Overview

2. Overview • The focus of this chapter is the mechanisms designed to protect FIs from liquidity crises. • Deposit Insurance Funds • Securities Investors Protection Corporation • Pension Benefit Guaranty Corporation • Deposit Insurance schemes in other countries

3. 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.

4. FDIC • FDIC created in wake of banking panics 1930-33: • 10,000 failed commercial banks. • Original coverage: $2,500. Now $100,000. • Between 1945-1980: FDIC worked. Failures accelerated in 1980.

5. 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 1.23% of insured deposits (2007). • Caveat: Superior Bank of Illinois • Fine of $460 million • $428 million cost to FDIC

6. FSLIC • FSLIC covered S&Ls. Other thrifts often chose FDIC coverage. • High levels of failed thrifts between 1980-88 generated losses of $42.3 billion. From 1989-92 additional 734 failures . Cost: $78 billion. • Result: FSLIC estimated net worth negative $40 to $80 billion. • Policy of capital forbearance.

7. Demise of FSLIC • Forbearance 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). • March 2006, SAIF and BIF merged to form DIF

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

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

10. Trade-off: Moral hazard & bank run risk • Insurance was not actuarially fairly priced. • Reduced incentive for runs. • Reduced incentives for depositors to monitor DIs • Increased moral hazard.

11. Controlling DI Risk Taking • Stockholder discipline • Limited liability of stockholders • Practical problems in applying option pricing to insurance premiums • DI’s asset values and risk are not easily observable • FDIC adopted risk-based premiums 1993

12. Risk-Based Deposit Insurance • Based on: • Categories and concentrations of assets • Categories and concentrations of liabilities • insured, uninsured, contingent, noncontingent • Other factors that affect probability of loss • Deposit insurer’s revenue needs. • Beginning in January 2007 • FDIC started calculating risk premiums in more aggressive manner (See Appendix 19A).

13. Increased capital requirements, stricter closure rules. • Require lower leverage • Impose stricter DI closure rules • Controls forbearance • Five capital zones • Prompt corrective action

14. Increased capital requirements • Proposal • Role of subordinate debt • Improve market discipline • Ease monitoring • Increase transparency and improve disclosure • Increase capital cushion

15. Web Resources Visit, Federal Reserve www.federalreserve.gov U.S. Treasury www.ustreas.gov

16. 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.

17. Depositor Discipline • Federal Deposit Insurance Reform Act of 2005: • Leaves coverage cap at $100,000 per person per account • Adjusted to inflation on 5-year basis ($10,000 increments as necessary) • Cap for retirement accounts increased to $250,000 • Role for deposit brokers • Controlled by FDICIA of 1991 • Implicit 100% coverage from “too big to fail”

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

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

20. Regulatory discipline (continued) • Capital forbearance: • 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; independent audits.

21. Non-U.S. deposit insurance • EC established a single deposit insurance system at end of 1999 • Coverage: 20,000 ECUs. • Co-insurance through deductibles. • Currently, 10 percent.

22. Non-U.S. deposit insurance • Japan: Similar system to U.S. • Over the late 1990s and early 2000s experienced problems similar to those of the U.S. during the 1980s • Over $400 billion in bad loans (2003) • 10 million yen coverage • Late 2006: • China planning to follow FDIC model

23. Discount Window • Traditionally, • 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”. • Implemented in January 2003 • Primary credit available on short-term basis even to sound banks • Secondary credit • Seasonal program • Easing of availability. Elimination of subsidy.

24. Discount Window • 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.

25. Other Guaranty Programs • National Credit Union Administration provides up to $100,000 coverage • Lower risk due to asset diversification • Substantial portion of assets in form of government securities • Changes in Deposit Insurance Reform Act of 2005 apply to NCUIF-insured credit unions as well

26. Other Guaranty Programs • PC and Life Insurance Companies regulated at state level. No federal guaranty fund. • Run and administered by the private insurance companies themselves. • Only NY has permanent guaranty fund. • Definition of small policyholder varies across states from $100,000 to $500,000. • Delays in settling claims against insurance companies.

27. Other Guaranty Programs • 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.

28. 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.

29. Pension Benefit Guaranty Corp. • 1994 Retirement Protection Act phases out premium cap. 1999: record surplus of $5 billion; auditors uncovered serious operational problems. • Risk-based premium scheme did not eliminate all problems. • Senate approval of pension bailout bill • 2005: Deficit increased to $23.0 billion • Deficit Reduction Act of 2005

30. Pertinent Websites FDIC www.fdic.gov Federal Reserve www.federalreserve.gov National Credit Union Admin. www.ncua.org Pension Benefit Guaranty Corp. www.pbgc.gov Sec. Investors Protection Corp. www.sipc.org U.S. Treasury www.ustreas.gov