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
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
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 ).
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
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
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
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.
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
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.
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,
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. ]
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).