Bank deposits ; Deposit insurance ; Interest rates

David Pyle

English

Research Papers in Economics

The practice ofdeposit brokering, however,
has been attacked by some legislators and
bank regulators for increasing the risks
insured institutions mightundertake, and it
has provoked various schemes intenton
regulating it. The regulators' primary con-
cern is that, because ofdeposit insurance, it
is possible for institutions in poor condition
to raise large quantititesoffunds from the
national deposit market. For example, the
Chairman ofthe Federal Deposit Insurance
Corporation (FDIC) recently told a Congres-
sional sub-committee that "many ofthe 72
commercial banks that failed between
February 1982 and October 1983 had sub-
stantial brokered deposits. Overall,
brokered deposits constituted 16 percent of
the total deposits held by the 72 banks that
failed." In the past, the existence ofdeposit
rate ceilings and lower insurance coverage
(i.e., $40,000) tended to limitweak institu-
tions' ability to tap the national deposit
market through deposit brokers. Thus, the
growth, ifnotthe risk-taking proclivities,
ofweak institutions was restricted. With
deregulation and brokered deposits, this
check on the riskier institutions has
been lost.
However, it is notthe availabilityoffunds
per se, buttheir insured status thatcauses
problems. The existence ofinsurance on
brokered deposits enables weaker institu-
tions to raise such deposits at a cost that is
not commensurate with the risks they are
undertaking. On the one hand, deposit
insurance lessens investors
l incentives to
evaluate the health ofthe institutions with
which they place their funds. On the other
.hand, the flat-rate deposit insurance prem-
ium structure does not require individual
institutions to pay higher rates for the higher
risks they undertake. Instead, the costs are
spread among the insuring agencies-FDIC
and FSlIC (Federal Savings and Loan Insur-
anceCorporation)-and an other insured
Deposit deregulation, mandated by the
Depository Institutions Deregulation and
MonetaryControl Act of 1980 and the
Garn-St Germain Actof 1982, has resulted
in thealmost complete removal ofinterest
rate ceilings imposed undertheInterest Rate
AdjustmentActof1966. In December 1979,
approximately 60 percent ofall time and
savings deposits were in accounts subject
to fixed rate ceilings. Now, less than 20
percent ofthese deposits are subject to such
ceilings. Moreover, proposals to allow the
paymentofinterest on demand deposits,
which have been introduced in the 98th
Congress, would virtually eliminate deposit
rate regulation for banks and thrifts. These
changes have important implications forthe
way depository institutions raise funds as
well as forthewaytheirregulators attemptto
control risk-taking. This Letterdiscusses two
aspects ofderegulation: the growth ofbro-
kered, insured deposits and the increased
volatility ofdeposit costs.
Brokered deposits
Deposit rate deregulation, combined with
an increase in deposit insurance coverage
from $40,000to $1 00,000, has given depos-
itory institutions additional incentives
to expand their deposit drawbeyond their
own geographically limited service areas.
Deposit brokerage represents one means by
which banks and thrifts can mobilize funds
from a broadening national deposit market.
The depositbtokerobtainsfunds from inves-
tors throughout the country and channels
them to the clientdepository institutions,
assigning title forthe deposit (in separate
unitsofupto $100,000) to a numberof
different investors. An increasing numberof
banks and thrifts arefinding that this is an
economical way to raise additional funds.
From an economist's perspective, it repre-
sents an efficient deposit-gathering mech-
anism thatenables'funds to flow to uses for
which the demand is greatest.
February 10, 1984
Some Implicationsof Deposit DeregulationIf(~cdl~ll~~ll IT«(~~~1l'W~
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()pinions exprL'::;sed in lhi~ newsletter do not
necessarilv reflect the views oj the managerT1Pnt
of thE' Federal Reserve Bank of San Francisco,
or of l'he Board of Covernors of the' Federal
Reserve System.
institutions in theforms ofhigherliquidation
expenses and lower premium rebates.
Underthese circumstances, deposit broker-
age may supplant the Federal Reserve's
discount window as the lenderoflast resort
for institutions in difficulty. Given a choice
between borrowing at the Fed, which re-
quires that an institution put upgood
collateral, and raising brokered funds,
weaker institutions may find itcheaper to
choose the latter. In effect, the federal
insurer guarantees the repaymentofuncol-
lateralized purchased funds at a rate that
does not cover the risk, while the Fed
implicitlycharges a'higher rate by requiring
collateral to cover the risk.
A second concern ofbank and thrift regu-
lators is that brokered deposits may be used
to exploit the federal deposit insurance
guarantee even when the issuing institution
is in no apparent danger ofdefault. It is
widely recognized that the current system,
which charges a uniform deposit insurance
premium, provides an Incentive for insured
institutions to engage in more risk-taking
than they otherwise would. The costs of
increased risk-taking are shared with the
federal insurer, while the rewards accrue to
the owners ofthe depository institution.
Deposit rate ceilings tended to constrain
depository institutions' ability to respond
to these risk-taking incentives by restricting
their ability to raise additional deposits.
However, without rate ceilings, institutions
that want to take advantage ofriskier invest-
ment opportunities (such as making more
and/or risker loans) need notwait for local
deposit growth to provide the funds. They
can turn to brokers to tap the national
market. Ofcourse, they may have to pay a
higher rate than they would for local
deposits, butthey do not incurthe costs
ofadditional branch offices and ancilIary
services to obtain these funds-and the rate
will certainly be belowthe rate onuninsured
deposits.
Clearly, then, the growth in insured deposit
brokerage is an important concern ofbank
2
and thrift regulators. However,thedirector
brokered sale of"uninsured" deposits that
are implicitly insuredoughtto be asourceof
concern as well. After all, deposit brokerage
is nota newphenomenon. Large banks have
tapped the money market forsome years
bothby directand brokered placementof
negotiable large CDs. These CDs have
generally been traded in lot sizes well in
excess ofthe $100,000 deposit insurance
limit. With the notable, and probably very
special, exception ofthe Penn Square
failure, the holders ofthese uninsured
deposits have notsuffered significant losses
when some ofthe issuers failed. In fact, it
was widely believed (at least until the Penn
Square failure) that the insuring agencies
would neverpayoffonly the insured depos-
its ofafailed largebank, butwould, instead,
arrange a purchase that would also protect
largedeposits. This view, supported by FDIC
and FSLlC practice, has resulted in less than
full risk-pricing oflarge-bank CDs, leaving
the insuring agencies to share the cost of
deposits that are notfully insured by statute.
The problems with deposit brokerage
shouId, therefore, be considered symp-
tomatic-not ofdeposit deregulation, but
ofa more general problem with the deposit
insurance system. The system as it is cur-
rentlystructured provides incentives for
greater risk-taking whether a bank uses
deposit brokers or not. Therefore, plans to
restrict insured deposit brokerage do not get
to the heart ofthe problem, but instead,
risk cutting offan economically efficient
mechanism. Instead oftrying to restrict
deposit brokerage, it wouId be more usefuI
andequitableto address the thornyproblem
ofdeposit.insurance reform.
An analogy mayhelpmakethis point: When
banks began to use large computers, it was
suggested that scale economies in comput-
ingwoulddrivesmall banks outofbusiness.
This hasn't happened since a small bank
neednotown a large computertobe able to
take advantage of its capabilities. Instead, a
small bank can purchase computerservices140
David Pyle
Now, however, any difference in the cost of
deposits and substitute liabilities is notan
economic cost to the issuer, but a reflection
ofdifferences in riskiness. For example, lia-
bilities that are subordinated todeposits
shouId bear a higher cost because they are
riskier, just as equity's greater riskiness
carries a higherreturn than debt. Thus, if
deposits are truly bargains without deposit
ceilings, itis becausesome bankmarkets are
not fully competitive orbecause deposit
insurance premiums are insufficient, on .
the margin, to cover the insurer's deposit
guarantee liability. Regulatory policies
regarding capital adequacy standards
should notallowdepository institutions to
take advantage ofthese sources ofdeposit
"cheapness;"
prepared to manage this volatility. But as
was the case with depositrate ceilings and
disintermediation, there will be problems
for undercapitalized institutions with too
many fixed rate and/or non-performing
assets. Instead offacing a liquiditycrisis
caused by withdrawals, weak institutions
nowwill more likely face an earnings crisis
caused by a negative spread between the
yield on assets and cost offunds. This dis-
tinction has important implications for the
way regulators monitorthe condition of
banks and thrifts, particularly those that are
in dangeroffailing. With access to national
marketsthrough deposit brokers, weak insti-
tutions are now less likelyto encounter
liquiditv. problems and thus, maybe able
tocontinue in operation longerthan they
should.
Ironically, deposit deregulation may make
the regulators' task ofenforcing capital
adequacy standards easier. Theelimination
ofdeposit rate ceilings undermines the
argument that deposits are acheaper source
offunds than capital and other non-deposit
liabilities. When deposit rate ceilings were
binding, deposit costs seemed, and perhaps
were, lowerthan that ofother liabilities, at
least on the margin.
3
Dopasll OlUcas par 100,000 Individuals·
•
60
80
20
401:.._----
In the long-run, the elimination ofrate ceil-
ings will mean thatdepositors will receive
larger interest payments and lower pay-
ments in the form offree orunderpriced
services, and depository institutions will
have to manage new marketing trade-offs
among interest payments, services, and
service fees. Oneofthe tricky problems for
existing banks is that they must dothis in
competition with newentrants that are not
weighed down with personnel and facilities
more suitable to the period ofdeposit rate
ceilings.
Bank and Thrift Non-Rate Competition
N""",o,
100
Deregulation and deposit costs
At the same time that deregulation has
opened opportunities for deposit brokerage,
it has also changed the nature ofbanks' and
thrifts' costs. When deposit rate ceilings
were binding, banks and thrifts were forced
into "non-rate" competition, such as the
provision ofextensive branch networks and
large staffs. As shown in the chart, bank and
thriftoffices per capita increased throughout
the 1970s along with bank and thrift em-
ployees percapita. Nowthat the ceiIings are
gone, we are seeing an expected reversal of
the trend toward more branches and more
employees. A numberofbanks have an-
nounced branch closings and employee
reductions, as is clear in the chart as well.
~'·l:-:60:--..,.::!60,-' -""!:70:--""::!"'-'-""l:-:60-"',,J,,,·
·20 Yanrs nnd Ovor
Deregulation also means that deposit costs
willbecomemorevolatile. This is themirror
image ofthe volatility in depositquantity-
"disintermediation"-thatoccurred when
fixed rate ceilings prevented depository
institutions from paying rates comparable
tothose available from non_depository insti-
tutions. Morevolatilitv in bank costs is not
a bad thing ifdepQsitory institutions are
120
from the ownerofa large computer, who
can pool thedemandsofanumberofbanks.
Competition among such owners results in
competitively priced services. Similarly, by
pooling the deposit offerings ofa numberof
banks, a deposit broker can offer smaller
banks the advantages ofthe large'banks'
access to national deposit markets.1006
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Change from
year ago
Change
from
Amount
Outstanding
1/25/84 1/18/84 Dollar Percent
loans,leasesand Investments1 2 173,881 - 471 1,018 0.6
loansand leases1 5 153,598 - 307 2,342 1.5
Commercial and Industrial 45,069 55 - 389 - 0.8
Real estate 58,897 - 7 865 1.4
loans to Individuals 26,650 54 2,073 8.4
Leases 5,039 - 11 - 248 - 4.7
U.s. Treasury and Agency Securities2 12,139 - 135 682 6.0
Other Securities2 8,144 - 29 NA NA
Total Deposits 181,947 -2,550 4,249 2.4
Demand Deposits 40,852 -2,337 2,520 6.5
Oemand'Oeposits Adjusted3 28,138 -1,177 NA NA
Other Transaction Balances4 11,700 - 369 NA NA
Total Non-Transaction Balances 129,395 156 NA NA
MoneyMarket Deposit
Accounts-Total 39,688 52 NA NA
Time Deposits in Amounts of
$100,000 ormore 38,456 141 - 9,716 - 20.2
Other liabilities for Borrowed MoneyS 19,133 -1,782 - 5,699 - 23.0
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and liabilities
largeCommercial Ban"s
Weekly Averages
ofDaily fi~ures
Weekended
1/25/84
Weekended
1/18184
Comparable
year-ago period
Reserve Position, All Reporting Banks
'Excess Reserves (+l/Deficiency (..;.)
Borrowings
Net free reserves (+J/Net borrowed(-)
75
10
65
266
22
244
393
° 393
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
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&lnotes, Fed Funds, RPs and othersources
6 Includes items not shown separately ,
Editorial commentsmay beaddressed totheeditor(GregoryTong) ortotheauthor•..•Freecopiesof
Federal Reserve publicationscan beobtained from the Public Information Section, Federal Reserve
Bank ofSan Francisc~, P.O:~ox7702, San'Francisco94120. PhQne (415) 974~2246.

Some implications of deposit deregulation

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Some implications of deposit deregulation

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