Chapter 171 Chapter 17. Deposit Insurance, Bank Failures, and the Savings- And-Loan Mess Learning Objectives: To understand … 1. Moral hazard and the cost of government guarantees 2. Alternative models of deposit insurance 3. How the FDIC resolves and handles failed banks 4. Causes of bank failure 5. Economic insolvency vs. bank closure 6. Causes and costs of the S&L mess

Chapter 172 CHAPTER THEME For almost 50 years, federal deposit insurance worked too well in the United States. The financial devastation of the 1980s and early 1990s, however, got everyone's attention. While the FDIC was able to survive, the Federal Savings and Loan Insurance Corporation (FSLIC) went bankrupt. Although the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the FDIC Improvement Act (FDICIA) of 1991 revamped federal deposit insurance, a lot of unfinished work remains (e.g., pricing deposit insurance, failure-resolution policies and procedures, and resolving incentive conflicts)

Chapter 173 “You can pay me now or you can pay me later” Forbearance and “Zombies” A $150-billion S&L bailout Responsibility for the mess Taxpayers Congress Regulators Managers

Chapter 174 Models of Deposit Insurance Passive model of casualty insurance Treats bank capital as a deductible Option-pricing model Treats bank capital as an inverse proxy for insurer loss exposure Trilateral performance bond (surety or guarantee) Incorporates agency costs into the bundle of contracts that makes up deposit insurance

Chapter 175 Trilateral Performance Bond (Surety) Parties 1. Insured depository (receives benefit of the surety or guarantee) 2. Insured depositor (receives contingent protection) Uninsured creditor receives protection because of the way failed banks are typically handled 3. FDIC (guarantor or surety with backing of the U.S. Treasury)

Chapter 176 Understanding Deposit Insurance Moral hazard Agency costs Marginal net benefit or burden of deposit insurance

Chapter 177 Modeling the FDIC’s Cash Flows (Table 17-1, p. 599) Components: F = P +r p R – C M – C L Loss-control instruments Linking the loss-control instruments to cash flow Goal function: W = f(F, D, J, B) F = cash flow (from above), D = distortions, J = job performance, B = bribes/tribute

Chapter 178 FDIC Bad Times, Good Times Bad times 1988: 221 cost of $6 billion 1991: 122 cost of $6.2 billion Good times : 22 cost of $1.2B (August): 8 failures (cost NA)

Chapter 179 Techniques for Managing a Guarantee Business Monitoring the value of collateral Restricting the kinds of assets available for collateral Charging risk-based premiums

Chapter 1710 Don’t Judge the FDIC by its Initials Entry regulation On- and Off-site bank examination and supervision Disposition of failed and failing banks

Chapter 1711 Failure-Resolution Considerations Cost Public confidence and stability (contagion and TBTF) Fairness of treatment (uninsured creditors) Market discipline

Chapter 1712 FDIC Failure-Resolution Methods (Box 17-1, p. 608) Deposit payoff Purchase-and-Assumption(P&A) transaction Other methods Insured deposit transfer Open-bank assistance Bridge bank and DINB

Chapter 1713 Essential Functions of a Salvage Operation Rescue or peril reduction Appraisal or damage evaluation Efficient asset or property management Sales How do these functions apply to FDIC operations?

Chapter 1714 Risk-Based Pricing Supervisory group: A, B, or C Capital adequacy Well capitalized (10%, 6%, 5%) Adequately capitalized (8%, 4%, 4%) Inadequately capitalized (below the above)

Chapter 1715 The Credit-Union Model and Private Insurance Idea: Two-way principal-agent relation Components Risk-based pricing Loss sharing Better supervision?

Chapter 1716 Keeping the Promise (Box 17-2, p. 616) The FDIC recommends Merging BIF and SAIF Charge risk-based premiums regardless of the level of the fund Eliminate volatility of premium income based on the designated reserve ratio (DRR)

Chapter 1717 Bank Failures: Hidden Action and Hidden Information Economic insolvency and bank closure In a time line, EI precedes BC The gap is the forbearance period Early-warning signals Causes of bank failures Fraud, abuse, and misconduct

Chapter 1718 The S&L Mess Three underlying causes 1. Mismanagement of interest-rate risk 2. Mispriced deposit insurance and regulatory shortcomings Legislative and political causes associated with subsidies without concern for proper pricing and incentives

Chapter 1719 CHAPTER SUMMARY FDIC insurance is best viewed as a surety or trilateral performance bond. This approach, which incorporates agency costs into the nexus of contracts that makes up deposit insurance, endogenizes risk, highlights incentive conflict, and focuses on optimal loss-control activity. Since the FDIC resolves and handles failed banks and regulates and examines insured nonmember banks, one can't judge the FDIC by its initials.