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The primary advantage of this system
is that it could be adopted easily. To
implement it would require only slight
modifications of the FDIC's existing
powers. Ex post pricing schemes based
on performance would allow the FDIC
to identify and price, after the fact,
previously unregulated forms of risk
that insured banks may be exploiting.
The most severe problem associated
with ex post pricing stems from the
loose relationship between ex post performance and expected (ex ante) risk.
A bank that performed poorly in the
past, for example, might be a conservatively run bank that poses little threat
to the FDIC's insurance fund. The profitable bank, on the other hand, might

11. There is evidence that uninsured depositors
exert some discipline over bank risk-taking by
charging riskier banks higher premiums for
funds. This is evident in the market for large certificates of deposit (CDs) where there appears to
be a tiering of CD rates according to the risk of
the bank. See, Herbert Baer and Elijah Brewer.
"Uninsured Deposits as a Source of Market Discipline: Some New Evidence." Economic Perspectives, vol. X, issue 5, September/October 1986,
Federal Reserve Bank of Chicago, pp. 23-31.
12. See, Paul M. Horvitz. "The Case Against
Risk-Related Deposit Insurance Premiums."
Housing Finance Review, July 1983, pp. 253-63.

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be a risky institution that happened to
bet correctly on oil prices or interestrate movements. Yet, under the ex post
deposit-insurance pricing system, the
safe bank would pay higher premiums
than the risky bank. However, one
would not expect this inconsistency to
persist over the long run because the
aggregate losses, and therefore the
aggregate deposit-insurance premiums
paid by the risky bank, should exceed
those of the conservatively run bank.
Conclusion
There are at least six general methods
for adjusting the cost of the FDIC's
deposit guarantees to insured banks.
Each method has its advantages and
disadvantages and, for simplicity, has
13. See for example Edward]. Kane, "A SixPoint Program for Deposit Insurance-Reform,"
Housing Finance Review, July 1983, pp. 269-278;
Edward]. Kane, "Appearance and Reality in
Deposit Insurance." Journal of Banking and
Finance vol. 10, no. 2, June 1986, pp. 175-88, and
Herbert Baer, "Private Prices, Public Insurance:
The Pricing of Federal Deposit Insurance," Economic Perspectives, vol, 9, no. 5 (September/October 1985) Federal Reserve Bank of Chicago, pp.
45-57. For a discussion of the potential problems
with private deposit insurance, see Tim S.
Campbell and David Glenn. "Deposit Insurance
in a Deregulated Environment," Journal of
Finance, vol. 39, no. 3, (Iuly 1984) pp. 775-87.

been presented here as a competing
method for pricing deposit guarantees.
However, in practice, many of these
methods could be combined to achieve a
pricing system that would be superior
to any of the separate pricing mechanisms by itself. Indeed, almost all of the
current deposit-insurance reform proposals rely on some combination of
these methods. The role that we want
federal deposit insurance to play in our
financial system in the future will be
the ultimate deciding factor in determining which combination of the
generic methods is adopted.

14. There is nothing magical about $10,000. We
could easily argue that the federally insured limits should be set at $5,000 or $25,000.
15. See for example, Robert B. Avery, Gerald A.
Hanweck, and Myron L. Kwast, "An Analysis of
Risk-Based Deposit Insurance for Commercial
Banks," Proceedings of a Conference on Bank
Structure and Competition, Federal Reserve Bank
of Chicago, Chicago, Illinois, 1985, pp. 217-250.
16. See for example, David P. Rochester and
David A. Walker. "A Risk-Based Deposit Insurance System," Unpublished Manuscript 1985.

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September 15, 1986

Federal Reserve Bank of Cleveland

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ECONOMIC
COMMENTARY
One of the most widely debated topics in
the political arena is the proposal to give
the Federal Deposit Insurance Corporation (FDIC) the power to vary the cost
of deposit-insurance on the basis of risk.'
The FDIC was created in 1933 and today is considered an integral part of the
federal banking safety net whose purpose is to protect the savings and transactions balances of small savers and to
help stabilize the banking system.
Federally-insured banks currently pay
a flat fe.efor the FDIC guarantee of the
first $100,000 of each deposit account in
the bank. Critics do not think this is
fair or efficient because banks that take
excessive risks with their depositor's
money pay exactly the same rate for
FDIC insurance as banks that are more
conservative in theiroperations."
As a result, there are currently at
least two dozen proposals for adjusting
deposit-insurance premia on the basis
of risk. Of these, there are at least six
different general proposals for reforming
the current system by using some form
of risk-based pricing. This Economic
Commentary provides an overview of
the various risk-based proposals.
A fragmented approach is used in our
discussion in order to highlight the features of each general proposal. With a
basic understanding of the intricacies
of the basic pricing methods, one can
better evaluate and understand the relative advantages and disadvantages of
the various reform proposals.
Before discussing any of the pricing
system proposals, we should review the
system currently used by the FDIC,
which features a flat-rate premium
levied against the total domestic deposits of the bank. The FDIC charges each

insured bank an annual premium equal
to a partially rebatable 1112 of 1 percent of total deposits, regardless of the
risk of the bank's portfolio. The size of
the rebate returned to the bank is determined by the FDIC's losses and other
expenses over the past year. The size of
the rebate per dollar of deposits is the
same for all banks regardless of risk. 3
The FDIC attempts to minimize its
exposure to risky institutions by
increasing regulatory pressure on
banks that are thought to be excessively risky. The increased regulatory
interference represents an implicit
premium adjustment that serves to
reduce the value of the bank.' However, deregulation and technological
innovations have increased the ability
of banks to circumvent the current
regulatory structure and thereby have
decreased the ability of the FDIC to use
regulation to adjust the total (explicit
plus implicit) deposit-insurance premium on the basis of risk." In contrast
to the FDIC's current pricing system,
the proposed risk-adjusted systems rely
more heavily on the use of incentives
other than regulatory interference to
force banks to bear more of the costs of
the deposit guarantees.
There are two primary ways in
which the FDIC could equate the premium it charges with the value of the
deposit guarantees received by the
bank. The first method is to charge a
risk-adjusted deposit-insurance premium that fully compensates the FDIC
for the risk-bearing services it provides.
This type of premium adjustment is
referred to as an explicit premium
adjustment. The second method is to

James B. Thomson is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank William T. Gavin, Gary Whalen, and
Walker Todd for helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

1. See Jay Rosenstein and Bartlett Naylor, "Garn
Bill Would Expand Bank Securities Powers,"
American Banker, vol. 151, No. 124, June 25,
1986.
2. See, James B. Thomson. "Equity, Efficiency,
and Mispriced Deposit Guarantees." Economic
Commentary, July 15, 1986, Federal Reserve Bank
of Cleveland.

Alternative Methods
for Assessing RiskBased DepositInsurance
Premiums
by James B. Thomson
alter the value of the guarantee so that
its value to the bank equals the depositinsurance premium. This is known as
an implicit premium adjustment. Our
discussion in this Economic Commentary will examine proposals for implicit
and explicit risk-adjusted depositinsurance premiums.
Implicit Risk-Adjusted Premiums
Implicit risk-adjustment schemes seek
to change the underlying risk-reward
incentive structure for the insured
bank. As we shall see, the majority of
implicit risk-adjusted premium proposals are aimed at reestablishing some
form of market discipline over the managers of insured banks. In the proposals
we discuss, either the stockholders or
the subordinated creditors of the bank
are relied upon to rein in a bank's risk
taking." The second feature of these
implicit premium adjustments is that
they insulate the FDIC insurance fund
from losses on the bank's portfolio.
Increased Capital Requirements. One
way of increasing stockholder discipline
over a bank's risk-taking is to raise the
costs of higher levels of bank risk to
bank stockholders through increased capital requirements. Higher levels of capital increase the amount of money that
stockholders have at risk in the bank,
thus making risky loan and investment
strategies pursued by bank managers
more costly and less attractive to stockholders. Increased capital requirements
thus serve to increase the incentives
for bank stockholders to discipline the
risk-taking behavior of bank managers'?
In addition, increased bank capital
requirements protect the FDIC's insur-

3. After deducting operating expenses and insurance losses from the gross insurance assessment,
the FDIC rebates 60 percent of the remaining
assessment income back to the banks. See Federal Deposit Insurance Corporation: The First Fifty
Years. The Federal Deposit Insurance Corporation 1984, Washington, D.C., pp. 60-61.

ance fund from losses on bank asset
portfolios because bank capital is the
first line of defense against losses on
the bank's assets. The greater the portion of any loss that is absorbed by bank
capital, the smaller the loss the FDIC
incurs. Higher levels of bank capital
also increase the FDIC's ability to alter
bank risk-taking behavior through regulatory interference by giving the FDIC
more time to detect problems and to
take the appropriate regulatory actions.
A major drawback of a uniform increase in bank capital requirements is
that it does not discriminate among
banks on the basis of risk. Banks that
aggressively exploit risky profit opportunities will face the same capital requirement as conservatively managed
banks. Although one can argue that increased capital requirements change
the risk incentive structure for risky
banks more than for conservatively
managed banks, it is doubtful that such
requirements change incentives enough
to remove all significant differences in
the risk of their asset portfolios." Furthermore, if the increased bank capital
requirements are binding on the conservatively managed banks, the use of
this tool to discipline the "high fliers"
of the banking industry has the undesired effect of punishing safe banks.

Risk-Adjusted Capital Requirements.

Banking regulators are considering
risk-based capital requirements as a
means of altering risk-taking behavior
of banks." A flat-rate deposit-insurance
premium, for example, combined with
risk-adjusted capital requirements,
may have effects equivalent to assessment of a risk-adjusted depositinsurance premium. With risk-adjusted
capital requirements, the level of capital a bank is required to hold is directly
related to the riskiness of its portfolio.
Under this method, the riskiness of the
bank would be reassessed periodically,
at least as often as the bank is examined, and if the bank's risk increased
since the last reassessment of its capital adequacy, it would be required to
increase its level of capital.
Risk-adjusted capital increases, in
concept, are a better disciplinary tool
than uniform capital increases. First,
they change the risk-reward incentive

4. Buser, Chen and Kane refer to this type of

implicit premium adjustment as a regulatory tax.
The FDIC uses increased regulatory interference
to tax away part of the gains the bank receives
by holding a riskier portfolio. See, Steven A.
Buser, Andrew C. Chen, and Edward]. Kane.
"Federal Deposit Insurance, Regulatory Policy,
and Optimal Bank Capital." Journal of Finance 36
(March 1981), pp. 51·60.

structure for risky banks without punishing conservatively managed banks.
Second, they protect the FDIC's insurance fund from risky banks by increasing the amount of potential losses
stockholders bear as the risk of the
bank increases.
However, there are some practical
problems associated with implementing
a risk-based capital requirement. The
most obvious-and common-problem
is the necessity of measuring the risk
of the bank's portfolio. (See box.) If the
procedures used to evaluate the risk of
the bank's portfolio are subject to systematic errors, then adjusting bank
capital (deposit-insurance premiums)
on the basis of the perceived riskiness
of the bank may be less accurate and
less effective than uniform capital
increases (flat-rate deposit-insurance
premiums). In fact, Pyle contends that
potential pricing errors associated with
risk-adjusted pricing (either riskadjusted capital or deposit-insurance
premiums) may provide banks with
perverse risk-taking incentives that
make risk-adjusted pricing systems less
effective, and potentially less stable,
than the current pricing system.'?
Subordinated Debt. One of the
potential flaws in the idea of using
stockholders to discipline the bank's
risk-taking is the fact that stockholders
can profit if the risky strategy pays off.
Therefore, raising equity capital to
place more of the losses on the stockholders may not always reduce the attractiveness of risky ventures to bank
managers. Also, one cannot rely solely
on depositors to exert discipline on a
bank because of the ability of large
uninsured depositors to withdraw or
set off their deposits by borrowing (that
is, by running) at the first sign of
trouble.'! Uninsured depositors who
believe that the FDIC will provide them
with 100 percent de facto insurance of
their deposits if their bank fails have
very little incentive to exert discipline
over bank risk taking.
The subordinated debt holder, however, is one class of creditor that does
have strong incentives to exert discipline over bank risk-taking-and
there
are advantages to using subordinated
debt as a means of increasing market
discipline over banks. Unlike the
stockholder, the subordinated debt
5. The FDIC presents a similar argument in its
study of risk-adjusted insurance premiums. See,
Federal Deposit Insurance Corporation. Deposit
Insurance in a Changing Environment, Washington, D.C., April 1983. For a discussion of why the
current system of federal deposit guarantees
needs to be reformed see, Edward J. Kane. The
Gathering Crisis in Federal Deposit Insurance,
MIT Press, 1985.

Measuring Risk
Risk is the degree of uncertainty
associated with future outcomes of
today's decisions. In a financial context, risk refers to the degree of
uncertainty of future income. The
more uncertain the outcome, the
greater the risk. Measuring the risk
of the insured banks is the most
important ingredient in many of the
risk-adjusted deposit-insurance
proposals. Unfortunately, measuring
the risk of insured banks is very difficult to do.
The risk of an insured bank to the
FDIC's insurance fund is typically
measured by the variation of its future income streams. Because we do
not observe the set of possible future
outcomes of decisions made by bank
managers today, we do not directly
observe the risk of the bank. The
most common way of measuring the
risk of the bank is to look at its past
performance, such as the historical
variation of its earnings, and use
that as an estimate of the variability
of the bank's earnings in the future.
In addition, bank regulators periodically examine insured banks and rate
the bank's riskiness according to the
results of the examination. The rating the bank receives is referred to
as its CAMEL rating. CAMEL
stands for the criteria on which
bank examiners base their risk ratings: Capital, Asset Quality, Management, Earnings, and Liquidity.

FDIC's insurance fund. The FDIC is
protected because subordinated debt
holders do not have a claim on the
assets of the bank until the FDIC,
uninsured depositors, and general creditors of the bank are paid."
The practical disadvantage of the subordinated debt proposal is the feasibility
of its use for medium-size banks. Large
banks with access to capital markets
theoretically would not have trouble
placing subordinated debt issues. Small
commmunity banks probably could sell
their issues in their communities. But
medium-size banks that are too large to
sell an entire issue in their community,
but too small to tap national capital
markets could have trouble issuing
enough subordinated debt to meet mandated standards. This problem is exacerbated by the necessity that the subordinated debt be short-term debt that
requires frequent refinancing.
Explicit Risk-Adjusted Premiums
The goal of this major category of pricing system proposals is to charge the
bank for the risks it imposes on the
FDIC. Unlike implicit risk-adjusted
premiums, explicit premiums are a
form of direct discipline on insured
banks. That is, the FDIC increases the
cost of its guarantees to the bank
directly, as opposed to relying on third
parties (such as stockholders and subordinated creditors), to limit excessive
risk-taking. There are three primary
types of explicit premiums.

Private Reinsurance of Deposit Guarantees. Private reinsurance of the fed-

holder does not receive profits from
risky ventures. Unlike the uninsured
depositor, the subordinated debt holder
can be cut off from any de facto deposit
guarantee if the FDIC chooses not to
liquidate a bank when it fails, and cannot withdraw his or her funds from the
bank at the first sign of trouble. Therefore, the subordinated debt holder's fortunes are inextricably linked to the risk
of the bank's portfolio.
Another advantage of forcing banks
to issue a significant amount of subordinated debt (Horvitz argues for a 3
percent subordinated debt capital
requirement in addition to primary
bank capital) is the additional protection that subordinated debt affords the

eral deposit guarantees is a way of
using the market's estimate of the
value of deposit guarantees to adjust
the deposit-insurance premium." The
basic concept behind the private reinsurance program is the extension of
FDIC guarantees to cover all deposits.
The FDIC then would assume direct
responsibility for the first $10,000 or so
of any deposit liability and private
companies would assume direct responsibility for each additional $10,000
layer or tranche of any deposit.'! This
procedure places private capital at risk
for any portion of an insured deposit
above the base FDIC insurance limit.

6. The subordinated creditors of the bank are investors with a claim on the assets of the bank
that is secondary to the claims of depositors, the
FDIC, and general creditors. In other words, if
the bank fails, and is liquidated ,the subordinated
creditors do not have a claim against the bank
until the claims of the its uninsured depositors,
general creditors, and the FDIC are paid in full.

7. See George]. Benston, Robert A. Eisenbeis,
Paul M. Horvitz, Edward]. Kane, and George G.
Kaufman. Perspectives on Safe and Sound Banking: Past, Present, and Future, MIT Press, Cambridge, MA: 1986.

The bank's total deposit-insurance
premium would be determined by the
firms in the private deposit-insurance
market. The premiums the bank pays
to the private insurers for their guarantees presumably would reflect the
risks to the private insurers arising
from those guarantees. The FDIC guarantee on the first $10,000 of deposits
would be tied to the premiums paid to
private insurers for their guarantees.
For the private insurance system to
provide the correct premium structure,
the government must allow private deposit insurers to fail when they cannot
meet their obligations. In such cases,
the FDIC would be responsible for guaranteeing the deposits previously guaranteed by the defunct private deposit
insurer. This approach also requires
sharing information on the condition of
banks between the private insurance
industry and the FDIC. Finally, private
insurers would have to be indemnified
against losses that would result if public policy allows a bank to continue to
operate after it becomes insolvent.
The current lack of interest, and
some would argue, lack of resources of
the insurance industry in providing deposit guarantees may make private reinsurance infeasible. However, if profit
opportunities were available for market
participants who provide deposit guarantees, then one would expect a private
insurance industry to develop. If a private deposit-insurance industry were to
develop, it probably would be necessary
to extend some form of capital regulation
to the private insurers to ensure that
they could reasonably meet their obligations. (Managers of private deposit insurers with little of their stockholders'
money at risk may be less likely to correctly price their deposit guarantees.)

Premiums Based on Ex Ante Risk
Measures. An alternative method of as-

sessing risk-adjusted premiums is to
base the premiums on current expectations as to the performance of the bank
over the next rating period. That is, to
set up a model that predicts the riskiness of the bank and to use the model to
set the criteria upon which the depositinsurance premiums are assessed."
These economic models attempt to estimate the risk exposure of the FDIC to
an insured bank. With such estimates,

8. It is possible that increases in capital requirements may have perverse effects on the risk
incentives of banks, causing them to increase the
risk of their portfolios. See Anthony M. Santomero and Ronald D. Watson, "Determining an
Optimal Capital Standard for the Banking Industry." Journal of Finance, vol. 32, no. 4 (September
1977), pp. 1267-82.

administrative prices could be set to
determine the aggregate risk levels for
the insured industry. Individual institutions would be allowed to determine
the level of risk that is appropriate for
their institution, given the administrative price set for the deposit insurance.
The main advantage of an ex ante
pricing system is that, like the riskbased capital proposals, it directly
affects the risk-taking incentives of
insured banks. The primary disadvantage is that we have to be able to measure the riskiness of insured banks. As
with risk-based capital guidelines, systematic errors in measuring bank risk
can make ex ante risk-adjusted premium systems unstable. In addition, if
the model is not flexible and forwardlooking, banks may seek to exploit new
forms of unregulated risks. The growth
of off-balance-sheet risks is an example
of how banks can avoid regulations
intended to limit risk taking.
Ex Post Premiums. An alternative
way of risk-adjusting deposit-insurance
premiums is to base them on the actual
(ex post) performance of the bank. This
would increase the costs of risk-taking
by bank managers by charging banks a
deposit-insurance premium that is
inversely related to the bank's performance. Typically, ex post risk-adjusted
pricing proposals would levy a flat-rate
deposit-insurance premium on the
insured bank at the beginning of the
period over which the premium is
assessed. The ex post risk adjustment
to the insurance premium comes in the
form of either a surcharge or a rebate
to the insured banks, depending upon
the quality of their actual performance.
The size of the premium surcharge or
rebate that the bank either pays or receives would be adjusted according to
the riskiness of the bank's operations
relative to the banking industry as a
whole. The total deposit-insurance premium paid by the banking industry
would be set to compensate the FDIC for
its risk exposure to the banking industry as a whole. The system of rebates
and surcharges, however, would allocate
the burden of the insurance premium on
individual banks on the basis of their
performance over the rating period. 16

9. See Robert M. Garson. "Comptroller Says
Regulators May Issue One Risk-Based Capital
Proposal by Fail." American Banker, vol. 151, no.
135 (Iuly 11, 1986).
10. See, David H. Pyle, "Pricing Deposit Insurance: The Effects of Mismeasurement" Federal
Reserve Bank of San Francisco, Working Paper
8305, October 1983.