Deposit Insurance and Other Liability Guarantees Chapter 19

1. Deposit Insurance and Other Liability GuaranteesChapter 19 Financial Institutions Management, 3/e By Anthony Saunders

2. Background issues and History • Bank runs can serve a useful purpose • Contagion has more serious consequences • FDIC created 1933 • Securities Investors Protection Corporation (SIPC) 1970. • Pension Benefit Guaranty Corporation (PBGC) created 1974.

3. FDIC • FDIC created in wake of banking panics. • 10,000 failed commercial banks. • Original coverage: $2,500. Now $100,000. • Between1945-1980: FDIC worked. Failures accelerated in 1980.

4. FDIC (continued) • In 1991: Borrowed $30 billion from Treasury and still generated a $7 billion deficit. • FDIC Improvement Act 1991. • The funds’ reserves now stand at a record high with reserves exceeding 1.4% of insured deposits.

5. FSLIC • FSLIC covered S&Ls. Other thrifts often chose FDIC coverage. • High levels of failed thrifts between 1980-88 generated losses of $78 billion. From 1989-92 additional 734 failures . Cost: $78 billion. • Result: FSLIC estimated net worth negative $40 to $80 billion. • Policy of forebearance.

6. Demise of FSLIC • Forebearance consequences: • Accumulation of greater losses. • Financial Institutions Reform, Recovery and Enforcement Act, (FIRREA) 1989. • Management transferred to FDIC. • Savings bank insurance fund became Savings Association Insurance Fund (SAIF). Managed separately from Bank Insurance Fund (BIF). • Resolution Trust Corporation (ended 1995) • $90.1 billion

7. Causes of depository fund insolvency • Financial Environment: • Rise in interest rates. • Collapse in oil, real estate and commodity prices. • Increased competition.

8. Depository Fund Insolvency (continued) • Moral Hazard: • Deposit insurance encouraged underpricing of risk and reduced depositor discipline. • Premiums not linked to risk. • Inadequate monitoring. • Prompt Corrective Action (1992).

9. Trade-off between moral hazard and bank run risk • Insurance was not actuarially fairly priced. • Reduced incentive for runs. • Increased moral hazard. M Run Risk (R)

10. Controlling Bank Risk Taking • Stockholder discipline • Practical problems in applying option pricing to insurance premiums • FDIC adopted risk-based premiums 1993 • Based on: categories and concentrations of assets & liabilities; other factors that affect probability of loss; deposit insurer’s revenue needs. • Increased capital requirements, stricter closure rules, prompt corrective action.

11. Controlling bank risk taking • Depositor discipline • Insurance cap can be increased by altering structure of deposit funds and by spreading deposits across banks. Higher interest rates provided incentive to deposit in riskier banks -up to coverage limit. • Limits on brokered deposits. • Implicit 100% coverage resulted from too big to fail.

12. Failure resolution pre-FDICIA • Liquidation (payoff) method unless alternative judged to cost less. • 1993 Depositor Protection Legislation • gave lower priority to foreign uninsured depositors and creditors supplying federal funds on the interbank market. • Purchase and assumption method. • Open Assistance. FDIC loans or capital funds to keep large failing bank open.

13. Failure resolution post-FDICIA • January 1995 FDICIA required least-cost resolution. • Systemic risk exception. • Insured depositor transfer (IDT) or “haircut” method encourages depositor vigilance.

14. Regulatory discipline • Perception of 2 weaknesses in regulatory practices: • Frequency and thoroughness of examinations • Forebearance shown to weakly capitalized banks pre-1991.

15. Regulatory discipline (continued) • Capital forebearance: • Prompt Corrective Action. Transition to rules rather than discretion. • Examinations: • improved accounting standards including market valuation of assets and liabilities; annual on-site examination of every bank.

16. Non-U.S. deposit insurance • EC proposed single deposit insurance system to be introduced at end of 1999. • Co-insurance through deductibles. • Currently, deductibles vary across countries.

17. Discount Window • Central bank as lender of last resort through discount window. Short-term, non-permanent. • Requires high-quality liquid assets as collateral. • “Need to borrow basis”. • Not permanent support for unsound banks. • Loans to troubled banks limited to no more than 60 days in any 120 day period unless authorized by FDIC and institution’s primary regulator.

18. Other Guaranty Programs • PC and Life Insurance Companies regulated at state level. No federal guaranty fund. • State guaranty funds run and administered by the private insurance companies themselves. • Only NY has permanent guaranty fund for PC and life insurance. • Definition of small policyholder varies across states from $100,000 to $500,000.

19. Other Guaranty Programs • Often delays in settling claims against insurance companies. • Securities Investor Protection Corporation: • Pro rata shares of liquidated assets. SIPC covers remaining claims up to $500,000 per individual. • SIPC losses have been small but concern has increased.

20. Pension Benefit Guaranty Corp. • PBGC established in 1974 under Employee Retirement Income Security Act (ERISA). • PBGC experienced deficit of $2.7 billion at end of 1992. Unlike FDIC, it has no monitoring power over insured pension plans. • 1994 Retirement Protection Act phases out premium cap. Deficit expected to be eliminated within 10 years. • Risk-based premium scheme.