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2000 Annual Report
2000 – The Year of Deposit Insurance
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.
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.
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 current system.
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 recommendations that ultimately resulted from this process were as follows:
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 competitive inequalities.
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 magnified.
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.
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.
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