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For release on delivery
9:30 a.m. EST
February 26,2003

Statement by
Alan Greenspan
Chairman
Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing, and Urban Affairs
United States Senate

February 26, 2003

Chairman Shelby, Senator Sarbanes, and members of the Committee, it is a pleasure to
appear once again before this Committee to present the views of the Board of Governors of the
Federal Reserve System on deposit insurance. Rather than refer to any specific bill, I will
express the broad views of the Federal Reserve Board on the issues associated with
modifications of deposit insurance. Those views have not changed since our testimony before
this Committee on April 23, 2002.
At the outset, I note that the 2001 report of the Federal Deposit Insurance Corporation
(FDIC) on deposit insurance highlighted the significant issues and developed an integrated
framework for addressing them. Although as before the Board opposes any increase in coverage,
we continue to support the framework constructed by the FDIC report for addressing other
reform issues.
Benefits and Costs of Deposit Insurance
Deposit insurance was adopted in this country as part of the legislative effort to limit the
impact of the Great Depression on the public. Against the backdrop of a record number of bank
failures, the Congress designed deposit insurance mainly to protect the modest savings of
unsophisticated depositors with limited financial assets. With references being made to "the rent
money," the initial 1934 limit on deposit insurance was $2,500; the Congress promptly doubled
the limit to $5,000 but then kept it at that level for the next sixteen years. I should note that the
$5,000 of insurance provided in 1934, an amount consistent with the original intent of the
Congress, is equal to slightly less than $60,000 today, based on the personal consumption
expenditures deflator in the gross domestic product accounts.
Despite its initial quite limited intent, the Congress has raised the maximum amount of
coverage five times since 1950, to its current level of $100,000. The last increase, in 1980, more

than doubled the limit and was clearly designed to let depositories, particularly thrift institutions,
offer an insured deposit free of the then-prevailing interest rate ceilings on such instruments,
which applied only to deposits below $100,000. Insured deposits of exactly $100,000 thus
became fully insured instruments in 1980 but were not subject to an interest rate ceiling. The
efforts of thrift institutions to use $100,000 CDs to stem their liquidity outflows resulting from
public withdrawals of smaller, below-market-rate insured deposits led first to an earnings
squeeze and an associated loss of capital and then to a high-risk investment strategy that led to
failure after failure. Depositors acquiring the new larger-denomination insured deposits were
aware of the plight of the thrift institutions but unconcerned about the risk because the principal
amounts of their $100,000 deposits were fully insured by the federal government. In this way,
the 1980 increase in deposit insurance to $100,000 exacerbated the fundamental problem facing
thriftinst uions—

a

concentration on long-term assets in an environment of high and rising

interest rates. Indeed, it significantly increased the taxpayer cost of the bailout of the bankrupt
thrift institution deposit insurance fund.
Despite this problematic episode, deposit insurance has clearly played a key—at times
even critical—role in achieving the stability in banking and financial markets that has
characterized the nearly seventy years since its adoption. Deposit insurance, combined with
other components of our banking safety net (the Federal Reserve's discount window and its
payment system guarantees), has meant that periods of financial stress no longer entail
widespread depositor runs on banks and thrift institutions. Quite the opposite: Asset holders now
seek out deposits—both insured and uninsured—as safe havens when they have strong doubts
about other financial assets.

Looking beyond the contribution of deposit insurance to overall financial stability, we
should not minimize the importance of the security it has brought to millions of households and
small businesses with relatively modest financial assets. Deposit insurance has given them a safe
and secure place to hold their transaction and other balances.
The benefits of deposit insurance, as significant as they are, have not come without a
cost. The very process that has ended deposit runs has made insured depositors largely
indifferent to the risks taken by their depository institutions, just as it did with depositors in the
1980s with regard to insolvent, risky thrift institutions. The result has been a weakening of the
market discipline that insured depositors would otherwise have imposed on institutions.
Relieved of that discipline, depositories naturally feel less cautious about taking on more risk
than they would otherwise assume. No other type of private financial institution is able to attract
funds from the public without regard to the risks it takes with its creditors' resources. This
incentive to take excessive risks at the expense of the insurer, and potentially the taxpayer, is the
so-called moral hazard problem of deposit insurance.
Thus, two offsetting implications of deposit insurance must be kept in mind. On the one
hand, it is clear that deposit insurance has contributed to the prevention of bank runs that could
have destabilized the financial structure in the short run. On the other, even the current levels of
deposit insurance may have already increased risk-taking at insured depository institutions to
such an extent that future systemic risks have arguably risen.
Indeed, the reduced market discipline and increased moral hazard at depositories have
intensified the need for government supervision to protect the interests of taxpayers and, in
essence, substitute for the reduced market discipline. Deposit insurance and other components of
the safety net also enable banks and thrift institutions to attract more resources, at lower costs,

than would otherwise be the case. In short, insured institutions receive a subsidy in the form of a
government guarantee that allows them both to attract deposits at lower interest rates than would
be necessary without deposit insurance and to take more risk without the fear of losing their
deposit funding. Put another way, deposit insurance misallocates resources by breaking the link
between risks and rewards for a select set of market competitors.
In sum, from the very beginning, deposit insurance has involved a tradeoff. Deposit
insurance contributes to overall short-term financial stability and the protection of small
depositors. But at the same time, because it also subsidizes deposit growth and induces greater
risk-taking, deposit insurance misallocates resources and creates larger long-term financial
imbalances that increase the need for government supervision to protect the taxpayers' interests.
Deposit insurance reforms must balance these tradeoffs. Moreover, any reforms should be aimed
primarily at protecting the interest of the economy overall and not just the profits or market
shares of particular businesses.
The Federal Reserve Board believes that deposit insurance reforms should be designed to
preserve the benefits of heightened financial stability and the protection of small depositors
without a further increase in moral hazard or reduction in market discipline. In addition, we urge
that the implementing details be kept as straightforward as possible to minimize the risk of
unintended consequences that comes with complexity.
Issues for Reform
The FDIC has made five broad recommendations.
1. Merge BIF and SAIF
The Board supports the FDIC's proposal to merge the Bank Insurance Fund (BIF) with
the Savings Association Insurance Fund (SAIF). Because the charters and operations of banks

and thrift institutions have become so similar, it makes no sense to continue the separate funds.
Separate funds reflect the past but neither the present nor the future. Merging the funds would
diversify their risks, reduce administrative expense, and widen the fund base of an increasingly
concentrated banking system. Most important, because banks and thrift institutions receive the
same level of federally guaranteed insurance coverage, the premiums faced by each set of
institutions should be identical as well. Under current arrangements, the premiums faced by
equally risky institutions could differ significantly if one of the funds falls below the designated
reserve ratio of 1.25 percent of insured deposits and the other fund does not. Should that occur,
depository institutions would be induced to switch charters to obtain insurance from the fund
with the lower premium, a result that could distort our depository structure. The federal
government should not sell a single service, like deposit insurance, at different prices.
2. Reduce Statutory Restrictions on Premiums
Current law requires the FDIC to impose higher premiums on riskier banks and thrift
institutions but prevents it from imposing any premium on well-capitalized and highly rated
institutions when the corresponding fund's reserves exceed 1.25 percent of insured deposits. The
Board endorses the FDIC recommendations that would eliminate the statutory restrictions on
risk-based pricing and allow a premium to be imposed on every insured depository institution, no
matter how well capitalized and well rated it may be or how high the fund's reserves.
The current statutory requirement that free deposit insurance be provided to wellcapitalized and highly rated institutions when the ratio of FDIC reserves to insured deposits
exceeds a predetermined ratio maximizes the subsidy provided to these institutions and is
inconsistent with efforts to avoid inducing moral hazard. Put differently, the current rule
requires the government to give away its valuable guarantee to many institutions when fund

reserves meet some ceiling level. This free guarantee is of value to institutions even when they
themselves are in sound financial condition and when macroeconomic times are good. At the
end of the third quarter of last year, 91 percent of banks and thrift institutions were paying no
premium. That group included many institutions that have never paid a premium for their, in
some cases substantial, coverage, and it also included fast-growing entities whose past premiums
were extraordinarily small relative to their current coverage. We believe that these anomalies
were never intended by the framers of the Deposit Insurance Fund Act of 1996 and should be
addressed by the Congress.
The Congress did intend that the FDIC impose risk-based premiums, but the 1996 act
limits the ability of the FDIC to impose risk-based premiums on well-capitalized and highly
rated banks and thrift institutions. And these two variables—capital strength and overall
examiner rating-do not capture all the risk that institutions could create for the insurer. The
Board believes that the FDIC should be free to establish risk categories on the basis of any
economic variables shown to be related to an institution's risk of failure, and to impose
premiums commensurate with that risk. Although a robust risk-based premium system would be
technically difficult to design, a closer link between insurance premiums and the risk of
individual institutions would reduce moral hazard and the distortions in resource allocation that
accompany deposit insurance.
We note, however, that although significant benefits from a risk-based premium system
are likely to require a substantial range of premiums, the FDIC concluded in its report that
premiums for the riskiest banks would probably need to be capped in order to avoid inducing
failure at these weaker institutions. We believe that capping premiums may end up costing the
insurance fund more in the long run should these weak institutions fail anyway, with the delay

7
increasing the ultimate cost of resolution. The Board has concluded, therefore, that if a cap on
premiums is required, it should be set quite high so that risk-based premiums can be as effective
as possible in deterring excessive risk-taking. In that way, we could begin to simulate the
deposit insurance pricing that the market would apply and reduce the associated subsidy in
deposit insurance.
Nonetheless, we should not delude ourselves into believing that even a wider range in the
risk-based premium structure would eliminate the need for a government back-up to the deposit
insurance fund, that is, eliminate the government subsidy in deposit insurance. To eliminate the
subsidy in deposit insurance—to make deposit insurance a real insurance system—the FDIC
average insurance premium would have to be set high enough to cover fully the very small
probabilities of very large losses, such as those incurred during the Great Depression, and thus
the perceived costs of systemic risk. In contrast to life or automobile casualty insurance, each
individual insured loss in banking is not independent of other losses. Banking is subject to
systemic risk and is thus subject to a far larger extreme loss in the tail of the probability
distributions from which real insurance premiums would have to be calculated. Indeed, pricing
deposit insurance risks to fully fund potential losses—pricing to eliminate subsidies—could well
require premiums that would discourage most depository institutions from offering broad
coverage to their customers. Since the Congress has determined that there should be broad
coverage, the subsidy in deposit insurance cannot be fully eliminated, although we can and
should eliminate as much of the subsidy as we can.
I note that the difficulties of raising risk-based premiums explain why there is no real
private-insurer substitute for deposit insurance from the government. No private insurer would
ever be able to match the actual FDIC premium and cover its risks. A private insurer confronted

8
with the possibility, remote as it may be, of losses that could bankrupt it would need to set
especially high premiums to protect itself, premiums that few, if any, depository institutions
would find attractive. And if premiums were fully priced by the government or the private
sector, the depository institutions would likely lower their offering rates, thereby reducing the
amount of insured deposits demanded, and consequently the amount outstanding would decline.
3. Relaxing the Reserve Ratio Regime to Allow Gradual Adjustments in Premiums
Current law establishes a designated reserve ratio for BIF and SAIF of 1.25 percent. If
that ratio is exceeded, the statute requires that premiums be discontinued for well-capitalized and
highly rated institutions. If the ratio declines below 1.25 percent, the FDIC must develop a set of
premiums to restore the reserve ratio to 1.25 percent; if the fund ratio is not likely to be restored
to its statutorily designated level within twelve months, the law requires that a premium of at
least 23 basis points be imposed on all insured entities.
These requirements are clearly procyclical: They lower or eliminate fees in good times,
when bank credit is readily available and deposit insurance fund reserves should be built up, and
abruptly increase fees sharply in times of weakness, when bank credit availability is under
pressure and deposit fund resources are drawn down to cover the resolution of failed institutions.
The FDIC recommends that surcharges or rebates be used to bring the fund back to the target
reserve ratio gradually. The FDIC also recommends the possibility of a target range for the
designated reserve ratio, over which the premiums may remain constant, rather than a fixed
target reserve ratio and abruptly changing premiums.
We support such increased flexibility and smoothing of changes in premiums. Indeed,
we recommend that the FDIC's suggested target reserve range be widened to reduce the need to
change premiums abruptly. Any floor or ceiling, regardless of its level, could require that

premiums be increased at exactly the time when banks,and thrifts could be under stress and,
similarly, that premiums be reduced at the time that depositories are in the best position to fund
an increase in reserves. Building a larger fund in good times and permitting it to decline when
necessary are prerequisites to less variability in the premium.
In addition to supporting a widening of the range for the designated reserve ratio, the
Board recommends that the FDIC be given the latitude to temporarily relax floor or ceiling ratios
on the basis of current and anticipated banking conditions and expected needs for resources to
resolve failing institutions. In short, to enhance macroeconomic stability, we prefer a reduction
in the specificity of the rules under which the FDIC operates and, within the broad guidelines set
out by the Congress, an increase in the flexibility with which the board of the FDIC can operate.
4. Modify the Rebates System
Since its early days, the FDIC has rebated "excess" premiums whenever it considered its
reserves to be adequate. This procedure was replaced in the 1996 law by the requirement that no
premium be imposed on well-capitalized and highly rated institutions when the relevant fund
reached its designated reserve ratio. The FDIC's 2001 proposals would re-impose a minimum
premium on all banks and thrift institutions and a more risk-sensitive premium structure. These
provisions would be coupled with rebates for the stronger entities when the fund approaches the
upper end of a target range and surcharges when the fund trends below the lower end of a target
range.
The FDIC also recommends that the rebates not be uniform for the stronger entities.
Rather, the FDIC argues that rebates should be smaller for those banks that have paid premiums
for only short periods or that have in the past paid premiums that are not commensurate with
their present size and consequent FDIC exposure. The devil, of course, is in the details. But

10
varying the rebates in this way makes considerable sense, and the Board endorses it. More than
900 banks—some now quite large—have never paid a premium, and without this modification
they would continue to pay virtually nothing, net of rebates, as long as their strong capital and
high supervisory ratings were maintained. Such an approach is both competitively inequitable
and contributes to moral hazard. It should be addressed.
5. Indexing Ceilings on the Coverage of Insured Deposits.
The FDIC recommends that the current $100,000 ceiling on insured deposits be indexed
to inflation. The Board does not support this recommendation and believes that the current
ceiling should be maintained.
In the Board's judgment, increasing the coverage, even by indexing, is unlikely to add
measurably to the stability of the banking system. Macroeconomic policy and other elements of
the safety net—combined with the current, still-significant level of deposit insurance—continue to
be important bulwarks against bank runs. Thus, the problem that increased coverage is designed
to solve must be related either to the individual depositor, the party originally intended to be
protected, or to the individual bank or thrift institution. Clearly, both groups would prefer higher
coverage if it cost them nothing. But the Congress needs to be clear about the nature of a
specific problem for which increased coverage would be the solution.
Depositors. Our most recent surveys of consumer finances suggest that most depositors
have balances well below the current insurance limit of $100,000, and those that do have larger
balances have apparently been adept at achieving the level of deposit insurance coverage they
desire by opening multiple insured accounts. Such spreading of assets is perfectly consistent
with the counsel always given to investors to diversify their assets—whether stocks, bonds, or
mutual funds—across different issuers. The cost of diversifying for insured deposits is surely no

11
greater than doing so for other assets. A bank would clearly prefer that the depositor maintain all
of his or her funds at that bank and would prefer to reduce the need for depositor diversification
by being able to offer higher deposit insurance coverage. Nonetheless, depositors appear to have
no great difficulty—should they want insured deposits—in finding multiple sources of fully
insured accounts.
In addition, one of the most remarkable characteristics of household holdings of financial
assets has been the increase in the diversity of portfolio choices since World War II. And, since
the early 1970s the share of household financial assets in bank and thrift deposits has generally
declined steadily as households have taken advantage of innovative, attractive financial
instruments with market rates of return. The trend seems to bear no relation to past increases in
insurance ceilings. Indeed, the most dramatic substitution out of deposits has been the shift from
both insured and uninsured deposits into equities and into mutual funds that hold equities, bonds,
and money market assets. It is difficult to believe that a change in ceilings during the 1990s
would have made any measurable difference in that shift. Rather, the data indicate that the
weakness in stock prices in recent years has been marked by increased flows into bank and thrift
deposits even without changed insurance coverage levels.
Depository Institutions. Does the problem to be solved by increased deposit insurance
coverage concern the individual depository institution? If so, the problem would seem
disproportionately related to small banks because insured deposits are a much larger proportion
of total funding at small banks than at large banks. But smaller banks appear to be doing well.
Since the mid-1990s, adjusted for the effects of mergers, assets of banks smaller than the largest
1,000 have grown at an average annual rate of 13.8 percent, more than twice the pace of the
largest 1,000 banks. Uninsured deposits, again adjusted for the effects of mergers, have grown at

12

average annual rates of 21 percent at the small banks versus 10 percent at the large banks.
Clearly, small banks have a demonstrated skill and ability to compete for uninsured deposits. To
be sure, uninsured deposits are more expensive than insured deposits, and bank costs would
decline and profits rise if their currently uninsured liabilities received a government guarantee.
But that is the issue of whether subsidizing bank profits through additional deposit insurance
serves a national purpose. I might add that throughout the 1990s and into the present century,
return on equity at small banks has been well maintained. Indeed, the attractiveness of banking
is evidenced by the fact that more than 1,350 banks were chartered during the past decade,
including more than 600 from 1999 through 2002.
Some small banks argue that they need enhanced deposit insurance coverage to compete
with large banks because depositors prefer to put their uninsured funds in an institution
considered too big to fail. As I have noted, however, small banks have more than held their own
in the market for uninsured deposits. In addition, the Board rejects the notion that any bank is
too big to fail. In the FDIC Improvement Act of 1991 (FDICIA), the Congress made it clear that
the systemic-risk exception to the FDIC's least-cost resolution of a failing bank should be
invoked only under the most unusual circumstances. Moreover, the resolution rules under the
systemic-risk exception do not require that uninsured depositors and other creditors, much less
stockholders, be made whole. The market has clearly evidenced the view, consistent with
FDICIA, that large institutions are not too big for uninsured creditors to take at least some loss
should the institution fail. For example, no U.S. banking organization, no matter how large, is
AAA-rated. In addition, research indicates that creditors impose higher risk premiums on the
uninsured debt of relatively risky large banking organizations and that this market discipline has
increased since the enactment of FDICIA.

13
To be sure, the real purchasing power of deposit insurance ceilings has declined. But
there is no evidence of any significant detrimental effect on depositors or depository institutions,
with the possible exception of a small reduction in those profits that accrue from deposit
guarantee subsidies that lower the cost of insured deposits. The current deposit insurance ceiling
appears more than adequate to achieve the positive benefits of deposit insurance that I mentioned
earlier, even if its real value were to erode further.
Another argument is often raised by smaller banks regarding the need for increased
deposit insurance coverage. Some smaller institutions say that they are unable to match the
competition from large securities firms and bank holding companies with multiple bank or thrift
institution affiliates because those entities offer multiple insured accounts through one
organization. I note that since the Committee's last hearings on this issue, the force of small
banks' concerns has been reduced by recent market developments in which small banks and
thrift institutions can use a clearinghouse network for brokered deposits that allows them to offer
full FDIC insurance for large accounts. The Board agrees that such practices by both large and
small depositories are a misuse of deposit insurance. Moreover, raising the coverage limit for
each account is not a remedy for small banks because it would also increase the aggregate
amount of insurance coverage that multidepository organizations would be able to offer. The
disparity would remain.
Conclusion
Several aspects of the deposit insurance system need reform. The Board supports, with
some modifications, all of the recommendations the FDIC made in the spring of 2001 except
indexing the current $100,000 ceiling to inflation. The thrust of our recommendations would call
for a wider permissible range for the size of the fund relative to insured deposits, reduced

14
variation of the insurance premium as the relative size of the fund changes with banking and
economic conditions, a positive and more risk-based premium net of rebates for all depository
institutions, and the merging of BIF and SAIF.
There may come a time when the Board finds that households and businesses with
modest resources are having difficulty in placing their funds in safe vehicles or that the level of
deposit coverage appears to be endangering financial stability. Should either of those events
occur, the Board would call its concerns to the attention of the Congress and support adjustments
to the ceiling by indexing or other methods. But today, in our judgment, neither financial
stability, nor depositors, nor depositories are being disadvantaged by the current ceiling. Raising
the ceiling now would extend the safety net, increase the government subsidy to depository
institutions, expand moral hazard, and reduce the incentive for market discipline without
providing any clear public benefit. With no clear public benefit to increasing deposit insurance,
the Board sees no reason to increase the scope of the safety net. Indeed, the Board believes that
as our financial system has become ever more complex and exceptionally responsive to the
vagaries of economic change, structural distortions induced by government guarantees have
risen. We have no way of ascertaining at exactly what point subsidies provoke systemic risk.
Nonetheless, prudence suggests that we be exceptionally deliberate when expanding government
financial guarantees.