January 28, 1991
"How to Avoid Losing $150 Billion"
San Jose Mercury News
By Timothy Taylor
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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
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
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
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
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
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.
WAYS TO REFORM DEPOSIT INSURANCE
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,"
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