Full text of Annual Report of the Federal Reserve Bank of Minneapolis : 1997 Annual Report : Fixing FDICIA: A Plan to Address the Too-Big-To-Fail Problem

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Federal Reserve Bank of Minneapolis

The Region

1997 Annual Report

Fixing FDICIA
A Plan to Address the Too-Big-To-Fail Problem

Special Issue

Special Issue
Volume 12 Number 1
March 1998
ISSN 1045-3369

The Region

Federal Reserve Bank of Minneapolis
1997 A nnual Report

Fixing FDICIA
A Plan to Address the Too-Big-To-Fail 'Problem
By Ron J. Feldman and A rthur J. Rolnick

Feldman is senior financial analyst, Banking Supervision Department,
and Rolnick is senior vice president and director of Research.
The views expressed herein are not necessarily those o f the Federal Reserve System.

The Region

President s Message

Last year, the M inneapolis Fed held a series o f m eetings w ith N inth D istrict bankers on
the subject o f deposit insurance reform , a controversial issue am ong bankers and o th
ers, m any of w hom consider deposit insurance a very successful program . W ithout
d oubt, deposit insurance accom plished two im p o rtan t goals: It protected small
savers and it helped stabilize the banking industry. But in so doing, it also introduced
the possibility o f putting th at very industry and, ultimately, taxpayers at risk. This irony
wasn’t obvious to m ost until the 1980s, w hen m any com m ercial banks and savings and
loans— em boldened by a deposit base th at was im plicitly 100 percent guaranteed— took
im p ru d en t risks, resulting in the biggest debacle in banking in 50 years.
But the issue didn’t go away w ith the resolution o f the problem s of the 1980s.
Last sum m er, finance officials and central bankers from around the w orld m et at the
Kansas City Fed’s annual bank sym posium in Jackson Hole, Wyo., to discuss “financial
stability in a global economy.” This was a tim ely topic, o f course, given the events that
were transpiring in certain Asian economies. The consensus of the m eeting was th at too
m uch protection o f bank deposits and creditors leads to excessive risk taking. However,
attendees also felt th at a prohibition on governm ent su p p o rt was n o t feasible because
the failure o f large banks could expose financial systems to crisis. The issue, then, was
how to im plem ent a governm ent safety net policy that achieves a m iddle ground.
Recently, the M inneapolis Fed suggested a plan th at seeks to achieve th at diffi
cult goal and, in this year’s A n n u a l Report, I have asked Ron Feldm an and A rt Rolnick
to provide a further explication o f o u r proposal. Congress took a first step tow ard
addressing the issue o f too m uch deposit insurance by passing legislation in 1991— b u t
the legislation does n o t go far enough. There is still too m uch protection for large cus
tom ers o f the largest banks. O u r plan seeks to reduce th at protection while m aintaining
the stabilizing benefits o f governm ent insurance.

Gary H. Stern
President

The Region

Regulators indicated that they
would take extraordinary steps in
response to the failure of a very
large bank not otherwise allowed
during a standard resolution.
Such steps have included
full protection for uninsured
depositors and other creditors,
as well as suppliers of funds
to the bank’s holding company
and potentially even shareholders,
without regard to the cost to the
FDIC. This practice became
known as too-big-to-fail (TBTF).

The Region

Federal Reserve Bank of Minneapolis
1997 Annual Report

Fixing FDICIA
A Plan to Address the Too-Big-To-Fail Problem

G overnm ent su p p o rt for depositors and other creditors o f failed banks is a tw o-edged
sword. It protects the less sophisticated depositor and helps to prevent banking panics
th at have historically led to econom ic retrenchm ent. But too m uch governm ent protec
tion encourages banks, often the largest in a country, to shift funds into high-risk p ro j
ects th at they w ould n o t otherw ise fund. This effect on banks’ behavior is know n as
m oral hazard and can lead to less productive use o f society’s lim ited resources.
The challenge for policy-m akers is determ ining how m uch protection is too
m uch. U nfortunately, econom ic theory does n o t prescribe an optim al am ount. Theory,
however, does suggest th at 100 percent coverage can lead to excessive risk taking. Yet, by
the 1980s, full protection o f all depositors (and in som e cases other creditors) becam e a
com m on practice and banks behaved as predicted, resulting in one o f the w orst finan
cial debacles in U.S. history.
In 1991, Congress partially fixed the problem o f 100 percent coverage by pass
ing the Federal D eposit Insurance Corp. Im provem ent Act (FDICIA). A m ong other
things, FDICIA substantially increased the likelihood th at uninsured depositors and
other creditors w ould suffer losses w hen their bank fails. The fix was incom plete, how
ever, because regulators can provide full protection w hen they determ ine th at a failing
b an k is too-big-to-fail (TBTF)— th at is, its failure could significantly im pair the rest o f
the in d u stry and the overall economy.
We th in k this TBTF exception is too broad; there is still too m uch protection.
The m oral hazard resulting from 100 percent coverage could eventually cause too m uch
risk taking and p o o r use o f society’s resources. Consequently, we propose am ending

The authors thank Mel Burstein,
Mark Flannery, Ed Green, Jim Lyon,
Gary Stern and Warren Weber for

FDICIA so th at the governm ent cannot fully protect uninsured depositors and creditors

helpful comments. Heidi Taylor Aggeler

at banks deem ed TBTF.

provided helpful research assistance.

The Region

To suggest reform ing o u r banking laws at a tim e w hen ban k failures are a dis
tan t m em ory for m ost m ay seem incongruous. But w aiting could prove costly. The con
tinuing consolidation in banking could lead m ore banks w ith m ore u ninsured deposits
to qualify for TBTF status. In addition, bank powers are expanding and will probably
grow further, so TBTF banks will have m ore activities potentially benefiting from full
protection. Now is also an o p p o rtu n e tim e to am end FDICIA because the robust econ
om y and record bank earnings m ake it easier for banks to absorb the costs o f reform .
O ur proposed reform attacks the problem o f 100 percent coverage head-on by
requiring uninsured depositors o f TBTF banks to bear som e losses w hen their b an k is
rescued. We also recom m end th at regulators treat unsecured creditors w ith depositlike
liabilities the sam e as uninsured depositors, while providing no protection to other
creditors. TBTF banks w ould th en have to pay uninsured depositors and other creditors
higher rates for funds w hen the chance o f bank default increases, thus m uting their
incentive to take on too m uch risk. To further address m oral hazard, we propose th at
the FDIC incorporate the m arket’s assessm ent o f risk, including the rate paid to u n in
sured depositors and other creditors, into insurance assessments.
We recognize th at these reform s, by increasing m arket discipline, will m ake
b an k runs and panics m ore likely. Consequently, we cap the losses th at uninsured
depositors and unsecured creditors w ith depositlike liabilities can suffer. Keeping losses
relatively low also makes o u r plan credible because it elim inates the rationale for fully
protecting depositors after a b an k has failed. In addition, we call for the disclosure o f
m ore supervisory inform ation and provide an incentive for banks to release additional
inform ation in order to help m arket participants evaluate the financial condition of
banks.
We do n o t claim to have struck the perfect balance betw een m arket discipline
and governm ent protection, or to have found the only credible way to increase m arket
discipline, b u t experience and theory cannot justify continuation o f 100 percent p ro
tection. M oreover, alternatives to o u r reform th at rely on regulation or the privatization
o f deposit insurance have m uch m ore serious drawbacks. We also recognize th at o u r
reform is unlikely to be the only action th at Congress will have to take to end 100 p er
cent coverage. Thus, we suggest an additional step th at Congress m ay need to consider
in the future.

Expansion to 100 Percent Coverage and its Danger
Until the financial debacle o f the 1980s, the federal governm ent’s program to stabilize
banks (used broadly to include all insured depositories) had been considered highly sue-

The Region

Fixing FDICIA
The Minneapolis Fed Proposal
To guarantee that uninsured depositors cannot be protected fully under
the too-big-to-fail (TBTF) policy, and to thereby minimize the impact of
the moral hazard problem, Congress should amend the Federal Deposit
Insurance Corp. Improvement Act of 1991 (FDICIA) as follows:

We think that the 100 percent
coverage and the financial
debacle of the 1980s were not
independent events. While other

■ Prohibit the full protection of uninsured depositors and other
creditors when TBTF is invoked.

explanations for the huge number
of bank failures are plausible,
we view too much protection as

■ Incorporate the risk premium that depositors and other creditors
receive on uninsured funds into the assessments on TBTF banks.

a critical underlying cause.
Once its depositors and other
creditors are fully protected, a

■ Require the disclosure of additional data on banks’ financial condition.

bank is likely to take much more
risk than it would otherwise.

cessful. Federal deposit insurance was established in 1933 to protect small depositors and
to prevent the systemwide banking runs that had plagued the U.S. econom y for close to
100 years. These goals were accomplished. Small depositors at failed banks were always
fully protected, and nationw ide banking panics in the United States becam e historical
curiosities.
However, the financial debacle o f the 1980s m ade clear th at depositor protec
tio n — w hich had gone well beyond the small saver— did n o t prevent turm oil in the
banking system. Indeed, betw een 1979 and 1989, 99.7 percent o f all deposit liabilities at
failed com m ercial banks were protected. Yet, roughly 1,000 com m ercial banks still
failed. At about the sam e tim e, while the federal governm ent was insuring nearly all
deposits at savings and loans, over half the industry failed.
This expansion to com plete coverage was the result o f several factors. First, the
coverage rules allowed for m ore protection. The am o u n t insured expressed in 1980 dol
lars had risen from roughly $30,000 in 1934 to $100,000 in 1980 and the FDIC insured

The Region

a w ider range o f deposits (for example, so-called brokered deposits, w hich are funds
th at banks purchase from depositors via a broker). Second, the FDIC chose resolution
techniques for failed banks th at fully protected virtually all uninsu red depositors and,
in m any cases, other unsecured creditors. In fact, in the FD IC ’s 1985 A n n u a l Report, the
chairm an o f the FDIC m ade it an explicit objective o f the standard resolution process
to fully cover all uninsured depositors. Finally, regulators indicated th at they w ould take
extraordinary steps in response to the failure o f a very large bank n o t otherw ise allowed
d uring a standard resolution. Such steps have included full protection for uninsured
depositors and other creditors, as well as suppliers o f funds to the b an k ’s holding com
pany and potentially even shareholders, w ithout regard to the cost to the FDIC. This
practice becam e know n as TBTF and em erged from the 1984 rescue o f C ontinental
Illinois, the seventh largest U.S. bank at the time.
We th in k th at the 100 percent coverage and the financial debacle o f the 1980s
were n o t independent events. W hile other explanations for the huge n u m b er o f bank
failures are plausible, we view too m uch protection as a critical underlying cause.2 Once
FDICIA makes routine, full

its depositors and other creditors are fully protected, a ban k is likely to take m uch m ore

protection of uninsured depositors

risk th an it w ould otherw ise.3 This is especially tru e at banks where owners can diversi

and other creditors at banks

fy their risk o r at banks that are seriously undercapitalized. In effect, it’s heads the bank

more difficult. However, FDICIA

wins and tails the taxpayer loses.

continues to allow full protection
of depositors and other creditors
at banks deemed TBTF.

Policy-makers in Congress and the Treasury D epartm ent recognized the d a n
gers resulting from 100 percent protection and m oral hazard. The Treasury’s recom
m endations for the bank reform legislation in 1991 pointed to the “overexpansion o f
deposit insurance” as a fundam ental cause for the exposure o f taxpayers to “unaccept
able losses.”4 Likewise, in preparing FDICIA, Congress found th at “taxpayers face a bank
fund bailout today prim arily because the federal safety net has stretched too far. FDIC
insures m ore kinds o f accounts th an was originally intended, and also frequently covers
uninsured deposits.”5W ith the recognition, came the legislative response.

FDICIA’s TBTF Policy Falls Short
FDICIA makes routine, full protection o f uninsured depositors an d other creditors at
banks m ore difficult. However, FDICIA continues to allow full protection o f depositors
and other creditors at banks deem ed TBTF.
Reduces Routine, Full Protection fo r U ninsured Depositors. FDICIA creates a new,

“least cost,” resolution process th at makes the FDIC less likely to offer full protection.
U nder the 1991 law, the FDIC m ust consider and evaluate all possible resolution alter-

The Region

Graph 1 Failed Commercial Banks by Uninsured Depositor Treatment
1986-1996
% of Banks (by assets)

100

80
|

Uninsured
Protected

Uninsured
Unprotected

0
1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

Source: Federal Deposit Insurance Corp.

natives and choose the option th at has the lowest cost for the deposit insurance fund.
This requirem ent has led to m any m ore resolutions in w hich acquirers only assum e
insured deposits.
G raph 1 indicates the extent to w hich the FDIC has reduced its coverage o f
u ninsured depositors. In 1986, for example, the FDIC fully protected uninsured depos
itors o f com m ercial banks th at held over 80 percent o f the assets o f all failed banks. In
sharp contrast, in 1995 the FDIC protected no uninsured depositors at failed banks.
W hile there have been only a lim ited n u m ber o f com m ercial bank failures since FDICIA
(about 190 com m ercial banks failed from 1992 to 1996 and none were very large), the
FDIC has established a pattern o f im posing losses on uninsured depositors at small
banks.
Allow s Full Protection a t TB TF Banks. FDICIA contains an exception to allow

100 percent protection. It allows full coverage for depositors and other creditors at
banks deem ed TBTF through a m ultiapproval process. The Secretary o f the Treasury
m ust find th at the lowest-cost resolution w ould "have serious adverse effects on eco
nom ic conditions or financial stability” and th at the provision o f extraordinary cover
age w ould “avoid or m itigate such adverse effects.” The Secretary o f the Treasury m ust

The Region

consult w ith the president in m aking this determ ination. In addition, tw o-thirds o f the
governors o f the Federal Reserve System and tw o-thirds o f the directors o f the FDIC
m ust approve the extraordinary coverage.
W hile these lim itations appear to constrain bailouts, they are n o t prohibitive.
Indeed, Congress appears to have codified, b u t n o t necessarily altered, the inform al res
cue process th at was previously in place. C onsider the 1984 testim ony o f the
C om ptroller o f the C urrency on the decision to bail out C ontinental Illinois:
We debated at som e length how to handle the C ontinental situation. ...
Participating in those debates were the directors o f the FDIC, the C hairm an o f
the Federal Reserve Board, and the Secretary o f the Treasury. In o ur collective
judgm ent, had C ontinental failed and been treated in a way in w hich depositors
and creditors were n o t m ade whole, we could very well have seen a national, if
n o t an international, financial crisis the dim ensions o f w hich were difficult to
im agine. N one o f us w anted to find out.6

Why the Time is Ripe for Fixing FDICIA
O u r rationale for questioning the exception un d er FDICIA is clear. O ne h u n d red p e r
cent protection has proven a high-cost policy. The lack o f m arket discipline u n d er such
a regim e suggests th at the current TBTF exception could encourage excessive risk tak
ing in the future.
The need to fix this aspect o f FDICIA now, however, m ay appear co u n terin tu
itive. The banking industry is enjoying record profits, banks have been able to broaden
the activities from which they can generate revenue and the largest U.S. banks have
grow n to the size th a t som e analysts believe is required to com pete internationally. Yet,
it is these very trends that m ake enactm ent o f o u r reform timely.
More TBTF Banks

M ore large banks controlling a greater share o f uninsured deposits have resulted from
recent bank consolidation. Hence, regulators m ay view m ore banks as requiring TBTF
treatm ent under FDICIA. Consequently, m ore uninsured depositors will assum e th at
their bank is TBTF and their deposits will be protected.
No w ritten list o f the TBTF institutions exists, b u t previous em pirical w ork
used the 11 largest institutions highlighted by the C om ptroller o f the C urrency in his
1984 testimony. Those banks controlled 23 percent o f all assets at the end o f 1983 and
h ad an average size, in 1997 dollars, o f about $94 billion. The 11 largest banks as o f the
end o f 1997 held 35 percent o f all assets and had an average size o f nearly $157 billion.

The Region

The growing n um ber o f large banks also m eans th at the TBTF list m ay have expanded
past the 11-bank list. The sm allest o f the 11 TBTF banks in 1983 had assets o f just over
$38 billion in 1997 dollars. Using $38 billion as a cutoff suggests th at regulators m ay
view depositors at the n ation’s 21 largest banks as benefiting from im plied deposit
insurance (see Table on follo w in g p a g e).
The top 21 banks th at regulators m ay view as TBTF have increased their share
o f u n insured deposits from 30 percent in 1991 to 38 percent in 1997. (The top 50 banks
increased their share from 44 percent in 1991 to 55 percent in 1997.) At the sam e tim e,
total u n insured deposits have increased. Consequently, the taxpayers’ exposure at TBTF
banks has increased significantly since FDICIA.*
More Bank Powers

The need to fix this aspect of
FDICIA now, however, may

Banks are n o t only growing in size, they are growing in powers, th at is, in their ability

appear counterintuitive. The

to offer n o n bank financial services such as the sale and underw riting o f insurance and

banking industry is enjoying

securities. Both the Office o f the C om ptroller o f the C urrency and the Board o f

record profits, banks have been

G overnors o f the Federal Reserve System have expanded the types an d /o r the am o u n t

able to broaden the activities

o f n o n b an k financial activities in w hich banking organizations can participate. Both
regulators also su p p o rt legislation th at expands their n o n b an k financial and com m er

from which they can generate
revenue and the largest U.S.

cial activities (they disagree as to the organizational structure in w hich such powers will
be exercised and the specific type and am o u n t o f new powers m ade available).

banks have grown to the size

E xpanding powers w ould increase the role o f banking organizations in the financial sys

that some analysts believe

tem , m aking it m ore likely th at regulators will consider the failure o f a large institution

is required to compete interna

as destabilizing. For these reasons, we view banking deregulation before deposit in su r

tionally. Yet, it is these very

ance reform as “p utting the cart before the horse,” a view long held by researchers at the

trends that make enactment of

Federal Reserve Bank o f M in n eap o lis.7

our reform timely.

More Bank Profits

The m ost extensive reform s to the bank regulatory system have occurred after or d u r
ing banking crises. A lthough som e o f these reform s were well-conceived, good tim es

* In addition to potentially m ore TBTF banks, recent research suggests that large banks have no t reduced
their exposure to a significant risk since FDICIA. Specifically, the largest 10 percent o f publicly traded
bank holding companies had significant interest-rate risk b oth before and after FDICIA. If FDICIA had
reduced the interest-rate risk that large banks are taking, the relationship between interest-rate move
m ents and bank stock prices should no t be as strong after FDICIA as before it. Instead, the research finds
no decline in the level of interest-rate risk at large banks since FDICIA. See David E. Runkle, “Did
FDICIA Reduce Bank Interest-Rate Risk?” Working Paper, Federal Reserve Bank o f Minneapolis,
December 1997.

The Region

TBTF Banks Have Increased in Size and May Have
Increased in Number
In 1984 congressional testimony, the C om ptroller o f the C urrency suggested th at
the 11 largest banks were TBTF. As o f year-end 1997, the banks in the right
colum n exceeded the m in im u m size required— $38.2 billion— to m ake the
C om ptroller’s TBTF list.

Assets as of 12/83 (billions of $)

Assets as of 12/97 (billions of $)

1983 Dollars

1997 Dollars

$113.4

$182.1

2 Bank of America

109.6

178.0

2 Citibank

262.5

3 Chase Manhattan

79.5

127.6

3 Bank of America

236.9

4 Manufacturers Hanover

58.0

93.1

4 NationsBank

200.6

5 Morgan Guaranty

56.2

90.2

5 Morgan Guaranty

196.7

6 Chemical

49.3

79.1

6 First Union

124.9

7 Continental

40.6

65.2

7 Bankers Trust

110.0

8 Bankers Trust

40.1

64.4

8 Wells Fargo

89.1

9 Security Pacific

36.0

57.9

9 PNC

69.7

10 First Chicago

35.5

57.0

10 KeyBank

69.7

11 Wells Fargo

23.8

38.2

11 U.S. Bank

67.5

12 BankBoston

64.9

13 Fleet

63.8

14 NationsBank (TX)

60.0

15 First Chicago

58.4

16 Bank of New York

56.1

17 Wachovia

51.6

18 Republic

50.2

19 CoreStates

45.4

20 Barnett

42.8

21 Mellon

38.8

1 Citibank

Source: Consolidated Reports of Condition and Income

1997 Dollars

1 Chase Manhattan

$297.0

The Region

present a superior tim e for action for at least two reasons. First, we should p u t deposi
tors and other creditors at risk now precisely to avoid a future debacle. Second, a reform
m ay p u t institutions in a weaker financial position by increasing their cost o f funds. We
should, therefore, enact reform s w hen banks have m ore resources to absorb the higher
costs.

Putting Uninsured Depositors and Other Creditors
of Large Banks at Risk
We propose th at Congress am end FDICIA so th at uninsured depositors cannot be p ro
tected fully w hen a troubled bank is rescued un d er the TBTF policy. Congress can
im plem ent this reform in several ways described below, b u t the basic idea is to require
som e form o f coinsurance— the practice o f leaving some risk o f loss w ith the protected
party. Regardless o f the form ulation, we think all uninsured depositors should be sub
ject to the same coinsurance plan, including banks w ith uninsured deposits at their cor
respondent. In addition, we propose treating unsecured creditors holding bank
liabilities th at have depositlike features the same as uninsured depositors. Also, we p ro
pose th at the coinsurance plan under a TBTF bailout be phased in over several years to
avoid any ab ru p t change in policy.
O u r other key recom m endation is for regulators to incorporate a m arket
assessm ent o f risk in the pricing o f deposit insurance. In particular, after im plem enta
tion o f this proposal, we recom m end th at regulators include the risk prem ium deposi
tors and other creditors receive on uninsured funds in the assessments on TBTF banks.
Lastly, to help uninsured depositors and other creditors m o n ito r and assess
b an k risk, we propose th at regulators disclose additional data on banks’ financial con
dition. We th in k th at banks will have an incentive under o u r proposal to disclose addi
tional in form ation th at the m arket requires. Regulators should consider m andated,
cost-effective disclosures only if voluntary release does n o t occur.
Coinsurance under TBTF

To address the potential problem s created by 100 percent coverage un d er the TBTF
exception, we tu rn to the conventional technique th at private insurance com panies have
used to m itigate m oral hazard. Analysis identified coinsurance about 30 years ago as a
prim ary m eans for insurance underw riters to com bat m oral hazard.8 In th a t vein, we
propose that uninsured depositors and other creditors face a sm all b u t m eaningful loss
when regulators exercise the TBTF policy.

Congress could form ulate a coinsurance policy in several ways. A simple

The Region

approach w ould set a “m axim um loss rate” th at uninsured depositors could face, say at
20 percent, and phase it in over tim e. Congress could set an initial, m axim um 5 percent
loss and have it rise 5 percentage points a year for the following three years. U nder the
m axim um loss rate approach, uninsured depositors w ould receive no protection if they
w ould suffer losses o f less than 20 percent o f their uninsured deposits, for example, after
they receive proceeds from the liquidation o f failed bank assets. This approach m ay be
objectionable if the rate is set so high as to effectively elim inate TBTF coverage. To
address this, the m axim um loss rate could be lowered or Congress could apply the coinsurance rate to the loss th at uninsured depositors w ould have faced if the FDIC did
n o t protect uninsured depositors. This “loss reduction rate” w ould ensure th at u n in
sured depositors always receive som e coverage above w hat they w ould have received
from the liquidation of the failed bank’s assets.* In 1990, the A m erican Banker’s
We cap the losses that uninsured
depositors and unsecured credi
tors with depositlike liabilities

Association proposed a coinsurance form ulation som ew hat sim ilar to the loss reduction
approach for elim inating 100 percent coverage at TBTF banks.
Congress m ust address a critical trade-off w hen choosing a coinsurance policy.

can suffer. Keeping losses rela

T he potential loss should be set high enough so th at uninsured depositors will be

tively low also makes our plan

induced to m o n ito r the financial condition o f their bank, b u t n o t so high as to elim i

credible because it eliminates

nate the stabilizing benefits o f governm ent protection. Certainly, the details o f a co-

the rationale for fully protecting
depositors after a bank has
failed.

insurance policy under this m axim will always be som ew hat arbitrary. However,
policy-m akers do n o t escape the difficult decision o f determ ining how m uch m arket
discipline to im pose on depositors by m aintaining the status quo.
The TBTF exem ption in FDICIA should also n o t allow full coverage o f all unse
cured creditors o f failed banks. Indeed, Congress recently indicated a preference for
im posing post-resolution losses on such creditors by passing a national depositor pref
erence statute in 1993 (which p u t unsecured creditors further back in the queue for
receiving revenue realized from the resolution o f a failed in stitu tio n ). In scaling back
potential coverage for unsecured creditors, we think Congress m u st address the same
critical trade-off it faces w hen p u ttin g uninsured depositors at risk. Thus, we recom
m end th a t unsecured creditors holding depositlike bank liabilities should face the same
coinsurance policy as uninsured depositors. All other unsecured creditors should
receive no special coverage. This form ulation w ould protect, for example, holders o f
' An example where an uninsured depositor suffers a $10,000 loss clarifies the difference in the two
approaches. A 20 percent rate under the m axim um loss form ulation would provide no insurance if the
$10,000 loss is less than 20 percent of the depositor’s total uninsured deposits and complete coverage for
any losses above 20 percent. In contrast, a 20 percent coinsurance rate under the loss reduction form ula
tion would reduce a $10,000 post-liquidation loss to $2,000.

The Region

The most extensive reforms to
the bank regulatory system have
occurred after or during banking
crises. Although some of these
reforms were well-conceived,
good times present a superior
time for action.

The Region

very short m aturity bank liabilities like the overnight loans banks m ake to each other,
certain com m ercial paper and foreign deposits b u t n o t holders o f longer-term liabilities
or claims arising from the provision o f services or court judgm ents.
Incorporating R isk into Insurance Assessm ents

P rior to 1993, the FDIC charged all banks the same assessm ent for deposit insurance
regardless o f their risk o f m aking a claim against the insurance fund. Banks did n o t face
the cost o f excessive risk taking because the insurer— like the depositor w ith 100 percent
insurance coverage— did n o t charge risk penalties w hen the probability o f ban k failure
increased.
FDICIA required the FDIC to create a system o f risk-based insurance assess
Policy-makers do not escape the

m ents because a flat-rate assessm ent encourages excessive risk taking. The initial risk-

difficult decision of determining

based assessments tu rn ed o u t to be too high for low -risk banks and too low for the

how much market discipline
to impose on depositors by
maintaining the status quo.

highest-risk banks.9 R ather th an correcting this failure, the FDIC was, in essence, forced
back to flat-rate assessments (due to restrictions on the insurance reserves it can hold).
Since 1996 over 90 percent o f banks have paid the statutory m in im u m assessment,
w hich has fallen from $2,000 per year to zero.
The problem here is that, even if uninsured depositors and o ther creditors have
the potential for bearing losses, TBTF banks m ay still take on too m uch risk if insurance
assessments are n o t risk-based. This occurs because taxpayers w ould continue to bear
som e o f the banks’ risk. Thus, we recom m end th at any FDICIA reform to elim inate the
potential for 100 percent coverage at large banks be accom panied by efforts to make
their assessments m ore sensitive to risk.
To this end, we recom m end m arket-based, risk-adjusted insurance assessments
for TBTF banks. We suggest th at the FDIC include the risk prem iu m im plicit in rates
paid on uninsured deposits (as well as other m arket m easures o f risk) into insurance
assessments for the largest banks. The FDIC, for example, could charge the largest banks
w ith a risk prem ium above policy-m akers’ com fort level, say th at on the A -rated co rp o
rate bond, m uch higher assessments in order to halt exploitation o f insured status.
Alternatively, the FDIC could incorporate the risk prem ium m ore gradually so in su r
ance assessments rise or fall increm entally w ith changes in the risk prem ium .
Proposals to incorporate risk prem ium s on uninsured deposits into FDIC
assessments date at least as far back as 1972. Critics o f this reform usually argue th at
depositors and other m arket participants will n o t price risk correctly, either because
they believe they will receive a bailout or because they do n o t have adequate in fo rm a
tion. As a result, assessments based on m arket risk prem ium s will n o t accurately price

The Region

risk. O u r proposal makes clear th at uninsured depositors cannot receive full protection.
Recent em pirical reviews find th at suppliers o f funds to banks charge risk prem ium s if
they will, in fact, face losses w hen their bank defaults.10 As for the lack o f inform ation
ab out banks’ behavior tow ard risk, we add one additional reform to o u r proposal.
More D isclosure

The m ore inform ation depositors and o ther creditors have on the financial and opera
tional condition of their bank, the m ore the risk prem ium on uninsured deposits and
other ban k funding will reflect tru e underlying risk. Thus, we recom m end ensuring that
m arket participants have data th at m ake the financial condition o f banks less opaque.
Regulators, for example, receive nonpublic inform ation on loans w ith late
repaym ents th at could be m ade public along w ith other inform ation or assessments that
regulators gather o r produce. Some o f this data m ay contain new inform ation for m a r
ket participants, and disclosure o f such inform ation m ay im prove the ability o f funders
to evaluate their banks.11
Banks will have an incentive under o u r proposal to reveal m ore inform ation
ab out their business. The m ore germ ane data banks provide, the less opaque they are
and the lower the interest rate they will have to pay uninsured depositors. Regulators
should consider requiring cost-effective disclosure only if banks do n o t voluntarily dis
close the inform ation th at m arkets need to properly assess b an k financial condition.
O f course every uninsured depositor does n o t have the sam e skills o r desire to
analyze disclosures provided by banks and regulators. But existing firms, and firms that
will develop in the future, will surely provide analysis o f banks’ condition for uninsured

We recommend that any FDICIA
reform to eliminate the potential
for 100 percent coverage at large

depositors just as specialized firm s provide evaluations o f m utual funds and the claims-

banks be accompanied by efforts

paying ability o f insurance firms. The lack o f interest in bank conditions currently m a n

to make their assessments more

ifested by uninsured depositors and the absence o f firm s providing evaluations o f banks

sensitive to risk.

for these depositors reflect current incentives, n o t innate features o f the h u m an or busi
ness condition.

Addressing the Fundamental Trade-off
We began this essay noting th at deposit insurance is a tw o-edged sword. O n the one
hand, it protects the small saver and lim its the probability o f banking panics. O n the
o ther hand, too m uch deposit insurance leads banks to take on m ore risk th an they
w ould otherwise. All deposit insurance systems m ust face this fundam ental trade-off.
O ur plan clearly adds m arket discipline. It also addresses the concern o f
increased instability in four ways.

The Region

First, we p u t only a small percentage o f uninsured depositors and other credi
tors’ funds at risk. Lim iting the am o u n t o f the potential loss should help contain
spillover effects from any one large bank failure to other banks and the rest o f the econ
omy. A bank th at has uninsured deposits at a large failing bank, for example, is n o t like
ly to suffer losses so great as to b an k ru p t it. Thus, depositors do n o t have cause to ru n
all banks w ith deposits at large failing institutions for fear o f interbank exposure.12
Moreover, the small potential loss makes it less likely th at the benefit o f pulling deposits
out o f a bank will outweigh the costs o f m aking alternative investm ents.
Second, our reform should increase the inform ation th at m arkets have on
Can we guarantee that our
plan achieves the right balance?
No reform plan can make such
a c la im .... But one cannot
reasonably judge the plan’s
potential costs in the abstract.
Rather, interested parties must
compare this proposal to the
current system and alternative
proposals.

banks’ financial condition. D epositors are less likely to ru n sound banks if they are m ore
transparent.
Third, by increasing m arket discipline, we m ake it m ore likely th at banks will
n o t take excessive risk.
Finally, we call for a gradual increase in the coinsurance rate. Policy-makers and
analysts will have tim e to review the response o f depositors and o ther creditors and
adjust the rate. Likewise, incorporating a m arket-based risk prem ium into the insurance
assessm ent need n o t occur at once.
Can we guarantee th at o u r plan achieves the right balance? No reform plan can
m ake such a claim. We m ay have too m uch or too little o f uninsu red depositors’ funds
at risk. U nder o u r plan, uninsured depositors at risk o f loss m ight pull their funds from
all large banks regardless o f their solvency. But one cannot reasonably judge the plan’s
potential costs in the abstract. Rather, interested parties m ust com pare this proposal to
the current system and alternative proposals.
Alternative Proposals

Some analysts have argued th at FDICIA’s regulatory reform s— in conjunction w ith
existing m arket discipline provided by stockholders, bondholders and bank m anagers
fearing for their jobs— adequately address the potential problem s th at 100 percent cov
erage at TBTF banks can create. Yet, as we noted, stockholders are the beneficiaries o f
excessive risk taking and are unlikely to act as a bulw ark against it. M oreover, experience
over the last 15 years suggests to us th at these other sources o f m arket discipline are n o t
sufficient to control the deleterious effects o f m oral hazard. A nd while the FDICIA reg
ulatory reform s were a step in the right direction, reviews o f these changes do n o t sug
gest th at they adequately curtail risk taking.13 Moreover, we are skeptical th at additional
regulations can effectively substitute for putting uninsured depositors and o ther credi
tors at risk. Certainly, prom ulgating D raconian regulations could prevent the problem s

The Region

Under our proposal, uninsured
depositors at banks deemed
TBTF cannot be fully protected.
The potential loss to uninsured
depositors should be set high
enough so that they w ill be
induced to monitor the financial
condition of their bank.

The Region

Our reform is unlikely to be the

arising from 100 percent coverage, b u t such a strategy w ould im pair the ability o f the

last that Congress w ill need

banking system to efficiently allocate financial resources.

to pass. However, the potential
for future reform should not
dissuade policy-makers from

Elim inating federal deposit insurance altogether offers an o th er alternative for
addressing the m oral hazard o f 100 percent coverage at the largest banks. We do n o t find
this reform credible. Banking panics were n o t elim inated in the U nited States un d er p ri
vate deposit insurance systems. Consequently, it is likely th at banking regulators, in

using the current window of
opportunity to avoid the mistakes
of the past.

order to address the threat o f such panics, w ould still w ant to fully protect depositors at
large failing banks after privatization. Thus, the public w ould still assum e th at their
deposits are fully protected at banks considered TBTF and m oral hazard w ould still
rem ain a problem .
In contrast to privatization options, we view reform s requiring TBTF banks to
hold subordinated debt as differing from o u r ow n in im plem entation detail rather th an
intent or substance.14Both plans seek to increase m arket discipline by p u ttin g those who
supply funds to TBTF banks at risk, and b o th allow the FDIC to incorporate ad d itio n
al m arket data into their assessm ent-setting process. And, like o u r plan, credible su b o r
dinated debt reform s m ust address the trade-off betw een depositor safety and b an k risk.
Further Reform

U nfortunately, our proposed reform will alm ost certainly n o t be the final action th at
Congress m ust take to elim inate 100 percent coverage. For example, uninsured deposi
tors m ay divide their funds into m ultiple insured accounts in order to avoid the p o ten
tial for loss. In response, Congress m ay have to curb the ability o f depositors to receive
m ore th an $100,000 in insurance coverage thro u g h m ultiple accounts, or apply a coinsurance policy to all deposits.

A Unique Opportunity
Econom ic theory and experience b o th suggest th at providing 100 percent governm ent
protection for bank depositors and other creditors can be extrem ely costly. O ne h u n
dred percent coverage quashes m arket discipline, encourages banks to take on too m uch
risk and can massively misallocate society’s lim ited resources. It can lead to the very type
o f bank failures and costs to society th at deposit insurance aim s to prevent. These costs
are so high th at Congress should prohibit bank regulators from providing 100 percent
coverage as is currently allowed at the n ation’s largest banks. We th in k th at a credible
reform is to am end FDICIA so th at uninsured depositors and other creditors cannot be
fully protected under the TBTF exception b u t do n o t suffer losses so large as to elim i
nate the stabilizing benefits o f governm ent protection. In anoth er step necessary to

The Region

address m oral hazard, we recom m end th at the FDIC use m arket signals, from at-risk
depositors and other available sources, to m ake insurance assessments o f TBTF banks
risk-related.
O u r reform is unlikely to be the last th at Congress will need to pass. However,
the potential for future reform should n o t dissuade policy-m akers from using the cu r
rent w indow o f o p p o rtu n ity to avoid the m istakes o f the past. The FDIC sought to
increase depositor discipline in the early 1980s through a resolution m ethod, called
m odified payoff, in w hich uninsured depositors w ould receive no extraordinary cover

Congress can now establish a

age, b u t rather a p ro p o rtio n o f their m oney based on the liquidation value o f the bank’s

commitment in law to impose

assets. The FDIC had “experim ented” w ith the m ethod and “hoped to expand the m o d
ified payoff to all banks regardless o f size.”15 But the failure o f C ontinental soon after the
pilot program began led to its demise. Now, Congress can establish a com m itm ent in
law to im pose losses on uninsured depositors and other creditors at banks deem ed

losses on uninsured depositors
and other creditors at banks
deemed TBTF. Without such a

TBTF. W ithout such a credible com m itm ent, Congress m ay find itself in the u n co m

credible commitment, Congress

fortable position o f conducting the p o st-m ortem o f another financial debacle.

may find itself in the uncomfort

able position of conducting the
post-mortem of another financial
debacle.

The Region

Notes

1Moyer, R. Charles, and Lamy, Robert E. 1992. Too Big To Fail: Rationale, Consequences, and
Alternatives. Business Economics 27 (3): 19-24.
2Alternative explanations are found in John H. Boyd and Arthur J. Rolnick. 1989. A Case for
Reforming Federal Deposit Insurance. 1988 Annual Report. Federal Reserve Bank of
Minneapolis.
3 Kareken, John H., and Wallace, Neil. 1978. Deposit Insurance and Bank Regulation: A PartialEquilibrium Exposition. Journal o f Business 51 (3): 413-438.
4 U.S. Treasury. 1991. Modernizing the Financial System: Recommendations for Safer, More
Competitive Banks. Washington, D.C.: Department of the Treasury, pp. 8-10.
5 House Report 102-330 (November 19, 1991). US Code Congressional and Administrative News,
vol. 3, 102nd Congress, First Session, 1991, p. 1909.
6 Inquiry Into Continental Illinois Corp. and Continental Illinois National Bank. Hearings
Before the Subcommittee on Financial Institutions, Supervision, Regulation and Insurance of
the House Committee on Banking Finance and Urban Affairs, September 18, 19 and October
4, 1984, p p. 287-288.
7 Kareken, John H. 1983. Deposit Insurance Reform or Deregulation Is the Cart, Not the Horse.
Federal Reserve Bank o f Minneapolis Quarterly Review 1 (Spring): 1-9.
8 Dionne, Georges, and Harrington, Scott (eds.). 1992. Foundations o f Insurance Economics:
Readings in Economics and Finance. Boston: Kluwer Academic Publishers, p. 2.
9 Fissel, Gary S. 1994. Risk Measurement, Actuarially-Fair Deposit Insurance Premiums and the
FDIC's Risk-Related Premium System. FDIC Banking Review 7 (Spring/Summer): 16-27.

l0Flannery, Mark J., and Sorescu, Sorin M. 1996. Evidence of Bank Market Discipline in
Subordinated Debenture Yields: 1983-1991. Journal o f Finance 51 (4): 1347-1377.
"DeYoung, Robert; Flannery, Mark; Lang, William; and Sorescu, Sorin. 1998. Could Publication
of Bank CAMELS Ratings Improve Market Discipline? Manuscript.
12An alternative method for limiting the potential of one bank's failure to spill over to another
focuses on the payment system. Hoenig, Thomas M. 1996. Rethinking Financial Regulation.
Federal Reserve Bank o f Kansas City Economic Review 81 (2): 5-13.
13See Jones, David S., and King, Kathleen Kuester. 1995. The Implementation of Prompt
Corrective Action: An Assessment. The Journal o f Banking and Finance 19 (3-4): 491-510 and
Peek, Joe, and Rosengren, Eric S. 1997. Will Legislated Early Intervention Prevent the Next
Banking Crisis? Southern Economic Journal 64 (1): 268-280 for reviews of Prompt Corrective
Action.
14See Calomiris, Charles W. 1997. The Postmodern Bank Safety Net: Lessons from Developed and
Developing Economies. Washington, D.C.: American Enterprise Institute for Public Policy
Research for an example of a subordinated debt plan.
15Federal Deposit Insurance Corp. 1997. History o f the Eighties: Lessons for the Future. Volume I,
An Examination of the Banking Crises of the 1980s and Early 1990s. Washington, D.C.: FDIC,
pp. 236 and 250.

The Region

Full text of Annual Report of the Federal Reserve Bank of Minneapolis : 1997 Annual Report : Fixing FDICIA: A Plan to Address the Too-Big-To-Fail Problem

FRASER