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Proposed solutions to the FDIC deposit insurance fund.

Executive Summary

The objective of this paper is to update practitioners/instructors on the sustainability of the FDIC's Deposit Insurance Fund (DIF) and provide discussion questions for each section on how to apply this to the classroom environment. One of the consequences of the recent turmoil in the banking industry has been many more banks failing than have in the recent past. An important question facing the FDIC is whether or not it has adequate resources to continue the purchase and assumption of these failing banks.

The Federal Deposit Insurance Reform Act of 2005 created the DIF, which the FDIC uses to manage failures of insured banks, and this fund has been depleted. One of the conditions of sustainability is to better analyze the risk of a potential bank failure, and another is to collect adequate premiums (or fees) needed for the expected value of future failures. These solutions will increase confidence and stability in the banking industry, but at a cost of more financial pressure on current successful banks.

Introduction

The number of bank failures has skyrocketed in recent years, putting extreme pressure on the FDIC's Deposit Insurance Fund (DIF). In 2009, there were 140 FDIC Insured banks that failed; in 2010, 157 banks failed. By comparison, in the years leading up to the recession of 2008/2009 only three banks had failed, as shown in Exhibit 1. Even though the FDIC has a $500 billion line of credit with the U.S. Treasury, the DIF faces even more pressure going forward as the number of bank failures is likely to continue. This paper provides recent data and issues facing the FDIC and the DIF, to provide practitioners and instructors with updated information, and it offers discussion questions that can be readily applied in their courses.

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Problems with the Deposit Insurance Fund

The Federal Deposit Reform Act of 2005 has set many of the new restrictions and limits for the FDIC moving forward, even though this has brought extreme pressure on the FDIC'S ability to continue to fund the purchase and assumption of failing banks in the U.S. The FDIC collects assessments from insured financial institutions in order to fund the DIF. These rates are expressed in cents per one hundred dollars of assessable deposits, and are known as basis points (FDIC, 2010a). In addition to charging banks according to the amount of assessable deposits held, the FDIC also charges insured financial institutions different rates according to a broad measure of risk. Insured banks face higher rates from the FDIC when the likelihood of a failure increases (FDIC, 2010b).

The FDIC uses two measures of risk in order to separate insured financial institutions into different categories of risk labeled I - IV. The capital group assignment is the first measure employed by the FDIC. Insured banks are separated into the categories of well capitalized, adequately capitalized, and undercapitalized based on their capital ratio. Banks are then assessed according to the individual bank's CAMELS safety rating system in order to characterize other relevant risk information regarding the financial institution (FDIC, 2010a). The CAMELS rating system assesses banks according to capital, assets, management, earnings, liquidity, and sensitivity to market risk. Banks are assigned a rating of 1 - 5 for each category. A score of 1 indicates a strong rating while a score of 5 indicates a serious problem. The individual scores are combined into a composite rating of 1 - 5 (Board of Governors of the Federal Reserve System, 2010).

The FDIC uses these scores in conjunction with the capital group assignment to determine the rate for an individual insured bank. Additionally, the FDIC includes long term debt issuer ratings for large firms. The FDIC may impose additional rates on riskier large firms of up to 1 basis point (FDIC, 2010c). The current FDIC assessment rates for insured banks are displayed in Exhibit 2.
Exhibit 2: Current FDIC Assessment Rates

                        Risk      Risk            Risk       Risk
                     Category I  Category II  Category III  Category VI

Initial Base             12-16          22          32               45
Assessment Rate

Unsecured Debt         -5 to 0     -5 to 0     -5 to 0          -5 to 0
Adjustment (added)

Secured Liability       0 to 8     0 to 11     0 to 16        0 to 22.5
Adjustment (added)

Brokered Deposit           N/A     0 to 10     0 to 10          0 to 10
Adjustment (added)

Total Base           7 to 24.0  17 to 43.0  27 to 58.0       40 to 77.5
Assessment Rate

Risk Category I:     Well Capitalized with generally a CAMELS
                     composite of 1 or 2

Risk Category II:    Well Capitalized with generally a CAMELS
                     composite of 3; or Adequately Capitalized with
                     generally a CAMELS composite of 1, 2, or 3

Risk Category III:   Well or Adequately Capitalized with generally a
                     CAMELS composite of 4 or 5; or Under Capitalized
                     with generally a CAMELS composite of 1, 2, or 3

Risk Category IV:    Under Capitalized with generally a CAMELS
                     composite of 4 or 5

Source: FDIC


In order to help ensure that the DIF has the proper funding to assist in the handling of failed banks, a set of guidelines regarding the reserves held in the DIF against insured funds was outlined in the Federal Deposit Insurance Reform Act of 2005. The Reform Act allows the FDIC board of directors to set the designated reserve ratio, the ratio of funds held in the DIF to insured funds, at a rate between 1.15% and 1.5%. However, the Reform Act does specify that the FDIC board of directors is required to provide a plan to restore the DIF to at least a reserve ratio of 1.15% within a five year timeline if the reserve ratio falls below 1.15% or is in danger of falling below 1.15% in a span of six months (1932, 109th Congress).

Despite an increase in the rate at which insured banks are assessed and a special assessment requiring insured banks to prepay their estimated assessments through the end of 2012, the DIF balance remained negative at the beginning of 2010 (FDIC, 2009). While the current methods employed to assess the capital adequacy and risk of insured banks does help the FDIC collect higher rates from banks that are more likely to fail, they have proven inadequate in the wake of the recent financial crisis.

Discussion Questions:

* What are the complications in analyzing the risk of bank failures for the FDIC?

* How are other institutions or items analyzed in terms of their risk: i.e. Automobiles, Life, Health, etc?

* Is it reasonable to collect assessments that are pre-paid, when risk is continually changing?

* Currently, the FDIC is using Long Term Debt Ratings as a basis to assess risk. Does this seem reasonable, considering the extreme short-term fluctuations we have experienced?

Proposed Solutions to the Deposit Insurance Fund

There are several options available to the FDIC for funding the DIF. Campbell et al. (Campbell, LaBrosse, and Mayes, 2009) note that deposit insurance funds can be financed prior to the disbursement of the funds (ex ante), after the funds are needed (ex post), or a through a hybrid system that collects funds before they are needed but allows for special assessments after the fact. A study by the International Association of Deposit Insurers (IADI) finds that over four-fifths of countries employ a collection system that uses ex ante collections or a hybrid method (IADI, 2008). Ex ante funding systems have an advantage over ex post systems as they help provide confidence in the system by maintaining a fund that can be used to assist in the handling of failed banks. Additionally, an ex ante system collects funds from all banks instead of just relying on healthy banks once a problem develops, and spreads the costs of insurance over time instead of collecting fees at a time when the banking industry is fragile (Campbell, LaBrosse, and Mayes, 2009). However, the collected funds may not be enough to cover all losses during a period of high bank failure rates. While the FDIC employs ex ante collections that are risk adjusted to maintain a DIF, it was unable to cover the losses in 2009.

In November, 2010 the FDIC released a proposal to revise assessment rates for insured banks, employ a system that better evaluates the future risk of large insured institutions, and attempt to provide a more accurate estimate of the impact of failed insured banks on the DIF. One of the primary goals of the FDIC is to be able to gauge changes in the risk levels of large banks accurately and promptly. While the FDIC plans to continue employing capital ratios and CAMELS ratings, the FDIC plans to use a variety of available statistics to help evaluate the risk level of an individual insured large bank.

Additionally, two different scorecards are proposed to combine all relevant rating information for large banks. Most insured large banks would be assessed using a standard scorecard, while the FDIC would utilize a special scorecard for large banks with significantly complex operations.

The FDIC hopes that the new assessment system will allow it to collect adequate funds to stabilize the DIF by accurately measuring each bank's long-run risk. In theory, this would permit the FDIC to collect appropriate rates during periods of economic expansion instead of relying on large rate increases in times of economic decline. The FDIC will ultimately consider other measures, including meetings with industry leaders and regulators to discuss the amended system (FDIC, 2010b).

Given the inherently risky nature of fractional reserve banking, the FDIC is charged with an extremely difficult task in creating a sustainable Deposit Insurance Fund. The new FDIC proposal regarding bank assessment, outlined above, is a vast improvement over the old assessment system, allowing the FDIC to evaluate individual banks more accurately in terms of risk. It is critical for the FDIC to use current information to evaluate insured banks, as the risk each individual banks faces changes constantly.

Discussion Questions:

* What are the benefits and drawbacks of collecting funds ex-ante vs. ex-post? For example, collecting ex-ante has inherently more risk in whether or not the collected amount in assessments is correct, while ex-post could put more pressure on successful banks - which brings up equity issues.

* Are the costs of maintaining a completely updated system for the banks worth the potential information the FDIC can receive and make decisions upon?

* The regulatory costs of new regulations can be a large burden on the banks and the analysts in the FDIC. Will they be able to synthesize all the information quickly enough to respond to potential crisis?

Conclusion

The proposed solutions that the FDIC has proposed can help improve its solvency. However, given the extreme pressure the FDIC is currently under in terms of its ability to pay for failing banks, any solution to the current problem requires that the FDIC be better funded. The question is how should it fund its insurance fund?

An initial step that the FDIC has implemented was a three-year prepayment of required fees. This measure increases the amount of immediate cash-flow into the DIF; however, it does nothing to increase the FDIC's ability to better predict the probability of a bank failure.

The two parts vital to an insurance co (public or private) rests upon its ability to accurately assess the risk and probability of an insured loss, and to collect enough premiums to cover those insured losses. Therefore, the only solution that is necessary for the FDIC to remain solvent is to appropriately assess the risk of bank failures, and to ensure that the premiums it collects (or pre-collects) are adequate to cover the insured losses.

Since the DIF is currently out of available funds, changes to its system are obviously necessary, but the question that remains is whether the proposed solutions will provide an adequate level of funding to the DIF, and whether it can accurately predict bank failures. When and if these proposals are accepted and implemented by the Federal Reserve, more analysis will be necessary to determine if these measures are adequate for the FDIC facing a similar economic decline in the future.

Discussion Questions:

* Are there alternative solutions that the FDIC should consider?

* It could work more closely with private insurance companies, in order to better assess risk.

* In light of the World financial crisis, how have other central banks found solutions to similar problems?

* Multi-national talks among officials to find a unified response and solution.

* Have students work on a case study for a particular country.

The number of bank failures has skyrocketed in recent years, putting extreme pressure on the FDIC's Deposit Insurance Fund.

The FDIC plans to a variety of available statistics to help evaluate the risk level of an individual insured large bank.

For the FDIC to remain solvent [it must] assess the risk of bank failures, and ... ensure that the premiums it collects ... are adequate to cover the insured losses.

References

Board of Governors of the Federal Reserve System. 2010. Bank Rating System. Available from: http://www.fedpartnership.gov/bank-life-cycle/topic-index/bank-rating-system.com.

Campbell, Andrew, J. R. LaBrosse, D. G. Mayes, and D. Singh. 2009. A New Standard for Deposit Insurance and Government Guarantees after the Crisis. Journal of Financial Regulation and Compliance, Vol. 17, No. 3, 210 - 239.

FDIC. 2009. 12 CFR Part 327: Assessments. Fee/era/Register, Volume 74, No. 220. Available from: http://www.fdic.gov/regulations/laws/federal/2009/09finalAD51Nov17.pdf.

FDIC. 2010a. FDIC Assessment Rates. Available from: http://www.fdic.gov/deposit/insurance/assessments/proposed.html

FDIC. 2010b. 12 CFR Part 327: Assessments; Proposed Rule. Federal Register, Volume 75, No. 84. Available from: http://www.fdic.gov/deposit/insurance/2010-10161.pdf.

FDIC. 2010c. Risk Categories and Risk-Based Assessment Rates. Available from: http://www.fdic.gov/deposit/insurance/assessments/risk.html

Federal Deposit Insurance Reform Act of 2005. [section] 1932, 109th Congress.

IADI. 2008. Core principles and effective practices, IADI, Basel, 29 February, available at: www.iadi.org/IADI%20Core%t20Principles/FSF520-%IADI%20Core%principles%20final%029%20Feb2008.pdf

Michael T. Tasto, Southern New Hampshire University

m.tasto@snhu.edu

Gregory M. Randolph, Southern New Hampshire University

g.randolph@snhu.edu
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Title Annotation:Federal Deposit Insurance Corporation
Author:Tasto, Michael T.; Randolph, Gregory M.
Publication:Review of Business
Geographic Code:1USA
Date:Dec 22, 2011
Words:2352
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