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10:00 AM
JULY 31, 1990

Hr. Chairman and members of "the Committee: We appreciate
this opportunity to testify on the need for legislation to
modernize the regulation of financial services. There is no doubt
in our view that change is necessary to enhance the competitive
position of financial institutions and reduce the exposure of the
taxpayers to the costs of the federal safety net. In the
invitation to testify, we were asked to focus on three
interrelated issues. These are:
(1) How should the current system of Federal deposit
insurance be reformed?
(2) What should be done to improve the current Federal
regulatory structure? What changes in Federal supervision
would be needed to deal with expanded powers?
(3) Should new powers be granted to banks or their
a^filiates? If so, what powers should be granted, when
should they take effect, and with what protections for the
deposit insurance fund? Should new powers be granted only to
a bank's holding company affiliates, rather than to the bank
or its subsidiaries?
Our testimony on these very broad, complex issues does not
contain definitive recommendations. Along with the other federal
banking agencies and the Office of Management and Budget, the
FDIC is participating in the Treasury Department's comprehensive
study of deposit insurance. This study was mandated by the
Financial Institutions Reform, Recovery, and Enforcement Act of
1989. Treasury intends to complete the study by the end of this


Because 'the study will draw conclusions and make
recommendations regarding the subject matter of this testimony,
providing final conclusions and recommendations now would be
premature. Since we are still studying these matters with our
colleagues, our purpose in this testimony is to report on our
thinking and define the important issues we believe are involved.
In laying out the issues, our testimony first reviews
several general considerations that should be kept in mind when
the topics of financial industry and deposit insurance reform are
examined. Then issues involving structural reform of the deposit
insurance industry are discussed. The topic of structural reform
concerns obstacles to the maintenance of a healthy banking
system. In the final analysis, a healthy deposit insurance fund
depends on the viability of the banking industry itself •
Next, suggestions for reforms in the deposit insurance
system are considered. Although the deposit insurance reforms are
important, the point needs to be emphasized that in the long run
they would be ineffective if the structural problems of the
industry are not addressed. The United States has operated for
far too long with an economically irrational financial structure.
Financial institutions need freedom, subject to adequate
supervision, to respond and adjust to changes in the competitive
The testimony concludes with a brief look at the topic of
changes in the federal regulatory structure.


To say that the last decade or so has been a period of
change and turmoil in the financial industry is, if anything, an
understatement. Secondary evidence of the volatile environment
and its effects on various segments of the financial industry can

found in the actions of this very body. Since 1978, Congress

has passed an extraordinarily large number of far-reaching laws
pertaining to depository institutions.
These laws include: The Financial Institutions Regulatory
and Interest Rate Control Act of 1978 (FIRIRCA); the
International Banking Act of 1978; the Depository Institutions
Deregulation and Monetary Control Act of 1980 (DIDMCA); the Bank
Export Services Act of 1982; the G a m —St Germain Depository
Institutions Act of 1982; the International Lending Supervision
Act of 1983; the Competitive Equality Banking Act of 1987 (CEBA);
and most recently the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 (FIRREA).
What is the point of this mind-numbing recitation? The point
is to emphasize the many rapid changes that have taken place in
the financial environment, changes considered serious enough to
warrant action by Congress. Never before in the nation's history,
not even during the legislatively prolific years of the 1930s,
have such a large number of important banking laws been passed in
such a relatively short period of time.
And many contend that an appropriate point for a legislative


hiatus has not yet been reached.
In hindsight, some of the actions— both legislative and
regulatory— taken during the last decade appear unwise. As a
general matter, the deregulation of the savings and loan industry
was not accompanied by a concurrent strengthening of capital
standards and the industry's supervisory structure. This
contributed to the S&L crisis, a financial disaster of major
Among the lessons that should be absorbed from the S&L
debacle is that adequate supervision is necessary to the
maintenance of a safe and sound system of depository
institutions. Regulation— the mere promulgation of rules— is no
substitute for supervision because the rules must be enforced.
And the nature of the business of depository institutions is such
that enforcement requires judgement «aid hands-on efforts by
competent, trained examiners.
In determining what additional banking laws should be added
to the prodigious output of the recent past— either to cope with
problems that have not yet been adequately handled or to correct
prior efforts— several considerations need to be kept in mind.
These are s (1 ) the changing nature of the banking industry in the
nation and the world; (2) the uniqueness of the problems in the
S&L industry; and (3) the misunderstandings concerning the Too
Big To Fail concept.


Changing Industry
Reform of the deposit insurance system must begin with

reform of the antiquated legal structure burdening the financial
industry in general and the banking industry in particular.
Reform of this structure is necessary because the competitive
environment within which banks operate is changing significantly.
Banks and other financial institutions have been hampered in
their ability to adjust to the changes.
In Appendix I, a number of tables and graphs are used to
identify three interrelated trends: banking is becoming a
riskier, more volatile business; banks are encountering greater
degrees of competition; and what constitutes the business of
banking itself is undergoing a rapid evolution.
One way to summarize what is happening is to say that the
banking industry's monopoly on financial information has been
eroding. Credit histories are more widely available. The ability
to acquire and analyze economic and financial data has become as
ubiquitous as the personal computer. The development of complex
financial instruments and strategies is being accomplished
internally by an ever greater number of corporations.
Consequently, banks and the traditional intermediary function
they perform are no longer as necessary as they once were.

S&L Crisis Versus Bank Problems
The savings and loan industry crisis and the difficulties
facing the banking industry should not be confused. A unique


situation and a particular series of events combined to produced
the multi-billion dollar S&L disaster.
For many decades, S&Ls performed successfully the task of
funding long-term assets with short-term liabilities. The
underpinning of this process eroded in the latter half of the
1970s, however, when interest rates rose to unprecedented
heights. As the high rates persisted, the total interest expense
of many S&Ls grew to exceed their total interest income, the
interest expense rising because of the reliance on short-term
In an attempt to mitigate the growing difficulties facing
the S&L industry, the federal government and several states
relaxed restrictions on the activities the institutions could
engage in. Most unfortunately, however, little attention was paid
to supervising the exercise of the expanded powers. The results
are well known. A number of S&Ls went on the institutional
equivalent of a bender, and the nation will be paying the tab and
nursing the hangover far into the future.
There were, of course, additional factors that contributed
to the S&L debacle. One among them was that the federal S&L
supervisor, the Federal Home Loan Bank Board, was not just a
"policeman.*' It was also something of a "cheerleader" for low
cost home financing and for the S&L industry, having been given
the mandate to encourage local thrift and home financing and to
promote, organize, and develop thrift institutions. The
incompatibility of the two functions may have hindered the


FHLBB's ability to act objectively as the industry's troubles
A related problem was that there was in effect no separation
between the federal chartering and deposit insurance
responsibilities for S&Ls. The federal deposit insurer,, the
Federal Savings and Loan Insurance Corporation, was under the
supervision of the FHLBB. This substantially reduced the
possibility that a second independent supervisory agency might
apply the objective oversight that was neglected by the first
The closeness between the regulators and the regulated in
the S&L industry probably contributed to the ill-advised efforts
to protect institutions as the problems deepened. An example of
these ill-advised efforts was the relaxation of accounting
standards to forestall the recognition of losses• The deviation
from.proper accounting practices only compounded the developing
Banks do not have the maturity mismatching problems that
S&Ls had in the late 1970s. No change in the banking system has
required a large increase of supervisory resources in a short
period. The chartering and deposit insurance responsibilities for
the banking industry are separate. And although some aspects of
bank accounting have been criticized, banks have been required to
adhere to generally accepted accounting principles. Thus the
difficulties facing the banking industry today are not comparable
to the situation that produced the S&L crisis.


The banking laws enacted during the 1980s, particularly
FIRREA in 1989/ made a number of beneficial changes in the
supervisory structure of the bank and thrift industries and added
a number of weapons to the arsenals of the supervisors. For
example, enforcement powers have been strengthened. Generally
accepted accounting principles and higher capital levels have
been mandated for thrift institutions. And the federal chartering
and deposit insurance functions for S&Ls have been separated.
In summary, the point to be emphasized is that although
banking industry structure and the deposit insurance system are
in need of reform, the problems are not the same problems that
brought the S&L industry to its knees. Consequently, the measures
that have been taken regarding the S&L industry should not
necessarily serve as a blueprint for legislative action for the
banking industry.

Too Big To Fail
Too Big To Fail is an imprecise term that has received
considerable attention lately. It concerns one of the more
important things that must be understood before meaningful
deposit insurance reform can be addressed: deposit insurance
reform proposals that do not acknowledge the perception of large
banks being Too Big To Fail could result in a shift in the
competitive balance between big banks and small banks. The latter
would suffer. This would be the case even though the FDIC does
not in fact have a Too Big To Fail policy.


The term "Too Big To Fail" is used in referring to troubled
banking organizations that supposedly are too large for the
government to handle by closing the bank and paying off deposits
up to the $100,000 insurance limit. There are many nuances in the
resolution methods for troubled banks that are not handled
through a liquidation and deposit pay off. To generalize, if the
deposit pay off method is not used, a troubled bank resolution is
accomplished either by arranging for the bank's liabilities, both
insured and uninsured, to be acquired by another institution, or
less often by providing direct financial assistance.
Who is aided in the various resolution methods varies. In
the past, uninsured depositors and creditors of the troubled bank
were benefitted in most cases in which a resolution method other
than the deposit pay off method was used. Stockholders and
management of the institution were benefitted much less
frequently. The FDIC's pro rata power— which was legislatively
endorsed in FIRREA and in recent years has been considered for
use more frequently— enables it to distinguish between categories
of uninsured depositors and creditors under all methods of
resolving failing banks.
The Too Big To Fail concept came into prominence with the
1984 assistance package arranged for Continental Illinois
National Bank and Trust Company. As a result of the assistance
package, both the creditors of the holding company and the
uninsured depositors and creditors of the bank itself were
benefitted. The actions of the banking supervisors in the


Continental case and in a number of subsequent cases involving
large troubled institutions have been widely interpreted as the
product of a Too Big To Fail policy.
It bears repeating, however, that there is no such explicit
policy. Continental and subsequent cases need to be put in the
context of the FDIC's longstanding preference for handling
troubled bank situations in the most expeditious, least
disruptive way possible. Furthermore, in those subsequent cases
the FDIC has not only been much less willing to include holding
company creditors and equity holders in rescue efforts that
benefit the uninsured depositors and creditors of a subsidiary
bank. It has also not automatically adopted a resolution method
that fully protects all of the bank uninsured depositors and
creditors themselves.
Of more general significance, however, is the fact that Too
Big To Fail is much more than a problem of the deposit insurance
system. Altering the present regulatory structure in an attempt
to eliminate the perception of large banks being Too Big To Fail
would merely shift responsibilities. The possible failure of a
large financial organization presents macroeconomic issues that
some arm of the government must consider. The evaluation of the
economy-wide ramifications of the demise of a big bank is a
government duty.
To put the matter another way. Too Big To Fail as an issue
would exist even in the absence of an explicit deposit insurance
program. And the result of protecting large institutions is to


provide 100 percent insurance for the deposits in such
institutions. Past experience in all major countries supports the
contention that a Too Big To Fail policy exists, de facto if not
de jure.
Therefore, the possibility that a failing large bank will be
handled in a way that results in losses to uninsured depositors
and creditors cannot be guaranteed. Many participants in the
financial marketplace conclude based on past practices that large
banks are safer than small banks. If changes in the deposit
insurance system resulted in this view being more widely adopted,
many marketplace participants might move funds to large banks
regardless of any explicit policy requiring large bank depositors
and creditors to suffer losses. The explicit policy would simply
not be believed.
Thus the effectiveness of depositor discipline put in place
by deposit insurance reforms designed to impose losses on
uninsured depositors and creditors in all cases of bank failure
is a difficult question. The stability of the system under such
conditions must be evaluated.

A healthy deposit insurance system depends ultimately on the
existence of a healthy banking system. The discussion in Appendix
I shows that the health of the banking system has been
deteriorating. To halt this deterioration and give banks the
opportunity to compete and remain viable in a fast-changing world


should be the goals of efforts to reform the structure of the
banking industry.
Structural reform of the banking industry primarily concerns
three topics:

1. The Glass-Steagall Act;
2. The ownership and product limitations of the Bank Holding
Company Act; and
3. Geographic barriers to bank expansion.

In 1987, the FDIC considered in detail the first two of
these topics. The results were set forth in Mandate for Chance:
Restructuring the Banking Industry. The events of the interceding
three years have not detracted from Mandatefs conclusions that
the Glass-Steagall Act and many of the restrictions of the Bank
Holding Company may be not only unnecessary but also actually
harmful to the banking industry. As is discussed in the
Background section and Appendix I of this testimony, the
financial environment has been changing to the detriment of the
traditional banking business. The laws constraining the business
have not changed, however.
Two of the conclusions reached in Mandate were that product
limitations on bank holding companies and regulatory or
supervisory authority by bank regulators over nonbanking
affiliates of banks are not necessary to protect either the
deposit insurance system or the payments system. Banking


organizations should be free to offer a wide range of products
and services, with the major caveat being that many of the
products and services should be in uninsured subsidiaries or
affiliates of a bank rather than in the bank itself. In addition,
the FDIC in 1987 could discern no valid reason to limit the type
of entities that can own or be affiliated with banks.
To carry the conclusions of Mandate a step further, there
might be substantial benefits from eliminating the current
ownership and activity restrictions. Risks could be diversified.
Cross-marketing activities could enhance the profitability of the
overall organization, although there would have to be
restrictions on the use of insured funds to support uninsured
activities. And the U.S. system for governing depository
Institutions could be brought into alignment with the systems of
most of the other industrialized nations.
Regarding the last point, it is worth noting that the
nations of the European Community, which is rapidly removing
internal barriers to the movement of goods and services, have
nothing that is comparable to the U.S. Bank Holding Company Act.
Bank supervisory systems in Europe are aimed at the bank rather
than at both the bank and any corporate owners.
In Mandate. the FDIC presented an order of precedence for
the elimination of the excessive controls and regulation imposed
by the Glass-Steagall Act and the Bank Holding Company Act. The
first step would entail the enactment of the necessary
legislation or the promulgation of the necessary regulations to


ensure 'that: ‘the bank supervisors have adequate tools to police
banks under the new regime.
Specifically, if the Glass-Steagall and Bank Holding Company
Acts were substantially altered, the following controls should be
part of the new supervisory systems

1. Restrictions relating to dividend payments and general
loan limits should be uniform for all banks, whether chartered by
the state or federal government;
2. The interaffiliate restrictions of Sections 23A and 23B
of the Federal Reserve Act should cover transactions not only
between banks and their affiliates but also between banks and
their subsidiaries;
3. Equity investments in subsidiaries should be excluded
from the determination of banks' required levels of capital;
4. Bank supervisors should have the authority to audit both
sides, of any transactions between a bank and its affiliates or
subsidiaries and to require reports as needed from the affiliates
and subsidiaries;
5. Bank supervisors should have broad explicit authority to
determine which activities can be performed in the bank and which
have to be conducted in affiliates or subsidiaries; and
6• The legal and financial separateness of the insured bank
from subsidiaries and affiliates should be fully disclosed and
criminally enforced.


Controls such as these are designed in large measure to
insulate a bank from difficulties in affiliates and subsidiaries.
Can separateness be effectively established between the banking
and nonbanking portions of a banking organization so that the
bank's capital and the federal deposit insurance fund are not
endangered by the nonbanking activities? The FDIC argued in
Mandate that such separateness can be achieved. The suggested
restrictions and limitations would merely be extensions of
existing safeguards to protect banks from insider abuse,
conflicts of interest, and the risks of certain types of
endeavors. Where they have been adequately enforced by bank
supervisors, such safeguards have worked well•
A case in point concerns the operation of life insurance
programs by savings banks in Massachusetts. While the insurance
programs and other programs within a bank have shared common
names and quarters, there has been no commingling of assets or
funds. The insurance programs have been separate and distinct
from the other operations of the bank. No significant problems
with the provision of life insurance by Massachusetts' savings
banks have arisen.
The second step suggested in Mandate to bring about a new
regime of bank supervision would be to eliminate the GlassSteagall restrictions on banking organizations. A gradual phase­
out of those restrictions would appear to be unduly cautious. For
one thing, many securities activities would have to be conducted
in subsidiaries or affiliates of banks, and these subsidiaries or


affiliates would be subject to supervision and regulation by
securities industry regulators.
For another thing, securities firms should be allowed to
enter the banking business at the same time that banking
organizations are given the right to conduct a full range of
securities activities. Such an equitable removal of GlassSteagall restrictions might be difficult under a gradual phase­
out approach.
Some use of phasing, however, might be appropriate for
Mandate's third step in a move away from excessive control over
bank holding companies— the elimination of the ownership and
activities restrictions of the Bank Holding Company Act. If these
eliminations were legislated, affiliations with financial firms
should probably be allowed to take place on a faster schedule
than affiliations with nonfinancial businesses. Other than this
broad guideline, the exact timetable would probably not be
important. What would be important is that certainty be part of
the process. There should be a specific sunset date when all
limitations on affiliations would terminate.
The third topic regarding structural reform was not
discussed in Mandate, but it is related to the bank holding
company concept. To put the matter simply, the time may have come
to allow unfettered nationwide banking. This means removing all
restrictions on the establishment of bank branches across state
lines. In this regard, the FDIC is pleased to note the initiative
just taken by Senator Dodd in introducing a bill to bring about

full interstate banking by 1994.
Interstate banking exploded in the 1980s, but the explosion
was at the holding company level. Moreover, it came as the result
of state rather than federal action. First in New England, then
in the Southeast, and finally in all geographic regions, state
legislatures moved to permit some form of interstate banking. The
result is a bewildering variety of reciprocity laws, regional
reciprocity laws, failing institution laws, and the like.
The states were responding to the imperatives of the
marketplace. Halting the banking business at state boundaries was
becoming more and more economically inefficient. In the Douglas
Amendment to the Bank Holding Company Act, the states had a means
to rectify matters. The Douglas Amendment permits the Federal
Reserve Board to allow a bank holding company to acquire a bank
outside its home state if the laws of the target bank's state
authorize such an acquisition.
Unfortunately, the free market ideal of no geographic
restraints on the banking business has still not been achieved.
The mishmash of state laws imposes substantial restrictions on
interstate expansion by bank holding companies. Just working
one's way through the maze of state interstate banking laws
requires a high-priced legal team. But more important, what is
often the most economical way to expand geographically— by
branching— is not readily available.
The 1927 McFadden Act severely restricts the ability of
national banks and state banks that are members of the Federal


Reserve System to branch across state lines. There is no such
federal constraint on state banks that are not members of the
Federal Reserve System, but very few states have opened their
borders to branches from out-of-state banks.
Interstate banking restrictions have contributed to the
increase in risk in the nation's banking industry and to the
decrease in banks' competitive capabilities. Banks have been
hampered in attempting to lower risk through diversification. And
banks have been constrained in expanding operations to match the
expansion of banking markets that has been caused by technology
and economic growth.
The nation's archaic geographic banking restrictions will
become even more obvious and unpalatable in the near future as
the European Community eliminates restrictions on branch banking.
While European banks, and U.S. banking organizations with
subsidiaries in Europe, make growth decisions based on market
opportunities, banks operating in the United States will make
growth decisions based to a large extent on what statutory
loopholes can be found by the aforementioned teams of highpriced legal talent.
To summarize, the FDIC believes that deposit insurance
reform should start with reform of banking industry structure.
And structural reform should begin by identifying and examining
the underlying obstacles to a competitive and viable banking
industry. Topics that should be considered in this process are
the Glass-Steagall Act, the product and ownership limitations of


the Bank Holding Company Act, and interstate banking

Given a viable and competitive banking industry, the deposit
insurance system should be designed to ensure that the
industry— both the institutions that provide products and
services and their customers— bears the appropriate costs. The
deposit insurance system should not result in a subsidy to the
banking industry, particularly a subsidy that eliminates the
penalties the marketplace imposes on reckless conduct.
It is easy to lose sight of the fact that any system of
supervisory controls creates costs and benefits. Some sectors of
the economy receive implicit subsidies, and other sectors pay
implicit taxes. A complete tabulation of these costs and benefits
is extremely difficult. The issue sometimes comes to the fore
only when changes in the supervisory system are considered, or
when a disaster such as the S&L crisis sheds light on the costs
and benefits.
Regarding the S&L crisis, taxpayers were surprised, and not
pleasantly, at the amount of the costs they had unknowingly
accrued over the years.
One charge that has been made is that the banking industry
has received a benefit from underpriced deposit insurance. The
banking business has become riskier. The cost of deposit
insurance, however, has not kept pace with the increased risk. As


a result, the ratio of the bank insurance fund to insured
deposits is at its lowest level in the FDIC's history (Figure 1).
At year-end 1989, the fund, at $13.2 billion, amounted to 0.70
percent of insured deposits.
Increasing what banks pay for deposit insurance could be
done directly, by increasing the insurance premiums, or
assessments, that banks pay, as was done in FIRREA. The increase
could be equally applicable to all banks, or it could be based on
the level of risk in a bank's operations.
Imposing higher costs on banks for deposit insurance could
also be done in a variety of indirect ways • One such way would be
to increase required capital levels. Another way would be to
reduce what is covered by the deposit insurance system, thus
shrinking the amount of insured deposits, and perhaps the banking
industry itself.
The mere mention of these possibilities highlights the fact
that changes in the deposit insurance system, and the bank
supervisory structure in general, entail shifts in costs and
benefits. Such shifts are not painless.
In the remainder of this section, the topic of deposit
insurance reform is examined under three headings. The headings
ares liabilities, assets, and capital and structure.

Many proposals to reform the deposit insurance system
concentrate on the liabilities side of the balance sheet. These


Figure 1: State of the Bank Deposit Insurance Fund
Ratio of Fund to Insured Deposits

Source: FDIC Annual Reports

proposals have the goal of limiting government's exposure by
restricting or curtailing the amount of liabilities guaranteed.
Among the proposals— several of which are examined in
greater detail in Appendices II and III— are the followings
reduction in the statutory coverage limit from the current
$100,000; limitation of coverage for each individual to a maximum
of $100,000 per institution, across all institutions, or per
lifetime; and limitation of coverage according to type of
A particularly noteworthy proposal is the American Banker's
Association coinsurance mandatory "haircut" proposal. Under this
proposal, all uninsured depositors would suffer a loss in a bank
failure. The loss would be based on the FDIC's average rate of
recovery of assets in past failure resolutions. Since this
average has been in the 85 to 95 percent range, uninsured
depositors would suffer losses in the 5 to 15 percent range. The
proposal envisions that even the largest banks could be
successfully liquidated.
The FDIC is in favor of reducing its exposure to loss.
However, limiting the cost of banking industry difficulties to
the deposit insurance fund will entail tradeoffs, such as
increased risk of instability in banking markets and the
resulting possible adverse economic effects. This in turn could
lead to reduced international competitiveness on the part of U.S.
Such tradeoffs are likely to be more pronounced if a


component of any alteration in the deposit insurance system is a
reduction in the FDIC's options regarding failing institutions.
That is, the less flexibility the FDIC is allowed in handling a
troubled institution, the more likely it will be forced to select
a more costly, more disruptive approach to resolving the
Although one benefit of these types of proposals would be to
increase the incentives for depofitors to monitor more closely
bank operations, it must be realized that there is currently a
significant amount of market discipline in the banking system.
The stock market, credit rating agencies, large depositors, all
are sources of discipline. The fact that banking organizations in
trouble do lose access to funding— Continental in 1984 and First
Republic in 1988 are two examples— shows that considerable
discipline already exists.
Moreover, deposit insurance reform proposals that are
designed to increase depositor oversight of banks through the
monitoring of deposits have their limitations • Only a small
proportion of depositors have the resources and ability to make
informed judgments about the condition of a bank. Even the best
regulators, Wall Street types, and financial gurus have a very
poor record of foreseeing banking problems much in advance.

Various proposals would approach deposit insurance reform
from the asset side of the balance sheet. The idea behind these


proposals Is to limit what government insured deposits can be
used to fund. The basic approach is to limit government risk by
restricting the types of activities funded with insured deposits
to those with the least risks. This approach has both promise and
problems, as do all of the proposed changes.
One subset of these proposals focuses on a "narrow bank"
concept. A "narrow bank" would be limited to investing in high
quality, mostly government, securities.
The difficulty with the "narrow bank" idea— and indeed with
any proposal that would reduce the type of assets that banks are
currently allowed to hold— is the unpredictable effect it would
have on the major beneficial function of banks: the provision of
credit and liquidity to the private sector, which results
ultimately in economic growth. Limiting deposit insurance
protection to deposits that are only invested in the highest
quality securities could well result in less credit and liquidity
being provided to the private sector, and less economic growth.
Another subset of asset-related proposals would expand what
banking organizations can do but limit use of insured deposits to
a small part of the total operations. If the banking industry
were given increased powers— primarily through relaxations in the
restrictions of the Glass-Steagall and Bank Holding Company
Acts— a major issue is where the new powers would be exercised:
in banks themselves, in bank subsidiaries, or in bank affiliates.
This is a question for which there is no readily apparent
precise answer. As a general guideline, traditional credit-


granting functions could continue to be funded with insured
deposits. Other financial activities could be performed in
subsidiaries. And the most risky financial activities, along with
nonfinancial activities, could be confined to bank affiliates.
Bank size could be a factor in the determination of whether
activities would be conducted in the bank or in subsidiaries or
affiliates. Small banks would most likely have less desire to
engage in nonbanking activities. The costs of setting up
subsidiaries or affiliates would not vary much by bank size, thus
making it relatively more expensive for small banks to establish
separate nonbanking entities. Difficulties in a single small bank
pose less danger to the banking system than do difficulties in a
single large bank. And small banks are easier to supervise.
Therefore, a requirement to conduct some types of activities in
subsidiaries or affiliates could be limited to banks above a
certain size, say $100 million in assets.
Regulatory discretion would be necessary to implement a
banking system freed from the restraints of the Glass-Steagall
and Bank Holding Company Acts. For example, the development of
the appropriate degree of separateness among banks, their
subsidiaries, and their affiliates to achieve a balance between
prohibiting improper use of insured funds and permitting economic
synergies would require the capability of making a number of
incremental decisions.


Capital and Structure
While the level of risk in the banking system has increased
since the 1940s, the proportionate amount of capital has remained
static (see Appendix I). In addition, failures in the banking
industry increased dramatically in the 1980s, and the ratio of
the deposit insurance fund to insured deposits is at the lowest
level in the FDIC's history (Figure 1). Thus it seems appropriate
that serious consideration should be given to phasing in higher
capital requirements for banks.
Capital serves to protect both individual banks and the
deposit insurance system. An adequate commitment of capital on
the part of the owners of a bank can curtail the temptation to
take excessive risks with the bank's funds. Curtailment of risky
activity at individual banks would result in a more stable
banking system and a healthier deposit insurance fund.
In addition, capital encourages more efficient and equitable
pricing for the banking industry's products and services. One of
the undesirable effects of deposit insurance is to enable banks
to offer some products and services at prices below those that
would prevail in an uninsured banking industry. Capital can serve
to mitigate this subsidization effect. All other things being
equal, more capital would require a bank to earn more revenue in
order to maintain its return on equity. The requirement for more
revenue would reduce the bank's ability to underprice.
Phasing in higher capital requirements would not be a
painless process, however. Moreover, a general increase in


capital requirements should probably not take place in isolation.
Any such increase should depend on banking industry structural
reforms, such as the alterations that were discussed earlier
concerning the restraints of the Glass-Steagall and Bank Holding
Company Acts. Then, as capital requirements for banks were
raised, banking organizations would have various options
regarding the movement of activities to uninsured affiliates or
subsidiaries. The banking regulators would mandate the
capitalization of banks, but the marketplace would determine the
capitalization of the overall company.
Some proposals would alter the structure of the deposit
insurance system by either eliminating deposit insurance or
placing some exposure on private-sector insurance companies. The
private insurance alternatives range from a totally private
system with little, if any, governmental presence to partially
private systems where the private and public sectors coordinate
and share the insurance function. The basic premise is that the
integration of private insurers into the deposit insurance system
would lead to greater efficiencies in terms of pricing, risk
monitoring, and closure of insolvent institutions.
The three main private insurance proposals ares private
cross-guarantees of deposits; private insurance guarantees for
deposits in excess of the statutory $100,000 limit; and
reinsurance. Under the cross-guarantee proposal, deposit
insurance would be mandated by the government but capitalized and
operated by the private sector. Banks would be required to


purchase deposit guarantees from insurance syndicates comprised
of other banks. Additionally, banks could act as insurers by
investing their capital in one or more of the syndicates. The
government, at least implicitly, would be the backup insurer.
Under the excess insurance proposal, private insurers would
offer voluntary insurance for deposits in excess of the statutory
$100,000 limit. Prices for the excess coverage would become, in
theory, market-based, thus capturing the efficiencies of a
competitive market. In the reinsurance scheme, the FDIC would, as
primary insurer, sell to private insurers part of the risk it has
underwritten in the form of deposit guarantees.
These proposals have some degree of merit. Each of the
proposals, however, entails pricing and administrative
difficulties. Moreover, in the final analysis each fails in the
ability to cope with systemic risk. If the banking industry
encounters deep troubles, it is unlikely that a private insurance
system could handle the situation. The government would remain
the ultimate risk-bearer.
Additionally, private insurance most likely would not reduce
the Government's supervisory responsibilities and the moral
hazard problem. Any lessening of the need for the Government to
supervise banks could be offset by the need to supervise the
insurer or insurers. Indeed, it is unlikely that any private
insurance system would impose more effective supervisory
restraints on imprudent conduct by banks than does the present
system. Detailed supervision is largely what controls improper


activity and the moral hazard problem now, and detailed
supervision is what would be necessary under any replacement
There are other useful ideas that could help the deposit
insurance system. One type of proposal would convert deposit
insurance to a risk-based system. Deposit insurance assessments
would be determined by certain indicators of risk in a bank. The
FDIC has been examining this topic for some time, and is required
by a provision of FIRREA to report its conclusions to Congress by
the end of the year.
Market-value accounting is also a concept that could have
useful application in bank supervision. The market values of some
types of assets, such as securities, can be ascertained without
too much difficulty. Requiring such assets to be carried at their
market values could result in more realistic financial statements
for banking organizations.

Regulatory structure reforms should not be the tail that
wags the dog. The issue of regulatory structure should be
addressed only after the problems of structural reform of the
industry and changes in the deposit insurance system are
considered. How the regulatory structure should be altered will
depend on how the problems of industry structure and deposit
insurance reform are handled.
To put the matter another way, issues of regulatory


responsibility and supervisory authority should not be allowed to
obscure the more important need to rejuvenate banking industry
competitiveness and viability. Nor should issues of regulatory
reform be the predominant factors regarding changes in the
deposit insurance system.
Once reforms concerning banking industry structure and the
deposit insurance system are agreed upon, the difficult task of
improving the rationality and efficiency of the regulatory
structure can be tackled. That structure currently consists of
three federal bank regulators, one federal thrift regulator, one
federal credit union regulator, and a variety of regulators in
the 50 states. Responsibilities are often overlapping and
redundant. The concept of functional regulation takes second
place to the concept of institutional regulation. The elimination
of many of the outdated aspects of this structure would appear to
be possible.
As a general guideline, experience indicates that the
independence of financial regulators and insurers is essential to
accomplishing the task of supervising the financial system
without bowing either to the current political fad or to
potentially large economic pressures. Further, banking
supervisors should not be put in a conflict of interest by also
being responsible for other important functions and objectives,
such as monetary policy, international economic stability, and
revenue production.
Supervision can be more uniform than it is today. More


uniformity, however, would make it even more important that
supervision be kept independent of other public concerns and
political pressures.

The banking system has been undergoing significant changes.
One way to characterize the changes is to say that the banking
industry's monopoly on financial information has been eroding.
Other players in the financial arena have been gaining ever
greater access to financial information and consequently are
relying less upon banks and the intermediary function they
perform. Where these changes are leading is certainly one of the
more intriguing economic questions of the Twentieth Century's
last decade.
To enable banks to function in the changing environment, a
number of alterations in the industry's structure appear to be
needed. The major topics for examination are the Glass-Steagall
Act, the Bank Holding Company Act, and the McFadden Act. When the
appropriate changes are made, banks should be better able to
adjust, under proper supervision, to the ongoing revolution in
the financial marketplace.
Certain reforms in the deposit insurance system should
probably accompany any changes in the legal underpinnings of the
banking industry's structure. A number of such reforms have been
suggested, many of them mentioned in this testimony. In the
months ahead, the FDIC will be continuing its evaluation of these


and other proposals.
The proposals cannot be looked at in isolation, however.


piecemeal approach to financial industry reform will not succeed.
An overview is needed, an overview that recognizes the many
interrelationships among industry structure, the deposit
insurance system, and regulatory responsibilities.


Reform of the deposit insurance system must take into
account not only what is happening in the world of depository
institutions but also what changes are underway in the financial
industry as a whole. Attempts to improve deposit insurance will
come to naught if they are offset by conditions and trends
elsewhere in the financial marketplace.
In an accompanying series of tables and graphs, three
significant interrelated trends are isolated: banking is a
riskier, more volatile business; banks are encountering greater
degrees of competition; and the banking business is changing.

Banking Is Riskier
Perhaps the most persuasive piece of evidence that banking
is a riskier business is the number of failed banks (Figure 1).
Between 1943 and 1981, the greatest number of banks that failed
in any one year was 17, in 1976. Annual failures increased
dramatically in the 1980s, however, reaching a peak of 206 in
Net loan chargeoffs also rose significantly in the 1980s,
reaching a peak of 1.15 percent of total loans in 1989 (Figure
2). A decade by decade comparison of the banking industry's
return on assets reveal a fall in that measure of profitability
during the most recent decade (Table 1). The slide is more
evident when a trend line is fitted to industry return on assets
for the period 1960-1989 (Figure 3).

I - 1

One cause of bank difficulties has been a general rise in
both the level and volatility of interest rates (Figure 4).
Double-digit interest rates became common in the 1980s.
The marketplace has reacted to the banking industry's
difficulties by being wary of bank stocks. As a percent of the
Standard and Poor's 500 Stock Index, the Salomon Brothers 35 Bank
Index has generally fallen since 1975 (Figure 5). The Bank Index
was 55 percent of the S&P 500 in 1975, but only 38 percent in

Banks Are Encountering More Competition
The financial marketplace has become more crowded. A greater
variety of players are offering a wider variety of products and
services. One result is that the banking industry's share of
financial sector assets fell from 34 percent in 1960 to 27
percent in 1987 (Table 2). The decline was most pronounced in the
1980s— banks still had 33 percent of the total in 1980.
The decline in the proportion of financial sector assets
held by the banking industry was due to increasing proportions
held by government-sponsored mortgage agencies, pension and
retirement funds, and mutual and money market funds.
Figures 6 and 7 present more vivid evidence of the increased
competition being encountered by U.S. banks. The commercial paper
market has attracted a number of quality organizational customers
that once relied on bank loans for short-term funds. The ratio of
bank commercial and industrial loans to commercial paper


outstanding has accordingly decreased (Figure 6). C&I loans fell
from almost 10 times the amount of commercial paper outstanding
in 1960 to only 1.2 times in 1989.
In Figure 7, the growth in competition afforded by foreign
banking organizations is depicted. In 1972, foreign banking
organizations controlled 3.6 percent of U.S. domestic banking
assets. In 1989, the proportion was 21.4 percent.
A major change in the financial industry has been the growth
of what might be termed nontraditional financial instruments. One
example is provided by the packaging of mortgages for resale or
to back the issuance of various types of securities. The
proportion of mortgages in mortgage pools grew from one percent
in 1970 to 23 percent in 1987 (Figure 8).
As another example of the growth of nontraditional financial
instruments, the volume of financial futures contracts traded
each year increased from 0.6 million in 1977 to 117 million in
1988, for an annual growth rate of 61 percent (Figure 9).

The Banking Business Is Changing
Defining with precision just what it is that banks do has
provided economists, lawyers, and other interested parties with
many hours of enjoyment but has not resulted in a great deal of
success. One general function that banks can be said to perform
is to provide credit. This only raises further questions,
however, such as in what form and to whom.
The making of loans is probably the form that most often


comes to mind when the credit-providing function of banks is
mentioned. Loans, however, have not constituted a stable
percentage of the banking industry's assets (Table 1). During the
1930s, loans were only 30 percent of industry assets. The
percentage actually fell during the 1940s. The decline was due to
the large quantities of government securities that banks acquired
during World War II and to the constraints on non-war related
economic activity during those years.
Since the 1940s, the proportion of loans in bank portfolios
has steadily increased, reaching a peak of almost 60 percent for
the period 1985-1989. While the loans to assets ratio of the
banking industry was increasing, however, the equity to assets
ratio remained static (Table 1). This has most likely resulted in
a steadily increasing level of risk in the banking system because
loans are for the most part more risky than the other major
category of bank assets— investment securities.
As the percentage of the banking industry's assets devoted

to loans has risen, the composition of the loan portfolio has
changed. Two major changes are that the proportion of real estate
loans has increased and the proportion of commercial and
industrial loans has decreased (Figure 10). Real estate lending
appears to be a more risky endeavor than C&I lending, so this
change in loan composition has also likely increased the degree
of risk in the banking system.
It bears emphasizing that the reduction in C&I lending by
banks has not been a unilateral move. The rise of the commercial


paper market has forced banks to seek other lending
Other changes in the banking business bear noting. For one
thing, noninterest income has become more important, constituting
16 percent of total income in 1989 (Figure 11). And off-balance
sheet activities have increased substantially. The major
categories of such activities grew in dollar terms from 58
percent of bank assets in 1982 to 116 percent of bank assets in
1989 (Figure 12).

Thus the banking industry, and the financial marketplace in
general, are undergoing significant changes. Volatility and risk
seem to be on the increase, and there is no single simple way to
contain the hazards. Moreover, legislative and regulatory efforts
that do not recognize the changes taking place are likely to be



Figure 1: Number of Failed Banks by Year


1940 1945 1950 1955 1960 1965 1970 1975 1980 1985
Number of Failures

Source: FDIC Annual Reports and Statistics on Banking

Figure 2: Net Charge-Offs to Total Loans
Insured Commercial Banks
I 9 6 0 - 1989
1.2 n-----------------------------------------------

61 63 65 67 69 71 73 75 77 79 81 83 85 87 89

I M Net Charge-Offs to Loans
Source: FDIC Annuel Reporte end Stetietice on Benking

Figure 3: Return On Assets
Insured Commercial Banks


I- Return on Assets
Trend Line.
Source: FDIC Annual Reports and Statistica on Banking

Figure 4: Average Interest Rates

—*— Mortgage Rates


—+~ Commercial Paper [2]

Govt Securities (3)


8ource: US Department of Commerce, Buelneee Statistics

Trend Line, Government Securities
111 E x i s t i ng Homs Purchases - U.8. Average

|2, A„ r, g, Ylt|d on , . Monlh

131 Yi eld on new Issue 90~day t- b l l l s

p. p„

Figure 5: Bank Stocks as a % of S&P 500

Source: Salomon Brothers

Figure 6: The Growth of the Commercial Paper Market
Ratio of Bank C&l Loans to Commercial Paper Outstanding

Source: US Department of Commerce, Bueineea Statietics


Figure 8: The Growth of Mortgage Pools
Mortgages in Pools as a % of Total Mortgages

25 -fl-------------------------------— -------------------------------------------------------------- 1









Mortgage Pools %
Source: US Department of Commerce, Statistical Abstract of the United States


Figure 9: Growth of the Financial Futures Market
Volume, in millions, of Financial Futures Contracts Traded

Source: Commodity Futures Trading Commission Annual Report

Figure 10: Real Estate and C&l Loans as a % of Total Loans
Insured Commercial Banks







Real Estate Loans

------ Trend Lines
Source: FDIC Annual Reports and Statistics on Banking



—Q— c&l Loans




Figure 11: Non-Interest Income as a % of Interest Income
Insured Commercial Banks









Source: FDIC Annual Reports and Statistics on Banking




Figure 12: Selected Bank Off-Balance Sheet Activities
as a Percentage of On-Balance Sheet Activities














Note: Off-balance sheet activities Include loan comlttmenta, standby and commercial letters of credit, futures and
forwards contracts, and commitments to purchase foreign exchange
Source: FDIC Annual Reports and Statistics on Banking














11.M X

















































































Source: FDIC Annual Report and Statlatlca on Banking

Table 2:


Financial Assets held by Financial Sector


Agencies &





Pension and

Mutual and
Money Market


isssstssssssss SSSSS8ZSSSSSSSSiis z s s s tm n s s i




Source: Federal Reserve Board Annual Statistical Digest





6 .02%

4 .64%
3 .90%
3 .81%
4 .12%
4 .07%
3 .65%

The American Banker's Association has presented a deposit
insurance reform proposal for consideration by Treasury. The
FDIC welcomes constructive proposals from all sectors of the
public. This paper is an effort to contribute to the serious
consideration that the proposal deserves.
The paper begins with a summary of the ABA proposal.
Section II enumerates the benefits of the proposal. For the most
part, these benefits are well recognized and speak for
themselves• Subsequent sections of this paper describe some of
the FDIC's concerns regarding the proposal. That these concerns
are described in greater detail should not be construed as
casting judgement on the merits of the proposal.
Rather, these
concerns are expressed in an effort to advance the public policy
discussion in the most constructive way.
Section III discusses the potential systemic aftershocks of
a major bank failure in which losses are imposed on uninsured
depositors• Emphasis is placed on three avenues through which
the effects could spread beyond the initial institution:
correspondent balances; the impact on s i m i l a r or neighboring
solvent institutions; and disruption of the payments system. A
key element of the ABA proposal is to minimize these aftershocks
by developing computer systems at large banks that would enable
the FDIC to resolve a failure at such an institution overnight.
Section IV examines the demands on bank operations created
by the requirement that the FDIC make an overnight determination
of insured balances and impose losses on uninsured balances in
time to reopen the bank the next morning. It will be very
difficult for these complex procedures to take place in the
limited time frame at large banks. Developing, implementing,
maintaining and monitoring these systems may be very costly.
The section closes with a discussion of the specific method that
the ABA recommends be used to calculate the exposure of uninsured
depositors of failed banks.
Section V closes the paper with a discussion of market
discipline in the banking industry and possible effects of
increased reliance on depositor discipline in moderating risk.
The section ends with a summary of issues that need to be
considered before implementing the ABA's proposal or other
measures of deposit insurance reform.

II - 1

I - Summary of



The proposal changes FDIC failure resolution policy. A new
procedure, called "Final Settlement Payment", would be mandated.
The mechanics are as follows:

Failed institutions would be placed in receivership at the
close of a business day. Overnight, a determination would
be made of exactly which deposits are eligible for
insurance. The key to enabling this to occur in a large
bank failure is the proposed development computer programs
and data bases at all large banks that would automate this


The following business day, a new entity assumes all insured
deposits. This entity would either be an acquiring
institution or a bridge bank.


The successor institution would also assume a fixed
percentage of all uninsured deposits (approximately 85% 95%). This percentage would be adjusted over time and is
intended to reflect the FDIC's average rate of recovery of
assets in past failure resolutions.


Uninsured depositors would not have any further claim on the
assets of the receivership. Any gain or loss on the
disposition of receivership assets would remain with the
FDIC. For example, if the FDIC's experience was to collect
92% of all receivership assets, all uninsured depositors in
the next failure would receive 92% of their funds
immediately. If the FDIC subsequently recovered more than
92% of this specific bank's assets, it would keep the
Similarly, if the FDIC recovered less than 92% in
the specific instance, it would absorb the added loss.

Other elements of the ABA proposal include:

The elimination of deposit brokerage. (A pending ABA
report will elaborate on this topic).


The continued improvement in the strength of the bank
examiner corps.


The suggestion that additional attention be paid when
granting new bank charters and supervising newly
chartered banks.


An appeal to bank regulators in other industrialized
nations to develop depositor protection programs that
incorporate market discipline and allow for depositors

II - 2

in major institutions to suffer losses in the event of
II- Benefits of



The ABA proposal mandates that uninsured depositors face
losses in bank failures. It also resolves many of the
administrative hurdles that reduce the likelihood that losses
will be imposed on uninsured depositors in major banks. The
result could be the following public welfare gains:

Increased levels of depositor discipline. This should
act to encourage safe and sound banking practices and
discourage excessive risk taking by bank managements.


The elimination or reduction of the systemic risks that
would occur in a major bank failure.


The equalization of the treatment of depositors at
large and small institutions.


The minimization of costs to the insurance fund and to
the banking industry which finances the fund.


A greater reliance on market forces, as opposed to
governmental intervention, to control bank risk.
Ill - Systemic Risks in Large Bank Closings

Caution needs to be exercised when considering policies
concerning failure resolution of major banks. These cases have a
greater potential of triggering larger economic disruptions or
At the same time, over protection of these institutions
can distort the efficient allocation of resources in the economy.
Areas of concern regarding systemic risk in major bank failures
are discussed in this section. Three avenues are considered
through which the destabilizing effects of a major bank failure
can spread through the financial sector or the larger economy.

Impairment of correspondent banks.


The effects of market perception on neighboring or
similar banks.


Disruption of the payments system.

II - 3

1. Correspondent Banks
The ABA proposal will impose
depositors in the event of a bank
among the newly shorn depositors,
which could: 1) create liquidity

a haircut on all large
failure. If other banks are
these banks may face losses
problems or; 2) exceed net

Large banks tend to be net borrowers from smaller banks.
These moneys may originate from correspondent banking activity
(clearing checks, safekeeping of securities, etc.) or through Fed
funds borrowings. Large banks also hold extensive balances with
each other, often as a result of check clearing arrangements.
Thus, a large bank failure could affect many other institutions.
The ABA suggests that one reason that the FDIC was reluctant
to impose losses on depositors at Continental was because of the
large number (976) of banks that held deposits over $100,000.
The ABA proposal, because it envisions the overnight adjustment
of account balances and the normal functioning the next day of a
successor institution, would not cause direct liquidity problems
for the banks holding deposits at the failed institution.
However, if the losses imposed on the banks is great enough to
impair net worth, the correspondent banks could suffer from runs
by uninsured depositors, or even insolvency.
The ABA argues that, because depositor losses would be a
fraction of the total uninsured balances, the impact on the net
worth of a correspondent bank would be minimal. In the case of
Continental, if a 30% haircut had been imposed, 6 banks would
have faced losses greater than their capital, and 22 other banks
would have incurred losses greater than 50% of their capital.
Had the haircut been only 10% (which is closer to expected the
level that would be set under the ABA proposal), only 2 banks
would have suffered losses greater than 50% of capital, neither
of which would have exceeded capital.
One reason that small banks hold correspondent balances at
large banks in their district is to clear checks (see
Attachment A on the check clearing system to learn about options
available to small institutions). By their nature, these
activities involve large amounts of money. If an economic
downturn adversely affected all major banks in a region, a small
bank might be hard pressed to find a completely safe, major,

1 The numbers cited in this paragraph, and the next, are from
the ABA proposal.

II - 4

local bank to use for these services2. For example, 9 of the 10
largest banks in Texas were closed or assisted during a 3 year
It is easy to imagine a community bank moving its check
processing business from one failing bank to another, taking
several haircuts which, in total, cause insolvency.
Another conduit through which banks would be exposed to
losses from another bank's failure is the Fed funds market. This
market is primarily overnight loans from banks with excess
reserve balances to banks with deficient reserves. The general
pattern of Fed funds lending is for large, urban banks to be net
borrowers on this market and for small, rural banks to be net
In their proposal, the ABA envisions this market acting as
an adjunct to the Federal Reserve's role as lender of last
resort. The ABA argues that banks are among the depositors who
are best able to judge the viability of competing firms. If the
public flees otherwise healthy banks, and moves funds into
institutions that it believes are stronger, the recipients of
these funds could rechannel this money to the threatened
institutions via the Fed funds market. Thus, the ABA sees other
banks providing both market discipline and market stability.
There is a concern, however, that these two roles may be
mutually exclusive. Bank runs can become self-fulfilling. Even
if a bank believes that, absent a run, another bank is
financially sound, given that a run is taking place, it would be
uncertain about the viability of the exposed bank. The exposed
bank's survival will depend on the behavior of its remaining
depositors and the willingness of other institutions and the
central bank to lend to it. A bank lending Fed funds could not
accurately measure these factors, and would not want to risk the
possibility of an overnight loss. A system which imposes losses
on bank creditors of failed institutions in order to increase
market discipline, may not be compatible with the goal that banks
provide stable funding during panics.


Small banks could utilize the local Fed for check clearing.
However, it may not be wise policy to drive this business away from
major banks in distressed regions •
This activity can be
profitable, and the risks are uncorrelated to those within a loan
Check clearing operations are driven by scale
economies, so taking business away from a troubled bank would
reduce revenues without an
equivalent short term reduction in
costs, further weakening the firm.

II - 5


Effects on Similar / Neighboring Institutions

One other mechanism through which the effects of an
ndividual bank failure could spread to other institutions would
u if?® ? , ge in the behavior of depositors at an otherwise
ealthy bank. Under the ABA plan, depositors with uninsured
funds would have incentives to run. Therefore, if a particular
bank failed due to credit problems in a distressed region or
industry, depositors at banks in the same market might fear that
their institution is also at risk and begin running.
The ABA plan assumes that there will be greater stability
^ o E +-r?fr:Lfd.uep08it0r8 5 ® * their Plan than if depositors were
°î ^ © e x t e n t of their potential loss. It is not clear
T°iatil^ y of a deposit base is a function of the
«Kofti0nal loss that would be felt in a failure. A depositor who
°^8®rves.a Potential failure/run would want to join in the run as
long as the transaction cost of moving funds is less than the
potential loss from staying in the bank. In other words, if
A beared that they might lose 30% of their
tunas in a failure, and depositors at bank B feared that they
of bbeir funds in a similar situation, both banks
experience the same deposit drain if transaction costs are
balances jWhlCh they are for transaction and money market
he ABA system would continue to protect banks from runs by
smâll depositors. However, it would expose the industry to the
possibility of runs on otherwise healthy institutions by
uninsured depositors. In many large banks, runs of small
depositors are not threatening. Continental Bank, for example,
tailed when large overseas depositors lost confidence.
This proposal might impair the ability of banks to provide
services which involve large flows of funds. The reasons that
correspondent banks might take check clearing activity away from
a troubled bank are discussed above. Corporate users of check
clearing seprices would have similar incentives to bypass the
entire banking industry. Lockbox operations are an important
non-credit source of revenue for banks (the risks of which are
uncorrelated with the risks in a loan portfolio). A corporation
using such a service directs its customer's payments to a post
office box which is rented and controlled by the corporation's
bank. The bank continuously collects the mail that has been
delivered to the box, quickly deposits the funds into the
corporation's account, and immediately enters the check payment
into the collection system. Two criteria guide the choice of
lockbox processor. One is optimal geographic location to
minimize the time that payments from the corporation's customers
are in the mail. The other important criteria is the ability of
the bank to rapidly collect payment on the checks it processes.
This ability is a function of the breadth of the correspondent

II - 6

network maintained by the bank. Therefore, large banks have an
advantage in providing this service.
If a lockbox customer became concerned about the viability
of the bank providing the service, it would not be able to
quickly end its exposure to losses at that bank.
At present,
because there may be a wide spread perception that regulatory
policy will protect large depositors at the large bank providers
of lockbox service, corporate customers may be m i n i m a l l y
concerned about this potential exposure. However, if a large
bank failure occurred in which lockbox customers experienced
losses, corporations might be tempted to use providers of these
services outside of the banking industry. Private lockbox
servicers do not offer economic advantages over bank providers
(in fact, because banks have monopoly access to the payments
system, private firms could not match the funds availability
offered by banks). This potential movement of business out of
banks would be solely to avoid losses during an unexpected bank
failure. Therefore, it would not be a form of discipline
directed at a poorly run institution. Rather, it would be a
flight from the entire industry.4

Payments System Integrity

Much of the ABA's proposal is concerned with maintaining the
integrity of the payments system. The three major components of
the system are CHIPS, Fedwire and check processing networks. The
ABA makes recommendations concerning CHIPS that would reduce
disruptions to that system. However, such reforms involve the
possibility of CHIPS participants sharing a loss that would occur
if a member failed while in an overdraft position. The risk of
such losses is an unavoidable conseguence of the operation of
such a payment network. However, it emphasizes the vulnerability
that the entire system has in the event of a major bank failure.
CHIPS participants will have adjusted their exposure levels so

Many lockbox arrangements involve custom-made processing
agreements• Negotiating these terms with new potential providers
may take time.
Once a new provider is selected, it may take 90
days or more for previously mailed invoices to be paid.
that time the firm is still exposed to the risk of failure of the
old bank.
4 The checks processed in a lockbox would still have to be
deposited in a bank for clearing.
However, the other services
provided by bank lockbox departments, including direction of
remittances to optimal post offices and the capture and reporting
of accounts receivable data, could be provided by non-bank firms.
The final step, entering the check into the payments system, could
be quickly redirected if the clearing bank's viability was

II - 7

'that potential losses there are sustainable. However, if any of
these participants have additional exposure to the failed bank
from other inter—bank activity, its own viability may be
threatened and its own depositors might start running. We must
be cautious about establishing policies which might mandate
additional losses on these institutions.
An important element of the Fedwire system is payment
finality — an institution receiving funds is guaranteed payment
by its Federal Reserve bank, even if the institution that
the transfer subseguently defaults on its obligation
to its own Federal Reserve bank. Payment finality enables a bank
to immediately credit the account of its customers receiving
electronic payments• This permits the funds to be immediately
other payments or investments and increases the
efficient allocation of capital resources in the economy.
Payment finality prevents a bank failure from affecting other
banks that transacted business with it prior to failure. The
risk is transferred to the Federal Reserve banks or, if the
intra-day credit is fully collateralized, to the FDIC, uninsured
depositors and unsecured creditors.
The Federal Reserve Board has developed policies during the
past several years that are aimed at reducing its potential
exposure to losses from Fedwire operation. Banks are restricted
in the amount that they may overdraw their reserve accounts at
any moment in time. These restrictions are tightened as the
viability of an institution is threatened.
It may be difficult to balance the ABA's desire to wait
until the close of business before declaring a bank insolvent
with the Fed's requirements to protect itself from Fedwire risk.
An interesting question is what should happen if the Fed refused
Fedwire transactions from a failing institution which, facing a
run, had exceeded its daylight overdraft limits. Depositors in
the bank would be unable to withdraw their funds.
What would be
the legal standing of a customer who had requested a funds
transfer before a bank was declared insolvent at the close of the
business day, but whose funds were not wired due to the Fed's
refusal to accept debit transactions from the failing bank?
Would this depositor be subject to a haircut from the liquidator?
Does such a potential event add to instability by increasing the
likelihood that uninsured depositors will run quickly instead of
waiting for events to develop?
Check Clearing
The rest of this section describes the disruptions that
would be likely to occur to the check collection system if a

II - 8

major bank were closed for several days during a failure
resolution. The ABA proposal resolves most of these problems by
suggesting that failed banks be re-opened the next morning.
Section III describes why it may be difficult to develop the
necessary systems to accomplish this. Given the disruptions
described below, it may be prudent to develop the necessary
technology before establishing certain policies.
The check clearing system has a certain amount of resiliency
built into it. Deposit-taking institutions provide their
customers with provisional credit when receiving checks. If the
check^s later dishonored, and returned to the bank of first
deposit, the customer's account is debited. Because of the large
volume of dishonored checks, systems have been built to minimize
potential losses to deposit taking institutions. The recent
implementation of Regulation CC holds out hope for further
improvement to this system.
Approximately 1% of checks written are dishonored by the
drawee bank.
In order to return these checks, they are manually
encoded with magnetic ink with the amount and the code for the
bank of first deposit (Determined by searching the back of the
check for a specific endorsement stamp). The encoding permits
rapid movement through the clearing network back to the point of
origin. Checks dishonored due to bank failure could be handled
through these channels - even in the case of large banks - though
not without imposing great strain. Essentially, the work load of
the clerks performing this task would increase 100 fold. Deposit
taking banks are entitled to timely notification by telephone or
wire if items over $2,500 are to be dishonored. It would be
difficult to make timely notification if all large items drawn on
a major bank were to be returned since again, the workload of the
clerks performing this function will have increased 100 fold.
Delays in processing these returned items could lead to
losses to the banking sector. The bank of first deposit, absent
timely notification or presentment of the dishonored check, will
be providing its customers with access to the deposited funds
within 2 to 5 days6. If notice of the return arrives late, the
funds may have left the bank, and the customer be unavailable or
unable to refund the money (the customer may have also released
goods or payments under the assumption that the deposited check
was honored). Under the Uniform Commercial Code, the bank of
first deposit can protest to the drawee bank if the return was

Bank Administration Institute Survey of the Check
Collection System Bank Publishing, Rolling Meadows, 1987 page 33.
6A s mandated by Regulation CC.

II - 9

not initiated timely (within 36 hours). Ultimately, one of the
two banks will have to absorb the loss7.
In order to protect themselves from accepting checks drawn
on large banks that are about to fail, many deposit taking banks,
their check clearing agents, could program their computer
systems to refuse items drawn on such banks. At present,
customer access to funds deposited by check is based on the
geographical location of the check, and the transportation
schedules to those parts of the country. If final settlement
payment methods were mandated in all bank failures, and banks in
the check collection chain were at greater risk due to late
return of items drawn on failed banks, banks would wish to delay
the availability of good funds to depositors based credit
of drawee banks. This would mimic, in miniature
scale, the discounting of bank notes that occurred during the
Free Banking Era. However, because Regulation CC would prohibit
such delayed availability, the bank of first deposit might refuse
the check, and return it to the depositor for manual collection.
In this manner, the efficiency of the check payments system could
begin to deteriorate.
In the case of a major bank failure, the check processing
system could be affected in other ways. Section I briefly
discussed the difficulties, in a world of haircuts, faced by
small institutions in need of check clearing services. Major
disruptions would occur if a significant provider of these
correspondent services was unable to accept deposits while closed
for failure resolution. In some markets, there may not be
®u^fici©nt outside capacity to handle the volumes processed by
the major provider. Other local banks would suffer financial
loss as it would take longer for them to convert check deposits
into good funds. Any delay in entering their checks into the
collection stream will also delay their learning which items were
dishonored by the drawee bank.
Significant disruptions would occur in other sectors of the
economy• Customers of failed banks might find that payments they
had made (including those made before the bank failed but which
were still in process) to suppliers and employees were being
dishonored. This could cause hardship, especially if the
checking account balances remained frozen and alternative sources
It would be possible to pass some of the processing burden
on to the local Fed in its role of "Returning Bank" under
Regulation CC. Unencoded (raw) items can be presented to the Fed,
at an earlier deadline, for processing and entry into the automated
Regulation CC is unclear as to whether liability for
delayed processing of raw returns exposes the Fed to potential
losses if it is unable to process these items within standard time
frames •

II - 10

of funds were unavailable. If a firm had a lockbox arrangement,
as well as its checking accounts, at the failed bank, both
existing funds and new receipts could be tied up or frozen.
These disruptions would act to increase the social cost of a bank
IV - Operational Considerations
The ABA proposal resolves much of the systemic risk posed by
a major bank failure by assuming that conditions can be
established which enable the FDIC to calculate the insurance
level of each depositor, apply appropriate haircuts to the
uninsured balances, and open a bridge bank the next morning.
Under such a scenario, the following procedures would need to be

Account balances are aggregated by some type of coding
that links like ownership categories together.


Owners with aggregate balances over $100,000 are

Using complex decision rules8, the computer
assigns the full amount of the haircut to the
depositors' excess balances. Or


FDIC Liquidators pick and choose which balances to


Reductions are posted to the accounts. The transactions
are balanced.


Reports are produced listing the reduced accounts.


. Notices are generated to inform customers about their
haircuts. These notices would have to identify all of
their accounts.

Because the FDIC would be depending on the computer systems
to perform these tasks flawlessly the first time that they are
put into operation, exacting compliance verification procedures
would be required. At minimum, full dress rehearsal tests would


The decision rules become complex if they do anything other
than apply the loss equally across a single depositor's accounts.
Some writers suggest applying the haircut to accounts with long
maturities first in order to minimize disruptions to the payments
system. The depositor would object if his longest term account was
locked into a favorable interest rate compared to contemporaneous

II - 11

have to be conducted during bank exams in order to have any
confidence that the systems would work if needed.
Even if these programs were created, and were operational,
it is uncertain that there would be time to execute them. It is
easy to imagine that a bank shuts down when the Tellers go home.
This is far from the truth. Major banks have operations going on
24 hours a day. In fact, most of the day's transactions are not
posted to the customers' accounts until overnight processing
begins. A typical bank operations schedule is described in
Attachment B. The ABA envisions that the complex special
programs complete their operation between the time that normal
processing is completed and the start of the next business day.
This may not be possible in the case of a large bank even if the
closing were postponed until the weekend.
The ABA proposal also acknowledged that all current bank
accounts would have to be re-coded to specify the ownership
relations that determine insurability. Such labor intensive
activity could be even more costly to banking firms than
developing the new computer programs that the ABA plan would
It appears that the costs to the banking industry of
implementing this proposal would be considerable. The FDIC is
very sensitive about the imposition of costly regulatory burdens.
Ultimately, a healthy industry will expose the insurance fund to
less stress. However, the FDIC welcomes the development of such
systems to the extent that they can be completed in a cost
effective manner. These systems have the attractive feature of
reducing the cost of the FDIC 's option to pay off or transfer a
failed bank's insured deposits. To the extent that
administrative and technical problems can be addressed and
resolved in advance of the crisis atmosphere of a major bank
failure, the costs of a payoff will be reduced.
Final Settlement Payment
The FDIC has serious reservations about the ABA's proposed
method of applying losses in bank failures. Because their plan
requires that a failed institution be re-opened the next day, the
ABA would not base the percentage loss on the expected recovery
of the remaining assets. Estimating the recovery rate could take
several days or weeks. Instead, the payment would be based on
the rate of recovery on assets in past resolutions. 1
In a final settlement payment, as described in the ABA
proposal, a single payment is immediately made to all uninsured
depositors and unsecured creditors. A final settlement payment
differs from past methods in that depositors and unsecured
creditors at one bank may receive less than what they would have
in a straight or modified payoff. The difference would be given

II - 12

to their counter-parts at failed banks in which recovery is worse
than normal.
The legality of seizing property in excess of recovery costs
from uninsured depositors and unsecured creditors in some
failures is questionable. Although the ABA does not anticipate
that the FDIC would make a profit across resolutions, it
anticipates that the FDIC will make a profit in some resolutions.
V - Market Discipline
All business enterprises, including banks, are subject to
market discipline. This discipline is enforced through the
actions of several different economic agents including:
customers, suppliers, employees, equity owners, and creditors•
This section will begin with a description of how these agents
act on commercial firms and on banks without deposit insurance.
The causes of depositor runs in such an environment are then
described. Deposit insurance prevents such runs, but at a cost
of introducing new distortions. Several proposals have been
advanced which seek to minimize these distortions by increasing
the reliance placed on depositor discipline. These proposals
involve the imposition of losses on large depositors of failed
banks. This section ends with a discussion of the effectiveness
of limitations of such policies.
Agents of Market Discipline
When the long term viability of a commercial firm is
questioned (because of technological changes, loss of key
employees, changing markets, etc.), the firm will have trouble
maintaining its size. At the margin, customers will begin using
competing firms or substitute goods in order to avoid future
disruptions (spare parts, quality of service, etc.). Capable
employees will start leaving for greener pastures. Financing
will dry up for expansion projects, or only be available at high
interest rates making fewer projects worthwhile. Suppliers will
begin to focus more attention on other customers, perhaps
resulting in a deterioration of the quality of resources• It
will become difficult to attract new equity owners into the firm.
Those whom remain intensify their scrutiny of the directors and
top officials in order to maintain the value of their investment.
There is constant pressure on the firm to reduce its operations.
Unit costs may be driven up as scale economies are lost.
When the firm's short term viability is questioned, more
direct pressure is placed on its cash flow. Customer defections
will accelerate. Employees are laid-off in an effort to reduce
expenses. Banks and other creditors will refuse to renew credit
lines. Suppliers will demand payment in advance. If the firm is
unable to withstand the pressure, and becomes inviable, it will

II - 13

enter voluntary or involuntary bankruptcy. At this time,
outstanding obligations will be resolved in an administrative
proceeding in which all creditors of comparable standing are
dealt with equally. It is important to note that, although
^nc^yidual creditors may try to obtain as much payment as
possible in advance of a bankruptcy declaration, their claims are
generally not payable on demand. Therefore, there is no analogy
to a bank run in a commercial firm. All of the agents of market
discipline assist commercial firms with bright prospects and
place obstacles in front of firms with dim prospects. These
forces affect growth rates over the long term. Commercial firms
do not walk along a razor's edge, facing certain death if they
ever stumble.
The forced exiting of inefficient or obsolete firms improves
the performance of the overall economy. Because banking is a
vital sector of the economy, it is important that the vigor of
industry be maintained and enhanced through similar free
market operations.
Depositor Runs
When the long term viability of a bank is questioned, (even
m a world of deposit insurance) various market forces work to
restrict the growth of the firm. Bank customers will also begin
moving business to competing firms for many of the same reasons
that the customers of a commercial firm do.
The negotiation of
credit arrangements is often firm specific and complex.
Businesses will want to avoid having to repeat this process with
the new owners of a bank's assets. The value of some bank
products, specifically letters of credit, are tied to the bank's
credit-worthiness • As this diminishes, customers of the bank are
likely fco establish relationships with other institutions•
^®pl®y®®s will have the same set of incentives to leave as their
counterparts in the commercial sector. In a bank, investors
include equity holders, unsecured debt holders, and deposit
holders. Equity holders and unsecured creditors in a bank will
behave the same way as their counterparts in a commercial firm.
Thus banks are subject to much the same discipline as commercial
firms. The difference is in the actions of deposit holders, of
whom there is no equivalent in a commercial enterprise•
Deposit holders can behave as customers (purchasing services
from the bank), suppliers (funding is the raw material of a
bank), and investors. Demand deposit holders are distinctive in
holding callable debt. This distinguishes them from most debt
holders of commercial firms. Their actions will differ from
those of a commercial debt holder when the viability of the debt
issuer is questioned.
A deposit holder has an incentive to liquidate deposits from
a troubled institution if transactions costs are less than

II - 14

potential losses• Demand deposit holders face virtually no
transactions costs. Therefore, any time that the solvency of a
bank is questioned, uninsured depositors can be expected to run.
The flight of depositors' funds could cause an otherwise viable
bank to collapse because bank assets are illiquid. A bank that
must sell its assets to honor the withdrawals will have to accept
fire sale prices. As these discounts erode the net worth of the
bank, a deposit run can become a self-fulfilling prophesy and
lead to the collapse of the bank. Thus, a depositor who observes
a panic run on his bank would have every incentive to join in the
run, contributing to the bank's demise.
Deposit Insurance
The implementation of a deposit insurance system eliminates
the incentives that depositors would otherwise have to run from
troubled institutions. However, the improved stability does not
come without a cost. Insured depositors face little incentive to
monitor the riskiness of their institution. Bank managers can
assume greater risks in their asset portfolio without
experiencing an equivalent increase in the cost of funds raised
by deposit. The additional risk is borne by the insurer. This
moral hazard can be reduced through vigorous supervision. It can
also be reduced through the activities of the other market agents
previously mentioned.
Therefore, whenever it is believed that the banking industry
has transferred an excess amount of risk on to the insurer,
several policy responses are possible. Increased regulation and
supervision is one avenue. Placing more risk on different market
agents would also alleviate the pressure on the insurance fund.
The ABA supports the efforts made by the FDIC to improve the
training given to bank examiners and to increase their level of
compensation. The ABA proposal also advocates that more explicit
risk be shouldered by depositors by imposing losses on uninsured
depositors'in all failures.
Depositor Discipline
Dependence on depositor discipline to relieve the burden on
the insurer can create undesirable side effects. These include:
1) an increase in systemic instability; 2) a loss of flexibility
in limiting the economic damage of a major bank failure and 3) a
competitive disadvantage for the US banking industry. In
addition, 4) it is unclear that the bank deposit market is well
suited to imposing discipline on banks.
1) Systemic Instability
A policy regime that mandates losses on uninsured depositors
introduces instability because it increases both the possibility
of bank runs and the ripple effects of the bank failure. As the

I I - 15

pool of uninsured depositors increases, the likelihood of bank
runs also increases, as does the potential for damage in any
lnd^v,*'dua^•# When failures occur, the losses imposed on
uninsured depositors will have economic repercussions. These
include possible impairment of correspondent banks, disruptions
to the payments system, and damage to the local economy as firms
and individuals adjust to their losses. Once again, the greater
the pool of uninsured depositors, and the greater the loss at the
railed bank, the greater the economic impact will be.
2) Regulatory Flexibility
Any policy that imposes mandatory losses on uninsured
depositors only has meaning if it is expected to apply to all
iullure?' includi?9
largest. It is difficult to imagine
are ultimately responsible for macroeconomic
ability would abandon the flexibility to handle a truly large
? r f 6 °n a .case-by-case basis. If legislation prohibits
tnerEHC from acting with discretion, other government bodies either the Federal Reserve Board or the Department of Treasury
might act to support a major failing bank. In this event,
uninsured depositors will be treated better than they would have
.,?®n ky th® FDIC. The reality that the largest banks are more
5°^receive such treatment will continue to influence
market behavior, providing major banks with a competitive
advantage over smaller institutions and reducing the
effectiveness of depositor discipline on those large banks.
3) International Competitiveness
^ m a n d a t o r y losses on uninsured depositors must be
reconciled with policies followed by bank regulators in other
major industrialized countries. Large depositors would have great
incentive to transfer their funds into institutions that are
believed to have more government support than others.
The ABA urges other nations to adopt policies that would
place large depositors at risk in the major banks of their
respective countries. The FDIC will host an international
conference of bank regulators this fall. An ultimate goal of the
conference is to start a process that will lead to international
co-ordination of failed bank policy. It would be imprudent to
institute mandatory haircut proposals before international
agreements are reached.
4) Effectiveness of Depositor Discipline
Although the FDIC believes that depositor discipline can
play a role in maintaining a sound banking industry, it is
important to recognize limitations on the extent to which an
institution's riskiness will be reflected in deposit rates.
These limits are illustrated when the informational content of a

II - 16

bank's share price on the equity markets is compared to the
informational content of a CD rate. The opinions of industry
analysts will be fully incorporated into stock prices, because
equity markets include short sellers as well as call and put
option writers. The actions of investors who believe a firm's
shares are overpriced will lower the share price of the bank's
stock. However, only one position can be taken in a bank's
certificates of deposit. A financial aqent who believes that a
bank has begun to pursue riskier or ill advised policies can not
affect the market for the bank's certificates. There is
correspondingly less information in the rates a bank would have
to pay on uninsured deposits, reducing the value of the
discipline imposed by those rates.
The ABA mentions that depositors would make better use of
evaluations published by private bank analysts. While such a
result would be an improvement, it is important to recognize that
there are limits to the information provided by these firms • In
many cases, analysts' forecasts are based on bank financial
statements and analyzing performance based on key ratios compared
to peer groups. This type of analysis offers some insight into a
bank's current performance, but does not indicate as much about a
bank's prospects. Bad loans and fraud continue to be the major
causes of bank failure. Bad loans look good — and very
profitable - for a long time before they turn sour. Only a few
y®®^*® before failing, Continental Bank was hailed as a model bank
organization. The type of analysis required to determine the
quality of a loan portfolio is so intrusive, it is doubtful that
it could be performed by agents other than bank examiners • Even
if the bank were willing to submit to the intrusion of such
analysis, the need to maintain confidentiality of customer
information may prevent a third party from making an accurate
assessment of individual credits. Private analysis is not a
substitute for the information reflected in a market generated
price in which each analyst takes a monetary position.


There are many worthy goals of the ABA proposal, including
the effort to overcome some of the technical and
administrative problems in large bank failures, the
equalization of the treatment of depositors at banks of
different sizes, and the reliance on market forces instead
of government intervention to control banks with excessive
Banks, even under 100% deposit insurance, face forces of
market discipline. Deposit insurance reduces the systemic
instability of depositor runs at the cost of enabling bank
managers to transfer risk to the insurer.

I I - 17


The ABA proposal recommends that depositor discipline be
increased through the imposition of mandatory haircuts on
uninsured depositors at failed banks. While the FDIC is in
favor of reducing its exposure to loss, it is concerned that
attempts to augment market forces through increased
depositor discipline will extend the potential instability
bank runs and of aftershocks following a failure.


The FDIC is also concerned that, without international
, mandatory haircuts could result in a funding
advantage for foreign banks which are perceived as being
fully insured de facto.


Any system of mandatory haircuts must recognize the reality
that, in truly large bank failures, those who are ultimately
responsible for macroeconomic stability will retain the
flexibility to handle the situation on a case—by—case basis•
To the extent that depositors anticipate such intervention,
the effectiveness of haircut proposals will be mitigated.


The FDIC has doubts about the legality of the method the ABA
recommends to determine the percentage of loss to impose on
uninsured depositors of failed banks• Any determination of
the amount of loss to impose on uninsured depositors in a
failed bank should reflect the conditions of the specific
bank. A system which pays a fraction of uninsured balances
based on experience in past failures would be questionable
in individual cases, uninsured depositors received less
than they would have in an ordinary payout.


Banks may not be able to quickly redesign computer systems
and re—code account data to accommodate the overnight
processing demands of the final settlement payment
Pa-*oc®^ure• In addition, the costs to the industry appear to
be considerable. However, the FDIC welcomes any development
which reduces the cost of opting to pay off or transfer the
deposits of a failed bank.

I I - 18

Whenever a bank's customer writes a check against his
account balance, the check will eventually be physically
presented to the bank for payment. The check may arrive from the
following sources:

The check is presented over the Teller window for
payment or deposit into another customer's account.


The check is included with other checks deposited by a
correspondent bank for credit to the correspondent's


The check is received from a local bank clearinghouse
in which member banks exchange checks drawn on each
other. Members make daily settlement payments with the


The check is presented by the local Federal Reserve
Bank. The bank's reserve account at the Fed is debited
for the amount of checks presented.

Whenever a bank receives a check drawn on another
institution (as a deposit or payment) it must enter the item into
a processing stream that ends at the drawee bank. Ultimately,
the check will reach its destination through one of the above
channels• The item may pass through several intermediaries
before reaching the drawee bank.
These intermediaries may
include correspondent banks, the Federal Reserve Bank in the
initial bank's district, or the Federal Reserve Bank in the
drawee bank's district.
Clearing items drawn on banks across the country can be
costly. Banks are willing to incur this cost in order to avoid
float loss• A depositing bank will attain funds for the check on
the day that the intermediary expects to receive funds for the
check. Because checks received throughout the day constitute
large sums of money, the lost interest on a single day's delay
can be significant. Therefore, banks are more concerned with the
clearing time offered by correspondent banks than with the fees
they charge.
As a bank's check volume grows, it becomes cost effective to
build faster processing systems and more elaborate transportation
networks. As these systems and networks grow, check clearing
8?rvfc?s can ke offered to other institutions. Fixed costs are a
significant component of these operations• High speed processing
The average check is handled by 2.4 financial institutions
according to Bank Administration Institute, op cite.

II - 19

equipment and air transportation couriers can handle an
additional check at a low incremental cost. Smaller banks are
therefore unable to replicate the check clearing system of larger
banks. In order to clear their items, they must piggyback onto
another local institution's system.
Large banks around the country establish relationships with
each other. Each bank will accept checks drawn on smaller, local
banks that it receives from other large banks across the country.
These checks are then cleared through local clearinghouses or
other local channels.
In some markets, correspondent check clearing is very
competitive with several banks offering services• In other
markets, small local institutions and large banks in other
regions are limited to one or two major providers.
Checks in process create large correspondent balances. If
these balances were subject to a mandatory haircut in the case of
the failure of the intermediary, banks would be among the first
to run whenever there was a question about the viability of the
intermediary. In some markets, alternative processors have the
capacity to absorb the fleeing business without much disruption.
In other markets, adequate alternatives may not exist.

II - 20

The overnight processing schedule of a major bank might look
like the following (obviously some banks will have two or three
hour differences in start or completion times for certain
3s00 PM

Bank officially closes for the day. Tellers stop
posting transactions on the current day's date.
Lockbox Department (may have different out-off
time altogether) continues preparing transactions
already in the building on current date. New
deposits will be processed with tomorrow's date.
Wire transfer desk closes.

9:00 PM

Bank starts receiving large deposits of checks for
clearing from local correspondents. Will be on
receiving bank's books as tomorrow's activity.

10:00 PM

Today's transactions from the branches and Lockbox
Departments have probably been posted to a batch
file. Lockbox Department begins to receive a
large quantity of deposits from Post Office.
These will be processed on next day's date. This
inflow will continue until about 8:00 AM.

11:00 PM

Batch file of day's transactions begins to post to
customer file. May take some hours. Processing
of checks received during the day continues until
morning deadline at clearing house. Processing of
items on tomorrow's date (from correspondents and
Lockbox) continues until the following close of


Bank begins to receive deposits from major
correspondents around the country to clear local
items. Such deposits continue until slightly
before clearing house deadline. If any checking
account statements are going to be prepared the
next day, system will begin sorting the
appropriate checks into account number order.
This processing could continue until the following

3:00 AM (or later) Transactions have posted to appropriate
accounts, system determines which inclearing items
from previous day are potential return items.
5:00 AM

System pulls out potential return items from
previous day's work. Prepares reports for
printing (balances, potential overdrafts, late
payments, etc•).
II - 21

8:00 AM

Bank receives transmission from Fed indicating the
amount of items drawn on major accounts at
controlled disbursement banks. Information is
relayed to customers (generally by 10:00 AM) along
with balance information from previous day and
preliminary information about lockbox receipts for
today that are already processed.

9:00 AM

Bank open for business. Tellers receive deposits,
make withdrawals. Wire transfer desk open.
System begins printing account statements for
accounts with yesterday cut-off dates.

10:00 AM

Clearing house deadline. Inclearings received and
posted to batch file for final posting at night.

2:00 PM

Deadline for account officers to make pay/return
decisions concerning previous day's inclearings.
Information about these decisions is input into
the system during the next few hours.

9:00 PM

Regulation CC deadline to enter previous day's
return items into system.

II - 22

This appendix analyzes three deposit insurance reform
proposals which could reduce the FDIC's potential obligations.

Limit the insurability of an individual's1 funds to
$100,000 per institution by eliminating ownership
categories used for insurability (eg. joint accounts,
testamentary accounts).


Limit the insurability of an individual's funds to
$100,000 across all institutions at any point in time.
This proposal could eliminate or maintain ownership
categories. If the categories are maintained, each
insurable account relationship would be limited to
$100,000 across institutions.


Limit deposit insurance to a single lifetime
entitlement of $100,000 per person. Again, this
proposal could maintain or eliminate some ownership
categories. Variations on this proposal could involve
different time periods (eg. $100,000 of insurance every
five years or six months).

Section I of this appendix describes the possible benefits
of these proposals. Section II discusses two issues that need to
be addressed when considering all three proposals. One is the
effect of the possibility that the relevant authorities might
elect to handle a truly large bank failure differently from the
rules set forth in these proposals. The other issue is the
distinction between market discipline and depositor runs. In
Section III, the main body of the paper, each of the proposals
will be described, its specific administrative requirements
discussed, and its unique economic implications considered. The
paper ends with a brief summary.
In considering these proposals, it is also assumed that the
restrictions will apply across insurance funds, whether FDICBIF, FDIC-SAIF, or NCUA. If separate limits apply to deposits at
each of these funds, depositors seeking to increase their
protection will find ways to create deposit relationships at
institutions insured at each fund. This would cause economic
distortions as funds flow to institutions based on insurance
rules rather them economic advemtage.
In this paper, the term individual or depositor refers
to both persons and business firms holding deposits at insured
financial institutions, unless otherwise indicated.

I ll - 1


Potential Benefits of Proposals

These proposals have a common set of worthwhile goals. To
e extent that the proposals would be effective in achieving
S S I goals 'include?”0111^ Jg! the bankin9 industry would

Increased Depositor Discipline.

P®r?entage of bank deposits should become
Depositors can be expected to exercise more care in
heioh^nHrtrt^ank•in Whlch *° deP°8it their uninsured funds. This
bankers ^
S v 81t0r
BcrutLnyit more difficult for
to^xp!ndh t k
excessive risks to generate the funding needed



Reduced Failure Resolution Costs to FDIC.

Tnninflfr,« ®maller percentage of the total deposits held by banks
insurance, it may be possible that the percentage of
deposits in specific failed banks will also be reduced.
shared bvC«nfn= moJe .of tbe losses in those failed banks will be
shared by uninsured depositors, and less will be absorbed by the

Equalization of Treatment Between Depositors at Large and
bmaii Institutions•


fifiP°licy m?kefs are able to follow the same set of rules in
fe?olutions, there will be an equal treatment of
at ln8txtutionB of all sizes. This would eliminate
a s L m » H d^ 9>,»dVanta9fS that curr®ntly exist at banks which are
greater government protection than their
II - Concerns Common to Each Proposal
Effects of "Too Big To Fail" Perceptions on Proposals

order for any of these plans to be effective, the FDIC2
*ave to commit to handling all bank failures in a manner
which imposes losses on uninsured depositors. The credibilitv of
a commitment might be questioned by depositors who believe
that the macroeconomic repercussions of major bank failures might
motivate those responsible for macroeconomic stability to
intervene in support of those institutions.

In this paper, FDIC, tinless otherwise indicated, wil]
refer to any insuring agency: FDIC-BIF, FDIC-SAIF, NCUA.

Ill - 2

To the extent that large banks are perceived by the public
as "Too Big To Fail" we would expect a flight of funds to large
institutions. This movement of deposits would provide large
banks with a lower cost of funds than small banks. This would be
caused by distortions stemming from failure resolution policy
rather than from a developed advantage in deposit generation.
The result would be a sub-optimal allocation of financing across
firms in the banking sector. If significant amounts of money are
affected, small banks will have to reduce their activities due to
a cutoff of funding while large banks would increase activity to
accommodate these funds. This change in market shares would also
result from a market distortion rather than a developed advantage
in credit creation.
The public's perception of the protection afforded to large
banks is not without foundation. In the past, public officials
who were confronted with major bank failures have opted to act in
a way that minimized short term economic disruptions. Officials
in different administrations and nations have reacted in similar
ways. These proposals do not directly address the concerns which
motivated the policy makers to act as they did in the past. If
such actions are repeated in the future, we will not have reduced
the total potential public liability. Rather, the composition of
a portion of the potential liability would have been transferred
from deposits at small banks to deposits at large banks.
Depositor Discipline vs. Depositor Runs
These proposals would create a larger pool of deposited
funds which is at risk in the event of a bank failure than exists
today. Appendix II describes the concerns we have about the
effectiveness of depositor discipline and the potential
instability that may be introduced into the banking industry by
exposing depositors to greater risks. These concerns also apply
to the proposals.
Ill - Implications for Each Proposal
The above discussion would apply to all three of the
proposals. Implications of each specific proposal are discussed
Current regulations establish complex types of ownership
categories, each of which is separately insured at a single
financial institution. For example, the joint account of a
husband and wife is insured separately from individual accounts
that they may keep. Furthermore, revocable trusts can be
established (by signing the appropriate signature card at the

III - 3

bank) that are also insured separately - but only if the
beneficiary is a spouse, child or grandchild of the trustee. Such
trusts established with great-grandchildren, nieces or nephews as
beneficiaries do not qualify for separate insurance. Apparently,
these regulations have been adopted in response to statutory
provisions that suggest insurance be based on ownership capacity.
Certain ownership capacities are specified by statute•
An alternative system would mandate that a single tax ID
number or| social security number be attached to every account to
indicate insurability. Regardless of ownership type, only
$100,000 (or some other prescribed amount) would be insured for
that individual or firm. Such a change would probably have
little economic impact. Wealthy depositors (with sufficiently
large, qualified families) who currently utilize the system to
insure more than $100,000 in a single institution could spread *
those accounts across several institutions. However, such a
change might effect the provision of pass-through insurance that
is currently available to certain pension and employee benefit
This proposal could make a payout resolution easier and
quicker by streamlining some of the administrative tasks • It
would also ease the burden on financial institutions should they
be required to maintain and report accurate information about the
insurance status of their depositors. This increases the set of
institutions for which the FDIC might opt to pay-off insured
depositors in the event of failure•
There are two general ways to design this type of plan. With
the first method, depositors designate, in advance of any
failure, which specific institutions or accounts are to be
insured. An alternative method limits coverage of any individual
depositor as multiple failures occur in institutions used by that
depositor• The second method would not reduce insured funds as
much as the first. Depositors could maintain accounts for the
maximum amount at several institutions in the hope that no two of
them would go into receivership simultaneously.
Specific procedures that appear necessary to implement each
proposal are described below. Each of these systems would
involve administrative burdens that are not presently incurred.
In addition, there are economic implications to consider with
each system.

Ill - 4

Method 1.
Individuals must designate in advance which specific
accounts in which specific institutions are to be insured. The
total of these accounts may not exceed $100,000. Any other
deposits at the designated banks or at other banks would not be
insured. When an institution is put into receivership,
designated deposits would be insured, but all other deposits
would not be insured.
Administrative Requirements
There would have to be some controls established that would
prevent individuals from intentionally or inadvertently insuring
funds in excess of the $100,000 limit. This task is complicated
by the dynamic nature of bank deposits. Not only do customers
change institutions, depositors may also switch their savings
among different accounts within the same institution (eg. from
short term CD's to long term CD's or money market accounts), and
balances within accounts also vary over time.
Presumably individuals would wish to insure the balances of
their checking accounts in order to avoid situations in which
checks that are in process are returned by the failed bank.
However, these balances fluctuate by considerable amounts
throughout a month or year. As investment funds are liquidated
or reinvested checking account balances can experience major
changes. As salary is deposited, and then spent through the
payment period, smaller shifts will occur. An individual who
anticipates that his checking account balance would seldom exceed
$10,000, might designate the checking account and a $90,000
certificate at another institution as his insured accounts.
However, the depositor will be exposed whenever larger amounts of
money are flowing through the checking account or there is a
delay in the processing of checks he has already written. The
insuring agencies would need to have access to records that
indicate the pre-designated amount of each account that is
In addition, the designated accounts and amounts at the
failed institution would have to be verified against a master
file that contained all such designations in all institutions to
prevent excess designation by individuals. Penalties would
probably need to be established (criminal or civil) for
individuals who intentionally over designate in order to increase

Ill - 5

Depositors would have to be allowed to switch designation
among institutions. As concern over a specific bank's viability
began to spread, depositors with time accounts at that
institution would want those funds to be designated (protected)
t k ^ ^ . ^ p o s i t s at other institutions which may have
been previously designated. Whenever a bank failed, FDIC would
Yeri£y ,that depositors with designated accounts at that
institution had not designated other accounts at other
În .excess of their limit. Because such designations
ch^n5in? daily, FDIC would need to maintain a database of
account designations that is continuously updated.
°Jfder t? keeP the file current, FDIC would have to
receive these changes electronically, rather than on paper. This
uggests that banks would become responsible for reporting
nnur??aten accoun^ ' balances and ownership on a daily basis.
^his could create problems in verifying that the data
provided by a bank is consistent with the desires of the
FDIC would have to audit the veracity of reported
b^th^vn??"«- A11 ^ comi;ng data would have to be compiled daily
funds® « H Ctî
that individu«ls have not designated excess
funds, and to have accurate information whenever a failure

. Be^ause individuals would be responsible for the accurate
•t5eir account balances, they would need to have
access to the information kept on the master file. However,
there are real security and privacy concerns raised by this
requirement. FDIC would not be able to verify the identity of
any inquirer. However, the potential for fraudulent use of the
w?8ed.<?ank' account number, balance) is significant.
Conceivably, information requests could be channelled through
not want a bank to know what other
accounts are being held at competing institutions.
Economic Implications
The reporting requirements imposed on the banking industry
could be onerous enough to act as a tax. The costs of this
burden would be passed on to customers in the form of lower
yields on bank deposits and higher loan rates. Maintaining the
fata_{?aae that would run this system would impose heavy costs on
the FDIC. These operating costs would be reflected in the
insurance premiums assessed to banks.
These burdens could impose deadweight drags on the banking
sector and make it less efficient relative to other types of
financiel intermediaries. To the extent that this occurs,
activity would flow away from the banking sector toward other
types of financial service providers. This flow would not result

III - 6

from any economic advantage created by the competing industries.
It would be a direct result of the burdens this proposal places
on banks.
Method 2,
Accounts at all institutions currently in receivership are
combined and analyzed for insurability using a process similar to
what currently occurs within a single institution.
Example 1: Joe Jones has $100,000 on deposit at Bank A, Bank B,
and Bank C ($300,000 total). If any one of these institutions
goes into receivership, Joe's funds would be insured.
Example 2: Same as example 1, but Bank A goes into receivership.
After Bank A is taken out of receivership (either through a P&A
or payout), Bank B fails. Joe's funds in Bank B would be
Example 3: Bank A goes into receivership. While A is still in
receivership, Bank B fails. When we analyze the accounts at Bank
B, we see that Joe already has $100,000 in receivership held
funds, so the funds in Bank B are not insured.
Example 4: Same as in example 3, but after Bank A is settled,
Bank C fails. In this case, analyzing accounts at Bank C
indicates that Joe no longer has funds protected in a
receivership (the funds in Bank B had lost their protection).
Joe's money in Bank C is protected.
Example 5: Same as example 4, but Bank B is settled first.
Before Bank A is settled, Bank C fails. Joe still has money
protected by FDIC receivership (from Bank A), therefore the money
in Bank C is not protected.
Administrative Requirements
At present, the FDIC scrutinizes the ownership arrangements
of accounts for insurability only in payout situations.
Generally, all depositors are given immediate access to a portion
of their funds. In order to avoid over-insuring depositors with
more than $100,000 in the institution divided among two or more
accounts, the bank's records are carefully scrutinized. After
one or two days (in the case of a small institution), the various
balances are aggregated by owner and insurability is fully
ascertained. The insured balances are paid out at that time.
The larger an institution is, the longer this process takes.

Ill - 7

Because uninsured as well as insured depositors are kept
whole in purchase and assumption resolutions, such record keeping
is not presently performed during most bank failures • Using
Method 2 to reduce FDIC exposure would reguire that the record
keeping take place in every receivership, even those ultimately
resolved through purchase and assumption. Otherwise, when
resolving any other contemporaneous failures, FDIC would be
unable to identify when it was in situations like examples 3 and
5 above (the only situations in which FDIC coverage would be
reduced from current levels). Administrative costs of failure
resolution would increase as the intensive record keeping burdens
are assumed in all cases.
The lengthy amount of time it takes to accurately sort out
and aggregate the ownership of accounts in an institution creates
several problems. First, holding failed banks in receivership
for longer periods of time may reduce their franchise value.
Additional technical problems might also occur. Returning
to the example situations described above, assume that Bank A
goes into receivership. Under current practices, a P & A
transaction could be arranged after one week. However, two weeks
are needed to complete the record keeping required by the new
system. Bank B fails during the second week. Is this a case of
Example 2 or Example 3? Would depositors accuse the insuring
agency of keeping Bank A in prolonged receivership in order to
reduce potential liability when another institution failed?
There are also potential inter-agency disputes. If a
regional economic downturn threatened the viability of
institutions insured by all three funds (FDIC-BIF, FDIC-SAIF,
NCUA), each fund would have an incentive to wait until another
fund began closing institutions. The first fund to act would
become Bank A in the above examples while succeeding funds would
become Bank B for many common depositors.
An alternative device which would speed the handling of a
failed institution would be to require that banks keep up to date
account records on insurability of accounts in a standardized
format so that insurance liabilities are rapidly identified
during a failure resolution. The records would have to be in an
electronic format so that the file from any failed institution
could be quickly compared to the files from other institutions in
Economic Implications
Individuals with more than $100,000 in bank deposits would
probably get skittish whenever there was an economic downturn or

III - 8

threat to the banking sector. Because they would be unsure of
the viability of any institution, they would have incentive to
move their funds to large banks where there is a "Too Big To
rail" perception. The lack of confidence could also intensify
regional economic disturbances. Fearing that the banks in the
distressed region were weakened, and more likely to fail than
previously, depositors might transfer funds out of that area of
the country. If this occurred, it would cause funding problems
for the banks and intensify a local credit crunch.
The deposit outflow would become especially strong whenever
a bank is put into receivership. Depositors at that bank who
have more than $100,000 in the banking system would lose some or
all of their protection at other institutions until the failure
is resolved. They will have incentives to run, adding
instability to the system.
Even depositors whose
have more than $100,000 in
have incentives to panic.
precarious state after one
incentives to run from any

banks have not yet failed, but who
deposits at various institutions would
Because they would be in a more
of their banks closed, they would have
bank that got into trouble.

Suggestions have also be made that deposit insurance should
be a once in a lifetime entitlement. Under such plans, a person
would be protected from successive bank failures until the sum of
the deposits in past and present failed institutions equalled a
cut-off level (eg. $100,000). After that point, the depositor's
funds would not be insured. Variations of this proposal could
shorten the time period that the individual would be uninsured.
For example, every five years an individual would be insured for
$100,000. The administrative and economic implications of these
plans would be similar.
Administrative Requirements
It would be necessary to maintain records of all depositors
at failed institutions and the balances of their accounts.
Whenever a failure occurred, the insurability of accounts would
have to be determined in the manner described on page 8 above.
If the failure is to be resolved through a payout of insured
depositors, the accounts records of the institution will have to
be compared against the historical file of depositors at failed
institutions before final determination of insurability can be
made. In the case of a purchase and assumption transaction a
rigorous analysis of account records will also have to be
undertaken in order to record which depositors have extinguished
their insurance benefits.

Ill - 9

As explained in the discussion of the previous proposal, the
time requirements of completing such an analysis can reduce the
franchise value of the failed institution. Such delays could be
avoided by imposing requirements on banks that they maintain, in
standardized electronic format, timely and detailed tracking of
the insurability of depositors accounts•
Special problems arise under these plans in dealing with
corporate entities. Presumably insurance entitlement for
corporations would be based on tax payer ID numbers. However,
what controls would prevent a business from reincorporating in
order to obtain a new TIN and thereby renew insurance protection?
Also, how would other forms of corporate re—organization
(mergers, spin-offs, acquisitions) effect the new entities'
insurance entitlement?
Economic Implications
Under this type of plan, depositor behavior would be very
similar to behavior without any insurance program. There would
be two groups of depositors, those whose insurance benefits have
been exhausted and those who still have some or all of their
entitlement remaining.
The fi^st class will behave in a manner as destabilizing as
if there was no deposit insurance at all. The second class of
depositors would also have an incentive to withdraw funds before
institution failed. In a failure, these depositors would
keep their money but lose something else of value — insurability.
Therefore, the proposal would eliminate the major benefit of a
deposit insurance program - stability - while creating formidable
administrative burdens on the insurance agency (and probably on
the banking industry too).
Each of the three proposals have worthy goals. These
include: increasing depositor discipline; reducing FDIC expenses
and; equalizing the treatment of depositors at large and small
There are issues which need to be considered prior to
implementing any of these plans • If depositors in the largest
banks continue to be perceived to be immune from loss, the
uninsured ^funds will shift from deposits in small institutions to
deposits in large institutions• Should the perception prove to
be true, total public liability will have also shifted instead of

III - 10


being reduced. In addition, to the extent that the proposals
might be successful in creating a larger pool of uninsured
deposits, instability will be increased in the system. The
overall benefits of these plans are uncertain.
On the other hand, the costs will probably be significant in
new administrative burdens placed on insuring agencies and
probably on the firms within the industry. Economic distortions
may occur as funds move to other financial service providers that
are not similarly burdened. Additional distortions would be
expected to occur as funds within the industry shift to larger

I I I - 11