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Deposit insurance and the unsophisticated investor: FDIC insured?

Congress established the Federal Deposit Insurance Corporation (FDIC) in 1934, following the collapse of the banking system during the Great Depression. A major objective of deposit insurance is to enhance the stability of the banking system by preventing runs on banks. Although widespread bank panics have not occurred since 1933, more banks failed in the mid-1980s than at any time since the 1930s.|1~ This coupled with the scandalous problems in the savings and loan industry has focused attention on the structure of deposit insurance.

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), established two new deposit insurance funds replacing FSLIC with SAIF (Savings Association Insurance Fund) and FDIC with BIF (Bank Insurance Fund), with both Funds under the administration of the FDIC. Although bank and thrift insurance premiums have been increased by moderate amounts in early 1991, critics of the current structure advocate more radical changes. They see the present system as one which provides an implicit subsidy to weak (and imprudently managed) depository institutions at the expense of healthy ones; and one which removes the incentive of depositors to scrutinize the soundness of alternative institutions.|2~ Called "moral hazard", both problems trace to the apparent willingness of financial institutions to expose depositors to excessive risks because of the existence of the depository insurance safety net.

Suggested remedies include: requiring financial institutions to maintain greater proportions of their assets in cash, Treasury Bills, and other low risk liquid assets; linking the federal deposit insurance premium directly to the risk associated with the loan portfolio of each institution; shifting all, or a portion of the insurance coverage to private insurers; and increasing the incentive of depositors to demand (and of institutions to follow) prudent investment strategies.|3~ All of these are subject to debate. For example, backstopping deposit insurance through private insurers rather than the Treasury, as noted by researcher Lawrence White simply moves the question of safety and stability one step back (who protects the private insurers?).|4~ This article, however, focuses on the fourth remedy above, shifting the responsibility for security of deposits to the depositor. How would this be done? Should this be done? What are the consequences?

The Problem of Co-Insurance

Co-insurance is the idea of reducing deposit insurance below 100 percent. In its broadest definition, it means that deposits would be insured at less than full value. Thus, all the following suggested remedies would involve co-insurance: lowering the $100,000 deposit protection to, say $40,000 (as recommended in 1988 by the Council of Economic Advisors); applying insurance coverage to each depositor, rather than to each deposit; or limiting coverage to a portion, say 80 percent, of the total amount deposited.

It is argued by proponents of such policies, that reductions in the size and scope of the federal safety net--coupled with the adoption of market-value accounting (as opposed to book-value accounting currently used to value bank assets)--will encourage and allow bank depositors to evaluate the risks of alternative institutions.|5~

While little doubt exists that the series of increases in deposit insurance removed any incentive of the depositors to question excessive risk taking by their banks, we believe that co-insurance is not the solution. We argue that: the typical depositor is not a sophisticated investor; politically, the current insurance safety net is viewed as an entitlement by society; and disintermediation--the likely consequence of "sophisticated" depositor actions--is not efficient and not in the best interest of the economy.

Are Depositors Sophisticated Investors?

To argue that depositors are sophisticated enough to analyze bank statements and judge the quality of bank assets is tantamount to ignoring the failure of "expert" thrift examiners to thwart the savings and loan chaos. What bank would give an individual depositor permission to scrutinize its loans? In addition to the problem of correctly estimating the market value of bank assets, the depositor would have to correctly predict the impact of changes in the economic environment on assets. Such occurrences as oil crises, poor agricultural harvests, natural catastrophes, failure of a major employer in town, and others would play havoc with the quality of bank assets. Consider the statement of Robert L. Clarke, the Comptroller of the Currency and chief regulator of 4,200 federally chartered banks, which appeared in a recent Wall Street Journal article on property valuation: "We're not smart enough to tell precisely how much loss there is in a loan, and neither are the bankers".|6~

In the spring of 1990, the Consumer Federation of America, a coalition of 240 consumer groups, sponsored the administration of a consumer test (developed by the Educational Testing Service) to adult shoppers in cities across America. Consumer knowledge on six subject categories, including banking and insurance, were tested.|7~ The average score for the entire test was only 54 percent--54 percent for banking and 53 percent for insurance. In a sub-category of banking, "checking/saving", the score equaled the lowest of any topic score, 50 percent. After reviewing the test's results, Stephen Brobeck, executive director of the Consumer Federation of America coalition, concluded: "Many consumers are not equipped to function competently in the market place".|8~ On specific topics: only 37 percent are aware that annual percentage rate (APR) represents the best indicator of a loan's cost; only 38 percent are aware that, among deposit accounts, a certificate of deposit pays the highest rate; only 39 percent know that, among financial institutions, insurance companies usually charge the lowest loan rates (34 percent did not realize finance companies charge the highest rates); in buying a home, only 30 percent understand the meaning of a point while only 19 percent know the approximate interest charge on a typical mortgage loan; and with regard to insurance, only 21 percent understand the meaning of uninsured motorist coverage.|9~

Based on selected demographics, the survey results report scores less than the overall mean score of 54 percent for blacks and other minority groups (score was 45 percent), for those 60 years old or older (score was 52 percent), and for those with less than four years of high school education (score was 43 percent). Furthermore, females scored less than males (54 percent versus 55 percent). Considering demographic patterns of the U.S. population, these findings are troublesome. For example, as Figure One shows, the population is aging, the proportion of blacks and minorities is growing, and in 1988, nearly half the U.S. population had completed less than 4 years of high school. One of the fastest growing age groups is the 85 years old and above.

Probably the only data available on depositor characteristics by size of deposits are those obtained from the 1983 Survey of Consumer Finances, and noted in the Federal Reserve Bulletin of November 1990.|10~ In that publication, Alan Greenspan reported that between 1.0 and 1.5 percent of U.S. households held, in 1983, deposit balances in excess of $100,000. These account holders were mainly older, retired citizens with most of their financial assets in insured accounts. Further, it is reported that these characteristics of heads of households owning deposits are remarkably stable as the size of deposits declines to $50,000.|11~ These characteristics would seem to reinforce our concern expressed above.

Another example of the lack of sophistication of many investors is found in comments by investors of a popular mutual funds program reported in the Wall Street Journal. The target customers, says a salesperson, is middle America: "You'll make 12.25% on your money. Guaranteed ... I was under the impression you couldn't lose money." Some shareholders say they had no idea they had their money in the riskiest sector of the bond market (junk-bonds).|12~

Is the Insurance Safety Net an Entitlement?

Insurance risks may be categorized as "fundamental" or "particular."|13~ Fundamental risks are the result of losses which are impersonal in origin and in consequence. They are caused by malfunctioning of the economic system as a whole, such as a recession, inflation, technological unemployment, foreign competition, changing trends (such as deregulation of banking}, changing customs, etc. As author H.S. Denenberg and others point out in their book on insurance risk, fundamental risks may be catastrophic and thus are not well suited to commercial insurance.|14~ Particular risks arise from losses having their origin in individual events, such as a home electrical fire, an automobile collision, a bank robbery, a bad loan, etc.
 Figure One
 Selected Demographics of U.S. Population
Population Parameter 1960 1970 1980 1990
Age 85 Years or More 6.3% 8.0% 10.3% 11.8%
 60 Years or More 13.2% 14.0% 15.8% 16.8%
 50 Years or More 22.2% - - 52.7%
Age & Gender
 Females Age 60 or More 54.0% 56.7% 57.9% 58.3%
Race White 88.6% 87.6% 85.9% 84.3%
 Black 10.6% 11.1% 11.8% 12.3%
 Other 0.9% 1.3% 2.3% 3.4%
 Age 65 or More (less than
 four years high school) - 71.1% 59.3% 46.2%
Households (in millions) - 64.4 80.8 91.1
Source: Statistical Abstract of United States, U.S. Department
of Commerce, Bureau of the Budget, 1990.

It would seem that a significant amount of financial institution failure in recent years involves fundamental risks. Examples of these fundamental risks include loans made to finance commercial developments which have gone bad as property values declined, loans made to energy-related industries that turned bad when oil prices tumbled in the 1980s, farm loans which soured when agricultural prices and land prices fell in the 1980s, and the unpaid loans to Third World nations made difficult by the oil crises in the 1970s. Historically, significant depreciations in the market value of assets used to collateralize bank loans have weakened the financial strength of financial institutions.

We argue here that individual banks are not "particularly" responsible nor, in the absence of federal deposit insurance, affordably resistant to such broad economic events. Further, just as society today expects unemployment assistance in times of economic downturns, society would also expect their banked deposits to be similarly protected. By way of IRAs, Tax Deferred Annuities, etc., the government has followed a policy of encouraging families to increase their savings in order to supplement their retirement income. It has long been recognized that Social Security benefits must be supplemented to reach a reasonable standard of living. This will be even more significant for baby boomers. In a Business Week review of the Frank Levy and Richard Michel book, The Economic Future of American Families, the point is made that baby boomers own fewer assets than their parents at similar points in their lives and those in the 35 to 44 age group are little more than half as wealthy as their parents' generation.|15~ As data from the 1983 Survey of Consumer Finances suggests, unsophisticated investors are comfortable using certificates of deposit as the major vehicle to invest their life savings. Many groups such as farmers, small businessmen, and other individuals who have not enjoyed high incomes over their working years have been able to accumulate financial assets by selling their businesses, farms, and homes as well as saving a nominal amount on a regular basis over a long period of time.

An individual saving $2000 per year will accumulate $188,921 in thirty years when these savings are continuously invested at an annual rate of seven percent. This sum would be sufficient to provide a family $13,224 per year in annual interest at an APR of 7 percent. It would also provide $16,211 per year for 25 years for a family investing in certificates of deposit at an APR of seven percent assuming the principal is used. Therefore, a significant reduction in the amount of deposit insurance available would subject previously frugal groups to fundamental risks during periods of bank failures. This represents a potential source of social cost when one considers that many in these groups will be in retirement.

Having had deposit insurance for over half a century, we suspect it has existence value (to use the term of environmental amenities analysts) to depositors, and it would be viewed as an entitlement. In a recent address to members of the Southern Economic Association, Kerry Smith illustrated the idea of existence value saying: "We assume the Grand Canyon will 'be there' ... In many cases ... people feel that they are entitled to the conditions they have become accustomed to having. A change in these circumstances may be perceived as an alteration in a nonmonetary endowment."|16~ Although it is not known whether the benefits of this entitlement outweigh the current taxpayer bail-out cost, one might argue that costs of the current crisis are abnormal and largely the result of the failure of bank regulators to discover weak financial institutions and to act decisively. If government attempts to lower deposit insurance levels, it should not be surprised to meet significant public resistance to a loss of this perceived entitlement.... whether fundamental or particular (such as mismanaged banking).

Disintermediation and Co-Insurance

Author J.B. Thompson and others argue that co-insurance would provide incentives for bank and thrift depositors to withdraw funds from problem institutions and invest elsewhere, such as in U.S. Treasury bills which, they say, are close substitutes for insured deposits.|17~ In essence sophisticated depositors, likely those with significant funds in the institution, say, in excess of $10,000, would force the institutions to practice sound decision making or face the loss of deposits. We argue however that coinsurance, given the difficulty of bank depositors to adequately evaluate bank statements, would move these funds from banks to safe alternatives.

Between 1980 and 1984, uninsured deposits in FSLIC thrifts increased from 3.2 percent of total industry assets to 6.2 percent.|18~ Federal Reserve Chairman Alan Greenspan, in a recent statement to Congress on banking problems, noted that runs of uninsured deposits from banks under stress have become commonplace. Greenspan adds: "Nevertheless, the clear response pattern of uninsured depositors to protect themselves by withdrawing their deposits from a bank under pressure raises the very real risk that in a stressful environment the flight to quality could precipitate wider financial market and payment distortions ... Thus while deposits in excess of insurance limits should not be protected by the safety net at any bank, reforms designed to rely mainly on increased market discipline by uninsured depositors raise serious stability concerns."|19~ In its "The Economy in Perspective," the Federal Reserve Bank of Cleveland's Economic Trends reports that the recent restructuring of the savings and loan industry is believed to be responsible for the weak deposit growth in savings deposits, small time deposits, and money market deposit accounts since March of 1990. Although banks acquired some of these funds following the drop off of such deposits at thrifts, the extra deposits have only partially offset the contraction at thrifts.|20~

Disintermediation would not only reduce bank and thrift deposits, but would likely cost the institution its most sophisticated depositors thus allowing, possibly encouraging, the institution to make more risky loans and even offer greater interest to attract new deposits. Further, as such withdrawals grow in number--say in response to "fundamental" risk--disintermediation results in lower cost borrowing by government (as the demand for Treasury instruments increase) and higher cost borrowing for banks and thrifts. The impact of lower cost Treasury borrowing might encourage greater, possibly wasteful, government spending.

Returns to depositor investors are also reduced because of increased transactions costs. In another statement to Congress, Greenspan said "...the benefits of lowering deposit insurance coverage at this time must be balanced against the readjustment and unwinding costs imposed on individuals, institutions, and markets that have adopted the $100,000 deposit insurance level."|21~ He added " is clear that the higher level of protection has been in place long enough to be fully capitalized in the market value of depository institutions and embedded in the financial decisions of households."|22~ This loss must be evaluated in terms of its possible dampening effect on the incentive to save.

Reforms are the Key

A consensus of the causes of the thrift industry crisis is mirrored in an article by R.D. Brumbaugh and Andrew S. Carron in which they attribute the cause to be the "moral hazard" inherent in the deposit insurance system. Yet, in the same article the authors identify the mechanism of deposit institution regulation as: capital requirements to induce risk-adverse behavior and to act as a buffer against capital erosion, regulations to discourage excessively risky conduct, examination and supervision to monitor compliance with regulations, and finally enforcement.|23~ The authors provide information which would support a conclusion that thrift regulators were just as responsible for the crisis by allowing a breakdown in this mechanism. For one thing, regulatory accounting principles (RAP) were applied as opposed to generally accepted accounting principles (GAAP). Using RAP, the number of insolvent thrifts was 80 in 1982 and 251 in 1986. Under GAAP, the numbers were 201 and 468 respectively.|24~ They also state, "failure to close insolvent thrifts created incentives to take excessive risks" by the thrifts.|25~

In a more recent article, these authors conclude that lowering the ceiling on deposit insurance "can be largely mooted by effective enforcement of capital standards."|26~ In Alan Greenspan's statement before the Committee on Banking, Finance and Urban Affairs are, we believe, the most promising reform actions, namely: higher capital requirements and prompt corrective action.|27~ We agree with the arguments supporting higher capital requirements for banks as well as taking prompt corrective action in closing insolvent banks. An increase in deposit insurance premiums may also be needed. However, a significant reduction in the maximum amount of deposit coverage, we believe, will be detrimental to our economy. Many citizens who use certificates of deposit as a source of supplemental income to social security benefits will be forced to absorb fundamental risks over which they have no control. We concede that partial elimination of deposit insurance would shift a portion of the risk to the shoulders of depositors. However, given the difficulty of experts to judge the financial condition of intermediaries coupled with the low level of financial sophistication of the typical investor, risk sharing by depositors would seem unfair and an inefficient way to assume prudent investments by banks and thrifts. In the future, depositor sophistication on financial matters can hopefully be improved by economic education.

Meanwhile, maintaining the current level of deposit insurance will not be without cost. We support provisions in the banking reform bills now before Congress, of Senator Riegle and the U.S. Treasury, which would establish a riskbased deposit premium assessment. This would link the cost of insurance to the risk a bank poses to the insurance fund. Both bills call for limiting depositor insurance coverage to $100,000 per individual per institution plus $100,000 for retirement savings. The bills also call for eliminating coverage for all or most passthrough or brokered accounts.|28~

DONALD SHADOAN Ph.D., is a professor of economics at Eastern Kentucky University in Richmond, Kentucky.

ROBERT SHARP, Ph.D., is a professor of economics at Eastern Kentucky University. Drs. Sharp and Shadoan wrote, "Decision-Makers Take Heed: Accountants and Economists Must Join Hands" which was published in the Summer 1990 issue of BUSINESS FORUM.

1 Dolan, E. and Lindsey, D., Economics, Dryden Press, 1988, 303.

2 Gwartney, J.D. and Studenmund, A.H., Economics, Harcourt, Brace Jovanovich Publishers, 1990, 287.

Nakamura, L.I., "Closing Troubled Financial Institutions," in Robert W. Kolb, ed., Financial Institutions and Markets, Kolb Publishing Co., Miami, Florida, 1991, 228-233.

Thompson, J.B. and Todd, W.F., "Rethinking and Living With the Limits of Bank Regulation," The Cato Journal, Vol. 9 (Winter 1990-forthcoming, 240-245.

3 Ibid.

4 White, L.J., "The Reform of Federal Deposit Insurance", The Journal of Economic Perspectives, Vol. 3, No. 4, Fall 1989, 11-29.

5 Thompson, J.B., "Using Market Incentives to Reform Bank Regulation and Federal Deposit Insurance", in Robert W. Kolb, ed., Financial institutions and Markets, Kolb Publishing Co., Miami, Florida, 1991, 239-251.

6 Hilder, David B. "Property Problem: As Loans Sour, Banks and Regulators Argue How to Value Realty," The Wall Street Journal, December 13, 1990, 1.

7 U.S. Consumer Knowledge: The Results of a Nationwide Test, a report sponsored by the Consumer Federation of America, Washington, D.C., 1990, 1-16.

8 Scanlan, Christopher (Knight-Ridder News Service), "We Buy More But Know Little About Process," Lexington Herald-Leader, September 25, 1990, A3.

9 U.S. Consumer Knowledge: The Results of a Nationwide Test, 6.

10 Greenspan, Alan, "Statement to the Committee on banking, Finance and Urban Affairs, U.S. House of Representatives, September 13, 1990," Federal Reserve Bulletin, November 1990, 919.

11 Ibid.

12 Clements, Jonathan, "First Investors Funds Teach Clients Lessons In Junk-Bond Risks," The Wall Street Journal, September 13, 1990, 1A.

13 Denenberg, H.S., Eilers, R.D. Melone, J.J., and Zelten, R.A., Risk and Insurance, Second Edition, Prentice Hall, Inc.,1974, 6-7.

14 Ibid.

15 Koretz, Gene, "Downward Mobility Is Stalking The Baby Boomers," Business Week, January 28, 1991, 22.

16 Smith, Kerry V., "Can We Measure the Economic Value of Environmental Amenities?," Southern Economic Journal, April 1990, 875.

17 Thompson, J.B., "Using Market Incentives," 239-251.

18 Barth, J.R., et al, "Insolvency and Risk Taking in the Thrift Industry: Implications for the Future," Contemporary Policy Issues, 3(5) Fall 1985, 1-32.

19 Greenspann, Alan, "Statement to the Committee," 919.

20 "The Economy in Perspective," Economic Trends: Federal Reserve Bank of Cleveland, January, 1991, 4.

21 Ibid, 1025.

22 Greenspan, Alan, "Statement to the Subcommittee on Commerce, Consumer, and Monetary Affairs on the Committee on Government Operations, U.S. House of Representatives, October 3, 1990," Federal Reserve Bulletin, December 1990, 1024-1025.

23 Brumbaugh, R.D. Jr. and Andrew S. Carron, "Thrift Industry Crisis: Causes and Solutions," Brookings Papers On Economic Activity, 1987, (2), 349-377.

24 Ibid, 356.

25 Ibid, 361.

26 Brumbaugh, R.D. Jr., Carron, A.S. and R.E. Litan, "Cleaning Up The Depository Institutions Mess," Brookings Papers On Economic Activity, 1989, (1), 276.

27 Greenspan, Alan, "Statement to the Committee," 923-924.

28 Greenspan, Alan, "Statement to the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, April 23, 1991," Federal Reserve Bulletin, June 1991, 430-445.
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Title Annotation:Federal Deposit Insurance Corp.
Author:Shadoan, Donald; Sharp, Robert
Publication:Business Forum
Date:Sep 22, 1992
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