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13) @\ Ik\((5) 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. C2'"S ...... ))/·0'\ :\1. .. ,:..,,' \.:,'.. 'I Jl "'" IT'\(:' Y''c"' , 1 II "-.', on eG" 11 1 \ cXrHes'led in thi.'- nel;v<.;lettt'f do not ('ef!ect lhe vie\\'" of tht' managen1 ent o( the' Fpdera\ Reserve Bank or San Francisco, 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 lSl:Il:I U OI8UI4Sl! M.4l!ln • U08<l10 • l!Pl!/\<lN • 04l!PI !!l!Ml!H •. l!!Ul0)!Il!:) p.u O Z!1 V. l!>fSl!IV y:;j)\illW2 Jrd[ CD)24I\illW2 em 'J!lll::> 'OlSpUllJ:IUllS ZSL 'ON ll Wlt:ld (]JVd :J9V1SOd 's'n ll VW ssvnlS}l1:! aU}lOS: J}ld 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. .