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September 17, 1982

Risk, Insurance, and Central Banking
In the last two years, news of weakness in
large domestic and foreign depository institutions has shaken the financial markets. The
recent failure of some institutions has highlighted the increased level of risk and the role
of monetary authorities in dealing with it.
When the subject of risk for depository institutions is raised, most people in the United
States think of deposit insurance. However,
this insurance is but one form of support
which monetary authorities around the world
provide to their financial systems. These
various forms of support are designed to protect depositors and institutions from risk but
they also directly affect the risks taken.
Hence, the way in which authorities react to
recent developments is of widespread concern.ln this Letter, attempt to putthis issue
we
in perspective by applying the economics of
risk and insurance to the behavior of depository institutions.
The "moral hazard" problem
Individuals who are fully insured against loss
(e.g., fire, theft) may be expeCted to take
greater risks than if they were not fully
insured. To counteract this tendency, insurance companies try to discriminate among
individuals by charging higher premiums to
those who take lesscare and hence undertake
greater risks. However, the insurance company cannot always observe the level of care
taken by the insured individuals and so must
base its policy premiums on the average
historical experience of the potentially insurable population. This inability to price actual
risk and to influence risk-taking behavior
tends to reduce the level of care taken by
some insured individuals. As a result, insurance companies are exposed to the potential
for large losses. This is known as the problem
of "moral hazard."

To minimize this problem, the insurance
company needs to provide some incentive to
the insured to act more prudently. Most insur-

ance policies contain this incentive in the
form of a deductible
and cover only losses
above the deductible.
A similar moral hazard problem can occur in
the relationship between banks and monetary authorities. The monetary authorities
wish to assure their countries of a sound payments system by providing certain explicit
and implicit assurances of aid to the financial
industry in times of stress. However, they do
not wish to make commitments which
increase the likelihood that depository institutions will take on "excessive" or "imprudent" risks. Thus, although the payments
system may be made more secure by stronger
assurances of support to financial institutions,
such assurances may induce those
institutions to acquire more risky assetsthan
they otherwise wou Id have and so cause too
many of society's savings to be channeled
into highly risky enterprises. On the other
hand, eliminating or greatly reducing such
assurances increases the chance of d isru ption
to the payments system and, at the same time,
may cause institutions to channel too few
resources into risky but potentially productive investments.
Insurance and assurance
Most depositors are familiar with the most
prominent form of support provided to
depository institutions in the U. S.-deposit
insurance. All federally-chartered banks, savings and loan associations, and credit unions
are required to carry deposit insurance. The
vast majority of state-chartered banks and
savings and loans are insured even though
some states do not require coverage. However, a substantial number of state-chartered
credit unions are not insured.

Deposit insurance, however, is not common
around the world. Only thirteen countries
possessdeposit insurance and of these only a
few are large industrial countries. There are
no compulsory deposit insurance require-

IT1 1 (G)
k
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 Covernors of the Federal
Reserve System.
ments for commercial banks in Italy, France
or Germany, although the last does have a
voluntary industry-operated program.

tary authorities is particularly acute in view of
the major changes taking place in our financial system today. By any measure, depository institutions now have to cope with more
competition and risk than ever before.

Monetary authorities do provide a range of
alternative support services to depository
institutions. Instead of explicit insurance,
they provide "assurance"-the
assurance
that the authorities will provide certain
services when depository institutions face
unexpected or uninsurable risks. This assurance is often implicit and influenced by the
legal and socioeconomic customs of the
country. In many countries, the existence ofa
central bank functioning as a lender of last
resort to private financial institutions provides
this assurance. In the U.s., for example, the
assurance that the Federal Reserve will provide additional reserves to the banking
system in times of financial crisis increases
the public's confidence in the banking system, reduces the likelihood of "runs" on
banks, and thus, lowers the risks they face.

A wide variety of financial institutions now
offer transactions deposits, a service which,
until recently, was the sole prerogative of
commercial banks. In June 1 982, 58 percent
of the short-term liabilities of banks and thrift
institutions consisted of deposits whose
yields fluctuated with market rates. This
compares with only 12 percent five years
ago. Nominal interest rates, both short and
long, have become more volatile, while real
interest rates-nominal
market rates less
observed inflation rates-have, until very
recen.tly, been at levels not seen since the
1930s. New institutions-including
not only
the money market mutual funds but also a
growing number of conglomerates such as
Sears Roebuck, Shearson-American Express,
and Merrill Lynch-are offering financial
services which encroach uponthetraditional
"turf" of banks and other depository
institutions.

The justification for having a lender of last
resort and/or a deposit insurance scheme is
twofold. First, because depository institutions
do not match the maturities of their assets to
those of their liabilities, their continued
viability depends on their customers' confidence that deposits will be redeemable in
cash when they are due. In the case of transactions deposits, of course, this means "on
demand."

In the next few years, the Depository Institutions Deregulation and Monetary Control Act
of 1 980 will continue to liberalize our financial system by further raising interest rate
ceilings and by creating new financial instruments. This liberalization will increase competition among financial institutions and raise
questions about the types of i nsu rance and
assurance that monetary authorities traditionally have provided.

Second, these institutions function not only
as financial intermediaries-channelling
funds from savers to borrowers-but
also as
providers of our payments system. When an
institution which issues transactions accounts
fails, it disrupts the payments system and
causes inconvenience and perhaps financial
loss to individuals and businesses other than
its own customers and owners. It is generally
thoughtto be socially desirable to avoid these
harmful "spill-over" effects by reducing the
number of bank failures, or at least, by minimizing their disruptive impact.

Regulation and deductibles
Historically, there have been two principal
solutions to the moral hazard problem in the
United States. First, the monetary authorities
in their role of "insurer" observe and regulate
the operations of the "insured" financial
institutions. Much of this activity of both federal and state authorities is designed to ensure
that depository institutions do not accept
"undue" amounts of risk. For example, they
mon itor the capital adequacy and the loan

Financial innovation
The moral hazard problem facingthe mone2

however, the FDIC chose to close the bank
and payoff only the formally insured
depositors. As a prominent business weekly
put it, the regu lators sent a "very expensive
message: Be more careful" to banks and their
depositors.

quality of institutions. Depository institutions
are also barred by statute from engaging in
certain types offinancial activity, such as corporate and revenue bond underwriting,
which are considered too risky. Some regulations have limited the yields which depository institutions may offer on their liabilities,
and thereby reduced their cost of funds.
These regulations were designed partly to
channel low cost loans to particular sectors
but also to discourage institutions from
acquiring high-yielding, but risky, earning
assets.

In the Banco Ambrosiano case, the central
bank of Italy did not provide the same treatment to the creditors of the Banco Ambrosiano's holding company in Luxembourg as it
did to the Milan bank's domestic creditors. A
recent Wall Street
Journal rticle by PauI
a
Blustein quotes Beniamino Andreatta, Italy's
Treasury minister, as saying that creditors
knew of the additional risk of the Luxembourg affiliate and accordingly demanded a
premium over loans made to the Milan
parent. The Wall StreetJournal quotes Mr.
Andreatta as saying, "I think it's useful for the
international community to know that banks
are risky enterprises and that it's possible and
necessary to evaluate risk."

The second way of dealing with moral hazard
has been via a "deductible." In the United
States, deposits up to $100,000 per account
are insured butthose in excess of this level are
not. At the end of 1 981 , on Iy 70 percent of the
deposits of insured banks were covered by
insurance. Although not quite the same as a
deductible in conventional insurance policies, this dollar ceiling serves the same purpose of discouraging excessive risk exposure.

Both explicit deposit insurance programs and
implicit central bank assurances of help for
commercial banks in times of stress change
the behavior of the institutions. The deregu lation ofthefinancial system worsens the moral
hazard problem. In the cases of
Square
Bank and Banco Ambrosiano, the regulators
appear to have reacted to these changes by
re-defining the risks they believe the market
should evaluate and bear. (There are already
signs that the market is reflecting this in the
higher deposit rates demanded from some
institutions.) This apparent change in the regulators' behavior may be interpreted as an
increase in the deductible designed to offset
their reduced ability to control the assured
institutions.

The increased risk in today's financial market, coupled with reduced control of the
insured institutions by regulatory authorities,
would prompt a private insurer to raise the
deductible in its insurance policies. Two
recent cases suggest that the monetary
authorities are doing likewise. These two
recent illustrations of the moral hazard
problem in banking, one domestic and the
other international, are the Penn Square Bank
and the Banco Ambrosiano S.A. of Milan,
Italy, cases.
With most bank failures in recent years, the
Federal Deposit Insurance Corporation has
arranged for a healthy institution to take over
the failing bank. All depositors-notonly
those with accounts of less than $1 00,000were thus protected. In the Penn Square case,

Joseph
Bisignano
BrianMotley

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BAN KING DATA-TWE LfTH FEDERAL
RESERVE
DISTRICT
(Dollaramounts.in
millions)
Selected
Assets ndLiabilities
a
Large
Commercial
Banks
Loans
(gross,
adjusted) investments*
and
Loans
(gross,
adjusted) total
#
Commercial industrial
and
Real
estate
Loans individuals
to
Securities
loans
U.s.Treasury
securities*
Othersecurities*
Demand
deposits total#
Demand
deposits adjusted
Savings
deposits total
Timedeposits total
#
Individuals, & corp.
part.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves )/Deficiency- )
(+
(
Borrowings
Netfreereserves )/Netborrowed
(+
(-)

Amount
Outstanding

Change
from

9/1/82
161,450
141,567
44,921
57,445
23,560
2,435
6,334
13,549
41,852
28,471
31,221
99,090
89,487
37,263

8/25/82
1,585
1,612
919
136
101
95
0
27
4,136
1,655
442
- 627 .
532
- 452

Weekended

Change
from
yearago
Dollar
Percent

-

Weekended

9/1/82

8/25/82

606
6
600

192
87
105

8,662
9,954
5,104
3,281
552
1,067
416
1,708
1,126
473
1,388
12,417
11,067
1,728

5.7
7.6
12.8
6.1
2.4
78.0
7.0
- 11.2
2.8
1.7
4.7
14.3
14.1
4.9

Comparable
year-ago
period
270
64
206

* Excludes
trading
account
securities.
# Includes
itemsnotshown
separately.
Editorial
comments beaddressedtheeditoror to theauthor.... Free
may
to
copies thisandotherFederal
of
Reserve
publications beobtained callingor writingthePublicInformation
can
by
Section,
Federal
Reserve
Bankof SanFrancisco, Box7702,SanFrancisco
P.O.
94120.
Phone
(415)544-2184.

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