The views expressed herein are not necessarily
those of the Federal Reserve System.
Government support for depositors and other creditors of failed
banks is a two-edged sword. It protects the less sophisticated depositor
and helps to prevent banking panics that have historically led to
economic retrenchment. But too much government protection encourages
banks, often the largest in a country, to shift funds into high-risk
projects that they would not otherwise fund. This effect on banks'
behavior is known as moral hazard and can lead to less productive
use of society's limited resources.
The challenge for policy-makers is determining how much protection
is too much. Unfortunately, economic theory does not prescribe an
optimal amount. Theory, however, does suggest that 100 percent coverage
can lead to excessive risk taking. Yet, by the 1980s, full protection
of all depositors (and in some cases other creditors) became a common
practice and banks behaved as predicted, resulting in one of the
worst financial debacles in U.S. history.
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 too-big-to-fail (TBTF)that is, its failure
could significantly impair the rest of the industry and the overall
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.
To suggest reforming our banking laws at a time when bank failures
are a distant memory for most may seem incongruous. But waiting
could prove costly. The continuing consolidation in banking could
lead more banks with more uninsured deposits to qualify for TBTF
status. In addition, bank powers are expanding and will probably
grow further, so TBTF banks will have more activities potentially
benefiting from full protection. Now is also an opportune time to
amend FDICIA because the robust economy and record bank earnings
make it easier for banks to absorb the costs of reform.
Our proposed reform attacks the problem of 100 percent coverage
head-on by requiring uninsured depositors of TBTF banks to bear
some losses when their bank is rescued. We also recommend that regulators
treat unsecured creditors with depositlike liabilities the same
as uninsured depositors, while providing no protection to other
creditors. TBTF banks would then have to pay uninsured depositors
and other creditors higher rates for funds when the chance of bank
default increases, thus muting their incentive to take on too much
risk. To further address moral hazard, we propose that the FDIC
incorporate the market's assessment of risk, including the rate
paid to uninsured depositors and other creditors, into insurance
We recognize that these reforms, by increasing market discipline,
will make bank runs and panics more likely. Consequently, we cap
the losses that uninsured depositors and unsecured creditors with
depositlike liabilities can suffer. Keeping losses relatively low
also makes our plan credible because it eliminates the rationale
for fully protecting depositors after a bank has failed. In addition,
we call for the disclosure of more supervisory information and provide
an incentive for banks to release additional information in order
to help market participants evaluate the financial condition of
We do not claim to have struck the perfect balance between market
discipline and government protection, or to have found the only
credible way to increase market discipline, but experience and theory
cannot justify continuation of 100 percent protection. Moreover,
alternatives to our reform that rely on regulation or the privatization
of deposit insurance have much more serious drawbacks. We also recognize
that our reform is unlikely to be the only action that Congress
will have to take to end 100 percent coverage. Thus, we suggest
an additional step that Congress may need to consider in the future.
Expansion to 100 Percent Coverage and its Danger
Until the financial debacle of the 1980s, the federal government's
program to stabilize banks (used broadly to include all insured
depositories) had been considered highly successful. Federal deposit
insurance was established in 1933 to protect small depositors and
to prevent the systemwide banking runs that had plagued the U.S.
economy for close to 100 years. These goals were accomplished. Small
depositors at failed banks were always fully protected, and nationwide
banking panics in the United States became historical curiosities.
However, the financial debacle of the 1980s made clear that depositor
protectionwhich had gone well beyond the small saverdid
not prevent turmoil in the banking system. Indeed, between 1979
and 1989, 99.7 percent of all deposit liabilities
at failed commercial banks were protected.1 Yet, roughly 1,000 commercial banks still failed. At about the same
time, while the federal government was insuring nearly all deposits
at savings and loans, over half the industry failed.
This expansion to complete coverage was the result of several
factors. First, the coverage rules allowed for more protection.
The amount insured expressed in 1980 dollars had risen from roughly
$30,000 in 1934 to $100,000 in 1980 and the FDIC insured a wider
range of deposits (for example, so-called brokered deposits, which
are funds that banks purchase from depositors via a broker). Second,
the FDIC chose resolution techniques for failed banks that fully
protected virtually all uninsured depositors and, in many cases,
other unsecured creditors. In fact, in the FDIC's 1985 Annual
Report, the chairman of the FDIC made it an explicit objective
of the standard resolution process to fully cover all uninsured
depositors. Finally, regulators indicated that they would take extraordinary
steps in response to the failure of a very large bank not otherwise
allowed during a standard resolution. Such steps have included full
protection for uninsured depositors and other creditors, as well
as suppliers of funds to the bank's holding company and potentially
even shareholders, without regard to the cost to the FDIC. This
practice became known as TBTF and emerged from the 1984 rescue of
Continental Illinois, the seventh largest U.S. bank at the time.
We think that the 100 percent coverage and the financial debacle
of the 1980s were not independent events. While other explanations
for the huge number of bank failures are plausible,
we view too much protection as a critical underlying cause.2 Once its depositors and other creditors are fully protected, a bank
is likely to take much more risk than it would
otherwise.3 This is especially
true at banks where owners can diversify their risk or at banks
that are seriously undercapitalized. In effect, it's heads the bank
wins and tails the taxpayer loses.
Policy-makers in Congress and the Treasury Department recognized
the dangers resulting from 100 percent protection and moral hazard.
The Treasury's recommendations for the bank reform legislation in
1991 pointed to the "overexpansion of deposit insurance" as a fundamental
cause for the exposure of taxpayers to "unacceptable losses."4 Likewise, in preparing FDICIA, Congress found that "taxpayers face
a bank fund bailout today primarily because the federal safety net
has stretched too far. FDIC insures more kinds of accounts than
was originally intended, and also frequently covers
uninsured deposits."5 With
the recognition, came the legislative response.
FDICIA's TBTF Policy Falls Short
FDICIA makes routine, full protection of uninsured depositors and
other creditors at banks more difficult. However, FDICIA continues
to allow full protection of depositors and other creditors at banks
Reduces Routine, Full Protection for Uninsured Depositors. FDICIA creates a new, "least cost," resolution process that makes
the FDIC less likely to offer full protection. Under the 1991 law,
the FDIC must consider and evaluate all possible resolution alternatives
and choose the option that has the lowest cost for the deposit insurance
fund. This requirement has led to many more resolutions in which
acquirers only assume insured deposits.
The graph below indicates the extent to which the FDIC has reduced
its coverage of uninsured depositors. In 1986, for example, the
FDIC fully protected uninsured depositors of commercial banks that
held over 80 percent of the assets of all failed banks. In sharp
contrast, in 1995 the FDIC protected no uninsured depositors at
failed banks. 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.
Allows Full Protection at TBTF Banks. FDICIA contains an
exception to allow 100 percent protection. It allows full coverage
for depositors and other creditors at banks deemed TBTF through
a multiapproval process. The Secretary of the Treasury must find
that the lowest-cost resolution would "have serious adverse effects
on economic conditions or financial stability" and that the provision
of extraordinary coverage would "avoid or mitigate such adverse
effects." The Secretary of the Treasury must consult with the president
in making this determination. In addition, two-thirds of the governors
of the Federal Reserve System and two-thirds of the directors of
the FDIC must approve the extraordinary coverage.
While these limitations appear to constrain bailouts, they are
not prohibitive. Indeed, Congress appears to have codified, but
not necessarily altered, the informal rescue process that was previously
in place. Consider the 1984 testimony of the Comptroller of the
Currency on the decision to bail out Continental Illinois:
We debated at some length how to handle the Continental situation.
... Participating in those debates were the directors of the
FDIC, the Chairman of the Federal Reserve Board, and the Secretary
of the Treasury. In our collective judgment, had Continental
failed and been treated in a way in which depositors and creditors
were not made whole, we could very well have seen a national,
if not an international, financial crisis the dimensions of which were difficult to imagine. None of us wanted
to find out.6
Why the Time is Ripe for Fixing FDICIA
Our rationale for questioning the exception under FDICIA is clear.
One hundred percent protection has proven a high-cost policy.
The lack of market discipline under such a regime suggests that
the current TBTF exception could encourage excessive risk taking
in the future.
The need to fix this aspect of FDICIA now, however, may appear
counterintuitive. The banking industry is enjoying record profits,
banks have been able to broaden the activities from which they
can generate revenue and the largest U.S. banks have grown to
the size that some analysts believe is required to compete internationally.
Yet, it is these very trends that make enactment of our reform
More TBTF Banks
More large banks controlling a greater share of uninsured deposits
have resulted from recent bank consolidation. Hence, regulators
may view more banks as requiring TBTF treatment under FDICIA.
Consequently, more uninsured depositors will assume that their
bank is TBTF and their deposits will be protected.
No written list of the TBTF institutions exists, but previous empirical work used the 11 largest institutions highlighted
by the Comptroller of the Currency in his 1984 testimony. Those
banks controlled 23 percent of all assets at the end of 1983 and
had an average size, in 1997 dollars, of about $94 billion. The
11 largest banks as of the end of 1997 held 35 percent of all
assets and had an average size of nearly $157 billion. The growing
number of large banks also means that the TBTF list may have expanded
past the 11-bank list. The smallest of the 11 TBTF banks in 1983
had assets of just over $38 billion in 1997 dollars. Using $38
billion as a cutoff suggests that regulators may view depositors
at the nation's 21 largest banks as benefiting from implied deposit
insurance (see Table below).
The top 21 banks that regulators may view as TBTF have increased
their share of uninsured deposits from 30 percent in 1991 to 38
percent in 1997. (The top 50 banks increased their share from
44 percent in 1991 to 55 percent in 1997.) At the same time, total uninsured deposits have increased. Consequently,
the taxpayers' exposure at TBTF banks has increased significantly
More Bank Powers
Banks are not only growing in size, they are growing in powers,
that is, in their ability to offer nonbank financial services
such as the sale and underwriting of insurance and securities.
Both the Office of the Comptroller of the Currency and the Board
of Governors of the Federal Reserve System have expanded the types
and/or the amount of nonbank financial activities in which banking
organizations can participate. Both regulators also support legislation
that expands their nonbank financial and commercial activities
(they disagree as to the organizational structure in which such
powers will be exercised and the specific type and amount of new
powers made available). Expanding powers would increase the role
of banking organizations in the financial system, making it more
likely that regulators will consider the failure of a large institution
as destabilizing. For these reasons, we view banking deregulation
before deposit insurance reform as "putting the cart before the
horse," a view long held by researchers at the Federal Reserve Bank of Minneapolis.7
More Bank Profits
The most extensive reforms to the bank regulatory system have
occurred after or during banking crises. Although some of these
reforms were well-conceived, good times present a superior time
for action for at least two reasons. First, we should put depositors
and other creditors at risk now precisely to avoid a future debacle.
Second, a reform may put institutions in a weaker financial position
by increasing their cost of funds. We should, therefore, enact
reforms when banks have more resources to absorb the higher costs.
TBTF Banks Have Increased in Size and May Have Increased in
In 1984 congressional testimony, the Comptroller of the Currency
suggested that the 11 largest banks were TBTF. As of year-end
1997, the banks in the right column exceeded the minimum size
required$38.2 billionto make the Comptroller's TBTF
Assets as of 12/83
(billions of $)
Assets as of 12/97
(billions of $)
| 1983 Ranking
|| 1983 Dollars
|| 1997 Dollars
|| 1997 Ranking
|| 1997 Dollars
||1 Chase Manhattan
|2 Bank of America
|3 Chase Manhattan
||3 Bank of America
|4 Manufacturers Hanover
|5 Morgan Guaranty
||5 Morgan Guaranty
||6 First Union
||7 Bankers Trust
|8 Bankers Trust
||8 Wells Fargo
|9 Security Pacific
|10 First Chicago
|11 Wells Fargo
||11 U.S. Bank
||14 NationsBank (TX)
||15 First Chicago
||16 Bank of New York
Putting Uninsured Depositors and
Other Creditors of Large Banks at Risk
We propose that Congress amend FDICIA so that uninsured depositors
cannot be protected fully when a troubled bank is rescued under
the TBTF policy. Congress can implement this reform in several
ways described below, but the basic 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 include the risk premium depositors and other
creditors receive on uninsured funds in 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
Coinsurance under TBTF
To address the potential problems created by 100 percent coverage
under the TBTF exception, we turn to the conventional technique
that private insurance companies have used to mitigate moral hazard.
Analysis identified coinsurance about 30 years
ago as a primary means for insurance underwriters to combat moral
hazard.8 In that vein, we propose that uninsured depositors and other creditors
face a small but meaningful loss when regulators exercise the
Congress could formulate a coinsurance policy in several ways.
A simple approach would set a "maximum loss rate" that uninsured
depositors could face, say at 20 percent, and phase it in over
time. Congress could set an initial, maximum 5 percent loss and
have it rise 5 percentage points a year for the following three
years. Under the maximum loss rate approach, uninsured depositors
would receive no protection if they would suffer losses of less
than 20 percent of their uninsured deposits, for example, after
they receive proceeds from the liquidation of failed bank assets.
This approach may be objectionable if the rate is set so high
as to effectively eliminate TBTF coverage. To address this, the
maximum loss rate could be lowered or Congress could apply the
coinsurance rate to the loss that uninsured depositors would have
faced if the FDIC did not protect uninsured depositors. This "loss reduction rate" would ensure that uninsured depositors always
receive some coverage above what they would have received from
the liquidation of the failed bank's assets.** In 1990, the American Banker's Association proposed a coinsurance
formulation somewhat similar to the loss reduction approach for
eliminating 100 percent coverage at TBTF banks.
Congress must address a critical trade-off when choosing a coinsurance
policy. The potential loss should be set high enough so that uninsured
depositors will be induced to monitor the financial condition
of their bank, but not so high as to eliminate the stabilizing
benefits of government protection. Certainly, the details of a
co-insurance policy under this maxim will always be somewhat arbitrary.
However, policy-makers do not escape the difficult decision of
determining how much market discipline to impose on depositors
by maintaining the status quo.
The TBTF exemption in FDICIA should also not allow full coverage
of all unsecured creditors of failed banks. Indeed, Congress recently
indicated a preference for imposing post-resolution losses on
such creditors by passing a national depositor preference statute
in 1993 (which put unsecured creditors further back in the queue
for receiving revenue realized from the resolution of a failed
institution). In scaling back potential coverage for unsecured
creditors, we think Congress must address the same critical trade-off
it faces when putting uninsured depositors at risk. Thus, we recommend
that unsecured creditors holding depositlike bank liabilities
should face the same coinsurance policy as uninsured depositors.
All other unsecured creditors should receive no special coverage.
This formulation would protect, for example, holders of very short
maturity bank liabilities like the overnight loans banks make
to each other, certain commercial paper and foreign deposits but
not holders of longer-term liabilities or claims arising from
the provision of services or court judgments.
Incorporating Risk into Insurance Assessments
Prior to 1993, the FDIC charged all banks the same assessment
for deposit insurance regardless of their risk of making a claim
against the insurance fund. Banks did not face the cost of excessive
risk taking because the insurerlike the depositor with 100
percent insurance coveragedid not charge risk penalties
when the probability of bank failure increased.
FDICIA required the FDIC to create a system of risk-based insurance
assessments because a flat-rate assessment encourages excessive
risk taking. The initial risk-based assessments turned out to
be too high for low-risk banks and too low for
the highest-risk banks.9 Rather than correcting this failure, the FDIC was, in essence,
forced back to flat-rate assessments (due to restrictions on the
insurance reserves it can hold). Since 1996 over 90 percent of
banks have paid the statutory minimum assessment, which has fallen
from $2,000 per year to zero.
The problem here is that, even if uninsured depositors and other
creditors have the potential for bearing losses, TBTF banks may
still take on too much risk if insurance assessments are not risk-based.
This occurs because taxpayers would continue to bear some of the
banks' risk. Thus, we recommend that any FDICIA reform to eliminate
the potential for 100 percent coverage at large banks be accompanied
by efforts to make their assessments more sensitive to risk.
To this end, we recommend market-based, risk-adjusted insurance
assessments for TBTF banks. We suggest that the FDIC include the
risk premium implicit in rates paid on uninsured deposits (as
well as other market measures of risk) into insurance assessments
for the largest banks. The FDIC, for example, could charge the
largest banks with a risk premium above policy-makers' comfort
level, say that on the A-rated corporate bond, much higher assessments
in order to halt exploitation of insured status. Alternatively,
the FDIC could incorporate the risk premium more gradually so
insurance assessments rise or fall incrementally with changes
in the risk premium.
Proposals to incorporate risk premiums on uninsured deposits
into FDIC assessments date at least as far back as 1972. Critics
of this reform usually argue that depositors and other market
participants will not price risk correctly, either because they
believe they will receive a bailout or because they do not have
adequate information. As a result, assessments based on market
risk premiums will not accurately price risk. Our proposal makes
clear that uninsured depositors cannot receive full protection.
Recent empirical reviews find that suppliers of funds to banks
charge risk premiums if they will, in fact,
face losses when their bank defaults.10 As for the lack of information about banks' behavior toward risk,
we add one additional reform to our proposal.
The more information depositors and other creditors have on the
financial and operational condition of their bank, the more the
risk premium on uninsured deposits and other bank funding will
reflect true underlying risk. Thus, we recommend ensuring that
market participants have data that make the financial condition
of banks less opaque.
Regulators, for example, receive nonpublic information on loans
with late repayments that could be made public along with other
information or assessments that regulators gather or produce.
Some of this data may contain new information for market participants,
and disclosure of such information may improve
the ability of funders to evaluate their banks.11
Banks will have an incentive under our proposal to reveal more
information about their business. The more germane data banks
provide, the less opaque they are and the lower the interest rate
they will have to pay uninsured depositors. Regulators should
consider requiring cost-effective disclosure only if banks do
not voluntarily disclose the information that markets need to
properly assess bank financial condition.
Of course every uninsured depositor does not have the same skills
or desire to analyze disclosures provided by banks and regulators.
But existing firms, and firms that will develop in the future,
will surely provide analysis of banks' condition for uninsured
depositors just as specialized firms provide evaluations of mutual
funds and the claims-paying ability of insurance firms. The lack
of interest in bank conditions currently manifested by uninsured
depositors and the absence of firms providing evaluations of banks
for these depositors reflect current incentives, not innate features
of the human or business condition.
Addressing the Fundamental Trade-off
We began this essay noting that deposit insurance is a two-edged
sword. On the one hand, it protects the small saver and limits
the probability of banking panics. On the other hand, too much
deposit insurance leads banks to take on more risk than they would
otherwise. All deposit insurance systems must face this fundamental
Our plan clearly adds market discipline. It also addresses the
concern of increased instability in four ways.
First, we put only a small percentage of uninsured depositors
and other creditors' funds at risk. Limiting the amount of the
potential loss should help contain spillover effects from any
one large bank failure to other banks and the rest of the economy.
A bank that has uninsured deposits at a large failing bank, for
example, is not likely to suffer losses so great as to bankrupt
it. Thus, depositors do not have cause to run all banks with deposits at large failing institutions for fear of interbank exposure.12 Moreover, the small potential loss makes it less likely that the
benefit of pulling deposits out of a bank will outweigh the costs
of making alternative investments.
Second, our reform should increase the information that markets
have on banks' financial condition. Depositors are less likely
to run sound banks if they are more transparent.
Third, by increasing market discipline, we make it more likely
that banks will not take excessive risk.
Finally, we call for a gradual increase in the coinsurance rate.
Policy-makers and analysts will have time to review the response
of depositors and other creditors and adjust the rate. Likewise,
incorporating a market-based risk premium into the insurance assessment
need not occur at once.
Can we guarantee that our plan achieves the right balance? No
reform plan can make such a claim. We may have too much or too
little of uninsured depositors' funds at risk. Under our plan,
uninsured depositors at risk of loss might pull their funds from
all large banks regardless of their solvency. But one cannot reasonably
judge the plan's potential costs in the abstract. Rather, interested
parties must compare this proposal to the current system and alternative
Some analysts have argued that FDICIA's regulatory reformsin
conjunction with existing market discipline provided by stockholders,
bondholders and bank managers fearing for their jobsadequately
address the potential problems that 100 percent coverage at TBTF
banks can create. Yet, as we noted, stockholders are the beneficiaries
of excessive risk taking and are unlikely to act as a bulwark
against it. Moreover, experience over the last 15 years suggests
to us that these other sources of market discipline are not sufficient
to control the deleterious effects of moral hazard. And while
the FDICIA regulatory reforms were a step in the right direction,
reviews of these changes do not suggest that
they adequately curtail risk taking.13 Moreover, we are skeptical that additional regulations can effectively
substitute for putting uninsured depositors and other creditors
at risk. Certainly, promulgating Draconian regulations could prevent
the problems arising from 100 percent coverage, but such a strategy
would impair the ability of the banking system to efficiently
allocate financial resources.
Eliminating federal deposit insurance altogether offers another
alternative for addressing the moral hazard of 100 percent coverage
at the largest banks. We do not find this reform credible. Banking
panics were not eliminated in the United States under private
deposit insurance systems. Consequently, it is likely that banking
regulators, in order to address the threat of such panics, would
still want to fully protect depositors at large failing banks
after privatization. Thus, the public would still assume that
their deposits are fully protected at banks considered TBTF and
moral hazard would still remain a problem.
In contrast to privatization options, we view reforms requiring
TBTF banks to hold subordinated debt as differing from our own
in implementation detail rather than intent
or substance.14 Both plans seek to increase market discipline by putting those
who supply funds to TBTF banks at risk, and both allow the FDIC
to incorporate additional market data into their assessment-setting
process. And, like our plan, credible subordinated debt reforms
must address the trade-off between depositor safety and bank risk.
Unfortunately, our proposed reform will almost certainly not be
the final action that Congress must take to eliminate 100 percent
coverage. For example, uninsured depositors may divide their funds
into multiple insured accounts in order to avoid the potential
for loss. In response, Congress may have to curb the ability of
depositors to receive more than $100,000 in insurance coverage
through multiple accounts, or apply a co-insurance policy to all
A Unique Opportunity
Economic theory and experience both suggest that providing 100
percent government protection for bank depositors and other creditors
can be extremely costly. One hundred percent coverage quashes
market discipline, encourages banks to take on too much risk and
can massively misallocate society's limited resources. It can
lead to the very type of bank failures and costs to society that
deposit insurance aims to prevent. These costs are so high that
Congress should prohibit bank regulators from providing 100 percent
coverage as is currently allowed at the nation's largest banks.
We think that a credible reform is to amend FDICIA so that uninsured
depositors and other creditors cannot be fully protected under
the TBTF exception but do not suffer losses so large as to eliminate
the stabilizing benefits of government protection. In another
step necessary to address moral hazard, we recommend that the
FDIC use market signals, from at-risk depositors and other available
sources, to make insurance assessments of TBTF banks risk-related.
Our reform is unlikely to be the last that Congress will need
to pass. However, the potential for future reform should not dissuade
policy-makers from using the current window of opportunity to
avoid the mistakes of the past. The FDIC sought to increase depositor
discipline in the early 1980s through a resolution method, called
modified payoff, in which uninsured depositors would receive no
extraordinary coverage, but rather a proportion of their money
based on the liquidation value of the bank's assets. The FDIC
had "experimented" with the method and "hoped
to expand the modified payoff to all banks regardless of size."15 But the failure of Continental soon after the pilot program began
led to its demise. Now, Congress can establish a commitment in
law to impose losses on uninsured depositors and other creditors
at banks deemed TBTF. Without such a credible commitment, Congress
may find itself in the uncomfortable position of conducting the
post-mortem of another financial debacle.
The Minneapolis Fed Proposal
To guarantee that uninsured depositors cannot be protected fully
under the too-big-to-fail (TBTF) policy, and to thereby minimize
the impact of the moral hazard problem, Congress should amend
the Federal Deposit Insurance Corp. Improvement Act of 1991 (FDICIA)
- Prohibit the full protection of uninsured depositors and
other creditors when TBTF is invoked.
- Incorporate the risk premium that depositors and other creditors
receive on uninsured funds into the assessments on TBTF banks.
- Require the disclosure of additional data on banks' financial
* In addition to potentially more TBTF banks,
recent research suggests that large banks have not reduced their
exposure to a significant risk since FDICIA. Specifically, the
largest 10 percent of publicly traded bank holding companies had
significant interest-rate risk both before and after FDICIA. If
FDICIA had reduced the interest-rate risk that large banks are
taking, the relationship between interest-rate movements and bank
stock prices should not be as strong after FDICIA as before it.
Instead, the research finds no decline in the level of interest-rate
risk at large banks since FDICIA. See David E. Runkle, "Did FDICIA
Reduce Bank Interest-Rate Risk?" Working Paper, Federal Reserve
Bank of Minneapolis, December 1997.
** An example where an uninsured depositor
suffers a $10,000 loss clarifies the difference in the two approaches.
A 20 percent rate under the maximum loss formulation would provide
no insurance if the $10,000 loss is less than 20 percent of the
depositor's total uninsured deposits and complete coverage for
any losses above 20 percent. In contrast, a 20 percent coinsurance
rate under the loss reduction formulation would reduce a $10,000
post-liquidation loss to $2,000.
1 Moyer, R. Charles, and Lamy, Robert E. 1992.
Too Big To Fail: Rationale, Consequences, and Alternatives. Business
Economics 27 (3): 19-24.
2 Alternative explanations are found
in John H. Boyd and Arthur J. Rolnick. 1989. A
Case for Reforming Federal Deposit Insurance. 1988 Annual
Report. Federal Reserve Bank of Minneapolis.
3 Kareken, John H., and Wallace, Neil.
1978. Deposit Insurance and Bank Regulation: A Partial-Equilibrium
Exposition. Journal of Business 51 (3): 413-438.
4 U.S. Treasury. 1991. Modernizing
the Financial System: Recommendations for Safer, More Competitive
Banks. Washington, D.C.: Department of the Treasury, pp.
5 House Report 102-330 (November 19, 1991). U.S. Code Congressional and Administrative News, vol. 3,
102nd Congress, First Session, 1991, p. 1909.
6 Inquiry Into Continental Illinois
Corp. and Continental Illinois National Bank. Hearings Before the
Subcommittee on Financial Institutions, Supervision, Regulation
and Insurance of the House Committee on Banking Finance and Urban
Affairs, September 18, 19 and October 4, 1984, pp. 287-288.
7 Kareken, John H. 1983. Deposit
Insurance Reform or Deregulation Is the Cart, Not the Horse. Federal Reserve Bank of Minneapolis Quarterly Review 7 (Spring): 1-9.
8 Dionne, Georges, and Harrington,
Scott (eds.). 1992. Foundations of Insurance Economics: Readings
in Economics and Finance. Boston: Kluwer Academic Publishers,
9 Fissel, Gary S. 1994. Risk Measurement,
Actuarially-Fair Deposit Insurance Premiums and the FDIC's Risk-Related
Premium System. FDIC Banking Review 7 (Spring/Summer):
10 Flannery, Mark J., and Sorescu,
Sorin M. 1996. Evidence of Bank Market Discipline in Subordinated
Debenture Yields: 1983-1991. Journal of Finance 51
11 DeYoung, Robert; Flannery, Mark;
Lang, William; and Sorescu, Sorin. 1998. Could Publication of Bank
CAMELS Ratings Improve Market Discipline? Manuscript.
12 An alternative method for limiting
the potential of one bank's failure to spill over to another focuses
on the payment system. Hoenig, Thomas M. 1996. Rethinking Financial
Regulation. Federal Reserve Bank of Kansas City Economic Review 81 (2): 5-13.
13 See Jones, David S., and King,
Kathleen Kuester. 1995. The Implementation of Prompt Corrective
Action: An Assessment. The Journal of Banking and Finance 19 (3-4): 491-510 and Peek, Joe, and Rosengren, Eric S. 1997. Will
Legislated Early Intervention Prevent the Next Banking Crisis? Southern
Economic Journal 64 (1): 268-280 for reviews of Prompt Corrective
14 See Calomiris, Charles W. 1997. The Postmodern Bank Safety Net: Lessons from Developed and
Developing Economies. Washington, D.C.: American Enterprise
Institute for Public Policy Research for an example of a subordinated
15 Federal Deposit Insurance Corp.
1997. History of the Eighties: Lessons for the Future.
Volume I, An Examination of the Banking Crises of the 1980s and
Early 1990s. Washington, D.C.: FDIC, pp. 236 and 250.