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Business
Review
Federal Reserve Bank o f Philadelphia
S e p te m b e r • O c to b e r 1 9 9 0

ISSN 0 0 0 7 -7 0 1 1

Should States Fear the Effects of a Changing Dollar?
Gerald A. Carlino

Curing Our Ailing Deposit-Insurance System
Loretta J. Mester

SEPTEMBER/OCTOBER 1990

SHOULD STATES FEAR THE EFFECTS
OF A CHANGING DOLLAR?
The BUSINESS REVIEW is published by the
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Gerald A. Carlino
Movements in exchange rates can have
differential—and at times significant—effects
on state economies. But no matter what
they do, policymakers at the state and local
levels cannot influence exchange rates di
rectly. What they can influence is some
thing else that affects a state's international
competitiveness: the productivity of its
workers. A recent study by the Philadel
phia Fed shows that the effect of changes in
U.S. productivity relative to foreign pro
ductivity has been quite large for many
states.

CURING OUR AILING
DEPOSIT-INSURANCE SYSTEM
Loretta J. Mester
The savings and loan debacle brought to
light, as never before, the problems with
our system of federal deposit insurance.
The Treasury Department is studying these
problems, and regulators, trade groups, and
private economists have offered their own
proposals for reforming the system. The
more radical proposals suggest taking
deposit insurance out of the federal govern
ment and putting it in the hands of private
insurers. The rest, however, focus on the
fundamental flaws of the current system
and on what can be done to repair it.

FEDERAL RESERVE BANK OF PHILADELPHIA

Should States Fear the Effects
of a Changing Dollar?
Gerald A. Carlino*
ince the introduction of flexible exchange
rates in August 1971, economists have
sought to measure the effects of a changing
dollar on the national economy. Recently, they
have given some attention also to the effects a
changing dollar has on the economic activity of
states and regions.
Movements in exchange rates can have dif
ferent effects across states for several reasons.
Some states specialize in the production of
certain goods. Some make goods that are more
exportable than others. And some are better

^Gerald A. Carlino is a Senior Economist and Research
Adviser in the Urban and Regional Section of the Philadel
phia Fed's Research Department.

positioned geographically for foreign trade.
According to recent studies, movements in the
exchange rate appear to have their largest ef
fects on states in the East North Central, West
North Central, and Mountain regions.
Policymakers at the state and local levels
cannot affect exchange rates directly. They
can, however, influence other things that affect
a state's international competitiveness. One is
the productivity of a state's workers. A recent
study has shown that the effect of changes in
U.S. productivity relative to foreign productiv
ity has been quite large for many states.
States often have focused attention on at
tracting foreign investment, promoting exports,
and lobbying for protection from international
3

BUSINESS REVIEW

competition. This new study suggests that
state governments can also improve their for
eign competitiveness by adopting policies that
increase the productivity of their firms.

HOW EXCHANGE RATE MOVEMENTS
AFFECT A COUNTRY'S NET EXPORTS
The nominal exchange rate is one currency's
price in terms of another—for example, 1.5
German marks per U.S. dollar.1 When the
dollar appreciates in value— rising to, say, 2.0
marks—people need fewer dollars to buy a
given number of marks. In the U.S., German
goods become relatively less expensive than
comparable goods made in the United States,
and imports from Germany rise. Meanwhile,
in Germany, U.S. goods become relatively more
expensive than German goods, and imports
from the U.S. fall.2
The reverse happens when the dollar depre
ciates in value against the mark. People need
more dollars to buy marks. In the U.S., German
goods become relatively more expensive than
comparable U.S. goods, and imports from Ger
many decline. Meanwhile, in Germany, U.S.
goods become relatively cheaper than German
goods, and imports from the U.S. increase.
By itself, however, the nominal exchange
rate does not necessarily indicate how much
more (or less) expensive U.S. goods will be
relative to foreign goods. If the dollar is appre
ciating at a time when inflation rates are higher
in foreign countries than in the U.S., then some
of the dollar's appreciation will merely be com
pensating for the higher inflation abroad.
Economists have developed the notion of
the real exchange rate to measure a country's

E xcep t for the dollar/pound exchange rate, most ex
change rates are expressed as units of foreign currency per
dollar.
2This assumes that the home-currency prices of U.S.produced goods relative to foreign-produced goods remain
unchanged.

Digitized4 FRASER
for

SEPTEMBER/OCTOBER 1990

competitiveness in world trade. The real ex
change rate is the nominal exchange rate ad
justed for the price level across countries.3
Productivity Differences Matter. Among
other things, relative inflation rates can be in
fluenced by changes in productivity levels across
countries. When U.S. productivity increases,
U.S. firms can produce more units of output
with the same number of worker-hours, and
the average cost of production falls, or at least
rises less than it would have if productivity
had not increased. The higher productivity
leads to an increased supply of U.S. goods and
thus to a lower price (or at least a smaller
increase in price) both at home and abroad.
If productivity levels in other countries remain
the same, or increase at a slower rate than in the
U.S., then the prices of U.S. goods compared to
foreign goods will fall at home and abroad.
The relatively lower prices of U.S. goods abroad
lead to higher U.S. exports to foreign countries.
And in the U.S., the relatively lower prices of
domestic goods lead to what is called import
substitution, the substituting of domestic goods
for imported goods. With fewer foreign goods
being imported and more U.S. goods being
exported, net exports increase.4*

3In the long run, any change in relative prices may be
offset by changes in the nominal exchange rate that keep the
real exchange rate constant. According to the purchasingpower-parity (PPP) doctrine, a country's exchange rate is
linked closely to the ratio of domestic prices to foreign
prices. If domestic prices rise more than foreign prices, the
home nation's currency should depreciate proportionally.
There is some debate about whether deviations from PPP
are in fact temporary. The evidence suggests, however, that
if PPP holds, it is a long-run proposition. See J.A. Whitt,
"Purchasing-Power Parity and Exchange Rates in the Long
Run," Federal Reserve Bank of Atlanta Economic Review
(July/August 1989) pp. 18-32.
4For an extended discussion of the effects of changes in
productivity on the market for foreign trade, see J.A. Tatom,
"The Link Between the Value of the Dollar, U.S. Trade and
Manufacturing Output: Some Recent Evidence," Federal
Reserve Bank of St. Louis Review (November/December
1988) pp. 24-37.

FEDERAL RESERVE BANK OF PHILADELPHIA

Should States Fear the Effects of a Changing Dollar?

REGIONS ARE AFFECTED BY CHANGES
IN REAL EXCHANGE RATES
Many studies have looked at the effects of
real exchange rates on the national economy,
but far less is known about their effects on U.S.
states and regions. The few regional studies
that have been conducted find that the effects
of a changing dollar are uneven across states
and regions. Two factors that matter are a
state's location and its industry mix.
Geographic Proximity. States that are geo
graphically close to a major U.S. trading part
ner may have a relatively larger share of their
total trade with this particular country. Inter
national evidence shows that a country first
establishes trade relations with bordering
countries. Not only are transportation costs
lower, but more information is generally avail
able about these countries, and the historical
and cultural ties are closer.5 In many instances,
this may also be true for regions within a
country. A region will tend to have relatively
more information and closer ties—and hence a
relatively larger share of total trade— with the
foreign country closest to it.
If there are transportation costs associated
with the shipping of goods between U.S. and
foreign markets, goods may become more
expensive for the states furthest from foreign
markets. This is particularly true for goods,
such as wheat, that have a low value per pound.
For these goods, transport costs will be a larger
portion of the delivered price than will be the
case when a high-value-per-pound good, such
as computer chips, is shipped the same dis
tance.
In a study conducted at the Kansas City Fed,
Tim Smith finds that regional export relation
ships are determined largely by geographic

5See Irving B. Kravis and Robert E. Lipsey, "The Loca
tion of Overseas Production and Production for Export by
U.S. Multinational Firms," Journal o f International Economics
12 (1982) pp. 201-23.

Gerald A. Carlino

proximity to trading partners. Smith looked at
nine U.S. regions' shares of manufactured exports
to the nation's top 10 export destinations in
1987. The regions were chosen by grouping
states with similar manufacturing activity and,
where possible, by grouping states according
to proximity to major ports. He found that the
Great Lakes states ship around 50 percent of
their manufacturing exports to Canada, while
the average for the U.S. as a whole is just over
23 percent. To Mexico go about 28 percent of
the Southwest states' share of manufactured
exports, compared with just 6.2 percent for the
nation. The Rocky Mountain states ship 20
percent, and Western states about 21 percent,
of their manufactured exports to Japan, com
pared with about 10 percent for the nation.6
*
Since the states differ in their amount of
trade with particular countries, some have been
much more affected by real exchange rate
declines than others. For example, in recent
years the dollar has fallen more against the
Deutsche mark, the British pound, and the
Japanese yen than it has against the Canadian
dollar. According to Smith's findings, other
things equal, states that export mainly to Eu
rope or Japan would have been affected more
by changing exchange rates than have those
states that export mainly to Canada.
Industry Mix. Some sectors, such as agri
culture and manufacturing, are more exposed
to exchange rate swings than others, either be
cause their industries export more of their
output to other countries or because their
products are easily substituted for foreign prod

6See T.R. Smith, "Regional Exports of Manufactured
Products," Federal Reserve Bank of Kansas City Economic
Review (January 1989) pp. 21-31. Smith also finds evidence
that manufactured exports make varying contributions to
personal income across regions. Manufactured exports as a
percentage of personal income ranged from highs of 6.2
percent in the Southwest and 5.9 percent in the West to a
low of 2.7 percent in the Rocky Mountain states. Thus,
location may be a factor in the foreign sector's total effect on
a region's economy.

BUSINESS REVIEW

ucts. And even within these sectors, some
industries are more exposed than others. Among
manufacturing industries, for example, pro
ducers of durable goods are more export-ori
ented than producers of nondurable goods.
Looking at exchange rate effects by indus
try, Dallas Fed researchers Michael Cox and
John Hill calculated the effects of dollar depre
ciation between March 1985 and June 1987 for
various U.S. manufacturing industries.7 They
found that individual industries were affected
far differently by the dollar's fall. When weighted
to reflect a state's industrial mix, the industry
responses indicated the degree to which a lower
dollar affects a state's manufacturing output.
The results showed manufacturing production
gains in much of the Northeast, the upper
Midwest, and the West exceeding the national
average. Below-average production gains were
found for most of the South Atlantic, the South
Central, and the Northern Plains states.

CAN THE EFFECTS ON STATES
BE ESTIMATED DIRECTLY?
As much as the two Fed studies reveal about
the state and regional effects of exchange rate
movements, they provide no direct estimates
of how much a state's output or employment
will change as a result. Only recently have
economists attempted to estimate these effects
directly.
Using a statistical (multiple regression)
analysis, William Branson and James Love
consider what effect the dollar's 1980-85 ap
preciation had on state manufacturing employ
ment. They found that 35 states responded
significantly to changes in exchange rates ad
justed for unit labor costs and that the dollar's
rise was a major cause of job losses in the Great

7SeeM .W .Coxand J.K. Hill, "Effects of the Lower Dollar
on U.S. Manufacturing: Industry and State Comparisons,"
Federal Reserve Bank of Dallas Economic Review (March
1988) pp. 1-9.

Digitized 6 FRASER
for

SEPTEMBER/OCTOBER 1990

Lakes states, from Ohio westward, and in the
central states.8
But in addition to direct effects on manufac
turing employment, there are indirect effects to
consider. When manufacturing employment
falls because of dollar appreciation, for in
stance, the incomes of manufacturing workers
decline, and this has a multiplier effect on state
output. Moreover, little is known about the
international exports of industries other than
manufacturing, such as financial services, and
the effects of import substitution on a state's
output. And finally, a state's output can be
affected by subcontracting on export orders
received by other states. For example, auto
companies in Michigan could hire New York
advertising firms to help boost sales abroad.

Relating State GSP to Exchange Rates and
Productivity. An aggregate measure of state
production, such as gross state product (GSP),
captures both the direct and indirect effects of
exchange rate movements. A Philadelphia Fed
study, by Gerald Carlino, Brian Cody, and
Richard Voith, looks at GSP growth to assess
what effect changes in real exchange rates had
on the 48 contiguous states during the period
1973-86.9 The authors relate growth in GSP to
changes in the real exchange rate, to growth of
foreign income, to growth of U.S. income, and
to relative growth in foreign productivity (in
other words, growth in foreign manufacturing

8By adjusting for unit labor costs, Branson and Love's
exchange rate variable combines the effects of changes both
in exchange rates and in foreign productivity relative to U.S.
productivity. See W.H. Branson and J.P. Love, "The Real
Exchange Rate and Employment in U.S. Manufacturing:
State and Regional Results," National Bureau of Economic
Research, Working Paper 2435 (November 1987).
9Unlike Branson and Love, Carlino, Cody, and Voith
separate the effects on GSP growth of changes in the real ex
change rate and in foreign productivity relative to domestic
productivity. See G.A. Carlino, B. Cody, and R. Voith,
"Regional Impacts of Exchange Rate Movements," Regional
Science Perspectives 20 (1990) pp. 89-102.

FEDERAL RESERVE BANK OF PHILADELPHIA

Gerald A. Carlino

Should States Fear the Effects of a Changing Dollar?

productivity relative to growth in U.S. manu
facturing productivity).1
0
States respond differently to changes in
exchange rate movements and to changes in
relative growth in foreign productivity. The
size of the state's response depends on its
sensitivity to changes in both variables, as well
as on the extent of such changes. Moreover,
state growth responds to changes in exchange
rates and in the relative growth of foreign
productivity in the current year, as well as to
changes in these variables in the previous year.
Over the period covered by the study, the
relative growth of foreign productivity had a
bigger effect on a state's economy than did the
change in the dollar's value (after controlling
for changes in relative productivity growth).
First, GSP growth responds more to changes in
the former than the latter. Second, relative
foreign productivity changed more than the
exchange rate during the 1972-86 period. The
dollar's trade-weighted value, though subject
to short-run swings, appreciated only 2.7 per
cent between 1972 and 1986 (Figure 1).
During the same period, however, the growth
of foreign productivity greatly exceeded the
growth of U.S. productivity. In 1972, foreign
manufacturing workers were only 61 percent
as productive as American workers, but by
1986 this ratio had increased to 76 percent—an
increase of 24.5 percent, or about 1.6 percent
per year. In the period 1972-84, U.S. productiv
ity declined relative to foreign productivity.
However, in the two years that followed, U.S.
productivity rebounded a bit and in recent
years has kept pace with the growth of foreign
productivity (Figure 2).

10Since the study considers the growth in aggregate
GSP, the growth in overall foreign productivity relative to
overall domestic productivity is the appropriate productiv
ity measure. Since a measure of relative productivity in the
service sector is not available, studies use the growth in
manufacturing productivity at home relative to abroad as a
proxy for overall productivity growth.

FIGURE 1

Real Trade-Weighted Value
of the Dollar
Index

Source: Morgan Guaranty

FIGURE 2

Foreign Productivity Grew
Faster*

* The ratio of foreign manufacturing productiv
ity relative to domestic manufacturing productivity
Source: Peter Hooper and Kathryn A. Larin, "Inter
national Comparisons of Labor Costs in Manufac
turing," Board of Governors of the Federal Reserve
System, International Finance Discussion Paper 330
(August 1988).

SEPTEMBER/OCTOBER 1990

BUSINESS REVIEW

The Effects of Productivity Changes. Ac
cording to the Philadelphia Fed study, 21 states
are significantly affected by changes in relative
foreign productivity. The results show that the
average annual growth in GSP for these 21
states was 1.2 percentage points lower than
what it would have been if foreign productiv
ity had not grown faster than domestic produc
tivity between 1972 and 1986 (Table 1). Fifteen
states were affected negatively by the higher
growth of foreign productivity. Eight of those
states are located in the manufacturing belt
(Figure 3).
Michigan was hit hardest by the increase in
relative productivity, which reduced growth
of Michigan's GSP by 2.0 percentage points per
year between 1973 and 1986. This substantial
reduction resulted in an actual growth rate of
only 1.3 percent. During this period, eight
other states experienced average annual re
ductions in their GSP growth rates of at least
1.5 percentage points because of relatively faster
foreign productivity growth: Illinois, Indiana,
Louisiana, New York, Ohio, Pennsylvania,
Rhode Island, and West Virginia. Six other
states—Delaware, Iowa, Kansas, Missouri,
Nebraska, and South Dakota—were also af
fected negatively, though to a lesser extent.
The results show that the increase in relative
productivity was associated with faster GSP
growth rates in six states: Arizona, Colorado,
Florida, Nevada, New Hampshire, and Utah.
Average annual GSP growth rates in these
states increased at least 0.9 percentage point
during the period. Interestingly, many of these
states are located in the Sunbelt (the Southwest
and Florida). While these states are not major
manufacturing states, all have seen their manu
facturing share of GSP increase over time.1
1
1

TABLE 1

Relative Growth of
Foreign & U.S. Productivity
Affects GSP Growth
in the Long Run
1973 -1986
Average
annual
change
in real
GSP

Average annual
change in real
GSP due to the
relative increase
in productivity*

Arizona
Colorado
Delaware
Florida
Illinois
Indiana
Iowa
Kansas
Louisiana
Michigan
Missouri
Nebraska
Nevada
New Hampshire
New York
Ohio
Pennsylvania
Rhode Island
South Dakota
Utah
West Virginia

5.0%
4.1
1.8
4.6
1.3
1.5
1.9
2.1
0.1
1.3
2.1
2.2
5.0
6.0
1.5
1.4
1.2
1.8
2.2
4.1
0.8

1.3%
1.2
-1.1
1.3
-1.6
-1.6
-1.1
-0.9
-1.8
-2.0
- 1.0
- 1.0
1.8
1.7
-1.5
-1.5
-1.6
-1.5
-0.6
0.9
-1.6

21-STATE
AVERAGE**

1.8

-1.2

*See Appendix for details on calculations.
1!See G. A. Carlino, "What Can Output Measures Tell Us
About Deindustrialization in the Nation and its Regions?"
this Business Review (January/February 1989) pp. 15-27.

^Represents a weighted average (based on a
state's GSP share in 1972) of the individual states'
average annual growth rates.

FEDERAL RESERVE BANK OF PHILADELPHIA

Gerald A. Carlino

Should States Fear the Effects o f a Changing Dollar?

FIGURE 3

Increases in Relative Productivity Affect Gross State Product
1973 -1986

□
□

Productivity differential affects
GSP growth negatively.
Productivity differential affects
GSP growth positively.

Source: Carlino, Cody, and Voith (1990)

The Effects of Exchange Rate Changes.
The Philadelphia Fed study, after controlling
for changes in relative productivity growth,
finds that fewer states— 11 in all—were af
fected significantly by changes in the dollar's
trade-weighted value (Table 2, p. 10). The re
sults indicate that the average annual growth
of GSP for these 11 states would have been only
0.05 percentage point greater if the dollar had
not changed in the years from 1972 to 1986.
This effect is much smaller than that found for
relative productivity. Growth rates decreased
in seven states, which tended to be grouped in
the Midwest and Northwest—Iowa, Montana,
Wyoming, North Dakota, South Dakota, Ore
gon, and Washington (Figure 4, p. 10). Wyo
ming was hit hardest by the dollar's fluctua
tions. On an average annual basis, Wyoming's
GSP grew 0.8 percentage point more slowly
than it otherwise would have.

Not all states were hurt by the changing
dollar, however. For example, Massachusetts,
New Hampshire, and Vermont experienced
faster GSP growth during the 1973-86 period.
A Boston Fed study by Jane Little argues that,
within the manufacturing industries, the rising
dollar caused a shift from unskilled labor-in
tensive industries to skilled labor-intensive
industries, such as the high-tech firms employ
ing scientists and engineers.12 Since the New
England region has a relatively large concen
tration of high-tech firms, it is not surprising
that many of its states experienced faster GSP
growth, despite the dollar's appreciation.

12See J.S. Little, "The Dollar, Structural Change, and the
New England Miracle," Federal Reserve Bank of Boston
New England Economic Review (September/October 1989)
pp. 47-57. Georgia's GSP growth rate also responds posh
tively to dollar appreciation.

SEPTEMBER/OCTOBER 1990

BUSINESS REVIEW

TABLE 2

How Flexible Exchange Rates Affected GSP Growth
1973 - 1 9 8 6
Average annual change in
real GSP
Georgia
Iowa
Massachusetts
Montana
New Hampshire
North Dakota
Oregon
South Dakota
Vermont
Washington
Wyoming
11-STATE AVERAGE**

4.3%
1.9
2.9
1.7
6.0
2.4
2.5
2.2
3.6
3.7
2.4
3.2

Average annual change in real GSP due to
the relative increase in the exchange rate*
0.2%
-0.5
0.2
-0.4
0.4
-0.6
-0.2
-0.3
0.2
-

0.1

-0.8
-0.05

*See Appendix for details on calculations.
**Represents a weighted average (based on a state's GSP share in 1972) of the individual states' average annual
growth rates.

Digitized 10 FRASER
for

FEDERAL RESERVE BANK OF PHILADELPHIA

Should States Fear the Effects of a Changing Dollar?

CONCLUSION
All the recent studies on the regional effects
of exchange rate movements tend to find the
largest impact in the states of the East North
Central region: Ohio, Indiana, Michigan, and
Wisconsin. Similarly, large effects are gener
ally found for states in the West North Central
and the Mountain regions.
Some differences across studies do emerge.
The studies from the Dallas Fed and the Phila
delphia Fed find that many of the New Eng
land states respond strongly to exchange rate
movements, while the other studies find little
or no response. Moreover, the Philadelphia
Fed study finds that two of the three MidAtlantic states (Pennsylvania and New York,
but not New Jersey) respond strongly to rela
tive productivity changes, while the other stud
ies looking only at changes in exchange rates
find little or no response.
The findings in this article suggest that, in
the long run, states have more to fear from slow
productivity growth than from fluctuations in
the dollar. Relative productivity constant,
exchange rate changes have had small effects
on most states' GSP growth. More important,
however, have been changes in the relative
growth of foreign productivity. In the past,

Gerald A. Carlino

state governments have focused their foreignsector efforts on attracting foreign direct in
vestment, promoting exports, and lobbying
the federal government for protection from
foreign competition. However, the importance
of changes in relative productivity suggests
that state governments may want to put more
emphasis on policies designed specifically to
improve productivity.
Numerous studies have documented the
contribution of public infrastructure in increas
ing a state's aggregate productivity.13 Under
this category, states can adopt policies de
signed to improve their roads, highways, and
bridges. In the long run, they can enhance the
productivity of their workers by making a
greater investment in education to improve
their skills. Manpower-retraining programs may
also be an effective way to increase worker
productivity in the short run. And finally,
states can develop programs to promote the
technical progress of their firms.

13See, for example, K.T. Duffy-Deno and R.W. Eberts,
"Public Infrastructure and Regional Economic Develop
ment: A Simultaneous Equation Approach," Federal Re
serve Bank of Cleveland, Working Paper 8909 (1989).

SEPTEMBER/OCTOBER 1990

BUSINESS REVIEW

APPENDIX
This Appendix describes the method used to calculate the estimated effects of changes in relative
productivity and exchange rates on state GSP growth rates reported in Tables 1 and 2. The basic
empirical model, pooled cross-sectional time series for 48 contiguous states, covers the period 197386 and is summarized by the general form:3
gjt = a o + a iyt* + a 2yt + I j 48
=iPj,oSp t + 2 j-iP j,iSf t-i
+ Z j48iYj/0Sj(ajt-Wt) + Zj=iYj/1Sj(a)t*_1-c6 t_1) + gt
=
g^ = GSP growth rate in the jth state in year t

where:

= the growthrate of foreign gross domestic product in year t

= the growthrate of U.S. gross domestic product in year t

= the growthrate of the trade-weighted exchange rate in year t, adjusted
for relative prices of finished manufactured goods

Sj = dummy variable for the jth state
(b*

= the growthrate of output per man-hour in foreign manufacturing in year t

ot
b

= the growthrate of output per man-hour in U.S. manufacturing in year t

pt = random error term

Data. Real GSP data for the 48 contiguous states are obtained from the Bureau of Economic
Analysis, U.S. Department of Commerce. Foreign (OECD countries excluding the U.S.) and U.S.
gross domestic product variables are obtained from the OECD's Main Economic Indicators. The real
exchange rate is Morgan Guaranty's trade-weighted index of the value of the dollar, adjusted for final
goods prices, against the United States' 24 largest trading partners. The manufacturing productivity
variables, measured for the national economy, are taken from a study by Hooper and Larin.b
The estimated parameters from this model can be used to calculate what effect the changing dollar,
for example, had on the average annual GSP growth rates for each of the 11 significantly affected states
during the 1973-86 period. The effect on GSP growth from a changing dollar in year t can be computed
A

as (pj 0et -I- 1et_1), where |j 0 and
3
xare the estimated parameters on the exchange rate variable for
the significantly affected states. The effect on GSP growth over the entire 14-year period is given by:

^i,t= i973^

(Pi,oet + Pi,iet-i)]

From this expression, the changing dollar's effect on the compound average annual growth rate of
real GSP is calculated and reported in column 2 of Table 2.
A similar procedure is followed to arrive at the estimated effects of changes in relative foreign
productivity on the 21 significantly affected states that are reported in column 2 of Table 1.
aThe model was estimated using log differences. For more details, see G. A. Carlino, B. Cody, and R. Voith, "Regional
Impacts of Exchange Rate Movements," Regional Science Perspectives 20 (1990) pp. 89-102.
bPeter Hooper and Kathryn A. Larin, "International Comparisons of Labor Costs in Manufacturing," Board of
Governors of the Federal Reserve System, International Finance Discussion Paper 330 (August 1988).

Digitized12 FRASER
for

FEDERAL RESERVE BANK OF PHILADELPHIA

Curing Our Ailing
Deposit-Insurance System
Loretta J. Mester*1
*

surance. Recent reports suggest that the cost of
bailing out savings and loan associations and
their insurance fund will be much higher than
the $160 billion originally projected. In fact, in
just one year, estimates have more than tripled
to $500 billion.1 And on top of the distressing

news about S&Ls, other reports suggest that
the fund that insures commercial banks may be
running out of money as well.
What's wrong with the federal deposit-in
surance system and what can be done to repair
it? A forthcoming Treasury Department study
may provide some answers. In the meantime,
various regulators, trade groups, and econo-

*Loretta J. Mester is a Senior Economist and Research
Adviser in the Banking and Financial Markets Section of the
Research Department, Federal Reserve Bank of Philadel
phia.

1Both estimates include 10 years of interest expense. The
$500 billion estimate is L. William Seidman's, chairman of
the FDIC and RTC. See "Seidman Says Bailout Could Cost
$200 Billion Plus Interest," American Banker (July 31,1990).

day go
more
R arely does athe stateby withoutdepositbad
news about
of federal
in

BUSINESS REVIEW

mists have their own proposals for reforming
deposit insurance. The more radical proposals
suggest taking the system away from the fed
eral government and putting it into the hands
of private insurers. Most of the proposals,
however, focus on the fundamental flaws of
the current system and on what can be done to
repair it.

GOALS OF DEPOSIT INSURANCE
Banks serve an important role in our econ
omy.2 By intermediating between investors
(depositors) and borrowers, they provide an
efficient way to get funding to projects that
would otherwise have a hard time getting capital.
Typically, banks invest in assets that aren't
readily marketable. An example would be a
loan to fund a company's plan for expansion.
Since the market isn't putting a price on the
expansion plan, it is up to the bank to deter
mine if the firm is creditworthy and if expan
sion makes sense given the current economic
environment.
In a world without banks, the plan, even if
sound and socially beneficial, might go un
funded. A small investor would probably find
it too costly to do the necessary credit analysis,
given the return she could expect on her invest
ment. Moreover, it would be inefficient for
each investor to do her own evaluation. Banks,
however, specialize in such information-gath
ering, so they can usually do the analysis at a
much lower cost, and only once on behalf of
many depositors. Thus, the banking system
provides an efficient conduit between inves
tors and borrowers.
Banks also provide depositors with a safer
investment than those they could make on
their own. By pooling the funds from many
depositors and making a variety of different

2The term "bank" will refer not only to commercial banks
but to other depository institutions, including savings and
loans, savings banks, and credit unions.

Digitized 14 FRASER
for

SEPTEMBER/OCTOBER 1990

loans, banks are able to diversify their portfo
lios and lower their risk.3 Depositors, mean
while, are promised a fixed rate of return; they
get the benefit of a diversified portfolio at a
lower cost than if they had to diversify on their
own. And their deposits are very liquid—people
can withdraw their money from the bank
whenever necessary. This would not have
been possible had depositors invested directly
in firms' projects, which might not pay off until
some future date. The payments system relies
on this liquidity.
Preventing Bank Runs. But the benefits
banks provide to society can be disrupted by a
costly bank run. Without deposit insurance, if
a depositor learned her bank had made poor
investment decisions and was on the verge of
insolvency, then she would have an incentive
to be among the first to withdraw her deposits
before the bank ran out of money. If news
about the bank spread, more and more deposi
tors would rush to take their money out of the
bank as well, a situation known as a bank run.
Depositors who got to the bank too late would
lose their money, but those who got to the bank
in time would typically redeposit their money
in another bank. The bank that had misman
aged its funds would be out of business (as it
should be), but the rest of the banking system
and the payments system would be intact.
Occasionally, though, depositors' confidence
is shaken so much that they would rather keep
their money out of banks altogether. Thus, a
run at one bank can spread to other banks,
regardless of their health. These contagious
bank runs can drive solvent banks insolvent if
they have to sell assets at "fire sale" prices to
meet liquidity needs.

3Of course, this is not true of all depository institutions.
To meet the "qualified thrift lender" test, an S&L must hold
at least 70 percent of its portfolio in housing-related assets.
This requirement reduces the S&L's ability to lower the
riskiness of its portfolio via diversification.

FEDERAL RESERVE BANK OF PHILADELPHIA

Loretta ]. Mester

Curing Our Ailing Deposit-Insurance System

Historically, most runs have been stopped
before they could hurt the banking system as a
whole.4 But system-wide contagious bank runs
did cause the collapse of the banking system
4For an informative summary of the historical evidence,
see Chapter 2 of Perspectives on Safe and Sound Banking: Past,
Present,andFutureby George J. Benston, Robert A. Eisenbeis,
Paul M. Horvitz, Edward J. Kane, and George G. Kaufman
(Cambridge, MA: MIT Press, 1986).

during the Depression, when some 9,000 banks
failed in a four-year period. While the first
banks to fail in the early 1930s did so because of
poor-quality assets, the other, fundamentally
sound banks were forced into bankruptcy as
depositors rushed to withdraw their money.
Deposit insurance is one way to stop such
contagious bank runs and promote the stability
of the payments system (see The History ofU.S.
Deposit Insurance). If depositors are confident

The History of U.S. Deposit Insurance
Although the banking panic of the 1930s spurred creation of the Federal Deposit Insurance
Corporation (FDIC) in 1933 and the Federal Savings and Loan Insurance Corporation (FSLIC) in 1934,
the idea of deposit insurance had been around for a long time before that. The first government
insurance fund was New York's Safety Fund, established in 1829. Between 1831 and 1858, Vermont,
Indiana, Michigan, Ohio, and Iowa established insurance programs as well. All systems but Indiana's
involved the creation of an insurance fund, to which all banks paid an assessment. In Indiana, all
participating banks mutually guaranteed the liabilities of a failed bank, and special assessments were
made as needed. The Ohio and Iowa programs also included this mutual-guarantee provision. These
state programs faded after the Banking Act of 1863 established a national currency, legislating statechartered banks' notes out of existence.
During the next 50 years there were several banking panics. (The Federal Reserve System was
established in 1913 after a particularly severe panic in 1907.) Between 1907 and 1917, eight states
adopted deposit-insurance systems, but by the early 1930s all had failed. The systems had insufficient
funds to handle the numerous bank failures caused by the 1921 depression and that decade's severe
agricultural problems.
Some 150 proposals for deposit insurance or guarantees were introduced into Congress between
1886 and 1933, but none came close to passage until the Banking Act of 1933. Opponents to deposit
insurance included President Roosevelt's Secretary of the Treasury, William H. Woodin, some
members of Congress, and part of the banking industry. They argued that the demise of the state funds
showed that deposit insurance would not work. However, support for federal insurance by the
Chairman of the House Banking Committee, Henry B. Steagall, and the public led to eventual passage
of the Banking Act of 1933. The Act authorized a temporary FDIC— funded by the Treasury, Federal
Reserve System, and premium assessments on the banks— which insured each deposit account up to
$2,500. The permanent FDIC was established by the Banking Act of 1935, which also raised the amount
of coverage to $5,000 per account. Subsequently, the limit was raised five more times: to $10,000 in
1950, to $15,000 in 1966, to $20,000 in 1969, to $40,000 in 1974, and to $100,000 in 1980. Similarly,
insurance coverage of savings and loan deposits was increased to its current $100,000 level.
The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 abolished the FSLIC and
replaced it with the Savings Association Insurance Fund, which insures savings and loan deposits.
This fund and the separate Bank Insurance Fund, which insures commercial bank deposits, are
administered by the FDIC.

Source: Federal Deposit Insurance Corporation: The First Fifty Years (Washington, D.C.: FDIC, 1984).

BUSINESS REVIEW

they will be paid even if their bank fails, they
feel no urgency to withdraw their money. Solvent
banks won't be forced into insolvency because
of rumors. And even if the rumors turn out to
be true, insured depositors won't suffer losses:
another goal of our federal deposit-insurance
system is to protect small depositors, since
they are considered less able than large deposi
tors to evaluate the safety of their banks.

WHAT'S WRONG
WITH THE CURRENT SYSTEM?
An increase in bank failures and the finan
cial problems of the insurance funds have pointed
out some fundamental problems with our fed
eral deposit-insurance system. Up until the
1980s, the system was working well. Conta
gious bank runs had been eliminated and bank
failures were few. But beginning in the 1980s,
increased interest rate volatility, severe prob
lems in the energy and agriculture sectors, and
increased competition from nondepository
institutions caused the number of bank failures
to increase sharply.5 This put a huge burden on
the deposit-insurance funds— indeed, the Fed
eral Savings and Loan Insurance Corporation's
fund became insolvent in 1986.6
The health of the Bank Insurance Fund (BIF),
which insures commercial bank deposits, is
also being questioned. In 1989, the Federal
Deposit Insurance Corporation (FDIC), which
administers BIF, posted its second operating
loss in history, and the ratio of BIF's reserves to
insured deposits fell to 0.7 percent, down from
1.10 percent just two years before. If deposi

5In the 40 years from 1940 through 1979, only 299 in
sured commercial banks were closed, while in the nine
years from 1980 through 1988,879 banks were closed. (See
Dwight M. Jaffee, "Symposium on Federal Deposit Insur
ance for S&L Institutions," Journal o f Economic Perspectives 3
(Fall 1989) pp. 3-10.
6Savings Institutions Sourcebook (Washington, D.C.:
United States League of Savings Institutions, 1989) p. 64.

SEPTEMBER/OCTOBER 1990

tors' confidence in the insurance system is
eroded, then the system cannot work to avert
bank runs. (A recent example is the Ohio S&L
crisis. In 1985, reports of losses at Home State
Savings Bank in Cincinnati caused a run. When
the Ohio Deposit Guarantee Fund, which in
sured Home, was unable to bail out the deposi
tors, the run spread to other S&Ls insured by
this state fund.) If we expect the deposit insur
ance system to be able to meet its goals in the
future, we must repair its problems now.
Incentive Problems. Risk-taking is neces
sary for economic progress, and banks facili
tate this by investing in risky assets. But the
current deposit-insurance system encourages
banks to take on more risk than is best for
society. A bank's equity holders get all the
benefits if the risk pays off, but they don't have
to pay for taking on more risk. Insured deposi
tors have no incentive to demand a higher rate
on deposits they put in riskier banks. Often at
the larger banks, large depositors, who are
supposedly uninsured, don't demand much of
a risk premium since typically they don't suffer
losses because of the way the FDIC has chosen
to close large banks. For large banks, the FDIC
usually finds a buyer who takes on all the
liabilities, both insured and uninsured, of the
failed bank. Or the FDIC makes direct loans to
the bank, again covering the bank's uninsured
creditors. Also, under the current system, each
bank pays a flat rate for insurance, regardless
of the riskiness of its portfolio.7 Under this flatrate system, regulations and examinations are
intended to control bank risk-taking, but they
have been increasingly ineffective.8

7Before FIRREA was passed, commercial banks paid a
premium of 8.3 cents per $100 of deposits. Under FIRREA,
the premium is scheduled to rise to 12 cents per $100 of
deposits for 1990 and to 15 cents thereafter.
8FSLIC's problems were exacerbated by deregulation in
the early 1980s, which permitted the fatal combination of
expanded S&L powers with relaxed net-worth require
ments.

FEDERAL RESERVE BANK OF PHILADELPHIA

Curing Our Ailing Deposit-Insurance System

Thus, neither the regulators nor the insured
depositors demand that banks pay more for
taking on more risk. As a bank gets closer to
bankruptcy, there is a tendency for stockhold
ers to "bet the bank," since they have every
thing to gain and little to lose. If the risk doesn't
pay off, the deposit insurer takes the loss.

CAN WE FIX IT?
The S&L crisis threw into bold relief the
shortcomings of our federal deposit-insurance
system. To avoid another crisis, we could take
one of two paths: find another way to avert
bank runs and ensure the stability of the finan
cial system, or retain federal deposit insurance
but reduce the incentives it creates for exces
sive bank risk-taking. In the near term, the first
path seems infeasible.
Loans From the Lender of Last Resort. Some
feel that federal deposit insurance is not the
best way to avert systemic bank runs. They
argue that the Federal Reserve, as lender of last
resort, could play a much bigger role than it
currently does in stabilizing the payments
system. Bank runs are costly when they cause
solvent banks to fail and disrupt the payments
system. These banks have good assets, but
they aren't liquid enough to satisfy depositor
demand during a run. Rather than having to
liquidate their assets at fire-sale prices, these
banks might be allowed to pledge the assets as
collateral for loans from the Fed. The loans
would solve the temporary liquidity problems,
preventing runs from sending these banks into
insolvency. According to this view, deposit
insurance could play a much smaller role in
such a design and might even be privately
administered.9

9Anna J. Schwartz makes this argument in "Financial
Stability and the Federal Safety Net," Chapter 2 of Restruc
turing Banking and Financial Services in America, William S.
Haraf and Rose M. Kushmeider, eds. (Washington, D.C.:
American Enterprise Institute, 1988).

Loretta J. Mester

Opponents of this approach fear the Fed
would not act swiftly enough to prevent the ill
effects of a run once it started. To support this
view, they point to the banking crisis of the
1930s, when the Fed failed to provide the needed
liquidity. Increasing the Fed's role in provid
ing liquidity to solvent banks experiencing
temporary problems is desirable, but informa
tion problems probably preclude it from being
the sole source of stability. To avoid extending
loans to truly insolvent banks, the Fed would
need very good information about the quality
of the assets being pledged as collateral. If a
bank that had taken on too much risk and had
gotten itself into trouble found it easy to bor
row from the Fed, then the Fed would, in effect,
be subsidizing excessive risk-taking.
Private Insurance. It is unlikely that deposit
insurance can be totally private rather than
government sponsored. First, private insur
ance lacks the credibility of federal insurance.
The federal government, unlike private insur
ers, can impose taxes to maintain the solvency
of the insurance fund. (The bailout of FSLIC is
a case in point.) This credibility is essential if
insurance is to prevent bank runs. Second, it
isn't clear that private insurers will be able to
obtain as much capital as is necessary to sup
port such insurance, since the level of deposits
to be insured is so large— total deposits in
commercial banks averaged over $2 trillion in
1989. And unless private insurers were given
sufficient powers to close insolvent banks, the
number of these banks permitted to remain
open and engage in risky behavior is likely to
be higher in private-insurance schemes, expos
ing the funds to larger losses. Finally, since the
social benefits of a stable financial system do
not accrue to individual banks, a totally private
insurance system would probably provide too
little insurance for the system.
Narrow Banks. Another alternative to the
current system of federal deposit insurance is
the "narrow bank" plan. This plan would
reduce the need for deposit insurance by re
17

SEPTEMBER/OCTOBER 1990

BUSINESS REVIEW

stricting the activities a bank could fund with
insured deposits. A bank would provide trans
actions services by investing deposits in virtu
ally riskless assets.10 Essentially, the narrow
bank could invest in short-term Treasury and
federal-agency securities, the least risky assets
available. Under this setup, the narrow bank
could be one affiliate of a bank holding com
pany. All other bank activities would be placed
in other affiliates and funded with uninsured
funds. Actually, because of the safeness of the
narrow banks' assets, there would be little
need for deposit insurance to cover losses from
credit risk or interest rate risk. However, in
surance might still be offered to cover losses
from fraud or mismanagement.
While on the surface the narrow-bank plan
seems a feasible way to solve the problem of
banks using insured deposits to fund exces
sively risky activities, it actually just shifts the
problem of potential payments system insta
bility to the non-narrow-bank affiliates of the
holding company. The uninsured liabilities of
the non-narrow-bank affiliates are likely to
become a significant part of the payments sys
tem because banks will be willing to pay higher
rates for these funds since they fund the more
profitable activities. If so, the government
would want to prevent runs on these affiliates
as well. Thus, the narrow-bank proposal would
probably not solve the problem.1
1
These economic arguments, along with the
political infeasibility of doing away with fed
eral deposit insurance, suggest we should
concentrate, at least in the immediate future,
on reforming the system.*
1

10Robert E. Litan is the major proponent of the "narrow
bank" plan. See his What Should Banks Do? (Washington,
D.C.: Brookings Institution, 1987).
1G eorge J. Benston and George G. Kaufman make these
arguments in "Regulating Bank Safety and Performance,"
Chapter 3 of Restructuring Banking and Financial Services in
America.

Digitized18 FRASER
for

REFORMING FEDERAL DEPOSIT
INSURANCE
Under the current system, bank risk-taking
is not being priced by insured depositors, nor
do regulators impose a high enough cost on it.
Accordingly, banks have an incentive to invest
in assets that are too risky from society's point
of view. If risk-taking carried a higher cost,
banks would take on less risk than they cur
rently do. And less risk-taking by banks would
reduce the insurance fund's exposure to exces
sive losses, bolstering depositors' confidence
in the fund and making it easier for the fund to
achieve its goals. The current proposals for
reforming the deposit-insurance system focus
on ways to discipline bank managers from
excessive risk-taking.

Depositor Discipline
Adjusted Ceilings. Some proposals for re
forming the deposit-insurance system focus on
depositors providing market discipline (see
Key Provisions of Key Proposals). Proposals to
lower the ceiling for insured deposits to as low
as $10,000, from $100,000, or to impose coinsurance (insuring only a certain percentage
of deposits) are intended to have depositors
discipline banks by demanding a risk premium
for placing deposits in riskier banks. This
would curb risk-taking by increasing the price
a bank must pay for engaging in risky activi
ties. Some argue, too, that the ceiling should be
lowered on the grounds that depositors with
$100,000 are not the small depositors deposit
insurance was intended to protect.
A major problem with this approach is that
it isn't clear whether small depositors have
enough information to discipline banks effec
tively. Rather than try to assess the health of
their bank, depositors might find it easier just
to withdraw their money if they suspected
(correctly or not) any trouble. As a result, we
might end up with more bank runs—something
deposit insurance was intended to avoid in the
first place.
FEDERAL RESERVE BANK OF PHILADELPHIA

Curing Our Ailing Deposit-Insurance System

Loretta ]. Mester

Key Provisions of Key Proposals
American Bankers Association3
• Leave insurance coverage ceiling at $100,000
• End "too big to fail" by using the "final-settlement-payment" method to resolve insolvent
bank cases—a "haircut" would be imposed on uninsured depositors and unsecured
creditors of failed banks
• Close banks as soon as equity capital equals zero
• Improve examination and supervision of banks
The Conference of State Bank Supervisors1
*
• Leave insurance coverage ceiling at $100,000
• End "too big to fail"
• FDIC should impose risk-based premiums based on the amount of risk-based capital a bank
has and on its latest CAMEL rating
Independent Bankers Association of America0
• Insure all depositors— remove the $100,000 ceiling on coverage
• Banks should pay premiums to the FDIC on nondeposit liabilities and foreign deposits
New York Clearing House Association1
1
• Leave insurance coverage ceiling at $100,000
• End "too big to fail" via the ABA's "haircut" or some other modified payout procedure
• Brokered deposits should be allowed for healthy banks; they pose a problem only if used by
undercapitalized banks
Federal Reserve Bank of Cleveland8
• Lower insurance coverage ceiling, perhaps to as low as $10,000
• End "too big to fail"
• Encourage quick closure of insolvent banks
Federal Reserve Bank of Minneapolis1
• Limit coverage to $10,000 per depositor
• End "too big to fail" via "haircut"
• Increase capital requirements
Federal Reserve Bank of San Francisco8
• Leave insurance coverage ceiling at $100,000
• End "-too big to fail"
• Increase capital requirements
• Use market-value accounting when possible
• Encourage quick closure of insolvent or nearly insolvent banks

aAmerican Bankers Association, Federal Deposit Insurance: A Program for Reform, Washington, D.C. (March 1990);
bThe Conference of State Bank Supervisors, Comments on Federal Deposit Insurance Reform, Washington, D.C. (March
9,1990); independent Bankers Association of America, Protecting the Federal Deposit Insurance System, Washington,
D.C. (February 1990); dJohn R. McGillicuddy, Chairman of the New York Clearing House Association, "Insurance
Reform Alone Can't Save Bank Industry," American Banker (April 5,1990); 8Federal Reserve Bank of Cleveland, 1988
Annual Report; fFederal Reserve Bank of Minneapolis, 1988 Annual Report; gRobert T. Parry, President of the Federal
Reserve Bank of San Francisco, "Insurance Reform Can Stop 'Bet-the-Bank' Syndrome," American Banker (April 19,
1990).

BUSINESS REVIEW

It also isn't clear that $100,000 is really that
much money anymore. Adjusted for inflation,
the $100,000 limit on coverage today is nearly
equivalent to the $40,000 limit that was in effect
in 1974, and the coverage relative to per capita
GNP is less.1 (Today's $100,000 level of cover
2
age would have been equivalent to $43,000 of
coverage in 1974.) Finally, now is probably not
the right time to lower the level of coverage,
with depositor confidence already shaken by
the S&L crisis.1
3
Individuals Versus Accounts. A less radical
proposal is to keep the insurance ceiling at
$100,000, but enforce it by insuring each indi
vidual rather than each account up to the ceiling.
The Minneapolis Fed suggests allowing each
depositor to designate one particular account
as her insured account; the deposits in her
other accounts would be uninsured.1 * Under
4
the current system, which insures each account
up to the $100,000 limit, brokers can collect
large investors' deposits, break them up into
$100,000 bundles, and move them around in
search of the highest deposit rates, all the while
getting full coverage.
One benefit of these "brokered deposits" is
that they ease temporary liquidity problems at
solvent banks. However, they also allow large
depositors to be fully insured, mitigating any
incentive these depositors have to monitor the
riskiness of their banks. That is, without the
deposit-insurance coverage, large depositors

1^ e e Alex J. Pollock, "Deposit-Insurance Debate Should
Consider Inflation," American Banker (February 5,1990).
13Edward G. Boehne, President of the Federal Reserve
Bank of Philadelphia, made this point in "Banking in the
1990s," Remarks to the Annual Convention of the Pennsyl
vania Bankers Association, Philadelphia, May 22,1990, as
did Federal Reserve Board Chairman Alan Greenspan in
testimony before the Senate Committee on Banking, Hous
ing, and Urban Affairs, July 12,1990.
14See the Federal Reserve Bank of Minneapolis's 1988
Annual Report.

Digitized 20 FRASER
for

SEPTEMBER/OCTOBER 1990

would demand higher deposit rates at these
banks. Insuring individuals rather than ac
counts would prevent coverage of brokered
deposits and reduce their attractiveness. The
Fed, provided it had sufficient information
about the bank, could play a larger role in
providing temporary liquidity.
"Too Big to Fail." But covering individuals
rather than accounts won't increase depositor
discipline as long as the "too big to fail" doc
trine is in place. The FDIC is required to
resolve insolvent bank cases in the most costeffective way. For small banks this is often
with a "deposit payout"—depositors with
$100,000 or less are paid off in full and larger
depositors suffer losses. However, with larger
banks, the FDIC usually uses either the pur
chase and assumption (P&A) method or direct
assistance.
In a P&A, another institution purchases some
or all of the assets and assumes all the deposits
(insured and uninsured) and all the other debts
of the failed bank. Thus, even those depositors
with more than $100,000 in the failed bank
suffer no losses. Since there is de facto 100
percent insurance coverage in the P&A method,
large depositors have no incentive to monitor
their banks.
In some cases with very large banks, the
FDIC may deem that allowing the bank to fail
would risk a major disruption to the payments
system—that is, the FDIC may decide that the
bank is "too big to fail." If so, then the FDIC is
permitted to make loans to or purchase assets
from the failing bank to keep it afloat. (This is
what the FDIC chose to do in 1984 with Conti
nental Illinois. Uninsured depositors and general
creditors were given explicit guarantees that
they would not lose any money.) Since largebank failures have a higher potential of dis
rupting the payments system, the FDIC is more
likely to use direct assistance with large banks
than to let them fail. Thus, larger depositors
and other creditors at large banks have little
incentive to monitor their bank.
FEDERAL RESERVE BANK OF PHILADELPHIA

Curing Our Ailing Deposit-Insurance System

To remedy this, the American Bankers As
sociation proposes that the FDIC impose a
"haircut" on the uninsured depositors and
other creditors at a failed bank before it is sold
to another institution. Rather than being paid
the full book value of their deposits and debt,
these creditors would receive a "final-settlement-payment" from the FDIC equal to the
average amount likely to be recovered in the
bank's sale. The ABA estimates that, given the
FDIC's recent experience, the uninsured credi
tors would receive about 88 percent of the book
value of their debt.15 If an uninsured depositor
knew she would suffer a loss if her bank failed,
she would have an incentive to keep a watchful
eye on the bank. The assumption here, of
course, is that larger depositors (who are unin
sured) are more sophisticated than smaller
depositors, having access to more information
concerning their banks. It's also assumed that
the FDIC will be able to close the bank quickly,
before these large depositors can run the bank
and avoid the haircut.1
6

Equity Holder and Nondepositor Discipline
Capital Requirements. A danger of relying on
depositors to discipline banks is that bank runs
might become more common if depositors find
it too costly to assess the condition of their
banks. Recognizing this possibility, other pro
posals emphasize discipline from banks' eq-

15See American Bankers Association, Federal Deposit In
surance: A Program for Reform, Washington, D.C. (March
1990).
16One group that doesn't believe "too big to fail" can be
done away with is the Independent Bankers Association of
America (IBAA), which represents smaller, community
banks. They favor de jure as well as de facto 100 percent
deposit insurance coverage at all size banks. Since deposits
in banks' offshore offices would now have explicit insur
ance coverage, banks would be required to pay premiums
on these foreign deposits, something that currently is not
required. See IBAA, Protecting the Federal Deposit Insurance
System, Washington, D.C. (February 1990).

Loretta J. Mester

uity holders or from nondepositor creditors,
essentially through higher equity requirements,
subordinated debt requirements, or both. In
creasing banks' equity-capital requirement
would have two desirable effects. First, higher
capital means that shareholders have more at
risk and may exert more discipline on bank
managers to be prudent. Second, higher capi
tal reduces the expected loss to the insurer by
reducing the chances that the bank will become
insolvent—capital acts like a deductible cush
ioning the insurer from losses.
Banks currently must hold capital equal to
at least 6 percent of their assets. However,
under the Basle Accord, U.S. and European
banks will be required to hold capital equal to
at least 8 percent of their risk-weighted assets
by the end of 1992.17 Although this will require
the typical bank to increase the amount of
capital it holds, bank capital ratios will still be
well under the average 12 percent equity-toasset ratio that prevailed in the late 1920s.18
Subordinated Debt. In addition to increasing
the equity-capital requirement, requiring the
use of subordinated debt could also increase
market discipline.1 The claims of these debthold
9

17The risk-weighted capital standard requires banks to
hold more capital against riskier assets. A bank's assets are
assigned to one of four different risk categories, weighted
according to their category's risk, and then summed to
determine the bank's risk-weighted asset level. See Neil S.
Millard and Brian W. Semkow, "The New Risk-Based
Capital Framework and Its Application to Letters of
Credit," Banking Law Journal 106 (November-December
1989) pp. 500-14.
18Alan Greenspan, "Subsidies and Powers in Commer
cial Banking," Remarks before the Annual Conference on
Bank Structure and Competition, Federal Reserve Bank of
Chicago, May 10,1990. Also see the Chairman's testimony
before the Senate Committee on Banking, Housing, and
Urban Affairs, July 12,1990.
19Benston and others suggest that banks be required to
hold subordinated notes equal to about 3 to 5 percent of
deposits, in Perspectives on Safe and Sound Banking, p. 193.

BUSINESS REVIEW

ers would be subordinate to those of the unin
sured depositors and the deposit insurer.
Because these debtholders (unlike the equity
holders) do not share in the upside benefits of
risk-taking, they might be expected to exert
even more discipline on the bank than equity
holders if the bank's failure exposed them to
risk. Currently, in the typical P&A method of
liquidation, these debtholders don't suffer losses.
But if they were treated like equity holders in
the P&A, the possibility of a loss would encour
age their monitoring of the bank. Potential
debtholders would buy a riskier bank's issues
only if promised a higher rate. This “higher
cost for higher risk-taking" would tend to dis
cipline the bank, and the rate the bank prom
ises for new issues of subordinated debt would
provide a signal to regulators about the bank's
health.

Regulatory Discipline
Risk-related Premiums. To discourage exces
sive risk-taking, regulators might also begin
charging riskier banks higher premiums for
their insurance coverage. With the current flatrate premium, regulators have to control risk
taking via supervision and regulation rather
than price. In theory, if riskier banks had to pay
more for insurance coverage, making risk-tak
ing more costly, some of their risk-taking be
havior would be discouraged. However,
implementing the right set of premiums—that
is, the premiums that would induce the correct
amount of risk-taking from society's point of
view—is easier said than done. For one thing,
it is hard to measure risk until it is too late. Did
loans to Brazil look as risky in 1978 as they did
in 1985?
Also, activity-specific risk-related premiums
miss the point that risk should refer to the
riskiness of the bank's entire portfolio, not just
to the risk of individual assets. For example,
suppose cash flows from trust services are high
when cash flows from commercial loans are
low, and vice versa (that is, the flows are nega

SEPTEMBER/OCTOBER1990

tively correlated). Then, even if the cash flows
from trust services are more volatile than those
from commercial loans, adding them to the
bank's portfolio would reduce the risk of the
entire portfolio.
Categorizing assets into risk-classes and
charging higher premiums for banks with more
high-risk assets might not be the best way to
implement risk-related premiums, since this
does not correctly measure the portfolio's credit
risk. This method also would miss the bank's
exposure to interest rate risk. Banks and thrifts
are exposed to interest rate risk to the extent
that interest rate changes have a different effect
on the cash flows from their assets than on the
cash outlays on their liabilities. The typical
S&L mainly funds long-term, fixed-rate mort
gages, using short-term deposits. So when
interest rates rise unexpectedly, the S&L pays
more for deposits than it makes on its assets.
Ideally, risk-related insurance premiums would
take into account the institution's interest rate
risk as well as its credit risk.
As an alternative, premiums might be re
lated to how a bank fares relative to bank
ruptcy-prediction models, or to its CAMEL
rating. (The CAMEL rating is given by the
bank examiner and reflects the overall health of
the bank, taking into account the bank's capi
tal, asset quality, management, earnings, and
liquidity. Thus, the rating should reflect the
riskiness of the bank's portfolio, including inter
est rate risk.) A proposal by the Conference of
State Bank Supervisors would relate premi
ums to a bank's latest CAMEL rating and to its
level of risk-based capital.20* While CAMEL

20Risk-based capital could play a role similar to that of
risk-based insurance premiums. However, one advantage
of risk-based insurance premiums over risk-based capital
requirements is that, with risk-based premiums, banks can
be rewarded for operating with more capital than the re
quired minimum. See Lawrence J. White, "The Reform of
Federal Deposit Insurance," Journal of Economic Perspectives
3 (Fall 1989) p. 22.

FEDERAL RESERVE BANK OF PHILADELPHIA

Curing Our Ailing Deposit-Insurance System

Loretta J. Mes ter

ratings aren't a perfect measure of risk, the
proposal seems a workable way to implement
risk-based premiums.
Increased Supervision. While it is very impor
tant that we change the incentives of bankers, it
is equally important that regulators be able
(and be encouraged) to close failed banks
quickly.2 If regulators closed banks before
1
banks' equity were exhausted, then the insur
ance fund's costs would be minimized. The
largest claims on the insurance fund have come
from fraud and from risky gambles made by
banks allowed to stay open while insolvent.22
Part of the problem was caused by regulators
practicing "forbearance" in the 1980s and de
liberately allowing insolvent thrifts to remain
open, hoping that their condition would im
prove with time. With hindsight, this policy
was ill-advised.
But even without such a policy, it is difficult
for a regulator to know when equity is ex
hausted and it is time to close a bank. Since
most banks aren't publicly traded companies,
the stock price can't be used to estimate the
value of the bank's equity. And, by the nature
of banking, a bank's assets tend to be
illiquid—there is no market on which these
assets are frequently repriced. So the book
value of a commercial loan may grossly over
state its market value. However, with certain
assets, such as traded securities, market-value
accounting is easy and should be encouraged.
The estimates of the market value of the bank's
other assets would not be perfect but would be
at least as accurate as their historical book
values. Well-run banks make such estimates
now, so these measurements are feasible.

More frequent and thorough supervision of
financial institutions will make it easier for
regulators to measure banks' net worth accu
rately. Because changes in economic circum
stances can quickly cause solvent banks to
become insolvent, banks should be closed when
their capital is small but still positive.23 Closing
a bank before its net worth turns negative
would circumvent the ability of banks with
little at stake to "bet the bank," reducing the
losses to the insurance fund. This, in turn,
would increase depositor confidence in the
fund and, accordingly, the fund's efficacy in
maintaining a stable financial system.
Rebates. The solvency of the insurance fund
could also be secured if the current system of
rebates were abolished.24 Presently, banks will
be rebated any premiums they have paid into
the fund after its reserves reach 1.25 percent of
insured deposits. However, if the FDIC be
lieves it faces a significant risk of future losses,
it is permitted to suspend the rebates and
impose higher premiums until the fund's re
serves reach 1.5 percent of insured deposits.
The experience over the last several years sug
gests that the fund can be depleted very quickly.
It would make more sense to build up the fund
in years when banks are healthy and can afford
to do so, rather than wait until multiple bank
failures cause a depletion of the fund and re
quire the FDIC to make a special assessment at
the time when banks can least afford to pay it.

21Leonard Nakamura discusses bank closure in "Clos
ing Troubled Financial Institutions: What Are the Issues?"
this Business Review (May/June 1990) pp.15-24.

24Even with the higher premiums mandated by FIRRE A,
there is a significant probability that the fund will become
insolvent at some point during the next 55 years. See Sherrill
Shaffer, "Aggregate Deposit Insurance Funding and Tax
payer Bailouts," Working Paper 90-14, Federal Reserve
Bank of Philadelphia (April 1990).

22See Chapter 10, "Supervision and Examination," in
Benston and others, Perspectives on Safe and Sound Banking.

23Benston and Kaufman suggest closing a bank when its
capital-to-asset ratio, measured at market values, falls to 3
percent. See Chapter 3 of Restructuring Banking and Financial
Services in America. Closing a bank means the bank's owner
ship is transferred to the FDIC, which then sells, merges, or
liquidates the bank.

BUSINESS REVIEW

CHANGES WILL HAVE TO BE MADE
The savings and loan debacle pointed out
some basic problems with our federal depositinsurance system that must be corrected if we
are to avoid a similar crisis in the future. Under
the current system, banks have an incentive to
take on more risk than is prudent from soci
ety's point of view. This is especially true as a
bank approaches bankruptcy and is betting
with other people's money.
Proposals to remedy this incentive problem
seek to increase market and regulatory disci
pline on bank risk-taking. Several reforms
seem desirable. If capital requirements were
increased, equity holders would have more at
stake and so would behave more prudently.
Moreover, the increased capital would pro
vide a cushion between the insurance fund and
banks' losses. In addition, making subordi
nated debtholders and other nondeposit credi
tors face greater risk of losses were their bank
to fail would give them incentives to monitor
their bank and to discipline the bank into be
having more cautiously. This could be accom
plished by using some sort of "haircut" when

Digitized 24 FRASER
for

SEPTEMBER/OCTOBER1990

paying off creditors of failed banks, thereby
invalidating the assumption that some banks
are "too big to fail." Enforcing the current
deposit-insurance ceiling of $100,000 by insur
ing individuals rather than accounts and end
ing "too big to fail" would increase discipline
by large depositors. Small depositors would
still be protected and so would have no incen
tive to run the bank.
The cost of risk-taking could also be in
creased if riskier banks had to pay higher depositinsurance premiums or hold more capital. One
of the least complicated ways to implement
risk-based premiums would be to link the
premium to a bank's CAMEL rating. In order
to protect the insurance fund from excessive
losses, regulators must have the ability to close
banks before equity is exhausted. More fre
quent examinations and a move to marketvalue accounting, where feasible, would en
hance this ability. Finally, for the proposed
reforms to work, it is essential that regulators
do their job. Oversight by other government
bodies may help in this regard.

FEDERAL RESERVE BANK OF PHILADELPHIA

Philadelphia/RESEARCH
Working Papers
Institutions and libraries may request copies of the following working papers, written by our staff
economists and visiting scholars. Please send the number of the item desired, along with your address, to
WORKING PAPERS, Department of Research, Federal Reserve Bank of Philadelphia, 10 Independence
Mall, Philadelphia, PA 19106. For overseas airmail requests only, a $2.00 per copy prepayment is required;
please make checks or money orders payable (in U.S. funds) to the Federal Reserve Bank of Philadelphia.

1989
No. 89-1

Sherrill Shaffer, "Pooling Intensifies Joint Failure Risk."

No. 89-2

Brian J. Cody, "Optimal Exchange Market Intervention: Evidence From France and West
Germany During the Post-Bretton Woods Era."

No. 89-3

James J. McAndrews, "Strategic Role Complementarity."

No. 89-4

Douglas Holtz-Eakin and Harvey S. Rosen, "Intertemporal Analysis of State and Local Govern
ment Spending."

No. 89-5

Brian J. Cody and Leonard O. Mills, "Evaluating Commodity Prices as a Gauge for Monetary
Policy." (Superseded by Working Paper 90-2.)

No. 89-6

Sherrill Shaffer, "Can the End User Improve an Econometric Forecast?"

No. 89-7

Theoharry Grammatikos and Anthony Saunders, "Additions to Bank Loan-Loss Reserves:
Good News or Bad News?"

No. 89-8

Behzad T. Diba and Seonghwan Oh, "Money, Inflation, and the Expected Real Interest Rate."

No. 89-9

Linda Allen and Anthony Saunders, "Incentives to Engage in Bank Window-Dressing:
Manager vs. Stockholder Conflicts."

No. 89-10

Ben S. Bernanke and Alan S. Blinder, "The Federal Funds Rate and the Channels of Monetary
Transmission."

No. 89-11

Leonard I. Nakamura, "Loan Workouts and Commercial Bank Information: Why Banks Are
Special."

No. 89-12

William W. Lang, "An Examination of Wage Behavior in Macroeconomic Models with LongTerm Contracts."

No. 89-13

William W. Lang and Leonard I. Nakamura, "Learning in the Marketplace: Free Entry Is Free
Riding."

No. 89-14

Robert H. DeFina and Herbert E. Taylor, "The Optimal Response of Monetary Policy to Oil
Price Shocks."

No. 89-15

James J. McAndrews and Leonard I. Nakamura, "Entry-Deterring Debt."

No. 89-16

John F. Boschen and Leonard O. Mills, "Real and Monetary Explanations of Permanent
Movements in GNP."

No. 89-17

Sherrill Shaffer, "Cournot Oligopoly With External Costs.'

No. 89-18

Sherrill Shaffer, "Transaction Costs and Option Configuration."

No. 89-19

Behzad T. Diba, "Bubbles and Stock Price Volatility."

No. 89-20

Dean Croushore, "Transactions Costs and Optimal Inflation."

No. 89-21

Herb Taylor, "In Search of a Stable Velocity Relationship."

No. 89-22

Loretta J. Mester, "Multiple-Market Contact in an Incomplete-Information Model with
Imperfectly Correlated Costs."

No. 89-23

William W. Lang and Leonard I. Nakamura, "The Dynamics of Credit Markets in a Model
With Learning."

No. 89-24

Joel Houston and Aris Protopapadakis, "The Effect of Government Bonds on Asset Prices:
An Asset Markets Equilibrium Approach."

No. 89-25

Dean Croushore, "Money in the Utility Function: An Adequate Microfoundation of Money?"

No. 89-26

Paul Calem and Gerald Carlino, "Does Concentration Affect Conduct and Performance in
Bank Deposit Markets?"

No. 89-27

Loretta J. Mester, "Testing for Expense Preference Behavior: Mutual Versus Stock Saving and
Loans."

No. 89-28

Sherrill Shaffer, "Regulatory Distortion of Competition."

No. 89-29

Paul Calem, "On the Reasons for Gradual Markdowns by Retailers."

No. 89-30

Paul Calem and John Rizzo, "Are Bank Loans Unique? The Case of Hospital Debt Financing."

No. 90-1

1990
Gerald Carlino and Richard Voith, "Accounting for Differences in Aggregate State Produc
tivity."

No. 90-2

Brian Cody and Leonard Mills, "The Role of Commodity Prices in Formulating Monetary
Policy." (Supersedes Working Paper 89-5.)

No. 90-3

Loretta J. Mester, "Traditional and Nontraditional Banking: An Information-Theoretic Ap
proach."

No. 90-4

Sherrill Shaffer, "Investing in Conflict."

No. 90-5

Sherrill Shaffer, "Immunizing Options Against Changes in Volatility."

No. 90-6

Gerald Carlino, Brian Cody, and Richard Voith, "Regional Impacts of Exchange Rate Move
ments."

No. 90-7

Richard Voith, "Consumer Choice With State-Dependent Uncertainty About Product Quality:
Late Trains and Commuter Rail Ridership."

No. 90-8

Dean Croushore, "Ricardian Equivalence Under Income Uncertainty."

FEDERAL
RESERVE BANK OF
PHILADELPHIA
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