A Case for Reforming Federal Deposit Insurance

The views expressed in this annual report are expressly those of the authors; they are not intended to represent a formal position of the Federal Reserve System.

Federal deposit insurance has long been regarded as one of our most successful government programs. It is now in need of serious repair. Established in 1933 to stem an instability problem in banking, deposit insurance succeeded as well as Congress could have hoped. More recently, however, as federally insured institutions have become less regulated, a problem with deposit insurance has surfaced. In order to allow banks to survive in a more competitive environment, Congress and bank regulators, over the past eight years, have relaxed the regulatory reins. But they did not, as some advised, reform deposit insurance.¹ As a result, banks have become more competitive but at the expense of taking on considerably more risk. In effect, a fundamentally difficult problem with deposit banking has been exchanged for one with deposit insurance.

Over the years, many economists have warned of a problem with the federal deposit insurance system. While protecting depositors, deposit insurance encourages banks to take on more risk than they otherwise would. This is the so-called "moral hazard" problem that is inherent with almost all insurance policies. However, because the deposit insurance system appeared to work so well and because so few banks failed, these warnings went unheeded. Proponents of bank deregulation argued that the supervisory agencies were well-equipped to contain moral hazard and that the low bank-failure rate provided strong support for this point of view.

Something is now amiss. The low bank-failure rate did not continue into the 1980s. Since the beginning of this decade over 800 banks have failed, including a few of the largest in the industry. Many more are facing some financial difficulties. A much worse situation has developed in the savings and loan industry, which is protected by its own federal deposit insurance. This industry has demonstrated just how high the cost of moral hazard can be. Estimated losses to the Federal Savings and Loan Insurance Corporation (FSLIC) now range up to $100 billion or higher, a cost that will likely be borne by the taxpayer. No longer does it appear that those who warned of moral hazard were crying wolf.²

There is now an obvious need to reform the way banks are regulated and depositors are protected. What is not so obvious is the best way to reform. Some suggest that banks be constrained to holding only safe assets. Others argue that closer monitoring and pricing of bank risk will solve the problem. Still others believe troubled banks should be closed before their net worth becomes negative. An examination of such reforms, however, suggests that they won't work and/or are extremely costly.

The reforms, we think, that will be effective involve a larger role for market involvement. And they reflect what we see in private insurance contracts that are successful in containing moral hazard. In particular, private market experience suggests that the costs of containing moral hazard will have to be shared by the insured. Depositors will have to bear some risk of loss—and bank owners a greater share than they do now. This, in turn, will mean the banking system will be potentially more prone to depositor instability. Nevertheless, given the problems with the current banking system, some tradeoff is warranted.

The Federal Deposit Insurance System is in Need of Serious Repair

Before federal deposit insurance was in place, the banking system was in periodic turmoil. Bank panics, a large number of bank failures caused at least in part by a general loss of confidence in the banking system and accompanied by a major economic contraction, were a regular feature of the U.S. economy. Such panics occurred in virtually every decade following the passage of the National Banking Act of 1863. The panic of 1907 finally convinced Congress that more direct government involvement was necessary. While federal deposit insurance was discussed, it was ultimately rejected. In 1913 Congress created the Federal Reserve System to be the lender-of-last-resort: a central bank that commercial banks could turn to when depositors' confidence waned. Nevertheless, less than 20 years later, the United States experienced its worst banking panic as over one-fifth of U.S. commercial banks suspended operations (Friedman and Schwartz [1963, p. 299]).

To build depositor confidence and help prevent bank panics, Congress established the Federal Deposit Insurance Corporation (FDIC). On January 1, 1934, the FDIC went into business insuring deposits up to $2,500 in banks that had chosen to become members of this new government corporation (on July 1 the maximum coverage was raised to $5,000). Over the years the fraction of total deposits that the FDIC insured has gradually increased, as more depositors chose insured banks and maximum deposit coverage was raised. (See Table 1). Today, the FDIC insures deposits up to $100,000 per account, and this insurance covers over 75 percent of all bank deposits. But even so-called "uninsured deposits," those in accounts that exceed $100,000, have almost always been protected as well. Consider that of the 184 banks that failed in 1987 only 14 percent of the uninsured deposits were not paid in full.³ Because of the FDIC, most depositors no longer have any reason to withdraw their funds based on fears and rumors that their bank is failing. Indeed, widespread bank panics (of the sort experienced in the 1930s) have become interesting curiosities in banking history, rather than contemporary policy problems.

One Problem Solved, Another Introduced

Deposit insurance solved an inherent problem with deposit banking, but it introduced an inherent problem with insurance. Most insurance has a potentially costly side effect called "moral hazard," which is well known in the industry. People who are insured against a particular risk have an incentive to change their behavior. Consider the owners of a factory who purchase fire insurance. Prior to this purchase, they would have to bear the entire cost of a conflagration. Once insured, though, a great part of the cost will be borne by the insurance company. For a fixed annual fee the owners' concern about such a loss is significantly alleviated, which is the obvious benefit of insurance. Consequently, the insurance company should expect the insured to take more risks than they would have without the insurance. The insured can now afford to be a little less cautious about the disposing of flammable materials such as old paint cans or chemical containers. If the insurance company hopes to remain in business, it must take account of such behavioral changes when pricing and administering policies.

The federal deposit insurance system suffers from this sort of problem. Other things equal, deposit insurance encourages banks to hold riskier portfolios than they otherwise would. This follows immediately from the protection provided by FDIC insurance: once insured, depositors have no reason to worry about the riskiness of their bank's activities. Regardless of how the bank invests their funds, insured depositors' claims are guaranteed. Depositors, therefore, do not require a risk premium; and banks, therefore, have an incentive to invest in riskier projects. If these riskier projects are successful, the bank owners reap the higher returns; if not, the government insuring agency bears most of the loss. Depositors' funds earn the safe rate of return and are secure in either case.⁴

One might question whether the moral hazard problem is really that serious in banking because bank owners and managers are not protected by deposit insurance—depositors are. Indeed, the owners can lose their equity if the bank's loans go sour, and managers can lose their jobs. Such losses, therefore, would seem to offset the effects of moral hazard.

This view, although intuitively appealing, misses the point. Equity is an integral part of the moral hazard problem, and the owners of the bank are the ones who benefit from having a high-return/high-risk portfolio. Moreover, some bank owners are able to diversify much of this risk by having only a small fraction of their total resources invested in any one bank. Consequently, owners could very well behave as if they were risk neutral; that is, they may simply seek to maximize expected return. If this is the case, we would expect such banks not just to take on more risk than otherwise, but in fact to seek as much risk as possible.⁵

Moral Hazard Kept in Check by Protective Subsidy . . .

Policymakers were aware of moral hazard from the beginning. Historically, the response to this problem has been heavy supervision regulation of banking activities. This approach mitigates the moral hazard problem in two ways: first, by limiting risky bank activities, and second, by protecting banks from competition.

Direct limitations of risky activities have taken a variety of forms. For example, bank risk is monitored by three federal agencies and each state's chartering authority. National banks are examined regularly by the Comptroller of the Currency; state-chartered banks are examined by the FDIC or the Federal Reserve (if they are a member), as well as the state in which they are chartered. All bank holding companies are examined by the Federal Reserve. Besides formal examinations, banks have been restricted in the types of businesses they can own and operate, in how much lending they can do with one person or one company, in what types of loans they can make, and in how much of their portfolio must be in liquid reserves.

Regulatory impediments to bank competition have included constraints on the number of bank charters, on where banks could do business, on how many branch offices banks could maintain, and on the interest rates banks could pay. In addition, nonbank financial firms were prohibited from offering traditional bank products.

How successful has this strategy been in limiting the effects of moral hazard? Until recently, the record looked quite good, and banks appeared as safe as the government-insured deposits they offered. Over the 40-year period 1940 to 1979, for example, on average less than seven banks failed per year. (See Table 2.) In fact, there were so few failures that many economists argued that the government was over-regulating banks. They claimed that banking, like other industries, needed to weed out its inefficient firms. What was lost in efficiency, though, was gained in safety. With relatively few exceptions, the U.S. banking industry appeared safe and sound.

The most effective part of this supervisory and regulatory strategy was to isolate the banking industry from competition, allowing it to earn high rates of return. Banks themselves were confined to well-specified geographic locations via interstate and intrastate branching restrictions. And nonbank financial firms could not offer transaction accounts. In addition, for many years banks were prohibited from paying interest on checkable deposits and limited in the rates they could pay on time and savings accounts (Regulation Q). With few competitors and few restrictions on the rates banks could charge on loans and earn on investments, banking was a lucrative business even without taking much risk. Short-term, self-liquidating commercial loans and well-collateralized, long-term loans, along with government securities, were the standard type of bank assets.⁶

These high rates of return, as reflected in the market value of a bank charter, presumably provided the bank with a strong disincentive to take on too much risk. While the bank could have earned more by taking on more risk, the cost of bankruptcy was substantial; that is, the cost of losing a bank charter may have far outweighed the gain from a risky portfolio strategy. The value of a bank's charter, therefore, reflected the subsidy that was the quid pro quo for not taking too much risk. This protective subsidy effectively reversed the risk-return tradeoff facing the banker. The subsidy was high enough so that incurring more risk would lower—not raise—the banker's expected return.

The protective subsidy was the cost of successfully containing moral hazard in banking. This cost was manifested by the lack of competition in bank services. What has been labeled 3/6/3 banking characterized the industry for decades—borrow at 3 percent, lend at 6 percent, and be on the golf course by 3 p.m.—a good life that presumably few were willing to risk losing, despite the incentives created by deposit insurance.⁷

. . . But the Protective Subsidy has been Eroded by Competition

Since 1980 the protective subsidy appears to have lost its effectiveness. Over 800 banks have failed, 522 in the last three years. And a significant part of the savings and loan industry, first-cousin to banking, is facing bankruptcy. (According to unpublished Federal Home Loan Bank reports, on June 30, 1988, 16 percent of all savings and loans were bankrupt on an adjusted regulatory capital basis.) Table 2 clearly illustrates the problem that beset the banking industry in the '80s. As noted earlier, from 1940-79, this country averaged less than seven bank failures per year. By contrast, from 1980-88, an average of about 92 banks failed per year. The data also suggest that most failures prior to 1980 involved relatively small banks. Beginning in 1980 that was no longer true, and in fact a few of the largest banks were getting in trouble. For example, from 1945-54, total assets of closed banks averaged about $5.8 million annually. From 1980-87, total assets of closed banks averaged about $6.2 billion annually. The figures for deposits of closed banks tell the same story. Of course, part of the increase in failed bank assets and liabilities simply reflects the effects of inflation. But, some of the largest problem banks in the 1980s were reorganized with government assistance, and thus are not included in the Table 2 data.

What went wrong? Why had a previously well-managed problem become difficult to control? What had happened to the protective subsidy? These are complex questions that we may not be able to answer satisfactorily for many years. Nevertheless, at least part of the explanation is clear now. The double-digit inflation experienced in the 1970s opened the door to nonbank competition and within a few years eroded the value of bank charters.

Competition from nonbank financial firms came quickly on the heels of inflation. With higher rates of inflation came higher rates of interest. Once market rates exceeded the maximum rates banks could offer their depositors, a host of nonbank competitors emerged. Thrift institutions were among the first to challenge the commercial banks' monopoly on transaction accounts. Until the mid-1970s it was easy for the public to differentiate banks from thrifts. Banks offered checking accounts and savings accounts; the thrifts offered only savings accounts. In 1972, however, two New England states permitted their mutual savings banks to offer a checking deposit that became known as the NOW account (Negotiable Order of Withdrawal). Several important court decisions supported the view that banks could not be granted a monopoly on the issue of three-party negotiable instruments payable upon demand (i.e., checks). While there were initially limitations on withdrawals, these NOW accounts, unlike demand deposits at banks, paid interest. Not surprisingly, they were an overnight success, as is clearly shown in Table 3. Between 1976 and 1981 NOW accounts grew from $2.7 billion to $78.5 billion. Over the same period demand deposits at banks increased only about 5 percent.

About the same time, the large brokerage houses saw opportunities in this area and began to offer money market mutual funds. In the late 1970s they added checkwriting privileges. Typically, these money market accounts carried a higher rate of interest than NOW accounts but had more restrictions on withdrawals. Table 3 illustrates the success of these funds, which grew from $3.4 billion in 1976 to over $188 billion by 1981.

New competition hit banking from the asset side of the business as well as the liability side. In the 1970s, foreign commercial banks began capturing a growing share of the U.S. commercial loan business. Many large corporations abandoned banks for their borrowing needs by going directly to the commercial paper market. And nonfinancial firms such as the auto manufacturers and large retailers began a concerted effort to expand their share of the consumer loan markets.

This increased competition did not go unnoticed by the policymakers. To allow banks to compete on a more equal basis, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which called for the most radical changes in banking regulation since the 1930s. The act contained several major provisions designed to allow banks to compete more effectively with their nonbank competitors. Interest rate ceilings on bank deposits were to be phased out over the next several years, and federal reserve requirements were lowered across the board and imposed on all institutions offering insured transaction accounts. (To allow the savings and loan industry to compete, Congress passed the Garn-St Germain Depository Act of 1982 which allowed a savings and loan to make commercial loans as well as home mortgages.)

In addition to DIDMCA, regulators expanded allowable bank activities. Many states permitted their state-chartered banks to own subsidiaries in other lines of business. The Federal Reserve also was more lenient with bank holding company activities, and an increasing number of securities activities were permitted.⁸

All this competition has had the expected effect on the market value of bank charters. Explicit charter values are not available, but they can be estimated. Since charter values are included in the market value of bank equities and not included in the book value (under standard accounting procedures), the ratio of market to book reflects to some extent the value of a bank charter. As shown in Figure 1, and as expected, the market value of bank equities exceeded the book value from the early 1950s until the early 1970s when the ratio began to decline. By the mid-1970s, market value actually fell below book value, where it remains today. Of course, charter values can never fall below zero and, therefore, there must be some other reasons why bank equities have been selling at such low prices. Most probably, this is due to an overstatement of some book assets due to unrealized loan losses. Nevertheless, several recent studies have documented the decline in bank charter values, and one has presented evidence that banks with below-average charter values have above-average willingness to take risk (Keeley [1988]).

In summary, as banking became less protected from competition and less regulated, the incentive to take on risk increased. Moral hazard, long latent, started to be a force and the results were as expected: banks began reaching for profits by reaching for risk. Even though banks continued to be monitored and supervised by a plethora of government agencies, such regulation proved ineffective in the face of increased competition and the loss of the protective subsidy.

Fixing Deposit Insurance: No Easy Choices

With inflation, competition, deregulation and the resulting decline in the protective subsidy, moral hazard has emerged as a serious concern. Addressing this problem is neither going to be easy nor inexpensive. The approach which appears the most logical, reimposing the regulatory structure that produced the halcyon years before deregulation, is not realistic. Once the doors to competition are opened, closing them is extremely difficult. It would require a severe retrenchment of the entire financial industry.

A realistic solution requires some recognition of the tradeoff between the two inherent problems: the instability in deposit banking versus the moral hazard in deposit insurance. This tradeoff cannot be ignored. Avoiding moral hazard is difficult if deposits are insured, and avoiding depositor instability is difficult if they're not. Because of this tradeoff, there are no perfect or easy answers to either problem. The first-best solution is simply unattainable. Policy proposals which claim to have first-best solutions are simply misguided. Nevertheless, there is a much better answer than our current regulatory framework.

To better understand the choices facing policymakers, consider the two polar options: full-coverage insurance (where all deposits are fully protected), or none at all. The former eliminates instability, but results in moral hazard in the extreme. The policies we have in place today are closest to this option. The latter option eliminates moral hazard, but results in depositor instability in the extreme. This was the policy before 1934, but as noted, the banking system was subject to periodic panics.

Having seen the results of these polar options, we think neither is correct. Rather, the best policy solution lies somewhere between these alternatives. Before presenting our concept of what such a more moderate system might entail, however, we first discuss some recent reform proposals that we view to be ineffective, extremely costly, or both. These include 100 percent reserve banking, closing banks before they fail, and risk-adjusting capital or insurance premiums. Then, we turn to proposals that we think are better.

100 Percent Reserve Banking

One proposal that has been around at least as long as deposit insurance is 100 percent reserve banking. Known today as the narrow banking concept, it takes the regulation of banking to its very limit.⁹ Under narrow banking, banks could only invest in safe, liquid assets. (Holding 100 percent cash reserves would obviously satisfy this requirement.) The narrow banking concept would also allow banks to hold short-term Treasury debt as well as noninterest-bearing reserves. On the surface, this proposal appears to solve both the moral hazard problem and the depositor instability problem at once. Moral hazard is simply regulated away because banks cannot invest in risky assets. Instability is overcome because deposits are 100 percent backed by safe assets—there is no reason for depositors to lose confidence or to ever fear a bank failure.

Appearances are deceptive. While the narrow banks would be safe, what would happen to all the intermediation (that is, matching of borrowers and lenders) that they did previously as "wide banks"? Intermediation services would still be demanded, and presumably other financial institutions would fill the gap—operating much like the old wide banks. As such, the new institutions would be prone to depositor instability if they were not insured and moral hazard if they were. The problem, in other words, would not be solved but only shifted to a different part of the financial sector. And if the regulators were able to prevent this shifting, most of the borrowing and lending that was historically performed by banks would be eliminated, a cost that would surely exceed the benefits of narrow banking.

Closing Banks Before They Fail

Another proposal that looks like it would solve both moral hazard and instability with very little cost is to close troubled banks before they go bankrupt (Shadow Financial Regulatory Committee, 1988). The idea here is that if banks are closed when their net worth is close to zero, the insurer's exposure (the administrative costs of closing the bank and selling its assets) is relatively small. Presumably, if banks know they will be closed that quickly, they will also be less prone to take risks. The moral hazard problem then is solved (since the FDIC never takes losses) and depositors' funds are always safe.¹⁰

Like the narrow banking proposal, the costs of such an arrangement are much greater than they might appear. It's one thing to say troubled banks should be closed before they are bankrupt, but another to put this principle into practice—that is, to determine precisely when any particular bank should be closed. Regulators currently monitor the net worth of banks; through call reports and formal bank examinations they determine the net worth of banks at least four times a year, an expensive process. And even these data are subject to errors. Evaluating the value of assets that are not traded in a secondary market (such as most commercial loans) is open to considerable uncertainty and sometimes quite arbitrary. Under the proposal to close banks quickly, one would have to monitor banks more frequently and more accurately than we now do, and the costs could well be prohibitive.

Further, the information problem is more complex than identifying low-quality loans. By the very nature of banking, many loans are worth relatively little if sold on the market today, but are in fact good loans with high future payouts. Only if regulators were able to gather the same quality of information the banks have could they make the distinction between short-run and long-run values. This would not only be expensive, but inefficient as well because it would entail a replication of information costs that banks have already incurred.¹¹

Risk-Adjusted Insurance Premiums or Risk-Adjusted Capital Requirements

Risk-adjusted insurance premiums or risk-adjusted capital requirements are proposals that also appear to solve the moral hazard problem while keeping deposits safe. In addition, these proposals appear to be market-oriented, for presumably private insurers would charge their riskier customers a higher premium or require larger deductibles. On closer examination, however, the costs of effectively administering such policies would likely be prohibitive, even for private insurers.

To administer a risk-adjusted insurance policy requires some way of accurately assessing risk. And again, there is the cost of some very expensive information. What do private insurance companies do in this situation? In practice, insurance companies generally engaged in limited monitoring of risk behavior. Physical examinations, drivers' tests and property inspections are typically required before the insurance is granted but rarely will the insurer continually monitor the health of a patient or the condition of a factory. Given the cost of monitoring, it is likely that private insurers of banks would not operate much differently. Regular monitoring of banks' behavior toward risk is labor-intensive and expensive. And even if the risk could be measured accurately, pricing this risk without market data on the value of bank loans would be difficult and arbitrary.

That is not to say some broad-risk categories could not be established and priced (as age is used, for example, with health and auto insurance). Indeed, the new capital standards established under the Basle Agreements of 1988 feature this sort of rough-and-ready risk categorization.¹² While the new capital standards are surely an improvement over the old, there are still continuing problems. For one thing, by definition, they favor bank investment in some asset categories over others. There is always the danger that these standards may become politicized (here, or in other countries), which could result in a significant misallocation of resources. Moreover, the new capital standards invite loophole exploitation on the part of banks, which have a natural incentive to find (or create) assets which have had their true risk underestimated. In fact, this process is already beginning, and the effectiveness of the capital standards will depend substantially on the authorities' zeal in finding and plugging loopholes. This approach will not help much with the moral hazard problem. Too many arbitrary decisions have to be made, and too many loopholes have to be closed.

Need to Rely More on Private Market Involvement

We have questioned those proposals that don't face up to the tradeoff between moral hazard and depositor instability. Each of the above proposals attempts to reduce moral hazard without affecting the safety of bank deposits. That is not possible, at least not at any reasonable cost. These proposals either require exorbitant information costs or don't, in fact, avoid the tradeoff. An effective solution must recognize that there is a tradeoff. The current state of the system is near one extreme; it minimizes the possibility of bank runs at the expense of maximum moral hazard. Since there appears to be no panacea, the tradeoff necessarily means accepting somewhat more depositor instability than is now the case.

The problem, then, is to reform deposit insurance so that there is a better balance between moral hazard and depositor instability. Because the private market tends to allocate resources efficiently, the way to do this is to redesign deposit insurance so that it incorporates features found in most private insurance contracts—higher deductibles and some degree of co-insurance. This in turn will mean more market discipline of banks and private bearing of risk.

Increasing the Deductible

The deductible is one way most insurance contracts are designed to limit the insurance company's loss. Required bank capital, at least from the FDIC's point of view, is the deductible in deposit insurance—the higher the capital, the lower the FDIC's exposure.

Raising capital requirements would also help to reduce moral hazard. It would do this in two ways, and the first is fairly obvious. To the extent that bank owners are risk-averse and cannot completely diversify their investments, more capital helps to offset the incentive to risk taking because owners have more at stake. The second effect is less direct and considerably more subtle. Other things equal, a higher capital requirement will reduce the expected losses of the FDIC, effectively reducing the net subsidy to banking due to deposit insurance. Reducing this subsidy will cause some shrinkage of the banking industry—either as banks cut back on marginally profitable lending or as marginally profitable banks are driven out of business. To the extent the industry is made smaller as the insurance subsidy is reduced, so is the moral-hazard problem.

Furthermore, raising capital requirements will bring capital-asset ratios closer to their pre-deposit insurance levels, levels that presumably reflect a more prudent amount of bank capital. Consider the historical bank capital ratios shown in Figure 2. Before 1933, banks held much more capital than they now do. In fact, from 1844 to 1900, average capital ratios exceeded 20 percent of assets. In recent years, the average has been around 6 percent. Figure 3 shows contemporary capital ratios for banks (actually consolidated bank holding companies) in comparison with other financial intermediary firms in different industries. The other industries are generally less regulated than banking and none have deposit insurance. The capital ratios of the nonbank firms are in all cases much higher than in banking. Both data comparisons suggest that were it not for deposit insurance, banks would most likely hold much more capital.

Establishing Coinsurance

In searching for other ways to mimic a private-market solution to moral hazard, we found an answer in co-insurance.¹³ This technique is often used by private insurance companies to control moral hazard. It makes the insured bear some of the cost of a bad outcome and encourages safe behavior. In banking, this will mean some loss of depositor confidence, since only a percentage of deposits would be insured. The tradeoff, as we have noted, however, is unavoidable. At least with coinsurance the tradeoff would be made explicit and the ability to manage the tradeoff should be enhanced.

In many private insurance arrangements there is at least some risk-sharing, which can take a variety of forms, but the most typical is coinsurance With medical insurance, for example, the insured (after some deductible) may be covered for only 90 percent of expenses. The incentives created by such coinsurance are obvious. The insured are more likely to consider the costs of medical problems. Just as important, the incentives encourage the insured to consider health programs that reduce the need for medical care in the first place.

Coinsurance in banking wouldn't work exactly as it does in the health industry, but the incentive effects would be similar. If deposits were insured only up to 90 percent, for example, all depositors would have an interest in the financial health of their bank. To be competitive with banks that hold relatively safe portfolios, banks that chose riskier portfolios would have to offer their depositors a higher rate of return. Consequently, because risk would now be priced, banks would have less incentive to choose such portfolios and the moral hazard problem would be reduced.

Coinsurance could also be designed to totally protect small savers. For example, the first $10,000 of savings could be 100 percent insured. To avoid the brokering of deposits, this 100 percent insurance limit would apply to the individuals, not to accounts. An individual would be able to identify only one account anywhere that would have this coverage, and anything over this limit (and all funds in other accounts) would be subject to coinsurance.

Some might argue that if we simply enforced the insurance system we have in place today, with its $100,000 ceiling, we could achieve the same result. Of the billions of dollars in deposits, about 23 percent are large, uninsured deposits. In practice, however, regulators have been extremely reluctant to let these relatively few large depositors bear the brunt of a bank failure—especially when many of them are, themselves, commercial banks.

Two major advantages exist in adopting coinsurance over simply putting teeth in the present $100,000 limit. First, it is a very different situation when all depositors suffer small losses than it is when a few depositors suffer large losses. The likelihood of failures transmitted from one bank to another is greatly reduced. And second, modifying the formal structure of the deposit insurance system would send a strong message to the marketplace (and, for that matter, to regulators) that a real change was taking place. Just announcing a "get tough" policy under the present insurance system is a strategy that has been tried, with very limited success.

Time Inconsistency: A Policymaker's Dilemma

The limited success of the get tough policy is symptomatic of a more general problem. If coinsurance is to mitigate moral hazard, policymakers must confront what is known as the "time inconsistency" dilemma: A policy that is best for the long run may not be best for the short run, and vice-versa.¹⁴ Consider the dilemma as it arises with deposit insurance. Once a bank is on the verge of failing, it often appears that the best policy is to protect all depositors, both insured and uninsured. The FDIC can protect all depositors by arranging the purchase and assumption of a troubled bank by a healthy one. For decades this approach was often used because it minimized the FDIC's cost of handling a failing bank. This was the low-cost method, at least partly because in a purchase and assumption transaction the charter value is captured by the FDIC. This approach (or publicly announcing that all depositors will be protected) has the additional advantage that actual or potential bank runs are halted, allowing the reorganization to proceed in an orderly manner.

While such policies may indeed minimize the cost of any particular bank closure, they do not necessarily represent the best long-run policy. That's because the uninsured depositors will learn over time that, whatever is the announced policy, their deposits are actually safe. When that happens, "uninsured depositors" no longer care about bank risk and market discipline is lost. Consequently, there are more bank failures than there would have been, had uninsured depositors not been protected.

Time inconsistency is also a problem in the treatment of large, troubled banks. The current announced policy is that all bank failures are handled under the same set of regulations and general principles. But the announced policy is clearly time-inconsistent, because regulators fear the financial havoc that could result if a large bank were allowed to fail. Quite predictably, the announced policy has not been followed; and just as predictably, it is now widely perceived that all depositors in large banks are fully protected under virtually all circumstances. This market perception confers a significant (albeit unintended) competitive advantage on the largest banks.

For present purposes, the point is obvious. If coinsurance is to be made effective, it must be time-consistent. That is, the authorities must not protect the uninsured portion of depositors' accounts, whether they're in small banks or large ones. With a system of higher capital ratios and coinsurance, however, FDIC losses would be fewer than with the current system. Thus, the short-run cost advantage of purchase and assumption transactions would be reduced. As far as failing large banks are concerned, losses would be spread across a wide spectrum of depositors, and not concentrated in a relative few large, uninsured ones. Of course, any depositor's maximum loss would be bounded by the coinsurance percentage limit. Thus, the likelihood of catastrophic losses for a few depositors would be greatly reduced.

Perhaps more important, market discipline would work both before and after the fact. By this we mean that depositors would be more careful, paying some attention to the financial condition of their banks in good times as well as bad. In net, this would tend to concentrate deposits in well-run, lower-risk institutions, unlike the present system. Smaller banks would be more careful about leaving balances of several times their capital in correspondents, and so on. For all these reasons, the dangers of permitting a large bank failure would be greatly reduced.

Conclusion

We have argued that deposit insurance should be reformed to better reflect private insurance principles and to encourage market discipline. This implies more direct market involvement in bearing bank risk. Through higher deductibles (capital requirements) and coinsurance, shareholders and depositors will have an increased stake in the soundness of their banks.

This proposal has the significant advantage of gradual implementation with modification to the present system. As Professor Robert Lucas, University of Chicago, once observed,

. . . attempting various policies that may be proposed on actual economies and watching the outcome must not be taken as a serious solution method: Social experiments on the grand scale may be instructive and admirable, but they are best admired at a distance. (Lucas, [1983, p. 288].)

Our proposed changes can be implemented on a small scale and carefully, thus avoiding the obvious risks of massive regulatory upheaval. Capital requirements can be raised gradually and with advance warning to the industry. Similarly, coinsurance can be phased in as deemed appropriate. For example, we could adopt a system of 100 percent deposit insurance up to $10,000 and coinsurance for any greater deposit balances, say 2 percent the first year and increasing by a percent or so each year after that. The point is, the initial coinsurance burden of depositors would be small (raising their risk consciousness a bit) but hardly reducing their insurance coverage. An important and difficult question is: How large should the fractional coinsurance burden of depositors ultimately become? We do not pretend to know the answer, and it will surely require an analysis beyond the scope of this essay.

Who Would Gain and Who Would Lose

This proposal, even if fully successful in containing moral hazard and correcting a potentially costly problem, will not necessarily benefit everyone. Some will benefit more than others, and some will be worse off than they are under the current system. Who would gain and who would lose? Those made better off would include the FDIC, the taxpayers and some commercial banks. The FDIC would be an obvious winner, since its insurance liabilities would be directly reduced. How would this benefit the taxpayers? As the U.S. public is in the process of painfully discovering, the taxpayers ultimately stand behind federal deposit insurance, the $100 billion estimated loss of the FSLIC being a case in point. Since our recommended changes would take the FDIC stronger and less likely to become insolvent, all taxpayers would benefit. Moreover, since an essential aspect of our proposal is that all banks operate under the same capital and coinsurance rules—meaning that no bank is too big to fail—smaller banking organizations, which currently are confronted with unfair and unfortunate competition, would also benefit.

All banks would lose to the extent the expected losses of the FDIC were lowered, thus reducing the net subsidy to the banking industry. Banks, and of course depositors, would also lose the blanket insurance protection now offered depositors, making them less competitive with the myriad of uninsured savings instruments. With a better system of deposit insurance in place, though, bank powers could be expanded with less concern about soundness issues, that is, less concern that moral hazard was being spread to nonbank lines of business.

On balance, the benefits of this proposal far outweigh the costs. That there will be costs and that they cannot be avoided should be clear. We see no way to make progress on moral hazard without increasing the potential for depositor instability. If the experience in the savings and loan industry, however, is any indication of the potential problems in banking, some tradeoff is warranted.

[NOTE: This is only the text of the annual report. ]

Endnotes

1 The point that reform should logically precede further deregulation was forcefully made as early as 1983 by Kareken.

2 This essay deals with bank regulation in general, and the Federal Deposit Insurance Corporation (FDIC) in particular. But, most of our policy recommendations would be equally applicable to the savings and loan industry and their insurer, the FSLIC. What is not discussed here is the current financial crisis of the FSLIC, a problem which is (thankfully) unique to that institution.

3 Data for uninsured deposits in failed banks that were purchased by other banks are not available. We estimate uninsured deposits as the difference between total assets and total insured deposits, based on the assumption that equity of failed banks is zero.

4 The moral hazard problem is, in fact, more extreme with deposit insurance than it is with many forms of private insurance. The FDIC does not prohibit troubled banks from buying more insurance (that is, acquiring more deposits). This is analogous to allowing the owners of a factory to buy more fire insurance when their factory is on fire.

5 While bank stock owners may be able to effectively diversify their risks, this is much more difficult for the senior management of banks. That is so because when a bank fails it may reflect on their skill as managers, and thus on the value of their human capital. This point is sometimes raised as an important force countervailing the incentive effects of moral hazard. However, if bank owners genuinely want managers to pursue high-risk strategies, it seems they can get their wish. One obvious way is to pay managers sufficiently high current salaries to offset their risk of loss should bankruptcy occur in the future.

6 The high potential earnings in commercial banking were undoubtedly dissipated, in part, by subsidizing loan rates and by non-price competition for depositors. But the monotonously low failure rate through the 1970s strongly supports the notion that bank owners were still doing well.

7 The protective subsidy notion is more fully discussed and defended in Benveniste, Boyd and Greenbaum (1988).

8 Continuing this trend, on January 18, 1989, the Board of Governors ruled that five major banking firms could underwrite and deal in corporate debt. The Board also indicated at that time that (if all went well with debt underwriting) it would consider permitting banking concerns to underwrite corporate equities within about a year. In a previous decision (April 30, 1987), the Board approved applications to underwrite commercial paper, mortgage-backed securities, municipal revenue bonds and consumer related receivables. Even earlier, discount brokerage was determined to be a permissible activity for banking organizations on January 7, 1983.

9 100 percent reserve banking was proposed by Simons (1936) and later by Friedman (1959).

10 In theory, at least, the incentive effects of closing banks before they fail are much like those of the protective subsidy.

11 We are not suggesting that banks should be kept open when all available information indicates that the value of their liabilities exceeds the value of their assets. This policy invites end-gaming strategies on the part of bankrupt institutions, and is in large part to blame for the recent losses of the FSLIC.

12 In 1988, new capital guidelines were announced for banks in the United States and a number of other countries, pursuant to an international agreement in Basle, Switzerland. The Basle Agreement calls for minimum capital of 7.25 percent of assets by the end of 1990 and 8 percent of assets by the end of 1992. The new capital requirements are risk-progressive, at least in terms of asset risk. Five risk classes are established for assets and off-balance sheet items. Each is weighted from 0 to 1.0 with cash and short-term U.S. Treasury bills receiving the lowest weight, whereas most bank loans receive the highest weight. All other assets are assigned weights of 0.1, 0.2, or 0.5, depending on their assessed risk. For a detailed discussion of the Basle Agreement risk classifications, see Federal Reserve System (1988).

13 We claim no originality for this proposal. In fact, it has some historical precedent. Co-insurance was part of the original deposit insurance plan that was to go into effect on July 1, 1934 (FDIC, p. 44). Deposits up to $10,000 for each depositor were to be fully insured. Over $10,000 but under $50,000 was to have 75 percent coverage, and over $50,000 only 50 percent coverage. This plan, however, was superseded by a new plan that was part of the Banking Act of 1935 which provided only full coverage up to $5,000.

14 The seminal work on time inconsistency is Kydland and Prescott (1977). For a less technical discussion of this problem, see Chari (1988).

Bibliography