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TESTIMONY OF
FEDERAI DEPOSIT INSURANCE CORPORATION
ROGER A. HOOD
ASSISTANT GENERAL COUNSEL
FEDERAL DEPOSIT INSURANCE CORPORATION
WASHINGTON, D.C.
ON
THE DEPOSIT INSURANCE PROVIDED FOR
BANK INVESTMENT CONTRACTS
BEFORE THE
SUBCOMMITTEE ON GENERAL OVERSIGHT AND INVESTIGATIONS
OF THE HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
10:00 AM
June 21, 1990
Rayburn House Office Building - Room 2222
Good Morning Mr. Chairman and Members of the Subcommittee.
We
are pleased to testify on behalf of the Federal Deposit Insurance
Corporation regarding "pass-through" deposit insurance currently
provided for Bank Investment Contracts ("BICs").
In February of this year, the FDIC prepared and submitted to
Congress a report on "pass-through" deposit insurance.
The
report included an extensive discussion of the "pass-through"
deposit insurance provided for BICs.
Since the facts and the
FDIC's information have not changed appreciably since February,
many of the statements and conclusions from that report to
Congress are reiterated in our testimony today.
Definition of "BIC"
A BIC is a deposit contract entered into between a bank and its
customer which provides that the customer will deposit funds with
the bank over a period of time and the bank will repay the
amounts deposited plus interest at a guaranteed rate at the end
of the contract term, generally from six months to as long as ten
years.
It is a non-transferable liability (not saleable in a
secondary market) of a bank.
A BIC is the counterpart of the
insurance industry's Guaranteed Investment Contract ("GIC").
The
customers for BICs and GICs are, in most cases, sponsors of
employee benefit plans such as pension plans or deferred
compensation plans which qualify under section 401(k) of the
Internal Revenue Code (commonly referred to as "401(k) Plans").
2
Like a certificate of deposit, a BIC is an agreement whereby the
bank agrees to repay the depositor the amount deposited plus a
specified rate of interest after a specified period of time or on
a specified date.
However, in order to make BICs more attractive
to defined contribution plans, they often have contractual terms
that are marginally different from a traditional certificate of
deposit ("CD").
Two features distinguish BICs from traditional CDs:
window" feature and a "benefit response" feature.
a "deposit
The "window"
feature is simply an initial period of time during which pension
plan sponsors or participants can deposit monies into a
particular BIC contract.
Any deposits made during this period
are paid a contractual or indexed rate of interest for the life
of the BIC contract.
The "window" period generally may vary
anywhere from a few months to a year.
Based on a recent survey,
the Federal Reserve Board concluded that the median window period
is six months, with no bank having a typical window length of
over one year.
In an effort to limit some of the uncertainty concerning the
amount of deposits that will be made during a "window" period,
contracts frequently contain provisions which place limits on
maximum deposit amounts and impose penalties if minimum deposit
levels are not reached.
In addition, it is not uncommon for BICs
to involve one lump-sum deposit (i.e. not to permit additional
deposits at all).
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The "benefit response" feature provides for withdrawals from the
BIC to accommodate certain plan provisions that allow plan
participants, under certain circumstances, to make withdrawals
from the fixed-income option (an option that usually invests in
BICs or GICs) at book value.
Common circumstances under which
withdrawals are allowed prior to maturity of the BIC/GIC contract
include retirement, disability, termination of employment,
hardship, transfers to other investment options under the same
retirement plan, and loans.
Other withdrawals may take place
because of corporate-initiated events.
For example, plant
closings, reduction-in-force programs, and ownership changes
could result in large withdrawals.
Increasingly, penalty-free
withdrawals are not allowed under many types of corporate
initiated events.
Estimate of the Size of the BIC Market
Since banks do not separately report their BIC involvement to the
FDIC or any other bank regulatory agency in their Reports of
Condition (commonly referred to as "Call Reports"), the FDIC does
not have a definite count of how many insured banks offer BICs or
the total dollar amount of their outstanding contracts.
However,
after discussions with bankers, money managers involved in the
BIC market and other persons who are knowledgeable about the BIC
market, the FDIC estimated that about 25 to 35 banks were
actively involved in the BIC market during 1989.
The FDIC
believes that most of the institutions offering BICs are very
large institutions.
The Federal Reserve Board recently conducted a survey on BICs
involving 51 banking organizations.
The survey was intended to
capture all institutions that are major participants in the BIC
market.
Of the 51 institutions surveyed, 26 indicated that their
institutions had BIC liabilities outstanding at the time of the
survey and five additional institutions planned to begin offering
BICs during 1990.
This is consistent with the FDIC's previous
estimate that there were about 25 to 35 banks actively involved
in the BIC market during 1989.
The responses to the Federal Reserve Board's survey suggest that
bank involvement in the guaranteed contract market has grown
rapidly in recent years.
The FDIC believes that the emergence
and rapid growth of the BIC/GIC market during the last 15 years
has been in response to a shift from defined benefit retirement
programs to defined contribution plans.
Under defined
contribution plans, employees select directly from several
investment options and the relatively conservative BIC/GIC option
(sometimes referred to as a fixed-income or fixed-interest
option) has been a popular choice.
The GIC first appeared around 1970 and by the mid-seventies most
major insurance companies had entered the GIC market.
The most
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rapid growth in the GIC/BIC market, however, occurred during the
1980s.
By 1988, roughly one-third of all funds in defined
contribution plans were invested in some type of a fixed-income
investment, e.g., a GIC or BIC investment.
Banks began offering
BICs only a few years ago, but their market-share has grown
substantially.
In 1988, it is estimated that new BICs accounted
for about 10 percent of the $30 billion in new guaranteed
contracts, up from one percent in the previous year.
The total dollar amount of outstanding GICs and BICs at year-end
1988 was estimated to be around $150 billion.
As a result of
their survey, the Federal Reserve Board estimates that the market
expanded by about 15% in 1989, which would place the total dollar
amount of outstanding BICs and GICs at about $172 billion by
year-end 1989.
Based upon its survey, the Federal Reserve Board estimates that
the total dollar amount of BICs outstanding was $2.3 billion at
year-end 1988, and $7.5 billion at year-end 1989.
The
respondents to the Federal Reserve Board survey indicated that
they anticipate about another $3 billion in new BICs will be
issued in 1990.
The FDIC/s Legal Position
Section 3(1) of the Federal Deposit Insurance Act defines the
term "deposit," and in so doing, sets the parameters for what
r
types of bank obligations are insured by the FDIC.
The FDIC
staff has taken the position that each BIC must be examined in
light of section 3(1) of the FDI Act to determine whether it is a
"deposit."
If a BIC falls within the meaning of the term
"deposit," it would be insured on a pass-through basis like most
other trusteed employee benefit plan deposits.
The FDIC legal staff has reviewed BICs issued by three insured
banks and has concluded, in each instance, that the BIC was a
"deposit."
The instruments that the FDIC staff examined had
several common characteristics.
The obligations were incurred by
the bank in the usual course of business to obtain funds for the
conduct of its business.
Each specified a maturity date on which
the principal and interest would be returned to the customer.
Each provided for interest to be credited periodically and at
maturity.
Each permitted the withdrawal of all or part of the
deposit prior to maturity, provided that the customer gave seven
days notice (as is required for all time deposits pursuant to
FDIC regulations and the Federal Reserve Board's Regulation Q).
In addition, each included the words "deposit agreement" in the
title and two used the phrase "time deposit" in describing the
nature of the instrument.
Although the FDIC staff has not issued any blanket legal opinion
that would apply to all BICs, the three BICs which have been
examined are within the meaning of the term "deposit" and thus
are entitled to deposit insurance.
7
Pursuant to certain provisions of the FDI Act, the FDIC's
existing and newly revised deposit insurance regulations provide
that deposit accounts maintained by fiduciaries (i.e.. agents,
nominees, custodians, conservators, guardians or trustees) are
insured in the amount of up to $100,000 for the interest of each
principal or beneficial owner in such accounts, provided that
certain recordkeeping requirements are satisfied.
Since the
insurance coverage for such accounts passes through the fiduciary
and is measured by the interests of the beneficial owners of the
funds, this type of insurance coverage is commonly referred to as
"pass-through" insurance.
Under existing provisions of the FDI Act and the FDIC's
regulations, the vast majority of pension plans, profit-sharing
plans and other trusteed employee benefit plans are entitled to
pass-through insurance for their deposits.
In other words, the
deposits of most trusteed employee benefit plans are insured in
the amount of up to $100,000 for the interest of each
beneficiary, provided that the FDIC's recordkeeping requirements
for fiduciary accounts are satisfied.
This insurance coverage is
separate from (in addition to) the insurance coverage provided
for any other deposits maintained by the plan sponsor, the
trustee or plan beneficiaries in different rights and capacities
in the same insured bank.
For the reasons stated above, BICs,
like most other trusteed employee benefit plans, are eligible for
deposit insurance.
8
Pass-through insurance coverage for the deposits of most pension
plans, profit-sharing plans and other trusteed employee benefit
plans has been provided by the FDIC since the FDIC's insurance
regulations were first adopted in 1967 and even before 1967,
pursuant to staff interpretations of the FDI Act.
Prior to 1978,
however, there was no specific regulation which addressed the
insurance coverage provided for deposits of pension and other
trusteed employee benefit plans.
Pension and other trusteed
employee benefit plans usually qualified as irrevocable trusts
and their deposits were insured according to each individual
trust interest (on a per-beneficiary basis).
However, only the
vested portions of the participants' interests were considered in
determining the participants' insurable interests.
All nonvested
interests were aggregated and insured up to the insurance limit
(which was $40,000 prior to 1980).
In 1978, the FDIC amended its deposit insurance regulations to
specifically address the insurance provided for the deposits of
pension and other trusteed employee benefit plans.
The
regulations were amended to expressly provide that the interest
of each participant in pension and other trusteed employee
benefit plans would be evaluated for insurance purposes as if the
interest of the participant had fully vested as of the date that
the insured bank was closed.
This represented a codification of
the FDIC's staff position which was that the deposits of pension
and other trusteed employee benefit plans were insured on a
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pass-through basis (according to the interest of each participant
in the accounts).
However, the amendment also broadened the
insurance coverage provided for such deposits by treating all of
the participants' interests as having vested, regardless of
whether or not they had actually vested.
BIC Risks
Financial institutions incur certain risks when the maturities of
their liabilities do not match the maturities of their earning
assets.
For example, if a bank funds relatively short-term
earning assets by issuing long-term liabilities, such as CDs or
BICs, then a general decline in interest rates would reduce its
interest income on earning assets, while leaving its interest
obligations to depositors unchanged.
As a result, the bank's
income would fall and could fall quite dramatically if the
maturity mismatch between assets and liabilities were large
and/or if interest rates declined dramatically.
On the other
hand, if the general level of interest rates rises rather than
falls, the bank's income would increase.
Of course, if a bank
funded long-term assets with short-term deposits, then the
effects of changing interest rates would be the opposite of those
just discussed.
This risk associated with the maturity mismatch
between assets and liabilities is common to the banking industry
and is generally referred to as interest-rate risk.
10
Banks may incur interest-rate risk with traditional forms of
deposits as well as BICs.
However, the nature of BIC contracts
presents some unique risks not generally associated with other
types of bank liabilities.
These unique risks may be created or
magnified when deposit inflows or withdrawals are substantially
different than initially anticipated.
Deposit inflows may vary
because of corporate events, such as changes in employment levels
or program benefits, or they may vary as a reaction to market
developments, such as developments in the stock market or changes
in the level of interest rates.
The effects of changes in the level of interest rates on deposit
inflows is a frequent and unpredictable risk confronting the
BIC/GIC issuer.
For example, if a BIC contract provides for a
relatively long deposit window and prevailing interest rates fall
after the contract interest rate has been established, the bank
may experience a larger than anticipated inflow of deposits as
plan sponsors or participants attempt to take advantage of an
above-market interest rate.
Depending on the magnitude of the
change in prevailing interest rates and the inflow of deposits,
the bank may not find profitable investments for this increased
amount of higher-priced funds.
On the other hand, if prevailing
interest rates increase after the contract rate has been
established and before the deposit window closes, actual deposit
levels may be below what was anticipated, since the contract rate
would be below prevailing market rates.
If the anticipated funds
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had been committed to investments, the bank would have to replace
the shortfall with alternative sources of funds priced at the
higher, prevailing market rate.
In either case, the combination
of changes in the level of interest rates and unanticipated
deposit flows (inflows or outflows) will alter interest margins
and profitability on the accounts.
For many of the same reasons that deposit inflows may vary during
the window period, withdrawals over the life of the contract also
may vary.
Here again, changes in the level of interest rates
will be a major factor influencing withdrawals otherwise
permitted by the terms and conditions of the BIC contract.
For
example, if prevailing market rates move above the contract yield
on the BIC/GIC investment, then it is likely that plan
participants will increase their withdrawals from the fixed
income option by transferring their investments to other
investment options under the plan or by obtaining a loan under
the plan rather than using funds from other sources that are
yielding higher returns.
In addition, where contract terms
permit it, plan sponsors may make benefit payments by withdrawing
funds from the lowest-yielding BIC/GIC contract within a
particular fixed-income option.
Even a sponsor's decision to
terminate a plan (employees receive their accounts at book value)
versus suspending a plan (cease contributions but leave current
investments in place) may be heavily influenced by the BIC/GIC
yield relative to the prevailing market yield.
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This process, whereby cash flows (either deposit inflows or
withdrawals) vary depending on whether prevailing interest rates
are above or below the BIC/GIC rate, is generally referred to as
cash-flow antiselection.
If funding from BIC sources is large
relative to a bank's total funding sources, the risks posed by
cash-flow antiselection also could be large.
There are a number of ways that a BIC issuer can limit these
risks.
With respect to limiting the risks associated with
deposit inflows, BIC/GIC issuers can shorten the window during
which deposits will be accepted and incorporate language into the
contract that imposes penalties if some minimum level of deposits
is not reached or some maximum level is exceeded.
Increasingly,
BIC/GIC issuers have taken such steps. In fact, in our
discussions with banks active in this market, we were told that a
large portion of BIC contracts included no window at all, that
is, they were simply a lump-sum deposit.
In many other cases,
deposit windows are no longer than three months and dollar floors
and caps are included in the contract language.
Withdrawal risks also can be controlled by limiting the
circumstances under which penalty-free withdrawals are allowed
and by limiting plan sponsors from paying benefits from the
BIC/GIC contract earning the lowest interest rate.
Increasingly,
penalty—free withdrawals are limited to certain specified events
such as death, termination of employment, retirement, or transfer
to a non-competing fund (such as an equity fund) within the
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retirement plan.
The contract language nearly always contains
some sort of penalty for withdrawals that result from plan
termination, mass lay-offs, a reduction-in-force, or sale of the
corporation.
Contract terms normally prescribe how withdrawals are to be made
from the various BIC contracts in order to meet retirement
benefits.
These contract terms limit the extent to which plan
sponsors can withdraw funds from low-rate contracts in paying
plan benefits.
Also, contract terms often limit employees from
making interfund transfers to a competing fixed-income fund,
thereby further limiting the withdrawal risk associated with a
particular BIC contract.
Risks in the banking industry are further limited by the fact
that their involvement in the BIC/GIC market is concentrated in
the shorter maturity end of the market, i,e.. maturities ranging
from one to three years.
Since bank assets also tend to have
shorter maturities, the consequences of antiselection risk for
the industry also are relatively small.
Institutions limit antiselection risks in a number of ways.
The
most common way is to ensure that the contract is designed to
limit penalty-free deposits and withdrawals to certain specified
events, thereby limiting the adverse consequences of changing
interest rates.
In fact, the BIC/GIC market has been moving in
this direction and plan sponsors have been willing to accept more
14
deposit and withdrawal restrictions in return for higher contract
yields.
Of course, it is also important for banks involved in
the BIC market to employ the more traditional tools in
controlling interest-rate risk as well, such as limiting the
mismatch in maturities between assets and liabilities and/or
hedging with options or forward contracts.
It is important to note as well that the terms and conditions of
BIC funding are but part of a larger process of asset/liability
management at banks participating in this market.
Consequently,
such funding must be considered on a case-by-case basis and in
the context of a bank's overall asset/liability management
practices.
The FDIC believes that the management of BIC funding
is well within the traditional capabilities of bank management.
We have no evidence to suggest that BICs are causing losses or
having other detrimental effects to the banks involved, or that
BICs, despite their unique characteristics, pose any undue risk
to the banking system or the insurance funds.
Nonetheless, given
the growth of the BIC market and the interest in the issues
raised, it may be useful to develop more definitive information.
To this end, we plan to raise with our sister agencies on the
Federal Financial Institutions Examination Council the
possibility of developing more specific information on bank
involvement in BICs.
F
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Conclusion
Pursuant to the provisions of the FDI Act, the FDIC has been
providing pass-through insurance coverage for the deposits of
most pension plans and other trusteed employee benefit plans for
several decades.
Providing pass-through insurance coverage for
BICs does not represent an expansion of deposit insurance
coverage.
If a BIC meets the statutory definition of "deposit"
then it is accorded the same insurance coverage that is provided
for most other trusteed employee benefit plan deposits, provided
the FDIC's recordkeeping requirements are satisfied.
The FDIC realizes, however, that there are some unique risks
associated with BICs that are not characteristic of other bank
liabilities.
Nevertheless, operating procedures and contractual
arrangements for limiting these risks are well understood.
There
is no reason to believe that banks lack the ability to understand
or use the same methods that are now widely utilized by other
market participants.
Therefore, the FDIC does not believe that
BICs pose an inordinate risk to the Bank Insurance Fund ("BIF").
As we concluded in our report to Congress on pass-through
insurance, the extent to which deposit insurance should be
provided for various owners and types of deposits should be
evaluated by Congress.
Any change, however, should be made only
after a comprehensive review of the deposit insurance system has
been completed.
We do not believe that a piecemeal approach to
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deposit insurance reform would be appropriate.
The comprehensive
review should take into account the public policy reasons for
providing deposit insurance for various types of depositors and
deposit instruments.
In other words, who should be covered, for
how much, and for what policy reasons?
We must proceed carefully
because we are dealing with extremely complex institutions and
markets that have a very direct link to the stability and
prosperity of our economy.
@FedFRASER