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Deposit insurance, too big to fail and small banks

Minneapolis Fed President Gary Stern reacts to the concerns that small banks have about the Minneapolis Fed's deposit insurance proposal

April 1, 1998


Gary H. Stern Former President (1985 - 2009)
Deposit insurance, too big to fail and small banks

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 Annual Report.

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 political system.

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 TBTF—that 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 coinsurance—the 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 banks.

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."