In the previous issue of the fedgazette, we published two
responses to the Minneapolis Fed's proposal to address
the problem of too much federal deposit insurance: one from the
Independent Bankers Association of America (IBAA), and a rejoinder
to the IBAA from one of our Ninth District bankers, Bob Meyerson
of Atwater, Minn. Their debate points up a curious response to our
plan: the opposition of many small banks, including their representative
trade group, the IBAA. The small banks' response is curious because
our proposal would seem to level the playing field; that is, those
banks considered too big to fail would no longer be granted the
implicit assurance of 100 percent coverage for large depositors
and creditors, an assurance that is not granted to smaller banks.
But before I address further the concerns of small banks, let me
first summarize the current problem with federal deposit insurance
and our bank's proposal to address this issue. I should begin by
mentioning that this bank has a history of dealing with this issue,
beginning in the 1970s with research by our economists, and continuing
with the publication of our 1988 Annual Report, "A
Case for Reforming Federal Deposit Insurance." Last year, we
held a series of meetings with Ninth District bankers on deposit
insurance reform, after which we formulated our proposal to amend
the system; that proposal was further refined in our 1997
The Problem With Deposit Insurance
Recent history provides ample evidence of the need for a reconsideration
of deposit insurance. The savings and loan fiasco and increased
failures of commercial banks in the United States during the 1980s
and early 1990s consumed considerable resources. Explicit resolution
expenses were quite high, of course, as the S&L cleanup is estimated
at 2.5 percent or more of GDP. Indeed, this estimate is probably
low, since it ignores both deadweight losses resulting from resource
misallocation and damage to public confidence in the financial and
Despite its size and significance, the American experience of
this period was not unique. The World Bank reports that at least
70 banking crises occurred in the 1980s throughout the developed
and developing worlds. The quantitative impact of some of these
crises equaled or exceeded the U.S. experience. Interestingly enough,
Asia saw its share of banking crises in the 1980s in countries such
as Indonesia, Malaysia, Japan, Thailand and the Philippines.
Macroeconomic shocks, deficiencies in supervisory policies and
an unwillingness to close insolvent institutions are factors often
cited to explain the above financial debacles. However, there seems
to be a growing consensus on another factor: the breakdown in, or
absence of, market discipline, caused by a belief that the government
will absorb the losses that bank creditors would otherwise bear.
This is the well-known problem of moral hazard. In the United States,
moral hazard resulted in part from the deposit insurance system
that provides explicit coverage to $100,000 per account. Protected
depositors did not have adequate incentive to price their funding
according to the riskiness of the bank, thereby allowing some institutions
to attract funds at below market rates. So-called brokered deposits
exacerbated this problem significantly, since the $100,000 umbrella
could be exploited despite geographic and other "natural" barriers.
But perhaps more devastating than explicit insurance coverage
was the influence of the government's implied support. Oftentimes
the coverage of uninsured depositors is referred to as a policy
of too big to fail (TBTF), implying that, for systemic reasons,
an institution is too important to expose its creditors to loss.
Actually, however, widespread protection of all uninsured depositors
is a more accurate description, for the FDIC protected 99.7 percent
of all deposits at failed commercial banks from 1979 to 1989. This
implicit coverage created widely held expectations of government
protection of depositors, especially at large institutions, and
further undermined market discipline significantly.
The Minneapolis Fed Proposal
In 1991, Congress partially fixed the problem of 100 percent coverage
by passing the Federal Deposit Insurance Corp. Improvement Act (FDICIA).
Among other things, FDICIA substantially increased the likelihood
that uninsured depositors and other creditors would suffer losses
when their bank fails. The fix was incomplete, however, because
regulators can provide full protection when they determine that
a failing bank is TBTFthat is, its failure could significantly
impair the rest of the industry and the overall economy.
We think this TBTF exception is too broad; there is still too
much protection. The moral hazard resulting from 100 percent coverage
could eventually cause too much risk taking and poor use of society's
resources. Consequently, we propose amending FDICIA so that the
government cannot fully protect uninsured depositors and creditors
at banks deemed TBTF.
Basically, our idea is to require some form of coinsurancethe
practice of leaving some risk of loss with the protected party.
Regardless of the formulation, we think all uninsured depositors
should be subject to the same coinsurance plan, including banks
with uninsured deposits at their correspondent. In addition, we
propose treating unsecured creditors holding bank liabilities that
have depositlike features the same as uninsured depositors. Also,
we propose that the coinsurance plan under a TBTF bailout be phased
in over several years to avoid any abrupt change in policy.
Our other key recommendation is for regulators to incorporate
a market assessment of risk in the pricing of deposit insurance.
In particular, after implementation of this proposal, we recommend
that regulators incorporate the risk premium depositors and other
creditors receive on uninsured funds into the assessments on TBTF
Lastly, to help uninsured depositors and other creditors monitor
and assess bank risk, we propose that regulators disclose additional
data on banks' financial condition. We think that banks will have
an incentive under our proposal to disclose additional information
that the market requires. Regulators should consider mandated, cost-effective
disclosures only if voluntary release does not occur.
Small Banks' Response
Under FDICIA, no small bank (a broad definition in this case, including
all banks not considered too big to fail) benefits from the assumption
of 100 percent depositor coverage. Indeed, while there have been
only a limited number of commercial bank failures since FDICIA (about
190 commercial banks failed from 1992 to 1996 and none were very
large), the FDIC has established a pattern of imposing losses on
uninsured depositors at small banks.
It would seem, then, that smaller banks would favor a proposal
that assures losses at banks that are deemed too big to fail. But
that hasn't been the case. Perhaps the most vociferous opponents
of our reform are the smaller banks and their representatives. Yet,
small banks would be among the leading beneficiaries of our plan.
Providing 100 percent coverage to certain large banks under the
TBTF exception in FDICIA places smaller banks at a competitive disadvantage.
Uninsured depositors at small banks can reasonably expect to suffer
losses under FDICIA if their bank fails. In contrast, depositors
at the nation's largest banks would likely escape unharmed under
exceptional FDICIA treatment. Thus, depositors have reason to transfer
their deposits from smaller to larger banks or demand a small bank
rate premium. Imposing losses on uninsured depositors at larger
banks should help to level the playing field.
In its response published in the last issue of the fedgazette,
the IBAA warns its members that our proposal creates "the appealing
illusion that too big to fail can be done away with, at least to
the extent of putting large depositors at too big to fail banks
at risk. It is imperative that community bankers don't buy into
illusions in this regard."
But this is no illusion. The passage of FDICIA in 1991 made clear
that Congress is willing to address the problem of TBTF; our proposal
simply goes one step further and, in the end, assures that TBTF
banks are treated like their smaller counterparts.
Bob Meyerson would seem to agree. He was a member of a group of
district bankers that gathered at the Minneapolis Fed last year
to discuss this issue, and in his response to the IBAA he offers
a fitting final word: "You seem to argue that [curbing TBTF] is
an impossible goal. I am not so sure. At a minimum there is surely
a group of banks which would be TBTF under the present arrangement,
but not TBTF under Stern's regime."