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Deposit Insurance Deposit Insurance and Other Liability and Other Liability
GuaranteesGuarantees
Chapter 19
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin
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Overview
The focus of this chapter is the mechanisms designed to protect FIs from liquidity crises. Deposit Insurance Funds Securities Investors Protection Corporation Pension Benefit Guaranty Corporation Deposit Insurance schemes in other countries
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Background issues and History
Bank runs can serve a useful purpose Contagion has more serious consequences
FDIC created 1933 Securities Investors Protection Corporation
(SIPC) 1970. Pension Benefit Guaranty Corporation
(PBGC) created 1974.
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FDIC
FDIC created in wake of banking panics 1930-33: 10,000 failed commercial banks. Original coverage: $2,500. Now $100,000.
Between 1945-1980: FDIC worked. Failures accelerated in 1980.
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FDIC (continued)
In 1991: Borrowed $30 billion from Treasury and still generated a $7 billion deficit.
FDIC Improvement Act 1991. The funds’ reserves now stand at a record high
with reserves exceeding 1.23% of insured deposits (2007).
Caveat: Superior Bank of Illinois• Fine of $460 million• $428 million cost to FDIC
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FSLIC
FSLIC covered S&Ls. Other thrifts often chose FDIC coverage. High levels of failed thrifts between 1980-88
generated losses of $42.3 billion. From 1989-92 additional 734 failures . Cost: $78 billion.
Result: FSLIC estimated net worth negative $40 to $80 billion.
Policy of capital forbearance.
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Demise of FSLIC
Forbearance consequences: Accumulation of greater losses.
Financial Institutions Reform, Recovery and Enforcement Act, (FIRREA) 1989.
Management transferred to FDIC. Savings bank insurance fund became Savings
Association Insurance Fund (SAIF). Managed separately from Bank Insurance Fund (BIF).
March 2006, SAIF and BIF merged to form DIF
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Causes of depository fund insolvency
Financial Environment: Rise in interest rates. Collapse in oil, real estate and commodity
prices. Increased competition.
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Depository Fund Insolvency (continued)
Moral Hazard: Deposit insurance encouraged underpricing of
risk and reduced depositor discipline. Premiums not linked to risk.
Role of implicit premiums Inadequate monitoring. Prompt Corrective Action (1992).
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Trade-off: Moral hazard & bank run risk
Insurance was not actuarially fairly priced. Reduced incentive for runs.
Reduced incentives for depositors to monitor DIs Increased moral hazard.
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Controlling DI Risk Taking
Stockholder discipline Limited liability of stockholders Practical problems in applying option pricing to
insurance premiums DI’s asset values and risk are not easily observable
FDIC adopted risk-based premiums 1993
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Risk-Based Deposit Insurance
Based on: Categories and concentrations of assets Categories and concentrations of liabilities
insured, uninsured, contingent, noncontingent Other factors that affect probability of loss Deposit insurer’s revenue needs.
Beginning in January 2007 FDIC started calculating risk premiums in more
aggressive manner (See Appendix 19A).
-1319-13Increased capital requirements, stricter closure rules.
Require lower leverage Impose stricter DI closure rules
Controls forbearance Five capital zones
Prompt corrective action
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Increased capital requirements
Proposal Role of subordinate debt
Improve market discipline Ease monitoring Increase transparency and improve disclosure Increase capital cushion
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Depositor Discipline
Insurance cap can be increased by altering structure of deposit funds and by spreading deposits across banks.
Higher interest rates provided incentive to deposit in riskier banks -up to coverage limit.
Limits on brokered deposits.
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Depositor Discipline
Federal Deposit Insurance Reform Act of 2005: Leaves coverage cap at $100,000 per person
per account Adjusted to inflation on 5-year basis ($10,000
increments as necessary) Cap for retirement accounts increased to
$250,000 Role for deposit brokers
Controlled by FDICIA of 1991 Implicit 100% coverage from “too big to fail”
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Failure resolution post-FDICIA
January 1995 FDICIA required least-cost resolution. Systemic risk exception. Insured depositor transfer (IDT) or “haircut”
method encourages depositor vigilance.
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Regulatory discipline
Perception of 2 weaknesses in regulatory practices: Frequency and thoroughness of examinations Forbearance shown to weakly capitalized
banks pre-1991.
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Regulatory discipline (continued)
Capital forbearance: Prompt Corrective Action. Transition to rules
rather than discretion. Examinations:
improved accounting standards including market valuation of assets and liabilities; annual on-site examination of every bank; independent audits.
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Non-U.S. deposit insurance
EC established a single deposit insurance system at end of 1999 Coverage: 20,000 ECUs.
Co-insurance through deductibles. Currently, 10 percent.
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Non-U.S. deposit insurance
Japan: Similar system to U.S. Over the late 1990s and early 2000s
experienced problems similar to those of the U.S. during the 1980s
Over $400 billion in bad loans (2003) 10 million yen coverage
Late 2006: China planning to follow FDIC model
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Discount Window
Traditionally, Central bank as lender of last resort through
discount window. Short-term, non-permanent. Requires high-quality liquid assets as collateral. “Need to borrow basis”.
Implemented in January 2003 Primary credit available on short-term basis
even to sound banks Secondary credit
Seasonal program Easing of availability. Elimination of subsidy.
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Discount Window
Not permanent support for unsound banks. Loans to troubled banks limited to no more
than 60 days in any 120 day period unless authorized by FDIC and institution’s primary regulator.
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Other Guaranty Programs
National Credit Union Administration provides up to $100,000 coverage Lower risk due to asset diversification Substantial portion of assets in form of
government securities Changes in Deposit Insurance Reform Act
of 2005 apply to NCUIF-insured credit unions as well
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Other Guaranty Programs
PC and Life Insurance Companies regulated at state level. No federal guaranty fund. Run and administered by the private insurance
companies themselves. Only NY has permanent guaranty fund. Definition of small policyholder varies across
states from $100,000 to $500,000. Delays in settling claims against insurance
companies.
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Other Guaranty Programs
Securities Investor Protection Corporation: Pro rata shares of liquidated assets. SIPC
covers remaining claims up to $500,000 per individual.
SIPC losses have been small but concern has increased.
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Pension Benefit Guaranty Corp.
PBGC established in 1974 under Employee Retirement Income Security Act (ERISA).
PBGC experienced deficit of $2.7 billion at end of 1992. Unlike FDIC, it has no monitoring power over insured pension plans.
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Pension Benefit Guaranty Corp.
1994 Retirement Protection Act phases out premium cap. 1999: record surplus of $5 billion; auditors uncovered serious operational problems.
Risk-based premium scheme did not eliminate all problems.
Senate approval of pension bailout bill 2005: Deficit increased to $23.0 billion Deficit Reduction Act of 2005