Deposit insurance ; Federal Deposit Insurance Corporation ; Bank failures

Frederick T. Furlong

English

Research Papers in Economics

Functions ofdeposit insurance
Through the modified payout, the FDIC is
attemptingto address the undesirable moral
hazard side effects ofdeposit insurance.
Howeverit is notclear at first glance that
increasing the riskiness oflarge deposits to
achieve this goal does nothave undesirable
sideeffectsofits own,especiallyaftertaking
into accountthe reasons why we have
deposit insurance in the first place.
So far, modified payouts have been used
only in the failures of relatively small com-
mercial banks. Some question remains as to
whether this approach to increasing the
riskiness of large deposits can be success-
fully applied to the largest commercial
banks. Ifitturns outto be impractical to use
modified payouts when large banks fail, the
FDIC has indicated that itwill reevaluate its
currentexperiment. Itwould be unworkable
to leave large deposits at some banks truly
uninsured and to provide such deposits at
the biggest banks implicitcoverage.
However, underthe new modified payout
approach, holders of large-denomination
deposits will receive only pro rata. shares of
whatthe FDIC thinks itcan recoverfrom the
liquidation ofassets immediately after a
bank has failed. With agreater chance of
financial loss, holders of large-denomina-
tion depositswill havean incentivetomoni-
tor banks more closely, and serve to check
bank risk-taking. The modified payout has
the added advantagethatdepositorswill not
have their funds tied up in bankruptcy pro-
ceedings as is the case with ordinary
payouts.
Modified payout plan
Underthe FDIC's plan, insured deposits will
continue to be handled as they have in the
past, either being assumed by another insti-
tution willingto buy the failed bank, or
being paid offby the FDIC when no buyer
can be found.
FDIC's Modified Payout Plan
The FDIC has decided to address this prob-
lem by shifting back to the private market
(i.e., large depositors) moreofthe responsi-
bility for monitoring and pricing bank risk.
To this end, the FDIC is experimentingwith a
"modified payout" approach for dealing
with bank failures. This Letter examines this
modified payoutplan and discusses whether
using account size to determine which
accounts should be insured is consistent
with the basic purpose ofdeposit insurance.
May 18, 1984
With deregulation in banking, the FDIC
(Federal Deposit Insurance Corporation),
the Congress and others have become
increasingly concerned about the deposit
insurancefund'sexposuretothe risk ofbank
failures. One way in which the FDIC is
attempting to reduce the cost ofbank
failures borne bythe insurance fund is
to force large deposit holders to share in
thosecosts, and thereby eliminate what has
been an implicit insurance guarantee on
large deposits-thosedeposits in excess of
the insurance limitof $100,000.
In the past, the FDIC commonly has
arranged for another institution to purchase
the assets and assume the liabilities ofa
fai led bank and thereby protected all de-
positors from losses. This has been particu-
larly true when larger banks have failed-
the notable exception beingthe failure of
PehriSquare Bank in 1982.
Such an implicit guarantee removes the in-
centive for large depositors tobe concerned
aboutthefinancial conditionofbanks. Con-
sequently, these depositors do notdevote
resources to monitorrisk-taking by banks, or
demand interest-rate premiums that reflect
the risk exposureofabank. This situation, in
turn, enhances the incentives for banks to
engage in risky activities. This potential that
providing deposit insurance would increase
risk-taking is, in essence, the so-called
"moral hazard" problem faced by all
insurers.
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o( the' Fpdera\ Reserve Bank or San Francisco,
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One objective often ascribed to deposit in-
surance is the protection of"small·deposi-
tors," It is based on the particular rationale
that deposit insurance is needed to address
the impactofbankfailures on depositors per
se, rather th,an on the economy in general.
Because small depositors are thought to be
unable to protect themselves, depositinsur-
ance agencies assume the responsibility of
checking bank risk-taking, The agencies are
assumed to be better able both to acquire
information on banks and to enforce con-
straints on their risk-taking, Large depositors
are leftuninsured becausetheyare assumed
to be atleast as good as, ifnotbetterthan, the
insurance agencies at determiningthe riski-
ness ofbanks and pricingthe risk according-
ly, Such a limited objective argues for using
account size as the criterjon for insuring
deposits,
In contrast, a second objective attributed to
deposit insurance focuses on protectingthe
economy in general from the impactofdis-
ruptions in the banking industry, In particu-
lar, federal deposit insurance is thought to
contribute to the overall stability ofthe
economy by averting bank runs and their
adverse effects, One reason the economic
cost ofbank runs could be widespread and
pronounced is that banks are integral parts
ofthe payments mechanism and constitute
channels through which monetary policy
operates. For example, acollapse ofthe
banking system could lead to a large and
2
, unexpected contraction in the money
supply which, with a lag, would result in a
severe and pervasive reduction in economic
activity,
The monetary impactofbank runs, of
course, has been used as adefense for de-
posit insurance for some time. However,
some analysts argue that the adverse conse-
.quenc'es ofbank runs go beyond those
associated with moneyand the moneycrea-
tion process, For example, recent articles by
Bernanke (AER, June 1983) and Diamond
and DybvigUPE,June 1983) pointoutthatthe
breakdown ofthe intermediation process
that would result from bank runs could
impose real costs on the entire economy,
The connection between federal deposit in-
surance and economy-wide losses associ-
ated with bank runs raises some question
about the FDIC's plan to increase the riski-
ness of large-denomination deposits, Under
the economic-stability rationale, deposit
insurance is warranted on the grounds that
depositors protecting themselves is not
sufficientto guarantee stability in the
banking system. While putting large deposi-
tors atrisk-as the FDIC's modified payout
approach does-may reduce the moral
hazard problem introduced by deposit
insurance, itdoes not address the issue of
bank runs or ensure that the total cost to
society ofbank risk-taking and bank runs
will be considered, Ifone sees a need for
deposit insurance because ofthe presence
ofsome degree ofmarketfailure, itwould
seem somewhatcontradictoryto lookto the
marketforasolution toaproblem created by
the existence ofdeposit insurance,
Insuring liquid deposits
The economic-stability rationale for deposit
insurance dictates that the foremost role of
deposit insuranceshould beto preventbank
runs, As a result, the goal ofreducing the
susceptibility ofbanks to runs should be the
majorcriterion for determining which
deposits are insured,. Kareken(AER, May 1983) has maintained
that depository institutions are subjectto
runs because deposits are fixed-dollar
claims against risky assets. With risky port-
folios, depository institutions can incur
losses that exceed net worth, while the
fixed-dollar claimmeans that a depositor
can avoid sharing in those losses ifhe can
withdraw funds before other depositors.
The problem of"runs" is particularly acute
for banks becausetheytend to hold acertain
volume of liquid assets funded by deposits
that essentially are available on demand-
checking, savings, and money market de-
posit accounts-and short-term time
deposits. The holders ofthese liquid
deposits can react quicklyto a real or a
perceived deterioration in thefinancial con-
dition ofbanks. This is true as much for
depositors with large-denomination liquid "
accounts as for depositors with small liquid
balances. Holders of longer-term deposits
could "run" in the sense thattheywould not
roll their accounts over at maturity. How-
ever, such a process would be drawn out
over a period oftime, allowing bank assets
to mature and givingdepositors and regu-
lators an opportunity to assess more accur-
ately the condition ofthe individual institu-
tions. (WhiIe banks havethe option toallow
withdrawals from time deposit accounts
priorto maturity, undercurrent regulations,
banks are notobliged to honor requests for
early withdrawals except in the case ofthe
death or mental incapacitation ofthe
depositor.)
Withinthecontextofthe economic-stabiIity
argument for deposit insurance, the particu-
lar characteristics ofbank assets and liabili-
ties suggest that accounts should be insured
on the basis oftheirterms ofmaturity. Such a
distinction would satisfy both the desire to
increase risk for the depositor and the desire
to ensure a stable banking system. Liquid
deposits, which precipitate runs on banks
that in turn impose costs on the economy,
should be insured. In principle, and without
3
convincing arguments explaining why the
probabilityofruns should declineas thesize
ofan account rises, liquidlarge-denomina-
tion accounts should be insured as well.
Conclusions
The FDIC's modified payout approach for
handling failed banks delegates to large
depositors at least part ofthe responsibility
ofmonitoring and pricing bank risk. This
shiftreduces the moral hazard problem con-
nected with the provision ofdeposit insur-
ance, but only ensures that the cost ofbank
risk as itaffects uninsured depo$itors will be
taken into account.
The modified payout plan certainly is in
keeping with the small-depositor protection
justification fordepositinsurance. However,
ifdeposit insurance is thought to be needed
to enhance the stabilityofthe banking sys-
tem, then the FDIC's plan is lacking. The
foundation ofthe stability argument is that
private market arrangements cannot be
expected tosolve theproblem ofbank runs
and that bank runs lead to economy-wide
losses. Putting large depositors at risk does
not address the bank run issue and could
well exacerbate the problem. Ifthe
economic-stability rationale suggests any~
thing, it is that liquid deposits should be
insured, which would include liquid large-
denomination accounts.
Frederick T. FurlongSS"'~ lSl:Il:I
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
'J!lll::> 'OlSpUllJ:I UllS
ZSL 'ONllWlt:ld
(]JVd :J9V1SOd 's'n
llVWssvnlS}l1:!
aU}lOS:J}ld
SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
5/2/84
Change
from
4/25/84
CD):;j)~y:;j)\illW2Jrd[ \illW2C£
~CD) 24I\illW2em
~.mJr~~~CQI TIW2Jr~1P@d[
~\\1l~m~Jl\2?<dI~@ \\{(~Jl\2?~~~(Q[
Changefrom 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments' 2 180,066 1,477 4.041 6.6
Loans and Leases' 6 160,380 1,505 5,025 9.3
Commercial and Industrial 48,101 726 2,138 1304
Real estate 59,691 77 792 3.8
Loans to Individuals 27,940 5 1,289 13.9
Leases 5,000 6 - 63 - 3.5
U.S. Treasury and Agency Securities2 12,070 - 4 - 437 - 10.0
OtherSecurities2 7,616 - 23 - 547 - 19.3
Total Deposits 187,856 3,266 - 3,141 - 4.7
Demand Deposits 46,226 3,083 - 3,011 - 17.6
Demand Deposits Adjusted3 29,110 256 - 2,221 - 2004
OtherTransaction Balances4 12,197 70 - 578 - 13.0
Total Non-Transaction Balanc~s6 129,433 113 448 1.0
Money Market Deposit
Accounts-Total 39,308 - 309 - 289 - 2.1
Time Deposits in Amounts of
$100,000or more 38,481 477 316 2.3
Other Liabilities for Borrowed MoneyS 21.532 349 - 1,475 - 18.5
.Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency (- )
Borrowings
Netfree reserves (+)/Net borrowed(- )
Weekended
4/23/84
68
102
- 33
Weekended
4/9/84
273
118
155
, Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephonetransfers
s Includes borrowingvia FRB, n &L notes, Fed Funds, RPs and othersources
6 Includes items notshown separately
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor•.••Freecopiesof
Federal Reserve publicationscanbeobtainedfrom the Public InformationSection, Federal Reserve
"Bank ofSan Francisco, P.O. Box 7702,San Francisco94120. Phone (415) 974-2246. .

FDIC's modified payout plan

http://www.frbsf.org/publications/economics/letter/1984/el84-20.pdf

FDIC's modified payout plan

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