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FABSF WEEKLY LETTER Number 91-36, October 18, 1991 Deposit Insurance: RecapitaliLe or Reform? Public dismay over the poor financial health of the Federal Deposit Insurance Corporation's Bank Insurance Fund (BIF) has grown in recent months. The FDIC makes payments from BIF if an insured bank fails or must be assisted. The resources of the fund reached an all-time high of $18.3 billion in 1987, but a General Accounting Office audit revealed that BIF had only about $4 billion at the beginning of 1991, and was projected to be at or near zero by the end of the year. The U.s. Office of Management and Budget has predicted a $22.5 billion shortfall by the end of fiscal year 1995. Congress is considering two types of solutions to the problem: First, to pump more money into BIF in the short run to "recapitalize" the fund, and second, to undertake a more fundamental overhaul or "reform" of the u.s. deposit insurance system. In this Letter, I argue that both recapitalization and reform are appropriate solutions, but to two different types of financial problems. Determining the relative merits of the solutions therefore requires a thorough understanding of BIF's current difficulties. Illiquidity or insolvency? BIF could be having a simple cash flow problem: the fund may have plenty of money in the long run, but be strapped in the short run, a condition of illiquidity. Illiquidity appears to be at least part of BIF's financial trouble. Before 1988, income to the fund exceeded payouts, and the difference was either rebated to insured banks or added to insurance fund reserves every year. Since then, payouts have exceeded income due to an unusually large number of bank failures. On top of these losses, projected failures over the next few years are likely to cause payouts to exceed both premium collections and the remaining balance in BIF's reserve fund. Illiquidity is a problem of timing: receipt of income is spread out over time, whereas spending needs are concentrated in the present. The straightforward solution is that BIF should borrow to cover the shortfall, and payoff the debt in future periods using future revenues. Borrowing is the fundamental financial tool for shifting resources between time periods. No opprobrium should be associated with borrowing under these circumstances: it is simply the flip side of BIF's usual practice of lending (by investing in securities) during less lean periods. However, the shortfall might be so severe, and the amount of required borrowing so large (or the interest rate so high), that BIF might be unable to pay back both principal and interest out of future income. In that case, the fund is insolvent. (This is a financial, rather than legal, definition of insolvency; the requirement that the borrowing be repaid with interest makes this definition equivalent to looking at the "present value" of BIF's net worth.) Insolvency cannot be fixed by shuffling resources from one time period to another. The problem is like trying to cover oneself with a fig leaf: the leaf can be moved around some, but if it is too small for the area to be covered, then the situation demands more leaves. And insolvency demands that either expenditures be reduced, or that current and future income be increased. Borrowing adds nothing to BIF resources in the long run and pushes any insolvency problem into the future without resolving it. At the very least, BIF suffers from illiquidity. Whether it is insolvent is harder to determine. Most projections for the fund focus on the next few years, but examining only these near-term cash flows is not sufficient to distinguish between the two types of problems. The real question is whether there is any time interval-and it could be quite long-over which BIF could borrow the needed funds and generate sufficient income to repay principal and interest. Such a longer-run view of insolvency generally requires the use of economic models of insurance. Research using these models reveals that the fund may have been insolvent in the late FRBSF 1980s, when premiums were relatively low. Premiums have been raised substantially since then, but by some estimates insolvency may still be a component of the current problem. If there are elements of both illiquidity and insolvency in BIF's current financial squeeze, each must be dealt with. Recapitalization One way to recapitalize BIF is through a large injection of cash, in a form that need not be repaid. The money could come from a supplemental insurance premium or special assessment, in effect a one-time tax on the banking system. Alternatively, taxpayer money could be injected into the insurance fund by the Treasury. The only significant difference between these two is the incidence of the tax. An injection of this type could solve the liquidity problem and at the same time make the fund solvent. However, most recapitalization proposals implicitly assume that the problem is illiquidity, since most involve some type of borrowing to be repaid from collected premiums. Debate has revolved around the amount and source of the borrowing; suggested sources have included the u.s. Treasury, the Federal Reserve, and the banking industry itself. The press often refers to borrowing from the Treasury as a government "bailout" of BIF. However, the term "bailout" would seem to imply a transfer, or outright gift. As long as the loan is repaid with interest, it is hard to discern a meaningful sense in which this borrowing constitutes a gift, except to the extent that borrowing at the government rate may understate the true economic cost of the financing. The Federal Reserve has expressed reservations about lending to BIF, not on financial grounds, but rather because it sets a dangerous precedent: Such a loan might create expectations that the Fed would lend to equally troubled, but perhaps less creditworthy, borrowers in the future. This concern may be especially germane given the delicate financial health of a number of state and local government entities. A typical proposal for BIF to obtain funding from the banking industry envisions preferred stock issued by BIF and purchased by insured banks. This scheme vividly illustrates the fact that re- sources are shifted rather than enhanced in such a recapitalization: any payments BIF makes to the banks as preferred stockholders would be funded by insurance premiums those same banks pay to BIF. A more subtle proposal for borrowing from the industry would shift banks' reserve deposits from the Federal Reserve to BI F. Currently, banks use these legally required deposits as clearing balances and to maintain adequate liquidity, both of which are legitimate business functions. It is not clear how the funds ever could be used by BIF to pay for bank failures without creating further problems for banks in general. Reform Most reform proposals address BIF insolvency by structurally changing some combination of the deposit insurance system, the regulatory system, or the banking system. Reforms aim to increase the flow of BIF income relative to expenditures over time; some incidentally may provide sufficient current funds to solve the liquidity problem. BIFincome can be increased by raising the rate banks pay for deposit insurance or by broadening the base against which premiums are assessed. The premium rate already has increased several times over the past two years, to the current level of 23 cents per 100 dollars of deposits. As I argued in a previous Letter (91-3), a few banks could afford to pay-and in all fairness should pay-even higher rates. However, a general rate hike might ledd to a counterproductive increase in failures, as healthy, low-risk banks would suffer financially under a higher rate. Instead of (or in conjunction with) raising rates, the assessment base could be broadened to include more than just domestic deposits: Foreign deposits could be included in the deposit base, or premiums could be assessed against total bank assets. The effect is little different from an increase in the premium rate, although broadening the base might eliminate some of banks' bias toward funding sources, such as foreign deposits, that currently are not subject to premium assessment. In a different vein, one proposal would require the Federal Reserve to pay interest on banks' reserve deposits into the insurance fund, thereby increasing BIF's income stream. The Fed currently pays no interest on these deposits, so such a policy would directly reduce the income of the Federal Reserve System. Since the Fed transfers its excess income to the U.S. Treasury each year, this proposal is equivalent to injecting taxpayer funds into BIF. On the other side, expenditures can be trimmed by reducing payouts on bank failures. Proposals include reducing the coverage limit from the current level of $100,000, reducing the number of insured accounts per person, and instituting coinsurance, under which depositors would bear some fraction of any losses due to the failure of their bank. Other proposals would eliminate or reduce insurance coverage of brokered deposits, or would restrict BIF from choosing to cover any deposits beyond those that are legally insured. These and similar steps to cut BIF expenses by reducing deposit insurance coverage should be taken only with extreme care. Deposit insurance was established to achieve important public policy goals, including protecting depositors and enhancing the stability of the banking and financialsystem. Reducing coverage makes these goals more difficult to attain. BIF may save money in the short run, but sacrificing the stabilizing effect of deposit insurance in a quest for solvency may not be a desirable tradeoff. Permanent repair of the system The best way to deal with any current insolvency and avoid future problems is to cut BIF expenditures by reducing the probability of bank failures. Several reform proposals could reduce failure costs without affecting the degree of protection and stability provided by deposit insurance. These include measures to restrict the range of bank activities, require more frequent examinations of banks, raise bank capital requirements, and link deposit insurance premiums to bank risk. Additional restrictions on banks' freedom to engage in riskier activities could reduce the chances of insured bank failures from large, unexpected losses. But regulators would have to determine which bank activities constitute necessary parts of the banking business, a burden that markets are probably better suited to bear in a changing financial environment. If regulators are too restrictive, failures could become more likely as bank profitability declines. Requiring annual on-site examinations would cut the expected cost of bank failures by reducing the leeway banks have for taking undue risk. Of course, examinations are themselves costly, and the increased costs of more frequent exams must be weighed against the likely reduction in costs to BIF. Compelling banks to maintain higher capital also reduces the expected cost of bank failures by giving banks a larger cushion against financial shocks. Raising capital might be costly for some banks in the short run, but the industry may find this preferable to higher flat-rate deposit insurance premiums, as argued by Pozdena (FRBSF Letter, 91-10). An important side benefit of higher capital is that it alters the incentives facing insured banks. Bank managers and stockholders ultimately have considerable control over the probability that a bank will fail; economic theory says that those with more capital invested have less incentive to take undue risk. Risk-based premiums would have similar incentive effects, by forcing banks to pay more for deposit insurance if they take greater risks. These measures that change the incentive structure are the surest road to long-run solvency for BIF. Conclusion The current pol icy debate on deposit insurance often fails to discriminate adequately between "reform" and "recapital ization." Proposals treat different aspects of the Bank Insurance Fund's current financial problems, with reform generally addressing insolvency and recapitalization addressing illiquidity. In the short run, illiquidity can be resolved through borrowing from any of several sources. In the longer run, proposals for reform are vastly more important, especially those that create a healthier set of incentives for insured banks. Recapitalization must not be viewed as an alternative to reform: Without meaningful reform, an endless succession of recapitalizations may loom. Mark E. Levonian Senior Economist Opinions expressed in this newsietter do not necessariiy refiect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor or to the author. ... Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. OUt6 V) 'OJSpUPJ:I UPS lOLL x08 'O'd O)SI)UOJ:J UOS JO ~U08 al\Jasa\:J IOJapa:J ~uew~Jodea 4)JOeSe~ Index to Recent Issues of FRBSF Weekly Letter DATE NUMBER 4/5 4/12 4/19 4/26 5/3 5/10 5/17 5/24 5/31 6/7 6/14 7/5 7/19 7/26 8/16 8/30 9/6 (91-14) (91-15) (91-16) (91-17) (91-18) (91-19) (91-20) (91-21 ) (91-22) (91-23) 91-24 91-25 91-26 91-27 91-28 91-29 91-30 9/13 9/20 9/27 10/4 10/11 91-31 91-32 91-33 91-34 91-35 TiTlE AUTHOR Probability of Recession Huh Depositor Discipline and Bank Runs Neuberger European Monetary Union: Costs and Benefits Glick Record Earnings, But... Zimmerman The Credit Crunch and The Real Bills Doctrine Walsh Changing the $100,000 Deposit Insurance Limit Levonian/Cheng Recession and the West Cromwell Financial Constraints and Bank Credit Furlong Ending Inflation Judd/Motley Using Consumption to Forecast Income Trehan Free Trade with Mexico? Moreno Is the Prime Rate Too High? • Furlong Consumer Confidence and the Outlook for Consumer Spending Throop Real Estate Loan Problems in the West Zimmerman Aerospace Downturn Sherwood-Call Public Preferences and Inflation Walsh Bank Branchingand Portfolio Diversification Laderman/Schmidt/ Zimmerman The Gulf War and the U.S. Economy Throop Hermalin The Negative Effects of Lender Liabil ity M2 and the Business Cycle Furlong/Judd International Output Comparisons Glick Is Banking Really Prone to Panics? Pozdena The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.
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