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February 15, 1994

Federal Reserve Bank of Cleveland

The National Depositor Preference Law
by James B. Thomson

-Liast August 10, Congress passed the
Omnibus Budget Reconciliation Act of
1993 (OBRA93). Contained in this legislation was a provision that dramatically
revised the priority of claims on failed depository institutions. The Act's effect was
to give depositors (and, by implication,
the Federal Deposit Insurance Corporation
[FDIC]) a superior, or preferred, claim on
a failed bank's assets relative to that of
other general creditors. By doing so, Congress hoped to reduce the FDIC's losses
from bank failures. In fact, the Office of
Management and Budget estimated that a
national depositor preference law could cut
the FDIC's expected losses by $1 billion
over the next five years.
Being buried in a much larger piece of
legislation, depositor preference received
little public attention and was passed with
almost no debate. This is unfortunate, because economic policies often have unintended, secondary effects that dominate
the intended ones. In the case of depositor preference laws, the general creditors
of banking firms are likely to take action
to protect their claims. As a consequence,
the loss exposure of the FDIC could actually increase.
In this article, we take a critical look at
depositor preference. The first section
outlines the new legislation and the
FDIC's implementation of it, and the
second examines the way in which depositor preference restructures a bank's
liabilities. We then examine the possible reactions of nondeposit creditors to
this restructuring and discuss the implications for policy.

• The Legislative Provisions
Title III of OBRA93 instituted depositor
preference for all insured depository institutions by amending Section 1 l(d)(l 1) of
the Federal Deposit Insurance Corporation Act.2 The amendment establishes
the following priority of payment in resolving failed depositories:
1. Administrative expenses of the

Deposit liabilities


General or senior liabilities


Subordinated obligations


Shareholder claims

Prior to passage, general or other senior
liabilities had the same priority of payment as deposits. As before, secured
creditors of the failed institution will
have their claims satisfied first, up to the
amount of the collateral. This is an important detail, since one avenue for general
or senior creditors to pursue in reaction to
depositor preference laws is to take collateral to protect their claim.
On August 13, 1993, the FDIC issued
an interim rule interpreting the depositor preference amendment.3 The importance of this rule is that it clarifies
what the FDIC will consider as administrative expenses of the receiver. Under the FDIC's interpretation, these include "post-appointment obligations
incurred by the receiver as part of the
liquidation of an institution ... and certain expenses incurred prior to the appointment of the receiver."4 In other
words, the receiver (which for most
banks and thrifts is the FDIC) may pay
expenses it deems consistent with the
orderly closure of the institution, even

The national depositor preference
law was added to the 1993 budget act
to reduce the government's cost of
providing deposit insurance. A careful look at depositor preference and
its attendant effects suggests that it
will provide only minor cost savings.
In fact, in some cases it could increase
the Federal Deposit Insurance Corporation's losses from bank failures.

Liabilities with No Depositor Preference


Collateral (CA)
General assets (GA)

Collateralized claims (CC)
Senior claims (SC)
Insured deposits (FDIC)
Uninsured deposits (UD)
General creditor claims (GCC)
Subordinated debt claims (SDB)
Equity (E)
Liabilities with Depositor Preference
Collateralized claims (CC)
Deposit claims (SDC)
Insured deposits (FDIC)
Uninsured deposits (UD)
Other senior claims (OSC)
General creditor claims (GCC)
Subordinated debt claims (SDB)
Equity (E)

if those expenses were incurred prior to
closure. These pre-receivership costs
include payment of the institution's last
payroll, guard services, data processing
services, utilities, and leases. Examples
of expenses that would be excluded
from administrative expenses are items
such as golden parachute claims, severance pay claims, and liabilities arising
from the repudiation of contracts.
One issue not addressed by the interim
rule is the status of deposits in foreign
branches of insured depositories. Such
deposits are excluded from the assessment base of the FDIC and thus, for purposes of deposit insurance, are different
from domestic deposit claims. Consequently, a reasonable interpretation of the
depositor preference statute is that foreign depositors are considered general
creditors.5 It is possible that the FDIC's
final ruling will reflect this view.
• A Simple Look
at Depositor Preference
To understand the impact of depositor
preference, it is useful to look at a simple example of the bank receivership
process both before and after passage
ofOBRA93.6 We assume here that the
administrative claims of the receiver
have already been paid. Above, we
show a simplified bank balance sheet
with and without depositor preference.

Liabilities are listed in order of priority
of payment.
When a depository enters receivership,
secured creditors take possession of the
specific collateral securing their claim.
For simplicity, we assume that collateral equals collateralized claims (CA =
CC), so that the value of the collateral
exactly exhausts the claims of the secured creditors.7 Without depositor
preference, the general asset pool (GA)
is used first to pay the claims of senior
creditors. If this amount is less than the
general asset pool, then the residual
funds (GA - SC) are used to meet the
claims of the junior (subordinated)
creditors, with any remainder accruing
to equityholders. If, however, senior
creditor claims exceed the value of the
institution's assets, then each senior
claimant will share in the shortfall in
proportion to his claim. That is, each
will receive W*(GA) in payments,
where Wi is the percentage of total
senior claims accounted for by the /"'
senior creditor (/ = FDIC, uninsured deposits [UD], and general creditor
claims [GCC]).
To see how depositor preference is intended to work, consider the following
example. Let the value of collateralized
assets and collateralized claims be
equal. Furthermore, let the total general
asset pool equal $10 million and senior

claims equal $12 million, distributed as
follows: insured deposits (FDIC) = $8
million, uninsured deposits = $3 million, and general creditor claims = $1
million.8 The proportion of senior claims
by type are WFDIC = 0.6667 (8/12), WUD
= 0.25, and WGCC = 0.0833. Since senior
claims exceed the general asset pool by
$2 million, senior creditors are not repaid
in full: Each loses $0.17 per dollar of
claim. Without depositor preference, total
payments to senior creditors are $6,667
million to the FDIC, $2,500 million to uninsured depositors, and $0,833 million to
general creditors (see table 1).
Under depositor preference, general
creditor claims would be paid after
those of both the uninsured depositors
and the FDIC (see box). Therefore, after netting out the collateralized claims,
the available general asset pool is used
first to satisfy the claims of depositors,
with any remaining funds going to satisfy the claims of the other senior creditors and then the subordinated debtholders. Using numbers from the above
example, we can see the intended effect
of depositor preference. Depositors'
claims (the FDIC and uninsured depositors) equal $ 11 million. By giving each
a higher priority of payment in receivership, general creditor claims now provide them with a loss buffer. Since general assets equal $10 million, the FDIC
and uninsured depositors will exhaust
the asset pool. Losses per dollar of deposit are $0.09, 45 percent less than
without depositor preference. For comparison purposes, payments are $7,273
million to the FDIC, $2,727 million to
uninsured depositors, and $0 to general
creditors. Depositor preference reduces
the losses of the FDIC and uninsured
depositors by redistributing wealth to
them from the general creditors.
• Unintended Effects
of Depositor Preference
The above example illustrates how depositor preference is intended to work.
However, general creditors of insured
depositories will certainly respond to
the changes in the priority of their
claims and the attendant increase in
riskiness. At the very least, they will
charge the depository institution a


(Millions of dollars)
Depositor Preference
No Depositor Preference
(GA = $10 Million)

Intended Outcome
(GA = $10 Million)

Unintended Outcome
(GA = $9.16 Million)





























W, = Weight of the /''' claimant in the general asset pool.
GA = General asset pool remaining after secured creditors' claim.
FDIC = Federal Deposit Insurance Corporation's claim.
UD = Uninsured depositors' claim.
GCC = General creditors' claim.
SOURCE: Author's calculations.

higher rate of interest to compensate
for their increased risk of loss. As the
cost of nondeposit funds rises relative
to deposits, depositories will decrease
their funding in nondeposit markets.
Thus, the loss buffer that nondeposit
creditors afford to uninsured depositors
and the FDIC will be reduced.

buffer afforded by general creditor
claims will be reduced. Second, and
more important, the general asset pool
available to pay unsecured claims will
also shrink. If enough general creditor
claims take collateral, the total loss
exposure of the FDIC and uninsured
depositors could increase.

A second possible response by senior
nondeposit creditors would be to shorten the average maturity of their claims.
By doing so, they would enhance their
ability to "run" on the institution if its
condition deteriorates. In fact, financially distressed depositories may find
it difficult or even impossible to issue
unsecured nondeposit claims. This response has two implications: First, if
nondeposit creditors can effectively
exit a troubled institution before it is
closed, little or no loss cushion will be
afforded to the uninsured depositors or
the FDIC by the general creditors. Second, the failure of nondeposit creditors
to renew their claims could trigger a
liquidity crisis that would result in closure of the institution.9

To see this, consider the example in the
previous section. If $840,000 of general creditor claims become fully secured (that is, 100 percent collateral ized) in response to the depositor
preference law, then the general asset
pool available to pay the FDIC and uninsured depositors would be $9.16 million. The total payouts would then be
$6,662 million to the FDIC, $2,498 million to uninsured depositors, and $0 to
general creditors. As a result, depositor
preference would increase the losses of
the FDIC and uninsured depositors by
$5,000 and $2,000, respectively.

The third option for unsecured creditors
is to take collateral against their claim.
By becoming secured creditors, they
transform their claim into one that is
senior (to the extent of the collateral) to
deposit claims. This in turn will have
two effects on the claims of uninsured
depositors and the FDIC. First, the loss

A recent study of state depositor preference laws finds that the unintended effects negate most of the intended
ones.10 The authors conclude that introducing depositor preference at the
federal level "would sharply increase
the use of collateralization by nondeposit creditors...." They also show that
the highest degree of collateralization
by nondeposit creditors in states with
depositor preference laws is in troubled
and insolvent thrifts. Overall, the study

concludes that depositor preference
may provide marginal benefits to the
deposit insurer and uninsured depositors, but it also warns that each could
experience higher losses if enough nondeposit creditors secure their claims by
taking collateral.
• Conclusion
The overall impact of national depositor
preference is likely to be minimal.
Clearly, the law will result in some
changes in the liability structure of
banks. Depositors and the FDIC will
benefit from these changes to the extent that nondeposit creditors serve as a
loss buffer when a bank is closed. The
FDIC may also gain in another way.
Deposit insurance premiums are assessed
only on domestic deposits. Since depositor preference raises a bank's cost of
nondeposit funds relative to deposits, it
reduces the advantages of issuing senior nondeposit liabilities to avoid deposit insurance assessments. This is
especially true if foreign deposits are
classified as nondeposit liabilities under
the new law.
On the flip side, nondeposit creditors will
not react passively to the subordination
of their claims. This means that while depositor preference may produce some
cost savings for the FDIC in the short
term, the long-term benefits are likely to
be greatly diminished. Moreover, if a sufficient number of nondeposit creditors
take collateral and hence convert their
claims to ones senior to deposits, the
losses of uninsured depositors and the
FDIC could actually increase.

• Footnotes
1. The Office of Management and Budget's
estimate can be found in Statement 98 of the
Shadow Financial Regulatory Committee,
"The New Depositor Preference Legislation,"
issued September 20,1993.
2. 12U.S.C. 1821 (d)( 11). At the time national depositor preference was enacted, 29
states had similar laws covering state-chartered
banks and 18 had statutes covering statechartered thrift institutions.
3. The interim rule was issued because the
law went into effect immediately upon enactment of the legislation. Thus, the FDIC did
not have the luxury of issuing a rule for comment and then implementing a revised version. See Federal Register, vol. 58, no. 155
(August 13, 1993), pp. 43,069 - 070. At the
time of this writing, the FDIC had not issued
its final ruling.
4. Ibid.
5. In fact, the Shadow Financial Regulatory
Committee adopted this interpretation. See
"The New Depositor Preference Legislation"
(footnote 1).

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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6. For a more thorough presentation of how
depositor preference affects the cost of capital for banks and federal deposit insurance,
see William P. Osterberg and James B. Thomson, "Depositor Preference and the Cost of
Capital for Insured Depository Institutions,"
Federal Reserve Bank of Cleveland, Working
Paper 9405 (forthcoming).
7. If CA > CC, then the excess collateral
(CA - CC) is dumped into the general asset
pool for distribution to noncollateralized
creditors. If CC > CA, then the ex post unsecured claims (CC - CA) are lumped into the
senior claim pool as a general creditor.
8. The FDIC guarantees the principal and
interest of all deposit accounts up to $100,000.
When a bank enters receivership, it is appropriate to think of the FDIC as paying off the
insured depositors in exchange for their claim
on the institution's assets. Hence, our discussion of how depositor preference works refers to deposits as uninsured depositor claims
and FDIC claims.

9. The decision to close a bank is based on
one of two measures of solvency: the incapacity to pay obligations as they mature or
book-value balance-sheet insolvency. Inability to renew nondeposit credits could trigger
insolvency under the maturing obligations
test. See James B. Thomson, "Modeling the
Bank Regulator's Closure Option: A TwoStep Logit Regression Approach," Journal of
Financial Services Research, vol. 6, no. 1
(May 1992), pp. 5-23.
10. See Eric Hirschhorn and David Zervos,
"Policies to Change the Priority of Claimants:
The Case of Depositor Preference Laws," Journal of Financial Sendees Research, vol. 4, no.
1 (March 1990), pp. 111-26.

James B. Thomson is an assistant vice president and economist at the Federal Reserve
Bank of Cleveland.
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

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