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ECONOMIC IMPUCATIONS OF THE "TOO BIG TO
FAIL" POLICY

HEARING
BEFORE THE

SUBCOMMITTEE ON
ECONOMIC STABILIZATION
OF THE

COMMITTEE ON BANKING, FINANCE AND
UEBAN AFFAIKS
HOUSE OF KEPRESENTATIVES
ONE HUNDRED SECOND CONGRESS
FIRST SESSION

MAY 9, 1991
Printed for the use of the Committee on Banking, Finance and Urban Affairs

Serial No. 102-31

For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402




ISBN 0-16-035335-1

HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
HENRY B. GONZALEZ, Texas, Chairman
CHALMERS P. WYLIE, Ohio
FRANK ANNUNZIO, Illinois
JIM LEACH, Iowa
STEPHEN L. NEAL, North Carolina
BILL McCOLLUM, Florida
CARROLL HUBBARD, JR., Kentucky
MARGE ROUKEMA, New Jersey
JOHN J. LAFALCE, New York
DOUG BEREUTER, Nebraska
MARY ROSE OAKAR, Ohio
THOMAS J. RIDGE, Pennsylvania
BRUCE F. VENTO, Minnesota
TOBY ROTH, Wisconsin
DOUG BARNARD, JR., Georgia
ALFRED A. (AL) McCANDLESS, California
CHARLES E. SCHUMER, New York
RICHARD H. BAKER, Louisiana
BARNEY FRANK, Massachusetts
CLIFF STEARNS, Florida
BEN ERDREICH, Alabama
PAUL E. GILLMOR, Ohio
THOMAS R. CARPER, Delaware
BILL PAXON, New York
ESTEBAN EDWARD TORRES, California
JOHN J. DUNCAN, JR., Tennessee
GERALD D. KLECZKA, Wisconsin
TOM CAMPBELL, California
PAUL E. KANJORSKI, Pennsylvania
EUZABETH J. PATTERSON, South Carolina MEL HANCOCK, Missouri
FRANK D. RIGGS, California
JOSEPH P. KENNEDY II, Massachusetts
JIM NUSSLE, Iowa
FLOYD H. FLAKE, New York
RICHARD K. ARMEY, Texas
KWEISI MFUME, Maryland
CRAIG THOMAS, Wyoming
PETER HOAGLAND, Nebraska
RICHARD E. NEAL, Massachusetts
BERNARD SANDERS, Vermont
CHARLES J. LUKEN, Ohio
MAXINE WATERS, California
LARRY LAROCCO, Idaho
BILL ORTON, Utah
JIM BACCHUS, Florida
JAMES P. MORAN, Virginia
JOHN W. COX, JR., Illinois
TED WEISS, New York
JIM SLATTERY, Kansas
GARY L. ACKERMAN, New York
SUBCOMMITTEE ON ECONOMIC STABILIZATION

THOMAS R. CARPER, Delaware, Chairman
JOHN J. LAFALCE, New York
THOMAS J. RIDGE, Pennsylvania
MARY ROSE OAKAR, Ohio
BILL PAXON, New York
BRUCE F. VENTO, Minnesota
MEL HANCOCK, Missouri
PAUL E. KANJORSKI, Pennsylvania
JIM NUSSLE, Iowa
ELIZABETH J. PATTERSON, South Carolina RICHARD ARMEY, Texas
PETER HOAGLAND, Nebraska
CRAIG THOMAS, Wyoming
CHARLES J. LUKEN, Ohio
JAMES P. MORAN, Virginia




(II)

CONTENTS
Page

Hearing held on:
May 9, 1991
Appendix:
May 9, 1991

1
65
WITNESSES
THURSDAY, MAY 9,

1991

Brandon, William H., Jr., president, First National Bank of Phillips County,
Helena, AR, American Bankers Association
Clarke, Robert L., Comptroller of the Currency, Office of the Comptroller of
the Currency
Ely, Bert, president, Ely & Company, Inc., Alexandria, VA
Finch, Johnny C, General Acconutig Office, Director of Planning and Reporting, General Accounting Division, accompanied by Craig Simmons and
Steve Swaim
Glauber, Robert R., Under Secretary of the Treasury for Finance, Department
of the Treasury
Kaufman, George G., Professor of Finance and Economics, Loyola University
of Chicago, Chicago. IL
LaWare, John, Governor, Board of Governors of the Federal Reserve System...
Seidman, L. William, Chairman, Federal Deposit Insurance Corporation
Wright, Howard L., Director of Regulatory Matters, Office of Financial Markets, Arthur Anderson & Company, Member, The Committee for Responsible Financial Reform

48
5
50
36
6
52
9
3
54

APPENDIX
Prepared statements:
Carper, Hon. Thomas R
Ridge, Hon. Thomas J
Brandon, William H., Jr., with attachment
Clarke, Robert L
Ely, Bert
Finch, Johnny C
Glauber, Robert R
Kaufman, George G
LaWare, John
Seidman, L. William
Wright, Howard W

,
<

v.

66
68
147
96
218
131
102
191
Ill
69
202

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

American Bankers Association, Washington, DC., paper entitled "A Response
to the Concerns About Final Settlement Payment Approach"
Chicago Clearing House Association, News Release, "Chicago Bankers Oppose
Too Big Too Fail" dated April 26,1991
Ely, Bert, oral statement "Abandoning Too-Big-To-Fail: The Impossible
Dream"




(in)

163
214
216

ECONOMIC IMPLICATIONS OF THE "TOO BIG TO
FAIL" POLICY
THURSDAY, MAY 9, 1991
HOUSE OF REPRESENTATIVES,
COMMITTEE ON BANKING, FINANCE AND URBAN FINANCE,
SUBCOMMITTEE ON ECONOMIC STABILIZATION,

Washington, DC,
The subcommittee met, pursuant to call at 10:05 a.m., in room
2128, Rayburn House Office Building, Hon. Thomas R. Carper
[chairman of the subcommittee] presiding.
Present: Chairman Carper, Representatives Vento, Patterson,
Hoagland, Luken, Moran, Ridge, Hancock, Nussle, and Thomas.
Also Present: Representative McCandless.
Chairman CARPER. Welcome to each of you here with us today.
The Democratic Caucus of the full House of Representatives is
having a session this morning. I think it deals with the confirmation of a subcommittee chairman or a committee chairman, and we
will be joined probably during the next hour by most of the Democrats on the panel:
We have already been joined by a number of our Republican colleagues, including Mr. McCandless, who is sitting in today, though
not a member of our subcommittee. We welcome him.
I want to thank my fellow members of our subcommittee and our
witnesses for joining us here today to discuss the economic implications of the too-big-to-fail policy and proposed legislative changes to
this policy.
Bank failures occurred at a record level in the 1980's. In the last
3 years alone, close to 600 banks have failed or received assistance,
and this trend is not likely to significantly change in the near
future. Yet, not all of these failed institutions have been resolved
in the same manner.
While deposit insurance protection has been routinely extended
to insured depositors when large banks fail, such protection has not
always been afforded to uninsured depositors when small banks
fail.
This policy of protecting uninsured depositors in large bank failures in order to prevent adverse effects on the financial system and
the macro economy is commonly referred to as the too-big-to-fail
doctrine.
While some argue that the policy has been important in maintaining a stable financial system in our country, it has resulted in
inequitable treatment of depositors and banks, increased costs to




(l)

2
the bank insurance fund, increased taxpayer exposure, and market
discipline.
For those reasons, the too-big-to-fail policy is one of the most controversial issues in the banking community today. It presents
Members of the House and Senate Banking Committees with one of
the thorniest problems to resolve as we debate bank reform this
year.
Congress' ultimate goal should be to reform the banking industry
in a way that will restore vitality to the banking industry, benefit
consumers and avoid another taxpayer bailout.
To reach that goal, the too-big-to-fail issue must be resolved. I
commend Chairman Gonzalez and Chairman Annunzio for beginning to address the too-big-to-fail issue in H.R. 2094, but I believe
that important questions still remain unanswered.
The purpose of today's hearing is to review in detail the economic justifications for a too-big-to-fail policy, and the economic implications of proposed changes to this policy. We have a full plate
before us today, with a number of witnesses scheduled to testify.
I will save all of you from a long opening statement at this point,
and just say that I look forward to hearing from each of our distinguished panel of witnesses. Having said that, I will defer to any of
our colleagues who have an opening statement. Please.
Mr. NUSSLE. Thank you, Mr. Chairman, and thank you for the
opportunity to participate in an important debate on the too-big-tofail policy. I also want to thank the distinguished members of the
panel for coming before the subcommittee.
I realize my duties in Congress are two-fold. First, I have the interests of Iowa to consider, but I also have a national responsibility
to work for sound national policies. Quite frankly, I have a concern
that too-big-to-fail policy is neither.
Is it good policy and is it good for Iowa? I come from a small
town in Iowa with a population of 5,000, some say, when everyone
is there visiting relatives and friends, and the communities surrounding my town are not much bigger.
The current situation with too-big-to-fail banks is, in some people's opinions, unfair to Iowa bankers who run the healthiest banks
in the Nation, and who are paying deposit insurance premiums
which go to cover uninsured deposits.
We now have an opportunity to fix this inequity in the banking
system via the proposed banking reform legislation. I am encouraged by the Treasury's proposal for early intervention into troubled banks to solve the problem before the question arises about
covering those uninsured deposits.
However, I am troubled with the legislation the way it is now. I
am afraid that limiting deposit insurance for individuals, while toobig-to-fail policy is still intact, will drive deposits out of Iowa banks
and into big city banks. And when loan making authority is taken
from local bank officials, community needs are not given the same
consideration as the bottom line.
In closing, I want to reiterate my strong desire to see the banking industry nursed back to wellness, but I ask that it not be done
at the expense of Iowa banks and those small community banks
that we find in towns like the town I come from.
Thank you, Mr. Chairman.




3

Chairman CARPER. Thank you, Mr. Nussle.
Any other opening statements?
Mr. THOMAS. Thank you, Mr. Chairman.
This is the first time I have been on this subcommittee. I appreciate very much your talking about this subject.
Chairman CARPER. We are always glad to have another at-large
representative here.
Mr. THOMAS. Yes, there aren't many of us, are there? I probably
have heard more about this than most any of the other several
items we talk about from the banks in Wyoming, so I look forward
to this hearing. Thank you.
Chairman CARPER. Thank you very much.
Gentlemen, we have three panels today.
The first of those panels is assembled before us, and I will call on
Mr. Seidman to present the first testimony. Before I do, I would
just share with our audience that I noted to Mr. Seidman that I
had not seen him earlier this year on Capitol Hill, and he said this
was the first time he has been called to testify.
He said that with tongue firmly in cheek, but we are glad you
were able to work this into your schedule.
Mr. Clarke, I noted that this year as the number of hearings is
going up, banking failures seem to be diminishing, so maybe we
can continue to hold more hearings and hopefully that trend line
will continue.
In any event, we welcome you all. Chairman Seidman, why don't
you be our lead off hitter. Thank you.
STATEMENT OF L. WILLIAM SEIDMAN, CHAIRMAN, FEDERAL
DEPOSIT INSURANCE CORPORATION
Mr. SEIDMAN. Thank you, Mr. Chairman, members of the subcommittee. I am pleased to appear before you today to discuss the
Federal Deposit Insurance Corporation's views on the resolution of
large failing banks and on proposed legislative changes to the
FDICs cost test.
These issues have become known as too-big-to-fail problems.
First, let me point out that too-big-to-fail is not really a deposit insurance issue.
Every major country has to deal with the problem, whether or
not they have a deposit insurance system. In our country it has
become a deposit insurance issue because the fund is where money
is available to deal with the problem.
As Willy Sutton said, when asked why he robs banks, he replied,
that is where the money is, and that is how deposit insurance fund,
I think, has become the focal point for this issue. There is no question that our too-big-to-fail system has raised problems.
Unfortunately, there are no easy answers. We want to provide
both fairness between small and large banks, and at the same time
to provide safety and soundness for the system in the event of a
major institution failure. Our long run goal, of course, should be to
strengthen the entire banking system so that the question of which
institutions can fail will no longer be of paramount concern.
In the interim we suggest that constructive ambiguity as to who
will be too big to fail should continue, and too big to fail should be




4

administered and paid for by the administration in power, after
consultation with other regulators.
In making such a recommendation, we must realize that it puts
small banks at a competitive disadvantage that can only be compensated for by fairly extensive deposit insurance coverage. Without it, funds will flow from the small to the large institutions because too-big-to-fail is still a possible event.
As I have said, in our view there can be situations in which the
need to maintain financial stability is the overriding concern and
an institution is too big to be allowed to have its depositor—uninsured depositors take losses and therefore action is required.
However, I would point out that over the past 5 years the FDIC
has determined that only four banks were, 'too big to fail"—that
is, essential under the statute. Therefore we have protected all depositors under that doctrine in only four banks. The cost of protecting the uninsured depositors of these institutions was less than $1
billion or about 3.5 percent of the FDICs total insurance losses over
this time period.
If one is looking for a way to insure that the BIF fund restores
its solvency, one should not look to eliminating the too-big-to-fail
doctrine as a major source of revenue. The losses have simply been
very small in relation to the total losses we have suffered. So toobig-to-fail is not a major factor in the situation that we are facing
with respect to recapitalization of the fund.
Although most other countries do not have a deposit insurance
entity with powers equivalent to the FDICs, as I have said, all
other major countries have reserved for themselves considerable
flexibility in the handling of large bank failures.
While publicly no foreign government will admit that their country has a too-big-to-fail policy, privately they acknowledge that
there may be banks that are too big to fail, simply because large
banks often are such important components in the Nation's payment system, and the failure of a major bank could have very adverse macroeconomic effects, particularly where the concentration
in banking is much larger than it is in the United States. So I
think that the countries of the world agree that an absolute elimination of the government's ability to deal with a failure of a large
institution by law is not wise and that there must be in the government somewhere the ability to deal with the possible effects of a
large bank failure.
In recognizing this fact of life, however, we must also recognize
that we have an unusual banking system, with over 30,000 small
institutions using deposit insurance to help them in the competition in gathering funds. To the extent that we find we cannot
eliminate too big to fail entirely, we must view deposit insurance
as a compensating factor in keeping our small banks and our dual
banking system healthy.
The two are intimately related and in my view cannot be separated. Thank you, Mr. Chairman.
[The prepared statement of Mr. Seidman can be found in the appendix.]
Chairman CARPER. Mr. Seidman, we thank you very much. I am
going to turn to Mr. Clarke as our second witness.
Mr. Clarke.




5
STATEMENT OF ROBERT L. CLARKE, COMPTROLLER OF THE
CURRENCY, OFFICE OF THE COMPTROLLER OF THE CURRENCY
Mr. CLARKE. Thank you. Mr. Chairman and members of the subcommittee, I am pleased to be here with my colleagues this morning to discuss whether and when it may be necessary, under limited circumstances, to preserve the stability of financial markets by
protecting the uninsured depositors of a bank that fails. I have submitted a detailed written statement for the record, and so in the
interest of time this morning I would like to focus my opening remarks on the approach to the issue that has been outlined in the
administration's bill, H.R. 1505, an approach that has my full support.
The Treasury has developed a reasoned and balanced approach
to the issue in a legislative package that would narrow the circumstances under which coverage of uninsured depositors would be
provided, in large part by strengthening supervisory standards and
by stressing the importance of equity capital.
Deciding when and how much protection to grant these depositors is an extraordinarily difficult choice to make. Too little protection could threaten the stability of financial markets. Why do I say
that? Because of two distinct risks. The first is the possibility that
the failure of a prominent bank may provoke both insured and uninsured depositors at other banks to withdraw their funds. The
second is that the failure of a large bank could seriously disrupt
the payment system and the markets for Federal funds, government securities, mortgage-backed securities, foreign exchange and
a variety of other financial instruments. Large banks provide clearing and settlement services to smaller banks, and they play a central role in organizing these markets.
On the other hand, too much protection for uninsured depositors
also causes problems. It raises serious questions about competitive
equity. It can reduce incentives for uninsured depositors to monitor
the riskiness of institutions, and it has the potential to strain the
resources of the Federal deposit insurer.
The administration's proposal strikes a balance between the conflicting objectives of preservation of systemic stability, protection of
the insurance fund, and the equitable treatment of large and small
banks. I stress again that it is a difficult issue to come to grips
with.
Determining policies to resolve the failures of banks, particularly
large ones, is a complex task. It involves weighing the need to control the risks that I noted earlier against the objectives of limiting
exposure to the insurance fund and promoting market fairness and
discipline.
Some have proposed to eliminate altogether the policy of covering uninsured deposits at any bank that fails. That would go too
far in one direction. While it could greatly increase market discipline, it would do so at the cost of preventing action in those instances when covering insured deposits is necessary. It would also
place U.S. banks at a disadvantage in competing with banks in
other countries, as Chairman Seidman just indicated, where full
protection is frequently provided to all deposits, although not necessarily through a deposit insurance system such as we have in




6
this country. It could also reduce the willingness of foreign banks
to deal with U.S. banks.
But the opposite extreme, covering uninsured deposits at all
banks, which others have proposed as a fair solution, would go too
far in the other direction. It might solve the systemic risk problem,
but at the cost of exposing the deposit insurance fund and taxpayers to far too much risk.
A more reasoned approach is for the government to retain the
authority to protect uninsured depositors in exceptional cases when
failing to do so would pose unacceptable systemic risk, but to use
that authority sparingly. The administration's banking reform bill
would accomplish this objective by doing two things: First of all, requiring the FDIC always to resolve bank failures at the least cost
and, second, by giving the Federal Reserve Board and the Treasury
Department joint authority in consultation with the Office of Management and Budget and the FDIC, to direct the FDIC to provide
broader coverage if they consider it necessary to protect the financial system.
At the same time, as I noted earlier, other provisions in the administration's bill should reduce the frequency with which the government is faced with these types of decisions. The bill's emphasis
on equity capital and prompt corrective action can be expected to
modify banking behavior and attitudes to make costly failures of
large banks less likely.
This is the sensible approach. Mr. Chairman, the current deposit
insurance system, in effect, provides coverage for virtually all bank
deposits, an extension of the Federal safety net that goes well
beyond the original purpose of deposit insurance. The deposit insurance system should generally limit protection to insured deposits, except where more extensive coverage is less costly to FDIC,
while retaining the flexibility to deal with the genuine and very
real issues of systematic risk. The administration's bill is designed
to do just that.
Thank you, and I look forward to your questions.
[The prepared statement of Mr. Clarke can be found in the appendix.]
Chairman CARPER. Mr. Clarke, we thank you for your testimony
today. I note the arrival of Mr. Luken, and we welcome you to our
hearing today. Now, I would like to turn to a representative from
the Department of the Treasury, Mr. Glauber, who is the Under
Secretary of the Treasury for Finance. We welcome you and look
forward to your testimony.
STATEMENT OF ROBERT R. GLAUBER, UNDER SECRETARY OF
THE TREASURY FOR FINANCE, DEPARTMENT OF THE TREASURY

Thank you, Mr. Chairman, members of the subcommittee, with
your permission, I will read a shortened form of my full testimony
and ask that all of it be put in the record.
It is a pleasure to explain the administration's proposal to roll
back the Federal Deposit Insurance Corporation's too-big-to-fail
policy, which currently results in the protection of all uninsured
deposits in most bank failures, particularly larger ones.




7
This broad expansion of the Federal Deposit Insurance guarantee
has greatly increased taxpayer exposure. It is also unfair to those
smaller banks that do not receive this blanket de facto protection.
Our proposal ends this routine protection of uninsured depositors
without compromising the safety and stability of our financial
system. We firmly believe that this is the most sensible way to address this very difficult problem. Let me acknowledge at the outset
that the administration's proposal preserves the flexibility of the
government to protect the Nation's financial system in times of
crisis.
In rare cases this may result in the protection of uninsured depositors in bank failures. These rare occasions will no doubt raise
some of the same questions of unfairness and taxpayer exposure as
today's policy of routinely protecting most uninsured deposits. But
a policy that risks our financial system to avoid an exceptional
case of "unfairness," would be dangerous and irresponsible, in my
view.
In the end, the only way to truly eliminate our continual confrontations with the unfairness of protecting uninsured depositors
is to fix the underlying system. Other countries rarely confront the
too-big-to-fail issue because they rarely have bank failures.
We simply must have fewer costly bank failures and fewer
threats to our economy. That means comprehensive reform that results in stable and profitable banks, prompt corrective action for
weak banks, streamlined supervision, and a recapitalized Bank Insurance Fund.
That, Mr. Chairman, is exactly what the administration has set
forth before the Congress in H.R. 1505. Too big to fail is a part of
the FDICs current policy to routinely extend deposit insurance protection beyond $100,000 limit to uninsured depositors.
There are three fundamental problems arising from this policy,
increased taxpayer exposure to losses, the removal of market discipline over weak and risky banks, and the unfairness of protecting
some uninsured deposits, but not others. Since the first two problems are self-evident, let me concentrate on the fairness issue. Protection of uninsured depositors in large banks, but not small banks
can give large banks an unfair funding advantage for large deposits.
This unfairness was brought into sharp contrast with the recent
decisions to protect uninsured depositors in the resolution of the
Bank of New England and not to protect them in the resolution of
the Freedom National Bank in Harlem.
We all know the unfairness of protecting some uninsured depositors and not others has become the battle cry of smaller banks and
the public, and with good reason. There are basically three ways to
address this fairness problem.
First is to expand the current practice even further; that is to
simply protect all depositors, insured and uninsured at all banks.
This is the position preferred by small banks as being most fair because it would neutralize bank size as a major factor in the competition for funds.
But it would not be fair to the taxpayers. Their exposure could
go up. Extending the Federal safety net of deposit insurance to all




8
deposits eliminates all market discipline, even from sophisticated
depositors. That can only make the banking system more risky.
The second approach is never to protect uninsured deposits at
all. This approach, too, would be "fair." Banks of all sizes would be
treated identically and uninsured depositors would have no incentive to place funds on the basis of protection in the event of failure,
but this approach creates problems of systematic risk.
It is simplistic and I think dangerous. We believe that the only
sensible solution is a third approach that balances all of the factors
involved—one that rolls back the routine protection of uninsured
depositors, preserves the government's ability to protect the financial system, and embraces new ways to reduce the systematic risk
involved in bank failures.
Our approach is intended to reduce taxpayer exposure and
reduce unfairness to small banks. It would roll back the too-big-tofail doctrine to true instances of systematic risk and make it the
rare exception in bank failures. The routine coverage of uninsured
deposits would be eliminated by demanding least cost resolutions.
The regulators would be made more visible and accountable
when they do decide to protect uninsured depositors. And specific
measures would directly reduce systematic risk. Let me not go
through the details of our proposal because I think it is well known
and has been outlined in both our submissions and by Mr. Clarke
just a minute ago.
Let me turn for just a moment to H.R. 2094, the bill that your
committee or the Subcommittee on Financial Institutions has just
marked up. Let me provide some observations about the treatment
of uninsured depositors in H.R. 2094. This will prohibit the FDIC
from protecting uninsured depositors beginning in 1995, even if it
would reduce costs to the taxpayer. And while the bill was improved in subcommittee with an amendment that would preserve
the Federal Reserve's current authority to address liquidity problems in undercapitalized banks, we believe that even the amended
text leaves too little flexibility to address systematic risk.
We will continue to support amendments that would improve the
language to address both of these problems. In conclusion, we believe that ours is the most balanced approach to the problem of
protecting uninsured depositors, given the competing considerations of systematic risk, taxpayer exposure, market discipline, and
fairness.
Still, as long as we have repeated instances of costly bank failures, there will still be some unfairness resulting from systematic
risk considerations. What we really need to do is what I said at the
outset, fix the system so that we don't continually have these costly
failures.
We cannot afford to keep putting ourselves in the position of
having to make the choice between protecting small banks and protecting the taxpayer. The key is to making the banking industry
economically viable through comprehensive reform. Banking organizations must be able to offer a full range of services to compete
with their rivals, domestically and internationally.
They must be able to locate their places of business where they
choose and attract capital from financial and non-financial firms.
And they must be regulated more effectively with prompt correc-




9
tive action that stops smaller problems from mushrooming into
large losses to the insurance fund.
H.R. 1505 addresses all of these requirements, those who suggest
we must end the too-big-to-fail problem before we fix the system
have got it exactly backwards, in my view. Instead, we must fix the
system in order to eliminate the unfairness of too-big-to-fail. Thank
you, Mr. Chairman.
[The prepared statement of Mr. Glauber can be found in the appendix.]
Chairman CARPER. Thank you, Mr. Glauber. We have been joined
at the subcommittee hearing by Mr. Ridge, who is the Ranking Republican. We welcome you, Tom.
I don't know if you have a statement that you would like to offer.
Mr. RIDGE. I do have a statement, Mr. Chairman, but I would ask
unanimous consent that it be considered as part of the record.
People are here not to listen to my statement, but to listen to the
statement of the witnesses.
Chairman CARPER. Fair enough. Without objection.
[The prepared statement of Mr. Ridge can be found in the appendix.]
Chairman CARPER. I notice the arrival of Mrs. Patterson.
We welcome you, as well. Governor LaWare, you get to be our
clean-up hitter again, the second time in 2 weeks. We welcome you,
and we look forward to your testimony.
STATEMENT OF JOHN LaWARE, GOVERNOR, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Mr. LAWARE. Thank you, Mr. Chairman and members of the subcommittee.
I have submitted detailed testimony on this subject, but I would
like to read into the record a brief summary of it with your permission.
The concerns encompassed by "too big to fail" are among the
most important reasons why we need to reform our deposit insurance system and the broader structure of financial institutions in
regulation.
I want to emphasize that the Board is extremely uncomfortable
with any regulatory policy that differentiates among banks or their
customers, largely on the basis of a bank's size.
Thus, the Board supports the Treasury's proposals that would enhance the accountability, of and tighten the criteria used by, regulators in resolving failed banks. However, we believe that it would
be imprudent for the Congress to exclude all possibility of invoking
"too big to fail" under any circumstances.
Situations may arise where uninsured liabilities of failing institutions should be protected, or normal regulatory actions delayed,
in the interest of macroeconomic stability. Indeed, implicitly or explicitly, a policy of "too big to fail" is followed in most industrialized countries.
In general, it is appropriate to invoke too big to fail only in cases
of clear systemic risk. By systemic risk, I mean the possibility that
financial difficulties at a single very large bank or even a small




10
number of banks could spill over to many more financial institutions. Practical situations representing true systemic risk are rare.
Unfortunately, the specific considerations relevant to such determinations vary over time with, for example, the underlying
strength of the financial system itself. The board endorses reforms
that would foster a stronger and more resilient banking system.
The goal should be a system in which even if a very large bank
failed, the strength of other institutions would be sufficient to limit
the potential for systemic risk.
Thus, over the years, we have been committed to higher capital
standards, to the reduction of risk in the payment system, and to
improved international cooperation in the areas of payment systems and banking supervision. For the same reasons, we also support the Treasury's proposals calling for frequent, on-site examinations, prompt corrective action policies, interstate branching, and a
broader range of activities for financial services holding companies
that have well-capitalized banks.
Even in such an environment, it would be impossible to guarantee that systemic risk would never occur. In our view, therefore, it
is essential that policymakers retain the capacity to respond quickly, flexibly and forcefully in conditions involving extensive risk to
the financial system and the economy.
One of the most serious potential effects of the failure of a very
large bank is an impairment of the system that is so widespread as
to disrupt the economic activity of the Nation. There are several
aspects to this potential problem.
First, when a bank fails, the ability of its depositors to make payments from their accounts would be severely limited were it not for
government intervention designed to maintain the liquidity of insured and sometimes uninsured balances.
A second aspect of systemic risk reflects the fact that large banks
are major providers of payments and other correspondent banking
services for smaller depository institutions.
The loss of access to their uninsured balances at a failed correspondent could cause other financial institutions to experience liquidity and solvency problems of their own. In addition, the failure
of a major correspondent bank could cause significant problems for
the customers of other banks and financial institutions that ultimately depend on the correspondent for payment services.
Both of these possibilities were concerns, for example, in the
1984 failure of Continental Illinois National Bank. Some of the
clearest examples of payment system-related systemic risk are associated with foreign exchange markets.
An important concern in these markets is the risk arising from
the practice, due to differences in time zones, of paying out foreign
currencies in settlement of foreign exchange contracts before counterpayment in U.S. dollars is fully completed.
This practice exposes participants to the risk of losing the full
amount of foreign currency paid out while they are awaiting dollar
payments. Failure to complete these foreign exchange transactions
in a timely manner would subject counterparties to greater risk of
loss and could undermine confidence in domestic and international
payment systems.




11
Another serious aspect of systemic risk is the possibility of widespread depositor runs. Such runs could be engendered by the failure of a major bank if such a failure generated significant uncertainty regarding the health of other banks.
Widespread runs away from domestic bank deposits could seriously disrupt the process of intermediation on which many borrowers depend. We need only look at the costs imposed by the recent
credit crunch to get a sense of the critical importance of credit creation by banks to the economy.
For the foreseeable future, there will always exist borrowers for
whom banks serve as the primary source of funds. Widespread difficulties in the banking sector could reduce confidence in the
broader financial system.
Virtually all types of financial institutions depend on the maintenance of public confidence for the successful conduct of their business. For instance, investment banks depend on commercial banks
for substantial amounts of short-term credit.
A significant reduction in the supply of bank credit would reduce
the ability of these institutions to provide underwriting services
and liquidity support to securities markets. Furthermore, many securities are backed by bank credit guarantees or liquidity facilities.
The continued provision of credit to nonbank financial institutions was one of the Board's primary concerns in our efforts to
minimize the adverse effects of the October 1987 stock market
crash. Larger commercial banks are also major and direct participants in many key financial markets, including government securities, mortgage-backed securities, and foreign exchange. The collapse of a major bank's participation could, for a time, significantly
impair the functioning of those markets. It is important to understand that even where too big to fail is invoked, the stockholders,
bond holders, and senior management of the insolvent bank loses.
That is, even when all depositors are made whole and the bank
continues in operation, senior management is replaced and the financial interests of stockholders and bond holders are extinguished.
The board believes that it should have a role in determining
when systematic risk exists. As the Nation's central bank, the Federal Reserve has responsibilities for the health of the domestic and
international payments and financial systems. Thus, the Federal
Reserve has both the perspective and the expertise that are useful
for evaluating the systemic risk implications of a given crisis or imminent bank failure.
Inevitably a determination of whether systemic risk is a substantial concern must be made on a case-by-case basis. Furthermore,
the Board understands that it may be all too tempting for regulators to declare that systemic risk requires deviation from normal
regulatory procedures. For these reasons, the Board supports the
Treasury's proposal that both the Board and the Secretary of
Treasury should jointly determine when systemic risk justifies such
deviation.
In closing, I would reiterate the Board's strong support for the
principle that regulatory actions should apply equally to banks of
all sizes. However, a primary reason for the safety net for deposito-




12
ry institutions is to prevent systemic risks from imposing major
costs on the economy.
The broad set of financial reforms proposed by the Treasury
would help to reduce the likelihood of serious systemic risks, but
we should not fool ourselves into believing that an impending bank
failure will never be a threat to the stability of our economy.
Therefore, the Board strongly urges Congress to continue to
allow policy-makers the flexibility to intervene for the purpose of
protecting against systemic destabilization.
Thank you, Mr. Chairman.
[The prepared statement of Mr. LaWare can be found in the appendix.]
Chairman CARPER. Governor LaWare, we thank you very much.
Gentlemen, I have a few questions I would like to ask. Then I
will turn it over to Mr. Ridge.
There seems /to be general agreement on a number of themes in
your testimony. One, you seem to agree that we need strong capital
standards for our financial institutions.
Two, there seems to be agreement that what we need is comprehensive reform in the delivery of financial services in our country.
The third point you seem to agree on is that—I think Mr. Glauber alluded to it, the notion that the Bank of New England's uninsured depositors are protected and at Freedom National Bank of
Harlem, they are not. There is a matter of inequity or unfairness
that none of us are comfortable with.
The fourth point that I seem to sense agreement on is that while
the too-big-to-fail policy must be limited, you don't want the Congress to bar with a law the protection of uninsured deposits in all
instances.
Those seem to be among the major points that you agreed on. I
sense, at least from some of the body language I was picking up
from the witnesses, there might have been one or two points that
there was some disagreement on.
I recall during Mr. Glauber's testimony, I might have seen Mr.
Seidman's head shaking, no, and shocking as that might be, but,
Mr. Seidman, why don't you just specify what you were thinking
there for us.
Mr. SEIDMAN. Well, I seldom disagree with Mr. Glauber, who I
have the highest respect for, but I must say when he said that
under the too-big-to fail doctrine, we protect practically all depositors in all cases, I think that would be misleading.
As I said, and he seems to disagree, we have used the essentiality
provision of the statute four times in the last 5Vz years. In the
other cases to which I believe he was referring, we have covered all
depositors, as we do both in small banks and large banks, because
it has been less costly to the fund than the cost of the liquidation.
Whether that liquidation is done by a payout or by an insured
deposit transfer, which is a method of pay out, makes very little
difference. So I think we would be making a mistake if we look at
the fact that uninsured depositors have been covered in 99 percent
of all cases and say that has anything to do with too big to fail.
It has nothing to do with too big to fail. It has to do with the
lowest cost way of resolving a failure. Now, the cost of the failure
comes on the asset side, from the loss from the value of assets




13
when an institution fails. It sometimes is mistakenly thought if we
could just close a bank while it had 2 percent capital, there
wouldn't be any loss.
Well, if we are going to liquidate that bank, I can tell you from
experience that there will be a substantial loss because the assets
themselves lose value when you throw them on the junk pile. I
guess if there was any body English, it was that I hate to see us
getting mixed up between too big to fail and least cost resolutions
of failed institutions.
I think in general the provisions that the Treasury has proposed
will make very little difference. We gave you the four cases where
that we had actually invoked that doctrine. In every case we have
been encouraged to invoke it by the Federal Reserve, and at least
the Treasury has not been willing to say that they would advise us
not to invoke it.
I am concerned that we look at reality here in terms of what is
really going on.
Chairman CARPER. All right. Mr. Glauber, any follow up there?
Mr. GLAUBER. Well, first, let me state a bit of reality, and that is
that for whatever the reason, while roughly 75 percent of deposits
are insured, we have managed to cover 99 V2 percent of deposits in
resolution. Now, the reasons we can dispute, and that is really
looking backward, and I prefer not to spend a lot of time looking
backward.
What is a fact is that under current law the FDIC is not required
to look at all methods of resolution and determine the legist cost.
Under what we propose, they would be. I think that that is the way
it should be.
I think it would make a difference in the future. But in any case,
I think we ought to have on the books a law that requires that
they use the least cost method of resolution.
Chairman CARPER. All right. Let me take a somewhat different
course now. The Subcommittee on Financial Institutions met in
this room on Tuesday. They marked up a bill, H.R. 2094.
I would welcome the specific responses of each of you to the
action taken in that subcommittee with regards to too big to fail,
your specific reactions and any specific changes that you would recommend at full committee when we take up that legislation.
Governor LaWare, why don't you lead off.
Mr. LA WARE. Well, we were very pleased that the 5-day limitation on borrowing at the Federal Reserve discount window was removed in the markup because we felt that that was much too rigid
a limitation on our ability to provide emergency liquidity, that, in
the final analysis was one of the principal reasons for establishing
the Federal Reserve in the first place.
We are concerned that the language that remains in the bill,
however, that after 1994, "too big to fail," if we can simplify the
procedure in that fashion, may not be invoked, and that the FDIC
may not, in fact, use any of its funds to protect uninsured depositors. That is the reason for our testimony today as much as anything, to try to persuade Congress to rethink that section of the
bill.
Mr. Clarke.




14
Mr. CLARKE. Mr. Chairman, I agree with Governor LaWare on
both counts. I think it was desirable not to limit the use of the discount window, as had been proposed. I think it is very unfortunate
to completely bar the FDIC or anyone else from the ability to deal
with systemic risk when it is upon us. As I have urged in my written statement and as I have urged in my opening statement this
morning, it is very important that there be a mechanism that permits dealing with systemic risk. The administration's proposal provides that mechanism.
Chairman CARPER. All right.
Mr. Glauber.
Mr. GLAUBER. Mr. Chairman, we believe that under H.R. 2094
that the Fed does retain some ability to deal with systematic risk,
but we don't believe it is fully adequate. We would continue to support amendments which would bring the provisions of the final legislation more closely in line with what we originally proposed.
We think it is still necessary to have some more flexibility than
what is provided by H.R. 2094.
Chairman CARPER. Thank you.
Mr. Seidman.
Mr. SEIDMAN. The principal provision that we think needs further study is the limitation on paying depositors above $100,000,
which comes into effect in 1994, and says even if it is less costly we
want you to take the more expensive route in order to not pay insured depositors.
It seems to me that that is, you know, shooting off your own foot.
It is hard for me to justify the Congress would want us to take a
more expensive way of resolving institutions. Let me just take a
second to explain why it is that it is often less expensive to cover
all depositors.
The reason is that we are selling a bank and a bank franchise.
Bankers do not want to buy an institution where their first act of
buying the institution is to take their best customers and tell them
that they have just lost a portion of their deposits. So bankers will
pay more for an institution where all depositors can be covered
than they will for one in which the best customers that they are
taking over in the new institution are being penalized.
Only when they are willing to pay more can we find it to be less
costly than a liquidation or an insured deposit transfer, which is a
form of liquidation. So it would seem to me that it is very unwise
for us to provide that even though there is a less costly way to
handle matters, the fund will be prevented from doing that because
we are not going to pay anybody over $100,000 in any event, no
matter what.
Chairman CARPER. All right. Thank you very much.
Mr. Glauber, the last word, then I will yield to Mr. Ridge.
Mr. GLAUBER. Thank you. I would just like to seize the opportunity to agree with my friend, Chairman Seidman. On this I think
absolutely the FDIC should be permitted to consider the full range
of resolution methods, and pick the cheapest one, even if that includes a purchase and assumption transaction, which it would be
prohibited from doing under H.R. 2094.
Chairman CARPER. OK, thank you. We welcome Mr. Vento.
Thank you for coming, Mr. Ridge, you are on.




15
Mr. RIDGE. Thank you, Mr. Chairman.
If we check the attendance records of the full committee and the
subcommittees, that the four of you have better attendance records
than most of the Members. I have to tell you how much we appreciate your willingness to testify, your access, and most importantly,
your time.
I think I can speak for all of my colleagues that we are very
grateful for all of that. Governor LaWare, I want to follow up on
some things that my colleague alluded to and that relate to the
subcommittee's removal of the provision objected to by Chairman
Greenspan that would have limited the Fed's ability to advance
funds to institutions.
It is my understanding that the Bank of New England was lent
about $2 billion by the Fed during a liquidity crisis in the spring of
1990. It seems to me that under those circumstances, and I think
some of the data collected during and after that process suggested
that a lot of that money was lent and went out because uninsured
depositors were leaving the system.
In order to bolster up a troubled bank that is having problems,
you infused substantial dollars going to potentially uninsured depositors. That obligation then becomes an secured obligation. You
are then a secured party. Basically, we have a sinking ship; stowaways get off with their luggage. The rest may go down with the
ship or if they survive, they don't have their luggage or their luggage gets a hair cut. The Fed is protected.
It seems to me that one of the concerns that my colleagues have
is that the Fed's well-intentioned involvement ultimately can exacerbate the problem and cost the taxpayers even more money. Or
cost BIF potentially more money, as well. Shall we give a hair cut
to Fed advances?
Mr. LAWARE. I am not quite sure I know what you mean by a
hair cut to Fed advances. Our role in the Bank of New England is
the classic role of the central bank in providing emergency liquidity to an institution.
You likened it to a sinking ship. At that stage it was leaking,
and the pumps were being manned and the life boats were being
swung out to be lowered in case of necessity, but it was not an insolvent institution at that point. We are required to take collateral
for loans that we extend under those circumstances, and I don't
think that the role of the Fed was in any way improper.
I would also argue that the ultimate cost to the FDIC was probably less as result of the actions taken by the new management
that was installed in the spring of 1990 significantly reduced the
expenses of that institution, worked down the assets, and I believe
that by June they were completely out of the Fed.
They were not borrowing from us, and the institution still had
capital, not at desired levels, but they were not capital insolvent at
that point. I think that role was an appropriate one and one that
we are chartered to do.
Mr. RIDGE. Any body else care to comment?
Mr. Clarke, I saw you nodding in agreement.
Mr. CLARKE. I totally agree that that is the classic function of the
central bank. The central bank does not lend to an institution at a
point where it is deemed to be slumping, when it is insolvent, but




16
when has a temporary need for liquidity. The management team
that was put in place in the early spring of 1990 was busily downsizing the institution. They were selling assets. They were transferring assets from the holding company into the bank to try to get its
capital up. They were doing all the kinds of things that you would
like to see being done in an institution that is trying to save itself.
I think it is very important to note that they were out of the
window. Despite the fact that they borrowed substantial amounts
from the Fed, they were able to pay all of those back in full and
stayed out of the discount window until very close to the failure of
the institution.
Mr. RIDGE. Have there been instances when, in spite of your
intervention and your well-intentioned efforts as a Central Bank
where these illiquid institutions eventually became insolvent?
Mr. CLARKE. Yes.
Mr. RIDGE. With what

frequency has that happened, and do you
have any idea what ultimately the resolution was?
Mr. LA WARE. I think that is far less frequent than instances
where we have provided that liquidity.
Mr. SEIDMAN. Mr. Ridge, I think the illustration you need is not
the Bank of New England, but the National Bank of Washington
because that is a case where at least you can argue that the costs
to the BIF fund were increased. That wasn't the intention, but that
is the way it worked out, so in my view it isn't that the Fed is misguided or doing the wrong thing, but occasionally it worked out
that what we thought was solvent turns out to be insolvent.
In the interim, the Fed's money has gone out either in losses or
in uninsured deposits. I don't think it is wrong to say that there is
a problem there that we need to look at, but I don't think the Bank
of New England is a good illustration of that.
Mr. RIDGE. YOU said—you referred to the National Bank of
Washington. You reluctantly admitted that there was an argument. My sense is you don't think there is much of an argument
for the discomfort that Members of Congress have with the Fed's
posture perhaps interfering with the congressional intent dealing
with too big to fail?
Mr. SEIDMAN. Well, I would say that the Fed was carrying out
what they believe, and I believe, is their obligation to meet liquidity problems, but presumably they are not to meet liquidity problems of insolvent institutions. When, in fact, they turn out to be
insolvent, then there may be a cost to the BIF fund because they
have—they and we have all misjudged the exact extent of that institution's financial problems.
Mr. CLARKE. It is interesting to point out, though, Mr. Ridge,
that when the National Bank of Washington was closed, it had $25
million of equity left in it. It was technically not insolvent.
As Chairman Seidman indicated earlier, once an institution is
closed and once the assets go into the FDIC receivership, the assets
become of much less value and the FDIC does lose money on them.
But in the case of the Fed, at such time as an institution is judged
to be insolvent or unable to get itself out of the discount window,
the lending stops.
Mr. RIDGE. I very much appreciate this public discussion of that
role of the Central Bank because I do believe that we may revisit




17
that issue in full committee because of the discomfort level of some
Members up here.
Again, I appreciate your responses to these questions. I believe
my time has expired.
Chairman CARPER. Thank you, Mr. Ridge.
The Chair notes the arrival of Mr. Hancock, Mr. Hoagland, Mr.
Moran. I want to recognize Members as they have arrived.
I believe Mr. Luken is next. If I misstep, I hope that the Members will correct me.
Mr. Luken, you are recognized.
Mr. LUKEN. Thank you, Mr. Chairman.
Let me congratulate you on putting this important hearing together. It is one of the most difficult issues we face as we approach
the question of bank reform. My question is maybe a little bit different. I want to address the question of what happens to small and
medium-sized banks if we adopt the Treasury Department's position, and I want to raise two factors.
One is, no matter how we might argue to the contrary, clearly
too big to fail provides an advantage, of what magnitude, we can
argue, some advantage to banks who would be perceived as falling
under that doctrine.
In addition, there are proposals that will permit interstate banking, and I understand the logic behind them, but I wonder if there
is not a feeling that all of these things together might, in the long
run, make it more difficult for small and medium-sized banks to
exist, and particularly if we look at the history that those institutions have in investing in what we might call middle America.
The homes, the small businesses, whether or not the combined
impact of this legislation doesn't have a negative impact on small
and medium-sized banks and whether that is good for the United
States generally.
Mr. GLAUBER. Well, let me begin. I think really quite the opposite.
I think the impact of the legislation on small and medium-sized
banks is positive and not negative. First, on "too big to fail", I
think the current situation is unfair, and that we have to cut back
on the incidence of protecting uninsured deposits in full. We propose to do it, as I said, in several ways, most importantly by cutting
down on failures, but also by making it more difficult to declare
that a situation is a systemic risk situation in which we have to
protect all uninsured deposits.
I think that that can only be fairer to small banks, as it should
be.
As regards the other parts of the bill, I think, first of all, anything that cuts down on failures, and failures often occur to the
largest banks, anything that cuts down on failures has to be fairer
to small banks because they tend to be the best capitalized banks,
and they shouldn't have to bear the burden of failures that can be
avoided, and I think, again, the bill that we have put forward
would do that.
On the issue of branching, I must tell you that I believe—and a
large number of the small bankers with whom I have spoken believe, as well—that branching is not going to endanger their
future. They have withstood the onslaught of branches of larger




18
banks over and over again and done extremely well. They do well
because they provide the services in the community better than
any other banking company could do.
We have really run this experiment, if you want to call it that,
in a number of States, when they go on to statewide branching.
California may be as good an example as any. California is as big
as most countries.
California's small community banks have thrived in the face of
what amounts to nationwide branching within California. The
same thing is true in New York. So I don't believe that what we
propose will endanger small banks.
Indeed, I think it will clearly help them, as it should.
Mr. LUKEN. Mr. Glauber, let me just follow up. Do you think
after this legislation that the Treasury envisions, if it is adopted by
Congress, that without regard to whether that is a good thing or a
bad thing, do you project out that there will be fewer banks in this
country necessarily?
Mr. GLAUBER. I think there will be. There, of course, have been
fewer banks each year in this country. I will hazard a guess that if
you look to see where the contraction will come, it will come as
much at the end of the large banks as it will among small banks,
that what we are doing in this legislation is to require that banks
either be well capitalized or get out and get out usually through a
merger. Since some of the larger banks are less well capitalized
than the small ones, I think that you will see some of them disappearing generally through merger.
Mr. LUKEN. Thank you, Mr. Chairman.
Chairman CARPER. Thank you, Mr. Luken.
I believe that Mr. Thomas may have been here next. I will recognize you at this time.
Mr. THOMAS. Thank you, Mr. Chairman.
Due to my newness here, my questions will be a little broader, I
think. First of all, I assume you know that each time we go home
we hear more about taxpayers supporting failed financial institutions than almost anything else, so it is a terribly serious problem.
Mr. Seidman, you have been to Wyoming, and I appreciate that.
You talk about moving towards larger banks in this whole philosophy, at least the Secretary did, and says we have to compete in the
world and need larger banks, and if that is the policy direction, but
then you play down at the same time this same matter of "too big
to fair'. I see a little conflict there. Would you comment on that,
please, sir?
Mr. GLAUBER. Certainly, Mr. Thomas.
I don't think we necessarily want to move towards larger banks
in particular. Indeed, I think that there are elements in the legislation we put forward that will make it possible for larger banks to
be more competitive, but also for middle-sized banks and for the
community banks. For middle-sized banks, branching is going to
take a tremendous amount of cost out of their operations, which
can only help them. Of course, with the largest banks, allowing
them to compete with a range of activities which are the same as
their international competitors have, ought to help them.
Our philosophy is not to try and make larger banks. Our philosophy is to take out of the system regulations which prevent the




19
system from adjusting to the demands of the marketplace and then
let the marketplace decide what it should look like so long do it is
in a safe and sound way.
I don't think that we are trying to tip things towards larger
banks at all. We are trying very seriously in this legislation to help
community banks and to help middle-sized regional banks as well.
Mr. THOMAS. I recall the Secretary's talking about us dropping
out, not being in the largest of the world banks and feeling very
sorry about that.
Mr. GLAUBER. Well, Mr. Thomas, I think that is one of the segments of the banking industry, and I think we need to be competitive in that segment. We need also to have efficient, competitive
banks in the middle-sized regional part of the banking system so
that they can deliver their services more cheaply. I don't think you
should take the Secretary's comments as focusing unduly on the
largest banks.
Mr. THOMAS. Good.
Mr. Seidman, I understand that even the largest bank, I think
Citibank, only represents about 3 percent of the market, really, as
opposed to some of the other businesses that have been too large to
fail. How do we handle other businesses? Why should we handle
the banking business with that sort of concentration any differently than we do Chrysler or anyone else?
Mr. SEIDMAN. I don't think we should. I think Chrysler and Lockheed were public policy decisions made and paid for by the Treasury. I think that large banks should be treated in exactly the same
way. Let me indicate, so I get it on the record, that I don't think
the proposals that are now before you in the administration bill
are going to make any difference in "too big to fail".
We already cut all those parties. It may make it a little easier
because the parties deciding whether or not we will invoke the doctrine don't have to pay for it. At least when we invoke the doctrine, we have to pay for it.
So in my view, the proposals before you insofar as the fears of
the small banks are concerned cannot be very comforting.
Mr. THOMAS. Let me—I didn't quite understand what you said.
You said we have to pay for it. If you invoke the doctrine, who pays
for it now?
Mr. SEIDMAN. The FDIC. Let me make it clear that we have only
invoked the doctrine four times. This is not something that is happening day and night. It has happened four times.
I have been there all four times. I have spoken with all the
other—well, Mr. Clarke is on our board and has been a part of it.
We have always spoken with the Fed. They have attended the
meetings, they have supported it all four times.
We have spoken with the Treasury about it, although they have
not necessarily given us their OK. I can tell you that in the last
one, the Bank of New England, I told the Treasury that if the administration believed that we should not support the Bank of New
England with coverage of uninsured depositors, I would vote for
that because I thought it was a public policy question that ought to
be decided by the administration.
Mr. THOMAS. Who decided on Lockheed and Chrysler?




20

Mr. SEIDMAN. Congress. The problem with banking is you don't
have time to hold hearings and go through that when you have to
act. That is why I have proposed that the administration have a
fund available which they can use. They have got a couple of funds
around there they could use with the total fund being only a billion, you know.
They have got a lot of that laying around that they could handle
it with.
Mr. THOMAS. Let me ask another naive question.
The four of you represent, I suppose, the basic regulators. All of
you have talked about moving more quickly, I believe.
You use capitalization as a sign of being strong. Why don't you
move more quickly? I hear you saying we need to move more
quickly, we have been having failures for a long time.
Why don't you move more quickly?
Mr. SEIDMAN. Well, I am only the recipient of the move after it
takes place. I guess Mr. Clarke could answer that.
Mr. THOMAS. Mr. Clarke.
Mr. CLARKE. I will be glad to tackle that one. You have correctly
pointed out that the proposals that are being suggested for moving
more quickly are geared to capital. We have changed our policy
with respect to national banks to provide that when a bank runs
out of equity capital, it is insolvent, and it is closed if the owners of
the bank have no means available to recapitalize the bank. We, obviously, try to give people a fair opportunity to raise additional
capital in the capital markets or sell the bank to someone else or
otherwise get it recapitalized. But this policy results in a much earlier closure of institutions than formerly. We used to close them
when they ran out of primary capital, which meant that the loan
loss reserve also had to be fully exhausted. That meant that insolvent banks were able to stay open longer and banks that failed had
had all of their loan reserves already exhausted.
I think it is important to focus also on actions that we can take
at a time when everything is going great. That is the most difficult
aspect of bank supervision, but something we have to come to grips
with. A lot. of the loans that are put on the books when all the
trends are going up and all the asset values are going up and the
borrowers are paying a lot of money and the banks have a lot of
capital and they are earning a lot of money are the ones that ultimately cause the banks problems. Those are put on the books because the banks let their guard down; they forget that the curves
will someday turn down. They lower their underwriting standards
in some cases because of competitive pressures. That is the most
difficult time to go into a bank and get the bank to correct its actions, because their response is, "Where are the problems? Look at
all the capital we have; look at all the money we are making. Look
at the way the values are going up in this particular market." The
administration's proposal would give us the opportunity to move in
that area with a little bit more decisiveness, and I believe you will
see that happening.
Mr. THOMAS. Thank you.
I appreciate your candor, all of you. I think we all have to be
very candid in addressing this problem so that we don't end up
with something that we have had before.




21
Thank you very much, Mr. Chairman.
Chairman CARPER. Thank you, Mr. Thomas.
The Chair would now recognize Mrs. Patterson. I think you were
the next to join us. Mrs. Patterson.
Mrs. PATTERSON. Thank you,' Mr. Chairman.
I appreciate your holding this hearing. I regret that we had a
delay in getting started. I appreciate the gentlemen appearing
before us.
I know that what we have been dealing with in Subcommittee on
Financial Institutions and before the committee is of interest to
lots of us, but I think it is primarily interesting to the taxpayers, at
least in my district it is all we talk about, bank failures and who is
going to pay for them in the long run and whether the BIF is out
of money or will soon be out of money, and so that really has
gotten a lot of attention in my district.
The other elements of the Treasury bill may be have not gotten
so much as you all would like, but this is what has gotten the attention of the media and the folks in my district. I am sure that all
of you, if you were not present, had a representative present as we
dealt with the mark-up this week, and I would like to ask a couple
questions.
Number one, I think it has already been alluded to. I would like
to hear from you how you feel about the overall bill, but then I
would also like to ask each of you, and maybe, Mr. Seidman, you
would be the place I should begin, during that mark-up I proposed
an amendment dealing with BIF that I thought was a good amendment.
It broadened the base for the assessment. It didn't pass, but I
think that is something we really do need to look at as we deal
with the "too big to fair' or if you want to call it the "least cost to
fail" institutions, whatever you want to call it.
I do think that broadening the assessment base is direction we
should look toward. I just wondered how you feel about that and
wondered how in general the rest of you felt about the bill as reported out.
Mr. SEIDMAN. Well, I think the bill as reported out is a good first
step. It would be sad, however, if the subcommittee feels that by
acting with respect to that narrow issue, they have dealt with the
problem, so I think we have made certain comments on the bill so
far, but I would be very much concerned if the subcommittee—if
that is the full product of their labors. I think they have to look at
the broader issues.
With respect to your proposal, we believe that the FDIC should
have the authority to use a broader base if it appears appropriate.
Much of that depends on whether or not "too big to fail gets
eliminated, as Chairman Gonzalez would propose, and as this bill
would propose down the line or whether it becomes accepted that
there is going to be that power in the Government because clearly
"too big to fail" affects foreign as well as domestic deposits.
If you save an institution that has large foreign deposits, then
there is certainly a basis for saying that the premiums ought to be
paid on all deposits or all assets, Therefore, I would, in general,
favor giving the FDIC the power to use a different base if it appears appropriate when we see how this all settles out.




22
Mrs. PATTERSON. I would look forward to working with you and
those on your staff in relation to that. Mr. Glauber, we keep seeing
body language up here. Evidently, you want to say something.
Mr. GLAUBER. NO, but I am happy to respond to your question.
First, on the general thrust of what the subcommittee did, I
think it is quite positive. I think there may be some things we
would like to see changed on some of the issues, but I would want
to start by emphasizing what Chairman Seidman just did, that we
think it is very important that the subcommittee go is forward as it
intends to do next week and begin to treat the broader structural
reform issues because we believe that any attempts simply to fund
the problem, to put more money in the fund without fixing the underlying structural problems is a mistake.
On the specific issue you raise, I understand well the desire to
broaden the assessment base, but in doing that, of course, it then
calls into question what liabilities are assessed, and our concern is
by broadening the range of liabilities that are assessed, we implicitly broaden the safety net, and we think that is a mistake. We think
that we ought to, in fact, narrow what it is that we protect.
We believe that "too big to fail" should be changed to do that,
and we believe we shouldn't take steps to broaden what we insure.
Mr. CLARKE. I would like to comment just on a couple of aspects
of the legislation. One of the things that I would very much hope
would be revisited is the absolute prohibition in the bill currently
on the ability to protect uninsured deposits. I simply think you
have to provide the mechanism to deal with systemic risk, as I indicated in my opening statement.
The other thing I hope everyone will please keep in mind as this
legislation is looked at is the need to maintain a sufficient amount
of flexibility on the part of bank supervisors to deal with problems
on an individualized basis. Every problem bank has different characteristics. The administration has sought in its bill to provide balance between a triggering mechanism that give bankers an expectation of things that can happen to them when they reach certain
capital levels and giving the supervisor who has to deal with the
facts as he or she finds them the ability to make judgments and
take actions designed to correct the problems in that particular institution. I would hope that there wouldn't be absolute required actions in all cases, regardless of what the circumstances happen to
be.
Mrs. PATTERSON. I appreciate that. Let me just say to the panel, I
listened with interest in some of the sections of the bill that we
will be looking at next week,, in my State of South Carolina, which
was in the State legislature, we dealt with the interstate banking
compact, and it was a big issue. Everyone said our small banks and
our community banks will die out. That was the thrust of that
whole debate. For a few months, years, we did see a few of them,
but in recent years, we have seen more and more thriving and new
ones popping up.
I think we need to consider that when we look at that section in
the big bill next week.
Mr. GLAUBER. I am very heartened by your comments.
Mrs. PATTERSON. Thank you, Mr. Chairman. I will yield back the
balance of my time.




23

Chairman CARPER. Thank you, Mrs. Patterson.
The Chair would now recognize the gentleman from Iowa, Mr.
Nussle.
Mr. NUSSLE. Thank you, Mr. Chairman.
I listened with some interest here, Chairman Seidman, when you
mentioned Willy Sutton robbing banks, and that is because that is
where the money is. That is probably why Bonnie and Clyde came
to Iowa many years ago, because that is where the money is.
As I read in my Iowa newspaper here last week, it says that
more.banks in Iowa were profitable at the end of 1990 than in any
other State, according to figures released Thursday. The Federal
Reserve Board said 97 percent of Iowa banks recorded a profit on
December 31st, so you can see where we are concerned. We are also
very proud of these accomplishments because that hasn't always
been the case, as you well know.
One of the questions I have and one of the assumptions that the
chairman went through here early on, he said there were some
things that you all agreed on. One of the things you agreed on is
that every country does this, and I guess I am curious within the
same period of time that we have realized four such instances of
bailouts—or, not bailouts, but "too big to fail" type instances. Are
there other countries that have experienced that same type of situation?
Mr. SEIDMAN. Well, there is no country that has a system like
ourselves, to begin with, so we are looking at a much greater
number of banks, but there have been instances in Germany and
England, I think in Switzerland where there have been institutions
that have had to require Government rescue, and essentially in
those cases they have supported all depositors.
However, none of them have had any institution comparable to
the size that we have had to deal with.
Mr. NUSSLE. YOU mentioned, too, the public versus private or explicit versus implicit discussion of "too big to fair'. Do you think
that the fact that we have a more public "too big to fail" policy—
for instance, we are having a discussion here, television cameras,
and so forth—do you think that has affected the way it is used in
this country, as opposed to other countries that you indicated
where it is a little more private?
Mr. SEIDMAN. Well, we have a tendency to deal with things in an
important public way in this country. Our fellow regulators in
other countries wish we would stop talking about it so much.
We usually can't accommodate them under our system. So I
think it has brought it much more to the fore here, but what has
really brought it to the fore here is that we have had $20 billion
and $30 billion banks that were failing. Therefore, we had to make
a decision very publicly and up-front what we were going to do
about them.
Mr. NUSSLE. It has been mentioned Lockheed, New York City,
Chrysler, in those instances it was my understanding that they
were required to pay back. Do you think that there should be paybacks in instances where "too big to fail" is exercised, and how
could that work if you think that would be a viable policy?
Mr. SEIDMAN. Well, I think it




24
Mr. NUSSLE. Because it is my understanding that there is no payback currently.
Mr. SEIDMAN. In essence, that is true. The way you get a payback
is by having the Government own all or part of the institution
during the period when it is supported and ultimately recovers.
The reason that Continental Illinois, the largest failure we ever
had, has cost us the least by far of the major failures is because we
owned it. We simply ran it until it could recover. As a result, we
didn't lose the franchise value, we didn't throw the junk pile operation at it, and that institution will cost us, when we are all done,
probably less than a billion dollars, whereas some of these others
are going to cost us $2V2 to $3 billion.
The difference is that we were willing, if you will, to nationalize
those institutions and run them as government operations.
The problem in banking is that if you start in that direction, we
have a great many candidates that we might end up owning. We
might really move to nationalize our banking system in a way that
would be very unfortunate. Therefore, we are paying for not nationalizing these institutions.
Mr. NUSSLE. OK. Mr. Clarke, I listened with interest in your
frustration over maybe being able to get involved coming in sooner,
so to speak, in some of these instances. Do you think we are tough
enough in the legislation? I know that—I guess I am referring to
early intervention, especially. Is there a way to come in even
sooner than what is proposed so that we don't even have to worry
about "too big to fail in the future?
Are there ways to do that that are even tougher than what we
are experiencing in the current legislation?
Mr. CLARKE. In the administration's proposal, with the early
intervention stops along the way, there is a point at which there is
an ability to step in and establish a conservatorship, with the conservator having the authority to sell the institution or merge it
with another institution. We have that authority today, incidentally. Congress gave us in FIRREA a conservatorship authority which
works. We had some conservatorship authority prior to FIRREA,
but it really didn't work. We have used the new conservatorship
authority in several instances.
The kind of early intervention that I was talking about earlier is
the ability to step in way before you are even thinking about selling the institution, way before its capital has deteriorated, and
bring about the correction of banking practices that can lead to the
demise of an institution if they are not fixed. That is going to require greater acceptance on the part of the industry of the regulatory process' stepping in and assisting in those corrections. I suppose that had we done that in some instances, over the last five
years, your mail and the mail of many of your colleagues would
have been scorched around the edges talking about the heavyhanded regulators who were coming in, trying to run the institutions and force management to do things when there were really
no problems. I think we should intervene earlier, but there is also
going to have to be a greater acceptance of our doing that.
Mr. NUSSLE. I am just amazed as I travel around my district talking to bankers. I have to say that I admire Mr. Thomas' candor in
saying that he is learning the issues. So am I.




25

I am a new member to the subcommittee, and this is not my
background, so I have been talking to a number of my bankers.
They tell me that they want a little stronger regulation, that they
want that oversight, they are looking forward to it.
I think it is because they see themselves as being a little bit
better run than some other areas, and they want, I guess, the incentive or the ability to go into other areas.
Is it capital requirements that we should look at or are there
other areas?
I mean, should we just say that at a certain point capital requirements, eight, seven—I don't know—that at a certain point we come
in and should we increase those? I guess that is what I am searching for.
Mr. CLARKE. We have, I believe, a very workable capital adequacy measuring stick now, the combination of risk-based capital
standards, which became effective this year, with an underpinning
of the leverage ratio, and the ability to increase those levels above
the minimums, depending on the level of classified assets, depending on the risk that is in the institution. But, I don't believe we
should just look at capital standards. Bad management practices
are what ultimately bring down a bank, and it is the management
practices that erode capital away no matter how much capital you
have. Therefore, there has to be an opportunity to get management
practices corrected.
I agree with you that the banker who has 10 percent capital,
Who is making a whole bunch of money, and who realizes that this
has become a dollars and cents issue for him because he is now
having to pay more for deposit insurance as a result of the failure
of some of these other institutions is out there cheering us on,
saying we need to be more aggressive, we need to do more of these
kinds of things. When that banker's capital gets down to 2 percent,
or 1.5 percent, his attitude changes radically because he is a
human being. We would all have the same reaction.
Mr. NUSSLE. I see my time is running out. I guess this launches
us into risk-based premiums a little bit, but I will pass on that. I
know there is other people that have questions.
I would be very interested in any of your comments maybe at
some point on risk-based premiums as well.
Thank you, Mr. Chairman.
Chairman CARPER. Thank you, Mr. Nussle.
Now, I would like to recognize Mr. Moran. Welcome.
Mr. MORAN. Thank you, Mr. Chairman.
We thank you gentlemen for joining us this morning. I would
like to focus on those four instances of "too big to fail" banks that
have brought us here this morning, not because there is much to
be gained by crying over spilt milk, but we may be able to examine
those instances in an effort to determine how that situation might
have been avoided.
First of all, I would like for you to supply for the record, unless
you have the figures now, what proportion of depositors' money
would have been covered with the $100,000 cap, had we been purist
about it and simply restricted insurance coverage to $100,000 per
account and covered it literally, what proportion of depositors'
money and what number of depositors, and within that number of




26

depositors, how many were individual accounts versus corporate or
pension or whatever, non-individual accounts?
If you have information in that regard, you might supply it now.
Otherwise, you could do so for the record.
Do any of the witnesses have such information?
Mr. SEIDMAN. We can supply it for the record. I don't have it
with me.
Mr. MORAN. OK. Thank you. I would be interested to have those
figures.
[The information referred to can be found in the appendix.]
Mr. MORAN. NOW, let's just do a speculation, if you would. I appreciate the breakfast we had this morning, Mr. Seidman. One of
the things that we discussed was the concept of a two-track approach within banks that would leave choice to the individual or
corporate investor on the one hand, one track would have all of the
deposits fully covered, and insurance premium would be assessed
on all of those deposits, but the money could only be invested in
what would meet strict standards of fiduciary responsibility, so
there would probably be a somewhat lower proportion of real
estate investments perhaps, but at least there would be balance,
and those accounts would be much safer investments and much
less likely to not be able to pay off whatever loans were made.
On the other hand, if people chose, they could enter into the
second track, which would be investments that were not covered by
insurance, which would allow the bank to make somewhat more
speculative loans, to be able to pay a higher interest, and, in fact, if
the private sector wished to become involved, they might very
likely offer a risk-based insurance premium for those wishing to
pay a portion of the additional interest on an insurance premium
to cover their deposits with private insurance, but it would be up to
the depositor.
With that two-track approach, what I know of the National Bank
of Washington and the Bank of New England, we clearly would
have prevented the situation that has led to the hearing today and
has led to such a heightened concern on the part of all Americans
over the viability of our banking institutions.
Now, there are obviously a lot of aspects of that proposal which
would need to be further studied, but would any of you care to
offer some observations on how you think that might have played
out had such a system been in effect and applicable to the four
major banks that have failed to date? Mr. Seidman has some receptivity to the idea, so maybe we should start with you, Mr. Chairman.
Mr. SEIDMAN. Well, Mr. Moran, I think first it should be noted
that the administration's program moves in that direction because
they have proposed that these newer and riskier activities be done
outside of the bank in separately capitalized institutions.
They haven't proposed that they be financed through a second
window in the bank, but the general approach is comparable. In
my view, if we had had that kind of an approach in some of these
failures and we had been willing to force the riskier kinds of lending outside of the bank, we would not be facing these problems.




27
I mean, I can tell you today how to cure the entire problem, and
that is to make every construction and development loan by a bank
money good, and we wouldn't have any bank failures.
Mr. MORAN. Clarify what you mean by "money good".
Mr. SEIDMAN. Simply that they made very risky construction and
development loans. As Mr. Clarke has said, the standards fell, the
standards fell right when the banks were making all the money. It
is a very difficult supervisory program. If we had a two window or
however you want to describe it approach, where those kinds of
things simply could not be done with assured funds, we wouldn't be
facing the problem we are looking at today.
Mr. MORAN. SO you think that probably would have prevented
perhaps some, if not all, of the failures that we have encountered?
Mr. SEIDMAN. I think it certainly would have, if properly administered, made a big difference.
Mr. MORAN. Thank you, Mr. Seidman.
Mr. Glauber. A
Mr. GLAUBER. Mr. Moran, I think the general thrust of what you
are suggesting, as I take it, is central, and that is we have to put
the riskiest activities outside of the bank and make sure they are
not funded with insured deposits. As Chairman Seidman said, we
intend to do that in what we propose.
Mr. MORAN. A fire wall?
Mr. GLAUBER. That is correct. Furthermore, we say certain activities which currently go on inside the bank shouldn't—direct investment in real estate, for example, and indeed we say that activities which State banks do which go beyond what national banks
are allowed should not go on inside the bank unless Mr. Seidman
and the FDIC says so, so I think the general thrust of what you are
saying, and that is to get very risky activities outside the bank so
the insured deposit money doesn't back them is right.
Mr. MORAN. The problem with what you are suggesting, though,
Mr. Glauber, is that Northern Virginia would not be as healthy as
it is today if there had not been many of those commercial loans
that initially might not have seemed like good investments, but, in
fact, worked out. I am afraid that you are cutting off the source of
capital, and what this would do is really hopefully have the best of
both worlds.
It would not endanger the banking system, the insurance fund,
but it would still make capital available for those who knew what
they were doing, who were willing to waive the safety that is naturally assumed the bank has.
Mr. GLAUBER. I agree with you. If someone wants to invest directly in real estate, they should be allowed to, they should be encouraged to, but not with insured deposit money.
Mr. MORAN. But still through the banking system perhaps?
Mr. GLAUBER. The bank could have an affiliate, and we would be
delighted for the bank to have an affiliate of a holding company
that does that kind of thing, but not with insured deposits.
Mr. MORAN. Thank you.
Mr. Clarke.
Mr. CLARKE. What we are talking about, what Chairman Seidman is talking about, is quite different from direct investment in
real estate or the participation in securities activities or the other




28
things contemplated by the administration's bill. What we are talking about here is just plain lending, which can be very risk-free if
it is done right and, can be very risky, as we have discovered, when
it is not done right. When a market gets overdone, even the loans
that were made to good borrowers and on good terms and conditions can produce a lot of pain for a lot of lenders.
To accomplish what you are suggesting would mean that many
of these loans would have been made in an affiliate or at a different window of the bank funded by uninsured deposits. If you could
create a mechanism where you could make certain that depositors
understood what they were getting and the risk they were taking
and understood that there was a difference—if they got a different
color certificate of deposit, a different kind of deposit slip for an
unprotected instrument—perhaps it would work. But you are
really talking about a fundamental change in the way the banking
system in this country has operated for a number of years.
Mr. MORAN. It would also, though, have rates that would be competitive with money market funds, more competitive, and thus it is
conceivable that it would, if handled right, bring more money into
the banking system for those who went in with their eyes open.
Mr. CLARKE. YOU just said the magic words, "if handled right". I
would be very complex to make that change and have everybody
understand what they were really doing.
Mr. MORAN. Any comment, Mr. LaWare?
Mr. LAWARE. Well, what troubles me about the narrow banking
concept is that you implied that such a narrow bank could only
invest insured deposits in investments on an approved investment
list, and that seems to me to be fraught with problems because who
is going to determine what that list of activities is?
If you want to be perfectly safe, it would be government securities, but then you don't need insured deposits.
Mr. MORAN. NO. But there are parameters of fiduciary responsibility. We have standards for people who are responsible for estate
accounts and so on.
Really, it would be going back to the more traditional concepts of
banking loans.
Mr. SEIDMAN. Mr. Chairman, if I might just in that regard, one
of the big imprudences has been concentration, so you could simply
say to an institution, all right, if you want to make loans and concentrate beyond a certain level, then you move it over to the other
window.
Mr. MORAN. Diversification and balance in the saver window.
Mr. GLAUBER. I think, I believe that the regulators presently
have the authority to deal with concentration issues, and as I understand it, they are discussing that, so I think a lot of that is well
within the bounds of what is permissible now.
Mr. LAWARE. What we don't want to get into is allocation of
credit. I think that is very dangerous, and the important thing is to
have an examination and supervisory system in place that can
properly identify emerging problems in banks and have the authority to insist that they be corrected.
I think it would be a grave mistake to set out ratios in any firm
way that would tend to determine for a bank exactly how its loan
portfolio has to be split down.




29
Mr. MORAN. Thank you, gentlemen.
Thank you, Mr. Chairman.
Chairman CARPER. Thank you, Mr. Moran.
The Chair will now recogniz,e Mr. Hancock, a member of the subcommittee, and subsequent to that, Mr. McCandless, if he has questions.
Mr. HANCOCK. Thank you, Mr. Chairman.
I am a little curious about how many times the Federal Reserve
makes advances in the event of liquidity problems. I know about
the Bank of New England, but in the past 10 years, has the Federal Reserve had to step in with other advances?
Mr. LAWARE. Well, we have essentially three different ways of
lending funds at the window. One program is for seasonal needs of
banks, for example, rural banks who finance the agricultural industry have seasonal requirements for loans that generally outstrip
their deposit base, and so they borrow seasonally for long periods of
time, several months at a time over a planting season, let's say, to
carry a larger portfolio than their ordinary deposit base will support.
That is called seasonal borrowing.
Then we have adjustment borrowing, which is done by banks on
a fairly standard basis when their reserves with the Federal Reserve System fall below what is required either as required reserves against their deposits or as amounts necessary to cover their
transactions, their clearings and their wire transfers and so on
with the Federal Reserve. Those borrowings are called adjustment
borrowings.
There is a regular pattern of that kind of borrowing. Then finally there borrowing for emergency liquidity situations, and I would
say over a 10-year period we have lent for liquidity purposes dozens
of times. I can get the information together for you if you want it
in detail, and we can supply that information to the subcommittee.
Mr. HANCOCK. Mr. Clarke mentioned that the problem really
started snowballing roughly 5 years ago. You know there were a
lot of us in the private sector that predicted that the 1986 tax law
was going to create a major problem.
If in your opinion, the major changes we made in the 1986 Tax
Reform Act created the problem.
Should we look at the underlying cause and fix the cause before
proceeding with other matters?
So what would happen now if, in fact, we would go back and take
a real good look at that 1986 tax law and take a look at 18 year, 19
year depreciation on real estate, capital gains, and put back into
effect the good parts that we took away in 1986? What would that
do doing the next 5 years to solve the problems that we are facing
now?
Mr. LAWARE. One school of thought in thinking about that whole
process would say that to some extent the problem was created by
the over-abundance of capital seeking real estate opportunities
prior to the 1986 changes, and that then when you removed that
impetus, you damaged the industry in the other way.
In other words, the feeding frenzy for real estate started because
of the attractive tax opportunities, and then when they were suddenly taken away, that created a different kind of a problem, so



30
that there wasn't much equity investment in a lot of these loans
that were made after that period of time, and consequently no
cushion to absorb the changes in the marketplace that have taken
place since then.
So it is a chicken-and egg-kind of a proposition.
Mr. HANCOCK. Are you saying maybe that we over-corrected
them in 1986?
Mr. LA WARE. Well, one man's opinion, I think so.
Mr. HANCOCK. There is another comment I would like to make
that concerns me a little bit. I also have been on this subcommittee
a very short time, and only in Congress a short time. Prior to that,
I was in private business—a small businessman. When Mr. Clarke
mentioned that we need to allow regulators flexibility to deal with
the problem, I am reminded that the nature of government is its
inflexibility.
How do you go about writing a manual giving people flexibility
when everything they can do is written down in a little book. I am
a little confused how we are going to go about giving people in the
field flexibility when they have got to operate with 14,000 pages of
regulations.
Mr. CLARKE. Mr. Hancock, there are undoubtedly a lot of rules
and regulations that banks have to follow and that bank supervisors have to check up on, but fundamentally bank supervision in
many respects is still a judgment business, just as bank management is in many respects a judgment business.We don't have a
recipe that tells a banker every move he has to make. What I was
suggesting to you is we want to make sure we don't do that, and we
want to make sure that we don't tie the hands of banking supervisors in making judgments when certain events occur.
The administration's proposal seems to strike a balance. Banks
have an expectation of what will lilely happen to them, particularly as capital levels begin to drop. That provides a powerful inducement in the first place for the bank not to let its capital level drop,
and, second, it provides some predictability to the banker as to
what will happen if the capital level drops. But, supervisors also
have the ability to make judgments and take actions designed to
correct problems in particular institutions. I would simply hate,
though, for us to be in a position where when the capital level
reaches a particular point we have no choice in the kind of remedies that we might apply to an institution.
Mr. HANCOCK. Well, that is the point I was trying to make. That
is why, frankly, I think that you have to have that flexibility. But I
don't know how to go about getting it, knowing the way the Government operates.
One final comment, and I think my time is up.
Are we getting to the point that, for the lack of fiscal resources,
that we are trying to get to a time where we have absolutely no
bank failures?
Is that where we are trying to head?
Mr. CLARKE. I hope not, Mr. Hancock, because in order to have a
system where we have no bank failures, we would have a pretty
smothered, non-competitive banking industry.
Mr. HANCOCK. Well, we will have ruined the capitalistic system
when we get to the point that we say that there is no risk involved



31
banking—in expansion and job creation. I just wanted to make
sure that we recognize that it is not bad to have some banks get in
trouble once in awhile, otherwise, we are being too restrictive.
Mr. GLAUBER. I just would hasten to add—and I agree with everything you have said, we have a good distance to go from where
we are now to where we would be in danger of never having bank
failures.
Mr. HANCOCK. Thank you.
Thank you, Mr. Chairman.
Chairman CARPER. Amen.
Mr. McCandless, we are glad you could join us today. We welcome you for some questions.
Mr. MCCANDLESS. Thank you, Mr. Chairman, for the invitation to
join the subcommittee. I have an idea it is because "too big to fail"
is a bit issue with me, and in order to share some thoughts with
the panel, we have had successful small banks, as members of the
panel have stated, in California, because there is a quality in banking, and that the money from the Fed is the same price for a small
bank as it is for the big bank and all of the other transactions that
take place as well as the insurance.
There is a perception now, correctly or incorrectly perceived,
that there is no longer equality in the banking system. To give you
a couple of direct examples, in an area in my district, the Treasury
of the United Way has moved that account from a small to
medium-sized bank to a larger bank, and as was stated during the
markup yesterday or whenever it was, there is possible personal liability if he had not done that because he had not properly attributed his responsibility as treasurer to the funding deposit institution.
Another example is one who has a brokerage insurance company
and has a trust account where the money is coming and going.
That individual now has moved that trust account from a very popular three deposit institution bank, three branches, to another
larger institution.
Another example, a real estate resolution company has also
moved its trust fund because there is a certain fidelity there that is
a part of that particular organization's requirements to fulfill its
obligations when it comes to the escrow process.
I took time to give you examples here because I feel that even
though the language of H.R. 1505 gives what one would perceive to
be proper regulatory management options in the "too big to fail"
area, that the average person is going to have to look at this in a
little different way because of the experience, however small in
numbers it has been, and Mr. Seidman has told us that, it has been
there and, therefore, there is a further perception that it is going
to be there possibly in the future.
Therein lies the real problem, how do we approach that so we
can get back to what the average person would call equality in
banking, and therefore the way that I have outlined here to be
movement of accounts.
How can we do that? I have offered an amendment which was
ruled non-germane, which I will offer again this coming week, but I
would be interested in any comments that you gentlemen have.




A

32
Mr. GLAUBER. Mr. McCandless, I think the issue of equality or
fairness is absolutely an important one, and we have to do something to make the system be perceived as more fair. I think there
are clearly some things we can do, and the first is to cut down on
failures so that that depositor or those depositors you talked about
don't have to worry as much as they do today about the possibility
of bank failure.
Mr. MCCANDLESS. I understand that. Let me interrupt you because that has been the response that other panels have given
other subcommittees and the full committee, banks will be better
capitalized, banks will be better regulated, will have greater opportunities, and, therefore, "too big to fail" will not apply because
these banks will be too strong to fail.
That is the answer that has been given in the past. That is not
necessarily going to be acceptable to the parties in question that I
have taken the time to give you examples of.
Mr. GLAUBER. I realize that. Someone has to go further, and I
would propose to do so. I think we have got to cut back on the
number of times that we declare there is a systemic problem, and I
think we have to convince people that we are going to cut back on
that.
I think the mechanism we propose would both cut back on it and
make clear that we are going to cut back on it by changing where
the decision is made and how the decision is made. I think we can
believe that this would happen less frequently.
Once we believe it will happen less frequently, it will have to
happen less frequently.
Mr. MCCANDLESS. Right, but how in the meantime do we stop
this silent run that I have given you examples of?
Mr. GLAUBER. I think we do it first by assuring people that their
money is safe. My bet is that each one of these people that moved
their account, or at least the couple you have mentioned, had less
in it than the limit on insurance, at least in many of the cases that
have been told me, there have been people whose money is totally
insured, and they still have taken it out.
Mr. MCCANDLESS. I happen to know the numbers, and they were
in excess of $100,000.
Mr. GLAUBER. If they were, then that is the case. I think what we
have to do is assure people that the system really is safe, that we
are going to make it safer and not disturb them. Let's say that I
cannot agree with the argument that says that because this is a
tender time we should do nothing.
I think we have to fix the system, and if we wait until there are
no problems, then I think my successor would be sitting here and
you would say, "If it ain't broke, don't fix it."
Mr. MCCANDLESS. This is a given. I would not argue with this.
Mr. Clarke, do you have a thought?
Mr. CLARKE. I would just like to make the observation that while
we talk about the unfairness that sometimes can result from the
application of the so-called "too big to fail" doctrine, and it undoubtedly does produce some unfair results, and may even be producing some of the results that you described in your illustrations,
we should not lose sight of the fact that many smaller banks benefit when uninsured depositors are protected in an effort to deal



33

with systemic problem. If it works, and so far, fortunately, it has, it
stops drains of deposits out of those smaller institutions. When the
Bank of New England was closed, we had a number of depositors
withdrawing insured money from institutions all over the region
because they were uncertain about whether their deposits were
really protected. At the same time, remember, we had a Rhode
Island deposit insurance failure, and a lot of people were concerned
about whether even their insured deposits were protected. Being
able to deal with Bank of New England as we did stopped that
withdrawal activity and benefitted those institutions. It also benefitted the insurance fund because it may well have prevented a
number of banks from failing that would not otherwise have failed.
Mr. MCCANDLESS. I understand the systemic aspect of it. Let me
pose a question.
I think I have got just a little bit more time, pose a question to
you. We talked about reducing the $100,000, and we talked about
limiting the number of $100,000 accounts, and we have gone
through a whole series of events dealing with what we are going to
insure and what are' we not going to insure.
Along with that, Mr. Seidman has said, well, we have been able
to recover to date 88 percent of what it is that we were obligated to
pay off when we have done what we have done with these institutions.
I would like to play "what if" with the panel. What if we said
that the department insurance would be good up to $100,000, full
face, and then we said after that because of our experience in
recent years with the cost of the failures, that 85 percent of whatever the individual had in that one institution would be covered
over and above the $100,000, and if the individual wanted to have
insurance in excess of $100,000, 100 percent, that they would have
to move to another institution and put that $100,000.
What would be the reaction there, and that this would apply irrespective of size or shape of the institution?
Mr. SEIDMAN. That is the American Bankers Association Program, which is that we take past experience and not cover depositors above $100,000. Whatever loss there is, based on past experience, is automatic and those depositors above $100,000 find they
have 15 percent less in their account.
We don't know what the effect of that will be. Will people run
because they are going to lose 15 percent? I guess that so far we
haven't been willing to experiment with that.
Mr. MCCANDLESS. Would this create a run on the bank?
Mr. SEIDMAN. The runs that we have had, such as First Republic,
are caused mainly by smaller banks who are using that bank as a
transfer agent. It is the small banks that, when this occurs are the
ones who are after us to make sure that we declare essentiality
and cover all depositors.
Mr. MCCANDLESS. Because we have received up front from day
one this is what is insured and this is what is not. It would appear
to me that the idea of a run on a bank would not take place because the individuals automatically realize what is at risk and
what isn't.
Mr. SEIDMAN. A run takes place when people become aware that
something is at risk. At First Republic, $2 billion went out of the




34

bank in an hour and a half, transfers from small banks who panicked to get their money out when it became clear that the institution might not survive.
If they had known they were going to get 85 percent of their
money back, would they have taken all their money out? We can't
answer that. It is a catch 22 because as long as we agree that the
government has to have some way of dealing with that, how can
we protect the small banks?
My testimony has been to the effect if you are going to protect
the small bank, under those circumstances you have to protect the
deposit insurance side and make sure there is enough so they can
compete. With too big to fail, money has not gone out of the small
banks into the big banks until we started talking about reducing
deposit insurance.
Mr. LAWARE. It is systemic risk that fails to be controlled and
stopped at the inception that is a nightmare condition that is
unfair to everybody. The only analogy that I can think of for the
failure of a major international institution of great size is a meltdown of a nuclear generating plant like Chernobyl.
The ramifications of that kind of a failure are so broad and
happen with such lightening speed that you cannot after the fact
control them. It runs the risk of bringing down other banks, corporations, disrupting markets, bringing down investment banks along
with it.
That is the kind of situation in which we have to be able to intervene to protect the innocent, the people who have nothing to do
with the situation that creates the collapse, but who are sucked
into the maelstrom as a result of the discontinuation of that vital
cog in the payment system.
I think that that is what we are all talking about. We are not
talking about some of these other situations that have been used as
illustrations. We are talking about the failure that could disrupt
the whole system.
Mr. MCCANDLESS. The Chairman has been very kind in allocating
my time.
Chairman CARPER. Mr. Hoagland, who has gone to Rules to testify, asked for a comment on a question very similar to that posed by
Mr. McCandless.
Mr. Hoagland offered and withdrew in subcommittee on Tuesday
a proposal to provide for a-15 percent limit on deposit insurance for
$100,000. He was anxious for members of this panel to comment on
the merits or lack thereof of his proposal.
Mr. GLAUBER. Mr. Chairman, I think that proposal is a perfectly
sensible approach because it provides liquidity in the system and
what the administration proposed, the FDIC could implement such
a program. The real question is what happens beyond that.
Do you say that is all you will do or will you allow under some
extraordinary circumstance the Fed to declare that we have to protect more, that last 15 percent or 10 percent because there is a systemic risk.
I think that is the question, and do we want to go to a system
that prohibits ever doing that. It is a very difficult question. I think
we cannot go to a system that prohibits it flat out, but should make
it as infrequent as humanly possible.




35
Chairman CARPER. Any other members of the panel who would
like to comment on this point?
Mr. LAWARE. I don't think it solves the stability problem at all.
If you have $1 million in a bank and you run the risk of losing
$15,000 of it, it seems to me that that is as vital a reason for
moving your deposit somewhere else or moving into liquid financial
assets as it is for the man who has a $110,000 and moves it somewhere else in order to be fully protected.
It is a question of where for any individual depositor the perception of risk lies and how much that person is willing to tolerate in
terms of losses in order to continue to do business there.
Chairman CARPER. In fairness to Mr. Hoagland, I am not well
versed with his proposal. I believe it provides escape clauses where
such a situation exists.
Mr. GLAUBER. His proposal does indeed allow for an override
versus systemic risk.
Chairman CARPER. Mr. Hoagland has arrived.
We have backed your proposal
Mr. HOAGLAND. YOU are very kind.
Chairman CARPER. YOU had asked that we submit to the panel
some questions for their consideration and their thoughts on your
proposal in subcommittee, which you withdrew. Their comments, I
think, were constructive. I would recognize you for any further
questions you might have.
Mr. HOAGLAND. Thank you, Mr. Chairman.
This is an excellent hearing. I am very pleased that you have
scheduled it and arranged for these panelists. The bill that I am
cosponsoring before the Rules Committee will be on the floor next
Tuesday so I had to go over there, and I am sorry to have missed
the comments.
But given the fact there are two more packages to go and these
issues, I know having been thoroughly explored, I will look forward
to reading what is in the record and please do. This has probably
been said already, if you generally feel the proposal is on the right
track, which I believe you do based on my review of your testimony
and conversations we have had Mr. Glauber, please let us in so we
can test it out and approve it for full subcommittee markup.
Chairman CARPER. Mr. Seidman, I may have misinterpreted
what I thought I heard you say. Did you tell us that there have
been four instances in the last 5 years where a too-big-to-fail policy
was essentially implemented and followed?
Mr. SEIDMAN. There have been instances in which we have protected all depositors on the basis of essentiality, which is the provision of the statute that allows us to find an institution if you will,
too big to fail.
There are only four instances. In other instances where depositors have been protected above $100,000, it is because we have determined that that is the least costly way to handle the transaction, less costly than a liquidation or an uninsured deposit transfer.
Chairman CARPER. Did I understand you to say that if the administration proposal were adopted, we would see no change in the
actions taken for those four institutions?
Mr. SEIDMAN. I don't see how it makes too-big-to-fail decisions
different than they have been. It makes it easier because the deci-




36
sion is made by the Fed and Treasury, but they can charge it to the
FDIC, whereas, if we make the decision, we have to pay for it.
I find it difficult to see how in practice it will be more difficult.
Beyond that, those two organizations have participated in every
one of these transactions. At least the Fed in every case has advised us to use the essentiality doctrine and the Treasury has been
asked whether they wished to object, In no case have they objected.
Chairman CARPER. This has been most illuminating. This is a
very difficult subject. We need your help beyond today and we look
forward to your cooperation as we try to come to grips with this
problem.
The House is voting on a supplemental appropriation for aid to
the Iraqi refugees. The subcommittee will adjourn for 10 minutes
and then we will try to come together again by 12:25.
We want to thank you each for being with us today, for your testimony. We look forward to working with you in the future.
[Recess.]
Chairman CARPER. We will now reconvene.
We expect another vote in an hour. We will go ahead and get
started. I want to welcome the General Accounting Office, Mr.
Johnny C. Finch, Director of Planning and Reporting for the General Government Division, and I see that you are joined by two colleagues of yours.
I will ask you to introduce them. Mr. Finch, we welcome you.
STATEMENT OF JOHNNY C. FINCH, GENERAL ACCOUNTING
OFFICE, DIRECTOR OF PLANNING AND REPORTING, GENERAL
GOVERNMENT DIVISION; ACCOMPANIED BY CRAIG SIMMONS
AND STEVE SWAIM
Mr. FINCH. Thank you, Mr. chairman.
Seated to my left is Craig Simmons. Craig is the Director who
oversees all of the work we do on financial institutions. To my
right is Steve Swaim. Steve is the Assistant Director who is specifically responsible for banking issues.
We appreciate this opportunity to give GAO's views on the complex issues associated with resolving large bank failures. I do have
a detailed statement which I will now summarize, Mr. Chairman
members of the subcommittee.
Perhaps more than any other aspect of banking, the problems
and incentives associated with resolving large bank failures show
the need for comprehensive reform of the deposit insurance and
bank supervisory systems.
Solutions must comprehensively deal effectively and fairly with
today's incentive problems, problems that make it easy for undercapitalized or risky banks of all sizes to obtain funding that is
nearly always insured by the full faith and credit of the U.S. Government.
The reforms that we have recommended to deal with the incentive problems that give rise to the too-big-to-fail policy are all designed to insure industry stability through the safe and sound operation of banks instead of through deposit insurance guarantees
that could result in large expenses for healthy banks and taxpayers.




v,
37

Any attempts, we feel, to increase depositor discipline must be
preceded by other reforms to improve the safety and soundness of
banking organizations. Starting with the 1984 failure and rescue of
Continental Illinois, bank regulators have preferred to err on the
side of guarding confidence in the banking system when large
banks fail.
FDIC has protected all deposits in the 14 failures of banks with
assets over $1 billion at a cost of approximately $11.8 billion. The
de facto protection provided to large banks uninsured depositors
and non-deposit liabilities has successfully protected the stability of
the banking system, yet it has also led to a widespread perception
that some banks are too big to fail or, perhaps more accurately, too
big to be liquidated.
This situation is troublesome because large banks, whose failures
pose the greatest threat to FDICs finances, have fewer incentives to
control risk. In addition, depositors have incentives that favor the
placement of uninsured deposits in large banks, putting small
banks at a competitive disadvantage.
If legal coverage limits on insured deposits or the de facto protection afforded uninsured depositors were cut back or eliminated, all
banks, but especially large banks, would no doubt be operated more
safely in order to win and retain depositor confidence.
But the real possibility of destabilizing bank runs cannot be ignored. Uninsured deposits and nondeposit liabilities account for
over 60 percent of the funding of 10 of the top 25 banks in the
country. Runs on our largest banking institutions could have significant destabilizing effects through disruptions to the settlement
system, correspondent banks, or foreign and domestic confidence in
the U.S. banking system, particularly if a run at one large institution becomes contagious, leading to runs at others.
The potential for such a contagion arises from a number of factors. First, uninsured depositors do not currently have options,
such as purchasing additional insurance for safeguarding their deposits.
Second, it is unreasonable to expect many uninsured depositors
to make informed decisions about the condition of the institutions
in which they place funds. Third, the losses that would be faced by
uninsured depositors must be reduced by improving bank supervision.
Losses in banking organizations closed between 1985 and 1989
averaged nearly 16 percent of the failed banks' assets. We believe
this represents an unacceptably high level of loss for risk adverse
depositors to accept. For these reasons, we do not believe that scaling back coverage for insured deposits or eliminating de facto protection for uninsured deposits is wise at this time.
We do believe it is possible through other means to control the
ability of banks, especially those which are large and poorly managed aimed, to attract deposits, while at the same time maintaining continued market stability. We have recommended several reforms to accomplish this objective.
First, better supervision of banks is essential. Bank regulators
must take prompt corrective action to stop unsafe banking activities. We have recommended that regulators be required to develop
an early intervention or tripwire supervisory system that focuses




38

enforcement actions on the earliest signs of unsafe behavior in all
banks—large or small.
Implementation of the tripwire system, we propose, should help
prevent poorly managed banks from offering above market interest
rates to attract deposits and would lower the cost to the FDIC
when banks do fail.
Second, capital requirements should be strengthened to discourage bank owners and managers from taking excessive risk and to
provide a financial buffer between losses resulting from poor business decisions and the resources of the Bank Insurance Fund.
Third, disclosure policies that give depositors and the general
public better information on the condition of banks must be adopted. A risk-based deposit insurance premium system that can be
used as a supplement to risk-based capital requirements should be
implemented. Finally, uninsured depositors should be provided the
choice of insuring their deposits at an additional cost.
In the past, decisions by uninsured depositors to withdraw funds
from weak banks, like the Bank of New England, forced regulators
to deal with insolvent banks that probably should have been resolved earlier. If such discipline is to play an expanded role in the
future, certain conditions must be met so as not to jeopardize
market stability.
The banking system and the Bank Insurance Fund must be in a
much sounder condition than they are today, and the near-term reforms I have discussed should be substantially implemented. Even
with our recommended reforms, however, it may still be necessary
for regulators to protect uninsured depositors in a failed large bank
for stability reasons.
Under certain conditions—a severe recession or an unstable
international environment, for example—the threat of irrational
runs may be so great that it would be reasonable to protect uninsured depositors. Thus, even in the long run, a formal policy requiring the FDIC to follow a least cost resolution method and
impose losses on uninsured depositors under all circumstances
would not be wise.
Instead, the Federal Reserve, in conjunction with FDIC, should
be given the authority to determine whether the failure of a bank
would be detrimental to the stability of the U.S. financial system.
If so, such a bank could be resolved in ways that protect uninsured liabilities. We are uncertain how often such intervention
would be needed. However, if all of the reforms I have mentioned
are implemented, such intervention should become the exception,
not the rule.
This concludes my statement, Mr. Chairman. My colleagues and
I will be pleased to take questions.
[The prepared statement of Mr. Finch can be found in the appendix.]
Chairman CARPER. Let me just ask, in retrospect, do you believe
that systemic risk—Mr. Seidman alluded to four institutions that
he and the FDIC deemed too big to fail in consultation with the
Federal Reserve and with Treasury.
Do you believe that systemic risk was present in those four cases
that were determined that a bank was too big to fail?



39
Mr. SIMMONS. We haven't studied them in any detail, Mr. Chairman.
I suspect that the determination was accurate. The principal
thing that they would probably have looked at was the relationship
of the four banks that he mentioned, one of which was the Bank
New England, with other banks in the region or in the economy.
I suspect that other banks, many of them small, cleared through
those bigger banks or had correspondent banking relationships
with them, that may have been jeopardized in the event that those
banks failed. All of them were pretty good sized and no doubt had
correspondent banking relationships with other banks.
Chairman CARPER. The second question: What specific reactions
do you have or specific recommendations for further change would
you have to H.R. 2094, the legislation marked up in this room in
subcommittee 2 days ago, and specifically changes in the area of
too big to fail?
It is a question similar to that—I asked that same question to
our first panel, and I would ask the same of you.
Mr. FINCH. AS I said in my statement, Mr. Chairman, I think we
have to maintain the too-big-to fail policy under certain circumstances. A problem with the bill as we see it, therefore, is that it
seems to repeal too-big-to-fail altogether. We support a lot of the
comments that the regulators made in terms of concerns that they
had with the bill.
We do think it is a step forward, but we think there should be
broader reforms. We think certainly that there should be more
kinds of interventions written in for the regulators so that they
can take earlier actions against unsafe practices by seemingly
healthy banks. In order to do that, there also needs to be some accounting and internal control reforms so both the regulators and
bank managers and directors can make more informed decisions
about the conditions of the bank.
Chairman CARPER. Reforms that go beyond what is in the bill as
reported out of the subcommittee?
Mr. FINCH. Yes. Also
Chairman CARPER. Any specifics?
Mr. FINCH. Well, some of the specific recommendations in our
report, like the recommendation which would set up tripwires.
These would put the regulators and the banks on notice that
unsafe practices such as excessive credit or poor internal control
would require specific acions at that point in time.
The purpose of this is to get at the underlying causes of the problems that cause capital to deteriorate. A lot of the administration's
proposal is geared towards capital as the indicator, and by the time
capital starts deteriorating, it is often a little too late to reverse the
situation.
Our proposals include recommendations for regulators to get in
much earlier to deal with the underlying causes that ultimately
result in capital deterioration.
Mr. SIMMONS. Let me just expand on that.
We did a study of 72 problem banks, and issued a report recently
on the supervisory and examination histories of those banks. What
we found repeatedly was that capital was the lagging indicator of
more fundamental problems in a bank's management, and the fun-




40
damental problems are really what got the bank into trouble in the
first place. Problems with management were cited by the examiners in the exam reports.
There is no mystery about these problems—management lack,
needed expertise. The bank had a passive board of directors. There
was an unwillingness or inability to address prior enforcement actions. Banks simply ignored the regulators. There was no system
for ensuring compliance with laws and regulations, and the list
goes on and on.
All of those relate to bad management practices that result in
bad lending decisions that result subsequently in the reduced earnings, reduced capital, and ultimately failure. What we found was
that the regulators weren't taking actions early enough to prevent
the underlying causes from ultimately depleting capital, and our
position has been that you need to start earlier than at a finding of
an insufficient capital level to save a bank or to turn it around because frequently by the time capital falls below the minimum it is
too late to do anything about the bank.
Chairman CARPER. If we are going to have a too-big-to-fail policy,
who should pay for the cost of that policy?
Mr. FINCH. Our position, sir, all along has been that the insurance fund should pay for that.
Chairman CARPER. What is the rationale for that?
Mr. FINCH. The rationale for that is that the industry benefits,
really, from the insurance fund. It is there to help the industry,
and that is one rationale. The rationale is that by having a vested
interest, by paying into the insurance fund, it gives the industry a
greater incentive to really discipline itself, number one, and
number two, to demand of the regulators that the regulators intervene when they should. So it is a better self-policing mechanism.
Chairman CARPER. There are some arguments against doing that.
You may have heard some from Mr. Seidman today. How would
you respond to the arguments against paying for this policy out of
the FDIC.
Mr. FINCH. Against what, sir?
Chairman CARPER. YOU were here, I think, earlier today when
Mr. Seidman, the first panel, spoke on this subject. There are some
arguments against using the FDIC to pay for the cost of too-big-tofail policy. How would you rebut those arguments?
Mr. FINCH. I guess I would use basically the same argument that
I just made. The FDIC is responsible for determining, under the
present procedure, the essentiality of banks and institutions, and
we think that should stay, and we also really view the incentive of
the industry participating in terms of paying its own way.
I think if you get beyond that, it really becomes a bailout by the
taxpayers to the extent that the industry can't pay its own way.
Chairman CARPER. In your opinion has the FDIC always resolved
banks in the least costly manner, or at least in recent years has
the FDIC resolved banks in the least costly manner?
Mr. FINCH. I don't think we have studied all of the resolutions
that FDIC has made.
Mr. SIMMONS. We have looked at some, and of course it depends
on the assumptions that are made, the value of assets in liquidated
institutions and how long it will take to dispose of |;hem. But I



41
think in the institutions that we have looked at, it is fair to say
they have followed the procedures that they are supposed to follow
in making the determination.
Chairman CARPER. One last question: Do you feel that the least
cost provisions in H.R. 2094 are adequate?
Mr. FINCH. Well, there again, sir, our position is that there
should be a too-big-to-fail relief valve, an escape valve. Now, are
you talking about that, sir, or are you talking about the detailed
provisions of how they go about making least cost determination?
Chairman CARPER. The latter.
Mr. FINCH. The latter.
Mr. SIMMONS. I haven't studied it.
Mr. SWAIM. In general, picking up the statement that we have
made, our view is that before going to a definite least cost requirement as of a drop-dead date, in this case it would be the end of
1994, that certain reforms need to be in place and working so that
we in fact have a banking system that is being operated in a safe
and sound manner and has established public confidence.
We are concerned that depositors have alternatives for protecting their deposits, but 2094 makes no provision for depositors who
maintain the types of accounts that Mr. McCandless was mentioning earlier this morning.
Under 2094 there would be no opportunity for the United Way or
other uninsured depositors tp protect their those accounts. There
are a lot of reasons why people have accounts over $100,000, and in
our judgment the safety and soundness and stability of the banking
system would warrant making provisions for people to make a
trade off against yield to be able to protect their deposits.
The other area would be that there are no provisions in 2094 for
greater disclosure about the condition of banks. It is very difficult
for depositors to know the true condition of the bank under current
accounting rules and disclosure requirements, so the question becomes, then, how will the depositors exercise this discipline? What
they will do is at the first sign of trouble, they will remove money
from the banks, so we will introduce the potential for a great deal
of instability.
This is true, of course, in large banks where of the top 25 banks,
ten of those have more than 60 percent of all of their assets funded
with uninsured liabilities. They can run in a twinkling with electronic transfers. The $2V2 billion moving out of a bank, I think in a
morning was mentioned earlier.
That certainly is a realistic possibility, and in smaller banks
where the uninsured deposits are not such a great percentage,
nonetheless money can move very quickly at the first sign of trouble. So we feel that it is important to have this early intervention
system actually operating and being able to prove to the public
that banks can be closed at relatively little loss to the deposit insurance system, and that there be opportunities for protecting uninsured deposits before a drop dead date comes into effect that
would require such an absolute decisionmaking process.
Chairman CARPER. Thank you.
Mr. Hoagland.
Mr. HOAGLAND. Thank you, Mr. Chairman.




42

Gentlemen, let me ask you about two additional proposals that
have been noted to reinforce the strength of the banking system
and make it less likely that we will wind up in a too-big-to-fail situation. One is a recommendation that banks, large banks, say banks
with over $10 billion, I think this was your recommendation, as a
matter of fact, be required to issue subordinated debt periodically,
every 3 months, every 6 months.
Mr. Finch, hadn't GAO developed a proposal along those lines?
Mr. FINCH. One of our proposals is that in strengthening the economic incentives for banks to be safely and soundly managed, that
capital requirements should be further strengthened after the
Basel requirements go into effect..
We said that as a part of the strengthened minimum capital requirement we would recommend that part of that be subordinated
debt, and the reason for that would be because of the market discipline that the holders of that debt could bring to bear in bank
management.
Mr. HOAGLAND. Why don't you explain to the volunteers of this
hearing what subordinated debt is and what it would do by way of
injecting market discipline and market evaluation into the stability
of a large bank.
Mr. FINCH. OK. I am going to defer to one of my experts.
Mr. SIMMONS. In general, subordinated debt is not protected in
even large bank failures. Subordinated debt has typically been
issued by a holding company, I should clarify that.
We are recommending that it be issued by the bank itself.
Mr. HOAGLAND. It is not insured. That money is completely at
risk by those who choose to invest in the bank?
Mr. SIMMONS. It has been at risk in the failures that have occurred recently. The only case that I am aware of where it was not
at risk was in the Continental Illinois situation.
I believe creditors, general and subordinated debt-holders were
protected in that one. Since that time, I believe that they have had
to get in line with others to share in losses. As a result of that,
those people have an incentive to keep an eye on banking organizations and make sure they are operated safely and soundly because
if the bank takes a gamble, they don't participate in the upside.
All they participate in is the losses of the institution if the gambling doesn't pay off. That is generally the reason why we support
this kind of a mechanism.
Mr. HOAGLAND. These individuals you are talking about are outside investors that will buy this subordinated debt on the market?
Mr. SIMMONS. That's correct.
Mr. HOAGLAND. If the bank fails, they lose their investment entirely?
Mr. SIMMONS. They wouldn't lose it entirely. They would get in
line and share in the proceeds of the bank, if it is 70 cents on the
dollar or 80 cents, they would get the 70 or 80 cents on the dollar.
Mr. SWAIM. They would have also a vested interest to make sure
the regulators move quickly so the value of the subordinated debt
retains some value. In contrast to the uninsured depositors, these
are people who are investing, knowing what risks they are
taking—and they are individuals who would be as skilled as any-




43

body could be in evaluating the condition of the banks in which
they are making this investment.
Mr. HOAGLAND. So we would have an objective external market
indicator of how well a bank was going, based on what people were
willing to pay for that subordinated debt as they traded it among
themselves or with the bank?
Mr. SIMMONS. That's right.
Mr. SWAIM. There may also be attached to the subordinated debt,
some covenants that would give the subordinated debt holders certain rights to effect, perhaps, a reorganization of the Board of Directors, for example, so that before the bank actually failed and
came into the government's hands there could be an opportunity
for a private sector reorganization that would be triggered at a
time when there was the best chance of saving the value of that
bank.
Mr. HOAGLAND. IS it GAO's official position that we should place
a provision like that into the American Banking Statues?
Mr. FINCH. Yes.
Mr. HOAGLAND. It is a recommendation that you have made?
Mr. FINCH. Yes.
Mr. HOAGLAND. NOW let me ask you about another proposal that

is being floated, that will make it less likely that we will ever be in
a situation where some authority in government would have to
consider paying off uninsured depositors and that is in the early
intervention system, we have higher capital requirements for the
large banks.
Large banks are treated differently on an early intervention
system, the system is tougher on the large bank. Have you all considered that proposal?
Mr. SIMMONS. NO, I haven't seen that one. I would only comment
that the risk-based capital standards that were developed under
the international agreements, under the Basel accord, currently
treats large banks differently than small banks, because it covers
off balance sheet activities.
The large banks are the banks that typically engage in off-balance sheet activities—interest rate swaps, certain foreign currency
transactions, letters of credit, any number of other activities that
have credit risk and interest rate risk associated with them, but
don't show up on the balance sheet. So I think in a sense what we
have now is a system that does treat the larg;e banks differently,
and in fact the large banks are the ones that will need to raise capital in markets or through retentions to meet the standard by the
end of 1992.
Right now some of them don't. Small banks, on the other hand,
are there. They have—they meet the standards right now. So I
would say that right now we have a system that differentiates between large banks in terms of the standard.
Mr. FINCH. One of the things that we would suggest in addition
to that, I think, or after we get some of the other controls in place,
that risk-based insurance premiums would be a part of the scheme
of things, which would also differentiate between the weaker banks
would have to pay more.
Mr. HOAGLAND. Gentleman, with the chairman's permission, let
me direct you to one third—a third and final point of inquiry, if I




44
might, and that is that—and the chairman may have covered this
in his questions. I assume all of you agree that it is not good public
policy to leave in a bill that has been advanced by the Financial
Institutions Subcommittee and sent to the Full Banking Committee, a provision that attempts to outlaw the reimbursement of uninsured depositors under all circumstances, no matter what the
systematic risk is.
Mr. FINCH. That's right, sir.
We believe that you have to have an escape valve, that you have
to have a too-big-to-fail policy in the instance of systematic risk.
Our approach is to try to get the safety and soundness enhanced
enough so that you really cut down the number of times that you
have to invoke that particular policy, but the policy has to be
there, we think.
Mr. HOAGLAND. and in that respect, you concur, then, with
Chairman Seidman of the FDIC and Comptroller Clarke of the
Office of the Comptroller of the Currency, Mr. Glauber of the
Treasury Department, and Mr. LaWare of the Board of Governors?
You agree with the testimony they presented, this panel earlier
today?
Mr. FINCH. Yes, sir, in terms of that.
I think we are all coming from the same place, that you have to
be able to protect against systematic destabilization.
Mr. HOAGLAND. SO this subcommittee really faces no alternative,
in your opinion, but to devise an amendment—by this subcommittee, I mean the full Banking Committee, faces really no option, but
to devise an amendment that instead of trying to deal with the toobig-to-fail doctrine by totally prohibiting it under all circumstances,
instead channelizes it and defines it and lays the rules out in clear
form and makes it as difficult as practical to apply?
Mr. FINCH. That's correct, sir.
Mr. HOAGLAND. I have no further questions, Mr. Chairman.
Thank you.
Chairman CARPER. Thank you, Mr. Hoagland.
Mr. Vento.
Mr. VENTO. Mr. Chairman, I regret that I have been absent for
most of the hearing. I think it was a good hearing. I would like to
have asked some questions of the panel members in the first panel.
Maybe the General Accounting Office has assessed and reviewed
the impact of 2094.
The assumption was made or the assertion was made by Mr.
Seidman and Mr. Glauber, apparently, that they feel that the 2094
precludes purchase and assumption with regards to the least cost
test.
That certainly isn't my reading of what occurs, and so I would
challenge that most vigorously, Mr. Chairman, and would ask the
witnesses at the table whether they have reviewed the provisions
with regard to the least cost test and feel as though they are able
to make any statements with regards to it.
Mr. FINCH. I don't think we have read it in that much detail yet,
Mr. Vento.
We would be glad to and give you our opinion for the record.
Mr. VENTO. Mr. Chairman, I would just point out that forbearance and the too-big-to-fail issue is enormously important. We have




45
done a little bit of a review here with regards to this in the RTC
task force and have done somewhat of an analysis of it. The crux is
that assumptions about the value of assets, how you value the remaining assets, is key to the cost of a purchase and assumption.
Almost any premium that is paid under purchase and assumption,
therefore, would render a greater benefit to the government than
going into liquidation, which of course has some other problems.
But I think that the weak point in that is the assumptions on
what the recovery is possible from the portfolio of bad assets. That
is a key point, and the assumption is made there—in other words,
if you go with an FDIC historic loss of 15 percent or 20 percent at
the most, all of a sudden you render a different number than you
would if you had losses higher than that.
The reason that this becomes key, and I think the reason that
there was a difference to some extent between Mr. Glauber and
Mr. Seidman, as you rightly pointed out, was because, I think the
Treasury has made the observation that the way that his cost test
works trips them over into what they would characterize as being
the essentiality test. Seidman and the FDIC have said that recues
of all depositors have taken place only in four instances.
They would suggest that because of the nature of the way they
evaluate this, it is tripped much more frequently, and it is key because if you go into liquidation, clearly, then the obligation to limit
the payment of insurance to the $100,000 limit is so much stronger,
so I think that as we focus on this, and I think these hearings are
useful from that particular sense.
Here are some flash points that we need to look at as we move
ahead and as we effect it. Of course, Mr. Seidman's attitude is that
this language will not change anything.
Well, I sure as hell hope that the language that we have will
change things. I would yield on that particular point that I think it
will. We hope it will. If it doesn't, then I think we ought to look at
it again and make sure it does change.
Chairman CARPER. Would the gentleman yield?
Mr. VENTO. I would be happy to yield to the chairman.
Chairman CARPER. I think his point was the language under the
administration's proposal would not change things. Clearly the language under 2094 would change things.
Mr. VENTO. I understand too—that is correct, Mr. Chairman.
I ran those two ideas together, but nevertheless I think we want
to change things, and we obviously want to do it in a positive way.
I think the question of the loss in portfolio is a loss whether it
occurs in the time frame of 3 or 4 or 5 years or whether it occurs
up front.
Obviously the issue of early intervention, there are many, many
questions we could ask here about this.
One of them that maybe you could just refer to is the case of the
Bank of New England, where we are talking about the utilization
of too big to fail. There were a series of events that occurred prior
to that, Mr. Chairman, and one of them was the calling in of all
loans that were callable in the region, in the area, through the
Bank of New England.
What effect did that have in terms of a multitude of small businesses in the process of this bank trying to come up with money?




46

In other words, there wasn't just the fact that we have had an open
discount window, it wasn't only the fact that we dealt with this
and treated this as a systematic or an essentiality test, in essence.
But there are also other ramifications practicing forbearance.
I am certain there are many individuals that came to us and suggested that their loans were being called, loans in which they were
current, but obviously the bank of New England and its affiliated
banks, had the power to call in those loans.
I think we have to look at that in terms of the total impact. That
is what we should be looking at here in answering questions with
regards to economic stability.
One thing that the FDIC looks at or at least that they claim to
look at is the loss to the fund, but they don't look at some of the
other aspects in terms of what their conduct is in this case. Can
the General Accounting Office witness, Mr. Finch, give us any insights into that particular phenomena, in terms of the calling in of
loans?
Mr. FINCH. I will defer the specific question of calling in loans
early to one of my colleagues, but I will comment, sir, that this ties
into the point I was making earlier, Mr. Chairman, about earlier
intervention, and intervention that is geared towards unsafe practices on the part of the banks that are the underlying causes of
capital subsequently deteriorating.
One of the things that we think really needs to be done in the
way of improvement and change and reform is some accounting
and internal control reforms. One of the things that we would like
to see, which gets at the asset deterioration value,, is that we would
like to see banks value their problem assets on the basis of existing
market conditions, and we would like to see more disclosure and
more information available to both the regulators and the managers in terms of the actual condition of the banks.
Mr. VENTO. Well, I appreciate that particular response. I think
that that gets into another problem in this case where they are
causing assets that are really sound loans to become unsound loans
by accelerating them.
Any time you have a loan, you have a depressed real estate
market, and if it is a 10-year or 15-year loan, you are going to instantly recognize the loan is actually going to go into a negative
evaluation, and, of course, there is a concern about how you read
that and what that means in terms of actions and how the market
reads it. So here is another concern that if in fact we are saying
that it is all right for these loans to have that value, we don't know
how the market will digest it.
Can you give us any assurances of how the market in New England, for instance, would digest a mark to market valuation of a
loan portfolio at institutions that appear on paper today to be adequately capitalized, but in marking to market, they would face a
rather volatile situation, would they not, Mr. Finch.
Mr. FINCH. I am sure that is true today, sir.
My point was to try to get in on the front end of the issue, before
the situation deteriorates so badly.
Mr. VENTO. Yes.

Well, I think all of us agree with that, but trying to read that
situation as being a loan that may be valued somewhat less now




47
because of an aberration or a recession problem in a specific
market may, in fact, be current. They may be making payments.
The business may be making profit, and if you value it in a certain way, and we had this happen repeatedly during the agriculture crisis during the 1980's in the middle West and because the
acreage value had dropped, the collateral had dropped. They immediately made a call on the loan. That is what they were required to
do, and of course, precipitated a lot of problems. So, again, this relates to how you evaluate this and what you do with the information.
In the case of the Bank of New England, there was no question
that the loans were valid. They had the power to call these loans.
That is the way they are written. That is a major issue in terms of
how banks conduct themselves today.
If we wanted to provide stability and certainty, this type of question has to be addressed in terms of their conduct. The only answer
they have is that they show a better balance because they got a
better capital sheet, but they have almost necessarily either
tripped loans over into being non-performing loans by the fact that
they haven't responded to the call and/or just a bad loan in terms
of valuation.
Well, I have taken enough of the subcommittee's time, but I
think that it does relate to the too-big-to-fail issue in terms of liquidation versus purchase and assumption. Purchase and assumption
isn't liquidation. I don't think you can sell it as liquidation, and so
I think it is at the heart of how we deal with the issue of too big to
fail.
Chairman CARPER. I thank the gentleman for his comments and
for those questions. I am going to ask unanimous consent that the
members of the subcommittee be able to submit for the record
questions and ask you to respond in writing.
With that, I will excuse our witnesses from this panel. We thank
you very much for being with us.
Mr. FINCH. Thank you, Mr. Chairman.
Chairman CARPER. We are probably going to have another vote
within a half hour. What I would like to do is go ahead and begin
our third panel. We may—I understand we have to be out of this
room by 2. There is a briefing that is being held by the Financial
Institutions Subcommittee.
What I may do if we have a vote in the interim, ask one of our
two panel members to go vote and then return to chair while I
vote, if that would be convenient.
Mr. VENTO. Mr. Chairman, if I may make a suggestion, as our
witnesses—perhaps if each of the witnesses were to summarize
their statement in about 5 minutes, we could try and
Chairman CARPER. They have been doing a good job of that. We
welcome you here today, and we look forward to your testimony.
Mr. Brandon, I understand you are representing the American
Bankers Association. You are the President of the First National
Bank of Phillips County in Helena, AR.
We welcome you. We are going to recognize you first and ask you
to lead off for us. Thank you.




48
STATEMENT OF WILLIAM H. BRANDON, JR., PRESIDENT, FIRST
NATIONAL BANK OF PHILLIPS COUNTY, HELENA, AR, AMERICAN BANKERS ASSOCIATION

Mr. BRANDON. Thank you, Mr. Chairman.
First of all, thank you for letting me come and express my views.
This is a subject that is dear to all bankers' hearts. It is dear to my
heart as an American. It is a very complicated, very difficult, very,
very important subject.
Congressman Vento, I certainly do agree. I ought to be able to
summarize this in 5 minutes. If I don't, raise your hand, and I will
stop.
The reason I can summarize it in 5 minutes, is because I think
that the written testimony that I have submitted thoroughly explains the ABA position and my position on too big to fail. It explains our position on several other things, as well, but primarily
too big to fail.
A little background on Helena, AK. I have been in the banking
business since 1964. Prior to that I was in the manufacturing business. Prior to that, I was in the Air Force. Helena, AK, is an area
that if we could get to the point that we are having a mild recession like the rest of the country, we would improve dramatically.
Unemployment in our area has been over 10 percent for over 20
years. It is chronic unemployment. The only reason I say that is we
are not an area that is high-flying in any way. We have to be very
conservative. We think very conservatively.
Let me also explain the development of my thinking, it is directed and derived from being co-chairman of the Deposit Insurance
Reform Committee for the American Bankers Association. I mention that because it was a committee of 16 people. Four of the
members of that committee were money center banks. Six were
banks that would be considered community banks.
The balance were banks anywhere from 1 billion to 10 billion.
We came to the conclusion as a unit that too big to fail was the
single biggest problem of the banking community today, and when
I say that, keep in mind that four members of that committee were
money center committee banks.
We came to the conclusion that was the biggest single problem.
The FDIC, in our mind, if it would take care of insuring insured
depositors, if it would take care of regulating and supervising the
banks, and if it would take care of disposing of the assets when
they were called on to dispose of the assets, and if it would not feel
obligated to pay people who neither expected nor were promised
nor were intended to be paid, then the system would probably dramatically improve.
Let me give you an example. There are three things wrong with
too big to fail. One of them is that the cost is enormous. It is absolutely enormous. One of them is that you can have no discipline. I
know people say you can't put discipline into the system. But let
me tell you, as a banker, there is discipline in there, and the other
is fairness.
All three of them are good issues. On the part of cost, my cost
has gone up nearly 200 percent in 18 months. The increase in my
bank—I am a $90-million bank—is about $145,000. If I make a .5




49
return on assets, that is nearly 30 percent of my return in 18
months. I have got to convert that to capital.
That is where it needs to go. Capital is what all of the previous
people were telling us we need to have. It is very difficult to have
capital when you can't make a decent profit. Very difficult to have
capital if you are a larger bank when the capital markets feel like
a subordinated debenture would be wiped away, their stock would
be wiped away. It is a costly, expensive thing to do.
The second thing is fairness. It is very difficult for a depositor in
a small rural town in Arkansas to feel like they are being treated
as fairly as someone in New England if they know they would lose
everything over their insured deposit, whereas somebody else
doesn't.
That fairness drives a lot of things. If you want to have fairness,
then about the only way you can do it would be to have 100 percent deposit insurance. If you have 100 percent deposit insurance,
if we think too big to fail is expensive, let's try to insure everything
for everybody, and in addition to that, what difference would it
make if I had capital if everybody is insured and the next guy has
no capital?
The money simply flows to the rate. It is just common sense. It
flows to the rate. There can be no discipline in that thing. That
comes to the third part of this, and that is the discipline. I have got
to determine what I am going to do to make the public perceive my
bank as a strong place to do business, and the only way I can do
that is to make moves that make my capital in my bank stronger.
With too big to fail in there driving us toward deposits being 100
percent, I lose my discipline. The net of those three things, then, is
that we feel like, as a whole, too big to fail has to go. Too big to fail
has to go.
How are we doing it? Basically like the FDIC has done it in the
past, with this exception, if you have got over $100,000—you all are
talking about putting this in in 1995. You are not talking about
putting this in tomorrow..
By 1995 people know and expect, one of the previous testifiers
said that, they know what to expect, they have got plenty of time
to expect it. By 1995, if you are insured and a bank fails, you are
going to catch a hair cut, and that hair cut is going to be roughly
what the average of the FDIC failure cost has been for the last 5
years or 10 or whatever the U.S. Congress wants to make it.
That means, then, when the assets are all sold, then the cost to
the fund will be zero over time; some will be more, some will be
less. There is an additional catch to that, though.
You can't simply take that much liquidity out of the system, so
what we do is say 12 percent is what you are going to lose, and we
will kick you back your 12 percent and we will collect ours back
over time. All right, we feel like those things will work.
They talk about a systemic failure and the bank fund paying for
it. Systematic failure, as the Fed described it this morning, we have
a melt down of a huge nuclear reactor, a melt down, so what he is
talking about is some huge bank goes down, and international implications are all over the place.
Implications of industry after industry falling, huge banks,
wham, it goes down in a few cases. That fund would be gobbled up




50

in 15 seconds. There is no way if you are going for systemic reasons
to save the fund that the FDIC fund could pay, so if that is a valid
thing to do, then let's find a valid way to pay for that thing.
I thank you, Mr. Chairman.
Chairman CARPER. Thank you for your testimony as well.
[The prepared statement of Mr. Brandon can be found in the appendix.]
Mr. Ely, welcome.
STATEMENT OF BERT ELY, PRESIDENT, ELY AND COMPANY, INC.,
ALEXANDRIA, VA
Mr. ELY. Mr. Chairman, and Members of the subcommittee, I
want to thank you for inviting me to testify today about one of the
most difficult and important issues in deposit insurance—"the too
big to fail" policy.
Enormous and very sincere effort has been devoted in recent
months by the administration and the Congress to determine how
to convincingly abandon this policy. But, Mr. Chairman, the title of
my testimony says it all—abandoning "too big to fail" is an impossible dream.
I will devote the rest of my time to explaining why. Abandoning
the "too big to fail policy" is premised on the notion that deposit
insurance reform requires more depositor discipline. Put another
way, the feeling of many is that Federal deposit insurance cannot
be reformed unless more depositor discipline is injected into the
banking business.
I reject this premise. Depositor discipline represents the third
best source of banking discipline. Stockholders represent the best
source of discipline; regulators are a distant second.
Worse, depositor discipline can quickly become counterproductive
and even dangerous if relied upon too much.
Depositor discipline is like a fragile bridge that cannot carry too
much traffic. Overload it and it will quickly collapse.
Depositor discipline is dangerous because depositors are very risk
adverse with regard to their bank and thrift deposits. Worse, they
can quickly withdraw their deposits if they fear they will lose any
portion of their money.
This brings us to the central reason why a distinct no "too big to
fail" policy will never work. No matter how fast the regulators
move to close a troubled institution, thereby sticking its insured depositors with a loss, the more sophisticated depositors will run even
faster. Only the least sophisticated will suffer a loss. However, they
will garner the greatest political sympathy. Freedom National is
just the latest failure that teaches that lesson.
Faster, more dramatic runs will be bad for two reasons. First, a
depositor run on a troubled bank greatly increases the probability
that the bank will fail.
A faster run also will increase the loss that BIF will suffer when
it disposes of the bankrupt institution.
Second, more frequent runs on troubled banks will increase the
potential for contagious runs, by both insured and uninsured depositors, on institutions who need not fail at a loss to the BIF. As
irrational as it may seem, insured depositors have very rational




51
reasons for withdrawing their deposits from a bank they fear may
be closed.
As one woman said on Monday when pulling her insured deposit
from the troubled Madison National Bank here in Washington, "I
just don't want the hassle if the bank fails. I know my money is
insured, but that is only part of the concern.,,
Madison had $382 million in deposits at the end of the last year.
As of last June 30, it had 47,000 deposit accounts and $74 million of
uninsured deposits, an amount which undoubtedly is lower today.
Clearly, Madison is small enough to be liquidated, but imagine
liquidating a bank with $10 billion in deposits and 1 billion in deposit accounts. Now we are talking about the reality of abandoning
"too big to fail." And this is why abandoning "too big to fail" is an
impossible dream, for when this dream clashes with the realities of
the cost and complexity and the risk and danger of bank runs, reality will win out.
Those regulators who have their finger on the trigger will blink
when the tough decisions have to be made, and "too big to fail"
will win out again. Just yesterday former triggerman Paul Volcker
declared that "too big to fail" cannot be abandoned. He spoke the
truth about "too big to fail."
Deposit insurance must be reformed and more discipline must be
injected into banking, but reform must be premised on strengthening the first line of defense, stockholder discipline.
Tougher regulations can't do the job because technology is rapidly and irreversibly destroying the efficacy of all forms of financial
services regulations. That is why Congress has no choice eventually
but to strengthen stockholder discipline over banking so there no
longer is a need to rely on increasingly ineffective regulatory discipline and the potentially dangerous and destructive depositor discipline.
Unfortunately, today, stockholder discipline in banking has one
major structural flaw. Once a bank, which is after all a limited liability corporation, exhausts all of its own on-balance sheet equity
capital, any additional insolvency losses have to be born by uninsured depositors and taxpayers; that is, healthy banks who increasingly are over charged for their deposit insurance. Neither party is
a desirable bearer of loss.
I have good news, though. This structural flaw can be fixed quite
easily. The fixed—always keep someone's stockholder capital at
risk in every single bank, no matter how strong or how weak it is.
This means that when a bank exhausts its own capital and therefore fails, any additional solvency loss will be borne by stockholder
capital invested in other banks. One way to tap capital within the
banking system to absorb bank insolvency losses is the 100 percent
cross-guarantee concept. This concept is described in attachment A
to my written testimony.
Essentially, cross guarantees would utilize the enormous earning
power and equity capital of the banking system to construct a solvency safety-net under every single bank and thrift in this country.
No longer would the Congress have to fear that taxpayers will pay
for deposit insurance losses, a fear that came true in the S&L
crisis, and no longer would "too big to fail" be an unsolvable dilem-




52
ma. Move to cross guarantees, and the "too big to fail" issue becomes moot.
Thank you.
I welcome your questions.
[The prepared statement of Mr. Ely can be found in the appendix.]
Chairman CARPER, Thank you very much.
We look forward to offering some questions.
Before we do, let me recognize Mr. Kaufman to the subcommittee for your statement.
STATEMENT OF GEORGE G. KAUFMAN, PROFESSOR OF FINANCE
AND ECONOMICS, LOYOLA UNIVERSITY OF CHICAGO, CHICAGO, IL
Mr. KAUFMAN. Mr. Chairman, I am happy to testify on the implications of continuing a "too big to fail" (TBTF) policy in banking
on effective deposit insurance reform that would both strengthen
the banking system and protect the taxpayer against sharing in
the costs of the bank failures. I will summarize my longer statement.
TBTF is the single biggest obstacle to achieving these objectives
and is the major loophole in the Treasury proposal. Indeed, in light
of the recent experience in the thrift industry, the taxpayer is not
safe until TBTF is buried once and for all.
As presently employed, TBTF is a policy of not asking private
sector uninsured depositors to share in the losses of insolvent large
or important banks. Instead, the losses are borne by the FDIC, paid
for by the other banks, and if its resources are depleted, by the taxpayers as in the ongoing thrift debacle. This is significantly different than what happens in other industries.
Their losses beyond those that deplete a firm's shareholders' capital are borne totally by the firms private creditors. TBTF is a
harmful and counterproductive policy for a number of reasons: It
permits banks to operate with dangerously low capital ratios and
excessively.risky portfolios. It is blatantly unfair to smaller banks
whose larger depositors are put at greater risk.
It creates uncertainty about which banks regulators will consider
"too big to fail" at which times and thereby increases bank insurance premiums and bank costs. It encourages bank management to
place growth above earnings in its objectives.
By permitting "bad" near insolvent and even insolvent "zombie"
institutions to continue to operate, it increases the cost of living to
"good" banks by bidding up deposit rates and undercutting loan
rates.
Because the larger losses may require taxpayer assistance, it is
accompanied by greater government intervention and regulation
than otherwise.
Why, in light of all of these adverse implications, do most regulators support continued TBTF? There are a number of reasons: Pressure from the insolvent institutions—shareholders, managers, employees, and larger borrowers—to delay resolution.
Pressure from Congress responding to the same parties as above,
who are important constituents. Fear of spillover of bank failure to




53
other banks, the financial sector as a whole and the national
macro-economy.
Fear of reduction in money and credit to the community. Fear of
breakdown in the payments system from defaults in clearing.
Fear of receiving a public black mark on their record for failing
to maintain bank safety and fear that the public and Congress may
shoot the messenger of bad news. Thus, regulators prefer to delay
public recognition of failures in hope that conditions will reverse
or, if not, that the failure or at least recognition of it occurs on
their successors' watches.
Fear of antagonizing future potential employers. Similar to the
well publicized "revolving door in the Defense Department, many
employees of bank regulatory agencies join banks and related firms
after their tenure at the agency.
Last, fear of loss of discretion, which enhances the visibility,
power and "fun" of the regulatory job.
As I review in my written statement, these qualifications are not
desirable or persuasive. I document that systemic risk is today a
phantom issue. It is a scarce tactic. If one includes the thrift debacle, bank runs, failures and depositor losses were less costly in the
pre-FDIC era than they were in the last decade.
The runs on the Continental Bank in 1984, the large Texas banks
in 1987-1989, and the Bank of New England in 1990-1991 were rational runs on economically insolvent institutions that moved funds
not into currency to start systemic risk, but to safer banks. The delayed resolutions by the regulators did little more than increase
FDIC losses substantially.
Contrary to regulators' claims at the time of the Continental
rescue in 1984, the change in policy by the FDIC not to make all
creditors of bank holding companies whole in 1986 and to fail
banks legally in 1988 did not cause disruptions.
Continuation of "too big to fail" is a battle between bank regulators, and today I find out also the General Accounting Office, on
the one side, and the bankers and taxpayers on the other.
There is hardly another issue today on which bankers are as
united as on the need to end TBTF.
I recently attended a meeting of the chief executive officer's of a
cross section of banks in Chicago and they unanimously voiced
their opposition to TBTF. I would like to enter into the record a
news release that summarizes that meeting.
[The information referred to can be found in the appendix.]
Mr. KAUFMAN. It would be different to believe in wake of the
S&L debacle that taxpayers do not feel the same way. It is time to
stop bowing to the regulators and heed the concerns of the people
as in your bill 2094.
Thank you.
[The prepared statement of Mr. Kaufman can be found in the appendix.]
Chairman CARPER. Thank you very much.
Is it Dr. Kaufman?
Mr. KAUFMAN. Yes.
Chairman CARPER. YOU

are a professor from Loyola in Chicago.
Mr. Ely, do you still have your firm down in Alexandria?
Mr. ELY. Yes, I do.




54
Chairman CARPER. Mr. Wright, I understand you are the Director of Regulatory Affairs for the Office of Financial Markets,
Arthur Andersen and Co.?
Mr. WRIGHT. That is correct.
Chairman CARPER. We welcome you and recognize you at this
time.
Mr. WRIGHT. Thank you.
STATEMENT OF HOWARD L. WRIGHT, DIRECTOR OF REGULATORY MATTERS, OFFICE OF FINANCIAL MARKETS, ARTHUR AN. DERSON & COMPANY
Good afternoon, Mr. Chairman and Members of the subcommittee. I appreciate the opportunity to share the views of the Committee for Responsible Financial Reform regarding "too big to fail"
and how this issue relates to deposit insurance reform.
The Committee for Responsible Financial Reform consists of 10
individuals who are prominent in financial circles. The committee
was formally organized on February 4, 1991 to support efforts to
achieve comprehensive and meaningful reform of the banking and
financial system in 1991, with such reform directed at the broad
public interest rather than that of any industry group.
The committee is chaired by Frederick H. Schultz, former Vice
Chairman of the Federal Reserve Board. Donald P. Jacobs, Dean of
the J.L. Kellogg Graduate School of Management at Northwestern
University, serves as Vice Chairman. Other members of the committee are: Richard P. Cooley, retired CEO of Seafirst Bank; W.
Peter Cooke, Chairman, World Regulatory Advisory Practice; Price
Waterhouse, formerly Head of Banking Supervision at the Bank of
England and Chairman of the Basle Committee of Banking Supervisors; Maurice R. Greenberg, CEO of the American International
Group, Inc.; William M. Isaac, CEO of The Secura Group and
former Chairman of the FDIC; James D. Robinson III, Chairman of
the American Express Co.; Gary H. Stearn, President of the Federal Reserve Bank of Minneapolis; Thomas I. Storrs, retired Chairman of the Board of NCNB Corp.; and Howard L. Wright, Director
of Regulatory Matters, Office of Financial Markets of Arthur Andersen & Co.
Clearly, "too big to fair' is the linchpin of the deposit insurance
reform equation. Its elimination, to the extent possible, should be
the critical centerpiece of any deposit insurance reform proposal
adopted by the Congress.
We have reviewed the study submitted to the Congress by the
Secretary of the Treasury and find it to be a thoughtful, comprehensive report that serves the full attention of the Congress. Meaningful reform of the Nation's banking and financial system is
needed.
Not only in the interest of the financial institutions but also and
much more important in the interest of the public.
While agreeing with the basic thrust and major recommendations of the Treasury report, the subcommittee finds that the
report falls short in failing to recommend fundamental reform of
the deposit insurance system.




55
It is essential that the market be restored as an important regulator of banking, and this could be accomplished only by requiring
that depositors share with the government the cost of bank failure.
The present policy of "too big to fail" is inequitable and costly and
must be eliminated.
The report's failure to recommend fundamental insurance
reform and an enhanced role for market discipline compels it to
rely too heavily on expenses and potentially stifling government
regulations.
Moreover, it forecloses the possibility of substantial future reductions in the cost of insurance to the banks and to the public. Clearly, market discipline can be restored only when the market is convinced that all banks can fail and, more important, that failure
will imply losses for uninsured and unsecured depositors and creditors.
The subcommittee is fully aware that the prospect of eliminating
"too big to fail" raises substantial concerns in the minds of many,
some perceive that without "too big to fail" the temporary inaccessibility of funds in accounts over $100,000 could disrupt the payments system, money supply, and market liquidity.
These difficulties may be mitigated by changing the structure of
the deposit insurance system. It is important to note that "too big
to fail"and the structure of deposit insurance cannot really be separated.
Further, it is generally agreed that the elimination of "too big to
fail" would represent a major change for many banks and their depositors and their creditors. Accordingly, deposit insurance reform
along the lines we suggest should be enacted with a delayed effective date of at least 3 years after the adoption of the legislation. An
insurance system, for example, that covered fully transactions and
90 percent or so of interest-bearing liabilities over $100,000 mitigate the concerns associated with "too big to fail."
Liabilities up to $100,000, of course, would be fully covered and
subordinated debt would remain completely uncovered. Such a
system of deposit insurance would fully protect small depositors
and assure the functioning of the payments system. It would introduce market discipline for banks by exposing large interest-bearing
accounts to a degree of risk of loss.
This approach would curtail insurance coverage only slightly
from the current de facto level of 100 percent in the larger banks.
It is precisely this modest reduction in coverage that will allow
for the elimination of "too big to fail." We see several advantages
to the haircut approach with respect to large interest-bearing accounts. It is irresponsible to allow depositors earning rates will
above these paid by conservative, well-managed institutions to
escape risk under the government guarantee umbrella. Under this
proposal depositors will tend to be prudent in selecting an institution.
Those in the fast lane will have their radar detectors on to avoid
the speed traps. It is unfair to the sound institutions that are
forced to bear the burden of high deposit insurance premiums and
to the public at large who, as taxpayers, act as a back stop to the
deposit insurance fund.




56

Weak institutions, prone to pay higher rates for deposits, will
find it more difficulty to attract depositors. Thus, obtaining funds
to adopt a "bet the bank" strategy, if you will, would be more difficulty.
Elimination of "too big to fail" will reduce substantially the costs
of the BIF fund. The BIF's expenses will be reduced considerably
because a portion of the costs of all failures will be shared by those
in interest-bearing accounts over $100,000, and the market discipline so created will reduce future costs by eliminating the growth
of the weak and risky institutions. Importantly, this system will
eliminate the inequity between the large and small banks inherent
in the "too big to fail' policy.
As you can see, the subcommittee believes it is possible to reform
the deposit insurance system to mitigate the most serious systemic
concerns associated with large bank failures. The question remains
whether there are any circumstances under which the government
must intervene to prevent losses to all depositors and general creditors.
It is difficult to imagine a situation where this would be the case,
but should it arise, the question has no relevance to the deposit insurance reform. A government's right to intervene whenever a
business failure threatens the national interest is absolute, whether the business is a bank or an industrial concern.
Should the government decide to intervene in the case of a bank,
the decision, the form and nature of assistance, and the cost should
be handled outside the deposit insurance system.
Mr. Chairman, that concludes my testimony. I would be pleased
to answer any questions.
Chairman CARPER. I am going to ask that the Members of the
subcommittee adhere to the 5-minute rule so we can get out of here
in a timely manner and let our witnesses go on their way.
Mr. Brandon, where do you and Mr. Wright agree and where do
you disagree in your statements, where do you think you agree?
What are the principal differences?
Mr. BRANDON. It appears that we both agree that "too big to
fail" is too expensive and it is not fair to the depositor and it needs
to go.
It appears that we agree that "too big to fail," if you take it as a
national interest, is not something that is a matter for the FDIC.
The FDIC insures insured deposits, so we agree on those two
things.
Chairman CARPER. Where do you disagree?
What are your principal disagreements?
Mr. BRANDON. I would have to read his testimony very carefully
to see if there were any nuances that we disagreed on. Pretty rare
that you are going to find in "too big to fail" anybody that totally
agreed on anything.
Chairman CARPER. Mr. Wright, where do you see you and Mr.
Brandon agreeing and disagreeing?
Mr. WRIGHT. I think the real distinction in our approach is the
protection of all the payments system accounts, if you will, the
non-interest bearing accounts, and I think that takes away the fear
of a payment system collapse, and putting the burden for the policing on the high interest—or the high-yielding deposits of depositors




57
seeking high yields in on deposits excess of $100,000, that will have
been guaranteed irrespective of yield by the existing "too big to
fail" approach.
Chairman CARPER. Dr. Kaufman, is it fair to say that you, of the
witnesses we have heard from today, most agree with the action of
the Financial Institutions Subcommittee, the legislation, H.R. 2094?
Dr. KAUFMAN. I haven't read it in detail. All I know is what has
been reported in the press. I think it is a very good first step in
stopping "too big to fail", which I have argued is very costly to the
taxpayer, unfair to the banks, and I know that there was an
amendment that was lost about the Federal Reserve being able to
lend to banks.
I think eventually you may want to deal with that, but I would
like to see us make progress, and that can only happen one step at
a time, so I do agree with the thrust of the bill 2094 of stopping
"too big to fail".
Chairman CARPER. All right. Mr. Ely, in the second page of your
summary, of your testimony, you said "I have good news, though,
this structural flaw can be fixed quite easily."
Could you just go back and sketch that for us again, please, your
explanation of how this fix can occur.
Mr. ELY. There are various ways that the fundamental structural
flaw of deposit insurance could be dealt with. What I talk about,
and have proposed for some time, is what I call the cross-guarantee
concept. It is nothing more than a self-insurance mechanism for
the banking industry in which ad hoc syndicates of banks would
uarantee each other's liabilities in full and not just the first
100,000 of deposit balances.
The purpose for doing this is not to improve depositor protection.
That is a given in the countries of the industrialized world. The
whole thrust of this proposal is to improve taxpayer protection; to,
in effect, use the earning power of the banking system, and the
over $200 billion of equity capital to link together all banks in constructing what I call a solvency safety net that would stand between the banking system and each bank in it on the one hand and
the Treasury Department or the taxpayer on the other. Any bank
insolvency loss that effectively wipes out the capital of an individual bank would be spread laterally across the banking system and
not imposed upon the general taxpayer in any way. Essentially,
this is the way to set up an actuarially sound deposit insurance
mechanism that, among other things, would allow for risk-sensitive
deposit premiums.
I think there are many in Congress today who believe there
should be risk sensitivity in deposit insurance pricing, but pricing
can only be done accurately in a private, competitive marketplace.
One of the reasons to move toward the cross-guarantee concept
or a comparable type of insurance mechanism is to allow that pricing to take place. In all candor, the FDIC will never be able to
price properly.
Coming back to the purpose of this hearing, if we establish a
sound insurance mechanism that is based on the capital and earning power of the banking system, we can protect every dollar of deposit, we can get away from the notion of having depositor discipline, and "too big to fail" just disappears as an issue.

f




58

Chairman CARPER. Let me ask each of the other panelists to respond very briefly to this proposal from Mr. Ely.
Mr. BRANDON. I will start.
I have not read Mr. Ely's total plan thoroughly. I have seen his
plan. I don't think that it is practical, and I don't think that it
could work in a reasonable world.
I think we can't get there from here, frankly.
Chairman CARPER. All right. Dr. Kaufman.
Mr. KAUFMAN. I agree. I think in practice it would not work very
well. There is not enough capital in the banking system to protect
all the banks with the cross guarantee.
Second, I think that deposit insurance, up to a certain amount,
$100,000, or something, is ingrained, in the public. The small depositors are the only ones you need to worry about because they
are the only ones who could run into currency. The big depositors
can't.
The only way that systemic risk, if there is such a thing, can
occur is if there is a run on all banks into currency. So you have to
worry about the small depositors. I think that they look forward to
a government guarantee.
Chairman CARPER. Mr. Wright.
Mr. WRIGHT. I would share the view that the small depositor
looks forward to the Government guarantee. I also believe firmly
that the discipline provided by the large depositor will be very real
if, in fact, it will put the large depositor at some modest degree of
risk.
Chairman CARPER. OK. My time has expired. Let me yield now
to Mr. Ridge for his questions.
Mr. RIDGE. Mr. Chairman, I know my colleagues, Congressmen
Vento and Hoagland, have been here and they have been waiting
along time. I will yield to them and I will conclude.
Chairman CARPER. Good. Thank you.
Mr. Hoagland.
Mr. HOAGLAND. I don't know where to begin because this subject
is so complicated.
Each of you gentlemen has presented such interesting testimony.
First, in defense of Mr. Ely's proposal, I guess Canada sort of has
that, doesn't it?
Canada has six or seven big banks. Isn't that right? How many
banks?
Mr. ELY. They have a number of smaller banks also, but their
banking system is dominated by a handful of very large institutions.
Mr. HOAGLAND. That have Canadian-wide banking?
Mr. ELY. That is correct.
Mr. HOAGLAND. SO if a branch somewhere fails, why, the rest of
the bank is there to keep that branch from failing, in effect?
Mr. ELY. That is correct, and protecting depositors 100 percent.
Mr. HOAGLAND. That is right. So is that an appropriate analogy
to say your system really sort of is in place in Canada?
Mr. ELY. Well, Canada also has a deposit insurance system. The
Canada Deposit Insurance Corporation provides protection up to
$60,000, but they have—I was just looking at their numbers the
other day—probably including their trust companies, about 150 de-




59
pository institutions operating in the whole country, so in some
ways their problems are more manageable.
Interestingly enough, they also are thrashing around with this
issue of "too big to fail". My testimony cites a $1.5 billion institution that they closed just a couple weeks ago, a trust company that
is a lot like a thrift in this country, in which they have decided to
liquidate the institution, but they delayed long enough that most of
the uninsured deposits in the institution had fled by the time they
finally closed it.
Mr. HOAGLAND. Maybe we can talk about this some more. I
would like to follow up, but we are under a strict 5-minute limitation with this vote looming over and the fact that we have to give
the room up in 20 minutes, so let me shift, if I can.
Mr. Brandon, the official ABA position—correct me if I am
wrong—is in favor of the least cost, immediate payout resolution
procedure, and otherwise not ensuring or not reimbursing uninsured depositors; is that right?
Mr. BRANDON. That is correct.
Mr. HOAGLAND. SO the ABA position would concur with the current version of the bill that was reported by the subcommittee?
Mr. BRANDON. With the exception of the amendment for the Fed.
As the Governor spoke this morning, he mentioned that amendment. That is a huge loophole that can end up with the Fed stepping in at the last minute, lending money to allow the uninsured
deposits to flee, and the uninsured creditors to flee, taking the
assets, the good assets, dumping it back on FDIC fund at the end
and you have got the same result, you have got "too big to fail" all
over again.
Mr. HOAGLAND. SO something needs to be done with that, if possible.
Mr. BRANDON. Right.
Mr. HOAGLAND. AS I read Mr. Wright's testimony, it is very similar to your testimony. You two are sort of both saying we should
use that least-cost resolution system and not—how do you respond,
Mr. Brandon, to the testimony from the regulators this morning
and from Mr. Glauber from Treasury that somewhere in the Government there needs to reside the authority because—I think Mr.
Ely said hat in his testimony. I don't believe Mr. Kaufman did, but
how do you and Mr. Wright respond to the problem that there can
be such severe systemic failures that somewhere in government
somebody has to have the authority to step in, shouldn't be paid for
by the Bank Insurance Fund, but nonetheless that authority has to
reside somewhere. What is your
Mr. BRANDON. It is interesting.
First of all, we started with a small subcommittee, but that
wasn't the end of the banker involvement of whether or not "too
big to fail" can go. It is our industry, it is our business, so we are
paying pretty close attention to this.
But it went from there to a subcommittee of 100, it went from
there to the subcommittee of 400. It went from there to the Board
of Directors. It went from there to almost every State in the Union,
to talk about the question of, is "too big to fail something that can
be eliminated? It is almost unanimous.




60
Nothing is ever unanimous, but it is almost unanimous that, yes,
we don't have any choice but to do this, we have got to do this. It
was also pretty well unanimous that if you did have that unusual
rare systemic risk, that was outside the fund, it was a national priority, congressional priority and should be dealt with in a different
way.
Mr. HOAGLAND. But you were conceding that that authority—you
are essentially agreeing with Mr. Ely, that it is in the end an impossible dream, and that somewhere in government there needs to
reside that authority or would you totally take out of the statutes
any authority or require that a bill be brought in a la the Chrysler
bailout?
Mr. BRANDON. I would be back to Mr. Wright's proposal on that.
What we are saying is "too big to fail" simply means that you
come in and that you pay uninsured depositors and uninsured
creditors 100 percent because you think that there might be some
system risk to the banking industry.
That is what you are saying. We are saying that we believe you
can eliminate that, that if we go to a haircut type of approach, if
we give ourselves enough time, if everybody understands the situation, then there is nowhere to go.
You have got the same thing everywhere. You simply go to the
bank that you think is run the best, and you have got a market
discipline that comes in there. We are not saying that under any
circumstances ever there might not be something that would be in
the nature of the Chrysler situation, the New York situation, the
railroad situation that the Congress wouldn't have to deal with.
We are simply saying that is outside the FDIC.
Mr. WRIGHT. I would have to agree. There would have to be a
catastrophe before the Government would step in in the strictest
sense of the word.
The concept is if you put enough market discipline in the system,
in effect, you should be able to lower premiums because the marketplace itself will help regulate the system, and only in a very,
very catastrophic situation, it would have to be a Chernobyl as discussed by one of the other witnesses this morning—we haven't had
one of those in this country.
Mr. HOAGLAND. Thank you, gentlemen. Your testimony has been
most helpful.
Chairman CARPER. Mr. Vento.
Mr. VENTO. Thank you, Mr. Chairman. I think the whole issue is
whether we have got an insurance system that costs more than the
banks can support. I mean, that is what the problem is, so we are
trying to reallocate those costs somehow.
I guess I have got about 5 minutes before we really have to go.
But the point is, if we, for instance, and I know that my good
friend, Congressman Hoagland and others are advocating that we,
in fact, put in place some sort of a system that would provide a
haircut. Right now the FDIC could any time they want employ that
particular technique. But they don't, and there are probably a lot
of good reasons why they don't, one of which is they might get involved in a lot of litigation.



61
My concern is that if we were to do that, then we would really be
extending insurance coverage. Today we do it implicitly, then we
do it explicitly.
Mr. Ely, you agree, so I will ask you a little bit about it.
Mr. ELY. Well, I think that we are slowly moving in that direction, whether we like it or not, of having increasingly explicit coverage for deposit balances over $100,000.
Mr. VENTO. But this system, when the banks were profitable it
was a different thing. Then we had moral hazard, Mr. Bartholomew. The point is, now the moral hazard is something we really
can't afford.
There is no actuarial table, there is no way to do it. How does
your proposal, Mr. Ely, really differ from raising the premiums on
everyone?
Doesn't it really come back and tax everyone for the problem in
a way that we say, well, this is so bad that it would cause other
banks to go into default?
Mr. ELY. NO, this is where you get into the area of risk-sensitive
deposit insurance premiums so that in effect the drunk drivers of
the banking world pay a lot more than their sober siblings for their
deposit insurance. My calculations are that the riskiest banks
should be paying as much as 20 times what the soundest banks
ought to be paying for their deposit insurance.
We have right now a flat rate deposit insurance system where
the cross subsidy that is flowing from the good banks, from Mr.
Brandon's bank and others, to pay for bad banking is growing all
the time.
The cross subsidy next year will be in excess of $3 billion. That is
wrong. That is bad for the better banks in this country.
If we go to a system that allows for a private, competitive marketplace to engage in the assessing of risk and the pricing of risk,
we will get away from the problems that we are so concerned about
with Federal deposit insurance.
Just to clarify the record on that point, the cross-guarantee concept does not envision rolling back Federal deposit insurance protection one iota.
Under cross-guarantees, the Government would specify that the
banking system and its capital and resources stand there first in
an actuarially sound way. There is no reason why the FDIC sticker
can't stay in the door and why the Government in a catastrophe, if
the banking system as a whole is bankrupt, couldn't come in and
protect depositors.
The thing that is interesting is that in the Depression there was,
even then, enough capital in the banking system to have fully protected all depositors at that time.
Mr. VENTO. I wanted you to have an opportunity, because I knew
you didn't earlier, to respond. I think the witnesses agree with
regard to the essentiality test.
Mr. Seidman said it had only been employed four times. Do you
agree that the "too big to fail" has only been invoked four times in
that timeframe? I don t know what his timeframe was.
I think he started with Continental and ended up with Bank of
New England.



62
Mr. BRANDON. I am eventually regulated by the FDIC, so I
always agree with everything they say.
However, it would appear to me that is a rather narrow definition. We as bankers feel like it has been used one way or the other
a lot more than that.
Mr. VENTO. We have all these discussions about the benefits of
free enterprise, but when it really comes down to it, it sounds to
me like a lot of people don't want to practice it, the downside of it.
Mr. Kaufman, do you agree with that essentiality issue?
Mr. KAUFMAN. I looked at the list Mr. Seidman presented to us,
and it left out the Continental Illinois Bank. I would think any list
that leaves out the Continental would not be a complete list.
Mr. WRIGHT. I think he was referring to the list while it was on
his watch.
Mr. VENTO. I am sorry. I think you are probably right. I didn't
know what the timeframe was.
Mr. WRIGHT. I guess the other view I would have is if you are
going to have "too big to fail", in effect, you are providing funds to
institutions who are too weak to go ahead and make additional
loans, and that is one of the problems.
Once the institution has a bad loan, it is too late.
Mr. VENTO. Well, I agree that that is a problem, but, Mr. Wright,
I was sort of fascinated by the thought that you had given to this,
and of the suggestions, but is there anyone here who really thinks
that the current insurance system we have is something we can
afford?
Don't we really need to trim this back?
I don't know that we do it enough with the 85 percent because
right now, for instance, they have discretion that they could cut
way back and they don't examine that particular technique.
So if we actually say we are going to do 85 percent, you know, we
are really extending or expanding it.
Mr. WRIGHT. I think the real issue is one of looking at it over
time. I think you have to phase in to whatever changes you make.
If you make a change immediately, you have got to provide for
some transition.
Mr. VENTO. We are all for that. I appreciate it, Mr. Chairman.
Thank you very much. My time has expired.
Chairman CARPER. Thank you, Mr. Vento.
For the last word, Mr. Ridge.
Mr. RIDGE. Thank you, Mr. Chairman.
Mr. Brandon, first of all, let me thank you for your testimony, all
panelists, and let me also thank you for you leadership within the
ABA, as well as your colleagues on your deposit insurance reform
effort. I have read what you wrote.
I think it is a very good succinct primary primer of a broad
range of concerns that not only Members of Congress but the panelists had, the taxpayers had in terms of identifying what the problems are, and what we should be alerted to. I think you did an excellent job, and I certainly think it was a thoughtful responsible alternative that you have offered.
I just want to thank you for the contributions of the ABA to this
process. I am not sure we are going to get there from here, borrow


63

ing your words, but it was a thoughtful contribution, and I for one,
appreciate it.
Perhaps, you heard this morning the discussion I had with the
panelists with regard to the Fed's intervention into ailing institutions, and I used the Bank of New England, which probably wasn't
the best example, and Chairman Seidman referred to National
Bank of Washington, and either one is still illustrative of the concern that many Members of Congress have, that you have an early
run on "X," and more often than not it is involving uninsured depositors. Because of their run, there exists a liquidity problem.
The liquidity problem is addressed by the Fed. The Fed then
takes a position as a secured creditor rather than an uninsured depositor and, therefore, if that institution ultimately goes belly up,
you have got an even greater insurance problem because there are
now secured liabilities rather than uninsured liabilities, so my colleagues understandably have considerable discomfort that that
may exacerbate the problem.
Their response, as you heard, was, well, that is what central
banks do, we haven't intervened that often, and we still need the
flexibility to do that.
Would you give me your thoughts on that problem and that gives
some of my colleagues so much discomfort because I think we are
going to have to come back and address it.
Mr. BRANDON. First, thank you for your complimentary comments. I did hear the testimony and your dialog and the questions.
That is of the great concern to the ABA, it is of great concern to
me. I don't know exactly what the solution is, but I do know it appears to us that as you characterize it, that is exactly what could
happen.
Now, how you solve that, I am not prepared to say at this time,
except that that is a huge loophole in eliminating "too big to fail"
that we feel like you need to look into very strongly and very emphatically and let s see if we can't work out a solution.
Mr. RIDGE. Mr. Ely, just a quick review of your testimony.
I know that you cite many reasons for the "too big to fail" policy,
and you referred to it in all kinds of ways in avoiding the wrath of
depositors and, I guess, the army, the acronym used to COIA, so I
think you have some feelings on this.
Would you share them with me as well ap the rest of the panelists?
Mr. ELY. Well, the basic problem is that when the crunch comes
it is a matter of who is going to take the loss. The regulators would
prefer that the pain be diffused, and the easiest way to diffuse the
pain is to have the FDIC pick up the loss because the banks finance the FDIC. In a more serious situation, the Government, and
the general taxpayer will absorb the pain.
The problem that will come up is that if an attempt is made to
get even more serious about imposing losses on specific depositors,
then we will have some concentrated hurts, and those folks will
scream bloody murder. I think the regulators want to avoid that.
We see this every time it is attempted, most recently in Freedom
National. There was $11 million of uninsured deposits in that institution, a drop in the bucket compared to big institutions, and yet
there have been enormous cries of pain and also suggestions that



64
maybe in that case we ought to bend a little bit and protect some
of those poor depositors that had uninsured balances in that institution.
I think the Freedom National experience is the type that stays in
the minds of regulators, and tilts them towards avoiding the concentrated pain whenever a larger troubled bank situation comes
up.
Mr. RIDGE. OK.

Mr. Kaufman.
Mr. KAUFMAN. I wish to disagree with Mr. Ely.
What we are talking about, what bill 2094 does, and what my
colleagues here are talking about is a different system with early
intervention. By the way, I would like to mention that early intervention in a structured program, such as in 2094, such as in the
Treasury proposal, such as in the Gonzalez bill, is a new idea..
Three years ago, it was a radical idea when I and my co-author
George Benson developed it for the American Enterprise Institute.
So in 3 years it has swept in. You can do such things.
Mr. RIDGE. It is that vision thing, you had it.
Mr. KAUFMAN. With such a structure you are going to have far
fewer banks that are going to go down into the lower tiers, into the
lower zones which require the re-capitalization. If you pass a law,
the regulators are going to stick to that law, and I think you are
going to have a different banking system.
Let me remind you, when we talk about runs on uninsured institutions, look at the money market funds. They are viewed as safer
than banks, yet they are not insured. People have greater faith in
them because they monitor the assets. I have been trying to get a
money market fund to see if they would run an experiment for me
go into 30-year mortgages.
But they know better; they know there would be a run. But don't
worry about runs. The threat of a potential run is a major from of
market discipline.
\
I have studied banking history, going way back to the early
1800's, and banking history in this country was very stable. We
had very few runs. The bank failure rate from 1865 to 1920 was
lower than the non-bank failure rate.
Even during the Depression the losses were pretty small, because
of market discipline and because we closed the institutions quickly.
If you don't have a closure rule, you can throw everything else
away.
Mr. RIDGE. Mr. Wright, I am afraid my colleague and I have to
leave, but I will give you the last word.
Mr. WRIGHT. One last comment. I don't doubt the sophistication
and ability of the marketplace to provide discipline. I think many
times the marketplace also provides better discipline than people
who are trying to figure their way around whatever structural
rules are imposed by regulation.
Mr. RIDGE. On that interesting and controversial note
Chairman CARPER. Mr. Wright, Dr. Kaufman, Mr. Ely, Mr. Brandon, thank you very much for being with us today.
[Whereupon, at 2 p.m., the hearing was adjourned.]






65

APPENDIX

May 9, 1991

66
VE'-

:

,.'j£-'. - _p:^^SW-.,
CHAHLCS'.•!"=. c-o"
.AMES M C R - «

U.S. HOUSE OF REPRESENTATIVES

"

—iSCCC*

TIUPHONC. (202!

ONE HUNORED SECONO CONGRESS

v;3GiNIA

SUBCOMMITTEE ON ECONOMIC STABILIZATION
OF THE
COMMITTEE ON BANKING. FINANCE AND URBAN AFFAIRS
ROOM MO FORD HOUSE OFFICE BUILDING

WASHINGTON, DC 20515
STATEMENT OF CONGRESSMAN THOMAS R. CARPER, CHAIRMAN
SUBCOMMITTEE ON ECONOMIC STABILIZATION
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
HEARING ON
THE ECONOMIC IMPLICATIONS OF THE "TOO BIG TO FAIL" POLICY
MAY 9, 1991

I WOULD LIKE TO THANK MY FELLOW MEMBERS OF THE SUBCOMMITTEE
AND OUR WITNESSES FOR JOINING ME HERE TODAY TO DISCUSS THE ECONOMIC
IMPLICATIONS

OF

THE

"TOO

BIG

TO

FAIL"

POLICY

AND

PROPOSED

LEGISLATIVE CHANGES TO THIS POLICY.
BANK FAILURES OCCURRED AT RECORD LEVELS IN THE 1980s. IN THE
LAST THREE YEARS ALONE, CLOSE TO 600 BANKS FAILED OR RECEIVED
ASSISTANCE, AND THIS TREND IS NOT LIKELY TO SIGNIFICANTLY CHANGE IN
THE NEAR FUTURE.
YET NOT ALL OF THESE FAILED INSTITUTIONS HAVE BEEN RESOLVED
IN THE SAME MANNER.

WHILE DEPOSIT INSURANCE PROTECTION HAS BEEN

ROUTINELY EXTENDED TO UNINSURED DEPOSITORS WHEN LARGE BANKS FAIL,
SUCH

PROTECTION

HAS

NOT

ALWAYS

BEEN

AFFORDED

TO

UNINSURED

DEPOSITORS WHEN SMALL BANKS FAIL.
THIS POLICY OF PROTECTING UNINSURED DEPOSITORS IN LARGE BANK
FAILURES IN ORDER TO PREVENT ADVERSE EFFECTS ON THE FINANCIAL
SYSTEM AND THE MACROECONOMY IS COMMONLY REFERRED TO AS THE "TOO BIG
TO FAIL" DOCTRINE.




MiSSCOP.I

HiCHARD < A S V S * "EXAS
CSAlG THOMAS . W O M I N G

WHILE SOME ARGUE THAT THE POLICY HAS BEEN

22S-7S11

67
IMPORTANT IN MAINTAINING A STABLE FINANCIAL SYSTEM IN OUR COUNTRY,
IT HAS RESULTED IN INEQUITABLE TREATMENT OF DEPOSITORS AND BANKS;
INCREASED COSTS TO THE BANK INSURANCE FUND; INCREASED TAXPAYER
EXPOSURE; AND DISCOURAGED MARKET DISCIPLINE.
FOR THESE REASONS, THE "TOO BIG TO FAIL" POLICY IS ONE OF THE
MOST CONTROVERSIAL ISSUES IN THE BANKING COMMUNITY TODAY.
IT PRESENTS MEMBERS OF THE HOUSE AND SENATE BANKING COMMITTEES WITH
ONE OF OUR THORNIEST PROBLEMS TO RESOLVE AS WE DEBATE BANK REFORM.
CONGRESS' ULTIMATE GOAL SHOULD BE TO REFORM THE BANKING INDUSTRY IN
A WAY THAT WILL RESTORE VITALITY TO THE BANKING INDUSTRY, BENEFIT
CONSUMERS AND AVOID ANOTHER TAXPAYER BAILOUT. TO REACH THAT GOAL,
THE TOO-BIG-TO-FAIL ISSUE MUST BE RESOLVED.
I

COMMEND

CHAIRMAN

GONZALEZ

AND

CHAIRMAN

ANNUNZIO

FOR

BEGINNING TO ADDRESS THE TOO-BIG-TO-FAIL ISSUE IN H.R. 2094, BUT I
BELIEVE THAT IMPORTANT QUESTIONS STILL REMAIN UNANSWERED.

THE

PURPOSE OF TODAY'S HEARING IS TO REVIEW IN DETAIL THE ECONOMIC
JUSTIFICATIONS FOR A TOO-BIG-TO-FAIL POLICY, AND THE ECONOMIC
IMPLICATIONS OF PROPOSED CHANGES TO THIS POLICY.
WE HAVE A FULL PLATE BEFORE US TODAY, WITH A NUMBER OF
WITNESSES SCHEDULED TO TESTIFY.

I'LL SAVE ALL OF YOU FROM A LONG

OPENING

FORWARD

STATEMENT.

I

LOOK

DISTINGUISHED PANELS OF WITNESSES.




TO

HEARING

FROM

OUR

68
OPENING STATEMENT
THE HONORABLE THOMAS J. RIDGE
RANKING MEMBER, SUBCOMMITTEE ON ECONOMIC STABILIZATION

Thank you, Mr. Chairman.
Events have made this hearing very
timely. In the Financial Institutions Subcommittee markup two days
ago, Members tried but failed to begin to address this very crucial
policy. I think a number of those on the Banking Committee are
sympathetic to allowing the Federal Reserve and the Treasury a
small window to take action to prevent systemic risk, but aside
from Mr. Hoagland, they were very quiet yesterday. A significant
number—and they did make themselves heard—believe any window is
too large, and the risk of codifying too big to fail far outweighs
any benefits of reducing current regulatory practice.
The result is the current mark of HR 2409: a simple statement
preventing the FDIC from paying off uninsured depositors. That is
our starting point today.
The Treasury proposal allowing the
Federal Reserve and the Treasury make the FDIC pay uninsured
depositors is no longer in the mark.
Some good ideas are out
there, however, and I hope we will hear comment on these topics,
as well as explore in detail the various components of systemic
risk.
I do know that if we do not make progress in this area, other parts
of the bill will not be agreed upon readily.
Securities firms
worry that large financial services holding companies will receive
100% federal backing, thus providing unfair competition*to them.
Small banks worry that deposit reform means cutbacks in their
coverage while large banks retain full backing, leading to an
outflow of funds from small communities. These groups and others
will have a legitimate incentive to block needed reforms unless we
resolve our dilemma•
I look forward to the testimony.




69
TESTIMONY OF

L. WILLIAM SEIDMAN
CHAIRMAN
FEDERAL DEPOSIT INSURANCE CORPORATION

ON

THE IMPLICATIONS OF wTOO BIG TO FAILM

BEFORE THE

SUBCOMMITTEE ON ECONOMIC STABILIZATION
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
UNITED STATES HOUSE OF REPRESENTATIVES

10:00 A.M.
MAY 9, 1991
ROOM 2128, RAYBURN HOUSE OFFICE BUILDING




70
Mr. Chairman and members of the Subcommittee, I am pleased
to appear before you today to discuss the Federal Deposit
Insurance Corporation's views on the resolution of large failing
banks and on proposed legislative changes to the FDIC's cost
test.

These issues have become known as the "too big to fail"

problem.

The FDIC believes that this problem needs to be

addressed by Congress as it studies recapitalization of the Bank
Insurance Fund and the necessary modernization of the U.S.
banking industry.

It also is important to address the evident

unfairness in a system which seems to provide greater protection
for depositors in large institutions than it does to those who
place funds in smaller institutions.

We applaud your initiative which supports our view that
this problem is a matter of concern to the overall economic
stability of our nation, as well as to the banking agencies.

Your letter of invitation detailed several areas of
interest to this Subcommittee.

Before addressing those

directly, I would like to provide some background information on
the insurance coverage of depositors in large bank failures.

Introduction
"Too big to fail" (TBTF) is imprecise shorthand for N too
big to allow uninsured depositors to suffer losses."




TBTF

71
- 2 -

arises when a bank fails (or may fail) and the FDIC and other
federal regulators find the institution essential and thus act
to prevent consequences of allowing depositors above $100,000 to
sustain their proportion of the loss in the institution.

In

large bank failures, essentiality involves systemic instability
arising from possible disruption to the payments system, fear of
contagion effects on other banking organizations, or increased
instability in the banking system as a whole.

In small bank

failures, essentiality may involve essential financial services
required in the community it serves.

However, it is unlikely

that the failure of a small bank in a large community will meet
the essentiality test.

In the bank failures where TBTF is not involved, either an
insured deposit payout is used, or a failed bank is acquired by
another institution in a closed-bank purchase-and-assumption
(P&A) transaction.

In a P&A transaction, an acquirer normally

purchases some of the assets and assumes liabilities of the
failed bank, and pays a premium that reflects the franchise
value of the institution.

The acquirer assumes both the insured

and uninsured deposits, and in some cases other nondeposit
liabilities of the failed bank.

In some cases, a resolution is

accomplished by providing direct financial assistance on an
open-bank basis to facilitate a merger with a healthy
institution or an acquisition by new investors.
transaction all depositors are protected.




Thus, in this

72
- 3 -

Prior to 1951, the P&A transaction became the most common
failure-resolution method employed by the FDIC.

This

transaction was viewed as an efficient means of handling an
insolvent bank because generally protecting all depositors
resulted in fewer disruptions to banking services to the
community, and the transaction provided the FDIC with maximum
flexibility in the failure-resolution process.

In 1951, Congress questioned the FDIC's policy of providing
de facto 100 percent deposit insurance to banks, and suggested
that failures were being resolved without regard to relative
cost.

In response, the FDIC began to use a cost test when

determining how a bank failure should be resolved.

The FDIC

interpreted Section 13(e) of the Federal Deposit Insurance Act
of 1950 to mean that a cost test must be undertaken whenever a
resolution transaction is performed to determine its cost
relative to an insured-deposit payout.

The Garn-St Germain Act

of 1982 significantly revised Section 13 of the FDI Act,
specifically mandating a cost test.

Other than cases where an

1

"essentiality * finding is made by the Board of Directors, the
1982 Act permits the FDIC to pursue an alternative
failure-resolution method only in situations where the
transaction is less costly than an insured-deposit payout.

The FDIC has always preferred to handle bank-failure
resolution cases in the most cost-effective and least disruptive
way possible.

There are several important policy objectives




73

that the FDIC has considered when determining the most
appropriate failure-resolution method.

These include the need

to minimize cost to the insurance fund, maintain stability in
the financial system, encourage market discipline, minimize
disruptions to the community, and provide consistent treatment
for banks of all sizes.
always compatible goals.

Experience has shown that these are not
Nevertheless, the fact remains that

there will be situations in which the need to maintain financial
stability is the overriding concern.

Over the past five years,

the FDIC has determined that only four banks were "too big to
fail" and protected all depositors.

The cost of protecting the

uninsured depositors of these institutions was less than one
billion dollars or about 3.5 percent of the FDIC's total
insurance losses over this time period.

Attachment A to this

testimony provides the names and asset size of these
institutions.

The TBTF concept came into prominence with the 1984
assistance package arranged for Continental Illinois National
Bank and Trust Company.

In that case, the FDIC in conjunction

with other federal regulators made an essentiality finding on
the basis that a failure and statutory payout would threaten the
stability of the financial system.

As is discussed more fully later, fear of adverse
macroeconomic consequences or financial system instability
resulting from the failure of a major bank is not a deposit




74
- 5 -

insurance problem cex 1ft*

Nor is the incidence of government

assistance to large organizations unique to banking.

During the

1970s, public-policy makers determined that certain
organizations should not be reorganized under the protection of
bankruptcy lavs even though these laws, in general, have worked
well to protect claimants and minimize disruptions when
corporate firms become insolvent.

Thus, for example, Lockheed

Aircraft Corporation and the Chrysler Corporation were deemed
"too big to fail."

Since the Continental Illinois open-bank assistance
package, in which both the creditors of the holding company and
the uninsured depositors and creditors of the bank itself
benefitted, the FDIC has gained additional powers that have
permitted us to limit coverage provided under TBTF.

In

subsequent cases, the FDIC has used its authority to establish
bridge banks to exclude holding company creditors and equity
holders in rescue efforts that provide the uninsured depositors
and creditors of a subsidiary bank with protection.

For

example, this authority was exercised in the resolution of the
Bank of New England.

Moreover, the FDIC's Etfi £&£& power —

which was

legislatively endorsed in FIRREA and has been used more
frequently in recent years —

enables us to distinguish between

categories of uninsured depositors and creditors under all
methods of resolving failing banks.




75

Some believe that small banks are allowed to fail and are
usually resolved through a payout of insured deposits, but this
is not true.

Most small banks are resolved through P&A

transactions in a manner identical to larger institutions.

Of

the 169 banks that failed in 1990, only eight were resolved
through an insured-deposit payout and only 12 others were
resolved through an insured-deposit transfer.

The remaining

failure resolutions provided full coverage to all depositors
through a P&A transaction which was determined to be the least
costly way to handle the failure.

Th? International Experience
One of the issues we were asked to address today is how the
TBTF policy affects the overall soundness and competitiveness of
our banking system both domestically and internationally.

For

several years now, the FDIC has taken an active interest in how
other major countries handle bank failures.

This is not an easy

task because many countries either do not allow their banks to
fail, or they step in and take action before a troubled bank
becomes newsworthy.

In any event, most other countries do not

have a deposit insurance entity with powers equivalent to the
FDIC.

However, all other major industrial countries have

reserved for themselves considerable flexibility in the handling
of large bank failures.

During the annual joint meeting of the

World Bank and the IMF last September, representatives from the
central banks, finance ministries, and national banking




76
- 7 -

associations of the G-10 countries joined us at the FDIC to
discuss TBTF and other issues related to the provision of
financial safety nets.

A summary of the proceedings of this

meeting is included as Attachment B.

It was noted that the U.S. system of federal deposit
insurance is virtually unique in that, although statutorily
limited in the amount of coverage provided, the FDIC has
authority to extendfle.facto coverage through its powers to
arrange purchase-and-assumption transactions and financiallyassisted mergers, or to provide direct assistance to banks.
These tools, along with the need to handle bank insolvencies in
a least-costly manner and several well-publicized rescues of
large banks in recent years, have contributed to a widespread
belief in the U.S. that uninsured depositors will only suffer
losses in the failure of small banks.

This belief has raised

competitive concerns among commercial banks in the U.S. and also
has led to concern that equity considerations may result in the
FDIC extendingfle.facto 100 percent deposit insurance coverage
to all banks.

While most foreign representatives at the conference felt
that the U.S. federal deposit insurance system is overly
generous, it was apparent that direct comparisons of deposit
insurance coverage are difficult, if not impossible, due to
differences in national banking structures and safety-net
arrangements.

For example, unlike other nations, the U.S. does




77
- 8 -

not have any government-owned banks which, by definition, cannot
fail.

Nor does the U.S. have a postal savings system in which

the government explicitly guarantees principal and interest.
Additionally, many countries tend to rely on failure-prevention
methods, including direct capital injections, government
acquisition of nonperforming assets, nationalization of troubled
banks, provision of liquidity through central banks or with
industry support ("lifeboats**), and government-assisted
mergers.

As a result, costs which in the U.S. are incurred by

the FDIC are incurred in these countries by the central bank,
the finance ministry, or a consortium of banks.

Publicly, no foreign government representative will admit
that their country has a TBTF policy.

Privately, conference

participants acknowledged that there may be banks that are too
big to fail, simply because large banks often are important
components in a nation's payments system and the failure of a
major bank could have adverse macroeconomic effects.
Additionally, in many of these other countries a handful of
banks control the majority of domestic banking assets and,
therefore, an implicit assumption may exist that one of these
major banks would not be allowed to fail.

Nevertheless, the conclusion with respect to TBTF was best
summed up by one of our international colleagues when he said,
••Too important to fail, perhaps; too big to suffer, no."

The

implication of this statement is that even if official support




78
- 9 -

is given in a particular situation, it does not necessarily mean
that a significant increase in moral hazard, or the tendency for
a bank's management to increase risk-taking behavior as it
approaches insolvency, is a certain result.

Authorities can

exact penalties for imprudent behavior by demanding the
replacement of senior management, change of ownership, and a
write-off of stockholders' investment.

Penalties can be applied

even if the deposits are fully protected.

There was less agreement among our international colleagues
regarding the role and effectiveness of depositor discipline.
All representatives agreed that market discipline is desirable,
but none seemed willing to rely on it entirely.

While some

participants felt that more market discipline is needed in
today's banking environment, others were skeptical about the
effectiveness of expecting individual depositors to police the
condition of their banks.

Moreover, it was noted that in

several countries, political forces are sometimes brought to
bear against decisions by the central bank to allow depositors
to lose money.

All representatives agreed that the focal point in failureresolution decisions is the trade-off between maintaining public
confidence in the financial system and preserving a degree of
market discipline.

Thus, most regulators preferred taking

corrective action prior to a bank's actual insolvency so that
failure-resolution decisions can be avoided entirely.




It should

79
-10be noted that most insolvencies or near-insolvencies in other
countries have been resolved via bailout or merger.
Liquidations typically have been limited to small, local
depository institutions.

Finally, conference participants were specifically asked by
the FDIC what the reaction in their countries would be if the
U.S. were to impose losses on depositors in a large bank.

One

representative expressed skepticism that such an event would
ever occur, except under the most extraordinary circumstances.
Others felt that any foreign bank doing business with the failed
U.S. bank should be prepared to accept the consequences of their
decision.

At the same time, however, participants noted that

such a failure probably would cause foreign banks to re-evaluate
the creditworthiness of all American banks.

We concluded from these discussions that TBTF is an issue
that exists even in the absence of explicit deposit insurance
programs.

That is, the possible failure of a large financial

organization presents macroeconomic issues that some arm of the
government must be able to consider.

The evaluation of the

economy-wide ramifications of the demise of a large bank is a
government responsibility.

FDIC's Position on TBTF

In some cases, it may be necessary to have the flexibility
to resolve the failure of a large troubled bank in a manner that




80

-nprotects all depositors.

As mentioned above, the need for this

flexibility arises because of macroeconomic and financial
stability considerations (systemic risk) that are much broader
than those pertaining specifically to the deposit insurance
safety net.

The Treasury's legislative proposal provides that

the decision that a bank is "too big to fail** should be made by
the government agencies charged with maintaining macroeconomic
stability, and not by the FDIC.

However, it requires the FDIC

to bear the costs associated with protecting the uninsured
creditors in these situations.

The FDIC believes that decisions on TBTF should be dealt
with on a public-policy basis by the administration.

Funding

for TBTF should come from the U.S. Treasury through funds
available for that purpose.

Because of the short-term nature of

bank liabilities, these decisions must be made within hours.
The availability of stand-by funding is essential because there
simply is not time to go to Congress for an appropriation.

If,

as we suggest, Treasury pays for TBTF, then the decision-making
authority should rest with Treasury, in consultation with the
Federal Reserve Board and the FDIC.

If Congress instead decides

that the insurance fund should pay for TBTF, any decision to use
it should be made by the FDIC with the concurrence of the
Federal Reserve Board and the Treasury.

If the insurance fund

must bear these costs, then it is necessary that the FDIC have
the authority to adjust the assessment base as may be
appropriate.




81
- 12 -

If Congress makes the decision that all depositors should
not be protected if a large troubled bank fails, a great deal of
potential disruption to depositors can occur unless prompt
information on insurance coverage is available.

Thus,

resolution methods are needed that can sort out the various
insured and uninsured claims swiftly and accurately.

This may

require a "final settlement" arrangement similar to that
proposed in the American Bankers Association's study of deposit
insurance reform and contained in the Treasury's proposal.
However, it must be recognized that this type of approach would
require that the larger banks maintain systems capable of
differentiating between insured and uninsured claims on a
real-time basis.

This will involve considerable additional

costs to the institution.

Additionally, Congress may want to be mindful that the
establishment of criteria authorizing the protection of
uninsured depositors, only in cases of systemic risk, would
exclude small and minority banks that may be essential to their
communities.

In summary, Mr. Chairman, the FDIC believes that any
deposit insurance reform package must adequately address the
TBTF issue.

Any solution should include both a source of

funding and the establishment of a credible mechanism to handle
large bank failures in a manner that ensures the stability of




82
- 13 -

international and domestic financial markets.

Proposed remedies

should recognize that small banks are treated unfairly under the
present system and are handicapped in competition with large
institutions.

If TBTF continues in some form then small banks

need broad deposit insurance protection to offset the TBTF
advantage.

There is no question that our TBTF system is in need of
reform but unfortunately, there are no easy answers which
provide both fairness and safety and soundness to the system.
Our goal should be to strengthen the entire banking industry so
that the question of which institutions can fail will not be of
paramount concern.

In the interim, we suggest that

"constructive ambiguity11 as to who will be too big to fail
should continue, and TBTB should be administered and paid for by
the Administration, after consultation with other regulators.




83
Attachment A

1986

First National Bank & Trust Co.
Oklahoma City, Oklahoma
Total Assets $1.6 billion

1988

First Republic Bank
Dallas, Texas
Total Assets $32.9 billion

1989

MCorp
Houston, Texas
Total Assets $15.8 billion

1991

Bank of New England (3 banks)
Boston, Massachusetts
Total Assets $22.9 billion




84
Attachment 6

SUMMARY OF PROCEEDINGS
INTERNATIONAL CONFERENCE ON DEPOSIT INSURANCE
AFP PROBLEM-BAMi RESOLUTION POLICIES
by Alan* K. Moysich*
This conference was convened by the FDIC on September 26,
1990, for the purpose of discussing issues related to the operation
of deposit insurance systems and government policies for
intervention in problem-bank situations. Officials from countries
represented at the Basle Committee on Bank Supervision, the
Commission
of European Communities, and national banking
associations were invited to share their experiences and concerns
regarding the provision of national safety nets, and to consider
whether there is a need to coordinate these policies on an
international level.
From the U.S.'s perspective, this meeting was especially
timely in light of the current debate on deposit insurance reform
and restructuring of the U.S. banking industry.
International
bankers, in particular, were asked to share their views on the
American Bankers Association's proposal to change failureresolution procedures in the U.S. Other areas of interest included
the future of deposit insurance programs and problem-bank
resolution policies in the post-1992 European Community and, more
generally, how national bank regulators can best maintain safeand-sound financial systems in a global marketplace.
The conference was divided into four panel discussions. The
morning session, which concentrated on government policies for
problem-bank resolutions, was restricted to government officials
to facilitate private dialogue. Banking industry representatives
were invited to share their views during the afternoon session,
which concluded with a discussion of prospective trends in deposit
insurance and problem-bank resolution policies.

Panel I
The first panel discussion centered around the role that
governments should play when confronted with problem-bank cases.
Of particular concern was how confidence in the banking system can
be maintained without unduly eroding market discipline and whether

*Alane K. Moysich is a financial economist in the FDIC's
Division of Research and Statistics.




85
2
there are Indeed banks that are "too big to fail."1 Panel members
were central bankers who have had considerable experience dealing
with these issues.
They included:
William Taylor, Director,
Division of Banking Supervision and Regulation, Board of Governors
of the Federal Reserve (moderator); Johann Wilhelm Gaddum, Member
of the Directorate, Deutsche Bundesbank; Tadayo Homma, Director,
Financial and Payment System Department, Bank of Japan; Kuib
Muller, Executive Director, the Mederlandsche Bank and Chairman of
the Basle Supervisors• Committee; and Brian Quinn, Executive
Director, Bank of England.
There was general agreement among the panelists that bank
supervision and adequate capital levels ara the first lines of
defense against bank failures. Some panalists expressed a desire
to see capital standards increased above the current Bank for
International Settlements* (BIS) guidelines which require banks to
have equity capital, subordinated debt, and other reserves
equivalent to eight percent of weighted-risk assets by year-end
1992.
However, panelists also agreed that in free-market
economies, bank failures can, and indeed should, occur.
All
panelists acknowledged at least several recent examples of bank
failures or, in some cases, government-sponsored rescues, in their
respective countries. Most insolvencies or near-insolvencies were
resolved yjjj. bailout or merger; liquidations typically ware limited
to small, local depository institutions.
While the possibility of bank failure was viewed as a
necessary market-discipline tool, panel members stressed the need
to retain flexibility in resolving problem-bank cases.
The
prevailing view was that decisions on how to handle a particular
crisis involve each situation's unique causes and effects and,
therefore, cannot be prescribed in advance. One panelist noted
that in his country, judgments regarding problem-bank resolutions
are based on the net benefit to the community, not just on narrow
financial calculations. Threats of contagion due to direct links
to the failed bank, or to a general loss of confidence in
institutions performing similar functions, vera cited as factors
favoring a decision to provide official support.
Panelists acknowledged that there may be banks that are too
big to fail, simply because large banks often are important
components in a nation's payments system and, thus, the failure of
a major bank could tie up much of an economy's working capital.
At the same time, however, panalists stressed that "too big to
fail" should not be accepted as public policy. Xf that were the
case, however, then those benefitting should be forced to pay in
'"Too big to fail" is imprecise shorthand for "too big to
allow depositors to suffer losses." A situation in which a large
bank fails but depositors are protected fully is thus consistent
with the application of a "too big to fail" policy.




86
3
the form of more-demanding supervision or greater prudential
requirement*. Moreover, panelists cited cases where government
rescues were mounted for nonbanking companies that were considered
too big to fail, as well as for small banks that were considered
too important to fail, Zt was noted, however, that even if support
is given, penalties should be imposed on managers, owners, and
investors. Thus, in the words of Brian Quinn of the the Bank of
England, while a bank nay be too big to fail, it is never "too big
to suffer.1*
Panelists firmly agreed that the focal point in failureresolution decisions is the trade-off between maintaining public
confidence in the financial system and preserving a degree of
market disciplinei.thus, most regulators preferred taking prompt
corrective action prior to a bank's actual insolvency.
Zt was
noted that overly-generous deposit insurance programs give rise to
the so-called moral hazard problem, or excessive risk-taking by
insured financial institutions. However, there was less agreement
on the effectiveness of market discipline in controlling the risktaking activities of banks. One panelist's view was that today's
markets are not fully aware of the competitive environment in which
banks operate and, therefore, heed to face the consequences of a
failure in order to be made aware of the new risks.
Another
panelist argued that while market discipline should be encouraged,
it cannot be relied on exclusively due to the conflicting goal of
maintaining financial stability. Additionally, it was noted that
political forces sometimes may be brought to bear against the
decision to allow depositors to lose money.
Deposit insurance funds or guarantee programs were seen by
most panel members as supplemental tools to protect the small saver
and to aid general financial stability when a bank is declared
insolvent. Several panelists noted that the U.S. federal deposit
insurance systam is far »ore extensive than its European or
Japanese counterparts. For example, individual limits on deposit
insurance coverage in Great Britain and the Netherlands are rather
low, while Germany's deposit insurance fund, which covers each
depositor up to 30 percent of the bank's equity capital, does not
cover interbank deposits and is run entirely by the banking
industry. Hence, it was suggested that in Germany the government
is not perceived to be the ultimate insurer of commercial bank
deposits.
Direct comparisons of deposit insurance coverage among various
countries are difficult, however, due to differences in national
banking structures and safety-net arrangements. For example, the
U.S. does not have any government-owned banks which, by definition,
cannot fail, or a postal savings systam in which tha government
explicitly guarantees principal and interest. Additionally, many
countries tend to rely on failurs-pravantion methods, including
direct capital injections, government acquisition of nonpar forming
assets, nationalization of troubled banks, provision of liquidity




87
4
through eantral banks or with industry support ("lifeboats"), and
government-assisted mergers. As a result, costs which in tha U.S.
ara incurrad by tha FOIC ara incurrad in thasa countries by the
central bank, tha finance ministry, or a consortium of banks.
The need to maintain flexibility in problem-bank resolution
policies, particularly with respect to the lender-of-last-resort
policies of central banks, has been referred to as "constructive
ambiguity" by E. Gerald Corrigan, President of the Federal Reserve
Bank of Key York, who believes it is a necessary force countering
the moral hazard problem inherent in the proviaion of financial
safety neta. While paneliata agreed that "constructive ambiguity"
is an appropriate policy for central bankers, several expressed a
desire to revisit the Basle Concordat, which spells out the
responsibilities for supervision of international banks and banking
groups, but does not directly address policies for dealing with tha
resolution of international bank failures. They noted that while
it might not be desirable to suggest that a particular central bank
will always act as lander of last resort, it is important to
determine just which central bank la responsible for deciding
whether to intervene in a problem-bank situation.
Several
panelists suggested that a aarioua gap currently exiata between the
globalized nature of financial marketa and the decentralized
structure of central banks. Moves to bridge this gap during noncrisis times would save valuable time and help to ensure that
financial stability is maintained in the event of an international
bank failure.

Pantl XI
The second panel discussion focused more specifically on the
role of deposit insurance programs.
Paneliats ware asked to
comment on their own country's philosophy regarding the protection
of depositors and the rescue of insolvent banka, aa well aa the
role deposit Insurance playa in maintaining stability within their
banking systems. This panel waa moderated by Paul Fritts, Director
of the FDIC's Division of Supervision. Speakera were drawn from
countries that have a variety of mechanisms for dealing with
deposit protection. They includedi Monique Dubois, Assistant
Director, Economic Studies Section, Swiss National Bank; Pierre
Dubois, Director, Belgian Banking Commission; Ronald A. McKinlay,
Chairman, Canada Depoait Insurance Corporation; and, Robert Ophele,
Representative, Banque da Franca.
*Xn December 1975, the central bank govemore of the Baale
Committee on Bank Supervision approvad a group of broad guidelines
for the division of responsibilities among national authorities
governing the supervision of foreign banking establishments. These
guidelines, which were later revised in 1983, became known aa the
"Basle Concordat."




88
5
Of tha four foreign countrias raprasantad on this panel, the
government of Switzerland appeared to be the least actively
involved in bank-failure resolution issues. Although regulation
and supervision are the principal mechanisms to prevent bank
failures, the Swiss banking industry itself plays an important role
in saintaining a sound financial system by establishing codes of
conduct for member banks that supplement regulations imposed by
Swiss banking legislation* One example is the joint guarantee of
savings deposits at insolvent institutions which vas agreed upon
in 1984 in lieu of a legalized deposit insurance program. This
guarantee (up to 30,000 Swiss francs) supplements the Swiss
depositor preference law in which certain deposits receive a
priority claim in the case of bankruptcy. Zn the past, most failed
Swiss banks were taken over by other banks; however, since the 1984
deposit guarantee agreement there have been no failures and thus,
the guarantee has never been used.
The Association of French Banks (AFB) also operates a losssharing agreement among all commercial banks operating in France.
Deposit protection is limited to approximately $75,000 per person,
with a yearly cap on total industry payouts.
Only personal
deposits held in French francs are insured; specifically excluded
are foreign-currency deposits, interbank funds, and funds with
••abnormally high rates of remuneration."
Losses are shared
according to each bank's market share, although smaller banks pay
a larger percentage of their deposit base than do larger banks.
This arrangement primarily is designed to protect small banks; the
yearly cap precludes payouts of even a medium-sized bank.
Additionally, tha governor of the Banqua da Franca legally may
request that French banks participate in assisting the rescue of
a troubled institution, as was the case with the 1987 rescue of Al
Saudi Bank.
Zn contrast to the industry-sponsored Swiss and French deposit
guarantee programs, Belgium has a deposit protection fund which is
managed by the Rediscount and Guarantee Institute, an organization
which has close ties to the central bank. Annual contributions are
0.02 percent of covered liabilities, which are limited to deposits
in Belgian francs, up to $15,000 per person.
The deposit
protection fund Bay contribute to the liquidation of an Insolvent
bank, to financial rehabilitation, or to the complete or partial
takeover of the activities of a member bank, providing that such
interventions would be less costly than a payoff* However, the
fund has no receivership capacity and interventions are limited to
the total amount of the fund. These constraints do not appear to
concern the Belgian public, Bainly because the three laroest banks
control 76 percent of covered deposits and thus, according to the
Belgian representative, Pierre Dubois, it is perceived that they
would not be allowed to fail.




89
6
Of tha four countries represented on this panel, the Canada
Deposit Insurance Corporation (CDIC) has powers most similar to
those of the FDIC, including the ability to acquire assets from
member institutions and to act as receiver of a failed bank.
Additionally, the CDIC is ampowared to borrow up to $3 billion from
the consolidated revenue fund, if necessary. Annual premiums are
currently 0.1 percent of insured deposit liabilities. Each deposit
is insured up to $60,000 in Canadian funds, with maturities not
exceeding five years. The CDIC has handled over 20 bank failures
since its. inception in 1967 and strongly favors going-concern
problem-bank
resolutions
over
more-costly
liquidations.
Additionally, Chairman McKinlay noted that once an institution is
known to be in financial difficulty, confidence is lost and
rehabilitating
the
institution becomes nearly
impossible.
Therefore, the CDIC actively is engaged in a program to develop
atandards of sound business and financial practices, whose purpose
is to preclude problems from developing. Similar to most European
countries, Canada has a highly concentrated banking system, with
about ten institutions controlling over 75 percent of deposits.
This high degree of concentration was cited as a significant
contributing factor to the country's ability to avoid losses of the
magnitude of the U.S. savings and loan crisis.

Panel III
This panel was designed as a forum for international bankers
to express their views on deposit insurance and other governmentsponsored safety nets. Issues addressed included the relationship
between the private and public sectors in the provision of deposit
insurance and decisions or actions concerning problem banks, the
competitive effects of different deposit insurance systems, and the
American Bankers Association's proposal (which would mandate an
automatic loss for uninsured depositors) and other ideas to reform
the U.S. deposit insurance system. The panel moderator was C.G.
("Kelly") Hoithus, President of the American Bankers Association.
The speakers included: Professor Piaro Barucci, Chairman of the
Italian Bankers' Association; Torn Hashimoto, Deputy President,
Fuji Bank, Ltd., Tokyo; Thomas S. Johnson, President, Manufacturers
Hanover Trust Company, New York; and G. Malcolm Williamson, Group
Executive Director, Standard Chartered Bank, London.
Several panelists expressed the view that private banks, and
their managers, play an important role in maintaining public
confidence in the safaty and soundness of financial systems. How
this is accomplished varies from country to country and several
interesting differences were apparent. For example, during Great
Britain's "fringe" banking crisis in the 1970s, all banks stepped
in to prevent a general loss of confidence spreading throughout the
financial system. This procedure was in keeping with the informal
nature of the British banking system whereby a close working




90
7
relationship between bankers and their supervisors at the Bank of
England takes the place of many written regulations.
Japanese
bank
managers
also
take
seriously
their
responsibility for maintaining public confidence in the financial
system.
However, in contrast to Great Britain where the
supervisory style was characterized as being by "hint and nod,"
Japanese law emphasizes the public nature of banks and supervision
is very strict. Although Japan has a government-sponsored deposit
insurance system, it is rarely used and problem banks are either
helped financially and managerially by other banks, or sold or
merged into another bank.
In Italy, political pressure, stemming from the belief that
bank crises should be borne by the banking system itself, led to
the creation in 1987 of tha Interbank Fund for tha Protection of
Deposits. Membership is voluntary, and member banks are legally
bound to maintain certain balance-sheet ratios. Interventions by
the Fund must be approved by the central bank which is represented
at ita board meetings. In cases of liquidation, deposits are fully
insured up to approximately $170,000 with an additional $675,000
covered at the rate of 75 percent. If less-costly than paying off
deposits, the Fund also may assist in transferring the failed
bank's
assets
and
liabilities
to
another
institution.
Alternatively, the Fund may provide support to the ailing bank
itself, under the following conditiona: (1) tha institution has
been placed under special administration by tha Bank of Italy; (2)
the financial assistance must be lass-costly than the estimated
cost of paying off depositors in the event of liquidation; and,
(3) there must be prospects for the bank to be restored to sound
and viable condition.
There was general agreement among the foreign representatives
that the current U.S. federal deposit insurance system and bankfailure resolution policies create a moral hazard problem that is
not prevalent in other countries. However, most panelists agreed
with the position that daposit insurance reform must extend beyond
the federal safaty nat and addrass structural changas in the
banking industry, particularly interstate branching laws. Several
bankers noted that tha ability to diversify risk geographically
would enhance tha efficiency and profitability of U.S. banks and,
therefore, strengthen their performance at home and improve their
international competitiveness. Stronger banks would attract hew
capital and facilitate an orderly and efficient consolidation of
the U.S. banking industry.
Bankers on this panel expressed thoughts similar to those
offered by government representatives during previous panels, with
respect to the combined roles of market discipline and regulatory
attantiveness
in maintaining
bank
safaty
and
soundness.
Additionally, 100 percent deposit insurance coverage, either for
all banks or only for those banks deemed too big to fail, was




91
8
viewed by panelists as an inappropriate government policy.
In
general, foreign bankers agreed with the American Bankers
Association's position that more market discipline is needed to
minimize the potential costs of deposit insurance or other
financial system safety nets.
During the ensuing discussion, some representatives expressed
reservations about the ABA's proposal to treat each failed bank in
a manner that automatically subjects uninsured depositors and
unsecured creditors to a percentage loss based on the FDIC's
average receivership loss rate. One discussant suggested that this
concept was incompatible with denouncing "too big to fail,** since
it actually guarantees depositors more than the stated insurance
limit of $100,000. In addition, the proposal's intended effect
could be subverted by politicians vho, in some instances, might
decide to reimburse depositors in full anyway. Zn general, foreign
bankers favored regulatory flexibility over passage of any law in
their own countries that would impose fixed problem-bank resolution
techniques.
Finally, panelists were queried regarding the reaction of the
international financial community if the U.S. were to impose losses
on depositors in a large bank. One panelist expressed skepticism
that such an event would ever occur, except under the most
extraordinary circumstances. Others felt that any foreign bank
doing business with the failed bank should be prepared to accept
the consequences of their decision.
At the same time, panelists
noted that such a failure probably would cause foreign banks to reevaluate the creditworthiness of all American banks.

Panel iv
The final panel served to summarize some of the earlier
discussions and to address future trends in deposit insurance and
problem-bank resolution policies. In particular, panelists were
asked to focus on what kinds of international coordination of
safety nets will be needed in the future, and how much
standardization, if any, will be necessary. The panel moderator
was Paul A. Volcker, Chairman of James D. Wolfensohn, Inc. and
former Chairman of the Board of Governors of the Federal Reserve.
Speakers included:
Kasahiro Akiyama, Deputy Director General,
Banking Bureau, Japanese Ministry of Finance; Paolo Clarotti, Head
of Division, Banks and Financial Establishments, Commission of
European Communities; Robert Glauber, Under Secretary of Finance,
U.S. Treasury Department; and Harry Walsh, Under Secretary, Her
Majesty's Treasury, Great Britain.
Mr. Volcker noted that while a vide diversity of banking
systems and safety-net arrangements exist, a remarkable degree of
agreement on the nature of the problems surrounding deposit
insurance and bank-failure resolution policies was expressed by the




92
9
various representatives. This common understanding, which was not
evident in international settings as recently as a decade ago, was
seen as one indication that alignment of the various banking
systems already may be occurring. Although most representatives
from outside the U.S. had expressed satisfaction with the current
structure and operation of their own domestic banking systems and
regulatory mechanisms, this panel speculated on how well these
systems will perform in the long run.
Observing that international bank safety and soundness begins
with domestic financial systems, one panelist noted that regulators
in his country are closely monitoring the effect that interestrate deregulation will have on the future stability of the domestic
banking market. This uncertainty has led authorities there to
focus their efforts on prevention of failures, a strategy preferred
by a number of countries to contain the costs of deposit Insurance.
While this approach has great merit, it was recognized that the
style of bank supervision of an individual country depends on a
number of factors including the degree to which the financial
industry is developed, its legal system, and even the social
climate or national character.
Zt has been noted that the U.S. system of federal deposit
Insurance is virtually unique in that, although statutorily limited
in the amount of coverage provided, the FDIC has authority to
extend de facto coverage through its powers to arrange purchaseand-assumption transactions, financially-assisted mergers, or to
provide direct assistance to banks. These tools, the need to
handle bank insolvencies in the least-costly manner, and several
well-publicized rescues of large banks in recent years have
contributed to a widespread belief in the U.S. that uninsured
depositors will only suffer losses in the failure of small banks.
This belief has raised competitive concerns among commercial banks
in the United States and also has led to concern that equity
considerations may result in the FDIC extending de facto 100
percent deposit insurance coverage to all banks.
This panel suggested that there are really two issues raised
by the Mtoo big to fail" debate, only one of which can be dealt
with through legislation. All panelists recognized that there are
times when a particular bank failure could lead to a general loss
of confidence in the system. These genuine cases of unacceptably
high systemic risk, which are not limited to large banks, are the
foundation for the argument in favor of "constructive ambiguity,**
or the maintenance of regulatory flexibility.
Zt is the other component which Mr. Glauber argued that the
U.S. should try to change:
that is, discrimination in the
treatment of uninsured deposits at large versus small banks present
in the current failure-resolution procedures.
While the U.S.
should not move towards a system where failures are prevented, it
was suggested that an appropriate long-run strategy might be to




93
10
rastructura the ralationahip batvaan tha financial institution and
ita regulator. Thia would includa restructuring tha U.S. financial
ayetem to allow banks to adapt to naw lines of business, as
advocated by a number of bankers on the third panel. At the same
time, appropriate firewalls ahould protect insured deposits from
the riskiest activitlaa and to allow supervisors to focus more
attention on the bank itself, and lass on the holding company
structure. Theae measures, designed to limit the safety net, could
reduce both the number of inatitutions requiring reaolution and the
number of cases where a purchase-and-aesumption tranaaction is
justified and, ultimately, return deposit insurance to its
historical purpose of protecting small depositors.
Other ideas mentioned by panelists to reduce the U.S. safety
net Included limiting deposit insurance to natural peraons rather
than companies, excluding brokered deposits from Insurance
coverage, and reducing individual coverage limits. Risk-related
deposit insurance was mentioned by one panelist, who felt it would
only be marginally-effective given appropriate risk-related capital
requirements and supervisory arrangementa that ansure enforcement
of prudential standards.
Kith respect to the convergence of international safety nets,
the experience of the European Community (EC) provided a fruitful
area for diacuasion.
Tha majority of EC countries astabliahed
deposit insurance programa following tha Commission of European
Communities* 1986 recommendation, although it was noted by Mr.
Clarotti that these programa share few common characteristics.
With passage of the Second Banking Directive in December 1989, it
became clear that deposit insurance programs that require branches
of foreign banks to join the local system are incompatible with the
principle of home country control for banking superversion set
forth in the Directive.
Therefore, the Commission has decided that it will establish
certain basic guidelines for harmonization of the individual
deposit insurance programa. It ia axpected that these minimum
standards will not legislate uniformity among the systems, but
rather allow the EC countriea flexibility in deciding how their
deposit insurance systems are astabliahed and operated. Panelists
axpreased the opinion that theae different systems can co-exist
successfully in tha post-1992 environment if small depositors
continue to use domeatic banks and if protection is limited to
individuals and not extended to financial institutions themselves.
However, further harmonization might be required if banks begin
holding foreign-currency deposits for small depositors or if the
mechanics of a particular insurance program give rise to a
competitive edge.
Harmonization of deposit insurance and other safety-net
arrangements on a world-wide baais was not anviaionad aa necessary
or desirable in the near future. Not only was such an attempt


http://fraser.stlouisfed.org/
42-688 0 St. Louis
Federal Reserve Bank of- 9 1 - 4

94

n
thought to be politically unrealistic, but also nearly impossible
given the vast differences that currently exist in regulatory
structures, safety-net provisions, and bankruptcy lavs. However,
as globalization of financial markets proceeds, panelists felt that
there most likely vill be further alignment by vay of Increased
communication and cooperation among regulators. Familiarity vith
one another's supervisory styles vas seen to be important for banks
operating across borders and for regulators vho vill need to
anticipate a given country's reaction in a crisis situation.
Additionally, it vas noted that the insurance status of deposits
in foreign banks or branches is one area of inconsistency that
should be clarified. Hovever, the point vas made that regardless
of the pace or future degree of international safety-net
convergence, reform of the U.S. banking industry and deposit
insurance system should proceed as soon as possible.

The purpose of this meeting vas to convene policy-makers and
private bankers from the major industrialized nations to share
their thoughts and concerns regarding financial system safety nets
in the context of a global marketplace. Much vas learned about the
vast differences among the various banking systems, but common
goals also vere found to exist. Chief among these vere the desire
to preserve the stability and integrity of national banking systems
and to provide mechanisms that protect the small, unsophisticated
saver. All representatives expressed a desire to vork together to
ensure that these goals are met in the event of an international
bank failure.
Several speakers felt that the discussions should not be
limited to the "too big to fail" doctrine, or even to failureresolution methods in general. It vas noted that some portion of
the value of a bank's assets is lost vhen the institution becomes
insolvent or is known to be in trouble.
Thus, a number of
regulators expressed a desire to continue efforts to strengthen
capital standards, vhile all stressed the need for strong and
effective supervisory procedures to limit the number of bank
failures.
One of the major themes expressed throughout the day vas the
need for bank regulators to have at their disposal a vide variety
of mechanisms to deal vith actual or potential insolvencies at
financial institutions. Moreover, regulators need the flexibility
to use these measures on a ease-by-ease basis. It may be concluded
from the discussions that attempts to have bank-failure resolution
policies cemented into lav in the United States vould not be copied
by other countries.
The desire to retain a measure of "constructive ambiguity" in
failure-resolution policies vas prevalent in discussions on "too




95
12 big to fail." While savaral speakers acknowledged that imposing
losses on depositors in the failure of a major bank could provide
a number of unacceptable public-policy choices for regulators and
politicians, none was prepared to advocate a "too big to fail*'
doctrine, and a few speakers expressed dismay that this subject has
even been discussed in public. In general, it was felt that in
order to encourage market discipline, no bank ahould be considered
too large to fail; if a situation dictates that it is in the public
interest to provide official support to an ailing financial
institution, then the means should be available to impose penalties
on its owners, investors, and managers.
It was shown that several countrias have viable deposit
insurance funds or guarantee programs run entirely by the private
banking aector, or in conjunction with the central bank. For the
most part, however, these exist in countries where few bank
failures have occurred, where penalties for mismanagement are
severe, and where the banking industry is concentrated enough for
banks to be diligent about aelf-policing. Additionally, there was
the general perception that the relationship between bankers and
their regulators is much closer in many countrias than in the U.S.
and, in some cases, independent auditors play an important
examination role.
While there were some representatives who expressed a desire
for increased coordination of international safety-net policies,
it was generally felt that convergence of these policies is neither
necessary nor desirable at this time. However, there were two
areas that conference participants thought required clarification
in the near future. The first was the allocation of responsibility
among
international
financial
regulators
for problem-bank
intervention deciaions that may affect more than one country. This
would include a clear understanding as to which is the lead
authority in a given situation, who also may be involved, and what
affects a decision will have on other countries. Tha second area
in need of clarification is tha insurance status of dsposits in
foreign bank subsidiaries or branches. As a result of the current
disparity in deposit insurance systems, soma daposits may be
covered by more than one program while others remain uninsured.
Zn summary* this conference highlighted tha need for
international financial regulators to continue to communicate and
to share information with each other as banking markets continue
to undergo change. Each country is faced with tha prospect of
adapting national banking systems and supervisory styles to a
globalised financial marketplace. Technological change and tha
trand toward multi-function financial conglomerates ansura that the
need for international cooperation and coordination will become
even mora critical in tha future.




96
For release:
May 9, 1991, 10:00 a.m.

TESTIMONY OF
ROBERT L. CLARKE
COMPTROLLER OF THE CURRENCY
Before the
SUBCOMMITTEE ON ECONOMIC STABILIZATION
of the
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
of the
U.S. HOUSE OF REPRESENTATIVES
May 9, 1991
Mr. Chairman and members of the Subcommittee, I am here this
morning to discuss the policies of the Federal Deposit Insurance
Corporation (?DIC) regarding the extension of deposit insurance
coverage to uninsured depositors in large bank failures.

In discussing this topic, we need to have a clear
understanding of just what the issue is.
M

too-big-to-fail

M

The common reference to

policy can be misleading: the issue is not

whether large insolvent banks are allowed to fail; insolvent
banks of all sizes do fail.

Shareholders lose their investment

in the bank; subordinated debt-holders and other unsecured
creditors recover their investments only to the extent that the
FDIC is able to collect on the assets of the failed bank; and, in
virtually every case, bank managers lose their jobs.

Rather, the

issue is whether it may be necessary, under certain limited
circumstances, to protect uninsured depositors of large failed
banks in order to preserve the stability of financial markets.




97
- 3 "contagiousN runs on other banks, and threats to the payments
system.

Contagious runs.

Because depositors generally possess only

limited knowledge about the financial condition of banks, they
may take the failure of one bank as a sign that other banks are
likely to fail.

If the FDIC is prevented from offering

assurances to uninsured depositors, a prominent bank failure may
provoke uninsured depositors at other banks to withdraw their
funds.

In extreme cases, there could be a loss of confidence in

the banking system in an entire region of the country, resulting
in widespread disintermediation, a decline in credit
availability, and substantial damage to the regional economy.

Payment System Risk.

Large banks provide clearing and

settlement services to smaller banks, and play a central role in
organizing the markets for federal funds, government securities,
mortgage-backed securities, foreign exchange, and a variety of
other financial instruments.

The failure of a large bank could

seriously disrupt these markets.

For example, small banks typically maintain deposit accounts
with a larger correspondent bank in connection with the checkcollection, settlement, and other services that the correspondent
bank provides.

If a major correspondent bank were to fail, a

large number of smaller respondent banks might lose the funds
they have on deposit.




These losses could result in the

98
- 5 markets.

But that does not mean that uninsured depositors at

larger banks should always be protected.

Three considerations

argue in favor of narrowing d£ facto coverage of uninsured
depositors at large banks.

First, limiting coverage to insured

depositors would generally (although not always) reduce the cost
of failure resolution to the FDIC.

Second, it would restore the

balance that deposit insurance was intended to strike between
protection for bank deposits and market discipline.

And third,

providing the same degree of coverage in large and small bank
failures would be more fair.

Minimizing Resolution Costs.

Current law does not require

the FDIC to use the least costly method to resolve bank failures;
it requires only that whatever method is used be no more
expensive than liquidating the bank and paying off its insured
depositors.

A purchase-and-assumption can often meet this test,

since bidders are generally willing to pay a premium for the
franchise value of the bank, which is dissipated if the bank is
liquidated.

On the other hand, a purchase-and-assumption, even if less
costly than a liquidation, could be more costly than an insured
deposit transfer, in which the acquiring institution assumes only
insured deposits.

This would tend to be the case whenever most

of the failed bank's franchise value resides in the value of its
"core" deposits.

A purchase-and-assumption could still be

cheaper, however, if it saved the FDIC substantial administrative




99
- 7 uninsured deposits.

Large banks, benefitting from the

government's implicit guarantee of "uninsured" deposits, can
attract these funds at interest rates much closer to the riskless
interest rate.

Serious questions of fairness must be raised

regarding a government policy that confers valuable guarantees on
some banks while withholding them from others that are equally
well managed.

Determining failure resolution policies involves weighing
the need to control systemic risk against the objectives of
minimizing resolution cost and promoting market discipline and
fairness.

Eliminating the too-big-to-fail policy altogether, as

some have proposed, would go too far in one direction: it would
greatly increase market discipline, but at the cost of preventing
bank regulators from acting in those instances when going beyond
the statutory limits on insurance coverage is necessary to
control systemic risk.

Eliminating too-big-to-fail protection could also place U.S.
banks at a disadvantage in competing with the banks of foreign
countries, which generally provide full protection to all
deposits, although not necessarily through the deposit insurance
system.

Reducing the protection afforded to depositors could

drive up the cost of funds at U.S. banks, and erode public
confidence in them, compared with their overseas competitors.




100
- 9 A key element of the Administration proposal is the
separation of the responsibility for making systemic risk
determinations from the normal process of failure resolution.
That separation will reinforce the presumption in favor of the
least-cost method resolution, which will be reversed only in
exceptional cases.

The Federal Reserve Board should be involved

in systemic risk determinations because it is the government
agency primarily responsible for financial market stability.
Since actions to protect the financial system could have profound
effects on the economy and the federal budget, the Treasury
Department, in consultation with OMB, should also be involved.

When Should Uninsured Depositors be Protected?

The determination that the government will satisfy the
bank's liabilities to its uninsured depositors should depend in
part on the size of the bank and the extent of its involvement in
broader financial markets.

The more extensive the bank's

correspondent relationships with other banks, for example, or the
greater its role as a market-maker in financial markets, the
greater is the potential for systemic shock in the event the bank
fails.

Systemic risk determinations should also depend on economic
conditions in the markets in which the bank operates.

Adverse

economic conditions can make a region more susceptible to
systemic shock.

Thus, to take a recent example, the decision to




101
- 11 would be published, so that uninsured depositors would know the
exact extent of their potential loss.

In any particular bank failure, the FDIC might pay more, or
it might pay less to uninsured depositors than they would be
entitled to receive under current law.

But, over time, over-

payments and under-payments would tend to average out, and the
FDIC would break even.

This approach would enable the FDIC to

provide more liquidity immediately to uninsured depositors.

At

present, the FDIC must be conservative in advancing liquidity to
uninsured depositors, to avoid the possibility of significant
losses to the insurance fund if the proceeds of a particular
liquidation are smaller than expected.

Conclusions

The current deposit insurance system providesfle.facto
coverage for virtually all bank deposits: an extension of the
federal safety net that goes well beyond the original purpose of
deposit insurance.

Rather than extending blanket protection to

uninsured deposits, the deposit insurance system should generally
limit protection to insured deposits—except where more extensive
coverage is less costly to the FDIC—while retaining flexibility
to deal with genuine instances of systemic risk.

The

Administration's proposal is designed to achieve this change in
policy and priority, and it has my full support.




102
EMBARGOED UNTIL GIVEN
EXPECTED AT 10:00 A.M.
TESTIMONY OF
THE HONORABLE ROBERT R. GLAUBER
UNDER SECRETARY OF THE TREASURY
BEFORE THE
SUBCOMMITTEE ON ECONOMIC STABILIZATION
OF THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
May 9, 1991
Chairman Carper, Mr. Ridge, and members of the Subcommittee,
thank you for this opportunity to explain the Administration's
proposal to roll back the Federal Deposit Insurance Corporation's
"too-big-to-fail" policy, which currently results in the
protection of all uninsured depositors in most bank failures,
particularly larger ones. This broad expansion of the federal
deposit insurance guarantee has greatly increased taxpayer
exposure. It is also unfair to those smaller banks that do not
receive this blanket dg facto protection. Our proposal ends this
routine protection of uninsured depositors without compromising
the safety and stability of our financial system. We firmly
believe that this is the most sensible way to address this very
difficult problem.
Let me acknowledge at the outset that the Administration's
proposal preserves the flexibility of the government to protect
the nation's financial system in times of crisis. In rare cases
this may result in the protection of uninsured depositors in bank
failures. These rare occasions will no doubt raise some of the
same questions of unfairness and taxpayer exposure as today's
policy of routinely protecting most uninsured deposits. But a
policy that risks our financial system to avoid an exceptional
case of "unfairness" would be dangerous and irresponsible.
In the end, the only way to truly eliminate our continual
confrontations with the unfairness of protecting uninsured
depositors is to fix the underlying system. Other countries
rarely confront the "too big to fail" issue because they rarely
have bank failures. We simply must have fewer costly bank
failures and fewer threats to our economy. That means
comprehensive reform that results in stable and profitable banks;
prompt corrective action for weak banks; streamlined supervision;

NB-1264




103
- 2 and a recapitalized bank insurance fund. And that, Mr. Chairman,
is exactly what the Administration has set forth before Congress
in H.R. 1505, the "Financial Institutions Safety and Consumer
Choice Act of 1991."
With that introduction, let me now turn to the body of my
statement, beginning with a description of what we do and don't
mean when we use the term "too-big-to-fail."
Understanding Too-Big-to-Fail
The term "too-big-to-fail" is a misnomer. When the doctrine
is invoked, the institution involved still fails — shareholders
are wiped out; subordinated debtors and unsecured creditors
typically lose part of their investments; and management is
replaced. There is no FDIC or taxpayer "bailout" of shareholders
or managers.
Instead, "too-big-to-fail" is a part of the FDIC*s current
policy to routinely extend deposit insurance protection beyond
the $100,000 limit to uninsured depositors. Indeed, over 99
percent of uninsured depositors have been protected in the
resolution of failed banks during the last five years. In a very
few of these situations, the failure to provide such protection
would clearly have resulted in serious risk to the financial
system. But in most cases, the protection of uninsured
depositors occurred in resolutions that did not involve systemic
risk through the routine use of so-called "purchase and
assumption" transactions, or "P&As." Both situations are
described in more detail below.
Protecting uninsured Depositors to Prevent Systemic Risk
Protecting uninsured depositors to prevent systemic risk —
the classic "too big to fail" policy — first gained notoriety in
1984 when the FDIC protected the uninsured depositors and other
creditors of the Continental Bank of Illinois and its holding
company. The policy came into sharp public focus again with the
recent failure of the Bank of New England. In both of these
cases it was feared that imposing losses on uninsured depositors
would create genuine risk to the financial system.
What is systemic risk? Gerald Corrigan of the Federal
Reserve Bank of New York described it as the danger "that failure
or instability in one institution or in one segment of the
financial markets can quickly be transmitted to other
institutions or segments of the markets, thereby causing a more
generalized crisis of confidence with all of its potential for
instability in the financial and real sectors of the economy."
This would include cases that threaten (1) widespread loss of
consumer confidence and resulting contagious depositor runs, (2)
potentially severe problems for the correspondent banking




104
- 3 network, and (3) the breakdown of the payments system. Any or
all of these events could result In major dislocations In the
provision of regional or national business and trade credit, and
potential disruption of domestic and international economic
stability.
In the case of Continental there were significant concerns
about the financial impact that bank closure and a deposit-payoff
might have had on the large number of Continental•s smaller,
correspondent banks. Approximately 1000 banks had correspondent
relationships with Continental at the time of its failure.
Sixty-six of these banks had uninsured deposits exceeding 100
percent of capital, and 113 had deposits equalling 50-100 percent
of capital. If Continental's uninsured depositors had not been
protected, its failure would have substantially weakened a large
number of its small correspondent banks with serious consequences
for consumer confidence and the financial system.
More recently, the threat of systemic risk resulted in the
protection of uninsured depositors of the Bank of New England.
As you may recall, the situation was a tinder box. Uninsured
credit unions in nearby Rhode Island had recently failed, with
widespread publicity attending the inability of average
depositors to withdraw their funds. As the Bank of New England
teetered on the brink of insolvency, there were signs that even
federally insured depositors in neighboring banks were beginning
to line up for the withdrawal of their deposits. This volatile
situation, along with the considerable concern over the impact
closure and a deposit-payoff would have on the availability of
credit in the fragile New England economy, led to the decision to
protect uninsured depositors.
Much as we might not like it, the threat of systemic risk is
real. While much progress has been made to reduce the threat of
systemic risk in bank failures, and while more steps can and
should be taken to further reduce such risk, we cannot blindly
dismiss the fact that it remains with us. Indeed, to our
knowledge no government has forfeited its ability and
responsibility to protect the stability of its financial system,
even if that means protecting uninsured depositors. None. We
should not be the first to try this dangerous experiment.
Routine Protection of Uninsured Depositors in P&As
While the cases of genuine systemic risk caused by bank
failures are relatively rare, the FDIC has nevertheless extended
full insurance protection to virtually all uninsured depositors
in recent years. This is so because of the almost exclusive
reliance by the FDIC on purchase and assumption transactions. In
P&A transactions, acquiring institutions purchase all of the
assets and assume all of the liabilities — including uninsured
deposits — of failed institutions.




105
- 4 How has this broad expansion of the federal safety net been
justified? P&As have long been defended as less expensive to the
FDIC than simply paying off Insured depositors and liquidating an
Institution's assets. It has been argued that the cost of
protecting uninsured deposits Is offset by the premium paid by
acquirers for core deposits and the going concern value of an
Intact Institution. As a result, while one of every three
failures — the smallest ones — received no FDIC coverage for
uninsured depositors in recent bank failures, over ninety-nine
percent of uninsured deposits have been fully protected during
the record period of bank failures since 1985.
While the P&As may very well be less costly than an insured
deposit payoff, they may not always be the least costly
resolution method — indeed, current law does not require the
FDIC to adopt the least costly resolution method. An alternative
resolution method, called an insured deposit transfer, may often
be the least costly. In this method an acquirer pays a premium
to acquire a failed bank's assets and only its insured deposits,
not its uninsured deposits. Almost by definition, an insured
deposit transfer will be less costly than a P&A whenever the
failed bank's franchise value resides largely in its core
deposits — the FDIC receives essentially the same premium as it
would in a P&A, but it would not incur the additional cost of
protecting uninsured depositors.
Protecting uninsured depositors when it is not the least
costly resolution method is an unjustified expansion of the
federal deposit insurance guarantee that increases taxpayer
exposure and removes market discipline from the system. It is
also unfair to the smallest depository institutions that receive
no such protection.
Problems from Protecting Uninsured Deposits
There are three fundamental problems arising from the
current policy of routinely protecting most uninsured deposits:
increased taxpayer exposure to losses; the removal of market
discipline over weak and risky banks; and the unfairness of
protecting some uninsured deposits but not others.
Increased Taxpayer Exposure. Increasing the scope of the
federal guarantee directly increases taxpayer exposure whenever
protecting uninsured deposits is not the least costly resolution
method. By one estimate, protecting uninsured deposits in the
six transactions involving systemic risk in the last five years
cost the FDIC $883 million. In addition, the FDIC fully
protected approximately $5 billion of uninsured deposits in
purchase and assumption transactions where insured deposit
transfers might have been a less costly resolution method.




106
- 5 Removal of Market Discipline. Deposit insurance is intended
to provide stability to the banking system by protecting small,
unsophisticated depositors. But it was never intended to cover
sophisticated investors with large deposits in banks, who are an
important source of market discipline on bank risk-taking. The
routine extension of deposit insurance to all such investors
removes this market discipline, allowing weak banks to stay in
business longer and accumulate losses that will ultimately be
borne by the insurance fund or the taxpayer. Such a policy also
undermines the nominal statutory limits on deposit insurance
coverage•
Unfairness. The protection of uninsured depositors in large
banks but not small banks can give large banks an unfair funding
advantage for large deposits. This unfairness was brought into
sharp contrast with the recent decisions to protect uninsured
depositors in the resolution of the Bank of New England, and not
to protect them in the resolution of the Freedom National Bank in
Harlem.
As we all know, the unfairness of protecting some uninsured
depositors but not others has become the battle cry of smaller
banks around the country, and with good reason. There are
basically three ways to address this fairness problem.
The first is to expand the current practice even further —
that is, to simply protect all depositors, insured and uninsured,
at all banks. This is the position preferred by small banks as
being most fair because it would neutralize bank size as a major
factor in the competition for funds. But it would not be fair to
taxpayers. Their exposure could only go up. Extending the
federal safety net of deposit insurance to all deposits
eliminates all market discipline, even from sophisticated
depositors, and that can only make the banking system more risky.
The second approach is never to protect uninsured deposits.
This approach, too, would be "fair." Banks of all sizes would be
treated identically and uninsured depositors would have no
incentive to place funds on the basis of protection' in the event
of failure. But this approach creates problems of systemic risk.
It is simplistic and dangerous.
We believe that the only sensible solution is a third
approach that balances all of the factors involved — one that
rolls back the routine protection of uninsured depositors,
preserves the government's ability to protect the financial
system, and embraces new ways to reduce the systemic risk
involved in bank failures.




107
- 6 The Administration*s Proposal
In our recently completed study of deposit insurance and
banking, the too-big-to-fail problem was among the most difficult
addressed. We arrived at our recommendations only after a long
and hard examination of the issue and considerable dialogue with
the regulatory agencies, representatives of the industry, and
other interested parties.
Our approach is intended to reduce taxpayer exposure and
reduce unfairness to small banks. It would roll back the toobig-to-fail doctrine to true instances of systemic risk and make
it the rare exception in bank failures. The routine coverage of
uninsured deposits would be eliminated by demanding "least cost
resolutions.11 The regulators would be made more visible and
accountable when they do decide to protect uninsured depositors.
And specific measures would directly reduce systemic risk.
Least Cost Resolution. Our legislation would amend the
Federal Deposit Insurance Act to explicitly require the FDIC to
choose the bank resolution method that results in the least cost
to the insurance fund. While this provision does not prohibit
the FDIC from using P&A transactions, we expect that it would
generally lead to greater reliance on insured deposit transfers
that would not protect uninsured depositors.
Systemic risk exception. While systemic risk could still be
used as a reason to protect uninsured depositors, the
Administrations proposal includes new procedures to make this a
much more visible and accountable determination — which we
believe will help limit its use to rare instances of genuine
systemic risk. The FDIC would not be permitted to factor
systemic risk into its selection of a resolution method. Rather,
the determination of systemic risk would be reserved to the
Federal Reserve Board and the Treasury Department acting jointly,
but in consultation with the Office of Management and Budget and
the FDIC. Upon such a determination, these agencies could direct
the FDIC to provide insurance coverage for all depositors or take
other appropriate action to lessen risk to the system.
The Federal Reserve is responsible for financial market
stability, and because government action could require Federal
Reserve discount window loans, it ought to be formally involved
in systemic risk decisions. Also, since the Administration is
directly accountable to the taxpayer, the Treasury and OMB have a
legitimate role to play in this determination. By broadening the
decision-making in this way, both government flexibility and
accountability can be achieved. Furthermore, we think that
lodging this decision at the highest levels of government with
high visibility will mean that uninsured depositors are protected
much less often.




108
- 7 Proposals to Reduce Systemic Risk. Finally, our legislation
would reduce systemic risk directly, which in turn will reduce
the occasions when uninsured depositors need to be protected.
Our principal proposal in this area is to improve the liquidity
mechanism in bank failures.
Uninsured depositors that are unprotected in bank failures
do not lose all their funds; instead, they typically receive a
partial recovery based on their claim on bank assets. This
partial recovery can be substantial, sometimes amounting to over
90 percent of the value of uninsured deposits.
The problem is that partial recovery can take long periods
of time during which the value of the deposits can be tied up in
a failed bank receivership. This temporary loss of liquidity
magnifies the systemic risk problems associated with depositor
losses, especially from the payments system and correspondent
banking networks.
Our proposal authorizes a new means for the FDIC to provide
immediate liquidity to uninsured depositors in bank failures
based on the FDIC!s average recovery experience from
receiverships over a time period to be determined by the Agency.
This provision in our bill, based on a proposal by the American
Bankers Association, could significantly reduce the systemic risk
involved in bank failures.
In addition, our legislation includes measures to reduce
payments system risks, including (1) the bilateral netting of the
mutual obligations of banks, (2) statutory elimination of the
risk that a receiver or liquidator of a failed member of a
clearing organization could negate the netting rules of the
clearing organization, and (3) preemption of any injunction or
similar order issued by a court or agency that would interfere
with the netting procedures governed by the Act.
Indeed, our proposals build on the numerous efforts that
have been made over the years to reduce the risks associated with
payments, clearance and settlement arrangements. The Federal
Reserve already has mechanisms in place to secure its large
dollar payments system, Fedwire. These mechanisms include
guaranteed final payment, bilateral caps among institutions, and
real time monitoring of the flow of funds over the system. In a
similar vein, the Clearing House for International Payments
(CHIPS) not long ago instituted a cross guarantee arrangement
among its member institutions that significantly reduces systemic
risk in the event of a large bank failure.
We will continue to work to reduce threats of systemic risk
based on liquidity problems and faulty payments mechanisms. By
doing so we will progressively diminish the number of systemic
risk situations that require uninsured depositor protection.




109
- 8 Paying for TBTF
The decision as to who pays for genuine systemic risk
resolutions is a difficult one to make. It is argued by some
that the cost should be borne by the taxpayer because of the farreaching economic implications of a systemic breakdown.
Protecting the financial system protects more than just banks,
and banks should not be held uniquely accountable for the costs
of maintaining stability.
On the other hand, preventing systemic risk uniquely
benefits the banking industry, and not just the largest banks.
Stability and depositor confidence are critical to the viability
of all banks. And although the protection of large deposits in
large banks clearly benefits large banks generally, it also
directly benefits smaller correspondent banks and indirectly
benefits all banks that are susceptible to contagious depositor
runs.
On balance, because of these direct benefits, we believe
that the industry should pay for the costs of preventing systemic
risk. Accordingly, H.R.1505 requires the FDIC to pay for the
cost of protecting uninsured depositors in the rare circumstances
of systemic risk where it would be required.
H.R. 2094
Before concluding, let me provide some observations about
the treatment of uninsured depositors in H.R. 2094, which was
marked up in the Subcommittee on Financial Institutions last
Tuesday. This bill prohibits the FDIC from protecting uninsured
depositors beginning in 1995, even if it would reduce costs to
the taxpayer. And while the bill was improved in Subcommittee
with an amendment that would preserve the Federal Reserve's
current authority to address liquidity problems in
undercapitalized banks, we believe that even the amended text
leaves too little flexibility to address systemic risk. We will
continue to support amendments that would improve the language to
address both of these problems.
Conclusion
In conclusion, we believe that ours is the most balanced
approach to the problem of protecting uninsured depositors given
the competing considerations of systemic risk, taxpayer exposure,
market discipline, and fairness. Chairman Greenspan has said
that not all large bank failures require a too-big-to-fail
resolution. We agree, and we provide a specific mechanism for
handling bank failures that should decrease the number of such
resolutions without ignoring the dangers of genuine systemic risk
situations.




110
- 9 Furthermore, by making the protection of uninsured
depositors the rare exception, not the rule, we help to
accomplish several fundamental objectives. Taxpayer exposure Is
reduced. Market discipline Is Increased, as the doctrine of
"constructive ambiguity1* becomes much more of a reality — even
depositors In the very largest banks will never be completely
sure about whether their deposits will be fully protected, which
Is healthy. And small and large banks will be treated much more
equally, resulting In few unfair funding advantages to large
Institutions.
Still, as long as we have repeated Instances of costly bank
failures, there will still be some unfairness resulting from
systemic risk situations. What we really need to do Is what I
said at the outset — fix the system so we don't continually have
these costly failures. We cannot affort to keep putting
ourselves In the position of having to make the choice between
protecting small banks and protecting the taxpayer.
The key is to make the banking industry economically viable
through comprehensive reform. Banking organizations must be able
to offer a full range of services to compete with their rivals,
domestically and internationally. They must be able to locate
their places of business where they choose and attract capital
from financial and non-financial firms. And they must be
regulated more effectively with prompt corrective action that
stops smaller problems from mushrooming into large losses to the
insurance fund. H.R. 1505 addresses all of these requirements.
Those who suggest we must end the Mtoo-big-too-failM
problem before we fix the system have it got it exactly
backwards; instead, we must fix the system in order to eliminate
the unfairness of Mtoo-big-to-fail.w

**********
Mr. Chairman, that concludes my formal statement. I would
now be pleased to answer any questions you or other members of
the Subcommittee might have.




Ill
For release on delivery
10:00 a.m. E.D.T.
May 9, 1991

Testimony by
John P. LaWare
Member, Board of Governors of the Federal Reserve System
before the
Subcommittee on Economic Stabilization
of the
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives




May 9, 1991

112
I am pleased to appear before this subcommittee on
behalf of the Federal Reserve Board to discuss the economic
implications of the so-called "too-big-to-fail" doctrine and
proposed legislation dealing with this issue.

The concerns

encompassed by the term too-big-to-fail are among the most
important reasons why we need to reform not only our deposit
insurance system, but also the broader structure of
financial institutions and regulation.

The Board urges the

Congress to view too-big-to-fail as one element of a very
complex set of problems that need to be attacked on several
fronts.
At the outset, I want to emphasize that the Board
appreciates and is sensitive to the equity and efficiency
arguments frequently advanced for eliminating too-big-tofail policies.

We are extremely uncomfortable with any

regulatory policy that differentiates among banks, or their
customers, largely on the basis of that institution's size.
Under the too-big-to-fail doctrine, uninsured deposits at
large banks typically have been protected in full —
purchase and assumption resolution methods —

through

while those at

smaller institutions generally face a greater risk of some
loss.
Fairness alone would seem to argue that the
treatment of depositors at a failed bank be independent of
its size.

Indeed, on many occasions the Board has indicated

its view that the presumption should be that regulatory




113
- 2 -

policy is equally applicable to banks of all sizes.

It is

desirable that no bank should assume that its scale
insulates it from market or regulatory discipline, nor
should the depositors with uninsured balances in a large
bank assume that they face no risk of loss should that
institution fail.

For these reasons, the Board supports

those provisions of the Treasury proposal that would enhance
the accountability of, and tighten the criteria used by,
regulators in resolving failed banks.
However, we believe strongly that it would be
imprudent for the Congress to exclude all possibility of
invoking too-big-to-fail under any circumstances.

One can

contemplate situations where uninsured liabilities of
failing institutions should be protected, or normal
regulatory actions delayed, in the interest of macro
economic stability.

Such a finding typically would be

appropriate only in cases of clear systemic risk involving,
for example, potential spillover effects leading to
widespread depositor runs, impairment of public confidence
in the broader financial system, or serious disruptions in
domestic and international payments and settlement systems.
In practice, situations representing true systemic
risk are rare.

Indeed, one can envision improved

circumstances in which even a very large bank could fail and
not pose an inordinate risk to the economy.

Unfortunately,

the specific considerations relevant to such determinations




114
- 3 -

are not fixed, but will vary over time with, for example,
the underlying strength of the financial system and the
economy.
In principle, systemic risk also could develop if a
number of smaller or regional banks were to fail.

Partly

because such failures could potentially have severe
consequences for a community or region, purchase and
assumption resolutions have not only been used with large
banks, but often with small institutions as well.
Nevertheless, in practice systemic risks are more likely to
be associated with failures of large institutions that are
major participants in interbank financial markets, and in
clearance and settlement systems for securities
transactions.
The Board endorses reforms that would foster a
stronger and more resilient banking system, one in which
bank failures would be less likely and, should even a very
large bank fail, the strength of other institutions would be
sufficient to limit the potential for systemic risk.

Thus,

over the years we have been committed to higher capital
standards, to the reduction of risk in the payments system,
to finality criteria for clearing houses and payment
systems, and to improved international cooperation in the
areas of payments systems and banking supervision.

For the

same reason, we also support the Treasury's proposals
calling for frequent on-site examinations, prompt corrective




115
- 4 -

action policies, interstate branching, and a broader range
of permissible activities for financial services holding
companies with well-capitalized bank subsidiaries.

With

these changes, we believe that over time the financial
system and the economy could better tolerate large bank
failures, thereby minimizing the likelihood that regulators
would need to invoke too-big-to-fail.
Even in such an environment, however, it would be
impossible to confidently assert that a systemic risk
situation involving one or more troubled banks would never
occur, in large part because of varying macroeconomic and
other circumstances.

In our view, therefore, it is not only

prudent, but essential that policy makers retain the
capacity to respond quickly, flexibly, and forcefully in
conditions involving extensive risk to the financial system
and the economy.

I would note that while there surely are

elements of unfairness in too-big-to-fail policies,
unfairness also would result if regulators were required to
ignore systemic risks.

Such a mandate could needlessly

expose banks and other financial institutions, their
customers, and the broader society to severe economic
disruptions and hardships that were neither of their own
making nor within their control.
Mr. Chairman, the remainder of my remarks today
will amplify on the reasons that have led to Board to these
views.




116
- 5 -

Systemic Risk
The fundamental reason why it may sometimes be
necessary to protect certain uninsured creditors or delay
normal regulatory actions is systemic risk.

Systemic risk

refers to the possibility that financial difficulties at one
bank, or possibly a small number of banks, may spill over to
many more banks and perhaps the entire financial system.

So

long as problems can be isolated at a limited number of
banks, but confidence maintained in the broader banking and
financial system, there is little or no systemic risk.
One of the most serious and immediate potential
effects of the failure of a very large bank is an impairment
of the payments system that is so widespread as to disrupt
the economic activity of the nation.

In modern economies,

the ability of individuals and firms to make and receive
payment for goods and services is usually taken for granted.
But, clearly, trade and commerce would be curtailed if this
ability were substantially impaired for a major portion of
the economy.

One aspect of the potential problem is clear:

When a bank fails, the ability of its depositors to make
payments from their accounts would be severely limited were
it not for government intervention designed to maintain the
liquidity of insured, and sometimes uninsured, balances.
Recent examples of the potential hardship such disruptions
could place on exposed depositors can be seen in the
failures of the Ohio, Maryland, and Rhode Island deposit




117
- 6 -

insurance systems.

Clearly the problems could be greater in

the case of the failure of a large bank, or a contagion of
failures at many banks.
There is another aspect of systemic risk that is
generally not as well understood.

Large banks are major

providers of payments and other "correspondent" banking
services for smaller banks, as well as other financial
institutions.

Often these interbank relationships involve

holdings of relatively sizable compensating or clearing
balances at correspondent banks.

Such interbank

relationships are a key mechanism by which problems at a
large correspondent bank can be transmitted to other
financial institutions.

There are two ways this can occur.

First, the loss of access to their balances at the
correspondent could cause other financial institutions to
experience liquidity and solvency problems of their own.
Second, the failure of a major correspondent bank could
cause clearing and settlement problems for the customers of
other banks and financial institutions that, ultimately,
depend on the correspondent for payments services.

Both of

these possibilities were concerns, for example, in the 1984
failure of Continental Illinois National Bank, which was an
especially important participant in interbank markets.
Some of the clearest examples of payments systemrelated systemic risk are associated with foreign exchange
markets, which involve the largest banks from all the major




118
- 7 -

industrial countries, and are closely linked to and
integrated with domestic money and capital markets.

On any

given day, a major bank will have entered into foreign
exchange contracts to be settled on a future day, typically
two days hence in the case of "spot market" contracts.

If

for any reason exchange rates were to move in the interim, a
bank failure during this period could subject its
counterparties, both banks and nonbanks, to unexpected
capital losses.
Usually of greater immediate concern is the
settlement risk arising from the traditional practice of
paying out foreign currencies in settlement of foreign
exchange contracts before counter-payments in U.S. dollars
are fully completed.

This practice arose because European

banking markets operate in time zones at least 5 or 6 hours
earlier than U.S. markets, while far eastern markets operate
in time zones 13 or 14 hours earlier.

The result is that

both U.S. and foreign banks are typically exposed to the
risk of losing the full amount of foreign currency paid out
while they are awaiting dollar payments.

This settlement

risk, although managed by banks through various techniques,
may amount to substantial temporary exposures lasting for a
few hours during the day.

Failure to complete these

transactions in a timely manner would not only subject the
counterparties to risk of loss, but could undermine
confidence in domestic and international payments systems,




119
- 8 -

whose smooth functioning is essential to flows of goods and
financial capital around the world.
To reduce systemic risks in the payments system, in
recent years the Federal Reserve has worked with private
payment and clearing systems to develop policies and
procedures to reduce payments system risk.

We believe that

these initiatives have lowered the potential disruption to
counterparties on large dollar networks.

Still, it is the

case that general instability in the banking system, such as
would occur in a true systemic risk situation, could lead to
multiple clearing and settlement failures.

The Board

believes that it is in the public interest for policy makers
to have the tools and flexibility to prevent such an event.
Another serious aspect of systemic risk is the
possibility of widespread depositor runs on both healthy and
unhealthy banks.

Such runs could be engendered by the

failure of a major bank, for example, if such a failure
generated significant uncertainty regarding the health of
other banks.

In days past, the primary concern was that

depositors would run to currency, thereby causing a rapid
and precipitous decline in the money supply and in the
ability of banks to maintain old and make new loans.

Today,

while a flight to currency is not a realistic concern, in
large part because of the success of the safety net, rapid
and expanding runs from domestic bank deposits to government
securities, other money market instruments, and foreign bank




120
- 9-

deposits could still seriously disrupt the process of
intermediation on which many borrowers depend.
The process by which savings are turned into loans
and other forms of financial investment is crucial to the
creation of real capital in our economy, and therefore
central to the means by which increased productivity and
higher living standards are achieved.
major contributors to this process.

Banks are obviously
Indeed, the primary

value added of banks is their ability to attract and pool
depositors' funds by issuing liquid liabilities, and then
provide financing to individuals and firms for productive
purposes by creating relatively illiquid loans.
A credit relationship between a borrower and a
particular bank is not necessarily easily transferred to
another financial institution.

The unique information

collected by individual banks about their customers is often
expensive to acquire, and may be the result of years of
close interaction.

True, securitization and technological

change are making it increasingly possible for many bank
customers to access credit markets directly, and the
resultant decline in the value of the bank franchise is one
of the key issues that needs to be addressed in banking
reform.

But for now —

and for the foreseeable future —

there will exist a core of business and other borrowers for
whom banks serve as a primary source of funds. For example,
data from our 1988 National Survey of Small Business




121
- 10 -

Finances indicate that of those small businesses having a
loan or lease with a financial institution, more than half
obtained such financing exclusively from one depository
institution; and more than 80 percent had a loan or lease
with a commercial bank.

Moreover, it should be recognized

that many securities are backed by bank credit guarantees or
liquidity facilities.
We need only look to the economic and other costs
imposed by the so-called "credit crunch" to get a sense of
the critical importance of credit creation by banks to the
stability and growth of our economy.

In addition, research

on the Great Depression points to the destruction of this
function, caused by widespread bank failures, as a major
contributor to the severity and length of the Depression.
These arguments suggest that a rapid shift of deposits from
one major portion of the banking industry to another —

say

from banks considered weak to those considered strong —
would seriously disrupt credit creation.

Such a disruption

could easily feed into the real economy.
The implications of widespread difficulties in the
banking sector —

including perhaps major disruption of the

payments system and extensive depositor runs on healthy
banks —

are not likely to be confined to banks.

In large

part this is due to the interconnections that I have already
described between banks, other financial and commercial
firms, and households.




But there are other reasons why a

122

-nloss of confidence at banks could spread.

For example, all

types of financial institutions depend on the maintenance of
public confidence in the broad financial system for the
successful conduct of their business.

Problems in banking

could reduce confidence in this broader system.
In addition, other financial intermediaries, for
example investment banks, depend on commercial banks for
substantial amounts of short-term credit.

A significant

reduction in the supply of bank credit would reduce the
ability of these institutions to provide underwriting
services and liquidity support to a wide variety of
securities markets, including those for stocks, bonds, and
commercial paper.

The resultant contraction in the

availability and liquidity of such investment vehicles would
tend to exacerbate the effects of a reduction of loans at
banks.

Indeed, the continued provision of credit to other

financial intermediaries was one of the Board's primary
concerns in our efforts to minimize the adverse effects of
the October 1987 stock market break.
Large commercial banks are also major and direct
participants in a variety of key financial markets.
Examples include the markets for government securities,
mortgage-backed securities, and foreign exchange.

In their

role as major participants and market-makers, large banks
are a primary source of liquidity for these markets.
this reason alone, the collapse of a major bank's




For

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- 12 -

participation could, for a time, significantly impair the
functioning of these markets.

In short, a variety of strong

arguments can be made for the need to manage carefully the
withdrawal of a major bank from financial markets.
The Congress and the banking regulators should take
pride in the fact that systemic risk seems today to be a
somewhat remote problem.

One of the fundamental purposes of

our banking safety net is to prevent systemic risk from
becoming an observable reality.

I think there can be no

doubt that over the last half century we have been extremely
successful in achieving this goal.

Indeed, stability in the

banking system has undoubtedly contributed to the much
milder contractions in the economy that we have experienced
since World War II relative to earlier times.

The problem

is that we have also paid a price for our success. An
excessive degree of moral hazard has been allowed to develop
within the system.

This has been manifested in various

ways, including low bank capital ratios, high asset risk at
many banks, reduced market discipline by depositors, and
ultimately large losses by the deposit insurance funds. But
reform should not deny or eliminate the benefits of our
success; rather, it should attempt to maintain the benefits
while minimizing their costs.




124
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Further Actions Needed to Reduce Systemic Risk
As I noted earlier, the Board urges the Congress to
view too-big-to-fail as one element in a complex set of
problems that should be attacked simultaneously.

In this

regard, Chairman Greenspan and other Board members have
argued repeatedly in favor of fundamental reform of our
system of banking and financial regulation.

Most recently,

Chairman Greenspan testified last week before the Financial
Institutions Subcommittee of the House Banking Committee on
the Board's views on these issues.

I shall not repeat his

remarks here today except to reiterate my earlier
observation that a vital component of the ultimate solution
to too-big-to-fail is a stronger banking system.

We should

promptly adopt reforms that will achieve this goal,
including greater emphasis on capital adequacy, prompt
corrective action to deal with financially distressed
depositories, timely on-site examinations, full interstate
branching, and a broader range of permissible activities for
financial services holding companies with well-capitalized
banking subsidiaries.

As I noted earlier, by increasing the

safety and soundness of our banking system, these reforms
would lessen the likelihood of a major systemic threat and a
need to invoke too-big-to-fail.
A way to equalize the benefits of too-big-to-fail
policies across depository institutions is to eliminate the
deposit insurance limit, implying explicit 100 percent




125
- 14 -

insurance for all deposits, including those in excess of
$100,000.

I would note that such a change in policy would

further increase the degree of moral hazard in the banking
system, virtually eliminate depositor discipline, and
increase potential taxpayer liability.

To offset these

effects, much higher capital ratios and unacceptably
intrusive regulation might be required.
It is important to understand that, even in a
circumstance where too-big-too-fail is invoked, the
stockholders, bondholders, and senior managers of the
insolvent bank lose.

This occurs even when all depositors

are made whole and the bank continues in operation.

Thus,

from the point of view of the owners, bondholders, and
senior managers, the application of too-big-to-fail policies
still would imply de facto failure of the bank, since their
financial interest in the bank would be extinguished.

In

this sense, too-big-to-fail implies no inequity of treatment
across banks. Moreover, in the Board's view it is these
very agents —
managers —

stockholders, bondholders, and senior

who are in the best position to exert market

discipline on the bank so as to limit the risk that the bank
will ever become financially impaired.

federal Reserve Role in Identifying Systemic Risk
The Board believes that it should have a role in
determining when systemic risk exists. As the nation's


http://fraser.stlouisfed.org/
Federal Reserve 42-688 0 - 9 1 - 5
Bank of St. Louis

126
- 15 -

central bank, the Federal Reserve has responsibilities for
the health of the domestic and international payments and
financial systems.

Thus, the Federal Reserve has both the

perspective and the expertise that are useful for evaluating
the systemic risk implications of a given crisis or imminent
bank failure.

Our responsibilities in this regard are

carried out in part through administration of the discount
window, which would likely be involved in any attempt to
manage the demise of a major bank in an orderly way.

To

carry out our responsibilities for assessing systemic risk
and administering the discount window it is particularly
important that we have the thorough understanding of banks
and the payments system operations that we obtain through
close and frequent contact with large banking organizations.
With the increasing globalization of banking, the
world's central banks will need more than ever to coordinate
responses to developments that may originate anywhere and
may impact domestic and international payments systems and
financial markets.

Thus, the Board believes that it is

essential that the Federal Reserve —

in order to conduct

its stabilization policies, including protecting against
systemic risk —

have intimate familiarity with all banking

organizations having a substantial international presence.
Inevitably, a determination of whether systemic
risk is a substantial concern must be made on a case-by-case
basis.

Furthermore, the Board understands that it may be




127
- 16 -

all too tempting for regulators to declare that systemic
risk requires deviation from normal regulatory procedures.
For these reasons the Board supports the Treasury's proposal
that both the Board and the Secretary of the Treasury, who
also has major responsibilities for ensuring financial
stability, as well as protecting taxpayers' funds, should
jointly determine when systemic risk justifies such a
deviation.

Such a requirement would help to ensure that a

systemic risk exemption is not abused without rendering the
decisionmaking excessively cumbersome and time consuming.

Other Issues
Mr. Chairman, in your letter of invitation you
inquired as to how a policy of too-big-to-fail, by which I
understand you to mean a policy of protecting against
systemic risk, should be funded.

This is a difficult issue.

On the one hand, banks, and particularly the largest banks,
are clear beneficiaries of a policy that greatly reduces the
likelihood of depositor runs on healthy banks.

Thus, a case

can be made for funding such a policy through deposit
insurance premiums.

On the other hand, the general public

surely benefits from too-big-to-fail policy, and thus
taxpayer funding may be justifiable.

Moreover, the Board is

concerned about the adverse impact of continued high —
alone rising —

let

deposit insurance premiums on the

competitiveness, size, and viability of our banking system.




128
- 17 -

Rather than focus on the relatively narrow issue of
funding systemic risk, the Board would prefer to concentrate
on the more general need to recapitalize the bank insurance
fund.

The Board believes that any plan to recapitalize BIF

must provide sufficient resources without imposing excessive
burdens on the banking industry in the near term.

The Board

also believes that loans to BIF that would be repaid with
future premium revenues are the best means of striking this
difficult balance.

But I would stress that BIF

recapitalization should be considered within the context of
the broader set of reforms I described earlier.

If such

reforms are enacted, the Board fully expects that the
probability of facing a failure with systemic implications
will decline over time.

Thus, in the long run, the issue

may become moot.
The final aspect of a policy of ensuring against
systemic risk that I would note is that it is very rare to
observe large bank failures in other industrialized nations.
Two important reasons for this experience include the
operation of financial safety nets abroad, and the structure
of foreign banking and financial markets.

Indeed, many

observers argue that an implicit policy of too-big-to-fail
is followed in these nations.
Virtually all of the industrial countries have
deposit insurance systems.

Often, however, these systems do

not provide the same explicit protection for depositors as




129
- 18 -

the FDIC.

Support for the largest banks appears most likely

to be channeled through countries' tax systems.

In a few

nations, the direct government ownership of some banks can
also be regarded as part of the banking safety net.

In

addition, the possibility of direct government intervention
to deal with severe problems at key financial institutions
is not ruled out in most countries, although such
intervention has been highly unusual.

The fact is that

regardless of institutional structure, observers conclude
that explicitly or implicitly the norm in other industrial
nations is that the largest banks will not be allowed to
collapse.

Thus the United States is far from being alone in

having policies in place to deal with systemic risk.

The

Board believes that the widespread adoption of such policies
abroad bears witness to the possible systemic cost of the
uncontrolled collapse of a major bank.

Conclusion
In closing, I would reiterate the Board's strong
support for the principle that the presumption of policy
should be that regulatory actions apply equally to banks of
all sizes. However, one of the primary reasons why there is
a safety net for depository institutions is that failure of
these firms can produce systemic risks, and unchecked
systemic risk can impose major costs on the entire economy.
Over the last half century a fundamental, and successfully




130
- 19 -

achieved, goal of policy has been to avoid systemic problems
in the banking sector.

In addition, the broad set of

financial reforms proposed by the Treasury and supported by
the Board would, in the Board's view, help further to reduce
the chance that we would find ourselves in a situation of
serious systemic risk.

But we should not fool ourselves

into believing that we can guarantee that an impending bank
failure will not be a threat to the stability of our
economy.

Real life is never so neat and tidy, the structure

of the economy is not so fixed, and our ability to
understand fast-breaking developments is not so perfect that
we could ever ensure that.

Therefore the Board strongly

urges Congress to continue to allow policy makers the
flexibility to interrupt our normal regulatory and failure
resolution procedures for the purpose of protecting against
systemic destabilization.




* * * * * *

131
United States General Accounting Office

GAD
For Release
on Delivery
Expected at
10:00 a.m. EDT
Thursday
May 9, 1991

Testimony

Resolving Large Bank Failures

Statement of
Johnny C. Finch
Director of Planning and Reporting
General Government Division
Before the
Subcommittee on Economic Stabilization
Committee on Banking, Finance and Urban
Affairs
House of Representatives

GAO/T-GGD-91-27




• M*(ll/f7)

132
Resolving Large Bank Failures
SUMMARY OF STATEMENT BY
JOHNNY C. FINCH
Director of Planning and Reporting
General Government Division
U.S. General Accounting Office
GAO is testifying today on the issues associated with resolving
large bank failures. The views presented are discussed in
greater detail in GAO's recently issued reports on deposit
insurance, bank supervision, and accounting reforms.1
Perhaps more than any other aspect of banking, the problems and
incentives associated with resolving large bank failures show
the need for comprehensive reform of the deposit insurance and
bank supervisory systems. Solutions must comprehensively deal
effectively and fairly with today's incentive problems that make
it easy for undercapitalized or risky banks of all sizes to
obtain funding that is nearly always insured by the full faith
and credit of the U.S. government. Just reducing legal or de
facto coverage of deposits, as some have proposed, would no
doubt increase depositor discipline and improve bank management
incentives to operate more safely and soundly. But such changes
to coverage may also result in an unacceptably high level of
instability in our financial system.
GAO does not believe that scaling back coverage for insured
deposits or eliminating de facto protection for uninsured
deposits is wise, at this time. The potential for systemic
instability caused by reliance on uninsured depositors to
discipline risk-taking is too high. The risk of instability is
especially evident at the present time because of the weak
financial condition of many banks, including some of the nation's
largest, and the weak condition of BIF.
GAO recommends several reforms to control the ability of banks—
especially those which are large and poorly-managed—to attract
deposits, while at the same time maintaining continued market
stability. First, better supervision of banks is essential.
Bank regulators must take prompt corrective action to stop unsafe
banking activities before capital deteriorates. Accounting,
auditing and financial management reforms designed to improve
information on banking organizations and internal controls are
also necessary to make the system of prompt corrective action
effective. Second, capital requirements should be strengthened
to discourage bank owners and managers from taking excessive
^Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26, March
4, 1991); Bank Supervision; Prompt and Forceful Regulatory
Actions Needed (GAO/GGD-91-69, April 15, 1991); Failed"^anks;
Accounting and Auditing Reforms Urgently Needed (GAO/AFMD-91-43,
April 22, 1991)




133
risks and large banks should be required to hold subordinated
debt. Third, disclosure policies that give depositors and the
general public better information on the condition of banks must
be adopted if uninsured depositors are to be placed at greater
risk. Finally, depositors with over $100,000 should be provided
the choice of insuring those deposits at an additional cost.
In the long term it may be possible to place uninsured depositors
at greater risk if GAO's recommended reforms have been
implemented. Nevertheless, it may still be necessary for
regulators to protect uninsured depositors in a failed large bank
for stability reasons.




134
Mr. Chairman and Members of the" Subcommittee:

We appreciate this opportunity to give you GAO's views on the
complex issues associated with resolving large bank failures.
The views I am providing and the reforms we are recommending are
discussed in greater detail in our recently issued reports on
deposit insurance, bank supervision, and accounting reform1.

Perhaps more than any other aspect of banking, the problems and
incentives associated with resolving large bank failures show
the need for comprehensive reform of the deposit insurance and
bank supervisory systems.

Solutions must comprehensively deal

effectively and fairly with today's incentive problems that make
it easy for undercapitalized or risky banks of all sizes to
obtain funding that is nearly always insured by the full faith
and credit of the U.S. government.

Just reducing legal or de

facto coverage of deposits, as some have proposed, would no
doubt increase depositor discipline and improve bank management
incentives to operate more safely and soundly.

But such changes

to coverage may also result in an unacceptably high level of
instability in our financial system.

The reforms that we have recommended to deal with the incentive
problems in banking that give rise to the "too big to fail"
JPeposit Insurance: A Strategy for Reform (GAO/GGD-91-26, March
4,1991); Bank Supervision; Prompt and Forceful Regulatory Actions
Heeded (GAO/GGD-91-69, April 15, 1991); Failed Banks; Accounting
and Auditing Reforms Urgently Needed (GAO/AFMD-91-43, April 22,

is?T)—:—a—^^—*—l




135
policy are all designed to ensure industry stability through the
safe and sound operation of banks instead of through deposit
insurance guarantees that could result in large expenses for
healthy banks and taxpayers.

Any attempts to increase depositor

discipline must be preceded by other reforms to improve the
safety and soundness of banking organizations.

BACKGROUND

Starting with the 1984 failure and rescue of Continental
Illinois, bank regulators have preferred to err on the side of
guarding confidence in the banking system when large banks fail.
FDIC has protected all deposits in the 14 failures of banks with
assets over $1 billion.

It is important to note that while

depositors in these institutions have been protected,
shareholders, creditors and managers have suffered almost total
losses.

The cost to FDIC of resolving these banks has totalled

approximately $11.8 billion.

FDIC has protected the vast majority of deposits in all banks—
both large and small.

About 99.6 percent of all deposits—

insured and uninsured—were fully covered in bank failures from
1985 through 1989.

Nevertheless, we estimate that 32 percent of

the uninsured deposits in small liquidated banks suffered losses,
totalling about $100 million.

2




136
The de facto protection provided to large banks* uninsured
depositors and non-deposit liabilities—such as fed funds,
repurchase agreements and demand notes—has successfully
protected the stability of the banking system.

Yet, it has also

led to a widespread perception that some banks are "too big to
fail"—or perhaps more accurately "too big to be liquidated."
This perception has led to a belief that uninsured depositors can
safely ignore the quality of a bank if it is large enough.
situation is troublesome for a number of reasons.

This

Among others,

large banks, whose failures pose the greatest threat to FDIC's
finances, have fewer incentives to control risk.

In addition,

depositors have incentives that favor the placement of uninsured
deposits in large banks, putting small banks at a competitive
disadvantage.

STABILITY CONSIDERATIONS
ARE IMPORTANT

If legal coverage limits on insured deposits or the de facto
protection afforded uninsured depositors were cut back or
eliminated, as some have proposed, all banks, but especially
large banks, would no doubt be operated more safely in order to
win and retain depositor confidence.

However, depositors who are

not fully protected will also have a strong incentive to withdraw
funds at the first hint of problems.

The real possibility of

destabilizing bank runs cannot be ignored.

Stopping bank runs

that stem from loss of confidence in the banking system is one of
3




137
the reasons deposit insurance was established.

The reasons for

being concerned about disruptive runs are as valid today as when
the system was created.

Uninsured deposits and nondeposit

liabilities account for over 60 percent of the funding of 10 of
the top 25 banks in the country.

Runs on our largest banking

institutions could have significant destabilizing effects,
through disruptions to the settlements system, correspondent
banks, or foreign and domestic confidence in the U.S. banking
system, particularly if a run at one large institution becomes
contagious leading to runs at others.

The potential for such contagion arises from a number of factors
that must be addressed before any reduction in insurance
protection--de facto or otherwise—can be contemplated.

First,

uninsured depositors do not currently have options—such as
purchasing additional insurance—for safeguarding their deposits.
Second, it is unreasonable to expect most uninsured depositors to
make informed decisions about the condition of the institutions
in which they place funds.

Even the most sophisticated of

uninsured depositors cannot be expected to accurately assess the
condition of banking organizations because information on those
organizations is not always available.

Without such information,

it is all too likely that destructive bank runs will be caused by
misinformed depositors.

Third, the losses that would be faced by

uninsured depositors must be reduced by improving bank
supervision.

Losses in banking organizations closed between

4




138
1985 and 1989, averaged nearly 16 percent of the failed banks'
assets.

We believe this represents an unacceptably high level of

loss for risk-averse depositors to accept.

For these reasons, we do not believe that scaling back coverage
for insured deposits or eliminating de facto protection for
uninsured deposits is wise, at this time.

The potential for

systemic instability caused by reliance on uninsured depositors
to discipline risk-taking is too high.

The risk of instability

is especially evident at the present time because of the weak
financial condition of many banks, including some of the nation's
largest banks, and the weak condition of BIF.

A NEAR TERM APPROACH IS
NEEDED THAT DOES NOT PUT
DEPOSITORS AT GREATER RISK

I indicated at the outset that the most important problem needing
attention involves dealing with a system in which
undercapitalized and otherwise risky banks can easily obtain
funding that is backed by the full faith and credit of the U.S.
government.

While we do not believe it is possible to rely more

on uninsured depositors to help solve this problem at this time,
it is possible, through other means, to control the ability of
banks—especially those which are large and poorly-managed—to
attract deposits while at the same time maintaining continued

5




139
market stability.

We recommend several reforms to accomplish

this objective.

First, better supervision of banks is essential.

Bank regulators

must take prompt corrective action to stop unsafe banking
activities.

As described in our recently issued reports on

deposit insurance reform and bank supervision, we have found
that, although bank regulators have the authority to prevent
unsafe and unsound activities, they do not always use it when
they discover deficiencies.

They prefer to work cooperatively

with bank managers rather than take swift action to discipline
unsafe banks.

As a result, banks may continue to engage in risky

practices that can increase BIF losses.

To address such

problems, we have recommended that regulators be required to
develop an early intervention or "tripwire" supervisory system
that focuses enforcement actions on the earliest signs of unsafe
behavior in all banks—large or small.

An important feature of

the tripwire system is that the earliest tripwires enable
regulators to take forceful action to stop risky practices in
seemingly healthy banks before bank capital begins to fall.
Implementation of the "tripwire" system we propose should help
prevent poorly managed large banks from offering above market
interest rates to attract deposits, and would lower the cost to
the FDIC when banks do fail.

6




140
The success of any early intervention strategy depends on good
information on the value of insured banking institutions.

To

provide regulators with more accurate information we have
recommended a strengthening of financial and management reporting
requirements for banks and their external auditors, valuing
problem assets based on existing market conditions, strengthening
the corporate governance mechanisms for banks, and requiring
annual, full scope, on-site examinations of all banks.

Second, capital requirements should be strengthened to discourage
bank owners and managers from taking excessive risks and to
provide a financial buffer between losses resulting from poor
business decisions and the resources of the Bank Insurance Fund.
We recommend that strengthened capital requirements be phased in
after the risk-based Basle capital standard is fully implemented
in 1992, and that they include provisions for better controlling
interest rate risk.

As part of the effort to strengthen capital

requirements, we recommend that large banks be required to hold a
minimum level of subordinated debt so that they become subject to
the market discipline associated with such debt.

Because

subordinated debt holders are in danger of losing their
investment when a bank fails, they have a strong incentive to
control bank risk-taking, imposing many of the disciplinary
benefits generally believed to exist if uninsured depositors were
exposed to greater losses.

The costs of raising subordinated

debt would increase with the riskiness of the bank, and would

7




141
therefore give a clear signal to bank owners, uninsured
depositors and the bank regulators of the health and perceived
risk of the bank.

Unacceptably high costs for such debt should

force bank management to reevaluate its strategies.

Third, disclosure policies that give depositors and the general
public better information on the condition of banks must be
adopted.

If uninsured depositors are placed at greater risk,

they must have accurate and readily available information about
their banks.

This information could include capitalization

ratios and levels, the relative performance of loan portfolios,
CAMEL ratings and deficiencies noted by examiners.

We have

recommended that bank regulators, in consultation with industry
experts, be required to develop appropriate disclosure
requirements.

Fourth, a risk-based deposit insurance premium system that can be
used as a supplement to risk-based capital requirements should be
implemented.

Such a system would provide an incentive for the

owners and managers of institutions to control risk and would
help regulators focus on risks incurred by the banks they are
supervising.

Finally, uninsured depositors should be provided the choice of
insuring their deposits at an additional cost.

Options for

accomplishing this result include collateralizing accounts with
8




142
lower yields to reflect their comparative safety or the purchase
of additional insurance protection through the FDIC.

This would

allow depositors to make a more rational trade-off between risk
and return than is now possible and should make the banking
system less susceptible to bank runs.

IN THE LONG-TERM, IT MAY
BE POSSIBLE TO PLACE
DEPOSITORS AT GREATER RISK

In the past, decisions by uninsured depositors to withdraw funds
from weak banks—like the Bank of New England—forced regulators
to deal with insolvent banks that probably should have been
resolved earlier.

The ambiguity present in the current system

generated sufficient market discipline to finally curtail the
amount of regulatory forbearance shown toward these troubled
.banks.

If such discipline is to play an expanded role in the future,
certain conditions must be met so as not to jeopardize market
stability.

The banking system and BIF must be in a much sounder

condition than they are today and the near term reforms I have
discussed relating to bank supervision accounting and auditing
standards, bank capital, improved information, risk-based
insurance premiums, and alternative coverage options should be
substantially implemented.

9




143
When these conditions have been met, it may be appropriate to
consider requiring FDIC to resolve failed banks in ways that more
frequently impose losses on uninsured depositors.

While such a

requirement would not automatically impose losses in every
instance, we believe it could significantly increase depositor
discipline at large banks.

Nevertheless, even with our recommended reforms it may still be
necessary for regulators to protect uninsured depositors in a
failed large bank for stability reasons.

Under certain

conditions—a severe recession or an unstable international
environment, for ex ample-*-the threat of irrational runs may be so
great that it would be reasonable to protect uninsured
depositors.

For these reasons, we believe that even in the long-

run a formal policy requiring the FDIC to follow a least cost
resolution method, as some have proposed, and impose losses on
uninsured depositors under all circumstances would not be wise.
Instead, the Federal Reserve, in conjunction with FDIC, should be
given the authority to determine whether the failure of a bank
would be detrimental to the stability of the U.S. financial
system.

If so, such a bank could be resolved in ways that

protect uninsured liabilities.

We are uncertain how often such

intervention would be needed.

However, if all of the reforms I

have mentioned are implemented, such intervention should become
the exception, not the rule it is today.

10




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The Bank Insurance Fund, not the Federal Reserve or Treasury,
should continue to finance such resolutions.

Requiring the

industry, through its BIF premiums, to pay for large bank
failures will create powerful incentives for the industry to
pressure FDIC to effectively deal with problems in large banks,
thereby limiting losses from those that do fail.

CONCLUSIONS

Regulatory policies for resolving large bank failures have
successfully protected the stability of our financial system but
have reduced the incentives for owners and managers of large
institutions to operate their banks in a safe and sound manner.
They have also placed small banks at a competitive disadvantage.

The reforms we have recommended to resolve these problems do not
require cutting back legal or defacto deposit insurance coverage.
Yet they will curtail the ability of risky banks to attract
uninsured deposits.

These reforms also go a long way towards

reducing the disparity between large and small bank regulation.
Our "tripwire" system will restrict the access poorly operated
large banks have to uninsured deposits, thereby reducing the
advantage they have under de facto protection of uninsured
depositors.

In addition, our recommendation to strengthen

capital standards—particularly with respect to subordinated
debt—will specifically affect larger banks.

11




Finally, other

145
reforms that we have recommended—such as relaxing restraints on
interstate branching—not specifically designed to deal with the
incentive problems of large banking organizations and depositors,
might also strengthen banking organizations and reduce their
probability of failure.

It would be beneficial, in the long term, to make de facto
protection much less predictable for uninsured depositors.

In

pursuit of this goal, however, the ability of the Federal Reserve
and FDIC to take whatever actions are needed to protect systemic
stability should in no way be compromised.

This concludes my prepared statement.
be pleased to answer any questions.

12




My colleagues and I will

146
Copies of GAO reports cited in this statement are available upon
request. The first five copies of any GAO report are free.
Additional copies are $2 each. Orders should be sent to the
following address, accompanied by a check or money order made out
to the Superintendent of Documents, when necessary. Orders for
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discounted 25 percent.
U.S. General Accounting Office
P.O. Box 6015
Gaithersburg, MD 20877
Orders may also be placed by calling (202) 275-6241.




147
STATEMENT OF

WILLIAM H. BRANDON, JR.
on behalf of
THE AMERICAN BANKERS ASSOCIATION

presented to the
SUBCOMMITTEE ON ECONOMIC STABILIZATION
of the
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS




U.S. HOUSE OF REPRESENTATIVES

May 9, 1991
Washington, D.C.

148
TABLE OF CONTENTS

INTRODUCTION

1

THE MARKET FOR FINANCIAL SERVICES HAS CHANGED DRAMATICALLY

2

TOO-BIG-TO-FAIL MUST BE ELIMINATED

3

Too-Big-To-Fail is a Problem for All Banks - Small and Large
Too-Big-To-Fail has Serious Economic Implications
Banks Should Not Underwrite Too-Big-To-Fail Policies
Protecting Every Dollar of Uninsured Deposits is Prohibitively Costly
Deposit Insurance Coverage On Multiple Accounts Should Not Be Changed

4
4
6
7
8

THE FINAL SETTLEMENT PAYMENT METHOD SHOULD BE USED TO RESOLVE ANY
FAILED INSTITUTION - LARGE OR SMALL

9

The Final Settlement Payment Would be Based on the FDICs Past Receivership
Experience
Secondary Effects from Depositor Losses Would be Minimized
The Final-Settlement-Payment Applied to the Continental Illinois Bank Failure

10
11
11

r...
".'...

CONCLUSION

12

EXHIBIT 1: Final-Settlement-Payment Procedure

14

APPENDIX: A Response to the Concerns About
the Final Settlement Payment Approach




15

149
STATEMENT OF WILLIAM H. BRANDON, JR.
ON BEHALF OF THE AMERICAN BANKERS ASSOCIATION
MAY 9,1991
INTRODUCTION
Mr. Chairman and members of the Subcommittee, I am William Brandon,
President of the First National Bank of Phillips County, Helena Arkansas and CoChairman of the Deposit Insurance Reform Committee of the American Bankers
Association. The member organizations of the American Bankers Association range in
size from the smallest to the largest banks, with 85 percent of our members having assets
of less than $100 million. The combined assets of our members comprise about 95
percent of the total assets of the commercial banking industry.
The issue of "too-big-to-fail", which is the subject of these hearings, is central to
the debate on deposit insurance reform - in fact, it is the single most important
component of deposit insurance reform. ABA's Deposit Insurance Reform Committee
spent many weeks debating this issue, and the result of those efforts was the
development of a method for resolving the failure of any bank - large or small without undue disruption to the financial markets. We commend you, Mr. Chairman, for
holding these hearings, and we appreciate this opportunity to present our views on the
economic implications of the current Htoo-big-to-failM policy and to outline our FinalSettlement-Payment program.
Deposit insurance reform, as important as it is, cannot by itself guarantee the
stability of the deposit insurance system. Ultimately, the health and safety of the deposit
insurance fund rests squarely on the health and safety of the industry it insures. It is
therefore critical that deposit insurance reform be a part of a comprehensive package of
reforms which includes modernizing our financial structure to allow banking
organizations to compete as equals in today's financial marketplace. If the industry
remains shackled by out-dated laws which inhibit banks' abilities to meet the financial
needs of customers, no amount of deposit insurance reform - or recapitalization of the
deposit insurance fund - will be able to protect the fund or the taxpayer over the long
run.
In addition, we must not ignore or underestimate the strong linkage between the
banking industry and the economy. This linkage means that we must consider the
economic consequences of various reform proposals. For example, pulling large amounts
of capital from banks to recapitalize the Bank Insurance Fund and imposing ever-higher
regulatory burdens on banking organizations will reduce banks' ability to support
economic growth. If banks find themselves less able to meet the credit needs of their
local economies, recovery from the current recession will be undermined.




150
In sum, Mr. Chairman, there are no quick fixes - we must address each
dimension of the problem, recognizing the interconnections between them, if we are to
reach our goal of a safe and sound financial system. Comprehensive reform will not be
easy to achieve - but by working together, we believe it can and will be accomplished.

THE MARKET FOR FINANCIAL SERVICES HAS CHANGED DRAMATICALLY
Before I talk more fully about the too-big-to-fail problem and its solution, it is
important to understand the competitive environment the banking industry currently
faces.
Most of us have a sort of "conventional wisdom" view of what a "bank" is. This
view has certainly changed as new products burst on the financial scene over the past ten
years. But public perceptions change slowly - far more slowly than the pace of change
in financial markets. The fact is that in today's market, the line between banking firms
and other financial firms, including insurance companies and securities firms, exists only
in theory - in practice, it has been overrun by market forces.
Nonbank providers of financial services do not operate under the same constraints
as banks, and affiliations between securities firms, insurance companies, and real estate
brokerage firms are common. Many of these firms own thrift institutions (which now call
themselves banks and advertise that they are FDIC-insured) ~ and many firms, ranging
from Aetna Life and Casualty Company to Textron, Inc., also own banks (so-called nonbank banks). These firms are taking advantage of their greater freedom to develop and
market combinations of financial products that banks cannot offer.
I would just like to highlight a couple of the financial activities of some of these
firms. For example, Prudential Insurance Company (the largest life insurance company
in the country), American Express (the largest domestic financial firm ranked by capital),
and Merrill Lynch (the largest securities firm in the country) offer federally insured
deposits, consumer loans, credit cards, commercial finance, mutual funds, securities
brokerage and underwriting, insurance sales and underwriting, and a host of other
financial services ~ all under the same corporate umbrella.
And it is not just securities firms and insurance companies that are offering
attractive combinations of financial products. Ford, General Electric and Sears, for
example, began as nonfinancially-based companies. But while their public image remains
associated with cars and light bulbs, the fact is that these companies - and many other
"nonfinancial" companies - are very involved in the provision of financial products to
both businesses and consumers. For example, Sears says that about one half of the
corporation's revenues come from financial services, half from retailing. Even AT&T better known for telephones - has become a major competitor in the consumer credit
card market




2

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In short, the question of whether or not to mix banking with securities and
insurance - or increasingly, even banking and commerce - is being answered by the
marketplace. Moreover, it is important to note that these types of firms do not operate
with the kind of "firewalls" that are often included in discussions about allowing banks to
engage in a broader array of financial activities, nor are they subject to many of the
"consumer" laws applicable to banks.
My purpose in citing these examples of broad-based financial companies at the
beginning of this testimony is to point out that some of the questions being raised about
the need to reform our banking laws seem to us to totally ignore the reality of today's
marketplace. For example, questions about whether or not we should allow banking,
insurance, and securities firms to be affiliated ignore the net that these types of firms
are already affiliated in major organizations involving billions and billions of dollars in
assets. In fact, any firm, - except a traditional commercial bank - can combine "banks",
insurance and securities through the acquisition of an S&L, which the acquirer can call a
bank and advertise as being FDIC insured.

TOO-BIG-TO-FAIL MUST BE ELIMINATED
In the remainder of my testimony, I would like to detail the ABA's concerns
about the too-big-to-fail problem and present our proposal for reform. Let me first
summarize the ABA's position on this issue:
The most important element of deposit insurance reform must be to end the
current FDIC policy of too-big-to-fail. The ABA strongly believes that this concept must
be legislatively eliminated for three reasons:
(1)

in order to ensure that market discipline is maintained in the
system;

(2)

in order to ensure fairness among banks of all sizes; and

(3)

because the perception in the capital markets is that, as long as the
banking industry is obligated to underwrite all the losses under the too-bigto-fail concept, the industry has unlimited liability.

If the final legislative product does provide some new mechanism for permitting the
implementation of a too-big-to-fail policy in limited cases, under no circumstances should
the Bank Insurance Fund be required to pay the cost of implementing that policy.




3

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Too-Big-To-Fail Is a Problem for All Banks - Small and Large
Mr. Chairman, you have indeed picked a most important issue to be the subject of
these hearings - the economic implications of the current too-big-to-fail policies of the
FDIC There are, indeed, severe economic consequences of this policy and eliminating it
as an option in the resolution of bank failures is the single most important reform that
can be undertaken. One needs only to read the popular press to see the implications.
For example, three weeks ago in the Washington Post Sunday Magazine, Joseph Nocera,
a well-known business writer, wrote responses to commonly asked questions about
finance in an article called "Fear of Finance." Asked where he would advise people to
place their money, he stated:
I tell them that the less they want to think about their money, the more it
should be in a bank, even with all the banks' problems. A big bank, of
course. A too-big-to-fail bank. You may not like this policy, but it's stupid
not to take advantage of it.

As a community banker, I know how quickly money can flow out of an institution
and out of local communities to these too-big-to-fail banks. I have no doubt about my
ability to compete with my larger counterparts on the basis of quality. But I cannot even
begin to compete, nor adequately service the needs of my community, if deposits are
flowing to the large banks just because they are too big to fail.
But the impact of too-big-to-fail is not just a burden on small banks; it is a burden
on off banks, since all banks must shoulder the costs of this policy. Extending de facto
insurance to almost $900 billion in uninsured deposits creates an enormous and
unnecessary liability for the FDIC We are pleased that both Chairman Gonzalez and Chairman Riegle recognize this, and each have introduced legislation containing a
January 1,1995 deadline for phasing out the too-big-to-fail doctrine. We fully support
their efforts on this issue.
Too-Big-To-Fail has Serious Economic Implications
The implications of the FDIC's ad hoc policy of 100 percent coverage are
becoming clear. On the surface, it would seem that covering all depositors would be a
stabilizing influence by preventing possible disruptions in deposit markets. In reality, 100
percent deposit insurance has significant adverse long-term consequences for the industry
and the economy.
Protection of all deposits, whether or not they are legally entitled to insurance,
creates an enormous and unnecessary liability for the FDIC and ultimately for the
taxpayer. As the current policy of 100 percent protection becomes increasingly




4

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embedded in the minds of investors - as is happening, no doubt, following the full
protection afforded to depositors in the Bank of New England - it will systematically
erode the incentives of investors in large deposits to choose their banks based on the
soundness of the bank, at least if the bank is large. The result is to encourage funds to
flow to the highest bidder, regardless of risk. Thus, in a de facto 100 percent deposit
insurance world, the deposit insurance funds are burdened with costs they were never
intended to bear.
True deposit insurance reform must address the fundamental problem with the
current system - we simply cannot afford to continue to guarantee all deposits. We
must move away from 100 percent deposit insurance and eliminate the too-big-to-fail
policy. The heart of ABA's proposal for reform - the Final Settlement Payment
Approach - is one of the approaches which could be used to do this. All of these
approaches basically require that uninsured depositors share in the FDICs losses when
their depository institution fails.
Moving to a system in which uninsured depositors are truly at risk raises
operational and transitional questions. The principal operational problem stems from
the current lack of a framework for handling a large bank insolvency. Approaches which
require uninsured depositors to share in FDIC losses can enable the regulators to handle
the insolvency of any bank - large or small - without undue disruption to the system.
They would permit uninsured depositors to receive access to most of their balances with
no loss of liquidity, while at the same time sharing in the losses of the FDIC in an
amount determined by the insurance agency's historical experience.
The problem of transition to a new system can be handled by establishing a
credible program and announcing it well in advance of its effective date. The Gonzalez
and Riegle bills do just that by setting a date of January 1,1995, after which the FDIC
could not invoke too-big-to-fail. This delayed effective date will give investors in
uninsured deposits time to assess the financial condition of their depository institutions
and to take whatever steps they may feel are appropriate to minimize their exposure to
loss. It will also give banks the time needed to adjust their own operations to a new
system in which they will be subjected to intensified competition and discipline in the
markets for deposits.
The delayed effective date will also enable record keeping systems to be adjusted.
It is important to understand that the current configuration of bank record keeping and
reporting is, in part, a result of the FDICs policy of de facto 100 percent insurance of all
deposits. Since uninsured deposits are fully protected, it is not necessary to have
detailed knowledge of the insurance status of individual accounts.
Certainly, determining which deposits are insured and which are not can pose
important challenges. Record keeping systems in place today in many banks, especially
smaller ones where uninsured deposits are relatively unimportant, might require little




5

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change. For larger banks, where the numbers and sizes of accounts tend to be larger,
and the proportion of uninsured deposits to total deposits tends to be higher, substantial
modifications might be required.
There is no doubt that technology makes it feasible to keep records in a manner
consistent with identification of uninsured deposits in a timely manner. For those
institutions with systems that require substantial modification, the delayed effective date
would provide the time necessary to facilitate this transition.
Thus, the operational problems related to implementation of any one of the
possible loss-sharing approaches such as the ABA final settlement payment proposal can
be resolved. The problems are manageable and resolving them is not particularly
complex. Moreover, the cost of modifying existing or implementing new record-keeping
systems - while not inconsequential - are likely to be far less than the cost burden of
maintaining the current too-big-to-fail policies of the FDIC. Simply because current
record-keeping systems may not be fully aligned with deposit insurance needs is no
reason to maintain a costly too-big-to-fail system of coverage.

Banks Should Not Underwrite Too-Big-To-Fail Policies
The banking industry strongly believes that too-big-to-fail should be eliminated.
However, to the extent that some elements of the too-big-to-fail policy may be
maintained, under no circumstances should the Bank Insurance Fund's resources be used
to pay the extra cost of protecting uninsured depositors. There are several reasons for
this position:
(1)

Banks will find it extremely difficult to raise capital if markets perceive banks as
having unlimited liability to underwrite all losses under the too-big-to-fail policy;

(2)

If the Bank Insurance Fund continues to be used to pay the extra costs of insuring
large depositors, there will be continuing incentives for those deciding how to
resolve failed institutions to perpetuate the too-big-to-fail doctrine;

(3)

Unless the FDIC is removed completely from the too-big-to-fail equation, the
market will remain unconvinced that there has been any real change in
government policy and, therefore, will not adjust This lack of adjustment will, as
a kind of self-fulfilling prophecy, make it harder for policy makers to implement a
changed policy; and




6

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(4)

The too-big-to-fail doctrine is intended to avoid the potential for economic
disruptions, i.e., "systemic risk"; however, the cost of dealing with such risk should
not be borne by the deposit insurance system, which was not designed for that
purpose. In most developed countries, "systemicrisk"costs are, in fact, borne by
the central bank.

ABA is concerned that the Treasury bill does not move to effectively eliminate
too-big-to-fail even though it takes that decision out of the hands of the FDIC. One
reason for the ineffectiveness is that the Bank Insurance Fund is still obligated to finance
the too-big-to-fail policy even though the decision to protect uninsured depositors (and
perhaps general creditors) was made by the Fed and the Treasury.

Protecting Every Dollar of Uninsured Deposits is Prohibitively Costly
Providing for insurance coverage on some $900 billion in uninsured deposits is not
cheap. And in addition to the direct costs of providing de facto insurance for all
deposits, there is something much more subtle and, in the long run, more costly - the
increasing risk of the whole banking system that derives from the perverse incentives
created as the too-big-to-fail policy undermines market discipline. In other words, toobig-to-fail not only increases the costs of individual failures, in the long run it causes
more failures.
Moreover, the too-big-to-fail policy is also unfair between banks. This fact was
brought into sharp focus in the recent disparate treatment of depositors in the National
Bank of Washington and the Bank of New England, where uninsured depositors were
protected, and the Freedom National Bank, a small bank in Harlem where uninsured
depositors were not protected. This unequal treatment of uninsured depositors results in
funds flowing out of smaller banks into larger institutions where depositors believe their
deposits will be fully protected.
By undermining incentives for large depositors to evaluate and monitor the
financial condition of the banks in which they place their funds, 100 percent deposit
insurance places the entire burden of detecting and controlling excessive risk-taking on
the supervisory agencies. Given the inherent shortcomings of regulatory discipline, it
would be a mistake to assume that the problems arising from full protection of uninsured
deposits can be mitigated by still more regulation. It is essential to recognize the
practical limitations of both the regulatory system and the system of deposit insurance,
and to search for feasible opportunities to decrease the strains put upon both. Increasing
incentives for holders of large deposits to assess the soundness of the banks in which
they place their funds presents just such an opportunity.




7

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The deposit insurance system must strengthen incentives of investors with
substantial resources to exercise care when placing funds in a depository institution - just
as they would with any other investment With a heightened awareness of their exposure
to loss, these depositors will be inclined to choose their banks more carefully, either by
shifting funds out of less well-managed banks or by demanding premium interest rates
from them to compensate for their added risk. The increased cost that risky institutions
would have to pay for deposits will provide them with a powerful inducement to get their
houses in order.
Institutions considered by the market to be in sound financial condition and
prudently managed will, over time, be able to expand their shares of the banking
business. Equally important, the entire job of monitoring and controlling the risk-taking
of individual institutions will not be thrown in the lap of the regulators. Tapping the
resources of the private market to assist in the assessment of a bank's financial condition
not only broadens the monitoring system, it also means that fewer scarce resources need
to be employed to do the job. This will help contain the need for regulatory
intervention, result in fewer bank failures, and put less strain on the deposit insurance
fund.

Deposit Insurance Coverage On Multiple Accounts Should Not Be Changed
One of the proposals on deposit insurance receiving a great deal of attention is to
place limitations on the number of insured accounts an individual may hold. First, such
limitations on multiple accounts will do little or nothing to improve the system or reduce
the exposure of the Bank Insurance Fund if we continue with de facto 100 percent
coverage of all deposits.
Furthermore, to the extent that the FDICs too-big-to-fail policy has convinced the
public that large banks are safer than community banks, changes in the definition of
accounts eligible for deposit insurance may cause a significant shifting of funds away
from small banks into larger institutions. This potential movement of funds points up
perhaps the most serious problem with proposals to limit the number of insured
accounts. Until the FDICs policy of too-big-to-fail is eliminated, smaller banks will
continue to operate at a competitive disadvantage relative to large banks that have de
facto 100 percent deposit insurance coverage. It would be unfair and unwise to
aggravate this situation by tinkering with well established and well understood rules
governing deposit insurance for individuals but to do nothing to address the real problem
facing the deposit insurance system - that is, the exposure resulting from the FDICs toobig-to-fail policy.
Making piecemeal changes in individual account coverage is particularly
inappropriate at this time. In view of the current public perception of the fragility of the
financial system, restricting multiple account coverage may well cause unnecessary




8

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confusion and anxiety even among those whose accounts would be unaffected by the
action, i.e. those with less than $100,000 on deposit.
THE FINAL SETTLEMENT PAYMENT METHOD SHOULD BE USED TO RESOLVE
ANY FAILED INSTITUTION ~ LARGE OR SMALL
Eliminating the too-big-to-fail doctrine would require that a method be in place
that could resolve the failure of any institution without causing undue disruption to local
and regional economies. The Final Settlement Payment approach is such a method.
This approach, which was developed by a committee of bankers of the ABA, has stood
the test of time since its release in March of 1990. A response to its critics is attached as
an appendix to this testimony.
One of the important characteristics of the Final-Settlement-Payment method is
its simplicity. Let me describe briefly how it would work:
When a bank's equity capital falls to zero (1)

its primary regulator will declare it insolvent, and the FDIC will take
control of the institution in its receivership capacity;

(2)

insured accounts will be credited with 100 percent of the balance up to
$100,000;

(3)

holders of uninsured accounts (i.e., domestic deposits in excess of $100,000
and all foreign branch deposits) and unsecured creditors will become
claimants on the receivership and their claims will be settled by a "final "
settlement payment" based upon an industry-wide average of the FDIC's
bank receivership recovery experience and calculated in such a way that
over time the FDIC receives no more or less than its legitimate claim as a
general creditor, standing in place of insured deposits; and

(4)

the full balance of insured deposits and the written-down portion of
uninsured deposits (i.e., the final settlement payment) will be assumed by
an acquiring banking institution or a "bridge bank" run by the FDIC in
cases where the sale of the institution is more complicated and would
require more time to complete (as would likely be the case for many larger
banks). The acquiring institution or bridge bank would then immediately
open for business.




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It is important to note that the only difference in selling a failed institution under
final settlement payment method and the current method used by the FDIC is the
writedown of the balances of uninsured depositors.
In any particular bank failure, the final settlement payment may be above or
below what the FDIC would have had to pay off to the general creditors of that specific
bank. But over time, the over-payments and under-payments will net each other out.
The FDICs longer-term exposure will be no greater than if it had settled general
creditor claims on a bank-by-bank basis. An example of how this works is contained in
Exhibit 1.
The final settlement payment to general creditors disposes of their receivership
interests in the FDICs disposition of the institution. When the payment is made,
investors in uninsured deposits and unsecured creditors have no further receivership
claim on the failed bank or the FDIC.

The Final Settlement Payment Would be Based on the FDICs Past Receivership
Experience
The FDICs past receivership loss experience is instructive. From discussions with
FDIC staff, the asset-weighted average recovery rate from bank failures in the second
half of the 1980s is about 88 percent. If this rate were used to set final settlement
payments, uninsured depositors and unsecured creditors would expect to receive a
settlement payment equal to 88 percent of the face value of their claims.
Under the proposed system, the bank receivership loss experience is likely to be
significantly less under the final-settlement-payment procedure recommended than it has
been under recent practices. Strengthening market discipline will prevent problem banks
from growing as fast or as large as in the past and will cause them to be dealt with more
quickly. In addition, as FDIC and other federal banking agency examination and
supervisory capabilities continue to improve, problems will be identified and insolvency
ascertained more promptly.
The use of a single industry-wide rate to determine final settlement payments in
the event of failure is intended to meet the parallel goals of enhancing market discipline
and assuring financial stability. Use of the final-settlement-payment approach alerts
uninsured depositors and unsecured creditors to the fact that losses are unavoidable in a
bank failure and enables them to know in advance what the magnitude of those losses
will be. As distinct from traditional FDIC procedures involving 100 percent protection,
the approach will drive home to the general creditors the need to pay careful attention
to the behavior of the banks with which they are involved. At the same time, however, it
will assure the maintenance of a high degree of depositor and creditor liquidity. The




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final-settlement-payment approach enables the FDIC to instantly settle creditor claims
without risk of losses of its own in conducting its receivership responsibilities.
Uninsured depositors and unsecured creditors will incur losses in line with their
general creditor status. Businesses, governments, and other banks, will have timely
access to their deposit and creditor balances to enable them to continue essential
economic activities. Potential losses in the range of five to fifteen percent will stimulate
market discipline, but not endanger depositor or creditor viability.

Secondary Effects from Depositor Losses Would be Minimized
The final settlement payment is intended to minimize the secondary effects from
losses to depositors and unsecured general creditors. It is the ABA's belief that the final
settlement payment, which is likely to be between 85 percent and 95 percent oi general
creditors' claims, will not create adverse problems.
When a bank is paid off today, uninsured depositors and unsecured creditors
initially get receivership certificates. Rarely are these marketable. Uninsured depositors
and unsecured creditors suffer considerable uncertainty regarding their ultimate recovery
and have to wait a long time before receiving any payments. It is obvious that a straight
payoff of a large institution would cause considerable disruption.
The final-settlement-payment approach, on the other hand, provides instant
liquidity at a level that would not cause serious disruptive effects. There is no
uncertainty regarding recoveries, since the final settlement payment rate would be set
and announced well in advance. Uninsured depositors and unsecured general creditors
would therefore know their exposure and would seek to minimize losses by placing their,
funds in high-quality institutions.

The Final-Settlement-Payment Applied to the Continental Illinois Bank Failure
The most important aspect of the final-settlement-payment method is that it
would be effective in resolving a large bank insolvency. Perhaps the best illustration of
this is the case of Continental Illinois bank. It was believed at that time that the failure
and liquidation of Continental Illinois would cause the failure of many other banks that
used Continental Illinois as their correspondent bank.
Specifically, the FDIC determined that on April 30, 1984, 2,229 banks had
deposits in Continental Illinois. This was just a few weeks before the FDIC's first
assistance package, and two and a half months before the final assistance program was
implemented. Of these 2,229 banks, 976 had an exposure in excess of $100,000. Some
banks had a depositor relationship with Continental Illinois and had funds in demand




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accounts, time deposit accounts, or both. Other banks had sold unsecured federal funds
to Continental Illinois, and many had a depositor and creditor relationship with it In
all, 65 banks had uninsured balances exceeding 100 percent of their own capital, and
another 101 banks had uninsured balances between 50 and 100 percent of their capital.
These 166 banks were located in Iowa, Indiana, Wisconsin, and eight other states, with
the major concentration in Illinois.
If Continental Illinois had been closed on April 30,1984 and correspondent banks
had to wait for their pro rata share of the receivership proceeds, serious operational
problems would have developed. Fear of these problems made such an alternative
unacceptable. For a great many of these banks, more than the entire amount of their
equity capital would have been in the form of a receivership claim on the FDIC. In
addition, essential check-clearing and other services would have become suddenly
unavailable.
Moreover, the large deposit customers of these banks - in addition to the nonbank uninsured depositors of Continental Illinois - could have had considerable
difficulty in meeting their obligations to employees and creditors. This severe loss of
liquidity could have potentially led to the bankruptcy of these individuals and businesses
as well.
If afinal-settlement-paymentprocedure had been available and used,
correspondent banks would have continued to have essential correspondent services since
Continental Illinois would have essentially remained open for business either as a bridge
bank or as the subsidiary of an acquiring bank holding company. Moreover, the losses
incurred by correspondent banks would have been manageable. If a final settlement
payment equaling only 70 percent of general creditors' claims had been made on April
30th, just six banks would have faced a loss greater than their own capital and only 22 banks would have incurred losses between 50 and 100 percent of their capital. If a final
settlement payment of 90 percent had been made - which is more likely - there would
have been no banks with losses greater than capital and only 2 banks with losses between
50 and 100 percent of their capital.
Clearly, under thefinal-settlement-paymentprocedures, correspondent banks are
not fully protected. And in our judgment they should not be. Monitoring by other
commercial banks is regarded as one of the most important sources of risk-constraining
market discipline.
CONCLUSION
Mr. Chairman, we must reform our deposit insurance system. The key is to
eliminate the too-big-to-fail doctrine - without dealing with this critical element, other
changes will do little, or indeed will be counterproductive.




12

161
The legislative landscape ahead for major financial services reform will not be
easy to traverse. But the current situation is untenable. The banking industry simply
cannot continue to function effectively with an overly expensive, unfair, and ultimately
unworkable deposit insurance system; with a growing body of regulations which impose
increasing burdens on the banking industry - burdens which are not borne by
competitors offering virtually identical products; and with a legal structure that bears no
rational resemblance to the realities of today's marketplace for financial services.
Comprehensive reform is needed to deal with these critical issues.




13

162
EXHIBIT 1
FINAL-SETTLEMENT-PAYMENT (FSP) PROCEDURE
o

Using an average receivership loss rate causes receivership losses to be shared
between the FDIC and the general creditors

o

The FDICs receivership losses are no greater than they would be if all
insolvencies were handled as insured deposit payoffs

THREE BANK RECEIVERSHIPS

A

Insolvent Bank
Total Assets
Insured Deposits
General Creditors*
Capital

B

c

Average

$10000
8500
1500
0

$10000
8500
1500
0

$10000
8500
1500
0

$10000
8500
1500
0

$500
5%

$1000
10%

$1500
15%

$1000

Receivership Loss
Loss Receivership Loss

10%

Average Receivership Loss
P&A TRANSACTION (Protects general creditors. FDIC absorbs full loss.)
FDIC Loss
Gen Crdts Loss**

$500
0

$1000
0

$1500
0

$1000
0

DEPOSIT PAYOFF TRANSACTION (General creditors not protected. FDIC shares loss)
FDIC lOSS
Gen Crdts Loss**

$425
75

$850
150

$1275
225

$850
150

FSP TRANSACTION (General creditors not protected. FDIC shares loss.)
FDIC Loss
Gen Crdts Loss**

$350 (-75)
150 (+75)

$850 (0)
150 (0)

$1350 (+75)
150 (-75)

(Amounts in parentheses are amounts relative to a deposit payoff
transaction.)
* General creditors include uninsured depositors and unsecured creditors.
** Receivership losses incurred by the general creditors.




14

$850
150

163

A RESPONSE TO THE CONCERNS ABOUT
THE FINAL SETTLEMENT PAYMENT APPROACH




American Bankers Association
Washington, D.C.

164
A RESPONSE TO THE CONCERNS ABOUT
THE FINAL SETTLEMENT PAYMENT APPROACH

INTRODUCTION

1

MARKET DISCIPLINE
Introduction
A Response to Concerns About the ABA Approach
Systemic Instability
Regulatory Flexibility
Competitive Disadvantage for U.S. Banks
The Suitability of Bank Deposit Markets to Impose Discipine on
Banks
Market Discipline is a Significant Force in Reducing Systemic Risk
The Size and Breadth of the Market for Uninsured Deposits Assure BroadBased, Consensus Messages
Conclusion

4
4
5
5
7
8
8
10
11
13

OPERATIONAL CONSIDERATIONS
Introduction
Determining Deposit Insurance Coverage
Balance Aggregation
Timeliness of Account Information
Check Clearing
Correspondent Banking
Lock Box Services
Large Transactions
Conclusion

14
14
14
15
18
19
20
20
20
21

THE CONSTTTUTIONALrrY OF THE FINAL SETTLEMENT PAYMENT
Introduction
The Fifth Amendment
Economic Legislation and Due Process
Taking" of Property Without Fair Compensation
Conclusion

22
22
22
23
24
26




165
INTRODUCTION
There is a consensus that deposit insurance reform must be an integral pan of the
overall restructuring of the financial services industry. Because of the importance of
deposit insurance reform issues to its membership, the American Bankers Association
(ABA) in 1989 convened a committee of 19 bankers from across the country,
representing banks of various sizes operating in all types of banking markets, to study the
issue and recommend needed changes. Over an extended period the Deposit Insurance
Reform Committee studied the issues, heard from expert witnesses, and hammered out a
program for reform to enhance the financial strength of the deposit insurance funds and
enhance outside pressures on banks to manage their risks with care. Details of this
program were released in March, 1990.
The key policy question is deceptively simple - who is insured? Over the past
decade, the FDICs answer has been that all depositors are covered - especially
depositors in large banks. There have been few exceptions to this policy of de facto 100
percent deposit insurance, and the excepuons have all been small banks. The protection
of all deposit obligations - especially in large banks - is sometimes called the "too-bigto-faiT policy.
The implications of the FDICs ad hoc policy of 100 percent coverage are only
now becoming clear. On the surface, it would seem that covering all depositors would
be a stabilizing influence by preventing possible disruptions in deposit markets. In
reality, 100 percent deposit insurance has significant adverse long-term consequences for
the industry and the economy.
Protection of all deposits, whether or not they are legally entitled to insurance,
creates an enormous and unnecessary liability for the FDIC and ultimately for the
taxpayer. It also undermines incentives of large depositors to evaluate and monitor the
financial condition of the banks in which they place their funds. The result is to
encourage funds to flow to the highest bidder, regardless of risk. Thus, in a de facto 100
percent deposit insurance world, the deposit insurance funds are burdened with costs
they were never intended to bear while the entire burden of detecting and controlling
excessive risk-taking tends to be shifted to the supervisory agencies. In today's complex
and fast-paced financial world, this is a Herculean task. It will require a massive
increase in resources devoted to regulation, place a huge regulatory burden on the
industry, and probably not achieve the desired results.
In sum, de facto 100 percent deposit insurance is unnecessarily risky and
prohibitively expensive.
Many proposals for deposit insurance reform under discussion today attempt to
"fix" the system without changing the current case resolution policy of the FDIC that
results in complete protection of uninsured deposits. Some of the proposals, such as




166
risk-based premiums and limitations on the number of insured accounts, will do little or
nothing to improve the system or reduce the exposure of the BIF if we continue with de
facto 100 percent coverage of all deposits. Other proposals, such as significantly
increased capital requirements and limitations on activities (or proliferation of firewalls),
may actually increase systemic risk rather than reduce it.
True deposit insurance reform must address the fundamental problem with the
current system - we simply cannot afford to continue to guarantee all deposits. We
must move away from 100 percent deposit insurance and eliminate the too-big-to-fail
policy. For this reason, the ABA's Deposit Insurance Reform Committee recommended
a deposit insurance system that places uninsured depositors in all banks at risk of loss in
the event of insolvency.
The deposit insurance system must strengthen incentives of investors with
substantial resources to exercise care when placing funds in a depository institution - just
as they would with any other investment. As large depositors make more careful
assessments of their exposure to loss, poorly managed institutions will be forced to pay
higher interest rates to attract funds, thus limiting their ability to grow. Over time, an
increasing share of the banking business will be channelled to well-managed, sound
institutions. As a result, there will be fewer bank failures, and less strain on the deposit
insurance fund.
Equally important, the entire job of monitoring and controlling the risk-taking of
individual institutions will not be thrown in the lap of the regulators. Tapping the
resources of the private market to assist in the assessment of a bank's financial condition
not only broadens the monitoring system, it also means that fewer scarce resources need
to be employed to do the job.
Moving to a system in which uninsured depositors are truly at risk raises
operational and transitional questions, a matter that was considered with care by the
ABA's Deposit Insurance Reform Committee. The principal operational problem stems
from the current lack of a framework for handling a large bank insolvency. The ABA
has developed a plan that will enable the regulators to handle the insolvency of any bank
- large or small — without undue disruption to the system. This plan would call for
uninsured depositors to receive access to most of their balances with no loss of liquidity,
while at the same time sharing in the losses of the FDIC in an amount determined by
the insurance agency's historical experience.
The problem of transition to the new system can be handled by establishing a
credible program and announcing it well in advance of its effective date. This will give
investors in uninsured deposits time to assess the financial condition of their depository
institutions and to take whatever steps they may feel are appropriate to minimize their
exposure to loss. It will also give banks the time needed to adjust their own operations




2

167
to a new system in which they will be subjected to intensified competition and discipline
in the markets for deposits.
The ABA proposal has received a great deal of attention since it was set forth in
the March 1990 report. Much of the commentary has been favorable, but as could be
expected, concerns have been raised about the desirability of undertaking such a
fundamental change. The issues raised can be grouped into three general categories:
(1) the possibility of undesirable side effects if uninsured depositors are truly at risk; (2)
whether operational hurdles of eliminating too-big-to-fail can be overcome; and (3)
potential constitutional problems with the ABA program. These issues are examined in
some detail in the remainder of this paper.
The most thorough review of the ABA recommendation to require large
depositors to share in the FDICs risk was set forth by the FDIC itself, in a document
published last summer. The FDICs comments are typical of the array of arguments
raised in opposition to doing away with the too-big-to-fail policy and requiring uninsured
depositors to shoulder the risks now routinely absorbed by the FDIC. It will therefore
be used as a basis for a response throughout much of this paper.




3

168
MARKET DISCIPLINE
Introduction
The case for market discipline by depositors is based on a simple idea: individual
depository institutions should be subjected to the same kind of policing that banks and
other creditors apply to those to whom they lend money. Many uninsured depositors
already evaluate the condition of their banks with care. But others, comforted by the
perception of total protection of uninsured deposits at large banks, devote too little
attention to bank soundness. As the current policy of 100 percent protection becomes
increasingly embedded in the minds of investors - as is happening, no doubt, following
the full protection afforded to depositors in the Bank of New England - it will
systematically erode the incentives of investors in large deposits to choose their banks
with an eye to the risks they run, at least if the banks are large.
By undermining incentives for large depositors to evaluate and monitor the
financial condition of the banks in which they place their fund, 100 percent deposit
insurance places the entire burden of detecting and controlling excessive risk-taking on
the supervisory agencies. Given the inherent shortcomings of regulatory discipline, it
would be a mistake to assume that the problems arising from full protection of uninsured
deposits can be mitigated by still more regulation. It is essential to recognize the
limitations of both the regulatory system and the system of deposit insurance, and to
search for feasible opportunities to decrease the strains put upon both. Increasing
incentives for holders of large deposits to assess the soundness of the banks in which
they place their funds presents just such an opportunity.
The heart of the ABA proposal for reform is the requirement that uninsureddepositors share in the FDICs losses when their banks fail. With a heightened
awareness of their exposure to loss, these depositors will be inclined to choose their
banks more carefully, either by shifting funds out of less well-managed banks or by
demanding premium interest rates from them to compensate for their added risk. The
increased cost that risky institutions would have to pay for deposits will provide them
with a powerful inducement to get their houses in order.
Of equal importance, institutions considered by the market to be in sound
financial condition and prudently managed will, over time, be able to expand their shares
of the banking business, bringing more of the risks that must be managed into competent
hands. This will help contain the need for regulatory intervention.




4

169
A Response to Concerns About the ABA Approach
In deliberating on its recommendations for reform, the ABA considered with care
the concerns that are normally raised about proposals for ending the FDICs too-big-tofail policy. Not surprisingly, these concerns have surfaced in discussions of the ABA
proposal, and it is useful to take a fresh look at them.
In its critique of the ABA plan, the FDIC did not defend the current practice of
providing 100 percent guarantees to uninsured depositors, nor did it attempt to counter
criticisms that such a policy has serious long-term consequences. It did, however, express
reservations about any plan that would require investors of large deposits to share in the
loses of the FDIC.
Summarizing its concerns, the FDIC stated:
Dependance on depositor discipline to relieve the burden on the
insurer can create undesirable side effects. These include: 1)
an increase in systemic instability; 2) a loss of flexibility in
limiting the economic damage of a major bank failure and 3) a competitive
disadvantage for the U.S. economy. In addition, 4) it is unclear that the bank
deposit market is well suited to imposing discipline on banks.
Each of these FDIC arguments concerning market discipline will be considered below.
Systemic Instability
The first potential undesirable side effect of market discipline cited by the FDIC
is the threat of bank runs. The agency states:
...any time that the solvency of a bank is questioned, uninsured
depositors can be expected to run. [This]... could cause an
otherwise viable bank to collapse because bank assets are illiquid.
In a different section of its critique, the FDIC raised a warning that financial problems at
one bank may lead to runs on other banks that are similar in outward respects but
otherwise in healthy condition. The two points are closely related. Together, they
constitute the very heart of the traditional view of Federal bank regulators that a too-bigto-fail policy is necessary and justified. But in its review of ABA's recommendations, the
FDIC pays little attention to the enormous costs of providing total protection to all
depositors, no matter how large. It is not appropriate to assess current policy as if these
costs did not exist, or were not significant.




5

170
The most obvious cost of de facto 100 percent protection is the drain on the
FDIC's financial resources from protecting uninsured deposits.
The other serious cost of using the deposit insurance system to extend protection
to uninsured deposits is the destruction of incentives of investors in large deposits to
choose banks with an eye to soundness. Protection of uninsured deposits actually
provides support to banks that may need to be reined in.
Both types of costs are immensely important, and both figured importantly in
shaping the ABA's recommendations for reform. But they were given little attention in
the FDIC critique.
Moreover, the ABA recommendations take into account alternative mechanisms
for dealing with bank runs, whereas the FDIC critique appears to assume that there are
no such alternatives. When a run occurs, deposits withdrawn from a bank or banks
would generally be moved, directly or indirectly, to other banks, rather than being
transformed into currency hoards. The market for interbank loans provides a vehicle for
banks experiencing deposit inflows to put the funds to work in loans to solvent banks
losing deposits. The interbank market is highly developed, redistributing billions of
dollars every day.
Of course, bank runs are most likely to take place in times of great uncertainty,
and it is not certain that banks gaining deposits would be willing to lend to those losing
them. But banks unable to replace deposits through the interbank market could and
would turn to the Federal Reserve discount window, which is designed precisely for the
purpose of providing liquidity to institutions that are unable to manage outflows of funds.
Thus, runs by uninsured depositors and unsecured creditors might require decisive action
by the Federal Reserve, but they would not endanger the banking system.
In addition, it is possible, though not likely, that holders of large deposits would
withdraw completely their funds from the banking system, rather than moving them from
one bank to another. In this case it would be necessary for the Federal Reserve to use
open market operations to offset any adverse effect on bank reserves.
This is not to say that dealing with a major run, presumably resulting from a
shock to confidence, would be easy. It is, as it always has been, important to maintain
mechanisms for dealing with systemic disturbances. But it is even more essential to
avoid policies that create the conditions conducive to panic - mismanagement of risk,
growth of unsound banks, and misplaced faith in the effectiveness of bank regulation.
One of the greatest potential virtues of increased market discipline is that it would help
prevent systemic breakdowns by encouraging prudent management of risk. Current
FDIC policy works in the opposite direction because it assures even the largest
depositors that they are not a risk of loss - at least if they place their money in a large
bank - no matter how unsound that bank might be.




6

171
Regulatory Flexibility
The FDIC argues that it must have the ability to decide on a case-by-case basis
whether to protect uninsured depositors from loss in bank failures. The idea is that such
losses could result in unacceptable economic disruption, particularly if the failed bank is
large and has very substantial uninsured deposit liabilities.
There are two reasons why the losses of uninsured depositors might lead to
disruptions. The first is impaired liquidity and the second is loss of wealth. The ABA
proposal provides for immediate restoration of liquidity after uninsured deposits have
been written down by the loss ratio determined from FDIC experience. Historically, the
losses taken by the FDIC (on a discounted present value basis) have averaged about 12
cents per dollar. Thus, under the ABA approach, uninsured depositors would have
immediate access to about 88 cents for each dollar of uninsured funds. This protection
of liquidity would help to minimize the potential for any disruptions.
The write-down is the important difference between the ABA proposal and the
customary resolution of most batik failures. Under current policy, the FDIC sells the
failed institution to an acquirer unless a buyer cannot be found. The same can be done
under the ABA plan. In this case, however, the FDIC would transfer to the purchasing
bank 100 percent of the insured accounts plus the written-down portion of the uninsured
accounts.
There remains the potential threat that losses of wealth from the write-down of
uninsured deposits could lead to severe economic dislocations. This is no different from
the possibility that losses by investors from any source might lead to unacceptable
disruptions. The first thing to note is that such losses generally do not lead to disasters.
The second is that if losses to any group of investors or sector of the economy poses the
threat of unacceptable spillover effects, government programs can be shaped to deal with
them. The ABA proposal, however, would end the automatic treatment of any and every
failure of a major bank as if it did portend disaster, and prevent the use of funds
accumulated for the purpose of protecting small depositors from being dissipated in the
name of too-big-to-fail.
The fact, of course, is that the FDIC is inflexible in its treatment of uninsured
deposits when a sizeable bank fails. The automatic invocation of the too-big-to-fail
policy represents a systematic misuse of financial resources intended for a different
purpose, and encourages large investors to place their deposit balances with too little
regard for risk.
The ABA proposal presents a way out of this predicament. It provides for
protection of liquidity, thereby helping to minimizing the probability that losses taken by
uninsured depositors will have serious repercussions. It eliminates bias against small




7

172
banks and those who hold uninsured deposits issued by them. And it husbands market
discipline, rather than discouraging it.
Competitive Disadvantage for U.S. Banks
The third adverse side effect raised by the FDIC concerns the competitive
position of U.S. banks in international markets. The FDICs concern is that if investors
in uninsured deposits are required to share in the losses that would result if their banks
failed, U.S. banks will be regarded as inferior risks, and uninsured depositors would shift
their funds to banks whose countries were believed to provide "more government
support."
In shaping its recommendations for deposit insurance reform, the ABA Deposit
Insurance Reform Committee considered this question very carefully. While the ABA
agrees that there is reason to be concerned about unequal treatment of banks from
different countries that compete the same markets, we cannot accept the FDIC argument
that it "would be imprudent to institute mandatory haircut proposals before international
agreements are reached." It is important, of course, to participate in international efforts
to improve bank regulation, and the ABA and its members stand ready to do so. The
prudent course, however, is to move ahead with meaningful reforms of a deposit
insurance system badly out of step with the times.

Tfie Suitability of Bank Deposit Markets to Impose Discipline on Banks
Bank regulators tend to dismiss the idea that investors in uninsured deposits are
capable of making useful judgments as to the safety of individual banks. The FDIC, in
its critique of the ABA plan, sets forth three reservations about the suitability of
uninsured deposit markets to play a role in policing the institutions that use them to
raise funds.
First, the FDIC argues that depositor discipline cannot be effective because bank
stock prices have more informational content than deposit interest rates. The reasoning
is that stocks can be sold short, and there are even options markets for some stocks of
banks. By way of contrast, says FDIC, "only one position [long] can be taken in a bank's
certificates of deposit." From this observation the agency jumps to the conclusion that:
A financial agent who believes that a bank has begun to pursue
riskier or ill advised policies cannot affect the market for
the bank's certificates.
This statement is startling and incorrect. Many investors in uninsured deposits
exercise care in choosing where they put their funds. If substantial numbers of these
investors believe "that the bank has begun to pursue riskier or ill advised activities" the




8

173
bank will soon find out, unless the investors are confident that whatever happens to the
bank they will be protected. Investors in uninsured deposits who have no interest in
taking either short or long positions in a bank's equity, or in related options, can exert
very powerful influences on the way risk is managed simply by placing a premium on
safety. In fact, because investors in uninsured deposits focus on the risk of negative
outcomes, their evaluations are particularly well suited to encouraging prudent
management at banks. Moreover, private markets are well-suited to putting new
information into action with minimum delay. As individual investors revise their
evaluations, the amounts they are willing to invest, and the terms on which they will do
so, banks are likely to change their risk-taking behavior very quickly.
Second, the FDIC argues that while analysis performed by private investors and
those who advise them, including rating agencies, may offer some insight into a bank's
current performance," private sector analysis based on publicly-available financial
statement information "does not indicate much about a bank's prospects." In particular,
the FDIC holds, analysis of a bank's loan portfolio probably cannot be "performed by
agents other than bank examiners."
Examiners are, to be sure, in an advantaged position to judge the quality of
individual loans, although there have been instances when the private sector was ahead
of the bank examination force in spotting and acting on trouble. It is most certainly not
true, however, that examiners are the only competent judges of management, liquidity,
capital adequacy, or the economic environment - all factors that are important in
detennining the future prospects of any bank. The private markets make these
assessments all the time, for all types of creditors. The diversity of viewpoints and
flexibility to recognize and correct errors that characterize private judgments are not
features one would cite in a list of the virtues of bank supervision. The correct
conclusion is not that market discipline is likely to be ineffective, but that it is capable of
providing an immensely valuable complement to regulatory oversight as exercised by the
banking agencies.
Third, the FDIC points out "there are limits" to the value of information supplied
by rating firms, and that "private analysis is not a substitute for the information reflected
in a market-generated price in which each analyst takes a monetary position." But
advisory services are not used as substitutes for market prices. The volume of publiclyavailable information about banks is enormous, and for some investors, the way this
information is interpreted and distilled by third-party analysts contributes to its
usefulness. Ratings and other evaluations are used by investors to make more informed
judgments, and these judgments determine the cost and availability of funds to banks
that issue uninsured deposits.
Moreover, private analysts do have a major "monetary interest" in the evaluations
of a banking company. Rating firms gain business when they do their work well.
Brokerage firms provide analyses of industries and firms in them not as a courtesy, but




9

174
as a way to improve the value of their services. These third-party analyses contribute
significantly to the market's understanding and assessment of investment risks.
Market Discipline is a Significant Force in Reducing Systemic Risk
Holders of uninsured deposits tend to look for the same things in a depository
institution that are important to regulators: good risk management, sound capital and
adequate liquidity. That is why rewards and penalties doled out by discriminating
investors in uninsured deposits help channel funds to banks that are best equipped to
perform the intermediation function with appropriate attention to risk.
Examples of steps taken by prudent investors in uninsured deposits include the
following:
Investors evaluate the credit quality of issuing banks using
a variety of information, including condition and income reports
filed with the regulatory agencies, financial reports of bank
holding companies, and in some cases direct contact with issuing
banks.
There is a substantial and profitable market for ratings of the
safety of banks and the credit quality of their deposits. A
number of advisory services and rating firms offer opinions in a
nationwide and even international market for advice. Some of
these firms specialize in larger banks, but others will provide information
and advice on the financial condition of any bank in the country. Investors
use such information to determine which banks' deposits they might buy,
and to establish lines, or maximum investments, for each of the banks
selected. It would not be possible for these firms to prosper as they do
unless their clients placed substantial value on the opinions and
information they offer.
Managers of large blocks of deposit funds typically diversify
their holdings among a number of banks on their approved lists.
Diversification is a common practice by investors who seek to
limit concentrations of exposure to loss.
Distinctions among issuers typically sharpens during periods of
financial stress, and "tiering" of rates develops. This is a
typical phenomenon in other markets where risk is a factor in
investment decisions. As rate differentials widen, banks
singled out by the market for penalty rates have strong
incentives to pull back.




10

175
Some investors in large time deposits are quite confident that their deposits would
be fully protected even if the bank that issued them failed, at least if the bank was very
large. Others may be careless, which is true in any financial market. But even in the
face of the disincentives created by FDICs 100 percent protection policies, many
investors in large time deposits continue to choose their banks with care. In fact, these
investors exhibit the same risk-aversion as buyers of, say, commercial paper issued by
finance companies and other business firms.
Market discipline, like regulatory discipline, is neither perfect nor painless. There
are times when the markets for large time deposits close down for banks that appear to
be in trouble. The affected banks must scale back or turn to other sources of funds,
including the Fed funds market and if necessary the Federal Reserve discount window.
Sometimes the alanns are false, and in these cases the difficulties pass; there is no recent
record of any bank that was in sound condition being ruined by a loss of uninsured
deposits. Where passage of time reveals that the affected banks are in fact deeply
troubled, they may find their access to uninsured deposits and other non-guaranteed
liabilities dries up.

The Size and Breadth of the Market for Uninsured Deposits Assure Broad-Based,
Consensus Messages
The uninsured deposit
Chart 1. Estimated Uninsured Deposits
market is well positioned to
by Issuer, 12/31/89
exert a restraining influence on
Dollar amounts in billions
banks that rely on it. At the
end of 1989, U.S. banks and
thrifts had nearly $1 trillion of
uninsured deposit liabilities
(see Chart 1). This was nearly
BlF-lnsursd Thrifts
$12 1*
one-third of all deposits. All
Commercial Banks
SAiF-inaured Thrifts
$800 92%
$60 7*
types and sizes of depository
NCUAHnaured Thrift!
institutions issue uninsured
$3 0%
deposits, and significant
amounts of these deposits are
held by every major sector of
the domestic economy as well
as a variety of foreign investors
(see Chart 2). The large
number of uninsured deposit
accounts - well over 2 million at BIF-insured institutions alone - is important because it
assures a decentralized market that brings together evaluations made by numerous
individual investors. This decentralized evaluation system nicely complements the
authoritative, but ponderous, process of government regulation.




11

176
The variety of types of investors is important as well (see Chart 2). It means that
the disciplines exened by uninsured depositors reflect a broad cross-section of viewpoints
and approaches toward assessing and managing risk-taking. Every major sector of the
domestic economy - nonfinancial business, households, financial firms and state and
local governments - has major investments in uninsured deposits. And customers of
foreign branches of U.S. banks, primarily other banks, business firms and governmental
entities, held more than $300 billion, or almost a third of total uninsured deposits, at the
end of 1989.

Chart 2. Estimated Uninsured Deposits
by Type of Holder, 12/31/89

1

Dollar amounts in billions
Fen Olle Depositors $312 32%

iiii!iijii'i>"\ Fpn Dap at Dom Oftcs $40 4%

r^N^M
Unallocated $114 12* J

'

'

-C^kSI *

Loc 1 G o v

*

" *23

2%

^ ^ J ? S ^ S S S S S S S S ^ Nonoank Pin Sactora $105

^^C^W^^JB
^^^^HLr
Houaanoioa SH7 12*

Commercial Banka $28 3%

N^j^^H
Nonfln But $231 2 4 *

Eatanatad uelng Federal R m r n and
FOIC data

The greatest potential effects of market discipline relate to large commercial
banks. Estimates based on data from the regulatory agencies indicate that commercial
banks accounted for more than 90 percent of the $971 billion total uninsured deposits at
U.S. financial institutions at the end of 1989 (see Chart 1). And banks with assets of
more than $1 billion accounted for over 85 percent of the commercial bank total (see
Chart 3).
Most uninsured deposits are in the form of large (over $100,000) time deposits.
While uninsured deposits are held for a variety of reasons, it is important to note that
large-denomination short-term CDs compete directly with both commercial paper and
Treasury bills, and longer-dated large time deposits with a large array of private and
public debt issues.




12

177

Conclusion
There are only two choices: a world where uninsured depositors are fully
protected or a world where they are not. We can no longer afford the luxury of too-bigto-fail policies. They burden the deposit insurance system with unnecessary costs that
were never intended and thrust the entire burden of detecting and controlling excessive
risk-taking on the supervisory agencies. Market discipline, on the other hand,
strengthens incentives of investors with substantial resources to exercise care when
placing funds in a depository institution just as they would with any other investment.
Money will flow, overtime, to well-managed, sound institutions thereby resulting in fewer
bank failures and less strain on the deposit insurance fund.




13

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OPERATIONAL CONSIDERATIONS
Introduction
The ABA proposal to do away with full protection of uninsured deposits raises
two important questions of an operational nature. The first is whether it is technically
feasible, at least in the case of a large bank failure, to determine rapidly which deposits
are uninsured, and therefore not entitled to full protection. The second question is
whether imposing losses on uninsured depositors might disrupt the operation of the
payments system so seriously as to cause severe economic dislocations.
Both questions were raised in the FDIC critique of the ABA's proposal. While
the FDIC does not contend that operational problems are necessarily insurmountable,
neither does it conclude that they are manageable. It is, therefore, important to address
the concerns the FDIC has raised.
The ABA's Deposit Insurance Reform Committee considered both the need to be
able to quickly determine which deposits in a failed bank are not insured and whether
the imposition of losses on large depositors would seriously upset the payments
mechanism. It concluded that the first potential problem is manageable as long as every
depositor is entitled to separate protection at each institution with which he banks. With
respect to protecting the payments mechanism, the Committee worked carefully to
fashion its proposal in a manner that would limit the loss of liquidity experienced by
holders of uninsured balances in failed banks and would enable them to know in advance
the proportionate losses they would face in the case of a failure.
This section considers both matters in some detail.
Determining Deposit Insurance Coverage
Determining which deposits are insured and which are not can pose important
challenges. Record keeping systems in place today in many banks, especially smaller
ones where uninsured deposits are relatively unimportant, might require little change.
For many or most larger banks, where the numbers and sizes of accounts tend to be
larger, and the proportion of uninsured deposits to total deposits tends to be higher,
substantial modifications might be required.
There is no doubt that existing technology makes it feasible to keep records in a
manner consistent with identification of uninsured deposits in a timely manner. But if
existing systems require substantial modification, it would take time to develop and
implement the needed changes. This should not pose a substantial problem, for in any
event it would be necessary to give ample advance notice of a reform of current too-big-




14

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to-fail policies of the FDIC in order to permit depository institutions and their customers
to make portfolio and other changes called for by the new system.
It is important to understand that the current configuration of bank record
keeping and reporting is, in part, a result of the FDICs policy of de facto 100 percent
insurance of all deposits. Since uninsured deposits are fully proteaed, it is not necessary
to have detailed knowledge of the insurance status of individual accounts. It is
interesting to note that more than five years ago the FDIC hired an outside consulting
firm to examine the possibility of effecting transfers or payoffs of insured deposits in
connection with large bank failures. The general conclusions of the first phase of the
study suggested that systems could be developed to handle very large bank failures,
particularly if modest record keeping requirements were imposed on banks. The FDIC
decided not to have such systems developed because they were not likely to be used, not
because they could not be developed or would not work. Had the FDIC followed up
five years ago, the state of bank record keeping and reporting as it relates to
identification of insured accounts would be different today.
Once there is agreement to go ahead with the ABA proposal, technical expertise
from the banking industry, the banking agencies and elsewhere can be brought to bear
on development of appropriate systems and reporting requirements to implement the
proposal.
To its credit, the FDIC has recently developed a system that apparently has the
capability of determining insurance coverage very quickly for banks whose deposit
records are in satisfactory condition, without imposing record-keeping requirements on
those banks. While the FDIC has not made use of such a system in connection with any
very large bank deposit transfer or payoff (there have not been any), the FDIC staff
indicate that their system could handle a very large bank failure if records are in
satisfactory condition. If the FDICs newly-developed system is not sufficient, then the
way banks keep deposit records will have to be modified. There is no question in the
mind of the ABA that such modifications are practicable.
The discussion below suggests how certain operational problems related to the
ABA proposal can be resolved. This is not to say that better systems could not be
developed. Rather, the intent is to suggest that potential problems are quite manageable
and resolving them is not all that complex.
Balance Aggregation
It is easy to spot some uninsured deposits using ordinary bank records, since in no
case are balances in accounts of more than $100,000 insured. But other uninsured
deposits are held in accounts with balances under $100,000.




15

180
If a depositor holds more than one account in any given capacity, limiting
insurance protection to $100,000 may require aggregating all balances held in that
capacity at the failed institution. For example, a depositor might hold $30,000 in a NOW
account and $80,000 in a time deposit at the same bank, for a total of $110,000. Only
$100,000, however, is insured. On the remaining $10,000, the depositor would be subject
to loss.
In addition, depositors who hold accounts in different capacities (e.g. accounts
held jointly with others, and IRA and Keogh accounts) are entitled to separate coverage
for each eligible capacity. Aggregation of accounts must recognize this fact.
Under the ABA plan, aggregate balances held in each eligible capacity exceeding
$100,000 would be written down by a percentage based upon the average historical
recovery in all failed banks. Thus, depositors would receive 100 percent of balances up
to $100,000 and a final settlement payment (FSP) for the percentage applied on the
uninsured portion. In the example above, the depositor with $110,000 would stand to
lose $1,500 if the FSP on the uninsured portion ($10,000) was 15 percent. This method
of payment could be accomplished in any type of failure resolution.
The account information required to determine the amount of uninsured balances
held by a depositor with more than one account or in different rights and capacities
would be as follows:
Name(s) and Social Security or Taxpayer Identification
Number(s) of account owner(s);
The capacity in which the account is held;
For accounts held by an executor or administrator, the identity of the
decedent;
For corporate, partnership or association accounts, the identities and
percentage ownership of each party to the account;
For joint accounts, (1) the identities of each participant; (2) the percentage
ownership of each, (to make things easier it could be assumed that in the
absence of specific designations on file with the issuing bank, the
percentage ownership shares are equal for all parties on the account);
(3) proof that each owner has executed a signature card and has equal
withdrawal powers;
For trust accounts (including IRAs and Keoghs): (1) the identity of the
grantor; (2) the identity of the beneficiary; (3) if the account is a qualified




16

181
pension or profit-sharing plan; (4) the type of account (time or savings or
demand deposit);
For custodial accounts, the identity of the ward or minor;
Whether the account is managed by a "deposit broker;" and
The account balances at close of business.

Resolution of Errors
As long as a depositor does not have aggregate balances of more than $100,000 in
a failed bank, there is little potential for error. But potential for error does arise if
accounts are held in different capacities, since balances held in different capacities could
be mistakenly aggregated and losses improperly imposed where the total exceeds
$100,000.
The incidence of errors due to mistaken aggregations is likely to be small in
relation to a bank's total deposits, even without any change in record keeping
requirements. First, most individuals do not have deposit balances of more than
$100,000, even when all accounts held in all capacities are aggregated. Federal Reserve
survey data collected in the mid 1980s indicated that 98 percent of households had
combined deposits of less than $40,000, with the average around $3,000. A 1985 FDIC
survey of all deposit accounts in several large banks indicated that fewer than two
percent of deposit accounts (including non-personal accounts) had balances in excess of
$20,000. Such smaller accounts are, of course, fully insured and would not be affected by
the final settlement payment for uninsured deposits contemplated in the ABA proposal.
Furthermore, since uninsured balances are credited with a final settlement
payment, any dispute over insurance coverage would involve only a small fraction of the
balance involved (the write-down would be about 12 percent of the uninsured portion
based on the average historical loss in bank failures). For example, if two $100,000
accounts held in different capacities were mistakenly aggregated, the depositor would be
short-changed by about $12,000. This error would be unlikely to cause serious
disruptions, particularly if one or both of the accounts were non-transaction accounts, as
would be the case with IRAs, Keoghs, or certain other types of trust accounts.
Where errors or omissions did occur, they could be rectified later. Posttransaction adjustments are a common FDIC practice in current deposit transfers and
payoffs.
Of course, the best policy is to minimize the number of mistaken write-downs of
insured deposits. This might require that record-keeping systems be established to




17

182
permit enhanced ability to cross-reference accounts and special coding to identify
account capacities. Many banks already have the capacity to cross reference accounts
based on names, addresses, social security numbers, or tax identification numbers. This
is done partly to meet different tax and reporting requirements for interest earning
accounts. For example, under current law, social security or tax identification numbers
must be referenced on interest-bearing accounts if the depositor is to avoid withholding
by the bank. In addition, some banks cross-reference different accounts held by the
same depositor for internal monitoring of account relationships, marketing activities,
profitability analysis, and to provide customers with useful account summaries.
To handle problems raised by depositors who do not provide social security or tax
identification numbers, it could be required that such information be provided by
depositors to banks as a condition of deposit insurance coverage.
Reconciliation of legitimate disputes over insurance coverage could take place
after the initial final settlement payment. To minimize potential confusion, it might be
appropriate to require that large banks with substantial uninsured deposits periodically
provide information to larger depositors on their level of insurance coverage. That way,
depositors would better understand the system and have an opportunity to correct errors.
This likely would be preferable to "trial runs" of the reporting system as some have
suggested.

Timeliness of Account Information
A second requirement for successful implementation of the ABA final settlement
payment approach is that it be possible to generate account balance information needed
to determine which deposits are not insured with little delay after a bank has failed.
Because account balances are updated daily, this will be possible as long as aggregation
routines have been established in advance.
A related question, raised by the FDIC in its critique of the ABA plan, is the
feasibility of a next-day opening of a failed bank. Obviously, the more time available,
the less difficult the account reconciliation. Closing the failed bank at the end of the day
on a Friday - as is common practice - allows extra time over the weekend for account
reconciliation. With appropriate systems and coding in place, account aggregation and
final settlement payments could begin immediately following the posting of transactions
for the previous day. Some of the necessary work related to account aggregation and
detennining where uninsured deposits are present could even be done before prior-day
posting has been completed. The new bank would open following the weekend with no
interruption. Thus, no adverse consequences would be likely.




18

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Check Clearing
The final settlement payment procedure is likely to cause an increase in checks
drawn against insufficient funds, since it involves writing down uninsured balances. Of
course, most deposit accounts are fully insured and checks in process drawn on these
accounts will be unaffected.
Equally important, banks deal with overdrafts every day, so that the dishonoring
of checks following a bank failure occurs frequently even when uninsured depositors are
fully protected. As would be expected, the FDIC has procedures for handling such
transactions, and those receiving bad checks still have a claim on the check writers.
The increase in the volume of returned checks under the ABA reform proposal
will be modest, especially if appropriate procedures for minimizing it are put in place.
Where depositors have several accounts, losses on uninsured balances could be applied
first to non-transaction accounts, perhaps starting with the longest maturity. That would
minimize the impact on transaction accounts and keep down the volume of returned
checks.
In summary, the increase in returned checks from adopting the reform proposed
by ABA should be modest because (1) most depositors will continue to be fully insured;
(2) losses on uninsured balances could first be applied to non-transaction balances where
they are present; and (3) under the proposed final settlement payment arrangement,
most uninsured deposit balances would continue to be available without interruption.
The FDICs critique of the ABA proposal expressed concern about the violation
of existing time limits on reversing payments in connection with checks written with
insufficient funds. It is important not to overstate this potential difficulty. Today's rules
and procedures have been fashioned to work in a system where deposits are fully
protected, at least if they are held in large banks. A new system will require different
procedures to be sure, but it makes little sense to judge the feasibility of a reform by
questioning its workability with unchanged procedures. For example, adjustments can be
made to existing rules on timely notification and minimum size cutoffs for such
notification, and new procedures can be established. Rules might be established to
protect third parties from loss due to overdrafts traceable to bank failures.
In sum, the procedures needed to make a reformed system work properly can be
implemented. What is important is that the system gets the job done, makes sense for
most users, is perceived to be fair, specifies in advance where "arbitrary" rules are to* be
put in place, and has appropriate procedures for dealing with conflicts with minimal
litigation.




19

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Correspondent Banking
The FDIC critique expresses concern that the insolvency of a large bank might
impose losses on smaller banks that hold balances with it for check clearing. The
critique also states that where regional economic problems are present, small banks
might be subjected to repeated losses because they could not find a safe correspondent
bank in their region. The market for correspondent services, including check clearing is,
however, considerably less regional in scope than is suggested in the FDIC paper, and it
is hard to imagine that there would not be sound correspondent banks available.
In addition, it is likely that institution of the ABA reform would hasten the trend
toward substitution of explicit fees for implicit interest on correspondent balances, an
attractive alternative for a bank that wishes to minimize potential losses on balances held
with other banks. Of course, banks that are not satisfied with private sector alternatives
would continue to have the option of relying more heavily on the Federal Reserve
system for check clearing.

Lock Box Services
The FDIC paper expresses concern that exposing depositors at large banks to
losses if their banks fail will cause profitable lock box services (collecting bill payments
and providing quick access to funds, particularly for large retail-oriented corporations) to
shift away from the banking sector. A major reason for this concern appears to be the
FDICs desire to protect and subsidize the lock box function, which it notes is a
profitable one. But protecting profits is not a legitimate function of deposit insurance.
Even in today's environment, where FDIC policy protects holders of uninsured deposits
in large bank failures, larger corporations are likely to exercise care in choosing among
banks that offer lock box services. The encouragement of such selectivity through a
reform that requires holders of uninsured deposits to share in the FDICs risk of loss
from bank failures is entirely consistent with the development of improved market
discipline.

Large Transactions
The report that presented the ABA proposal devoted considerable attention to
issues related to large wire-transfer transactions. The report concluded that the two
major wire transfer systems, CHIPS and Fedwire, would not be seriously vulnerable to
the depositor and creditor losses contemplated in the proposal.
Wire transfer systems are constantly being unproved. For example, since the
ABA paper was competed, additional steps have been taken to control risk and prevent
disruptions of wire transfer transactions. CHIPS has moved to a system of transaction




20

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finality, eliminating the possibility that complex unwinding of past transactions might be
necessary.
The CHIPS system has also recently demonstrated how banks will act to limit
exposure to another bank. When a large U.S. bank that was a member of CHIPS
encountered serious difficulty last year, other members, following procedures that had
been established to limit risk, dramatically reduced their exposures to that bank. This
made it virtually impossible for the weakened bank to effect large transactions through
CHIPS. The troubled bank withdrew from the system, a move that no doubt reduced its
ability to retain large deposit balances. This indirectly provided support for the ABA
position that the major clearing systems will be able to handle failures of large banks
that are accompanied by depositor and general creditor losses.
The FDIC paper presents little criticism of ABA's position that the reform it
proposes would not result in unacceptable payment system risk. It does, however,
express a concern that exposure of one bank to losses occasioned by the failure of
another may be compounded because of wire transfer relationships. It appears that this
concern, if it had merit when the critique was written, is no longer relevant because of
the new finality of payment rules adopted by CHIPS.

Conclusion
Operational problems related to implementation of the ABA proposal can be
resolved. The problems are manageable and resolving them is not all that complex.
Moreover, the cost of modifying existing or implementing new record-keeping systems while not inconsequential - are likely to be far less than the cost burden of maintaining
the current too-big-to-fail policies of the FDIC. Simply because current record-keeping
systems may not be fully aligned with deposit insurance needs is no reason to maintain a
costly too-big-to-fail system of coverage.




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THE CONSTITUTIONALITY OF THE FINAL SETTLEMENT PAYMENT
Introduction
A central feature of the ABA approach is that, in any bank failure, uninsured
depositors (domestic or foreign branch) and unsecured creditors would receive a single
payment, based on the average recovery in all failed banks. This "final settlement
payment" would dispose of the receivership interests of these general creditors and they
would have no further claim on the failed bank or the FDIC.
The use of an "average" figure for calculating the amount due to uninsured
depositors and unsecured creditors necessarily implies that some such claimants would
receive less under the ABA approach than they would have received under current law
and practice. With respect to these claimants, it has been suggested that Congressional
enaament of the ABA proposal into law would result in a taking of private property for
public use without just compensation, in violation of the Fifth Amendment and would,
therefore, be unconstitutional.
Such concerns are without merit. The concept behind the ABA proposal is by no
means unprecedented. There are many programs operating in a similar fashion in other
contexts which have been upheld in court.
This section reviews the key issues in determining constitutionality of the ABA
approach. This review summarizes the findings of two more extensive studies that detail
the legal precedent for the Constitutionality of the Final Settlement Payment approach
as presented by the American Bankers Association.1
The Fifth Amendment
The Fifth Amendment provides in part that:
No person ... shall be deprived of property without due process of law nor
shall private property be taken for public use without just compensation.

J
Mary S. Binder, esq., Federal Deposit Insurance Reform: Final Settlement Payment.
Law Department, The First National Bank of Chicago, August 10, 1990; and American
Bankers Association, Memorandum on the Constitutionality of the ABA Deposit Insurance
Reform Proposal, Office of the General Counsel, September, 1990.




22

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Given that a bank deposit is property protected by the Fifth Amendment,2 the final
settlement payment statute (FSP) must satisfy the due process and "taking" provisions of
the Fifth Amendment.
The issues of concern are:
(1)

whether a statutory waiver ("Waiver") of deposit claims in excess of the
FSP ("Excess Deposits") constitutes a deprivation of property without due
process of law; and

(2)

whether a Waiver results in a Fifth Amendment "taking" of property.

Economic Legislation and Due Process
Economic legislation is presumptively constitutional with respect to the Fifth
Amendment. Since the FSP Statute would be economic legislation designed to allocate
the risk of loss of uninsured deposits between the FDIC and depositors, it too would be
presumptively constitutional.
The FSP statute will, therefore, withstand a Fifth Amendment challenge unless a
claimant proves that such legislation is demonstrably arbitrary, unreasonable, or unfair.
A statute will be held to be non-arbitrary if the statute bears a rational relationship to a
legitimate legislative objective.3 The FSP Statute would satisfy this since it can be
assumed to enhance market discipline among FDIC insured banks and to allocate the
risk of loss between FDIC and depositors in a rational manner.
It is also "reasonable" and "non-arbitrary" to spread a cost or loss among those
who generally profit from a certain activity. If uninsured depositors were at risk, as they
would be under the FSP plan, riskier banks would have to pay more to attract deposits.
Those uninsured depositors would be benefiting from the market forces created by the
FSP statute. Therefore, the FSP would be considered a rational means of allocating the
risk of loss among those who attempted to profit from such risk.

2
This is by no means obvious. Property can include vested rights such as those
arising under a valid contract. In that context, a depositor has a vested right to obtain
repayment in full of all deposits placed with an FDIC bank. On the other hand, it could
be interpreted that unsecured creditors and depositors have only a "claim" against a
bank. In this context, the deposit in not the "property" of the depositor; it is the property
of the bank. In this context, the deposit is a debtor/creditor relationship, not a bailment.
3
Whether it in fact accomplishes Congress's stated objective is not a question of
constitutional dimension.




23

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Besides being non-arbitrary and reasonable, due process also requires that a
person be provided adequate notice and an opportunity to be heard before the ultimate
disposition of one's property. Constitutionally adequate notice is usually provided by the
publishing of the statute and affording those within the statute's reach a reasonable
opportunity to familiarize themselves with the statute and to comply with its provisions.
Since the FSP Statute would be adopted with a reasonably prospective effective date,
depositors would have adequate notice.
The statute would also be structured so that depositors have an opportunity to be
heard. Examples of situations where a depositor may desire a hearing include a
challenge to the computational accuracy of the "recovery rateM used to determine one's
FSP amount or a claim of unrecorded or mis-recorded uninsured deposits.
In summary with respect to due process, a waiver of Excess Deposits would
probably be held to be a non-arbitrary, rational and reasonable means of achieving
market discipline among FDIC banks and allocating losses among general creditors.
Since the FSP Statute would have a prospective effective date, depositors would be
presumed to know the law and will therefore be aware of the risk of loss of Excess
Deposits. Given this, the FSP statute would not constitute a taking of property without
due process of law.

Taking" of Property Without Fair Compensation
Even if due process requirements were satisfied, the FSP Statute would be
unconstitutional with respect to the Fifth Amendment if the loss of Excess Deposits was
so confiscatory as to amount to a "taking'' without fair compensation. Courts will
consider:
o

whether the cost or loss imposed is reasonably and fairly calculated;

o

whether the FSP constitutes a reasonable means of allocating costs to those
who enjoy a benefit; and

o

whether one could have avoided loss of property by one's own actions.

Moreover, a single determining factor in establishing whether a statute effects a taking of
property is whether a person has a "reasonable expectation" that a property interest will
be preserved.
The recovery rate used to establish the FSP would be a historical aggregate of the
results of the liquidation of failed insured banks. Historical results have been upheld as
a valid and reasonable basis on which to base current recoveries. Therefore, the
recovery rate would probably be held to be a reasonable means of calculating the FSP.




24

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It is also likely to be upheld that the FSP is a reasonable means of allocating costs to
those who enjoy a benefit. In fact, there is no constitutional requirement that the
method be perfect, the best, or even free from error.
Depositors enter into transactions voluntarily. Knowing that they are exposed to
loss in the event that their bank fails they may choose to deal with a particular bank or
not as they see fit. Thus, depositors control the actual risk of loss through the selection
of an insured bank and could avoid altogether any loss by investing in instruments other
than uninsured deposits. Since the loss of property could be avoided by one's own
actions, the waiver of Excess Deposits would not constitute a "taking."
Moreover, the certainty and immediacy of the FSP might be a valuable benefit in
an uncertain investment environment. Certainty of compensation is a benefit for which
one may be compelled to bear some cost. This is similar to the seminal case of
constitutionality of workmen's compensation statutes. Generally, these laws disallow
litigation by employees against their employers for injuries incurred on the job, make it
irrelevant that the employer was not at fault for any such injury, and compensates
employees for such job-related injuries, typically through a state administrative agency which employers are obligated to fund. Without workers compensation laws, an injured
worker might, in any given case, be able to recover more in damages as a result of
litigation against his employer than he or she is allowed to recover under the workers
compensation law. But by the same token, the worker is guaranteed a meaningful
recovery of injuries suffered, even though in any given case the worker might otherwise
lose a lawsuit against the employer. The FSP Statute involves the same trade-off: an
mandated certainty of remedy as a sufficient substitute for a doubtful right. Thus, the
FSP Statute would not constitute a taking of property.
If one could possess a reasonable expectation that uninsured deposits would be
fully protected, it would constitute a Fifth Amendment taking. After the effective date
of an FSP Statute, depositors could not possess a reasonable expectation that Excess
Deposits would be recovered upon the failure of an insured bank. In the absence of
FDIC or other government guarantees on which one could reasonably rely, such
expectations would be inconsistent with the provisions of an FSP Statute, legislative
policy, and the market rate of interest paid on uninsured deposits. A depositor could not
avoid a loss even if he had been extremely dihgent in placing his deposit since more than
a unilateral expectation is required.
In summary with respect to a Fifth Amendment "taking," a waiver of Excess
Deposits would not be confiscatory. The recovery rate based on historical information
would be a reasonable basis for setting the FSP, depositors have certainty and prompt
access to the FSP in the event of a bank failure, and depositors could avoid any loss
whatsoever by choosing not to invest in uninsured deposits. Additionally, after the




25

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effective date, no depositor could possess a "reasonable expectation" to recover Excess
Deposits upon a failure. Therefore, a waiver of Excess Deposits would not constitute a
Fifth Amendment "taking" of property.
Conclusion
Finally, the conclusion is that the FSP Statute would not be unconstitutional on
Fifth Amendment grounds since the condition of due process of law would be satisfied
and the waiver of Excess Deposits would not be a "taking" of property.




26

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4/29/91
Implications of "Too Big To Fail"
For The Safety of the Banking Industry
and the Protection of the Public
Statement by
George 6. Kaufman
John F. Smith Jr., Professor of Finance and Economics
Loyola University of Chicago
and
Co-Chair, Shadow Financial Regulatory Committee
Before the
Subcommittee on Economic Stabilization
of the
Committee on Banking, Finance and Urban Affairs
U.S. House of Representatives
Washington, D.C.
May 7, 1991
Mr. Chairman, I am happy to testify on the implications of
continuing

a

"too

big

to

fail"

(TBTF) policy

in banking

on

effective deposit insurance reform that would both strengthen the
banking system and protect the taxpayer against sharing in the
costs of bank failures.

Too big to fail is the single biggest

obstacle to achieving these objectives.

Indeed, in light of the

recent experience in the thrift industry, the taxpayer is not
safe until TBTF is buried once and for all.
As presently employed, too big to fail is a policy of not
asking private sector uninsured depositors to share in the losses
of insolvent large banks.
FDIC, paid
depleted,
This

is

Instead, the losses are borne by the

for by the other banks, and if its resources are
by the taxpayers as in the ongoing thrift debacle.

significantly

industries.

There




different

losses beyond

than

what

happens

in

other

those that deplete a firm's

192
2
shareholders

1

capital are borne totally by the firm's private

creditors.
It has been amply demonstrated in recent years that losses
at insolvent banks and S&Ls that are not resolved quickly can be
very large and passed through to the taxpayers.
Bankers

Association

uninsured

has

correctly

As the American

noted recently

deposits continue to be covered,

"As long as

recapitalizing

the

FDIC through increased premiums [or anything else] will be like
bailing out a boat with a hole in the bottom".1

Resolution of

TBTF is also required if any legislated insurance coverage limits
are to be effective.2
banks are
capital

Moreover, as long as TBTF is continued,

likely to continue to operate with dangerously

ratios

and

excessively

risky

portfolios

because

low
of

reduced depositor concern and manager/owner belief that delayed
resolution will give them additional time to regain profitability
1.
Hobart Rowen, "Lightening Strikes Twice," Washington
Post National Weekly Edition, April 8-14, 1991, p. 5. Bracketed
terms added by the author.
2.
A recent report
Committee concluded that:

by

the

staff of the House

Banking

Only in rare instances will the FDIC reluctantly
resolve an institution in a way that results in some of
the uninsured deposits not receiving coverage.
Any
reforms which limit the scope and amount of deposit
insurance coverage will be useless unless the
resolution policies of the FDIC are corrected.
Staff, Committee on Banking, Finance and Urban Affairs,
Regulatory
Treatment
of Uninsured
Deposits
in Failed
Institutions. September 25, 1990 ^ n Committee on Banking,
Finance, and Urban Affairs, U.S. House of Representatives,
Deposit Insurance Reform. September 13, 19, 25 and 26, 1990, p.
337.




193

and retain the bank.
But TBTF does additional damage:
o

It is blatantly unfair to smaller banks whose larger
depositors are put at greater risk.
The Federal Reserve
Bank of San Francisco has recently documented that of the
1,086 commercial bank failures in the 1980s, 225 involved
losses to depositors. Of these banks, 210, or 93 percent,
had deposits of less than 100 million.3

o

It creates uncertainty about which banks regulators will
consider too big to fail at which times and thereby increase
the cost of capital to the banking industry.

o

By increasing potential bank losses to the FDIC, it
increases bank insurance premiums and thereby bank costs.

o

It encourages bank management to place growth above earnings
in its objectives.

o

By permitting "bad" near insolvent and even insolvent
"zombie" institutions to continue to operate, it increases
the cost of living for "good" banks by bidding up deposit
rates and undercutting loan rates. One need only recall the
recent Texas and New England deposit premiums of more than
100 basis points.

o

Because the larger losses may require taxpayer assistance,
it is accompanied by greater government intervention and
regulation than otherwise.
Why, in light of all of these adverse implications, do most

regulators

support

continued

TBTF?

There

are

a

number

of

3. Kenneth H. Bacon, "Banking-Reform Proposals Are Already
Rattling The System and Making Credit Crunch Worse", Wall Street
Journal. April 16, 1991, p. A16. These data also indicate that
TBTF has been effectively broadened to cover most banks, at least
in terms of the FDIC not having uninsured depositors share in its
losses. The staff of the House Banking Committee found that in
1990 as of August 8, "the FDIC has resolved 110 of the 115 bank
failures by way of a P&A sale, which has resulted in billions of
dollars of uninsured deposits receiving insured treatment".
Staff, p. 342.




194
4
o

Pressure from the insolvent institutions - - shareholders,
managers, employees, and larger borrowers, who prefer to
delay repayment - - to delay resolution.

o

Pressure from Congress responding to the same parties as
above, who are important constituents.

o

Fear of spillover of bank failures to other banks, the
financial sector as a whole and the macroeconomy.

o

Fear of a reduction in money and credit to the community.

o

Fear of a breakdown in the payments system from defaults in
clearing.

o

Fear of receiving a public blackmark on their record for
failing to maintain bank safety and fear that the public
and Congress may shoot the messenger of bad news. Thus,
regulators prefer to delay public recognition of failures in
hope that conditions will reverse or, if not, that it
occurs on their successors' watches.

o

Fear of antagonizing future potential employers. Similar to
the well publicized "revolving door" in the Defense
Department, many employees of the bank regulatory agencies
join banks and related firms after their tenure at the
agency.

o

Fear of loss of discretion, which enhances the visibility,
power and "fun" of the regulatory job.
These justifications do not hold up to scrutiny.

A primary

purpose of creating "independent" bank regulatory agencies was to
insulate them from industry and political pressures.

Because

TBTF permits regulatory discretion, it weakens this protection.
The

fears

of

spillover

damage

from

not making

depositors whole are greatly exaggerated.

all

uninsured

Before the FDIC era,

bank failures were relatively rare up to the 1920s and the cost
to depositors small.

Between 1865 and 1920, the bank failure

rate

of

was

below

that

nonbanks

and

failures during the 1920s was almost
smallest banks.

the

sharp

increase

in

entirely among the very

Losses to depositors at insolvent institutions




195
5
from 1865 through 1933 averaged on by 0.20 percent of total bank
deposits annually and were less than 1.0 percent annually even in
crisis

years

such

as

1929-1933.

A

study published

in

1931

reported that losses to depositors at insolvent banks only were
less than losses suffered by bondholders of nonbank firms.4

Such

losses did not create serious harm then nor will they now.
Spillover or contagion to other firms occurs for all firms
and products when losses or damage of any kind occur.

Thus, all

headache products are temporarily boycotted by Tylenol scares and
all

airlines

contagion

is

by

plane

that

it

crashes.
may

result

What
in

differentiates

a

nationwide

bank

multiple

reduction in money and credit that would adversely affect both
the financial condition of otherwise healthy banks in greatly
different

geographic

and

product

activity across-the-board.

areas

and

national

This is a scary prospect.

business
But both

theory and history show that this is highly unlikely to happen
and, when it may have occurred in U.S. history, it was more the
fault of poor discretionary policy by the bank regulators, such
as by the Federal Reserve in the 1930s, than that of the market
place.
Depositor runs are viewed as the germs that spread contagion
from sick to healthy banks.

But evidence suggests that healthy,

4.
George G. Kaufman, "Banking Risk in Historical
Perspective", in George G. Kaufman, ed., Research in Financial
Services. (Greenwich, CT.:
JAI Press, 1989), pp. 151-164 and
George J. Benston, Robert A. Eisenbeis, Paul M. Horvitz, Edward
J. Kane and George G. Kaufman, Perspectives on Safe and Sound
Banking (Cambridge, MA.: MIT Press, 1986).




196
>6
economically solvent banks are generally able to withstand such
runs.

A study by the Comptroller of the Currency in 1938 of all

national bank failures from 1865 through 1936 reported that runs
were the primary cause of less than 15 percent of the 3,000
failures and accounted

failure identified.5

causes of
banks

for less than 10 percent of the 4,500

and

the

widespread.
economically

1929-33
Runs

And this includes the larger

period,

appear

to

when
have

bank

runs

occurred

were

most

primarily

on

insolvent banks and were the result and not the

cause of the insolvency.

This is not much different than the

runs we have observed more recently on the economically insolvent
Continental
England.
market

Bank, the large Texas banks and the Bank of New

Indeed, the threat of a run is a powerful force of
discipline

that

has

over

the

years

before

deposit

insurance made banks less risky and depositor fears and runs less
necessary.6
Nor
credit.
safe

did bank runs

cause national

declines

in money

and

Most runs resulted in redeposits at banks considered

either directly

by the fleeing depositors

or

indirectly

after the purchase of Treasury securities by the depositors and
deposit

of

the

proceeds

by

the

seller.

Total

reserves

or

deposits (money) in the banking system did not change, although
5. J.F.T. O'Connor, The Banking Crisis and Recovery Under
th9 RQQgevelt Administration. (Chicago: Callaghan, 1938), p. 90.
6
George 6. Kaufman, "The Truth About Bank Runs" in
Catherine England and Thomas Huertas, eds., The Financial
Services Revolution (Boston: Kluwer, 1987), pp. 9-40.




197
7
they were
caused

redistributed

temporary

among

the banks and this

dislocations.

Only

when

the

undoubtedly
depositors

considered no bank in the country, or for that matter overseas,
as safe and held the withdrawn funds as currency did aggregate
money

and

credit

decline.

Under

such

conditions,

runs

on

individual banks or groups of banks turn into runs on the banking
system.
But serious runs to currency and a large number of bank
failures have occurred in only two periods in U.S. history, 1893
and 1929-33.

And even in these periods, the evidence suggests

that the runs resulted from problems in the economy feeding back
on the banks at least as often as bank runs ignited problems
elsewhere.

Moreover, with credible deposit insurance in force

up to $100,000, small depositors, who are the only parties that
can conduct business in currency and will run into currency, have
no incentive to do so.
viable concern today.

Thus, nationwide systemic risk is not a
No serious ill spillover effects occurred

from the runs on the Continental Bank in 1983-84, the large Texas
banks in 1987-89 and the Bank of New England in 1990-91, despite
the uncertainties in the markets from the uncertainty about the
regulators1
effects

closure rule.

would

have

In addition, no additional

occurred

had

any

of

these

adverse

failures

been

handled without TBTF by the regulators and losses to the FDIC
would have been less.7

The runs by uninsured depositors were to

7.
George 6. Kaufman, "Are Some Banks Too Large To Fail?
Myth and Reality", Contemporary Policy Issues. October 1990, pp.
1-14; George G. Kaufman, "Too Big To Fail Has Failed Big", Biline




198
8
safe banks not to currency.

8

When a bank, even a large one, fails it does not leave a
hole in the ground.

The bank is typically sold or merged and,

even in the rare case when it is liquidated, other banks will
enter the market area if there is sufficient demand for banking
services.

Indeed,

it

is

ironic

that

there

is concern

over

reductions in credit to a community from a bank failure at the
same

time

viability
decline

that
of

in

there

the
market

institutions.

also

banking
share

is

concern

industry
and

in

over

light

inroads

by

the
of

continued

its

nonbank

secular
financial

Banks are no longer a unique source of credit and

the failure of a bank is unlikely to cause greater, costlier or
more lasting dislocations than the failure of any other credit
supplier of similar size serving the same market.
Defaults

by

insolvent

banks

will

interfere

with

the

efficient operation of the payments mechanism and cause problems
for third parties.
methods

of

But there are more efficient and less costly

preventing

liabilities of banks.

such

losses

than

guaranteeing

all

Indeed, both the clearing houses and the

Federal Reserve are limiting daylight overdrafts, which are the
(Chicago Clearing House Association), 1, 1991, pp. 1-3; and
George J. Benston, et. al., Chapter 2.
For example, despite
stated fears by the regulators at the time of the Continental
Bank in 1984, no adverse effects occurred when the FDIC
ultimately stopped making all creditors of insolvent BHCs whole
in 1986 and started legally failing insolvent banks in 1987.
8. In the 1980s, there was also a new and different kind of
run from good banks to bad banks, which offered higher deposit
rate on fully insured, safe deposits.




199
9
clearing

only

with

good

funds

so

no

overdrafts

occur

and

preclearing netting.
The best way to guarantee that systemic risk will not occur
is to adopt a structure of deposit insurance that minimizes the
probability

of bank failures with large losses to depositors.

Such a structure is incorporated to varying degrees in a number
of bills currently being considered by Congress, including the
Gonzalez Bill

(HR 6) and the Riegle Bill (S 543).

Basically,

this structure centers on higher capital ratio that would prevail
in the

absence

mandatory

of deposit

intervention

condition

begins

to

by

insurance, early discretionary
regulators

when a bank's

deteriorate

to

and

financial

discourage

further

deterioration and mandatory recapitalization by existing or new
shareholders at some point before the bank's capital has been
fully depleted.9
Resolution by recapitalization needs to be mandatory both to
protect

the

regulators

from

pressures

to

forbear

and

accept

larger losses and to produce greater certainty in the market.
bank would

be

too

large or too

special

to avoid

No

regulatory

intervention and eventual recapitalization before losses accrue
to

depositors.

Losses

would

be

restricted

to

shareholders.

There is little of any downside risk to such a system.

The cost

to the economy of requiring recapitalization too soon is vastly
9. Shadow Financial Regulatory Committee, "An Outline of a
Program for Deposit Insurance and Regulatory Reform", February
13, 1989 and George J. Benston and George G. Kaufman, Risk and
Solvency Regulation of Depository Institutions
(New York:
Salomon Brothers Center, New York University, 1988).




200
10
less than requiring

it too late.

The failure to provide for

regulator protection and close the TBTF loophole is the major
weakness of the deposit insurance reform section of the Treasury
proposal.

As long as TBTF persists, the U.S. banking system will

be riskier and less stable than otherwise.
It is sometimes argued that TBTF is necessary in the United
States because all other major countries pursue such a policy
either explicitly or implicitly.

But a recent GAO study suggests

that this generalization may not be totally true. 10
it were,

if other

countries

wish

to

subsidize

But even if

their

banking

industry or agriculture industry or any other sector it does not
follow that the U.S. need to follow automatically.

Moreover, to

the extent that TBTF weakens U.S. banks by encouraging them to
operate at a higher risk level than otherwise, U.S. banks are
likely to lose large international deposits to better capitalized
banks in other countries.

There is no evidence that TBTF helps

international competitiveness, but there is clear evidence that
bank profitability and prudential capitalization does.
Continuation of TBTF is a battle between bank regulators on
the one side and bankers and taxpayers on the other.

There is

hardly another issue today on which bankers are as united as on
the

need

to

associations

end

TBTF.

polled

by

Only

one

of the

the American

11

financial

Banker believed

trade

that

the

Treasury's TBTF proposal went far enough in avoiding bailouts and
10.
Overview
1991).

U.S. General Accounting Office, Deposit Insurance:
of Six Foreign Systems (Washington, D.C.: February




201

n
two associations did not take a position. 11
the

New

York

and

Chicago

Clearing

House

The members of both
Associations,

which

comprise the banks most directly favored by the current policy,
have recommended its discontinuance, as have the CEOs of a crosssection of Chicago-area banks. 12

To them, the benefits are less

than the costs.
It would be difficult to believe after the S&L debacle that
taxpayers do not

feel the same way. • TBTF

preserve to please the regulators.

is too costly to

Even if their worst fears

came to pass, as is now almost impossible without a major policy
error on their part, it is difficult to imagine that the costs
incurred would come close to exceeding the $200 billion present
value cost of the S&L rescue and any additional potential costs
of further problems in the commercial banking industry under the
current

regulatory

regime.

concerns and end TBTF.

It

is

time

to

heed

taxpayers'

The cost-benefit tradeoffs are clear.

11.
Robert M. Garsson and James M. Pethokoukis, "Trade
Group Rift May Stall Reform Bill", American Banker, March 1,
1991, pp. 1, 8, 9.
12.
Chicago Clearing House Association, "Chicago Bankers
Oppose Too Big To Fail", Press Release. April 26, 1991.




202
TESTIMONY OF

HOWARD L. WRIGHT
DIRECTOR OF REGULATORY MATTERS
OFFICE OF FINANCIAL MARKETS OF ARTHUR ANDERSEN & CO.
AND MEMBER OF
THE COMMITTEE FOR RESPONSIBLE FINANCIAL REFORM

ON

ELIMINATION OF MTOO-BIG-TO-FAILM

BEFORE THE

SUBCOMMITTEE ON ECONOMIC STABILIZATION
OF THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
U.S. HOUSE OF REPRESENTATIVES

10:00 A.M.
THURSDAY, MAY 9, 1991
ROOM 2222, RAYBURN HOUSE OFFICE BUILDING




203
Good afternoon, Mr. Chairman and members of the Subcommittee,
I appreciate the opportunity to share the views of the Committee
for Responsible Financial Reform1 (the "Committee") regarding "toobig-to-fail" and how this
reform.

issue relates to deposit

insurance

Clearly, "too-big-to-fail" is the linchpin in the deposit

insurance reform equation; its elimination, to the extent possible,
should be the critical centerpiece of any deposit insurance reform
proposal adopted by the Congress.

We have reviewed the study submitted to the Congress by the
Secretary of the Treasury and find it to be a thoughtful, comprehensive report that deserves the full attention of the Congress.
Meaningful reform of the nation's banking and financial system is

1
The Committee for Responsible Financial Reform consists of
ten individuals who are prominent in financial circles.
The
Committee was formally organized on February 4, 1991 to support
efforts to achieve comprehensive and meaningful reform of the
banking and financial system in 1991, with such reform directed at
the broad public interest rather than that of any industry group.

The Committee is chaired by Frederick H. Schultz, former Vice
Chairman of the Federal Reserve Board. Donald P. Jacobs, Dean of
the J.L. Kellogg Graduate School of Management at Northwestern
University, serves as Vice Chairman.
Other members of the
Committee are: Richard P. Cooley, retired CEO of Seafirst Bank; W.
Peter Cooke, Chairman, World Regulatory Advisory Practice, Price
Waterhouse, formerly Head of Banking Supervision at the Bank of
England and Chairman of the Basle Committee of Banking Supervisors;
Maurice R. Greenberg, CEO of the American International Group,
Inc.; William M. Isaac, CEO of The Secura Group and former Chairman
of the FDIC; James D. Robinson, III, Chairman of the American
Express Company; Gary H. Stern, President of the Federal Reserve
Bank of Minneapolis; Thomas I. Storrs, retired Chairman of the
Board of NCNB Corporation; and Howard L. Wright, Director of
Regulatory Matters, Office of Financial Markets of Arthur Andersen
& Co.




204
- 2 needed, not only in the interest of financial institutions but
also, and much more important, in the interest of the public.

While agreeing with the basic thrust and major recommendations
of the Treasury Report, the Committee finds that the Report falls
short in failing to recommend fundamental reform of the deposit
insurance system.

It is essential that the market be restored as

an important regulator of banking and this can be accomplished only
by requiring that depositors share with government the cost of bank
failure.

The present policy of "too-big-to-fail" is inequitable

and costly, and must be eliminated.

The Report's failure to recommend fundamental insurance reform
and an enhanced role for market discipline compels it to rely too
heavily on extensive and potentially stifling government regulation.

Moreover,

it forecloses the possibility of

substantial

future reductions in the cost of insurance to banks and to the
public.

Clearly, market discipline can be restored

only when the

market is convinced that all banks can fail and, more important,
that

failure

will

imply

losses

for

uninsured

and

unsecured

depositors and creditors.

The Committee is fully aware that the

prospect

"too-big-to-fail"

of

eliminating

concerns in the minds of many.




raises

substantial

205
- 3 Some perceive that without "too-big-to-fail" the temporary
inaccessibility of funds in accounts over $100,000 could disrupt
the payments system, money supply, and market liquidity.

These

difficulties may be mitigated by changing the structure of the
deposit insurance system.

It is important to note that "too-big-

to-fail" and the structure of deposit insurance cannot be separated.

Further, it is generally agreed that the elimination of "toobig-too-fail" would represent a major change for many banks and
their depositors and creditors.

Accordingly, deposit insurance

reform along the lines we suggest should be enacted with a delayed
effective date of at least three years after the adoption of the
legislation.

An insurance system, for example, that covered fully transaction accounts and 90 percent or so of interest-bearing liabilities
over $100,000 would mitigate the concerns associated with "too-bigto-fail."

Liabilities up to $100,000, of course, would be fully

covered and subordinated debt would remain completely uncovered.
Such a system

of deposit

insurance would

fully protect

small

depositors and assure the functioning of the payments system.
would

introduce market discipline for banks by exposing

interest-bearing accounts to a degree of risk of loss.




It

large

206
- 4 This approach would curtail insurance coverage only slightly
from its current de facto level of 100 percent in larger banks. It
is precisely this modest reduction in coverage that will allow for
the elimination of "too-big-to-fail."

We see several advantages to the "haircut" approach with
respect to large, interest-bearing accounts.
to

allow

depositors

earning

rates

well

It is irresponsible

above

those

paid

by

conservative, well-managed institutions to escape risk under the
government guarantee umbrella. Under this proposal depositors will
tend to be more prudent in selecting an institution.

Those in the

"fast lane" will have their "radar detectors" on to avoid the speed
traps.

It is unfair to the sound institutions that are forced to bear
the burden of high deposit insurance premiums and the public at
large who, as taxpayers, act as a backstop to the deposit insurance
funds.

Weak institutions, prone to pay higher rates for deposits,

will find it more difficult to attract depositors. Thus, obtaining
funds to adopt a "bet-the-bank" strategy will be more difficult.

Elimination of "too-big-to-fail" will reduce substantially the
costs of the Bank Insurance Fund ("BIF").

The BIF's expenses will

be reduced considerably because a portion of the costs of all
failures will be shared by those with interest-bearing accounts
over $100,000, and the market discipline created will reduce future




207
- 5 costs by

limiting the growth of weak and risky

institutions.

Importantly, this system will eliminate the inequity between large
and small banks inherent in the "too-big-to-fail" policy.

As you can see, the Committee thinks it is possible to reform
the deposit insurance system to mitigate the most serious systemic
concerns associated with a large bank failure.
remains

whether

there

are

any

circumstances

The question

under

which

the

government must intervene to prevent losses to all depositors and
general creditors.

It is difficult to imagine a situation where

this would be the case, but should it arise the question has no
relevance to deposit insurance reform.

A government's right to

intervene

threatens

interest

whenever

a business

failure

is absolute, whether that business

industrial concern.

the

national

is a bank or an

Should the government decide to intervene in

the case of a bank, the decision, the form and nature of assistance, and the cost should be handled outside the deposit insurance
system.

Mr. Chairman, this concludes my testimony.
to answer any questions you may have.

Attachment




I would be pleased

208
March 15, 1991

Background Memorandum
Statement on the Treasury Report by the
Committee for Responsible Financial Reform

In a statement on the study and report of the Treasury
Department (Modernizing the Financial System: Recommendations
lor. Safer, , More Competitive Banks) , the
Committee
for
Responsible Financial Reform compliments the Secretary of the
Treasury for the thrust and scope of the Report and pledges
its full support for the accomplishment of meaningful reform
of the banking and financial industry. The Committee endorses
the approach and many of the recommendations of the Treasury
Report, but takes serious exception to the absence
of
sufficient recommendations to accomplish needed reform of the
deposit insurance system
itself.
The
Committee
also
identifies the three elements of a reform package that it
believes to be of primary importance.
This
background
memorandum provides additional information on the Committee's
conclusions.
Deposit Insurance Reform
The Committee recommends that:
No uninsured balance in an interest-bearing account, of
whatever description and regardless of size of bank,
should be accorded full coverage in the event of a bank
failure.
However, all noninterest-bearing deposit
accounts should be fully covered in the event of a bank
failure.
Discussion of recommendation.
While the Committee
agrees completely with the objective of narrowing the scope of
deposit insurance, it does not believe that the Treasury
Report goes far enough in this direction.
The
Report
recommends, for example, that the number of fully insured
accounts that would henceforth be available to any individual
depositor in any bank be significantly restricted.
The




209
- 2 -

Committee believes that this is a desirable
little to enhance market discipline.

step

but

does

The Treasury Report also recommends that an additional
cost test be met by the FDIC before it may conclude that a
purchase and assumption transaction is the most cost efficient
way of proceeding in resolving a failing bank situation, and
it would require that in cases involving systemic risk
problems the Federal Reserve Board and the Treasury make a
determination that protection of all depositors by the FDIC is
necessary. While these recommendations clearly head in the
right direction, the Committee does not believe that if
implemented they would accomplish meaningful reform of the
deposit insurance system.
In the unanimous view of the Committee, it is essential
that market discipline play an important role
in
the
regulation of banks and thus reduce future demands on the BIF.
That discipline has been significantly eroded during the past
several decades because of the policies and procedures that
have been developed by the FDIC in resolving failing bank
cases.
As the Treasury Report points out (p.7), from 1985
through 1990, "over 99 percent of uninsured deposits have been
fully protected in bank failures." It is the Committee's view
that effective reform of deposit insurance and the restoration
of market discipline can be obtained only through providing,
unequivocally, that regardless of the type of transaction
adopted by the FDIC to resolve a failing bank situation, the
uninsured portion of deposits must share the cost with the
government.
The Committee is particularly concerned that the policy
best known as "too-big-to-fail" will remain alive if the
reforms recommended by the Treasury are adopted. To be sure,
it is the intention of the authors of the Treasury Report that
the exercise of this power be made more difficult. More is
necessary; it must be made impossible. And more than market
discipline is involved here, important as that discipline is.
The policy is grossly inequitable, discriminating
among
depositors in terms of the particular institutions with which
they decide to do business.
It should be abandoned.
The
disparate treatment of the depositors of Bank of New England
and Freedom National Bank of New York is a prime example of
this inequity.
It is the Committee's impression that one reason for
the failure of the Treasury recommendations to go as far as
would
be
desirable
is
concern
over payments system
implications. That is, the failure in certain instances to
w
apply too-big-to-fail" procedures would constitute a threat
to the money supply and pose potential liquidity disruptions




210
- 3 -

resulting from the temporary inaccessibility of funds in
accounts with balances over $100,000. While the Committee is
not entirely convinced that the payments system problems
cannot be dealt with in other
ways,
nonetheless
its
recommendation
mitigates that problem since noninterestbearing deposits (i.e., checking accounts) would be fully
covered.
However, in no circumstance would interest-bearing
accounts with balances in excess of the insurance maximum be
fully protected.
This would constitute a significant change
in present insurance coverage.
Illustrative proposal. While the Committee has not
endorsed the specifics of a deposit insurance reform proposal,
an illustration may be useful for discussion purposes. Such a
proposal may be outlined as follows:
All noninterest-bearing transaction accounts would be
fully
insured.
Interest-bearing
accounts
(both
transaction and nontransaction) would be fully insured
up to a maximum of $100,000 per account holder; in
addition, 90 percent of amounts over this limit would
be covered. This policy would apply to all insured
depository institutions without exception.
While a 10 percent "haircut" for all interest-bearing
balances above $100,000 is probably appropriate, a lower
percentage might be more desirable.
Over time, and after
study, a "haircut" of more than 10 percent might also be
feasible.
It should be noted that this illustration extends
insurance coverage to all interest-bearing accounts (except
those subordinated to general creditor status). This includes
non-deposit accounts such as federal funds and
foreign
deposits, accounts not technically covered under the current
system. While this will be viewed by some as an expansion in
insurance coverage, the opposite is the case. Elimination of
"too-big-to-fail" will reduce substantially the costs of the
BIF. Not only will the BIF's expenses be reduced considerably
because a portion of the costs of all failures will be shared
by
those
with accounts over $100,000, but the market
discipline created will reduce future costs by limiting the
growth of weak and risky institutions.
If such an approach were to be considered, an expansion
of the assessment base for insurance purposes should also be
considered.
The current assessment base of total domestic
deposits bears no relationship to the liability base that




211
- 4 -

receives
full de facto coverage under present
especially with regard to large institutions.

policies,

The implementation of such a plan would represent a
major
change
for many banks and their depositors and
creditors. Accordingly, a reform along these lines should be
enacted with a delayed effective date of at least three years
after the adoption of the legislation.
Multi-Office Pankjng
The Committee recommends that:
Federal statutes now restricting the ability of banks
and bank holding companies to expand geographically
(the McFadden Act and the Douglas Amendment) should be
amended or repealed, as recommended by the Treasury.
The Treasury Report recommends that full nationwide
banking on a holding company basis become available at the end
of three years. It further recommends that the provisions of
the McFadden Act which prohibit national banks from branching
on an interstate basis be repealed, such that national banks
may branch within the geographic areas in which interstate
banking can be conducted. This means, of course, that after
three years branching could be conducted nationwide.
The
Committee heartily endorses these recommendations.
The rationale offered in the Treasury Report for its
multi-office banking recommendations is sound and need not be
repeated here.
The Committee simply endorses the view that
there is an urgent necessity to modernize banking laws and
that the recommendations relating to multi-office banking will
take a long step toward assuring a more competitive and a more
efficient
banking
system,
with substantially increased
benefits to the users of banking services.
Financial Services Holding Companies
The Committee recommends that:
Financial services holding companies be authorized and
empowered to engage in an appropriate variety of
financial activities, including banking; and
nonfinancial firms be allowed initially to own up to 25
percent of such companies, which limit Congress should




212
- 5 -

review and consider
has been gained.

increasing after some experience

The creation of financial services holding companies
(FSHCs) as recommended in the Treasury Report is a useful way
to encourage diversity in the banking system.
Banking
organizations
house
the expertise to provide financial
services that are closely related to banking which they are
currently prohibited from offering.
The creation of FSHCs
could be helpful if the future health of the banking system is
to be maintained.
It has been well recognized, as the
Treasury Report points out, that market forces have been
eroding the core franchise of many banking organizations.
There is no reason to expect that these forces will abate; it
is more likely that they will accelerate, especially if
meaningful deposit insurance reform is adopted.
The Committee fully endorses the "two way" street which
would be created with implementation of the Treasury Report
recommendations, namely that non-bank financial firms may also
affiliate with banks.
The Committee did not review each of
the specific financial activities for which affiliation with
banks would be permissible. At a later date the Committee may
comment more directly on specific activities; at this point it
believes that a broad and liberal interpretation of financial
activities is desirable.
There is a strong consensus within the Committee in
support of the recommendation in the Treasury Report that nonfinancial commercial firms be permitted to
own
FSHCs.
However, not all members of the Committee are convinced that
this reform should be fully implemented.
Moreover, the
Committee is aware of significant opposition in many quarters
to taking such a step and is concerned that this may delay the
enactment of such essential reforms as the elimination of
"too-big-to-fail" and the modernization of laws relating to
interstate banking and product diversification. Accordingly,
the Committee concluded, and so recommended, that a limited
step be taken in this direction, namely, authority for
commercial firms to own at least 20 percent of a FSHC and not
more than 25 percent. Equity ownership of 20 percent would
allow for accounting for the interest in the FSHC on the
equity method, which would be important to such investors.
It
is
the Committee's belief that even limited
investment opportunities for commercial firms will go some way
toward meeting one of the Committee's basic objectives, set
forth in its February 4, 1991 statement, namely, the "crucial
importance of providing banks improved access to capital."




213
- 6 -

The members of the Committee also believe that the way
may be open in the future for expanding the investment limits
contained in its recommendation. It suggests that Congress
require a study, due in 18 months, examining whether these
equity limitations should be expanded or eliminated.
The Committee f Q r pesponsjble Financial Refprm
The Committee for Responsible Financial Reform consists
of ten individuals who are prominent in financial circles.
The Committee was formally organized on February 4, 1991 to
support efforts to achieve comprehensive and meaningful reform
of the banking and financial system in 1991, with such reform
directed at the broad public interest rather than that of any
industry group.
The Committee is chaired by Frederick H. Schultz,
former Vice Chairman of the Federal Reserve Board. Donald P.
Jacobs, Dean of the J.L. Kellogg Graduate School of Management
at Northwestern University,
serves
as
Vice
Chairman.
Administrative and research assistance is provided by The
Secura Group, headquartered in Washington, D.C.
Members of the Committee, in addition to the Chairman
and Vice Chairman, are: Richard P. Cooley, retired Chief
Executive Officer of Seafirst Bank; W. Peter Cooke, Chairman,
World Regulatory Advisory Practice, Price Waterhouse, formerly
Head of Banking Supervision at the Bank of England and
Chairman of the Basle Committee of Banking Supervisors;
Maurice R. Greenberg, Chief Executive Officer of the American
International Group, Inc.,; William M. Isaac, Chief Executive
Officer of The Secura Group and former Chairman of the FDIC;
James D. Robinson, III, Chairman of the American Express
Company; Gary H. Stern, President of the Federal Reserve Bank
of Minneapolis; Thomas I. Storrs, retired Chairman of the
Board of NCNB Corporation; and Howard L. Wright, Director of
Regulatory Matters, Office of Financial Markets of Arthur
Andersen & Co.




214

CHICAGO CLEARING HOUSE ASSOCIATION
Organized March 3 , 1865

•K: -—

~NEWS RELEASE

President

230 So. LaSalle St.

Apr i 1 26,

1991

Contact:

Thomas C. Tucker
312-408-2111

Suite 600

Chicago, IL60604
312.408.2110
FAX: 312.427.9352

*

U O

^

1 1 ±

CHICAGO BANKERS OPPOSE TOO BIG TO FAIL
No commercial bank should be too big to fail and Federal
Deposit Insurance coverage should, at minimum, not be increased
above the current $100,000 limit per account.
These were
conclusions reached by a group of chief executive officers of
Chicago area banks participating in a public policy conference on
deposit insurance reform sponsored by the Chicago Clearing House
Association
on April
12, 1991.
The CEOs
reached
their
conclusions at a luncheon after listening to Senator Alan Dixon
of Illinois; Silas Keehn, President of the Federal Reserve Bank
of Chicago; Thomas Theobald, CEO of the Continental Bank; James
Lancaster, Chairman of NBD Illinois, Inc.; Kenneth Skopec, CEO of
The Mid-City National Bank of Chicago and Professors Stuart
Greenbaum
(Northwestern University), Edward Kane
(Ohio State
University) and George Kaufman (Loyola University of Chicago).
Some 100 Chicagoland bankers attended the conference and 35 CEOs
of banks of all sizes attended the luncheon.
Too big to fail, or TBTF, is a policy in which regulators do
not require losses at insolvent large banks to be borne by
uninsured depositors as they often require at smaller insolvent
institutions.
TBTF has been used frequently by the FDIC in
recent years.
Although a number of speakers, including Senator
Dixon, supported regulatory discretion in continuing the TBTF
policy or believed that TBTF was too ingrained to change, the
Chicago
bankers
believed
otherwise.
In
their
opinion
continuation of TBTF would:
o

seriously undermine current efforts at effective deposit
insurance reform,

o

be unfair to smaller banks,

o

not reduce the number of bank failures or the
accompanying large dollar losses and thus not reduce
either deposit insurance premiums or the possibility
that the losses might be shared with the taxpayer,




215
CHICAGO CLEARING HOUSE ASSOCIATION

o

increase the cost of capital to banks by maintaining
uncertainty about which banks gualify as too big and
which do not,

o

justify undue government regulation and interference
in banking, and

o

delay the exit of poorly capitalized or even insolvent
banks thereby damaging well-managed banks by bidding up
deposit rates and underpricing loans.

The last phenomenon was clearly evident in the Texas and
New England deposit rate premiums of recent years brought about
by zombie banks and savings and loan associations in these
areas. The bank executives believed that TBTF is too costly to
both banks and taxpayers to continue and urged policy makers to
end its use. Uninsured depositors at all insolvent banks should
be treated equally.
The bank CEOs were in less agreement about the precise limits
of deposit insurance coverage.
None favored increasing the
amount of coverage. Some CEOs believed that coverage should be
reduced both in dollar amount and in number of accounts per
depositor in order to increase market discipline on banks.
Others supported the proposal by the Treasury Department to
effectively limit insurance to $100,000 per depositor per bank
and still others preferred to maintain the existing $100,000
multiple account coverage.
It was felt by some CEOs that the
coverage issue would become less important if no bank was
considered too big to fail, and if a system of early regulatory
intervention and recapitalization of weak banks before their net
worth was depleted was adopted.
If successful, such a system
would effectively limit losses to only bank shareholders.




-2-

216
Oral statement by Bert Ely
to the
Economic Stabilization Subcommittee
May 9, 1991
ABANDONING TOO-BIG-TO-FAIL:

THE IMPOSSIBLE DREAM

Mr. Chairman and members of the Subcommittee, I want to
thank you for inviting me to testify this morning about one of the
most difficult and important issues in deposit insurance today:
The too-big-to-fail (TBTF) policy.
Enormous and very sincere effort has been devoted in recent
months by the Administration and the Congress to determine how to
convincingly abandon this policy.v But Mr. Chairman, the title of
my testimony says it all: Abandoning TBTF is an impossible dream.
I will devote the rest of my time" this morning to explaining why.
Abandoning the TBTF policy is premised on the idea that
deposit insurance reform requires more depositor discipline. Put
another way, the feeling of many 4fe that federal deposit insurance
cannot be reformed unless more depositor discipline is injected
into the banking business. I reject this premise.
Depositor discipline represents the third-best source of
banking discipline; stockholders represent the best source of
discipline and regulators are a distant second. Worse, depositor
discipline can quickly become counter-productive and even
dangerous if relied upon too much. Depositor discipline is like a
fragile bridge that cannot carry too much traffic — Overload it
and it will quickly collapse.
Depositor discipline is dangerous because depositors are
very risk adverse with regard to their bank and thrift deposits.
Worse, they can quickly withdraw their deposits if they fear they
will lose any portion of their money. And this brings us to the
central reason why a strict no-TBTF policy will never work: No
matter how fast the regulators move to close a troubled
institution, thereby sticking its uninsured depositors with a
loss, the more sophisticated depositors will run even faster.
Only the least sophisticated will suffer a loss. However,
they will garner the greatest political sympathy.
Freedom
National is just the latest failure that teaches that lesson.
Faster, more dramatic runs will be bad for two reasons. First, a
depositor run on a troubled bank greatly increases the probability
that the bank will fail. A faster run also will increase the loss
the BIF will suffer when it disposes of the bankrupt institution.
Second, more frequent runs on troubled banks will increase the
potential for contagious runs, bv both insured and uninsured
depositors, on institutions who need not fail at a loss to the
BIF.
As irrational as it may seem, insured depositors have very
rational reasons for withdrawing their deposits from a bank they
fear may be closed. As one woman said on Monday when pulling her
insured deposit from the troubled Madison National Bank here in
Washington: "I just don't want the hassle if the bank fails ... I
know my money is insured, but that's only part of the concern."




217
- 2 -

Madison had $382 million in deposits at the end of last
year. As of last June 30, it had 47,000 deposit accounts and $74
million of uninsured deposits, an amount which undoubtedly is
lower today. Clearly Madison is small enough to be liquidated.
But, imagine liquidating a bank with $10 billion in deposits and
one million deposit accounts! Now we are talking about the
reality of abandoning TBTF.
And this is why abandoning TBTF is an impossible dream, for
when this dream clashes with the realities of cost and complexity
and the risk and danger of bank runs, reality will win out. Those
regulators who have their finger on the trigger will blink, when
the tough decisions have to be made, and TBTF will win out again.
Just yesterday, former triggerman Paul Volcker declared that TBTF
cannot be abandoned. He spoke the truth about TBTF.
Deposit insurance must be reformed and more discipline must
be injected into banking. But, reform must be premised on
strengthening the first line of defense, stockholder discipline.
Tougher regulation cannot do the job because technology is rapidly
and irreversibly destroying the efficacy of all forms of financial
services regulation. That is why Congress has ho choice
eventually but to strengthen stockholder discipline over banking
so there no longer is a need to rely on increasingly ineffective
regulatory discipline and the potentially dangerous and
destructive depositor discipline.
Unfortunately, today stockholder discipline in banking has
one major structural flaw: Once a bank, which is after all a
limited-liability corporation, exhausts all of its own
on-balance-sheet equity capital, any additional insolvency losses
have to be borne by uninsured depositors and taxpayers; that is,
healthy banks who increasingly are overcharged for their deposit
insurance. Neither party is a desirable bearer of loss.
I have good news, though — this structural flaw can be
fixed quite easily. The fix — always keep someone's stockholder
capital at risk in every single bank, no matter how strong or weak
it is. This means that when a bank exhausts its own capital, and
therefore fails, any additional insolvency loss will be borne by
stockholder capital invested in other banks.
One way to tap capital within the banking system to absorb
bank insolvency losses is the 100% cross-guarantee concept. This
concept is described in Attachment A to my written testimony.
Essentially, cross-guarantees would utilize the enormous earning
power and equity capital of the banking system to construct a
solvency safety net under every single bank and thrift in this
country. No longer would the Congress have to fear that taxpayers
will pay for deposit insurance losses, a fear that came true in
the S&L crisis, and no longer would TBTF be an unsolvable dilemma.
Move to cross-guarantees and the TBTF issue becomes moot.
Thank you.

I welcome your questions.




218

TESTIMONY BY BERT ELY

to the
SUBCOMMITTEE ON ECONOMIC STABILIZATION
COMMITTEE ON BANKING, FINANCE, AND URBAN AFFAIRS
UNITED STATES HOUSE OF REPRESENTATIVES

ABANDONING TOO-BIG-TO-FAIL: THE IMPOSSIBLE DREAM

May 9, 1991

Submitted by:
Bert Ely
Ely & Company, Inc.
803 Prince Street
Alexandria, Virginia 22314
703-836-4101
® 1991 Bert Ely. Permission granted to reproduce in
whole or in part, with attribution.




219
ABANDONING TOO-BIG-TO-FAIL: THE IMPOSSIBLE DREAM
by Bert Ely
Ely & Company, Inc.
Alexandria, Virginia
May 9, 1991
I - INTRODUCTION
Mr. Chairman and members of the subcommittee, I am pleased to be able to
testify today regarding the "too-big-to-fair issue (TBTF). TBTF is certainly one of the
thorniest, if not the thorniest issue in the area of deposit insurance reform. In fact, there
can be no genuine reform of federal deposit insurance until this issue is resolved
definitively and credibly. More specifically, any attempt to impose more depositor
discipline on banks will not succeed until the TBTF issue is resolved convincingly. In
effect, TBTF is the first hurdle that must be cleared in attempting to impose more
depositor discipline on banks.
However, as the title of this testimony suggests, abandoning too-big-to-fail is an
impossible dream for reasons I will present below. Further, I question the fundamental
assumption of many that banking needs more depositor discipline. I recommend instead
that deposit insurance be reformed in a manner that greatly strengthens stockholder
discipline. If stockholder capital is always voluntarily at risk when a bank fails, then
depositor discipline becomes unnecessary and TBTF becomes a moot issue.
In preparing this testimony, I have kept in mind the following questions posed to
me in Mr. Carper's letter of invitation. I hope I have addressed these questions
satisfactorily in the context of presenting this testimony. His questions were as follows:
1) What changes should or should not be made to the TBTF policy? Do the
Treasury and other major legislative proposals to reform the financial system
adequately address the TBTF issue?
2) Specifically, what systemic risk would result from depositor losses or the threat
of depositor losses at a large financial institution?
3) How does the TBTF policy affect the overall stability and competitiveness of
our banking system both domestically and internationally? To what extent does
the current policy discourage institutional and depositor discipline?
4) How does a TBTF policy affect the stability of small institutions?
5) What are the best options for preventing large bank failures?




2

220
n - TOO-BIG-TO-FAIL: THE ISSUE
What Is TBTF? TBTF really means too big to liquidate. Thus, when the TBTF
policy is invoked, all depositors in a failed bank are fully protected against any loss of
their principal, accrued interest or withdrawal rights. The deposits protected in a TBTF
situation include all deposits in foreign offices and deposits exceeding the statutory
insurance limit. In other words, it's business as usual for all depositors in a failed bank.
Some have suggested that TBTF really means some banks are "too-small-to-save."
That is, the statutory deposit insurance limit is enforced against all depositors in smaller
failed banks. This is a fair interpretation of the TBTF policy.
Only through a formal liquidation or receivership proceeding can a bank
insolvency loss be imposed on statutorily uninsured depositors and other creditors of a
1
bank. The liquidation of a bank can take one of two forms: The more extreme case,
the payoff of insured depositors, or the less extreme case, the transfer of insured
deposits to another bank. A deposit transfer has the same effect on uninsured depositors
as a depositor payoff, but it may be less costly to the deposit insurer than a payoff.
When the TBTF policy is invoked, regulators effectively have decided that it is
preferable for taxpayers to bear the bank's insolvency loss rather than uninsured
depositors or other unsecured creditors of the failed bank. The first group of taxpayers
to bear the loss are healthy banks which are overcharged for their deposit insurance. In
a worst case situation, in which bank insolvency losses become so burdensome for
healthy banks as to be damaging to the economy, the remaining bank insolvency losses
would be borne general taxpayers. This, of course, is what happened in the S&L
industry.
The Cost of TBTF. So far, banks insured by the BIF have borne the entire cost
of the TBTF policy through the deposit insurance premiums, or tax they have paid.
However, the deposit insurance tax they pay has been rising steadily as bank insolvency
losses have skyrocketed. Bank Insurance Fund (BIF) premiums will have almost tripled
in 18 months when they rise to 23 basis points on July 1. As of that date, this deposit
tax will be six times higher than it was in 1980.
Higher BIF losses have driven this tax increase. For the 1988-90 period, the
BIF's recorded bank insolvency losses have averaged $6.66 billion annually. By way of
a very stark contrast, BIF losses in the 1970-80 period, on an inflation-adjusted basis,
averaged just $45 million annually, less than one percent of the 1988-90 loss experience.
FDIC Chairman William Seidman recently testified that the TBTF policy cost
$883 million in four cases where the "essentiality" test has been invoked over the last

1
References to banks include any type of federally insured depository institution, except where the
context of the testimony limits the use of the term "bank" to BIF-insured commercial and savings banks.




3

221
five years.2 The essentiality test is the legal justification for invoking TBTF in cases
where the FDIC has estimated that the liquidation of a bank would be cheaper to the
Bank Insurance Fund (BIF) than protecting all depositors. The essentiality test permits
the broad public policy objective of systemic financial stability to override the narrower
concern of minimizing the cost of disposing of a failed bank.
Ely & Company has estimated that the TBTF policy has cost the FDIC $2-$2.5
billion, if the costs of all failed bank resolutions are distributed proportionally over
insured and uninsured deposits in these banks at the time they failed. We are gathering
additional data at this time to better estimate the cost of the TBTF policy, using this
allocated cost method.
It can be argued, though, that even this cost estimate is too low because it does
not include the hidden cost of TBTF, which is the steady substitution of insured for
uninsured deposits in a failing bank before it is closed; i.e., when it is merged or
liquidated with BIF assistance. In effect, pre-closure bank runs, which drag out over
many months or even a few years, give more sophisticated and fleeter depositors ample
time to pull their uninsured ftmds from the bank before the regulators act officially.
Often, these pre-closure runs are partially funded with discount window loans from the
Federal Reserve.
For example, the Fed lent $2 billion or more to Bank of New England (BNE)
during the height of its liquidity crisis in the Spring of 1990. This liquidity crisis was
caused largely by uninsured depositors making a mad dash for the door. Based on call
report data, two-thirds, and perhaps more, of the $7.3 billion in deposit shrinkage in
1990 in the three BNE banks represented the flight of uninsured deposits. That is, $5
billion of BNE's deposit shrinkage represented the runoff of uninsured deposits,
including a $2.9 billion shrinkage of deposits in foreign offices.
In effect, the Fed, as the nation's "lender of last resort," is a major barrier to
abandoning TBTF. This is the case because the Fed provides the wherewithal to permit
those who otherwise would be tapped for a loss to abandon a bank before losses are
imposed on the uninsured saps who are caught when the bank's doors are closed. Thus,
logic would dictate that the TBTF policy cannot be abandoned until such time as the
Fed's power to provide emergency liquidity is limited to all but the very strongest banks;
i.e., those banks where there is only a remote chance that the bank might become
insolvent.
The regulators, and especially the Fed, have engaged in recent years in a policy
of "constructive ambiguity," in deciding which banks are TBTF. In other words, they
have been very vague about who will and who will not be assisted. One senses, though,

2
Seidman testimony to the Financial Institutions Subcommittee of the House Banking Committee,
April 30, 1991, page 15. He testified that six groups of related banks met the essentially test; today,
according to an FDIC source, Chairman Seidman will testify that only four groups of related banks met this
test.


http://fraser.stlouisfed.org/
42-688 0 9 Louis
Federal Reserve Bank of -St. 1 - 8

4

222
that constructive ambiguity is nothing more than a sophisticated term for "winging it."
In effect, the regulators play it case-by-case as problems arise. While the constructive
ambiguity strategy may seem to be a way to reduce the scope of TBTF, this policy may
in fact have the opposite outcome because in specific situations, the arguments for
applying the TBTF policy far outweigh arguments to the contrary. In other words, those
who have their fingers on the trigger blink when the pressure to act bears down on
them.
Who Really Has Paid for the TBTF Policy? The deposit insurance tax
assessments that always have been levied on explicitly uninsured domestic deposits
(deposits over $100,000) would have paid for the entire cost of the TBTF policy even if
there had been no flight of uninsured depositors from troubled banks. From 1934 to
1990, the FDIC collected $6.2 billion of deposit insurance taxes on deposits reported by
banks as being uninsured. However, the total amount of deposit insurance tax collected
on uninsured deposits undoubtedly has exceeded $6.2 billion because actual uninsured
deposits are higher than reported. This is the case because banks do not reflect in the
uninsured deposit balances they report to the FDIC the aggregation rules used to
compute deposit insurance coverage in a failed bank. These rules have the effect of
reducing coverage.
For the four failed bank cases mentioned above that supposedly met the
essentiality test, the FDIC estimated that uninsured depositors would have lost $2.84
billion had the banks been closed as of the last call report date "... prior to a major news
announcement regarding the FDIC's resolution transaction for each institution."3
Adding in other major failed banks, notably Continental Illinois and Bank of New
England, it appears likely that the maximum cost of protecting uninsured depositors in
failed banks has been in the range of $5-$6 billion, slightly less than what the FDIC has
collected in the deposit insurance tax on explicitly uninsured deposits. Adding in the
time value of money resulting from the accumulation of this tax before large banks
began failing, the BIF may actually be several billion dollars ahead at this time in
protecting explicitly uninsured depositors.
Viewed from another perspective, it can reasonably be argued that the BIF
probably would have a lower fund balance today if uninsured depositors never had been
protected and if the BIF premium tax had never been levied on explicitly uninsured
deposits. Interestingly, the Canada Deposit Insurance Corporation levies its deposit
insurance tax only on explicitly insured deposits.
Depositor Discipline: An Argument in Favor of Abandoning TBTF. Reducing
deposit insurance losses is one argument given for abandoning the TBTF policy. The
real argument, though, for abandoning TBTF is to force depositors to do what
stockholders and regulators increasingly have failed to do: Force failing banks to

3
"Modernizing the Financial System," U.S. Department of the Treasury, February 1991, pg. 111-30.
The four banks were First City in Texas, FirstRepublic, MCorp, and Texas American Bancshares.




5

223
revitalize themselves or disappear through voluntary mergers or liquidations before they
become insolvent.
Stockholders absorb the first dollars of loss in a failed bank and therefore
supposedly have the greatest incentive to force corrective action in a troubled bank. As
a practical matter, though, stockholder discipline often is ineffective. Under existing
concepts of financial disclosure and corporate governance, managements of deteriorating
banks are able to stay in power far too long. Perhaps stockholders leave poor
management in place because the stockholders too easily become resigned to losing their
investment in a failing bank. The concept of limited liability for bank stockholders,
which limits their loss to their initial investment, less tax write-offs, may fuel this
resignation.
This failure of stockholder discipline raises two important questions: One, why
does stockholder discipline not work in some banks? Perhaps the flat-rate deposit
insurance premium, coupled with inherent regulatory delay, muddy the marketplace
signals that normally drive stockholder discipline. Two, is stockholder discipline weaker
in banks than in organizations with uninsured liabilities? The 100% cross-guarantee
concept described in Section VI of this testimony proposes one way to strengthen
stockholder discipline over banks.
Regulatory discipline is supposed to be the backstop to stockholder discipline.
Thus, regulatory action should force an involuntary closure or merger of a failing bank
before or at the point when the bank becomes insolvent. Prompt action by regulators
protects taxpayers and uninsured depositors against any loss. Increasingly, though, bank
regulators are unable or unwilling to close banks as they reach insolvency. Thus, each
failure of an insolvent bank raises this embarrassing question: How is the insolvency
loss not allocated to protecting insured depositors supposed to be split between taxpayers
and uninsured depositors and creditors?
The inability of regulators to close larger banks before insolvency occurs is not
limited to the United States: The closure of the Standard Trust Company (US$1.3
billion in deposits) in Canada on April 18, nine months after reports first surfaced about
its real estate problems, is perhaps the most recent example of foreign regulators asleep
at the switch. The failure in Australia last July of the Pyramid building society
(US$1.04 billion in deposits) is another example of delayed regulatory action.4
Bank Runs - Depositor Discipline That Forces Regulators to Finally Act. The
fear of bank runs is how depositor discipline really asserts itself. In effect, the fear of
runs becomes a check on regulatory moral hazard; i.e., the unwillingness of regulators
to act in a timely manner to close failing banks. In this way, the fear of bank runs
serves as an increasingly necessary but still unfortunate backup source of discipline to
regulators and stockholders. Consequently, adopting a strict no-TBTF policy and thus

4

The Economist. June 6, 1990, page 80; July 7, 1990, page 76.




6

224
attempting to impose losses on uninsured depositors and creditors represents giving up
on having effective stockholder or regulator discipline of banks.
Depositors are quick to run because they are highlyrisk-adversewith regard to
their bank deposits. Many insured bank depositors are unclear about the scope of deposit
insurance and therefore are unsure whether or not their deposits are in fact insured.
Therefore, a run from a bank rumored to be in trouble is a very rational act, from a
depositor's perspective. Better safe than sorry. Evenrisk-pronepersons who shoot
high-stake craps every weekend in Atlantic City still seek a safe haven for their bank
deposits.
There are two types of bank runs — the single shot run and the contagious run.
The most feared type of run is a virulent, contagious run on many banks, some of which
are very sound. Many innocent banks can be swept into insolvency by a contagious run.
A nationwide contagious bank run, beginning on February 14, 1933, is what escalated
into the national bank holiday President Roosevelt declared nineteen days later.
The second type of run is focused only on one or more clearly troubled
institutions. While many praise this type of run as stimulating a necessary cleansing of
the banking system; in fact, a run of any type is a highly undesirable way to rid the
banking system of weak banks. Such runs needlessly rattle insured depositors,
increasing the probability that the bank will fail, and adding to its insolvency loss. One
major challenge to eliminating the TBTF policy is developing a more efficient way for
reversing the decline of failing banks and disposing of those whose decline cannot be
reversed. The cross-guarantee proposal discussed in Section VI represents one way to
achieve this goal.
Regulators are afraid to impose losses on uninsured depositors when they are
finally forced to close a bank which they, the regulators, have let slide into insolvency.
The oft-stated reason to invoke TBTF is the fear of creating financial instability if losses
are imposed on large numbers of uninsured depositors. Financial instability means that
depositors in other banks get nervous and begin a supposedly irrational, contagious run
from the other banks. These runs are economically damaging to the other banks and
also create losses in the market value net worth of other economic actors. If broad
enough, this deflationary effect can depress real economic activity. Price deflation
depresses economic activity because borrowers suddenly feel more burdened by their
debts, and scale back their purchases and investments largely financed by debt.
There is ample evidence of the contagion effect of bank runs. Most recently, the
run in January on non-federally insured Rhode Island credit unions caused a run by
federally insured depositors on several Bank of New England (BNE) banks that forced
their closure. The run on BNE also came on the heels of a report of further losses at
BNE, reports which raised fresh doubts about BNE's survivability. The run on BNE in
turn triggered runs by insured depositors on some other banks. In March 1985, runs on
non-federally insured Ohio S&Ls triggered scattered runs by insured depositors on some
federally insured Ohio S&Ls.




7

225
Many bankers currently believe that a silent run is now underway from banks into
Treasury securities, money market mutual funds, other types of investments, and
possibly even into foreign banks. This run suggests a very pernicious contagion effect
that is harming many innocent banks. Aggregate data displayed in Chart 1 support this
assertion. The ratio of domestic deposits in banks and thrifts (excluding credit unions)
declined from 63.9% of GNP at the end of 1989 to 59.8% of GNP as of March 31 of
this year. This decline of 4.1 percentage points (about $230 billion in deposits) over 15
months is quite sharp ; the decline dropped this percentage below the 1981 deposits/GNP
percentage, when depository disintermediation was at a peak due to record high interest
rates. Expressed another way, bank and thrift deposits declined $200 million during
1990 while nominal GNP increased $238 billion.
This decline in the deposits/GNP ratio during 1990 and early 1991 cannot be
explained by interest rate controls which drove prior bouts of depository
disintermediation nor can it be fully explained by deposit shrinkage in S&Ls. Its
continuation could have seriously adverse consequences for banking and for credit
availability.
Runs at two troubled banks on Monday of this week certainly will hasten their
demise and add to BIF's eventual cost of disposing of them. According to The
Washington Post on May 7, "Jittery depositors yesterday crowded Madison National
Bank's branches in downtown Washington to withdraw their funds and query tellers
about the bank company's future." Said one depositor, "I just don't want the hassle if
the bank fails. I know my money is insured, but that's only part of the concern." The
Wall Street Journal also reported on May 7 that the announcement of large loan loss
provisions "... spurred significant withdrawals at First National Bank of Toms River
[New Jersey] by depositors yesterday."
Bank runs are properly feared, from a public policy perspective, because bank
deposits are the hazardous liabilities of a market economy. Hazardous liabilities have
one of two characteristics. One, they can be withdrawn on demand or upon very short
notice. Checkable deposits are hazardous liabilities as are certificates of deposit or other
types of time deposits that can be withdrawn before maturity.
Two, hazardous liabilities are used to fund maturity mismatching; i.e., the assets
funded by hazardous liabilities have a longer maturity or a longer time until the interest
rate is reset than does the source of funding. Because debtors, on a net basis, want to
fix an interest rate for a longer period of time than do creditors, there always will be,
within market economies, a demand for maturity mismatching. This demand will be met
by banks or by other types of organizations displaying the same financial risk
characteristics as a bank.
Like hazardous chemicals, hazardous liabilities are an inescapable element of
modern, market-driven economies, yet like hazardous chemicals, these liabilities can be
very destructive if not handled with care. There would, however, be fewer hazardous
liabilities in an economy in the absence of deposit insurance or any type of government




8




Bank and Thrift Deposits
as a Percent of GNP
72%

70%

68%

66%
CO

to
Q.
<
D
Q

|E

62% h

S
m
60% h

58%

I
1964

I
1966

1970

1972

l
1974

1976

J
_

1978

I
1980

1982

1984

J
_

19

I
1988

1990

Note This ratio is calculated as follows: Total deposits in all federally insured commercial banks, savings banks, and S&Ls
(but not credit unions) at the end of a year were divided by the average of the GNP (annualized) for the fourth quarter
of that year and the first quarter of the following year.
= first quarter 1991

227
safety net. However, attempting to minimize the quantity of hazardous liabilities within
an economy may impair the performance of that economy. Thus, the absence of any
deposit insurance is not necessarily desirable. An actuarially sound deposit insurance
system will be far more desirable because it will permit the optimal amount of hazardous
liabilities to exist within the economy while permitting the banking system to operate in a
safe-and-sound manner.
A run by the owners of hazardous liabilities (depositors) can be systemically
destabilizing in several ways. Debtors funded by hazardous liabilities (banks) are forced
to sell assets at fire sale prices, which lessens their net worth and may even drive some
banks into insolvency. Non-bank owners of comparable assets also may be driven into
insolvency because of the sudden decline in the value of their assets. These insolvencies
may cause real economic activity to contract. This risk is magnified in a rigid mark-tomarket accounting environment where net worth must immediately be reduced by market
value losses. Banks experiencing a run or a liquidity crisis also are forced to curtail
credit extensions, which can force a contraction of real economic activity.
A government lender-of-last-resort can provide liquidity to a bank experiencing a
run so as to limit the economic contraction caused by the run. However, this provision
of liquidity provides uninsured depositors with the escape hatch described above.
Although bank runs have enormous academic appeal, the real world seems much
less enamored of them. Dwyer and Gilbert, for example, document very well the
numerous steps taken repeatedly before the founding of the Federal Reserve System,
usually through local bank clearinghouse associations, to mitigate the affects of runs.5
The driving force for founding the Federal Reserve was to lessen the destructive affects
of bank runs. In effect, the formation of the Fed nationalized and also knitted together
the local, independent private bank clearinghouse function.
The bankruptcy laws are further evidence of a public policy distaste for sudden
withdrawals of credit from a troubled business. The automatic stay provision of the
Bankruptcy Code (11 U.S.C. Sec. 362) effectively prevents a run by creditors on a
company that has filed for protection under the bankruptcy laws.
A Very Real Argument in Favor of a TBTF Policy: Avoiding the Wrath of
Depositors. A seldom stated but very real reason that TBTF is invoked is to avoid the
concentrated wrath of uninsured depositors who might otherwise suffer losses. A
handful of depositors who suffer material losses will raise much more intense political
hell with regulators than will the banking industry (which bears the first dollars of loss
when uninsured depositors are protected) or the general taxpayer in a more severe
situation.

5
Dwyer, Gerald P., Jr., and R. Alton Gilbert, "Bank Runs and Private Remedies," Bulletin of the
Federal Reserve Bank of St. Louis, May/June 1989, pp. 43-61.




9

228
The imposition of losses on depositors in the failed Freedom National Bank of
Harlem is one recent incident where political scorn is dumped on regulators when they
do not invoke TBTF. This scorn raises embarrassing questions about why the regulators
failed to act earlier to save the bank or to close the bank before it became insolvent.
Worse, the losses after closure finally occurs are suffered by less sophisticated
depositors who garner the greatest political sympathy. More sophisticated and watchful
depositors, of course, escape any loss because they withdraw their uninsured deposits
before the regulators act.
In effect, abandoning the TBTF policy is premised on the idea that regulators will
sneak up on a troubled bank, close it, and thereby impose losses on its least
sophisticated depositors; i.e., those who were not smart enough to withdraw their
uninsured deposits before the bank was closed.
Yet Another Argument in Favor of a TBTF policy: Avoiding Regulatory
Accountability. Another reason regulators invoke TBTF is to avoid accountability for a
decision to close a bank if that closure subsequently creates systemic instability or a
painful political backlash. The regulators who actually decide to close a bank are very
reluctant to take the political heat for closing a bank if that closure would create
economic distress or a political uproar. A regulator does not want to go down in history
- as having triggered the collapse of the Western world if his or her decision to not invoke
TBTF creates a financial panic.
FDIC Chairman Seidman expressed this sentiment very succinctly when he stated
in 1988: "The bottom line [re TBTF] is that nobody really knows what might happen if
a major bank were allowed to default, and the opportunity to find out is not one likely to
be appealing to those in authority or to the public."6 The strongest support for
abandoning TBTF comes from those who will not have to pull the trigger.
It is the fear of both systemic instability and political wrath that causes regulators
to delay closing a large, insolvent bank until such time as most uninsured depositors can
beat it out the door. In effect, then, a TBTF policy greatly diffuses unhappiness over
regulatory actions.
In addition to the deposit shrinkage in BNE discussed above, substantial deposit
shrinkage, before closure, also occurred in other large failed banks, notably
FirstRepublic and Continental Illinois. In the latter case, the Fed in 1984 provided a
peak of $7.6 billion in emergency liquidity as Continental deposits plunged from $29.4
billion to $17.5 billion in the second quarter of 1984 and to $15.1 billion by the end of
1984.
It apparently was a stated policy of the Federal Home Loan Bank Board and more
recently is a policy of the Resolution Trust Corporation (RTC) to actively work to

6

Remarks by Chairman Seidman to the Garn Institute Deposit Insurance Forum, November 14,

1988.




10

229
reduce uninsured deposits in insolvent S&Ls before they are closed. The staff of the
House Banking Committee provided explicit detail to the committee just last year about
this policy.7 In effect, delayed closure of a failing or insolvent bank is a.backdoor way
of implementing a TBTF policy.
The practice of squeezing uninsured deposits out of a troubled bank is not limited
to the U.S. The same thing happened at Canada's Standard Trust Co. According to one
news account, "The regulators had been discouraging the trust company from taking
deposits over the insurable limit of $60,000 in recent months, and some customers had
reduced their accounts below that level."8
The Treasury Department, through its placement of tax-and-loan deposits also
occasionally provides some of the liquidity needed by a troubled bank to enable
uninsured depositors to make their getaway. This allegation was made most recently in
the BNE situation.9
Delayed closure also gives troubled banks time to liquidate assets and to sell
business units to raise cash to fund deposit outflows. These forced sales of a bank's
better assets is comparable in outcome to the long discredited 18th century medical
practice of bloodletting. That practice, of course, killed George Washington, among
many others; it also is very successful today in killing banks.
Troubled banks often become very aggressive solicitors of insured deposits to
replace the departing uninsured deposits. In effect, uninsured deposits and unsecured
credit are replaced by insured deposits. The regulators are empowered under FIRREA
to grant a waiver to a troubled bank so that it can gather brokered, insured deposits to
help maintain its liquidity. In effect, the regulators themselves abuse the often unfairly
maligned brokered deposits to facilitate their efforts to protect uninsured depositors from
losses.
Thus, in many failed banks, the greater amount of protection for uninsured
depositors is provided before the regulators dispose of the bank. Unfortunately, from
the regulators' perspective, not all uninsured depositors take the hint. Despite its highly
publicized troubles, BNE reportedly had $2 billion of uninsured deposits at the time it
was closed. Perhaps these depositors were the hard-core believers in the TBTF policy
or they were persons who felt they had to support BNE to the end or they simply were
naive. In any event, these depositors were winners because they were paid high rates of
interest by the troubled BNE and in the end TBTF protected them from any loss.
7
"Regulatory Treatment of Uninsured Deposits in Failed Institutions" in the report on Hearings
before the Committee on Banking, Finance and Urban Affairs, House of Representatives, Serial No.
101-169, September 25, 1990, pp. 336-358.
8
Howlett, Karen, "Trust's Branches Padlocked by Ottawa," Toronto Globe and Mail. April 19,
1991, page Al.
9

The New York Times. December 13, 1990, page Al.




11

230
Despite the best efforts by the RTC to scare off uninsured depositors, there still
are some uninsured deposits in S&Ls resolved by the RTC. However, many of these
deposits are protected from loss when the S&L's deposits are disposed of through a
"purchase-and-assumption" transaction that protects all deposits.
Thus, regulators are in an increasingly unenviable position: They are damned if
they delay so that uninsured depositors can run and then they are damned whether or not
they protect the uninsured depositors who did not run. On balance, regulators probably
take less heat politically if they delay closure to allow the maximum runoff of uninsured
deposits and then invoke TBTF once they no longer can postpone closure. This calculus
reinforces why it will be extremely difficult to enforce a no-TBTF policy even if it is
enacted into law. Who, for instance, will force the regulators to actually abandon
TBTF? Congress? Treasury? Bankers? Also, how will enforcement be obtained?
Would a banker or a member of the general public be empowered, through the right of
mandamus, to seek a court order forcing the closure of a large, failing bank?
Regulatory delay to allow depositor flight unfortunately greatly erodes the
franchise and organizational value of the insolvent bank. This erosion further adds to
the deposit insurer's loss when closure finally occurs. Because intangible franchise and
organizational values are not recorded as an asset of a bank, it is difficult to measure a
loss in their value. However, this loss does represent the destruction of real economic
resources. I have estimated that the extremely rapid shrinkage of Continental Illinois in
1984 probably added at least $100 million to the FDIC's cost of resolving that bank
failure.
Thus, regulators impose great costs on a deposit insurer when they delay closure
of a failing bank so as to protect fleeing uninsured depositors. However, the cost of
bank failures would be increased if all failing banks, regardless of size, were quickly
and suddenly liquidated in an effort to impose losses on uninsured depositors. This will
be the case because depositors, both insured and uninsured, will be even quicker to
abandon a bank merely rumored to be in trouble, thus destroying franchise value while
they are running out the door. Thus, the deposit insurer loses either way when closure
is delayed or when a bank is liquidated in an attempt to impose losses on uninsured
depositors. Surely there must be a better way?
The debate over abandoning TBTF has had one beneficial effect: It has helped to
expose the myth that federal deposit insurance exists to protect just small depositors. In
reality, deposit insurance exists to promote financial stability. Because money is
fungible, a $1 billion run by a few large depositors is just as destabilizing and damaging
as a $1 billion run by many small depositors. Increasingly, though, runs by large
depositors may be more destabilizing because technology, specifically wire transfers,
now enables large depositors to run much more quickly than was the case a few decades
ago.




12

231
m - DETERMINING WHEN A BANK IS TOO-BIG-TO-FAIL
If the TBTF policy is to be abandoned, it first is important to understand relevant
characteristics of institutions that are TBTF. Below are some characteristics that Ely &
Company has quantified.
The Presence of Foreign Branches. There apparently is a great fear among
regulators that if a bank closure imposes losses on depositors in the foreign branches of
a bank, these losses will greatly damage foreign confidence in all American banks.
Because foreigners generally do not understand the irrationality of American banking
policies and because foreign governments make far fewer threats to abandon TBTF, it
apparently is important to protect foreigners from seeing firsthand the attempted
application of depositor discipline. Thus, any bank with at least one foreign branch
probably is TBTF. The importance of foreign branches in the TBTF decision-making
process was demonstrated last year when the National Bank of Washington was
deemed TBTF and all of its deposits accordingly were protected against any loss.
Size, Measured From Several Perspectives.
Total Assets. One billion dollars in total assets probably is the biggest American
bank that can be liquidated without creating systemic disturbances. Therefore, banks
over that size are TBTF. The largest banks that have been liquidated (and their
deposits) were 1st Service Bank for Savings, Leominster, Massachusetts ($707.7 million
in a deposit transfer); Yankee Bank for Finance and Savings, Boston ($475 million in a
deposit transfer); and Penn Square Bank, NA, Oklahoma City ($470 million in a
depositor payoff). A few larger S&Ls have been liquidated, but these were long-term
basket cases in which the regulators had flushed out just about all uninsured deposits.
Standard Trust in Canada, which was closed last month with about C$1.5 billion
(US$1.3 billion) in deposits, will be liquidated through a transfer of insured deposits to
another institution. Standard Trust reportedly had $21 million in uninsured deposits
when it was closed. Although this institution has over $1 billion in deposits, its
depositors will have to wait at least a month to get their money (except in hardship
cases). This is a circumstance that would be unacceptable in the U.S., as the recent
Rhode Island deposit insurer failure has demonstrated.
Total Number of Deposit Accounts. The largest number of accounts handled so
far in a deposit transfer was 70,000 (First American Bank for Savings, Boston). The
largest depositor payoff had 30,000 accounts (Capitol Bank & Trust, Boston). There are
140,000 accounts at Standard Trust in Canada which will be transferred, but that process
is taking weeks to organize.
By way of contrast, there are 38 banks and thrifts in the U.S. that have more than
one million deposit accounts. Another 76 banks and thrifts have between 500,000 and
one million accounts. The time and resources it would take to organize the




13

232
transfer of just the insured portion of 500,000 or more accounts to a bridge bank would
be sufficient to enable many uninsured depositors to beat it out the door before the
transfer actually took place. Thus, from an administrative perspective alone, these
banks, and those with even a few hundred thousand deposit accounts, truly are TBTF.
Because large issuers of checks tend to clear their checks through larger banks,
shifting only insured deposits of a large, failed bank to a bridge bank probably would
cause tens of thousands of checks to be bounced. This will occur because the aggregate
amount of checks drawn on one depositor in the bridge bank would far exceed
$100,000. Unless the check issuer can make rather dramatic arrangements within a few
hours to feed sufficient cash into the bridge bank from sources other than the failed
bank, his checks will start bouncing with possibly very widespread and damaging
repercussions throughout the nation's payments system.
Number of Depositors Who Will Suffer a Loss. Based on available data, the
largest number of depositors in an FDIC-insured bank in which uninsured depositors
have suffered a loss was 3,888, in the Sharpstown Bank (Texas) failure in 1971. This
figure suggests that the TBTF cutoff is at or above this number of depositors.
Amount of Uninsured Deposits. Based on available data, the largest amount of
uninsured deposits in an FDIC-insured bank in which uninsured depositors were exposed
to a loss was $35.9 million in the Western Bank-Westheimer (Texas) failure in 1987.
This figure suggests that the TBTF cutoff is at or above this amount. Ely & Company
has filed a freedom-of-information request with the FDIC to obtain missing data on some
bank liquidations. This request may reveal larger numbers than those cited above.
Freedom National, with $11 million of uninsured deposits at the time of closure,
suggests that in the future banks with uninsured deposits of at least this amount may be
treated as TBTF.
Substantial Amounts of Interbank Deposits. The presence of substantial amounts
of interbank deposits is often given as the reason the TBTF policy was applied to
Continental Illinois. The fear reportedly was that imposing large losses on these deposits
would have caused the insolvency of many small banks. However, the number of
failures that actually would have occurred is widely disputed.
Time Since last Embarrassing Imposition of a Large Amount of Losses on
Depositors. The Herstatt failure in Germany in 1974, which imposed substantial losses
on large depositors and other creditors, apparently still discourages foreign bank
regulators from imposing large losses on depositors. The Johnson-Matthey failure in
Britain in 1984, in which all depositors were fully protected, undoubtedly reflected the
lessons of both Herstatt and Britain's Secondary Banking Crisis of the early 1970s. The
uproar over the Freedom National liquidation probably has lowered the TBTF floor, at
least temporarily and perhaps permanently.
Domicile of Depositors. While experience is mixed, one senses that it is easier to
impose losses on foreign-domiciled depositors and creditors in a foreign-domiciled




14

233
subsidiary of a failed bank. This is quite different than imposing losses on foreigndomiciled depositors or creditors in a foreign office of a U.S.-domiciled bank. This
distinction apparently is recognized by the Basle Concordat (adopted in 1975), which
provides guidance to central banks in supervising banks that operate in more than one
country.
In 1982, the Bank of Italy assumed no responsibility for the insolvency of Banco
Ambrosiano Holdings, a non-bank, 70%-owned Luxembourg affiliate of Italy's failed
Banco Ambrosiano. Creditor losses in the Luxembourg affiliate are estimated to have
totaled about $130 million10
However, in 1983, the German authorities went in the opposite direction and
protected all the creditors of the Luxembourg subsidiary of Schroeder, Munchmeyer,
Hengst & Co., a failed German bank. More recently, in 1988, the French government
insisted that all foreign as well as all domestic depositors in Al Saudi Banque be
reimbursed in full when it failed. Thus, one senses a shift towards protecting foreigndomiciled depositors of a failed bank unless those depositors are two or three levels
removed from the failed parent bank.
IV - THE REALITY OF TOO-BIG-TO-FAIL
MUST BE ACCEPTED FOR SEVERAL REASONS
Unilaterally Abandoning TBTF Is Not Feasible. It will be extremely difficult for
the U.S. to abandon TBTF unilaterally because unilateral abandonment of TBTF will
harm the domestic competitiveness of American-domiciled banks. Large depositors will
be tempted to shift deposits, and related borrowing relationships, into the domestic
branches of foreign-domiciled banks and into American-domiciled banks owned by
foreign banks in order to better protect themselves against suffering a loss in a failed
bank.
An international compact on abandoning TBTF will not be reliable either. Unlike
the risk-based capital standards being implemented under the Basle accord, an
international no-TBTF accord will be unenforceable since any one country could
abandon this policy on a moment's notice. Because other countries have much less
punitive attitudes towards large depositors in failed banks, politicians in those countries
will quickly overrule their banking regulators if a large bank failure might impose losses
on a substantial number of voters.
Perhaps the lower level of zeal in other countries to abandon TBTF also reflects
the fact that no other country was ever invaded by the Puritans although England was
their breeding ground. I say this because one senses that an almost Puritanical-like

10
Defaulted borrowings of $400 million times a loss rate of 33%. Based on data set forth in
"Modernizing the Financial System," U.S. Department of the Treasury, February 1991, pages XXI-10
andXXI-11.




15

234
desire for revenge against large depositors drives those Americans who advocate
abandoning TBTF. Perhaps this drive also reflects an understanding that continued large
bank insolvency losses not borne by depositors may eventually undermine the political
support for government regulation and therefore close government control over banks.
The fear is that if regulation cannot prevent large bank insolvency losses, then the
political process will be forced to seek non-regulatory methods for reducing the threat
bank insolvency losses increasingly pose to taxpayers/voters.
Some Hard-to-Answer Questions About Abandoning TBTF Further Illustrates the
TBTF Dilemma:
• When to abandon TBTF?
• How to phase in a no-TBTF policy?
• How to credibly abandon TBTF?
• How to justify invoking TBTF, once the TBTF policy has been officially
abandoned, when reality intrudes and losses really should not be imposed on
uninsured depositors in an insolvent bank?
• How to reestablish the credibility of a no-TBTF policy once an exception has
been made to that policy?
• What to do when credibility cannot be reestablished convincingly?
This testimony will suggest no answers to these questions because I believe that it
is unwise to attempt to abandon the TBTF policy, for the following reasons.
It Will Be Impossible to Convincingly Abandon TBTF. The banking regulators
and the Fed in particular want to preserve TBTF because it preserves their options and
their power in dealing with banks, especially those in trouble. No matter what is done
to force earlier closure, the intent of a strict no-TBTF policy will largely be defeated by
the Fed's discount window lending. The only way to effectively shutter the discount
window is to prohibit the Fed from lending on a collateralized basis. Then the Fed,
fearful of losing taxpayer monies, will lend only to the strongest banks who are least
likely to need or desire to borrow at the Fed. However, barring the Fed from making
collateralized loans will effectively kill its role as lender of last resort.
Thus, illiquid banks of questionable solvency will have to look elsewhere for
emergency liquidity even if they have plenty of good collateral to pledge. If they cannot
find sufficient liquidity in a crunch, they will have to shut their doors and begin to
liquidate. The Fed was created of course, to prevent just this type of situation. Thus,
Congress faces this dilemma: A key element that keeps the TBTF policy alive also is the
mechanism for providing emergency liquidity to banks. This conundrum reflects this




16

235
dichotomy: The ultimate beneficiaries of loans made by the lender of last resort, large,
uninsured bank depositors, are the same parties who benefit from the TBTF policy.
The Cost of Attempting to Abandon TBTF is Not Worth the Price. Adopting and
enforcing a no-exception or very limited exception TBTF policy will not be a cost-free
exercise. The number of failed banks actually may increase because an increased
certainty that a troubled bank will be liquidated will trigger more quickly a broader run
of both insured and uninsured deposits from a troubled bank than currently is the case.
These runs will ensure that a higher percentage of the banks that hit the FDIC's problem
bank list will fail. In effect, a heightened fear of failure may make bank failure a selffulfilling prophecy more often.
Eliminating TBTF Actually Will Increase the Cost of Disposing of Failed Banks.
Broader, quicker runs on troubled banks will more dramatically shrink the franchise or
going-concern value of troubled banks, especially as departing depositors take their
borrowing and other banking relationships with them to other banks. Losses in franchise
value can only add to a deposit insurer's loss. Franchise value is a very real and
significant banking asset. It represents the value that has been created over the years as
banks have opened branches, built reputations, and created a base of customers, largely
depositors. Conservatively assuming an average franchise value equal to 4% of
deposits, the total amount of franchise value in BIF-insured banks exceeds $100 billion.
This amount is equal to almost half of the tangible capital in the banking system.
Liquidations or insured deposit transfers of banks are even more destructive of
franchise value, which further adds to the cost of disposing of a failed bank. Strict
adherence to a no-TBTF policy effectively means an end to purchase-and-assumption
transactions in which the buyer of a failed bank assumes liability for all deposits. These
transactions now seek to minimize the deposit insurer's loss by maximizing the recovery
of the failed bank's going-concern value.

V - THE CONSEQUENCES OF ABANDONING TOO-BIG-TO-FAIL
There are adverse consequences of a no-TBTF policy that must be acknowledged
and addressed, specifically increased financial instability. Runs on larger banks will
occur sooner than they now do; they also will sweep a larger portion of uninsured
deposits out of these banks than now occurs. More dramatic runs will have at least
three likely adverse consequences:
One, the Fed, through its discount window activities, will have to fund a larger
portion of the run. This will be the case because the troubled bank will not have as
much time to sell assets to raise cash.
Two, a troubled bank will have to sell assets at a deeper discount, thus reducing
its chances for executing a turnaround and survival. As a result, its insolvency loss,




17

236
should insolvency occur, will be larger than would occur if the bank experienced a slow,
silent run.
Three, the regulators will have to act under greater (foress tQ engineer a merger
of the bank in order to avoid an outright closure of the bank. This duress will lower the
probability of an assisted merger and therefore increase the probability that the bank will
have to be closed and liquidated at a higher cost to the deposit insurer.
Even the probability of having more runs will have at least three adverse
consequences on American banks, even in the absence of runs.
One, shifting deposits to uninsured depositories. The increased regulatory burden
on insured depository institutions that will accompany the implementation of the noTBTF policy will drive deposits towards explicitly uninsured firms, such as MMMFs.
This shift will increase the probability of systemic financial instability. This shift will
occur because the rising regulatory burden will raise the operating and capital costs of
insured institutions relative to the costs of uninsured depositories such as MMMFs.
This increased cost differential will enable the MMMFs to pay even more
attractive yields that will enable the MMMFs to attract more rate sensitive deposits from
insured institutions. This growing cost differential explains why total MMMF deposits
grew 12.8% annually from the end of 1986 to the end of last year while domestic
deposits in insured banks and thrifts grew only 2.8% annually in that same four-year
time period. Viewed from another perspective, general purpose MMMFs grew from
8.2% of the retail deposit market to 11.9% between December 1986 and February of
this year. There is every indication that these percentages will continue to grow.
However, as deposits in uninsured institutions grow, these institutions will become an
increasing threat to the taxpayer-backed federal safety net.
Chart 2 illustrates how uninsured financial institutions which potentially could
borrow from the Fed represent a direct threat to the general taxpayer. As this chart
shows, the general taxpayer is protected from insolvency losses in federally insured
banks and thrifts, to the extent that those losses do not overburden healthy institutions.
No comparable insurance or guarantee mechanism exists for those presently uninsured
institutions that conceivably could borrow from the Fed in a crisis situation.
Because MMMFs are not explicitly insured by the federal government, any
concerns about the safety of MMMFs will cause even the smallest depositor to run from
these funds if one or a few funds are rumored to be unable to redeem their shares at par.
Although MMMF depositors theoretically are investors in these funds and thus are not
guaranteed to always be able to redeem their shares at par value, in reality, MMMF
depositors expect to get their funds back on demand and at par value. SEC regulations
also support the policy that MMMFs maintain a stable net asset value. MMMF
depositors in a troubled fund who do not run in time are subject to an immediate,
automatic "haircut" in the value of their principal if their fund shares suddenly are
redeemable at less than par value or they begin to carry a below-market interest rate.




18

f




Structure of Federal Safety Net
Banking and
Thrift Industry
Collectively

U.S. Treasury

s

General taxpayer money used only
banking and thrift industry unable
Lto cover all FDIC losses.

Direct taxpayer liability for all
losses the Fed incurs in lending
^ Lto uninsured institutions.

JL
FDIC

FDIC-insured banks and thrifts

-•

Direct liability for any loss (flow of
money to cover losses).

Any uninsured institution with explicit or
implicit access to the Fed discount window
Fed as a fully collateralized lender of last resort avoids any loss
because FDIC bears all insolvency losses in these institutions.

238
Because of their enormous size ($500 billion in assets on February 28, 1991)
MMMFs are implicitly protected by the federal safety net. Continued growth of the
MMMFs increases the probability that this safety net will be made explicit when the first
wave of nervousness causes a run on MMMFs. In a few years, MMMFs could become
a $1 trillion gorilla that even the Fed cannot ignore. The Fed will have no choice but to
open the discount window to MMMFs if they experienced a sudden run so that the
MMMFs will not have to dump securities on the market to fund deposit withdrawals.
The Fed, like any other regulator, will much prefer the political heat of risking a loss to
taxpayers to incurring the much more intense wrath of MMMF depositors who might
suffer a loss. The provision of Fed cash to MMMFs will, of course, indirectly protect
fully those MMMF depositors who run fastest.
MMMFs also may become riskier as their growth, relative to total financial assets
in the economy, makes it more and more difficult for them to maintain short-term
maturity matching within their portfolios. Thus, attempts to abandon the TBTF policy,
which are in concert with efforts to shrink the size of the explicit federal safety net will
have the ironic effect of broadening the federal safety net by forcing vast quantities of
hazardous liabilities into depository institutions only implicitly backed by the federal
safety net.
Two, a strict no-TBTF policy may cause higher deposit insurance losses to fre
imposed on a static or possibly shrinking base of deposits in explicitly insured
institutions. Imposition of a strict no-TBTF policy will reduce total domestic bank
deposits as a percent of GNP as deposits are driven out of the insured institutions. The
dramatic shrinkage in 1990 in the deposit/GNP ratio may merely be the start of a longterm shrinkage of bank and thrift deposits. The deposit insurance tax currently is
assessed on total domestic bank deposits, not just insured deposits.
If a strict no-TBTF policy drives deposits out of insured institutions, and weakens
banks in the process, then higher bank and thrift insolvency losses, as posited above,
will have to be spread over a shrinking deposit base. The resulting higher deposit
insurance premiums will make insured institutions even less competitive relative to
uninsured institutions such as MMMFs.
Three, the U.S. market share for American-domiciled banks will shrink because
of a strict no-TBTF policy. Because moving from one bank to another is timeconsuming and expensive, increasing numbers of uninsured and even insured depositors
may seek to deposit and borrow from banks operating within the U.S. that are chartered
by countries with a more explicit TBTF policy. Because many small businesses, nonprofit groups, and retirees also at times have deposit balances over $100,000, they too
would find it prudent to bank with foreign domiciled banks deemed TBTF by their
regulators.
Given that international trade, including the provision of domestic services such as
banking, should be governed by the rules of comparative advantage, is Congress
prepared to concede a broad comparative advantage in domestic banking to other




19

239
nations? In effect, are we prepared to concede that other countries are better regulators
of financial institutions than U.S. regulators?
VI - ABANDONING THE CONCEPT OF DEPOSITOR DISCIPLINE
MAKES THE TOO-BIG-TO-FAIL ISSUE MOOT
Accepting the reality of the TBTF policy is not an argument against preventing
banks from failing. Instead, it is an argument over who should bear the cost of bank
failures: equity capital invested in banking or depositors and other creditors. Extending
the TBTF policy to all banks merely states that depositors will not bear any loss in a
failed bank; a TBTF policy does not answer the crucial question of who will bear the
loss, taxpayers or equity capital invested in banking. That question must be addressed
separately.
Legal Challenges to the Present TBTF Policy Will Undermine Depositor
Discipline. Any ambiguity about the reality of TBTF may be ended by a court decision
which finds that the present TBTF policy discriminates against explicitly uninsured
depositors in banks deemed too small to save. Freedom National may just be that test
case. A court might rule, for example, that statutorily uninsured depositors in all banks
must be treated equally; i.e., explicitly uninsured depositors must be fully protected in
all bank failures or uninsured depositors in a bank of any size must share in the
insolvency loss of that bank.
Such a decision would force the extension of the TBTF policy to banks of all
sizes because as a practical matter, TBTF cannot be abandoned for larger banks,
especially those with foreign branches. The effect of such a decision would be to
explicitly extend deposit insurance to all deposits. This extension also would effectively
end the concept of depositor discipline.
The Freedom National case raises a second, provocative question: Is it lawful for
a bank regulator to knowingly permit a clearly insolvent bank (as Freedom was) to
accept or renew uninsured deposits? According to its call reports, Freedom was
insolvent at the end of 1989, more than ten months before it was closed. Freedom
reported a positive book equity capital of $428,000 on December 31, 1989, but it also
had unrecorded securities losses of $1.12 million on that date, indicating that it actually
was insolvent by at least $692,000, or almost .6% of its assets. However, Freedom's
call reports indicate that Freedom was accepting or renewing uninsured deposits in 1990,
after the institution had clearly become insolvent.
In an interesting parallel, in some states in years past, bank directors could be
held personally liable for losses suffered by depositors if the bank was insolvent at the
time the deposits were accepted by the bank. Why should this concept of personal
liability not be extended to those regulators who permitted an insolvent Freedom
National to accept uninsured deposits.




20

240
Stockholder Discipline-The Better Option. Abandoning the concept of depositor
discipline (in effect, providing 100% deposit insurance) would force public policy to rely
entirely on stockholders and regulators to discipline wayward bankers. Providing 100%
protection for depositors also will automatically make TBTF a moot issue. However,
because electronic technology is rapidly destroying the efficacy of financial services
regulation, the regulatory establishment can no longer be relied upon to protect taxpayers
from escalating deposit insurance losses. 11
Thus, establishing effective stockholder discipline over the activities of all banks
under all economic conditions is the only way to make TBTF a moot issue. Effective
stockholder discipline means that every dollar of loss within any failed bank has to be
absorbed by private sector equity capital voluntarily committed to accepting the risk of
bank insolvency. Ensuring that someone's equity capital always will be available to
absorb all bank insolvency losses means that neither depositors nor taxpayers will ever
bear a bank insolvency loss. Depositors will have no reason to panic and run from a
bank and increasingly undependable regulators will not have to be relied upon to protect
taxpayers from losses incurred in protecting depositors from losses.
Because banks are limited liability corporations, losses within any one bank can
exhaust that bank's equity capital. However, it is highly, highly unlikely that the equity
capital of the entire banking system could ever be exhausted. Thus, a deposit insurance
mechanism that explicitly places the entire earning power and equity capital of the
banking system behind every dollar of deposit in every bank effectively eliminates all
depositor risk. TBTF then disappears as a political issue.
Even during the Great Depression, member banks of the Federal Reserve, as a
whole, had positive capital and positive current earnings. In 1933, the bottom of the
Depression, member banks of the Federal Reserve System had operating earnings
(before loan loss provisions) of $378 million and equity capital at the end of 1933 of
$4.96 billion. On June 30, 1933, Fed members held 82% of all assets owned by
commercial banks. The total book capital of all commercial banks on that date was $6.2
billion, almost five times the losses depositors experienced in banks that failed in the
1930-33 period. Thus, there was enough earning power and equity capital within the
banking system during the worst of the Depression to have absorbed all depositor losses
in insolvent banks and still have left the banking system adequately capitalized to rebuild
itself as the country pulled out of the Depression.
The 100% cross-guarantee concept, which is described in Attachment A,
represents one way in which to more effectively use the earning power and equity capital
of the banking system to fully protect all depositors in all banks against bank insolvency
11
The witness has described in numerous forums how electronic technology is destroying the efficacy
of financial services regulation, including "Technology, Regulation and the Financial Services Industry in
the Year 2000," Issues in Bank Regulation. Fall 1988, pp. 13-19; "Fundamental Issues in Deposit
Insurance Reform," testimony on October 3, 1990, to the Subcommittee on Commerce, Consumer, and
Monetary Affairs, House Committee on Government Operations; and "The Narrow Bank: A Flawed
Response to the Failings of Federal Deposit Insurance," Regulation. The Cato Institute, Spring 1991.




21

241
losses in any adverse economic circumstance. The cross-guarantee concept also will
allow for the optimal amount of maturity mismatching within the economy, within the
context of safe and sound banking.
Placing the entire burden of disciplining bankers on equity capital voluntarily
placed at risk (and properly compensated for that risk) should dramatically reduce bank
insolvency losses while allowing marketplace mechanisms to bring greater efficiency to
the depository intermediation business. Unlike regulators who suffer no personal
financial loss when a bank fails, equity capital voluntarily placed at risk would bear the
full cost of all bank insolvency losses.
VII - CONCLUSION
The TBTF policy is an inescapable reality of today's industrialized world. The
various legislative remedies proposed this year to escape from TBTF will not work.
Instead of continuing to fight the reality of TBTF, we must move quickly to reshape the
disciplining forces that act on bankers. The notion of depositor discipline must be
abandoned as the necessity of TBTF becomes more evident. Attempting today to impose
losses on large numbers of depositors is increasingly counter-productive and costly.
Instead, we must look to an unfailing application of stockholder discipline to bring safe,
sound, and efficient banking to America. The cross-guarantee concept described in the
attached appendix is one way, and perhaps the only way, to achieve that goal.




22

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Attachment A
REFORMING DEPOSIT INSURANCE WITH 100% CROSS-GUARANTEES
How 100% Cross-Guarantees Would Work
Briefly, the 100% cross-guarantee concept is an industry self-insurance mechanism
which would more effectively use the earning power and the equity capital of the entire
banking system to protect all deposit balances in all banks and thrifts against any loss
whatsoever. The 100% cross-guarantee concept modifies the existing system of federal
deposit insurance in three important, yet easily implemented ways. One, it substitutes
risk-sensitive premiums established in a private, competitive marketplace for the present
flat-rate deposit insurance premiums now charged by the FDIC. Two, it would insure all
deposits so as to reduce insolvency losses should a bank fail. Three, the bank closure
decision would effectively be shifted from government regulators to the private guarantors
of a bank. Chart 3 contrasts the present system of federal deposit insurance with the
100% cross-guarantee concept.
Under 100% cross-guarantees, individual banks would enter into a voluntary
cross-guarantee contract with other banks and even other types of guarantors. This
contract would protect all of a bank's deposits, including balances over $100,000, from
any loss of principal, interest, or liquidity. Other liabilities of the guaranteed institution
also could be protected under the contract. Each cross-guarantee contract would be issued
by an ad hoc syndicate of banks called "first-tier" guarantors. Conceivably, non-bank
firms and wealthy individuals also could participate as guarantors. Each guarantor bank
would itself be guaranteed by a separate syndicate of guarantors. Syndicates would be
organized and managed by specialized firms called syndicate agents.
Guarantors would periodically collect a risk-sensitive deposit insurance premium
from each of the banks they guaranteed. Premium formulae would be negotiated solely
between the guaranteed bank and its guarantors, with the riskiest banks probably charged
as much as 15 or 20 times the rate charged the safest banks. The formula for each
guaranteed bank would be designed to adjust the premium rate as the riskiness of that
bank to its guarantors varied.
In order to reinforce depositor confidence in banks, the FDIC could continue to
insure all deposits up to $100,000, in effect, forming an insured bank within a guaranteed
bank as shown in Chart 4. However, due to the low level of insolvency losses
anticipated with cross-guarantees, it is highly unlikely that the FDIC would ever suffer a
loss since the bank's equity capital and the guaranteed liabilities would be the first to be
wiped out in the case of a large insolvency loss.




l




Flow of a Bank's Insolvency Loss If It Fails
Future with
100% Cross-Guarantees

Today with
Federal Deposit Insurance

Share of Insolvency Loss

Uninsured
Depositors
F D

I C

(BIF,

SAIF)

Losses, if any, that
flow to guarantors
first-tier guarantors

Earnings and capital of all
banks and thrifts taxed to
pay for FDIC's losses

Solvency safety net formed by the earning power and equity
capital of the banking system. This safety net includes all bank
insolvency losses not borne by first-tier guarantors. This safety
net can easily be expanded to include non-bank guarantors.
Flow of loss in the highly unlikely evenl
that the earnings and capital of the
entire banking system are not sufficient
to absorb all bank insolvency losses.

Note: Dotted line around the FDIC fund denotes the fact that this fund does not actually exist because it is incorporated
in the consolidated federal budget. Losses paid by the FDIC actually count as government spending when money is disbursed.

Flow of insolvency loss

244
Chart 4

Larger Bank With Guaranteed Liabilities
"An Insured Bank Within a Guaranteed Bank"
Assets
(Book Value)




Estimated Market
Value of Assets
(FDIC Calculation)

Liabilities
and Capital

Conservative,
marked-down
value of all
bank assets
except assets
securing
specific
liabilities

FDICInsured
Deposits
(up to
$100,000)
[(FDIC effectively
lis a senior creditor
of the bank)

Guaranteed
Liabilities
(general creditors
of the bank)

Subordinated
Debt
Equity
Capital
Penetration of
an insolvency
loss

From the FDIC's
perspective, this is
the bank's capital

245
Safeguards Built Into Cross-Guarantees
Numerous safeguards have been incorporated into the 100% cross-guarantee
concept, some of which are discussed below. Working together, these safeguards would
permit both the banking system and the ongoing risk syndication process to operate
smoothly and efficiently while providing depositors, public officials, taxpayers, and the
rest of the world unsurpassed confidence that the American banking system would
function without hesitation even during times of enormous economic and financial stress.
Guarantors Must Be Guaranteed Institutions and Also Must Have "Stop-Loss"
Protection. All guarantors would have to have their deposits and their cross-guarantee
obligations guaranteed by yet other guaranteed institutions. This feature, plus the stoploss feature in all cross-guarantee contracts, is perhaps the most important safeguard for
100% cross-guarantees. It is the device by which the occasional large bank insolvency
loss would be spread very widely, but thinly, across the earnings and equity capital base
of the entire banking system and to others who voluntarily contracted to be guarantors.
Thus, in the rare event of a large loss or concentration of losses, the "stop-loss"
provision in each cross-guarantee contract would permit a portion of that loss to be passed
through the guarantor banks to their own guarantors. This "stop loss" provision would,
therefore, prevent any guarantor losses from driving a guarantor bank into insolvency.
Chart 5 illustrates how a very large insolvency loss would flow from tier to tier of
guarantors until the loss had been fully but safely absorbed by private equity capital.
Risk Diversification Requirements Imposed on Guarantors. In order to diversify
their risk as guarantors, even large guarantors could assume only a small portion of many
cross-guarantee risks. Thus, a guarantor's exposure to a cross-guarantee loss in any one
bank would be limited to just a small portion of the guarantor's equity capital that it could
risk as a guarantor. A guarantor's aggregate cross-guarantee risk exposure also would be
limited by its capital resources.
Risk Diversification Requirements for Any One Cross-Guarantee Contract. Each
guaranteed bank would have to have a minimum number of guarantors, with a larger
number of guarantors required for larger banks. No one guarantor could assume more
than a small share of the total risk of any one cross-guarantee contract. Also, a small
group of banks could not join together to cross-guarantee each other in an undiversified
manner that consequently contained all or most of the risk of failure within this group of
banks. The failure of one bank in this "closed loop" situation could trigger a string of
domino-like failures among the other banks in the closed loop.
Bank Run Protection. Providing unlimited amounts of liquidity to a bank
experiencing a run is the only effective way to stop the run. The emergency liquidity
injected into a bank would let its nervous depositors protect their wealth by pulling their
money out of the bank in accordance with the original terms of their deposit contract.
Therefore, guarantors would be prepared to provide whatever liquidity was necessary to
arrest a bank run. However, protecting every dollar of deposit, as 100% cross-guarantees
would do, would, as a practical matter, eliminate bank runs. Minimizing the threat of




2




Example of How a Very Large Insolvency Loss Might Flow Through Multiple Tiers of Guarantor Banks
under the Stop-Loss Reinsurance Provision of 100% Cross-Guarantee Contracts

Syndicate of
first-tier
guarantors

Second-tier
guarantors

Third-tier
guarantors

Four first- and second-tier guarantors (Banks 1,145,146, and 147) and all the third-tier guarantors have no losses flowing
out of them because their share of the failed bank's insolvency loss does not reach their stop-loss reinsurance limit.
Flow of insolvency losses

247
bank runs also would help to preserve (the franchise value of a troubled bank which, in
turn, would reduce the insolvency loss in any guaranteed bank that actually failed.
The Many Benefits of Cross-Guarantees
The 100% cross-guarantee concept would provide many benefits to the banking
system, to the economy, and to the American taxpayer. Most significantly, 100%
cross-guarantees would not take away any existing protection for depositors or the
financial system. Instead, cross-guarantees would vastly improve taxpayer protection by
absorbing bank insolvency losses within the solvency safety net constructed by the stoploss feature.
Since private guarantors, and not the regulators, would be responsible for closure
decisions, early closure of failing banks would finally become a reality. Timely takeovers
of failing banks, before they became insolvent, would improve the overall efficiency of
the economy by ridding the banking system of inefficient competitors.
Protecting all deposits, including balances over $100,000, would eliminate
completely the need for depositor discipline. Risk assessment activities would be shifted
from a highly risk-averse set of creditors (bank depositors) to that source of funds (equity
capital) that is best suited to assess and price financial risks. With full protection for all
deposits, the regulatory practice of TBTF would be eliminated since large depositors
would be no more exposed to loss than small depositors. By protecting aJL deposits in a
guaranteed institution, cross-guarantees represent the only way to truly get rid of TBTF by
making TBTF a moot issue. Eliminating TBTF through 100% cross-guarantees also
would greatly improve the competitiveness of community banks which in the past have
been discriminated against by regulators due to the TBTF policy.
Risk-sensitive premiums would deter unwarranted risk-taking by banks and
encourage wiser lending and investment practices, thus allowing banks to innovate at their
own pace. Wiser lending also would lead to a more productive use of credit within the
economy, which in turn would enhance GNP growth. Risk-sensitive premiums, based on
leading rather than lagging indicators of banking risk, finally would force the drunk
drivers of the banking world to pay for the risks they are assuming. Thus, properly
priced risk-sensitive premiums would largely eliminate the cross-subsidy now flowing
from good banks to bad due to flat-rate deposit insurance premiums.
Risk-sensitive premiums based on leading indicators of banking risk, such as risk
mismatching, asset concentrations, and operational deficiencies, would steer most banks
away from trouble long before they became insolvent. In effect, properly structured
risk-sensitive premiums would provide an enormous deterrent to risky banking and
wasteful extensions of bank credit. Chart 6 illustrates how risk-sensitive premiums would
work in three different situations. The actual capital in a bank is assumed to be a proxy
for the riskiness of the bank.




3

248
In Bank 1 (the top bank in Chart 6), the premium rate rises as the bank's riskiness
increases until finally the bank's management takes corrective action. The bank's
riskiness then begins to decline and its premium rate drops accordingly. In Bank 2 (the
middle bank), the bank's condition continues to decline until it is recapitalized, at which
time its premium rate drops dramatically to reflect the suddenly reduced riskiness of the
bank. The newly invested capital will reasonably be able to bargain to capture the lion's
share of the premium savings. These savings will provide a powerful incentive to attract
fresh capital to troubled banks that now is absent with the FDIC's flat-rate premiums.
Bank 3 (the bottom bank) does not turn itself around nor does it attract fresh capital. It
eventually is taken over by its guarantors, most likely when the premium rate hits a
certain level, but before it actually becomes insolvent.
The 100% cross-guarantee concept would greatly increase financial stability within
the banking system by explicitly protecting all domestic and foreign deposits of American
banks. Cross-guarantees also would dramatically reverse the rapidly declining creditworthiness of American banks because guaranteed banks would be AAA credit risks.
This would make guaranteed banks much more competitive. They would not only enjoy a
lower cost of funds, but properly capitalized banks also would pay far less for their
deposit insurance than they now pay. In addition, there would be far fewer regulatory
burdens on banks and thrifts that now add greatly to their operating expenses while
limiting their activities. Thus, cross-guarantees offer the only way to integrate deposit
insurance reform and the restructuring of financial services because 100%
cross-guarantees would completely shift restructuring decisions and their associated
insolvency risks to private sector capital.

Transition to 100% Cross-Guarantees
The transition to 100% cross-guarantees would be fairly easy and straightforward.
Initially, healthy, well-capitalized banks would be permitted by enabling legislation to
obtain cross-guarantees, beginning one year after the enactment of the legislation. The
one-year period preceding this opt-in date would allow sufficient time for the crossguarantee marketplace to establish itself and to begin organizing cross-guarantee
syndicates. The capital requirement for banks to opt-into cross-guarantees should be
lowered each year for five years, by which time uninsured liabilities in all banks should
be protected by 100% cross-guarantees. A bank that could not obtain a 100%
cross-guarantee contract by the end of that period effectively would be insolvent or would
be in such marginal condition that the FDIC would have to liquidate or merge that bank
out of existence. Mandatory deposit insurance coverage should be retained, however, to
eliminate the "free-rider" problem that would arise if uninsured banks got into trouble.




4

249
Charts

Interaction Between a Risk-Sensitive Deposit Insurance Premium Rate
and Capital Levels for Three Banks
(All three banks are declining at the same rate until they pull out, are pulled out, or do not pull out of their decline)
| Bankl

3

4 %

'i
|

3%

Capital

-

^s^

-\
H150 '

W

m
,c

Bank 1 's management arrests the decline ~ 100 I
E
in the bank and begins a slow but steady
3
return to financial health.
1

? 2%
£

-

Market Va

<>
x
3

Premium rate

o

50

\—^_^^

-

*

noii

Passage of Time (from left to right)
|Bank 2

4%

a 3%

—

• 2%

N.

Capital

:
-

J
-\ 150^
Bank 2 is recapitalized.

Premium rate

_

100 c
S

-

A

z 1%

50

-

\-


http://fraser.stlouisfed.org/
42-688 (256)
Federal Reserve Bank of St. Louis

^ ^

Passage of Time (from left to right)
| Bank 3

Capital

Bank 3's decline is not arrested;
it is then taken over before it
becomes insolvent.

100 [
J

50

Passage of Time (from left to right)

o