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

Frederick T. Furlong

Michael W. Keran

English

Research Papers in Economics

FRBSF WEEKLY LETTER
August 3, 1984
The Federal Safety Net for Commercial Banks:
Part II
This Weekly Lettercontinues lastweek'sdiscussion
ofthe problems involved in administering the
federal safety net for commercial banks. Last
week's Letter focused on the lender-of-Iast-resort
function ofthe Federal Reserve. It concluded that
there is no inherentconflictfor the Federal Reserve
between meetingthe Iiquidityneeds ofdepository
institutions and achieving the goals ofmonetary
policy. This Letter takes upthe issue offederal
deposit insurance for commercial banks.
Deposit insurance
The Federal Deposit Insurance Corporation (FDIC)
was established in the wake ofthe devastating
banking panic ofthe early 1930s. From its incep-
tion, the FDIC has had two basic functions. The
first has been to protectdepositors ofmodest
means from incurring losses when banks fail. The
second has been toprotectthe economy in general
from the adverse effects ofbank runs. In meeting
thesegoals, the effectiveness ofthe deposit
insurance guarantee has been fargreaterthan what
mighthavebeen expected given the limited sizeof
the insurance fund. Atthe end of1983, the FDIC
fund totaled onlyabout $15.4 billion, or less than
one percentoftotal domesticdeposits at insured
commercial banks.
The impactofdeposit insurance goes beyond the
size ofthe insurance fund primarily because the
majorbenefitofthe insurance guarantee is that it
averts bank runs and thus avoids the need for
extensive payouts. Also, thesystem foradminister-
ingdeposit insurance can afford the FDIC some
control overthe cost it bears when a bank fails.
The failure ofeven a large bank, in principle at
least, does not have to force the FDIC to take on
heavy losses. The size ofthe losses to the FDIC
depends on the valueofthe net worth ofthe bank
when itfails, which, in turn, depends partly on
howpromptlythe FDIC and other regulatory
agencies take action to close a troubled bank.
Moreover, the FDIC has more resources at its
disposal than the insurancefund itself, since the
FDICcan borrowfrom the Treasury. Finally, the
Congress has passed a resolution, albeit a non-
bindingone, placingthefull faith and creditofthe
federal government behind thedeposit insurance
guarantee.
Incentives to risk-taking
Overthe past 50 years, the FDIC clearly has been
successful in achieving its assigned goals byalle-
viatingdepositors' concerns overthe soundnessof
commercial banks. Nevertheless, the movement
to reform the deposit insurance system has never
been stronger because ofthe growing awareness
that federal deposit insurance can affect the
behavior ofcommercial banks. The problem is
thatas long as depositors and othercreditors of
banks knowthatdepository institutions(oratleast
large banks) in trouble will be bailed out, deposi-
tors and others donothavetoconcernthemselves
with the conditionofabank's portfolio. Therefore,
banks will nothave to bear the full cost oftheir
risk-taking, unless they are kept in check bythe
FDIC and the other bank regulatory agencies.
This pointcan be illustrated through a simple
numerical example. Consider a bankwith $3 mil-
lion in capital and an investmentopportunity that
will return $3 million orgenerate a loss of$3
million with equal probability. The expected value
ofthe investmentto the market (i.e., the share-
holders) would be zero. As an alternative, consider
abankwith $2 millionincapital and $1 millionin
insured deposits. Nowthe shareholders atmost
can lose $2 million. The expected valueofthe
investmentto the shareholderthen would be the
averageofthe $2 million loss ofcapital andthe$3
million potential gain-which comes to $500,000
instead ofzero. The deposit insurance in this case
increases the expected return ofthe risky invest-
ment, and thus makes the investment more
attractive.
Another pointthat can be brought out through the
example is that the lowerthe level ofshareholder
capital ofa bank the greaterthe expected gain
from risky loans. Continuingwith the example, if
capital in the bank were only $1 million (and
insured deposits were $2 million), then the ex-
pected value ofthe investmentwould be $1 mil-
lion. With federal deposit insurance, the mostFRBSF
leveraged institutionshavethe mosttogain from a
given risky investment. And, needless to say,
institutions that are allowed by regulators to
continue operating when net worth is negative
can only stand to benefit from risky enterprises.
These incentives for risk-taking inherent in the
federal safety net have been recognized for some
time, and they have been kept in check to a large
degree through supervision and regulation.
However, with deregulation in banking, the task
ofcurbing banks' desires ta'<l<:ton the incentives
presented to them likelywill be more difficult.
This is notnecessarilybecausederegulation means
thatbanks havetopaymoreforfunds and therefore
mustseek outhigheryielding, riskier assets, orthat
all new activities sought by banks are inherently
more risky than traditional lines ofbanking
business. Indeed, in principle, many aspects of
deregulation couId reduce bankrisk. Forexample,
greater asset powers would allow morediversifi-
cation, and the removal ofdeposit rate ceilings
means that banks have more efficientways of
acquiring funds from a broader source.
Whatderegulationdoes is give institutionsgreater
scopeto acton the incentives for risk-taking. A
case in point is the use ofbrokered deposits.
Deposit brokers can obtain funds from investors
throughoutthecountryin unitsofupto $100,000,
and channel the deposits to commercial banks or
thrift institutions. The deposits that a depository
institution receives from a brokerfar exceed the
insurance limitof$100,000, but, sinceeach unitis
at the limitor below it, the entire pool is insured.
Depositors therefore do nothave to concern
themselves with the financial condition ofthe
depository institutions to which their funds are
directed and can lookforthe highest interest rate
paid.Thus, with fully insured brokered deposits, a
bankhas access tofunds on anationwidebasis ata
cost that wiII notfuIly reflect the riskiness ofthe
bank's loans or its capital position. Once again,
the institutions with the weakest capital positions
would gain the most by acquiring insured
brokered deposits.
To blockthe "abuse" ofthe deposit insurance
guarantee, especially by weaker institutions, the
FDICand the Federal Savings andLoan Insurance
Corporation (FSLlC) took steps to limitthe insur-
ancecoverage on brokered deposits. Their attempt
to limit insurance on brokered deposits to
$100,000 per broker per institution would have
taken effect October 1, 1984 had itnot been chal-
lenged successfully in court. The deposit insurance
agencies apparently are considering an appeal of
the decision.
Withoutdeposit insurance, banks, ofcourse, sti II
would fund some oftheir assets through "borrow-
ings" in the formofdeposits. However, in the
absence ofdeposit insurance, the cost ofdeposits
can be expected toreflectthe riskiness ofabank. If
depositors were not insured, the risk-return trade-
offfaced by a bank in its investmentdecisions
would notchange materially. Consequently,
banks' risk-taking proclivities would not be
encouraged.
Controlling risk-taking
To mimic a "market" approach to checking bank
risk-taking, it has been suggested thatthe FDIC
replace the current fixed-rate insurance premium
with a structure ofvariable rate premiums that
reflect the risk exposure ofan institution. In fact,
the FDIC has had legislation introduced in the
Congress that would give the insurance agency
authority to use a system of risk-based insurance
premium rebates. However, the impactofthis
proposal likelywould be minimal since the dif-
ferences in rebates amongthe risk categories for a
bank would be quite small.
The FDIC has been especially sensitive to the im-
pactofderegulation on risk-taking by banks and
theconsequentexposureofthe insurancefund. In
addition to the steps taken to curb brokered
deposits, the FDIC attempted to reduce the distor-
tions created bythedepositinsurance through the
"modified payout" plan for handlingfailedbanks.
(This plan was the subject ofthe May 18, 1984
Weekly Letter.) The plan was designed to make
largedepositors share in the losses ofbankfailures
as ameans of imposinggreater marketdiscipline
on banks. However, the modified payouthas only
been used on relatively small banks. Its rejection
inthe handlingofthetroubled Continental Illinois
bank raises grave doubts as to whether this plan
would be applied to any large bank.
DevelopmentsatContinental Illinoisstrongly point
outthat the modified payout plan, with its
emphasis on protectingsmall depositors, conflicts
directlywith the second objective ofdeposit
insurance-to prevent bank runs. In reaction to
the massive withdrawal of large deposits at
Continental, the FDIC abandoned the principlesbehind the modified payout approach and pro-
vided insurance coverage for all depositors. The
FDIC's actions clearly were intended to address
the problem ofbank runs, which notonly affect
particular banks butthe economy as awhole. The
FDICcurrently is evaluating the experimental
modified payout, and itmaybe acoupleofmonths
before it announces a final verdict regarding the
plan.
Perhaps recognizing the implications-ofthe com-
bination ofa weak capital position and the avail-
ability ofdeposit insurance, the FDIC along with
the Comptrollerofthe Currency also have pro-
posed a rule that would require banks to maintain
a primary ratio ofcapital to assets of5.5 percent
and asecondary capital minimum, including some
convertibledebtand the valueofintangibleassets
in the definition ofcapital, of6 percent. Prior to
this proposal, the FDIC policy recommended a
primary ratio ofcapital to assets of5 percent.
While higher capital requirements could have
some bearing on bank risk-taking, the proposed
requirements continue the convention ofcon-
sidering the book value of net worth, rather than
the market value. However, the gains from risk-
taking in bankingwhen depositinsurance is avai 1-
ableare related tothe marketvalue ofabank's net
worth. The continued focus on book value net
worth is problematic because the bookvalue of
networth can exceed the market value and, for
some banks, the difference can be quite striking.
For example, forthe troubled Continental Illinois
Bankatthe end ofthe first quarter ofthis year, the
ratioofits market value ofequity to its bookvalue
ofequity was far less than one-half.
There are, ofcourse, problemswith usingamarket
evaluation ofabankforregulatorypurposes (aside
from the fact that most bank stocks are nottraded
regularly). For example, the market price ofa
bank's stock will reflect the presence ofthe deposit
insurance guarantee, notto mention the possibility
that, say, a large bank would be bailed out if it
were to experience problems-bailed outeven to
the extent ofproviding some protection to share-
holders, as in the case ofthe First Pennsylvania
Bank. Nevertheless, more attention should be
given to evaluating bank networth on the basis of
"market" rather than book value.
Conclusion
The current problems facing banks have madeus
more awareofthe importanceofthefederal safety
nettothe stability ofthe banking system. Atthe
same time, the heightened role ofthe FDIC (and,
as discussed in the preceding Weekly Letter, the
Federal Reserve as lenderof last resort) has raised
concerns overthe side effects ofthe safety net.
Federal deposit insurance may increase the risk-
taking proclivities of insured banks. In response, a
numberofmethodsforkeeping bank risk-taking in
check have been suggested. The arrangements
announced.on July 26, 1984 bythe FDIC for deal-
ingwith Continental Illinoisundoubtedlywill add
fuel to this ongoing debate over deposit insurance
reform, particularly regarding the properscope of
the FDICguarantee. In theend, however, the FDIC,
in conjunction with the other bank regulatory
agencies, probablywill continue to rely on super-
vision and regulation-particularly capital
requirements-as the main tools to restrain banks
from engaging in excessively risky enterprises.
Frederick T. Furlongand Michael W. Keran
MONETARY POLICY OBJECTIVES FOR 1984 AND 1985
On July 25, Federal Reserve Board Chairman Paul Volcker presented a mid-year report to the
Congress on the Federal Reserve's monetary policy objectives for the remainder of 1984 and
proposals for 1985. The report includes a reviewofeconomicand financial developments in 1984
and the economic outlook heading into 1985. Single or multiple copies of the report can be
obtained upon request from the Public Information Department, Federal Reserve Bank of San
Francisco, P.O. Box 7702, San Francisco, CA 94120. Phone (415) 974-2246.
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthemanagementofthe Federal Reserve Bank ofSan
Francisco, orofthe Board ofGovernorsofthe Federal Reserve System.
Editorial commentsmaybeaddressed totheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reserve publications
can beobtainedfrom the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.'1!11!;) 'o:>sPU1!J::I U1!S
ZSL 'ON IIWH:ld
(]IVd:l9VISOd 's'n
llVWssvn ISHI::I
(]UHOS:lHd
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
uo~6lJ!4S0m 4o~n U060JO OpOA0U
040PI !!omoH O!UJoJ!l0) ouoz!J~ 0lisol~
O)SI)UOJ::J UOS
JO ).juo8
aAJaSa~ IOJapa::J
~uew~Jodea LpJoese8
Selected Assets and Liabilities
LargeCommercial Banks
Amount
Outstanding
7/18/84
Change
from
7/11/84
Change from 12/28/83
Percent
Dollar Annualized
Loans, Leases and Investments' 2 181,515 - 264 5,490 5.5
Loans and Leases1 6 162,430 - 239 7,075 8.1
Commercial and Industrial 49,066 - 224 3,103 12.1
Real estate 60,499 76 1,600 4.8
Loans to Individuals 28,763 51 2,112 14.2
Leases 5,009 - 22 - 54 - 1.9
US. Treasury and Agency Securities2 11,950 - 34 - 557 - 7.9
OtherSecurities2 7,135 8 - 1,028 - 22.5
Total Deposits 187,925 -1,844 - 3,072 - 2.8
Demand Deposits 44,014 -1,812 - 5,223 - 19.0
Demand Deposits Adjusted3 28,995 -1,619 - 2,336 - 13.3
OtherTransaction Balances4 12,250 - 190 - 525 - 7.3
Total Non-Transaction Balances6 131,661 159 2,676 3.7
MoneyMarketDeposit
Accounts-Total 38,099 - 327 - 1,498 - 6.7
Time Deposits in Amountsof
$100,000or more 40,205 396 2,040 09.5
OtherLiabilities for Borrowed MoneyS 21,027 2,163 - 1,980 - 15.4
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
, 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 telephone transfers
S Includes borrowingvia FRB, n &L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately

The Federal safety net for commercial banks: pt. II

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The Federal safety net for commercial banks: pt. II

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