Deposit insurance ; Risk ; Bank supervision ; Federal Deposit Insurance Corporation

Barbara Bennett

David Pyle

English

Research Papers in Economics

FRBSF
August 10, 1984 WEEKLY LETTER
Risk-Adjusted Deposit Insurance Premiums
The on-goingderegulation ofdepository institutions
has made reform ofthe deposit insurance system
an idea whose time has come. In particular, the
deregulation ofdeposit rates poses a substantial
threattothedepositinsurance fund because ithas
given depository institutions the abilityto expand
their insured deposit base and stay in operation
even afterthey have become insolventon a
market-value basis. As a result, undercapitalized
institutions have been given expanded incentives
to take risks.
A numberofreforms to the present system have
been proposed to enable the Federal Deposit
Insurance Corporation (FDIC) to manage these
increased risks. This Letter examines, first, the
nature ofthe deposit insurance problem and why
better control of risk-taking is necessary. Second,
itevaluates the imposition ofrisk-adjusted pre-
miums, which presumably would provide this
control bychargingeach insured institution forthe
risks it imposes on the insurance fund. Such an
approach has much theoretical appeal, but, as we
shall see, itis notthe panacea its proponents make
itoutto be.
The problem...
The problem with the present deposit insurance
system is that it removes depositors' incentives to
monitorthe financial condition ofthe institutions
where they place theirfunds. Deposit insurance
thus gives insured institutions an incentive to take
on more risk than they otherwise would. To
prevent excessive risk-taking, the insuring agency
mustprovidedisciplineby monitoringand closing
insured institutions before their market net worth
becomes negative. The failure to close insured
institutions as they become insolvent creates a
particularly large distortion in risk-taking. Share-
holders of insolvent institutions are allowed, in
effect, to continuegamblingwith someone else's
(the FDIC's) moneyeven after they have lost their
stake in thegame. Indeed, insured institutions need
not actually be insolvent to have an incentive to
undertakeexcessive risk. Just the observation that
most insolvent institutions are notclosed until
after their net worth is substantially negative will
induce solvent institutions to take on more risk.
In effect, the insurer is granting a greater than
normal expected return on capital risk. To obtain
this higher return, shareholders are Willing to
acceptgreater leverage and portfolio risk, even
though, in a competitive banking system, the
higher return will be shared by shareholders and
purchasers ofbankservices (e.g., depositors and
borrowers). Closing or reorganizing insured insti-
tutions before their market net worth becomes
negative would eliminatethis distortion. But
marketinsolvency is hard todetermine. Unless all
ofa bank's uninsured liabilities or all of its assets
are publicly traded securities, the insurer must
estimate market values where no objective prices
exist.
In the absence ofa timely insolvency proceeding
bythe insurer, one mightexpectaweak institution
to be closed by a liquidity crisis. Yet this does not
happen in many cases because virtually all
deposits are insured, givingdepositors little incen-
tive to withdraw funds no matter howweak the
institution appears to be. (Ofcourse, as the Conti-
nentalillinois experience shows, ifa signficant
fraction ofdeposits is uninsured and the
depositors involvedare madetofeel at risk, abank
can be subject to a run on the basis ofa rumor,
founded or unfounded.)
To make matters worse, the FDIC does noteven
have the legal authority to close a bank that, by its
valuation, is insolvent. Instead, the bank'scharter-
ingauthority(i.e., theComptrolleroftheCurrency
foranational bankortheappropriatestate banking
agency forastate-chartered bank) mustdetermine
that a bank is insolvent before the FDIC can take
action. This division of responsibility can create
problems for the control ofrisk to the deposit
insurance fund. Not having the insurance liability
ofthe FDIC, the other regulators' concern for the
perceived soundness ofthe banks they supervise
may lead them to keep a bank open long after
capital has been exhausted on a market-value basis.
Given available data, it is impossible to estimate
accurately the amountof negative net worth (on a
marketvalue basis) that the FDIC is exposed to or
has actually absorbed, let alone how much this
has distorted banks' risk-taking decisions. How-FRBSF
ever, based on the FDIC's recent losses, the amount
ofnegative networth and the resulting distortion is
undoubtedly sizeable. Between 1980 and 1982,
the FDIC's realized losses amounted to $2.2 bil-
lion-alower-boundestimateofnegative networth.
The present system
Unless insured institutions are closed or reorga-
nized beforetheybecome insolvent, some form of
directcontrol ofrisk-taking is necessary. Short of
reducing oreliminating insurance coverage, at
least two approaches are possible: regulation of
bank portfolios (including capital) and/or risk-
adjusted pricing ofdeposit insurance. Underthe
present system, the FDIC must charge a uniform
assessment rate regardless ofthe different risk
postures of individual institutions. That annual
assessment rate is set by law at one-twelfth ofone
percent perdollaroftotal deposits (or 8.3 basis
points), butthe actual rate paid typically is lower,
depending on the FDIC's operating expenses and
insurance losses. (The agency isrequired to rebate
60 percentof its net assessment income-total
assessments less operating expenses and loss
reserves-to the insured institutions.) Since this
flat-rate premium does not reflect the risk ofthe
individual bank, the task ofcontrolling bank risk-
taking falls to bank regulators and uninsured lia-
bility holders.
Critics ofthe present system argue that bank regu-
lators have notmaintained sufficiently stringent
regulatory standards. Notonly has the insurance
fund incurred large losses over the past few years,
butother indicators pointto increased risk-taking
as well. Capital ratios have declined over the last
20or so years from 8.1 percent in 1960to 5.8
percentoftotal assets in 1982. On a market-value
basis, leverage is probably even higherdueto
large unrealized losses banks have incurred,
particularly in their foreign and energy loan port-
folios. The higher interest rate volatility ofthe past
few years also has increased the riskiness ofbank
portfolios to some extent. And the recent deregu-
lation of insured institutions' asset and product
lineconstraints mayhaveenhanced opportunities
for risk-taking.
The solution?
Many have argued that risk-adjusted pricing of
depositinsuranceoffers the solution tothe problem
ofexcessive risk-taking. Risk-related premiums are
attractive from the viewpointofeconomic effi-
ciencybecausethedecisionstoundertakerisk can
be leftwith insured institutions while the insurer
provides risk-taking disciplinethrough the risk
premium in the insuranceassessment. Those insti-
tutionswishingtopursue ahighly risky investment
strategy would be free to do so, butwould pay a
higher premium than those that choose a more
conservative strategy.
The FDIC has, in fact, proposed a modest step in
the direction of risk-related pricing. The agency's
recommendation is embodied in the proposed
Federal Deposit Insurance Improvements Act,
introduced in the Congress in May 1984. The FDIC
is seeking the authorityto retain part orall ofthe
assessment rebate forany insured bankthatrepre-
sents a sizeable risk to the insurance fund. Since
the rebate is 60 percentofthe FDIC's net assess-
ment income, the maximum size ofthe risk pre-
mium would be approximately four basis points.
Thus, the range ofthe actual net insurance pre-
miumfrom low-risktohigh-risk institutionswould
be 4.3 to 8.3 basis points per year.
Such a proposal is a modest one, even in the
FDIC's view. Unfortunately, a risk premium as
modest as four basis points is not likelyto have
much, ifany, impacton the risk-takingproclivities
of insured institutions. The economically efficient
approach to risk-pricing requires that insured
institutions be charged a premium equal to the
present value ofthe insurer's potential loss
weighted by the probabilitythat the insured insti-
tution mightfail priorto the insurer's nextexam-
ination ofthat institution. Two studies that have
estimated risk premiums for deposit insurance show
that this economically efficient premium is well
above the four basis points proposed by the FDIC.
A model ofthecostofdepositinsurance developed
by Robert Merton suggests that the premium for a
typical "high-risk" institution would be on the
orderof100 basis points per dollarofdeposits!
(This assumes a capital ratio of5 percent and a
standard deviation ofasset return 30 percent
greater than the standard deviation of return on
long-term Treasury bonds.) A less risky institution
(capital ratio of10 percent and the same level of
asset risk) would be charged a 22 basis point pre-
mium according to Merton's model. An alternative
model ofdeposit insurance developed by Pyle
produced similar results: the hypothetical high-risk
bankand lowerrisk bankin Merton'sstudyshouId
be charged 100 and 40 basis points, respectively.
These premiums are roughly ten times those
recommended by the FDIC.It is interestingto note that in both studies, the
premium goes up sharply even for seemingly
modest increases in the riskiness ofthe institution.
These results suggest that not only must the FDIC
charge substantially higherpremiumsthan those it
has proposed, but itmust also raise premiums
almostexponentiallyas risk increases. Otherwise,
there is Iittledeterrentto increased risk-takingonce
an institution's condition begins to deteriorate.
Measurementproblems
Even ifthe FDIC could surmountthese obstacles,
measurement problems associated with calcula-
tingthe correct premium could make the risk-
pricing approach ineffective as a means ofcon-
trolling risk-taking. The conceptof risk-pricing
rests on the assumption thatthe insurer can
measure the riskiness of insured institutions. This
is no easy task. While research has greatly im-
proved our abilityto measure interest-rate risk,
state-of-the-art techniques still are less than ideal.
Credit(defauIt) risk is even moredifficuIttoassess.
In defense ofthe conceptof risk-pricing, one could
argue, ofcourse, that privatedebtmarkets are able
to measure risk sufficiently well to set risk pre-
miums on corporate debt instruments. However,
regulators do not face the same "bottom-line"
consequences as those who price private debt.
Thus, itwouldbedifficuItforthe FDIC tocomeup
with the correct premium.
The problems associated withsetting risk-related
premiumsgobeyondthequestion ofaccurate risk
measurement. Economicallyefficient pricingof
deposit insurance also requires that an insured
institution be closed promptly when, upon exam-
ination of its portfolio, the market value of its
assets is found to be no greater than the insurer's
liability. This means that the insurer (technically,
chartering authority) must be able to appraise
market value accurately, which, as mentioned
earlier, is fraughtwithdifficulty. Itcertainlycannot
be done consistently when insolvency rules are
based on the book value ofassets. The failure to
enforceamarketvalue insolvencyrule has a large
impact on the value ofthe economicallyefficient
insurance premium. Recent research (Pyle, 1983)
suggests that errors in the measurementofan
insured institution's market value will produce a
bias in the insurance premium that is five oreven
ten times greater than that produced by mistakes
ofequal proportional size in the calculationofthe
riskiness ofthat institution.
In asense, then, wehavecomefull-circle. To price
deposit insurance correctly, we need to measure
market value accurately. But ifwe could measure
marketvalue accurately, we should be able to
close insolvent institutions in time and generally
avoid the problem ofencouraging excessive risk-
taking in the first place.
Another approach?
Atfirst glance, risk"related pricing has a lotof
appeal as ameans ofreducing insured institutions'
incentives to undertake excessive risk. On closer
examination, however, ithas three majorweak-
nesses. First, to be an effective deterrent to risk-
taking for high risk institutions, the FDIC must
demonstrate awillingness to raise premiums
exponentially. Second, the limitationsonourabil-
ityto measure asset risk make the calculation of
the correct premium difficultat best. Finally, the
problems associated with appraising the value of
insured institutions introduce potentially large
errors in the calculation ofthe insurance premium.
Thus, unless wecan find an effectivewayofclosing
orreorganizing institutions beforethey have nega-
tive net worth, we are still faced with the original
problem ofcontrolling risk-taking. The regulatory
approach is considered in next week's Letter.
Barbara Bennett
David Pyle
Opinionsexpressed in this newsletterdo not necessarily reflect theviews of the managementofthe Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reservepublications
can beobtained from the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!4S0m 4o~n u061:lJO OpOAI:lU
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
largeCommercial Banks
Amount
Outstanding
7/25/84
Change
from
7/18/84
Change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments1 2 181,543 39 5,518 5.4
Loans and Leases1 6 162,440 21 7,085 7.9
Commercial and Industrial 49,023 - 67 3,060 11.5
Real estate 60,492 27 1,593 4.6
Loans to Individuals 28,872 103 2,221 14.4
Leases 5,005 - 4 - 58 - 1.9
U.S. Treasury and Agency Securities2 11,944 - 6 - 563 - 7.8
OtherSeqJrities2 7,160 25 - 1,003 -21.2
Total Deposits 186,153 -1,962 - 4,844 - 4.3
Demand Deposits 42,180 -2,024 - 7,057 - 24.8
Demand Deposits Adjusted3 28,627 - 444 - 2,704 - 14.9
OtherTransaction Balances4 12,073 - 177 - 702 - 9.5
Total Non-Transaction Balances6 131,900 239 2,915 3.9
Money Market Deposit
Accounts-Total 37,989 - 110 - 1,608 - 7.0
Time Deposits in Amounts of
$100,000or more 40,499 294 2,334 10.6
Other Liabilities for Borrowed MoneyS 19,514 -1,513 - 3,493 - 26.3
Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
7/16/84
23
59
81
Period ended
7/02/84
140
96
44
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
5 Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately

Risk-adjusted deposit insurance premiums

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Risk-adjusted deposit insurance premiums

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