Timothy T. Taylor Home Page
Journal of Economic Perspectives
Articles and Writing
Economics Textbook
Classroom Teaching
The Teaching Company
High School Pedagogy

Articles and Writing

January 28, 1991
"How to Avoid Losing $150 Billion"
San Jose Mercury News

By Timothy Taylor
<< Back to 1991 menu

METHODS OF reforming deposit insurance can sound like a real snoozer of a topic. But I've found the subject becomes considerably more interesting, even entrancing, if I contemplate the $150 billion or so it will cost to bail out the depositors in failed savings and loans institutions.

In fact, during the State of the Union speech, President Bush is expected to announce proposals for restructuring deposit insurance to avoid such losses in the future.

For the happy majority who don't spend their time studying up on the banking system, here's a nutshell description of deposit insurance. The government sets up a corporation which collects insurance premiums from institutions that accept deposits (like S&Ls and banks), based on the deposits they hold. If too many of a depository's loans aren't repaid and it goes broke, the insurance fund assures that

depositors don't lose their money.
Normally, taxpayers would not be involved. But if the insurance fund itself goes broke, as has happened with the Federal Savings and Loan Insurance Corp., the federal government guarantees to make up the difference.

TO UNDERSTAND how deposit insurance might be changed, consider an agenda of 15 possible reforms taken from a report published last fall by the Congressional Budget Office.

Under current law, deposits are insured up to $100,000. This limit might be altered in two ways. First, the government could lower the amount of insurance coverage, perhaps guaranteeing only $50,000. Second, the government could change coverage from $100,000 per account, which allows depositors to deposit as much as they want in insured accounts as long as it is broken up into five-digit chunks, to $100,000 per individual.

Either of these steps would reduce the potential liabilities of the insurance fund. But if possible, it would be better to find ways to expand deposit insurance, rather than contracting it.

Reducing the quantity of insured deposits can backfire. If large depositors become edgy about losing their uninsured money if a bank goes broke, they may yank out their funds at the first whiff of a hint of a possibility of trouble. Such withdrawals can push otherwise sound banks to collapse, which would defeat the intention of limiting the insurance coverage in the first place.

The third item on the CBO list is to use "market-based" accounting. Under current "book-value" accounting, depositories value their loans as if they are sure to be repaid, which tends to overestimate the financial strength of the institution. Market-based accounting would attempt to estimate what a loan to, say, Brazil, is actually worth, given the current chance of partial or complete default. This isn't easy to do, but it's worth a try.

The results of such accounting are not currently disclosed to the public, or even to Congress, but they could be. Such disclosure would put a spotlight of embarrassment on bankers, and make it harder for the problems of troubled institutions to be swept under the rug.

To protect taxpayers, the size of the deposit insurance reserve fund might be increased. But this can only be done slowly, since jacking up the premiums too fast would push some marginal depositories into bankruptcy, and thus reduce the size of the fund all over again.

Although it may seem counterintuitive, increasing the line of credit from the Treasury to the bank regulators makes sense. If the government is going to be responsible for losses eventually, it makes sense to close down bankrupt institutions and pay off the depositors right away. But now, the lack of funds is slowing down the effort to clean up the S&L industry, and leading to an additional $300 million in losses per day, according to Treasury Secretary Nicholas Brady.

Under current law, all deposit institutions are charged the same rate of insurance premiums and have the same capital requirements, regardless of how risky their loans are. This is peculiar indeed; what sensible insurance company charges its riskiest and safest customers the same amount?

The federal regulators could charge higher deposit insurance premiums to risky institutions and require owners of such institutions to put up more capital. This could raise more money for the deposit insurance reserves, and also give depositories a cash incentive to avoid overly risky behavior.

Risk is hard to measure, and changes frequently. Nonetheless, rough risk-based distinctions would be an improvement over the present system of no distinctions.

One lesson of the S&L debacle has been that regulatory discretion can lead to political pressure for regulatory slackness. To avoid that pressure, it would be useful to have mandatory rules about what will happen as a depository approaches bankruptcy. There will always be some who try to bend the rules, but clear, stiff rules are at least harder to bend.

Proposals for narrow banking would split banks into two parts. One set of accounts would be insured but pay a low interest rate, because the narrow bank would invest that money only in very safe investments (like federal government securities). A second set of accounts would be uninsured and offer a higher interest rate, and the (wider) bank could invest that money in whatever it wanted. Every depositor could choose how much to deposit at the insured lower rate or the uninsured higher rate.

The idea of narrow banking is intellectually interesting, but since it would involve a major restructuring of all banks, it seems least likely of any item on this list.

THE NEXT four proposals all attempt to transfer to other parties some of the risk that the federal government will have to pay out money.

For example, the federal government might require that depositories insure themselves, either through existing companies or by setting up their own company. Self-insurance is an appealing idea, but remember that it's what the current system was supposed to be. When self-insurance breaks down, the federal government will have to decide whether to step in.

Depositors could be forced to bear some risk by insuring only 75 percent of deposits up to some amount, as is done in Britain, or by insuring 100 percent of deposits up to some amount but only a fraction above that amount, as is done in Italy.

Another place to transfer risk might be to the reinsurance market. The federal deposit insurance company could buy private insurance against the chance that its losses will grow too large.

One last way to transfer risk would be for the government to require that every depository find outside investors willing to put up part of its capital requirement. This investment would be subordinated and uninsured, which just means that if the depository goes broke, the money would be totally lost; thus, such an investor would have very good incentives to monitor the bank or S&L very closely. If a depository couldn't find anyone willing to invest on these terms, that would signal to federal regulators that they might want to close the place down.

I'VE SAVED most people's favorite proposal until last: tighten regulatory supervision, increase the number of bank examiners and the number of examinations, and raise the penalties for lawbreaking.

There's nothing wrong with these ideas, but they need to work together with reforms of the entire deposit insurance system. Having fewer bank owners tempted to make risky loans is probably better than a system where they are tempted, but have a risk of heavy punishments. If market-value accounting, risk- based premiums, clear rules for closure and some types of risk-sharing are put into place, then the current number of bank examiners is plenty. Without those changes, more examiners may not make much difference.

The collapse of the savings and loan industry has been bad enough. Now, there are nasty rumors that the federal corporation that insures banks may be financially wobbly, too. Until the system of deposit insurance is thoroughly reformed, no taxpayer's wallet is safe.

1. Lower the amount of insurance coverage
2. Change coverage from per account to per individual
3. Evaluate risk with market-based accounting
4. Disclose bank evaluations to the public
5. Increase the reserve fund
6. Increase the Treasury line of credit
7. Charge risk-based premiums
8. Set risk-based capital requirements
9. Set clear rules for closing depositories
10. Narrow banking
11. Create industry self-insurance
12. Coinsure with depositors
13. Reinsure with other insurers
14. Require subordinated, uninsured debt
15. Tighten regulatory supervision and stiffen penalties

Source: Congressional Budget Office, "Reforming Federal Deposit Insurance," September 1990.

<< Back to 1991 menu