**A Theory of Bank Resolution: Political Economics and Technological
Change**

Robert DeYoung\*\*

Capitol Federal Professor in Financial Markets and Institutions

University of Kansas

Lawrence, KS 66045

Jack Reidhill\*

Federal Deposit Insurance Corporation

Washington, DC 20219

THIS DRAFT: January 31, 2008

**Abstract:** The policy tradeoff between protecting liquidity and
imposing market discipline when resolving failed banks is well
recognized, but it is seldom formally modeled. We develop a simple
theoretical framework in which the bank resolution authority prefers
protecting uninsured creditors (providing liquidity) to imposing losses
on uninsured creditors (imposing discipline) at the margin. The
authority is constrained in its choices by existing laws, technologies,
economic circumstances, and bank size, and we demonstrate how changes in
these conditions can alter the authority's behavior. We then show how
the framework compares to the long history of failed bank resolution in
the United States. Our analysis illustrates how a combination of
increased authority and reduced latitude helped mitigate the
liquidity-discipline tradeoff at large bank failures during the 1980s
and 1990s. Our analysis may be especially prescriptive outside of the
U.S., where weak bankruptcy laws and inefficient information systems
will not support such socially efficient outcomes, leading to blanket
guarantees at failed banks that render their deposit insurance systems
superfluous.

**JEL codes:** G21, G28

**Key words:** bank failure, deposit insurance, failed bank resolution

\* The views expressed in this paper are those of the authors and do not
necessarily reflect positions held by the Federal Deposit Insurance
Corporation. The authors thank George Kaufman for his insights and
suggestions.

\*\* DeYoung is the corresponding author: University of Kansas School of
Business, Department of Finance, Summerfield Hall, 1300 Sunnyside
Avenue, Lawrence, KS 66045, <rdeyoung@ku.edu>.

**1. Introduction**

Commercial banks play a special role in our economy. Banks provide funds
to businesses that are unable to access credit in public markets; as
such, a large portion of bank assets are difficult to value and hence
are illiquid. And as the central institution in our payments system,
banks provide liquidity to depositors through demandable deposit
accounts; as such, a large portion of bank liabilities are unstable.
This combination of risky, illiquid assets financed by highly liquid
debt makes banks financially fragile and susceptible to depositor runs
which, in some circumstances, can lead to credit shortages and
disruptions to payments. Depending on the size of the bank involved,
these phenomena can have deleterious effects (i.e., contagions) on other
banks and on the economy at large.[^1] Repeated banking panics during
the nineteenth and early twentieth centuries led law makers in the U.S.
to insure a large portion of banks' deposit funding, thus reducing the
chance that small depositors would suffer losses if their bank failed as
well as the likelihood that depositor runs would occur and precipitate
insolvency. To further ensure that payments to and from depositors are
not disrupted should a bank become insolvent, U.S. banks are not subject
to the same lengthy bankruptcy proceedings as other corporations, but
rather are resolved using special rules established Congress and
implemented by the Federal Deposit Insurance Corporation (FDIC).

Like all regulatory solutions to market failure, deposit insurance
protections and bank resolution procedures are second-best arrangements
that result in incentive incompatibilities. Both bank depositors and
bank managers have incentives to chase higher returns without fully
suffering the associated risks. Facing reduced downside risk due to the
"deposit insurance put option," managers of troubled banks face
incentives to "gamble for resurrection" by paying above-market rates for
deposits and investing those funds in risky loans. Knowing (or
suspecting) that their deposits are protected from loss, insured (and to
a lesser extent, uninsured) depositors have little incentive to monitor
the financial condition of their banks, keeping their funds deposited at
troubled banks and often earning above-market interest rates in the
process. In both cases, these behaviors are enabled by the reduction in
market discipline engendered by the presence of deposit insurance
regulation, and the costs of these behaviors are ultimately borne by
society in the form of higher overall costs of deposit insurance, i.e.,
higher deposit insurance premiums or taxpayer bailouts failed depository
institutions.

As a first principle, regulatory authorities have *ex ante* preferences
for bailing out depositors rather than imposing losses upon them.
Government deposit insurers strongly identify with their mission of
protecting insured depositors, and when administratively possible, this
culture can easily err on the side of bailing out uninsured depositors
as well. This predilection is exacerbated during economic crises, when
political pressures arise to protect both insured and uninsured
depositors. Kane and Klingebiel (2004) offer a more cynical assessment:
Regulators exhibit a bias toward bailing out depositors because they do
not want to be blamed (rightly or wrongly) for the bank failure by
disgruntled (unprotected) depositors. Given these realities, the degree
to which the failed bank resolution process imposes discipline on
depositors rests not so much on *[whether]{.underline}* depositors get
bailed out, but *[how quickly]{.underline}* regulators pay off
depositors. On the one hand, delaying payments to insured depositors may
have positive market discipline effects by imposing costs on insured
depositors who decided to provide funds to risky banks; if authorities
can credibly commit to such a practice, depositors will have incentives
to monitor the banks and demand higher rates on funds they deposit in
risky banks. But long delays in paying depositors may create political
pressures to speed up payments---in the end, this can create an
environment in which *all* depositors are protected, squashing attempts
to hold even uninsured depositors responsible for their own actions and
making regulatory forbearance (i.e., keeping an insolvent bank open in
hopes that it will recover) even more likely.

Much has been written about the incentives facing deposit insurers and
the impact of these incentives on efficient bank resolution policy. For
example, Kane (1995) characterizes the relationship between the deposit
insurer, taxpayer, and depositor as a surety bond. He shows how the
current legal and regulatory arrangements represent an incomplete market
that creates incentives for regulators to practice forbearance---even
under the so-called "prompt corrective action" (PCA) features introduced
by the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of
1991. Kaufman and Seelig (2002) and Kaufman (2003) propose a combination
of quick access to insured deposit funds and a partial "advance"
dividend payment to uninsured depositors (based on a first approximation
of the value of the failed bank's assets) in order to maintain financial
liquidity while still imposing at least a modicum of discipline on
depositors. A continuing line of policy proposals in this same vein is
provided by Kaufman (2004), Mayes (2004), Kaufman and Eisenbeis (2005),
and Harrison, Anderson, and Twaddle (2007). Much earlier, Rosengren and
Simon (1992) suggested that transferable put options---whereby banks
purchasing loans from a failed bank could return those loans to the FDIC
in the case of future default---would reduce failed bank resolution
costs by increasing the marketability of failed bank assets.

In this paper, we argue that the tradeoff between maintaining financial
*[liquidity]{.underline}* and encouraging deposit markets to impose
*[discipline]{.underline}* on banks and depositors is the central
defining feature of bank resolution authority behavior, and that this
fundamental tradeoff and its attendant economic implications grow more
intense for large bank resolution. There has been only incomplete
discussion to date regarding the nature or necessity of this tradeoff,
the manner in which this tradeoff has been implemented over the past
century, or how technological advance, regulatory constraints, and the
preferences of the resolution authority affect this tradeoff. We discuss
each of these phenomena within the context of a simple theoretical
framework; hopefully, this model will help policymakers, banking
authorities, and industry analysts understand the tradeoff and its
consequences, and provide a platform for theoreticians to develop more
analytic solutions to mitigating the harmful effects associated with the
tradeoff.

The paper proceeds as follows. Section 2 provides a short review of the
fundamental economics of liquidity provision and market discipline in
failed bank resolutions. We highlight two extreme episodes from the U.S.
experience: the pre-FDIC years in which failure resolution policy
stressed market discipline with little concern for liquidity provision,
and the thrift crisis of the 1980s-1990s in which failure resolution
policy stressed liquidity provision with little concern for market
discipline. We introduce the concept of "insurance determination" in
Section 3, an arcane but crucial activity central to the resolution of
failed banks, and discuss how the technology of insurance determinations
constrains the ability of the FDIC to quickly resolve large banks.
Section 4 presents a simple theoretical framework of bank resolution
policy. The framework shows how the bank regulator's choice of a
resolution policy is jointly driven by the regulator's preferences for
maintaining liquidity in the financial system versus enhancing market
discipline in financial markets, existing administrative and legislative
restrictions, and the limitations of available resolution technology. In
Section 5 we use this framework to illustrate how and why FDIC
resolution methods have changed over the past 75 years---sometimes
preferring market discipline at other times preferring liquidation---and
how changes in laws and improvements in resolution technologies can (as
posited by Kaufman 2003) reduce the friction between maintaining
liquidity and imposing market discipline. Section 6 concludes,
summarizes, and discusses the implications of our analysis for bank
resolution in the U.S., in other developed economies, and in developing
nations.

**2. The Resolution Conflict: Liquidity versus Discipline**

Academic experts and banking authorities tend to have different
appetites for imposing losses on uninsured bank creditors. Academics are
especially cognizant of moral hazard. They advocate strict adherence to
*ex ante* rules that encourage market discipline, quickly closing and
resolving troubled financial institutions and imposing appropriate
losses on uninsured creditors. Banking authorities, and central bankers
in particular, are well aware of moral hazard's corrosive effects but
weight more heavily the macroeconomic damage caused by the illiquidity
that results from closing banks and imposing losses on the uninsured
depositors and creditors. To some extent, these differing points of view
stem from the long-term view enjoyed by academics versus the short-term
pragmatism often required of banking authorities.

While bank resolution authorities are implicitly charged with making
decisions that maximize the welfare of society at large, the actual
strategies they select can also reflect their own more narrow objectives
and preferences. Whether or not this rises to the level of a serious
principle-agent problem is the subject of some debate (Kane 1990,
Mishkin 1992). As we discuss below, divergence between the actions of
the FDIC and the objectives of Congress has more than once elicited
legislative changes proscribing the decision-making latitude of the
deposit insurer.

The FDIC has used a wide variety of resolution techniques during its
nearly 75 year history. Some of these techniques have only recently
become available to the FDIC via new laws or improved technologies,
while others are no longer available or have fallen into disuse over
time. Table 1 provides a brief definition of each of the major
resolution techniques used by the FDIC over time, displaying them in
rank order based on the degree to which they preserve liquidity. Because
there is a roughly inverse (though not necessarily monotonic)
relationship between protecting liquidity and enhancing market
discipline among these techniques, the figure also illustrates the
economic tradeoffs facing policymakers. As political, economic, legal,
and technological conditions have shifted over time, the FDIC's
preferred resolution choices---or the choices imposed upon it by
Congress---have switched between and among these various techniques

Although most of the commentary on bank resolution policy focuses on
banks' deposit liabilities, some authors have found that much of the
economic damage caused by bank failures is transmitted through banks'
lending channel. Bernanke (1983), Calomiris and Mason (2003), and
Ramírez (2007) have observed that the loss of banking relationship by
borrowers caused significant economic damage after bank failures in the
20s and 30s. Ashcraft (2005) examined the closure of a large (solvent)
affiliate in a regional bank holding company in Texas in the 1990s, and
found that curtailed lending activity after the closure was associated
with a decline in local GDP. Because the degree of borrower liquidity
and lender liquidity associated with each resolution technique tend to
be correlated---for example, if a receivership liquidates a failed
banks' loans and other assets only gradually over time, then some
depositors will not have full access to their funds until the receiver
sells enough assets to cover their deposits, and some borrowers will
have to delay further draw-downs of their lines of credit until the
receiver sells their existing loan to another bank---the rank ordering
in Table 1 captures both depositor and borrower liquidity (in a similar
vein, if a bank is liquidated both borrowers and lenders will need to
establish new banking relationships).

The details of these various resolution techniques, as well as the
historical episodes during which they were applied, are discussed at
length below in Section 5. The full menu of alternative resolution
strategies theoretically allows the resolution authority to make
marginal tradeoffs between providing additional depositor/borrower
liquidity and enhancing market discipline. Before advancing to our
theoretical framework in which such marginal tradeoffs are possible, we
first compare and contrast two discretely different and polar opposite
resolution approaches from U.S. history. At one extreme is a strategy of
liquidating failed banks without any special depositor protections. At
the other extreme is a strategy of complete regulatory forbearance that
keeps liquid but insolvent banks operating.

***2a. Bank failures prior to the FDIC.*** Prior to the establishment of
the FDIC in 1933, bank failures were typically resolved in a manner
analogous to chapter 7 bankruptcies of non-bank corporations. Insolvent
banks were closed and a receiver was named to manage the resolution,
usually the state banking authority for state chartered banks or the
Office of the Comptroller of the Currency (OCC) for national banks. The
receiver was responsible for liquidating the assets of the failed bank
and repaying the depositors and other creditors of the bank. This
process could take many years, during which depositors and other
liability holders of the failed bank lost access to their funds. Anari,
Kolari and Mason (2005) showed that depositors and other creditors of
national banks that failed in 1929 received only 66.12 percent of their
funds; only about 20% of this amount (13.22 cents on the dollar) were
returned during the first year, approximately double that amount was
returned during the second year, and declining amounts were returned
each year after that. The average liquidation period was about four
years. Borrowers also faced potentially large costs, having to establish
new banking relationships, pay off their loan from the closed bank, and
losing the liquidity in their deposit accounts.

Today, in a time when failed banks are closed in orderly fashion and
most bank deposits are protected by insurance, it is easy to
underestimate the frequency and depth of economy-wide financial crises
occurred in the U.S. in the pre-FDIC era. Financial crises and
widespread banking panics occurred at least eight times between 1819 and
1929---in 1819, 1837, 1848, 1873, 1893, 1907, 1921, and 1929-1933
(Kindleberger, 1978). During these crises, reduced liquidity was the
primary concern of all of the interested groups, especially so in the
banking and financial center of New York City. Amid the uncertainty,
nervous depositors faced incentives to withdraw their funds from banks
and trust companies to preserve their liquidity. Banks responded by
building up their reserves in order to withstand demands by depositors,
thus depriving borrowers of needed funds. Whenever borrowers and/or
depositors were denied funds by their banks, the banking panics
intensified and spread.

A number of articles have commented on the breadth and depth of the
damage caused by the Panic of 1907. Andrew (1908) focused on the
hoarding of cash by both banks and individuals during the panic:

> "The strong institutions thus made it more difficult for the weak, for
> what is hoarded in the vaults of one bank under such circumstances is
> virtually taken out of another. In accumulating these abnormal
> reserves, the hoarding banks were largely responsible for the
> existence of a currency premium in New York; they contributed
> seriously to the general collapse of credit; and by reducing their
> accommodation for their customers they even made conditions worse than
> they need been in their particular localities."

Noyes (1908) documented some of the real economic damages:

> "...iron production (in December 1908) in the United States is 28 per
> cent below the corresponding month in the active year 1906, the Steel
> Corporation's output is less than 60 per cent. Of capacity, and
> general trade does not average three-fourths of normal volume."

And Horace White (1908), a well known macro-economist of the day,
stated:

> "Something must be done to put an end to the periodical suspensions of
> the banks. The greatest evil attending them is the bad education they
> give. They tend to deaden the sense of commercial honor. Every such
> suspension is a license to every financial institution to scale it
> debts or postpone the payment of them. They assume the right to pay or
> not to pay according to their convenience. Some banks in such cases
> pay their own debts and those of their weaker neighbors also. Others
> refuse to pay even when they are able to. Each is a law unto itself
> for the time being, and the time indefinite.
>
> "While the chaos continues the banks assume the right to pay their
> obligations with something which is not money. They pay with a rubber
> stamp, which is elastic in a double sense. Sometimes it is worth 100
> cents, sometimes 90 or any price between...
>
> "When the banks thus repudiate their obligations their depositors can
> hardly do otherwise. Frequently they are compelled to pay their
> workmen with stamped cardboard, which the latter force upon retail
> shopkeepers and street peddlers at a loss to both payer and payees.
> All things are done in disregard of law and defiance of it."

For the banks and trusts that were closed but proved to be solvent, the
1907 Panic was relatively short-lived. Knickerbocker Trust, the first
trust company on which depositors ran during the Panic, failed on
October 22, 1907 but resumed business on March 26, 1908; the Hamilton
Bank failed on October 24, 1907 but resumed business even faster, on
January 20, 1908. Outright bank failures had deeper economic impacts,
especially if the banks were liquidated, causing significant delays for
payments to depositors and other creditors. A number of studies focusing
on the 1920's and early 1930's have shown that bank failures by
themselves, even if unaccompanied by extended financial panics, had
negative effects on the economy (e.g., Bernanke 1983, Calomiris and
Mason, 2003, Ramirez, 2007). The collapse of commodity prices in 1920-21
and the long agricultural recession followed were accompanied by a large
number of bank failures. In all, over 10,000 banks failed during the
1920s, and it is worth noting that the instability of the banking system
during that decade occurred despite the creation of the Federal Reserve
in 1913.

***2b. The savings and loan crisis.*** The creation of FDIC and the
introduction of federal deposit insurance eliminated or at least
mitigated many of the ill effects of bank failures. Insured depositors
were made whole immediately after failed banks were closed, and the
certainty with which this liquidity was provided defused bank runs, the
biggest catalyst for the banking panics of the past century. Only a
handful of banks failed annually during the half century following the
Great Depression, and none of these failures were associated with a
banking panic. Given the apparent success of this new regulatory regime,
and remembering the severe macroeconomic effects of past banking panics,
it wouldn't be surprising if going forward banking authorities leaned
toward resolution policies that stressed the maintenance of depositor
liquidity, as opposed to policies that relied on the market to
discipline banks and their depositors.

Nonetheless, the manner in which deposit insurance and bank resolution
were implemented created incentives for moral hazard behavior among
depositors and bank management, and incentives for laxity on the part of
bank supervisors. Knowing that their funds are protected (up to some
legal limit), depositors and other creditors will continue to lend to
troubled banks, even when the bank's condition is known. Similarly,
businesses that borrow from troubled banks have less reason to seek new
sources of funds, knowing that in the case of bank failure a seamless
resolution process will most likely prevent their credit access from
being badly disrupted. Managers of troubled banks are likely to make
increasingly risky loans, knowing that the entire upside risk of the
loans accrues to the bank while a large portion of the downside risk of
the loans will be absorbed by the insurance fund. And knowing that the
responsibility for monitoring banks' financial condition has passed
largely from bank depositors to bank supervisors (i.e., less reliance on
market discipline), bank insolvencies are interpreted by some as
evidence of supervisory failure, creating incentives for banking
authorities to keep insolvent institutions open and operating in the
short-run.

During the first half century first after the Federal deposit insurance
was created, the term moral hazard was rarely heard in conjunction with
deposit insurance. However, regulatory forbearance practiced during the
thrift debacle of the 1980's would change that. Mishkin (2006) points
out:

> "The good news of having a government safety net is that it can
> prevent bank panics as it has since the establishment of the FDIC in
> the 1930s. The bad news is that it creates moral hazard incentives for
> banks to take on greater risk. When a depositor is fully protected,
> she knows that she will not suffer losses if a bank fails and thus,
> has little incentive to monitor the bank's activities and withdraw
> funds if the bank is taking on too much risk. Without this discipline
> from depositors, banks know that they can engage in risky activities
> with impunity, and this can increase the probability of bank
> failures."

In the late 1970's inflation and interest rates increased dramatically
and unexpectedly. Inflation surged from 5.75 percent in 1975 to 11.22
percent in 1979, and 3-month treasury rates increased from 4.6 percent
in January 1977 to 15.5 percent in March 1980.[^2] The deleterious
effects of these trends on U.S. thrift institutions are well known.
These firms financed portfolios of long-term, fixed-rate mortgage loans
with short-run deposit liabilities, and the sudden spike in rates
generated massive operating losses as the rates thrifts had to pay for
deposits that substantially exceeded the rates they were receiving on
their loans. Tangible capital in the thrift industry fell from \$32
billion in 1980 to just \$4 billion in 1982. On an accounting basis, at
least 415 thrifts reporting negative tangible capital at the end of
1982, and it is roundly believed that a much larger number of thrifts
were insolvent on a market value basis. Despite this, the Federal Home
Loan Bank Board (the main supervisory agency of thrift institutions at
the time) closed only a small portion of these thrifts: only 103 thrifts
insured by the Federal Savings and Loan Insurance Corporation (FSLIC)
were declared officially insolvent and closed between 1980 and 1982, and
only 131 additional closures were performed between 1983 and 1985.

In the most extreme cases of supervisory forbearance, authorities
actually provided financial assistance to thrifts without removing
thrift management and without a pledge of additional support from thrift
owners.[^3] As Kane (1989, 1995) has argued, allowing these "zombie"
thrifts to operate, virtually without any safeguards, permitted thrift
managers to gamble for resurrection by making risky loans with big
financial upsides. With neither market discipline nor regulatory
discipline in place, already troubled thrifts continued to hemorrhage
and fell deeper into insolvency. Moreover, when these thrifts were
finally declared insolvent and were closed, the most common resolution
method protected both the insured and the uninsured creditors, and in
addition guaranteed the thrift or banking institution that acquired the
remaining assets against loss. Ultimately, these extreme supervisory and
resolution practices, motivated initially by a desire to maintain
liquidity, cost \$153 billion in resolution costs, with the U.S.
taxpayers paying about \$125 billion of this (Curry and Shibut 2000).

The main policy response to this episode---which included a string of
failures by commercial banks in the years that followed---came in the
form of the Federal Deposit Insurance Corporation Improvement Act
(FDICIA) of 1991. FDICIA constrained the latitude available to bank
supervisors and resolution authorities, tilting failure resolution
policy away from protecting the liquidity of uninsured creditors and
toward imposing discipline on both uninsured creditors and bank
management. Among other changes, the law set a series of stricter
minimum capital levels for banks and thrifts, required supervisors to
intervene at troubled institutions as they fell below these minimum
thresholds, mandated that the FDIC resolve banks in the "least costly"
manner (as opposed to, say, the manner that maximized liquidity),
required supervisors to examine banks and thrifts more frequently safety
and soundness, and took an initial step toward risk-based deposit
insurance by setting premiums according to banks' capital levels and
examination ratings.

**3. Insurance Determinations and Problems of Bank Size**

Most banks that fail are small, and in recent years the FDIC has made
both insured depositors and uninsured depositors in these banks whole.
However, payouts to uninsured depositors do not always occur
immediately---the resulting delay in access to even a portion of their
funds may cause considerable illiquidity and financial distress for some
of these creditors, and perhaps even cause some disruption to the local
economy. However, these measured amounts of illiquidity send a signal to
uninsured depositors in other small banks about the potential
illiquidity costs should their banks fail. Moreover, because these banks
are small, any local disruptions are unlikely to cause any further
disruptions to the regional or national economies. From the perspectives
of both academics and banking authorities, then, this approach to
resolving small bank failures appears to be efficient, as moral hazard
incentives are reduced and financial stability is unthreatened.

However, these efficient outcomes become more difficult to maintain as
the size of a failed bank increases. We characterize these difficulties
as "scale diseconomies of resolution," and these inefficiencies are due
largely to the manual processes that are used by the resolution
authority to identify uninsured depositors and creditors (FDIC 2005). To
fully understand these scale diseconomies and how they influence the
strategic choices of bank resolution authorities, we must first
understand the nuts and bolts of an arcane process known as the
"insurance determination."

The bank closure process in the U.S. begins when the relevant chartering
authority (the OCC for federally chartered banks, or the relevant state
banking authority for state-chartered banks) revokes a bank's operating
charter. The charting authority then names the FDIC as receiver of the
failed bank, similar in many respects to a bankruptcy judge for
insolvent commercial firms. After taking control of the bank, the FDIC
begins the insurance determination process, the details of which are
displayed in Table 2.

The normal procedure is to close the bank on a Friday afternoon just
prior to the end of the business day, and the insurance determination is
performed over the weekend. The objective is to determine how many of
the bank's deposits are insured, how many of the deposits are uninsured,
and to whom these deposits are owed. The verification of multi-owner
accounts (e.g., joint accounts, trust accounts) can be a largely manual
process, typically working from depositor signature cards and other
paper records which may be located at the main bank office or at any of
the bank's branch offices. If time permits to complete this process, by
Monday morning the insured depositors have full access to their funds
either (a) at the acquiring bank if the failed bank is being resolved
through a purchase and assumption (P&A) transaction or (b) by a direct
payout from the FDIC if the failed bank is being resolved through a
payout and liquidation of the failed bank's assets.

In contrast, uninsured creditors are issued a receivership certificate
that represents their claim. As time passes and FDIC is able to more
accurately determine the total losses of the failed bank, partial
"dividends" are paid to the uninsured creditors. On the one hand, this
process provides uninsured depositors with some degree of liquidity; on
the other hand, by imposing appropriate delays and in some cases losses
on uninsured creditors, this process imposes *ex post* discipline that
reduces moral hazard incentives among depositors at other banks. Bank
borrowers are also dealt a degree of discipline because their banking
relationships are disrupted: they may temporarily lose access to any
remaining balance in their lines of credit, they may lose access to a
portion of any compensating deposit balances that are part of the loan
contract, and they will incur the informational and administrative costs
of re-establishing a credit relationship at a new bank. In a P&A
transaction, borrowers retain credit in the short-run but must
re-establish their banking relationship with new loan officers at the
acquiring bank. In a liquidation transaction, the loans are retained and
eventually sold by the receiver (the FDIC), dissolving the existing
banking relationship and forcing borrowers to establish entirely new
financial relationships with other banks.

As the FDIC attempts to resolve increasingly larger failed banks,
completing the insurance determination over a single weekend becomes
operationally difficult due to the sheer number of accounts involved and
the manual, multi-site processes necessary to complete the task.
Moreover, even temporarily freezing the funds of insured or uninsured
creditors will create more illiquidity, with potentially larger
macroeconomic consequences. Table 3 illustrates the potential scope of
this problem. To date, the largest FDIC insurance determination was
First City Houston in 1992 with 322,983 separate deposit accounts; in
contrast, Bank of America currently has over 50,000,000 separate deposit
accounts. The disruption of such a large number of liquidity
arrangements---on both sides of the balance sheet---could have
significant macroeconomic effects. *Given current information and
resolutions technologies, as banks get larger, the benefits from a
policy that stresses market discipline become more expensive in terms of
lost depositor and borrower illiquidity*. Technological innovations that
allow banking authorities to process information more quickly could
improve or potentially eliminate this tradeoff. Otherwise, the large
bank resolution process will not be able to protect insured depositors
from loss, and pay dividends to uninsured depositors sufficient to avoid
economy-wide illiquidity effects, without shielding uninsured depositors
from losses.[^4]

**4. A Theoretical Framework**

At this point it is useful to have a more formal presentation of the
short-run liquidity versus long-run market discipline tradeoff facing
the resolution authority. We begin by assuming that the authority
selects a resolution strategy that provides a combination of liquidity
and market discipline that maximizes its own utility, which as discussed
above need not be consistent with maximizing social welfare. The
authority is constrained in its choices by the resolution methods or
"technologies" available to it, as well as by the legal and political
constraints placed upon it by other governmental bodies. We can write
down a simple constrained maximization problem facing the resolution
authority:

maximize U(LQ, MD) (1)

RM

subject to: t(RM) ≤ T

g(LQ, MD) ≥ G

where U is the authority's own utility function and is increasing in
both liquidity LQ and market discipline MD; T is a technological
constraint that defines the choice set of resolution methods RM
available to the authority; and G is a legal or political mandate
requiring that the authority choose a resolution method that produces
some minimum amount of liquidity and/or market discipline.

We illustrate the basic workings of this model within the confines of a
unit square in Figures 1 through 5. The unit square is defined on the
vertical axis by liquidity provision LQ and on the horizontal axis by
market discipline provision MD. The extreme top of the vertical axis
represents 100% liquidity provision, that is, zero loss of liquidity
during the resolution. The extreme end of the horizontal axis represents
100% provision of market discipline---that is, both deposit insurance
and bank liabilities are efficiently priced with regard to default risk,
and neither depositors nor bank management faces moral hazard
incentives. It may be useful to think of deposit market discipline MD as
the unit square complement of the incentives for moral hazard behavior
MH, or MD = 1 -- MH. The upper right-hand corner of the unit square
marks the social optimum, where the resolution causes no loss of
liquidity [and]{.underline} the resolution creates no incentives or
rewards for moral hazard behavior on the part of depositors. This
optimum is unlikely to obtain, however, chiefly because existing bank
resolution technologies constrain the authority and force it to tradeoff
between protecting depositor liquidity and encouraging depositor market
discipline. Indeed, this social optimum need not obtain even in the
absence of a technological constraint, if the preferences of the
resolution authority diverge from those of society (i.e., a
principle-agent problem).

The technological constraint T is the upper bound of the resolution
technologies available to the resolution authority. The slope of this
line---i.e., the marginal rate of transformation (MRT)---represents the
policy tradeoff available to the authority, the amount of liquidity that
must be sacrificed in exchange for a given increase in market
discipline. This tradeoff can improve (i.e., a decline in the liquidity
price of market discipline) with new information technologies or other
innovations that improve the efficiency of failed bank resolutions. We
anchor the upper end of T at 100% liquidity and 0% market discipline
because resolution technologies with these qualities do exist and have
been used by U.S. regulators in the recent past, e.g., open-bank
assistance or pure forbearance.[^5] While the dashed line T illustrates
a continuous tradeoff, this tradeoff is discontinuous in practice:
Authorities face a finite set of technologically efficient resolution
methods that are arrayed along T. Authorities also have access to
technologically inefficient resolution methods and tradeoffs,
represented here by T~INEFF~ .

The resolution authority has a positive preference for both liquidity
and market discipline, as illustrated by the downward-sloping
indifference curves in the figures. The slopes of these indifference
curves---i.e., the marginal rate of substitution (MRS)---represent the
policy tradeoff *preferred by* the authority, the amount of liquidity
willingly exchanged for a given amount of market discipline. As drawn,
the figures presume that the authority has a strong preference for
resolution outcomes that provide short-run liquidity, and only a weaker
preference for resolution outcomes that enhance long-run market
discipline. (Moving left-to-right on any given indifference curve, the
slope gradually becomes quite shallow, indicating a low MRS.)
Preferences such as these are plausible if, for instance, (a) bank
regulators and/or the government identify strongly with depositors, (b)
bank supervisors wish to conceal the extent to which the financial
condition of a bank or the banking system has deteriorated, (c) economic
authorities feel that a large liquidity shock would harm the
macro-economy, or (d) bank regulators wish to pursue a quiet life.[^6]

Given these constraints and preferences, a utility-maximizing
equilibrium (which may or may not be the welfare-maximizing equilibrium)
occurs when the resolution authority chooses some bundle (MD, LQ) that
lies on T and for which the MRT is approximately equal to its own MRS.
Figure 1 illustrates our base case, in which the authority maximizes its
utility by choosing the depositor payout (DP) resolution technique over
the open-bank assistance (OBA) and the asset-liquidation (AL) resolution
techniques. DP is an interior solution that provides more discipline
(and less liquidity) than OBA, but more liquidity (and less discipline)
than AL.

The next two figures illustrate how the equilibrium can change with
advances in information technology and/or the introduction of a new
resolution method. Figure 2 shows that a general improvement failed bank
resolution technology (from T to T\') can result in an unambiguous
improvement in social welfare: DP\' provides more liquidity
*[and]{.underline}* more discipline than DP. Improved information
technology could increase the speed of the insurance determination
process (increasing liquidity by giving insured depositors faster access
to their funds) while improved financial technology could increase the
accuracy of the asset valuation process (enhancing discipline by
imposing partial losses on uninsured depositors more quickly and more
accurately). Figure 3 shows that the introduction of a new resolution
technique---in this case, a bridge bank (BB) method that provides 100%
liquidity by permitting an insolvent institution to continue to operate
in the short run, but does so at the cost of imposing less discipline on
uninsured depositors---can increase the utility of a resolution
authority that favors liquidity over discipline, but does not
necessarily improve social welfare.

As discussed above, resolving large bank failures presents special
problems. Providing discipline in such cases requires the authority to
impose losses on large numbers of depositors, and the resulting
reduction in liquidity can have deleterious macro-economic effects. In
other words, the liquidity price of discipline increases, illustrated in
Figure 4 as an inward rotation of the technological constraint to T~BIG~
. With liquidity so dear, the authority foregoes discipline entirely
uses open-bank assistance (OBA) to resolve the failing
bank---essentially, the deposit insurance fund are used to prop up the
failing banking franchise. If this practice continues, government may
constrain the resolution authority to some maximum amount of liquidity
provision (e.g., law that mandate least-cost resolution methods,
stricter limits on deposit insurance coverage) in order to prevent
expensive taxpayer funded bailouts of the deposit insurance system. The
government constraint G in Figure 5 limits that amount of liquidity that
the authority can provide, forcing it to the lower cost resolution
approach (LC) that provides a non-zero amount of discipline. Note that
LC lies on a lower indifference curve for the authority, but (at least
in the minds of the government) it provides more social welfare than
OBA. In severe circumstances---e.g., when the insolvent bank is so large
that restricting liquidity to its depositors, borrowers, and other
counterparties could cause a systemic economic event---the government
may relax the constraint G and allow the resolution authority to choose
its more preferred high-liquidity resolution method OBA.

**5. FDIC Resolution Strategies Between 1933 and the early 1980s**

Failed banks have not always been resolved in the same way in the United
States. The existing laws, regulations, and technologies have sometimes
constrained the actions of the resolution authorities (the FDIC, the
FSLIC, and the RTC), and economic and political circumstances have
sometimes dictated the actions of the resolution authorities. As these
conditions evolved over time, resolution authorities developed a variety
of strategies for paying insured depositors and for disposing of failed
bank assets. These strategies developed sporadically, with much of the
innovation occurring during the banking and thrift crises of the 1980s
and 1990s, and especially in response to the idiosyncrasies of the large
bank failures during those years. New techniques were developed that
improved the authorities' ability to maintain liquidity for borrowers
while still carrying out an insurance determination. In this section and
the section that follows, we provide a brief historical review that
illustrates how changes in laws, technologies, and political pressures
have affected the tradeoffs between liquidity provision and market
discipline made by the resolution authorities.

**Deposit Insurance National Banks 1933-1935.** The 1933 Act that
created the FDIC did not empower the FDIC to make direct payouts to
insured depositors. Instead, the Act authorized the chartering of
Deposit Insurance National Banks (DINBs), newly chartered national banks
controlled by the FDIC, to help facilitate the payment of the insured
depositors of closed banks. The FDIC could inject funds into the DINB to
pay insured depositor claims, but (with one exception) for no other
purpose.

The DINBs were quite restricted in their operations. They were chartered
without capital and were, as liquidating entities, generally prohibited
from accepting new deposits or issuing new loans. If the FDIC determined
that a DINB was providing essential banking services to a community it
could accept new deposits, but those deposits were required to be demand
deposits (no interest paid), invested in cash or U.S. Government
securities, or deposited with the Federal Reserve. In the months
following the passage of the 1933 Act, but prior to the 1935 Banking Act
that established a permanent deposit insurance fund, 24 insured banks
were closed and their insured deposits paid out through a DINB.[^7]

In terms of our theoretical framework, the DINB resolution approach
represents an inefficient technology. Even if the FDIC wanted to inject
enough funds into the DINB to cover uninsured creditors
depositors---which was contrary to the spirit of the law---less than
100% liquidity would have been maintained in the local market because
DINBs could not issue new loans and generally did not accept new
deposits. Hence, the DINB technology is characterized by the constraint
T~INEFF~ in Figure 1. As applied by the FDIC between 1933 and 1935, DINB
resolutions are located somewhere on the interior of this constraint,
because discipline was imposed on the uninsured depositors.

**Direct Payouts and Purchase and Assumptions 1935-1950.** The Banking
Act of 1935 gave the FDIC the authority to directly pay off depositors.
Moreover, the agency now had a choice in resolution methods: it could
either payoff depositor directly (a payout) or it could arrange for an
existing bank to purchase the failed bank and assume its deposit
liabilities (a purchase and assumption, or P&A). In payouts only insured
deposit were protected and the closed bank's loans were liquidated over
time, with the FDIC and uninsured creditors sharing the proceeds. In
P&As all of failed bank's uninsured depositors and creditors could
potentially be protected---it is important to realize that the acquiring
bank(s) might wish to bid on only a portion of the failed bank---with
the depositors that were acquired by the healthy bank having immediate
access to their funds.

As can be seen in Table 4, in 1935 payouts were preferred by the agency
with 24 out of 25 transactions being payouts. But the share of failed
banks resolved through P&As began rising in 1936, and by 1940 the
majority of resolutions were P&As. Although there is no official
acknowledgement of a change in policy during this period, there was
clearly a change in FDIC preference away from payouts and toward P&As.
In 1944 the agency finally did acknowledge this shift toward increased
liquidity, claiming that P&As were the most efficient resolution method
and that "the community does not suffer the economic dislocations which
inevitably follow a bank suspension" (FDIC 1944).

In the context of our theoretical framework, the 1935 Act gave the FDIC
access to a more efficient resolution technology, illustrated in Figure
1 by the shift from T~INEFF~ to T. The act also permitted the agency to
make tradeoffs along T, either imposing more discipline by choosing a
payout that protected only insured depositors (DP), or providing more
liquidity by arranging a P&A that protected at least some of the
uninsured depositors. The P&A would be located on the edge of the
technology set T somewhere in-between DP and OBA, depending on how much
of the failed bank that was acquired in the P&A transaction. In
addition, the FDIC's more frequent use of P&As indicates that the
agency's preferences had changed. Although only one set of indifference
curves is illustrated in the figures, the FDIC was now willing to
exchange less liquidity to enforce a given amount of market discipline
(i.e., the MRS declined), and this change in preferences resulted in a
new equilibrium on T somewhere between DPand OBA.

**Payouts Return 1951-1966.** During a confirmation hearing for a FDIC
Director in 1951, Senator William Fulbright challenged the FDIC's
resolution policy, arguing that the agency's reliance on P&As had
extended deposit insurance beyond what Congress intended. Subsequent to
the hearing, the FDIC informed the Committee that it would develop a
cost test to determine when a P&A would be less costly than liquidating
the bank and directly paying depositors with the proceeds. The cost test
would not be formalized for over a decade, but this episode was the
first acknowledgement that liquidity-enhancing resolutions are costly
(although the cost of reduced market discipline was not explicitly
mentioned). In any case, the FDIC's resolution choices soon swung back
toward payouts: There were 36 bank failures between 1955 and 1965, and
the FDIC used P&As to resolve only six of these banks.

This shift in resolution choices shows that the actions, and perhaps
even the preferences, of the resolution authority can be influenced by
the preferences or edicts of the legislature. We can illustrate this
policy shift two different ways in our theoretical framework. The
pressure from the legislature could have changed the actual preferences
of the resolution authority, increasing the MRS of the FDIC and moving
back toward the equilibrium illustrated in Figure 1. Alternatively, the
preferences of the FDIC may have remained unchanged, but it felt bound
to behave according to the preferences of the legislature; this can be
illustrated as an implicit governmental constraint on liquidity
provision, similar to the one illustrated in Figure 5.

**P&As and bidding generate premiums.** In 1966 FDIC received its first
explicit "premium" in a purchase and assumption transaction, and soon
afterward the agency established a formal "cost test" based in part on
the size of these premiums. In a P&A resolution, the premium is the
difference between the deposit liabilities (insured plus uninsured) of
the failed bank assumed by the acquiring bank and amount of the failed
bank's assets that the acquiring bank purchases in exchange for assuming
those liabilities. For example, assume that the failed bank has \$100 of
deposits (say, \$95 insured and \$5 uninsured), that the FDIC values the
failed banks' assets at \$97, and that several healthy banks are bidding
against each other to acquire the failed bank from the FDIC. The winning
bank will be the one that asks the FDIC to include the lowest amount of
assets in the deal. If the winning (lowest) bid is \$93 of assets, then
the P&A premium is \$7, which makes the P&A \$4 less costly to the FDIC
than the \$3 it would have cost the FDIC to pay off the uninsured
depositors.[^8] Thus, the cost test: If the premium bid is larger than
the cost of protecting the uninsured creditors, then a P&A resolution is
justified.

By creating a justification for using purchase and assumption
mergers---indeed, P&A transactions once again became the dominant form
of failed bank resolution, until the early 1980's---the cost test
effectively allowed the FDIC to provide greater amounts of liquidity
when resolving failed banks. In terms of our theoretical framework, the
successful implementation of the cost test is best characterized as
increased freedom for the resolution authority, that is, a relaxation or
removal of the governmental constraint G.

**6. FDIC Resolution of Large Failed Banks**

At this point in our story (roughly, the mid-1970s), it is important to
note that the process of making insurance determinations at failed banks
had not materially changed since the creation of FDIC in 1933. Bank
examiners had to review hard copies of depositor records by-hand, and
this manual process placed a practical upper limit on the size of a bank
that the FDIC could resolve using a direct payout. This was an
immaterial concern prior to 1973, because until then failed banks were
small enough to allow insurance determinations to be completed over the
course of a weekend using manual methods. The largest payout involved
just \$67 million in deposits after the failure of Sharpstown State Bank
in Houston in 1971, while the largest P&A involved just \$93 million in
deposits after the failure of Public Bank in Detroit in 1966.

The situation changed dramatically in 1973 with the failure of United
States National Bank (USNB) in San Diego, which had \$932 million in
deposits. The next year Franklin National Bank in New York City failed,
with \$1.45 billion in deposits and \$3.6 billion in assets. Given the
size of these banks, using a P&A was the only practical resolution
alternative to give insured depositors full and immediate access to
their accounts.[^9] Paul Horvitz (1975), the FDIC's Director of Research
at the time, commented on the pressures the agency faced to resolve
large failed banks in a manner that maximized liquidity, rather than
minimizing costs and/or imposing market discipline on depositors:

> It must be stressed that this pressure, while perhaps selfishly
> motivated, is not necessarily counter to the general public interest.
> Failure of a large bank, with losses to many depositors, may have
> substantial undesirable repercussions. The damage to general public
> confidence may be very serious. Just how serious we cannot tell at
> this point, since we have always avoided such failures up to now. It
> may be wise public policy to continue to avoid testing the stability
> of public confidence in the banking system in this way.
>
> Nevertheless, the desire to avoid losses to depositors in a large bank
> failure does create a real problem of public policy. It is not clear
> that these considerations are appropriate under the Federal Deposit
> Insurance Act

Horvitz concluded that broader social issues are involved in large bank
failures and that "minimizing costs to the deposit insurance fund seems
particularly inappropriate." Moreover, he suggested that the
institutional and legal frameworks for resolving failed banks are
designed for small bank failures, and that new arrangements were
necessary for efficiently and effectively resolving failures of larger
banks. The FDIC grappled with these issues over the next two decades, as
increasingly larger banks failed.

**First Pennsylvania.** In 1980 the problems that Horvitz identified in
1975 came directly into play, when First Pennsylvania Bank, the second
largest bank in Pennsylvania, failed with \$5 billion in deposits and
\$8 billion in assets.[^10] The FDIC at the time lacked the legal
authority to sell a bank across state lines; Mellon Bank of Pittsburgh
was the only bank in Pennsylvania of sufficient size to absorb First
Pennsylvania, but FDIC did want to create such a large market
concentration in the state.[^11] The agency also felt that closing the
bank and paying off depositors would destroy financially important
borrower-lender relationships and cause harm to the regional economy.
These two considerations left the agency with only one choice, and that
was to provide open bank assistance to First Pennsylvania.

In this transaction, the FDIC and First Pennsylvania arranged a \$325
million note, which the bank eventually repaid in full. This transaction
signaled the agency's reluctance to close large banks, even ones with
assets far in excess of deposits, in order to maintain liquidity and to
avoid potentially disrupting financial markets (FDIC 1984). For large
banks, a 100% preference for liquidity seemed to exist, corresponding
with point OBA in Figure 4.

**Penn Square.** The collapse of Penn Square Bank in Oklahoma City in
1982 marked the FDIC's last use of its DINB authority, and also signaled
the FDIC's willingness (in certain circumstances) to impose losses on
uninsured depositors. Penn Square had grown rapidly through aggressive
lending in the energy sector, and many of these loans stopped performing
and had to be written off when oil and natural gas prices declined
sharply in the early 1980s. As the bank's insolvency approached, the
FDIC met with the Federal Reserve (Fed) and the Office of the
Comptroller of the Currency (OCC) to discuss resolution strategies.

The Fed and the OCC urged the FDIC to sell the bank through a P&A
transaction or to provide open bank assistance. But the FDIC favored a
depositor payout for financial reasons: almost 60 percent of Penn
Square's \$470 million of deposits were uninsured, and fully protecting
these creditors by keeping the bank open (OBA or P&A) would be
prohibitively expensive. The FDIC chose the DINB structure to administer
the payout for logistical reasons: it would permit the thousands of
depositors at Penn Square access to their funds without having to spend
hours standing in line waiting for a payment check. The DINB existed for
three months, the time necessary to liquidate Penn Square's assets and
make payouts to its depositors.

At the time Penn Square was the largest payout in FDIC history, and it
stands in marked contrast to the FDIC's usual practice---both before and
after Penn Square---of fully protecting uninsured creditors in large
bank failures. Under the special circumstances surrounding Penn Square,
at least, the FDIC was willing to impose market discipline on uninsured
deposits. As discussed above, however, using a DINB structure to impose
this discipline was inefficient (see Figure 1) and this choice likely
reflected the cost concerns of the FDIC at the time.

**Continental Illinois.** In 1984 the FDIC, working together with other
bank regulators, put together a complex plan to rescue the Continental
Illinois National Bank and Trust Company, at the time the seventh
largest bank in the U.S. Continental was a large money center bank
located in Chicago, Illinois, a "unit banking" state that prohibited its
banks from operating multiple banking offices outside of its
headquarters city. This regulation limited Continental's ability to
raise core deposits, and in order to grow it became increasingly
dependent on the Eurodollar market for funding. These short-term funds
made Continental vulnerable to high-speed electronic bank runs, and a
bank run started on May 9, 1984. The FDIC, OCC, and the Fed stepped in
eight days later on May 17. Given the economic and financial importance
of Continental, the regulators announced a blanket guarantee that *all*
creditors of the bank would be protected (Horvitz seems to have foreseen
this type of problem almost a decade earlier).

Setting up a P&A resolution was simply not feasible, because potential
acquirers would not be able to perform their due diligence fast enough
on such a large and complex bank. The FDIC instead negotiated an
extremely complex package of open bank assistance. Continental was
re-capitalized with large amounts of "non-common stock" that
substantially diluted the ownership share of the existing
stockholders---as a result, some small amount of market discipline was
imposed despite the fact that all uninsured creditors were made whole.
(In terms of our theoretical framework, this resolution might best be
described as a small improvement in technology that allows increased
discipline without giving up liquidity, similar to the shift shown in
Figure 3. However, because the discipline affected only the shareholders
and not the uninsured creditors, the equilibrium would be located only
slightly to the right of OBA.) This re-capitalization eventually cost
the FDIC \$1.1 billion.

The banking agencies' handling of Continental Illinois was driven by a
desire to maintain liquidity and prevent contagion but it also created
heated debate. Continental's assets exceeded its total deposits (insured
and uninsured) by well over \$10 billion, so closing and liquidating the
bank would have been a zero cost resolution for the FDIC. Due to the
blanket guarantee, creditors to the bank's holding company were
protected, extending the safety net beyond the insured institution.
Perhaps worst of all, the pronouncement that some banks were "too-big-to
fail" created the impression that there was an official policy of never
imposing losses creditors in large bank failures.

**First RepublicBank.** In 1987, the Competitive Equality Banking Act
(CEBA) gave the FDIC the authority to "bridge" the time between failure
and resolution with temporary "bridge bank" that would provide access to
existing deposit accounts and honor the failed bank's existing loans and
loan commitments to creditworthy customers. The FDIC's first use of this
new authority on a large failed bank was in the spring of 1988, when
First RepublicBank (First Republic) of Texas failed. At the time of
failure, First Republic was the fourteenth largest bank holding company
in the U.S., with approximately \$33.4 billion in assets in 40 separate
bank affiliates. It remains the largest bank failure in FDIC
history.[^12]

The FDIC used a combination of open bank assistance, bridge bank, and
P&A resolution techniques in serial order. First Republic's holding
company asked for FDIC assistance on March 16; the FDIC responded the
next day with a pledge of interim assistance to the 40 troubled
affiliate banks, but did not extend assistance to the holding company.
The FDIC then marketed the banks, with a bid from North Carolina
National Bank (NCNB, now Bank of America) accepted as the winner on July
28. On July 29 the FDIC created a bridge bank (the entity which NCNB
would eventually acquire) containing all of the assets, deposits, and
"certain other non-deposit liabilities from the failed banks." The
creation of this bridge bank (a) effectively wiped out \$1.2 billion in
debt and preferred stock claims on the new bank and (b) simplified the
resolution process by turning a 40-bank holding company into a single
bank.

The bridge bank authority can be seen as a new resolution technology
that allowed the FDIC to provide liquidity to all of the depositors and
creditors of the 40 FDIC-insured banks, while narrowing the safety net
to exclude the creditors of the parent holding company. The equilibrium
at BB shown in Figure 3 provides a fair representation.

**MCorp.** The failure of MCorp in 1989---or more exactly, the
insolvency of 20 of its 25 banking affiliates---marked a turning point
in the treatment of large bank creditors. The failure was the third
largest in FDIC history and the second most costly. But the resolution
was noteworthy not just for its size: it was the first time that the
FDIC was able to perform an insurance determination in a large bank
failure, and it was also the first time the FDIC used its bridge bank
authority as the first step in a large bank resolution, without
providing any interim open bank assistance.

In October 1988, the Federal Reserve issued a cease and desist order for
the holding company to support its failing banks. MCorp refused to
downstream any money and submitted a formal proposal to FDIC for open
bank assistance. Because the FDIC needed time to study this proposal, it
entered into a "standstill" agreement with MCorp that prevented
institutional creditors from filing bankruptcy petitions. However, in
March of 1989 three smaller creditors filed petitions, with forced MCorp
to file for bankruptcy and eventually forced the OCC to declare 20 of
MCorp's banks (holding \$16 billion of assets) to be insolvent. The FDIC
immediately created a bridge bank to facilitate the closings of these 20
banks. It then announced a two-month deadline for entertaining P&A
bids---the two months providing it with the necessary time to perform an
insurance determination---with Bank One the eventual winning bidder.

**Bank of New England.** The FDIC's role in the failure of the Bank of
New England (BNE) in 1991 caused a backlash in Congress, and may have
led to the new legislation (FDICIA) that constrained the FDIC's freedom
in resolving future failed banks. On Friday January 4, 1991, BNE Corp.
announced a fourth quarter loss of \$450 million that rendered it
insolvent, and two days later the OCC closed both Bank of New England
and Connecticut Bank and Trust---two of the three banking affiliates of
BNE Corp.---and appointed the FDIC as receiver. Invoking its cross
guarantee authority, the FDIC ordered the third banking affiliate, Maine
National Bank, to make payments that rendered it insolvent as well. The
FDIC then created three bridge banks, which reopened for business on
Monday. At the urging of the Federal Reserve and the Treasury
Department, the FDIC protected all of depositors in these three banks
(FDIC 1998). All of the deposits, as well as most other creditors
including qualified financial contracts, were transferred to the new
banks and were fully protected (although non-subordinated creditors of
the holding company were not protected and shared losses pro rata with
the FDIC). In the P&A auction that followed, Fleet/Norstar Financial
Group was chosen as the winning bidder and the sale was completed in
September.

In the aftermath of the BNE resolution there was considerable criticism
of the FDIC for protecting all of the depositors and most creditors,
with many critics invoking the familiar claim of "too-big-to-fail." Many
complained that uninsured depositors had losses imposed on them only at
small failed banks, while those in large banks were protected. This
perception encouraged the framers of FDICIA to include passages that
restricted the FDIC's discretionary ability to protect uninsured
creditors of failed banks. This was accomplished by requiring the FDIC
to choose the *[least costly]{.underline}* method of resolving failed
insured institutions rather than being able to choose any resolution
method as long as it was less costly than liquidation (FDIC 1998).[^13]
In effect, Congress was making the argument that providing full
liquidity is not free---the FDIC was spending taxpayers' money when they
chose to protect uninsured creditors---and by doing so the FDIC was
wasting important opportunities to impose discipline in financial
markets.

As already discussed, our theoretical framework captures restrictions
such as these with the governmental constraint G. However, by the 1990s
the FDIC had access to bridge bank authority and other technological
improvements. Hence, to the extent that FDICIA's least cost rule
constrains the resolution choices of the FDIC, it does so along a higher
technological constraint than those included in Figure 5.

**First City.** The consequences of FDICIA's least cost test were
apparent in the First City resolution in 1992. First City was one of the
few banks that FDIC had to provide with assistance twice. In 1987 the
\$11 billion Texas banking organization was approaching insolvency due
to large losses in its energy, agriculture and real estate loan
portfolios. The FDIC developed an open bank assistance package in
conjunction with an infusion of capital from an investment group.
Although the recapitalized bank was profitable for a time, it ultimately
made another series of financial mistakes. By early 1992, four of the
largest banks in the holding company were no longer meeting their
minimum capital requirements, setting off FDICIA's prompt corrective
action (PCA) triggers. Later in the year the OCC and the Texas banking
commissioner closed the two largest banks in the holding company, after
which the FDIC invoked its cross-guarantee authority, rendering the
remaining 18 banks in the organization insolvent.

It was at this point that the least cost changes introduced in FDICIA
affected how FDIC resolved the failure. After the 20 banks were closed,
each was placed in a separate bridge bank, which allowed the FDIC to
analyze the losses of each bank independently. The FDIC estimated that
only four of the banks had losses, and in these four cases uninsured
deposits [were not]{.underline} passed to the bridge banks, but were
left in the receivership where they shared in the FDIC's loss. All
depositors in the remaining 16 better capitalized banks were passed to
their bridge banks.

First City was the last large banking organization to fail from the
banking crisis of the 1980s and 1990s---just in time to show how
FDICIA's least cost test effectively forced the FDIC away from its
preferred full-liquidity approach to failed bank resolution. The First
City resolution also set the precedent for less than 100% protection of
uninsured depositors in a large bank failure. The lack of fallout from
this precedent is noteworthy: we have not witnessed depositor runs at
large unprofitable or troubled banks since First City.

**7. Conclusions, Implications, and Looking Forward**

Scholars and regulators who are concerned about the resolution of failed
banks have an implicit understanding of the economic tradeoff facing
policymakers: Protecting the uninsured depositors, creditors, and even
the owners of failed banks can be beneficial in the short-run because it
preserves liquidity in financial markets; but by squelching market
discipline, such a policy can exacerbate moral hazard incentives that
lead to increased risk-taking and potentially more widespread episodes
of bank failures in the long-run. In this paper we state this tradeoff
more formally and more explicitly. We develop a simple theoretical
framework in which bank resolution authorities prefer protecting
uninsured creditors (providing liquidity) to imposing losses on
uninsured depositors (imposing discipline) at the margin. The resolution
authority is constrained in its choices by existing resolution
technologies, and we demonstrate how changes in laws and economic
circumstances can alter the authority's behavior. We also describe how
technological advances and innovations in resolution strategies can to
some degree mitigate the underlying conflict between providing liquidity
and imposing market discipline, and lead to more efficient social
outcomes.

We then show that our simple framework is reasonably able to capture the
long history of failed bank resolution in the United States, including
(a) the asset liquidation practices and resulting liquidity crises prior
to the creation of the FDIC in 1933, (b) the FDIC's early practices of
providing liquidity by paying off both insured and uninsured depositors
and/or providing material assistance to insolvent banks, (c) the
resulting conflicts between the FDIC and those in the U.S. Congress
wanting to reduce the costs of bank resolution and harness the benefits
of market discipline in the bank resolution process, and (d) the
high-stakes policy problems of resolving large failed banks that began
in the 1980s and 1990s and remains unsettled to this day. Our analysis
illustrates how the resolution methods applied to these most recent
large bank failures---an innovative combination of restrictions on the
FDIC (for example, least cost rules) and increased authority for the
FDIC (for example, bridge banks and cross-guarantees)---have gone a long
way toward mitigating the natural conflict between providing liquidity
and imposing discipline. However, these methods have yet to be tested
(as they say, knock on wood) on today's large banks, which are ten times
the size and many times more complex.[^14]

The issues addressed in this paper are universal ones and are not
limited to the U.S. At one extreme, if a deposit insurance system cannot
provide liquidity quickly or within a reasonable time frame, then there
is really no limit to deposit insurance and a blanket guarantee system,
with all of the negative moral hazard consequences logically follows.
This was the situation in the U.S. for large bank failures during most
of the 1980s and 1990s, and it continues to be the situation in many
places outside the U.S. for failed banks of all sizes. At the other
extreme, if a deposit insurance system can provide insured depositors at
a large failed bank access to 100% of their funds on the next business
day, and also give uninsured depositors and creditors access to a
*substantial* portion of their projected claims the next business day
(for example, with an advance dividend), then the liquidity battle is
won and the short-run social costs of imposing market discipline are
greatly reduced. The latter policy requires improved information systems
at banks, appropriate operating incentives for regulators, and strong
legal frameworks that recognize the idiosyncrasies of banking companies.
Without such policies there will always be some institutions that are
"too-big-to-resolve." The U.S. has made some important headway in these
directions, although the same cannot be said for many other nations
(OECD 2002).

Our analysis may be especially prescriptive outside of the U.S. We
suggest that the observed preference by some countries for bailing out
failed banks may be the logical outcome of operating within legal and/or
technological systems that provide no other solutions for maintaining
liquidity during bank failures. For example, a country's bankruptcy laws
may not allow for unilateral revocation of a banking license or gaining
prompt control of the failed bank. In addition, if the deposit insurer
does not have the resources or systems to provide liquidity by promptly
paying insured depositors, then authorities have little incentive to
enhance market discipline by imposing losses on the uninsured
depositors. Countries that operate under these conditions are likely to
issue blanket guarantees and/or forebear when their moderate or large
banks fail, essentially rendering their deposit insurance systems
superfluous.

**References**

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Propagation of the U.S. Great Depression."* Journal of Money, Credit and
Banking, Vol 37, No. 4 (August 2005) pp. 753-773

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Ashcraft, Adam B. "*Are Bank Really Special? New Evidence from the
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1712-1730

Bernanke, Ben S. "*Nonmonetary Effects of the Financial Crisis in the
Propagation of the Great Depression."* The American Economic Review,
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Calomiris, Charles; Joseph R. Mason. "*Consequences of Bank Distress
during the Great Depression."* The American Economic Review, Vol 93, No.
3 (Jun., 2003) pp. 937-947.

Curry, Timothy; Lynn Shibut. "*The Cost of the Savings and Loan Crisis:
Truth and Consequences."* FDIC Banking Review, vol. 13, no. 3. FDIC
2000, pp. 26-35.

Federal Deposit Insurance Corporation, *The First Fifty Years,*
Washington, DC (1984).

Federal Deposit Insurance Corporation, *Annual Report*, Washington, DC
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Federal Deposit Insurance Corporation, *Managing the Crisis: The FDIC
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Federal Deposit Insurance Corporation, Large-Bank Deposit Insurance
Determination Modernization Proposal. 12 CFR Chapter III. Washington, DC
(2005).

Hoggarth, G., Jack Reidhill, and P. Sinclair. *"Resolution of banking
crises: A review."* Bank of England Financial Stability Report, 2003:
109-123.

Horvitz, Paul M., "*Failures of Large Banks: Implications For Banking
Supervision and Deposit Insurance,"* Journal of Financial and
Quantitative Analysis, Vol. 10, No. 4, 1975 Proceedings (Nov. 1975) pp.
589-601.

Kane, Edward J. "*The High Cost of Incompletely Funding the FSLIC
Shortage of Explicit Capital."*Journal of Economic Perspectives, vol. 3,
no. 4, Fall 1989, pp.31-47.

Kane, Edward J. "*Principal Agent Problem in S&L Salvage."* Journal of
Finance, July 1990, pp. 755-764.

Kane, Edward J. "*Three paradigms for the role of capitalization
requirements in insured financial institutions."* [Journal of Banking &
Finance](http://econpapers.repec.org/article/eeejbfina/), 1995, vol. 19,
issue 3-4, pp. 431-459

Kane, Edward J., and D. Klingebiel. *"Alternatives to blanket guarantees
for containing a systemic crisis."* Journal of Financial Stability 1:
31-63.

Kaufman, George G., *\"Depositor Liquidity and Loss-Sharing in Bank
Failure Resolutions\"* (March 21, 2003). FRB Chicago Working Paper No.
2003-02.

Kaufman, George G. *"Bank regulation and foreign-owned banks."* Reserve
Bank of New Zealand Bulletin 67(2): 65-74.

Kaufman, George G. and Robert Eisenbeis. *Bank crisis resolution and
foreign-owned banks."* Federal Reserve Bank of Atlanta Economic Review
2005(Q4): 27-41.

Kaufman, George G.and Steven Seelig A. *"Post Resolution Treatment of
Depositors atFailed Banks: Implications for the Severity of Banking
Crisis, Systemic Risk, and Too Big to Fail."* Economic Perspective
2Q/2002, pp. 27-41.

Kindleberger, Charles P. (2000) *Manias, Panics and Crashes: A History
of Financial Crisis* New York, New York, Wiley Investment Classics.

Mayes, David. *"Who pays for bank insolvency?"* Journal of International
Money and Finance 2004(23):515-551.

Mishkin, Frederik s. "*An Evaluation of the Treasury Plan for Banking
Reform*" The Journal of Economic Perspectives, vol. 6, no.1, Winter,
1992) pp. 133-153.

Mishin, Frederick S. "*How big a Problem is Too big To Fail? A Review of
Gary Stern and Ron Feldman's Too Big to Fail: the Hazard of Bank
Bailouts."* Journal of Economic Literature, Vol. XLIV (Dec., 2006) pp.
988-1004.

Noyes, Alexander D. *"A Year After the Panic of 1907*." The Quarterly
Journal of Economic*,* Vol. 23, No.2. (Feb., 1909) pp. 185-212.

OECD. "*Experience with the resolution of weak financial institutions in
the OECD area*." Financial Markets Trends 82: 107-146.

Persons, Warren M. *The Crisis of 1920 in the United States*. The
American Economic Review, Vol. 12, No. 1, Supplement, papers and
proceedings of the Thirty-fourth Annual Meeting of the American Economic
Association. (Mar., 1922), pp. 5-19.

Rameriz, Carlos D. "*What Can History Tell Us about the Consequences of
Bank Failures."* FDIC Banking Review forthcoming (2007).

Rosengren, Eric S.and Katerina Simons "*Failed Bank Resolution and the
Collateral Crunch:The Advantages of Adopting Transferable Puts."*
Federal Reserve Bank of Boston, Working Paper No. 92-5, 1992.

White, Horace; Joseph French Johnson, "Central Bank: Discussion."
*American Economic Association Quarterly,* 3^rd^ Series, Vol. 10, No. 1,
papers and Discussion of the Twenty-First Annual Meeting. Atlantic City,
N.J. December 28-31, 1908. (Apr. 1909), pp. 270-375.

Wicker, Elmus. *Banking Panics of the Gilded Age.* Cambridge, U.K.
Cambridge University Press, pp 95.

**Table 1**

A list of failed bank resolution techniques, in order by the amount of
liquidity preserved.

+---------------------+-------------------+----------------------------+
|                     | **Resolution      | **A short description of   |
|                     | Technique**       | each resolution            |
|                     |                   | technique**                |
+---------------------+-------------------+----------------------------+
| **Most liquidity    | Open bank         | Cash or in-kind assistance |
| preserved**         | assistance        | provided to bank, bank     |
|                     |                   | owners remain intact       |
| **Least liquidity   |                   |                            |
| preserved**         |                   |                            |
+---------------------+-------------------+----------------------------+
|                     | Forbearance       | Allowing insolvent or      |
|                     |                   | undercapitalized bank to   |
|                     |                   | continue to operate, often |
|                     |                   | with old management        |
|                     |                   | intact. No cash or in-kind |
|                     |                   | assistance is provided.    |
+---------------------+-------------------+----------------------------+
|                     | Bridge bank       | A temporary National Bank  |
|                     |                   | created with FDIC in       |
|                     |                   | control. Assets and most   |
|                     |                   | liabilities of failed bank |
|                     |                   | transferred to new bank.   |
|                     |                   | Old ownership, holding     |
|                     |                   | company creditors, and     |
|                     |                   | management are severed     |
|                     |                   | from bank.                 |
+---------------------+-------------------+----------------------------+
|                     | Purchase and      | Acquirer of failed bank    |
|                     | assumption        | purchases designated       |
|                     |                   | assets from the failed     |
|                     |                   | bank and assumes the       |
|                     |                   | liabilities.               |
+---------------------+-------------------+----------------------------+
|                     | Partial payout    | Acquirers of failed bank   |
|                     |                   | may only wish to bid on a  |
|                     |                   | sub-set of the failed      |
|                     |                   | banks deposits. Remaining  |
|                     |                   | depositors paid directly   |
|                     |                   | by FDIC.                   |
+---------------------+-------------------+----------------------------+
|                     | Asset liquidation | Failed bank assets are     |
|                     |                   | liquidated by the FDIC or  |
|                     |                   | its designees. Depositor   |
|                     |                   | coverage is limited to the |
|                     |                   | proceeds of the sale.      |
+---------------------+-------------------+----------------------------+

+-----------------------------------------------------------------------+
| **Table 2**                                                           |
|                                                                       |
| **FDIC Insurance Determination Process**                              |
|                                                                       |
| 1.  Collect data on all deposit accounts, using manual data entry for |
|     official items, as needed.                                        |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 2.  Group accounts together, based on name, address, and tax ID (SSN) |
|     number.                                                           |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 3.  Accounts in groups with balances at or below \$100,000 are        |
|     released.                                                         |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 4.  Accounts in groups with aggregate balances above \$100,000 are    |
|     reviewed by agent.                                                |
|                                                                       |
|     -   The agent must collect all relevant account information that  |
|         can be used to determine the account owner(s) and, if         |
|         necessary, beneficiaries.                                     |
|                                                                       |
|     -   This step might include pulling the account holder's          |
|         signature card that would detail the above information.       |
|                                                                       |
|     -   The agent then determines the insurance category.             |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 5.  Holds are then calculated. They may reflect uninsured balances    |
|     estimated on the basis of the electronic records, but might also  |
|     reflect the need for additional documentation.                    |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 6.  Holds are manually input into the bank's system.                  |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 7.  When the bank reopens there are meetings with depositors who have |
|     funds held back. Necessary documentation is collected, including: |
|                                                                       |
|     -   Affidavits from depositors related to kinship requirements    |
|         for trust accounts.                                           |
|                                                                       |
|     -   Trust documents*.*                                            |
|                                                                       |
| ```{=html}                                                            |
| <!-- -->                                                              |
| ```                                                                   |
| 8.  After considering the additional documentation, holds are then    |
|     adjusted, receivership certificates created, and funds are        |
|     released as needed.                                               |
+-----------------------------------------------------------------------+

**Table 3**

Five Largest Banks and Five Largest FDIC Insurance Determinations

+-----------+-------+---------+------+-------------+-------+---------+
| **Largest |       |         |      | **Five      |       |         |
| Insured   |       |         |      | Largest     |       |         |
| Insti     |       |         |      | Insurance   |       |         |
| tutions** |       |         |      | Deter       |       |         |
|           |       |         |      | minations** |       |         |
| **(as of  |       |         |      |             |       |         |
| June      |       |         |      |             |       |         |
| 2006)**   |       |         |      |             |       |         |
+-----------+-------+---------+------+-------------+-------+---------+
| Name      | Dom   | Number  |      | Name        | Dep   | Number  |
|           | estic | of      |      |             | osits | of      |
|           | Dep   | Deposit |      |             | in    | Deposit |
|           | osits | A       |      |             | Bil   | A       |
|           | in    | ccounts |      |             | lions | ccounts |
|           | Bil   |         |      |             |       |         |
|           | lions |         |      |             |       |         |
+-----------+-------+---------+------+-------------+-------+---------+
| Bank of   | \$564 | 50,     |      | First City  | \$2.5 | 322,983 |
| America   |       | 587,399 |      | Houston, NA |       |         |
| NA        |       |         |      |             |       |         |
+-----------+-------+---------+------+-------------+-------+---------+
| Wells     | \$299 | 30,     |      | First City  | \$1.3 | 172,047 |
| Fargo &   |       | 396,923 |      | Dallas, NA  |       |         |
| Company   |       |         |      |             |       |         |
+-----------+-------+---------+------+-------------+-------+---------+
| Wachovia  | \$306 | 22,     |      | Heritage    | \$1.0 | 140,079 |
|           |       | 740,254 |      | Bank        |       |         |
|           |       |         |      |             |       |         |
|           |       |         |      | for Savings |       |         |
+-----------+-------+---------+------+-------------+-------+---------+
| W         | \$210 | 18,     |      | Attleboro   | \     | 100,630 |
| ashington |       | 673,527 |      | Pawtucket   | $0.56 |         |
| Mutual    |       |         |      | SB          |       |         |
| Bank      |       |         |      |             |       |         |
+-----------+-------+---------+------+-------------+-------+---------+
| JPMorgan  | \$435 | 17,     |      | New England | \     | 99,323  |
| Chase     |       | 648,660 |      | Savings     | $0.72 |         |
| Bank NA   |       |         |      | Bank        |       |         |
+-----------+-------+---------+------+-------------+-------+---------+

**Table 4**

U.S. Commercial Bank Failures and FDIC Resolution Methods, 1934-2007.

  ---------- -------------- ---------- ------------- -------------- -- ---------- -------------- ---------- ------------- --------------
  **Year**   **Failures**   **P&As**   **Payouts**   **Open Bank       **Year**   **Failures**   **P&As**   **Payouts**   **Open Bank
                                                     Assistance**                                                         Assistance**

  2007       2              1          1             0                 1970       7              3          4             0

  2006       0              0          0             0                 1969       9              5          4             0

  2005       0              0          0             0                 1968       3              3          0             0

  2004       3              3          0             0                 1967       4              0          4             0

  2003       2              2          0             0                 1966       7              6          1             0

  2002       10             6          4             0                 1965       5              2          3             0

  2001       3              3          0             0                 1964       7              0          7             0

  2000       6              6          0             0                 1963       2              0          2             0

  1999       7              7          0             0                 1962       1              1          0             0

  1998       3              3          0             0                 1961       5              0          5             0

  1997       1              1          0             0                 1960       1              0          1             0

  1996       5              5          0             0                 1959       3              0          3             0

  1995       6              5          1             0                 1958       4              1          3             0

  1994       11             9          2             0                 1957       1              0          1             0

  1993       40             35         5             0                 1956       2              1          1             0

  1992       100            74         24            2                 1955       5              1          4             0

  1991       108            86         19            3                 1954       2              2          0             0

  1990       159            141        17            1                 1953       2              2          0             0

  1989       206            174        31            1                 1952       3              3          0             0

  1988       280            164        36            80                1951       2              2          0             0

  1987       201            133        50            18                1950       4              4          0             0

  1986       144            97         40            7                 1949       4              4          0             0

  1985       118            87         29            2                 1948       3              3          0             0

  1984       79             62         16            1                 1947       5              5          0             0

  1983       46             35         9             2                 1946       1              1          0             0

  1982       35             25         7             3                 1945       1              1          0             0

  1981       7              5          2             0                 1944       2              1          1             0

  1980       11             7          3             1                 1943       5              1          4             0

  1979       10             7          3             0                 1942       20             14         6             0

  1978       6              5          1             0                 1941       15             7          8             0

  1977       6              5          0             1                 1940       43             24         19            0

  1976       17             13         3             1                 1939       59             27         32            0

  1975       13             10         3             0                 1938       73             24         49            0

  1974       4              3          0             1                 1937       75             25         50            0

  1973       6              3          3             0                 1936       69             27         42            0

  1972       2              0          1             1                 1935       25             1          24            0

  1971       7              1          5             1                 1934       9              0          9             0
  ---------- -------------- ---------- ------------- -------------- -- ---------- -------------- ---------- ------------- --------------

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[^1]: Hoggarth and Saporta (2001) estimate that the economic costs of a
    systemic bank failure event could run as high as 15% to 20% of a
    nation's GDP.

[^2]: These data are taken from the Federal Reserve H15 table.

[^3]: The assistance came in the form of regulatory accounting
    adjustments that allowed thrifts to carry nonperforming loans at
    artificially high values, thus inflating their accounting capital
    and making the thrift "book solvent."

[^4]: Kaufman (2003) and Kaufman and Seelig (2002) suggest that an
    "advance dividend" be paid to uninsured depositors in these cases,
    with the amount based on a conservative estimate of the value of the
    failed bank. The idea is to reduce economy-wide illiquidity effects
    while avoiding a full bail-out of uninsured depositors, even in
    cases in which the resolution authority lacks the time, information,
    or other resources necessary to complete a full insurance
    determination.

[^5]: We theoretically could have anchored the technology constraint at
    the other extreme, where liquidity provision is 0% and market
    discipline is 100%, that is, a "no-deposit-insurance" bank
    resolution regime. Given that deposit insurance is permanent part of
    the bank regulatory regime in the U.S. and most other developed
    economies, we choose not to follow this path.

[^6]: As discussed in the next section, the resolution choices made by
    FDIC during the post-deposit insurance era are consistent with a
    strong preference for liquidity over discipline.

[^7]: If the FDIC determined that it was in the community's best
    interest to establish a new bank after the insured bank was closed,
    the local community could raise the required capital through a stock
    subscription and a de novo charter would be issued. This new bank
    could purchase only the failed bank's buildings and furniture,
    fixtures and equipment. Of the 24 original DINBs, only two new banks
    were subsequently formed.

[^8]: For simplicity, this example ignores FDIC administrative costs,
    which are accounted for in an actual premium calculation.

[^9]: For both USNB and Franklin National, the FDIC determined that the
    P&A approach was also less expensive than the payout approach (FDIC,
    1984).

[^10]: First Pennsylvania failed due to its exposure to interest rate
    risk, and as such this episode was a harbinger of the coming crisis
    in the savings and loan (S&L) industry. We will not discuss the
    resolution practices in the S&L industry here, as supervisory
    forbearance and complete protection of all liability holders was the
    order of the day for insolvent S&Ls up until 1989, when the
    Financial Institutions Reform, Recovery and Enforcement Act (FIRREA)
    passed.

[^11]: This restriction ended in 1982, when the Garn-St Germain Act
    allowed the FDIC to seek out-of-state bidders in emergency
    situations.

[^12]: First Republic was formed in June 1987---just nine months before
    it failed---by a merger of two large Texas bank holding companies,
    RepublicBank Corporation and InterFirst Corporation. Both of these
    companies had been experiencing problems in the depressed Texas
    market.

[^13]: FDICIA does provide an exception to the least cost rule for
    resolving systemically important banks that fail, but the FDIC must
    get the approval of the U.S. Treasury Department as well as all of
    the major federal bank regulatory agencies in order to invoke this
    exception.

[^14]: The FDIC has proposed that certain large banks maintain their
    records and systems in such a way that, if the bank failed, the FDIC
    could determine all depositor insurance status over the closing
    weekend, and provide for uninsured depositors and creditors having
    access to a portion of their funds on the next business day. The
    FDIC would then create a bridge bank that assumes all of the insured
    depositors and the projected portion of uninsured liabilities and
    "purchases" the assets of the failed bank (which presumably would be
    of a value equal to the assumed liabilities). The bridge bank would
    operate normally until a resolution was affected.