BUFN 722

1. BUFN 722 ch-19 Deposit Insurance and Other Liability Guarantees BUFN722- Financial Institutions

2. Overview • The focus of this chapter is the mechanisms designed to protect FIs from liquidity crises. • Federal Deposit Insurance Corporation • Securities Investors Protection Corporation • Pension Benefit Guaranty Corporation • Deposit Insurance schemes in other countries BUFN722- Financial Institutions

3. Background issues and History • Bank runs can serve a useful purpose • Contagion has more serious consequences • FDIC created 1933 • Securities Investors Protection Corporation (SIPC) 1970. • Pension Benefit Guaranty Corporation (PBGC) created 1974. BUFN722- Financial Institutions

4. FDIC • FDIC created in wake of banking panics. • 10,000 failed commercial banks. • Original coverage: $2,500. Now $100,000. • Between 1945-1980: FDIC worked. Failures accelerated in 1980. BUFN722- Financial Institutions

5. FDIC (continued) • In 1991: Borrowed $30 billion from Treasury and still generated a $7 billion deficit. • FDIC Improvement Act 1991. • The funds’ reserves now stand at a record high with reserves exceeding 1.3% of insured deposits. • Caveat: Superior Bank of Illinois BUFN722- Financial Institutions

6. FSLIC • FSLIC covered S&Ls. Other thrifts often chose FDIC coverage. • High levels of failed thrifts between 1980-88 generated losses of $42.3 billion. From 1989-92 additional 734 failures . Cost: $78 billion. • Result: FSLIC estimated net worth negative $40 to $80 billion. • Policy of capital forbearance. BUFN722- Financial Institutions

7. Demise of FSLIC • Forbearance consequences: • Accumulation of greater losses. • Financial Institutions Reform, Recovery and Enforcement Act, (FIRREA) 1989. • Management transferred to FDIC. • Savings bank insurance fund became Savings Association Insurance Fund (SAIF). Managed separately from Bank Insurance Fund (BIF). • Resolution Trust Corporation (ended 1995) • Estimated cost of $90.1 billion BUFN722- Financial Institutions

8. Causes of depository fund insolvency • Financial Environment: • Rise in interest rates. • Collapse in oil, real estate and commodity prices. • Increased competition. BUFN722- Financial Institutions

9. Depository Fund Insolvency (continued) • Moral Hazard: • Deposit insurance encouraged underpricing of risk and reduced depositor discipline. • Premiums not linked to risk. • Role of implicit premiums • Inadequate monitoring. • Prompt Corrective Action (1992). BUFN722- Financial Institutions

10. Trade-off between moral hazard and bank run risk • Insurance was not actuarially fairly priced. • Reduced incentive for runs. • Increased moral hazard. M Run Risk (R) BUFN722- Financial Institutions

11. Controlling DI Risk Taking • Stockholder discipline • Practical problems in applying option pricing to insurance premiums • FDIC adopted risk-based premiums 1993 BUFN722- Financial Institutions

12. Risk-Based Deposit Insurance • Based on: • Categories and concentrations of assets • Categories and concentrations of liabilities • insured, uninsured, contingent, noncontingent • Other factors that affect probability of loss • Deposit insurer’s revenue needs. BUFN722- Financial Institutions

13. Increased capital requirements, stricter closure rules. • Require lower leverage • Impose stricter DI closure rules • Controls forbearance • Five capital zones BUFN722- Financial Institutions

14. Increased capital requirements • Proposal • Role of subordinate debt • Improve market discipline • Ease monitoring • Increase transparency and improve disclosure • Increase capital cushion BUFN722- Financial Institutions

15. Depositor Discipline • Insurance cap can be increased by altering structure of deposit funds and by spreading deposits across banks. • Higher interest rates provided incentive to deposit in riskier banks -up to coverage limit. • Limits on brokered deposits. BUFN722- Financial Institutions

16. Depositor Discipline • Proposal to link coverage cap to inflation • FDIC suggests 5-year interval for adjustment • Initial coverage of $200,000 mentioned although this is the subject of current debate • Implicit 100% coverage resulted from too big to fail. BUFN722- Financial Institutions

17. Failure resolution pre-FDICIA • Liquidation (payoff) method unless alternative judged to cost less. • Could be overridden by essentiality provision • 1993 Depositor Protection Legislation • gave lower priority to foreign uninsured depositors and creditors supplying federal funds on the interbank market. • Purchase and assumption method. • Open Assistance. FDIC loans or capital funds to keep large failing bank open. BUFN722- Financial Institutions

18. Failure resolution post-FDICIA • January 1995 FDICIA required least-cost resolution. • Systemic risk exception. • Insured depositor transfer (IDT) or “haircut” method encourages depositor vigilance. BUFN722- Financial Institutions

19. Regulatory discipline • Perception of 2 weaknesses in regulatory practices: • Frequency and thoroughness of examinations • Forbearance shown to weakly capitalized banks pre-1991. BUFN722- Financial Institutions

20. Regulatory discipline (continued) • Capital forbearance: • Prompt Corrective Action. Transition to rules rather than discretion. • Examinations: • improved accounting standards including market valuation of assets and liabilities; annual on-site examination of every bank; independent audits. BUFN722- Financial Institutions

21. Non-U.S. deposit insurance • EC established a single deposit insurance system at end of 1999 • Coverage: 20,000 ECUs. • Co-insurance through deductibles. • Currently, 10 percent. • Japan: Similar system to U.S. • Currently experiencing problems similar to 1980s in the U.S. BUFN722- Financial Institutions

22. Discount Window • Central bank as lender of last resort through discount window. Short-term, non-permanent. • Requires high-quality liquid assets as collateral. • “Need to borrow basis”. • Not permanent support for unsound banks. • Loans to troubled banks limited to no more than 60 days in any 120 day period unless authorized by FDIC and institution’s primary regulator. BUFN722- Financial Institutions

23. Other Guaranty Programs • National Credit Union Administration provides up to $100,000 coverage • Lower risk due to asset diversification • Substantial portion of assets in form of government securities BUFN722- Financial Institutions

24. Other Guaranty Programs • PC and Life Insurance Companies regulated at state level. No federal guaranty fund. • Run and administered by the private insurance companies themselves. • Only NY has permanent guaranty fund. • Definition of small policyholder varies across states from $100,000 to $500,000. • Delays in settling claims against insurance companies. BUFN722- Financial Institutions

25. Other Guaranty Programs • Securities Investor Protection Corporation: • Pro rata shares of liquidated assets. SIPC covers remaining claims up to $500,000 per individual. • SIPC losses have been small but concern has increased. BUFN722- Financial Institutions

26. Pension Benefit Guaranty Corp. • PBGC established in 1974 under Employee Retirement Income Security Act (ERISA). • PBGC experienced deficit of $2.7 billion at end of 1992. Unlike FDIC, it has no monitoring power over insured pension plans. • 1994 Retirement Protection Act phases out premium cap. 1999: record surplus of $5 billion; auditors uncovered serious operational problems. • Risk-based premium scheme. BUFN722- Financial Institutions

27. Pertinent Websites BIS www.bis.org FDIC www.fdic.gov Federal Reserve www.federalreserve.gov U.S. Treasury www.ustreas.gov National Credit Union Admin. www.ncua.org Pension Benefit Guaranty Corp. www.pbgc.gov Sec. Investors Protection Corp. www.sipc.org Web Surf BUFN722- Financial Institutions