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TESTIMONY OF
L. WILLIAM SEIDMAN
CHAIRMAN
FEDERAL DEPOSIT INSURANCE CORPORATION
ON
DEPOSIT INSURANCE REFORM
BEFORE THE
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
UNITED STATES HOUSE OF REPRESENTATIVES
10:00 AM
February 21, 1990
Room 2128, Rayburn House Office Building
Mr. Chairman and members of the Committee, we appreciate
this opportunity to present the current thinking of the Federal
Deposit Insurance Corporation regarding reform of the federal
deposit insurance system.
After our recent experience with
losses in the thrift industry and in certain areas of the
country in the banking industry, it is most appropriate that we
consider changes to the deposit insurance system to reduce the
losses to that system and, thus, to taxpayers.
Last year, Congress passed one of the most significant
pieces of financial institution legislation since the Great
Depression: the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 ("FIRREA").
The most visible portion of
this legislation is the mechanism that was created to
recapitalize the insolvent thrift insurance fund and resolve the
currently insolvent thrift institutions.
However, perhaps the
more important provisions of FIRREA are those that are designed
to control risks within the system —
either through more
stringent standards placed on insured institutions or by means
of expanded powers granted to the supervisory agencies.
Those
provisions provide the framework for a longer-term review of the
deposit insurance system.
FIRREA is a sound first step in
resolving a complex problem: namely, how can the U.S. Government
protect against incurring an unacceptable level of risk while
maintaining a stable and efficient financial institution system?
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Over the next several months this will be one of the most
frequently asked questions in the congressional banking
committees, the thrift and bank supervisory agencies and the
U.S. Department of the Treasury.
I wish that we could tell you
that the FDIC has all the answers. The fact of the matter is, no
one has "the" answer.
desirable goods —
Each change involves trade-offs between
such as reduced costs, market discipline,
financial stability, etc.
The only definite thing that one can
say today is that any simple solutions to these problems most
likely will be counterproductive —
good if implemented.
perhaps doing more harm than
We must proceed carefully because we are
dealing with extremely complex institutions and markets that
have a very direct link to the stability and prosperity of our
economy.
Today, we will attempt to respond to each question
contained in the letter of invitation, but not necessarily in
the order that they are presented in that document.
As
indicated earlier, we are not able to provide many answers for
you at this time.
However, we will attempt to share our
experience and our current thinking with respect to deposit
insurance and control of risks within the system.
Although the
discussion is equally applicable to banks and thrifts, for the
sake of simplicity we will refer to both as banks.
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The current debate regarding deposit insurance reform
appears to focus on what has become known as the moral hazard
problem.
The scenario is as follows.
To the extent that bank
creditors are protected by the deposit insurance system, there
is no incentive for them to be concerned with the condition of
the financial institution.
In fact, their incentive is to seek
the highest return without having to be concerned with the
risk-return trade-off typical of other investments.
Further,
without any market penalties for assuming more risk, the
incentive for bank management is to assume a higher risk profile
than would be consistent with safe and sound operations.
Because it normally provides the lowest cost solution to the
insurance fund, the FDIC has handled most bank failures, and all
failures of large institutions, in a way that protects virtually
all depositors and other general creditors of the bank.
As a
result of these "least cost" means of resolution, it is alleged
that there is almost no constraint on bank risk-taking other
than that provided by the bank supervisory process.
If this story accurately portrays the real world, the
logical conclusion is that reintroducing risk of loss to bank
creditors will reduce risks in the system.
One of the most
popular proposals along this line is to limit in some way the
amount of federal deposit insurance available to depositors in
failed bank situations.
While the exact mechanism differs among
the various proposals, the basic idea is to expose depositors'
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funds above some limit to loss when a bank requires financial
intervention by the FDIC. For example, one proposal envisages a
mandatory deductible for deposit accounts above the basic limit
(e.a.. the insurance limit could be $100,000 plus 90 percent
insured for amounts over $100,000).
Proponents state there are two major advantages to limiting
insurance coverage.
First, large depositors will have an
incentive to monitor the condition of banks in which they place
funds and will exert market discipline on more risky banks by
either withdrawing funds or demanding a higher return to
compensate for increased risk.
Second, the system.would become
more fair in that depositors in both large and small
institutions would be treated similarly.
There are several observations that need to be made
regarding these types of proposals.
First, it would be
necessary for those who ultimately are responsible for
macroeconomic stability to be willing to take the risks
associated with subjecting depositors in a large, multinational
bank to the disruptions and loss associated with these plans.
Those involved in the rescue of Continental Illinois National
Bank and Trust Company were not willing to take those risks.
Failure to take those risks would accomplish nothing in terms of
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increasing market discipline and would increase the disparity of
treatment of depositors in large and small banks.
Is it conceivable that a very large bank could be handled
as described above without unacceptable disruptions to the
domestic economy and international financial arrangements?
answer probably is yes.
The
However, the outcome could be highly
uncertain until after the event occurred.
No one really knows
what would happen if a large bank were allowed to default on
deposit obligations with no back up system.
Providing some form
of emergency or back up ability to handle potential system
collapse seems prudent.
This back up could be provided by the
insurance fund or some other government agency that has
responsibility for handling large bank failures.
Another observation regarding plans that are designed to
increase market discipline is that there is considerable
evidence that significant market discipline exists today,
especially for the larger institutions that have large amounts
of uninsured deposits and are owned by publicly traded holding
companies.
Even in smaller institutions, where uninsured
deposits are minimal, owners and subordinated creditors and
managers have a very good incentive to be concerned with the
condition of their banks.
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With respect to larger banks, most are owned by publicly
traded holding companies that also raise funds by issuing
various types of debt instruments.
These companies must
convince analysts on a regular basis that the overall
institution, including the banking subsidiaries, is solvent and
profitable.
Moreover, these companies face the market at
frequent intervals as new debt is issued to finance new
activities or refund maturing obligations.
In recent years, the
FDIC has made it clear through its actions that holding company
claimants will not be protected by the deposit insurance system.
At the bank level, the rating agencies make credit quality
judgments regarding large CDs issued by the larger banks,
resulting in higher funding costs for*those institutions judged
to be less creditworthy.
Moreover, bank runs do occur in large
banks. The best known example is Continental, which was unable
to fund itself from private sources once the market made a
judgment that risk of default had become unacceptably high.
More recently, the First Republic system lost over 20 percent of
its deposits after the extent of its problems were recognized in
the market.
Those who argue that large banks are not subject to market
discipline fail to recognize two additional facts.
First, money
managers do not want to explain why they have an exposed
position in a bank that is perceived to be in trouble, even if
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there is virtual certainty that no loss will result in holding
such a position.
Second, many large depositors have other
business relationships with the bank; to the extent that a
weakened financial condition of the bank diminishes the quality,
or casts doubt on the continued availability of these services,
customers will seek other banking relationships.
Thus, it is unlikely that market discipline will be
significantly increased by any of these plans.
A reduction in
the insurance limit will not materially increase the exposure of
large depositors.
At the same time, small depositors easily
could neutralize any reduction in insurance coverage by
rearranging account relationships.
However, costs to the insurance fund could be reduced if
there is a willingness to inflict losses on large depositors in
banks that are currently considered to be Mtoo-largeto-default."
This is because the bulk of the FDIC's costs have
been incurred in large bank failures.
It is important to
remember that this type of policy does involve a trade-off with
an increase of systemic problems.
Another means to increase private-sector discipline is to
replace some portion of federal deposit insurance with insurance
from private-sector companies.
One plan envisages FDIC
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insurance up to the basic limit and private insurance covering
uninsured deposits.
There could be considerable merit to some of the private
insurance proposals that have been made and this area certainly
deserves further study.
cautions.
However, we would like to voice two
First, it will be difficult to fashion a suitable
arrangement with private-sector companies that would provide
flexibility to accommodate concerns about the effect of a bank
failure on macroeconomic stability —— that is, private—sector
insurance and too—large—to—default may not be compatible.
Second, it is important to ensure that the financial capacity
exists in the industry to absorb a realistic expectation of
loss.
The failure of many seemingly solvent state-sponsored
funds in the mid-1980s should not be forgotten.
Having raised these reservations with respect to attempts
to control excessive risk by means of increasing discipline on
the liability side of the balance sheet, it is fair to say there
would appear to be areas where constructive measures can be
taken.
One such area involves golden parachutes which often
provide management with perverse incentives.
Safety and
soundness issues clearly are raised when it is more lucrative
for management if a bank fails than if it continues in
operation.
attention.
These subjects certainly deserve more thought and
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Perhaps an equally promising means of controlling excessive
risk is by restricting the scope of activities that can be
funded with insured deposits while expanding the scope of
activities that can be conducted in separately capitalized
subsidiaries or affiliates of the insured bank.
This is a
proposal that the FDIC presented in 1987 in our study, Mandate
for Change; Restructuring the Banking Industry.
The basic idea is to restrict activities that are permitted
to be conducted within the bank to those that, in some sense,
are judged to pose an acceptable level of risk.
All other
activities could be conducted in separately capitalized direct
subsidiaries or affiliates of the bank, provided that a valid
and separate corporate identity is established and transactions
between the bank and sister companies are severely restricted.
We believe that these "firewalls," in conjunction with
appropriate auditing and supervisory activities, would
adequately protect the insurance fund.
As an integral part of this plan, the FDIC argued that the
bank holding company should be free to engage in whatever
activities management believes to be appropriate from a business
perspective, and that capital regulation at the holding company
level served to reduce the ability of the overall company to
diversify and to become a viable and profitable organization.
In essence, the FDIC's proposal was to eliminate most of the
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regulation at the holding company level, and concentrate
regulatory and supervisory resources on the bank and other
operating entities as appropriate.
The FDIC continues to support this position.
Clearly,
there remain numerous unanswered questions, including what
belongs "in the bank" and whether separate rules are necessary
for small banks.
In this regard, there are credible views that
range from restricting the insured bank's investments to
short-term government or government-guaranteed obligations to
permitting the insured entity to do what is permitted to
national banks under existing rules.
As a final note in this area, extending the cross-guarantee
provisions of FIRREA —
which are designed to treat insured
affiliates as if they are one company —
to nonbanking
subsidiaries likely would frustrate attempts to attract capital
to bank holding companies, and would be counter to the FDIC's
views as articulated in Mandate for Change.
However, it may be necessary to revise certain aspects of
the cross-guarantee provisions in order for them to be more
effective.
Most importantly, since the cross-guarantee
provisions now apply only to institutions affiliated at the time
of failure, there is an incentive for holding companies to sell
or otherwise separate the healthy insured affiliates prior to
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Thus, the insurance fund should be able to reach
assets of affiliated insured institutions that are separated
from the common control relationship within a certain amount of
time prior to failure of an insured affiliate.
For example, the
insurer could be permitted to serve notice on a holding company
when an insured affiliate has been identified as in danger of
failing.
The formal notice then would serve to legally obligate
the failing institution's affiliates under the cross-guarantee
provisions whether or not they are commonly controlled at the
time the institution actually fails or receives FDIC
assistance.
The proceeds of disposing of an insured affiliate
then would be subject to FDIC recovery regardless of where held.
Another avenue for controlling risk is to look to the level
of capital requirements as a means of providing a larger cushion
to protect the deposit insurer.
While adjusting capital levels
to control risks is attractive, it must be recognized that
raising capital standards might have implications for
international competitiveness and the ability to attract
capital.
In our view, the issues discussed thus far comprise the
heart of the options available for meaningful reform of the
banking system.
questions.
entity?
In essence, the decisions reduce to three
First, how do we control exposure within the insured
Do we limit coverage of liabilities, place activity
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restrictions on the asset side or increase capital
requirements?
The second question relates to the appropriate
position of insured depositories within broader corporate
structures, and the implications of this positioning to the
longer-term soundness of the banking system.
The final question
has to do with determining what institutional structure is
appropriate for resolving large bank failures.
It is important to note that caution should be exercised in
structuring further reform proposals based on either the thrift
or commercial bank experience viewed in isolation.
One
important difference is that thrift institutions typically are
funded by fully insured deposits and secured borrowings, whereas
banks, especially the larger institutions, rely on significant
amounts of uninsured and unsecured funds.
Another important
difference is the origin of the losses borne by the deposit
insurer.
The majority of losses in the thrift industry were
caused by relaxation of accounting and capital standards and lax
supervision; on the other hand, a majority of losses in the
banking area is attributable to application of the
«too-big-to-default” policy in cases where macroeconomic
stability became an issue.
Your letter of invitation raises other issues which we
would like to respond to in an abbreviated form.
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First, correct measurement of capital (i.e., appropriate
asset valuation) and measurement of overall risk clearly are
goals that regulators and auditors should strive to achieve.
A
move toward market—value accounting and/or a risk—based premium
system is desirable but neither method is fully developed at
this time.
Thus, they can not be the "answer" to the problem.
The FDIC will continue to attempt to improve techniques in both
areas, and FIRREA directs the FDIC to conduct a study of the
feasibility of instituting a system of risk-based premiums.
Second, the concept of insuring and assessing deposits in
foreign offices of domestic banks raises a host of rather
complex questions.
The answer to the "too big" doctrine can
affect the fairness of this proposal.
If there is no "too big"
doctrine the fairest basis for insurance premiums is insured
deposits, not total deposits as used today.
Further, foreign competitive conditions must be considered,
as well as the ability of banks to avoid premium payments by
converting foreign branches to subsidiaries.
At this point, we
see no clear case for including foreign deposits, but further
study is required.
Finally, your letter asked that we comment on the current
condition of both the Bank Insurance Fund ("BIF") and the
Savings Association Insurance Fund ("SAIF").
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Based on preliminary results, it appears that the BIF will
experience a small loss for 1989.
This will be the second
operating loss experienced during the history of the FDIC, but
much smaller than the over $4 billion loss taken in 1988.
From
what we see in the system at this time, our expectation is that
the fund will begin to increase in 1990 if no large institutions
must be restructured.
The major question with respect to the SAIF is the amount
of assessment income available from SAIF-insured members over
the next few years.
Attempts to project this income stream is
fraught with problems.
The savings association system is
entering a transitional period which will determine the fate of
the undercapitalized segment of the industry.
Events during
this transitional period will determine the size of the SAIF
assessment base, that is, the deposits of SAIF—insured
institutions.
over time.
The growth of this base has varied dramatically
From mid-1978 to the end of 1982, deposits at
SAIF-insured institutions grew at an annual rate of 7.4
percent.
This was followed by two years of rapid deposit growth
of 19.4 percent per year.
From the end of 1984 through the
first quarter of 1988, deposits grew at a more normal 6.4
percent annual rate.
As of the third quarter of 1989, savings
association deposits were as they were in March, 1988.
outflows, however, have occurred in recent months.
Deposit
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In light of the uncertainties facing the industry during
the next few years, the FDIC has not felt that a "projection" of
the SAIF assessment base would be meaningful.
The current
condition of many savings associations may vary sharply from
what is indicated by their public financial statements and old
examination reports.
Future events are even more uncertain.
These include the behavior of interest rates, the condition of
local real-estate markets, and the condition of the economy
generally.
All these factors will influence the ability of the
thrift industry to attract capital and hence to grow.
@FedFRASER