soundness IAIB-722 Economic Research Service/USD A Summary The Farm Credit System is safer and sounder than it was before the farm finan- cial crisis of the mid-1980's, but important issues related to the safety, soundness, and viabiUty of the system warrant continuous attention. According to this report, these issues involve finding a balance between regulation and regulatory burden, resolving the relationships among capital and accounting standards and risk exposure, and questions of managerial control and efficiency. The Farm Credit System (FCS) is a federally chartered network of coopera- tively owned lending associations and banks and is one of the Nation's primary lenders to farmers and rural America. TTie farm debt crisis of the mid-1980's led to large financial losses at, and in some cases liquidation of, FCS institutions. The debt crisis worsened problems inherent in FCS's structure and manage- ment. For instance, the system was inefficiently organized into units based on geography and function. Operational problems included emphasis on collateral value rather than repayment ability in underwriting decisions, average cost pric- ing of loans, and lack of asset/liabiUty management. These pohcies led to high default rates, loss of market share, borrower flight, low operating income, and capital losses. In the mid-1980's, Congress began passing legislation designed to address prob- lems inherent in the FCS, starting with the estabUshment of the Farm Credit System Insurance Corporation (FCSIC). Its primary mission is to insure timely payment of principal and interest on insured obligations issued on behalf of FCS banks. FCSIC also assists distressed FCS institutions, reducing the likeli- hood of future calls for Federal assistance. Other legislation transformed the Farm Credit Administration (FCA) into an in- dependent, arm's-length regulator with new oversight and enforcement powers. The Federal Farm Credit Banks Funding Corporation was required to deter- mine the conditions of participation by banks in issues of systemwide securities. In addition, FCS banks developed a system of economic incentives for individual banks to achieve and maintain strong financial standards. Yet, the report notes, important issues related to FCS safety, soundness, and competitiveness need continuous attention: • The mechanisms to deal with conflicts of interest in the system's manage- ment structure. • The need to deter banks from taking imprudent, unnecessary risks after they obtain insurance. • The distribution of insured liabilities across FCS banks. • The location of at-risk capital within the system. • The separation of ownership and managerial control. Economic Research Service/USDA Farm Credit System Safety and Soundness I Al B-722 List of Acronyms ACB Agricultural Credit Bank BC Bank for Cooperatives BIF Bank Insurance Fund CPA Capital Preservation Agreement CIPA Contractual Interbank Performance Agreement FCA Farm Credit Administration FCB Farm Credit Bank FCIF Farm Credit Insurance Fund FCS Farm Credit System FCSCC Farm Credit System Capital Corporation FCSIC Farm Credit System Insurance Corporation FDIC Federal Deposit Insurance Corporation FFCBFC Federal Farm Credit Banks Funding Corporation FFIEC Federal Financial Institutions Examination Council FICB Federal Intermediate Credit Bank FLB Federal Land Bank FLBA Federal Land Bank Association FRB Federal Reserve Board FSLIC Federal Savings and Loan Insurance Corporation GAAP Generally accepted accounting principles MAA Market Access Agreement NCUA National Credit Union Administration NCUSIF National Credit Union Share Insurance Fund OCC Office of the Comptroller of the Currency OTS Office of Thrift Supervision PCA Production Credit Association RAP Regulatory accounting principles SAIF Savings Association Insurance Fund IV Farm Credit System Safety and Soundness IAIB-722 Economic Research Service/USD A Farm Credit System Safety and Soundness Robert N. Collender Audrae Erickson* introduction were protected by joint liability of all FCS banks for outstanding bonds and by an implicit Federal guaran- In the mid-1980's, turmoil arose within the Farm Credit tee on FCS debt. Yield spreads between short- System (FCS), a federally chartered network of coop- maturity FCS securities and comparable Treasury is- eratively owned lending associations and banks. In sues widened. Spreads, which had averaged about 10 response, Congress established the Farm Credit System basis points, rose to as much as 140 basis points be- Insurance Corporation (FCSIC), required increased fore narrowing again as Congressional action took control over access to the federally sponsored agency shape. (A basis point is one one-hundreth of a percent- funds market, and reorganized the Farm Credit Admini- age point.) Less pronounced but still significant shifts stration (FCA) as an independent, arm's-length regulator. in the level and structure of spreads (cost over compa- In addition, FCS institutions voluntarily adopted other rable Treasury issues) occurred for securities from mechanisms to promote financial safety and sound- other government-sponsored enterprises (Duncan and ness. This report explores issues of FCS safety and Singer). Rising spreads in the agency market aroused soundness, particularly the roles of the FCSIC, FCA, fears of spillover effects that could harm the interest- and the FCS's voluntary mechanisms. The report also sensitive housing sector. compares financial institution insurance mechanisms in the United States and discusses
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