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May 18, 1 984

FDIC'sModified Payout
Plan
With deregulation in banking, the FDIC
(Federal Deposit Insurance Corporation),
the Congress and others have become
increasingly concerned about the deposit
insurance fund's exposure to the risk of bank
failures. One way in which the FDIC is
attempting to reduce the cost of bank
failures borne by the insurance fund is
to force large deposit holders to share in
those costs, and thereby eliminate what has
been an implicit insurance guarantee on
large deposits-those deposits in excess of
the insurance limit of $1 00,000.
In the past, the FDIC commonly has
arranged for another institution to purchase
the assets and assume the liabilities of a
fai led bank and thereby protected all depositors from losses. This has been particularly true when larger banks have failedthe notable exception being the failure of
PehriSquare Bank in 1982.
Such an implicit guarantee removes the incentive for large depositors to be concerned
about the financial condition of banks. Consequently, these depositors do not devote
resources to monitor risk-taking by banks, or
demand interest-rate premiums that reflect
the risk exposure of a bank. This situation, in
turn, enhances the incentives for banks to
engage in risky activities. This potential that
providing deposit insurance would increase
risk-taking is, in essence, the so-called
"moral hazard" problem faced by all
insurers.
The FDI C has decided to address this problem by shifting back to the private market
(i.e., large depositors) more of the responsibility for monitoring and pricing bank risk.
To this end, the FDIC is experimenting with a
"modified payout" approach for dealing
with bank failures. This Letter xamines this
e
modified payout plan and discusses whether
using account size to determine which
accounts should be insured is consistent
with the basic purpose of deposit insurance.

Modified payout plan
Underthe FDIC's plan, insured deposits will
continue to be handled as they have in the
past, either being assumed by another institution willingto buy the failed bank, or
being paid off by the FDIC when no buyer
can be found.

However, under the new modified payout
approach, holders of large-denomination
deposits will receive only pro rata. hares of
s
what the FDIC thinks it can recover from the
liquidation of assets immediately after a
bank has failed. With a greater chance of
financial loss, holders of large-denomination deposits will have an incentive to monitor banks more closely, and serve to check
bank risk-taking. The modified payout has
the added advantage that depositors will not
have their funds tied up in bankruptcy proceedings as is the case with ordinary
payouts.
So far, modified payouts have been used
only in the failures of relatively small commercial banks. Some question remains as to
whether this approach to increasing the
riskiness of large deposits can be successfully applied to the largest commercial
banks. If it turns out to be impractical to use
modified payouts when large banks fail, the
FDIC has indicated that it will reevaluate its
current experiment. It would be unworkable
to leave large deposits at some banks truly
uninsured and to provide such deposits at
the biggest banks implicit coverage.
Functions of deposit insurance
Through the modified payout, the FDIC is
attempting to address the undesirable moral
hazard side effects of deposit insurance.
However it is not clear at first glance that
increasing the riskiness of large deposits to
achieve this goal does not have undesirable
side effects of its own, especially aftertaking
into account the reasons why we have
deposit insurance in the first place.

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cXrHes'led in thi.'- nel;v<.;lettt'f do not
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or Pi' the BrXli"d of COVCrTlOrs of lh,' Federai
RE':;efVi;-\Sv;;,('en,.

One objective often ascribed to deposit insurance is the protection of "small·depositors," It is based on the particular rationale
that deposit insurance is needed to address
the impact of bank failures on depositors per
se, rather th,an on the economy in general.
Because small depositors are thought to be
unable to protect themselves, depositinsurance agencies assume the responsibility of
checking bank risk-taking, The agencies are
assumed to be better able both to acquire
information on banks and to enforce constraints on their risk-taking, Large depositors
are left uninsured because they are assumed
to be at least as good as, if not better than, the
insurance agencies at determining the riskiness of banks and pricing the risk accordingly, Such a limited objective argues for using
account size as the criterjon for insuring
deposits,

, unexpected contraction in the money
supply which, with a lag, would result in a
severe and pervasive reduction in economic
activity,
The monetary impact of bank runs, of
course, has been used as a defense for deposit insurance for some time. However,
some analysts argue that the adverse conse. quenc'es of bank runs go beyond those
associated with money and the money creation process, For example, recent articles by
Bernanke (AER, une 1983) and Diamond
J
and Dybvig UPE,June983) pointoutthatthe
1
breakdown of the intermediation process
that would result from bank runs could
impose real costs on the entire economy,
The connection between federal deposit insurance and economy-wide losses associated with bank runs raises some question
about the FDIC's plan to increase the riskiness of large-denomination deposits, Under
the economic-stability rationale, deposit
insurance is warranted on the grounds that
depositors protecting themselves is not
sufficient to guarantee stability in the
banking system. While putting large depositors at risk-as the FDIC's modified payout
approach does-may reduce the moral
hazard problem introduced by deposit
insurance, it does not address the issue of
bank runs or ensure that the totalcost to
society of bank risk-taking and bank runs
will be considered, If one sees a need for
deposit insurance because of the presence
of some degree of market failure, it would
seem somewhat contradictory to look to the
market for a solution to a problem created by
the existence of deposit insurance,

In contrast, a second objective attributed to
deposit insurance focuses on protecting the
economy in general from the impact of disruptions in the banking industry, In particular, federal deposit insurance is thought to
contribute to the overall stability of the
economy by averting bank runs and their
adverse effects, One reason the economic
cost of bank runs could be widespread and
pronounced is that banks are integral parts
of the payments mechanism and constitute
channels through which monetary policy
operates. For example, a collapse of the
banking system could lead to a large and

Insuring liquid deposits
The economic-stability rationale for deposit
insurance dictates that the foremost role of
deposit insurance should be to prevent bank
runs, As a result, the goal of reducing the
susceptibility of banks to runs should be the
major criterion for determining which
deposits are insured,

2

convincing arguments explaining why the
probabilityof runs should decline asthe size
of an account rises, liquidlarge-denomination accounts should be insured as well.

. Kareken(AER, May 1983) has maintained
that depository institutions are subject to
runs because deposits are fixed-dollar
claims against risky assets.With risky portfolios, depository institutions can incur
lossesthat exceed net worth, while the
fixed-dollar claim means that a depositor
can avoid sharing in those losses if he can
withdraw funds before other depositors.

Conclusions
The FDIC's modified payout approach for
handling failed banks delegates to large
depositors at least part of the responsibility
of monitoring and pricing bank risk. This
shift reduces the moral hazard problem connected with the provision of deposit insurance, but only ensures that the cost of bank
risk as it affects uninsured depo$itors will be
taken into account.

The problem of "runs" is particularly acute
for banks because they tend to hold a certain
volume of liquid assetsfunded by deposits
that essentially are available on demandchecking, savings, and money market deposit accounts-and short-term time
deposits. The holders of these liquid
deposits can react qu ickly to a real or a
perceived deterioration in the financial condition of banks. This is true as much for
depositors with large-denomination liquid "
accounts as for depositors with small liquid
balances. Holders of longer-term deposits
could "run" in the sensethatthey would not
roll their accounts over at maturity. However, such a process would be drawn out
over a period of time, allowing bank assets
to mature and giving depositors and regulators an opportunity to assessmore accurately the condition of the individual institutions. (Wh i Ie banks have the option to allow
withdrawals from time deposit accounts
prior to maturity, under current regulations,
banks are not obliged to honor requests for
early withdrawals except in the case of the
death or mental incapacitation of the
depositor.)

The modified payout plan certainly is in
keeping with the small-depositor protection
justification for deposit insurance. However,
ifdeposit insurance is thought to be needed
to enhance the stability of the banking system, then the FDIC's plan is lacking. The
foundation of the stability argument is that
private market arrangements cannot be
expected to solve the problem of bank runs
and that bank runs lead to economy-wide
losses. Putting large depositors at risk does
not address the bank run issue and could
well exacerbate the problem. If the
economic-stability rationale suggests
thing, it is that liquid deposits should be
insured, which would include liquid largedenomination accounts.

Frederick T. Furlong

With in the context of the econom ic-stabi I ity
argument for deposit insurance, the particular characteristics of bank assetsand liabilities suggest that accounts should be insured
on the basis of their terms of maturity. Such a
distinction would satisfy both the desire to
increase risk for the depositor and the desire
to ensure a stable banking system. Liquid
deposits, which precipitate runs on banks
that in turn impose costs on the economy,
should be insured. In principle, and without

3

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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand Liabilities
Large Commercial Banks
Loans, Leases
and Investments' 2
Loansand Leases' 6
Commercial and Industrial
Realestate
Loansto Individuals
Leases
2
U.S. Treasuryand Agency Securities
2
Other Securities
Total Deposits
Demand Deposits
Demand DepositsAdjusted3
4
Other TransactionBalances
Total Non-Transaction
Money Market Deposit
Accounts-Total
Time Depositsin Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
. Weekly Averages
of Daily Figures
ReservePosition, All Reporting Banks
ExcessReserves+ )/Deficiency (- )
(
Borrowings
Net free reserves(+ )/Net borrowed(- )

\illW2 £
C

Amount
Outstanding
5/2/84
180,066
160,380
48,101
59,691
27,940
5,000
12,070
7,616
187,856
46,226
29,110
12,197
129,433
39,308
38,481
21.532

Weekended
4/23/84

-

68
102
33

Change
from
4/25/84
1,477
1,505
726
77
5
6
4
- 23
3,266
3,083
256
70
113

Changefrom 12/28/83
Percent
Dollar
Annualized
4.041
6.6
5,025
9.3
2,138
1304
792
3.8
1,289
13.9
- 3.5
63
- 10.0
437
- 19.3
547
- 3,141
4.7
- 3,011
- 17.6
- 2,221
- 2004
- 13.0
578
448
1.0

-

309

-

289

477
349

-

316
1,475

-

2.1
2.3

- 18.5

Weekended
4/9/84
273
118
155

, Includes loss reserves,
unearnedincome, excludesinterbank loans
2 Excludestrading account securities
3 ExcludesU.S. governmentand depositoryinstitution depositsand cashitems
4 ATS,NOW, Super NOW and savingsaccountswith telephonetransfers
s Includes borrowing via FRB,n &L notes,FedFunds,RPsand other sources
6 Includes items not shown separately
Editorial commentsmay beaddressed the editor (GregoryTong)or to the author •.•• Freecopiesof
to
Federal Reservepublications can be obtained from the Public Information Section, FederalReserve
"Bankof San Francisco,P.O. Box 7702, SanFrancisco94120. Phone(415) 974-2246.
.