FDIC Banking Review The Liability Structure of FDIC-Insured Institutions: Changes and Implications
by Christine M. Bradley and Lynn Shibut*
Depository institutions have
traditionally looked to deposits to fund their asset growth. But since 1978, the value of bank assets has
increased proportionally much more than the value of bank deposits: between
1978 and 2005 the value of assets held in commercial banks insured by the
Federal Deposit Insurance Corporation (FDIC) rose by nearly 500 percent, but
total deposits held by these same institutions increased by only 393
percent. And between 1978 and 2005, the
percentage of U.S. banks that were able to fund at least two-thirds of their
total assets with core deposits fell from nearly 91 percent to 59 percent.1
In addition to core deposits shrinking,
banks are facing increased interest costs since bank customers are reacting to
higher interest rates and moving their money out of lower-yielding bank
accounts and into certificates of deposit and other higher-paying
accounts. As a result of these
developments, bank liability management demands more attention today than it
did just a few years ago.
In Part 1 of this
article we focus on the changes in bank liability structure, and in Part 2, on
the implications of the changes for regulators.
Part 1 describes the events that led to the decrease in banks’ reliance
on deposits, examines the changes banks made to their liability management in
response, and discusses the possible future of these changes. Part 2 looks at the possible effects of the
changing bank liability structure on market discipline, liquidity risk
examination, deposit insurance pricing, and failure resolution (domestic
depositor preference and operational issues).
PART 1. Changes in Bank Liability Structure
In this section of the paper we survey the past, the
present, and the possible future of banks’ liability structure. We explain some of the wholesale funding
options available to banks and describe other choices that bankers have
available in their nondeposit liability management. We observe how the tools bankers choose are
driven by developments in the financial marketplace, as well as existing legal
constraints. We also take a look at the
liquidity risk facing today’s banker.
For 45 years after the Great Depression, the business of
banking was largely a process of collecting deposits from people and businesses
and loaning the same funds to other people and businesses having credit
needs. A bank’s success greatly depended
on a depositor’s willingness to accept a rate of interest lower than the rate
the borrower paid for use of the funds.
But in the mid-1970s money-market rates rose above the rates that
depository institutions were authorized to pay on their time deposits,2 and by
1979 the savings patterns for U.S. households were affected by that
differential in rates: in 1978, U.S. households held $100.4 billion in time and
savings deposits, but by year-end 1979 that amount had fallen to $71.2
billion. Similarly, in 1978 U.S.
households had $5.7 billion in money market fund shares, but at the end of 1979
the figure had increased to $30.5 billion.3
Figure 1 shows how the percentage of financial assets of households held
by banks and thrifts fell from the mid-1980s until 1999, the year the U.S.
stock market hit record levels. The
chart further shows that as the stock market retrenched beginning in 2000,
depositors again sought the safety provided by a bank deposit.
In the early 1980s, legislative reforms and technological
advances became two-edged swords to bankers seeking to increase their
deposits. Chief among the legislative
changes during this period were the lifting of intrastate banking restrictions
and the deregulation of interest rates paid on deposit accounts. But these legislative reforms, which were
intended to give depository institutions tools to compete with the money market
for deposits, also resulted in increased competition among banks by allowing
bankers to go outside their local market to procure deposits. In addition, technological advances that
created new delivery channels and increased efficiencies for bankers also made
it easier for depositors to leave their local markets for better terms. With core deposits dropping as a percentage
of total assets, bankers recognized that they would need to increase their
reliance on managed liabilities to fund domestic credit, while managing
liquidity risk (see figure 2).
When deposits lagged behind loan growth in the 1990s,
some bankers argued that there was a funding crisis.4 And indeed, managing bank liquidity is not as
easy as it once was. However, calling it
a crisis gives short shrift to the funding options available to banks. Now both small and large banks regularly use
wholesale sources and rate-sensitive deposits as part of their funding
strategy. By wholesale sources, we mean
borrowings (such as federal funds, repurchase agreements, and Federal Home Loan
Bank [FHLB] advances) as well as brokered deposits. Bankers have also developed methods of
avoiding existing regulations that result in an increase in the bottom line
(sweep accounts and international banking facilities). The many products available have much to
offer banks, but they often entail more risk and require a more sophisticated
management strategy. Thus even though
management of liquidity has become more complex, it is by no means impossible.
Federal Home Loan Bank Advances
Congress established the FHLB system in 1932 to
facilitate the extension of mortgage credit by providing thrift institutions
with collateralized loans.5 In 1989 the
Financial Institutions, Reform, Recovery, and Enforcement Act
(FIRREA) expanded the role of the FHLB system by opening its membership to
commercial banks and credit unions, and in 1999 the Gramm-Leach-Bliley Act
expanded the type of assets that qualify as collateral for FHLB advances. Between year-end 1992 and year-end 2005, the
number of commercial banks in the FHLB system grew from 1,284 to 5,927. As of December 2005, the FHLB system had
8,157 members.6 Although the FHLB system
does not interact directly with U.S. households, the system has enhanced the
availability of residential mortgages by providing member institutions with a
way to liquefy the home mortgages they originate, thus ensuring the flow of
Some critics of the FHLB system have suggested that FHLBs
are no longer necessary because of the growth and strength of the secondary
mortgage market.7 But the FHLB system
has done more than help its members fund mortgage loans. The FHLB system also offers products that
help members in their asset-liability management, and it generally provides a
supplementary source of funds for expansion and liquidity that can address
imbalances between deposits and funding needs.8
There is no indication that the role of FHLBs in
providing a reliable source of bank funding will change in the future. But critics argue that FHLB advances enable
banks to evade the natural limits of their expansion and that the advances
thereby impede market discipline; thus, any future changes to the FHLB’s role
in liquidity management may well take the form of restrictions on the use of
FHLB advances.9 An additional impetus
for limiting the use of FHLB advances is the effect these advances can have on
the deposit insurance fund when an insured depository institution fails:
because all FHLB advances are required by law to be secured, they are paid in
full before the FDIC recovers funds after an insured institution fails.10
Nonetheless, FHLB advances are very popular with bankers (for the ten
years ending December 31, 2002, FHLB advances increased by 521 percent) and are
likely to remain an important funding tool, possibly with limitations placed on
their use by troubled institutions.11
A second funding substitute for core deposits is brokered
deposits, generally defined as deposits “issued by a financial institution and
purchased by an investor through a third-party intermediary.”12 Brokered deposits were used as far back as
the 1950s to aid the thrift industry whenever there was a regional shortfall of
funds. Before 1970, the brokered-deposit
market consisted primarily of institutional uninsured depositors, including
money-market funds, corporations, bank trust departments, and insurance
companies. In 1973, when interest-rate
ceilings were eliminated on deposits of $100,000 or more, deposit brokers
helped institutional investors find the highest rates available for their
deposits, while technological advances made a nationwide market possible. But in 1974, an FDIC study indicated that a
misuse of brokered funds was a contributing factor to many of the bank
In the early 1980s, the thrift industry used brokered
deposits to fund much of its growth.
Between 1980 and 1983, brokered deposits within that industry grew by a
yearly average of 60 percent. It was
during this period that the deposits gained much of their notoriety, and many
people concluded that brokered deposits contributed to the savings and loan
crisis. In 1984 regulators attempted to
curb the use of brokered deposits, and from 1984 through 1989 brokered deposits
held by savings and loans increased an average of only 4.27 percent per year.14 Although the use of brokered deposits is most
often associated with the thrift industry, commercial banks also found that
brokered deposits met their funding needs.
At the end of 1990, commercial banks had $72.6 billion in brokered
By 1989 Congress had concluded that brokered deposits
contributed significantly to the collapse of the savings and loan industry and
began restricting their use.16 Congress
adjusted the restrictions in 1991 by prohibiting any insured institution that
is not well capitalized from accepting any funds obtained directly or
indirectly from a deposit broker.
Institutions that are “adequately capitalized” can apply to the FDIC for
a waiver of this provision on a case-by-case basis.17
People on the periphery of the banking industry might
have concluded that brokered deposits would never again be thought of as a
conventional source of funding. But
brokered deposits have again become one of the tools bankers use in their
liability management programs. In fact,
as figure 3 shows, large banks’ use of brokered deposits has exploded in recent
years. From a bank’s perspective,
brokered deposits can be used to great advantage because they do not upset a
bank’s local savings market and they give the institution access to national markets:
banks can have one rate structure for local deposits and another for deposits
placed through brokers. Additionally,
because institutions that specialize in commercial lending are limited in their
ability to borrow from FHLBs,18 such institutions find brokered deposits
Two forms of brokered deposits that bank managers use for
liability management in today’s market are deposit splitting, used mainly by
large banks, and an Internet-based service, used mainly by small and midsize
banks. Other sources of brokered deposits
exist as well—for example, less-formal deposit-splitting arrangements, online
auctions, and deposit-listing services19—but are not discussed here. However, their availability is a reminder
that just as technological advances opened entirely new avenues of funding for
today’s bankers, other options for using brokered deposits will surely be
developed in the future.
Deposit splitting by affiliated brokers. Despite the regulatory scrutiny that brokered
deposits have received since the savings and loan crisis, the use of deposit
brokers is recognized as a legitimate method of obtaining deposits. Although many brokers specialize in locating
for their customers the highest rates of interest that are being paid on certificates
of deposit,20 our discussion here concerns the subset of brokered funds that
are used to expand deposit insurance coverage beyond the normal limits to much
higher levels. The insurance-related
risks associated with this form of brokerage are familiar. First, this form increases the exposure of
the federal deposit insurance fund.
Second, this form of brokerage does not subject banks to the market
discipline that is ordinarily brought to bear by larger depositors when they
are unable to obtain full insurance coverage.21
Paradoxically, two root causes of the recent funding
problem of depository institutions—the increased value of the stock market and
a preference for higher-paying investments—have indirectly been the means by
which larger institutions have found a reliable source of cash through brokered
deposits. The volatility that
characterized the stock market in the late twentieth century and the opening
years of the twenty-first led many investors to be content to wait on the
sidelines for future investment opportunities, and the result was a problem for
stock brokerage houses: how should the resulting oversupply of cash be
In the late 1990s, Merrill Lynch began breaking up its
customers’ accounts into amounts of $100,000 or less and distributing the money
across its affiliated insured depository institutions, thus offering its
clients additional deposit insurance coverage for their funds. Several other brokerage houses subsequently
adopted similar deposit-splitting programs.
But unlike Merrill Lynch’s program, many of the newer arrangements place
funds with unaffiliated institutions, a course that may prove more troublesome
for regulators. When deposit splitting
is restricted to affiliated institutions, the growth of such programs is
inherently limited, but when a brokerage uses unaffiliated institutions, the
number of depository institutions available is virtually unlimited, and if this
activity is taken to the extreme, the resulting influx of insured deposits
could lead to a reinstatement of deposit insurance premiums.22 In addition, when unaffiliated institutions
are used, volatility increases, since money that flows so easily into the
insured accounts from the brokerage house is just as likely to go elsewhere if
the least financial incentive arises.
Although nothing limits this type of deposit-splitting
program to large institutions, the largest institutions are currently the most
active participants. But other
deposit-splitting arrangements exist for mid- and smaller-size
institutions. One such arrangement is an
An Internet-based deposit-splitting arrangement. Brokered deposits seemed to gain some
respectability when the Promontory Financial Network (Promontory) launched the
Certificate of Deposit Account Registry Service (CDARS) in January 2003.23 Promontory was founded by former Comptroller
of the Currency and former FDIC board member Eugene Ludwig. Its board of directors includes a former vice
chairman of the Federal Reserve Board, Alan S. Blinder, and a former FDIC chairman,
L. William Seidman. Even though the
principals of Promontory are quick to contrast their program with traditional
brokered deposits,24 a skeptic could just as quickly disagree and argue that
the system is nothing more than a well-connected brokered-deposit service. Nevertheless, the new service has met with
approval from most observers.25
CDARS allows participating banks and thrifts to offer their customers
insurance on deposits greater than $100,000—currently, on deposits of up to $25
million.26 To illustrate how the service
does this, let us assume a customer goes into a CDARS-participating bank to
make a deposit of $200,000. The bank
holds $100,000 in an account and places the other $100,000 with another institution
belonging to the CDARS network and offering terms acceptable to the first
bank’s customer. At the same time,
another CDARS bank taking a deposit from one of its own customers arranges to
deposit $100,000 with the first bank. By
using the CDARS network, the first bank continues to hold $200,000 in its
deposit base—an amount that increases its lending capacity; the bank-customer
relationship is saved since the customer deals only with the first bank; and
the $200,000 deposit is completely covered by deposit insurance.
CDARS has been described as a clearinghouse that appears best suited to
the small or mid-size institution,27 and it is true that the bank customer who
benefits from CDARS is primarily an individual with over $100,000 in bank
deposits. Nevertheless, the program is
also being marketed to nonprofits, small businesses, and municipalities. In the case of municipal deposits, CDARS
provides an additional benefit to the depository institution since the
institution’s collateral is freed up under the program.28
Although the service may resemble a typical deposit brokerage, some
observers have favorably distinguished it from the brokered deposits that
caused problems during the savings and loan crisis.29 Time will tell, but CDARS may well make
brokered deposits a primary consideration when bank management is exploring
Sweeps and Reserve Requirements
Another area of a bank’s nondeposit liability management
has been driven by legal restrictions.
Under current law, depository institutions may not pay interest on
demand deposits or standard checking accounts.30 However, because nonbusiness account holders
are generally paid interest through the use of negotiable order of withdrawal
(NOW) accounts,31 the only group that is effectively barred from earning
interest on its demand deposit accounts (DDAs) are holders of business
accounts. To circumvent the restriction
on the payment of interest, many banks arrange for funds held in a commercial
account to be swept into an interest-bearing instrument (target account) on a
Current law limits the frequency of sweep activity
according to the nature of the target account.
If the target account being used by the sweep is a traditional savings
account or money-market account, banks must limit transfers and withdrawals
between the accounts to 6 per month or per statement cycle.32 However, if the funds are being transferred
to a nondeposit instrument, such as repurchase agreements or unsecured
instruments, the transfers (or “sweeps”) can be made daily. Consequently, bankers can offer the business
customer a sweep account that offers automatic investment in a high yield
account and a blended rate of interest that is closer to market rate.33
An additional impetus to establishing sweep accounts is
the dollar amount required to meet a bank’s reserve requirements. All depository institutions must reserve an
amount equal to between 3 percent and 10 percent of the funds they have in
interest-bearing and noninterest-bearing checking accounts. The total required to be held in reserve is
determined relative to the total deposits held in the qualifying accounts at
each bank. Once the amount of the
reserve is determined, banks may choose to hold their reserves in the form of
cash (vault cash) or in an account at a Federal Reserve Bank (FRB) (sterile
reserves), but in either case the funds are nonincome producing. As a result, a key strategy of bank liability
management has been to discover ways of building a bank’s deposit base while
keeping required reserves to aminimum.34
Bankers have successfully reduced their reserves in
recent years: reserve balances at FRBs fell approximately $3.5 billion between
1994 and 2004, while total deposits increased by 95.6 percent during the same
period.35 The American Bankers
Association cited the example of an institution that was able to reduce its
required reserves from $788,000 in August 2000 to $48,000 in August 2001, a
period when deposits at the institution rose by $36 million.36 Although many bankers have used sweep
accounts successfully to reduce their reserve accounts, many analysts view the
mechanisms being used to evade reserve requirements as “inefficient and costly”
and believe they result in price distortion.37
During the 109th session of Congress, the Senate
discussed whether banks should pay interest on commercial deposit accounts and
whether FRBs should pay interest on the reserves they hold.38 These two issues have been put before
Congress in the past, and like past bills, the recent bill combines the two
issues.39 In fact, interest earned on a
bank’s reserves is frequently viewed as an offset to the interest that the
institution would pay on deposits held in its transaction accounts. If legislation goes forward, banks will
likely unwind most of their sweep programs.
Until then, sweep accounts continue to be used effectively by bank
management. We next focus on retail
sweep accounts, and sweeps to third-party money brokers, repurchase agreements,
and international banking facilities.
Retail sweep accounts.
The history of retail sweep accounts shows clearly that even though
paying interest on deposit accounts may have been the primary motivation for
establishing sweeps, minimizing required reserves quickly became bank
management’s paramount goal.
As noted above, since the 1970s financial institutions
have used sweep accounts to avoid the prohibition of interest payments on
DDAs. In 1982, with the creation of the
money-market deposit account (MMDA), the use of sweeps increased dramatically. The MMDA was statutorily mandated to be
“directly equivalent to and competitive with money-market mutual funds.”40 With this new instrument, banks were finally
able to pay their depositors a market rate of interest by sweeping any funds
over an agreed-to amount into an interest-bearing MMDA. The funds were automatically returned to the
transaction account with interest paid as the bank and depositor had previously
agreed. By 1984, banks held more than
$370 billion in MMDAs.41 But even though
the MMDA gave banks a product without interest-rate ceilings, banks’ ability to
compete with the sweep accounts that were available on the open market
continued to be limited because MMDAs were prohibited from having more than six
transfers and withdrawals per calendar month or statement cycle.
Despite this disadvantage, when newly designed computer
software enabled a bank to analyze its depositors’ use of their transaction
accounts, sweeps became one of the main tools used to minimize a bank’s
required reserves: any funds deemed by the bank to be excess were automatically
transferred into MMDAs. (As a result of
these transfers, a bank’s required reserve ratio could go from 10 percent to
zero). And in 1994, when the Federal Reserve
Board authorized banks to use this software to reclassify any transaction-account,
retail sweep programs developed as banks notified their customers when they
opened an account that “your deposit may be reclassified for purposes of
compliance with Federal Reserve Regulation D. . . .” Banks began initiating sweeps
without the customers’ explicit approval, and the volume of transfers occurring
between transaction accounts and MMDAs increased dramatically.
The MMDA used in a retail sweep program operates as a
“shadow” account that is visible only to the depository institution. The bank reduces its required reserves while
leaving unchanged the transaction deposits that are available to the
depositor. A bank’s level of transaction
accounts decreases sharply, whereas the depositor’s view of the account appears
unaffected.42 Just as this transfer
occurs without the depositor’s explicit approval or knowledge, so, too, any
profits that the bank earns are not generally shared; in addition, banks also
can choose how the funds will be invested.
During 2002, the Federal Reserve estimated that banks
swept $526.6 billion into MMDAs, and when then Federal Reserve governor
Laurence Meyer testified before Congress, he expressed the belief that banks
would probably reduce or eliminate the use of deposit sweeping if the Federal
Reserve began paying interest on reserve accounts.43
Third-party money brokers. When institutions choose to use third-party
money-market brokers as a way to pay interest on commercial accounts, the
depositor enters into an explicit contract for the broker’s services and the
bank plays the role of conduit. The
bank’s customer sets a target balance to hold in his or her transaction
account, and any excess funds are wired out of the bank to a money-market
broker. A variety of these arrangements
are available, but in each of them the bank’s primary motivation is to make
available to its commercial depositors interest-paying accounts through daily
sweeps. Like retail sweep accounts,
these programs reduce a bank’s required reserves, but the net saving realized
by the bank is relatively insignificant, and unlike with retail sweep accounts,
a bank loses control of the funds.
Consequently, if new legislation authorized the FRBs to pay interest on
reserve accounts and banks to pay interest on DDAs, banks would probably
discontinue their use of third-party brokers (though the use of affiliated
brokers might continue). If so, they
may need to adjust their pricing strategies to maintain their profits.
Repurchase agreements (repos) are contracts between the depositor and
the bank that are considered short-term debt obligations in which the bank
secures its obligation to pay the amount due under the contract by a pledge of
government securities.44 From the
customer’s perspective the repo operates much like an insured deposit, since
the customer’s funds (including interest) are secured up to the value of the
collateral. In most cases, repos are
overnight agreements: the funds are moved from the deposit account at the end
of the business day and are returned to the account at the start of the
following business day. With an in-house
repo program, the bank decides how to invest the excess funds and retains the
net interest margin. The customer is
repaid under the terms of the repo from the general liquidity of the bank; that
is, the specific government securities being used as collateral under the
agreement are not generally sold.
Using repo agreements as a liability management tool has
several advantages. First, repos enhance
the bank’s flexibility: the bank determines the rate of interest to be paid in
the transaction and changes it as often as necessary to remain competitive in
the market. Second, the bank retains
total control: the bank decides how to invest the excess funds and retains the
net interest margin. Third, the money
remains in the community. But despite
these advantages, repos require a pledge of collateral and therefore restrict
the bank’s use of its securities. For
this reason, the payment of interest on reserves and DDAs would probably result
in a decrease in the number of sweep arrangements using repos.
International banking facilities. During the 1960s and 1970s the U.S. banking
industry developed a substantial offshore international banking sector that
allowed banks to attract deposits by avoiding statutory interest rate
ceilings. But in 1981, Congress
alleviated the need for any offshore investment when it authorized U.S. banks
to establish international banking facilities (IBFs). An IBF is merely a set of asset and liability
accounts for international banking transactions that is segregated on the books
and records of the establishing bank, with no separate organizational structure
needed. Dollar-denominated deposits held
at a U.S. IBF (or a bank located outside the United States) are
Eurodollars—Eurodollars are not subject to interest-rate ceilings, reserve
requirements, or deposit insurance assessments.
The Federal Reserve authorized the establishment of IBFs
at domestic banking offices in order to enhance the internationally competitive
position of U.S. banking institutions.45
The Board reasoned that since many banks avoided regulatory requirements
by conducting their international banking from foreign bank branches, IBFs
would make the cost of conducting international banking activities at domestic
offices competitive with the cost of conducting business from a foreign branch,
and the money would be held in accounts within the United States. In addition, since the cost of establishing a
foreign bank branch would prevent any institution except the largest
money-center banks from participating in the international banking business,
IBFs offered regional banks a way to become involved in international
banking. Although stringent requirements
limit the type of transaction that can be undertaken by an IBF, qualified funds
may be swept between a U.S. bank and its IBF.
The trends discussed above have changed the way banks
manage their liquidity positions and the associated risks. The basic principles of sound liquidity risk
management remain unchanged; however, those who apply them must take into
account the new challenges and opportunities faced by banks today.
Some banks have adjusted better than others, but
regulators have noted several problems.
Sound liquidity management requires that banks weigh the trade-offs
among liquidity needs, return on investment, and managerial flexibility. Problems arise when banks begin using new
funding sources without understanding them or making the appropriate changes to
their liquidity management programs. For
example, some banks chose structured FHLB advances that contained options they
may not have fully understood. When the
FHLBs exercised their options, or when the banks decided to change their
funding strategies by prepaying advances, an apparently inexpensive borrowing
could have unexpected and expensive consequences.46 Other areas where banks have sometimes failed
to make adjustments include liquidity reporting and the associated management
information systems support, as well as contingency planning: banks have not
always adjusted their contingency plans or “what-if” analyses to address the
characteristics of new funding sources.
In 2001, the Office of the Comptroller of the Currency (OCC) found that
up to 25 percent of the smaller banks that were represented at a large meeting
of bankers had no up-to-date written contingency plans.47
Some banks have addressed their funding needs by
securitizing assets rather than holding them in their portfolio. This strategy raises different issues that,
again, some banks have addressed more successfully than others. The most significant liquidity danger relates
to early amortization clauses in the contracts.
Such clauses are typically triggered by an indicator of deterioration in
the performance of the securitized portfolio.
When the clauses are triggered, the bank may suddenly be required to
fund a large volume of new lending associated with the portfolio.
For many banks, an increased reliance on wholesale funds
could lead to more severe liquidity problems if their financial condition
deteriorated. Most core deposits are
insured, so these depositors have little reason to exit from a troubled
bank. But many wholesale and
rate-sensitive funding sources could quickly evaporate if the bank’s solvency
were in doubt.48 Thus many banks should
be more careful about contingency funding plans.
Bank Liability Structure
in the Future
Having examined liability management strategies used by
banks in response to the changing environment, we now venture to make
predictions. We begin with core deposits
because most banks still use core deposits as their preferred primary source of
funding, turning to noncore deposits and other wholesale sources to supplement
the funding of their operations.
We expect that growth in core deposits will continue to
lag behind asset growth. Bank customers
do not need to keep their money in core deposits since technological
improvements have simplified (and will continue to simplify) the process of
shopping for competitive returns from a broad array of options. Furthermore, the aging of the U.S. population
has negative (as well as positive) effects on core deposits. Certainly aging customers are more likely to
need the liquidity and safety provided by deposit products and will therefore
tend to increase the demand for these products; nevertheless, as assets are
passed to the next generation, customers are likely to shift away from core
deposits in search of better returns.
Growth in core deposits will also be influenced by the
health of the general economy and the stock market. If the country’s wealth continues to increase
as it has in recent decades, the percentage of household wealth invested in
core deposits will continue to drop (because wealthy consumers normally have a
stronger appetite for and capacity to accept risk). A strong economy will bring about growth in
core deposits, but the rate of growth will probably be slower than the rate of
growth in bank assets. However, if the
economy—or the stock market—is weak, core deposit growth could be quite strong
during a period when loan demand is relatively weak.49
The future is even murkier for total deposits than for
core deposits. Of course, the factors
that influence core deposits will affect noncore deposits in a similar
way. But technological changes have
probably influenced noncore deposits more than they have core deposits, and
depositors holding large volumes of funds are more likely to be sensitive to
perceived trade-offs between risk and return.50
When deposits are split and distributed among banks, deposits are
insured at much higher levels than the level available through one
institution. Deposit splitting allows
investors to shift from low-risk low-return investments (money-market funds) to
low-risk low-return insured investments (deposits) at a very low cost. In the short term, we expect this type of activity
to continue generating deposit growth.
Although the long-term prospect for the use of deposit splitting is
particularly hard to ascertain, we expect these deposits to be more volatile
than core deposits.
Banks’ reliance on nondeposit sources, such as FHLB
advances, will probably be determined largely by two factors: the ability of
core deposits to fund asset growth, and returns on funds received from
nondeposit sources compared with returns on deposits. If core deposit growth lags behind asset growth
(as we expect), nondeposit instruments will continue to grow, as long as banks
continue to offer competitive interest rates.
Implications for Bank Regulators
Because these changes in bank liability structure have
yielded substantial benefits to U.S. consumers and businesses, the task for
regulators is not to find ways of turning back the clock but, instead, to
accommodate these changes wisely. From
this perspective we discuss several areas of bank regulation that are being
affected by bank liability structure: supervision, deposit insurance, and
failure resolution. Under supervision,
we look at market discipline (how to exploit the power of markets to encourage
good bank governance)51 and the examination of liquidity risk at banks. Under deposit insurance, we look at
deposit-insurance pricing and identify other issues. And under failure resolution we look at
depositor preference (the optimum order of payment for creditors in the event
of a bank failure) and some operational issues raised by changes in bank
In recent years, regulators and economists have become
increasingly interested in the use of markets to supplement or reduce the
reliance on traditional supervision as a mechanism for monitoring and policing
bank behavior.52 With banks relying more
heavily on unprotected funding sources, the potential is greater for creditors
to influence bank behavior—either directly (as banks respond to creditor
demands) or indirectly (as supervisors respond to the changes in creditor
behavior). Unprotected market
participants have an incentive to monitor banks, an independent viewpoint, and
certain advantages over supervisors.53
In addition, many market signals are available daily, whereas
examinations, and even Call Reports, are available much less frequently. And with liability structure now able to
change more quickly, the FDIC’s risk exposure could shift rapidly. Thus the regulatory community is taking some
steps to expand the role of markets in the regulatory process and is exploring
the possibility of other steps as well.
Perhaps the most visible sign of banking regulators’ resolve to
strengthen market discipline is the status it has in the Basel II accord:
market discipline is the “third pillar.”54
Conditions Necessary for Market Discipline to Succeed
The term “market discipline” is often used broadly to
represent the entire role that markets play in bank behavior. But to examine the effectiveness of market
discipline and the ways in which regulators could enhance its influence, we
need more specificity. We need a more
precise definition of market discipline, and we need to understand the
conditions necessary if market discipline is to succeed.
Flannery defined market discipline as the ability of
markets to perform two distinct functions: to monitor changes in the bank’s
condition and to influence the bank’s actions.55 Llewellyn used the same breakdown of
monitoring changes in condition and influencing actions, but he concentrated on
the conditions necessary if market discipline—monitoring and influencing—is to
succeed. He presented seven such
1. Relevant and accurate
information must be available to market participants.
2. There must be enough market
participants who are able to analyze the information.
3. The market participants must have
adequate, clear incentives to monitor banks.
4. A sufficient number of market
participants must act on the information.
5. The market response must be
6. The response must lead to
equilibrating change in market quantities or prices or both.
7. Bank managers must have the
incentives and ability to respond to the market changes (or must be conscious
of the potential threat of changes in quantities, prices, or both).56
The last condition is the only one that relates to the
market’s ability to influence banks. A
critical aspect of that criterion is timing.
When a bank is troubled, market discipline is most useful if it
influences bank managers before it is too late to avoid failure.57 In addition, regulators would naturally
prefer that the managerial response be directed at reducing the likelihood or
cost of failure (rather than taking on additional risk).
Assuming that market discipline is transmitted through
price and quantity signals, Llewellyn concludes that market discipline will not
work effectively if any of the seven conditions is violated. Furthermore, he concludes that actions taken
by banking regulators to address any of these conditions can improve the
effectiveness of market discipline.58
Evidence about the Provision of Relevant and Accurate
Data to the Markets
The availability of relevant and accurate data is
Llewellyn’s first condition for effective market discipline. The banking agencies primarily use two tools
to help ensure that this condition is met: reporting requirements and
examinations. Among the large number of
reporting requirements imposed on banks is the requirement that banks collect,
edit, and supply Call Report data quarterly.
The second tool—the examination function—reduces the ability of banks to
ignore or hide their financial difficulties from market participants. Managers at troubled banks have a strong
incentive to hide problems, since both markets and regulators impose discipline
when the problems become apparent. In
fact, several researchers have found that troubled banks frequently reveal bad
news (through increases in loan-loss reserves and reductions in equity) shortly
after a supervisory examination or an associated enforcement action.59 Therefore, changes made to enhance market
discipline cannot ignore the evidence that supervisors play an important role
in providing accurate data—particularly for banks that become troubled. This evidence also indicates that efforts to
supply the markets with negative information gleaned by supervisors might be a
fruitful avenue for enhancing market discipline.
Evidence about Whether Markets Monitor Banks
Most of Llewellyn’s conditions (conditions 2–6) relate to
the ability of markets to monitor banks and react rationally. The evidence that unprotected creditors are
able and willing to monitor banks and to act as expected on available
information is very strong. The volume
of uninsured and jumbo CDs drops substantially during the period leading up to
failure.60 CD yields increase with bank
risk.61 Stock market prices drop when
financial condition variables indicate problems and when examination ratings
fall, and subordinated debt yields are higher for riskier banking companies
than for less-risky ones.62 These
findings indicate that, to some extent, the first six conditions set by
Llewellyn are being met.
The evidence is less compelling (and less plentiful) when
one asks whether market information could be used to improve regulatory
monitoring. Gilbert, Meyer, and Vaughan
tested the use of jumbo-CD rates and runoff as a screening tool to predict
downgrades in supervisory ratings or as a factor to improve off-site monitoring
models (which are currently based on accounting data).63 They found that jumbo-CD information
contributed nothing in either capacity, and suggested that the strong economy
during their sample period (1991–1999) contributed to the weak relationship
(that is, depositors might have had little incentive to monitor banks because
the industry was so healthy). Jagtiani
and Lemeaux examined the stock, bond, and deposit data of five publicly traded
companies that failed.64 They found that
except at one bank, both bond and equity markets were slower to identify
problems than supervisors were.
Berger, Davies, and Flannery examined the success of bond
ratings, abnormal stock returns, and supervisory assessments (examination
ratings) in predicting the future performance of banks.65 They found that bond rating agencies (but not
stock market participants) acquire and use information that would improve the
ability of supervisory assessments to predict future changes in bank
condition. However, their method did not
test for the extent to which the benefits from bond rating and stock market
information were also captured in the financial data collected in the Call Reports.
A few studies have tested the ability of stock market
data to improve off-site monitoring models.
Curry, Elmer, and Fissel found statistically significant relationships
between various stock market variables and bank condition.66 They also found that the addition of these
variables to an off-site model improved performance, but the incremental
improvement was very small. Krainer and
Lopez studied the effectiveness of adding both stock market and bond market
data to off-site models. They had
similar results, finding that abnormal returns tended to anticipate examination
rating downgrades. They also found that
the addition of stock market and bond market data to off-site models improved
the in-sample fit but did not materially improve predictive ability in
In summary, researchers have found plenty of evidence
that uninsured depositors, bond investors, and stockholders impose penalties on
banks that become riskier. However,
researchers’ attempts to use market data to improve the predictive ability of
supervisory off-site models have to date been disappointing.
Evidence about Whether Markets Influence Banks
Llewellyn’s last condition addresses the ability and
incentive of bank managers to respond to market signals. Bank managers’ response is just as important
as the market’s ability to react to bank condition, but it has received far
less attention from researchers.68
Billett, Garfinkel, and O’Neal examined the abnormal
stock returns of banks that had been downgraded.69 They found that banks with high levels of
insured deposits did not experience a significant reduction in abnormal returns
from a downgrade, but banks with lower levels of insured deposits did. They also found that banks relied more
heavily on insured deposits for funding after the downgrade. Several other researchers have documented
significant shifts away from unprotected funds toward insured deposits and
secured liabilities as banks become troubled.70
There is also theoretical evidence that supports such a shift.71 This shift is frequently cited as evidence
that market discipline works, and in a way, those authors are correct: bank
managers clearly respond to market signals by shifting their funding strategy. But Billett, Garfinkel, and O’Neal concluded
that the ready availability of insured deposits undermines the ability of
markets to discipline bank management.
Billett, Garfinkel, and O’Neal have company. Jagtiani and Lemeaux reached the same
conclusion, based on their inspection of five publicly held banks that
failed. Ashley, Brewer, and Vincent came
to a similar conclusion about FHLB advances, based on their finding that during
the thrift crisis, insolvent thrifts tended to rely more heavily on FHLB
advances than healthy thrifts. Hall et
al. studied the effects of depositor discipline on the operating results of
healthy banks and found that the effects were too small to influence bank
management.72 Therefore, under the
current regulatory regime, the discipline imposed by bank creditors generally
causes bank managers to adjust their funding strategy but not necessarily to
reduce their risk exposure.
There is some evidence indicating that stockholders tend
to encourage rather than discourage risk-taking at banks—particularly when bank
condition is weak. Laeven found that
concentrated ownership in banks (which ameliorates the agency problem) is
associated with greater risk. Saunders,
Strock, and Travelos found that management-controlled banks are more risk
averse than stockholder-controlled banks.
Demsetz, Saidenberg, and Strahan found that the combination of low
franchise value and large insider holdings (the latter align the incentives of
managers and owners) is associated with higher levels of bank risk.73
We found two studies that documented evidence of a
beneficial (risk-reducing) managerial response to market discipline. Cannella, Fraser, and Lee found that senior
managers have more trouble remaining employed in the industry if their bank fails,
particularly if the reason for failure was arguably within the manager’s
control. Baumann and Nier found that
banks that were subject to more market discipline had higher capital ratios.74
Bliss and Flannery examined the effects that abnormal
returns on stocks and bonds had on a variety of managerial action
variables.75 Although they found
anecdotal evidence that markets influence bank management in extreme
circumstances, their results showed no significant relationship between
abnormal returns and subsequent managerial actions. They concluded that “in the absence of
specific evidence that bank holding company stock and bondholders can
effectively influence managerial actions under normal operating conditions,
supervisors would be unwise to rely on investors . . . to constrain bank holding
company risk-taking.”76 DeYoung et al.,
on the basis of their analysis of the effects of examination ratings on
sub-debt spreads, concluded that their “results suggest that bond investors
believe supervisory discipline to be more effective than what the market itself
Market Discipline in the Future
Most economists and regulators now believe that a heavier
reliance on market discipline could potentially improve both the supervisory
function and the corporate governance of the banking industry. Related proposals that have been put forth
vary widely but can be categorized in one of two basic groups: those that would
make major changes, replacing segments of the supervisory function and the
safety net with market-driven alternatives; and those that would make lesser
changes, enhancing (but not replacing) the basic supervisory scheme and safety
net that are currently in place. As may
be apparent, the largest differences of opinion are tied to fundamental viewpoints
about the need for bank regulation in the first place.78
Among the several proposals for major changes is one by
Stern, who recommended a mandate to haircut all uninsured depositors at
failure, regardless of the circumstances.79
Another is by Calomiris, who proposed that large banks be required to
issue sub debt with an interest rate below a specified threshold. If a bank were unable to meet these
conditions, its assets would have to shrink 1/24th each month until the debt
was issued (or the bank failed).80
Proposals along these lines reduce the opportunity for regulatory
forbearance and increase the market’s influence on bank behavior. Proposals for modest changes are illustrated
by calls for expanding disclosure regulations or for adopting off-site models
that incorporate market data.
There are a number of reasons that modest changes may be
viewed (at least by regulators and Congress) as more palatable than major
changes. First, the trade-offs related
to modest changes are far easier to understand than are those related to major
changes. Thus, the more sweeping
proposals may be viewed as riskier because of unanticipated consequences. Second, the lack of convincing evidence that
markets cause managers at troubled banks to reduce risk exposure is a
concern. Third, some stakeholders
(including regulators) may have a vested interest in the status quo.81
A fourth complicating factor is that regulatory policies
can have inconsistent effects over time.
The effects of any policy that is tied to market behavior are likely to
vary over the business cycle. Extensive
shifts in market behavior have been documented by several researchers. Covitz, Hancock, and Kwast found that
sub-debt yields were significantly influenced by issuance decisions, which in
turn were influenced by factors that varied substantially over time. Hall et al. suggested that shifts might occur
in the monitoring efforts of uninsured depositors, depending on the overall
health of the banking industry.
Danielsson and Shin described how market reactions to increases in risk
have sometimes amplified shocks to the system.82
Proposals for major change usually include “hard”
triggers based on market signals83 and therefore provide less room for
regulatory discretion in extreme circumstances.
Historically large banks become troubled or fail during periods of
industry-wide distress, and market volatility during those periods may bring
about results that were not anticipated when the regulatory system was
designed.84 Furthermore, not only the
market’s reaction but also the circumstances leading to the industry stress may
be unexpected. In large part, the safety
net was created to limit the spillover effects of bank failures during periods
such as these. During the hearings that
led up to passage of FDICIA, Congress spent a lot of time discussing these
issues, and the result was prompt corrective action (PCA) and the least-cost
test plus the systemic-risk determination.85
We see no trends in banking (or in recent research) that would support a
shift away from regulatory discretion in extreme circumstances. Therefore, we believe that any near-term
changes will probably aim for relatively modest enhancements to the current
Although there is no consensus about the best approach, some types of
proposals have more support than others.
The most frequent recommendation is for more research, and that is
already occurring. A basic view is that
improvements in the use of market discipline should be measured in terms of net
social benefits.86 In other words, one
should take into account the substantial differences (in costs and benefits)
that may exist between the type 1 and type 2 errors associated with market
responses. Along the same lines,
Flannery suggested that regulators should not insist on the perfect solution
before instituting changes but, instead, should adopt options that yield better
solutions more often, or better results for the most important circumstances.87
Some of the likely changes are well accepted in academic and regulatory
circles—in particular, increased disclosures to the market and increased use of
market data in supervisory judgments. In
addition, some economists have recommended incorporating market data into
deposit insurance prices at large banks.
Increased disclosure requirements are already moving toward adoption as
part of the Basel II effort.88 Given the
research showing that supervisors often have an advantage over markets in
uncovering private negative information, future research may advocate—and
future changes in the reporting requirements may institute—improved disclosures
by banks (or perhaps supervisors) when trouble arises.
Supervisors will probably continue to expand their use of these data in
multiple ways. Even though the research
to date has not produced large improvements in off-site models, supervisors
will probably continue to expand the use of these data in the off-site review
process.89 Additional research might
produce clearer—and thus more useful—signals for regulators. Also possible are changes in the training of
examiners (training them to understand market signals better) and in the
conducting of on-site examinations.90
Liquidity Risk and Other
Because many banks have adopted more complex funding
strategies to address shortfalls in core deposit funding, supervisors have
reconsidered their evaluation of liquidity risk. Regulatory agencies have increased their
emphasis on liquidity management and updated their examiner guidance and
training. In 2000 the Bank for
International Settlements (BIS) published revised principles on managing
liquidity.91 In 2001, the U.S. banking
agencies released an interagency advisory letter on brokered and rate-sensitive
deposits, reminding bankers to undertake risk-management measures that are
appropriate for banks that rely on these instruments.92
In 2001 both the OCC and the FDIC published new
examination guidance on liquidity. The
FDIC’s revisions incorporated changes and additions in several areas, including
FHLB advances, securitization, ratio analysis, contingent liabilities, brokered
and rate-sensitive deposits, and factors for examiners to consider when rating
banks on liquidity.93 In 2000 and 2002
the FDIC also published new guidance on specific areas related to liquidity.94 As banks continue to adjust their strategies
and examiners continue to identify weaknesses in some banks’ strategies,
additional changes in examination procedures and training may be needed.
If core deposit growth continues to lag behind asset
growth and banks are forced to rely more heavily on wholesale deposits,
contingency planning may require more emphasis.
For troubled banks, examiners may need to pay more attention to
liquidity pressures than they did in the past.
The easy availability of wholesale funding sources raises
other supervisory issues. It enables
nontraditional banks to grow (and take on additional risk) very quickly. There is a well-established link among high
growth, risk exposure, and bank failure.95
The OCC found a positive relationship between the reliance on wholesale
funding and risk exposure.96 Hall et al.
found that riskier banks used jumbo CDs more heavily than low-risk banks, and
McDill and Maechler found that banks with a CAMELS rating of 3 relied on
uninsured deposits more heavily than healthier banks.97 Supervisors have already instituted off-site
monitoring tools related to high growth.
Now that protected wholesale funding sources are becoming more readily
available, should regulators be considering other actions as well?
The supervisory function might also benefit from an
investigation into new standard performance ratios for liquidity
measurement. Liquidity measurement has
always been imprecise because it depends on future circumstances, including the
market’s future view of the bank. Jim
Moss, a managing director at Fitch Inc., phrased it well: “You can do a lot of
analysis, but there’s that human element attached to liquidity.”98 The traditional ratio of loans to core
deposits—never sufficient by itself—has become less meaningful and is now inadequate
since not only are many rate-sensitive deposits issued at retail for amounts
slightly below $100,000, in some cases, deposits in accounts above $100,000 may
behave like core deposits.99 Are there
other, more useful measures that could be adopted, or other data that should be
collected, to facilitate supervisory or peer-group analysis? These questions might be an area where future
research would be fruitful.
Deposit Insurance Issues
Bank liability structure a effects
not only supervision but also deposit insurance, and in several ways. As banks rely less on domestic deposits, the
relationship among the assessment base used for deposit insurance pricing, the
designated reserve ratio (DRR),100 and the FDIC’s risk exposure has
diminished. The FDIC’s risk exposure is
largely driven by the quantity and quality of industry assets and the
industry’s equity position.101 However,
the assessment base includes only domestic deposits, and the reserve ratio
includes only insured deposits. When
asset growth is funded by nondeposit liabilities, the FDIC’s risk exposure
changes with no similar change in the assessment base or the reserve ratio (or,
therefore, in the required minimum fund balance). When asset growth is funded by uninsured
deposits, the assessment base increases but the reserve ratio does not
increase. Thus the FDIC’s funding
mechanisms do not respond to changes in the fund’s risk exposure from asset
growth funded by nondeposit liabilities—or even by uninsured deposits.
Several economists and regulators have raised the
question of whether the FDIC’s pricing mechanism should be adjusted to reflect
shifts in the industry’s funding mix.102
Twice in the last decade the FDIC itself has asked for public comments
on the issue.103 Options include
changing the assessment base to: insured deposits; domestic deposits plus
secured borrowing; total assets; or total liabilities excluding subordinated
debt. Alternatively, the price (rather
than the assessment base) could be adjusted for the effects of liability
structure on the FDIC’s risk exposure.
Most of the deposit insurance pricing options apply to
particular priority classes defined under U.S. bank receivership law. In the event of failure, secured claims are
paid first (up to the amount of the collateral), and these have received the
most attention in the related literature.
Administrative expenses of the receivership are paid next, followed by
deposits (both insured and uninsured); then general trade claims, including
foreign deposits and other unsecured claims; then subordinated debts; and
finally shareholder claims.
Currently an institution’s assessment base is approximately equal to its
domestic deposits minus a deduction for float.
Because large banks rely on nondeposit liabilities much more heavily
than small banks, any potential changes to the assessment base raise profound
issues about the distribution of insurance costs across the banking industry.
There has been less research about the question of whether—given the recent
changes in liability structure—the reserve ratio is an appropriate measure of
the adequacy of the insurance funds. It
is not clear whether changes in bank liability structure have materially
detracted from the reserve ratio’s usefulness as a rough measure of fund
adequacy.104 This area may be worthy of
Recent developments in wholesale deposit practices raise other policy
issues that have received scant attention by regulators but may be worth
additional analysis as well, and possibly changes in policy. We list these other policy issues here, but
in the rest of the section we concentrate on the pricing issues. The first of these other issues is that some
banks (particularly those with affiliated brokerages) could easily shift from
deposit to nondeposit funding whenever insurance losses triggered substantial
premiums. Such shifting could increase
the volatility of the reserve ratios (and thus the volatility of premiums) and
could raise questions about equity across banks. Second, deposit-splitting practices can
circumvent the insurance coverage limits that Congress intended. Should regulators (or more likely Congress)
be taking action to make the $100,000 limit105 more meaningful for depositors? Another question is the most appropriate
treatment of sweep accounts for deposit insurance purposes.
Under the FDIC’s current pricing method, secured
nondeposit claims introduce the most distortion. If a bank fails, secured claimants are
invariably paid in full because collateral protects them.106 Thus, losses are usually borne by the FDIC
and other unprotected creditors.107 If a
bank shifts its funding strategy away from domestic deposits and toward secured
borrowing but makes no other change to its business strategy, the FDIC’s loss
exposure remains unchanged even though insured deposits fall.108 Moreover, most banks are currently in a
position to make this shift; that is, they can choose their asset portfolio
independently of their funding sources.109
And the FDIC’s pricing method provides an incentive for banks to shift
from uninsured deposits to secured borrowing, since investors are willing to
accept a lower interest rate when their investment is protected by
collateral.110 In addition, ceteris
paribus, banks that do not rely on secured borrowing for funding are
effectively subsidizing banks that do.
If two banks are identical in all aspects except that one relies on
domestic deposits for funding but the other relies on a mix of domestic
deposits and secured borrowing, both banks will expose the FDIC to identical
losses, but the second bank will pay smaller assessments.
Some researchers have argued that the ready availability
of secured borrowing may have important secondary effects as well. If bank managers know that they can easily
replace unprotected credits—uninsured and unsecured debt—with secured borrowing
if their financial condition deteriorates, they may choose to increase their
exposure to risk.111
Therefore, both Silverberg and Baer have urged that
secured liabilities be included in the FDIC’s assessment base. Bair, Seidman, Carnell, and Thomas have
recommended that the appropriate treatment of secured liabilities be considered
as part of deposit insurance reform.112
In contrast to the case of secured borrowing, if a bank
shifts its funding strategy away from insured deposits and toward uninsured
deposits but makes no other change to its business strategy, the FDIC’s loss
exposure decreases as losses are shifted from the FDIC to uninsured depositors
(provided that the uninsured deposits remain in the bank at failure). Nevertheless, the FDIC assesses uninsured
deposits even though they are unprotected at failure. On the surface, this appears to be patently
unfair to these depositors—particularly since some banks pass assessment costs
directly to depositors that receive no insurance protection.113 For this very reason, a number of countries
use insured deposits for assessments.114
However, most uninsured depositors do not lose money when
a bank fails because they manage to withdraw their deposits and receive full
payment beforehand. As the bank’s
condition deteriorates, these funds are sometimes replaced by insured deposits
or secured borrowing.115 This phenomenon
is well documented: from 1990 to 2002, on average an estimated 22.8 percent of
domestic deposits were uninsured, but during the same period only 1.5 percent
of deposits at failed banks were uninsured and exposed to losses.116 To the extent that uninsured depositors flee
troubled banks and banks respond by replacing the uninsured deposits with
insured deposits or secured instruments, the inclusion of uninsured domestic
deposits in the assessment base makes sense.
Uninsured depositors’ preferred status under domestic depositor preference
also provides some compensation for the assessments. In addition, the inclusion is easy to
administer, for the distinction between insured and uninsured deposits is hard
to make before failure.
Some banks, however, rely so heavily on unprotected funds
(including uninsured deposits) that, in the event of failure, many of the
unprotected creditors will be unable to exit in time to avoid losses. These are typically wholesale banks, where
the FDIC’s losses will be mitigated—or even wiped out—because other creditors
will bear significant losses.117 For
these banks, it may be unfair to charge assessments on uninsured deposits. In truth, their heavy reliance on unprotected
funding sources may merit a discount on their assessments.
General Trade Claims and Subordinated Debt
Both general trade claims and subordinated debt are
excluded from the assessment base. If a
bank fails, both of them serve to reduce the FDIC’s losses, since the FDIC
suffers losses only after these credits are wiped out.118 However, like uninsured deposits, many
unsecured claimants are able to exit from banks (and thus receive full payment)
before the banks fail. When this occurs,
the unsecured claimants effectively “put” losses to the FDIC. To the extent that these creditors succeed in
exiting from banks before failure, one can argue that they should be included
in the assessment base. Longer-term
credits (typically sub debt) or credits that are bank-specific (such as
lawsuits) are less able to exit from a troubled bank and thus more likely to
absorb losses at failure. As a result,
there is less justification for including these debts in the assessment base.
For credits that are likely to dodge losses at failure,
one can argue that they should be included in the assessment base. Silverberg concludes that all borrowing except
sub debt should be included because they all help to fund bad assets before
failure but are not around to suffer losses at failure.119 However, both general trade claims and sub
debt that remain in a bank at failure usually suffer a complete loss; moreover,
these types of credits may also provide useful corporate governance services in
the form of market discipline. Thus, the
case for including these items in the assessment base is far weaker than the
case for including secured credits.
In focusing on the relationship between various types of
liabilities and FDIC losses, we have looked at each type in isolation, but the
distribution of these instruments across the industry is also important. In addition, the discussion so far has
implicitly assumed that the current pricing method captures the FDIC’s risk
exposure well—except for the treatment of bank liabilities. It turns out that adjustments to deposit
insurance pricing are not nearly as straightforward as they first appear.
Of the major types of liabilities used by banks, only
uninsured deposits are relied on equally by large and small banks.120 Small banks rely much more heavily on insured
deposits than large banks, and large banks are much heavier users of nondeposit
liabilities. Unfortunately, no full
breakout of nondeposit liabilities into secured and unsecured components is
currently available. But even without
full information on the status of nondeposit credits, it is clear than any
significant adjustments will materially alter the distribution of assessments
across the industry. The inclusion of
secured credits in the assessment base, for example, would probably shift the
funding burden toward large banks, whereas the exclusion of uninsured deposits
would shift the burden toward small banks.
In fact, the reason the FDIC in 1935 advocated changing the assessment
base from insured deposits to total domestic deposits was that the corporation
thought the change would produce a fairer distribution of assessments across
Two aspects of bank size are not addressed in the current
pricing method. First, the pricing
matrix is designed to capture differences in the likelihood of failure, but not
differences in the anticipated loss severity if failure occurs. The FDIC has historically suffered much lower
loss rates from large banks than from small banks. From 1980 to 2000, the average loss rate for
banks under $100 million was 22.4 percent; for banks over $10 billion, only 5.6
percent.122 The exclusion of loss
severity from the pricing method means that large banks pay more, and small
banks pay less, than expected losses.
Second, the very largest banks pose unique challenges and
risks to the FDIC. The least-cost
resolution of some of these banks might pose a systemic risk to the financial
system. If so, regulators might pay some
creditors more funds than they would be entitled to under a normal resolution. To the extent that markets perceive these
banks as “too big to fail,” the banks benefit from less-expensive and more
readily available funding sources.123
Large banks also impose a great deal of concentration risk on the
insurance funds. Even though the loss
rates of these banks tend to be low, the size of the institutions alone is
enough to threaten the solvency of the deposit insurance fund. For that very reason, private insurance firms
generally do not accept this level of concentration risk. The appropriate pricing for concentration
risk is not at all clear.
In summary, the FDIC’s pricing method does not take into
account differences in liability structure, even though these differences can
materially influence the FDIC’s risk exposure.
Moreover, liability structure is not the only aspect of the FDIC’s risk
exposure that is excluded from the agency’s current pricing method: loss
severity and concentration risk are excluded as well. Because of the interrelationships between
liability structure and these other important (but thorny) aspects of deposit
insurance, we believe that the incorporation of liability structure into
deposit insurance pricing would probably be beneficial, but it would also
require careful thought about multiple related issues.
The movement away from deposit funding also has
ramifications for failure resolution, raising issues associated with depositor
preference and aggravating two operational challenges the FDIC sometimes faces
when resolving failed banks.
Domestic Depositor Preference
In 1993, Congress passed the Omnibus Budget
Reconciliation Act, which amended the Federal Deposit Insurance Act (FDI Act)
and instituted depositor preference nationwide.
The law states that when banks fail, deposit liabilities are to receive
priority over general trade claims.
Before the law was passed, deposits and general trade claims shared the
same priority class.124 As the banking
industry’s reliance on nondepository funding has increased, so also have the
ramifications of this change.
The change was not part of a banking bill, was made with
very little debate, and has received relatively little attention in the United
States since being enacted. However,
questions have been raised about both the lack of deliberation before the
provision was enacted and the change itself.125
Here we briefly review the questions and examine certain possible
changes to depositor preference.126
1983, the FDIC advocated a national depositor preference statute as a means to
increase market discipline, reduce the corporation’s costs, and permit the use
of purchase and assumption (P&A) transactions for more failures.127 At the time, the FDIC was allowed to select
any resolution method if it were less costly than a payout, but in the absence
of depositor preference, use of a P&A agreement required the FDIC to
satisfy all general trade claims. In
depositor preference states, in contrast, the FDIC could execute a P&A
agreement without satisfying all general trade claims (except for national
banks located in the state). The FDIC found
this to be an excellent way to reduce costs (particularly those associated with
contingent claims related to lawsuits, loan guarantees, and loan commitments)
while simultaneously simplifying the resolution transaction, minimizing the
FDIC’s cash flow requirements, and reducing the scope of its liquidation
operations.128 Large banks strenuously
objected to depositor preference, arguing that it would hinder their ability to
compete with foreign banks and nonbanks in affected markets.129
The Financial Institutions, Reform, Recovery and
Enforcement Act (FIRREA) in 1989 explicitly allowed the FDIC to treat
depositors differently from other general trade claimants at
resolution.130 Therefore, the FDIC’s
interest in depositor preference waned.131
Nonetheless, depositor preference was passed in 1993 for budgetary
Analyses and concerns.
The priority status of claimants affects more than just the treatment of
creditors once a bank fails. It also
influences the behavior of the various stakeholders (creditors, banks,
regulators) before failure, and it influences decisions about the method to use
for failure resolution. Judgments about
depositor preference should therefore consider the dynamic effects of the priority
rules in light of appropriate policy goals.
In discussing this issue, we find it helpful to look to the goals for
bankruptcy proceedings. Aghion, Hart,
and Moore articulated three generally accepted goals for bankruptcy
1. Maximize the ex post value of
2. Distribute the firm value
appropriately across the claimants.
3. Preserve the ex ante bonding role of debt (that
is, maintain the disciplinary role of debt and penalize the firm’s
Most observers agree that the appropriate distribution to
claimants in a bank resolution is one that retains the statutory priority order
in place at the time of failure. Because
of the role banks play in facilitating commerce, many economists have
articulated a fourth goal that applies to banks: the optimum treatment of a
failing bank—particularly a large bank—should minimize the harmful effects to
the overall economy. Disorderly or
contracted proceedings that disrupt the bank’s ability to continue operations
are more likely to cause harm to the overall economy.134 With these goals in mind, we review the
literature on depositor preference and consider options for change.
Birchler examined bankruptcy priority rules from a
contract theoretic viewpoint; he found that the establishment of dual
priorities (that is, depositor preference) is socially optimum, mainly because
it reduces costly monitoring for senior claimants (that is, depositors).135
Pages and Santos developed a theoretical model to examine the effect of
depositor preference on the closure policy of the deposit insurer. Under depositor preference, the deposit
insurer would close risky banks earlier (and at a more socially optimum time)
than it would if all claims were given equal status. If the deposit insurer were a junior
claimant, it would forbear much too long because it would have a stronger
incentive to “gamble for resurrection.”
Pages and Santos also found that the deposit insurer, as the senior
claimant, would monitor healthy banks less than was socially optimum, but that
as the junior claimant, it would not monitor unhealthy banks frequently
enough.136 However, Lutton and Becher
argued that supervisory monitoring would increase under depositor preference
because of heightened concerns about liquidity risk.137
One rationale for depositor preference has certainly been to reduce
costs for the deposit insurer.138
Barring any dynamic effects, depositor preference should achieve that
goal. However, as described above in the
section on market discipline, historical experience raises doubts about the
amount of savings that depositor preference might produce in the United
States. Both general trade claimants and
uninsured depositors have been successful in shifting losses to the FDIC before
failure. In addition, we found scant
evidence that depositor preference had diminished the market discipline imposed
by uninsured domestic depositors.139 On
the basis of anticipated changes in the behavior of unprotected creditors, a
number of economists have concluded that savings from depositor preference in
the United States are uncertain, and possibly negative.140 It appears that savings from on-book
creditors materialize primarily in situations in which either the bank fails
suddenly (as in some fraud failures) or some claimants cannot exit from the
bank quickly (long-term unprotected debt or contingent claims).141 To date, concerns about the ability of large
banks to compete in markets associated with unprotected general claims do not
appear to have been realized. From 1995
through 2005, foreign deposits have more than doubled; moreover, they grew a
little more quickly than domestic deposits.
It appears that most banks (even most large banks) have a large enough
retail deposit base to allow most unprotected creditors to flee the bank before
Several authors have found that domestic depositor preference would have
troubling consequences if a multinational bank were to fail.143 Curtis found that as depositor preference is
currently interpreted, it is inconsistent with international law because it
effectively uses assets from all affected countries to satisfy domestic
depositor claims ahead of foreign claims, thereby discriminating against all
other nations. He then states the
Insisting on the subordinate status of foreign deposits,
while attempting to implement a single-entity liquidation of a U.S.
multinational bank, would not be effective, as it is impossible to imagine that
foreign regulators would allow it. The
effect of such an attempt would simply be to force foreign governments to segregate
the assets of branches in their countries for the benefit of claimants against
The practice of separating assets and claims by country
at failure, commonly referred to as “ring-fencing,” is entirely legal. The FDIC would have no authority whatsoever
to prevent it. And except in rare
circumstances, the financial incentives to ring-fence under domestic depositor
preference are very strong.
If a multinational banking organization were to fail and
ring-fencing had been adopted, the FDIC might end up controlling the resolution
process only for the assets and liabilities located in the United
States.145 Planning and operations would
be more uncertain, since the FDIC would not know which assets would ultimately
fall under its control until after the failure.146 It is unlikely that the bank could be sold as
a whole. There would probably be a
scramble as governments sought to control the assets of the failed entity (with
associated lawsuits and other overhead costs).
Business lines that crossed international boundaries would be sold
piecemeal, even if the aggregate values were higher. The liquidation process would be slower, so
administrative costs would increase and more creditors would suffer liquidity
losses.147 Because of these problems,
the FDIC could lose more money under domestic depositor preference than it
would have lost without depositor preference despite the benefits that
depositor preference yields at domestic failures.
For large international banks, ring-fencing would probably
also exacerbate the market disruption associated with closure. The higher aggregate losses, the initial lack
of certainty about the distribution of assets across receivership(s), and the
necessarily piecemeal asset sales strategy could slow down the resolution
process considerably and thus reduce market confidence. The uncertainty about the resolution process
would probably compound the market disruption because it would hinder the
FDIC’s ability to mitigate liquidity losses and payments-processing concerns
through advance dividends to unprotected creditors.148
Bliss cites some benefits of ring-fencing: it places
assets at the disposal of the court that is most likely to control them; it
provides a way—an admittedly crude way—to settle conflicts in laws and legal
objectives; and it reduces the need for cross-border data sharing.149 Baxter, Hansen, and Sommer also find that
ring-fencing improves supervisory incentives and may reduce the chance of
Concerns about market disruption and the costs associated
with ring-fencing might lead bank regulators to use the systemic-risk exception
to the least-cost test if a bank with a large volume of foreign liabilities
were to fail.151 Depending on the
circumstances, use of the systemic-risk exception could hinder efforts to meet
the third goal of bankruptcy cited earlier (the ex ante bonding role of debt)
through market discipline. If regulators
were to provide substantial relief to creditors, there would probably be a
long-term reduction in market discipline at all large U.S. banks (with
associated long-term losses in market efficiency and increased risk to the
The problems associated with ring-fencing would
potentially disrupt the resolution of only a few banks since less than 1 percent
of FDIC-insured banks hold foreign deposits.
Moreover, most banks with foreign deposits have branches in only two
countries; for these banks, both the costs and the disruptions of ring-fencing
would probably be minimal. However, as
of year-end 2003, the few global banks that do have branches in several
countries hold more than 80 percent of foreign deposits and 30 percent of the
assets of FDIC-insured institutions.
Options. There are at least four
possible ways of treating depositors and general trade claimants at insolvent
1. Make no changes to the current
2. Give priority status to all
deposits (with foreign deposits remaining uninsured and excluded from the
Each option has different strengths and weaknesses. In terms of enhancing market discipline and
reducing insurance fund losses, the differences are clear for banks without
foreign deposits: option 3 is unquestionably the best, followed by options 1
and 2, and lastly option 4. Recent
changes in bank liability structure have probably expanded the differences
among the options, but the degree of change is difficult to gauge. The differences are probably greatest for
liquidity failures, unexpected failures, and failures where there is a large
volume of contingent liabilities or long-term unprotected borrowing. For banks with foreign deposits, one cannot
readily determine which option would most enhance market discipline or reduce
insurance fund losses (although the question would be an excellent one for
For a few large international banks, the current
preference order will limit the options of regulators in the event of
failure. Regulators may be left with
essentially two choices. First, they
could run a series of territorial receiverships (separate proceedings in
multiple countries), where market disruption could be significant, even
systemic, because continuing the normal ongoing operations of the bank would be
difficult or impossible. Creditor
recoveries might suffer because of competition across countries and the lost
franchise value, but market discipline would certainly be imposed. Second, regulators could try to avoid
territorial receiverships by paying some general claimants (for example,
foreign depositors) more than they would otherwise receive under the current
depositor preference treatment.153 If
the regulators succeeded, then the extent of market disruption would fall and
the franchise value of the bank would be retained, but market discipline would
be weakened and insurance fund losses might be larger. For banks with a substantial foreign deposit
base, this option does a poor job of meeting the three goals stated above and
has therefore been criticized by several researchers. Since the passage of FIRREA in 1989, no one
has proposed this option.
If priority status were provided to all deposits (option
2), the financial gains from ring-fencing would be significantly reduced and
U.S. banking regulators would be in a better position to contain systemic risk
while still imposing losses on unprotected creditors. On the basis of a legal analysis and concerns
about ring-fencing, Curtis recommended that the FDIC choose this option by
changing its interpretation of the statute.154
In terms of the likelihood of ring-fencing, option 3
(insured depositor preference) probably falls between options 1 and 2. If a large international bank had relatively
few insured deposits and a relatively low loss rate, the financial benefits of
ring-fencing would be small; in other circumstances, the benefits (and thus the
likelihood) of ring-fencing would increase.
Under option 4 (the elimination of depositor preference), the incentives
for ring-fencing would probably be similar to those under option 2 (all-depositor
Option 3 (insured depositor preference) would probably
raise concerns about fairness within the United States.155 To the extent that investors assume that
large banks are too big to fail and therefore that large banks have de facto
complete insurance coverage, small banks have a disadvantage in competing for
uninsured deposits. When the FDIC was
created in 1933, insured depositor preference was enacted at the same time, but
in 1935 it was revoked precisely because of concerns that it was unfair to
small banks. Option 2 (all-depositor
preference without deposit insurance for foreign deposits) might also raise
concerns about competitiveness across banks in the United States.
In conclusion, analyses of the optimum insolvency
priority order for U.S. banks are scarce, and no consensus on the best approach
has been reached. However, there is a
consensus that the current insolvency priority order could cause very serious
problems if a large international bank were to fail in the future. We recommend a thorough study of the issues
rather than specific changes. Perhaps
the best approach would be to commission a U.S. interagency group to study the
options in more depth and make recommendations, or to have an international
group tackle the research question and the difficult task of harmonizing the
treatment of creditors at insolvent international banks.156 After the options are studied more carefully,
any recommended changes should be pursued promptly, while the banking industry
is healthy and time is available for a reasoned debate.
Depositor preference is not the only failure-resolution
area affected by changes in bank liability structure. The movement away from deposit funding
aggravates two operational challenges the FDIC sometimes faces when resolving
failed institutions: one concerns situations when the FDIC has little or no
advance warning of failure, and the other concerns FHLB advances.
When most banks fail, the FDIC has advance warning that
failure is imminent. There is enough
time to prepare, and the FDIC normally has some flexibility in selecting the
failure date. Thus, most failures occur
on a Friday, and most insured depositors have access to their funds on the
following Monday. Often the FDIC has
time before failure to perform some of the insurance administration and quietly
arrange for the sale of at least some (and sometimes almost all) of the failed
The situation changes if a troubled bank relies heavily
on unprotected credits (either uninsured deposits or general trade claims) for
funding and then fails. In this case,
the timing of the failure may well be determined by the creditors, as they
attempt to exit from the bank and the bank’s liquidity dries up. The FDIC may have little or no time to
prepare for failure. The possibility of
such liquidity failures poses significant operational challenges for the FDIC,
particularly if the bank is large.
The changes in bank liability structure may have
increased the likelihood of liquidity failures in the future. If so, liquidity failures will still occur
less often than the typical capital-driven failure,157 but the combination of
more unprotected funding plus a more concentrated industry will be a continuing
challenge for the FDIC.
A second issue arises from FHLB advances. From 1992 to 2002, outstanding FHLB advances
at commercial banks increased fivefold.
The advance contracts almost always impose prepayment penalties. The FDIC has routinely paid these penalties
to facilitate a quick sale of the institution’s assets, but this policy has
sometimes been expensive. When the Bank
of the Alamo failed in 2002, the prepayment penalties amounted to 14 percent of
the outstanding balance of advances.
This is an area where the FDIC may want either to seek relief from
prepayment penalties (perhaps by avoiding prepayment through guaranteeing the
advances in exchange for the collateral, perhaps by seeking legislative
remedies) or to reconsider its standard policy of prepaying advances in order
to facilitate asset sales.
Bank deposit growth has not kept pace with the growth in
bank assets. As a result of the deposit
shortfall, bank management has looked to alternative funding sources. We describe the events that led to the gap
between asset growth and deposit growth, describe some of the ways bankers are
addressing the shortfall, and conclude that banks will continue to need
alternative funding sources since future deposit growth is not likely to meet
banks’ future funding needs.
Consequently, banks must continue to adapt the way they manage
their liability structure. Because banks
are relying more heavily for funding on wholesale funding sources and
rate-sensitive deposits, liquidity risk exposure has increased and liquidity
management has become more important—and more complex—for banks.
Changes to a bank’s liability structure raise several
issues for banking regulators. The one
that has received the most attention recently is market discipline—particularly
for large, complex banking organizations.
The research to date shows that unprotected investors monitor bank
performance and respond to changes in risk exposure. Supervisors play an important role in
ensuring that markets have accurate data on banks, since troubled banks
otherwise tend to overstate capital. The
evidence is weaker when it comes to the ability of markets to encourage banks
to reduce their risk exposure when troubles arise. We expect that in the future, the disclosure
of information to markets will receive more emphasis and the use of market data
to inform and enhance the supervisory process will increase; market data may be
incorporated into future deposit insurance pricing mechanisms as well.
Regulators have responded to the additional complexity of
bank liability management by making several updates to their examiner guidance
on liquidity risk. Regulators might want
to weigh whether further action is necessary in order to better monitor the
increasing use of wholesale funding. It
may also be worthwhile for regulators to seek better ways of measuring
An additional issue for banking regulators is whether the
FDIC’s insurance-pricing mechanism should be changed so that it better captures
the relationship between bank funding strategies and the FDIC’s risk
exposure. We summarize the rationale for
change and find that the relationship among funding strategies, bank size, and
fund exposure is too complicated for there to be any easy solutions.
Finally, we discuss issues that center on failure
resolution: domestic depositor preference and operational matters. Changes in liability structure have
highlighted the importance of priority status when banks become insolvent. Economists have questioned the cost savings
attributed to domestic depositor preference as well as the effects if a
multinational bank were to fail. We
describe the effects of four options and recommend further research—with prompt
pursuit of the appropriate changes—while the banking industry is healthy and
time is available for a reasoned debate.
Changes in liability structure may also have two other effects on
failure resolution: they may decrease the amount of preparation the FDIC can do
before failure, and they may affect the way the FDIC handles FHLB advances at
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authors are in the Division of Insurance and Research at the Federal Deposit
Insurance Corporation. Christine Bradley is a senior policy analyst and Lynn
Shibut is the chief of the Corporate Consulting Services Section. The views
expressed here are those of the authors and do not necessarily reflect the
views of the Federal Deposit Insurance Corporation. The authors would like to thank Timothy
Critchfield, Timothy Curry, Andrew Davenport, Joseph Fellerman, Warren Heller,
Mike Jenkins, Michael Krimminger, James Marino, Kathleen McDill, Chris Newbury,
Dan Nuxoll, Munsell St. Clair, and Mark Vaughan for their helpful comments, and
Tyler Davis, Aja McGhee, and Emily Song for research assistance. All errors and omissions are their own.
deposits are estimated as total deposits minus brokered deposits and other time
deposits that are in denominations greater than $100,000.
the banking crisis of the 1930s, interest-rate ceilings were imposed on
commercial banks to protect banks, both by holding the institutions’ cost of
funds below their return on assets and by restraining competition within the
industry. Interest-rate ceilings did not
apply to savings and loan associations (S&Ls) until 1966.
Federal Reserve Board of Governors (2006), chart B.100.
example, see Garver (2000), Jackson (2001), and Silverman (2001a, 2001b).
FHLB system is a government-sponsored enterprise (GSE) consisting of 12 banks
that raise funds by issuing consolidated debt securities in the capital
for example, Congressional Budget Office (1993).
Another benefit of FHLB advances is that the FHLB system is willing to make
both fixed and adjustable-rate advances that can have maturities ranging from
one day to 20 years, whereas most other funding sources do not offer long-term
maturities. (FHLBs also provide their
members with funding for small businesses, community development, and rural and
Stojanovic, Vaughan, and Yeager (2000); Ashley, Brewer, and Vincent (1998); and
Bennett, Vaughan, and Yeager (2005).
Concerns about the growth of FHLBs have resulted in a proposal by the
Federal Housing Finance Board to significantly raise retained earnings held by
the FHLBs. See Rucker (2006).
(1974). The study found that a misuse of
brokered deposits contributed to 30 percent of failures from 1960 to 1974. But regulators had expressed concerns even
before this study was released. In 1959
the Federal Home Loan Bank Board (FHLBB) limited the percentage of brokered
money that a thrift could accept to 5 percent of its total deposits. The limitation was repealed in 1981.
1980–1983 growth is documented in FHLBB (1980, 1983, 1984a). The 1984–1989 growth is documented in FHLBB
(1984b, 1989). The FHLBB and the FDIC
issued a joint regulation that would have limited deposit insurance on any
deposits placed by brokers (49 Fed. Reg. 13,003 ), but when the agencies
were challenged in federal court, the court rejected their action (FAIC Sec.,
Inc. v. U.S., 595 F. Supp. (D.D.C. 1984), aff’d mem., 753 F.2d 166 (D.C. Cir.
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), section
301, as codified in 12 U.S.C. § 1831f (2001).
The capital categories are statutorily defined (12 U.S.C.
Institutions with assets over $500 million are not able to use commercial loans
as collateral for their FHLB advances.
using such publications as Bank Rate Monitor or by surfing the Internet, bank
customers can locate the higher-paying CDs without ever talking to a deposit
broker. Customers’ use of these vehicles
has encouraged bankers who are in pursuit of funding sources to keep pace with
Market discipline is discussed in detail in Part 2.
possibility assumes that Call Report data will reflect the change in insurance
status. An increase in the total
deposits insured by the FDIC without a corresponding increase in the insurance
fund balance would cause a decrease in the reserve ratio. The effect of a change in the reserve ratio
is discussed at note 100 in the Deposit Insurance Issues section below.
26 As of March 2006, more than 1,100 banks were members
of the network. Initially the service
offered only four-week to one-year CDs, but within six months after it started,
it began accepting individual retirement account CDs and extended the available
terms to two- and three-year CDs.
28 In most cases, municipal deposits over $100,000 are required by law
to be either fully covered by deposit insurance or secured by a bank’s pledge
of securities. If municipalities can get
deposit insurance on their total deposit through CDARS, securities that would
otherwise be used as collateral will become available to the bank for other
activities. Information on CDARS is from
the Web sites www.cdars.com and www.promnetwork.com.
30 The prohibition arose in the 1930s, when it was feared that deposit
competition could destabilize the banking system. It was also feared that money-center banks
would draw funds from rural banks, diverting those funds from productive
agrarian uses to speculation in stocks.
As a result, the Banking Act of 1933 authorized the Federal Reserve to
limit the interest rate member banks could pay on time deposits; the Federal
Reserve implemented the law on November 1, 1933, by promulgating Regulation
Q. Interest-rate controls though
Regulation Q existed in some form until 1982.
31 NOW accounts are interest-bearing savings accounts with check-writing
32 Recent congressional proposals would increase the number of transfers
permitted between deposit accounts to 24 per month, allowing for a sweep on
each business day of the month.
33 The rate typically consists of the money market rate on the excess
funds and a NOW account rate on the threshold funds.
34 Saunders and Cornett (2003) provide a good discussion.
35Flow of Funds Accounts of the United States, Federal Reserve Board..
44 Another type of repurchase agreement allows banks to borrow from
major investment firms by pledging government, agency, or mortgage-backed
securities as collateral for a loan at market rates on a short-term basis
(usually extending from 30 to 180 days).
This type of repo is not discussed here and would not be affected by the
legislative changes in question.
48 See Shibut (2002) for a discussion of the incentives for various
types of liabilities to exit from a troubled bank. Note, however, that economists and
supervisors apparently disagree with each other on the likelihood that FHLB
advances will exit from the bank.
Economists argue that FHLBs have no incentive to exit from banks because
their collateral protects them from losses at failure; for example, see Shibut
(2002); Stojanovic, Vaughan, and Yeager (2000); and Ashley, Brewer, and Vincent
(1998). Supervisors, in contrast, warn
that the FHLBs may exit from the bank or demand additional collateral if the
bank’s condition deteriorates; for example, see Sexton (2000b) and FDIC (2002).
49 We concentrate on consumer issues here because most deposits are held
by consumers. But if legislation were
passed allowing interest payments on demand deposits, deposits held by
businesses could increase markedly.
50 The search costs and switching costs associated with maximizing one’s
return are similar for large and small depositors, but large depositors have
more to gain from a higher return.
51 One way to use market discipline relates to capital regulation. We explore market discipline imposed by
stockholders, but we do not address the question of capital requirements.
52 Sironi (2003), Federal Reserve Board (1999b), and Evanoff and Wall
(2000) discuss industry changes that support an increased emphasis on market
57 FDIC (1997), 487–88, describes the “anatomy” of a failure, with the
earliest decisions made some time before problems become apparent in the
accounting data. The literature on
prompt corrective action puts a strong emphasis on timing: the triggers must
occur before it is too late for the bank’s management to turn the bank
around. See Jones and King (1995) and
Peek and Rosengren (1996).
58 Llewellyn (2002). Similar
lists of conditions can be found in Llewellyn (2005) and Hamalainen, Hall, and
59 See U.S. General Accounting Office (1990, 1992); Dahl, O’Keefe, and
Hanweck (1997); Gunther and Moore (2000); and Curry et al. (1999).
60 See Jordan (2000); Goldberg and Hudges (2002); Silverberg (1993); and
Marino and Bennett (1999).
61 See Park and Peristiani (1998); Jordan (2000); Maechler and McDill
(2003); and Hall et al. (2003).
62 See Flannery (1998) for a brief review of the literature on a wide
range of related topics. The Federal
Reserve Board (1999b) provides a more thorough review on sub-debt literature,
and Krainer and Lopez (2002) provide a review of the literature on the stock
market. See also Berger, Davies, and
Flannery (2000); Morgan and Stiroh (1999); DeYoung et al. (2001); and Curry,
Elmer, and Fissel (2003).
66 Curry, Elmer, and Fissel (2003).
They found statistical significance even after controlling for relevant
accounting variables. Gunther, Levonian,
and Moore (2001) performed a similar analysis that also found a statistically
significant relationship between the estimated default frequency (EDF) implied from
stock market data and BOPEC (an acronym for a bank holding company rating: B
for bank subsidiaries; O for other nonbank subsidiaries; P for parent control;
E for consolidated earnings; C for consolidated capital) ratings. They found a small improvement in in-sample
tests, but they did not provide out-of-sample tests.
70 For evidence related to insured deposits, see Jordan (2000); Goldberg
and Hudges (2002); Silverberg (1993); and Marino and Bennett (1999). For evidence related to secured credits, see
Hirschhorn and Zervos (1990) and Ashley, Brewer, and Vincent (1998).
72 Jagtiani and Lemeaux (2000); Ashley, Brewer, and Vincent (1998); Hall
et al. (2003). Although Hall et al.
concentrated their analysis on healthy banks (with a CAMELS rating of 1 or 2),
the results did not change materially when they did robustness checks that
included weaker banks.
73 Laeven (2002); Saunders, Strock, and Travelos (1990); and Demsetz, Saidenberg, and Strahan (1997).
74 Cannella, Fraser, and Lee (1995); and Baumann and Nier (2003). There is also ample evidence that banks
generally held more capital before the introduction of deposit insurance.
75 Bliss and Flannery (2000). The
variables ranged from dividend payments and staff levels (presumably fully
under the control of management) to the book value of equity (where control may
have been less complete).
77 DeYoung et al. (2001), 924.
They found that sub-debt spreads fell when troubled banks retained a bad
examination rating (that is, when a bank with a CAMELS 4 or 5 rating was not upgraded
to a CAMELS 1, 2, or 3 during the examination).
They also found that spreads increased when moderately troubled banks
were upgraded (that is, when banks with a CAMELS rating of 3 were upgraded to a
rating of 1 or 2).
78 Benston (1993) provides an example of two diametrically opposed
79 Stern (1997). See also Feldman
and Rolnick (1997).
80 Calomiris (1997). The proposal
included additional requirements about the total amount outstanding (as a
percentage of assets) and the frequency of rollover.
81 See, for example, Kane (1990), Boot and Thakor (1993), and Rosen
82 Federal Reserve Board (1999b), especially 19 and 58; Covitz, Hancock,
and Kwast (2002); Hall et al. (2003), 25–26; Danielsson and Shin (2002).
83 We define a hard trigger as one where there is effectively no
84 A recent example occurred in 1998 after Russia defaulted on its debt
obligations. Bond spreads increased
dramatically and liquidity dried up.
Other, more extreme examples date from the pre-FDIC banking panics.
85 Under the systemic-risk determination, regulators can opt to ignore
the least-cost test if a bank has failed, but only after crossing several
statutory hurdles. In addition,
regulators must publish a written analysis of the reasoning behind the
86 Flannery (2001), 112. Meyer
(1999) echoes this view.
92 Office of the Comptroller of the Currency et al. (2001).
93 Zamorski (2001), 1–2. This
memo (that is, the FDIC’s new guidance) introduced a major revision of the
liquidity and fund management section of the examination guidelines.
94 See Sexton (2000a) on securitizations, Sexton (2000b) on FHLB
advances, and Zamorski (2002) on wholesale funding. Note that the guidance is designed not solely
to warn examiners of possible problems but also to remind them that sound
liquidity management can include the use of wholesale funding, securitization,
and so forth.
95 See FDIC (1997); Nuxoll, O’Keefe, and Samolyk (2003); and McDill
99 Some bankers have argued that this would be the case for certain
large banks that use brokered deposits from an affiliated broker. In addition, some jumbo CDs may be long-term
deposits that are fully insured.
100 Under FDICIA, the DRR—the reserve ratio calculated as the ratio between the
insurance fund balance and total deposits insured by the FDIC—was set by
statute at 1.25 percent. In addition,
the FDIC was required to impose hefty assessments on banks whenever the reserve
ratio of the Bank Insurance Fund or the Savings Association Insurance Fund fell
substantially below the DRR. Under the
Federal Deposit Insurance Reform Act of 2005, the fixed DRR of 1.25 percent was
replaced by a reserve range of 1.15 percent to1.50 percent, and the FDIC Board
of Directors was directed to set and annually publish a DRR within that reserve
range. If the reserve ratio falls below
1.15 percent, the legislation required that the FDIC set assessments at a level
that will bring the fund balance back to 1.15 within five years.
101 More specifically, one way to measure the FDIC’s risk exposure for a
particular bank is to calculate the bank’s expected probability of default
multiplied by the expected total loss, multiplied by the FDIC’s percentage of
the expected loss. The probability of
default and expected total loss tend to be related to asset composition. Equity holders normally lose their entire
investment at failure. The remaining
loss is, for the most part, borne by the FDIC because the FDIC cannot flee a
bank before failure, but other unprotected credits usually flee or protect
themselves through collateral arrangements before failure. See Shibut (2002) for a more detailed
discussion. This section draws heavily
from that paper.
102 See Silverberg (1993); Baer (2000); Bair (2001); Seidman (2001);
Carnell (2001); and Thomas (2001).
103 In 1994, the FDIC issued an Advance Notice of Proposed Rulemaking
(ANPR) focused on the assessment base; the notice did not result in changes to
the assessment base (FDIC 1994). In 2000
the FDIC’s options paper on deposit insurance reform also raised the issue of
the assessment base (FDIC 2000).
104 Other factors, such as the riskiness of the industry’s asset
holdings or its financial condition, are also not captured in the reserve ratio. Most of the discussion of fund sufficiency
focuses on the appropriate role of an insurance fund, public versus private
funding, ex ante versus ex post funding, measures of fund exposure, and
concentration risk (that is, funding adequacy, given the size of the largest
insured bank). Another way to gauge fund
adequacy is through the reserving process for near-term future losses. Liability structure also affects the FDIC’s
contingent-loss reserves. Both the
current method used by the FDIC to estimate contingent-loss reserves, and
recent proposals for change in the current method, take liability structure
into account. The FDIC hired McKinsey
and Company in 2003 to review its risk management program and contingent-loss
reserving methods. See McKinsey and
Company (2003) for details. One of the
short-term recommendations was to change the contingent-loss reserve to take
liabilities into account (p. 19); the FDIC has already made this change. McKinsey concurred with the FDIC’s plan to
move toward using credit-loss modeling techniques for measuring the
corporation’s contingent-loss reserve.
Jarrow et al. (2003) have developed a draft contingent-loss model for
this purpose. Their model also
incorporates liability structure into its loss estimates.
106 Theoretically, they could be haircut if the value of the collateral
were less than the outstanding balance of the borrowing.
107 Of course, the availability of collateral limits the volume of
secured credits that can be fully protected.
In practice, however, these limits have rarely been binding.
108 The funding shift would not influence total losses to unprotected
credits or the FDIC. Therefore, even
though the volume of deposits fell, losses imposed on deposits at failure would
not change. Shibut (2002) elaborates
109 Of course, there are important limits on asset growth related to
equity, but most banks meet the regulatory minimums for capital. Given the choices available for the types of
assets that can be pledged as collateral, most banks have the freedom to
increase their secured borrowing substantially without adjusting their asset
portfolio. Their ability to increase
unprotected––uninsured and unsecured––funding is tied much more closely to financial
110 See Birchler (2000) for a theoretical model that supports this
111 See Shibut (2002), 25, for a discussion. See also Stojanovic, Vaughan, and Yeager
(2001); and Ashley, Brewer, and Vincent (1998).
112 Silverberg (1993) and Baer (2000); Bair (2001), Seidman (2001),
Carnell (2001), and Thomas (2001).
Thomas recommended that deposit insurance prices be adjusted for secured
borrowing, but he did not specify how the adjustment should be made.
113 In testimony on deposit insurance reform, Mr. Nolan North of the
Association for Financial Professionals made exactly that argument (2001).
115 The bank often shrinks as well.
See Jordan (2000); Silverberg (1993); Marino and Bennett (1999); and
Billett, Garfinkel, and O’Neal (1998).
Jordan found that during the two-year period preceding failure, the
failed banks that relied most heavily on uninsured deposits recorded dollar
volume increases in small-denomination time deposits that exceeded the
reduction in large-denomination time deposits.
116 These are simple averages.
The figures for failed banks include only banks where the FDIC imposed
haircuts on uninsured depositors at failure.
For additional evidence, see the section above on market discipline; see
also Silverberg (1993); Jordan (2000); Marino and Bennett (1999); and McDill
and Maechler (2003).
117 Marino and Bennett (1999) discuss this phenomenon at length.
118 Ceteris paribus. If these
credits encouraged banks to take on additional risk or if they brought about a
more lax supervisory stance, the result could differ. Most of the theoretical literature suggests
that unprotected credits should encourage less risk taking; a notable exception
is Blum (2002). There is little
empirical evidence on the topic. For
more detail, see the section above on market discipline.
120 As of year-end 2000, uninsured deposits made up 15.7 percent of the
liabilities of banks with assets below $100 million, and 14.6 percent for banks
above $10 billion. Thrifts, however,
depended less on uninsured deposits for their funding. See Shibut (2002), 8.
122 Shibut (2002), 42. In recent
years, however, very small banks have had the lowest loss rates, largely
because of a few failures of fast-growing subprime lenders. See Salmon et al. (2003). Loss rates are calculated as a percentage of
total failed-bank assets.
123 The perception that the very largest banks are too big to be allowed
to fail was particularly strong in 1984 after Continental Illinois failed and
the Comptroller of the Currency testified that 11 banks were “too big to fail.” Since then, the perception has faded somewhat
but not disappeared. For related
analyses, see O’Hara and Shaw (1990); Billett, Garfinkel, and O’Neal (1998);
Morgan and Stiroh (1999); and Flannery and Sorescu (1996). Note that FDICIA required that the
incremental cost of a systemic-risk determination be paid through a special
assessment. The special assessment would
be paid on the basis of total liabilities excluding subordinated debt;
therefore, large banks’ share of the special assessment would be larger than
their share of regular assessments.
Because the special assessment would be imposed only after the failure
(and after the systemic-risk exception was invoked), large banks might well
enjoy the benefits of a too-big-to-fail aura without ever paying extra for the
124 In 1993, 29 states had depositor preference laws, but these laws did
not apply to national banks. See Curtis
125 See Silverberg (1994) for an account of the events leading up to
enactment of the change. The change was
motivated by budgetary considerations. In fact, we found no in-depth analyses of the depositor-preference
provision that came to a favorable conclusion.
For criticisms, see the Shadow Financial Regulatory Committee (1993);
Ely (1993); Silverberg (1994); Bureau of National Affairs (1994); Ratway
(1995); Kaufman (1997); Marino and Bennett (1999); and Curtis (2000).
126 There are other aspects of the payment priority order used in a
receivership that might merit a review in light of recent changes in bank
liability structure. Failure resolution
practices vary widely across the world, and there are significant disagreements
among economists and attorneys about the optimum policies. Although most of them are unrelated to bank
liability structure, one area of disagreement is related: the appropriate
treatment of secured credits. Some
researchers argue that the use of collateral is unfair to general (unsecured)
claimants; others argue that creditors should be allowed to protect themselves
from loss by demanding collateral. For
more general discussions about issues related to the appropriate resolution
policy for failed banks, see Aghion, Hart, and Moore (1992); Contact Group on
the Legal and Institutional Underpinnings of the International Financial System
(2002); and Hadjiemmanuil (2004).
128 Without the P&A transaction, the FDIC was required to execute a
payout transaction or an insured deposit payout, both of which required more
cash at resolution and more liquidation activity in the receivership. See Silverberg (1986) for details.
129 See U.S. Department of the Treasury (1991), III-17. FDIC (1989), 245–46, also discusses the
issue. The markets included letters of
credit and other guarantees and foreign deposits (if they were treated as
general trade claims in the statute).
Silverberg (1994) echoed some of these concerns and concluded that large
banks might incur costs (by forming separate banks in foreign countries or
taking other protective measures) to address investor concerns.
130 In 1988, the FDIC developed a rationale for paying general trade
claimants differently, as long as all claimants received at least as much as
they would receive under a liquidation.
See FDIC (1989). At the request
of the FDIC, FIRREA explicitly codified that rationale into law.
131 See Curtis (2000) or Marino and Bennett (1999) for a more detailed
discussion. Even so, the FDIC applauded
passage of depositor preference at the time (see Rehm ). However, the treatment of foreign deposits
might not have been clear just then. In
1989, the FDIC stated that “on balance,” FDIC authority to pay foreign and
domestic depositors in full (while their standing would remain the same as
other general trade creditors under U.S. bank receivership law) might be
superior to depositor preference. See
FDIC (1989), 244–48.
132 The OMB estimated that depositor preference would reduce FDIC’s
losses by $750 million from 1994 to 1998.
See Silverberg (1994).
136 Pages and Santos (2003); Kaufman (1997), 59. The prompt corrective action (PCA) provisions
of FDICIA may reduce (but not eliminate) the importance of incentives to close
banks at the optimum time. The mandatory
examination schedule in the United States, and the fact that the FDIC is not
the primary federal supervisor for many banks, may reduce the importance of the
findings about the deposit insurer’s incentive to monitor banks.
137 Lutton and Becher (1994), Rehm (1993), and Kaufman (1997) also
anticipated more liquidity risk for banks that were funded with unprotected
credits. For a more detailed discussion,
see the section above on liquidity risk.
138 Birchler (2000), especially p. 3; Garcia (2001), 67; and Silverberg
(1994). This goal relates to the
recoveries of one major creditor, rather than to the overall recoveries
associated with the value of the firm as a whole (the first goal set forth by
Aghion, Hart and Moore ).
139 McDill and Maechler (2003) found that domestic depositor preference
resulted in a small increase in uninsured domestic deposits for most
banks. The effect was much smaller than
the reduction in uninsured deposits associated with FDICIA.
140 Kaufman (1997); Thomson (1994); Silverberg (1994); Osterberg and
Thomson (2003). One big difference
between the savings associated with depositor preference in other countries and
the savings associated with it in the United States may relate to insurance
limits. In some countries, insured
depositor preference has been coupled with a low insurance limit, a coupling
that facilitates low-cost deposit insurance.
141 See Shibut (2002), 14–16, for a discussion of the incentives and
capacity of claimants to exit from a troubled bank. See Silverberg (1994), 12–13, and FDIC
(1998), 662, for examples of large contingent claims.
145 It appears highly probable that the FDIC would lose control of
foreign assets and liabilities unless a systemic-risk exception were invoked
and, at a minimum, foreign depositors were paid more than they would receive
under the least-cost test.
146 The FDIC has recognized these problems repeatedly. See Marino and Bennett (1999); Bovenzi
(2002); and Marino and Shibut (2002).
147 See Contact Group on the Legal and Institutional Underpinnings of
the International Financial System (2002), a study that was launched by the
G-10 deputies, for a discussion of the complexities of the bankruptcy
proceedings of an international bank.
See Marino and Shibut (2002) for a discussion of the FDIC’s resolution
options for megabanks. See Baxter,
Hansen, and Sommer (2004) for an alternative view.
148 Both Kaufman and Seelig (2002) and Marino and Shibut (2002)
emphasize the benefits of advance dividends as a means to reduce market
disruption at failure. Garcia (2001)
cites quick payments to insured depositors as a good practice for deposit
insurers. However, with the FDIC’s costs
associated with ring-fencing unclear until well after failure, the FDIC would
be taking a substantial financial risk if it were to pay a large advance
dividend at failure.
150 Baxter, Hansen, and Sommer (2004).
They cite additional reasons to prefer territoriality as well.
151 If regulators decided that a systemic-risk determination was
necessary regardless of the disruptions associated with ring-fencing, these
concerns could lead them to provide more relief to creditors than they
152 This list is not exhaustive.
For example, Silverberg (1986) discussed ring-fencing and concluded that
foreign deposits should be treated the same as domestic deposits in all
respects (including deposit insurance and assessments). However, we excluded that option from our
discussion because Congress deliberated on the insurance status of foreign
deposits during the hearings that led up to FDICIA and rejected equal insurance
treatment for them out of concern that that would harm the competitiveness of
large U.S. banks abroad (see Curtis ).
Another option might be to give contingent claims a lower priority than
other general trade claims, and place deposits and general trade claims in the
153 However, some countries might still ring-fence, regardless of any
clear financial incentive to do so. For
example, Japanese law requires ring-fencing.
The only option that would avoid all ring-fencing with complete
certainty is open-bank assistance.
155 See Garsson (1993); Lutton (1994): and Marino and Bennett (1999).
156 In recent years, several efforts have been made to harmonize bank
insolvency laws. Because of different
philosophies, such negotiations are difficult.
Even so, there have been some successes.
In 2001 the European parliament passed the Winding-up and Reorganization
Directive (which provides for a more coherent treatment of banks headquartered
in the European Union), and several countries in Europe have adopted its
provisions. In addition, many countries
have adopted “carve-out” provisions for derivatives that follow harmonized
netting agreements recommended by the International Swap and Derivatives
Association (ISDA). See Contact Group on
the Legal and Institutional Underpinnings of the International Financial System
(2002) for an excellent discussion of the issues involved and the harmonization
efforts to date.
157 Many researchers have found that most liquidity failures are, at
bottom, capital failures as well.
Unprotected creditors do not usually exit en masse from banks that are
unquestionably in sound condition. Even
if they do, such banks can normally arrange for alternative financing.