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1999 Annual Report

Challenges in Deposit Insurance

FDIC insurance has protected depositors and served as a symbol of confidence in our nation’s banking system for more than 66 years. During the last two decades of the twentieth century, there were significant changes in some of the underlying parameters of deposit insurance – in the risks the FDIC was underwriting, in the risk-management tools that banks and bank supervisors used to control those risks, and in the premium and funding structures for deposit insurance. These changes have created new issues for the operation of our deposit insurance system, and highlighted the importance of old issues. This article takes stock of the new challenges and offers thoughts on how the system might evolve in response.

 

 

New Risksline

At year-end 1999, the FDIC faced a more challenging risk environment than ever before. Cyclically, we stood at the ninth year of the longest and strongest economic expansion in U.S. history, an extraordinary period of low unemployment, low inflation, high productivity growth, low and stable interest rates, significant technological change, and soaring household wealth. One of the new risks in this economic landscape was the potential for highly integrated global financial markets to speed the transmission of financial risks across borders, sometimes in unexpected ways. And as the decade ended, there were signs of financial imbalances emerging in the U.S. economy: a buildup of household and corporate debt; a negative personal savings rate; a record and rising trade deficit; and more generally, an increasing reliance on financial markets as sources of wealth and cash flow. Some observers saw in the economic fundamentals a new age of limitless prosperity; others saw the financial imbalances in apocalyptic terms; but all agreed that the U.S. economy was in uncharted territory.

Structurally, risks within the banking industry were becoming more concentrated, a trend that ultimately could have ramifications for the ability of the banking industry to collectively insure itself. FDIC insurance gives each bank a contingent liability to pay for the failures of other banks, a contingent liability that is analogous to a credit exposure. Just as standard credit-risk measurement tools predict that the potential for extreme losses increases with the concentration of a loan portfolio, we may expect that over a long period of time, increasing banking industry concentration will place each bank at greater risk of extreme outcomes with respect to its mutual deposit insurance obligations.

As the nineties drew to a close, it also appeared that we were in the midst of a long-term trend in which the complexity of measuring and monitoring the risks assumed by insured institutions was increasing. In part, this trend was a function of the increasing size, scope of activities, and complexity of the largest institutions. Yet the FDIC has observed that the opacity of bank risk is not confined to the largest institutions. The proliferation of securitization vehicles, the ability to quickly assume – or hedge – significant risks off the balance sheet, the ability to raise loans and deposits quickly through aggressive price competition, the propensity to outsource significant bank functions, and entry to lines of business outside the traditional bank franchise, by small institutions as well as large, all can be used by bankers to manage risk, but also can increase both the speed with which risks can change and the complexity of measuring those risks. These trends will put continued pressure on the FDIC’s deposit insurance pricing system to use the best information available to assess risks – both from onsite examinations, the most reliable source of information about banks’ risk profiles, and from new and existing sources of offsite information.

 

 

New Approaches to Risk Management line

Standing between the FDIC and the risks we have described is an array of private sector and supervisory risk controls. By the end of the 1990s, it was clear that these risk-mitigating tools were undergoing significant change. There was substantial discussion about the implications of these trends for capital regulation, but discussions about the implications for deposit insurance were in their infancy.

Private sector risk management strategies evolved considerably during the 1990s. An ongoing dialogue that included the accounting profession, the financial regulatory community, and leading financial institution practitioners resulted in a significant increase in the degree to which best practices in risk management were formalized and made available. Quantitative tools to measure and monitor risk became more sophisticated as well. Asset-liability management software to assist in the evaluation and control of interest rate risk is now readily available to financial institutions; market risks are being measured in real time through value-at-risk models and other approaches; and credit risk modeling and measurement is becoming more rigorous. As the decade closed, the risks identified through these tools were being managed with financial instruments and financial technologies that did not exist twenty years earlier.

Bank supervisors have long emphasized that the successful management of bank risk is ultimately a function of the stewardship provided by bank management. During the 1990s, the operational and policy implications of this philosophy began to be explored more fully.

Supervisors placed more emphasis on risk-focused loan review and transaction testing for the purpose of validating policies and procedures, with more detailed testing where there was evidence of a need for further review. In the arena of large or publicly traded banks, there was a clear policy momentum towards improving the quality of management’s public disclosures, in order to enhance the potential risk-mitigating effects of private market discipline.

The impact of these trends in risk management on the FDIC’s losses will depend on the frequency of instances where specific aspects of risk control systems do not work as intended. Thus, we should be concerned with any systemic trend that increases the likelihood of such breakdowns. For example, we have seen some cases where the opportunities to generate revenue inherent in a long expansion – and the competitive pressures to do so – have led banks to compromise or neglect important aspects of risk-management discipline. Warnings from the Securities and Exchange Commission about the danger that some accounting firms may be compromising  their auditing business in favor of more lucrative consulting opportunities may provide another example of a systemic trend towards an increasing volatility of risk-management outcomes. Given these trends, it can be expected that the FDIC’s pricing and evaluation of risk will, over time, continue to place heavy emphasis on identifying the quality of banks’ risk controls.

 
Risk-Related Premiums
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 2000. 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 Subgroupsl
A B C
Well Capitalized:
Assessment Rate 0 3 17
Number of Institutions 8,291 (93.7%) 329 (3.7%) 50 (0.6%)
Adequately Capitalized:
Assessment Rate 3 10 24
Number of Institutions 150 (1.7%) 12 (0.1%) 10 (0.1%)
Undercapitalized:
Assessment Rate 10 24 27
Number of Institutions 2 (0.0%) 0 (0.0%) 8 (0.1%)
SAIF Supervisory Subgroupsn
Well Capitalized:
Assessment Rate 0 3 17
Number of Institutions 1,271 (91.6%) 77 (5.5%) 6 (0.4%)
Adequately Capitalized:
Assessment Rate 3 10 24
Number of Institutions 21 (1.5%) 5 (0.4%) 7 (0.5%)
Undercapitalized:
Assessment Rate 10 24 27
Number of Institutions 0 (0.0%) 0 (0.0%) 1 (0.1%)
 

l 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 1999.

n 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 1999.

 

 

 

A New Legislative Framework line

By a combination of legislative changes, regulatory choices and economic events, the funding and pricing of FDIC insurance evolved during the 1980s and 1990s into something fundamentally different from what existed during the first 50 years of the FDIC’s history. The banking crisis of the 1980s led to two major pieces of legislation, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the FDIC Improvement Act of 1991 (FDICIA). These laws have significantly changed the way the FDIC conducts business in a number of areas, including the institutions it insures, the insurance funds it administers, its enforcement powers, and the manner in which it resolves failing institutions. Most noteworthy for the purposes of this article are two requirements laid down by FDICIA: i) that the FDIC price insurance according to the risks posed by individual institutions, in order to mitigate the moral hazard problems that can attend any deposit insurance system; and ii) that it maintain the funds at designated reserve ratios.

The FDIC implemented its risk-based deposit insurance premium system in 1993, the Bank Insurance Fund achieved its designated reserve ratio in 1995, and it quickly became apparent that there were severe tensions between a requirement for risk-based pricing and a requirement to manage the insurance funds to a specific size. Implicit constraints on the size of the FDIC’s insurance funds placed constraints on deposit insurance pricing at the individual institution level. The tension between the twin requirements of risk-based pricing and management of fund size became far more explicit in 1996, when the Deposit Insurance Funds Act constrained both the FDIC’s ability to determine which insured institutions belong in the best category for insurance purposes, and the premiums it can charge those institutions.

In particular, when the insurance fund is above its Designated Reserve Ratio (1.25 percent of insured deposits at year-end 1999), the FDIC in effect cannot collect assessment revenue from institutions in its best insurance category, which at year-end 1999 comprised 93 percent of all insured institutions. Conversely, when the fund is below its designated ratio, the FDIC must collect sufficient assessment revenue to return the fund to that Designated Reserve Ratio within one year, or else collect average deposit insurance premiums of at least 23 basis points of domestic deposits.

The new legislative and regulatory framework has resulted in at least three striking departures from past practice. First is the zero deposit-insurance premium paid by most banks. In contrast to the period 1933-1995, when the FDIC assessed every dollar of domestic deposits at a rate of at least three basis points per annum, after 1995 most deposits were not assessed at all. A striking feature of a zero premium is that not only may the rate paid by vastly disparate banks be identical, but the dollar amount as well: a bank with $100 billion in deposits can be billed the same amount for its insurance as the smallest community bank.

Second, in reaching a point where the FDIC does not collect assessment revenue from most institutions during good times, we have clearly departed from any concept of spreading insurance losses over time. In contrast, prior to 1989 it could be argued that Congress intended the FDIC to operate under a form of long-term expected loss pricing. During the period 1933-1989, when premiums were set by statute and never departed from a range of between three and 8.9 basis points per annum, accumulated premiums and the investment income on those balances enabled the system to roughly pay for itself. The system in place today, in contrast, amounts essentially to charging nothing in times of prosperity and a lot in times of adversity, thereby potentially magnifying swings in the banking cycle.

A third change stems from the conjunction of two factors: the FDIC’s original decision to rely on examination ratings as a significant input to the risk based premium system, and the assessment revenue constraints of the 1996 Deposit Insurance Funds Act. The banks that were paying for deposit insurance at the end of the 1990s were those that had run afoul of capital regulations or the supervisory process. Thus, another departure from past practice was that the pricing of deposit insurance at the individual institution level had evolved into a penalty system for the few, rather than a priced service for all.

 

 

Issues for Deposit Insurance Fund Management line

From the FDIC’s standpoint, it was clear as the nineties drew to a close that the terms of the tradeoff between the ability to price deposit insurance based on risk and constraints on aggregate revenue needed to be re-evaluated. That tradeoff had been resolved by the Deposit Insurance Funds Act in favor of a zero premium for most institutions. As a result, by the end of the 1990s, the moral hazard problems FDICIA intended to address through risk-based deposit insurance premiums may have become more firmly entrenched than ever. At year-end 1999, the FDIC provided a non-priced guarantee of over two trillion dollars in bank liabilities.

Under pure risk-based pricing, it is likely that every bank in the U.S. with insured deposits would pay something for its deposit insurance, for the same reason that every bank pays at least some spread over Treasuries for unsecured debt. Given the long and uncertain duration of banking cycles, however, under such a system it would never be clear in advance whether the premiums accumulated during times of prosperity were more, or less, than what would ultimately be needed during periods of economic upheaval. Consequently, there will inevitably be questions about the appropriate disposition of these accumulated funds. The answer to such questions depends on one’s vision of how the costs and benefits of the deposit insurance system should be shared.

Under one extreme, deposit insurance could be viewed as completely private. Under this pure mutual model, monies collected by the insurer are the collective property of the banks that contributed, any insurance losses are their sole responsibility, and pricing of deposit insurance is not the subject for public policy discussions but is of concern only to the banking industry. The history of banking and financial crises in both the U.S. and other countries provides numerous examples where bank losses were so severe and so systemic that the government was forced to step in, either through loans or taxpayer bailouts. This experience calls into question whether pure private deposit insurance would be economically viable over long periods of time.

BIF Report              SAIF Report
Chart: FDIC-Insured Deposits
            (year-end through 1999)Chart:Real Value of Insured Deposit Coverage Has Declined Since 1980

PDF version of charts (40Kb PDF file - PDF help or hard copy)   

Another endpoint, in which the mutual aspect of insurance is removed completely, might be termed the user-fee or priced service model of deposit insurance. The insurer collects premiums on an expected-loss or risk-adjusted basis from each institution. The premium is simply a payment for a service, namely the use of the deposit guarantee for a specified time. In this "demutualized" model, the premium payer has neither an ownership interest in collected premiums nor a responsibility to pay for the insurance losses of other banks. An insurance fund to provide rapid resolution flexibility is consistent with this model, provided government reaps all surplus funds during good times and readily recapitalizes it to cover all insurance losses.

The pure priced service model, taken to its logical extreme, makes moot a number of issues raised in this article. Concentrations of deposit insurance exposure – although an issue for the government insurer and its ability to diversify risks – are not an issue for insured institutions because they are never asked to help pay for the failures of other banks. Rebates from the insurance funds are ruled out, but conversely banks are relieved of the responsibility to rebuild a fund during periods of economic hardship.

 

Whereas history casts doubt on the long-term economic viability of a pure private deposit insurance model, it also casts doubt on the long-term political sustainability of a pure user-fee model. It is human nature to keep score. As assessment revenues mount far above cumulative insurance losses during good times, bankers will point out that the costs of the system appear to be outstripping its benefits, and they will be heard, as they were heard in 1950 when Congress required the FDIC to institute rebates of excess assessment revenues, and again in 1996 with the Deposit Insurance Funds Act. Conversely, during bad times Congress is unlikely to sit by while losses mount, under the theory that everything will even out in the end. Instead, as they have in the past, the banking industry probably would be asked to pay for as significant a share of losses as possible before recourse is had to the taxpayer.

 

Between the two endpoints of a purely private system and a pure user fee system – between a pure mutual system and a completely demutualized one – are the intermediate models of mutual insurance with a federal backstop against catastrophic loss. Under these approaches, banks are mutually obligated to pay aggregate insurance losses up to a point, and mutually entitled to some of the benefits of favorable fund performance. Under any such approach, the federal government’s guarantee against catastrophic loss gives it a significant public policy stake in ensuring that the guarantee is appropriately priced. At the same time, all participants in the system have a significant stake in the manner in which aggregate system performance results in shared costs and shared benefits.

For example, under the current system, banks are mutually obligated to recapitalize the insurance funds if the funds fall below a designated ratio; conversely, when the funds remain above the designated ratio they are mutually entitled to a benefit, namely zero-cost federal deposit insurance for most institutions. This particular set of mutual obligations and benefits carries with it all of the issues we described: the zero premium during good times; a

Deposit Growth Since Funds Were Capitalized. The top 25 percent in terms of deposit growth have added $178 billion. 814 New banks have added $44 billion of insured deposits.  The lowest 25 percent in termsof deposit growth have lost $69 billion since the funds were capitalized.  $100 billion in deposits dilutes: BIF by five basis points SAIF by 18 basis points.
potentially heavy assessment during bad times; and a growing concentration of contingent deposit insurance exposures. Current arrangements also create an issue we have so far deferred: the tendency of a zero premium under a mutual insurance arrangement to create free-rider problems, in which new banks, fast growing banks and non-banks can, at no cost to themselves, increase the mutually shared obligations or reduce the mutually shared benefits of other members of the system.

There may be other quasi-mutual models where the rules for doling out mutual costs and benefits are different than in our current system, and that do not create the degree of perverse or unintended consequences as our current system. For example, it is not clear that the shared benefit that accrues to the banking industry during good times should necessarily be in the form of a zero deposit insurance premium. One could imagine, for example, that premiums collected during good times could go first to the insurance fund, and then to some asset in which member banks have a collective or individual interest. There are many ways banks’ collective interest in such an asset could be structured – through a rebate system, through a credit-union approach in which each bank carries its share of the asset on its books, or some other approach in which the collective asset only generates cash flows for banks during bad times. Under any of these approaches, if ownership of the collective asset were apportioned analogous to a mutual fund, with a dollar of premiums buying a dollar of shares, the free-rider problems described above could be mitigated.


Implications for Deposit Insurance Pricing line

Risk-based deposit insurance pricing at the individual institution level has two goals: to provide beneficial incentives to control excessive risk taking and mitigate the moral hazard problems associated with flat-rate deposit insurance; and to lessen the degree to which strong institutions subsidize weak and poorly managed institutions, so that the cost of the insurance program is shared in an equitable manner.

An interesting question is whether deposit insurance pricing is conceptually redundant with supervision as a policy instrument to accomplish these goals. There are reasons to think not. There are built-in limits in a market economy on the degree that supervisors can or should attempt to control individual institution behavior. To use a private insurance analogy, a supervisor is unlikely to take away someone’s driver’s license simply because that person owns a sports car; an insurer, without trying to change the behavior, can price it. Even under a theoretically perfect supervisory capital regime where all institutions have an identical estimated probability of failure, market pricing or other indicators may at times suggest that the risk profiles of some institutions are significantly different than others. In such instances deposit insurance pricing can be a policy tool that complements the tools available to supervisors.

In practice, there are limits to what deposit insurance pricing can and should try to achieve. The FDIC provides a monopoly-priced service, and it may be undesirable for a federal agency to make exceedingly fine subjective distinctions that have the effect of allocating credit to favored activities or institutions. Within those limits, however, risk differentiation is important, and the technical issues of how best to achieve it are significant.

     PDF version of chart (39Kb PDF file - PDF help or hard copy) Bar Chart: Deposit Concentrations Have Shifted 

If a significant adverse change in the banking and economic cycle occurs in the next few years, historical experience suggests that many of the resulting bank failures will come from institutions that did not pay insurance premiums at year-end 1999. The question will then be how many of those premium misclassifications were the result of what one might call random errors – the price we willingly accepted for not having an overly burdensome regulatory and supervisory structure – and how many were the result of systematically subsidizing certain types of riskier institutions at the expense of other members of the system.

 

When we consider the more than 9,500 insured institutions that all paid no premium at year-end 1999, there clearly were some systematic factors that distinguished their risk profiles. The distinction between banks with composite examination ratings of 1 and 2 is one example, but there may be others. For example, should new banks or fast growing banks pay additional premiums, both for reasons of risk differentiation and to force them to pay for the external cost they impose on other members in a mutual structure? Are there indicators that would identify those banks within the best risk-related premium category that have high concentrations of risky assets, significant interest-rate risk or market risk, or weak risk-management practices?

The best risk indicators may not be the same for large institutions as for small institutions, and indeed, both onsite and offsite examination procedures vary depending on the size, complexity and risk profile of a bank. FDICIA provided the FDIC with authority to establish separate premium systems for large versus small institutions. Because of their size, scope and complexity, large institutions and their supervisors necessarily measure and manage risk differently than is the case for a typical small bank. By the end of the nineties it was clear that some thought needed to be given to the implications of the developments in large-bank risk measurement for the way the FDIC measures risk for insurance purposes, so that the FDIC might benefit from the results of risk measurement undertaken by industry practitioners, as well as by their supervisors and publicly available sources. Likewise, risks taken by large banks are priced in a variety of markets, conceivably resulting in useful information that may be valuable in pricing deposit insurance. And the proliferation of financial instruments by which risks are transferred and priced is at least suggestive of the possibility that new instruments could be developed that could enhance risk-based pricing at the individual institution level, or provide market signals about the direction of the FDIC’s aggregate exposure.

Given the potential for a bank’s risk profile to change quickly, changes in risk profiles in the interval between examinations may take on added significance in the years ahead. The FDIC already has a number of offsite tools for evaluating these inter-examination trends, and the importance of continuing to refine such tools and develop new ones is likely to increase.

Finally, if risks are indeed becoming more opaque and complex to monitor as we have argued, there is room for discussion of the implications for deposit insurance pricing. An interesting public policy question is what role, if any, deposit insurance premiums should have in providing incentives to banks regarding the quality of their disclosures about the risks they undertake.

 

 

Insurance Coverage line

There has been considerable discussion since year-end 1999 about whether and how deposit insurance coverage should be adjusted for inflation. The merits of indexing coverage ultimately depend on one’s view of the role of deposit insurance in the financial system. Deposit insurance was implemented not only to protect small savers, but to correct a market failure: the susceptibility of banks to deposit runs, a susceptibility that arises from banks’ combination of illiquid assets and liquid liabilities.

There was always a danger that deposit insurance would simply replace one ill with another. While deposit runs are a thing of the past, in their place we have a greater potential for the distortions and moral hazard problems that come with a federal safety net. For those who do not think this has been a good tradeoff, the policy prescription is clear: allow the deposit insurance coverage limit to erode in real terms over time.

On the other side of the debate are those who point to the array of private sector and supervisory risk mitigation tools, and more recently, risk-based premiums, that can act as a counterweight to the potential moral hazard problems. In this view, the increased stability deposit insurance brings is not completely offset by other problems. There is also the view that every country has deposit insurance – whether it knows it or not – and that meaningful, explicit coverage results in lower costs in the event of banking crises than would occur under negligible or implicit coverage. The argument is that little or no formal coverage may well turn into unlimited coverage in times of crisis, while a meaningful and explicit coverage limit is more likely to be adhered to. Proponents of this view would be more likely to recommend a coverage limit that adjusts over time to maintain the same relative importance in the financial system.

* * *

None of the issues discussed in this article are easy to address, but their importance is undeniable. The time appears ripe for a productive debate on how the U.S. deposit insurance system should be strengthened to meet the new challenges.

 


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