1. Irwin/McGraw-Hill 1 Deposit Insurance and Other Liability Guarantees Chapter 19 Financial Institutions Management, 3/e By Anthony Saunders

2. Irwin/McGraw-Hill 2 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.

3. Irwin/McGraw-Hill 3 FDIC n FDIC created in wake of banking panics. 10,000 failed commercial banks. Original coverage: $2,500. Now $100,000. Between1945-1980: FDIC worked. Failures accelerated in 1980.

4. Irwin/McGraw-Hill 4 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 1.4% of insured deposits.

5. Irwin/McGraw-Hill 5 FSLIC FSLIC covered S&Ls. Other thrifts often chose FDIC coverage. High levels of failed thrifts between 1980-88 generated losses of $78 billion. From 1989-92 additional 734 failures. Cost: $78 billion. Result: FSLIC estimated net worth negative $40 to $80 billion. Policy of forebearance.

6. Irwin/McGraw-Hill 6 Demise of FSLIC Forebearance 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) »$90.1 billion

7. Irwin/McGraw-Hill 7 Causes of depository fund insolvency n Financial Environment: Rise in interest rates. Collapse in oil, real estate and commodity prices. Increased competition.

8. Irwin/McGraw-Hill 8 Depository Fund Insolvency (continued) n Moral Hazard: Deposit insurance encouraged underpricing of risk and reduced depositor discipline. Premiums not linked to risk. Inadequate monitoring. Prompt Corrective Action (1992).

9. Irwin/McGraw-Hill 9 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)

10. Irwin/McGraw-Hill 10 Controlling Bank Risk Taking Stockholder discipline »Practical problems in applying option pricing to insurance premiums »FDIC adopted risk-based premiums 1993 »Based on: categories and concentrations of assets & liabilities; other factors that affect probability of loss; deposit insurer’s revenue needs. »Increased capital requirements, stricter closure rules, prompt corrective action.

11. Irwin/McGraw-Hill 11 Controlling bank risk taking 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. »Implicit 100% coverage resulted from too big to fail.

12. Irwin/McGraw-Hill 12 Failure resolution pre-FDICIA Liquidation (payoff) method unless alternative judged to cost less. 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.

13. Irwin/McGraw-Hill 13 Failure resolution post-FDICIA n January 1995 FDICIA required least-cost resolution. Systemic risk exception. Insured depositor transfer (IDT) or “haircut” method encourages depositor vigilance.

14. Irwin/McGraw-Hill 14 Regulatory discipline n Perception of 2 weaknesses in regulatory practices: Frequency and thoroughness of examinations Forebearance shown to weakly capitalized banks pre-1991.

15. Irwin/McGraw-Hill 15 Regulatory discipline (continued) n Capital forebearance: Prompt Corrective Action. Transition to rules rather than discretion. n Examinations: improved accounting standards including market valuation of assets and liabilities; annual on-site examination of every bank.

16. Irwin/McGraw-Hill 16 Non-U.S. deposit insurance n EC proposed single deposit insurance system to be introduced at end of 1999. n Co-insurance through deductibles. Currently, deductibles vary across countries.

17. Irwin/McGraw-Hill 17 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.

18. Irwin/McGraw-Hill 18 Other Guaranty Programs PC and Life Insurance Companies regulated at state level. No federal guaranty fund. State guaranty funds run and administered by the private insurance companies themselves. Only NY has permanent guaranty fund for PC and life insurance. Definition of small policyholder varies across states from $100,000 to $500,000.

19. Irwin/McGraw-Hill 19 Other Guaranty Programs Often delays in settling claims against insurance companies. n 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.

20. Irwin/McGraw-Hill 20 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. Deficit expected to be eliminated within 10 years. »Risk-based premium scheme.