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ill) cE\ 1 (G)1r ffi\ k § n CC CD) CillIT1 I f Cillffi\ JF (C 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 3 !!eMeH • • 4eln • e!uJoJ!le:) • • epeA<3N o4epi • euozpv • e>jselV JJ CG) 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. \illWJCS