Melvin L. Burstein - Senior Vice President and General Counsel
Published January 1, 1992 | January 1992 issue
On the eve of Thanksgiving, Congress passed a bill entitled the Federal Deposit Insurance Corp. Improvement Act of 1991 (FDICIA). The bill recapitalizes the Bank Insurance Fund (BIF), establishes new safety and soundness measures including progressive discipline and prompt closure of problem banks, and substantially reforms deposit insurance.
The FDICIA reforms deposit insurance in several ways. First, it limits the authority of the Federal Deposit Insurance Corp. (FDIC) to protect uninsured depositors, both foreign and domestic, including those in banks deemed "too big to fail." In addition, it limits interbank liability transactions, prohibits all but the best, most well-capitalized banks from offering insured brokered deposits, limits the interest that can be paid on certain brokered deposits and eliminates pass-through coverage of certain bank investment contracts. Finally, it requires the FDIC to establish a risk-based premium system.
The FDICIA also indirectly reforms deposit insurance by constraining the Federal Reserve System (Fed) in the use of its lending authority to keep banks alive, even banks it may consider too big to fail. Nevertheless, the deposit insurance reforms should have the effect of restoring the Fed to its intended role as "lender of last resort." Until reformed by the FDICIA, the deposit insurance system had evolved into one that provided virtually full protection for all deposits, effectively eliminating the need for that Fed role.
The Fed was created to help stabilize the financial system by being the lender of last resort to banks faced with extraordinary withdrawals. Banks are inherently unstable because they rely upon short-term, often demand, deposit liabilities to support longer-term illiquid assets, making it difficult to meet extraordinary withdrawals. Historically, financial panics occurred when the failure of some banks unable to liquify these assets to meet extraordinary withdrawals led to the run on and failure of many. The Federal Reserve Act addressed this by establishing a mechanism for banks to borrow from Federal Reserve banks to meet extraordinary withdrawals by using these otherwise illiquid assets as collateral.
However, despite the presence of the Fed, between 1930 and the March 1933 bank holiday, thousands of bank failures led to financial panic. It is still a subject of debate whether the Fed did all that it could at that time to quell the bank runs and avert financial panic. In any case, in 1933, Congress established the FDIC and the deposit insurance system to add stability to the banking system by protecting depositors.
Originally, deposit insurance coverage was modest--$2,500 per account, leaving a role for the Fed in stabilizing the banking system. Deposit insurance was increased to $5,000 in 1935, $10,000 in 1950, $15,000 in 1966, $20,000 in 1969, $40,000 in 1974 and finally to $100,000 in 1980. Deposit protection was further enlarged in 1984 with the rescue of Continental Illinois Bank and Trust Co. The FDIC adopted an explicit policy of protecting all deposits in Continental and, subsequently, a number of other banks it determined were too big to fail.
By 1985, deposit protection was virtually 100 percent in all banks, regardless of size. The Treasury's February report to Congress on banking reform states that since 1985 over 99 percent of uninsured deposits have been protected in failed banks. With virtually full protection of all deposits providing as much stability to the U.S. banking system as one could hope for, there was no longer a need for the traditional central bank function of lender of last resort.
However, the price for that stability has been the erosion of market discipline of depositors and, in turn, the banks. Market discipline is needed to contain the moral hazard in deposit insurance. Moral hazard is an inherent characteristic of insurance that erodes, if not destroys, market discipline by reducing the insured's attention to the risks insured against. In the case of deposit insurance, full protection has made depositors indifferent to the risks undertaken by the banks that hold their deposits.
The FDICIA's deposit insurance reforms should restore some market discipline to banking, if properly administered. Unfortunately, the trade- off for this market discipline may by added instability to the banking system. However, still substantial deposit insurance, coupled with the Fed's effective use of its lender of last resort power, should provide adequate stability.
Although the act imposes limitations on Fed lending, the Fed is left with sufficient power to perform the lender of last resort role contemplated when it was created. By properly administering that power, the Fed has the opportunity to enhance the FDICIA's deposit insurance reforms as well as contribute to the stability of the banking system.