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DEPOSIT INSURANCE REFORM: SOME OVERLOOKED ISSUES Remarks by Thomas C. Melzer Day with the Bank Commissioner Little Rock, Arkansas June 27, 1990 The Financial Institutions Reform, Recovery and Enforcement Act, passed by Congress last year, required the Treasury Department to study deposit insurance reform. Their report is due by next February. While there are few "sure things" in this life, it is a reasonably good bet that, in the next year or so, Congress will make major changes in the nation 7 s deposit insurance program. Consequently, whether you think that such reform is a bad idea or a good idea, it is clearly an idea whose time is rapidly approaching. Unfortunately, like rapidly approaching thunderstorms and freight trains, rapidly approaching ideas can also be quite dangerous to the public at times. Whenever there are strong pressures on policymakers to reach significant and far-reaching decisions quickly, occasionally are overlooked. some important issues In the next few minutes, I would like to discuss some issues that I believe should be considered, carefully and thoughtfully, before deposit insurance reform becomes a reality. I want to assure you, before we consider these issues, that I do not believe Congress will necessarily overlook them in its debates on deposit insurance reform; 1 however, in my opinion, several of these issues have been overlooked in much of the recent public discussion on this matter. Therefore, because Congressional actions are influenced by public concerns and public opinion, I would like to see these issues receive some recognition. And, what better place to achieve this than right here at the Day With the Bank Commissioners. Now, I certainly don't have to tell you why deposit insurance reform is imminent. growing, The already huge, but still cost of the federal governments commitment to depositors at bankrupt savings and loan associations is certainly the primary reason to expect changes. Another, related reason reflects the strong pressures from large banks who want to obtain permission for activities that they are now locked out of by current banking regulations. Changes in the deposit insurance program are necessary if the range of permissible banking activities is to be broadened, while, at the same time, the deposit insurance fund's exposure to prospective and actual losses is to be reduced. Several types of deposit insurance reform have been proposed recently. Not surprisingly, all of them are intended to reduce the risk assumed by banks. There is one fundamental question that must be addressed before choosing which prospective change to adopt. That question is, who should be responsible for limiting the risks assumed by banks? Currently, bank shareholders and government bank 2 supervisors share this responsibility; however, given the current deposit insurance program, the cost of bad decisions and bad luck is borne primarily by taxpayers. Some proposed reforms would strengthen the powers of bank supervisors. Others would require depositors to assume a greater share of the costs of bank failures. be expected As a result, depositors would to take on increased assessing and limiting bank risk. responsibility for Let's consider each of these proposed reforms in turn. The arguments in favor of increased supervision by bank regulators are obvious; so much so, in fact, that there is no reason to detail them here. Unfortunately, it is all too easy to overlook the disadvantages of increased powers for bank supervisors; consequently, I want to focus on these. Two examples should illustrate both the proposed reforms that would increase powers for bank supervisors and the potential disadvantages associated with doing this. One proposal being considered is the introduction of deposit insurance premiums based on the risks assumed by banks as perceived by bank supervisors. The second proposal would require bank supervisors to apply progressively stronger discipline on banks whose capital ratios fall below the established standards. Now, how could these proposed reforms possibly have serious disadvantages? What have we overlooked? First, these proposals assume that bank supervisors are able to determine, better even than bank shareholders and 3 management, both the risks facing banks and the current market values of all bank assets and liabilities. Second, and much more serious, is that such bank supervision and regulation will, at the margin, stifle bank innovation and competition. To see why, consider that, from the bank supervisors perspective, the best of all possible outcomes would be zero bank failures—which could occur only if even the most bungling bank management couldn,t possibly fail. In order to reduce the chances of bank failure, supervisors will inevitably exaggerate the risks involved in new services or banking practices and retard their adoption. Moreover, one easy way to reduce the potential number of bank failures would be to restrict the extent of competition in banking. How? Simply by imposing restrictions both on the more aggressive banks and on new entry into banking. The key issue I want to emphasize is not whether good and valid reasons for strengthening the powers of bank supervisors actually exist. In fact, they do exist. My point is simply that there are costs associated with doing so. And, these costs, the potentially adverse social consequences of such regulatory actions, are often overlooked when the regulatory bandwagon rolls by. Now, what about the proposed reforms that would increase the role of depositors in limiting banking risk? As you know, these proposals include reducing the size of the insured account, introducing some form of co-insurance and, perhaps, limiting the total number of insured accounts 4 that any individual can hold regardless of where they are held. The intent of these proposals is to increase the risk or cost of bank failure borne by depositors. Now, of course, these proposed reforms will be for naught unless the notion that eliminated. some banks are too big to fail is also Otherwise, depositors will reduce their risks by shifting to those banks that they perceive as too big to fail. In this case, the reforms would simply raise costs at the smaller banks without limiting the risks assumed by the larger ones. Given the recent history of banking supervision in this country, the mere announcement that, henceforth, no bank will be considered "too big to fail" probably would not convince depositors at the biggest banks that their funds were at risk. I will leave it to your imagination to think of what might actually convince such skeptical depositors. Now, why would anyone really believe that giving depositors an increased regulatory role would be a good idea? What are the advantages of adding an additional bank risk "enforcer"—the bank depositor—to the game? At first glance, many individuals would consider such reform to be a step backwards, a reversion to times when banking risks were seemingly increased, not decreased, uninsured depositors. Could depositors really be a good idea? by the actions of increasing the role of What have we overlooked? First, deposit insurance reforms that place depositors with accounts in excess of the insurance limit at risk might 5 enhance the effectiveness of bank disciplining the more risky banks. supervisors in The more risk-averse depositors will place their funds with the less-risky banks; other depositors will force the riskier banks to pay higher interest rates for deposits. Thus, depositors, as well as bank supervisors, will point out to bank shareholders and management that greater risk is costly. These actions by large depositors will also reinforce bank supervisors7 actions intended to have banks achieve and maintain adequate capital ratios. Other things the same, banks with higher capital ratios are less risky banks. If less risky banks are able to attract funds at lower interest costs, banks will find that it pays them to increase their capital ratios. An additional overlooked benefit from this reform is that, if banks as a group maintain higher capital ratios, supervisors will be able to change the focus of their efforts. Instead of second-guessing management decisions at each and every bank, they will be able to concentrate more of their resources on those banks in poor financial condition and those who persist in engaging in higher-risk activities. Finally, the proposed reforms that place greater risks on large depositors might reduce the losses to the bank insurance funds by limiting the discretion of bank supervisors to offer forbearance to troubled banks. The mass exodus of large depositors from troubled banks would 6 force bank supervisors to deal with those problems much more quickly than they have in the past. Our experience over the past decade shows clearly that losses to the deposit insurance funds generally increased substantially whenever the supervisory agencies granted forbearance. Up to now, we have considered only the positive consequences that might arise if certain deposit insurance reforms that increase risks of large depositors are enacted. However, there is something about nature that abhors a "free lunch." And, unfortunately, these reforms also have some important, often overlooked, implications for international competition in banking services and for the scope of authority of U.S. banking supervisors. Our previous discussion, like many discussions of deposit insurance reform, ignored the fact that U.S. banks compete in an international banking arena. Suppose that, as a result of deposit insurance reform, large depositors at U.S. banks now find their deposits riskier, deposits at the largest U.S. banks. even those What would you expect them to do when they also discover that, unlike the new U.S. policy, the governments of other developed countries are willing to guarantee all deposits at their countries' banks—even those at their branches in the U.S. Obviously, large depositors will simply shift their deposits to the offices of foreign banks operating here and abroad. The net result would be to reduce the relative size and importance of the U.S. banking industry worldwide. 7 Another overlooked consequence of these reform proposals is that they will place increased pressures on the Federal Reserve System. Any deposit insurance reform that places large depositors at greater risk will increase the probability that, occasionally, there will be depositor "runs" on individual banks; even less often, perhaps because of unusually bad news affecting many banks, there may be runs on large numbers of banks. Thus, such reforms will contribute to increased importance of the Federal Reserve's role as the nation's "lender of last resort." This increased pressure on the Federal Reserve has both a "good news" and a "bad news" aspect to it. First, the good news is that the Federal Reserve has learned an important lesson from the 1930s, when its failure to act forcefully enough as a lender of last resort, according to some monetary history writers, contributed to the resulting economic downswing. We certainly would not make that mistake again. However, the bad news is that, in acting as the lender of last resort, the Federal Reserve might have to take considerable losses on its loans to troubled banks. How would this happen? In the event of a widespread depositor run on many banks at the same time, the Federal Reserve might have to concentrate more on preventing a nationwide liquidity crisis than on determining the solvency of the banks it lends to or the quality of their collateral. such a time, At it is extremely difficult to determine, particularly on such short notice, which banks are solvent 8 and which are not; this is especially true if the news that triggered the banking crisis raises substantial doubts about the underlying values of assets at many banks. conditions, the substantial losses. Federal Reserve could Under these end up with The irony in this situation is that the federal government would not eliminate its exposure to losses if it reduces deposit insurance coverage and presumably shifts the risk to depositors. Is this Ultimately, "shifty" operation a good idea anyway? Congress will have to make that decision. However, there is a story about the Fed's operation in the early 193 0s that might help to illustrate the potential conflicts that any central bank faces during a banking crisis. One day, in the midst of the nation's worst banking crisis, the president of a small bank called the Fed. Panic-stricken, he explained that his bank faced a run by depositors and that he needed our help. The Fed official who took the call, noticing that the Fed had lent to this bank previously, told the bank's president that an armored car would be dispatched immediately. When the armored car arrived at the bank, the president ran out, shouting "You arrived just in time. Bring the cash in right away." The Fed staff member who accompanied the armored car said, "Bring it in? We're here to get ours back." Now, as I noted earlier, the Fed has learned a lot about central banking since the early 1930s. The point of the story, however, and the point of my entire discussion is 9 simply that reform of the nation's deposit insurance program is likely to produce considerably more effects than have been generally recognized. In particular, the various proposals intended either to strengthen the role of bank supervisors or to induce greater depositor discipline of banking risk have broad but often overlooked implications for the operation of our banking system. Let us hope that these implications will not remain overlooked when Congress gets down to debating the merits of the various proposals for reforming deposit insurance. 10
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