During the year 2000, the FDIC undertook a major study of its deposit insurance
system. The decision to conduct the study was not made in an atmosphere of crisis. The
U.S. economy was beginning its tenth year of expansion and running at full throttle. Bank
capital and earnings were at record levels. The FDIC insurance funds began the year at a
combined $40 billion. The FDICs guarantee of the safety of insured deposits
So why the need for a study? The answer is
that while the FDIC has adequate revenues to discharge its responsibilities, the way it is
required to collect those revenues does not promote macroeconomic stability, fairness or
appropriate economic incentives. The FDICs goal during the year 2000 was not,
however, merely to critique specific aspects of the law governing its operations, but to
offer a concrete and constructive framework for change.
Insurance reform would require legislative changes, and one core recommendation
from the FDIC to Congress is to resume operating one insurance fund by merging the Bank
Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). The two funds
provide an identical insurance product, each provides that product to both banks and
thrifts, and they provide it in some cases to the same institution. Because BIF and SAIF
premiums must be set separatelyand in a way that is rigidly tied to the level of
each insurance fundinstitutions with similar risk characteristics can pay different
premiums. It would be entirely possible for one institution to be paying 23 basis points
for deposit insurance while a competitor across the street that posed similar risk to its
insurance fund was paying nothing. Moreover, some institutions have both BIF and SAIF
deposits and must track them separately, in order to know which deposits would pay
premiums at what rate.
Work begun in 2000 to study deposit insurance reforms led
to final recommendations announced at an April 5, 2001, press conference by Chairman Tanoue.
Also, existing law restricts the FDICs ability either to smooth insurance
costs over time or allocate those costs fairly among insured institutions based on the
risks they pose. To understand this constraint, one must go back to the roots of the
FDICs assessment system in the Federal Deposit Insurance Corporation Improvement Act
of 1991 (FDICIA). FDICIA required the FDIC to implement a risk-based insurance system. It
also required the FDIC to maintain funds at a designated reserve ratio (DRR), the ratio of
required reserves to insured deposits, of 1.25 percent. When a funds reserve
ratiothe ratio of a funds balance to the deposits it insuresfalls below
the DRR, the FDIC must either raise premiums by enough to bring the reserve ratio back to
the DRR within a year or charge at least 23 cents per $100 of deposits (23 basis points)
until the reserve ratio meets the DRR.
This requirement works against the loss-smoothing that is normally a feature of
insurance. The philosophy underlying the requirement would seem to be that banks should
pay for banking crises when they occurnot before and not after. The difficulty with
this is that during a period of heightened insurance losses, both the economy and banks in
general are likely to be in a distressed condition. A 23 basis point premium at such a
point in the banking cycle is likely to be a significant drain on bank net income, thereby
retarding bank lending and economic recovery.
Conversely, when the fund exceeds the DRR, the pendulum swings the other way,
and the FDIC is prohibited from charging any deposit insurance premiums to most banks.
Under a provision of the Deposit Insurance Funds Act of 1996, well-capitalized
institutions with the two strongest examination ratings (1 or 2 on a 5 point scale), a
group that comprised about 92 percent of all insured institutions at year-end 2000, are
generally exempt from paying premiums when the fund exceeds the DRR.
The FDICs inability to price risk when the fund exceeds the DRR presents a
number of issues. Insurers generally price their product to reflect their risk of loss.
The FDICs inability to do this encourages new deposits to enter the system and enjoy
the benefits of deposit insurance without shouldering any of the costs. Since very little
in premiums has been collected since 1996, the deposit insurance system is almost entirely
financed by those institutions that paid premiums in the past. There are currently over
900 newly chartered institutions that have never paid premiums. There are, moreover,
significant and identifiable differences in risk exposure among the 92 percent of insured
institutions now in the same risk group, and the current system in effect forces the safer
banks in the group to subsidize the riskier ones. Finally, some bankers may take risks
they would have avoided if the insurance had been appropriately priced.
The following tables show the number and percentage of institutions insured by
the Bank Insurance Fund (BIF) and the Savings
Association Insurance Fund (SAIF), according
to risk classifications effective for the first semiannual assessment period of 2001. Each
institution is categorized based on its capitalization and a supervisory subgroup rating
(A,B, or C), which is generally determined by on-site examinations. Assessment rates are
basis points, cents per $100 of assessable deposits, per year.
BIF Supervisory Subgroups 1
Number of Institutions
Number of Institutions
Number of Institutions
SAIF Supervisory Subgroups 2
Number of Institutions
Number of Institutions
Number of Institutions
1 BIF data exclude SAIF-member "Oakar" institutions
that hold BIF-insured deposits. The assessment rate reflects the rate for BIF-assessable
deposits, which remained the same throughout 2000.
2 SAIF data exclude BIF-member "Oakar"
institutions that hold SAIF-insured deposits. The assessment rate reflects the rate for
SAIF-assessable deposits, which remained the same throughout 2000.
During the year 2000, financial institutions outside the realm of traditional
banking began to make more use of FDIC-insured deposits in their product mix. A few major
investment banks began or announced plans to begin sweeping large dollar volumes of
brokerage accounts into deposits in their insured subsidiaries. This is, of course,
another example of the continuing erosion of barriers between commercial banking and
investment banking. Nevertheless, these institutions paid no insurance premiums and, by
lowering the funds reserve ratio, increased the likelihood that other banks would
face higher premiums in the futureand this highlighted some of the anomalies of the
There also was spirited discussion among policymakers during the year 2000 of
the appropriate level of deposit insurance coverage. One of the purposes of deposit
insurance is to provide unsophisticated investors with a safe place to invest without the
burden of monitoring their banks. Over time, inflation eats away at the value of deposit
insurance. The question, then, was whether the $100,000 coverage limit, which had remained
in place since 1980, ought to be changed.
The debate was couched in familiar terms. Those who argued against higher
coverage emphasized the potential for moral hazard, the danger that large increases in
coverage can encourage some bankers to exploit the ability to gather insured deposits and
deploy them to finance risky activities. On the other hand, there were those who asked
whether the erosion of coverage should be allowed to continue indefinitely: in constant
dollars, the coverage limit at year-end 2000 was almost 30 percent below its 1974 level.
Both of these concerns are legitimate, but the debate highlighted one fact that was
indisputable. Unlike other federal programs that are indexed, such as Social Security,
Medicare and taxes, deposit insurance levels are determined at unpredictable intervals by
the outcome of such a debate.
The FDICs Recommendations
The FDIC devoted considerable time and effort during the year to analyzing these
issues. In April the agency conducted a roundtable discussion with the leadership of the
major banking trade associations, several consumer organizations and interested
individuals. In May and June, Chairman Tanoue, Vice Chairman Hove and senior management of
the FDIC held outreach meetings with bank chief executive officers in Minneapolis, Dallas
and Kansas City. In August 2000, the agency published a comprehensive options paper that
discussed various approaches to deposit insurance pricing, funding and coverage that might
replace the current approaches. After the release of the options paper, staff devoted
extensive efforts to narrowing and refining the possible approaches to produce a workable
package of recommendations. There were numerous meetings with bankers, trade groups,
academics, outside experts, Capitol Hill and other interested parties along the way.
The recommendations that ultimately resulted from this process were as follows:
The BIF and the SAIF should be merged.
The current statutory restrictions on the FDICs ability to charge
risk-based premiums to all institutions should be eliminated; the FDIC should charge
regular premiums for risk regardless of the level of the fund.
Sharp premium swings triggered by deviations from the DRR should be eliminated.
If the fund falls below a target level, premiums should increase gradually. If it grows
above a target level, funds should be rebated gradually.
Rebates should be based on past contributions to the fund, not the current
The coverage limit should be indexed to keep pace with inflation.
The FDIC had been advocating a merger of the two insurance funds for some time.
The resulting $42 billion fund (based on year-end 2000 financial results) would be
stronger than either fund would be on its own. A merger is the only way to eliminate the
possibility of premium disparities between the deposits of the two funds and the attendant
Similarly, the FDIC had been suggesting for some time that it needs expanded
discretion to price risk. If deposit insurance premiums continue to be fixed at zero for
most banks most of the time, our deposit insurance system will continue to suffer from the
deficiencies described earlier: premiums will rise dramatically during periods of economic
adversity because the FDIC will be forced to charge banks for most of the losses all at
once; new deposits will impose risks and costs on other banks without sharing in any of
the costs of operating the system; the safer banks in the system will subsidize the
riskier ones; and the moral hazard problems caused by mispriced deposit insurance will be
In recommending steady risk charges over time, the FDIC recognized the
analytical challenges involved in implementing them. Staff spent considerable time after
the release of the options paper developing a scoring model for insured institutions
analogous to those used in the private sector for evaluating borrowers
creditworthiness. The results were promising.
Collecting premiums from all banks regardless of the level of the fund creates
the possibility that the fund will grow very large. At what point the fund becomes too
large is an important policy question. An insurance fund allows the FDIC to act quickly to
resolve banking problems when needed, facilitates paying for bank failures over time
rather than all at once, and buffers the taxpayer against loss. Determining an appropriate
range for the insurance fund involves a tradeoff, because there is a cost that must be
weighed against these benefits, namely, dollars in the fund could have been used to
support bank lending.
Chairman Tanoue and Vice Chairman Hove, along with senior
officials Arthur J. Murton (left) and William R. Watson (right), lead a panel of industry
experts in a discussion of key deposit insurance issues at an FDIC- sponsored roundtable
in Washington on April 25, 2000.
In coming to its recommendations, the FDIC recognized that this policy tradeoff
must be confronted and that, one way or another, the size of the fund has to be managed.
The current system manages the size of the fund by eliminating deposit insurance premiums
for most banks when the fund is above the DRR, and adjusting them upward abruptly when the
fund is below the DRR. The FDIC concluded that a better way to manage the size of the
fundone that mitigates premium volatility and preserves risk-based pricingwould be to increase premiums gradually rather than abruptly when the fund is below a
target, and to provide gradually increasing rebates when the fund is above a target.
The rebate system advocated by the FDIC would be a significant departure from
past practice. The reason the FDIC recommended a rebate system bears re-emphasizing:
rebates could allow the FDIC to price risk at individual institutions regardless of the
level of the fund. Under the scheme the FDIC has operated under since 1933, apart from
increases in coverage the only way to slow the growth of the reserve ratio has been to
reduce deposit insurance premiums. With a rebate system in place to provide a
self-correcting mechanism to control the growth of the fund, risk-based premiums could be
assessed on all institutions regardless of the level of the fund.
This argument in favor of a rebate system presumes that the rebates would not
themselves distort economic incentives or create new moral hazard problems. To put the
matter another way, the FDIC should not pay banks simply to exist, nor should it pay them
to grow. This reasoning led the FDIC to conclude that a banks rebate should depend
on what it has paid into the fund in the past, and not on its current assessment base.
As noted earlier, developments during the year 2000 highlighted the concern
raised by rapidly growing institutions that dilute the funds reserve ratio and pay
nothing for deposit insurance. At this point it is possible to summarize how the
FDICs recommendations would address this issue. First, under the assessment system
the FDIC recommends, a decrease in the reserve ratio would have, at most, a gradual effect
on banks net payments to the FDIC. This means the effect of new deposit growth on
other insured institutions would be substantially diminished.
Second, regular risk-based premiums for all banks would mean that fast growing
institutions would pay increasingly larger premiums as they gathered deposits. In
addition, fast growth, if it posed greater risk, could result in additional premiums
through the operation of the FDICs expanded discretion to price risk.
Finally, with rebates based upon past contributions, when the FDIC is paying
rebates, those rebates would be paid in relatively smaller amounts to fast growers and in
relatively greater amounts to established institutions or slower growers. Over time, as
all institutions paid assessments (and as rebates were made based upon past assessments),
new institutions and fast growers would build their "rebate shares."
The recommendation to index coverage to inflation was based on a presumption
that if deposit insurance is an important part of the federal governments overall
program to ensure financial stability, then its relative importance ought to be maintained
in a predictable manner.
The FDIC viewed the recommendations that resulted from the work done in the year
2000 as a package, arguing against picking and choosing some parts of the framework but
not others. For example, raising coverage with no change to the pricing system would
exacerbate the distortion of incentives that already exists. Paying rebates without
changing pricing would, again, not address the problems that come from a lack of premiums
when the fund exceeds the DRR, and would increase the need to raise premiums in bad times.
And a poorly designed rebate system could negate the benefits of any deposit
insurance pricing system, and make incentive problems much worse than they are now. For
example, giving rebates proportional to a banks deposits could mean the FDIC in
effect would pay a bank to exist, and pay it more to grow.
The FDIC has protected depositors and promoted the safety and soundness of insured
depository institutions for over 65 years. The year 2000 marked the end of a decade that
saw both a banking crisis and an economic boomand a decade that saw major
legislative changes to the FDICs assessment system. The year 2000 was, in short, a
good year for taking stock. The FDIC believes that the recommendations for
deposit-insurance reform developed during the year will provide a sound basis for helping
the agency achieve its mission, more efficiently and more fairly, for years to come.