Chapter Nineteen
Deposit Insurance and Other Liability Guarantees
Chapter Outline
Introduction
Bank and Thrift Guaranty Funds
- The FDIC
The Causes of the Depository Fund Insolvencies
- The Financial Environment
- Moral Hazard
Panic Prevention versus Moral Hazard
Controlling Depository Institution Risk Taking
- Stockholder Discipline
- Depositor Discipline
- Regulatory Discipline
Non-U.S. Deposit Insurance Systems
The Discount Window
- Deposit Insurance versus the Discount Window
- The Discount Window
Other Guaranty Programs
- National Credit Union Administration
- Property-Casualty and Life Insurance Companies
- The Securities Investor Protection Corporation
- The Pension Benefit Guaranty Corporation
Summary
Solutions for End-of-Chapter Questions and Problems: Chapter Nineteen
1. What is a contagious run? What are some of the potentially serious adverse social welfare effects of a contagious run? Do all types of FIs face the same risk of contagious runs?
A contagious run is an unjustified panic condition in which liability holders withdraw funds from a depository institution without first determining whether the institution is at risk. This action usually occurs at a time that a similar run is occurring at a different institution that is at risk. The contagious run may have an adverse effect on the level of savings that may affect wealth transfers, the supply of credit, and control of the money supply. Depository institutions and insurance companies face the most serious risk of contagious runs.
2. How does federal deposit insurance help mitigate the problem of bank runs. What other elements of the safety net are available to banks in the U.S.?
Bank runs are costly to society since they create liquidity problems and can have a contagion effect. Because of the first-come, first-serve nature of deposit liabilities, bank depositors have incentives to run on the bank if they are concerned about the bank's solvency. As a result of the external cost of bank runs on the safety and soundness of the entire banking system, the Federal Reserve has put into place a safety net to remove the incentives to undertake bank runs. The primary pieces of this safety net are deposit insurance and other guaranty programs that provide assurance that funds are safe even in cases when the FI is in financial distress. Other elements of the federal safety net are access to the lender of last resort (discount window borrowing), reserve requirements, and minimum capital guidelines.
3. What major changes did the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 make to the FDIC and the FSLIC?
The FIRREA ACT of 1989 closed down the FSLIC, the agency that used to provide deposit insurance to savings and loan associations (S&Ls). The responsibility of providing insurance to the S&Ls was transferred to the FDIC, which manages it through a separate program, the Savings and Insurance Fund.
4. Contrast the two views on, or reasons why, depository institution insurance funds became insolvent in the 1980s.
One view is that insolvency can be explained by external events in the financial environment such as the rise in interest rates and oil prices that took place in the early 1980s. The other view is that deposit insurance brings about the types of behavior that lead to eventual insolvency. In particular, deposit insurance contributes to the moral hazard problem whereby bank owners and managers were induced to take on risky projects because the presence of deposit insurance substantially reduced the adverse consequences to the depositors of such behavior.
5. What is moral hazard? How did the fixed-rate deposit insurance program of the FDIC contribute to the moral hazard problem of the savings and loan industry? What other changes in the savings association environment during the 1980s encouraged the developing instability of the industry?
Moral hazard occurs in the financial institution industry when the provision of deposit insurance or other liability guarantees encourages the institution to accept asset risks that are greater than the risks that would have been accepted without such liability insurance.
The fixed-rate deposit insurance administered by the FDIC created a moral hazard problem because it did not differentiate between the activities of risky and conservative lending institutions. Consequently, during periods of rising interest rates, S&Ls holding fixed-rate assets were finding it increasingly difficult to obtain funds at lower rates. Since the deposits were insured, managers found it easier to engage in risky ventures in order to offset the losses on their fixed-rate loans. In addition, as the number of failures increased in the 1980s, regulators became reluctant to close down banks because the fund was being slowly depleted. The combination of excessive risk-taking together with a forbearance policy followed by the regulators led to the S&L crisis.
6. How does a risk-based insurance program solve the moral hazard problem of excessive risk taking by FIs? Is an actuarially fair premium for deposit insurance always consistent with a competitive banking system?
A risk-based insurance program should deter banks from engaging in excessive risk-taking as long as it is priced in an actuarially fair manner. Such pricing currently is being practiced by insurance firms in the property-casualty sector. However, since the failure of commercial banks can have significant social costs, regulators have a special responsibility towards maintaining their solvency, even providing them with some form of subsidies. In a completely free market system, it is possible that banks located in sparsely populated areas may have to pay extremely high premiums to compensate for a lack of diversification or investment opportunities. Such banks may have to close down unless subsidized by the regulators. Thus, a strictly risk-based insurance system may not be compatible with a truly competitive banking system.
7. What are three suggested ways in which a deposit insurance contract could be structured to reduce moral hazard behavior?
Deposit insurance contracts could be structured to reduce moral hazard behavior by (1) increasing stockholder discipline, (2) increasing depositor discipline, and (3) increasing regulator discipline.
8. What are some ways of imposing stockholder discipline to prevent them from engaging in excessive risk taking?
Two ways of imposing stockholder discipline to prevent excessive risk taking are (a) through a risk-based deposit insurance program, and (b) through increased capital requirements and increased disclosure.
Risk-based deposit insurance premiums ensure that banks engaging in riskier activities will have to pay higher premiums. One reason for the S&L crisis has been the fixed-rate deposit insurance premiums that did not differentiate between risky and conservative banks. As a result, stockholders of FIs in financial difficulties had nothing to lose by investing in projects that had high payoffs because depositors were protected by the FDIC insurance program.
Stockholder discipline also is increased if banks are required to hold more capital as well as requiring more financial disclosures. The more capital a bank has, the less likely the failure of a bank in the event of a decline in the market value of assets. This protects not only the depositors but also the FDIC, which provides the insurance. Greater disclosure also allows regulators and outside analysts to make more informed judgments on the viability of the institution, raising the stock prices of better-managed FIs and lowering the stock prices of those that are excessively risky.
9. How is the provision of deposit insurance by the FDIC similar to the FDIC writing a put option on the assets of a DI that buys the insurance? What two factors drive the premium of the option?
As long as the DI is profitable, the owners of the DI benefit by maintaining a positive market value of equity. If the DI’s performance falters sufficient that net worth becomes negative, the owners can put the assets back to the FDIC who will pay off the insured depositors and sell the assets. The premium on this put option, or deposit insurance, is positively related to the level of risk of the assets and to the amount of leverage maintained by the DI.
10. What is capital forbearance? How does a policy of forbearance potentially increase the costs of financial distress to the insurance fund as well as the stockholders?
Capital forbearance refers to regulators’ permitting an FI with depleted capital to continue operations. The primary advantage occurs in the short run through the savings of liquidation costs. In the longer run, the likely cost is that the poorly managed FI will become larger, more risky, but no more solvent. Eventually even larger liquidation costs must be incurred.
11. Under what conditions may the implementation of minimum capital guidelines, either risk-based or non-risk-based, fail to impose stockholder discipline as desired by the regulators?
Regulators must be willing to enforce immediately corrective action provisions against banks that violate the minimum capital guidelines.
12. What four factors were provided by FDICIA as guidelines to assist the FDIC in the establishment of risk-based deposit insurance premiums? What has happened to the level of deposit insurance premiums since the risk-based program was implemented in 1993? Why?
The FDIC must base deposit insurance premiums on (1) different categories and concentrations of assets, (2) different categories and concentrations of liabilities, (3) other factors that affect the probability of loss, and (4) the revenue needs of the insurer. In most cases the ranking of an institution is based on regulators’ judgements regarding asset quality, loan underwriting standards, and other operating risks. As the industry risk profile has improved and the revenue needs of the FDIC insurance funds have decreased, the amount of the minimum risk premium has fallen to zero for most banks.
13. Why did the fixed-rate deposit insurance system fail to induce insured and uninsured depositors to impose discipline on risky banks in the United States in the 1980s?
The fixed-rate deposit insurance system understandably provided no incentives to depositors to discipline the actions of banks since they were completely insured for deposits of up to $100,000 per account per bank. Uninsured depositors also had few incentives to monitor the activities of banks because regulators had been reluctant to close down failing banks, especially larger banks. This is because of the anticipated widespread social implications. As a result, both insured and uninsured depositors were usually protected against bank losses, reducing the incentives to monitor the actions of banks.
a. How is it possible to structure deposits in a DI to reduce the effects of the insured ceiling?
Deposits are insured by the FDIC up to $100,000 per account per DI. Therefore, individual depositors could expand coverage beyond $100,000 by placing deposits as joint accounts and by having accounts in many DIs at the same time.
b. What are brokered deposits? Why are brokered deposits considered more risky than non-brokered deposits by DI regulators?
Individuals and companies who wish to place more than $100,000 of deposits in DIs often will hire brokers to place these deposits in blocks of $100,000 in DIs that pay the highest interest rates. This activity is considered risky by the regulators for two reasons. First, the DIs willing to pay the highest rates often have the highest need for deposits from a liquidity standpoint. Second, when the deposits mature, the risk of withdrawal may force the DI to pay even higher rates to keep the deposits. As a result, this higher cost of funds may force the DI to engage in even riskier lending activities.
c. How did FIRREA and FDICIA change the treatment of brokered deposits from an insurance perspective?
FIRREA specified that institutions that did not meet capital standards could not accept brokered deposits and could not solicit deposits by paying interest rates that were significantly higher than the prevailing market rates. FDICA further strengthened these prohibitions by including any DIs that did not have risk-based capital of at least ten percent.
d. What trade-offs were weighed in the decision to leave the deposit insurance ceiling at $100,000?
Lowering the deposit insurance ceiling potentially would give depositors the incentive to better monitor the risk of banks. However, such monitoring may also allow these depositors to run from banks that became too risky. Such action would perhaps cause more banks to fail that would put increased solvency pressure on the insurance fund.
14. What is the too-big-to-fail doctrine? What factors caused regulators to act in a way that caused this doctrine to evolve?
Large banks were not allowed to fail because of the draining effects on the resources of the insurance funds and the fear of contagious or systemic runs spreading to other large banks. Thus the fear of significant negative effects on the financial system usually meant that both large and small depositors in large banks were protected.
15. What failure resolution methods were available to regulators before the passage of FDICIA in 1991? What was the “essentiality” provision?
Prior to FDICIA, the failure resolution methods included the payoff method, the purchase and assumption method, and the open assistance method. The FDIC was forced to use liquidation unless an alternative method cost less than liquidation to implement. Further, the FDIC could choose to keep open a bank if the continued operation was considered essential to providing financial services to the local community.
16. What procedural steps are involved under the payoff method of failure resolution?
The payoff method of failure resolution requires the FDIC to liquidate the assets and to pay off the insured depositors in full or to transfer the deposits to another local bank. Uninsured depositors and the FDIC have pro rata claims on the remaining value of the banks assets.
17. How was the FDIC’s potential liability reduced by the 1993 depositor protection legislation? How does this method of failure resolution encourage uninsured depositors to monitor more closely the DI’s risk taking?
Under the 1993 legislation, the FDIC and the domestic uninsured depositors were given priority over foreign uninsured depositors and creditors supplying fed funds. Because uninsured depositors probably will share in the net loss of the DI upon liquidation, it is in their interest to monitor carefully the risk position of the DI on an ongoing basis.
18. What are the three types of purchase and assumption failure resolution?
The three types of P&A failure resolution are (1) total bank, (2) insured deposits only, and (3) clean P&A.
a. How does the “clean” P&A differ from the “total bank” P&A?
Under a clean P&A the good assets and all deposits of a failed institution are assumed by another bank. The difference between the total value of the deposits (larger) and the value of the good assets (smaller) is paid in a cash infusion by the FDIC. Under the total bank P&A, all assets are transferred to the assuming bank with the option that the bank could put back to the FDIC at a later date those assets that were identified to be questionable from a credit perspective. This method required a smaller cash infusion by the FDIC at the time of the assumption.
b. How are the uninsured depositors treated differently in a clean P&A as opposed to the payoff method of failure resolution?
The clean P&A treats large, uninsured depositors as de facto insured depositors. That is, the depositors do not face the risk of loss. Under the payoff method, the uninsured depositors share in the net worth loss with the FDIC.
c. How does the open assistance process solidify the too-big-to-fail guaranty?
The open assistance policy provides funds to keep open a large failing DI while a restructuring plan is designed and implemented. Uninsured depositors at other large DIs interpret this policy to be that all large DIs will not be allowed to fail, thus removing the incentive of these depositors to monitor the risk of the DIs.
19. What are some of the essential features of the FDICIA of 1991 with regard to the resolution of failing DIs?
The FDICIA of 1991 has made it very difficult for regulators to delay the closing of failing DIs unless the danger of a systemic risk can be shown. They are expected to use the least cost resolution (LCR) strategy to close down DIs, and shareholders and uninsured depositors are expected to bear the brunt of the loss. Unlike in prior years, the FDIC will only subsidize if the liquidated assets are not sufficient to cover the insured deposits. The General Accounting Office has also been authorized to audit failure resolutions used by regulators to ensure that the least cost strategy has been adopted.
a. What is the least-cost resolution (LCR) strategy?
The LCR requires the cost of each failure resolution alternative to be evaluated on a present value basis.
b. When can the systemic risk exemption be used as an exception to the LCR policy of bank closure methods?
The systemic risk exemption can be used only when it can be shown that the closure of a large DI will cause a significant threat to the entire financial system.
c. What procedural steps must be taken for the approval of using the systemic risk exemption?
Use of the systemic risk exemption requires the approval of two thirds of the Federal Reserve Board members and the FDIC board as well as the recommendation of the Secretary of Treasury and the President of the United States.
d. What are the implications to the other DIs in the economy of the implementation of this exemption?
The net cost of the bailout of a large DI will be shared by all other DIs by charging them an additional deposit insurance premium based on their size as measured by domestic and foreign deposits and borrowed funds.
20. What is the primary goal of the FDIC when employing the LCR strategy?
The purpose for implementing this strategy was to pass more of the failure resolution cost to uninsured depositors.
a. How is the insured depositor transfer method implemented in the process of failure resolution?
Upon failure the good assets and the insured deposits are transferred to a takeover DI. In addition an amount of uninsured deposits equal to the remaining amount of uncovered good asset also are transferred to the assuming DI. Uninsured depositors lose a portion of their deposits based on the difference between the estimated value of the assets and the amount of insured deposits in the DI.
b. Why does this method of failure resolution encourage uninsured depositors to more closely monitor the strategies of DI managers?
Because uninsured depositors assume all of the losses, they have a much stronger incentive to monitor and control the actions of DI owners.
21. The following is a balance sheet of a commercial bank (in millions of dollars).
Assets Liabilities and Equity
Cash $ 5 Insured Deposits $30
Loans $40 Uninsured Deposits $10
Equity $ 5
Total Assets $45 Total Liabilities & Equity $45
The bank experiences a run on its deposits after it declares it will write off $10 million of its loans as a result of nonpayment. The bank has the option of meeting the withdrawals by first drawing down its cash and then by selling off its loans. A fire sale of loans in one day can be accomplished at a 10 percent discount. They can be sold at a 5 percent discount if sold in two days. The full market value will be obtained if they are sold after two days.
a. What is the amount of loss to the insured depositors if a run on the bank occurs on the first day? On the second day?
Insured depositors will not lose any money because even if the bank does not make the payment, they will be paid by the FDIC. Specifically, the value of the loans on the first day is 0.90 x $30 = $27m and their value on the second day is 0.95 x $30 = $28.5m. With its cash reserves, it has a more than adequate amount to pay the insured depositors as long as the uninsured depositors are not given the opportunity to cash in their deposits first.
b. What amount do the uninsured depositors lose if the FDIC uses the insured depositor transfer method to close the bank immediately? The assets will be sold after the two-day period.
Based on book value, the uninsured depositors will receive $5 million out of their $10 million, and thus they will lose only $5 million. However, based on the present value of the loans, the uninsured depositors will lose $6.5 million since only $3.5 million is available for distribution. The equity holders will lose all of their capital.
22. A bank with insured deposits of $55 million and uninsured deposits of $45 million has assets valued at only $75 million. What is the cost of failure resolution to insured depositors, uninsured depositors, and the FDIC if the following occur?
a. The payoff method is used.
Insured depositors are fully paid by the FDIC and bear no loss. The FDIC receives $41.25 million ($75 million x 0.55) from the liquidation of the assets and bears a loss of ($55 - $41.25) = $13.75 million. Uninsured depositors receive $33.75 million against their liabilities of $45 million, for a loss of $11.25 million.
b. A purchase and assumption is arranged with no purchase premium.
Uninsured depositors are fully paid by the FDIC and bear no loss. Insured depositor liabilities are fully transferred to the acquiring bank and therefore they bear no loss. The FDIC bears the entire loss of $25 million ($55 + $45 - $75).
c. A purchase and assumption is arranged with a $5 million purchase premium.
Neither uninsured nor insured depositors lose. The cost to the FDIC is reduced by the purchase premium of $5 million. Since the FDIC only injects $20 million into the merged institution, the loss to the FDIC is $20 million.
d. A purchase and assumption is arranged with a $25 million purchase premium.
There is no loss to any claimant. The purchase premium is just equal to the negative net worth of the acquired bank.
e. An insured depositor transfer method is used.
Neither the insured depositors nor the FDIC lose under the insured depositor transfer method. Uninsured depositors receive the remaining bank assets of $75m - $55m = $20 million against liabilities of $45 million, for a loss of $25 million.
23. A commercial bank has $150 million in assets at book value. The insured and uninsured deposits are valued at $75 and $50 million, respectively, and the book value of equity is $25 million. As a result of loan defaults, the market value of the assets has decreased to $120 million. What is the cost of failure resolution to insured depositors, uninsured depositors, shareholders and the FDIC if the following occur?
a. A payoff method is used to close the bank.
Under the payoff method, the loss of $30 million will be borne mainly by shareholders, whose $25 million net worth will all be lost. The remaining $5 million loss will be borne by the FDIC and the uninsured depositors on a pro-rata basis. This is because after the $75 million is paid to the insured depositors, the assets will be divided between the FDIC and the uninsured depositors on a pro-rata basis. The FDIC will receive $72 million (and lose $3 million) and the uninsured depositors will receive $48 million (and lose $2 million).
b. A purchase and assumption method with no purchase premium paid is used.
Under the purchase and assumption method, the loss of $25 million will be borne by shareholders and the remaining $5 million by the FDIC.
c. A purchase and assumption method is used with $10 million paid as a purchase premium.
Under this method with a $10 million purchase premium, no loss is incurred by the insured depositors, uninsured depositors, or the FDIC. Shareholders will lose only $20 million.
d. An insured depositor transfer method is used.
Under the insured depositor transfer method, all losses will be borne by shareholders, followed by uninsured depositors, before the FDIC takes any loss. Thus, in this example, shareholders will lose $25 million and the uninsured depositors will lose $5 million.
24. In what ways did FDICIA enhance the regulatory discipline to help reduce moral hazard behavior? What has been the operational impact of these directives?
FDICIA approached the moral hazard problem in the separate areas of examinations and capital forbearance. In the area of examinations, FDICIA (1) required improved accounting standards that focused on market valuation, (2) required annual on-site examination of every bank, and (3) allowed private accountants a greater role in the auditing of banks. FDICIA also clarified immediacy and degree of actions in cases where bank capital fell into different rating zones. The effect of these policies is to reduce discretion in the treatment of banks that have financial distress.
25. Match the following policies with their intended consequences:
Policies:
a. Lower FDIC insurance levels
b. Stricter reporting standards
c. Risk-based deposit insurance
Consequences:
1. Increased stockholder discipline
2. Increased depositor discipline
3, Increased regulator discipline
Answer: a-2, b-3, c-1
26. Why is access to the discount window of the Fed less of a deterrent for bank runs than deposit insurance?
Although banks have access to the deposit window in the event of bank runs, this is less effective than deposit insurance because:
a. Banks have to put up collateral in order to borrow from the discount window, and collateral may not be available during bank runs.
b. Access is by no means guaranteed. Loans may be denied by the Fed if it is clear that the bank is insolvent.
c. FDICIA of 1991 has limited the Fed’s ability to lend to undercapitalized banks to only 60 days in any 120-day period. Extensions require approval by both the FDIC and the primary regulator of the bank to certify that the bank is viable.
d. If the bank ultimately fails, the Fed will have to compensate the FDIC for incremental losses.
27. How do insurance guaranty funds differ from deposit insurance? What impact do these differences have on the incentive for insurance policyholders to engage in a contagious run on an insurance company?
Insurance companies are regulated at the state level. As such, the state guaranty fund programs are administered by the private insurance companies. Further, there is no permanent guaranty reserve fund for the entire industry, and the amount of the required contributions required of surviving insurers to protect policyholders varies widely across the different states. Finally, small policyholders often must wait for an extended period of time before receiving benefits from the guaranty funds. As a result of these reasonable inefficiencies, the incentive for insurance policyholders to engage in a run on the companies is quite strong as compared to the banking industry.
28. What was the purpose of the establishment of the Pension Benefit Guaranty Corporation (PBGC)?
PBGC was established to protect pension benefits from the underfunding of pension plans by corporations.
a. How does the PBGC differ from the FDIC in its ability to control risk?
First, the premium is based on the number of participants, not on the amount of pension contributions or benefits covered. Recently, a variable-rate premium has been applied to those plans that are underfunded. Further, the PBGC has no monitoring power and thus cannot restrict the risk-taking of plan managers in the administration of the portfolios.
b. How is the 1994 Retirement Protection Act expected to reduce the deficits currently experienced by the Pension Benefit Guaranty Corporation (PBGC)?
Although the PBGC has no way of monitoring the pension fund it insures, it has been charging $19 per participant for funded plans and $72 for unfunded plans, the maximum allowed by law. The 1994 law phased out this ceiling by 1997 so that unfunded plans could pay more in premiums. This will allow an effective risk-based premium system.
