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Deposit insurance: a market-based reform proposal.

It is clear that there are major problems with federal deposit insurance as it is currently structured. Widespread failures in the savings and loan industry have forced an expensive federal bailout, and the number of bank failures is at an uncomfortably high and rising level[2,4].

While it is now generally accepted that reforms in federal deposit insurance are necessary, proposals to abolish such insurance[5,6,10,16] have not received significant support. These proposals are generally considered politically unrealistic. Also, they lead people to recall the early 1930's when failures of a few banks produced panic and a run on the entire banking system. The key purpose of the Federal Deposit Insurance Corporation (FDIC), established in 1933, was to assure such a panic would not recur. Arguments that panics could be prevented or controlled in the future through private deposit insurance and cooperative arrangements among banks are not convincing enough to make abolishing federal insurance a viable alternative[3,8,17].

A less extreme proposal receiving increasing support is a reduction in the maximum insured deposit level below the current $100,000[13]. The argument is that a lower insured level would put more depositors in a position of possible loss, leading them to pressure banks to maintain safety. Also, a lower insured level would reduce the obligations of the FDIC when failures occurred. A variation of this proposal is to introduce co-insurance above a certain deposit level, with the depositor bearing perhaps 10% to 15% of the loss when failure occurs[2,4].

Unfortunately, these proposals have their negative side as well. A lower insured level or co-insurance provision, by making more depositors possible losers, would increase the danger of panic. Given the difficulty the typical depositor has in judging the financial condition of his bank, frequent runs might occur as depositors reacted to local rumors, failures of other banks, adverse trends in the regional or national economy, and anything else creating an atmosphere of concern and pessimism. While these runs might remain limited, they could still cause substantial confusion and instability in the financial system.

Thus, depositor discipline as a way of restraining bank risk-taking inevitably is in fundamental conflict with the goal of financial stability. The appropriate action to be taken with respect to the insured deposit level is to move in the opposite direction from that suggested above and insure all deposits[9]. This action would eliminate all danger of panic while requiring the FDIC to come up with some alternative method to depositor discipline as a restraint on bank risk-taking.

Another reform proposal, aimed specifically at the risk-taking problem, calls for the FDIC to move away from its current level deposit insurance premium structure toward risk-based premiums. At present, all banks pay the same percentage of deposits as an insurance premium, meaning that high risk banks are subsidized by more conservative banks. Risk-based premiums would eliminate this artificial encouragement to risk-taking.

Unfortunately, this proposal has its difficulties as well. Could the FDIC come up with a precise measure of bank risk? Any serious attempt to produce such a measure would surely require more frequent and more intensive examinations of banks than have been carried out in the past. This proposal puts a very heavy burden on the FDIC, an agency many doubt is up to the task. In addition, with no alternative source of deposit insurance, there would be no competitive market to validate the FDIC'S judgment of risk. Thus, the key problem with risk-based premiums is that they would be determined bureaucratically and monopolistically by the FDIC rather than by market forces[12,16].

In summary, there are substantial difficulties with all three of these standard proposals for deposit insurance reform. Abolishing federal deposit insurance would return us to the pre-depression situation and reintroduce the danger of panic. Lowering the maximum insured level or introducing co-insurance would increase depositor surveillance of banks but again raise the possibility of panic. Risk-based premiums appear to offer the benefit of restraint on bank risk-taking combined with protection from panic (especially if supplemented with insurance of all deposits) but imply a very powerful FDIC assumed to be able to measure bank risk. What is really needed is a mechanism which restrains risk-taking and protects against panic without relying on a powerful federal agency bureaucracy.

The Subordinated Debt Option

Fortunately, such a mechanism is available. In fact, its use can easily be linked with another proposal already made and partially implemented - requiring banks to increase their equity capital. A higher equity percentage is suppose,d to increase the protection of the FDIC when failures occur. An increase in equity requirements from 5% of assets to 10% of assets would mean that the FDIC only had to recover 90% of assets in cases of liquidation in order to avoid losses[2,19].

Such higher equity requirements should be of.value in reducing FDIC losses, although there is some fear that banks might increase their risk-taking in order to attempt to earn the same percentage return on a larger equity base[14,15]. Regardless of the validity of this fear, a superior alternative is available which would increase the capital base of banks while also providing a restraint on bank risk-taking.

This alternative is to require banks to issue subordinated debt equal to some percentage of their assets[1,7,11]. A requirement of a minimum of 5% equity capital and 5% subordinated debt will be assumed here, although the analysis offered would apply to other combinations as well. The holders of this debt would be last in line after everyone but stockholders to be paid in case of bank failure. The FDIC would have exactly the same protection in cases of failure from 5% equity combined with 5% subordinated debt as it would from 10% equity. But the key advantage of the existence of subordinated debt is that the holders of that debt would have a strong incentive to keep a close eye on the issuing bank for safety. They would have nothing to gain from increased profits, since the debt would yield a fixed return, and everything to lose from failure. Thus, a new type of investor in banks would be created - someone who knowingly chose to put his money at risk and had a strong interest in pushing for conservative rather than aggressive bank behavior.

Each time a bank's subordinated debt matured, requiring it to issue new debt to meet the 5% standard, the bank would be subjected to a market judgment of its riskiness. The higher interest rate a bank considered to be high risk would have to pay would create an incentive to avoid excessively risky behavior. Thus, a market assessment of risk and penalty for excessive risk would replace the FDIC judgment necessary under a risk-based premium structure.

Make Debt Redeemable

What kind of maturity structure should this subordinated debt have? If it were all short-term, the investor might not have sufficient incentive to examine the bank carefully, since he could withdraw his funds quickly at any sign of difficulty. If it were all long-term, the bank might ignore the concerns of debt-holders for significant periods of time.

One possible solution to this dilemma would be to require intermediate term debt with staggered maturities, which would yield frequent market tests of the bank's status[7]. An even better approach would be to require that the majority of a bank's subordinated debt be of fairly long maturity (perhaps more than three years) at all times, but that all this debt be continuously redeemable at short notice perhaps ninety days)[18]. The long maturities would assure that investors were making a substantial commitment to the bank while the redeemability feature would subject the bank to continuous monitoring. The redeemability feature would have to carry some penalty (perhaps loss of interest between application and actual payout ninety days in the future) to discourage frivolous redemptions. Of course, a bank might well want to issue subordinated debt with an adjustable interest rate in order to avoid experiencing redemptions every time market rates rose.

Who Would Buy Debt?

What types of investors would be interested in buying subordinated debt? The broadest answer is that all investors in both the money and capital markets would be potential purchasers, but there are narrower groups which might well have a special interest in these securities. The first possibility is the stockholders of each bank. With their special knowledge of the bank, they might want to commit additional funds in a form less risky than additional stock purchases but more risky than deposits. While there might be some concern that such stockholders would continue to support high-risk activities, their self-interest would lead them to put greater emphasis on safety as the proportion of their total investment taking the form of debt increased.

A second group with possible special interest would be the depositors of a bank. In particular, relatively large depositors who were less risk averse than average and also considered themselves well-informed about the bank's financial condition might find these securities attractive. Also, with banks across the country issuing subordinated debt, mutual funds specializing in this form of investment would probably develop rather quickly[7].

Bank issuance of subordinated debt actually would result in the creation of a new type of account equivalent to a deposit (which is, after all, a debt of the bank to the deposit holder), but not insured by the FDIC. Of course, the FDIC would have to require that this lack of insurance be stated prominently on each subordinated debt security.

Would the Market Function Efficiently?

One criticism of the subordinated debt concept is that substantial weaknesses would exist in the market for such debt. One weakness is that the amount outstanding for a single bank, especially a small bank, would be so limited that a secondary market would be very thin if it existed at all [1]. This is a key reason why the redeemability provision is crucial to this proposal. Even if its debt were not being traded actively, each bank would be subject to the continual scrutiny of its subordinated debt holders. The redeemability provision actually would be superior to the existence of a secondary market in restraining bank risk-taking because the bank would feel the direct impact of redemption rather than simply seeing its securities decline in value on the secondary market. Thus, well-developed secondary markets for subordinated debt are not essential to the effectiveness of this proposal.

A second weakness, according to critics, is that investors in subordinated debt would be acting on the basis of very limited information and thus would find it very difficult to assess risk accurately. Again, this might be especially true for small banks. In responding to this argument, it is important to remember that the purchasers of subordinated debt would be voluntarily choosing these investments. By their purchase they would be indicating their confidence in their ability to evaluate the soundness of the issuing bank. If their judgment were wrong, they would bear the financial consequences. While such investors obviously could not perfectly assess the financial condition of each and every bank, the same is true of investors in all other areas of the economy. The relevant question is whether thousands of individual investors risking their own capital generally would be able to make better assessments of individual bank soundness than the FDIC bureaucracy. Surely a reasonable presumption is that market forces would be superior.

Possible Problems or Modifications

Other questions about this proposal need to be considered. One such question concerns the danger of excessively frequent calls for redemption by subordinated debt holders. Perhaps some such investors might be unreasonably sensitive to new information and have a tendency to call for redemptions after every piece of negative economic news. If this was thought likely, banks might be allowed to impose a modest penalty on debt holders demanding redemption[18]. Sacrifice of interest for the ninety days between application for redemption and actual pay out has already been suggested. Another possibility is that the debt might be priced slightly above par and redeemable only at par. Such choices would seem best left to the individual bank rather than imposed by the FDIC. After all, the greater the penalty on redemptions, the higher the interest rate a bank will have to pay to attract debt purchasers.

Another problem, suggested earlier, concerns purchase of subordinated debt by stockholders. If it was felt that an independent group of debt holders was preferable, stockholders might be banned from purchase of any or more than a certain percentage of subordinated debt.

Another question concerns small banks that might have difficulties selling subordinated debt. Rather than exempting small banks, it would be preferable to set up an option available to all banks. Perhaps any bank should be allowed to choose 10% equity capital rather than the 5% equity and 5% debt combination, with the banks making this choice subject to a somewhat higher deposit insurance premium because of the lack of debt holders scrutinizing bank soundness. This would provide an objective basis for a two step premium structure for the FDIC instead of the cuffent level premium structure. Any bank failing to meet the 10% total capital standard could be given a grace period to meet the standard and avoid being closed.

A final question is whether there might be a general panic among subordinated debt holders throughout the banking system. The possibility should not be dismissed out of hand, but the danger seems manageable for the following reasons: the debt holders would be better informed than the typical depositor, and thus more likely to react rationally rather than emotionally; they would have to wait ninety days for redemption, providing policy-makers time to prepare for difficulties; and the run would be limited to the amount of subordinated debt, which would be only about 5% of bank assets. Thus, a panic could create significant difficulties but could hardly result in a collapse of the banking system.

Summary and Conclusion

Reform of federal deposit insurance is clearly necessary. Abolishing the FDIC would be very questionable economically and is, in any case, politically impossible. A lowering of the insured deposit level or introduction of co-insurance would result in greater depositor surveillance of banks but also increase the danger of panic. Risk-based premiums appear to be an attractive solution but imply an extremely powerful FDIC exempt from any market test of its judgment of bank risk. What is needed is a reform that relies on market pressures encouraging conservative bank operations rather than bureaucratic evaluation of bank risk. Requiring banks to issue redeemable subordinated debt is the most promising proposal for providing such market pressures. A combination of this subordinated debt proposal with federal insurance of all bank deposits offers the best program for both restraining bank risk and preventing depositor panic, thereby solving the deposit insurance problem.

References

[1.] Baer, Herbert. "Private Prices, Public Insurance." Chicago Economic Perspectives, Federal Reserve Bank of Chicago, September-October, 1985, pp. 45-57. [2.] Boyd, John H., and Arthur J. Roinick. "A Case for Reforming Deposit Insurance." 1988 Annual Report, Federal Reserve Bank of Minneapolis, January, 1989. [3.] Campbell, Tim S. and David Glenn. "Deposit Insurance in a Deregulate,d Environment." Journal of Finance, 39, 3 (July, 1984) pp. 775-785. [4.] Duke, Paul Jr. "Deposit-insurance System That is out of Control Has Policy Makers Seeking Ways to Restrain it." Wall Street Journal, 30 August 1989, p. A 1 2. [5.] England, Catherine. "Federal Deposit Insurance Source of Savings and Loan Crisis." Cato Policy Report, 11, 2 (March/April, 1989) pp. 1,10-12. [6.] England, Catherine. "Private Deposit Insurance: Stabilizing the Banking System." Cato Policy Analysis, Cato Institute, Washington, D.C., June 21, 1985. [7.] Evanoff, Douglas D. Subordinated Debt: The Overlooked Solution for Banking," Chicago Fed Letter, 45 (May, 1991) pp. 1-3. [8.] Field, William. "The Case Against Private Deposit Insurance." Manhattan College Journal of Business, 16, 1 (1987) pp. 7-1 0. [9.] Field, William. "The Case for Insuring All Bank Deposits." Akron Business and Economic Review, 19, 1 (Spring, 1988) pp. 30-40. [10.] Glassner, David. "Abolish Deposit Insurance." Wall Street Journal, 5 May 1989, p. A 1 4. [11.] Horvitz, Paul M. "Comment on Campbell and Glenn." Journal of Finance, 39,3 July, 1984) pp. 785-787. [12.] Horvitz, Paul M. "The Case Against Risk-related Deposit Insurance Premiums." Housing Finance Review, 2,3 July, 1983) pp. 253-263. [13.] Kareken, John H. "Deposit Insurance Reform or Deregulation is the Cart, not the Horse." Quarterly Review, Federal Reserve Bank of Minneapolis, (Spring, 1983), pp. 1-9. [14.] Koehn, Michael and Anthony M. Santomero. "Regulation of Bank Capital and Portfolio Risk." Journal of Finance, 35,5 December, 1980) pp. 1235-1244. [15.] Lam, Chun H., and Andrew H. Chen. "Joint Effects of Interest Rate Deregulation and Capital Requirements on Optimal Bank Portfolio Adjustments." Journal of Finance, 40,2 (June, 1985) pp. 563-75. [16.] Short, Eugenie and Gerald P. O'Driscoll. "Deposit Insurance and Financial Stability." Business Forum, 8,3 (Summer, 1983) pp. 10-13. [17.] Stein, Herbert (ed). "Deposit Insurance in an Era of Change." The AEI Economist, February, 1988) pp. 1-8. [18.] Wall, Larry D. "A Plan for Reducing Future Deposit Insurance Losses: Puttable Subordinated Debt." Economic Review; Federal Reserve Bank of Atlanta, July-august, 1989) pp. 2-17. [19.] Wall, Larry D. "Capital Requirements for Banks," Economic Review, Federal Reserve Bank of Atlanta, March/April, 1989) pp. 14-29.
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Title Annotation:Federal Deposit Insurance Corp.
Author:Field, William
Publication:Review of Business
Date:Dec 22, 1991
Words:2902
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