**TESTIMONY**

**OF**

#### JOHN D. HAWKE, JR.

**COMPTROLLER OF THE CURRENCY**

**BEFORE THE**

**COMMITTEE ON BankinG, HOUSING, AND URBAN AFFAIRS**

**UNITED STATES SENATE**

**APRIL 23, 2002**

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#### 

Statement required by 12 U.S. C. § 250

The views expressed herein are those of the Office of the Comptroller of
the Currency and do not necessarily represent the views of the
President.

***Introduction***

Chairman Sarbanes, Senator Gramm and Members of the Committee, I am
pleased to have this opportunity to present the views of the Office of
the Comptroller of the Currency (OCC) on deposit insurance reform. As
the current and most recent past chairmen of the Federal Deposit
Insurance Corporation (FDIC) have noted\--and as I strongly agree\--the
system of Federal deposit insurance adopted by the Congress in the early
1930s has served this nation well for the greater part of a century. No
massive overhaul of the system is required to ensure that it will
continue to contribute to financial confidence and stability in the
21^st^ century.

Nonetheless, the efforts so far undertaken to address the weaknesses in
the system uncovered during the banking and thrift crises of the late
1980s and early 1990s have not been entirely adequate to the task.
Indeed, the legislation adopted in response to those crises has actually
constrained the FDIC from taking sensible and necessary actions. This is
particularly the case with respect to the FDIC's ability to price
deposit insurance in a way that reflects the risks posed by different
depository institutions, and to the funds' ability to absorb material
losses over the business cycle without causing sharp increases in
premiums. Failure to address these issues in the current financial
environment poses the danger that the next major domestic financial
crisis will be exacerbated rather than ameliorated by the Federal
deposit insurance system.

Current legislative proposals in the House and Senate to reform deposit
insurance address most, albeit not all, of the issues raised by the FDIC
staff in its excellent and wide-ranging "Options Paper" released in
April 2001. Among these issues are (1) how much discretion the FDIC
should have to set premiums reflecting the risks posed by individual
institutions to the insurance funds; (2) whether strict limits on the
size of the insurance funds result in excessive volatility of deposit
insurance premiums; (3) whether the deposit insurance coverage limit
should be increased and/or indexed to changes in the price level; and,
(4) whether the Bank Insurance Fund (BIF) should be merged with the
Savings Association Insurance Fund (SAIF).

In summary, the OCC recommends that (1) the FDIC be provided with the
authority to implement a risk-based premium system for all banks; (2)
the current fixed DRR be replaced with a range to allow the FDIC more
flexibility in administering the deposit insurance premium structure;
(3) coverage limits on deposits should not be increased; and (4) the BIF
and SAIF should be merged.

We believe that deposit insurance reform also provides an opportunity to
strengthen our supervisory structure by eliminating a distortion and
unfairness in the current system of funding bank supervision. Currently,
a portion of the earnings on the insurance funds, which state and
national banks paid into, is diverted to fund the federal supervision of
only one class of institutions, state banks supervised by the FDIC. The
FDIC has elected not to pass those costs on to the banks they supervise.
As a consequence, state nonmember banks pay only a small percentage of
the costs of their supervision. In contrast, national banks pay over
\$400 million each year to cover the full costs of their supervision by
the OCC. Ending this anomaly is not just a matter of fairness to
national banks. It is a necessary component of allocating the costs and
benefits of deposit insurance in an equitable and efficient manner among
insured banks. For that reason, in addition to our views on the issues
addressed by the legislative proposals to reform deposit insurance, my
testimony today will include our suggestion for remedying the inequity
that exists in the funding of supervision.

***Eliminating Constraints on Risk-Based Pricing***

The ability of the FDIC to set premiums for deposit insurance that
reflect the risks posed by individual institutions to the insurance
funds is one of the most important issues in the deposit insurance
reform debate. The banking and thrift crises of the 1980s revealed the
weaknesses of a flat-rate deposit insurance system in which the great
majority of sound, prudently managed institutions subsidize the risks
assumed by a few institutions. The Congress responded to this glaring
deficiency by enacting the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991, which required the FDIC to establish a
risk-based system of deposit insurance premiums, thereby bringing the
pricing of deposit insurance more in line with the practices of private
insurance companies. The FDIC's initial efforts to implement such a
system made meaningful, actuarially-based distinctions among
institutions based on the risk each institution posed to the insurance
funds, but fell short of creating a well-differentiated structure.

Unfortunately, the Deposit Insurance Fund Act (DIFA) of 1996 diminished
the FDIC's discretion to maintain, let alone improve, the risk-based
structure of deposit insurance premiums. DIFA effectively prohibited the
FDIC from charging a positive premium to any institution in the 1A
category\--that is, well-capitalized institutions with composite CAMELS
ratings of 1 or 2\--whenever the reserves of the deposit insurance funds
are at or above the designated reserve ratio (DRR) of 1.25 percent of
insured deposits. As a result, at December 31, 2001, 92.5 percent of all
insured banks fell into that category, and therefore pay nothing for
their deposit insurance\--even though their risk of loss may be far
above zero. Thus, today many institutions\--some of which have never
paid any deposit insurance premiums\--receive a valuable government
service free, and very well-managed institutions in effect subsidize
riskier, less well-managed institutions. Moreover, quite apart from the
risk that a specific bank might present, banks are not required to pay
even a minimum "user" fee for the governmentally provided benefit
represented by the deposit insurance system\--a benefit without which,
as a practical matter, no bank could engage in the business of taking
deposits from the public.

Aside from the obvious inequity to institutions that contributed heavily
to recapitalize the funds after the losses of the 1980s and 1990s, a
system in which the vast majority of institutions pays no insurance
premium forgoes one of the major benefits of a risk-based pricing
system\--creating an incentive for good management by rewarding
institutions that pose a low risk to the insurance funds. A mandated
zero premium precludes the FDIC from charging different premiums to
banks with different risks within the 1A category, despite the fact that
within the 1A category there are banks that pose very different risks to
the funds.[^1]

Whenever the reserve ratio of the BIF falls below 1.25 percent, however,
FDICIA requires the FDIC to charge an assessment rate to all banks high
enough to bring it back to the DRR within one year. If that is not
feasible, the FDIC must impose an assessment rate of at least 23 basis
points. This sharp rise in premiums, or "cliff effect," would hit banks
the hardest when they are most vulnerable to earnings pressure. To avoid
creating this procyclical volatility in deposit insurance premiums, it
would be preferable to offset losses to the funds through more gradual
changes in premiums based on the level of the insurance fund relative to
the FDIC's assessment of current risk in the banking system. In short,
we believe that as risks in the banking system change relative to the
level of the insurance funds, the FDIC should have the authority to
adjust premiums on all banks.

***Increasing Coverage Limits***

The question of deposit insurance coverage limits is a challenging one,
in part because it is extremely easy for depositors to obtain full
insurance of deposits in virtually unlimited amounts through multiple
accounts. Along with most academic economists and other bank regulators,
we are convinced that the sharp increase in the deposit insurance limit
from \$40,000 to \$100,000 in 1980\--at a time when the thrift industry
was virtually insolvent\--was a serious public policy mistake that
increased moral hazard and contributed to the weakening of market
discipline that exacerbated the banking and thrift crises of the 1980s
and 1990s. By encouraging speculative behavior, it ultimately increased
losses to the deposit insurance funds and taxpayers.

Proponents of an increase in coverage assert that it would ease
liquidity pressures on small community banks and better enable small
banks to compete with large institutions for deposits. None of these
assertions, however, is supported by substantial evidence.

First, we see no compelling evidence that increased coverage levels
would offer depositors substantial benefits. Anyone who wants to use
insured bank deposits as a means of holding their wealth can do so today
virtually without limits, subject only to the minor inconvenience of
having to open accounts at multiple banks. Despite the ability of
depositors to achieve almost unlimited coverage at banks, money market
mutual funds, which have some of the same features as bank transactions
accounts and generally offer higher returns than bank deposits, today
hold over \$2 trillion. Because these funds could easily be placed in
insured accounts, these facts suggest that many depositors are not
concerned about the additional risk involved in holding their liquid
funds in uninsured form and that households are comfortable with the
*status quo*.

Second, it is not at all clear that increasing deposit insurance
coverage would result in an increase in the deposits of the banking
system. One effect could be to cause a shift in deposits among banks. It
is far from clear that any such redistribution of existing deposits
would favor community banks. Depositors who multiply insurance coverage
today by using multiple banks might consolidate their deposits in a
single institution if coverage were raised, but there is no way of
determining which institutions would be the ultimate beneficiaries when
the switching process ended. Moreover, it is quite possible that larger,
more aggressive institutions might use the expanded coverage to offer
even more extensive governmentally protected investment vehicles to
wealthy customers. That could cause an even greater shift of deposits
away from community banks and increase the liquidity pressures felt by
some.

For many of the same reasons that we object to an increase in the
general insurance limit, we are also concerned about proposals to use
the federal deposit insurance system to favor particular classes of
depositors such as municipal depositors. For instance, at year-end 2001,
commercial banks had \$162 billion in municipal deposits. The FDIC
estimated in 1999 that less than one-third of municipal deposits was
insured. Applying that 1999 ratio to the 2001 total suggests that nearly
\$115 billion of municipal deposits at banks are uninsured. A
significant increase in the insurance limit for municipal deposits,
therefore, would undoubtedly raise the level of insured deposits and put
pressure on the DRR. In addition, an increase in insured coverage could
spur riskier lending because banks would no longer be required to
collateralize the municipal deposits with low-risk securities.

***Merger of the BIF and the SAIF***

One of the least controversial issues of deposit insurance reform is the
merger of the BIF and the SAIF. The financial conditions of thrifts and
banks have converged in recent years, as have the reserve ratios of the
two funds, removing one of the primary objections to a merger of the
funds. As of the fourth quarter of 2001, the reserve ratio of the BIF
was 1.26 percent, while that of the SAIF was 1.37 percent. The reserve
ratio of a combined fund would have been 1.29 percent as of the same
date. As is described in greater detail below, many institutions now
hold some deposits insured by each fund. But under the current
structure, BIF and SAIF deposit insurance premiums could differ
significantly depending on the relative performance of the two funds,
raising the possibility that institutions with similar risks could pay
very different insurance premiums. This would unfairly penalize low-risk
institutions insured by the fund charging the higher premiums.

Despite the tendency for the activities of the banking and thrift
industries to converge in recent years, substantial differences remain
in their portfolio composition. For example, residential mortgage loans
constitute 51 percent of the assets of insured savings institutions but
only 15 percent of the assets of insured commercial banks. Largely
because of these differences, merger of the two funds would result in
significant diversification of risks.

A related development affecting the potential for diversification is
industry consolidation, which has led to an increased concentration of
insured deposits in a relatively few institutions and increased the
risks to the deposit insurance funds. According to the FDIC staff, the
three largest SAIF‑insured institutions held over 15 percent of
SAIF-insured deposits in 2001, while the corresponding share of the top
three BIF‑insured banks was over 13 percent. Merging the funds would
reduce these concentrations, and thereby the risk that the failure of a
few large institutions could seriously impair the insurance fund.

Further, there is significant overlap in the types of institutions
insured by the two funds. As of March 2001, 874 banks and thrifts were
members of one fund but also held deposits insured by the other fund,
and BIF-member institutions held 41 percent of SAIF-insured deposits.
Finally, merger of the BIF and the SAIF would undoubtedly result in
operational savings as the two funds were combined into one.

#### 

#### Increased Flexibility for the Deposit Insurance Funds 

The OCC supports giving the FDIC the authority to establish a range for
the DRR to replace the present arbitrary fixed DRR of 1.25 percent. The
FDIC should have the authority to set the range based on its assessment
of the overall level of risk in the banking system. We also believe that
in establishing the range, the FDIC should provide notice and an
opportunity for the public to comment on the proposed range. Adoption of
a range and elimination of the 23 basis point "cliff effect" would allow
the FDIC more flexibility in administering the premium structure and
would minimize the likelihood of sharp increases in premiums during
economic downturns when banks can least afford them.

When the funds exceed the upper boundary of the DRR range set by the
FDIC, the FDIC should be authorized to pay rebates or grant credits
against future premiums. To ensure that rebates or credits to insured
institutions are equitable, the FDIC should have the authority to assess
the nature of the institutions' claims on the funds. Institutions that
have paid little or no insurance premiums to the funds have far less of
a claim on rebates or credits than those that contributed to building up
the funds.

While such rebates or credits seem reasonable on their face, there are
two obvious principles that should be observed in determining their size
and allocation. First, a system of rebates and credits should not
undermine the risk-based premium system. Institutions that paid high
insurance premiums because they posed a higher risk to the funds should
not receive larger rebates than less risky institutions of the same
size. The fact that these high-risk institutions did not fail during
that period does not alter the fact that they subjected the funds to
greater than average risks.

The second principle is that the payment of rebates and credits should
not have the unintended consequence of exacerbating the disparity in
supervisory fees that now exists between state and nationally chartered
banks. Today, the FDIC charges the insurance funds for its costs of
supervising state-chartered institutions. National banks, in contrast,
pay the full cost of their supervision despite the fact that they have
contributed almost 55 percent of the amount in the BIF. For example, in
2001, in addition to \$400 million in assessments that national banks
paid to the OCC for their own supervision, national banks can be viewed
as contributing 55 percent, or about \$273 million, of the \$525 million
that the FDIC spent on state nonmember bank supervision. Failure to take
this into account in fashioning a rebate program would be
unconscionable.

#### 

#### Fee Disparity 

State banks, on average, pay only modest assessments to state
regulators, which represent about 20 percent of the total costs of state
bank supervision. Far and away the largest component of state bank
supervision is that provided by their federal regulators\--the Federal
Reserve, in the case of state banks that are members of the Federal
Reserve, and the FDIC, in the case of nonmember state banks. In 2001,
the Federal Reserve and FDIC together spent over \$900 million on state
bank supervision. None of this was recovered directly from the banks
they supervise. The FDIC absorbs the cost of its supervisory and
regulatory activities through charging the BIF and SAIF, while the
Federal Reserve uses its interest earnings to absorb its supervisory and
regulatory costs. Neither the Federal Reserve nor the FDIC assesses
state banks for their costs in providing exactly the same supervisory
functions as the OCC provides for\--and assesses\--national banks. As a
result of this subsidy provided by the Federal Reserve and the FDIC,
there is a continuing incentive for national banks to convert to state
charters. Indeed, state supervisors aggressively proselytize for such
conversions, heavily exploiting fee disparity as a major part of their
sales pitch.

It should be emphasized that fee disparity has no relationship to the
relative efficiency of national and state bank supervision. It is
entirely a consequence of the fact that state banks are not charged for
the major portion of their supervision costs\--that provided by their
federal regulators. Indeed, the OCC has a strong externally imposed
incentive to run its operations efficiently, for if it fails to do so,
and must turn to its banks to pick up additional costs, it runs the risk
of causing increased conversions of banks from national charters to
state charters. Still, the effectiveness of supervision can suffer, and
serious inequities can result, when unavoidable pressures on
supervisors' budgets are created. For example, during the wave of large
bank failures in the late 1980s and 1990s\--a period of stress in the
banking system that had not been seen since the Great
Depression\--significant resource demands were placed on bank
supervisors in responding to severe problems in the banking system. Yet
just as these demands were being felt, the banking system was under
severe earnings pressure.

At the OCC this meant significant increases in direct assessments on
national banks\--14 percent in 1989, another 11 percent in 1991, and 30
percent in 1992. While there were reductions in assessments in
subsequent years, one conclusion is inescapable: the OCC assessment
mechanism works procyclically in times of stress in the banking system.
At the Federal Reserve and the FDIC, similar cost increases were easily
absorbed\--at the FDIC out of insurance funds and at the Federal Reserve
out of revenues that otherwise would have been paid over to the Treasury
Department. In other words, the OCC faces the threat of reduced
supervisory resources at the very time they are most likely to be
needed. National banks face a higher burden of supervisory costs at the
very time they are facing a troubled economy. Just as the need to
address the 23 basis point "cliff effect" has gained attention, so also
should the procyclical distortions raised by the present system of
funding supervision.

The question, of course, is what to do about this disparity. Proposals
to level the playing field by requiring the Federal Reserve and the FDIC
to impose new fees on state banks have been dead on arrival in Congress.
We believe it is necessary to come up with a new method of funding bank
supervision\--a method that will strengthen both the state and the
federal supervisory processes and ensure that all supervisors have
adequate, predictable resources available to carry out effective
supervisory programs without imposing additional fees on state banks.

#### Solution

There are a number of alternative approaches to solving this problem
that one might consider, and we believe that now is the ideal time to do
so, as the whole topic of the role of deposit insurance is being
reexamined. An idea that we think has considerable appeal would draw on
the earnings of the FDIC's insurance funds to cover the costs of both
state and national bank supervision. Today, with the level of the
combined funds at about \$42 billion and generating earnings of around
\$2.5 billion per year, there are considerably more funds available to
defray the costs of FDIC, OCC, and state supervision than those agencies
today spend in total. Working together, and using the present costs of
supervision as a baseline, state and federal supervisors could develop a
nondiscretionary allocation formula that would reflect not only the
breadth of responsibilities of the agencies, but the condition, risk
profile, size, and operating environment of the banks they supervise.
All agencies would remain free to impose supplemental assessments if
they chose, but competitive pressures would presumably work to keep
these charges at a minimum.

This arrangement would offer some meaningful advantages. First, it would
remedy the inequity to national banks that exists today, resulting from
the fact that the FDIC funds the supervision of only one class of banks,
state nonmember banks, out of the earnings of the deposit insurance
funds, to which all banks have contributed. As I mentioned earlier, we
estimate that national banks have accounted for more than half of the
contributions to the Bank Insurance Fund.

Another major advantage to a system under which the OCC and the state
supervisory agencies would be funded out of the earnings on the
insurance funds is that it would reinvigorate the dual banking system.
It would create a regulatory system under which banks choose their
charters on the basis of factors such as regulatory philosophy, access,
and the perceived quality of supervision. The result would be
competition based on characteristics of supervisors that are relevant to
maintaining a safe and sound banking system.

***Conclusion***

The OCC supports a merger of the BIF and the SAIF and proposals to
eliminate the current constraints on deposit insurance premiums. We
favor elimination of the current fixed DRR and its replacement with a
range that would allow the FDIC more flexibility in administering the
deposit insurance premium structure. We oppose an increase in deposit
insurance coverage limits at this time. Finally, as the entire role of
deposit insurance is being subjected to scrutiny by policymakers and
legislators, it is an opportune time to address the distortions and
unfairness in the current system of funding bank supervision that I have
highlighted in my testimony today.

[^1]: In its April 2001 Deposit Insurance Reform Options Paper, the FDIC
    reported that "the 5-year failure rate for CAMELS 2-rated
    institutions since 1984 was more than two-and-a-half times the
    failure rate for 1-rated institutions." (p. 13) As shown in Chart 1
    on page 12, the 5-year failure rate for CAMELS 1-rated institutions
    (commercial and savings banks) was 0.7 percent, while that for
    CAMELS 2-rated institutions was 1.8 percent.