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Deposit Insurance, Bank Regulation, and Financial System Risks by George Pennacchi Department of Finance University of Illinois FDIC - JFSR Conference on Emerging Risks in Banking and Financial Services, September 22-23 2005 Summary of the Paper The paper has three main parts :

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deposit insurance bank regulation and financial system risks
Deposit Insurance, Bank Regulation, and Financial System Risks


George Pennacchi

Department of Finance

University of Illinois

FDIC - JFSR Conference on Emerging Risks in Banking and Financial Services, September 22-23 2005

summary of the paper
Summary of the Paper
  • The paper has three main parts:
    • Empirical evidence is presented that FDIC insurance is necessary for banks to hedge liquidity shocks. Uninsured money funds can also hedge such risks.
    • Under-priced deposit insurance has led to excessive expansion of the safety net. Reforms that set insurance premiums to be actuarially fair would create incentives for banks to take excessive systematic risks.
    • An alternative insuranceplan may preserve the ability to hedge liquidity shocks but mitigate the incentive for systematic risks.
prior research on banks and liquidity risks
Prior Research on Banks and Liquidity Risks
  • Kashyap, Rajan, and Stein (2002) note that (demand)deposits and loan commitments are similar cash-management services.
  • Providing them together conserves liquid assets needed to support both transactions. This synergy is greatest if deposit inflows tend to coincide withcommitment draw-downs.
  • Gatev and Strahan (2005) (GS) present empirical evidence that during 1988 - 2002, banks experienced deposit inflows and increased loans at times of liquidity shocks as proxied by the commercial paper - Treasury bill spread.
  • Similarly, Gatev,Schuermann, and Strahan (2005) show that during the 1998 liquidity crisis, banks with the most loan commitments experienced the greatest deposit inflows.
hedging liquidity and deposit insurance
Hedging Liquidity and Deposit Insurance
  • Is this beneficial correlation between loans and deposit flows an inherent feature of banks or is it due to deposit insurance?
  • Similar to GS (2005), I estimate vector auto-regressions (VARs) to test whether an innovation to the commercial paper spread Granger - causes growth in various bank assets and deposits.
  • In addition to replicating tests during the recent period of 1988 to 2004, I also estimate VARs using banking and market interest rate data from the NBER Macro-History Database for the pre-FDIC period of 1920 to 1933.
deposit insurance is critical for bank hedging
Deposit Insurance is Critical for Bank Hedging
  • This evidence is consistent with deposit insurance being vital to banks’ ability to hedge liquidity risks. Today, investors view (de facto) insured deposits as a safe haven during “flights to quality.”
  • Prior to 1933, banks feared deposit withdrawals and held 99 % of all commercial paper to meet deposit outflows.
  • Unlike today, prior to the FDIC it was rare for banks to offer formal loan commitments.
  • Is there another financial intermediary that can hedge liquidity shocks? I re-run VARs but use the growth rate of money market mutual fund (mmmf) shares as the dependent variable.
mmmfs also experience inflows following liquidity shocks
MMMFs Also Experience Inflows Following Liquidity Shocks
  • Investors view mmmfs (especially institutional ones) as safe havens following market-wide liquidity shocks.
  • Indeed, mmmfs may be a primary conduit that purchases banks’ large time deposits (CDs) following liquidity shocks.
  • Investor confidence in mmmfs is consistent with Gorton and Pennacchi (1993) who find that mmmf shares do not decline following defaults on individual firms’ commercial paper.
governments have difficulty pricing insurance
Governments Have Difficulty Pricing Insurance
  • Stiglitz (1993) argues that a government deposit insurer faces political constraints that limit its ability to charge market-based deposit insurance premiums:

The difficulties government has in assessing risk, and that citizens face in evaluating the government’s performance on this score, provide an opportunity for granting huge hidden subsidies.”

  • Since 1996, over 90 % of all banks have paid nothing for deposit insurance, undoubtedly representing a huge subsidy.
free lunches
Free Lunches
  • Recent examples of excessive expansion of the safety net:
    • Promontory Interfinancial’s CDARS network allows banks to swap < $100,000 chunks of large CDs to skirt the $100,000 FDIC limit, allowing insurance for a $20 million deposit.
    • The 1999 GLB Act allowed brokerage firms to affiliate with insured banks and convert customers’ “sweep” accounts from mmmfs into FDIC-insured deposits.
      • Crane and Krasner (2004) estimate that $350 billion is in FDIC-insured deposits that would have been in retail mmmfs. A shift of $50 to $100 billion per year is forecast for 2005 and 2006.
      • From 2000-2005, MMDAs grew at a 16.4 % annual rate while shares of retail mmmfsdeclined at a 3.0 % annual rate.
actuarially fair premiums to the rescue
Actuarially Fair Premiums to the Rescue?
  • Most FDIC (2000, 2001) proposals to reform insurance pricing and Basel II capital requirements fail to distinguish between systematic versus idiosyncratic risks.
  • But deposit insurance is inherently systematic: bank failures tend to be greater during business cycle downturns.
  • The model in Kupiec (2004) shows that Basel II provides incentives for banks to take excessive systematic risks.
  • I use a similar model to show that if insurance premiums equal expected losses (actuarially fair), then banks continue to have incentives to take excessive systematic risks.
subsidizing financial instability
Subsidizing Financial Instability
  • Operationally, a bank can identify procyclical investments by choosing those loans, loan commitments, or selling credit protection swaps that have the highest spreads or fees for a given probability of loss.
  • In equilibrium, this subsidization of systematic risk can magnify the amplitude of business cycles. FDIC losses will occur when federal budget deficits are highest.
an alternative insurance plan
An Alternative Insurance Plan
  • Motivated by the empirical evidence that money funds experience inflows following liquidity shocks, I model a money fund whose assets are uninsured bank CDs and/or finance company paper.
  • The model shows that if a government provides actuarially fair insurance for this money fund rather than bank deposits, the incentive for systematic risk is mitigated.
    • Intuition: Total and systematic risk is less by insuring a portfolio of CDs (money fund) versus insuring a single CD (bank).
affiliation can preserve information capital
Affiliation Can Preserve Information Capital
  • An insured money fund could operate as a bank affiliate that issues insured deposits collateralized by money market debt.
    • Checking account information that reduces a lender’s monitoring costs can be preserved. Mester, Nakamura, and Renault (2003).
    • Bank credit information may be used by the fund to select CDs and commercial paper. Massa and Rehman (2005).
  • Government regulation of insured money funds is far less costly and complex. “Too-big-to-fail” bailouts would be less likely.
  • Following liquidity shocks, insured money funds would allocate inflows to credit-worthy banks and finance companies who, in turn, would extend credit to firms (under loan commitments).
  • Risks that are large and systematic are difficult for a private institution to insure. Pooling them does not eliminate systematic risk that can bankrupt a private insurer.
  • Thus, a government may insure systematic risks, but political constraints limit its ability to charge systematic risk premia.
  • As a result, the subsidization of systematic risk creates moral hazard that can worsen business cycles.
  • The proposed money fund-based insurance system is not radical. Prior to FDIC insurance, banks held the vast majority of money market securities, similar to the money funds of today.