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FRBSF

WEEKLY LETTER

April 21, 1989

Reforming Deposit Insurance
The deposit insurance system is facing a crisis
of historic proportions. The Federal Savings and
Loan Insurance Corporation (FSLlC) is insolvent
to the extent of at least $90 billion; bank and
thrift failures are at record highs; the Federal
Deposit Insurance Corporation (FDIC) just experienced its first-ever decline in reserves; and
some economists think the FDIC's reserves may
be inadequate.
Many blame these problems on adverse
economic conditions, such as high and volatile
interest rates and troubles in the farm belt and
the oil patch. Others argue that unscrupulous
bank and thrift management and inadequate
supervision and regulation are to blame. And
some fault deregulation, expansion of powers,
and increases in the ceiling for deposit insurance
coverage. All of these factors may have hastened
the deterioration of the deposit insurance funds.
They also may be partly responsible for the
timing and intensity of the problem.
But economists have long argued that at the root
of the current problem is an inherently flawed
deposit insurance system. By employing a flatrate pricing system that does not relate the insurance premium to the risks that are being insured,
deposit insurance provides an incentive for excessive risk taking. This is the so-called "moral
hazard" of deposit insurance.
This Letter evaluates ways to reform the deposit
insurance and regulatory systems to eliminate
this moral hazard. Such reform is vital to ensure
that problems similar to those we are facing
today do not recur.

Resolving current insolvencies
The obvious and necessary first step towards
deposit insurance reform is to deal with the
institutions that currently are insolvent or nearinsolvent. Insolvencies should be resolved as
quickly as possible, through liquidations or
through acquisitions by stwngly capitalized
firms, whichever is least costly. And institutions
near insolvency should be required to raise
additional capital as soon as possible.

Although resolving current insolvencies quickly
will help to limit the costs of the current problem, it will do little to ensure that similar problems do not recur. Thus, it is desirable to move
beyond current difficulties to design a system
that has desirable long-run properties.
A variety of reforms have been proposed. In
general, these proposals fall into one of two main
categories. The first involves enhancing depositor
surveillance of institutions' risk taking. The second focuses on providing bank capital holders
with appropriate incentives to control risk taking.
Because enhanced depositor surveillance might
reduce banking system stability, I argue that it
would be better to strengthen bank capital and
ensure that banks maintain sufficient capital over
time to absorb losses.

Depositor surveillance
Depositor surveillance of bank and thrift risk
taking could be enhanced in many different
ways. For example, the ceiling for insurance
coverage could be lowered from $100,000 to
$40,000, or even $20,000. Alternatively, coinsurance could be instituted, whereby each
deposit account would be only partially insured.
Or insurance coverage could be limited to deposits used to fund risk-free assets such as Treasury securities. This last approach, known as the
"narrow banking" proposal, would in effect shift
the saving-lending intermediation functions
banks now perform to uninsured institutions.
There is no doubt that such measures would
induce at least some depositors to monitor carefully the health of banks and thrifts and thus
would penalize those institutions that undertake
excessive risks by requiring them to pay higher
deposit rates. However, almost by definition,
increased depositor surveillance also means that
institutions will be exposed to an incr~ased risk
of depositor runs. Not only would the probability
of runs on individual institutions increase, but
perhaps the entire banking system would become less stable. Even under the narrow bank
proposal banking stability could be threatened

FRBSF
since "wide banks," where the actual savinglending intermediation would take place, would
have no deposit insurance. A less stable banking
system could, in turn, lead to a less stable financial system and economy.
Some proponents of diminished depositor protection argue that scaling back deposit insurance
coverage would cause only a little more banking
instabilityj and that a little more instability would
be a small price to pay for reducing the moral
hazard for excessive risk taking. But it is questionable whether there is such a thing as just a
little instability-partial coverage might lead to
nearly the same degree of instability as no
coverage.

Eliminate deposit insurance?
Others go even further and argue that a run
on an individual bank would not lead to runs on
other banks. They argue that sincean increased
likelihood of runs would not lead toan unstable
banking system or an unstable economy, there is
no fundamental economic reason for deposit insurance. Moreover, eliminating deposit insurance
altogether has the advantage that it eliminates
the incentive for excessive risk taking, whereas
proposals to merely scale back coverage do not.
The notion that government deposit insurance is
not necessary to ensure banking system stability
is not universally accepted, even among freemarket economists. And there is contrary theoretical and empirical evidence in support of a
centra.lized deposit insurance system. Thus, it
seems unlikely that the debate over whether
deposit insurance performs a vital economic
function will be resolved any time soon.
Perhaps even more important, proposals to
eliminate deposit insurance do not seem to have
much popular appeal. The public has grown
used to a system in which bank runs do not
occur. Neither the public nor the Congress is
likely to embrace proposals that solve the deposit
insurance problem by increasing the likelihood
of runs. This is especially so in light of the history
of banking panicsand runs in the U.s. priorto
the adventof deposit insurance.
In lieu of increased depositor surveillanceof
institutions' risk taking; some have advocated
stronger direct limitations on risk taking. But

most economists argue that such an approach is
ineffective when there are strong countervailing
economic incentives. It usually is more effective
to alter the underlying incentives. In essence, this
means that appropriate incentives must be given
to those providing non-deposit sources of funds
-either equity holders, other liability holders, or
both-to police risk taking.

Market-value capital
One way to change underlying incentives
would be to institute risk-based insurance premia. While sound in principle, most economists
believe such an approach is currently not feasible. An alternative would be to provide insured
institutions with incentive to maintain strong
market-value capital positions. Capital provides
a buffer to depositors and the insurance funds
against fluctuations in the values of bank and
thrift portfolios. The more capital, the greater the
protection against loss. And higher capital actually reduces banks' incentives to increase asset
risk. With more of their own capital at risk, bank
and thrift owners will be more concerned about
potential losses from the risks they take. In contrast,the owners of an institution with very little
capital have strong incentives to engage in betthe-bank, go-for-broke strategies since they enjoy
all the gains if their investments fare well, but
only a fraction of the losses if their investments
perform poorly.
For capital regulations to be fully effective, it is
essential that capital be measured on a current,
or market-value, basis, not on the historical cost,
or book-value, basis used now. Market-value
capital is the difference between the market
values of an institution's assets and liabilities. In
essence, this means that regulators need to mark
down (or up) the values of an institution's assets
and Iiabi Iities to reflect changes in interest rates
and/or credit risk. Marking institutions' assets
and liabilities to their current values is essential
because it is the current value, not the past value,
that determines the insurer's exposure and influences an institution's risk-taki ng incentives.
Market-value capital has the added advantage
that it cannot be manipulated to disguise institutions' true financial health as easily as bookvalue measures can.

A market test
To provide depository institutions with incentives

to maintain sufficient market-value capital ratios,
institutions whose capital fell below some predetermined amount, say, 10 percent, would be
subjected to a market test of their solvency. An
institution with capital below 10 percent would
be required to bring its capital ratio back up to
standard within a short time. A market-value
solvent institution should have no trouble raising
its capital ratio, either by issuing new capital
securities or by selling assets and using the proceeds to retire liabilities. Moreover, the possibility that the market might misjudge an institution's
true solvency would give it an incentive to hold
more capital in the first place.
If the institution could not raise its market-value
capital ratio, this would be prima facie evidence
that it was market-value insolvent, and regulators
would need to take prompt action to liquidate or
sell it. There is little economic rationale for allowing insured institutions that are unable to maintain their capital ratios above some prudent level
to continue in operation. In fact, allowing them
to do so can greatly increase the risk exposure of
the insurance fund.
A number of objections have been raised to this
type of proposal. However, each of these objections can be addressed. First, many argue that
market value capital regulation simply is not
feasible, primarily because many of banks' assets
are loans for which there are not readily ascertainable market values. However, market participants routinely evaluate the values of banks'
portfolios when they purchase and sell bank
equity, subordinated debt, and other securities.
Thus, while market-value accounting may never
be perfect, it need not be so for market-value
capital regulation to be effective, as the behavior
of private investors in bank and thrift securities
seems to attest.
Second, some argue that there may be ethical or
even legal problems with giving regulators the
authority to close institutions that are not bookvalue insolvent. An alternative would be to grant
the insuring agency authority to promptly remove
a poorly-capitalized institution's insurance guarantee, giving existing insured depositors a reasonable chance to withdraw their deposits if they
so desired. In fact, the FDIC has requested such

authority in its reform proposal. Although such an
approach probably would force insolvent (and
possibly even some marginally solvent) institutions into bankruptcy, it would not precipitate
runs since deposit insurance would remain in
force for existing depositors.
Third, it is argued that equity capital is a far
more costly source of funds than insured deposits. Consequently, heavy reliance on equity
capital could cause the banking industry to
become less profitable and shrink. But one of the
reasons that equity capital now appears to be
more costly is that deposit insurance is underpriced, at least for institutions that are financially
weak. And even if equity capital were truly more
expensive, it is possible to permit institutions to
count long-term subordinated debt (which cannot run) as regulatory capital.
A final problem is ensuring that bank and
thrift regulators have the incentive and the
wherewithal (in the form of adequate reserves) to
strictly enforce market-value capital standards.
If the current incentives are not deemed sufficient, regulators could be subjected to specific
penalties for failure to strictly enforce capital
requirements and/or provides specific rewards for
strict enforcement.

Credible commitment
Strengthening capital requirements and subjecting banks and thrifts to market tests of solvency
would provide insured institutions with incentives to maintain strong capital ratios. Such an
approach has considerable appeal as a way to
reduce the moral hazard of deposit insurance.
However, for this or any other reform to succeed,
it is essential that bank and thrift regulators credibly commit themselves to strictly follow a policy
that alters the risk-taking behavior of bank and
thrift managers. Regulatory reform cannot succeed if bank and thrift executives know that they
can pursue high-risk strategies and then invoke
special exceptions or expect forbearance. In fact,
it was just such forbearance that got us into the
mess we are in today.

Michael C. Keeley
Research Officer

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 (Barbara Bennett) 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.

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