Merton Deposit Insurance Reform

8/6/2019 Merton Deposit Insurance Reform

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Carnegie-Rochest er Conference Series on Publ ic Pol icy 38 (1993) 1-34North-Holland

D e p o s it in s u r a n c e r e fo r m : af u n c t i o n a l a p p r o a c h *Robert C. MertontHarvard University, Boston, MA 02163, U.S.A.andZvi BodieBoston University, Boston, MA 02215, U.S.A.

A b s t r a c tThe current system of deposit insurance has a basic structural problem because

there is a mismatch between the deposits insured by the FDIC and the opaqueand illiquid bank loans used to collateralize those insured deposits. There mayhave been, at one time, synergy created by using insured deposits as the primarysource to finance the commercial lending activities of banks, but we see no evidencethat such benefits, if any, exist in todays financial system. There are, however,significant costs for maintaining the current institutional structure. We concludethat an efficient solution is for commercial lending to be financed by standardinstruments such as debt, preferred stock, and equity, and that deposit insurancebe limited to institutions or accounts that collateralize deposits with U.S. Treasurybills or their equivalent.

1 . In t roduc t ionThere is widespread agreement in the United States today that our systemof deposit insurance is a major economic problem, but there appears to be

*We thank the Carnegie-Rochester Conference participants, and especially George Ben-ston, Mark Flannery, Ed Kane, George Kaufman, Robert King, Allan Meltzer, GeorgePennacchi, and Charles Plosser, for their helpful comments.

t Correspondence to: Robert C. Merton, Harvard University, Morgan 397, SoldiersField, Boston, MA 02163.0167-2231/93/$06.00 0 1993 - Elsevier Science Publishers B.V. All rights reserved.


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no general consensus about the cause or the solution of the problem. Politi-cians, journalists, and academics have offered many different opinions andproposals. In this paper, we do not attempt to provide either a comprehen-sive survey or critical review of all or even most of them. Instead, we apply aparticular analytical framework to arrive at a specific proposal for reform andthen use that framework to evaluate alternative proposals. To further focusthe analysis, we address deposit insurance only as it relates to commercialbanking in the United States.

In discussions of deposit insurance, it is common practice to use the cost tothe U.S. taxpayer of bailing out the depositors of failed depository institutionsas the measure of the problem. The true cost to our society, however, isthe misallocation of investment and the unintended redistribution of incomeand wealth caused by the current system. The current deposit-insurancesystem, accounting rules, and regulatory procedures can encourage excessiverisk-taking. In some cases, they may even encourage fraud and abuse. Anyproposed cure must address those true social costs. Thus, a proposed solutionthat leaves intact the incentives to misallocate and randomly redistributeresources is no solution at all.

As is evident from the literature, there are two fundamentally differentperspectives and frameworks for analysis of deposit insurance and the bank-ing system. The first takes as given the existing basic commercial-bankinginstitutional structure, and views the objective of public policy as helpingthe institutions currently in place to survive and flourish. This institutionalperspective a.ppears to be the one generally taken by banking practitionersand regulatory policymakers. 3 The alternative approach takes as given theeconomic functions performed by commercial banks and deposit insuranceand asks what is the best institutional structure to perform those functions.In contrast to the institutional perspective, this functional perspective doesnot posit that existing institutions, whether operating or regulatory, shouldnecessarily be preserved as presently constituted.

As is the tradition in neoclassical economics generally, the functionalperspective treats the existence of households, their tastes, and their en-

1 or a general overview of deposit-insurance reform, see Barth and Brumbaugh (1992),Barth, Brumbaugh, and Litan (1992), and Brumbaugh (1993). The specifi c analyticalframework of our paper is developed in Merton (199213) Merton and Bodie (1992a,b andc). In the banking literature, the analytical approaches of Black (1985), Black, Mil ler, andPosner (1978), Gorton and Pennacchi (1992a), and Pierce (1991) are most closely alignedwith the development here.

2We have discussed elsewhere deposit insurance as it relates to thrifts. See Merton andBodie (1992b,c, Section 6). More generally, see J. Barth (1991) and Brumbaugh (1988).

3The thrust of policymaker thinking is often reflected in the titles given to governmentreports. Thus, the U.S. Treasury entitl ed its February 1991 detailed proposals for financialsystem reform, Modernizing the Financial Syst em: Recommendat ions for Safer, MoreCompetitive Banks.

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dowments as givens, exogenous to the economic system. However, thistradition does not extend this fundamental right of continued existence toother economic organizations such as business firms, markets, financial in-stitutions, and government regulatory bodies. They are regarded as existingprimarily because of the functions they serve and are therefore endogenous tothe system. Thus, in the functional perspective, institutional form follows itsfunction. As part of an evolving process of change, it is thus to be expectedthat old institutional forms will be superseded by new ones that perform theunderlying economic functions more efficiently.

We therefore begin our analysis by identifying the two core economicfunctions performed by commercial banks.4 Commercial banks make loansand guarantee loans to businesses, households, and governments.5 The typesof loans for which banks are specialists are those that are difficult to assesswithout detailed, and often proprietary, information about the borrower.6These borrowers are reluctant to reveal to the general public the informationwhich would be necessary for a direct public placement of the debt. The loanstaken by banks are risky and tend to require careful monitoring. Thus, bankloans are relatively opaque assets. They are not traded on the secondarymarkets and therefore do not have observable prices. In most cases, propervaluation of the loans requires nonpublic information about the borrowerso that market values cannot easily be inferred from the prices of tradeddebt instruments with similar promised terms.8 Moreover, bank loans maycontain special terms and provisions not typically found in publicly-tradedinstruments. With such a large potential for asymmetric information, itfollows almost a fortiori that loans of this type would be illiquid. Our measureof liquidity is that the larger the bid-ask spread on a security, the less liquid

*As here, Diamond and Dybvig (1986) fecus on the functions of banks. They, however,identif y three core functions: (i) asset services, which is making loans; (ii) liability services,which is transaction clearing, providing currency and other means of payment (checks, cashcards); (iii) transformation services, which creates liquidity by buying illiquid loans andissuing liquid deposits. The role of banks i n liquidity creation is discussed in Section 3.

5According to the Federal Reserve, at the end of 1990 the breakdown of the loanportfolio of U.S. commercial banks was: commercial and industrial loans 30%, real-estateloans 37%, consumer loans 19%, all other 14%.

jFor discussion of the role of banks in the intermediation of asymmetric information,see Diamond (1984), Fama (1985), and James (1987).

7We use the term opaque here in the sense developed in depth by Ross (1989).The trend in the recent past is for banks to invest in marketable debt instruments

including securitized loans of other banks. To the extent they do so, they are becoming lesslike the institution we define as commercial banks. The b ank assets that lend themselvesto being securitized are the ones that are least opaque, such as credit-card and automobileloans. Corporate, commercial real-estate, and sovereign loans are not generally acceptablefor securitization and, therefore, tend to stay on the balance sheet of the firm. For anextensive discussion of asset securitization, see the Fall 1988 issue of Journal of Appli edCorporate Finance.

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is the security. A perfectly-liquid security trades with a zero bid-ask spread.The other function of banks is to take deposits from customers. These

deposits are of two types: transaction deposits and savings deposits. Trans-action deposits are, by definition, used by bank customers to make payments.The function of a payments system is to facilitate the exchange of goods andservices at minimal cost. If two parties have agreed on the terms of tradein a particular transaction (price, delivery date, etc.) and both have theresources to carry out the trade, then the function of the payments systemis to efficiently implement the trade. In modern economies where individu-als and especially business firms engage in many transactions every day, thecosts of acquiring information about the credit risk of every counterparty toevery transaction would be prohibitive. By having specialized intermediarieswhose function is to verify the ability of the parties to make good on theirtransaction commitments, to credit the appropriate accounts, and to guar-antee payment, enormous economies of scale in information-gathering andtransaction-processing can be achieved.

To perform this function efficiently the bank provides demand depositsto customers which are free of default risk regardless of the size of the trans-action. Customers then make payments by writing checks or making wiretransfers against those demand deposits. To achieve the primary goal ofan efficient payments system, therefore, transaction deposits should be com-pletely free of default risk.g

There may have been at one time efficiency gains from using insureddeposits as the primary source to finance the commercial lending activitiesof banks, but we believe there no longer are. Of course, even if there are

There is some disagreement among economists on whether government deposit insur-ance is the most efficient way of securing the payments system. However, there seems tobe widespread agreement among economists that, for a variety of reasons, the governmentis ultimately the de faclo insurer of demand deposits. For a discussion of the diff erentpoints of view, see Flannery (1988, 1991) and Merton and Bodie (1992b,c).

Gorton and Pennacchi (1992a) present several agency-cost arguments for using veryshort-term debt to finance in large part those specialized insti tutions that make opaqueand ill iquid loans. They show, however, that there is no need for this short-term debt totake the form of insured demand deposits that are part of the payments system. Indeed,we would argue that financing with insured deposits would defeat the agency purpose ofshort-term debt because the holders of that deb t would no longer have an incentive tomonitor the firm in making their decision whether to roll over the debt and continue tofinance the firm.

Benston and Kaufman (1988) argue that if the same institution that holds a customersdeposits also grants loans to that customer, economies of scale and scope can be achieved.Black (1975) and Fama (1985) appear to make similar claims, although Black (1985)later seems to reject such synergies. In these times, it is rare that either a business oran individual carries all its financial accounts including credit cards with a single bank.Moreover, we are unaware of any widespread practice to induce this behavior by offeringsignif icantly better loan terms to those who would do so. If, however, such potential

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no synergistic benefits to the linking of risky loans with demand deposits, ifthere are also no dysfunctional aspects of that combination, one could arguethat maintaining the existing institutional structure is probably cost-efficient,However, there are significant costs to maintaining the status quo. It is thefundamental mismatch between bank demand-deposit liabilities insured bythe government and the illiquid, risky, and opaque loans collateralizing thoseinsured deposits that gives rise to the current deposit-insurance problem.

We are therefore led to agree with Black (1985), Litan (1987), Pierce(1991), and Tobin (1985, 1987) that collateral be equal to 100% of transactiondeposits and that collateral should be restricted to U.S. Treasury bills or theirequivalent. * This proposed solution to the deposit-insurance problem doesnot require a narrow-bank structure that prohibits institutions which taketransactions deposits from engaging in other financial activities, includingrisky lending. Indeed, under these collateral conditions, we see no danger tothe safety of deposits from depository firms offering other financial services.Thus, our proposal does not eliminate any opportunities for economies ofscope or scale from one-stop shopping for consumers of financial services.

We believe that our proposal offers a minimal-cost structure for providingdefault-free deposits without subsidies, either advertent or inadvertent. Withthe recommended collateral arrangement, the cost of providing governmentdeposit insurance would be negligible. Currently, trading spreads in U.S.Treasury bills are only a few basis points, and with the opportunity to netdeposits and withdrawals, depositories should have tiny transaction costs forprocessing payments. With book-entry of the Treasury-security collateralat the Federal Reserve, custodial costs for this arrangement should also beminimal. Furthermore, firms that offer deposit services would require littleregulation, and there is no need for additional assurance capital.

The lending and loan-guarantee activities of banks, once separated frominsured deposits as the funding source, could then be carried on withoutgovernment restrictions designed to protect the Federal Deposit InsuranceCorporation (FDIC), which insures bank deposits. The financing of theselending activities would presumably consist of some combination of commonefficiency gains are really there, our proposal for reform does not rule out lending anddeposit-taking activities within the same company, provided that the loans do not serveas collateral for deposits.

In sum, we know of no study showing direct synergistic benefits from having risky loansserve as the collateral for insured demand deposits.

Kareken (1986) also proposes 100% U.S. Treasury collateral for deposits. However,his proposal differs because it allows bonds of any maturity to be used for collateral,and it does not permit depositories to engage in other financial activities. Accompanyinghis paper are several discussions of his proposal. The idea of requiring interest-earningobligations of the U.S. government as 100% reserves against bank demand deposits wasproposed by Friedman (1960). His proposal was, however, motivated by the objective ofachieving more effective control of the money supply.

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and preferred stock, long-term and short-term debt, and convertible securi-ties, as determined by competitive market forces. If, as some have suggested,government intervention is required in the area of commercial lending toovercome private-market failures, that intervention can surely be made moreefficient if it is not complicated by the existence of government-insured de-mand deposits. * Thus, by changing the institutional structure of commercialbanking-through separating banks lending and loan-guarantee activitiesfrom their deposit-taking activities, it is possible to achieve potentially largesocial benefits with no apparent offsetting costs.

A different approach to solving the deposit-insurance problem is to main-tain the existing structure, but to substitute private insurance of bank de-posits for government insurance. This could be accomplished in severalways. One way is to directly substitute private deposit insurance for FDICinsurance. l3 Another way is to impose high capital standards on banks. Ifagency and tax costs make equity capital too expensive, then the govern-ment could allow subordinated debt securities to count as bank capital.14The subordinated creditors would then be the guarantors of the banks de-posit liabilities.15 Ultimately, however, the government would still be thede facto guarantor of the system. l6 Such a system could be made to work,

Stiglitz (1991), for example, argues for government intervention to correct privatecapital market failure arising from incomplete or asymmetric information. However, herecognizes that the existence of deposit insurance gets in the way. His proposed solutionto the deposit-insurance problem is to increase bank capital requirements. We discussthe problems with this solution in Section 2.3. Flannery (1991) presents a comprehensiveinventory and analysis of the rationale for government intervention in the banking system.

13See Ely (1990). Eng lish (this volume) documents the rather unsuccessful historicalexperience with private deposit insurance in the United States. King (1983) discusses anhistorical experiment that occurred in New York State during the period 1840-1860,in which private insurance of demand deposits coexisted with 100% collateralization ofdemand deposits with U.S. government securities. According to King, collateralizationworked much better than private deposit insurance in securing demand deposits againstbank defaults.

14See Benston (1992).15Any time a loan is made, an implicit guarantee of that loan is involved. To see this,

consider the fundamental identity, which holds in both a functional and a valuation sense:Risky Loan + Loan Guarantee c Default-Free LoanRisky Loan - Default-Free Loan - Loan Guarantee

Thus, whenever lenders make dollar-denominated loans to anyone other than the UnitedStates government, they are implicitly also selling loan guarantees. For further discussion,see Merton and Bodie (1992b,c, Section 1).

16No matter how firm the governments commitment to relying on private markets,there is a problem of time inconsistency that limits their effectiveness. The essence ofthe time-inconsistency problem with respect to deposit insurance is that, under certaincircumstances, it is socially optimal for the government to renege on its threat to allowbanks to fail. It is widely acknowledged that even in countries without formal deposit-

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but it would be more costly than the proposed 100% default-free collateralsystem, with no apparent offsetting benefits. To better understand the na-ture of these costs, we now turn to a more detailed analysis of the guaranteebusiness.

2. M a n a g i n g d e m a n d -d e p o s it g u a r a n t e e s There are three basic methods available to any guarantor-whether privateor government-to manage its guarantee of bank demand deposits againstfailure of the bank:l Restrict the asset choice of the bank to ensure an upper boundary on theriskiness of the banks assets.l Monitor the value of the banks assets with the right to seize them if theyfall below a certain minimum capital standard. Holding fixed the premiumcharged for the guarantee, the capital standards required for viability in-crease with increases in the variance of the value of the banks assets or withincreases in the time between audits.l Set a premium schedule for the guarantee. Ceteris Paribas, the premiumrate required for viability increases with increases in the variance of the valueof the banks assets or the time between audits.

Although not one of the three methods can work by itself, they can sub-stitute for each other in terms of the degree of intensity of their use. Hence,there is room for tradeoffs among them. A fundamental issue is that theilliquid and opaque nature of the loans held by commercial banks and theloan guarantees issued by them make it very costly for outsiders to monitorthem and to set appropriate capital standards or deposit-insurance premi-ums. As noted, commercial and industrial loans and loan guarantees oftenrequire the lender to have detailed knowledge of the borrowing firms op-erations that cannot be made public. Consequently, those loans cannot beeasily securitized or otherwise resold. Their market values cannot thereforebe observed, or at least not observed frequently. In some cases, the marketprices of similar-type debt instruments such as junk bonds can be observed;in other cases, there are no such cornparables. Market-value assessments ofbank loans are costly to make and typically have quite limited accuracy.insurance schemes, the government is understood to stand behind demand deposits. Thegovernment, therefore, is caught in a paradox of power. For market discipline to work, thegovernment must bind itself convincingly not to bail out banks that get into trouble. Butthe government is too powerful not to intervene. Everyone knows that since governmentmakes the rules, it can change them, too. Indeed, only an incompetent government wouldnot intervene to stop a panic. But if t,he government will bail out depositors ~3:post, thenthere is implicit insurance, even if there is no explicit insurance ez aale.17This section is based on Merton and Bodie (1992b,c, Section 2).

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2.1 Asset restrictionsAs already discussed, in our view the most efficient method of insuring thepayments system against credit risk is to make sure that the collateral assetsof banks are closely matched in both value and risk characteristics to thebanks demand-deposit liabilities. In its strictest form, this proposal callsfor the FDIC to require insured banks to completely hedge their demand-deposit liabilities by investing in the shortest-term U.S. Treasury securitiesor their equivalent. Note that the asset restriction in this case covers boththe default-risk characteristics of the securities held by the insured bank andtheir maturity. If a bank is allowed to invest in long-term bonds, the FDICcan be subject to considerable interest-rate risk, even if the bonds are free ofdefault risk.l

To the extent that the range of permitted assets backing demand depositsis extended to include other securities, more resources would have to be putinto the monitoring process. To illustrate, consider the effect of allowingbanks to trade in derivative securities-financial futures, forward contracts,options, and swaps. The opportunity to take positions in these securitiesgreatly enhances the ability of banks to quickly reduce their exposure to risk.However, banks can just as easily use derivative securities to increase theirrisk exposure. Even if a bank serves as a simple market-maker in derivatives,it is not always an easy task to verify that the banks match-book is trulymatched, especially when there is credit risk among its counterparties.lg Al-lowing banks to trade in derivatives therefore greatly complicates the abilityof outside monitors to determine the net exposure of a bank.

This point is made by McCulloch (1986) in his discussion of Karekens (1986) proposedreform of the banking system.

lgSince 1990 every big U.S. bank has been obliged to disclose certain information regard-ing its positions in derivatives. Among this information is a measure called the credit-riskamount or CRA, which is the maximum loss the bank would suffer if every counterpartyto every derivative contract defaulted. In terms of credit-risk exposure, the CRA measurecan be used in the same way as total net loans. According to Grants Interest Rale Ob-server, April 10, 1992, p. 9, the net loans and CRAs for four money-center banks in 1991were:

(in $ billions) Bankers Trust Chase Chemical CiticorpNet Loans $15.2 $65.8 $81.0 $147.6CRA 25.6 25.2 22.5 29.6

The riskiness of the assets represented by the CRA may be different from the riskinessof the loans. Furthermore, the CRA overstates the default exposure because it does notrecognize the contractual right of the bank to net all its swap obligations (both gains andlosses) to a defaulting counterparty. These statistics nevertheless show that the poten-tial credit-risk exposure from off-balance-sheet items warrants significant monitoring by aguarantor.


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2.2 Continuous surveillance with the right to seize collateralIf the FDIC has a covenant right to monitor continuously and seize assets,shortfall losses can be minimized either by auditing the value of the assetsand seizing them before their value dips below the value of its insured de-posits, or by making sure that the assets accepted as collateral always havea value at least equal to the deposits. The surveillance and seizure systememployed by brokers in protecting themselves against default risk on the partof their customers is an example of a system that relies almost entirely onsuch monitoring. The futures and options exchanges in the United Statesand throughout the world employ similar methods.20

A good example to illustrate how monitoring with continuous surveillancecan work effectively to protect the provider of a guarantee is the case ofbroker margin loans. It is instructive, because the system functions withonly a minimal fee for the guarantee provided. When an investor opens amargin account with a broker and borrows money to buy stocks or bonds, thebroker effectively is in the position of loan guarantor. For example, consideran investor who invests $100,000 in stocks, borrowing half of the funds fromthe broker. In practice, a broker typically borrows the funds that it lends toinvestors from a bank (or the commercial paper market) and guarantees thebank payment in full even if the investor defaults. The loan from the bank tothe broker is collateralized by all of the brokers assets. These loans-boththe loan from the broker to the investor and from the bank to the broker-are due on demand. The brokers fee for providing its guarantee (that is,for absorbing the default risk of the investors collateralized loan) and forservicing the account is embodied in the spread between the interest rate itcharges the margin investor and the interest rate it pays to the bank.

As guarantors, brokers set two types of capital requirements: initial mar-gin and maintenance margin. The initial margin requirement is the requirednet worth of the investors account at the time the margin loan is madeand the securities purchased. 21 All the securities purchased by the margininvestor remain in the possession of the broker as collateral for the loan,and the broker calculates the market value of these securities daily (andsometimes more often on days when there is unusual volatility in price move-ments). The net worth of the investors account is calculated as the market

Miller (1990, Section 2.1.2), for example, describes how futures exchanges insure theparties to a futures contract against contract-default risk by employing perfected collateralthat is marked to market on a daily basis. There is an additional layer of protectionagainst default risk built into the system in the form of a clearing house. All contracts areformally between the buyer or seller and the exchange clearing house and thus carry thatinstitutions guarantee. The same is true for exchange-traded options.

lAlthough the terms are set by individual brokers, the Federal Reserve sets regulatoryminimum levels of initial margin requirements.

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value of the collateral less the debt to the broker. If the net worth of theaccount falls below a prespecified fraction of the value of the collateral, calledthe maintenance-margin ratio, the broker notifies the investor that he mustadd additional equity capital to his account immediately. If the investor doesnot respond to this margin call, the broker exercises its right to sell the se-curities serving as collateral and pays off the loan out of the proceeds. Theinvestor receives the remainder, if any. Brokers find that this system offersthem substantial protection despite the fact that the prices of the securitiesheld by investors are often quite volatile.22

The key elements of this system of monitoring margin loans are: (1) theguarantor has possession of the collateral; (2) the value of the collateral isrecomputed frequently at readily ascertainable market prices, and (3) theguarantor has the right to automatically liquidate the collateral to pay offthe guaranteed liability if the ongoing capital requirement is violated. Each ofthese elements is essential for the system to function properly. In particular,frequent monitoring of the market value of the collateral would be pointlessif the broker did not have the right to seize and liquidate the collateral assoon as the required maintenance-margin ratio was violated.

If the FDIC were to implement such a monitoring system for commercialbanks, the costs are likely to be significant. Effective monitoring requiresthat collateral be valued at current market value. Although the concept ofmarking to market is straightforward, its implementation can be complexand costly. 23 If the collateral assets are traded in well-functioning organizedmarkets such as national stock exchanges and government-securities markets,then reliable market values are readily observable, and marking to market isa relatively low-cost process. However, for the kinds of assets held by banks,estimates of market prices are subject to significant errors, and reachingagreement on the proper mark-to-market procedure is considerably moredifficult.

These estimation errors impose risks on both the guarantor and the in-sured bank. If the errors overstate values, the guarantor will not seize asquickly as it should, and the proceeds realized from seizure will be less thanexpected. If the errors understate the values, the bank will be seized a.nd liq-uidated when it is actually solvent. Thus, a conservative valuation method

22Note that volatil e assets, such as common stocks, can have small bid-ask spreadsand therefore be quite liquid. While illiquidity may be a barrier to the effective use of amonitoring system, volatility by itself is not a problem.

231ndeed one of the main arguments used by representatives of the commercial banksagainst maik-to-market accounting for bank assets is the high cost of implementation andthe poor quality of the valuation estimates. While they seem to view this as a reason toabandon the concept of market-value accounting, we view it as demonstrating the highcost of continuing to use traditional bank assets as the principal collateral for government-guaranteed demand deposits.

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from the perspective of one party to the system will be an aggressive val-uation method from the perspective of the other party. Hence, the valuationmethod should be unbiased. Protections for the parties from measurementerrors in the prices should be provided by other rules of the monitoringsystem-such as the minimum size of the banks net worth before seizure ispermitted.

Because of the natural tension between the FDIC and the insured bankover asset valuation, a key element of a mark-to-market system is that itseeks to minimize the opportunities for manipulation. Especially if its assetsare traded infrequently, the bank has information about their true valuesthat is not costlessly available to other parties, including the guarantor. Asindicated, the banks incentives favor biased-high estimates of prices of itsassets and biased-low estimates of the prices of its liabilities. Thus, while thebank may have information that could improve the accuracy of the valuation,it may be optimal to neglect its inclusion in the mark-to-market estimatesif inclusion of this information allows too much discretion on the part of thebank. That is, the accuracy of the valuation procedure is important, but justas important is that the procedure be known, agreed upon by both partiesin advance, and difficult to manipulate. In sum, a proper mark-to-marketmodel is one that, specified ex ante, gives the best estimate of market price,using verifiable data.

A word on book values in a monitoring system. It is sometimes sug-gested that circumstances in which estimates of market prices are noisyare ones that favor using book values-that is, amortized acquisition cost.This seems to us to be a non-sequitur. We are not aware of scientific ev-idence that book values are the best estimates of market prices, especiallyfor financial assets of the kind held by commercial banks.24 The evidence onmarketable junk bonds, which are reasonably close substitutes for many ofthe types of loans held by banks, points in the opposite direction. Junk-bondprices fluctuate substantially over time. It is therefore highly unlikely thatthe best-fitting unbiased, nonmanipulatable model would produce values forbank loans that remain virtually constant (around predictable amortized ac-quisition cost) over time. Standard accounting rules for marking down bookvalues of assets, such as crea.ting a reserve for bad loans, are usually subjectto considerable management discretion, and their application often occursonly after a considerable decline in value has already taken place.25 The

24M. Bar th s (1991) empirical findings are tha t . ma rk et valu e accoun ting for invest-men t securities is significant in explaining bank s sha re prices. . (p. 2).

The FDICs sta nda rd pra ctice, before th e Deposit I nsu ra nce Reform Act of 1991, wasto close banks when their book-value capital-to-assets ra tio reached zero. Neverth eless,Het zel (1991, p. 13) report s tha t for 1,000 bank s which failed between 1985 an d 1991, th eaver age loss rat io was 27% (the loss to th e FDIC divided by th e book value of th e failedbank s asset s). Thus , it would seem tha t th e book values of asset s provide biased-high

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FDIC should therefore be reluctant to let an insured bank use book valuesfor illiquid assets. 26 There is a certain irony that the assets with the mostuncertainty about their values would be valued by a book system which pro-duces almost no variation in price.

Apart from the fact that most loans in a banks portfolio have no observ-able price, another difficulty in applying this model to commercial banks isthe illiquidity of the debt instruments that do have observable prices. Therelevant market price to be used in valuing the banks assets for these pur-poses is the price at which they can be sold-the bid price. As long as assetsare marked to market at the bid price, the illiquidity of an asset serving ascollateral is not a problem for the guarantor. However, illiquid assets (whichby definition have a large bid-ask spread) are not suitable as collateral forguarantees of demand deposits because the bunk is vulnerable to having theasset seized and liquidated when the bid price falls, even if the average of thebid and ask prices falls by a relatively small amount.27 The spread cost fromthis bid-ask bounce is a deadweight loss to the collectivity of the bank andthe FDIC. Thus, if it is large and the chances of a violation are not negligible,this form of handling guarantee risk is inefficient for illiquid assets.

2.3 Capital requirementsThe measure of capital to be used as a trigger for seizure of assets shouldinclude only the value of assets that can be realized in a liquidation, netof any liquidation costs. To the extent that going-concern value or otherintangibles can be preserved in a liquidation, they should be included incapital, Otherwise, they should be excluded.

If capital is large relative to the value of insured customer claims, thenpremiums charged by the guarantor can be low, and surveillance can bedone less frequently. Since this saves surveillance costs, perhaps a lower-cost solution for the FDIC would be to simply require insured banks tohave large amounts of capital in the form of either equity or subordina.teddebt. However, this solution may be considerably less attractive upon closerexamination. The amount of capital required can be quite large, and it hasa nontrivial cost.estimates of their market values, at least in financially distressed banks.

26As M. Barth (1991) interprets her empirical results, mark-to-market accounting foronly a subset of assets and liabilities of a bank may significantly distort its reportedfinancial position. Hence, all assets, not just the easily valued liquid ones, should bemarked to market.

27For example, suppose that an investor buys an illiquid asset at an ask price of $100when the bid price is $50. Suppose that the price subsequently drops to $75 ask and $25bid. If a margin call occurs and the asset is liquidated, the total loss in value is $100 -$25 = $75, even though the average of the bid and ask price has declined by only $25.

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First, consider the amount of capital required. In the absence of FDICinsurance of deposits, the amount of investor capital required to assure thedepositors freedom from default risk increases with increases in the volatilityof the underlying asset portfolio or the amount of time between audits. Forthe kinds of assets held by commercial banks, the volatility can be quitehigh. We know that for junk bonds, which are similar to some commercialbank loans, the standard deviation of the percentage change in price is large,from lo-30% per year. Portfolio diversification helps to reduce the risk,but common factors across these bonds create positive covariances in theirreturns, which limit the amount of risk reduction. Much the same pointholds for commercial real-estate loans. Uncertainty about the true marketvalue of the loans effectively makes the variance rate larger still. If carefulmark-to-market audits are infrequent, the capital required to make defaultexposure negligible can easily exceed 20% of insured deposits.28

Moreover, setting appropriate capital requirements means that regulatorswould have to make assessments of the riskiness of bank assets. This is verydifficult to do even if the assets were traded securities that are relativelytransparent. It is even a harder task for the opaque assets actually held bybanks. The costs-both private and social-of setting capital requirementsat the wrong level can be substantial. * In the case of the thrifts, we haveseen the result of setting them too low. But there is also a cost of settingthem too high. Furthermore, single-premium rates accurately set on somenotion of average-asset risk can nevertheless distort investment decisionsamong accepted asset classes, often causing too much investment in higher-risk assets and too little investment in lower-risk ones.

To see why bank capital provided for assurance purposes has a net costeven if it is invested in assets that earn a fair market rate of return, considerthe equity-capital choice. As an empirical matter, financial intermediaries-both insured and uninsured-do not typically have large amounts of equitycapital relative to the size of customer liabilities. One theoretical explanationfor this behavior is the agency and tax costs associated with equity financingof any corporate enterprise. The very characteristic of the equity cushion

?Stiglitz (1991), perhaps somewhat casually, mentions a capital ratio of 20% as suff icientto cover virtually all contingencies, even when loans cannot be reliably marked to market.However, with asset volatili ty of even 10% per year, this ratio provides inadeq uate coverageagainst only a two-sigma event, even if a full mark-to-market audit of all assets takesplace each year. The more general point is that an adequate capital ratio cannot bedetermined without specif ying both the volatility of the underlying assets returns andthe frequency of careful mark-to-market audits. Since the values of most traditional bankassets are hard to assess, it is diff icult to measure true returns on those assets, and henceboth their volatility and the cost of mark-to-market audits are high.

2gSetting capital requirements through government regulation has the same potentiallydistorting effects on resource allocation as setting prices by regulation.

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that makes it attractive to the guarantor of the bank-that shareholdersof the bank have no contractually specified claims to the firms current orfuture cash flows-is the characteristic that creates a moral hazard for theshareholders who provide that equity cushion.30 The resulting agency andtax costs are thus the costs of using a large equity cushion as an alternativeto more frequent surveillance.

The agency and tax costs associated with using equity for assurance capi-tal can be significantly reduced by the use of debt, because debt instrumentsrequire the firm to make contractually specified payments in the future, andthose payments are tax-deductible for corporations. The use of subordinateddebt thus seems to offer a simultaneous lower-cost solution to the require-ments of both the providers of capital and the FDIC.31

But there are problems with subordinated debt too. The use of sub-ordinated debt effectively substitutes private guarantees for FDIC depositinsurance. 32 Private subordinated creditors will then monitor banks in ad-dition to (or instead of) government regulators. As long as the governmentis ultimately responsible for the guarantees, private creditors will alwaysattempt to get in front of the government in case of a failure of the in-sured bank. Debt instruments, such as corporate bonds, often offer investor-creditors ways of getting their cash payments out of a troubled institutionbefore the FDIC can-high-coupon payments, call provisions, sinking funds,and put-option provisions are examples. Furthermore, subordinated credi-tors may become aware of the financial difficulties of an insured bank beforethe FDIC, especially if the FDIC has reduced its surveillance activities tosave costs.

It may be in the interests of both shareholders and subordinated credi-tors to use the banks good assets to satisfy the uninsured creditors whileleaving the bad assets for the FDIC. Thus, banks in financial distress willtend to liquidate assets to meet interest and maturing principal paymentson subordinated debt to avoid immediate bankruptcy in the hope that con-ditions will change. The assets liquidated will tend to be the ones with thehighest market-to-book value so as to minimize the impact of those liquida-tions and payments on the banks (book-value) capital. This leaves the bankwith a disproportionate share of assets which tend to have low market-to-

30The only control shareholders have over managements decisions (including the distri-bution of future payments of dividends) is their right to elect management. See Jensen andMeckling (1976) and Jensen (1986) for further discussion of the agency problem associatedwith equity finance and corporate governance.

31Some propose that banks be required to maintain a minimum level of subordinateddebt as a way to impose market discipline on banks that undertake excessive risks in theirasset allocations. See Evanoff (1991), Keehn (1989), and Wall (1989).

32As explained in footnote 15, any debt instrument is equivalent to default-free debtless a guarantee provided by the creditor.

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book values. These low-value assets are the ones that will be available tothe FDIC to offset losses from coverage of deposits. Such asset-strippingbehavior is widely acknowledged to occur in cases of financial distress andis very difficult to prevent. 33 Another difficulty in relying on subordinateddebt in the United States is the uncertainty surrounding actual priority ofFDIC claims in the event of financial distress. As we know from the workof Tufano (1991), th e general problem of determining seniority is not new.34Bankruptcy judges have wide latitude in combining creditor classes to formlarger ones which are treated pari passv. In recent times, the courts haveinterpreted the bankruptcy laws in ways that create considerable ambigu-ity about the priority of the guarantors claims in the event of bankruptcy.In two recent cases, the courts have decided that the claims of the Federalagencies that have assumed the guaranteed deposit liabilities of failed thriftsand the guaranteed annuities of bankrupt pension-plan sponsors are to betreated pari passu with those of other creditors under Chapter 11 of the Fed-eral bankruptcy code. 35 It is therefore important for the guarantor to monitorthe value of assets serving as collateral, and-in the event of a violation ofthe required capital ratio-to seize them before the other liability-holders ofthe firm cause the firm to seek bankruptcy-law protections. Thus, unless thebankruptcy laws are changed to remedy the problem of settling the priorityof claims for firms in financial distress, high capital requirements in the formof subordinated debt may not be a good substitute for aggressive monitoringby the guarantor.

Finally, there is the issue of whether private parties would be willing toprovide banks with the assurance capital necessary to replace FDIC guar-antees. Even with FDIC insurance, new capital has been flowing to theinstitutions competing with banks rather than to banks.36 Under the cur-

?See Baldwin (1991) for evidence on the practice of asset-stripping in the thrift industry.As reported in footnote 25, the average loss ratio of 27% by FDIC lends further empiricalsupport for this claim.

?Xrfano (1991) hows that over a hundred years ago, creditors of the railroads in theUnited States were grappling with this issue. Some of the major financial innovations ofthat period-preferred stock, income bonds, and voting trusts-were motivated primar-ily by the need to find eff icient ways to resolve financial distress without incurring thedeadweight losses associated with bankruptcy proceedings.

35The first is the case of the Resolution Trust Corporation against Oak Dee SavingsBank, and the second is the case of the Pension Benefi t Guaranty Corporation againstLTV. Apparently, the FDIC has accepted the view that it does not have priority claimover other bank creditors since it has asked Congress on more than one occasion to providelegislation giving it seniority. Clearly, sub ordinated debt has littl e use as cushion capitalif it is not truly subordinated to the FDICs claims.

36Keeley (1990) pr esents evidence that b ank stocks have been losing market value forthe past 20 years. He attributes this to increasing competition both within the bankingindustry and with nonbank alternatives.

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rent banking structure in the United States, a typical cost estimate to breakeven is 200-400 basis points above the rate paid on deposits. In contrast, theexpenses of a money-market fund are about a tenth or 20-40 basis points peryear. In order to make banks more profitable and therefore better able to at-tract new capital, some proponents of the high-capital-requirements approachhave suggested allowing banks to engage in a wider range of activities.37However, as we have seen, greater latitude in asset choice for banks makesmonitoring them more costly. Moreover, from the functional perspective,this expansion of activities only makes sense if there are gains in efficiency(i.e., synergies) from having them combined in one institution without firewalls .

2.4Risk-based premiumsAn alternative method of managing a viable guarantee business is to chargerisk-based premiums, as in the property and casualty insurance industry. Aprecondition for the success of a system of risk-based premiums for depositinsurance is that the FDIC be able to measure the values of assets and lia-bilities and control the volatility of the value of the collateral-asset portfolio.For risk-based premiums to work, asset variability need not be reduced tozero, but it does have to be known (or at least bounded) and not subject tosignificant unilateral change by the insured bank after the premium has beenset. If the insured bank can unilaterally change the variability of the assetportfolio ez post, then the FDIC faces a problem of moral hazard.38There is a substantial and sophisticated academic literature on applyingthe methodology of contingent-claims pricing to deposit insurance.3g Thismethodology offers a consistent way of determining risk-based premiums and

37This sounds remarkably similar to the proposals designed to save the thrifts inthe 1980s. Such expansion in permitted activities is likely to have greatly increased thecost of the thrift bailout. For analysis of this point with respect to thrifts, see Barth,Bartholomew, and Bradley (1990) and Merton and Bodie (1992b,c, Section 6).

ssFor a discussion and analysis of this moral-hazard problem for guarantors, see Chan,Greenb aum, and Thakor (1992) and Merton (1990, S ection 3.2). Indeed, much of theacademic literature on deposit insurance throughout the 1980s stressed thi s problem asperhaps the most diff icult one for the deposit insurer. Evanoff (1991), Keehn (1989),and Wall (1989) propose using subordinated-debt requirements to help control this moral-hazard problem. John, John, and Senbet (1991) design a convex tax structure to createincentives for bank s not to increase the volatility of their assets. Other structures thatcreate this same incentive can be found in Keel ey (1990), Merton (1978), and Pennacchi(1987a).

3gSee, for example, Acharya and Dreyfus (1989), Crouhy and Galai (1991), Cummins(1988) Jones and Mason (1980), M arcus and Shaked (1984), Merton (1977, 1978, 1990,1992a), Osborne and Mishra (1989), Pennacchi (1987a, 1987b), Bonn and Verma (1986),Selby, Franks, and Karki (1988), Sharpe (1978), Sosin (1980), and Thomson (1987). Seealso the entire September 1991 issue of the Journal of Banking and Finance.

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relating them to a banks capital and asset composition. The essential insightis that deposit insurance is isomorphic to a put option, with the banksasset portfolio being the underlying security and the value of the insureddeposits corresponding to the exercise price. While we are not aware ofany country where the contingent-claims approach is currently used to setdeposit-insurance premiums, the U.S. Offi ce of Management and Budget hasbeen using it since 1991 to estimate the federal governments liabilities due toFDIC and other government guarantee programs.40 But, the opaqueness ofcorporate and commercial real-estate loans presents considerable difficulty inapplying any type of valuation model for establishing appropriate risk-basedpremiums.

In concluding this section, we note that recent legislation to protect tax-payers against a repeat with the banks of the costly thrift bailout seems torely primarily on strengthening the capital base of insured depositories.41This approach appears to be predicated on the objective of strengtheningthe current structure of commercial banks. We see this as exemplifying theinstitutional perspective of analysis that takes maintenance of the currentinstitutional structure as a primal postulate and seeks to make that givenstructure work as well as it can. Applying a functional perspective, we founda superior solution that requires changes in the institutional structure. How-ever, absent such changes in the structure, the proposal to strengthen thecapital base is a major improvement over the current system, because it callsfor comprehensive market-value accounting, a strict monitoring system, andestablishment of risk-based premiums. Moreover, the Danish experience witha system of mark-to-market accounting and strict enforcement of capital re-quirements seems to work for them. 42 Danish banking authorities pursuea very aggressive policy of seizing banks that violate capital standards andreselling them to new owners while the banks equity still has significantmarket value. Given the historical record on forbearance for both thrifts andbanks, there is reason to question whether such an aggressive seizure policyto protect the FDIC would be tolerated in the United States.43

40See Off ice of Management and Budget, Budget of the U.S. Government for 1993,Section 13, Identify ing Long Term Obligat ions and Reducing Underwritin g Risk s.

41We refer to the 1991 Deposit Insurance Reform Act. In May 1992, FDIC adopted newrules that classi fy banks into one of three categories baaed on their capital-to-asset ratios.The rules restrict the acquisition of brokered deposits and the interest rates paid by banksclassif ied in the lower two categories. FDIC also adopted risk-based insurance premiumsin a limited fashion.

42For further details about the Danish system, see the Appendix to this paper, Bernard,Merton, and Palepu (1992), and Pozdena (1992).

43Moreover, the asset mix of Danish banks may lend itself to more effective mark-to-market accounting than for the wider and more complex set of on- and off -balance-sheetactivities currently undertaken by U.S. commercial banks.

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3. F u n c t io n s o f d e p o s it i n s u r a n c eIf the collateralization reform proposed here were implemented, FDIC insur-ance would cover 100% of transaction deposits but would have little economicimpact, since it would serve only as a backup to collateralization with U.S.Treasury bills. Nevertheless, there is currently a widespread belief that de-posit insurance is desirable for other reasons. Among those are:l To encourage and enhance a safe and convenient form of investment forsmall savers.l To ensure an adequate and stable supply of credit to worthy borrowers whowould not otherwise have access to the nations supply of capital.l To facilitate the creation of liquidity.l To prevent a run on the banking system that might destabilize themacroeconomy.l To enhance the efficiency of the payments system.We believe that only the last of the five requires deposit insurance for effi-ciency. The other four are better served by alternative means. We offer abrief analysis of each below.3.1 Insurance of savings depositsWhile politically popular, it is not clear that government insurance of sav-ings accounts really adds to social value in todays financial environment inthe United States. For households who demand completely default-free in-struments, there are many other types of assets available in very convenientforms. Shares in a U.S. Treasury money-market fund are one example. In-deed, one of the great financial transformations of the last 20 years has beenthe growth of money-market funds and their displacement of depository in-stitutions as the repository of the liquid assets of households.

We suspect that the popularity of government-insured savings depositsstems from the belief that somehow insured depositors are getting a bargain.Given the competition that exists in this sector, it is hard to imagine that thisis the case, unless somehow the existence of government deposit insurancehas created a subsidy to insured depositors. A threat to the stability andefficiency of the financial system is the fostering of the illusion that there is afree lunch to be had through the mechanism of fractional-reserve bankingand FDIC insurance. Safety and liquidity of asset holdings carry a price, andwe see no reason for individuals desiring those features not to pay that price.If public policy is to subsidize those services for the poor, deposit insuranceis not the least-cost way of doing it.

A common objection to proposals like the one presented here is thatdemand deposits collateralized by Treasury bills would by necessity offer alower promised interest rate than that available on uninsured money-market

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funds. As the story goes, since money-market funds appear to be as safe andoffer checking privileges, households will use them as transaction accounts.The government will then be forced to guarantee them de facto. Becausethe assets of these funds are not as restricted as those permitted in ourtransaction-deposit accounts, these funds would have an unfair advantage.

We do not suggest forbidding mutual funds from offering check-writingprivileges. If a customer has shares in a mutual fund, it is a great conve-nience to be able to use a check to order the sale of enough shares to make apayment for some good or service. There is no need to prevent that, as longas these mutual funds are marking the value of their assets to market. Wedo, however, think that it is desirable to prevent money-market funds fromcreating the illusion of perfect liquidity and complete safety of principal bykeeping a fixed price per share. This practice, which is now very common,creates the illusion that the funds are offering an asset that is as risk-free andas liquid as insured demand deposits, but at a higher yield. We see no pur-pose for the practice of keeping the price per share fixed except to foster suchan illusion.44 Moreover, the assets of these funds, such as Al/PI-rated com-mercial paper, are far less risky and opaque than the corporate, commercialreal-estate and sovereign loans that are the core assets of commercial banks.Hence, by comparison to the status quo, proliferation of such substitutes fortruly default-free deposits is not a major problem.3.2 Insuring an adequate supply of funds to small borrow ersThere is a concern that without commercial banks which have access togovernment deposit insurance, there would not be enough credit flowing tohouseholds and nonfinancial businesses that do not have direct access to thecapital markets. Whether there was ever any merit to this argument, webelieve that in the current economic environment in the United States, thereis no longer any. The development of markets for junk bonds, securitizedloans (mortgages, automobile loans, trade receivables, etc.), and the growthof nondepository finance companies now provide alternative sources of creditto all sectors of the economy. There is every reason to believe that in arelatively short period of time, these alternatives could completely replaceinsured deposits as a financing source. Indeed, the loan and credit-evaluationfacilities that currently reside in banks could continue intact with a newfinancing facility that does not use deposits. Some commercial banks, suchas J.P. Morgan and Bankers Trust, do not rely on insured deposits as a majorfinancing source. And, as already noted, the current trend in the commercial

44Alternatively, funds that call themselves money market and post a fixed ($1.00)price per share could be greatly restricted as to the assets they can hold. An exampleis the recent SEC restriction of such funds against holding commercial paper that is lessthan top-rated (Al/PI).

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banking industry is that banks are shifting their assets more and more intomarketable debt instruments that are much more liquid than the bank loansof the past. As an example of just how rapidly the U.S. financial system canshift the flow of funds from one institutional mechanism to another, considerthe change in the system of housing finance during the past fifteen years.45None of these new institutional arrangements requires government depositinsurance.3.3 Facilitat ing t ransforma tion services: generaliz ed liquidit y creationDiamond and Dybvig (1986) identify transformation services as one of thethree functions of banks. They oppose policy moves toward 100% reservebanking because it ... would prevent banks from fulfilling their primary func-tion of creating liquidity (p. 57). It should be noted, however, that transfor-mation services are performed and liquidity enhanced whenever a collectionof assets is repackaged and the resulting liabilities created have a smallerbid-ask spread than the original assets. Thus, banks that hold illiquid corpo-rate, commercial real-estate, and sovereign loans as assets and finance theirportfolios by issuing term-debt and equity which are traded in markets areproviding transformation services and adding to liquidity. Financing such as-sets by issuing demand deposits is not the only means for increasing generalliquidity in the economy.

Conversely, banks that provide the specialized transformation service ofincreasing the supply of (nearly) perfectly liquid assets by issuing insureddemand deposits need not invest the proceeds in highly illiquid assets withlarge bid-ask spreads. Gorton and Pennacchi (1990, 1992a) make a casefor some economies of scope in jointly producing credit and perfect-liquidityservices, historically. However, they go on to provide theoretical analysisand empirical evidence that such synergistic benefits no longer exist becauseof technological progress and the associated development of new marketsand institutions. They also describe the asset characteristics which are bestfor transformation into perfectly-liquid demand deposits: namely, a well-diversified portfolio of (nearly) riskless assets which are easy to value andhave short maturities. These asset characteristics fit the profile of money-market mutual funds, which Gorton and Pennacchi see as far more suited forsupporting transactions liquidity than the typical bank portfolio.

We agree with the broad points of their analysis, but we go even farther.Demand deposits are both liquid and riskless. Liquidity and price uncer-tainty are logically distinct properties of assets. A perfectly-liquid security

45As in the case of housing, pension funds that have little need for liquidity may becomean important alternative source of financing for traditional bank assets. See, for example,the article, Pension Funds as Yeast for Rising Companies, in the Wall Skeet Journal,April 21, 1992, p. A17.

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trades with a zero bid-ask spread. Thus, shares of stock traded on securi-ties exchanges can be highly liquid yet have considerable uncertainty abouttemporal changes in price. 46 On the other hand, an individuals claim to agovernment pension may be completely riskless with no price uncertainty,yet be totally illiquid. Government insurance is thus neither necessary norsufficient to ensure liquidity.

Under the current system of FDIC insurance, the government guaranteesboth the temporal certainty of price and liquidity. However, the bank assetsthat traditionally serve as collateral are both illiquid and subject to consid-erable price-change uncertainty. This combination makes it very difficult forthe government guarantor to distinguish whether the low price obtainablefrom an immediate liquidation of those collateral assets is due primarily toilliquidity or to a change in their fundamental or intrinsic value.

Perhaps this structure was efficient in the past. However, the currentenvironment of low and secularly declining transaction costs for securitizationsupports a hierarchical or incremental approach as an efficient means forproviding liquidity. Thus, highly illiquid and opaque assets can be financedwith stocks, bonds, and short-term debt instruments.47 Portfolios of thosesecurities, in turn, can be used to collateralize other claims having evengreater liquidity. To create securities with minimal price uncertainty, seniorshort-term fixed-income claims could be issued against a portfolio of liquidassets which serve as collateral. The value of those liquid collateral assetswould have to be much larger than the promised principal on the fixed-incomeclaims, so that promised payments could still be met even with large pricedeclines on the collateral assets.4s

This hierarchical approach uses the next-nearest asset for transforma-tion to support perfectly-liquid and safe demand deposits. Thus, as ad-vocated at the outset, the asset collateral ideally should be U.S. Treasurybills. If the demand for highly liquid, riskless transaction deposits exceedsthe supply of U.S. T reasury bills, then add a well-diversified portfolio oftraded short-term, high-grade corporate debt such as Al/Pi-rated commer-cial paper.4g

46By price in this context we mean the full price realizable from an orderly unrushedsale of the stock.

47Ultimately the economic uncertainties associated with illiquid assets have to be borneby someone. But the form in which they are borne can be made more liquid.

4This approach differs from just having a large capital requirement on banks with theircurrent configuration of assets and liabilities because the assets here are liquid.

4gAs of December 1991, there were $590.4 billion of U.S. Treasury bills outstanding, andthe total of all interest-bearing marketable U.S. Treasury debt was $2,471.6 billion. Theapproximate size of the U.S. commercial-paper market is $530.3 billion. Demand depositsat commercial banks were $289.5 billion, and checkable deposits at other depository in-stitutions $333.2 billion. Source: Federal Reserve Bnllelin, July 1992, Tables 1.21, 1.32,1.41.

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3.4 Preventing runsThe worst-case scenario is a banking panic. Depositors are content to leavetheir deposits in banks as long as they are confident that their money is safeand accessible. However, depositors know that the bank is holding illiquidand risky assets as collateral for its obligation to depositors. If they believethat they will not be able to get back the full value of their deposits, thendepositors will race to be first in line to withdraw their money. This forcesthe bank into liquidating some of its risky assets. If the collateral assets areilliquid, then being forced to liquidate them quickly means that the bankwill have to accept less than full value for them. If one bank does not havesufficient funds to pay off its depositors, then contagion can set in, andother banks are faced with a run. However, such a contagion problem occursfor the banking system as a whole only if there is a flight to currency.50

The root cause of banking pa.nics is therefore the financing of illiquid bankloans with demand deposits. 5* Government deposit insurance is very potentmedicine to solve the problem of bank runs. While it seems to work, depositinsurance as a cure for banking panics has major drawbacks. It requires thegovernment to distinguish between good loans that a.re illiquid but willpay off in full and bad loans that will not. Essentially, all the models thatshow the welfare gains from eliminating panics (cf. Diamond and Dybvig,1983) assume away this problem by positing that it is known for certain thatilliquid bank assets will realize their full promised value if only they are heldto maturity. In the real world, the benefits of eliminating panics must betraded off against the prospect that the true economic value of the assetsis below the promised value of deposits (i.e., the panic is justified) and thegovernment is providing a windfall bailout. Surely, the opaque and illiquidassets held by commercial banks a.re a particularly difficult group in makingthat assessment. Hence, the case for welfare benefits from preventing runs isgreatly diluted if the insured institution holds assets of this type.52 Much thesame issue arises when the government intervenes by providing temporaryliquidity through the Federal Reserve discount window. The collateralized-deposit proposal of this paper solves this problem by stopping the financingof opaque, illiquid loans with insured demand deposits.

The improbability of a flight to currency distinguishes the current situation from theone that existed in the 1930s and contributed to the severity of the Great Depression. (cf.Meltzer (1967) and Tobin (1987, pp. 168-9)).

51 For a discussion of the history of panics in the United States, see Calomiris and Gorton(1991).

52Gorton and Pennacchi (1992b) fi n d no empirical evidence of contagion effects for non-banks providing banking services.

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3.5 Enhancing the eficiency of the paym ents syst emAs stated at the outset of this paper, the function of a payments system is tofacilitate the efficient exchange of goods and services. In the United States,checks and wire transfers drawn on commercial banks are an important meansof payment. For large transactions, the seller will often call the bank inadvance to verify that the buyer has sufficient funds in his account to coverthe check. Sometimes, for smaller transactions, there are insufficient fundsin the check-writers account. The resultant bad checks are a nuisance tothose who receive them and, if it is unintentional, to those who write them.

This system of making payments is nevertheless quite efficient becausesellers do not have to spend much time or effort verifying information aboutthe credit-worthiness of buyers, and buyers do not have to spend much timeor effort proving their credit-worthiness to sellers. Both parties rely on thebank to perform this verification and to guarantee payments up to the amountin the buyers demand-deposit account. But what if the solvency of the bankitself is in question ? Then a large part of the information-efficiency of thissystem is lost.

To understand the efficiency gains from Federal insurance of transac-tions deposits, it is helpful to draw a distinction between the customersand the investors of a commercial bank that provides demand deposits.53Customers who hold the banks demand-deposit liabilities are identified bytheir strict preference to have the payoffs on their deposits as insensitive aspossible to the fortunes of the bank itself.54 By contrast, investors in theliabilities (e.g., stocks or bonds) issued by the bank expect their returns tobe affected by the banks profits and losses. Indeed, the primary function ofthe investors is to provide the risk capital which protects depositors againstdefault risk stemming from a mismatch between the banks assets and itsdeposit liabilities. The investors are of course compensated for this serviceby an appropriate expected return. Note that while the roles of customersand investors are distinct, the same individual can be both a customer ofand an investor in a particular banking firm. Thus, we can be both a depos-itor at a particular bank and also hold shares of its common stock as part ofour investment portfolio.55

53For a more complete discussion of the distinction between the customers and theinvestors of a financial intermediary, see Merton and Bodie (1992b,c).54As a formal example of this general point, consider an economy where there are pure

Arrow-Debreu securities for every state of the world. It is well-known that a completeset of such securities permits Pareto-effi cient allocations. If, however, the payoffs on suchsecurities were also contingent on the solvency of the issuer of the securities, then theywould lose their efficiency. See Merton (1992a, pp. 450-1, 463~7) for a more completediscussion of this point.

By definition, mutual banks are organized in such a way that all of their depositors arealso investors. However, t,he depositors of mutual banks are probably unaware that, they

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If demand deposits are subject to default risk on the part of the bank,then sellers of goods seeking to verify the ability of buyers to make good ontheir promises to pay would have to verify not only that the buyer has enoughmoney in his account but also that the bank in which the account is held issolvent. Similarly, buyers who want the convenience of writing default-freechecks would have to monitor the solvency of the bank in which they havetheir account. Uncertainty about the ability of the bank to make good onits deposit liabilities thus creates deadweight losses.

The system of collateralized demand deposits that we advocate eliminatesthis deadweight loss for all parties at minimal cost.56 The role of the FDICin this system is simply to confirmthere and that if it is not, then the

to the public that sufficient collateral isFDIC will make good on the payment.

4. ConclusionsWe are certainly not the first to arrive at our proposed solution to the deposit-insurance problem in the United States. 57 However, we harbor the hope thatwe have strengthened the ca.se for this solution by setting forth familiar a.r-guments in a somewhat different way that perhaps highlights certain criticalissues. These are:l There is a continuing need for the government to serve as the ultimateinsurer of the payments system. We believe that the least-cost method fordoing so is to restrict FDIC coverage to deposits that are backed 100% bythe shortest-term U.S. Treasury securities.l If, contrary to our beliefs, one concludes that there is great value in pre-serving the current institutional structure of banks, there are other waysto improve the current system. Deposits that are collateralized by morevolatile assets can be guaranteed through a combination of monitoring andrisk-based premiums. The collateral assets used for this purpose must bemarked to market at their bid price, and capital standards must be strictlyenforced. However, these alternatives to the proposal of 100% U.S. Treasury-backed deposits are more costly.l A threat to the stability and efficiency of the financial system is the fos-tering of the illusion that liquid and riskless deposits can be used to financeare also investors. Indeed, if they believed that they were exposed to meaningful defaultrisk by virtue of holding their deposits at a mutual bank, they would probably hold theirtransactions balances elsewhere.

56Gorton and Pennacchi (1992a) point out that deposits can be made riskless either bythe government guaranteeing the deposits value or by guaranteeing the asset value byrequiring the banks to hold U.S. Treasury bills. The latter way avoids the problem ofunintended transfers of wealth caused by mispriced deposit insurance.

57We echo the view of our good friend, Stanley Fischer, M.I.T., that in matters of publicpolicy, he would rather be right than original.

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illiquid and risky assets at a small cost. The mechanism believed to providethis free lunch is traditional fractional-reserve banking and FDIC insur-ance. Belief in this illusion may explain the widespread popular support forinsurance of savings deposits. Safety and liquidity of asset holdings carry aprice, and if individuals demand these features, they should pay that price.If public policy is to subsidize those services for the poor, deposit insuranceis not the least-cost way of doing it.l Although there may have been at one time synergies from using insureddeposits as the primary means to finance the commercial lending activities ofbanks, there no longer are. There may be efficiency gains in having the sameinstitution that takes deposits also engage in making loans and performingother financial-service activities. Our proposed reforms do not rule this out.With deposits backed 100% by U.S. Treasury securities held in a custodialaccount at the Federal Reserve, there is no danger that the security of thosedeposits would be jeopardized by other activities of the depository institu-tion. Thus, under this proposal there is no need to have rules or laws (suchas the Glass-Steagall Act of 1933) restricting the other financial activities ofdepository institutions.

We close with a few words about the feasibility of implementing our pro-posal. The two functions traditionally performed by U.S. commercial banksare increasingly being taken over by other financial intermediaries. Somecompetitors, such as finance companies, compete with banks in making loanswithout using deposits as a source of financing. Junk bonds have replacedsome bank loans. Further innovations currently under way suggest that pen-sion funds may also serve as an alternative source for traditional bank-loancustomers. Indeed, as noted, even some commercial banks, such as J.P. Mor-gan and Bankers Trust, do not rely on insured deposits as their principalfunding source. Thus, as with the major changes in the sources of fundingfor housing during the 1980s) we see no major economic problem in shiftingthe financing of bank assets to nondeposit sources during the 1990s. Theremay, of course, be a political problem.

With respect to the deposit-taking function of banks, institutions suchas money-market funds compete with banks in providing safe and liquidassets in a convenient form. In effect, money-market funds offer depositsbacked 100% with collateral that is not opaque and illiquid. U.S. Treasury-bill money-market funds are close to the institutional structure for the trans-actions deposits proposed here. Thus, implementation of our proposal isfeasible. The short-run transition costs for this proposal may exceed thoseof some alternatives. However, as we have indicated, there are other inter-mediate and long-run costs of choosing those alternatives. Hence, includingthe present value of those longer-run cost differences, we believe that ourproposal is efficient.

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Under our proposal, the successor institutions to commercial banks arelikely to evolve from those banks. They will keep the same employees forcredit analysis and loan origination, and many will retain the same corporateidentity. 58 Banks with special expertise in originating and servicing corpo-rate, commercial real-estate, and sovereign loans would continue to performthose activities. The financing of those activities, however, would not comefrom insured deposits. Large banks would expand their fund-raising throughissuing debt and equity securities. Smaller banks without direct access tothe capital markets could arrange financing through syndication with insti-tutions that have such access. A number may find that the best solution isto merge with other institutions. Given the extraordinarily high operatingexpenses of the U.S. banking industry today, many observers agree that con-solidation is necessary to reduce those costs and improve efficiency.5g Ourproposal would thus facilitate that consolidation.

However, the greatest potential efficiency gains from reforming depositinsurance along the lines proposed here may well be the gains from reducedregulation. While the successor institutions to commercial banks would stillhave to comply with securities laws and other regulations that apply to allfinancial-service firms, they would be free of the extra regulatory burdenscurrently imposed on banks as a quid pro quo for deposit insurance andspecial treatment by the Federal Reserve.

5sFor example, Citibank has maintained essentially the same corporate identity through-out this century even though it has performed quite different functions during that timespan.

5gMuch the same transition is taking place in the thrift industry.601n an editorial, Dont Handcuff the Healthy Banks, New York Times, May 17, 1992,

L.J. White refers to this quid pro quo with the banks as ...the Faustian bargain that hasprotected them but also subjected them to regulated public utility treatment and extraCosts.

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Appendix: The Danish SystemDenmark has used a mark-to-market accounting system combined with

strictly enforced capital requirements for banks for many years. While onein eight Danish banks has failed within the last five years, all but one of thefailures were handled without explicit government financial assistance.

If a bank in Denmark falls below the required 8% capital ratio at theend of any quarter, the government regulatory agency (the Danish FinancialSupervisory Authority) allows six months for the institution to raise newcapital (including equity and up to 40% subordinated debt). If, at the endof six months, the bank is still not in compliance, the regulatory agencyimmediately places the bank under new control, generally by arranging anacquisition by a healthy bank. If an acquirer cannot be found, the bank isclosed.

Prior to 1988, Denmark had no formal deposit-insurance system. How-ever, when the C&G Banken bank failed in 1987 and was closed, the Danishgovernment covered the resulting deficit to depositors (about $50 million).Since that time, a deposit-insurance system has been established. However,although the regulatory a.uthority has intervened in 23 cases of capital defi-ciencies, there has not been one where government assistance was required.

See Bern ar d, Mert on, an d Pa lepu (1992) and Pozdena (1992)

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