Reforming FDIC Insurance with FDIC-Sponsored
by Panos Konstas*
FDIC Working Paper No. 2005-04
Insured depositors have no
reason to monitor how banks perform or how safe they are. Only uninsured depositors have that
incentive. This paper offers a plan to
replace some insured deposits with uninsured deposits. The plan: the FDIC would guarantee loan
contracts if the loan takers deposited the proceeds exclusively in uninsured
deposits and backed those deposits with equity. This equity would ensure that the loan takers
could share the likely costs if any of their depositories failed. The loans made under FDIC guarantee would
only require interest at the risk-free rate. Thus the loan takers could offer the proceeds
at lower rates than the rates paid on current deposits. Accordingly, funding by banks would shift to
the new deposits, and since the new “self-insured“ depositors would have equity
at stake, they would have no choice but to duly monitor their banks and impose
rate premiums based on each bank‘s indigenous risk. With these reforms, some very costly
imperfections of current deposit insurance would be eliminated: the FDIC would
now have in place a program that would dissuade banks from moral hazard and
high risk and set the foundation for better disciplined, safer, and more
Key Words: FDIC insurance, moral
hazard, market discipline, bank risk, funding efficiency
JEL Classification: G21, G22, G28
REFORMING FDIC INSURANCE WITH FDIC-SPONSORED
deposit insurance protects depositors against loss, it also creates
moral-hazard problems for the insurer.
Moral hazard is the tendency of those with insurance to take less care
and put forth less effort to avoid risks than they would if they had no
insurance. Deposit insurance therefore
allows banks that engage in riskier activities to obtain insured deposits at
risk-free interest rates, since all costs of bank failure fall on the
insurer. Another aspect of moral hazard
is that insurance often provides a motive for bank managers, especially when
threatened with insolvency, to take on additional risks. Empirical studies show that moral hazard was
a key contributor to the huge losses suffered when thrift institutions failed
during the 1980s.1
observers believe that regulators can sufficiently contain the moral-hazard
problem by increasing bank regulation and surveillance, offsetting moral hazard
with financial penalties for excessive risk taking, requiring banks to hold
more capital, and intervening sooner at failing banks to minimize losses. Others, however, have asked whether the
moral-hazard malady may not in fact reflect the inherently destabilizing effect
of deposit insurance protection—an effect that can be countered only if the
protection itself is removed or drastically reduced. This paper looks at the problem and offers a
solution in the context of the latter view.
There are two kinds of
deposit protection—statutory and implicit.
Statutory protection occurs when the Federal Deposit Insurance
Corporation (FDIC) insures deposit balances up to a certain amount, currently
$100,000. Implicit protection occurs
when regulators resolve bank failures at no loss to any depositor, and when
banks become insolvent but are not allowed to fail. The Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) attempted to limit this type of protection,
basically by making it harder for regulators either to use failure-resolution
policies that protect uninsured depositors or to invoke the too-big-to-fail
argument during a failure. 2
argument for removing implicit deposit protection is that if depositors consistently
suffer losses during failures, they will become sensitive to the actions taken by their depositories
and will require premiums according to
risk. Such an outcome would dull banks’
incentives for undue risk taking because higher risk would translate into
higher premiums for uninsured funds.
paper suggests a way to reduce deposit protection, not (as FDICIA did) by
affecting the implicit protection for deposits over $100,000 but, instead, by
affecting the statutory type of protection—that for deposits below
$100,000. Specifically, this paper
outlines a plan that would make it advantageous for banks to replace some of
their insured deposits with uninsured deposits.
The paper first compares the existing credit-flow chain with what the
chain would be under the proposed plan; explains how the financial model for
the proposed plan is the Federal Home Loan Bank system; defines the population
from which the new self-insured depositors would be drawn; sets the parameters
and criteria for conversion to self-insurance; calculates the amounts likely to
be converted; and provides specifics on the benefits to be conveyed and the
risks to be curtailed.
FEDERAL CREDIT-FLOW CHAIN, PRESENT SYSTEM COMPARED WITH PROPOSED SYSTEM
To understand more fully the problems and limitations of FDIC insurance
and the ways this plan would address them, consider first the two types of
federal credit-assistance—direct loans and loan guarantees. Both types are evident in the program for
student loans: the government can offer a loan directly to a student, or it can
guarantee a loan that another party (e.g., a bank) has made to the
student. In terms of risk exposure,
there is no difference between the two, for if a given lending is structured
half as direct loan and half as loan guarantee and the student later defaults,
the government will lose equally on each half.
The budgetary effects of these programs are also similar: federal
spending (outlays) and the deficit (or surplus) increase by the amount of the
net cost to the government (defined as the present value of expected
disbursements over the life of the loan less the present value of expected
collections) for both direct loans and loan guarantees. But the impact on the national debt of the
two programs is different. Under direct
loans, the national debt would rise by both the net cost amount and the amount
of the U.S. Treasury borrowing necessary to finance the direct loan, whereas
with guarantees the debt would rise by only the net cost figure. Furthermore, there is a cost disparity
between funds that the government provides and funds that it merely
guarantees. When the government borrows
funds to provide for direct loans or other outlays, it does so by using the
central financing mechanism of the U.S. Treasury; that is, it raises funds in
large amounts at a time, in highly liquid securities, and totally on a
risk-free basis, thus ensuring that the needed funds are raised at the lowest
cost possible. In contrast, when banking
institutions raise funds to make guaranteed loans, they proceed by issuing
types of debt obligations that vary in size, risk, and marketability. Often, raising the funds involves the use of
branch offices. As a result, the cost of
funds to institutions making guaranteed loans is significantly higher than the
government’s cost of funds in making direct loans. For the borrower, this difference in cost of
funds means lower costs under direct loans than under loan guarantees. To minimize the discrepancy, the government
has instituted central financing mechanisms that copy the model of the Treasury
for most loan-guarantee programs under its auspices. In the case of student loans, the central
mechanism is the Student Loan Marketing Association (Sallie Mae). Through Sallie Mae, banks can raise funds for
student loans almost as cheaply as if they borrowed the funds from the Treasury
insurance is a loan guarantee program.3 It guarantees that the money a depositor
loans to the bank will be repaid by the insurance fund, up to the statutory
limit, if the bank is unable to make payments.
Deposit insurance therefore shares the traits of other loan guarantee
programs: insured deposits do not count as outlays in the U.S.
budget, nor are they included in the national debt; only the net disbursements
to fund losses and purchase assets of failed banks are recorded as federal
outlays and enter the national debt total.
And in terms of risk exposure, the government assumes as much risk by
insuring deposits (loans) to banks as it would have if it had made the loans
directly to banks out of its own funds.
However, unlike other loan guarantee programs, deposit insurance has not
devised a central financing mechanism to enable banks to raise funds more
How the present system of
deposit insurance works is depicted in panel A of figure 1 below. The government, via its agency, the FDIC,
guarantees loans that savers (depositors) make to banks. Since government assumes all the default
risk, the bank gets to borrow money at the risk-free interest rate. To compensate for the assumed risk, banks
must pay assessment premiums sufficient to cover insurance losses and FDIC
operating costs and to maintain the reserve fund at a mandated ratio. These are flat-rate premiums for all banks in
a particular risk category, and may or may not match the underlying risk in a
bank’s activities. This means that some
banks are overpaying for deposit insurance whereas others are underpaying.
Figure 1. Current Deposit Insurance System and Proposed Supplementary System
A. Current System
1. FDIC guarantees (assumes default risk for) the saver’s loan to bank.
2. Saver lends to (deposits funds in) bank at the risk-free rate.
3. Bank pays the FDIC an assessment premium.
Shortcomings: Moral-hazard problems; small-deposit funding of banks.
B. Proposed System
1. FDIC guarantees (assumes default risk for) the saver’s loan to SI depositor.
2. Saver lends to SI depositor at the risk-free rate.
3. SI depositor lends the bank the loan proceeds plus equity at ownrisk; charges bank own cost of funds plus a risk premium.
Advantages: Bank risk priced into bank’s cost of funds; incentives for depositor discipline; less risk of loss for the government.
As noted above, a major
flaw in this system is the moral-hazard problem. Moral hazard can emerge both because the
insured depositors lack a motive for monitoring the viability of their
depositories and because some bankers who are already benefiting from underpriced
assessment premiums may decide to further exploit the advantage by taking on
even more risk. Either way, increased
risk ultimately means more bank failures and greater losses for the insurer.
To minimize the
moral-hazard occurrence and at the same time make bank funding more cost-efficient,
we propose a plan that is outlined in panel B of figure 1. This plan is not designed to replace the present
system or to limit the FDIC in any way. The FDIC would continue to insure deposits
(other than those of the proposed plan) up to the legal limit, and would retain
its existing supervisory and regulatory authority and functions with respect to
insured banks. In addition, participation
in the proposed system by banks would be an option, not a requirement.
The difference between
this plan and the current system is the placing of an intermediary in the
credit-flow chain, with the initial lender (the saver) serving as lender to the
intermediary and the intermediary serving as lender to (depositor in) the
bank. The FDIC would guarantee the
saver’s loan to the intermediary, to the effect that if the intermediary could
not repay its debt, the FDIC would repay it.
This guarantee would enable the intermediary to borrow at risk-free
interest rates. But the guarantee would
also dictate that the intermediary’s deposit at the bank be statutorily defined
outside the realm of FDIC insurance.
This constraint means that the deposited funds would remain at the bank
at the depositor’s own risk. We call
these depositors self-insured (SI) depositors.
To ensure that SI depositors were able to meet the “own-risk”
obligation, they would have to combine a certain amount of their own money with
the money they borrowed, so that if the bank in which the package was deposited
failed, it would be the depositor’s money that was used up first to absorb
losses, before loss spilled onto the guarantor of the borrowed portion. To remain viable, SI depositors would need to
earn a return at least equal to their cost of borrowing plus a risk premium
based on the risk profile of the bank.
To see how this would work, suppose
that you have $80,000 and I have $40,000.
Under the present system, if we each deposited our money in an account
at an FDIC-member bank, both accounts would be insured and both would be entitled
to compensation at the risk-free interest rate plus a premium based on the size
of the accounts, given that larger accounts embody greater economies for the
borrower.4 On this basis, assume that, given the same
time to maturity, the bank will pay 4.10 percent on your account and 4.00
percent on mine. In the proposed plan,
however, we would have the option of lending to each other under the same
guarantee that we now have at the bank.
That is, if you loaned me your $80,000 and I agreed to certain conditions,
the FDIC would guarantee that it would repay your loan if I could not repay
it. It follows that, since the guarantee
would be the same, you would be willing to lend me the money for the same
interest rate you would lend it to the bank.
The conditions to which I would have to agree would be (1) deposit the
loan proceeds at an FDIC-member bank, and (2) do so at my own risk. To fulfill the second provision, I would be
required to combine some of my own money with the loan proceeds and invest both
parts in bank deposits. The FDIC would
say how much of my money would be combined with the loan. If all $40,000 was needed, that would mean
that I could finance a $120,000 deposit asset with one-third equity and
two-thirds debt—a capital-to-assets ratio of 33.33 percent. Since SI accounts would not be eligible for
FDIC coverage, all of the $120,000 would be subject to loss in case of
default. Thus, if the bank with the
money failed and depositors were subjected to a loss of, say, 10 cents per
dollar of deposit, I would lose $12,000, all of which would be taken from
equity. (In contrast, if $120,000 was
deposited under current FDIC rules, the depositor’s loss would be $2,000 and
the FDIC’s loss $10,000.) If the loss
were 33.3 cents per dollar, the entire capital would be wiped out, although
enough would still remain in my account to pay off the loan. But if the loss exceeded 33.3 cents—if it
were, say, 35 cents—what would be left in my account would not be enough to pay
the loan, and the FDIC would be called upon to make good on its guarantee and
cover the deficit between the loan value ($80,000) and what remained in the
account ($78,000). Still, the $2,000
loss would be less than the $35,000 that the FDIC would have lost if the
$120,000 account had been insured.
Why would I want to undertake the
loan under these conditions? If I put
your money and mine as a sum in a single account, the bank would pay more on
that account than it would on separate accounts. Assume
that the bank would pay 4.15 percent on the larger account. I would then be able to increase my return
both because I would earn more on my own money (4.15 percent instead of 4.00
percent) and because I would realize a positive spread between what I would pay
you (4.10 percent) and what the bank would pay me (4.15 percent) on the money I
had borrowed. Since I would be financing
the deposit asset at the ratio of $2 of debt for each dollar of equity, the
return to equity would be 1(0.0415) + 2(0.0415 – 0.0410) = 4.25 percent, or 25
basis points more than I would have made if I had invested just my money alone.
|TABLE 1. RELATIONSHIP BETWEEN ACCOUNT SIZE AND INTEREST RATES ON CDs AS SHOWN IN A BANKS WEBSITE
Account Size ($)
||500,000 or more
Of course, the additional return would have to be weighed against the loss that I
would incur if the bank failed. How much
of a loss could I assume and still justify the borrowing? The equation for such loss (x) is 1(0.0415 –
x) + 2(0.0415 – 0.0410 – x) = 0.040. In
this case x = 0.00083. This means that
if I thought the risk of failure with a loss to depositors of less than 8.3
cents per $100 of deposit was small (less than 50 percent), becoming an SI depositor
would make sense; otherwise, I would be better off as an FDIC-insured depositor
at a 4.00 percent rate.
Suppose now that
you, with $80,000, are the SI depositor and I, with $40,000, am the
lender. Under the 33.33 percent
capital-to-assets ratio, the $80,000 of equity could support $160,000 of
guaranteed borrowing, for an SI deposit of $240,000. Assume that the bank paid 4.20 percent on
this (larger) SI deposit. In borrowing
the $160,000, you would have as one alternative the borrowing of $40,000 from
me at a cost of 4.00 percent and the borrowing of $120,000 from another lender
at a cost of 4.15 percent (thus bringing your average cost of borrowed funds to
4.11 percent). The return to equity then
would be 1(0.0420) + 2(0.0420 – 0.0411) = 4.38 percent, or 28 basis points more
than you would make as an insured depositor.
The higher return would enable you to attain a higher break-even point
between SI and insured deposits than was feasible in my case. Solving the equation 1(0.0420 – x) + 2(0.0420
– 0.0411 – x) = 0.0410 for x produces a value of 0.00093, meaning that the bank
could fail with a loss to uninsured creditors of up to 9.3 cents per $100 of
deposit (compared with 8.3 cents in my case) and you would realize the same net
return you would have as an insured depositor.
Since the likelihood of the bank’s failing with a 9.3 cents loss is more
remote than that of its failing with an 8.3 cents loss, you would be more apt
to invest on a self-insured basis than I would be.
now that after borrowing my $40,000 at a cost of 4.00 percent, you borrowed the
rest in separate $40,000 blocks from three other lenders like me at the same
cost. The return to equity would now be
1(0.0420) + 2(0.0420 – 0.0400) = 4.60 percent, or 22 basis points higher than
if you had borrowed the $120,000 in a lump sum.
The higher return would raise the break-even point for SI deposits. Solving the equation 1(0.0420 – x) + 2(0.0420
– 0.0400 – x) = 0.0410 gives a value for x of 0.00167. You could now justify investing in SI funds
even if you assumed a possibility of failure with a loss to depositors of up to
16.7 cents per $100 of deposit.5
THE FHLB SYSTEM AS A FINANCIAL MODEL
above, each SI depositor would be borrowing separately in order to raise the needed
funds. In terms of earnings, smaller
depositors would be at disadvantage to larger depositors because of the
economies limitation. Another limitation
that would be incurred under individual borrowing is that each SI account could
remain self-insured only up to its capital, leaving the FDIC (as the guarantor
of the SI depositors’ lenders) responsible for losses in excess of that
problems could be overcome if each depositor borrowed the funds through a
central financing facility rather than alone.
Such a "Self-Insured Depositors’ Financing Office" (SIDFO)
would issue securities in amounts to meet the needs of all SI depositors (see
panel A of figure 2).
Figure 2 Comparison between Proposed System with a Common Financing Office [SIDFO] and the Federal Home Loan Bank System
A. Proposed System
1. FDIC guarantees (assumes default risk for) the saver’s loan to SIDFO.
2. Saver lends to (i.e., buys securities of) SIDFO at the risk-free rate.
3. SIDFO lends to SI depositor at cost (risk-free rate) plus own operating expenses and excess loss from insolvent SI depositors.
4. SI depositor lends to bank at own risk; charges bank own cost offunds plus a risk premium.
Additional advantages: Better system implementation; maximized funding efficiency (economies of scale) on both borrowing and lending sides; virtually no risk ofloss for the government.
B. Federal Home Loan Bank (FHLB) System
1. Government implicitly guarantees the saver’s loan to OF.
2. Saver lends to (i.e., buys securities of) OF at near risk-free rate.
3. OF lends (transfers funds) to Federal Home Loan Bank at cost (near risk-free rate).
4. FHLB makes secured (collateralized) loans to thrifts or banks; charges thrift or bank own cost of funds plus own operating costs, OF costs, and costs for FHLB regulator.
Disadvantages relative to SI system: No incentive for market discipline; risk premium not included in bank’s or thrift’s cost of funds; failure losses shifted to government (FDIC); more government infrastructure and regulation; higher cost of funds for thrifts and banks.
The FDIC would guarantee the lenders (the buyers of the
securities) to SIDFO against default, and this guarantee would enable SIDFO to
raise its funds at risk-free rates. The
funds raised would serve as loans to SI depositors after they post the required
capital. The SI depositors would use the
proceeds (together with their capital) to buy certificates of deposit
(CDs). The CDs could be in maturities as
needed by the banks (3-month, 6-month, 1-year, etc.). This would tend to minimize SIDFO’s
interest-rate risk. SIDFO’s lending rate
to SI depositors would be based on three factors: SIDFO’s own cost of
borrowing, the expenses of operating SIDFO, and the costs during failures when
the loss exceeded the SI depositors’ equity.
The last of those three factors would render SI accounts wholly
self-insured.6 The SI depositors’ lending rate to a bank
would include their cost of funds plus a perceived risk premium>.
financial model for the FDIC-sponsored SI-depositor system would be that of the
Federal Home Loan Banks (FHLBs), which the SI system would parallel. Panel B of figure 2 is a chart of the FHLB
system. In that system, the guarantee is
effectuated through the government-sponsored enterprise (GSE) status of FHLBs,
which allows them a $4.5 billion line of credit from the U.S. Treasury. The FHLB equivalent of SIDFO is the Office of
Finance (OF). The OF sells (through
a network of underwriters and discount dealers) and services consolidated
obligations (bonds and discount notes) to fund the operations of all 12
FHLBs. The bonds and notes are the
joint-and-several liabilities of all FHLBs: if any particular FHLB becomes
insolvent, the remaining FHLBs have to pick up the insolvent Bank’s
obligations. This feature is similar to
that in the SI system whereby future SI depositors would absorb the loss from
an insolvent SI depositor. The counterparts of SI depositors are the
FHLBs. Why, then, set up a new system
when we have a similar one already in place?
There are three reasons. First,
although SI depositors and FHLBs would both hold loan assets of similar default
risk, only the former could realize loss in a failure. FHLB loans (called advances) are
collateralized—indeed, over collateralized—with the high quality of member
assets, so that when a bank or thrift fails, no loss incurs on the advances. The loss is instead shifted to the member’s
deposit insurer. Hence, with no risk on
loans, the FHLBs have no reason to conduct due diligence. Second, in pricing the
advances to members, the FHLBs include the cost of borrowing through the OF and
add to it their own operating costs, as well as the costs of the OF and those
of their regulator (the Federal Housing Finance Board).7 But the intrinsic
risk of the member—the all-important factor in the moral-hazard issue—is not
included in the price; indeed, at any given time all members are charged the
same rate by their FHLBs. Finally, since
the prospective SI depositors would already exist (see below), there would be
no need to create new entities and to pass on the costs of operating and
regulating them to banks.
THE POPULATION OF SELF-INSURED DEPOSITORS
Where would the SI depositors come from? Currently the usual sources of
funds to banks, thrifts, and other financial intermediaries are certificates
of deposit, checking accounts, and savings deposits. These sources are often referred to as retail
sources because the funds come directly from individuals, usually in small
amounts through branch networks.
Wholesale sources, in contrast—federal funds, jumbo CDs, brokered
deposits, and FHLB advances—are raised in large amounts, mainly from other
financial institutions. Where, in this
environment, would the SI CDs fit?
SI CDs, because of their leveraged
position, would not be suitable for the small savers. A household, for example, would not be likely
to convert the family savings into an SI CD when, as suggested in note 6, a 10
percent failure loss would wipe out the entire savings. Instead, the
institutions now handling large funds would be the parties most apt to
invest in SI CDs. This group includes
banks, thrifts, insurance companies, credit unions, various types of mutual funds, and hedge funds. Such institutions are already
involved in intermediation, borrowing in the financial markets and lending in
the same markets after first setting aside a portion of the borrowed funds as
capital. This process allows them to
leverage up their capital and capture interest-rate spreads between borrowing
and lending rates. As SI depositors,
these institutions would likewise be leveraging their capital for the sake of
rate spreads and would be taking risks like all intermediaries. For example, if an intermediary and an SI depositor
both invested, under the same leverage ratio, the same amount of money in an
uninsured debt of a certain bank and the bank later failed, both would stand to
lose an equal amount of capital. The
point is that by becoming an SI depositor, an intermediary would neither be entering a
new business nor taking a risk to which it was not accustomed.
What benefits would these intermediaries secure as
SI depositors that were not available to them already? The answer would be the option of raising
funds at rates equal to SIDFO’s cost of borrowing. No intermediary would be able to raise market
funds as economically as SIDFO unless the intermediary was able to back its
borrowings 100 percent with capital and was able to issue debt in as large
quantities as SIDFO. The FDIC’s
guarantee to SIDFO’s lenders would negate the need for 100 percent capital,
making it possible for SIDFO to borrow at government-equivalent credit ratings. SIDFO would likely pass the quantity test
because it would be raising funds for all SI intermediaries. Consequently, by becoming SI depositors and
being able to raise funds from SIDFO at cost, the intermediaries could earn
wider interest-rate spreads on their investments than they would as regular intermediaries
raising funds under their own names.
funds raised through SIDFO would likely be raised in larger blocks than funds borrowed
under an intermediary’s own name.
Consider, for example, an intermediary that currently acquired a $1 million bank
CD but, to finance it, had to use 10 separate accounts of $100,000 each. As an SI depositor, given a 10 percent
capital constraint, the intermediary could fund the purchase by combining just one of
these accounts with $900,000 of borrowing from SIDFO, thus eliminating 9 of its
accounts along with their associated service costs. This line of reasoning applies equally to
banks: a bank now funding a $1 million loan through 10 separate deposit
accounts could eliminate most or all of these accounts by just borrowing a big
lump sum from a single SI depositor.
Raising SI funds in the desired amount could follow the pattern used by
the FHLB system. A bank could approach
an SI intermediary for the desired amount of borrowing, and when the price was
agreed upon, the intermediary would turn to SIDFO to finance the
transaction. This process would not
differ much from the way banks now raise advances from their Federal Home Loan
Bank (except that in the case of SI funds, a bank could bargain with lenders
all over the country instead of with just one district lender that charged the
same regardless of borrower creditworthiness).
PARAMETERS AND CRITERIA FOR CONVERSION TO
To find out
why and when banks and investors would find it advantageous to switch their
status as depositors from FDIC-insured to self-insured, one must stipulate
certain parameters (“why?”) and recognize certain criteria (“when?”). The parameters for “why” would consist of the
capital ratios on SI accounts, the lending rate of SIDFO, and the bank-failure
risk to SI depositors. The criteria for
“when” would be the SIDFO lending rate and the relationship between that rate
and the rates paid on existing accounts.
As just noted, the three parameters that would
establish why a switch to SI status would be advantageous are capital
requirement, the SIDFO lending rate, and the spread between that rate and the
rates on existing accounts. For capital requirement we assume a ratio of
10 percent, which is equivalent to the current requirement by the regulators
for well-capitalized banks. This ratio
means that a depositor could borrow $9 of funds from SIDFO for each $1 of
equity. The SIDFO lending rate would be based on the borrowing experience of
the Office of Finance in the FHLB system.
In 1998 the interest cost on $329.4 billion of average balances of FHLB
consolidated obligations was 5.53 percent.
After considering that SIDFO would likely be able to borrow somewhat
cheaper than OF because the guarantee of SIDFO securities would be explicit (in
contrast to the implicit guarantee of the OF obligations) and after including 2
basis points for the costs of operating SIDFO (based on the OF experience), we
stipulate the SIDFO lending rate at 5.50 percent. But since SI depositors would be uninsured,
they would need to adjust their returns for the
risk of failure by the bank. This
risk would vary from bank to bank, but for all banks we assume it to be equal
to the ratio of the FDIC’s provision for losses to insured deposits. This ratio in 1998 was 0.02 percent.8
illustration, consider a bank in which depositors currently earn 5.60 percent
on CDs. After risk and taxes, these
depositors should be at earnings parity not only with depositors in other banks
but also with investors in other instruments, such as commercial paper,
Treasury and GSE issues, and tax-exempt issues—otherwise they would not be
where they are. Likewise for investors
in the other instruments: they, too, could transfer to banks if they felt they
would earn more there.
that one of these depositors switched to SI status. The depositor would then earn the CD rate of
5.60 percent on the $1 of equity and, on each of the $9 of borrowing from
SIDFO, would benefit from the 10 basis point spread between the CD rate and
SIDFO’s lending rate of 5.50 percent.
But the SI depositor would need to deduct for the cost of possible
failure by the bank. Suppose that in
this case the perceived cost was the same as the industry average of 2 basis
points. Thus, the return (SIr) for the
SI depositor would be SIr = 1(0.0560 –
0.0002) + 9(0.0560 – 0.0550 – 0.0002) = 6.38 percent. The depositor would now be netting 78 basis
points more than previously.
Would the SI depositor be able to keep that 78
basis point benefit? Most likely
not. The accrued extra return would
place the depositor out of equilibrium with other (non-SI) depositors in the
same bank, with depositors in other banks, and with depositors and investors
outside the banks. These non-SI
depositors would quickly realize that they, too, could increase returns by
securing positions as SI depositors.
However, a bank has only a finite need for borrowed funds, and SI
accounts could be established only with banks.
The non-SI depositors, as they competed with each other to secure a
portion of the more profitable SI deposits, could succeed only in raising
prices on SI issues and driving down their interest rates. Rates would keep going down until equilibrium
was reached between SI and non-SI investors.
This point would occur when the interest rate paid by the bank gave the
SI depositor, on a net-of-risk basis, the same return as before the depositor’s
conversion to SI status. That interest
rate would be 5.53 percent. With such a
rate the depositor would effectively earn a net return of (0.053 – 0.0002) + 9
(0.053 – 0.0550 – 0.0002) = 5.60 percent.
This would reposition the SI depositor to earnings parity with non-SI
depositors, while saving the bank 7 basis points (0.0560 – 0.0553) from what it
was paying earlier.
The underlying premise of these
conclusions is that the SI depositors would not have the power to secure more
than competitive returns. There are
three reasons for this to be so. First,
SI funds would constitute only a small portion of the aggregate market for
funds—a market that would include not only other types of bank funds but also
private, government, and municipal issues.
Second, the SI funds would be not an addition to, but a replacement for,
bank funds; there is no reason to expect that access to SI deposits would cause
banks to expand their assets. Third,
demand for SI funds could derive only from banks, whereas there would be no
limit as to the parties that could supply such funds. In other words, the demand for SI funds would
be limited and the supply unlimited, giving banks a high degree of monopsony
power and the ability to capture all the surplus value created from the conversion of existing
deposits to SI deposits.
Criteria for “When?”
criteria for determining when depositors would switch to SI deposits would be
the SIDFO lending rate and where that rate stood relative to rates paid on
existing accounts. Depositors would not
be interested in SI CDs unless the rates earned on their current accounts were
higher than the SIDFO lending rate. With
the rates higher, it would pay to switch to SI CDs because the depositors would
be earning positive spreads from the rates paid for SIDFO borrowings and the
rates received on SI CDs from banks. By
the same token, no bank would want to exchange any of its existing accounts on
which it was paying interest below the SIDFO lending rate for SI accounts
requiring interest above that rate. For
both depositors and banks therefore only accounts currently carrying interest
above the SIDFO lending rate would have possibility for conversion to SI
THE AMOUNTS LIKELY TO BE CONVERTED
What amount of
money are we talking about? Given the
parameters and criteria set forth above, roughly how much money in bank
deposits would be likely to become self-insured instead of FDIC insured?
estimate the funds that would convert to SI deposits, we would need data on
accounts within each bank now paying more than the SIDFO lending rate of 5.50
percent. However, interest-rate data on
an individual-account basis are not available.
We use, instead, the average interest expense ratio on deposit accounts
for the bank as a whole. The interest
expense ratio is defined as annual interest expenses on deposits divided by
average quarter-end deposit balances for the year. Banks with interest expense ratios above 5.50
percent would find it profitable to convert to SI CDs.9
Using Call Report data, we computed interest
expense ratios for time and savings deposits for all banks in 1998. It turned out that numerous banks had expense
ratios above 5.50 percent, but only on time deposits. On savings deposits, no banks had ratios
above 5.50 percent. Thus, we can infer
that all SI funds would come from time deposits. As shown in table 2, there were two types of
time deposits: deposits in accounts of $100,000 or more and deposits in
accounts of less than $100,000. For time
deposits of $100,000 or more, there were 4,535 banks that had expense ratios
above 5.50 percent and had issued $213.1 billion of CDs. This amount would convert to SI CDs and would
lose the partial FDIC coverage of $100,000 per account. For deposit accounts under $100,000, the
4,597 banks with ratios over 5.50 percent contained funds amounting to $320.3
billion, all under FDIC coverage. These
funds would also convert to SI status and would lose their FDIC protection. Accordingly, the sum of funds in SI accounts
in the banking system would likely come to $533.4 billion; all subject to risk at
the account-owners’ expense.
|Table 2. AMOUNTS OF TIME DEPOSITS CONVERTED TO SI DEPOSITS AND ASSOCIATED INTEREST COSTS
||Average Interest Cost
||Number of Banks
||Assets per Bank
|Banks with Expense Ratios above 5.50%
|Current Time Deposits of $100,000 or More
| As Converted to SI Deposits
|Current Time Deposits under $100,000
| As Converted to SI Deposits
| Total of Both over and under $100,000
| As Converted to SI Deposits
|Banks with Expense Ratios below 5.50%
|Current Time Deposits of $100,000 or More
|Current Time Deposits under $100,000
| Total of Both over and under $100,000
|Source: Federal Deposit Insurance Corporation.
CDs both over and under $100,000, the total converted to SI status would be
$533.4 billion, consisting of $53.3 billion of depositor equity and $480.1
billion of borrowing from SIDFO. It
should be noted that banks switching to SI CDs would be smaller on average than
banks not switching, suggesting that most SI deposits and their benefits would be
captured by smaller banks.
BENEFITS CONVEYED AND RISKS CURTAILED
As shown in
table 2, it was costing banks with CDs less than $100,000 and expense ratios
above 5.50 percent (banks that would be slated to convert to SI deposits) $18.7
billion in interest costs to maintain $320.3 billion of such CDs—a rate of
interest of 5.84 percent. How much would
the banks need to pay their depositors to induce them to switch to SI CDs? If (again) the SI depositors could secure
only competitive returns, the answer is 5.554 percent. At that rate, the SI depositors would earn
(0.055554 – 0.0002) + 9(0.05554 – 0.0550 – 0.0002) = 5.84 percent, bringing
them to par with the rate earned before they switched to SI CDs and with the
rates currently earned by other (non-SI) investors. The banks, however, would have saved 28.6
basis points (0.0584 – 0.05554) as a result of the SI switch. Likewise, we determined that for banks with
CDs over $100,000 the interest cost would decline from 5.90 percent to 5.56
percent after the shift to SI CDs. For
both groups of banks together, those with CDs under $100,000 and those with CDs
over $100,000, the rate would fall from 5.87 percent to 5.557 percent. With the lower rate, the cost on the $533.4
billion SI CDs would fall from $31.3 billion to $29.6 billion, thus improving
the banks’ net interest margin by 32 basis points and raising their return to
equity (given their 8.5 percent capital ratio in 1998) by 3.8 percentage
points. In addition, banks would save
conversion by being able to meet their funding needs with fewer SI accounts and
by not having to pay assessments to FDIC on SI deposits. And the SI intermediaries would benefit by being
able to borrow the money in larger amounts and at a lower cost from SIDFO.
Of the $533.4 billion SI CDs, $391
billion would have been insured, that is, the $320 billion of SI CDs switched
from accounts below $100,000 plus an estimated one-third of $213 billion of SI
CDs from accounts over $100,000. The FDIC
would shed liability for the $391 billion of insured bank debt (deposits) and
assume liability for $480.1 billion of SIDFO debt.
Yet, shifting guarantees from bank debt to SIDFO debt would dramatically decrease the FDIC's odds of incurring loss from bank failure. First, the SI depositors' pricing of bank risk into the cost of funds would prompt banks to lower their risk profile-for example, by improving the credit quality of assets or taking fewer interest-rate risks. This lowered risk profile would mean fewer bank failures, hence smaller losses for the FDIC.
Moreover, the SI plan would further distance the FDIC from failure loss by imposing additional barriers before such loss could occur. At present the FDIC could incur loss when the bank defaults. Under the plan, however, not only the bank must default, but also the SI depositor must default, SIDFO must incur loss, and SIDFO must become defunct before the FDIC suffered loss. A bank becomes insolvent when its capital reaches zero. SI depositors on the other hand would not default until the bank's capital had become negative to the extent of the SI depositors' capital requirement (10 percent in our case). For SIDFO to incur loss, the bank's capital must have become negative by more than 10 percent. (Note that under FDICIA regulators could close failing banks at even positive capital ratios). With respect to how SIDFO could become defunct and how the FDIC could incur a loss, consider a scenario in which SIDFO persistently sustains heavy losses year after year, requiring it to correspondingly increase its lending rate in order to recoup the losses. Since SIDFO would be a monopolist, it would be facing the entire demand curve for SI lending. As the lending rate moved up along the price axis to recover the SIDFO losses, some SI depositors at the equilibrium point of the downward-slopping demand curve would be compelled to drop out of the system. Others would remain until the next time that the lending rate was raised. Then, some more depositors would drop out. Eventually, as the SIDFO losses kept mounting, the lending rate would climb to the point where the demand curve crossed the price line. At this point all SI depositors would drop out, SIDFO would become defunct, and the FDIC would become liable for all losses sustained by SIDFO during the last year of its life.
SUMMARY AND CONCLUSIONS
Deposit insurance renders deposits at different banks equally attractive and perfectly secure. This effect can lead to unjustified risk taking by banks because raising funds for riskier, higher-yielding assets costs no more than raising funds for less-risky, lower-yielding assets. One way to limit this problem is to rely on uninsured depositors to price bank risk into banks' cost of funds.
This paper offers a plan to increase the amount of uninsured deposits. We note that at present there is one government-guaranteed lender (depositor), one recipient of guaranteed credit (bank), and one level of risk capital (bank's equity) protecting the guarantor (FDIC). In the plan offered here, the recipient of the guaranteed credit would still be the bank. However, no loan guarantee would be given to the depositor of a bank. Instead, the guarantee would apply to investors who bought the securities of a central financing office (SIDFO) that made equity-secured loans to financial intermediaries (SI depositors). The intermediaries would then invest the proceeds in uninsured bank deposits. Under these terms, the government would get more protection against loss (SI depositors' capital); and the SI depositors, to avoid loss and earn a competitive return, would have to monitor their banks aptly and demand premiums based on risk.
Significantly, unlike other proposals (for example, subordinated notes suggestions), this plan does not mandate that banks issue and assume any specified amount of SI-deposit liabilities. A bank would issue SI CDs only if it would cost less than raising funds from other sources. The analysis indicates that only the larger size time deposits paying interest above the SIDFO lending rate would meet the criteria for a switch to SI deposits. Savings and similar retail deposits would not qualify because banks could secure such funds at a cost below the SIDFO rate. I estimated that some $533 billion of time deposits would convert to SI CDs-an amount representing about 10 percent of all the funds in the banking system. The interest cost on the SI CDs would be less than the cost of the funds that would exchange into SI CDs. The reason for the lower cost would basically be the centralized SIDFO financing arrangement. The large-scale, FDIC-guaranteed borrowing of SIDFO would effectively ensure that banks could raise SI funds at a price close to that of funds raised under the more cost-efficient direct-loan method.
Another aspect of this plan relates to insured-deposit funding and undue risks for the deposit insurer. Some proposals, generally referred to as narrow-bank proposals, propose to limit the insurer's risk by regulating which banks can have insured deposits and what use can be made of the deposits once raised. From this perspective, SIDFO may be seen as a huge narrow bank: it would take in insured deposits and, via the SI middleman, would deliver them to banks without raising concerns for the insurer about failure risks and moral hazard. Such risks and worries would now become the exclusive possession of the SI depositors. But unlike other narrow-bank designs, SIDFO would not impose any limitations on where the banks could invest the borrowed SI funds. Again, it would be for the SI depositors to apply those constraints through their risk premiums.
Benston, George J., and
George G. Kaufman. 1997. FDICIA after Five Years. Journal
of Economic Perspectives 3, no. 11:139–58.
Brewer, Elijah. 1995.
The Impact of Deposit Insurance on S&L Shareholders' Risk/Return
Trade-offs. Journal of Financial Services Research 9:83–89.
Federal Home Loan Bank System.
1999. 1999 Financial Report (www.fhfb.gov).
Kane, Edward J. 1989. The S&L Insurance Mess. Urban Institute.
FDICIA: Where Did It Come from and Where Will It Take Us? Federal
Reserve Bank of Kansas City Financial Industry Perspectives
McKenzie, Joseph A.,
Rebel A. Cole, and Richard A. Brown.
1992. Moral Hazard, Portfolio
Allocation, and Asset Returns for Thrift Institutions. Journal
of Financial Services Research 5:315–39.
Office of Management and Budget.
1991. Budgeting for Federal Deposit Insurance. Office of Management and Budget.
* Senior Economist,
Division of Insurance and Research, Federal Deposit Insurance Corporation. I
want to thank Stephan Boyamian, Fred Carns, Dennis Clague, Tyler Davis, Mark
Flannery, Jay Golter, Steven Guggenmos, Ken Jones, Barry Kolatch, Kristina
Konstas, George Pennacchi, Marvin Phaup, Mike Pollei, Steven Seelig, Philip Shively, and Louis
Wright for their comments and Jane Lewin for editing the paper. The conclusions are mine and do not
necessarily reflect the views of FDIC. Email:email@example.com:
phone: 202 898-3932.
1 Brewer (1995); Kane (1989); McKenzie, Cole, and Brown
2 To learn more about FDICIA and
its effects, see Lemieux (1993) and Benston and Kaufman (1997).
3 See Office of Management and Budget
4 There is widespread evidence that larger accounts
attract higher rates. Banks routinely
present this information in their lobbies, in newspapers, or on the
Internet. Table 1 is an example of interest
rates paid on certificates of deposit, as advertised in a bank’s Web site on July 17, 2000.
5 These examples also demonstrate how pricing according
to risk would be arrived at.
6 For example, under a 10 percent
capital ratio, an SI depositor would lose 100 percent of posted capital if the
bank failed and depositors lost 10 cents on the dollar. If the loss exceeded 10 cents on the dollar,
the excess would fall on future SI depositors through the higher SIDFO rate,
instead of on the FDIC.
7 All FHLB statistics and references are from Federal
Home Loan Bank System, 1999 Financial
8 For this assumption to be meaningful in determining
the switch between SI and non-SI depositors, we must also stipulate that, in
terms of depositor preference, SI depositors would be equally senior to non-SI
depositors. Junior status would transfer
the risk away from non-SI depositors, rendering the failure risk ratio assumed
9 We realize that a bank with an average expense ratio
of 5.50 percent, although it would be taken as having switched all accounts to
SI status, may well have as many accounts earning more than 5.50 percent and
therefore meriting a switch to SI status as it has accounts earning less than
5.50 percent and therefore not justifying a switch. As noted in the text, it may be more precise
to estimate the switch on the basis of individual accounts, but such data do
not exist. We adopt the average-expense
method, thinking that accounts wrongly taken (because of ratios below 5.50
percent) as switching to SI CDs for banks with ratios over 5.50 percent would
likely be offset by accounts wrongly not
counted (because of ratios above 5.50 percent) as switching to SI CDs for banks
with ratios below 5.50 percent.
10 In 1998 the average capital ratio for banks stood at
8.5 percent. Raising that ratio to 18.5
percent would have meant increasing bank equity from $462 billion to $1,006