Gary H. Stern
Federal Reserve Bank of Minneapolis
Federal Deposit Insurance Corporation
Conference on Deposit Insurance
January 29, 1998
Last summer, in the wake of conversations with a representative of the community bankers, we hosted two meetings at our Bank to see if we could reach consensus about deposit insurance reform. The meetings included representatives of Ninth District banking institutions of various sizes and geographic locations, as well as a representative of the FDIC. Needless to say, we did not reach consensus, but the meetings stimulated us to consider the issue of deposit insurance reform once again.
Out of this reconsideration came our current proposal, namely to enhance market discipline by revising the Federal Deposit Insurance Corporation Improvement Act (FDICIA) by explicitly putting uninsured depositors at risk in situations where FDICIA's too-big-to fail (TBTF) provisions are invoked. (Recall that under FDICIA, uninsured depositors at banks deemed too-big-to-fail can be fully protected.) In our proposal, the exposure of such depositors would be limited, say, to 20 percent of their account, so that spillover effects and the potential for contagion and systemic risk are contained. Nevertheless, the clear intent of the proposal is to put large depositors on notice, so that they become more sensitive than at present to the condition of the banks with which they are doing business. If this reform is adopted, we would expect to see differential market pricing of bank liabilities, which would be salutary in its own right and could also prove valuable in establishing deposit insurance premia.
Clearly, this proposal is a variation of the coinsurance plan we suggested about ten years ago. The idea is to get before-the-event market discipline from large, uninsured depositors and not to "punish" them after the fact.
Perhaps the most surprising thing that came out of our meetings with Ninth District bankers last summer was their relative lack of concern about the issue of deposit insurance reform. Although certainly not true of all, many of the bankers were not bothered by the perverse incentives of the current system, even though the costs of moral hazard to taxpayers and to economic efficiency have been striking, both domestically and internationally.
Upon reflection, perhaps we should not have been so surprised because the United States banking system today appears to be sound and stable. But that is exactly why this is the appropriate time to consider seriously deposit insurance reform. Because our banking system is healthy, reform can be assessed deliberately and objectively. It can also be phased in over time, so that both bankers and depositors have ample opportunity to adjust, and disruptions can be held to a minimum. Further, it is not as if bank supervision is a free good; it requires considerable real resources from bankers as well as regulators, and it has not been foolproof. Thus, there appears to be a case for enhanced market discipline as a complement to supervision.
Both the Presidential commission that examined the causes of the savings and loan fiasco in this country and the U.S. Treasury in formulating its financial services restructuring proposal in 1991 concluded unequivocally that the moral hazard of deposit insurance had been fundamental in the savings and loan debacle and the exposure of taxpayers. Similarly, examination of the banking crises of the 1980s and earlier this decade in Asia and other parts of the world by the World Bank, the International Monetary Fund, and the Bank for International Settlements, among others, singled out the moral hazard of government depositor protection as a major culprit.
To be sure, introduction of additional market discipline raises the risk of instability, and some may consider this unacceptable. But as I have argued previously (see "Government Safety Nets, Banking System Stability, and Economic Development," remarks prepared for a conference on "Money and Financial Markets in Asia: A Challenge to Asian Industrialization"), the challenge to policymakers in this arena is to balance two competing objectives, namely banking system stability and elimination of the costs of moral hazard. There is clearly a trade-off here: stability can be achieved at the expense of high moral hazard costs, or moral hazard can be eliminated at the cost of instability. We think our revised coinsurance proposal strikes a reasonable balance between these objectives.
Let me emphasize that striking this balance is a critical issue. About a year ago, the FDIC hosted a symposium on the banking history of the 1980s and its lessons for the future. Many of you were probably in attendance. Near the end of that symposium, Paul Volcker commented on the repercussions of the TBTF decision to fully protect the creditors of Continental Illinois in 1984. He said: "Even when you had headlines about the weakness of an institution no depositors moved their money because they had been convinced that the government was going to take care of everything, so you had no market discipline .... How do you get some balance between the rescue and retaining some discipline?"
In concluding, I would offer four additional observations. (1) In our proposal, the burden of increased market discipline falls on large, presumably sophisticated depositors. More important, if our proposal is in place, we would expect the market for information about the financial condition of banks to broaden and deepen over time. We also would expect depositors to diversify more than formerly. (2) Community banks should welcome our proposal because it goes some distance to leveling the playing field. It does so because, as matters now stand, uninsured depositors have an incentive to bank with TBTF institutions, an advantage that is diminished by our scheme. (3) If our proposal is successful in enhancing market discipline, it should over time permit a reduction in the regulatory burden on banks. (4) History has shown that damage to a country's banks may well damage its growth prospects. If we are committed to attaining over time maximum sustainable economic growth, and I believe we are, then we should take the steps available to improve incentives in the banking system.