Remarks by

John D. Hawke, Jr.

Comptroller of the Currency

Before the

Exchequer Club

Washington, D.C.

December 20, 2000

Earlier this year, the FDIC launched a full-scale review of the nation's
deposit insurance system. I can scarcely imagine a more opportune time
for such a review to occur. BIF and SAIF are both at levels in excess of
their statutorily determined reserve ratios. The banking system's
earnings are robust; a ninth consecutive earnings record for the year is
still a possibility. Assets and deposits continue to grow, if more
slowly than in recent years. Capital is at historical highs. Bank
failures are a rarity.

It's also clear, however, that the economy and the banking system are
entering a period of uncertainty. Rising interest rates and a slowdown
in economic growth have already had an impact on bank financial
statements. In the third quarter of this year, we saw the consequences
of increasing credit risk: declines in credit quality and rising loan
loss provisions. Securities losses have increased and noninterest income
growth has slowed. In addition to opportunities, 2001 will undoubtedly
also bring stresses and challenges.

So it's particularly important that we act [now]{.underline} to take a
fresh look at our deposit insurance system while there's still time to
do it methodically, inclusively, and comprehensively.

An "options paper" released by the FDIC back in August highlighted a
number of fundamental issues and has stimulated an especially lively
dialogue on the issues of premiums and fund size, which are among the
most controversial aspects of the current deposit insurance system.

These areas are badly in need of reform. The law today sets a
"designated" reserve ratio for the deposit insurance fund of 1.25
percent of deposits, regardless of the level of risk to which those
deposits might be exposed, and severely constrains the FDIC's ability to
charge risk-based premiums when the reserve ratio is above or below that
level. That results in a system that charges little or nothing for this
insurance today, when banks are earning big profits, and then charges a
lot when banks are taking losses and their ability to pay is lessened.
And our system does not adequately discriminate in its pricing between
risky institutions and prudent, well managed institutions. To be sure,
low rated banks pay somewhat higher premiums, but well-rated banks that
choose to take higher risks do not. In fact, banks taking higher risks
receive a twofold deposit insurance subsidy: first, from their more
conservative counterparts; and then, like every insured institution,
from the U.S. taxpayer through the Treasury Department, which provides a
multibillion dollar line of credit and back-up guarantees, all free of
charge, to the FDIC. Finally, banks do not compensate the FDIC, or
taxpayers, for the use of the deposit insurance system, even though the
availability of federal deposit insurance is a government benefit that
is essential for the conduct of the banking business.

Most analysts today agree that risk-based pricing of deposit insurance
makes sense. But what exactly would a risk-based system look like? In a
speech last week before the Women in Housing and Finance here in
Washington, the OCC's chief economist, Jim Wilcox, discussed an approach
that he has developed, an approach he calls MIMIC \-- short for Mutual
Insurance Model with Incentive Compatibility. Jim was not speaking for
the OCC in this speech, but his thoughtful and perceptive analysis will
certainly have a bearing on any position the OCC may take in the future.

Under MIMIC, banks would pay a risk-based "user fee" to the FDIC; the
FDIC, in turn, would make payments to the Treasury in return for the
standing line of credit and "catastrophe insurance" that Treasury
currently provides at no cost. The FDIC would set and periodically
adjust a risk-based range for the reserve ratio, to ensure that the size
of the fund reflects the amount of risk currently in the system. When
the fund exceeded the specified range for the reserve ratio, the surplus
would be rebated to banks; when it fell short, surcharges would be
imposed. And, to ensure that banks adding deposits didn't reduce the
reserve ratio, the MIMIC model would assess a "dilution fee" for each
additional dollar of insured deposits. Conversely, banks with shrinking
deposits would receive a dilution refund.

MIMIC is one of several risk-based models that have been proposed by
various experts on deposit insurance issues. They differ on some key
details. But it's important to recognize that all of these models share
the same basic principles \-- principles that I believe should be
embodied in all facets of the deposit insurance reform effort.

First, whatever changes we adopt in the current deposit insurance system
should make that system more **efficient**, in the sense that the actual
costs and benefits of coverage are measured and rationally allocated.
Increasing reliance on risk-based pricing would take us at least some
distance toward that goal.

This implies that the subsidies that distort our current system \-- bank
to bank, taxpayer to bank, or otherwise \-- should be eliminated and, as
nearly as possible, deposit insurance should be **priced in accordance
with market principles**. Risk-based pricing could end or significantly
reduce the subsidies provided by safer banks to riskier bank; the
payment of fees to the Treasury, as provided in MIMIC, could reduce the
public subsidy that all insured depositories receive today.

Finally, our deposit insurance system must be **transparent**. In order
to be allocated equitably, the costs and benefits of deposit insurance
must be priced accurately and openly. Reliable and consistent
information about the level of risk in the financial system and the
ability of the deposit insurance system to cope with that risk would
help all the interested parties \-- financial institutions, investors,
bank customers, and taxpayers \-- make informed economic decisions.

Pursuing efficiency leads to another issue that needs to be resolved .
Since the inception of federal deposit insurance, the FDIC has funded
its own operations from premiums and earnings from the deposit insurance
fund. At present, with so few banks paying premiums, the FDIC relies on
the income generated by the fund to pay for FDIC operations. In 1999,
\$1.2 billion, out of \$1.8 billion in fund revenues, went to defray the
FDIC's costs of operation.

Nearly half of the 1999 amount \-- about \$600 million \-- was spent on
the FDIC's supervision of state non-member banks. If that amount did not
need to be diverted from the fund to defray FDIC's supervision expenses,
the future [insurance]{.underline} costs of the FDIC to
[all]{.underline} FDIC member institutions, including national banks,
would obviously be lower.

If we're to allocate the costs and benefits of deposit insurance
equitably and efficiently, we also need to measure and allocate the
FDIC's [non-insurance]{.underline} costs appropriately. In a regime of
risk-related premiums, deposit insurance premiums should pay for deposit
insurance. And non-insurance costs should be paid for on a similar,
efficient basis.

Unfortunately, that's not the way it happens today. The longstanding
practice of using insurance premiums paid by all insured institutions to
defray the FDIC's costs of routine bank supervision of state nonmember
banks is not only inequitable, but it deprives the FDIC of an important
source of market discipline over its use of resources. And, very
significantly, it has given rise to undesirable tensions in the dual
banking system.

Of course, the dual banking system is hardly "dual," in the sense that
the states and the federal government maintain and supervise completely
separate banking systems. For many decades, the FDIC and the Federal
Reserve have played the preponderant role in the examination and
supervision of state-chartered banks. For more than 30 years, almost
every time Congress has imposed new federal bank supervisory and
regulatory responsibilities, it has parceled out authority and
responsibility among the three federal banking agencies. The result is
that today the supervisory functions that the FDIC and the Fed perform
for state banks are virtually identical to those performed by the OCC
for national banks. To put it another way, while both the FDIC and the
Fed have some significant responsibilities beyond those of the OCC,
there is virtually no function performed by the OCC for national banks
that is not replicated by the FDIC and the Fed for state banks. In
short, the most important division of bank supervisory authority today
is not that between the states and the federal government, as may
earlier have been the case, but a division among the three federal
regulatory agencies.

I think fair-minded people would agree that there is an inherent
inequity in a system that requires national banks to pay the OCC for
their supervision and then to pay again to support the cost of
supervising some of their competitors, the state nonmember banks. At
present, national bank contributions account for almost 53 percent of
the funds in the insurance fund. Thus, every dollar expended by the FDIC
on state nonmember bank supervision represents, in effect, a charge of
53 cents to national banks. And the same can be said of the Fed's
supervision of state member banks, the cost of which is partially offset
by the reserve balances held by national banks. In other words, when one
considers the extent to which the costs of supervision are borne by the
banks themselves, it is clear that state chartered banks are the
recipients of substantial federal subsidies, delivered by their federal
supervisory agencies.

In addition to this inequity, I think most objective observers would be
concerned by the implications of this subsidy.

Competition between state and national charters has always been one of
the hallmarks of the dual banking system \-- and one of its greatest
strengths. It's encouraged efficiency, creativity, and responsiveness on
the part of the regulators, and enabled banks to choose the charter that
most closely matches their business needs and objectives. Typically,
banks have made this decision after weighing a variety of factors \--
among other things, regulatory philosophy, access, the perceived quality
of supervisory services, and how much they had to pay for those
services.

Yet, because of the subsidy, the assessment differential between a state
and a national charter can be substantial, and clearly can affect a
bank's choice of charter. Some states charge less than half of what a
comparably sized national bank would pay the OCC \-- enough to tip the
balance for some banks. As earnings pressures grow in a slowing economy,
such considerations may loom even larger for some banks. It is hard to
see any compelling reason why federal banking policy should create such
incentives to diminish the national banking system. A truly vigorous
dual banking system should not be founded on the maintenance of a
federal subsidy for state banks.

State supervisors sometimes argue that this fee differential between
state and federal charters stems from the greater "efficiency" of state
supervision. But efficiency has nothing to do with it. The fact is that
the predominant regulation of state banks is [federal]{.underline}, and
the scope of responsibilities of state bank regulators is typically far
narrower than that of the respective federal regulator. When you add up
the numbers and compare apples to apples \-- comparing the
[total]{.underline} costs of supervising state and national banks,
including the costs of federal supervision of state banks \-- it becomes
quite clear that the costs are comparable. Indeed, if there are any
inefficiencies in the structure, they are most likely to result from the
maintenance of a two-tiered supervisory system \-- state and federal \--
for all state chartered banks. Unquestionably, a single agency could
perform these functions at a lower cost than two separate systems of
supervision.

Let me be clear: I am not advocating merger of the federal agencies or
elimination of state supervision. I continue to believe in the dual
banking system. But so long as state banks are subject to overlapping
state and federal regulation, there is bound to be some inefficiency in
that component of the regulatory structure.

Last year, the OCC spent less than \$400 million to supervise
approximately 2300 national banks, which controlled roughly 58 percent
of the U.S. commercial bank assets. Neither we nor the banks we
supervise receive subsidies, direct or indirect; national bank
assessments cover almost 98 percent of our total expenditures.

Over the same period, the FDIC spent \$590 million on state nonmember
bank supervision, and the Federal Reserve spent \$280 million
supervising state member banks. When you add in the approximately \$160
million spent by the states, you come up with a grand total of more than
\$1 [billion]{.underline} \-- a number that represents the real cost of
state bank supervision.

There, in the difference between the \$160 million spent by the states
and the \$1 billion total cost of state bank supervision, is the
inequity \-- a funding gap the major part of which is paid by those
national banks that have contributed to the FDIC insurance fund and that
maintain reserves with the Fed. Of course, American taxpayers also pay
for part of these costs, for every dollar that the Federal Reserve
spends on the supervision of state member banks is a dollar that is not
remitted to the Treasury, as would otherwise be the case.

Those of you who are longtime followers of regulatory issues are
probably not hearing this discussion for the first time. The inequity in
the funding of federal supervision of state and national banks is an
issue that's engaged and vexed Comptrollers of the Currency going back
to the days of Jim Saxon in the 1960s, and one that's been the subject
of a fair number of academic studies and legislative reports since then.
One approach to the problem that has frequently been proposed in the
past would require the FDIC and the Fed to assess state banks directly
for their cost of federal supervision. Every year since 1993, the Office
of Management and Budget has proposed such a plan, and every year it has
been effectively dead on arrival in Congress. While this approach is in
many ways the most straightforward, since it would end the subsidization
of federal supervision for state banks by national banks and restore a
healthier competition to the dual banking system, one has to confront
the political reality that Congress is not likely to impose such a new
charge on state banks.

Others have suggested that the OCC could simply alternate national bank
examinations with the FDIC, as the states now do. While that might
reduce OCC's costs somewhat, it would clearly add to the FDIC's costs
\-- and it would do so in a most inefficient way, since both of these
federal agencies would have to maintain a capacity to examine the same
set of national banks. The sum of the parts would inevitably be greater
than the whole. As I mentioned earlier, it is precisely this
inefficiency that characterizes the current two-tier supervision of
state banks.

Moreover, such a plan would [increase]{.underline} the supervisory
burden on national banks by subjecting them to the jurisdiction of two
agencies, instead of one. This would effectively destroy one of the key
attributes of the national charter \-- the ability to deal with a single
primary regulator.

Some have suggested that the fees charged by the FDIC should simply be
unbundled into two components. The first, charged to all, would cover
the risk-adjusted cost of deposit insurance; the second would cover the
FDIC's cost of supervision, and would be paid by banks whose primary
federal supervisor is the FDIC. Others have suggested that the FDIC
should remedy the inequity of using national bank contributions to the
FDIC to pay for the costs of state bank supervision by rebating to
national banks \-- or to the OCC, for pass-through to national banks \--
an amount equal to their contribution to the cost of federal supervision
of state banks.

Which of these approaches is the most sensible? I don't have an answer
to that question for you today. My purpose in discussing the issue here
is simply to raise awareness of its importance and to encourage public
dialogue on an issue that we believe must be considered in the context
of deposit insurance reform. I look forward to hearing from you and from
other interested parties about this subject.