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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.

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An important contributor to the depth of most modern financial crises is the degree to which healthy market discipline was displaced by inefficiently managed systems of government supervision. Taxpayers and public servants around the world need to understand that the extent of a financial system's exposure to bad luck, aggressive management, and looting is an endogenous consequence of the economic principles public policies embody.

Economic insolvency strikes an individual financial enterprise when it suffers losses that destroy its capacity to repay depositors and other creditors without outside assistance. Destructive losses are rooted in poor or dishonest management, bad luck, defective information systems, and superior competitors.

For individual economic insolvencies to trigger a national crisis, cumulative losses across an important industry sector must exceed the safety-net support that creditors expect the government to provide. Entry pressure from more-efficient and better-capitalized competitors can create such losses if implicit and explicit governmental guarantees degenerate into a mechanism for retarding the recapitalization of insolvent deposit-institution competitors. Although no two financial crises unfold in exactly the same way, events are driven by the interaction of (a) risky lending and funding strategies that lead to the economic insolvency of individual institutions and (b) risky regulatory strategies that government supervisors and regulators use to handle individual insolvencies when they develop.

The major lesson of the U.S. savings and loans (S&L) mess is how dangerously regulatory and bank risk-taking can reinforce each other. For individual insolvencies to persist for years on end requires that--at some level of government--officials sell insolvent institutions protection against failure and conspire at least implicitly with internal and external auditors to conceal gaping holes in individual balance sheets. As long as the cover-up succeeds, the lending policies of troubled institutions escape the ordinary weight of depositor discipline.

Around the world, the valuation and itemization principles that deposit-institution accountants and regulators use to measure banking profits and net worth contain options that make it possible for large opportunity losses to be hidden from public view. Until and unless challenged by economic analysis, using these options can generate phantom and nonrecurring profits that overstate profits and net worths for years on end. Cooked books and earnings projections based upon them resemble the digital readouts from a scale rigged by a dishonest butcher. With a show of irrelevant precision, authorities can systematically and repeatedly mismeasure the obligations that deposit insurance is putting on the taxpayers' bill.

Accounting and regulatory dereliction is rooted in incentive conflict experienced by a country's designated watchdog institutions. The solution to incentive conflict lies in reworking the watchdogs' incentives in the social contracts that are breaking down. The conflict at issue is the tradeoff between regulators' and accountants' social missions and the personal and bureaucratic costs of resisting client pressure for relief. Ironically, the accounting and regulatory strategies that ruined the Federal Savings and Loan Insurance Corporation (FSLIC) and the U.S. S&L industry were of the industry's own making. Even more ironically, these discredited strategies closely resemble the policies that multinational firms and the IMF have implicitly urged on crisis countries in Asia and Latin America (e.g., Fischer, 2001).

Guaranteeing the debt of insolvent institutions and covering up the loss exposures this creates for a country's taxpayers is costly in three ways. First, by allowing important institutions to operate in an insolvent condition, authorities leave poorly performing assets and franchises in the hands of managers whose lending and funding incentives are distorted by capital weaknesses. Because the downside of future returns belongs to the guarantor, insolvent firms are tempted to invest the savings entrusted to them in lottery-like projects that combine a negative present value with a small chance of a very large payoff. Second, until the coverup begins to unravel, accounting disinformation insulates the guidance and forbearance decisions that government officials are making from financial and political review. Finally, any cover-up is likely to be accompanied by microeconomically inefficient pricing and entry restrictions intended to protect the markets of troubled firms from close competitors. However, because o f their inefficiency, these restrictions are apt to boomerang against the industry in the long run.

Industry-welcomed restraints on stronger U.S. deposit-institution competitors ultimately helped less-regulated outside competitors--such as foreign banks, money-market mutual funds, and brokerage firms offering cash management accounts--to snatch market share from the industry the restraints were supposed to help. While troubled S&Ls implored government officials to wall off intra-industry access to their customer base behind deposit-rate ceilings and geographic barriers, differently chartered institutions devised substitute instruments that used emerging electronic technologies to innovate through and around the industry's regulatory defenses.

Effective long-run regulatory performance requires improved accountability for policy mistakes, and accountability begins with accurate information. Throughout the S&L mess, authorities showed a propensity for blocking flows of information that threatened to harm their individual and collective reputations.

Incentive reform requires a serious effort to increase the costs and reduce the benefits of accounting coverup. To increase the timeliness and accuracy of information that managers of insured institutions, managers of deposit insurance funds, and incumbent politicians supply to taxpayers, improved economic and political incentives are needed in government service. The more a country's political and cultural environment tolerates de facto corruption, the more useful it would be to offer deferred compensation to the chief executives of banks and deposit-insurance enterprises and to tie retiring officials' right to draw down this compensation either to the absence of crisis during the first five years after their departure or (if information systems permit) to a market-value measure of the change in the insurer's net loss exposure observed during their term in office (Kane, 2002).

Accounting Cover-up in the S&L Mess

In the 1960s and 1970s, the core activity of U.S. thrift institutions was to make long-term mortgage loans financed with short-term deposits. Maintaining a short-funded portfolio exposed these institutions' economic income and net worth to losses whenever interest rates rose. The secular rise in interest rates and interest-rate volatility experienced between 1965 and 1982 generated unbooked losses on S&L mortgages that devastated the economic value of industry income and net worth.

FSLIC furnished dividend-free risk capital and supplied enough of it to fill in the holes in troubled firms' balance sheets for over thirty years. During this interval, red ink flowing through S&L income and balance sheets seeped into the accounts of FSLIC and, through FSLIC, onto U.S. taxpayers.