Increasing Deposit Insurance Coverage for Municipalities
and Other Units of General Government: Results of the 2006 FDIC Study
The Federal Deposit Insurance
Reform Conforming Amendments Act of 2005 (FDIRCAA) required that the Federal
Deposit Insurance Corporation (FDIC) study the feasibility and consequences of
privatizing deposit insurance, establishing a voluntary deposit insurance
system for deposits in excess of the maximum amount of FDIC insurance, and
increasing the limit on deposit insurance coverage for municipalities and other
units of general government. In February 2007, the FDIC sent its report to
Congress. The results of the FDIC’s findings on privatizing deposit insurance
and establishing a voluntary deposit insurance system for excess deposits
appeared in previous issues of the FDIC Quarterly (available at www.fdic.gov/bank/analytical/quarterly/index.html).1 This article summarizes the FDIC’s
findings on providing additional coverage for municipal and other public
Industry consolidation, globalization,
the expanding use of technology, and other changes in the banking industry have
dramatically altered the financial landscape. Accordingly, in March 2000, the
FDIC began a comprehensive review of the deposit insurance system to ensure
that it would continue to meet its responsibilities as deposit insurer in this
new banking environment. Additional coverage for municipal deposits was one of
many issues to emerge during this review, and the FDIRCAA required the FDIC to
study the issue further. This article examines the findings from the FDIRCAA
study, including the arguments for and against additional coverage for
municipal deposits. It then considers whether options that are currently
available in the private sector provide a viable alternative to traditional
public deposit collateralization programs.
Municipal, or public, deposits are the funds of a state, county,
municipal, or political subdivision that are held as deposits in an
FDIC-insured institution.2 Municipal deposits held in the same state
as the public entity are insured up to $200,000 ($100,000 in time and savings
accounts, and $100,000 in demand deposits) in any one depository. Out-of-state
public deposits are insured up to $100,000.3 To limit the risk to
public entities and, ultimately, local taxpayers, most state laws require banks
to collateralize public deposits, typically with high-quality government
securities, to the extent that they are not covered by federal deposit
insurance (see Text Box below.) At the end of 2006, state and local
governments had $2.4 trillion in financial assets.4 Of this amount,
FDIC-insured commercial banks held $289.7 billion, of which almost 76 percent
($219.3 billion) was uninsured and secured.
Throughout the 1990s and into the next decade, depository
institutions faced new funding challenges as asset growth outstripped the
growth of core deposits. It was against this backdrop that FDIC-insured
institutions began to look more closely at municipal deposits as a potential
source of liquidity.5 Between 2000 and 2005, several bills were
introduced in Congress that would have increased coverage of municipal
deposits. A number of the bills recommended that the FDIC insure 80 percent of
in-state municipal deposits above the basic insurance coverage limit, up to a
maximum of $2 million. Other legislative measures suggested that the maximum
coverage for in-state municipal deposits be raised to $5 million or that the
FDIC provide 100 percent coverage of all municipal deposits, regardless of
size. In August 2000, the FDIC evaluated various reform options, including
additional coverage for municipal and other public deposits, but did not take
an official position.6 In 2003, then FDIC Chairman Donald E. Powell
commented on one legislative proposal to increase coverage for municipalities:
Raising the coverage level on public deposits could provide
banks with more latitude to invest in other assets, including loans. Higher
coverage levels might also help community banks compete for public deposits and
reduce administrative costs associated with securing these deposits. On the
other hand, the collateralization requirement places a limit on the ability of
riskier institutions to attract public funds, while a high deposit insurance
limit would not. Traditionally, we [the FDIC] have taken a dim view of treating
one class of deposits—in this case, municipals—dramatically differently than
the others, and we have communicated that concern to Capitol Hill.7
While Chairman Powell expressed reservations about raising the
limit on municipal deposit insurance, proponents of excess deposit insurance
presented a number of reasons for increasing the coverage amount.
Arguments for Increasing Municipal Deposit Coverage
Early proponents of excess deposit insurance for municipalities
argued that increased coverage would allow municipal deposits to remain in
local institutions, where they would be used to meet local needs.8
In recent years, other arguments have emerged. Proponents contend that
increased municipal deposit coverage would make bank operations more efficient
and less costly, provide a higher degree of safety and additional protection
for taxpayers, and permit smaller institutions to compete more effectively for
Bank Costs. Increasing municipal deposit insurance
coverage would benefit insured institutions by lowering bank costs. State collateralization
laws that require banks to secure municipal deposits with low-risk, low-yield
investments impose opportunity costs by preventing participating institutions
from investing in higher-yielding assets. It is estimated that
collateralization typically costs 15 to 25 basis points in yield on the assets
used to collateralize the deposits.9
Safety of Public Deposits. Increasing municipal deposit
insurance coverage would provide a higher degree of safety for public deposits.
For collateralization to safeguard public deposits, the collateral must be
adequate and the security agreement enforceable. In situations involving bank
fraud, collateral may be missing or otherwise unavailable if an insured
institution fails. The failure of Oakwood Deposit Bank in February 2002
illustrates this risk. When the Ohio bank failed, some municipal depositors
discovered that the collateral securing their deposits was valued at
significantly less than agreed, while other depositors found that the bank had
pledged the same collateral multiple times. Even if there is no malfeasance,
the market value of the collateral may have deteriorated at the time of the
Proponents of additional coverage for municipal deposits argue
that because these deposits primarily consist of taxpayer funds, increasing the
coverage limits would reduce local government exposure to a bank’s credit risk
and, ultimately, provide additional protection to taxpayers.
Competition for Municipal Deposits. Increased insurance
coverage for municipal deposits may allow smaller institutions to compete more
effectively for these deposits without having to pay higher interest rates.
However, recent data suggest that smaller institutions are already attracting
these deposits. As of December 31, 2006, FDIC-insured institutions with less
$1 billion in total assets held only 15.2 percent of total insured deposits but
approximately 24 percent of all collateralized public deposits.
Arguments against Increasing Municipal
There are three primary arguments against increasing municipal
deposit insurance coverage: (1) additional coverage is not justified on the
basis of the traditional goals of deposit insurance; (2) increasing coverage
for municipal deposits could adversely affect moral hazard and market
discipline; and (3) excess coverage is likely to increase deposit insurance
Consistency with Traditional Goals
of Deposit Insurance. The traditional goals of deposit insurance are to
promote financial market stability by maintaining depositor confidence in the
banking system; to protect the country’s local, regional, and national
economies from the disruptive effects of bank failures; and to protect the
deposits of small savers.10 While there are credible arguments for
increasing the insurance coverage of municipal depositors, the traditional
goals for the insurance program provide little justification for such an
increase. In addition, as mentioned earlier, the FDIC does not generally
advocate favoring one depositor class over another.11
Effect on Moral Hazard and Market Discipline. Greater
insurance coverage for public deposits could remove an aspect of market
discipline that is currently in the system.12 State and local
governments are generally considered more financially sophisticated than the
average small saver and better able to monitor the performance of the
depository institutions they use. Increasing insurance coverage on public
deposits removes the incentive for public depositors to monitor the risk
behavior of their depository institutions, thus increasing moral hazard. Also,
to the extent that collateral requirements no longer constrain the investment
options of depository institutions to investments in “safe assets,” such as
Treasury securities, depository institutions have an incentive to invest in
riskier assets, increasing their overall risk profile.
Effect on Deposit Insurance Assessments. FDIC-insured
deposits would likely increase by at least $277.8 billion (the total amount of
uninsured, secured public deposits held by commercial banks and thrifts as of
year-end 2007) if all municipal deposits were fully insured.13 An
increase of this amount at the end of December 2007 would have reduced the
reserve ratio of the Deposit Insurance Fund from 1.22 percent to 1.15 percent,
potentially leading to higher assessment rates.14 The financial
industry press has reported that industry support for additional coverage of
municipal deposits diminished when it became apparent that deposit insurance
premiums might increase as a result.15
Structuring Increased Municipal Deposit Insurance
Congressional authorization would be required for the FDIC to
provide excess deposit insurance for municipalities and other general units of
government. However, the FDIC has considered a number of options for
structuring this additional coverage, including limiting its availability,
restricting excess coverage to protect taxpayers and the insurance fund, and
establishing a premium pricing structure based on risk.16 Each
option seeks to limit the FDIC’s loss exposure, constrain moral hazard, and
restrict the ability of riskier banks to use municipal deposits as a source of
deposit gathering. State legislatures could assist in meeting these goals by
amending their laws so that excess municipal deposits could be placed only in
institutions that are eligible to receive increased insurance coverage.
Availability. Excess municipal deposit coverage might be
made available only on a limited basis. For example, term policies could be
cancelled if an institution failed to maintain the qualifying standards, or
only well-capitalized institutions might be eligible to offer increased
coverage. If a participating institution lost its eligibility to offer extra
coverage, the insurance coverage of existing municipal deposits could revert to
the amount covered under the general deposit insurance rules after some period
(unless the excess coverage were allowed to continue on existing municipal
deposits).17 Although a depository institution could be required to
be responsible for informing public officials of any loss of coverage, this
responsibility might be shifted to the FDIC to ensure that depositors received
prompt and adequate notice.
Caps and Other Limits. A cap could be placed on the amount
of additional coverage for a municipal depositor. In addition, the municipal
depositor might share in any loss on the excess deposit. For example, insurance
coverage for any municipal depositor could be limited to a maximum of $2
million per institution, or only 80 percent of the excess deposit might be
insured up to the designated cap.
Despite the appeal of a system in which municipal depositors
share in any losses, such a system has the potential to contribute to a bank
run in the event of financial problems, as recently occurred in the case of
Northern Rock in the United Kingdom. Under the British deposit insurance
system, only 90 percent of the deposit above a basic level is covered by
insurance.18 As a result, most depositors stood to lose money if
Northern Rock failed, which contributed to a run on the bank when it
experienced financial difficulties.19 Because deposits made by
municipalities are typically quite sizable, public withdrawals during a period
of financial difficulty would likely exacerbate a bank’s liquidity problems.
The prevention of bank runs has been one of the great successes of the U.S.
deposit insurance system, and any change that might diminish the ability of
this system to contain bank runs would need to be carefully considered.
Other limits could be imposed on additional insurance coverage
for municipal deposits. For example, to control aggressive deposit gathering
and consistent with some state requirements, increased insurance coverage could
be limited to deposits from a municipality in the same state as the insured
institution. Limits could also be placed on the aggregate value of the public
deposits held by any one institution.
Pricing. A decision would need to be made as to whether
all participating institutions would pay a uniform premium. One option might be
to reduce the premiums of participating institutions based on the amount of
low-risk assets held, but not pledged, as security. Another possibility would
be to deduct low-risk assets from the total value of the municipal deposits
assessed, which might reduce some of the administrative costs associated with a
strict pledging arrangement.
Private Sector Options
There are public sector options currently available that allow
depository institutions to satisfy the safety requirements of many municipal authorities
without requiring collateralization or increased FDIC coverage. These options
include surety bonds and deposit-placement services. (Reinsurance, which was
discussed in a previous issue of the FDIC Quarterly, is a private sector
option that could be used to limit the FDIC’s exposure to excess coverage of
municipal deposits.20 Reinsurance is not discussed further in this
Surety Bonds. Most states allow municipal governments to
protect their local deposits by means other than collateralization. At least 30
states allow the use of a surety bond. Surety bonds, which are issued by
insurance companies, guarantee the payment of principal and interest on the
covered deposits. Most states provide guidelines for insurance company
eligibility. Surety bonds eliminate much of the administrative burden for both
the municipality and the bank because they do not require custodial agreements,
security agreements, or a continual revaluation of the collateral. In the event
of a default, payment on the bond is generally made within two days. From the
bank’s perspective, these bonds are more economical and efficient because they
do not tie up bank security, thus saving the bank administrative and
opportunity costs normally associated with collateralization.
Despite their advantages, some public officials are wary of using
surety bonds because the municipality must relinquish some control. For
example, the municipality is not part of the contract negotiation, which is
between the bank and the insurance company. Nevertheless, if proper precautions
are taken, surety bonds can be a reasonable and efficient alternative to
Deposit-Placement Services. As discussed in a previous
issue of the FDIC Quarterly, the FDIC issued an advisory opinion in 2003
confirming that pass-through deposit insurance rules apply to funds placed with
a deposit-placement service. As a result, FDIC-insured institutions that use
deposit-placement services can, in effect, insure deposits in excess of the
statutory limit.21 Currently, a depositor can obtain insurance
coverage for a $50 million deposit by using a deposit-placement service. These
services can reduce the administrative costs of collateralization. They also
reduce the opportunity costs incurred when the bank sets aside collateral
necessary to secure municipal deposits.
Because most state laws clearly describe how public deposits must
be secured, use of a deposit-placement service may require state legislative
action. However, some states (for example, Missouri, Ohio, and Oregon) have
amended existing laws to permit their use. Other states are allowing local
governments to use deposit-placement services with certain restrictions, such
as requiring municipal deposits to be kept within the state or placing a limit
on the amount of the deposit.
Current Practices in Supervising and Administering
All states currently require one of three options for the
supervision and administration of collateral: uniform statewide
collateralization; statewide collateral pools; or uncoordinated, autonomous
Uniform Statewide Collateralization. This model prescribes
a single system of collateralization for all political subdivisions throughout
the state. States that use a uniform statewide system commonly require that
public deposits be fully collateralized. Local officials are typically
responsible for enforcement and implementation of the collateral requirements
under this system. Banks bear the full expense of establishing the custodial
account and forgo the higher income they would normally earn by making loans.
Although full collateralization of public funds would appear to
completely protect municipal deposits, a number of risks remain. For example,
the market value of the collateral pledged by the bank may turn out to be less
than the face value, making the protection inadequate. This can occur when the
collateral accepted by the government entity is subject to interest rate risk,
credit risk, or liquidity risk. One example is municipal bonds. These bonds,
which are accepted as collateral in several states, are interest-rate sensitive
and contain liquidity risk because they have a limited secondary market. A
shallow secondary market can also delay recovery for the depositor. For
example, mortgage-backed securities, which are accepted as collateral in some
states, have recently lost market value because of their perceived credit risk.
Finally, fraud can result in unexpected losses to the collateralized depositor.
(Fraud is a potential risk in any of the three collateralization options.)
Statewide Collateral Pools. Some state legislatures have
created statewide collateral pools. These pools are supervised by a central
state agency that administers all collateral set aside by banks as security for
the portion of the municipal deposits not covered by FDIC deposit insurance.
For example, Florida requires that banks deposit with the state central agency
acceptable securities equal to 50 percent of the deposit not covered by FDIC
insurance. Statewide collateral pools reduce the costs to individual depository
institutions in two ways. First, banks save the cost of individually
supervising and administering the assets used as collateral. Second, because
full collateralization is not required, a greater portion of an institution’s
assets can be invested in higher-yielding assets, such as loans. Local
governments and agencies also save with this method, as a central agency
manages the administration of the collateral. States typically require the
collateral pool to exceed the total public deposits held by the largest
institution in the state.
Uncoordinated, Autonomous Collateral Pledging. Some
states permit public treasurers to obtain collateral for public funds at the
treasurer’s discretion. This method, called the “home rule” or permissive
approach, places complete responsibility for collateralization practices with
local officials. However, because of the lack of uniformity in
collateralization agreements, each agreement must be separately negotiated by
the depository institution and the public official. This lack of standardization
results in an increased risk of error or negligence in market-monitoring
processes and safekeeping procedures, as well as an increased cost to the
depository institution. This increased cost is usually passed on to the
municipality through deposits bearing a lower yield.
* Much of the information about the supervision
and administration of collateral is derived from Corinne M. Larson, An
Introduction to Collateralizing Public Deposits, Government Finance
Officers Association, 2006.
Increased federal coverage for public deposits could benefit
local communities, lower bank costs, and increase safety for taxpayers.
However, additional municipal deposit insurance would represent a departure
from the traditional goals of deposit insurance and would likely increase both
moral hazard and deposit insurance assessments. Credible private sector
options, in the form of surety bonds and deposit-placement services, currently
offer protection for municipal deposits. If federal deposit insurance coverage
were to be increased on municipal deposits, concerns about increased exposure
to the Deposit Insurance Fund, moral hazard, and appropriate pricing of such
coverage would need to be addressed.
Larson, M. Corinne. 2006. An Introduction to
Collateralizing Public Deposits. Government Finance Officers Association.
U.S. Congress. House. 2002. Report on Federal Deposit
Insurance Reform Act to May 16, 2002. 107th Cong., 2nd sess. H.
———. 2003. Report on Federal Deposit Insurance Reform Act
to March 27, 2003. 108th Cong., 1st sess. H. Rep. 50.
1 Christine Bradley and Valentine V. Craig,
“Privatizing Deposit Insurance: Results of the 2006 FDIC Study,” FDIC
Quarterly 1, no. 2 (2007): 23–32, and Bradley and Craig, “Establishing
Voluntary Excess Deposit Insurance: Results of the 2006 FDIC Study,” FDIC
Quarterly 1, no. 3 (2007): 30–35.
2 Public deposits also include deposits of Puerto
Rico and other U.S. possessions and territories, and deposits of Indian tribes.
12 C.F.R. § 330.15(a)(2)-(5)(2007).
3 12 C.F.R. §330.15(a)(2) (2007). Insurance
coverage for municipal deposits, as for general deposits, may be adjusted for
inflation beginning January 1, 2011. Federal Deposit Insurance Reform Act of
2005, Pub. L. No. 109–171, § 2101–2109, § 2103, 120 Stat. 4, 9–11 (2006) (to be
codified at 12 U.S.C. § 1821(a)(1)(F)).
8 For example, U.S. Congress, House Report on
Federal Deposit Insurance Reform Act to May 16, 2002, 107th Cong., 2nd
sess. H. Rep. 467; (2002) and U.S. Congress, House Report on Federal Deposit
Insurance Reform Act to March 27, 2003, 108th Cong., 1st sess. H. Rep. 50
9 Steve Cocheo, “You Want $5 Million in Deposits
to Be Insured?” ABA Banking Journal 95, no.11 (2003): 28–30.
10 See, for example, Christine M. Bradley,
“History of Deposit Insurance,” FDIC Banking Review (13: 2) 2000, pp.
1–25; Gail Otsuka Ayabe, “The Brokered Deposit Regulation: A Response to the
FDIC’s and FHLBB’s Efforts to Limit Deposit Insurance,” UCLA Law Review
(33), December 1985, pp. 594–641.
11 Although the FDIC supported increased coverage
for retirement accounts, it did so for unique reasons. First, increasing the
coverage level for retirement accounts should help increase the saving rate by
encouraging depositors to invest more of their retirement savings in insured
bank deposits. Second, retirement accounts are usually held for the long term
and depositors are less likely to respond to higher-yield offers or other
attempts by riskier banks to gather deposits quickly. This would not
necessarily be the case with insured municipal deposits.
13 As explained later in this article, excess
coverage might be made available only on a limited basis, in which case the
increase in insured deposits might be less.
14 Under the FDIC Reform Act of 2005, whenever
the reserve ratio for the Deposit Insurance Fund falls below 1.15 percent (or
is projected to fall below 1.15 percent within six months), the FDIC must adopt
a restoration plan that provides that the reserve ratio reach 1.15 percent within
five years. 12 U.S.C. § 1817(b)(3)(E) (2007).
15 See, for example, Steve Cocheo, “Community
Bankers See Pluses and Minuses in FDIC Reform Plan,” ABA Banking Journal
93, no. 6 (2001): 7–9.
16 Because of the added costs involved, we have
assumed in this part of the discussion that premiums for excess municipal
deposit coverage would be paid only by institutions that offered the additional
coverage. However, this need not be the case. Assessments for excess deposit
insurance could be structured so that all insured institutions bore the
17 Pass-through coverage for employee benefit
plans and coverage for brokered deposits do not terminate when a bank or thrift
ceases to become eligible to accept them. 12 U.S.C. §§ 1821(d) and 1831f.
18 Under the British deposit insurance system,
approximately the first $4,000 is fully insured, and 90 percent of the next
$68,000 receives insurance coverage. Unlike the U.S. system, deposits held at
failed British banks are not immediately available.
19 In the case of Northern Rock, the Bank of
England and the British Treasury provided depositors with greater assurances
than required under the law.
20 Bradley and Craig, “Establishing Voluntary
Excess Deposit Insurance.”
21 Ibid. A bank belonging to a deposit-placement
service can divide large deposits into $100,000 increments, which it transfers
to other participating institutions, resulting in full coverage of the deposit.