# O **NEWS RELEASE**

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| ## Comptroller of the Currency      | ##### NR 2000-100              |
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| Administrator of National Banks     |                                |
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FOR IMMEDIATE RELEASE Contact: Sam Eskenazi

December 12, 2000 (202) 874-5770

**Wilcox Discusses Deposit Insurance Reform**

Attached are remarks delivered today by James A. Wilcox, chief
economist, Office of the Comptroller of the Currency, on reforming
deposit insurance. He spoke before the Task Force on Financial
Institutions Regulation, Women in Housing and Finance, in Washington,
D.C.

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  banks and 56 federal branches of foreign banks in the U.S., accounting
  for more than 56 percent of the nation's banking assets. Its mission is
  to ensure a safe and sound and competitive national banking system that
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Remarks by

James A. Wilcox

Chief Economist

####### Office of the Comptroller of the Currency

Before the

Task Force on Financial Institututions Regulation

Women in Housing and Finance

On

Reforming Deposit Insurance

Washington, D.C.

December 12, 2000

I would like to thank Laricke Blanchard for providing me with the
opportunity to speak today before the Task Force on Financial
Institutions Regulatory Issues of the Women in Housing and Finance. At
the outset, I should note that the views I will present today are
entirely my own and do not necessarily represent those of the Office of
the Comptroller of the Currency.

### A Proposal

The FDIC has initiated discussion of reform of deposit insurance and
asked for comments and suggestions. Here I propose the Mutual Insurance
Model with Incentive Compatibility (MIMIC), a model for deposit
insurance that mimics the incentives and practices of a private-sector
mutual insurance organization. Although I discuss MIMIC and its benefits
and costs to banks in more detail later, here is a preview of its main
features:

-   Annual, fully risk-based premiums

-   Payments to Treasury for the line of credit and "catastrophe
    insurance"

provided to the FDIC

-   Rebates to banks when the reserve ratio exceeds a risk-based ceiling

-   Surcharges on banks when the reserve ratio dips below a risk-based
    floor

\- Dilution fees on deposit growth to maintain reserve ratio

\- Refunds when deposits shrink to maintain reserve ratio.

## *Opportune Time for Reform*

Policy reform often proceeds in the cauldron of crisis. In that
cauldron, demand for immediate action to alleviate the symptoms of a
flawed financial system often boils up so rapidly and strongly that more
fundamental flaws are not adequately addressed. In addressing FDIC
reform, we need not, and should not, wait for the heat to be turned up.
Rather, conditions now allow us to pursue reform deliberately and
thoughtfully.

FDIC Chairperson Donna Tanoue has said that, because neither the banking
industry nor the FDIC is facing any foreseeable crisis, now is an
opportune time for reforming deposit insurance. Just as skilled banking
management requires that policies and operations be set with an eye
toward the future, skilled banking policymaking should be at least as
forward-looking. Recognizing that the financial seas will not always be
tranquil, policymakers can ready their vessels now for the possibility
of rougher seas in the future.

Since the early 1990s, the financial health of the banking system as a
whole and that of the FDIC have rebounded. Earnings in the banking
industry have been high and loan losses have been low. Bank capital as
measured by the standard ratios has been replenished. As a consequence,
losses to the FDIC's deposit insurance funds have been low and the ratio
of Fund reserves to insured deposits has risen steadily.

Relatively recent experience, and some even more recent data, remind us
that financial stability is not a given. One needs only look back a few
years to find serious financial turmoil in important economies in
disparate parts of the world. The financial crises of 1997 and 1998 may
have originated abroad and may have been felt most keenly within the
regions surrounding their country of origin. But, partly as a
consequence of the operations of internationally-active commercial
banks, shocks that originate anyplace in today's interconnected,
sophisticated, financial markets can reverberate around the globe in
financial markets and in banking. The reverberations of such financial
shocks on real economic activity and on policy at home can also affect
the domestic banking industry.

More recently, the credit quality of loans held by U.S. banks has
slipped somewhat. The latest data from banking supervisors' Shared
National Credits program showed a doubling from 1998 to 2000 of the
percentage of credits that were adversely rated. In recent years,
non-performing and charge-off rates for commercial loans, though still
well below their levels in the early 1990s, have also risen. On the
macroeconomic front, the consensus among economic forecasters is that
economic growth over the next year or two will be considerably slower
than we have enjoyed in the immediate past. Thus, while the banking
industry and the FDIC are currently reporting strong results, there are
no guarantees that recent results will continue indefinitely. These
ongoing risks are the first reason that the opportune time to reform the
FDIC is now, before there is any sizeable deterioration in financial or
economic conditions.

The second reason that this is an opportune time to pursue deposit
insurance reform is that, at least for the near term, much of the
impetus for, and debate about, financial modernization was addressed in
late 1999 by the enactment of the Gramm-Leach-Bliley Act (GLBA). As a
result, banking and its regulators find themselves in a period of
considerable stability, in the sense that the legislative backdrop is
more settled than it has been in some years.

A third reason that this is an opportune time for deposit insurance
reform is that the banking industry and its regulators are now in a
better position to handle some of the proposed remedies for the current
flaws in deposit insurance. The development of risk management
techniques and the computational apparatus to carry them out enable both
the industry and regulators to adopt a considerably more forward-looking
approach to risk assessment. And, indeed, both the industry and its
supervisors now appear to be appropriately taking into account more, not
just current conditions, but also the conditions that might emerge in
the future and the likelihood of such conditions.

### Reform Issues

In its recently released "options" paper, the FDIC identified four
problem areas in current deposit insurance policy. The first area is
pricing policy, which the FDIC argued creates inappropriate incentives
and raises fairness issues. The Federal Deposit Insurance Corporation
Improvement Act of 1991 required the FDIC to charge risk-based deposit
insurance premiums and established a designated reserve ratio for the
insurance fund of 1.25 percent. The FDIC's authority to charge
risk-based premiums, however, was severely curtailed by the Deposit
Insurance Funds Act of 1996 (DIFA). DIFA effectively restrained the FDIC
from charging healthy banks anything at all for deposit insurance once
the reserve ratio exceeded 1.25 percent. DIFA also required that the
FDIC charge all banks at least 23 basis points if the reserve ratio is
expected to be below 1.25 percent for more than a year. Thus, premiums
can shift up abruptly\--independently of a bank's risk\--when the
reserve ratio falls below the designated reserve ratio.

In addition, current premium policy subsidizes banks' risk-taking at the
margin. Even the few banks that pay positive premiums probably do not
compensate the FDIC fully for the risks they impose on the Fund. And,
among the vast majority of banks that pay zero premiums, safer banks
subsidize riskier banks via the latter's greater likelihood of drawing
down the Fund's reserves and triggering increased premiums on all banks
sooner.

Second, deposit insurance premiums are "procyclical" in that the weaker
the condition of the banking industry and thus the lower the Fund's
reserve ratio, the higher deposit insurance premiums are likely to be.
The third problem area is the legal requirement to operate separately
the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund
(SAIF) funds, which the FDIC strongly argued is inefficient. The final
concern is whether the present \$100,000 insurance ceiling, which was
set in 1980, should be raised.

I will comment only briefly on the two latter issues. Now that BIF and
SAIF have similar, historically high ratios of reserves to insured
deposits and serve industries that are in similarly strong condition,
two of the major stumbling blocks to their merger are no longer present.
Since merging the two Funds conceivably would enable the FDIC to achieve
some operating efficiencies, I support the FDIC\'s recommendation to
merge the Funds.

The ceiling on deposit insurance coverage is as much a political as an
economic or analytical issue. Advocates of increasing the ceiling note
that the overall price level in the economy has approximately doubled
since 1980, when the coverage ceiling was last raised. On the other
side, the argument is made that raising the ceiling then from \$40,000
to \$100,000 reduced the market incentives to invest insured deposits
appropriately and contributed to the savings and loan crisis. Secretary
of the Treasury Summers, Federal Reserve Board Chairman Greenspan and
Senate Banking Committee Chairman Gramm have expressed opposition to
raising the deposit insurance coverage ceiling to \$200,000 per account.
To the extent that a ceiling makes sense, and I believe it does,
inflation-indexing would reduce the likelihood of large, arbitrary
adjustments.

***Primary Objective of Deposit Insurance Reform: Prices Right***

The primary objective of deposit insurance reform should be to ensure
that each of the financial services associated with deposit insurance is
rigorously priced on the basis of risk. More thoroughgoing risk-based
pricing will better align the incentives of banks and of the FDIC with
the broader goal of efficiency.

***The User Fee Model***

In its options paper, the FDIC discussed a "user fee" model of deposit
insurance, which might also be referred to as a pure government
guarantee model. The thrust of this model is that banks would pay
annual, risk-based, user fees, or premiums, for deposit insurance.
Risk-based premiums would not be based solely on banks' current
conditions but, rather, would be forward-looking. Fully risk-based
premiums would be sufficient over the long run to compensate the
government for all the risks, large and small, that it chose to bear. By
moving toward risk-based premiums, subsidies from safer to riskier banks
and the subsidies from Treasury through the FDIC to the banking industry
would be reduced.

These premiums would not be affected by the size of the Fund. Banks
would incur no additional responsibilities when the Fund balance was
deemed to be " too low"; nor would they have any extra claim on the Fund
when it was deemed to be "too high." Thus, the size of the Fund would be
economically irrelevant to banks.

In principle, the user fee model might be very attractive if the U.S.
were instituting a *de novo* deposit insurance program. But, we are not.
I doubt that an agreement could be reached to abolish and disperse the
Fund. And, if the Fund were to survive under the user fee model, it is
hard to believe that premiums would solely reflect risk and be
impervious to the size of the Fund. Thus, given past experience and
present realities, the user fee model seems unlikely to achieve the
objective of fully risk-based premiums for the future.

***MIMIC: Mutual Insurance Model with Incentive Compatibility***

To improve the prospects for a deposit insurance system with rigorous,
risk-based pricing, I propose MIMIC, a model for deposit insurance that
mimics the incentives and practices of a private-sector, mutual,
insurance organization. The main features of MIMIC are:

-   Annual, fully risk-based premiums

-   Payments to Treasury for the line of credit and "catastrophe
    insurance" provided to the FDIC

-   Rebates to banks when the reserve ratio exceeds a risk-based ceiling

-   Surcharges on banks when the reserve ratio dips below a risk-based
    floor

-   Dilution fees on deposit growth to maintain reserve ratio

\- Refunds when deposits shrink to maintain reserve ratio.

I will go through each of these in turn.

*Risk-based Premiums*

Under MIMIC, banks would pay the same risk-based premiums that they
would pay under the user fee model.

Moving to risk-based premiums, which reflect forward-looking assessments
of banks' prospects, may reduce the procyclicality in current premium
policy which tends to reflect recent past performance. First, when
banks' earnings reflect expected additional rewards to risk-taking,
risk-based premiums will tend to be higher when earnings are higher.
And, second, banks' current earnings may be less correlated with
forward-looking assessments of banks' prospects than they are with
banks' recent past performance. If so, then risk-based premiums will be
less procyclical than current premiums.

Risk-based premiums will fluctuate over time as the risks that banks
pose to the Fund fluctuate. Risk-based premiums are not likely, however,
to shift as abruptly as can happen under current law.

While it is easy to talk about imposing risk-based deposit insurance
premiums on banks, it is challenging to approximate those risks. One can
sympathize with the temptation to use readily available, objective data
for determining deposit insurance premiums. However, financial
statements are often better indications of what has been than of the
likelihood of future events. For larger banks in particular, data and
other information obtained through the supervisory process may provide
useful additional information. Regardless, while measuring risk at
individual banks may be challenging, we can surely do better than
charging nearly every bank the same zero premium.

*Payments to Treasury*

The government has come to recognize and to price some of the valuable
financial services that it provides. Valuable financial guarantees
provided by the government ranging from loan guarantees on FHA home
mortgages and on SBA business loans to flood insurance are already
priced, however imperfectly. Many remain unpriced. Earlier this year,
for example, Federal Reserve Board Chairman Alan Greenspan called
attention to the resource costs of the implicit but unpriced guarantees
provided by Treasury to housing-related GSEs.

The Treasury supplies two unpriced financial services to the FDIC.
Currently, by law the Treasury extends a \$30 billion (repayable) line
of credit to the FDIC. Treasury also backs the obligations of the FDIC
with the full faith and credit of the U.S. government. The backstop that
Treasury provides to the FDIC resembles the re-insurance that private
insurance companies purchase. An example of a backstop being called upon
took place as a result of the savings and loan crisis. The Treasury
"contribution" in the range of \$150 billion covered the losses beyond
those that the S&Ls and their insurer were called upon to pay. Because
the re-insurance provided by the Treasury to the FDIC is presumed to be
called upon only to cover large losses beyond those that banks and the
FDIC would be called upon to cover, this policy is referred to as
"catastrophe insurance."

Last week, the Shadow Financial Regulatory Committee suggested that
deposit insurance no longer poses any risk to the Treasury, due to
FDICIA provisions such as prompt corrective action and the requirement
that large losses would be funded, after the fact, by ex-post fees on
the remaining, solvent banks. I respectfully disagree with the Committee
on this issue. Although the probability that Treasury will have to fund
deposit insurance losses may be extremely low, Treasury remains at risk
for low-probability, large-loss events. Thus, the line of credit and
catastrophe insurance provided by Treasury remain valuable and
necessary.

Why does Treasury remain at risk? First, the deposit insurance fund is
not especially large relative to the size of the banking system or its
potential losses imposed on the Fund. Second, large enough losses can
overwhelm not only the deposit insurance fund, but also overwhelm the
ability of an industry to repay Treasury after the fact, as demonstrated
by the thrift crisis. Such large losses are likely to be associated with
a severely weakened industry. In that case, it is highly unlikely that
it will be either economically sound or politically feasible to extract
enough funds from the weakened banks to repay all the losses without
further weakening them, putting them at a distinct competitive
disadvantage relative to their non-bank competitors who will not be
paying ex-post fees, and disrupting bank credit flows.

Despite the value of Treasury's ongoing backstops to the deposit
insurance fund, at all times, under all circumstances, the FDIC has paid
a zero premium for the costs and risks that its line of credit and its
catastrophe insurance policy impose on the Treasury. This situation
bears the same hallmarks of inefficiency that the FDIC pointed out in
current deposit insurance premiums. The failure of the FDIC to pay
risk-based prices (and pass the costs along to insured banks) for these
financial services from the Treasury constitutes a public subsidy to
banks' risk-taking. Absent a compelling economic argument to the
contrary, these financial services should be priced according to the
costs and risks associated with providing them. MIMIC calls for the FDIC
to make two, separate, risk-based payments annually to the Treasury: one
for the \$30 billion line of credit and one for catastrophe insurance.

In addition, I prefer charging banks *ex ante* for the risks that they
impose on the Fund rather than settling up *ex post*, which the Shadow
Committee recommended. First, a bank's cash outlays for premiums based
on the risks it imposes on the Fund *ex ante* is likely to deter
risk-taking more than a less-certain, *ex post* arrangement to charge
for the Fund's losses. Second, although on average the riskiest banks
would be expected to be the banks that disappeared into insolvency and
that imposed actual losses on the Fund, they would not be around to pay
any of the *ex post* settling up charges.

It will also be challenging to measure the risk imposed on the Treasury
by the FDIC so that risk-based fees for the line of credit and
catastrophe insurance can be levied. However, again, it should not be
difficult to improve on the zero price currently charged by the
Treasury.

*Risk-based Reserve Ratio, Rebates, and Surcharges*

Further mimicking private sector insurance arrangements, MIMIC calls for
the FDIC to specify annually a risk-based target range for its reserve
ratio. The range would be re-calibrated from time to time as the FDIC's
estimate of the risks facing the Fund changed.

Choosing a range implies choosing a floor and a ceiling for the reserve
ratio. To maintain the reserve ratio within its chosen range, under
MIMIC the FDIC would impose surcharges on banks if the ratio dipped
below the floor and analogously would provide rebates from the Fund to
banks when the reserve ratio rose above the ceiling. These surcharges
and rebates should and can be designed to preserve the annual premiums'
risk-based incentives. Under MIMIC, banks will recognize that higher
current premiums raise not only the reserve ratio but also the
likelihood of future rebates. Thus, a risk-based range for the reserve
ratio reduces the current incentive for banks to pressure the FDIC to
set premiums and reserve ratios "too low."

The Fund's reserves serve as a "deductible" in the catastrophe insurance
policy. Thus, other things equal, the premiums paid by the FDIC to the
Treasury would vary inversely with the range established by the FDIC for
its reserve ratio. Explicitly paying for these Treasury services raises
the incentive for banks and the FDIC to maintain a larger average
reserve ratio than otherwise.

Some of the same practical difficulties will arise in setting the
appropriate risk-based range for the reserve ratio as in setting
risk-based premiums. At the same time, it seems very likely that we can
do better than, in effect, aim at a historical artifact like the current
designated reserve ratio of 1.25 percent.

*Dilution Fees and Refunds*

One notable feature of MIMIC is that it confers upon banks some of the
rights and responsibilities that attend the members (or owners or
residual claimants) of mutual organizations. While banks would have some
of the prerogatives of "ownership" of the federal deposit insurance
system, they would not have them all. For example, it seems very
unlikely that there would be voting shares in any meaningful sense.
Rather, the FDIC would remain as the arm of the federal government
charged with administering the deposit insurance system, including
setting premiums and the target range for the reserve ratio.

At the same time, under MIMIC, banks would have a financial stake in the
size of the Fund relative to insured deposits. Since growing banks
dilute the Fund by lowering the reserve ratio and raising the
probability of surcharges to replenish the ratio, it is appropriate to
charge them a dilution fee. This fee could be as simple as a one-time
charge equal to the current reserve ratio times the additional dollars
of insured deposits. Even-handed policy would then also refund to banks
whose insured deposits shrank an amount equal to the current reserve
ratio times the decline in their insured deposits.

*Markets on the March*

Market-based and market-like pricing have been spreading around the
globe for at least a decade. Entire countries have moved to market-based
systems. Closer at hand, U.S. financial markets have increasingly priced
and traded separately the distinct constituent parts of previously
composite financial products (and services). Banks have been in the
forefront of this "unbundling" of composites into their more homogeneous
components. As financial assets are unbundled, the resulting products
more closely match individuals' market demands and the resulting prices
are likely to better reflect the costs and benefits of those products.

For many years, the Federal Reserve System bundled into the package of
rights and responsibilities associated with being a member bank
financial services, such as check clearing and payments transfers, at no
explicit, separate cost. Eventually\--and ironically, given the economic
orientation of the Federal Reserve System\--Congress filled the pricing
vacuum by mandating a pricing scheme for some of the financial services
that the Fed supplies.

Some government-provided financial services remain bundled. In addition
to deposit insurance, the FDIC provides valuable supervision and
regulation at no explicit, separate cost. Moreover, some, but not all,
insured banks receive these unpriced services. Just as it can address
the pricing of deposit insurance *per se*, deposit insurance reform
should eliminate the inefficient pricing of these services. One way to
achieve efficient prices for the FDIC's supervision and regulation is to
unbundle them from deposit insurance; that is, to separate the pricing
of deposit insurance from that of FDIC supervision and regulation.

Rather than letting Congress or an Administration take the initiative,
banks and the FDIC should consider how to move toward a more rational
pricing scheme for each of the financial services associated with the
FDIC. Explicitly paying for each of these services may forestall other
costs being imposed on banks by those who perceive banks as receiving
government subsidies.

*Conclusion*

MIMIC calls for risk-adjusted deposit insurance premiums, as well as
risk-adjusted prices for the individual services that the Treasury
provides to the FDIC. As a result, MIMIC would reduce the current
subsidies from safer to riskier banks and from the Treasury to the FDIC.

In order to strengthen the incentives of banks and the FDIC to get the
prices right, MIMIC confers on banks some, but not all, of the rights
and responsibilities of ownership of the deposit insurance system. Thus,
MIMIC calls for the FDIC to maintain its reserve ratio within a
risk-based range through the use of rebates and surcharges. It also
advocates a dilution fee for deposit growth and, symmetrically, a refund
when deposits decline. Taken together, these features of MIMIC move the
deposit insurance system toward the policies and practices of
private-sector mutual insurance organizations.

The FDIC has stimulated a timely and valuable discussion of deposit
insurance reform. Because of the size of their stake in the efficient
operation of the deposit insurance system, banks should recognize their
significant interest in achieving the right reforms.