What Economic Principles Should Policymakers in Other Countries Have Learned from the S&L Mess?
Appropriate incentives for government supervisors are critical for avoidance of financial crises.
Edward
Kane, a professor in finance at Boston College, is the recipient of numerous
awards for distinguished teaching and scholarship. He is a research associate
of the National Bureau of Economic Research and a former Guggenheim fellow.
A banking agency consultant and expert witness in financial-services litigation,
his specialty is financial and ethical research. He has published three
books, writes regularly for professional journals, and serves on seven
editorial boards. He received his BS from Georgetown University and his
Ph.D. from the Massachusetts Institute of Technology.
This paper is adapted from a manuscript prepared for the Milken Institute/UCLA research roundtable, “What Can An Examination of S&Ls Reveal About Financial Institutions, Markets and Regulation?’ in Los Angeles, January 25, 2002 and is forthcoming in a volume edited by James Barth, Susanne Trimbath and Glenn Yago, as part of the Milken Institute Series On Financial Innovation and Economic Growth. James Moser provided valuable comments on an earlier draft. Much of the material was presented by the author in his Adam Smith Award address at the NABE Annual Meeting on September 30, 2002.
For individual institutions’ insolvencies to trigger a national financial crisis, cumulative losses across an important industry sector must exceed the safety-net support that creditors expect the government to provide. This happens when official supervisors acquiesce to pressure of threatened institutions to engage in risky lending in an effort to stay afloat. Such regulatory risk-taking takes the form of insurance against failure and concealment of the magnitude of the risks to which the insured institutions and their insuring governmental institutions are exposed. The source of such regulatory dereliction is rooted in conflicting incentives for regulators that must be resolved if future crises are to be avoided. The paper describes and analyzes the U.S. savings and loan crisis and financial crises in developing countries to illustrate these points.