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SM 88-1

RISK A N D

S O L V E N C Y

INSTITUTIONS:

R E G U L A T I O N

PAST POLICIES A N D

O F

D E P O S I T O R Y

C U R R E N T

O P T I O N S

George J. Benston and George G. Kaufman

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Risk a n d Solvency Regulation of Depository
Institutions:

P a s t Policies a n d C u r r e n t O p t i o n s
George J. Benston and George G. Kaufman*

It is generally agreed that an efficient financial system is a prerequisite for
an efficient developed economy. Because of the perceived importance for
the other sectors of the economy of breakdowns in the financial system, the
current instability in the financial sector, particularly the dramatic decline
in the profitability of depository institutions (collectively referred to as
banks) and the sharp jump both in the number of failures and in their costs
of resolution is an important public policy concern. This is not the first
time in history, either in the United States or elsewhere, that such instability
has been the focus of public attention. Indeed, during almost every one of
the many actual or perceived financial crises in world history, legislation
and regulation has been proposed and frequently enacted that purportedly
were designed to strengthen the system and prevent recurrence. This paper
reviews the basis on which public policy towards banks has been con
structed in the United States, analyzes why the existing legislation and
regulation are not achieving their intended dual objective of fostering sta
bility and efficiency and are in large part themselves the cause of rather
than the cure for the instability, and considers policy options for improving
the stability and efficiency of the banking system in the current environ
ment.

I. Present Reasons for Regulating Banks
Financial products and services loans, investments, and transfers of claims
over resources that usually are denominated in monetary units- are
produced by many different firms in a large number of forms. Although
the products, and sometimes the firms, are similar, the producers are regu
lated to different degrees by government, depending in large measure on the

*(Emorv University and Loyola UniversityofChicago. ProfessorKaufman isalsoaconsultant
to the Federal Reserve Bank of Chicago). This paper was funded in part by the American
Enterprise Institute. An earlier version was presented at a Conference on Restructuring the
Financial System in Washington, D. C., November 16 and 17, 1987, sponsored by the Ameri
can Enterprise Institute. We are thankful for helpful comments throughout the development
of this paper by the other members of the AEI Financial Services Project and the Advisory
Committee, and by the discussants at the Conference. The paper willbe a chapter in a forth
coming book, William S. Harafand Rose Marie Kushmeider, eds., Restructuring Banking and
Financial Services in America (American Enterprise Institute, 1988).

FRB CHICAGO Staff Memoranda

nature of their charters. For example, consumer loans are made by banks
(commercial, savings, and savings and loan associations), consumer and
sales finance companies, retail stores, securities dealers, and individuals.
Yet, only the banks and consumer finance companies must get a license
(charter) to offer these loans, and only the banks’ lending activities are
closely supervised.
The principal characteristic of banks with respect to regulation by govern
ment is that they are depository institutions. They offer investments (de
posits) that are withdrawable or transferable in whole or in part to third
parties at par (face value), usually on demand or with short terms to ma
turity. These deposits (and in earlier days, notes issued by banks) are used
as the principal means of payment in the United States and most developed
countries. It is the banks’ role in money supply and transfer that has
caused them to be regulated or controlled by the governments of most, if
not all, commercially developed countries almost since their beginnings.
(Benston, 1983)
Through the years, the reasons for government regulation o f banks has
expanded greatly. In this paper, we examine only those reasons related to
concern about the safety and soundness of banks and the banking system.1
Present reasons for such regulation include the following:
1. Concern for financial panics caused by bank failures. The series of
banking panics in the U.S. culminating with the financial debacle o f the
Great Depression of the early 1930s are put forth as disasters that can
be averted by means of bank regulation. Maintenance of public confi
dence in the banking payments system is a given as a collateral rationale
for bank regulation. (See Corrigan, 1982 and 1987B, for a current
explication of this reasoning.)
2. Prevention of disruptions to communities and costs imposed on other
banks (short of a full-blown financial panic) when a bank’s failure re
sults in runs on other banks. Again, the maintenance of public confi
dence is invoked, as when all the creditors of the Continental Illinois
Corporation were bailed out.
3. Protection of depositors. Deposit insurance has largely obviated this
concern, especially for holders of less than $100,000 per account in any
insured bank.
4. Fear that banks will take excessive risk because federal deposit insurance
and de facto guarantees remove all depositors’ concerns about the risks
taken. This moral hazard shifts the concern of the depositors to the
deposit insurance and chartering agencies.
5. Restriction of competition among banks and between banks and other
suppliers of financial and related services. The banking industry’s pro
fits are likely to be greater if they face less competition. However, laws
and regulations have also constrained banks from competing with other

FRB CHICAGO Staff Memoranda

institutions (e.g., securities dealers and insurance companies) and have
kept banks from efficiently diversifying their assets and liabilities.
Each of these five reasons for regulation are considered below. But first
we outline and discuss the types of risks to which banks are subject that
may result in their becoming insolvent.

Types of Banking Risk
The risks to which banks are subject can be grouped under the following
five headings:
1. System risk. Fractional reserve banking subjects banks to the risk that
base (high powered) money will decrease, thereby requiring a multiple
contraction of bank deposits and, consequently, the money supply. The
result is financial panic and decline in national economic activity.
2. Price risk. Prices for bank loans and securities that are not in default
may change adversely and unexpectedly, resulting in losses. Interest rate
and foreign exchange changes are the most important sources of unex
pected price changes and are sometimes referred to separately as “in
terest rate risk” and “foreign exchange risk” . Another form of price risk
occurs if assets have to be sold or funds obtained quickly to meet deposit
withdrawals, with insufficient time to search out the highest bidders or
lowest cost suppliers. As a result, the assets will have to be sold at
“ fire-sale’' prices, and the cost of funds will be higher than otherwise.
This type of price risk is often referred to as “liquidity risk” . However,
price risk does not include the risk that the general price level will
change unexpectedly. This risk is imposed by and/or can be controlled
by the central bank. (Schwartz, 1987A; Goodfriend and King, 1987)
3. Credit (default) risk. Borrowers may not repay their loans as promised
either in amount or on time, which can result in losses.
4. Fraud and operations risk. Banks may be fraudulently or incompetently
run, or bankers may undertake new or expanded operations that turn
out badly.
5. Regulatory risk. Laws and regulations designed to enhance bank prof
itability may change to the detriment of banks and/or may constrain
banks from increasing their earnings and diversifying their portfolios or
may subject them to additional expenses (e.g., overchartering is said to
have led to failures).
We now examine each of these risks.
Benston and Kaufman, 1986)

(Benston et al.. 1986, Chapter 1;

System risk. The Great Depression was accompanied by the most severe
collapse of the banking system in U.S. history. It resulted in the passage

IRB CHICAGO Staff Memoranda

of the Banking Act of 1933 (the Glass-Steagall Act), which imposed con
siderable additional restrictions on banks. These restrictions included:
a. prohibition of interest payments on demand deposits;
b. interest ceilings on time deposits (Regulation Q);
c. restrictions on new charters;
d. margin requirements on loans for the purchase of securities; and
e. separation of full commercial and investment banking. Federal deposit
insurance also was established in the form of the Federal Deposits In
surance Corporation (FDIC) for commercial and savings banks. (In
1934, the Federal Savings and Loan Insurance Corporation 0FSLIC—
was established to provide deposit insurance for savings and loan asso
ciations.) While not a restriction, per se, federal deposit insurance has
had far reaching consequences for risk taking, as we discuss further be
low.
These restrictions and deposit insurance have been justified as necessary to
prevent a future banking collapse. That the U.S. banking system was
devastated in the early 1930s is not questionable. The number o f com
mercial banks in operation dropped from more than 25,000 in 1929 to
14,000 in 1934. and all banks were closed completely for one week—and
some longer—as the first official act of newly inaugurated President
Franklin Roosevelt in March 1933. Public confidence in the banking sys
tem clearly was low, and drastic actions clearly were taken.
But now it is also clear that the collapse of the banking system was not
caused by excessive risks taken by banks of the type that the Banking Act
of 1933 was supposed to prevent or, at least, reduce. The evidence does
not support the belief that paying interest on demand deposits or higher
interest rates on time deposits forced or enticed banks into making more
risky investments. Indeed, banks that paid such interest had lower failure
rates than those that did not, perhaps because they could reduce their ex
penditures more quickly when their business contracted. (Benston, 1964;
Cox, 1964). Although it was charged by Senator Glass (co-author o f the
Banking Acts of 1932 and 1933 and principal author of the Federal Reserve
Act) and others that speculation by banks in securities was a major cause
of the collapse, in fact no bank that traded or held substantial amounts of
securities failed. (Benston, 1987) Further, securities speculation, which was
supposed to have been fueled by bank loans made to individuals and secu
rities dealers, was thought by Senator Glass and others to have been a cause
of the subsequent depression and financial collapse. However, few econo
mists believe that the 1929 securities price crash or the later collapse o f se
curities prices caused the Great Depression. Even fewer economists believe
that banks’ loans to investors and securities dealers caused or fueled a fi
nancial bubble that later burst. (Board of Governors of the Federal Re
serve System, 1984)

f RB CHICAGO Staff Memoranda

Rather, the banking collapse of the early 1930s was caused by a number
of forces, including the following three:
1. A one-third decline in the money supply, probably exacerbated by bank
failures and state-imposed bank holidays that encouraged people to
withdraw deposits and hold currency instead.
2. The hoarding o f gold that preceded the March 1933 bank holiday. Prior
to President Roosevelt’s taking office, those “in the know” assumed that
the dollar would be devalued in terms of gold. Thus, in the weeks before
his inauguration, there was a run on gold, which helped to create the
conditions for the President’s order for a bank holiday and exacerbated
the crisis. (Wigmore, 1987)
3. The unit banking system that hampered banks from diversifying ge
ographically and that encouraged—indeed, in states that suffered the
most failures, mandated —very small banks. Over ninety percent of the
3,500 banks that failed in 1930-31 had total deposits of less than $2
million (Benston, 1973). All but ten were unit banks. Geographical
concentration and small size also resulted in banks holding both loans
and deposits that were dependent on the economic well-being of a single
industry—timber, cotton, wheat and corn for banks in the farm states,
automobiles for the Detroit banks, and so forth. Hence, when these
crops and industries failed, the banks that served them also failed.
The general banking collapse and much if not all of the depression of the
1930s could have been prevented by the Federal Reserve. The Fed could
have stemmed the decline in the money supply with open market operations
and reductions in the required reserve ratio. Indeed, the central bank al
ways can offset a multiple contraction of the money supply. Hence, a fi
nancial panic and collapse of the banking system as a whole is entirely
preventable. Individual banks or groups of banks still might fail because
they made bad loans (as did Continental Illinois and Seafirst), hold insuf
ficiently diversified portfolios (as did many banks in the farm states in the
1920s and 1980s), maintain portfolios that are subject to the risk that in
terest rates could increase unexpected (as happened to the First
Pennsylvania Bank in the 1970s and to several thousand savings and loan
associations and savings banks in the early 1980s), be badly managed (as
was the case with the Franklin National Bank), or be defrauded (as oc
curred with the United States Bank of San Diego and the Butcher group
of banks in Tennessee). But none of these situations need start a chain re
action that affects other banks that are not directly subject to the same
shocks, thereby causing a systemic collapse. That can be both prevented
and caused by the central bank. (Schwartz, 1987A)
Price risk for banks is related primarily to the possibility that market rates
of interest will increase unexpectedly when they hold assets with longer
durations than liabilities. Banks that hold such portfolios will suffer capital
losses. This form of price risk is responsible for the official failure of at

f RB CHICAGO Staff Memoranda

least 200 savings and loan associations and savings banks, the unofficial
(when a merger was arranged to prevent liquidation or takeover by the
FSLIC ) failure of at least 300 additional associations since 1981, and the
temporary economic if not legal failure of the majority o f the thrift industry
in the early 1980s. (Benston, 1985B; Kane, 1985). However, neither gen
erally accepted accounting principles (G A A P ) nor regulatory accounting
principles (RAP) recognize the loss until it is realized, usually when the as
sets are sold. Hence, a bank that became economically insolvent as a con
sequence of higher market rates o f interest may nevertheless appear to be
solvent in terms o f book value and can continue operations (if allowed by
the authorities to do so), since federal deposit insurance permits it to con
tinue bidding for deposits and pay its bills when they come due. This was
true for the large majority of thrift institutions in the early 1980s. While
most of these thrifts may not have realized the risk inherent in holding
duration-unbalanced portfolios (fixed-interest long-term mortgage loans
funded with short-term liabilities), some appeared to have gambled that
interest rates would decrease.
Foreign exchange risk is another form of price risk. Banks can hold un
covered positions in foreign currencies and contracts that can result in their
taking considerable losses when exchange rates change unexpectedly. Such
was the case with Franklin National Bank, although it appears that the
failure of the bank was due primarily to operational incompetence and
fraud. (See Rose, 1974)
Interest rate futures contracts and options also may subject a bank to price
risk. While these financial instruments are most frequently used to reduce
interest rate risk when a bank holds an otherwise duration-unbalanced
portfolio, they also can be used as a means of gambling on a change in in
terest rates. The potential loss can be great since futures and options can
be highly levered obligations.
Savings and loan associations and savings banks may hold equities in
companies and real estate. Changes in the prices of these assets may result
in losses as well as gains. Thus far, however, there is no evidence that these
investments are important causes of failure. To the contrary, for many
savings and loan associations, investments in these assets have tended to
reduce the variance of their cash flows, while increasing their returns.
(Benston, 1985B)
Finally, a solvent bank that uninsured depositors believe to be insolvent
may suffer a precipitous outflow o f funds—a run.
As a result, the bank
may have to sell assets quickly at fire sale prices or borrow at higher than
expected rates. This form of price risk from insufficient time to search out
the highest bidder for assets or lowest cost supplier of funds often is called
‘liquidity risk” .

FRB CH ICAGO Staff Memoranda

Credit or default risk has always been an important cause of bank
insolvencies. As was discussed above, banks that lend to customers who
experience severe economic problems, such as those that have served
farmers, energy producers, and in recent years, experience credit losses.
Credit risk is a particularly important source of losses in periods of rapid
decelerations in the rate of inflation and of actual decreases in the general
price level. (Schwartz, 1987A) The major problems suffered by the Con
tinental Illinois, Seafirst, and Bank of America, to name but a few,
stemmed primarily from their having made loans to borrowers who could
not repay them. Risk of default by foreign borrowers, including foreign
governments, is referred to as “country risk" and, if the default is primarily
for political considerations, as “political risk’’ . Credit risk is. or should be,
the primary risk to which banks are subject, because the primary product
of most banks, other than fund transfer, is the estimation and monitoring
of credit quality.
Indeed, bank supervisors have directed their efforts
largely to estimating the credit risk to which banks are subject.
Fraud and operations risk are considered together because they both in
volve the way in which a bank is run and the extent to which the operations
of its employees, particularly its senior managers, are monitored and con
trolled. Fraud is by far the more serious risk, since it often results in very
large and very sudden losses. It also has been and is likely to continue to
be an important source of insolvencies. A recent Congressional study
concluded that fraud and other misconduct were the leading causes of fail
ure among the thirty SLAs in California that failed between 1983 and 1986.
(Yang, 1987) These failures cost the FSLIC almost $6 billion.
Operations risk, ranging from bad decisions to poor management to just a
run of bad luck, also can be very important, particularly when poor man
agement makes fraud and credit risks more likely to occur. The most recent
examples are the failures of Continental Illinois and Seafirst. The purchase
by these banks of billions of dollars of loans from the Penn Square Bank
which, when made, were unlikely to be repaid, imposed such large losses
on these major banks that they became insolvent. The banking officers
who purchased the loans accepted risks that, ex ante, should have been seen
as unacceptable, net expected loss situations. (Zweig, 1985; Singer, 1985)
Apparently they made these loans because of a combination of incompe
tence, reward structures that emphasized growth, inadequate credit controls
that permitted loans to be made without independent review, and (possibly)
dishonesty.
Operations risk, as such, appears responsible for some important failures.
The Bank of United States, whose failure in 1930 was believed to have
shaken public confidence in banks as it appeared to be an “official"
government-related bank (Friedman and Schwartz, 1963), became insolvent

FRB CHICAGO Staff Memoranda

because its owners expanded by purchasing other banks at very high prices.
The required payments drained the bank of resources, which the bank’s
owners (who ran the bank) covered up with false accounting, and the
shifting of bad loans and real estate investments to affiliates. Franklin
National Bank’s rapid expansion from Long Island to New York City, in
the process of which it incurred bad loans, has been cited as the major
factor leading to its failure. (Rose, 1974) It is not clear to what extent the
Bank of America’s problems stem from credit risk or from poorly con
ducted lending and other operations. Nor is it clear whether the failure of
Penn Square Bank is due to exceptionally poor lending, badly controlled
lending, deliberate risk taking, or fraud.
Regulatory risk includes both unexpected changes in regulations and laws
that reduce banks’ profits and constraints that prevent banks from operat
ing efficiently and safely. Unexpected regulatory changes may cause the
termination or substantial modification of ongoing activities with resulting
operating losses. Legally imposed constraints that increase the riskiness of
banking operations and portfolios are legion.
These include such re
strictions as not permitting banks to offer the public a full range of securi
ties underwriting and trading as well as discount brokerage, insurance
products, and branching prohibitions that limit geographical diversifica
tion. Initially, ceilings on interest rates that could be paid explicitly on
deposits (zero for demand deposits and Regulation Q ceilings for time and
savings deposits) benefitted banks, but later prevented them from adjusting
efficiently to market conditions.
Interrelationships among the risks. With the exception of extreme system
and regulatory risk, banks can manage the risks they face. Interest-rate
(price) risk can be reduced or even eliminated if duration-balanced portfo
lios were held, or either the spot or futures markets were used to hedge
against market-rate changes. Similarly, foreign exchange risk need not be
taken. Liquidity risk can be reduced when readily-marketable assets, such
as U.S. Treasury bills, are held, and when banks conduct their affairs so
as to reduce the probability that uninsured depositors will withdraw their
funds precipitously (run). Credit risk can be reduced to an amount that
does not deplete equity capital by means of more effective loan evaluation,
monitoring, and collection procedures and by banks holding diversified
portfolios that reduce the amount of loss that might be incurred from un
expected repayment problems. Controls and independent auditing can re
duce the probability that fraud and losses from operations will result in
large losses. The optimal trade-off between expenditures on risk reduction
and the losses that otherwise would be incurred depends on the circum
stances facing a particular bank, the propensity of its managers to take risks
in exchange for higher returns, and the managers’ competence.

i RB CHICAGO Stafi Memoranda

II. Evaluation o f the Present Reasons for
Regulating D epository Institutions
1. Financial Panics and Payments System Risk

The analysis presented above leads to the conclusion that banking regu
lation does little to decrease either the probability or the severity of a sys
tem collapse in terms of problems of individual banks progressively spilling
over to other banks not directly subject to the same problems. But laws
and regulations that keep banks from optimally diversifying their portfolios
can make a system collapse more severe and, in the absence of appropriate
action by the Federal Reserve, more likely. Such laws include restrictions
on intra- and inter-state branching, restrictions on the assets and liabilities
that banks can hold (e.g., the Glass-Steagall A ct’s separation of full in
vestment and commercial banking), and the inducements for savings and
loan associations and savings banks to hold duration-unbalanced portfo
lios.
Furthermore, there is no reason for the authorities to be concerned with
maintaining the public’s confidence in the payments or banking system.
Given trust in federal deposit insurance, depositors with less than $100,000
in any one insured account have no reason to be concerned about bank
failures. Such, indeed, has been the situation with all the post-Great D e
pression failures. Few, if any, depositors with over $100,000 in an account
would keep their funds in currency. Rather, if they feared the failure of
their bank(s) and believed that their funds were at risk, they would rede
posit those funds in one or more other banks believed to be safe or they
would purchase safe, e.g., U.S Treasury, securities. In the latter situation,
the seller o f the securities is likely to deposit the funds in a bank. Why else
would he or she have sold the safe security? In either event, the funds
would not leave the banking system and there would not be a systemic
collapse. Only if depositors lost faith in all 14,000-odd commercial banks
in the entire country and ran to convert deposits into currency would there
be a reduction in total bank reserves and the possibility o f a multiple con
traction in aggregate money and credit that could adversely affect national
economic activity. But this has occurred only rarely in U.S. history, even
before federal deposit insurance in 1934, and never since, even after the
well-publicized failures of recent years. Moreover, even if the funds were
kept in currency, the Federal Reserve can offset the reduction in base
money with open market operations, and/or through the discount window,
thereby preventing the money supply from contracting. (Kaufman, 1985A;
Benston et al., 1986, Chapter 2; Goodfriend and King, 1987)
Nor is there reason to believe that bank regulation is the best, or even an
effective, way to prevent a bank failure that would impose costs on the

FRB CH ICAGO Staff Memoranda

payments system by reducing its efficiency. (Huertas, 1986; Flannery, 1987)
It is true that the mechanism might be disrupted were a major bank to fail
before claims on it had cleared as some transactions would have to be re
versed. (Volcker, 1986A; Humphrey, 1987) But if this is considered to be
a serious problem, fairly stringent capital requirements should be imposed
on all banks that have access to the system. Furthermore, the threat o f a
bank failure from problems in the payments system could be mitigated were
the Fed to restrict or prohibit daylight overdrafts. An even simpler and
perhaps even more effective procedure would be for the Fed to charge
banks for daylight overdrafts. The result might be similar to that which
resulted from the Fed’s charging for float—the amount outstanding declined
from some $7,000 million per day to $800 million. (See Goodfriend and
King, 1987) The Fed could also consider removing its guarantee on each
item entering the clearing process, since this reduces the incentive for banks
to carry sufficient clearing balances and capital.
And more attention
should be paid to the consequence o f a computer breakdown, as occurred
to the Bank of New York. (Volcker, 1986B)
2. Disruptions o f Bank Failures to Communities and Costs
Imposed on Other Banks

Concern that individual bank failures are especially costly is based on a
belief that one or more of the following occurs: (1) failed banks are liqui
dated and disappear; (2) bank services are unique and even a brief inter
ruption is exceptionally harmful to the community; and (3) the failure o f
one bank can set in motion a domino effect resulting in the failure o f a large
number of other banks and disruption of the payments system, that is, a
systemic collapse. (Corrigan, 1982, 1987; Volcker, 1986A) The weight o f
available experience suggests that none of these fears is justified. Failed
banks generally do not disappear physically, leaving a “hole in the
ground” and the community without any banking services whatsoever.
Generally, only smaller failed companies are liquidated, be they banks or
other type of firms. The others are recapitalized, merged, or sold, although
some time in bankruptcy may be required to work out a least-cost solution
for larger institutions. Recent proposals, some already implemented, for
the F D IC to establish “bridge” or “trusteeship” banks would provide the
necessary time for these banks. The Federal Home Loan Bank Board now
operates failed larger savings and loan associations under a management
consignment program until they can be sold or privately recapitalized effi
ciently.
Nor is a bank failure likely to produce more harm in a community than the
failure of any private firm of comparable size. Like any private firm, a
bank fails economically when the market value o f its assets declines below
that of its liabilities. (Market values are present values that take into ac
count the market’s current expectations of future conditions.) A t that

FRB CH ICAG O Staff Memoranda

point, the bank would not be able to meet all of its liabilities in full and
on time unless conditions change unexpectedly for the better. If the bank
were legally declared insolvent exactly at the time it became economically
insolvent and ownership were transferred to the creditors, the only loss
would be to the shareholders, who would lose the value of their invest
ments.
But banks are generally not declared legally insolvent at the time that they
become economically insolvent. Nor can a bank be forced into insolvency
by the actions of its creditors, as can other firms. Rather, a bank is de
clared insolvent by the appropriate regulatory agency, generally the char
tering agency, when the value of its assets by whatever accounting standard
applied by the agency, usually generally accepted accounting principles or
regulatory accounting principles, declines below the value of its liabilities.
(Symons and White, 1984) Because, as already noted, these accounting
practices generally do not recognize losses until there is a missed cash pay
ment nor mark assets down until they are sold and regulators are frequently
reluctant to declare banks insolvent because such actions are popularly
viewed as a black mark on their record, legal failure is likely to lag eco
nomic failure.
As a result, losses may accrue to creditors, including
uninsured depositors and the federal deposit insurance agency, in addition
to shareholders. Indeed, as will be argued later, the sooner an institution
is declared legally insolvent after it becomes economically insolvent, the
smaller any losses are likely to be.
Furthermore, the sooner an economically insolvent bank is declared legally
insolvent and reorganized, the more fairly will all uninsured depositors be
treated. Until such a declaration is made, some depositors will be able to
withdraw their funds in full, thus increasing the loss to the remaining
depositors. This violates rules of equity and is a reason for the bankruptcy
process for nonbank firms.
Unless creditors operate under illusions or are unaware of the true financial
condition of the bank, as would happen when there was undetected fraud,
they will alter their market behavior when the losses actually occur, rather
than when they are recognized. As a result, the adverse impact of the fail
ure on the spending behavior of depositors is likely to occur before the
failure is legally recognized. To the extent that creditor losses accrue only
to the deposit insurance agency, either because the bank is small or because
the insurance agency de facto guarantees all deposits, the immediate ad
verse impact is spread throughout the country rather than in the local
community.
Other than through causing a currency run on all banks that is not offset
by reserve injections by the Federal Reserve, as was discussed in the previ
ous section, a bank failure may spread to other banks if the failed bank

FRB CHICAGO Staff Memoranda

owed funds to other banks and the losses realized were greater than the
capital of some or all of these other banks. A bank can owe funds to other
banks because it borrowed Fed funds from them, held their corresponding
balances, or incurred daylight overdrafts in the funds clearing process. But
the losses to these other banks are unlikely to be equal to the size of their
credits. Rather, they will be equal to the pro rata share of the failed bank’s
loss. Except for instances of massive fraud, for commercial banks this is
likely to be only a few cents on the dollar by the time a bank is declared
insolvent. For savings and loan associations, the losses have been greater
in recent years as a result of both massive fraud and long delayed declara
tions of legal insolvency, but these institutions rarely are greatly indebted
to other private financial institutions. In any event, if the creditor banks
follow usual practices of diversification, their losses should amount to only
a small fraction of their capital, regardless of the size of the failed bank.
The failure of the Continental Illinois Bank in 1984 illustrates this clearly.
The bank was not only was one of the largest banks in the country, but also
was one of the very largest correspondent banks. A t the time it failed, al
most 200 banks had correspondent balances at the Continental in amounts
greater than 50 percent of their capital; 66 of these banks had balances
greater than their total capital. Economic, although not realized, losses to
Continental creditors totalled only about two or three cents on the dollar.
Even if these losses had been as large as 10 percent, none of the banks
would have suffered a loss in excess of their capital and only two would
have suffered a loss between 50 and 100 percent of their capital. (Kaufman,
1985 A; House Banking Committee; 1984) Thus, even in the absence o f the
full F D IC guarantee, the impact of the Continental failure would not have
spread to its correspondent banks.
The larger the failed bank, the larger the expected number of creditor banks
and the expected absolute dollar amount of losses (although not the relative
amount). Large bank failures may require a longer time to work out and
untangle, but, as noted earlier, the means to provide this have been devel
oped and can be quickly put in place, e.g., bridge banks, conservatorships,
and trusteeships, so as to minimize adverse impacts. These procedures ap
ply equally well to defaults on daylight overdrafts as to defaults on Fed
funds and correspondent balances.
Nor would the failure of a large bank be likely to spill over or contaminate
other banks not subject to the same problems and lead to a reduction in
aggregate bank deposits and the money supply. As noted earlier, when
depositors flee banks that they believe to be insolvent, they are most likely
to redeposit directly at another bank or to purchase default-free securities,
which will result in an indirect redeposit. Thus, a large bank failure may
reshuffle funds among banks, but is unlikely to result in a loss of reserves
to the banking system.

f RB CHICAGO Staff Memoranda

The same outcome holds even if the deposits are transferred to banks out
side the United States, as occurred at the time of the Continental Bank
crisis. If this happens, there is an increase in foreign ownership of deposits
at U.S. banks, but the total amount of deposits and reserves in the U.S.
banking system remains unchanged. Only if currency is shipped abroad
would reserves and deposits at U.S. banks be reduced. (Kaufman, 1985A)
This is not to argue that runs on individual banks, in particular on large
banks, will not cause disturbances that are felt by other banks and possibly
by the economy as a whole. In addition to the shifting of deposits out of
the actual or perceived insolvent bank, the run may cause depositors at
other banks to scrutinize their banks more carefully and to transfer some
or all of their deposits to other banks. Thus, there may be churning of
deposits among banks. Because adjustments do not occur instantaneously
and transactions are not costless, such deposit churning may increase in
terest rate volatility and affect the market values of a wide range of assets.
These effects may increase uncertainty and thereby possibly increase the
overall level o f interest rates, if market participants require a higher uncer
tainty premium. Moreover, if the deposits are transferred overseas, the
churning may affect exchange rates. These changes may dampen levels of
real aggregate economic activity and welfare. The larger the banks in
volved, the larger such adverse impacts are likely to be. But these effects
are likely to be only temporary and not very costly to other banks or the
community. Indeed, these costs may be less to society than the costs that
would be incurred were banks shielded from the disciplinary effects of
depositor scrutiny.
The adverse economic impact on a community of a failed bank may rea
sonably be expected to be greatest if the bank were the only one in the area.
A recent article in the Am erican B an ker analyzed anecdotally the effects on
communities in the midwest of the closing of their only banks (Bennet,
1986). According to the author, these communities generally were very
small towns with populations under 300, too small to support another in
dependent bank or even a branch of a distant bank. Though the only
bank’s departure was an inconvenience and led to reductions in revenues
and even to the closings of some neighboring business firms, generally retail
shops, these effects are little different from the repercussions following the
loss o f a community’s only movie theater, department store, or supermar
ket.
But even liquidations rarely leave a community without reasonable banking
alternatives. For example, between 1927 and mid-1932, near the height in
the decline in the number of banks, less than four percent of the more than
10,000 cities in the United States with populations of 1,000 persons or more
lost their only commercial bank, and less than two percent of the nearly

/ RB CH ICAGO Staff Memoranda

1,000 cities with populations of 10,000 or more. (Kaufman, 1986B) In
more recent times, the number of savings and loan associations has declined
by almost 50 percent from 6,200 to 3,200 in the 20 years between 1965 and
1985 and by 30 percent in the five years since 1980 alone. This is not much
less than the decline in the number o f commercial banks in the 1920-1933
period. Yet, there has been no major outcry by consumers about a loss o f
services. In large part, this may be explained by a sharp increase in the
number of branches so that the total number of savings and loan associ
ation offices more than doubled from 9,200 to 20,300 between 1965 and
1985 and declined by less than 1,000 between 1980 and 1985.
Thus, bank failures generally do not leave communities without banking
facilities. Rather, customers are likely to face banks under different man
agements and ownerships. This may cause some hardships, but these
should not be overly severe. Deposit customers will be affected only to the
extent that the new bank charges different service fees and pays different
deposit rates. These changes are as likely to be favorable to the customers
as unfavorable. The hardships may be more substantial for loan customers.
The new banks could have different loan standards and loan officers, and
long-standing bank-customer relationships may have to be reestablished.
But it is unlikely that changes in bank management will result in changes
of all or even most loan officers so that the continuity of the personal re
lationship may well be unaffected. Indeed, strong bank-customer relation
ships are valuable intangible assets that are readily marketable to other
banks. If a bank failed because of poor loans, it may be possible that new
banks will be reluctant to assume the failed bank’s commitments not in
default because of distrust of its credit judgment and/or probity. But,
rather than reject all commitments, it is the acquiring bank that will benefit
from screening the failed bank’s loan portfolio and assuming those loans
that are consistent with its own lending standards. Thus, those loan cus
tomers who are inconvenienced are likely to be those who should not have
been granted bank loans to begin with.
Furthermore, the services offered by individual banks or even all banks are
no longer unique. Recent dramatic advances in computer and telecommu
nications technology effectively permit anyone with a large computer sys
tem to offer similar services almost anywhere on short notice. In addition,
different types of chartered financial institutions have been permitted to
offer services previously restricted to only one type o f institution. Surveys
report that hardly any household now uses only one financial institution,
fully 60 percent use three or more, and more than 50 percent o f small
business firms use two or more. (Whitehead, 1982, and Bennett, V., 1984)
Larger firms may reasonably be expected to use a larger number o f sup
pliers. Thus, failure and even liquidation of a bank is highly unlikely to
leave many customers stranded.2

FRB CH ICAG O Staff Memoranda

A recent study of bank failures in rural counties in Kansas and Nebraska
between 1977 and 1984 tests the hypothesis that commercial bank failures
have adverse effects on economic activity in their local communities. The
authors conclude that “ the weight of the evidence ... is consistent with the
hypothesis that bank failures do not cause subsequent declines in economic
activity in the communities where banks fail.” (Gilbert and Kochin, 1987)
The relatively small impact of bank failures may be attributed to the fact
that, except for massive fraud, losses to uninsured depositors at failed banks
are relatively small if the failures are resolved quickly after the economic
value of net worth touches zero. Thus, the communities’ wealth is not re
duced greatly, if at all. As noted above, even in the case of the Continental
Illinois Bank, it was unlikely that losses to uninsured depositors would have
been much more than two or three percent of their deposits.
As discussed earlier, the presence of federal deposit insurance, per se, has
all but entirely eliminated the threat of nationwide bank failure contagion
and multiple contractions in money and credit. Except for errors in public
policy, bank runs will not drive an economically solvent bank into equilib
rium insolvency nor spread to innocent banks.
It is important to note that bank failures generally yield benefits that more
than offset the relatively small costs incurred. If insolvent institutions were
permitted to continue without being reorganized or closed, there is reason
to believe that resources will be wasted, particularly if the insolvency oc
curred because managers or owners were incompetent or dishonest. Even
if the managers and owners were simply unlucky and the failure was at
tributable primarily to external events, they would still have considerable
incentives to take excessive risks in the hope of recovering their losses.
Recent analyses of economically insolvent but still operating banks support
this observation. The U.S. General Accounting Office found that only a
small minority of the savings and loan associations that were G A A P insol
vent in 1982 recovered by 1986 and that the aggregate dollar losses of the
others were many times greater than the earnings of the institutions that
were restored to health. (U.S. General Accounting Office, 1987A and B)
A study of some 550 serious problem commercial banks (C A M E L rating
of 4 or 5) in the Tenth Federal Reserve District between 1980 and 1986
found that by the first quarter of 1987 less than 10 percent had recovered
and gained a C A M E L rating of 1 or 2, while more than one-quarter had
failed and one-half remained serious problems (Huyser, 1987). The costs
of this risk taking are borne by the solvent banks that pay premiums to the
deposit insurance agencies; by the taxpayer, if losses exceed the agencies'
resources; and by uninsured depositors, if the losses are larger than the
banks’ net worth positions and are not covered by the deposit insurance
agencies.

FRB CHICAGO Staff Memoranda

The greatest benefit from failure, though, is its effect on reducing ex-ante
risk taking by bankers. The fear that they might fail and lose their invest
ment and/or employment should they take excessive risks should reduce the
banks’ incentives to take such risks. Similarly, bank runs may not be costly
on balance. Concern that depositors might remove their deposits were a
bank operated in a risky manner would provide bankers with incentives to
conduct their affairs so as to give depositors no reason to run. Rather than
something to be avoided at all cost, runs or even the threat of runs should
be seen as a desirable form of market discipline. The evidence clearly sug
gests that runs are primarily caused by bank insolvencies than a cause of
the insolvencies. (Kaufman, 1987C)
3.

Protection o f Depositors

A major reason for banking supervision in most countries is protection of
depositors from the loss of their investments. As noted above, the estab
lishment of federal deposit insurance has effectively eliminated this concern
for people with less than $100,000 in an account at an insured bank.
Considerably greater deposits can be insured by depositors by maintaining
their accounts in more than one bank. Indeed, the present availability of
computers and telecommunications makes it relatively inexpensive for al
most all household depositors and smaller business depositors to insure
from loss as much as they wish. Furthermore, depositors in very large
banks have some reason to believe that they will not absorb losses should
these banks fail. They can recall that all creditors of the Continental
Illinois Corporation, including nondepositors, were protected from loss by
the FD IC. However, uninsured depositors in smaller banks have reason to
be concerned, particularly where the banks failed because of fraud or gross
mismanagement, as was the situation with the Butcher banks, the Penn
Square Bank of Oklahoma City, and a number of smaller banks in recent
years.
But protecting depositors from loss carries costs as well as benefits. D e
posit insurance changes the incentives facing insured depositors so as to
increase the risks that banks are likely to take. (Kane, 1985) Insurance of
any type makes people somewhat less careful because the costs or penalties
from loss are perceived to be less than if there were no insurance. For
banks, deposit insurance removes the need for depositors to evaluate and
monitor the financial integrity of their banks, at least up to the de jure
maximum amount of the insurance coverage. This removes depositors as
a reliable source of market discipline. Because advances in computer and
telecommunication technology have reduced the cost of transferring funds
across distances almost to zero, risk-prone banks can now attract almost
unlimited funds almost overnight from throughout the country without
depositor concern, at least from those depositors who do not mind keeping
their balances in any one bank below $100,000, by offering a sufficiently

IRB CH ICAGO Staff Memoranda

higher rate than their competitors. As is evident from the recent experience
of thrift institutions, the fact that a bank is economically insolvent has little
effect on its ability to obtain funds. In addition, the continued solvency
of other banks is endangered to the extent that the higher deposit rate paid
by insolvent banks causes their solvent competitors to increase their rates.
(It should be noted that because banks that want to attract large amounts
of deposits quickly must publicize their rates, the bank regulatory agencies
should have little difficulty in identifying the potential problem cases.)
4.

Fear o f Excessive Risk Taking by Banks Because o f Deposit Insurance

Combined with the Federal Reserve discount window, federal deposit in
surance provides a “safety net” for banks, particularly when regulators are
reluctant to reorganize promptly economically insolvent banks. Both the
ory and evidence on safety nets in other activities indicate that they tempt
participants to increase the risk exposure they are willing to assume.
(Kaufman, I987E) Thus, highway engineers know that the presence of
guard rails causes automobile drivers to drive faster on mountain passes
(consequently, they omit such rails on the most dangerous passes), and
high-wire trapeze artists know that they will attempt maneuvers with a net
below them that they would not try without a net. So it also is with banks.
As noted, deposit insurance shifts the concern about how banks are oper
ated largely from depositors to the deposit insurance agencies. But, unlike
private insurance companies, the premiums charged and coverage offered
by the federal deposit insurance agencies are inefficient and inequitable in
several regards. First and foremost, the premiums charged are not related
to the risk assumed by the insured banks. Thus, banks are encouraged to
pursue riskier ventures as their cost of insured deposit funds is not likely to
rise proportionately to the expected increase in their revenues they can
expect to earn a higher risk-adjusted return than otherwise.
Second, the premium is not charged against all deposits de facto insured.
The fiat fee is instead imposed on all domestic deposits at insured banks
and not charged for the deposits of foreigners in domestic branches or all
deposits in foreign branches. Furthermore, very large banks are frequently
thought to be 100 percent de facto insured both domestically and overseas.
Thus banks having the same risk exposure but different deposit character
istics are not charged the same. The generally small banks and thrifts that
hold deposit balances under $100,000 per account pay premiums on the
amounts insured, the international, generally very large, banks underpay,
ceteris paribus, and the medium sized banks with accounts over $100,000
tend to overpay.
In the absence of explicit risk-related premiums, bank risk taking has been
“controlled” by the authorities in four ways. First, banks' operations are

IKB CH ICAG O Stait Memoranda

monitored by field examinations. Particular emphasis is placed on their
portfolio o f loans, and, since the massive failure of savings and loan asso
ciations in the 1980s, on the banks’ exposure to interest rate risk. Second,
banks are closely supervised. They must obtain permission to engage in
many operating activities, including such ordinary events as the opening
and closing of branches. Third, banks are prohibited from engaging in
many activities, including some investment activities, and from holding
specified assets on the grounds that this would reduce the risks in which
they could engage. Fourth, formal entry into banking is restrained, in part
based on the belief that overbanking and competition among banks led to
financial weakness and failures.
These methods o f control have been only partially successful, at best, in
controlling risk, and have entailed considerable costs. Field examinations
have often proved to be ineffective in keeping banks from undertaking ex
cessively risky or fraudulent activities. For example, the Penn Square Bank
was not closed by the authorities until after it had sold over $2 billion in
largely uncollectible loans to other banks, two of which—Seattle First and
Continental—absorbed hundreds o f millions of dollars in losses, resulting
in their economic failures. Many important frauds were not discovered
until after the banks had been substantially looted. The extent to which
savings and loan associations have been booking ex-ante highly risky and
even fraudulent loans in recent years and imposing millions of dollars of
losses on the F S L IC appears to be little affected by examination and
supervision by the Federal Home Loan Bank. While field examinations
have not been useless, there is reason to question their effectiveness in
controlling excessive risk taking by banks. (Benston, 1973; Benston et al..
1986, Chapter 12)
Supervision also has limited effectiveness. The preceding analysis o f the
risks faced by banks led to the conclusion that the optimal tradeoffs be
tween risks and returns is complex and subject to change. Hence, it is
doubtful that banking supervisors could determine which mix o f assets, li
abilities, and operations at each bank would reduce risk to an acceptable,
if not an optimal, level. For example, the authorities might determine that
particular assets, such as equities or real estate, may individually have a
higher expected loss potential than loans, and hence not permit banks to
hold the asset. But when the prohibited asset is held in a portfolio with
permitted assets, the total loss potential could be reduced if the cash flows
from the assets were imperfectly correlated.
Restraints on entry into banking and on competition among banks, e.g.,
Regulation Q and the prohibition o f interest on demand deposits, may have
reduced failures, but the cost in terms o f lost interest income to the public
is likely through time to have been greater than the benefit. In addition,
over time, such restraints tend to reduce the efficiency with which banks

FRB CH ICAG O Staff Memoranda

are operated, constrain innovation, and increase prices paid by consumers.
Furthermore, presently available technology and alternatives developed by
suppliers of financial service that are outside the authority of the bank
regulators, such as money market mutual funds and cash management ac
counts, have made many such constraints largely ineffective. But many of
the inefficiencies spawned by the constraints, such as branches built to offer
depositors convenience rather than higher interest, are difficult to eliminate
quickly. Hence, enhancing solvency among banks by imposing such con
straints is counterproductive in the longer-run.
Finally, while some of the restraints on banks1 investment activities appear
to have been useful for increasing solvency, others have been harmful.
Among the useful constraints are limitations on the magnitude of loans that
can be made to officers, directors, stockholders, and other insiders, and on
loans made to individual and related borrowers. The former limitations
reduce the opportunities for fraud and self-dealing, while the latter enforce
some degree of diversification. Both types of limitations have been found
to be desirable in most times and countries. But evidence suggests that
many of the statutes and regulations that constrain banks from engaging
in specified activities and from holding a full range of assets are designed
as much, if not more, to restrain them from competing with alternative
suppliers of services than to keep them from taking excessive risks.
5.

Restrictions on Competition

Many laws and regulations are designed to restrain competition among
banks and between banks and other suppliers of financial services. These
laws include state restraints on branching and federal submission to state
options that have, until very recently, prohibited full service interstate
banking and still prohibit interstate branching. The Glass-Steagall Act
prevents banks from competing directly with full-service securities dealers.
Both federal and state regulations prevent most commercial banks from
offering a full range of insurance products to their customers. The Bank
Holding Company Act restricts bank affiliates to a subset of financial ac
tivities and prohibits them altogether from nonfinancial activities. While
in effect. Regulation Q was used to limit competition among banks and
thrifts for savings and time deposits. Likewise, the prohibition of interest
payments on demand deposits has limited competition among correspond
ent banks for the deposits of respondents, and, among all banks, for
checking accounts. While such laws often are supported as limiting risk
taking by banks, they actually serve to constrain competition to the detri
ment of consumers.

RB CH ICAGO Staff Memoranda

Conclusions
The analysis presented above leads us to conclude that the principal ongo
ing reasons for regulating depository institutions are limitations on avoid
ance of the disruption that a bank failure is presumed to cause, particularly
when it is a very large bank that fails, including potential losses to the de
posit insurance funds, and limitations on competition. We have argued
that neither the fear of local or national contagion nor the restriction on
competition rationales appear to be warranted or in the public interest.
But more importantly, the system now is not working!
The increased level and volatility in prices and interest rates since the late
1960s, in large measure the result of poor macro-stabilization policies,
greatly weakened the financial strength of depository institutions and, in
more recent years, led to a sharp increase in the number o f economic
insolvencies (Schwartz, 1987A). The impact of adverse economic and fi
nancial factors on banks was magnified by regulations that restricted their
ability to diversify both across product lines (e.g., savings and loan associ
ations that were limited to fixed-rate residential mortgages), and across ge
ographical markets (e.g., unit banking limited some banks to lending in
agricultural and energy areas). A t the same time, dramatic advances in
computer and telecommunications technology that made it possible to
transfer funds across greater distances quickly and cheaply permanently
undermined the regulations protecting one institution’s or one sector’s turf
from intrusion by others. In addition, increased levels of deposit insurance
from $40,000 to $100,000 per account in 1980 severely reduced market
discipline.
In combination, these forces overwhelmed the ability of the regulations to
control either intentional or unintentional risk taking by banks and bank
rupted the F S L IC and greatly weakened the solvency of the FD IC . The
cost of these failed policies is estimated to be in excess of $40 billion, a cost
that is far beyond the current resources of the deposit insurance agencies
and most of which must ultimately be borne by the taxpayer Moreover, the
system is nearly out of control and is generating additional large losses
daily, even in an environment of stable or declining interest rates.3 Losses
promise to be even more substantial if interest rates were to rise signif
icantly. It is evident that the regulatory structure requires a major overhaul
as soon as possible.

II. Proposals for Changing the Present Bank
R egulatory System
In this section, we enumerate and evaluate the costs and benefits o f the
more credible, market-oriented proposals that have been suggested for in-

tKB CH ICAGO Staff Memoranda

creasing both the safety and efficiency of the banking system. These in
clude: (1) abolition of federal deposit insurance, (2) reform of federal
deposit insurance coverage and premium charges, (3) risk-related capital
requirements, (4) the narrow bank proposal, and (5) reorganization of
banks before their economic capital becomes negative. Several of these
proposals are not mutually exclusive.
1. Abolition o f Federal Deposit Insurance

Because the current structure of federal deposit insurance is frequently
identified as the major cause of the increased instability in the banking
system, since it encourages increased risk taking, elimination of federal de
posit insurance has been proposed. (Ely, 1985, England, 1985) In a world
without federal deposit insurance, banks would be subject to considerably
greater market discipline from all depositors, shareholders, and private in
surance companies, if they chose to insure their deposits. As a result, banks
are likely to assume less portfolio risk and maintain higher capital-to-asset
ratios. (England, 1987; Dowd, 1987A and 1987B) In effect, this would be
a return to the pre-FDIC period.
The proponents of this proposal argue that none of the major reasons for
introducing federal deposit insurance in 1933 remain valid today. These
include protection against a collapse of the money supply and payments
system, protection of small depositors, and protection of unit banking. As
already discussed, with the exception of a few periods, bank failures were
neither very frequent nor ignited the failure of other banks or an economic
downturn either locally or nationally. Runs on individual banks resulted
primarily in redeposits at other banks and bank failures did not either per
manently reduce the supply of banking services to a community or depress
the local economy more than the failure of any other firm of comparable
size.
The few periods in which bank failures did contribute importantly to na
tional financial and economic instability were characterized by a loss of
confidence in all banks and attempts to convert bank deposits into cur
rency. Thus, reserves were drained from the banking system, and causing
multiple contractions in money and credit. But, with the exception of the
1929-1933 period, the adverse impacts were short-lived. The banks acted
in common, generally through the major clearing houses and temporary
suspensions of convertability of deposits into currency, to provide time for
the orderly sale of assets and the restoration of depositor confidence. But
dissatisfaction with the ad hoc and questionable legality of these actions
resulted in the establishment of the Federal Reserve System in 1913 to
protect against reductions in aggregate bank reserves. (Timberlake, 1984;
Gorton, 1985)

f KB CH ICAGO Staff Memoranda

Unfortunately, for whatever reasons, the Federal Reserve did not offset the
currency drain in 1929-1933 and the private structure was not permitted to
act as before. The results were disastrous, but unique to that period. The
crisis led to a loss o f faith in the Federal Reserve System’s ability to per
form its lender o f last resort function appropriately and to the establish
ment o f the F D IC and F S L IC as supplements, if not replacements.
Later evidence has demonstrated clearly that the Federal Reserve could
have then and can now offset any reserve drain through open market op
erations and/or the discount window. (Schwartz, 1987A and King and
Goodfriend, 1987) If it had done so in 1929-1933, federal deposit insurance
would not have been enacted. Proponents of eliminating federal deposit
insurance believe that the Federal Reserve has learned its lesson and can
be counted upon to operate rationally in the future. Any perceived sup
plementary need for deposit insurance would be fulfilled either by private
insurance companies or by a system o f self-insurance and mutual guaran
tees by the banks themselves. (England, 1987; Ely, 1985) Small depositors
also could protect themselves against both default and price risks by pur
chasing short-term Treasury securities or money market funds, which pro
vide similar transactions services as bank deposits.
Finally, small unit banks no longer need to be protected. Indeed, the lib
eralization of state branching and holding company acquisition regulations
has been more damaging to the preservation o f unit banking (assuming that
this is or ought still to be a goal) than would be the removal o f deposit in
surance and suggests that unit banking is no longer the policy concern it
was in the 1930s.
Opponents of the elimination of federal deposit insurance argue that it is
necessary for a number of reasons. Some are not confident that the Federal
Reserve can be counted upon with absolute certainty to prevent a decline
in aggregate bank reserves. As already noted, while the risk from theft and
the necessity of transferring funds by check do not permit large depositors
to convert their funds to currency, a large number o f people with small
deposits could find it feasible and desirable to hold currency rather than
deposits or alternative safe securities or deposit-like investments. In the
absence of offsetting actions by the Federal Reserve, the result could be a
multiple contraction in the money supply with all of the accompanying
undesirable effects for the economy as a whole. Consequently, they prefer
an automatic mechanism or rule, to which they liken the F D IC , to human
discretion and fallibility.
Others believe that the private sector cannot protect itself against system
runs and bank failures and that any attempt to do so would require a fed
eral program of support for the insurance companies rather than the banks;

FRB CH ICAG O Staff Memoranda

thus there would be only a rearrangement rather than elimination of exist
ing guarantees.
Some also argue that private insurance companies would not be given the
legal authority to reorganize individual economically insolvent institutions
in as timely a fashion as the federal agencies could, if they so wished, and
thus private insurers would experience or expect large losses which would
require large insurance premiums.
(Horvitz, 1980, 1983; Bierwag and
Kaufman, 1983; FSLIC, 1983) Moreover, because private insurance com
panies can become insolvent, even those that have the blessing and moral
support of the state, e.g., those in Ohio and Maryland, depositors would
not have absolute faith in the protection of their deposits and might run to
currency at times of uncertainty.
Finally, even some of those who would prefer to have private deposit in
surance substituted for federal insurance doubt that federal insurance could
be repealed, de facto or de jure. They believe that even if federal deposit
insurance were withdrawn, the failure of a bank that resulted in a substan
tial loss to many depositors would be followed by a federal government
bail-out. This expectation is supported by a large amount of experience.
Examples include the payment to depositors in the Home State Savings
Bank of Cincinnati (Ohio) even though the State of Ohio had no legal ob
ligation for such payments. Canada paid off all depositors in two regional
banks that failed, even though deposit insurance covered them only to
$60,000 Canadian. The Bank of England bailed out the depositors in
Johnson Matthey, even though they were not obligated to do so. Hence,
even if it were politically possible to remove de jure federal deposit insur
ance, it is very unlikely that depositors would not, in fact, be insured.
We also do not believe that federal deposit insurance can be replaced en
tirely with private or no insurance. Therefore, we agree with those who
look for reform of the system rather than for its abolition.
2.

Reform o f Federal Deposit Insurance

Proposals for reform of federal deposit insurance focus on changes that
reduce the moral hazard problems inherent in the current structure and are
modelled on the structure developed by private insurance companies in
their operations.
A. Co-insurance
Private insurers frequently try to reduce moral hazard problems through
co-insurance, so that the insured and insurer share in some proportion of
the covered loss. The proportions differ depending on the particular pro
gram and can include: (1) a deductible , in which the insured pays 100 per

FRB CH ICAGO Staff Memoranda

cent of the first X dollars of loss up to a maximum amount and the insurer
alone or in some combination with the insured pays the remainder; (2) a
cap, in which the insurer pays up to X dollars of the loss and the insured
alone or in some combination with the insurer pays the remainder; and (3)
f i x e d proportional sharing , in which the insured and insurer share in the
total amount of the loss in a given proportion, e.g., 50-50, or 20-80. In
deed, the F D IC program enacted in 1933 and scheduled to go into effect
on July 1, 1934 to succeed the temporary program adopted on January 1,
1934, included such provisions. The plan provided for 100 percent insur
ance of the first $10,000, 75 percent of the next $40,000, and 50 percent of
all deposit amounts above $50,000. This plan was never put into effect
(FD IC, 1984).
Opponents of co-insurance reforms argue that such changes would not af
fect the system greatly. The current de jure structure already represents
co-insurance; the insurer pays 100 percent of up to the first $100,000 and
the insured pays 100 percent of the remaining loss. The question then be
comes what is the appropriate cap. Moreover, regardless o f the de jure
structure, unless the deposit insurance agencies were willing to abide by the
de jure limits, de facto insurance coverage would continue to be close to
100 percent.
B. Maximum Coverage
The amount of maximum coverage per account importantly affects the de
gree of aggregate market discipline applied by depositors. The lower the
maximum, the more the number of depositors and amount o f dollars that
are at risk and the more that depositors have incentives to monitor the ac
tivities of banks. Moreover, the lower the maximum amount o f coverage,
the more difficult and costly is it to divide large amounts into an equivalent
dollar amount of smaller fully insured deposit packages.
When introduced on January 1, 1934, the maximum F D IC coverage per
private account was only $2,500. It was increased to $5,000 six months
later, $10,000 in 1950, $15,000 in 1966, $10,000 in 1969, $40,000 in 1975,
and $100,000 in 1980. This thirty nine-fold increase is considerably greater
than the seven-fold increase in the general price level over the same period.
Thus, de jure protection has been given to increasingly larger “small”
depositors but at the cost of greater risk taking by banks and potential
losses to the insurance funds. In light of this greater-than-inflation-adjusted
increase and the ready availability of safe deposit-like outlets for these
depositors, a significant rollback of the coverage to $50,000 or even less
should reduce the moral hazard problems significantly and make raising
funds quickly considerably more difficult for risk-prone banks at little, if
any, cost to smaller depositors or protection of the money supply. Even if
the amount per account were not reduced, deposit insurance could be lim

FKB CHICAGO Staff Memoranda

ited to a total of $100,000 per depositor in all insured banks combined.
(Benston, 1983) Thus, if a bank failed, a depositor who wanted to be paid
would have to file a sworn statement giving the amount of insured deposits
at all banks at the time of the failure. Deposits in the failed bank would
be covered only to the extent that the depositor’s funds in other insured
banks were less than $100,000 in total.
Similarly, a lifetime $100,000
maximum per depositor has been proposed.
Arguments against a significant reduction in insurance coverage focus on
political infeasibilities, inconvenience to small depositors, greater individual
and social costs of depositors’ credit evaluations of banks, and the expec
tation that the legislators would act to bail out de jure uninsured depositors
if the losses were sufficiently widespread or if sufficiently powerful depos
itors were affected.
C.

Risk-Sensitive Insurance Premiums

The most widely and longest-standing proposed reform is to replace the flat
percentage of total domestic deposits premium structure with premiums
that are scaled to the risk of loss assumed by the bank. Risk-sensitive
premiums are charged for almost all the types o f insurance offered by pri
vate insurers, such as life, accident, fire, and automobile insurance. Private
companies attempt to match their premiums to the computed actuarial fair
value of the potential loss. Because the probability o f loss is related to the
risk assumed by the insured, the greater the risk, the higher the premium.
But risk-related premiums serve not only to protect the insurance company,
but to affect the ex-ante behavior of the insured. The higher the premium,
the more costly the activity, and the less likely is the insured to engage in
it. In this way, the insurance company can control its risk exposure.
Because all insurance companies, private or public, have an incentive to
minimize their losses, they all attempt to control the risks assumed by the
insured and relate their premiums to risk, either explicitly or implicitly.
The use o f flat percentage premiums forces the federal insurance agencies
to rely on implicit risk-related insurance premiums in the form o f regu
lations, capital requirements, and enforcement penalties. (Benston, et al.,
1986, Chapter 9) As discussed earlier in this paper, regulations restrict
permissible activities, permissible number of banks and banking offices,
geographical location, and prices paid and offered.
But, as demonstrated earlier, these regulations have been found to be highly
inefficient and costly to both the banks and society. In addition, recent
evidence suggests that the insurance agencies have not been very successful
in controlling bank risks through regulation, particularly for failing banks.
Enforcement penalties, which by definition are ex post, have also failed to

FRB CHICAGO Staff Memoranda

halt risk taking at risk prone banks. (Benston, et al., 1986, Chapter 10)
Thus, explicit risk-related premiums are preferred.
H ow ever, establishing risk-related insurance premiums is not easy. A large
body o f recent literature has considered the problem without devising an
operational way o f determining the premiums. (K an e, 1985; F D I C , 1983;
F S L IC , 1983; Bierwag and K au fm an , 1983; Benston et al., 1986) M o st
proponents o f risk-based premiums recognize that risk should be measured
with respect to market prices rather than accounting numbers. This would
involve the replacement o f book-value accounting with market- or
current-value accounting for both on- and off-balance sheet accounts. Just
how market-value accounting is to be done generally is not specified. Some
opponents o f risk-based deposit insurance emphasize the difficulties o f ap
plying such accounting in practice, in particular o f evaluating
nonmarketable assets and goodwill for purposes o f determining the premi
ums. This argument appears to be based on a reluctance to accept market
values in principle rather than on a careful benefit/cost analysis. It is ironic
that some bankers attempt to estimate the market value o f their customers,
but are unwilling to have an insurance agency evaluate their market value.
I f federal deposit insurance were to be replaced by private deposit insur
ance, it is highly unlikely that the latter firms would be willing to under
write the insurance i f they were not able to em ploy risk-related premiums
based on market value accounting.
The pros and cons o f market value accounting are discussed later in this
paper. H ow ever, we do not believe that perceived operational incomplete
ness is a sufficient reason for rejecting risk-based premiums. Indeed, we
suggest an operational market-value accounting procedure in section 5 be
low.
Som e proponents o f introducing risk-related premiums would use nonmarket measures, such as reported balance sheet inform ation and bank
examination ratings.
They argue that these values are preferred to
market-determined values because the former are easy to obtain and the
latter take into account market values where possible but supplement this
inform ation with subjective expert evaluations o f non-m arket factors. In
addition, bank examiners have access to information that the market m ay
not have and, as all banks are already being examined, the system would
not require the installation o f new and potentially costly reporting and
m onitoring systems.
Opponents o f explicit risk-related insurance premiums base their arguments
on both theory and practice. In theory, the opponents note that the insur
ance agency suffers no losses i f it could m onitor banks perfectly and
costlessly and reorganize the bank before the market value o f its net worth
falls to zero. Knowledge about the riskiness with which a bank is operated

FRB C H IC AG O Staff Memoranda

is required by the agency only to determine the extent to which the bank
must be monitored. For this purpose, much less precision in estimating
risks would be needed than would be required for establishing insurance
premiums. The premiums charged should be related to the costs o f m oni
toring and the perceived costs o f more timely failure resolution. T o the
extent that monitoring costs are related to the risk exposure o f banks, risk
could, however, serve as a surrogate for monitoring costs, and thus be a
basis for setting premiums. Additional premium amounts would be re
quired to cover losses that result from an optimal trade o ff between the cost
o f monitoring and supervision and expected losses, insufficient and inef
fective monitoring by the insurance agencies, the inherent inability o f any
agency to uncover all fraud, extreme bad luck, the inability o f the agency
to measure economic net worth accurately, and political pressure that pre
vents the agencies from reorganizing banks before their net worth becomes
negative.
Some analysts oppose activity-specific risk-related deposit insurance pre
m ium plans because they believe that the risk imposed on the insurance
agency is related to the total portfolio and operations o f a bank rather than
to individual assets, liabilities, and activities. Hence, relating the insurance
premium to individual assets or liabilities not only will not provide a valid
measure o f risk, but could result in more rather than less risk being under
taken. For example, real estate holdings, by themselves, might be more
risky in that the cash flows from and market values o f the assets m ay be
more variable than those derived from , say, bank loans, and hence have a
higher probability o f being negative at some time. But, the cash flows from
real estate might be imperfectly or even negatively correlated with cash
flows from bank loans. Hence, the risk a bank offers to the insurance
agency could be lower if it held both real estate and bank loans than if it
only held the loans. A s is noted above, the optimal com bination o f assets
and liabilities need not be stable and is not readily determined by a formula
or a banking supervisor. M oreover, in banking, ex-ante projections o f cash
flows and risk m ay be more difficult to obtain from ex-post evidence than
elsewhere. W o u ld loans to M exico and Brazil have been viewed as risky in
1978 as in 1985 or interest rate mismatches as risky in 1965 as in 1982?
Risk-related insurance premiums also would give banking regulators con
siderable power to direct banks towards and away from specific types o f
investments and activities. For example, bank examiners in the past have
objected to banks making loans to inner-city borrowers and mortgages to
race-integrated housing projects on the grounds that these investments were
too risky. Thus, such a premium structure may be used as a means o f credit
allocation, particularly if there is no competition am ong the federal insur
ance agencies so that the risk premiums assessed m ay differ from their
market determined values. (Benston et al., 1986) Perhaps m ost important,
opponents o f risk-related premiums doubt that they would dissuade risk-

FRB CH ICAGO Staff Memoranda

prone bankers from taking risks that are excessive from the point o f view
o f the insurance agency. The premiums would have to be sufficiently high
such that the net returns from excessively risky behavior is less than the
returns from acceptable behavior. In the absence o f effective monitoring
and co-insurance (such as capital requirements), the required premiums
would have to be so high that only a banker who expected to get very high
gross returns from risk taking would be willing to pay—thus the insurance
agency would suffer from adverse selection. A n d , as is discussed above, if
monitoring were efficient, there would be no need for risk-based premiums.
(H orvitz, 1983)

3. Risk-Related Capital Requirements
Regulators have always been concerned with bank capital. Even in earlier
periods o f more or less “ free banking” , minim um capital requirements ex
isted for new bank charters and examiners evaluated the am ount and ade
quacy o f the capital o f ongoing banks. M inim um capital requirements for
bank charters are explicitly included in the N ational Bank A c t and in many
state banking statutes. Capital provides a cushion to protect both depos
itors and the deposit insurance agencies from losses. The larger the amount
o f capital, the less likely are losses o f a given magnitude to wipe out the
bank’ s capital and impose losses on depositors and the insurance agencies.
A firm that has 100 percent capital, e.g., m oney market and other mutual
funds, can never becom e insolvent by definition.
A lthough bank capital ratios appear always to have been below capital ra
tios in other industries, the magnitude o f the difference has widened since
federal deposit insurance was enacted. A t the turn o f the twentieth century,
bank capital-to-asset ratios were about 20 percent. In 1930, the ratios av
eraged about 15 percent. But these ratios understate the protection to
depositors as shareholders o f all national banks and o f state chartered
banks in m any states were subject to double liability up to the par value
o f their investment. After federal deposit insurance was introduced, capital
ratios declined and double liability was discontinued. A t present, capitalto-asset ratios for all commercial banks average about 7 percent. In con
trast, they average about 20 percent for m ajor life insurance and property
insurance firms and 11 percent for diversified insurance firms. Capital asset
ratios average 45 percent for all manufacturing firms, 37 percent for mining
firms, and 34 percent for wholesale and retail trade firms.
U ntil the 1970s, bank examiners formally evaluated the adequacy o f a
bank’ s capital in relationship to the assigned risk values o f the bank’ s asset
portfolios and mix o f deposits using so-called A B C forms. A round 1970
this approach was abandoned as unnecessary because the rate o f bank
failures had declined to such low levels that concern about capital alm ost
disappeared. In this period, bank capital ratios declined and the regulatory

FRB CH IC A G O Staff Memoranda

agencies found they had little legal power to enforce capital standards. In
the mid-1970s, when the number of bank failures, including some larger
banks, increased, and bank profitability started to decline, concern about
capital standards reappeared. But it was not until the International Lend
ing Supervision Act of 1983 that bank regulators were given legal authority
to enforce capital standards.
In 1987, U.S. bank regulators formalized and issued for public comment a
proposal for uniform risk-based capital standards which they developed
jointly with their counterparts in the United Kingdom. Among other ob
jectives, the “measure ... attempts to ... temper disincentives inherent in the
existing capital requirements to hold low risk, relative liquid assets” (COC,
1986B; F D IC , 1986; Board o f Governors, 1987). Thus, the objective o f the
structure is the same as that of risk-based deposit insurance premiums. The
proposal includes provision for off- as well as on-balance sheet accounts.
This differs from current capital regulations which consider only on-balance
sheet accounts. Proponents prefer it because it builds on a base of capital
regulation that is already in place and does not involve out-of-pocket costs
as would insurance premiums.
Critics o f the proposal object to it on several grounds. (Aspinwall, 1987)
Overall, it appears to involve only a reshuffling of the existing capital in the
industry among the individual banks, which will have little effect on bank
safety generally, as banks tend to be undercapitalized. The proposal spe
cifics are seriously flawed in several important respects. First, capital is
valued on historical book basis rather than on economic market values.
Consequently, there is an imperfect and manipulable (by a risk-seeking
banker) measured relationship between risk and capital.
Second, the risk weights to be used are based on unjustified, apparently
subjectively determined, criteria (see Table 1) rather than on market valu
ations of risk. For example, a ten year fixed-interest U.S. government ob
ligation is subject to considerably more interest rate risk than is a five year
obligation or a variable-interest rate ten year obligation, yet all are subject
to a 30 percent capital requirement. What reason is there to believe that a
ten year fixed-interest rate state obligation is twice as risky (60% vs. 30%)
as a similar U.S. Treasury or agency obligation? Is a loan to Poland (an
industrial country) as risky as a collateralized and easily monitored broker’s
loan? (Both are classified as “moderate risks.”) Are equal amounts of
funds invested in consumer loans and in commercial loans to an oil
prospector or to the government of Peru all “ standard risks”?
Third, the effect on risk of combinations of assets and liabilities discussed
above is ignored. In particular, there is considerable room and incentive,
both among and within risk classes, for reshuffling to increase risk.

FRB CH ICAGO Staff Memoranda

Fourth, risk o f the bank is incorrectly measured. Interest rate risk cannot
be gauged by referring only to individual asset or liability accounts. The
actual interest rate risk exposure o f a bankas determined by the accounts
on the two sides o f the balance sheet considered together. By focusing only
on individual accounts, the proposal gives no recognition to the riskreducing characteristics o f portfolio diversification. Rather, appropriate
weights should measure the marginal contribution o f each account to
overall portfolio risk. (It should be noted that each o f these criticisms could
apply equally well to poorly designed risk-based deposit insurance premi
ums schemes.)

4. Narrow “Fail-Safe” Bank
This proposal focuses on constructing supposedly “ fail-safe” banks that can
provide the basic banking product—transaction balances or m oney
supply—(hence, narrow bank) which the government perceives as having
important safety concerns and as justifying intense regulation. A ll other
bank activities would be placed in another institution, the safety o f which
would concern the government no more or less than that o f other non
banking firms. This other institution could be independent or an affiliate
o f a diversified financial holding com pany that also owns the narrow bank.
I f successful, this proposal would reduce government risk regulation greatly
and permit bank holding companies to engage in a broader range o f activ
ities, both financial and nonfinancial, than is currently permitted or would
be permitted bank holding companies that would choose not to house the
transaction deposit business in a narrow bank affiliate. A lthough initially
appealing, careful consideration o f the plan has revealed serious flaws that
have reduced its popularity considerably. Both the plan and the flaws are
summarized here and discussed in greater detail in Appendix A .
A s proposed initially, the fail-safe bank would hold only securities that were
riskless in terms both o f default and interest rate changes. This would re
strict its investments essentially to short-term Treasury and federal agency
securities. In this scenario, federal deposit insurance would seem to be no
longer necessary. H owever, depositors could bear losses from fraud and
operations mismanagement.
Hence, deposit insurance and monitoring
might be retained.
A s the proposed investment restrictions are unlikely to permit the bank to
earn sufficient revenues to cover operating costs, fees would probably have
to be charged and interest paid only on the largest balances. Other insti
tutions, then, including affiliates in the same holding com pany, would have
an incentive to develop transaction balance substitutes that could be offered
at lower fees or higher interest rates. The result would be a shift o f funds
to these institutions, which would reduce the relative importance o f the
narrow banks and increase the concern o f the government for the safety

FRB CH ICAG O Staff Memoranda

Table 1
The Regulatory Agencies' Proposal for Supplemental
Capital Adequacy Measure Risk Categories and Weights
Weight
C a s h an d E q u iv a le n ts

U.S. currency and coin and due from F.R. banks
Cash items in process of collection and transaction accounts
due from U.S. depository institutions
Short-term U.S. Treasury securities in investment account
Foreign currency and balances due from central banks in
immediately available funds
M o n e y M a rk e t R is k

30%

Long-term U.S. Treasury securities held in investment account
U.S. Government agency securities held in investment account
Portions of loans fully guaranteed by U.S. government
Short-term claims on U.S. depository institutions
Acceptance on other U.S. banks
Fed funds sold
Loans to broker/dealers collateralized by U.S. Treasury and agency
securities and securities purchased under agreement to resell (RPs)
Assets held in trading account
Legally binding loan commitments (including note issuance facilities)
M o d e ra te R is k

60%

AM state, county, and municipal (SCM) securities in investment account
(excluding industrial development bonds)
All other claims on U.S. depository institutions
All claims on governments and banks of industrial countries
Acceptance of banks in industrial countries
Local currency claims on governments and banks of nonindustrial countries
Loans to broker/dealers collateralized by other marketable securities
Commercial letters of credit
Standby LCs backing SCM securities (excluding those backing
industrial development bonds), supporting broker/dealers on
secured basis or performance related
S t a n d a r d ^ isk

100%

All assets found in a typical loan portfolio, including;
All commercial and industrial loans and leases
Residential real estate and individual loans
Loans to nondepository financial institutions
All other claims on foreign obligors
Corporate securities and commercial paper, and industrial development bonds
Customers' acceptance liabilities
All assets not included elsewhere
All other standby LCs (net), including those backing
industrial development bonds
Loans sold with recourse
Source: Federal Reserve System, 12 C.F.R. Part 225, Appendix A [Reg. Y; Docket No.
R-0567], Capital Maintenance: Supplemental Adjusted Capital Measure.

FRB CH ICAGO Staff Memoranda

o f the alternative transaction deposit-offering institutions.
Thus, little
would have been gained at the expense of the cost of developing new insti
tutional arrangements.
To combat such potential shifts from the narrow banks, proponents of the
proposal progressively broadened the narrow permissible investment op
portunities to securities, e.g., commercial paper (credit risk), and long-term
Treasury securities (interest rate risk). Because banks holding these assets
would no longer be fail-safe, federal deposit insurance would be required.
Once the narrow bank is allowed to hold securities that offer some risk,
where is the line to be drawn? It was a simple step to expand the proposed
investment powers of the “narrow” bank to include all assets that have a
reasonable secondary market and that could be valued at current market
prices. (Huertas and Strauben, 1986) Capital standards could be intro
duced that were commensurate with the risk assumed by the bank. As the
proposed bank’s powers continue to be expanded, it would resemble today’s
broad bank, except that its assets and liabilities would be valued at market
prices. Thus, today’s problems would not be solved.
5. Reorganization Before Economic Capital Becomes Negative
A. The Advantages o f Timely Reorganization
The key failing with all the reform proposals discussed above is their ina
bility to resolve economic insolvencies (failures) effectively and costlessly.
Recent evidence has made it clear that the largest losses to the federal in
surance agencies and uninsured depositors have occurred from delayed
failure resolutions. (Horvitz, 1983; Benston et al., 1986, Chapter 4; U.S.
General Accounting Office, 1987A and B; Barth et al., 1986) The delay
has permitted insolvent banks to continue to generate losses and place
larger bets using the funds of others and has signalled other solvent insti
tutions that the penalty for insolvency may not be as great as it is generally
perceived to be. This has encouraged banks to take greater risks. Re
gardless o f how insurance premiums, capital standards, or investment
powers are structured, unless failures are resolved in a timely fashion, the
banking structure will continue to impose unnecessary risks and costs on
the economy. If depository institutions were reorganized (recapitalized,
sold, merged, or, as a last resort, liquidated) before the point when the
market value of their capital (net worth and subordinated liabilities) de
clined to zero, the incentives for excessive risk taking by their managers and
owners would be greatly reduced and any subsidies involved in the pro
vision o f the insurance would be eliminated. (Kaufman, 1987A and C;
Bennet, V., 1984; Pyle, 1986)
Timely reorganization offers four significant bonuses that may increase its
attractiveness and thereby its adoption. One, except for cases of major

FRB C H IC AG O Staff Memoranda

fraud, effective elimination of losses from bank failures reduces the need for
insurance premiums other than for paying the F D IC ’s and F S L IC ’s oper
ational expenses, including improved and more frequent monitoring o f in
sured institutions and the development of useful market value accounting
systems. Quicker action by the insurance agency also reduces the oppor
tunity for uninsured creditors to transform their unsecured claims to se
cured claims, which increases the loss to the insurance agency.
Two, as uninsured depositors are likely to experience smaller if any losses,
they are less likely to run on their banks when they receive unfavorable
news. This would reduce potential disruption to other institutions and the
economy as a whole.
Three, if the authorities would reorganize a bank expeditiously before it
became economically insolvent, there would be little justification for regu
lating or legislating the nature of the activities in which banks may or may
not engage on the basis of risk. These restrictions would have to be based
on other considerations, such as concerns for excess concentration, as
sumptions about conflicts o f interest, the undesirability of bringing an ac
tivity under the surveillance of bank regulators, or demands to restrict
competition among and by banks. Absent these considerations, the amount
of risk a bank wishes to assume and which products and services it would
provide could be decided by its own management, who may be expected to
be sensitive to the penalties of failure. Decisions to take portfolio risk,
then, would tend to be made on the belief that the bank’s capital is suffi
cient, rather than on the belief that the insurance agency will cover the
losses. Greater risk would be undertaken only with greater capital.
Four, all failed banks and their depositors would be treated equally. A t
present, uninsured depositors at large failed banks are reimbursed in full
regardless of a bank’s condition, while those at smaller failed banks fre
quently are assessed losses related to the market value o f their bank’s assets.
This policy has important inequitable competitive implications that are se
verely disadvantageous to smaller banks. Timely reorganization, by effec
tively eliminating depositor losses, would permit more equal treatment o f
banks regardless of their size, location, or nature of their business. N o
bank would be “too-large-to-fail” and the authorities need not be reluctant
to reorganize a bank for fear of touching off runs at other banks.
As a result of the lower premium costs to banks, the greater freedom from
regulation of bank risks and activities, and greater equity in treating banks
in similar financial predicaments, timely reorganization should be much less
costly than the narrow-bank proposal and more efficient and attract less
opposition than either risk-sensitive premiums or sharp reductions in in
surance coverage.

FRB CH ICAGO Staff Memoranda

Timely reorganization also offers considerable advantages to public policy
makers. As with any present policy structure or reform, policy makers
must have the resolve to apply the available remedies at the de jure speci
fied point without exception. But, as noted above, at least part o f the rea
son for the current banking situation is a reluctance of policy makers to
apply the available remedies on a timely basis. Thus, de facto deposit in
surance coverage frequently exceeds de jure coverage and bank capital is
permitted to decline below established minimum standards and even be
come negative for many troubled institutions under “ forbearance” pro
grams. (F D IC , 1986; C O C , 1986) This occurs because the utility function
o f public policy makers includes many variables other than economic effi
ciency, e.g., compassion and susceptibility to pressure from directly affected
parties. To remain in office, whether elected or appointed, policy makers
must balance various objectives. These include losses to individuals on
what the public has come to assume are “riskless” securities, such as bank
deposits, whether or not they are federally insured. They also are con
cerned with the loss o f jobs and disruptions in the payments system and
credit availability in their geographical or political districts. Losses to bank
owners might be a concern as well.
Under current procedures, bank failures could result in losses to depositors
and are widely perceived to result in the loss o f jobs, the interruption of
financial relations, and the threat o f severe spillover to other banks and
sectors. This paper has demonstrated that the first consequence occurs only
if failure resolution and reorganization are delayed, and that the other three
consequences are highly unlikely to occur. Failed banks are generally sold
or merged with the preservation of most of the banks’ services and the
employees’ positions or, if liquidated, replaced by other banks if the de
mand for banking services is warranted.
How, then, could policy makers be motivated to accept and stick with ef
ficient remedies? The theory o f public choice suggests that one needs to
appeal to their self interest. A policy structure that minimizes the possi
bility of loss to depositors, jobs to constituents, disruption to the payments
mechanism, and progressive domino effects to other banks and businesses
at a low cost to taxpayers and other banks should have strong political
appeal to policy makers. If timely failure resolution were adopted, the
primary losers would be shareholders, holders of subordinated debentures,
and senior management. Policy makers have generally been willing to
permit losses to these parties, while protecting others that have perceived
themselves to be less at risk. By restricting losses primarily to not-to-beprotected parties, timely bank failure resolution and reorganization would
result in less pressures on the authorities than imposed either by the current
structure or by most other proposed reforms.

FRB CH ICAG O Staff Memoranda

The same advantages should accrue to bank regulators. Moreover, because
under the proposal any losses to depositors and the community will be
small, bank failures (reorganizations) should no longer be a major blot on
their records. Thus, the regulators should be more willing both to recognize
bank failures officially and to avoid implementing inefficient and costly
means to prevent them.
As noted, the application o f timely reorganization rules requires the meas
urement o f capital in terms o f economic market values rather than generally
accepted or other non-market value accounting principles and the receipt
by the authorities of timely and sufficiently accurate information on an
institution’s capital. These reorganization rules also should be able to deal
effectively with fraud and gross mismanagement, since these are the pri
mary causes o f bank failures and large losses to the deposit insurance
agencies. We will examine each of these requirements.
B. The Measurement of Economic Capital—Market Value Accounting
The application of timely reorganization rules would be enhanced by the
measurement of capital in terms of economic market values rather than
generally accepted or other accounting principles. Banks and most other
firms keep their books and render their financial reports on the basis of
generally accepted accounting principles (G A A P) or of regulatory ac
counting principles (RAP), when these are prescribed, e.g., by the Federal
Home Loan Bank Board. Unfortunately, these accounting methods do not
provide measurements of the economic market values that clearly are re
quired for the deposit insurance agency to determine when reorganization
is required. (Benston, 1982; Benston et al., 1986, Chapter 8) Indeed, tra
ditional accounting was not designed to nor, on the whole, does it measure
economic market values. Moreover, there is strong reluctance among some
parties in banking as well as elsewhere to accept the “vagaries” of the
marketplace as the true valuation o f a security or a firm rather than the
evaluation of the owners or other experts.
The importance of measuring capital in market value terms rather than in
book value terms has been clearly demonstrated in a recent Federal Reserve
study. This study reported that while in book value terms the capital-toasset ratio of the 25 largest bank holding companies in the United States
declined from 8 percent in 1960 to 4 percent in the late 1970s before in
creasing again to near 5 percent in 1986, in market value terms the ratio fell
twice as sharply from 12 percent to 3 percent in 1980 before reversing.
(Keeley and Furlong, 1987) For the period from the early 1950s to the
mid-1970s, the market value of capital consistently exceeded the book
value, while it consistently fell short of book value from the mid-1970s
through 1986. Thus, in the first period, when bank failures were low, the
reported data understated the shareholders’ investment in the banks. In

FRB CHICAGO Staff Memoranda

the second period, when bank failures began to increase, the reported data
overstated the shareholders’ investment. This pattern is consistent with the
inverse relationship between the amount o f bank capital and a bank’s in
centive for risk taking hypothesized earlier. It appears that the regulators
may have badly underestimated the true decline in bank capital in the 1960s
and early 1970s and devoted insufficient resources to controlling risk.
The use o f market value accounting should improve the regulators’ ability
to evaluate the condition of their banks and respond more quickly to
changes in market forces.
In addition, were market value accounting
adopted for banks’ public reports, as well as for internal and regulatory
reporting, regulators would be subjected to a form of market discipline, as
their actions could be more effectively evaluated by others.
Fortunately, market-value accounting is much more feasible and inexpen
sive to adopt for financial institutions than for most other enterprises.
Unlike nonfinancial firms, banks have relatively small investments in assets
for which current market value are difficult to measure. Such assets include
land, buildings, and equipment, patents and trademarks, advertising, and
work-in-process inventory. These assets often are not traded in the market,
in part because they are specific to an enterprise. Hence, their economic
values are difficult to obtain. Nevertheless, the following review of the
principal items on a bank’s balance sheet illustrates how satisfactory eco
nomic market values can be obtained for banks.
Liabilities - On Balance Sheet.
Bank payables and deposit liabilities
(checking, time, and savings accounts and short-term certificates o f depos
its) tend to be stated at or very near current market values. The sole im
portant exception is fixed-interest long-term obligations when market
interest rates have changed. If these obligations are traded in the market,
their current values can be determined directly. But, even if they are not
negotiable or traded, their present values can be determined. Because these
deposit obligations would be riskless (under the present proposal), their
economic values can be measured simply by discounting the obligations by
the present (market) rate of interest on currently issued, similar obligations.
Some problems would be encountered in evaluating the effective maturity
of deposits that do not have specific maturity dates and for which depositor
can withdraw at par at any time, e.g., demand deposits, savings deposits,
and M M D A s.
These deposits are neither all withdrawn daily nor all
maintained permanently regardless o f interest rates and services offered.
Thus, assigning them a maturity of one day may be too short but assuming
that they are long-term core deposits may be too long. A realistic estimate
of their average maturity is required. Thus, on the whole, the liabilities side
of the recorded balance sheet presents few problems for market-value ac
counting.

FRB CH ICAG O Staff Memoranda

Liabilities - O ff Balance Sheet. Banks often issue letters o f credit and
guarantee loans, thereby assuming liabilities that are contingent on the
nonperformance of a customer. In effect, the bank has an asset— the right
to collect from the customer if that party does not meet its obligations to
a third party, as promised. It also has a liability—a promise to pay the third
party if the bank’s customer does not perform as promised. With respect
to a capital requirement, there should be no difference between this con
tingent liability and asset and an on-balance sheet liability and asset. For
on-balance sheet accounts, the total nominal amount is recorded, regardless
of the extent of the risk exposure, if any, to the institution. Hence, the li
ability or asset would be stated at the amount for which the bank is
contingently liable or a beneficiary, thereby increasing both assets and li
abilities. (If the obligation can come due only at a future date, its present
value would be the amount stated.) Thus, on- and off-balance sheet activ
ities would be treated consistently.
Assets - Marketable Securities. The market values o f a bank’s investments
in marketable and fixed-interest securities (including equities) can easily be
obtained. Where fixed-interest securities are not regularly traded their
present values can be determined as described above for fixed-interest li
abilities. (The procedure for estimating the market value o f nontraded se
curities is discussed below.)
Assets - Loans. The realizable value of loans presently is estimated by
banks. These estimates are attested to by certified public accountants for
all insured savings and loan associations and for banks that are subject to
the Securities Acts of 1933 or 1934. These estimates are close, but not
equal, to market values, since future expected payments are not discounted
to obtain present values. Nor are changes in market rates o f interest on
asset values accounted for. But such changes are not a serious problem
when assets carry interest rates that vary with market rates or are short
term so that they are repriced before interest rates change radically (as
presently is the case for most commercial loans and many mortgages).
Where institutions hold duration-balanced portfolios or have hedged inter
est rate risk, the problem is obviated. The remaining situations can be es
timated by reference to market prices on such obligations as
mortgage-backed bonds. Furthermore, an increasing proportion o f bank
loans are being packaged into marketable obligations and securitized.
These include mortgages, automobile and other consumer loans, and even
poor quality foreign loans. The value of these and similar loans can be
determined by reference to the market rates sat which securitized loans
trade. In addition, the economic value of loans to large businesses can be
approximated by reference to traded securities, such as commercial paper
and bonds, that are issued by those businesses. Alternatively, the debt o f
large companies and countries may be valued centrally by a government

FRB CH ICAGO Staff Memoranda

agency or private rating bureau, such as M oody’s and Standard and Poors,
with the values used by all banks.
Assets - Nonmarketed or Nontraded Investments.
Banks also invest in
nonmarketable investments, such as real estate, and nontraded securities,
such as bonds and stock in nonlisted companies. These assets would have
to be valued by independent appraisers. Obviously the valuations of such
assets would be subject to error, and the probity of the appraisers, who are
hired by the banks, should be questioned. Later in the paper, we offer a
means by which this problem can be handled satisfactorily, at least from
the point o f view o f the deposit insurance agency.
Assets - Investments in Subsidiaries. A bank may choose to conduct some
o f its activities in a wholly or partially owned subsidiary. In this event, the
bank has an asset for which a market value must be obtained. Since the
shares o f the subsidiary are unlikely to be traded, market value accounting
would have to be applied to the balance sheet o f the subsidiary unless the
bank and the deposit insurance agency is willing to accept the subsidiary’s
book value or a partial revaluation at market as a lower bound. Since the
bank is likely to be directly or indirectly liable for the debts o f the subsid
iary, and because it is very difficult to monitor or prevent transfers of re
sources between a bank and its subsidiary, subsidiary liabilities and asset
would have to be consolidated with the bank’s balance sheet numbers.
Assets - Operating Equipment, Buildings, Etc. The market values of many
long-term fixed assets may be determined by reference to their replacement
cost, where replacement is defined in terms of the services derived from the
assets. These values might be obtained from the new or used asset market
or from engineering appraisals, although these numbers often are expensive
to determine and are inexact, particularly when the assets are rarely traded.
However, because G A A P accounting requires accountants to record assets
at the lower of cost or market, this evaluation is not required unless a bank
wants to demonstrate that its capital is greater than it appears to be. In this
event, it would have to present appraisals that are accepted by the deposit
insurance agency.
Assets - Goodwill and Other Unrecorded Intangible Assets. Goodwill and
most other intangibles (such as personnel training, computer software, or
ganization costs, patents, and the value o f core deposits) are not recorded
on a bank’s (or other firm’ s) financial statements unless they are purchased
in the market directly or as a consequence o f a merger or acquisition. For
banks, such assets can rarely be sold separately from the entire organiza
tion. (An exception might be computer software packages.) Nor are simi
lar assets often traded in the market. While the market value of a bank’s
stock less the economic value of its assets less liabilities can provide an es
timate o f the market value o f intangibles, this method is not satisfactory for

FRB CHICAGO Staff Memoranda

two reasons. First, most banks’ shares are not actively traded. Second, the
market value of a bank’s equity reflects the value o f underpriced deposit
insurance—hence, the stock market value cannot be used directly as a means
o f determining the bank’s capital for purposes of eliminating or reducing
the risk to the deposit insurance agency. (If it could be so used, the stock
market value would be a sufficient metric.) Hence, the measured economic
value of bank equity will tend to be understated by the value of unrecorded
intangibles. (From the point of view of the deposit insurance agency, this
is no worse than the present system of accounting.)
Where goodwill was recorded as a result of an acquisition or other market
transaction, it should not be included as an asset, for two reasons. First,
the bank’s other assets will have been stated at market values, which should
account for the portion of goodwill representing the difference between the
market and book values of the acquired organization. Second, relatively
less capital would be required o f banks that grew by acquisition and merger
than of banks that grew internally, if the former could include goodwill in
their assets and (therefore) in their capital. There is no justification for this
bias.
Determination of and Reliance on Reported Market Values. An important
concern about market value accounting is the extent to which the banking
authorities can rely on the figures. This problem can be alleviated almost
entirely were the following proposal adopted. All insured banks should
have their accounts annually audited by certified public accountants who
are acceptable to the authorities.4 The CPAs would be charged with at
testing to the numbers reported as being no greater than current market
values as of the statement date. If they are unsure of these amounts, they
can attest to lower numbers or can refuse to give a bank an unqualified
opinion. Thus a bank would have to put up additional capital if it wanted
to invest in assets of undeterminable value, since its stated capital would
be reduced to the amount that its independent public accountants certify
as being no greater than market value. Because their reputations and for
tunes are at stake, the CP A s have a strong incentive to be conservative. (As
partnerships, C P A s can be sued jointly and severally to the extent o f their
personal wealth.)5 Furthermore, the cost of determining attestable market
values, i.e., the appraisers’ and C P A s’ fees, would be borne by the banks
that made the investments. This is a form of risk-related insurance pre
mium.
C. Supervisory Monitoring o f Capital and Banking Operations
For purposes of frequent and timely monitoring, detailed quarterly state
ments would be required using market values for marketable assets and
book values for others. These would be supplemented by more aggregated
monthly reports for all banks and weekly reports for larger banks. The

FRB CHICAGO Staff Memoranda

data reported should be confirmed by periodic and surprise audits and/or
attestations by certified public accountants.
Computerization permits rapid scanning o f these reports for supervisory
purposes. In the interim, changes in the values of traded assets can be ob
tained from market prices. Except for fraud, losses in nontraded assets
generally occur only slowly through time and should be detectable from the
periodic reports. In addition, information on potential risk taking insti
tutions can be obtained weekly from advertised deposit rates compiled by
private services.
A n insufficiently well diversified or excessively concentrated portfolio can
result in the sudden depletion of a bank’s capital if prices change greatly.
However, such portfolios can be observed from the reports rendered by
banks and from confirming field examinations. These situations should be
closely monitored. The cease and desist powers now held by the supervi
sory authorities can be used to control situations that pose an immediate
danger to the insurance fund.
D.

Fraud and Gross Mismanagement

The largest losses absorbed by the deposit insurance funds have been the
result o f fraud and gross mismanagement. (Benston et al., 1986, Chapter
10) Fraud is a particularly important problem because it is difficult to de
tect until it is too late. Furthermore, the incentives for bank managers and
owners to engage in fraud or gross mismanagement is unlikely to be af
fected sufficiently by higher insurance premiums, higher capital require
ments, or even prompt reorganization rules, either because they expect to
steal or otherwise gain much more than they might lose or because their
incompetence is so great that they cannot understand the nature of the risks
they are taking.
Two methods can be employed to deal with fraud and gross mismanage
ment. One is to continue the present practice of field examinations and
supervision. These procedures could be improved, however, were they di
rected specifically to the prompt detection o f fraud and gross mismanage
ment, rather than to a general review o f a bank’s operations. For this
purpose, more frequent reporting, the use o f frequent publicly available
information, e.g., deposit rates paid and loan rates charged, and the use of
statistical early warning models to direct field examinations to banks that
are likely to be serious problems could reduce the cost and improve the ef
fectiveness of supervision.
The second method is for the authorities to rely more on the annual reports
attested to by CPAs. As is noted above, C P A s have incentives to attest
correctly to accounting numbers. Furthermore, they could be explicitly

FRB CHICAGO Staff Memoranda

charged with an obligation to report any serious weaknesses in a bank’s
internal controls and other problems directly to the banking authorities, as
has been proposed in the United Kingdom.6 The two methods can, of
course, be used in combination.
6. Conclusion
Several o f the proposals for change discussed above have features that are
desirable and practical, both operationally and politically. However, some
do not. Abolition of federal deposit insurance is not desirable because we
do not believe that this action is politically feasible nor do we believe that
the federal government could refrain from bailing out depositors should
more than a few banks fail. Thus we would have de facto deposits insur
ance without the benefits of federal responsibility for controlling moral
hazard. Moreover, we need to protect small depositors, not so much for
their own sake but for the sake of maintaining the aggregate money supply
by not encouraging a run to currency. Private insurance is unlikely to instill
the confidence to eliminate this possibility altogether.
We also find that the narrow bank proposal is not feasible in a form that
is effective, or desirable in a form that is feasible. For it to be economically
feasible, the narrow bank would have to hold assets that would make it
similar to ordinary banks, with similar problems. To the extent that its
asset holdings were limited to “safe” credit and interest rate risk assets, it
would suffer the economic cost of inefficiency. Furthermore, alternative
reforms can offer the benefits of the narrow bank without its limitations.
Reduction of deposit insurance coverage to some lower level per account
would be desirable in order to increase monitoring by depositors. But it is
not clear whether or not this change is politically feasible. Furthermore,
to the extent that demand depositors are not insured, they have both the
incentive and ability to run. While the fear of runs by bankers is desirable
for providing them with incentives to be responsive to depositors’ concerns,
the banking authorities appear unwilling as of now, at least, to allow very
large banks to suffer a run. Risk-related deposit insurance premiums would
be desirable, but they do not appear to be operationally feasible sufficiently
quickly to deal with the problem at hand. Risk-related capital requirements
suffer from similar operational difficulties. Indeed, the scheme proposed
by the banking authorities has some important and obvious limitations. In
addition, it does not increase the economic capital base of the industry and
thereby is not likely to reduce overall risk greatly.
We believe that the last alternative discussed—reorganization before eco
nomic capital becomes negative—is both desirable and operational. A l
though it may lead, at least initially to the formal recognition of more bank
failures, it will not reduce the provision of banking services to customers.

FRB CHICAGO Staff Memoranda

The scheme does offer the advantages of reducing the costs o f deposit in
surance to the cost o f monitoring plus losses that are not worth preventing
or that cannot be prevented. It virtually eliminates the moral hazard from
deposit insurance because bank managers and owners will now be playing
only with their own funds and-bearing_almost all of the costs o f failure.
There would be little reason to regulate banks’ operations for purposes of
risk control. Other advantages include equal treatment of banks of all sizes.
Fraud and gross mismanagement can be reduced more efficiently by greater
reliance on CPAs, monitoring by the authorities o f more frequently re
ceived information, and prompt reorganization of insolvent banks. A l
though the scheme requires economic market value accounting, we have
suggested how this procedure could be implemented satisfactorily. Finally
, the suggested reform appears to be feasible because it offers several ad
vantages to public policy makers that the alternative proposals do not. The
proposal is described next.

IV. A Proposal for Timely Intervention and
Reorganization of Banks
1. The Optimal Capital Requirement. Because losses can occur quickly or
remain undetected until after a bank becomes insolvent, the optimal
amount of required capital clearly is greater than zero, and the authorities
must intervene and reorganize a bank before it becomes economically in
solvent. The larger the amount of capital required, the greater the incentive
o f bank managers and owners not to take excessive risks, which implies that
the capital requirement should be relatively high.7
A capital requirement for banks is a requirement for a specified ratio of
federally insured and uninsured debt (deposits) to subordinated, uninsured
debt and equity that, if measured in terms of economic market values, is
available to absorb asset losses before they must be met from the deposit
insurance funds and uninsured depositors. (“ Subordinated” refers to the
claims of the federal deposit insurance agencies on the assets of the bank.)
Thus, for purposes o f bank regulation and federal deposit insurance, capital
is equity plus subordinated debt and debt is all other liabilities that have
claims on assets, particularly insured and uninsured deposits.
An optimal capital requirement should protect the deposit insurance agen
cies adequately, while not imposing excessive costs on the insured insti
tutions. As the following analysis demonstrates, a higher rather than lower
requirement is preferable. A higher capital ratio would not only reduce the
probability and magnitude of losses to the insurance agencies, but would
reduce their need to monitor the banks as frequently and carefully as oth
erwise. Because the benefits of higher capital ratios to the insurance agency

FRB CHICAGO Staff Memoranda

are self obvious, we focus our examination on the costs and benefits o f such
ratios to the banks.
As is well known from finance theory, the relative amounts o f debt and
equity are unimportant and have no economic consequences for the firm,
with the following exceptions: (1) interest payments on debt are a tax
deductible expense while dividend payments and retained earnings on eq
uity are not deductible—hence debt is preferred to equity, ceteris paribus;
(2) bankruptcy costs are more likely to be incurred and monitoring costs
are higher when equity is relatively lower—hence equity is preferred to debt,
ceteris paribus; and (3) for banks, insured debt (deposits) is preferred to
uninsured debt or equity when deposit insurance premiums are less than the
benefit of the insurance to the institution, as presently is the situation for
many banks. This last advantage is precisely what we want to remove, and
the second factor argues for more capital. Therefore, from the viewpoint
of both the bank’s owner and the authorities, we need be concerned only
with the first factor.
The tax advantage of debt could be obtained by banks to the same extent
as other firms if they were permitted to count as capital subordinated
(unquestionably de facto as well as de jure uninsured) debentures that are
junior to the claims of the insurance agencies and that cannot be redeemed
before the authorities can force a reorganization o f the bank, and cannot
block that reorganization. To prevent flights of these funds (runs) from
occurring, these debentures must not be redeemable by the bank before the
authorities can intervene to reorganize the institution.
The banking authorities have severely limited the extent to which banks
may meet their capital requirements with subordinated debt. This limita
tion appears based on a belief that debt holders do not exercise as great a
monitoring function over bank operations as do equity holders, and that,
unless perpetual, debt capital may be withdrawn at maturity and thus not
as permanent as equity capital. But neither of these conclusions is valid.
If the debtholders’ claims are subordinate to those o f other creditors (in
cluding the deposit insurance agencies) and if they cannot remove their
funds when a bank experiences difficulties, they bear the cost o f a bank’s
failure. Hence, as is the situation for bondholders generally, they have an
incentive to monitor the risks taken by the equity holders and will insist on
a return that compensates them for the risk they are assuming. Equity
holders, then, have a concomitant incentive to reduce risk to the
bondholders (and hence a cost to the equity holders) by-altering the bank’s
operations and/or by increasing their capital (equity) investments More
over, debt need not be permanent to achieve this result. It must only be
restricted so that it cannot be redeemed before the authorities can act.
Thus, it will bear potential losses and protect the insurance fund. From the
viewpoint of the banking authorities, it should not matter how much of a

FRB CHICAGO Staff Memoranda

bank’s capital is in the form of equity or subordinated debt.
the same function.

It all serves

Indeed, subordinated debt capital offers several banking and supervisory
advantages over equity capital. First, smaller banks may be loath to sell
equities either because the price they could receive for minority stock in a
closely held bank would be low, or because the owners do not want to di
lute their control. They might find the cost o f selling relatively small
amounts o f stock to be high. Subordinated debentures, on the other hand,
could be offered to investors in their communities—in effect, they simply
would be selling explicitly uninsured time deposits to people who are likely
to have knowledge about how the bank is operated and the ability to
monitor its operations.
Second, if the debentures were traded, the yields determined by the sec
ondary market could give the authorities an early warning about the risks
undertaken by the bank. Even if the debentures were not actively traded
on secondary markets, any difficulties a bank might have in marketing its
new debentures on the primary market as the old ones become due could
provide timely information to the supervising authorities. Such signals
could be obtained best if banks were required to hold debentures with
evenly spaced maturity dates. For example, a rule might be that no less
than five percent or more than ten percent of the debentures could mature
in any one year. (Benston et al., 1986, Chapter 7)
A n additional concern about imposing capital requirements on banks
should be considered. It is possible that the amount o f capital required to
be invested could be more than the banking system can use efficiently. This
result could occur if banks were required to invest in a limited subset of
assets, such as U.S. Treasury obligations, or in physical assets that were
limited to producing goods subject to limited demand. This concern is
largely eliminated, however, by the removal of limitations on the assets in
which banks can invest. A t the extreme, however, a very high capital re
quirement could result in a misallocation o f resources if bankers had a
comparative disadvantage in using the funds they were required to obtain
from investors.
Thus, with the asset constraint removed, the capital requirement should and
can err on the side o f too much rather than too little capital. Too high a
requirement largely serves to reduce to zero the benefit to risk preferrers
of underpriced deposit insurance, while too low a requirement increases the
moral hazard cost of deposit insurance.

FRB CHICAGO Staff Memoranda

2. The Measurement of Capital
Capital is the difference between total assets measured at no more than
market values and total liabilities measured at no less than market values
less subordinated debentures serving as capital.8 As was discussed above,
the market values reported are to be attested to by a certified public ac
countant whom the deposit insurance agency does not disapprove. Con
tingent (off-balance sheet) assets and liabilities must be added to total
liabilities and total assets. The documents to which these liabilities refer
must state explicitly that they are not covered by federal deposit insurance.
However, the liabilities would not be counted as capital because they could
be withdrawn quickly.
As noted above, a bank’s investments in subsidiaries would be measured
at their net asset values when the bank has no liability for the subsidiaries’
debts and this fact is verified by the bank’s CPA . If the bank were directly
or contingently liable for the subsidiaries’ debts, subsidiary assets and li
abilities must be consolidated with those of the parent bank. The conse
quence of the rules with respect to contingent and subsidiary liabilities is
to increase required capital, since the requirement is stated as a percentage
of total assets. The allowance (reserve) for loan losses sometimes is con
sidered to be part of capital on the assumption that it is overstated. How
ever, G A A P and the tax regulations require that the allowance reflect the
expected amount of loans that will not be collected. Hence, the loan loss
allowance should be considered the amount necessary to reduce “loans
receivable” towards market value and thus the allowance should be re
corded as an asset contra account.
3. Banks That Are Subsidiaries of Holding Companies or Other
Corporations or That Are Not Diversely Owned
There is no reason for the authorities to examine or to be concerned with
the management decisions of the owners of banks, including holding com
panies, as long as the banks have adequate capital and as long as there are
controls against self-dealing and fraud. Self-dealing can occur when any
bank offers less-than-market prices to its owners or their interests. Fraud
against the federal deposit agency can occur when a bank that is in danger
of becoming insolvent transfers funds to avoid the claims of creditors, in
cluding the deposit insurance agency. These possibilities represent poten
tially important dangers to deposit insurance. Consequently, banks owned
by controlling interests must be monitored more closely than those which
are diversely owned, and transfers (loans, dividends, and payments for ser
vices) between the bank and the owners’ other interest may be restricted.
Holding company ownership of banks presents less risk to the insurance
funds than does ownership by controlling individuals. Individuals owners

FRB CHICAGO Staff Memoranda

generally have greater incentive than corporate executives to divert bank
funds to their own projects and to other uses because the owners benefit
personally and directly thereby. In addition, it is more difficult for the
banking supervisors to identify the interests of the owners in contrast to
readily available information about holding company subsidiaries.
A t present, holding companies are subject to Sections 23A and 23B (added
by the Banking A ct o f 1987) o f the Federal Reserve Act that limit the extent
to which funds can be upstreamed from the bank to its holding company
or other affiliates. (Benston et al., 1986; Saunders, 1987; Huertas, 1987)
Similar restrictions should be applied to all transfers between a depositinsured bank and enterprises in which the bank’s managers and owners
have a substantial interest, say, more than 10 per cent o f the stock.
With monitoring and restrictions on funds transfers in place the capital re
quirement would be applied only against the commercial bank (including
its subsidiaries), not the holding company or other owner. The holding
company’s capital requirement would be determined by market forces as it
is not the recipient o f federal deposit insurance, nor are the safety and
soundness o f its nonbanking activities o f concern to the government.
The managers or owners o f the bank might believe that it is more efficient
to include all affiliates within the same organization that offers federally
insured deposits. This poses no special problem; the requirement would
then apply to the entire organization. The measurement o f assets, liabilities
and capital is the same as is described above.
If the bank and its parent have the same or similar names, the deposit in
surance authorities might fear confusion by the public as to which is the
insured bank. This possibility could be reduced or avoided if the parent
were required to state clearly in writing on each security that it is not a
federally insured bank and that its obligations are not covered by deposit
insurance. Nor would the bank be permitted to guarantee the obligations
o f its affiliates.
In addition, timely insolvency intervention removes any subsidy associated
with the provision o f deposit insurance. This would remove any ability of
insured banks to shift the benefits o f underpriced insurance to other prod
uct lines or to its affiliates to gain competitive advantages, assuming that
such cross-subsidization occurred.
4. Reorganization Rules
The capital required should be sufficiently high to absorb almost all prob
able reduction in net asset values. As is discussed above, banks do not bear
costs from an overly high requirement (excluding the loss o f the deposit

FRB CHICAGO Staff Memoranda

insurance subsidy) unless this requirement is so high as to prevent them
from holding an optimal portfolio of assets. For commercial banks, we
suggest the numbers and reorganization rules shown in Table 2.
The
precise values of the capital ratios in each tranche are illustrative.
The values shown in Table 2 are likely to be on the low side and may need
to be revised upward in light o f the considerably higher bank capital ratios
that existed before the introduction of the F D IC in 1934, the considerably
higher capital ratios that exist in almost all other industries, and the rela
tively low cost of capital to banks when subordinated debt is included. The
primary criterion is that the capital ratios be high enough to minimize the
possibility o f loss to the insurance agency for any reason other than massive
fraud. Thus, the tranche ratios need to be related to the historical and
projected variability in the value of the institutions’ portfolios.
Application of the proposed capital requirements would, o f course, require
a transition period. The current values were, in part, selected because they
conform to the present capital standards of the commercial bank regulatory
agencies, although they are stated in market rather than book value terms.
Although it is possible at times for book values to exceed market values,
as a general principle, the tranche ranges in book value terms should be
increased, e.g., by three percentage points. Banks could be provided with
a choice about which set of accounting rules they wish to use.
It is important that dividends, interest payments on the subordinated
debentures, and fund outflows to a parent or affiliates could be suspended
by the insurance agency if the market value of a bank’s capital declines
below ten percent of its assets on a market value basis, and must be sus
pended if the capital ratio is below six percent. Indeed, with some ex
ceptions, banks now are permitted to pay dividends only if their capital
ratios exceed the regulators’ minimum standards and are limited to their
current and previous years’ earnings. These limitations are necessary be
cause, unlike other firms, banks that offer federally insured deposits can
obtain funds regardless of their solvency. The suspension of interest pay
ments gives the debenture holders the right to force a reorganization o f the
bank. Thus, in all except the extreme circumstance, when the market value
of a bank’s capital declines substantially and precipitously, the deposit in
surance agencies will not have to reorganize a bank—the reorganization will
already have been undertaken by the subordinated debenture holders.
Current owners of banks can always maintain their ownership by providing
sufficient capital. However, when, on the basis of quarterly or more fre
quent monitoring, the market value capital-to-asset ratio of a bank declines
to 3 percent or below (tranche 4), ownership of the bank would be auto
matically transferred to the FD IC . This would occur if the owners, who
may reasonably be assumed to know more about the true condition o f the

FRB CHICAGO Staff Memoranda

T a b le 2
Illu s t r a t iv e R e o r g a n iz a tio n R u le s f o r F e d e r a lly In s u re d C o m m e r c ia l B a n k s
C a p it a l- t o - A s s e t R a tio
(A ll a c c o u n ts v a lu e d a t m a r k e t )

10 Percent or Greater
No problem—minimum
regulation and supervision
level. Subject only
to general reporting and
examination requirements.
All intra-holding company
transfers must be fully disclosed
and fraud provisions strictly
enforced.

6-9.9 Percent
Potential problem—more
intensive regulatory
supervision and monitoring.
Regulatory agency discretion
to reduce or suspend
dividend payments and/or
up- or downstream payments
to parent or affiliates.

3-5.9 Percent
Problem—intensive
regulatory supervision
supervision and monitoring.
Mandatory suspension of
dividend payments, interest
payments on and redemption
of maturing subordinated debt,
and outflow of funds to
parent or affiliate.

Under 3 Percent
Reorganization—mandatory
recapitalization, sale,
merger, or liquidation
by federal insurance agency
in orderly fashion. May
require formation of "bridge"
institution or "trusteeship"by
insurance agency for no more
than two years. Nondeposit
funds distributed up to 90
days before to be recovered.

bank than the regulators, believe that the bank is not worth the investment
of the necessary additional capital. The F D IC would then attempt to sell
or merge the bank. Only as a last resort would it liquidate the bank. This
process does not represent expropriation of shareowners’ property, even
though their investment in the bank may not be fully exhausted. As noted,
current shareholders are given first choice to recapitalize their institutions.
If they fail to do so, the proceeds to the F D IC from sale or liquidation
would be passed through to the previous owners. They would thus receive
the fair market value o f their investment in the bank.
As discussed earlier, to provide sufficient time for the F D IC to accomplish
its task efficiently, it may be necessary for the agency to operate the very
largest banks temporarily in a bridge or trustee relationship for a few
weeks, but no longer than for, say, two years. Authority for the insurance
agencies to establish such arrangements was included in the Banking Act
of 1987. In addition, as in the bankruptcy law for nonbank firms, nonde
posit funds distributed by the bank up to 90 days before the date the reor
ganization tranche is breached are to be recovered by the FD IC .
The proposed reorganization scheme is different than that commonly ap
plied to nonbank firms and may appear to be more stringent. A nonbank
firm is generally declared involuntarily bankrupt and remedies for creditors
started when it fails to pay a major scheduled payment on time and in full.
Economic insolvency, per se, is not generally considered sufficient grounds
for creditors to file for involuntary bankruptcy and request remedies, al
though it may be for voluntary bankruptcy. (Weintraub and Resnick,
1986) Thus, nonbank firms may be permitted some time to continue to
operate after they become economically insolvent. However, more timely
failure resolution is required for banks because federal deposit insurance
makes it possible for them to continue operations even after them become
economically insolvent. Unlike creditors of noninsured firms, depositors
would continue to advance funds to banks as long as they could look to
an insurance agency believed immune to failure. In the absence of federal
deposit insurance, insured depositors would assess the economic solvency
(market value) of a bank much as creditors assess the solvency of any firm,
and would remove their funds (run) if they believed the bank to be insol
vent. This would quickly cause the bank to miss a payment and result in
involuntary bankruptcy. Thus, timely failure resolution based on market
valuations is simply a replication by the deposit insurance agency of the
situation that faces insolvent noninsured firms.
Evidence that more timely closure reduces losses to deposit insurance
agencies and to other creditors is quite strong. Until recently, the F D IC
closed banks reasonably quickly after it became evident that the market
value of their assets had declined below that of their liabilities and, except
in the cases of major fraud, experienced minor if any losses. (Benston, et

FRB CHICAGO Staff Memoranda

al., 1986, Chapter 4; Horvitz, 1983) In the absence o f major fraud, the
market values o f banks are unlikely to decline abruptly. Rather, they gen
erally will deteriorate slowly through time and can be monitored reasonably
accurately. Through 1931, estimated losses at failed and swiftly closed na
tional banks were 10 cents on the dollar, compared to 90 cents on the dollar
at nonfinancial firms. (Lawrence, 1931) In comparison, a recent study of
defaulted corporate bonds estimated that the immediate loss in market
bond values from 1974 through 1984 was about 60 percent. (Altman and
Nammacher, 1987) This is consistent with the loss ratios estimated for the
1900-to-1943 period. (Hickman, 1958) Losses to creditors primarily reflect
the delay in initiating involuntary bankruptcy procedures for nonfinancial
firms. These losses may reasonably be expected to be reduced even further
under the proposed capital scheme. As a bank’s capital declines through
the successively lower strata of capital tranches, progressively stricter
monitoring and supervision by the regulatory agency is triggered automat
ically. Such a scenario should result in “ soft landings” as bad news sur
prises are less likely.
Moreover, as noted above, most other types o f financial firms and almost
all types o f nonfinancial firms are forced by the marketplace to hold higher
levels o f capital relative to assets. Thus, speedier failure resolution would
be necessary if banks were permitted to hold lower capital. Banks could,
of course, hold higher capital voluntarily to reduce their probability o f be
ing reorganized when losses are larger than expected.
As more timely failure intervention when a bank’s capital is still positive
greatly reduces potential losses to depositors, the need for federal deposit
insurance would be diminished. The need would not be removed alto
gether, however. Losses could still accrue to depositors from a sufficiently
large fraud or other large declines in market asset values between moni
toring periods. As a result, it is still possible that small depositors would
suffer a loss of faith in all banks and shift their funds to currency and that
this should would not be appropriately offset by the Federal Reserve.

Summary of the Advantages of the Proposal
The proposed capital rules offer the following advantages:
1. The system would be voluntary in exchange for federal deposit insur
ance. Because the capital rules apply only to the incorporated entity pro
viding federally insured deposits, institutions would be free to determine
their own organization’s structure. They could offer nonfederally insured
deposits and avoid these requirements. In this event, they would have to
disclose clearly that the deposits are not covered by federal insurance.

FRB CHICAGO Staff Memoranda

2. Losses to the federal deposit insurance agencies (and, therefore, to banks
and ultimately to the taxpayer) would be minimized, as banks would be
recapitalized before their economic capital became negative. Thus, deposit
insurance premiums would be reduced.
3. Regulation of bank activities would be minimized. Because there would
be only minor, if any, losses to the deposit insurance agency, there would
be no justification for bank regulation based on solvency considerations by
any authorities other than the federal deposit insurance agencies. These
agencies would be responsible primarily for monitoring the reporting and
capital requirements and for supervising banks that did not meet these re
quirements or that appeared to be operated recklessly or fraudulently. In
deed, they could better target their energies and limited resources to those
banks that posed the greatest threat to the insurance funds. Since banks
satisfying the capital requirements would be primarily risking loss of their
own funds, there would be no need to restrict their activities. A t least with
respect to risk, they might engage in any financial or nonfinancial activity
that could be monitored reasonably accurately and to whose market values
recognized C P A firms were willing to attest.
4. Banks could be run more efficiently and could serve the public better,
because operating and product decisions would be made by bank managers
rather than by regulators.
5.
Banks of all sizes and characteristics in the same financial condition
would be treated equally. N o bank would be “ too large or too special to
fail” .
6.
Banks would be subject to increased market discipline not only from
subordinated debt holders but also from shareholders, who would not get
second or more chances to recoup their losses when the economic value of
their investments disappeared; from managers, who might lose their posi
tions faster when their banks became insolvent; and possibly from
uninsured depositors, who might experience losses if actual net worth at the
time o f reorganization was much below perceived net worth. The market
discipline would resembles that in a noninsured environment. Because,
except under conditions of fraud or highly unusual movements in market
places, net worth would not become zero or negative, the tendency to make
high risk end runs or take last chance plunges would be significantly re
duced.
7. The proposal is not as radical as it might appear at first. Mandatory
reorganization when capital requirements were violated existed under the
National Bank Act and were enforced until the Great Depression and the
introduction of federal deposit insurance.
(Upham and Lamke, 1934)
More recently, support for a similar proposal was voiced by Acting

FRB CHICAGO Staff Memoranda

Comptroller of the Currency H. Joe Selby in testimony before Congress in
1985. He suggested that
policy could be adopted that any time a bank’s capital falls below 3 percent
(the level at which the F D IC generally considers termination of deposit in
surance), the primary supervisor would be given the authority to require the
owners to seek a merger partner or to liquidate the bank. Alternatively, a
conservator could be appointed by the primary authority to exercise the full
range o f powers possessed by bank management, including the sale o f the
bank. (Selby, 1985, p. 23)
Moreover, this type o f rule was recently adopted by the Federal Home
Loan Bank Board, which has recently incorporated a “ sudden-death”
clause in some o f its agreements with buyers of failed savings and loan as
sociations by which the F S L IC will automatically reclaim the institution if
the new owners permit its capital to fall below 3 percent o f its liabilities.
A representative o f a large commercial bank has noted that
“ ...to the extent that there is a problem with deposit insurance, that
problem arises from the failure resolution policies pursued by the
F D IC and other bank regulators. Reforming the deposit insurance
system therefore requires reforming bank failure resolution policies
so that banks are closed as they become insolvent; nothing more and
nothing less will solve the problem.” (Huertas and Strauber, 1986,
p. 406)
Thus, our suggested reorganization rule provides an operational means of
extending the pragmatic response o f some banking authorities to the prob
lems they have been facing. Further research is required to establish the
precise values o f the optimal capital tranches, the schedule for implement
ing market value reporting and monitoring (which has recently been pro
posed by the Financial Accounting Standards Board), and the particulars
o f the reorganization procedures and the transition process.

FRB CHICAGO Staff Memoranda

Footnotes
1 Other reasons for regulating banks include concerns for conflicts of interest,
consumer protection (including discrimination concerns), and aggregation of eco
nomic or political power. We have not discussed them here because they do not
impinge on the solvency of banks. Indeed, to the extent that banks do engage in
conflicts of interest, take advantage of consumer ignorance, and are able to ac
quire the market power to raises prices, their solvency would be enhanced. These
concerns are addressed by Edwards (1987) and Flannery (1987). They do not find
the concerns to be justified. Regulation of banks as a means of allocating credit,
particularly towards housing, is analyzed and rejected by (Weicher, 1987). But
again, this is not a solvency issue. (Also see Benston, 1983, for a discussion of
these and additional reasons for regulating banks.)
2 James has recently argued that bank large business loans are “special” because
they signal to the market the borrowers have earned the bank’s “Good House
keeping seal of approval” . But, as the bank’s market share of the large corporate
loan market is declining, large corporate borrowers appear to be giving less weight
to this “advantage”. (James, 1987) For other arguments that bank loans are
unique see Bernanke, 1983 and Goodhart, 1985.
3 This cost should also include the costs of the incentives for outright criminal
activities and political corruption that the current system provides and that have
come to light in recent months in the SLA industry in Texas and California.
Senior members of Congress have reportedly been wined, dined, and financed
extensively to help turn back legislative attempts to curb the looting. These costs
are borne as much by the social, and political fabric of our society as the economy.
(Kaufman, 1987B)
4 If a CPA is unacceptable to the banking authorities on the basis of insufficient
capital, reputation, or so on, they can request that a firm acceptable to them be
engaged additionally. This procedure has recently been proposed to the U.K.
Parliament by the Government. (Chancellor of the Exchequer, 1985, Section 8.2
[«]>5 See Benston, 1985A, for a complete analysis of the incentives faced by public
accountants.
6 Germany and Switzerland presently rely on independent public accountants for
bank examinations and reports.
7 Some bankers and economists have argued that higher capital requirements ac
tually may encourage institutions to increase their risk taking in order to offset
the higher cost of capital. (Koehn and Santomero, 1980) But as we demonstrate
later, if subordinated debt were permitted to serve as capital to supplement equity,
there need not be an increase in the cost of capital. Moreover, these studies im
plicitly assume that all funds are de facto if not de jure insured and do not scale
a bank’s borrowing costs or deposit insurance premiums to its risk exposure. If
they did, the result would differ. (Furlong and Keeley, 1987)
8 If collateral were pledged to such debt, the amounts of the pledged assets would
be excluded from the computation of the bank’s capital.

FRB CHICAGO Staff Memoranda

APPENDIX A
Narrow, Fail-safe, or Money Market Banks:
Evaluation

Analysis and

A number o f students o f banking have recently proposed an alternative
strategy to abolishing or reforming federal deposit insurance. (Litan, 1986,
1987; Tobin, 1986; Kareken, 1986; Lawrence, 1985; Golembe and Mingo,
1985; Huertas, 1986B; Angermueller, 1986. For a criticism of these pro
posals see Aspinwall, 1987.) They claim that this strategy would simul
taneously increase the safety of the banking system, by reducing bank
failures, and increase the efficiency o f the system, by decreasing the extent
o f regulation, particularly with respect to permissible powers. In general,
this proposal involves creating narrow, presumably "fail-safe" banks (also
called money market banks) that would be restructured to invest in assets
with only a minimal chance o f declining in value due to either credit or in
terest rate risk. The proposals differ with respect to the types of invest
ments narrow banks could make, the types o f deposits they could offer, and
their insurance coverage.1
The narrow banks could be owned by holding companies that could also
own other affiliated entities that accepted noninsured deposits and would
be permitted to engage in a wide range o f activities, financial as well as
nonfinancial. These institutions could, and would be permitted to fail.
Bank holding companies that did not organize narrow banks would remain
restricted in their permissible powers. Unfortunately, these proposals have
several serious defects that invalidate many o f the claimed benefits.
One problem stems from a requirement in the first proposals that fail-safe
banks limit their investment to nearly riskless securities—Treasury securities
with maturities under six months. But the total amount of such Treasury
and even other federal-govemment-guaranteed securities is not much
greater than the total amount of transaction balances. Thus, nearly all of
these securities would have to be held by the fail-safe banks. This amount
is also far greater than the dollar amount o f such securities now held by
commercial banks. Thus, this plan would result both in major disruptions
of security prices at the time the fail-safe banks are established and major
shortages o f relatively riskless securities for the portfolios of nonfail-safe
banks and other investors. This, in turn, would hamper greatly the ability
o f nonfail-safe institutions to provide portfolio liquidity against potential
deposit withdrawals.
In a revised plan, Litan proposed that the fail-safe banks be permitted to
hold default-free securities with longer maturities—U.S. Treasury obli
gations with maturities o f more than one year. But, then, the narrow banks

FRB CHICAGO Staff Memoranda

no longer would be fail-safe, as they would be subject to interest rate risk.
The massive failure o f thrift institutions when interest rates increased in the
early 1980s should make it clear that this risk is not trivial.
Narrow banks with limited investment powers are also likely to have diffi
culty in attracting deposits. In a world with many alternative types of fi
nancial institutions and instruments, individual banks or the banking
system as a whole can attract deposits only if they offer a competitive (ex
plicit or implicit) interest rate. The rate they can profitably pay depends
on the return they can earn on their assets. The lower the return, the lower
the deposit rate they can afford to pay, and the less they can attract in de
posits relative to their competitors. But the return banks can generate on
their earning assets depends on the restrictions imposed on the safety o f the
assets they may hold. The safer the assets, the lower the return. A truly
fail-safe bank necessarily would have to hold assets yielding relatively low
rates o f return.
If a bank cannot offer a competitive rate for or has to impose high service
charges on deposits, depositors would search out alternative institutions
offering comparable services. The alternative, "nonfail-safe" institutions
would offer deposit services at higher interest rates, much like money mar
ket funds offered quasi-transaction accounts in the late 1970s when Regu
lation Q and the prohibition on cash interest payments on demand deposits
increased to very high levels the opportunity costs to consumers o f holding
bank deposits. Indeed, such competitive accounts might even be offered
by other affiliates within the same bank holding company. Thus, there
would be a shift of funds from fail-safe to nonfail-safe banks. If a suffi
ciently large percentage of transaction deposits were transferred, the ori
ginal concerns that led to the proposal—protecting the payments system,
dealing with failing banks without federal deposit insurance, and removal
of regulations on other bank activities—would reappear.
To prevent such disintermediation, Kareken (1986) suggests that the Fed
eral Reserve could refuse to process checks written on nonfail-safe banks.
However, he does not show how nonfail-safe banks could be prevented
from using fail-safe banks as a conduit for their checks, much as Merrill
Lynch used Bank One (Ohio) for its money market management accounts.
But even if Kareken’s proposal could be made operational, it is likely to
encourage the development of private clearing systems that bypass the
Federal Reserve altogether.
What, then, can be done to eliminate this shift of deposit funds to nonbank
institutions? One proposed solution would allow the fail-safe banks to earn
more on their assets, permitting them to invest in securities that have
greater default risk, interest rate risk, or both. But as long as they offer
deposits withdrawable at par, the original reason for establishing the fail-

FRB CHICAGO Staff Memoranda

safe banks would be defeated, which would probably lead to the reintro
duction o f federal deposit insurance.
The broader the permissible
investments, the less fail-safe the bank, and the more necessary it will be to
retain deposit insurance and/or regulations.
Alternatively, Kareken (1986) has suggested abandoning par deposits and
requiring that the fail-safe banks offer only market-value deposits similar
to those offered by money market funds. But there is substantial evidence
that there is strong widespread demand for fixed-value (par) deposits. For
example, at their outset money market funds marked their shares to market
daily. Thus, they offered variable-valued "deposits", similar to all other
mutual funds. But many o f the funds soon discovered that they could in
crease demand by offering nominally fixed-value shares, even at times at
lower interest rates. They were permitted to do so by the SEC if the aver
age maturity of their portfolio was less than 120 days. (It should be noted
that this is a voluntary accounting procedure. The funds would not be in
default if they were unable to repay deposits at par.) Constant value money
market funds soon dominated the industry.
Another proposal would permit fail-safe banks to invest in riskier assets if
the bank held capital sufficient at all times to absorb expected losses.
("Sufficient" may be defined as the amount that a bank would have held
were there no federal deposit insurance). These banks would be required
to mark their securities to market. (Huertas, 1987) They could invest in
securities o f any risk as long as these could be marked to market reasonably
accurately. Since losses now could be incurred that could exceed the bank’s
capital, this system would require explicit failure resolution strategies on the
part o f the regulatory agencies to avoid losses to depositors, interruptions
to the payments system, or reimposition of explicit or implicit deposit in
surance.2
Even if the narrow banks were prevented from taking default and interest
rate risks, they still would be subject to operating and fraud risks. Indeed,
to the extent that protection o f the payments system is a major concern of
the proposed schemes, losses from interbank clearing and failed delivery
that may be labelled operating risk should be of at least equal concern.
Yet, these risks are not considered. Thus, the narrow bank banks would
not be fail-safe, and the case for withdrawing deposit insurance is signif
icantly weakened.
Although in its more workable forms the narrow bank would offer the same
problems with respect to capital requirements and reorganization rules as
would current banks, it does not offer compensation in the form of greater
efficiencies. To the contrary, it will increase costs to bank customers be
cause it would prevent banks and their customers from taking advantage
o f economies of scope in production and demand. In particular, both

FRB CHICAGO Staff Memoranda

transaction deposit servicing and loan extension and monitoring involve
substantial knowledge about the customer. The knowledge gained from
providing one o f the services reduces the cost o f providing the other. This
complementary relationship explains why loan provision was the first and
is the most important service offered by depository institutions. Artificially
separating lending and deposit gathering in the same legal entity by regu
lation would reduce the efficiency of the process and increase the cost of
providing either.3
Lastly, monetary policy might be frustrated by reduced Federal Reserve
control over nonfail-safe banks, which would no longer be required to hold
legal reserves. As Li tan (1987) correctly notes, this would depend on
whether the monetary authorities want to control money (deposits) or
credit (bank loans). If all transaction balances were held at fail-safe banks,
control over the money supply (defined narrowly) would not be reduced,
although, as discussed in the note to this appendix, control also would not
be increased if the narrow banks could hold assets other than currency or
reserves at the central bank. Indeed, even if some transaction balances were
shifted to nonfail-safe banks, monetary control need not be reduced. The
nonfail-safe banks would still demand some cash reserves voluntarily to
meet deposit outflows optimally. Open market transactions by the central
bank could induce them or their customers to alter their portfolio mixes
and thereby the amount of deposits. If monetary policy were used to con
trol credit in the form of bank loans, redistributing the total pool of credit
among financial institutions or fail-safe and nonfail-safe banks would have
little, if any, lasting effects. Likewise, interest rate control is unlikely to be
affected one way or the other by a reshuffling of the types o f assets held
by different types of financial institutions.

Footnotes
1 The present proposals for a fail-safe bank should be distinguished from earlier,
superficially similar ideas. Some of its proponents mistakenly trace its intellectual
origins back to Milton Friedman’s and, even earlier, Henry Simons’ 100 percent
reserve banking proposal. But this is not correct. Friedman, Simons, and their
colleagues were concerned with central bank control of the money supply. They
believed that fractional reserve banking introduced leakages in the depositreserves multiplier relationship, such as unexpected changes in excess reserves and
differing legal reserve requirements across different banks or classes of deposits,
that reduced control. Under their scheme, the relationship between base money,
which the central bank controls, and the money supply would be precise (indeed,
identical), because all bank reserves would be held in the form of currency or re
serves at the central bank. Commercial banks would not be allowed to make any
other investments, including loans. Such a bank would be fail proof, except for
the risk of fraud and operations losses. However, unless the central bank paid
interest on reserves held with it, the banks could not generate revenues from their
assets and could not pay implicit or explicit interest on their deposit accounts.

FRB CHICAGO Staff Memoranda

Rather, they would have to levy service charge on their depositors to cover their
costs of operation.
If banks could be permitted to satisfy the 100 percent reserve requirements with
interest bearing Treasury securities instead of with central bank balances, the
Treasury would have to keep all of its balances at the central bank. If it did not,
the result would be fractional, not 100 percent reserve banking, and total bank
deposits would exceed total bank cash reserves. Furthermore, unless the Treasury
guaranteed to redeem all the securities at par value, interest rate increases could
reduce the market value of the securities below the par value of the bank’s de
posits and the bank could become insolvent. Thus banks would have to hold ex
cess reserves and capital to meet deposit withdrawals. This would reduce the
desired precision of money control. Thus, the only condition under which the
modern fail-safe would be equivalent to the Simons-Friedman 100 percent reserve
bank would be if it held only currency or central bank balances. But this re
striction is not included in any of the newer proposals. They all permit investment
in earning assets.
2 Marvin Goodfriend has suggested that the federal government could subsidize
the banks to offer a competitive deposit rate if it viewed this cost to be lower than
the losses it would incur from bank failures. However, a subsidy not only would
shift a portion of the expense of deposit banking to taxpayers generality, but
would be difficult to control and administer in the public interest, as are subsidies
generally.
3 Litan (1987A) mentions higher lending costs as a possible objection to his narrow
bank proposal. However, he mistakenly identifies reduced supply from the nar
row banks as the cause, apparently in the belief that other firms would not supply
the funds. He might also have noted that loan costs could increase if the benefits
banks received from underpriced deposit insurance were not passed on to bor
rowers. If this cross-subsidization were occurring, elimination of subsidized de
posit insurance would increase rather than decrease aggregate economic
efficiency.

FRB CHICAGO Staff Memoranda

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Viable Alternative to Federal Deposit Insurance” , P roceed in gs o f
C o n feren ce on B an k Structure and C om p etitio n , Federal Reserve Bank
o f Chicago, pp 338-353.
Federal Deposit Insurance Corporation, 1986, “ Statement o f Policy on
Principles of Capital Forbearance for Banks with Concentrations in
Agriculture and Oil and G as” (March 27).
Federal Deposit Insurance Corporation,
Washington, D.C.

FRB CHICAGO Staff Memoranda

1984,

The

F irst

F ifty

Years.

Federal Deposit Insurance Corporation, 1983, D e p o sit Insurance in a
Changing Environm ent. Washington, D .C. (April).
Federal Home Loan Bank Board, 1983, A g en d a f o r R efo rm .
D .C . (March).

Washington,

Flannery, Mark J., 1987, “Payments System Risk and Public Policy” , Paper
prepared for American Enterprise Institute.
Friedman, Milton and Anna J. Schwartz, 1963, A M o n e ta r y H isto r y o f the
U n ited S ta te s , 1 8 6 7 -1 9 6 0 .
Princeton, N.J.:
Princeton University
Press.
Furlong, Frederick T. and Michael C. Keeley, 1987, “Bank Capital Reg
ulation and Asset Risk” , E con om ic R ev iew , Federal Reserve Bank of
San Francisco (Spring), pp. 20-40.
Gajewski, Gregory and Deano Hagerman, 1987, “ Should the Feds Prop
U p Ailing Banks and S&Ls?” , R u ral D evelo p m en t , U.S. Department
o f Agriculture (October), pp.
Geis, Thomas G. and Lucy J. Reuben, 1977, “Impact o f Bank Failures on
Local Economies” , Paper presented at Annual Meeting o f Midwest
Finance Association (March 31).
Gendreau, Brian C. and Scott S. Prince, 1986, “The Private Costs o f Bank
Failures: Some Historical Evidence” , B usiness R ev iew , Federal Re
serve Bank o f Philadelphia (March/April), pp. 3-14.
Gilbert, R. Alton and Levis A. Kochin, 1987, “ Local Economic Effects of
Bank Failures” in P roceed in gs o f C on feren ce on B an k Structure and
C om p etitio n , Federal Reserve Bank of Chicago.
Golembe, Carter H. and John J. Mingo, 1985, “Can Suspension and Reg
ulation Ensure Financial Stability” , The Search f o r Financial
S ta b ility , Federal Reserve Bank o f San Francisco, pp. 125-146.
Goodhart, Charles, 1985, The E volution o f C entral Banks.
London:
London School o f Economics and Political Science (October).
Goodfriend, Marvin and Robert G. King, 1987, “ Financial Deregulation,
Monetary Policy, and Central Banking”, Paper for American Enter
prise Institute.
Gorton, Gary, 1985, “Clearing Houses and the Origin o f Central Banking
in the United States” , Journal o f E con om ic H isto r y (June), pp.
277-283.
Haugen, Robert A. and Lemma W. Senbet, 1978, “The Insignificance of
Bankruptcy Costs to the Theory o f Optimal Capital Structure” ,
Journal o f Finance (May), pp. 383-393.

FRB CHICAGO Staff Memoranda

Hickman, W. Braddock, 1958, “ Bond Quality and Investor Experience” ,
Princeton, N.J.: Princeton University Press.
Horvitz, Paul M ., 1983A, “The Case Against Risk-Related Deposit Insur
ance Premiums” , H ou sin g Finance R eview (July), pp. 253-263.
Horvitz, Paul M., et al., 1983B, “ Research on Federal Deposit Insurance” ,
P roceed in gs o f C on feren ce on B ank Structure and C om p etitio n , Federal
Reserve Bank of Chicago, pp. 196-298.
Horvitz, Paul M ., 1980, “A Reconsideration of the Role of Bank Exam
ination”, Journal o f M o n e y , Credit, and Banking (November, Part 1),
pp. 654-659.
Huertas, Thomas F., 1987, “ Redesigning Regulation: The Future of Fi
nance in the United States” , Paper presented at Conference on Re
structuring the Financial System, Federal Reserve Bank of Kansas
City (August).
Huertas, Thomas F., 1986A, “ Risk in the Payments System” , Appendix D
to Hans H. Angermueller Testimony Before a Subcommittee o f the
Committee on Government Operations, Structure and R egulation o f
Financial F irm s and H old in g C om pan ies (P a r t 3 ) : H earings.
U.S.
House o f Representatives, 99th Cong., 2nd Sess. (December 17 and
18), pp. 361-389.
Huertas, Thomas F., 1986B, “The Protection of Deposits from Risks A s
sumed by Non-Bank Affiliates” , Appendix C to Hans H.
Angermueller Testimony Before a Subcommittee of the Committee
on Government Operations, Structure and Regulation o f Financial
F irm s and H old in g C om pan ies (P a r t 3 ) : H earings. U.S. House of
Representatives, 99th Cong., 2nd Sess. (December 17 and 18), pp.
325-360.
Huertas, Thomas F. and Rachel Strauber, 1986, “An Analysis of Alterna
tive Proposals for Deposit Insurance Reform” , Appendix E to Hans
H. Angermueller Testimony Before a Subcommittee of the Committee
on Government Operations, Structure and R egulation o f Financial
F irm s and H old in g C om pan ies (P a rt 3 ) : H earings.
U.S. House of
Representatives, 99th Cong., 2nd Sess. (December 17 and 18), pp.
390-463.
Humphrey, David, 1987, “Electronic Payments System Links and Risks” ,
in Elinor H. Solomon, ed., E lectron ic Funds Transfers and P a ym en ts:
The Public P olicy Issues. Boston, Mass.: Kluwer-Nijhoff.
Humphrey, David B., 1986, “Payments Finality and Risk of Settlement
Failure” , in A. Saunders and L. White, eds., T ech nology and R e g u
lation o f Financial M a rk e ts. Lexington, Mass.: Lexington, pp. 97-120.

FRB CHICAGO Staff Memoranda

Humphrey, David B, 1984, The U .S . P a ym en ts S y s te m : C o s ts , P ricing,
C om p etitio n .
Monograph Series in Finance and Economics, New
York University.
Huyser, Daniel, 1987, “Problem Banks: The Phoenix Factor” , P roceed in g s
o f a C on feren ce on B an k Structure and C om p etitio n , Federal Reserve
Bank of Chicago.
James, Christopher, forthcoming, “ Some Evidence on the Uniqueness of
Bank Loans” , Journal o f Financial E con om ics.
Kane, Edward J., 1987A, “N o Room for Weak Links in the Chain o f D e
posit Insurance Reform” , Journal o f Financial S ervices R esea rch , Vol.
1, No. l,p p . 77-111.
Kane, Edward J., 1987B, “Dangers o f Capital Forbearance: The Case of
the F S L IC and ‘Zombie’ S& Ls” , C on tem p ora ry P o lic y Issu es (Janu
ary), pp. 77-83.
Kane, Edward J., 1986A, “Appearance and Reality in Deposit Insurance” ,
Journal o f Banking and Finance (June), pp. 175-188.
Kane, Edward J., 1985, The Gathering
Cambridge, Mass.: M IT Press.

Crisis

D e p o sit

Insurance.

Kareken, John H., 1986, “ Federal Bank Regulatory Policy” , Journal o f
B usiness (January), pp. 3-48.
Kaufman, George G , forthcoming A, “Bank Runs: Cause, Benefits, and
Costs” , C A T O Journal.
Kaufman, George G., forthcoming B, “Public Policies Toward Failing In
stitutions: The Lessons from the Thrift Industry”, C on feren ce on B an k
Structure and C om p etitio n , Federal Reserve Bank o f Chicago.
Kaufman, George G ., 1988C, “The Truth About Bank Runs” , in Catherine
England and Thomas Huertas, eds., The Financial S ervice R evolu tion :
P o lic y D irection s f o r the Future. Boston: Kluwer Academic.
Kaufman, George G., 1987D, “ Bank Capital Forbearance and Public Pol
icy” , C on tem p o ra ry P o lic y Issu es (January), pp. 84-91.
Kaufman, George G ., 1987E, “The Federal Safety Net: N o t For Banks
Only” , E co n o m ic P ersp ectives , Federal Reserve Bank o f Chicago
(November/December), pp. 19-28.
Kaufman, George G., 1986A, “Federal Bank Regulatory Policy” , Journal
o f B usiness (January), pp. 69-78.
Kaufman, George G „ 1986B, “ Banking Risk in Historical Perspective” ,
C o n feren ce on B an k Structure and C om p etitio n , Federal Reserve Bank
o f Chicago, pp. 231-249.

FRB CHICAGO Staff Memoranda

Kaufman, George G., 1985A, “Implications of Large Bank Problems and
Insolvencies for the Banking System and Economic Policy” , S ta ff
M em o ra n d a 8 5 - 3 , Federal Reserve Bank of Chicago.
Kaufman, George G., 1985B, “Implications of Large Bank Problems and
Insolvencies for the Banking Industry and Economic Policy” , Issues
in B an k R egulation (Winter), pp. 35-42.
Kaufman, George G. and Roger Kormendi, eds., 1986, D eregulating F i
nancial S ervices: Public P olicy in F lu x. Cambridge, Mass.: Ballinger
Press.
Keeley, Michael C. and Frederick T. Furlong, 1987, “A Deposit Insurance
Puzzle” , W e e k ly L e tte r , Federal Reserve Bank of San Francisco (July

3).
Koehn, Michael and Anthony M. Santomero, 1980, “ Regulation of Bank
Capital and Portfolio Risk” , Journal o f Finance (December), pp.
1235-1244.
Lawrence, Joseph S., 1931, “What is the Average Recovery of
Depositors” , A m erican B an kers A ssociation Journal (February), pp.
655-56, 722-23.
Lawrence, Robert J., 1985, “Minimizing Regulation of the Financial Ser
vices Industry”, Issu es in Bank Regulation (Summer), pp. 22-30.
Litan, Robert E., 1987, W h a t Should B anks D o .
Brookings Institution.

Washington, D.C.:

Litan, Robert E., 1986, “Taking the Dangers Out of Bank Deregulation”,
B rook in g s R eview (Fall), pp. 3-12.
Litan, Robert E, 1985, “Evaluating and Controlling the Risks of Financial
Product Deregulation” , Yale Journal on Regulation (Fall) pp. 51-52.
Mingo, John J., 1987, “ ‘Narrow Banks’ Part of Plan for Restructuring
Regulatory System” , A m erican B an ker (September 15), pp. 5, 7, 9, 13.
Moulton, Janice M., 1987, “New Guidelines for Bank Capital: An Attempt
to Reflect Risk” , Business R eview , Federal Reserve Bank of
Philadelphia (July/August), pp. 19-33.
Pyle, David H., 1986, “Capital Regulation and Deposit Insurance” , Journal
o f Banking and Finance (June), pp. 189-201.
Pyle, David H., 1984, “Deregulation and Deposit Insurance Reform” ,
E con om ic R ev iew , Federal Reserve Bank of San Francisco (Spring),
pp. 5-15.
Rose, Sandford, 1974, “What Really Went Wrong at Franklin National” ,
F ortun e M a g a zin e (October), pp. 118-121, 220-227.

FRB CHICAGO Staff Memoranda

Saunders, Anthony, 1987, “Bank Holding Companies: Structure, Perform
ance and Reform”, Paper for American Enterprise Institute.
Schwartz, Anna J., 1987A , “Financial Stability and the Federal Safety
N et” , Paper for American Enterprise Institute.
Schwartz, Anna J., 1987B, “The Lender of Last Resort and the Federal
Safety N et”, Journal o f Financial S ervices R esearch , Vol. 1, No. 1, pp.
1-17.
Selby, H. Joe, 1985, “ Statement” before Committee on Banking, Housing
and Urban Affairs, U.S. Senate (July 23).
Shadow Financial Regulatory Committee, 1987, “ Statements on Regula
tory Proposals for Risk-Related Capital Standards” (March 31 and
M ay 18).
Singer, Mark, 1985, Funny M o n e y . New York: Alfred Knopf.
Symons, Edward L., Jr., and James J. White, 1984, Banking L a w . 2nd ed.
St. Paul, Minn.: West Publishing.
Timberlake, Richard H., Jr., 1984, “The Central Banking Role o f Clearing
House Associations”, Journal o f M o n e y , C redit, and Banking (Febru
ary), pp. 1-15.
Tobin, James, 1986, “Financial Innovation and Deregulation in
Perspective” , in Y . Suzuki and H. Yomo, eds., Financial Innovation
and M o n e ta r y P o lic y : A sia and the W es t.
Tokyo:
University of
Tokyo Press, pp. 31-42.
Tussing, A. Dale, 1967, “The Case for Bank Failure” , Journal o f L a w and
E co n o m ics (October), pp. 129-147.
Tussing, A. Dale, 1968, “Bank Failure: A Meaningful Competitive
Force” , P roceed in gs o f C on feren ce on B an k S tructure and
C om p etitio n , Federal Reserve Bank of Chicago, pp. 99-109.
United

States

General

Accounting

Office,

1987A,

Thrift

Indu stry:

Forbearan ce f o r T rou bled Institutions, 1 9 8 2 -1 9 8 6 , Washington, D .C.

(May)
United States General Accounting Office, 1987B, Thrift In du stry: The
M a n a g em en t C on sign m en t P rogra m . Washington, D .C. (September)
Upham, Cyril B. and Edward Lamke, 1934, C lo se d and D istressed Banks.
Washington, D.C.: Brookings Institution.
Volcker, Paul A., 1986A, “ Statement” in Testimony Before a Subcommittee
o f the Committee on Government Operations, Structure and R e g u
lation o f Financial F irm s and H old in g C om pan ies (P a r t 1 ) :

H earings.

U.S. House o f Representatives, 99th Cong., 2nd Sess. (April 22, June
11, July 23), pp. 127-198 and Appendix 2, pp. 391-541.

FRB CHICAGO Staff Memoranda

Volcker, Paul A., 1986B, “Statement” , F ed eral R eserve Bulletin (February),
pp. 115-125.
Weicher, John C., 1987, “The Future Structure of the Housing Finance
System” , Paper for American Enterprise Institute.
Weintraub,

Benjamin and Alan N. Resnick, 1986,
Boston: Warren, Gorham, and Lamont.

B ankruptcy

Law

M anual

White, Lawrence J., forthcoming, “Mark-To-Market Accounting for
Thrifts: Vital to the F S L IC and Valuable to Well-Managed Thrifts”,
O u tlo o k , Federal Home Loan Bank Board.
Whitehead, David D., 1982, “The Sixth District Survey o f Small Business
Credit”, E con om ic R ev iew , Federal Reserve Bank of Atlanta (April),
pp. 42-47.
Wigmore, B., 1987, “Was the Bank Holiday of 1933 a Run o f the Dollar
Rather Than the Banks” , Journal o f E con om ic H isto r y (September),
pp. 739-755.
Yang, John E., 1987, “Fraud is Main Cause of Failure at S&Ls in
California, Congressional Study Says” , W a ll S treet Journal (June 15),
p. 6.
Zweig, Philip L., 1985, B elly U p : The C ollapse o f the Penn Square B a n k .
New York: Crown.

FRB CHICAGO Staff Memoranda

Full text of Working Papers (Federal Reserve Bank of Chicago) : Risk and Solvency Regulation of Depository Institutions : Past Policies and Current Options, SM-88-1

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