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EMBARGOED UNTIL DELIVERY j L ibrary h COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRSj UNITED ST-ArTES SENATE BY L. WILLIAM SEIDMAN CHAIRMAN FEDERAL DEPOSIT INSURANCE CORPORATION Room SD-538, Dirksen Senate Office Building — — March 13, 1986 j n 9:30 a.m. J a in (i 0 icjyi ♦ Mr. Chairman, I am pleased to have an opportunity to appear before this commit tee to discuss deposit insurance reform. You have held a number of hearings where a great many views on this subject have been expressed. ered these at the and FDIC our have own experience, concluded especially our recent We have consid experience. that, while the basic deposit insurance We system is performing well, there is an urgent need for selective change. In my testimony, I will indicate where I believe changes are necessary. changes will include those requiring Federal legislation, those These requiring state legislation and those that can be implemented by the FDIC under existing law. Last year there were likely, we will bank failures; 120 bank failures and FDIC-assisted mergers and, very see at least that many this year. in 1983, 48; and in 1982, the 1970s there were only 76 bank failures. banks on the FDIC's problem list. the spring of 1981, when 42. In 1984 there were 79 During the entire decade of As of March 3, there were 1,196 This number has increased steadily since there were 200 banks on the problem list. This dramatic change has provoked many questions about the condition of the banking system, the handling of bank failures, the role that deposit insurance has played and the role that it should play in the future. Banking System Problems Bank failures have increased primarily because of weaknesses in the economy. While the overall economy has performed well during the past three years, - 2 - performance has been uneven, leaving some parts of the country and some indus tries especially depressed. Weaknesses are likely to persist during the next year or more in energy and agriculture and in several foreign countries that are significant bank borrowers, and parts of the banking system will continue to be hurt by these strains. During this same period, change. the banking environment has undergone considerable Deposit rate ceilings were deregulated. Competition among domestic banks and between banks and other institutions (including foreign banks compet ing in the U.S.) has increased. The effect of increased competition has been uneven; in some cases, banks previously insulated from competition have encountered have significantly seen investments reduced margins in the marketplace; in branches and other facilities become some banks redundant in the face of technological change and greater price competition. Economic and competitive forces have made it more difficult for some banks to operate profitably. In some instances, reduced spreads on safe activities induced banks to take more risk and this led to increased loan losses. Years of operating in a very comfortable economic and competitive environment may have led some banks to become complacent in assessing risk and controlling expenses. An exact distribution possible. In other our geographic system, such restrictions of the causes of current problems problems which are exacerbated branching and limit diversification possibilities for banks and lead to excessive exposure to a single industry. by is not -3- Banks and regulators considerable And are evidence regulators have adjusting that banks sought to what has are placing more stress on There loan earlier, is quality. especially However, many of the current problems will be around for some time, and they may get worse. existing books the happening. to get on top of problems in the case of large banks. loans on been They reflect weaknesses of banks and weakened financial conditions in of those borrowers. Deposit Insurance What has been the role of deposit insurance in this process? of high deposit insurance coverage The existence (including what is perceived to be 100 percent de facto coverage for large banks) has probably contributed to expans ion and precarious funding by some banks. While some maintain that high insurance coverage has contributed to risk taking, I doubt that deposit insur ance has been a major contributor to the problems we currently face. that reason I do not believe the system is in need of fundamental For change that would impose greater risk on depositors or substantially increase capital requirements of banks. The insurance system has been seriously tested in recent years and for the most part it has performed well. most (though not all) Federal deposit insurance has fully protected depositors from bank failures; it has significantly reduced disruptions associated with bank failures; and it has generally pre served confidence in the banking system. - Clearly, the system has apparent as the 4- not performed perfectly, and this has become more number of failures has increased. Problems in the insur ance system have been identified in at least four areas: - The operation of the deposit insurance similar depositors in large and small banks system has not always treated in the same way, causing some to assert that the system is not altogether fair. - While the insurance system has lessened secondary effects of failures, the current methods of handling of bank failures may have placed too many asset» in a liquidation mode, cutting off borrowers from bank services and, possibly, increasing the cost of handling failures. - The current system does not provide the FDIC with all the essential tools for smooth, efficient handling of large bank failures. - The system does not provide a means of assessing those institutions that expose it to greater risk a premium that is commensurate with that risk. Additionally, the current system and the manner in which failed banks have been handled has sometimes given a free ride to some bank creditors — they receive the benefits of deposit insurance without paying for it. Of course, we operate with certain handicaps in the banking system that some times make difficult. private In some sector resolution states, branching of problems through acquisitions more restrictions significantly limit the - 5- feasibility or practicality of one bank acquiring another, failing, institu tion. Limitations in dealing with on interstate acquisitions large, troubled banks. And substantially reduce in some instances, options limitations on what banks can do limit the attractiveness of bank charters and of banks as acquisition candidates. During the remainder of my statement I will address in greater detail each of the suggested weaknesses in the deposit insurance system and how I propose the system be improved. is needed. In several key areas, I believe, Federal legislation In some instances changes in FDIC procedures within our existing statutory authority are necessary. I will also discuss some proposed "reforms" which I consider to be unnecessary or counterproductive at the present time. My recommendations will focus on practical ways to improve failure management and on ways to improve the efficiency and fairness of the insurance system. Fairness Issue During the large banks past 20 years a majority of bank failures and all failures of (those with assets over $500 million) have been handled through purchase and assumption transactions (P&As). In these transactions all déposit and most other liabilities to general creditors1 are assumed by an acquiring bank so that such creditors come out whole regardless of the size of their claim. In contrast, when a bank is liquidated through a payoff, only insured depositors are paid by the FDIC. Uninsured depositors, the FDIC (standing lîhe exception has been general creditor obligations, where they exist, in state-chartered banks located in states that have depositor preference statutes. 6- - in place of insured depositors) and other general creditors, rata from the proceeds of receivership collections. not receive the full and other general amount creditors of their claims. are paid pro In most cases they do Thus, uninsured depositors are not likely to come out whole in a payoff, whereas they do in a P&A. Most payoffs have occurred when in acquiring the failed bank there have been no institutions (typically where branching where fraud or contingent liabilities have made the FDIC to estimate loss and effect a P&A. is interested restricted) or it extremely difficult for Until the Penn Square Bank, N.A., in Oklahoma City was paid off, the largest bank paid off by the FDIC had liabilities of less than $100 million. Modified Payoff In the spring of 1984, the FDIC effected a number of so-called modified payoff transactions. However, Failing banks were closed and insured depositors were paid. the form of payment was the transfer of their accounts to another institution which usually of the failed bank. acquired the premises and certain other Most checks in process were paid as is done in a P&A and most depositors probably were unaware of the difference. liabilities of uninsured depositors assumed the acquiring bank. by the present value of future the receivership so that The and other FDIC made general However, creditors a conservative were estimate the not of receivership collections and advanced funds to a cash advance to uninsured general creditors. assets could be made almost immediately -7- The modified payoff preserved many of the advantages of the P&A transaction. It was less depositor disruptive discipline than from a straight payoff, while uninsured depositors and still other retaining bank some creditors. Some of the value of the failed bank's deposits and facilities were preserved and these were sold through a bid process as in a P&A. The cash advance to uninsured creditors removed some of the "sting" of a reduced payoff, al though uninsured depositors were payoff worked from the to a traditional still exposed to some loss. standpoint of mechanics payoff because it conserved The modified -- it clearly was FDIC personnel and superior financial resources and was less disruptive to the community. The FDIC was in the process of examining the modified payoff in April 1984 when Continental came along and the decision was made not to use a modified payoff. Since then, the modified payoff has been used infrequently, usually in situations where a P&A was not feasible. Paying off Continental was need for a major decision never considered came very quickly. to be a serious The Paying off Continental would have taken a considerable amount of time and caused in financial markets. option. substantial disruption Mechanically, it did not appear possible to determine all account balances promptly to allow any payments and the amounts involved were too large to be handled in the normal fashion. A substantial volume of depositor, lender and borrower relations would have been disrupted. More over, there might have occurred significant liquidity problems for many major U.S. banks and, very likely, some permanent disruptions in borrowing and - 8 - deposit relations among many financial institutions. Once it became apparent that a giant bank could not be handled as a modified payoff under current technology and market conditions, it seemed unfair to pay off smaller failing banks, and systematically expose large depositors to loss in such institutions. It is important to note that, even before the Continental situation occurred, many at the FDIC did not consider the modified payoff to be an unqualified success or the way to go in the future. discipline." Many were skeptical about "depositor Depositors generally have ample notice to get out of a troubled bank without incurring any loss. Once unfavorable news becomes public, they have no incentive to stay with a troubled bank, even if they think it is likely to survive and turn itself around. Actually, the increased probability of depositor loss would make it difficult for a troubled bank to turn itself around. Depositor discipline has always been a two-edged sword, which requires considerable disciplining in and of itself. In the case of a large bank with extensive overseas branches, under current conditions assets and it the is doubtful that the FDIC could disposition of their proceeds control in the foreign liquidation countries. of This further limits the feasibility of effecting a modified payoff for a really large bank. If we could and did pay off a large failing bank, what would be the impact on the system and on other banks funding primarily through uninsured creditors? Lots of assets would be tied up in liquidation as would the claims of many -9- depositors and lenders. Flights of deposits from large institutions perceived to be at risk might be considerable. tion and system, risk to the system. So, too, would be the potential disrup Some say we eventually would have a better although they might concede that it may be difficult or impossible to get from here to there. It is apt an environment where most be readily to be more unstable and depositor discipline transferred, transmitted. because of I'm not so sure it would be a better system. liabilities leverage are very, very is substantial, has its limits short-term, funds in can and information is easily After all, the FDIC and the Federal Reserve System were created the problems of too much depositor discipline at one time. the future, In systems might be developed to pay off large banks more easily and the banking environment might become less vulnerable to large payoffs. At such time, it might be appropriate to revisit depositor discipline. If universal modified payoffs are neither feasible nor, at the present time, desirable, how can we improve the fairness in the system so that depositors in large and small banks that fail are treated the same? A preferable alterna tive is to do P&As wherever feasible and eliminate those impediments to effect ing them. A principal impediment is restrictive limit potential bidders for failed banks. branching statutes which Since May 1984, when initial assis tance was given to Continental, there have been 41 payoffs of failed banks; 36 of these occurred in states that have substantial restrictions on branching. Partly in response to this situation, several states have liberalized permissi ble branching in failed bank situations. However, more needs to be done 10 - -- possibly a Federal - override permitting the establishment of a branch in connection with a P&A acquisition, regardless of state branching law or permis sion for the FDIC to charge higher insurance assessments in these states. Under existing law the FDIC is required to meet a cost test in choosing a P&A over a payoff, selecting the former only in situations where it appears to be the cheaper (liabilities possible costs. for alternative. loan unbooked Where commitments, claims, etc.) significant contingent claims exist law suits, off-balance-sheet guarantees, it becomes extremely difficult to estimate The FDIC typically must protect an acquiring institution from such claims to get them to bid. Should the claims become established as general creditor obligations, the FDIC would have to pay such claims in full, subsequent to a P&A transaction where the failed bank is not subject to a state depositor preference statute. It is frequently difficult to estimate with any precision which contingent claims will ultimately be established, and this complicates estimating P&A costs. Sometimes a These general failing bank will have obligations unsecured creditor obligations have creditor status equal where depositor preference is not applicable. treatment to deposits). No deposit borrowings. to depositors In order to do a P&A these obligations must be assumed by an acquiring bank equal for (i .e., they must be given insurance premiums are paid on such obligations even though they benefit from the deposit insurance system and the way bank failures are handled. -nIt is therefore enacted. those This recommended that a Federal would creditors who prefer depositors might establish This would substantially statute be to other bank creditors,2 including claims credit, other guaranties, law suits, etc. banks. depositor preference in connection with letters of It would apply to all FDIC-insured simplify the FDIC's cost calculations and facilitate satisfying the P&A cost test; it would reduce the cost of handling failed some banks; it may instances, result it would in create increased a class FDIC assessment income; and, in of creditor which might serve to discipline banks and monitor risk. This is an important proposal that has implications for remedying to some degree each of the problem areas I have suggested exist within the deposit insurance system. In a P&A under depositor deposit liabilities. ing foregone preference, an acquiring bank could only The FDIC would be entitled to recoup its outlays (includ interest) before nondeposit claimants receive anything. would probably cause some realignment of creditor relationships. to banks might be shifted to deposits — to pay insurance premiums on them. ties from weak assume institutions would This Some loans but the bank would then be required Standby letters of credit or other guaran have diminished marketability, and this would be a salutary development. 2It may be appropriate to place liabilities related to employment and other similar services on a par with deposits. An alternate version of this proposal would involve three categories of preferences: deposits, balance sheet liabil ities, and contingent claims. - 12 - A depositor preference statute would reduce the FDIC's cost in handling bank failures and make it to justify a P&A. fully at the considerably easier to meet the cost test necessary It would also mean that general creditors would look care financial position of the banks, thus creating an increased element of market discipline on the institution. A depositor preference statute would raise some interesting questions with respect to certain existing bank liabilities. Some institutions have resorted to collateralized nondeposit borrowing as a means of raising funds cheaply in the marketplace. If the collateral acquire a preferred status is substantial, such borrowings would in liquidation and this could weaken the FDIC's creditor position, raising FDIC losses. It may be appropriate for such borrow ings to be treated as deposits for purposes of calculating deposit insurance premiums so that they not become a vehicle for circumventing that expense of operation. The treatment of foreign branch deposits is an issue of greater quantitative importance. Foreign branch deposits currently exceed $300 billion, account for about 15 percent of bank deposits and a much larger percentage for money center banks. If we prefer foreign deposits to other bank creditors domestic deposits, they should be subject to insurance assessments. like An alter native would be to prefer domestic deposits and not subject deposits in foreign branches event central of to assessment. failure (they would banks might This control would expose be outside the them to the liquidation increased P&A process). of overseas risk in the While foreign assets and affect - 13 - the status of creditors, there might still be considerable uncertainty about the position of overseas deposits. Disposition of Failed Bank Assets The FDIC needs legislation which will failed or failing institutions. provided equal an acquiring In a P&A transaction the FDIC has generally bank with to assumed liabilities. recently, most P&As were provide it with more time to handle book assets, less a premium that is bid, The makeup of book assets has varied. relatively "clean." Until Book assets assumed consisted of physical facilities (appraised value), securities at market value, perform ing installment bring assets up loans to and, assumed sometimes, residential liabilities (less real estate premium), the FDIC cash, removing classified loans and most or all commercial loans. bank" P&A simplified on bidding banks. tion task. the bidding process and minimized the loans. To inserted This "clean burden placed However, it left the FDIC with a considerable loan collec In some instances, values associated with ongoing loan relation ships were lost and this also probably cost the FDIC. Those borrowers who were not sufficiently strong or established had difficulty getting new financing to pay off the FDIC. capacity the FDIC is naturally reluctant to provide may have In its liquidation additional financing to borrowers in situations where a bank holding a similar loan might be willing to provide such financing. services and, ultimately, Thus, borrowers may be cut off from needed banking the loss to the FDIC not only may be increased, but the economic activity in the area may be reduced. 14 - - Since last spring the FDIC has sought to pass more assets in P&As. P&A transactions most performing loans of all types are In current initially passed. The acquiring bank is typically given an opportunity to put back some share of such loans to the FDIC at book value within the first few months of the transaction. These Some additional loans can be sold back to the FDIC at a discount. changes have served to reduce Division acquires from failed banks. the volume of assets our Liquidation Nevertheless, the FDIC still about 35 percent of the loans of banks that failed last year. acquired (We currently own about $9 billion in book value loans taken in connection with bank failures and assistance transactions.) ated with handling failed We expect the changes to reduce losses associ banks because marginal loans are likely to have greater value in the hands of banks where financing is available. We are currently reevaluating our policies and developing procedures and incentives to pass not only all unclassified loans, but pass or develop incen tive arrangements so that collections on nonperforming by acquiring banks or other private institutions. loans can be done This will probably require some testing of new procedures and some imagination. It would be our goal to reduce the cost of handling bank failures, to reduce the FDIC's involvement in and, collections in some and in instances, banking service. potential provide adversarial borrowers relationships from failing with borrowers banks with ongoing To the extent that passing more assets can reduce our cost it will tilt the results of the cost test in the direction of more P&As. In order to get banks to take more assets of failing banks it will be necessary - to give more information on 15 - loan portfolios to failing banks. This would require stretching out the P&A process and, in some cases, keeping a failing bank operating for a longer period of time after potential bidders have been contacted. To prevent a run during this period, the FDIC might put a subordi nated note into the its operation. failing However, bank, imposing some restrictive For such situations we are considering legislation to enable the FDIC to control open institution through conservatorship powers the operation in order to provide time for potential bidders to review the bank's loan portfolio.3 ultimately reduce Under certain (say, where the cost This could and disruption of disposing of a failing bank. circumstances, where the range of potential interstate on that may not always be feasible and management of the failing institution may not always be cooperative. of an conditions acquisitions are feasible), bidders a satisfactory is large shopping process could lead to the disposition of the bank with minimal FDIC financial involvement and, possibly, on an open bank basis. As regional and interstate banking become the pattern in the country, more time to assemble bidders is necessary, and this further argues for providing more time for the FDIC. Large Bank Failures Over the past two decades, several large banks have failed, received direct assistance to avert failure or been merged while on the brink of failure. These transactions have involved special arrangements, emergency state legisla- 3In the case of some failing banks, including those with significant contingent liabilities, it may be preferable to have the FDIC keep the bank's operations intact by means of a "bridge bank", as described below. -16- tion and difficult negotiations in an uncertain environment. have sometimes been limited. crease options and provide Several for more Available options changes are needed, I believe, to in flexibility to handle future failures of large banks. Ideally, when a large bank gets into difficulty, the resolution of its problems would be handledthrough recapitalization or aprivate sector merger. And, ideally, supervisory pressure will be applied early enough so that FDIC assis tance isn't necessary to solve the problem. However, restrictions on inter state branching and acquisitions frequently limit options for private sector solutions contribute (as I have suggested, to concentrations branching and geographic and the development place).Interstate compacts enacted by states tions. of However, 1982 they still provides for interstate of $500 million or more. in several don't restrictions of problems have materially go far enough. acquisitions of in the also first expanded op The Garn-St Germain Act failed banks with assets That provision has materially increased FDIC options bank failures. Last month the interstate provision was used in a Florida failure and the provision has apparently saved the FDIC a substantial amount of money. to expire April The 15 and extend that provision. interstate provision of Garn-St Germain is scheduled it is very important that, at a minimum, Congress However, we believe the interstate provision should be materially broadened. Once a bank fails, its value to a potential acquiror is substantially dimin ished. FDIC options are reduced and potential costs are materially increased. -17- We recommend that Congress permit the interstate acquisition of failing banks that have assets of $250 million or more. In restrictive branching states the value of out-of-state entry may be very limited if the subsequent is not permitted. acquisition of other institutions in the state If a large bank is part of a holding company system, failure of that bank would only permit the interstate acquisition of that single-office institution under existing law as opposed to the other parts of the holding company. In such a situation it would be logical to permit the interstate acquisition of bank holding companies where one or more banks in the system is in danger of failing, the bank(s) satisfy the size requirement, and the failing institution(s) assets. account for a significant share of the holding company Another approach would be to permit the interstate acquisition of one or more failing banks, and thereafter allow the acquiror the same expansion rights enjoyed by banks or bank holding companies within the state. The extension banks and of also the bank interstate holding acquisition companies would provision enable to these include failing institutions to actively shop for mergers with out-of-state and foreign banking institutions while there is still volvement. financial That and some chance of saving the institution without FDIC in could substantially personnel resources. be necessary to effect a transaction. lessen our task In some instances, and conserve on our FDIC assistance may However, that is likely to be consider ably less than the cost to the FDIC if we wait for the institution to close. Even where an open bank transaction is not possible, the shopping process - will materially increase the amount 18 - of information available to potential bidders and facilitate a closed bank transaction. When a very large bank fails, options may still interstate and international be very limited, even when possibilities are considered. in the Continental assistance transaction. That was evident It will be difficult to put togeth er a satisfactory purchase and assumption in a short period of time unless the FDIC is willing to buy out a substantial volume of troubled assets, an option which is not desirable. What is needed in these circumstances is a method to "bridge" the gap between the failed bank and an orderly purchase and assumption transaction in which the FDIC does not have ongoing responsibilities for many troubled assets. It would be desirable for the bank to be closed and promptly reopened and run under the oversight of the FDIC (presumably using hired managers or con tracting with another bank to manage the institution). period, when asset problems have been sorted out, After an appropriate the extent of problems can be accurately gauged, and potential purchasers can make an informed judg ment, the FDIC could seek to sell the repositioned bank to another institution or a private investor group. organization under some Another option would be for an interested banking to make an investment in the bank and manage it for the FDIC profit-sharing arrangement with the FDIC. In either case, the objective would be to return the bank to the private sector in an orderly manner. -19- Present law does not allow the FDIC to operate a full-powered bank even on a transition or bridge basis. Legislation should be enacted so that the FDIC can be empowered to own and operate a bank for a limited period of time in those circumstances which have all I have described. the powers that national banks enjoy, Such a "bridge bank" would as well as certain protections currently afforded Deposit Insurance National Banks. special The "bridge bank" would operate as an entity separate from the FDIC and with a separate board of directors. The FDIC should be authorized to operate it for a reason able period of time, consistent with the transitional nature of the institu tion. These characteristics should allow the FDIC to maintain some franchise value of the failed bank, while arranging for an orderly transfer of assets and avoiding a windfall to shareholders. A depositor preference statute would also facilitate the handling of a large, failed bank. ties, Such institutions sometimes have considerable nondeposit liabili particularly in connection activities and litigation. with guaranties, other off-balance-sheet Depositor preference, the expansion of the Garn-St Germain interstate provision and providing the FDIC with authority to operate a "bridge bank" bank failures would and, materially over time, increase our options for handling lessen our costs, while contributing large to the stability of the system. Risk-Related Deposit Insurance Premiums Currently, al 1 FDIC-insured banks pay a premium of domestic deposits for deposit insurance. 1/12 of one percent of The FDIC then deducts its losses and operating expenses and rebates 60 percent of the balance to the banks. - 20 - We favor legislation to establish a system of risk-related insurance premiums. Such a system would at the same penalize time, would some risk-taking be more equitable. in the banking A risk-based system and, system would be less arbitrary in that currently all banks -- the best and the worst -- pay the same price for deposit insurance. financial It would also provide a significant incentive for banks to avoid excessive risk-taking and to correct their problems promptly. Perhaps as important, it would send a strong signal to a problem bank's management and board of directors. Last the September, general proposal, on Call the public the FDIC on a specific FDIC would Report-generated an above-normal (measured as than 90 days Those banks level rated based on the Call 5, data a percent of past due, as it would comment risk-based use objective to of risk. rate from the industry premium proposal. statistical banks banking Under that techniques based as having either and solely a normal or Banks would be rated on financial variables total assets) like primary capital, nonaccruing loans, net chargeoffs, having a second testing screen. or requested above-normal risk would have loans more and net income. been subject to If a bank were rated as having above-normal risk Report test and it had a composite CAMEL rating of 3, 4 have received no assessment credit. The above-normal risk banks which had a composite CAMEL rating of 1 or 2 would not have been denied their assessment credit but would have been subject to additional review. financial - 21 - So far, the FDIC has received more than a hundred comment letters addressing this proposal. The majority of them are supportive of the concept of risk- based premiums, although many recommendations were offered for revising the proposed system. After considering these comment letters and reviewing the initial we would suggest some modifications. We would measured first by a test based on Call still proposal, propose that risk be Report ratios and then by a CAMEL screen which is used only to exempt banks with a 1 or 2 rating from a high risk category indicated by the statistical data. Our tests show this type of use of CAMEL ratings to be very effective in classifying banks. We are continuing research to determine whether a wider range of financial variables would enhance our measurement of risk and the likelihood that an individual bank will become a problem to the FDIC. Since almost all insolvencies stem from credit quality problems, our formula is slanted heavily in that direction. Although other factors, such as liquidity, are important factors in a bank's operations, they often are more difficult to quantify, them into formulas has not improved predictive results. and incorporating Nonetheless, further research in this area may lead to an alternative list of financial variables to be included in any final proposal. As more data become available on off- balance-sheet risk, the incorporation of these data might improve predictive results. We recognize that our proposed measure of risk classifies banks according to currently observable problems rather than by a system designed to measure - 22 - risk before credit quality problems arise. The latter approach conceptually would be preferred; however, such measures of risk are difficult to construct and often result in subjective determination of what should be classified as a risky behavior or activity. We now propose that those banks the system determined to be risky would actual ly pay a higher premium (up to 2/12 of one percent) rather than just forfeiting their assessment credits. This would assure that riskier banks would pay significantly more even in times when the assessment credit is low or nonexis tent. In the future, after the system is more refined, the FDIC may wish to ask for authority to charge even higher premiums to the riskier banks. We believe two assessment classes are adequate for our initial system. From the beginning, the thinking at the FDIC has been to start simple and then, with experience, work toward a more sophisticated system. In the future, we may wish to fine-tune the system and divide banks into more than two risk classes. At it with broad this juncture discretion the to FDIC favors legislation implement a risk-based that would premium provide system without locking ourselves into specific variables or risk classes. The current assessment base is deposits in domestic offices of FDIC-insured banks. As nondeposit already noted, general present creditors who P&A procedures do not pay provide insurance full coverage assessments. If to a depositor preference statute is enacted, nondeposit creditors would not have to be covered in a P&A. However, some bank borrowings and other obligations -23- may be shifted to deposit relationships to upgrade their creditor position. To the extent this occurs, the FDIC assessment base will be broadened and assessment income will be increased. Most of my comments thus far have been concerned with "failure management" — how to handle failing and failed banks in a manner that will minimize their cost and their disruptive impact on the economy. improvements in the financing of the deposit I have also discussed insurance system. The FDIC is also concerned with preventing bank failures or at least preventing too many failures and allowing banks to become so insolvent that they become a significant drain on our resources. Independent Bank Supervisory System It is critical that we, along with other Federal and state supervisors, main tain high quality supervision and strive to improve that quality. and finance have become more complicated in recent years. Banking Increased competi tion and a more uncertain environment have made banking more difficult and, apparently, more risky. It is extremely important that bank supervision keep pace with changes in the banking environment. Deregulation has increased bank options with respect to what products banks can offer, where they choose to offer them and how they price them. have increased the potential their corporate owners. sion. for conflict of between "banks" and Deregulation does not imply that we can relax supervi The opposite is closer to the truth. interest It may As I have suggested, increased -24- competition among banks and between banks and other institutions (including nonbank banks) has placed strains on bank earnings and, possibly, encouraged risk taking. At this time, when demands on supervision are increasing, it is critical that we train and expand a quality staff to examine and super vise so banks that current and potential future problems Otherwise, the cost to the FDIC and the economy will soar. important that the buildup agencies of nor neither Gramm-Rudman-Hollings a capable limit the nor 0MB and controlled. It is particularly apportionment supervisory staff in the Federal independence are flexibility of prevent bank regulatory bank regulatory agencies. We need Federal legislation ensuring that adequate independent bank supervision is provided by responsible agencies. We are convinced that bank supervision must play an even larger role in monitoring risk and reducing the exposure of the deposit insurance system and our economy to unnecessary risk. Supervi sion must be increased as deregulation provides bankers with the needed oppor tunity to use their judgment in making business decisions. For the first time in over fifty years, the Office of Management and Budget has asserted new jurisdiction over three of the four regulatory agencies, overturn a half century of independent operations. attempting to The Congress should act swiftly to maintain the competence and flexibility of the regulatory agencies. Otherwise, the operation of the Comptroller, the Bank Board and the FDIC will be adversely affected to a significant degree. Supervision is not the only way to prevent excessive risk in the system. There -25- has been much discussion during the past two years about various kinds of market discipline. use I have increased indicated that, depositor discipline at this time, we don't know a way to to discipline can come in many ways. improve the system. However, market The relatively high failure rate of the past few years has imposed losses on bank stockholders and subordinated credi tors and job loss to bank managers; process. If depositor preference creditor will be exposed to loss. it has not been an altogether painless is enacted, an additional class of bank Risk-based insurance premiums will higher costs on those banks operating at higher risk. Capital impose requirements which have been raised in recent years impose a cost and discipline on the system. They would be raised again if additional capital requirements are found necessary as we examine a risk-based capital requirement. that future conditions warrant higher capital requirements, To the extent that presents a further opportunity to enhance market discipline. Financial Condition of the FDIC The FDIC1s insurance fund is adequate to handle the problems of the day and those likely to be faced in the near future. The FDIC's Deposit Insurance Fund, its net worth, currently is about $18 billion, and its assets include about $16 billion of U.S. Treasury securities. The size of the fund relative to insured and total deposit liabilities of banks remains high by historical standards. The fund is currently 1.22 percent of insured deposits, well above the average for the past 10 years, despite record numbers of insured bank failures during the past two years. two years has slowed as a result of The fund's growth during the last losses and reserves established in -26- connection with bank failures. receiving only small will These losses have resulted in insured banks assessment rebates for 1983 and 1984 operations. They receive no rebate for 1985, although, to a large extent, this reflects higher loss estimates in failures occurring prior to 1985. Last week, the FDIC added $2.3 billion to its allowance for insurance losses. However, only $600 million related to the 1985 failures. to the While 1984 that assistance transaction transaction still has with several Continental years to $1.3 billion related Illinois run, our Corporation. loss reserve reflects our assessment of likely ultimate loss on loans that have or might be put to the FDIC exclusive of potential future gains or losses on our stock investment in Continental. It is important to emphasize that we have attempted to conservatively account for to failures ultimate and assistance all projected losses and commitments related transactions. This includes estimates of our losses on assets acquired in connection with all failures as well as losses related to commitments in connection with assisted mergers. We have also established reserves for those savings banks with outstanding net worth certificates where the FDIC seems likely to incur a loss. While we believe the Deposit Insurance Fund and the basic assessment rate for satisfactorily performing banks are adequate at present, the assessment system and the long-run strength of the fund would be materially enhanced by enactment of our recommendations on risk-based insurance assessments and depositor preference. I believe that the FDIC's balance sheet conservatively reflects our exposure -27- from past bank failures. the adequacy of our It is more difficult to be absolutely certain about reserves for meeting future failures. Nevertheless, past experience suggests that current reserves are adequate. While our fund is coping with today's rapidly changing and difficult conditions in the banking field, we urge swift action to help the insurance system to be better prepared for future challenges.
@FedFRASER