Ch 19 Deposit Insurance Overview

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1 Ch 19 Deposit Insurance Overview The focus of this chapter is the mechanisms designed to protect FIs from liquidity crises. Deposit Insurance Funds Securities Investors Protection Corporation Pension Benefit Guaranty Corporation Deposit Insurance schemes in other countries 19-1 Background issues and History Bank runs can serve a useful purpose Contagion has more serious consequences FDIC created 1933 Securities Investors Protection Corporation (SIPC) Pension Benefit Guaranty Corporation (PBGC) created FDIC 19-2 FDIC created in wake of banking panics : 10,000 failed commercial banks. Original coverage: $2,500. Now $100,000. Between : FDIC worked. Failures accelerated in In 1991: Borrowed $30 billion from Treasury and still generated a $7 billion deficit. FDIC Improvement Act The funds reserves now stand at a record high with reserves exceeding 1.23% of insured deposits (2007). Caveat: Superior Bank of Illinois Fine of $460 million $428 million cost to FDIC 1

2 FSLIC 19-3 FSLIC covered S&Ls. Other thrifts often chose FDIC coverage. High levels of failed thrifts between generated losses of $42.3 billion. From additional 734 failures. Cost: $78 billion. Result: FSLIC estimated net worth negative $40 to $80 billion. Policy of capital forbearance. Demise of FSLIC Forbearance consequences: Accumulation of greater losses. Financial Institutions Reform, Recovery and Enforcement Act, (FIRREA) Management transferred to FDIC. Savings bank insurance fund became Savings Association Insurance Fund (SAIF). Managed separately from Bank Insurance Fund (BIF). March 2006, SAIF and BIF merged to form DIF Causes of depository fund insolvency 19-4 Financial Environment: Rise in interest rates. Collapse in oil, real estate and commodity prices. Increased competition. 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). 2

3 19-5 Trade-off: Moral hazard & bank run risk Insurance was not actuarially fairly priced. Reduced incentive for runs. Reduced incentives for depositors to monitor DIs Increased moral hazard. Controlling DI Risk Taking Stockholder discipline Limited liability of stockholders Practical problems in applying option pricing to insurance premiums DI s asset values and risk are not easily observable FDIC adopted risk-based premiums 1993 Risk-Based Deposit Insurance 19-6 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. Beginning in January 2007 FDIC started calculating risk premiums in more aggressive manner (See Appendix 19A). 3

4 Increased capital requirements, stricter 19-7 closure rules. Require lower leverage Impose stricter DI closure rules Controls forbearance Five capital zones Prompt corrective action Increased capital requirements: Proposal Role of subordinate debt Improve market discipline Ease monitoring Increase transparency and improve disclosure Increase capital cushion Depositor Discipline 19-8 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. 4

5 Depositor Discipline 19-9 Federal Deposit Insurance Reform Act of 2005: Leaves coverage cap at $100,000 per person per account Adjusted to inflation on 5-year basis ($10,000 increments as necessary) Cap for retirement accounts increased to $250,000 Role for deposit brokers Controlled by FDICIA of 1991 Implicit 100% coverage from too big to fail Failure resolution post-fdicia Systemic risk exception. Insured depositor transfer (IDT) or haircut method encourages depositor vigilance. Regulatory discipline Perception of 2 weaknesses in regulatory practices: Frequency and thoroughness of examinations Forbearance shown to weakly capitalized banks pre 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. 5

6 Discount Window Traditionally, 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. Implemented in January 2003 Primary credit available on short-term basis even to sound banks Secondary credit Seasonal program Easing of availability. Elimination of subsidy. 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. 6

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