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Risk - Based Assessment System

BIF Assessment Rates for the First Semiannual Assessment Period of 2004

November 3, 2003

MEMORANDUM TO:

The Board of Directors

FROM:

Arthur J. Murton, Director
Division of Insurance and Research

SUBJECT:

BIF Assessment Rates for the First
Semiannual Assessment Period of 2004

Recommendation
The staff recommends that the Board maintain the existing Bank Insurance Fund (BIF) assessment rate schedule of 0 to 27 basis points (bp)1 per year. This rate schedule complies with the statutory requirements of the Federal Deposit Insurance Act for the Board to establish a risk-based assessment system and set assessments only to the extent necessary to maintain the BIF at the DRR of 1.25 percent.

Summary
Staff believes that the BIF reserve ratio will remain above the DRR throughout the assessment period. Therefore, staff recommends maintaining the existing assessment rate schedule. Based on June 30, 2003, data and projected ranges for the relevant variables at June 30, 2004, this rate schedule would result in an average annual assessment rate of approximately 0.20 bp.

Staff has considered a range of plausible events that could produce significant movements in the BIF reserve ratio. We have continued to refine the methodology introduced in the previous assessment rate case. Our methodology provides ranges for estimated insurance losses that are primarily based on estimated changes to the contingent liability for anticipated failures (contingent loss reserve); changes in both interest income and in the market value of available-for-sale (AFS) securities resulting from changes in interest rates; and growth of insured deposits.

Analysis 
In setting assessment rates since the recapitalization of the BIF, the Board has considered: (1) the probability and likely amount of loss to the fund posed by individual insured institutions; (2) the statutory requirement to maintain the fund at the DRR, currently 1.25 percent, and (3) all other relevant statutory provisions2.

Projections for the BIF Reserve Ratio over the Next Assessment Period
Staff's best estimate for the BIF reserve ratio as of June 30, 2004 is 1.27 percent. The lower and upper bounds of the likely range for the BIF reserve ratio as of June 30, 2004 are 1.16 percent to 1.35 percent, respectively. Although the lower bound of the estimated range is well below the statutory requirement of 1.25 percent, staff believes the ratio most likely will be closer to the best estimate of 1.27 percent.

The following is an analysis of the anticipated effect of changes in the fund balance and the rate of insured deposit growth on the reserve ratio as of June 30, 2004.

1. Fund Balance
Staff evaluates three significant inputs in estimating potential changes to the fund balance. First, staff estimates the impact of probable insurance losses, which are primarily losses from failed institutions. Second, staff estimates the amount of interest income that the fund will receive during the year. Third, staff projects the level of unrealized gains and losses on available-for-sale (AFS) securities that will be present at the end of the period.

A. Insurance Losses
Insurance losses primarily consist of two components: a contingent liability for anticipated failures (contingent loss reserve) and an allowance for losses on banks that have already failed. The Financial Risk Committee (FRC) recommends the amount of the contingent loss reserve each quarter, and this recommendation represents the FRC's best estimate of BIF losses from potential bank failures. It reflects the staff's view of those potential losses that are "probable and estimable," as required by generally accepted accounting principles. Actual results could differ from these estimates. As of June 30, 2003 the BIF loss reserve stood at $785 million. The BIF loss reserve declined to $416 million as of September 30, 2003.

Staff estimates a likely range of insurance losses based on projected changes in the contingent loss reserve. Several factors drive changes in the contingent loss reserve for the twelve months ending June 30, 2004. These factors include: (1) the shifting of problem banks among different risk categories within the reserve, (2) the movement of banks out of the reserve due to improved financial conditions, mergers, or failures, and (3) the addition of new problem bank assets to the reserve. To capture the effects of these changes, staff estimates the probabilities of banks moving within categories, entering, or leaving the contingent loss reserve. These probabilities are based on the recent history of changes to the reserve. Other factors driving changes in the contingent loss reserve are changes in expected failure rates and changes in rates of loss given failure. For purposes of this nine-month estimation of the contingent loss reserve, staff assumes that failure and loss rates remain constant through the period.

Table 1 shows the range of potential loss provisions based on changes in the contingent loss reserve, adjustments for net losses/recoveries due to the resolution of closed banks, adjustments for litigation losses, and adjustments for other contingencies.

Table 1

Table 1
Potential Provisions and Adjustments for Loss Allowances
For the Twelve Months Ending June 30, 2004
  Low Estimate Best Estimate High Estimate
Provision Related to Future Failures (1) $1,679 million ($68 million) ($744 million)
Adjustment for Closed Banks’
Net Recoveries (2)
($118 million) ($143 million) ($168 million)
Adjustment for Litigation Losses (3) $14 million $0 ($14 million)
Adjustment for Other Contingencies (4) $19 million $0 ($19 million)
Potential Provision for Losses $1,594 million ($211 million) ($945 million)

Notes:

(1) Includes provisions required to account for the differences between the actual balance of the contingent loss reserve on June 30, 2003 ($785 million) and the June 30, 2004, balance estimated by statistical analysis. Changes in the contingent loss reserve occur from reductions in reserves after failures, reductions in reserves from improvement in problem institutions’ conditions, and additions of reserves due to problem institutions’ deterioration.

(2) Assumes a range of -5% to +5% (-$25 million to +$25 million) of the estimated net recovery value of bank resolutions, $505 million as of December 31, 2002. This line also includes actual third quarter 2003 adjustments of $143 million for reductions in estimated losses on prior failures.

(3) Based on the standard deviation of changes in the contingent liability for litigation losses for the period 1998 to 2002.

(4) Based on the standard deviation of changes in the contingent liability for representations, warranties, asset securitization guarantees, and assistance agreements for the period 1998 to 2002.

Staff believes that the range provided by the statistical analysis adequately represents the most likely range of additional provisions needed to cover insurance losses from future failures. However, the bounds of this range do not represent "best case" and "worst case" scenarios, and larger or smaller provisions could occur.

Staff believes that subprime lending continues to be the most likely source of near-term losses to the insurance funds. Subprime lending has been a significant factor in 28 percent of failures since 1997. While the number of subprime lenders and dollar volume of subprime loans have declined from 2000 levels, the percentage of "problem" subprime lenders to total subprime lenders has increased during the same period.

Staff continues to monitor the potential effects of higher interest rates on the bank and thrift industries. Rising interest rates have the potential to adversely affect some insured institutions through net interest margin compression, a substantial decline in the mortgage origination volume, and unrealized and realized losses on their security holdings. Institutions most sensitive to an upward movement in interest rates include mortgage lenders and other institutions with a high percentage of fixed-income assets in their portfolio. However, these institutions generally appear to have adequate capital to sustain a substantial decline in net interest margins that is comparable to 1993-95 experience.

Commercial real estate loan loss rates remain at historical lows. However, insured institutions with high exposure to commercial real estate loans may experience an increase in credit risk associated with persistent weak fundamentals in the commercial real estate and the rising debt service burden and lower property values that may result from rising interest rates. Newer banks and those in certain geographic areas are more vulnerable to deterioration in the commercial real estate loans than other insured institutions; however, insured institutions in general appear to be well positioned to withstand a significant stress in their commercial real estate portfolio.

Based on these findings, combined with signs of improving overall economic conditions, staff believes that current industry trends do not foreshadow widespread deterioration in the banking industry.

B. Interest Income and Unrealized Gains and Losses on AFS Securities
Staff relied upon expert forecasts as detailed in the Blue Chip Financial Forecasts to develop interest rate projections and analyze the potential effect of changes in interest rates on interest income and unrealized gains and losses on AFS securities. The forecasts defined as our "best estimate" were the consensus forecasts through the second quarter of 2004 as detailed in the September issue of the Blue Chip Financial Forecasts. Adopting the experts' consensus forecasts also allows for forecasted yield curves that change in shape over time.

Along with forecasting yield curves based upon the experts' forecasts, staff also calculated bounds within which interest rates are likely to fall using the historical differences between the experts' forecasts and the actual interest rates. These bounds vary over the assessment period and change in shape over time, as opposed to being parallel shifts in rates. The bounds are consistent with the notion that the projections represent the most likely scenarios and that the actual rates may be above or below the projections. In general, the projections indicate stable or slightly rising rates for the period under consideration. The lower (upper) bound generally reflects rates that are as much as one percentage point lower (higher) than current rates, with the range increasing over time. Charts showing the projected rates, upper bound, and lower bound are included as an appendix to this case.

Table 2 shows projections for low, best, and high estimates for interest income and unrealized gains and losses on AFS securities using the forecast rates and the bounds. Because of the significant percentage of AFS securities held in the insurance fund portfolio at this time, when interest rates change, the magnitude of the resulting change in market value of these securities dominates the effect of changes in interest income.

Table 2

Table 2
Potential Changes in Interest Income and
Unrealized Gains (Losses) on AFS Securities
June 30, 2003 to June 30, 2004 ($ in millions)
  Low Estimate (1) Best Estimate (1) High Estimate (1)
Interest Income 1,486 1,551 1,529
Unrealized Gain (Loss) on AFS Securities (2) -634 -408 -166

Notes:

(1)     The Low Estimate is calculated using upper bound interest rates, the Best Estimate is calculated using the projected rates, and the High Estimate is calculated using the lower bound rates Net estimated failure resolution outlays equal $25 billion for the Low Estimate and $89 million for both the Best Estimate and High Estimate Although the level of interest rates is assumed to be generally higher in the Low Estimate scenario than in the other two, overall interest revenue is actually lower in the Low Estimate due to a significantly smaller balance invested during the period (The Low Estimate assumes greater resolution activity requiring cash outlays that lower the investable amount during the period)

(2)     Includes actual unrealized gains on AFS securities for the period July 1, 2003 through August 31, 2003 and projected gains/losses for the remaining period through June 30, 2004

Staff does not anticipate dramatic changes in interest rates. Nevertheless, as the remaining maturity of the existing AFS portfolio shortens, previously identified unrealized gains will dissipate. In addition, falling interest rates would be detrimental to interest income in the long term.

C. Projected Fund Balance.
Table 3 summarizes the effects on the fund balance of the low, best, and high estimates assumed for insurance losses, interest income, and unrealized gains and losses on AFS securities. The projection also assumes that the current assessment rate schedule will remain in effect through June 30, 2004.

Table 3

Table 3
Projected Fund Balance (1)
($ in millions)
  Lower Bound Best Estimate Upper Bound
Assessments (2) 82 82 82
Interest Income (3) 1,486 1,551 1,529
Total Revenue 1,568 1,633 1,611
Operating Expenses (4) 800 800 800
Provision for Losses 1,594 -211 -945
Total Expenses & Losses 2,394 589 -145
Net Income -826 1,044 1,756
Unrealized Gain (Loss) on AFS Securities (3) -634 -408 -166
Comprehensive Income (Loss) (5) -1,460 636 1,590
Fund Balance – 06/30/03 32,800 32,800 32,800
Projected Fund Balance – 06/30/04 31,340 33,436 34,390

Notes:

(1)     Projected income and expense figures are for the twelve months ending June 30, 2004.

(2)     Assumes that the current assessment rate schedule remains in effect through June 30, 2004.

(3)     See also Table 2 for an explanation regarding changes in interest revenue and unrealized gain (loss) on AFS securities under these projections.

(4)     Operating expenses for 2003 allocated to the BIF are estimated based on the FDIC’s 2003 budget.

(5)     Comprehensive Income is used instead of Net Income due to the magnitude of the change in market value of AFS securities that occurs with fluctuations in interest rates See note (3) above.

2. Insured Deposits
Since June of 1990, annual growth rate for BIF-insured deposits has been as high as 6.3 percent and as low as an annual shrinkage of 1.8 percent (Figure 1). After declining June of 1992 through June of 1994, insured deposits grew between 1.5 percent and 3.3 percent annually from June of 1995 to June of 1999. Insured deposits grew by 5.1 percent, 6.3 percent, and 4.6 percent for the twelve months ending June 30, 2000, June 30, 2001, and June 30, 2002, respectively. Such growth slowed to a rate of 2.0 percent for the twelve months ending June 30, 2003. Staff projects that insured deposits will grow at a rate of 3.5 percent for the twelve months ending June 30, 2004. The projected growth rate, which is below the five-year average growth rate of 4.2 percent, is consistent with the recent slowdown in insured deposit growth.

Figure 1

Figure 1 - Estimated BIF-Insured DepositsD

It takes approximately $20 billion in insured deposit growth to create a 1 basis point decline in the BIF reserve ratio, all other things held constant. Based upon the June 30, 2003, fund balance, it would take about $81.3 billion in insured deposit growth (3.2 percent) to reduce the reserve ratio to the DRR at June 30, 2004, all else being equal. Our preliminary estimate indicates that deposit growth over the next year will be greater than this figure. However, the net worth of the BIF is likely to grow and the ultimate level of the reserve ratio will depend on how fast the net worth of the fund grows relative to the growth of BIF-insured deposits.

Staff developed a statistical model that projects insured deposit growth based upon previous growth in insured deposits and previous and current growth in total deposits. After analyzing the results of this model, the best judgment of the staff is that BIF-insured deposits are likely to experience a growth rate in the range of +0.2 percent to +6.7 percent between June 2003 and June 2004. This range represents the statistical margin of error in the estimate provided by the model3. The staff believes the most likely scenario is that insured deposits will grow at the midpoint of this range (3.5 percent), which will bring the total for BIF insured deposits to $2.6 trillion. The model estimates future growth rates in insured deposits through historical growth rates in insured and total deposits and, as such, does not explicitly incorporate economic shocks into the model. However, some events that could force insured deposits into the high range of our forecast are a depressed stock market with high volatility as well as monetary expansion. Some events that could force insured deposits into the low range of our forecast are an upturn in the stock market and in the U.S. economy as a whole.

3. BIF Reserve Ratio
Based on the projected BIF balance and the growth of the insured deposit base, the best estimate of the BIF reserve ratio at June 30, 2004, is 1.27 percent (Table 4, next page). The best estimate assumes a baseline of a moderate reversal of loss provisions, stable or slightly increasing interest rates, and an insured deposit growth rate of 3.5 percent.

The staff projects the lower bound and upper bound of the likely range to be 1.16 percent and 1.35 percent, respectively (Table 4, next page). The lower bound, which reflects a 13 bp decrease from the June 30, 2003, ratio, assumes a strong increase in the insured deposit base (6.7 percent growth) and a higher interest rate scenario, resulting in a downward adjustment to the fund balance due to a reduction in the aggregate amount of unrealized gains on AFS securities (Table 3). The lower bound also incorporates the high loss estimate for insurance losses from possible near-term failures as projected by staff. The estimate reflects the staff's view of a reasonably possible adverse scenario. It is not intended to represent a "worst case" scenario.

The upper bound produces a 6 bp increase in the reserve ratio at June 30, 2004. This estimate assumes slower growth (0.2 percent) in the BIF-insured deposit base, the low loss estimate for the provision for losses, and lower interest rates, resulting in an upward adjustment to the aggregate amount of unrealized gains on AFS securities.

Table 4

Table 4
Projected BIF Reserve Ratios
($ in millions)
  30-Jun-03
Fund Balance $32,800
Estimated Insured Deposits $2,539,994
BIF Ratio 1.29%
  Lower Bound (1)
30-Jun-04
Best Estimate (2)
30-Jun-04
Upper Bound (3)
30-Jun-04
Projected Fund Balance $31,340 $33,436 $34,390
Estimated Insured Deposits $2,711,030 $2,628,071 $2,545,112
Estimated BIF Ratio 1.16% 1.27% 1.35%

Notes:

(1)     The Lower Bound refers to the scenario of higher loss provisions (Low Estimate in Table 1), higher interest rates (Low Estimate in Table 2), and a higher insured deposit growth rate (+67 percent).

(2)     The Best Estimate refers to a baseline scenario of moderate loss provisions (Best Estimate in Table 1), stable or moderately rising interest rates (Best Estimate in Table 2), and the insured deposit growth rate projected by staff (+35 percent).

(3)     The Upper Bound refers to the scenario of lower loss provisions (High Estimate in Table 1), moderately declining interest rates (High Estimate in Table 2), and a lower insured deposit growth rate (+02 percent).

As indicated above, staff's best estimate of the reserve ratio for June 30, 2004 is slightly higher than the DRR, represents a 2 bp decline from the June 30, 2003 ratio and a 5 bp decline from the preliminary September 30, 2003 ratio. Although this appears inconsistent with recent history, where the ratio has increased for four straight quarters, staff believes several factors indicate that a decline in the reserve ratio between now and June 30, 2004 is most likely:

  • Nearly one-half ($682 million) of comprehensive income in the first nine months of 2003 is represented by a reversal of the provisions for insurance losses due to reductions in estimated losses on prior failures and due to significant reductions in the contingent loss reserve. Although staff remains cautiously optimistic about the condition of the banking industry, it is not reasonable to expect such substantial reversal to the loss provisions to continue through next June.
  • Interest rates have remained at very low levels throughout 2003, but staff believes rates are unlikely to decline further during the upcoming nine months. The BIF's unrealized gains on available-for-sale securities will be reduced even in a stable interest rate environment, because such unrealized gains disappear as securities move closer to their maturity dates. In a rising rate environment, reductions in unrealized gains would accelerate.
  • BIF insured deposit growth was low through the first three quarters of 2003. Although staff does not believe that insured deposit growth will approach growth rates seen from 2000 through 2002, staff believes that growth closer to the five-year average rate is not unreasonable.

    As a result of these factors, staff believes that a decline in the BIF reserve ratio is both reasonable and likely. However, given that the BIF reserve ratio is currently greater than 1.25 percent and that staff's best estimate of the ratio for June 30, 2004 is above 1.25, staff believes that it is reasonable to maintain the existing BIF rate schedule. Even if the BIF reserve ratio declines below the statutory DRR of 1.25 percent, the Board would have two semiannual assessment periods to bring the ratio back to the target.

    Risk-Based Assessment System
    Staff recommends retaining the current spread of 27 bp between the assessments paid by the best- and worst-rated institutions as well as the rate spreads between adjacent cells in the assessment rate matrix. The proposed assessment rate schedule appears in Table 5. The Board previously determined that the current rate spreads provide appropriate incentives for weaker institutions to improve their condition and for all institutions to avoid excessive risk-taking, consistent with the goals of risk-based assessments and existing statutory provisions. The current rate spreads also generally are consistent with the historical variation in bank failure rates across cells of the assessment rate matrix.

    Table 5

    Table 5
    Proposed Assessment Rate Schedule
    First Semiannual Assessment Period of 2004
    BIF-Insured Institutions
    Capital Group A B C
    1 Well 0 bp 3 bp 17 bp
    2 Adequate 3 bp 10 bp 24 bp
    3 Under 10 bp 24 bp 27 bp

    In setting assessment rates to achieve and maintain the reserve ratio at the target DRR, the Board is required to consider the effects of assessments on members' earnings and capital. The estimated annual revenue from the existing rate schedule is $82 million, which is $5 million more than the annual amount that was projected six months ago. In recommending that the Board maintain this schedule, the staff has considered the impact on bank earnings and capital and found no unwarranted adverse effects.

    The Assessment Base Distribution and Matrix Migration

    Table 6 summarizes the current distribution of institutions across the assessment matrix.

    Table 6

    Table 6
    BIF Assessment Base Distribution (1)
    Assessable Deposits as of June 30, 2003
    Supervisory Subgroup and Capital Groups in Effect July 1, 2003
    Capital Group A B C
    1. Well Number 7,413 91.70% 472 5.80% 87 1.10%
    Base ($billion) 3,927 96.20% 119 2.90% 20 0.50%
    2. Adequate Number 82 1.00% 9 0.10% 14 0.20%
    Base ($billion) 10 0.30% 1 0.00% 3 0.10%
    3. Under Number 0 0.00% 2 0.00% 1 0.00%
    Base ($billion) 0 0.00% 0 0.00% 0 0.00%

    Estimated annual assessment revenue    $82 million
    Assessment Base                                     $4,081 billion
    Average annual assessment rate (bp)       0.20 basis points

    Notes:

    (1)     “Number” reflects the number of BIF members, including BIF-Oakar institutions; “Base” reflects all BIF-assessable deposits.

    With 98.5 percent of the number of institutions and 99.4 percent of the assessment base in the three lowest assessment risk classifications of "1A," "1B," and "2A," as of July 1, 2003, the current distribution in the rate matrix reflects little fundamental difference from the previous semiannual assessment period. The current distribution reflects slight shrinkage in the best-rated premium category. Since the previous assessment period, 164 institutions migrated into the "1A" risk classification (Table 7), and 174 institutions migrated out of the "1A" risk classification. Only 667 institutions are classified outside of the best risk classification.

    Table 7

    Table 7
    BIF Migration To and From Assessment Risk Classification 1A
    Institutions entering 1A Number Base ($billion)
    Due to capital group reclassification only 75 11.9
    Due to supervisory subgroup reclassification only 89 10.1
    Due to both 0 0
    Total 164 22
    Institutions entering 1A Number Base ($billion)
    Due to capital group reclassification only 49 6.1
    Due to supervisory subgroup reclassification only 119 64.8
    Due to both 6 1.5
    Total 174 72.4

    Notes:

    The table reflects BIF-insured institutions that moved in and out of assessment risk classification 1A from the first semiannual assessment period of 2003 to the second semiannual assessment period of 2003 The numbers only include institutions that were rated in both periods The table does not reflect other assessment risk classification migrations that are not either to or from “1A”

    Overall, the supervisory subgroup component of the risk classification was upgraded since the previous period for 120 institutions with an assessment base of $12.9 billion and was downgraded for 149 institutions with an assessment base of $68.9 billion.

    Other Issues
    Refunds for second semiannual period of 2003. Since BIF-insured institutions classified as "1A" currently pay no assessments to the BIF under the proposed rate schedule they are ineligible to receive any refund for the First semiannual period of 2003.

    FICO Assessment. The Funds Act separates the Financing Corporation (FICO) assessment from the FDIC assessment, so that the amount assessed on individual institutions by the FICO is in addition to the amount paid according to the BIF rate schedule. All institutions are assessed the same rate by FICO, as provided for in the Funds Act, and the FICO rate is updated quarterly. The FICO rate for the first quarterly payment in first semiannual assessment period of 2004 will be determined using September 30, 2003 Call Report and Thrift Financial Report data.

    Staff Contacts
    For information about deposit insurance assessments, please contact Christopher Newbury, Chief, Fund Analysis Section, Division of Insurance and Research, at (202) 898-3504, or Joe DiNuzzo, Counsel, Legal Division (202) 898-7349. For FICO assessment information, please contact Richard Jones, Chief, Deposit Insurance Pricing Section, Division of Insurance and Research, at (202) 898-6592.

    Appendix - Interest Rate Assumptions

    Figure 1: Estimated Yield Curve and Interval for Third Quarter 2003D

    Figure 2: Estimated Yield Curve and Interval for Fourth Quarter 2003D

    Figure 3: Estimated Yield Curve and Interval for First Quarter 2004D

    Figure 4: Estimated Yield Curve and Interval for Second Quarter 2004D


    Footnote

    1 Although the current effective rate schedule is 0 to 27 basis points, the base rate schedule, established in 1995, is still 4 to 31 basis points. The FDIC may alter the existing rate structure and may change the base BIF rates by rulemaking with notice and comment. Without a notice-and-comment rulemaking, the Board has authority to increase or decrease the effective rate schedule uniformly up to a maximum of 5 bp, as deemed necessary to maintain the target DRR.

    2 The Board is required to review and weigh the following factors when establishing an assessment schedule: a) the probability and likely amount of loss to the fund posed by individual institutions; b) case resolution expenditures and income; c) expected operating expenses; d) the revenue needs of the fund; e) the effect of assessments on the earnings and capital of fund members; and f) any other factors that the Board may deem appropriate. These factors directly affect the reserve ratio prospectively and thus are considered as elements of the requirement to set rates to maintain the reserve ratio at the target DRR.

    3 The model is a regression model where the current growth rate in insured deposits is estimated as a linear function of the previous growth rate in insured deposits as well as the current and previous growth rates of total (insured and uninsured) deposits. The range (+0.2%, +6.7%) corresponds to a 95% confidence level. In other words, we can be sure with 95% confidence that the actual growth rate in insured deposits, from June 2003 to June 2004, will lie within this range. The growth rate predicted by the model (thus, the most likely rate) is the midpoint of this range (3.5% annual growth).


  • Last Updated 11/06/2003 insurance-research@fdic.gov