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FRBSF August 3, 1984 WEEKLY LETTER The Federal Safety Net for Commercial Banks: Part II This Weekly Letter continues last week's discussion of the problems involved in administering the federal safety net for commercial banks. Last week's Letter focused on the lender-of-Iast-resort function of the Federal Reserve. It concluded that there is no inherent conflict for the Federal Reserve between meeting the Iiqu idity needs of depository institutions and achieving the goals of monetary policy. This Letter takes up the issue of federal deposit insurance for commercial banks. Deposit insurance The Federal Deposit Insurance Corporation (FDIC) was established in the wake of the devastating banking panic of the early 1930s. From its inception, the FDIC has had two basic functions. The first has been to protect depositors of modest means from incurring losses when banks fail. The second has been to protect the economy in general from the adverse effects of bank runs. In meeting these goals, the effectiveness of the deposit insurance guarantee has been far greater than what mighthave been expected given the limited size of the insurance fund. At the end of 1983, the FDIC fund totaled only about $15.4 billion, or less than one percent of total domestic deposits at insured commercial banks. The impact of deposit insurance goes beyond the size of the insurance fund primarily because the major benefit of the insurance guarantee is that it averts bank runs and thus avoids the need for extensive payouts. Also, the system for administering deposit insurance can afford the FDIC some control over the cost it bears when a bank fails. The failure of even a large bank, in principle at least, does not have to force the FDIC to take on heavy losses. The size of the losses to the FDIC depends on the value of the net worth of the bank when it fails, which, in turn, depends partly on how promptly the FDIC and other regu latory agencies take action to close a troubled bank. Moreover, the FDIC has more resources at its disposal than the insurance fund itself, since the FDIC can borrow from the Treasury. Finally, the Congress has passed a resolution, albeit a nonbinding one, placing the full faith and credit of the federal government behind the deposit insurance guarantee. Incentives to risk-taking Over the past 50 years, the FDIC clearly has been successful in achieving its assigned goals byalleviating depositors' concerns over the soundness of commercial banks. Nevertheless, the movement to reform the deposit insurance system has never been stronger because of the growing awareness that federal deposit insurance can affect the behavior of commercial banks. The problem is that as long as depositors and other cred itors of banks know that depository institutions (or at least large banks) in trouble will be bailed out, depositors and others do not have to concern themselves with the condition of a bank's portfolio. Therefore, banks will not have to bear the full cost of their risk-taking, unless they are kept in check by the FDIC and the other bank regulatory agencies. This point can be illustrated through a simple numerical example. Consider a bank with $3 million in capital and an investment opportunity that will return $3 million or generate a loss of $3 million with equal probability. The expected value of the investment to the market (i .e., the shareholders) would be zero. As an alternative, consider a bank with $2 million in capital and $1 million in insured deposits. Now the shareholders at most can lose $2 million. The expected value of the investment to the shareholder then would be the average of the $2 mill ion loss of capital and the $3 million potential gain-which comes to $500,000 instead of zero. The deposit insurance in this case increases the expected return of the risky investment, and thus makes the investment more attractive. Another point that can be brought out through the example is that the lower the level of shareholder capital of a bank the greater the expected gain from risky loans. Continuing with the example, if capital in the bank were only $1 million (and insured deposits were $2 million), then the expected value of the investment would be $1 million. With federal deposit insurance, the most FRBSF leveraged institutions have the most to gain from a given risky investment. And, needless to say, institutions that are allowed by regulators to continue operating when net worth is negative can only stand to benefit from risky enterprises. These incentives for risk-taking inherent in the federal safety net have been recognized for some time, and they have been kept in check to a large degree through supervision and regulation. However, with deregulation in banking, the task of curbing banks' desires ta'<l<:ton the incentives presented to them likely will be more difficult. This is not necessarily because deregulation means that banks have to pay more for funds and therefore must seek out higher yield ing, riskier assets, or that all new activities sought by banks are inherently more risky than traditional lines of banking business. Indeed, in principle, many aspects of deregu lation cou Id reduce bank risk. For example, greater asset powers would allow more diversification, and the removal of deposit rate ceilings means that banks have more efficient ways of acquiring funds from a broader source. What deregulation does is give institutions greater scope to act on the incentives for risk-taking. A case in point is the use of brokered deposits. Deposit brokers can obtain funds from investors throughoutthecountry in units of up to $100,000, and channel the deposits to commercial banks or thrift institutions. The deposits that a depository institution receives from a broker far exceed the insurance limit of $100,000, but, since each unit is at the limit or below it, the entire pool is insured. Depositors therefore do not have to concern themselves with the financial condition of the depository institutions to which their funds are directed and can look for the highest interest rate paid. Thus, with fully insured brokered deposits, a bank has access to funds on a nationwide basis at a cost that wi II notfu Ily reflect the riski ness of the bank's loans or its capital position. Once again, the institutions with the weakest capital positions would gain the most by acquiring insured brokered deposits. To block the "abuse" of the deposit insurance guarantee, especially by weaker institutions, the FDIC and the Federal Savings and Loan Insurance Corporation (FSLlC) took steps to limit the insurance coverage on brokered deposits. Their attempt to limit insurance on brokered deposits to $100,000 per broker per institution would have taken effect October 1, 1984 had it not been challenged successfully in court. The deposit insurance agencies apparently are considering an appeal of the decision. Without deposit insurance, banks, of course, sti II would fund some of their assets through "borrowings" in the form of deposits. However, in the absence of deposit insurance, the cost of deposits can be expected to reflect the riskiness of a bank. If depositors were not insured, the risk-return tradeoff faced by a bank in its investment decisions would not change materially. Consequently, banks' risk-taking proclivities would not be encouraged. Controlling risk-taking To mimic a "market" approach to checking bank risk-taking, it has been suggested that the FDIC replace the current fixed-rate insurance premium with a structure of variable rate premiums that reflect the risk exposure of an institution. In fact, the FDIC has had legislation introduced in the Congress that would give the insurance agency authority to use a system of risk-based insurance premium rebates. However, the impact of this proposal likely would be minimal since the differences in rebates among the risk categories for a bank would be quite small. The FDIC has been especially sensitive to the impact of deregulation on risk-taking by banks and the consequent exposure of the insurance fund. In addition to the steps taken to curb brokered deposits, the FDIC attempted to reduce the distortions created by the deposit insurance through the "modified payout" plan for handlingfailed banks. (This plan was the subject of the May 18, 1984 Weekly Letter.) The plan was designed to make large depositors share in the losses of bankfailures as a means of imposing greater market discipline on banks. However, the modified payout has only been used on relatively small banks. Its rejection in the handling of the troubled Continental Illinois bank raises grave doubts as to whether this plan would be applied to any large bank. Developments at Continental Illinois strongly point out that the modified payout plan, with its emphasis on protecting small depositors, conflicts directly with the second objective of deposit insurance-to prevent bank runs. In reaction to the massive withdrawal of large deposits at Continental, the FDIC abandoned the principles behind the modified payout approach and provided insurance coverage for all depositors. The FDIC's actions clearly were intended to address the problem of bank runs, which not only affect particular banks but the economy as a whole. The FDIC currently is evaluating the experimental modified payout, and it may be a couple of months before it announces a final verdict regarding the plan. Perhaps recognizing the implications-of the combination of a weak capital position and the availability of deposit insurance, the FDIC along with the Comptroller of the Currency also have proposed a rule that would require banks to maintain a primary ratio of capital to assets of 5.5 percent and a secondary capital minimum, including some convertible debt and the value of intangible assets in the definition of capital, of 6 percent. Prior to this proposal, the FDIC policy recommended a primary ratio of capital to assets of 5 percent. While higher capital requirements could have some bearing on bank risk-taking, the proposed requirements continue the convention of considering the book value of net worth, rather than the market value. However, the gains from risktaking in ban ki ng when deposit insu rance is avai 1able are related to the market value of a bank's net worth. The continued focus on book value net worth is problematic because the book value of net worth can exceed the market value and, for some banks, the difference can be quite striking. For example, for the troubled Continental Illinois Bank at the end of the first quarter of this year, the ratio of its market value of equity to its book value of equity was far less than one-half. There are, of course, problems with using a market evaluation of a bank for regulatory purposes (aside from the fact that most bank stocks are not traded regularly). For example, the market price of a bank's stock will reflect the presence of the deposit insurance guarantee, not to mention the possibility that, say, a large bank would be bailed out if it were to experience problems -bai led out even to the extent of providing some protection to shareholders, as in the case ofthe First Pennsylvania Bank. Nevertheless, more attention should be given to evaluating bank net worth on the basis of "market" rather than book value. Conclusion The current problems facing banks have made us more aware of the importance of the federal safety netto the stability of the banking system. Atthe same time, the heightened role of the FDIC (and, as discussed in the preceding Weekly Letter, the Federal Reserve as lender of last resort) has raised concerns over the side effects of the safety net. Federal deposit insurance may increase the risktaking proclivities of insured banks. In response, a number of methods for keeping bank risk-taking in check have been suggested. The arrangements announced.on July 26, 1984 by the FDIC for dealingwith Continental Illinois undoubtedly will add fuel to this ongoing debate over deposit insurance reform, particularly regarding the proper scope of the FDIC guarantee. In the end, however, the FDIC, in conjunction with the other bank regulatory agencies, probably will continue to rely on supervision and regulation-particularly capital requirements-as the main tools to restrain banks from engaging in excessively risky enterprises. Frederick T. Furlong and Michael W. Keran MONETARY POLICY OBJECTIVES FOR 1984 AND 1985 On July 25, Federal Reserve Board Chairman Paul Volcker presented a mid-year report to the Congress on the Federal Reserve's monetary policy objectives for the remainder of 1984 and proposals for 1985. The report includes a review of economic and financial developments in 1984 and the economic outlook heading into 1985. Single or multiple copies of the report can be obtained upon request from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, CA 94120. Phone (415) 974-2246. Opinions expressed in this newsletter do not necessarily reflect 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 (Gregory Tong) 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. uo~6lJ!4S0m 4o~n 040 PI !!omoH O!UJoJ!l0) U060JO ouoz!J~ OpOA0U 0lisol~ O)SI)UOJ::J UOS JO ).juo8 '1!11!;) 'o:>sPU1!J ::I U1!S ZSL 'ON IIWH:ld (]IVd:l9VISOd 's'n llVW ssvn ISHI::I (]UHOS:lHd aAJaSa~ IOJapa::J ~uew~Jodea LpJoese8 BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Loans, Leases and Investments' 2 Loans and Leases 1 6 Commercial and Industrial Real estate Loans to Individuals Leases US. Treasury and Agency Securities2 Other Secu rities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances4 Total Non-Transaction Balances 6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Weekly Averages of Daily Figures Reserve Position, All Reporting Banks Excess Reserves (+)/Deficiency (- ) Borrowings Net free reserves (+)/Net borrowed( - ) Amount Outstanding Change from 7/18/84 181,515 162,430 49,066 60,499 28,763 5,009 11,950 7,135 187,925 44,014 28,995 12,250 131,661 7/11/84 264 - 239 - 224 76 51 22 34 8 -1,844 -1,812 -1,619 - 190 159 - - 327 396 2,163 38,099 40,205 21,027 Change from 12/28/83 Percent Dollar Annualized 5,490 7,075 3,103 1,600 2,112 54 557 1,028 3,072 5,223 2,336 525 2,676 5.5 8.1 12.1 4.8 14.2 - 1.9 - 7.9 - 22.5 2.8 - 19.0 - 13.3 7.3 3.7 - 1,498 - 6.7 - 2,040 1,980 - 09.5 15.4 - - - Period ended Period ended 7/16/84 7/02/84 23 59 81 140 96 44 , Includes loss reserves, unearned income, excludes interbank loans Excludes trading account securities 3 Excludes U.s. government and depository institution deposits and cash items 4 ATS, NOW, Super NOW and savings accounts with telephone transfers S Includes borrowing via FRB, n &L notes, Fed Funds, RPs and other sources 6 Includes items not shown separately 2
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