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

John L. Scadding.

English

Research Papers in Economics

FRBSF
October 19, 1984 WEEKLY LETTER
Insurance and Managing Bank Risk-Taking
This Weekly Letter is part ofa series ofdigests of
articles that appear in the Federal Reserve Bank of
San Francisco's quarterly Economic Review. These
digests are intended to make the majorfindings of
research conducted at the San Francisco Reserve
Bank available to a wideraudience. Readers who
wish toobtain individual copies ofa Review, or
whowould liketobe placedonthemailing listfor
the Review, maydoso bywriting the Public Infor·
mation Department, P.O. Box 7702, San Francis-
co, California 94120. The articles summarized
here appear in the Spring 1984 issue ofthe Eco-
nomic Review.
Deposit Insurance Reform
Manyobservers credittheestablishmentoffederal
depositinsurance in the 1930swith preventingthe
periodic banking panics that had destabilized the
U.S. banking system before 1933. Recently, how-
ever, wehavecometoappreciatethattheexisting
system ofdeposit insurance may actually encour-
age banks (and other depository institutions) to
assume more risk in their loan making and invest-
ment activities than is socially desirable. Deposit
insurance may reduce depositors' incentives to
monitorthe financial health ofthe institutions in
whichthey have invested theirfunds. Depository
institutionsthemselves maybe encouraged to take
on more risk than they would otherwise because
the potential costs offailure are shared with the
insurer.
This concern thatthe current system ofdeposit
insuranceencourages excessive risk taking has led
to periodic proposals for reform. Mostnotable
amongthese proposals is the one calling for insti-
tutions to be charged differential insurance fees
(rather than the currentflatfee) based on the riski-
ness oftheir portfolios. Difficulties with imple-
menting such reforms, however, call their practi-
cality intoquestion. Three ofthefourarticles inthe
Spring 1984Economic Reviewsuggest alternative
reforms the FDIC and other insurers can under-
take. The fourth describes a method ofpricing
mortgages borrowedfrom optionspricingmodels.
Improved solvencycontrol
In "Deregulation and Deposit Insurance Reform"
David Pyle lists several ways in which financial
deregulation is increasingthe scopefor risk-taking
by banks and otherdepository institutions. These
includenewasset and productIineactivities, such
as real estate and insurance; the increased uncer-
tainties ofcopingwith deposit rate competition;
and financial innovations such as brokered funds,
which allowbankstoraise funds nationallyand to
reduce their reliance on local markets in which
they are better known. His analysis suggests that
improved monitoring and control ofbank activi-
ties to prevent fnsolvency may be more important
than differentially pricing risk in protecting the
insurance funds.
Pyle emphasizes that the insurer's liability-
consisting ofthe difference between the market
value ofa bank's assets and its deposits when it is
closed-dependsboth on the riskiness ofabank's
assets and on the insurer's insolvency policy. By
insolvency policy, he means the ratio ofthe market
value ofan institution's assets to its deposit liabili-
ties atwhichthe insurerwiII declarethe institution
insolvent. To examine the relative importanceof
bankasset risk andthe insolvency ratio, Pyledraws
on optionspricingtheory, reasoningthatthe insur-
er in effect has agreed to "buy" the bank's assets
(where the price is the total valueof insured de-
posits thatmustbe paid off)when abank's asset-to-
liability ratio falls belowthe insolvency value.
For representative values ofasset rate risk and
different levels.ofauditcosts, Pyle's calculations
suggest that preventing the insolvency ratio from
falling belowone (at which net worth becomes
negative) maybe much moreeffective in reducing
the insurer's liabilitythan measures designed to
reduce bank risk. As the author notes, the use of
bookvaluenetworth standards has allowed some
institutionstooperate at negative networth, signif-
icantly increasingthe cost to the insurer in the
event that the institution must be closed. In this
context, Pyle's calculations suggest that "im-
proved solvency control is a...more important
focal pointfor deposit insurance reform
legislation."
Greater use ofenforcement powers
Barbara Bennett, in "Bank Deregulation and
Deposit Insurance: Controllingthe FDIC's Losses,"FRBSF
examinestheways inwhichthe FDIC could use its
current regulatory and supervisory powers to
reduce the risk to the insurancefund caused by
excessive risk-taking. Bennett notes thatthe ten-.
dency for bank regulators, includingthe FDIC, to
letan institution's net worth become negative
before taking action offers a powerfuI incentiveto
banks to take extraordinary risks because, at that
point, the costs offailurewill be borneentirelyby
the insurer.
Bennettconsiders the FDIC's(and otheragencies')
regulatory powers in such areas as loan concen-
trations, insider transactions, and capital adequacy
standards analogous to restrictive covenants in
bond indentures. Their purposes are the same: to
restrict risk-taking activities that would reduce the
value ofthe insurance fund and the value ofthe
bondholders' claims on the firm, respectively.
Minimumcapital standards, forexample, Iimitthe
extent to which a bank can increase its deposit
liabilities (and hence the potential claim on the
insurance fund) without also increasing its capital
base.
The author argues thatdespitethe substantial
powersofenforcement atthe FDIC's command,
"On the whole, the FDIC has tended to make
limited use of its currentenforcement powers,
particularly those involving legal proceedings,
...tend(ing) to rely (instead) mainlyon informal
agreements and on more frequent examina-
tions..." Bennett concludes that "the FDIC's
apparentreluctancetoresortto moreserious mea-
sures until institutionsare on the vergeofinsolven-
cy unnecessarily increases the risk tothe insurance
fund."
Terms ofmaturity
In the third articleon deposit insurance, "AView
on Deposit Insurance Coverage," Frederick Fur-
long analyzes theFDIC's recent "modified pay-out
policy," which puts large-denomination deposits
atrisk. Furlong concludes thatthispolicy "could
make the banking system more unstable by in-
creasing the probabilityof'bank runs'," and that
"...itmay be moreappropriatet6 base insurance
on terms ofmaturity, with short-run deposits re-
ceiving coverage."
Since the inception ofFederal Deposit Insurance,
insured and uninsured deposits have been segre-
gated on the basis ofaccount size. In practice,
however, and with a few exceptions, holders of
lIuninsured" deposits have not incurred losses
from bankfailures. Themodified payoutplan is an
attemptto reinstate some market discipline by
giving large depositors agreater incentive to
monitorbank risk-taking activities. Under the
plan, uninsured depositors would receive imme-
diatelyapro-ratashare ofwhatthe FDIC thoughtit
could recoverfrom liquidating a failed bank's
assets.
In assessing the FDIC's modified payout policy,
Furlong distinguishes two rationales for deposit
insurance. The first, protecting the small saver, is
based on the presumption that such individuals
are atadisadvantage in calculatingthe riskiness of
a depository institution's liabilities. Moreover,
such small savers are pr"sumed to be more sus-
ceptibleto risk exposurebecause ofa limited abil-
ity to diversify their portfolios. Furlong argues that
the currentdeposit insurance system does protect
thesmall saver, butdoes so at someexpensetothe
second objectiveofdeposit insurance, thatofen-
suring aggregate financial stability. Moreover, he
maintains that contemporary financial markets
offer ample opportunities for safe investments by
the small saver.
Furlongbelievesthatthe moredefensibleobjective
ofdepositinsurance is to maintain stable financial
markets by forestalling the sort ofdepositor runs
and associated banking panics that severely dis-
rupted financial markets before the establishment
ofthe FDIC. Heargues thatputting largedepositors
atrisk does notdirectlyaddress this threattofinan-
cial stability because the critical dimension in the
problem ofbankruns is the term to maturity of
deposits. Highly liquid deposits-withdrawable
at paron demand oron short notice-enable
depositors to withdraw such funds as soon as they
becomeconcernedaboutan institution'sfinancial
health.The authorargues, therefore, thatadistinc-
tion be made between insured and uninsured de-
posits on the basisoftermsofmaturity, notaccount
size.
An optionsapproach topricingmortgages
In the final article, "PricingMortgages: An Options
Approach," Randall J. Pozdena and Ben Iben
demonstrate how a numerical options pricing
technique can be used to price mortgages with
different contract provisions, such as interest rate
"caps" on adjustable rate mortgages (ARMs).
Their simulation results, among other things, sug-
gestthatcurrenttechniques forpricingARMsmaycause them to be "overpriced," that is, lead to
original contract rates that are too high relative to
whatthe market is willingto pay.
The application ofthe options pricing model to
mortgages relies on the observation that a mort-
gage can be thoughtofas a coupon-type bond
with certain options attached to it. A mortgage
with a prepayment option, for example, can be
thoughtofasapackageconsistingofa bond (the
mortgage) plus a call provision (the option ofthe
borrower to payoffthe "bond," usually at a price
equal to the existing balanceofthe loan plus any
prepayment penalty).
The valueofan option comes from its effectiveness
as a hedge against interest rate risk. The prepay-
ment option on a mortgage, for example, has value
because it "insures" the borrower against being
locked into a relatively high interest rate should
market interest rates fall. OptiOns pricing models
use this idea to inferthe value ofan option from
the priceofthe underlying security and the pre-
vailing rate of interest. The valueofa mortgage
according to such a model wouId reflectboth the
value ofthe bond component and the value ofthe
attached options(s), ifany.
Pozdena and Iben use anumerical options pricing
model to simulate contract interest rates on mort-
gages with differentcontract provisions. Simula-
tions ofyields for both fixed and adjustable rate
mortgages resulted in several interesting findings.
First, the large spreads between fixed and ARM
rates suggest thatthe insulation from interest rate
risk offered a lending institution byARMs are
obtained only attheexpense ofa substantial re-
duction inthe ratethatcan be charged onthattype
ofmortgage. Second, the spreads between ARMs
withdifferent-sized "caps" onthetotal increase in
the contract interest rate allowableoverthe Iife of
the mortgage are smallerthe lowerthe level of
prevailing short-term market rates of interest. This
finding, the authors argue, "suggest(s) that 'mark-
up' rules ofthumb in pricingvariable-rate mort-
gages...probably should not be employed by
mortgage lenders."
Finally, Pozdena and Iben notethatthesimulations
ofARM yields are typicallyclosertothe short-term
rate Of interest than is, at least on the basis ofthe
casual evidence, observed in the marketplace.
The authors speculate that this may have meant
ARMs were "overpriced" in the market, and that
this would help explain why such contracts met
widespread market resistance when first
introduced.
John L. Scadding
Opinionsexpressed in this newsletterdo not necessarily reflect the views of the managementof the Federal Reserve Bank ofSan
Francisco, orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybe addressedtotheeditor(GregoryTong) ortotheauthor....Freecopiesof Federal Reserve publications
can beobtained from the Public Information Department, Federal Reserve BankofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.'ml!:) 'o:>spUl!J:I Ul!S
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
uo~6U!4S0m 4o~n U060JO 0pOA0U
040PI !!omoH O!UJoJUO) ouoz!J~ oljsol~
O)SI)UOJ:::J UOS
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SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
10/3/84
Change
from
9/26/84
Change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments] 2 183,446 608 7,421 5.4
Loans and Leasesl 6 164,668 836 9,313 7.7
Commercial and Industrial 49,745 659 3,782 10.6
Real estate 60,882 - 55 1,983 4.3
Loans to Individuals 30,226 127 3,575 17.4
Leases 5,042 - 4 - 21 - 0.5
U.S. Treasury and Agency Securities2 11,715 - 92 - 792 - 8.2
Other Securities2 7,063 - 135 - 1,100 - 17.5
Total Deposits 192,186 4,380 1,189 0.8
Demand Deposits 46,236 3,008 - 3,001 - 7.9
Demand Deposits Adjusted3 29,626 1,122 - 1,705 - 7.0
OtherTransaction Balances4 12,648 749 - 127 - 1.2
Total Non-Transaction Balances6 133,302 623 4,317 4.3
MoneyMarketDeposit
Accounts-Total 37,765 242 - 1,832 - 6.0
Time Deposits in Amounts of
$100,000or more 41,142 33 2,977 10.1
Other Liabilities for Borrowed MoneyS 20,324 -2,581 - 2,683 - 15.1
WeeklyAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Netfree reserves (+)/Net borrowed(-)
Period ended
9/24/84
105
47
58
Period ended
9/1 0/84
23
39
15
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
5 Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately

Insurance and managing bank risk-taking

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Insurance and managing bank risk-taking

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