Keeping the Promise:

Recommendations for

Deposit Insurance Reform

Federal Deposit Insurance Corporation

April 2001
LETTER FROM THE FDIC CHAIRMAN

In the 67 years since it was founded to put an end to the devastating bank runs that

contributed to the Great Depression, the deposit insurance system managed by the Federal

Deposit Insurance Corporation (FDIC) has served our country well. It has been an anchor for

public confidence in the banking system. The reform measures the FDIC is recommending

in this paper will ensure that the deposit insurance system will continue to serve well in the

new century the many individuals, families, small businesses, charities, and local

governments that rely on their local depository institutions.

These reform recommendations could not come at a better time, positioned as we are

between a past of unprecedented prosperity and an uncertain future. The past decade of

economic expansion has contributed to a strong, well-capitalized banking industry. Both the

bank and savings association insurance funds are fully capitalized. The numbers of troubled

institutions and bank failures are very low by historical standards. But good times never last

forever, as the recent slowdown in the economy shows.

Deposit insurance is intended to help bank depositors weather uncertain times, and, in the

process, to help limit the downside of economic cycles. Flaws in the current system,

however, undermine that intent. The lack of risk-based pricing for most institutions can

encourage imprudent risk-taking. By placing financial burdens on banks when they are least

able to bear them, and by limiting credit availability when the economy needs liquidity, the

current deposit insurance system could make an economic downturn longer and deeper than

it would otherwise be. For example, it is possible that, in difficult times, deposit insurance

premiums could reduce the pre-tax net income of insured institutions by almost $9 billion.

On the basis of recent average capital- and loans-to-assets ratios for all insured institutions,

this could reduce bank lending by more than $60 billion at the precise time in the business

cycle when credit is most needed in communities around the country.

We need to address these flaws now – while the industry is strong and the overwhelming

majority of institutions remain healthy. If we wait, an economic downturn can trigger

unintended consequences that would harm the public that deposit insurance is intended to

protect.

April 5, 2001 Donna Tanoue

FDIC Chairman
Table of Contents

EXECUTIVE SUMMARY.............................................................................................i

I. INTRODUCTION.........................................................................................................1

II. THE CURRENT DEPOSIT INSURANCE SYSTEM .................................................2

III. WHY CHANGE THE CURRENT SYSTEM?.............................................................4

A. Two Deposit Insurance Funds ......................................................................................4

B. Inadequate Pricing of Risk............................................................................................4

C. Volatile Premiums That Are Likely to Rise Substantially in an Economic Downturn ....5

D. Deposit Coverage Does Not Keep Pace with Inflation in a Predictable Fashion.............5

IV. RECOMMENDATIONS FOR REFORMING THE DEPOSIT INSURANCE

SYSTEM........................................................................................................................6

A. Recommendation: The BIF and SAIF Should Be Merged Now.....................................7

B. Recommendation: The Current Statutory Restrictions Regarding Risk-Based

Premiums Should Be Eliminated ...................................................................................7

C. Recommendation: Sharp Premium Swings Should Be Eliminated ...............................12

D. Recommendation: Rebates Should Be Based on Past Contributions ............................17

E. Recommendation: The Coverage Level Should Be Indexed to Keep Pace with

Inflation .......................................................................................................................17

V. CONCLUSION..............................................................................................................23
i

EXECUTIVE SUMMARY

Introduction

Deposit insurance is a federal program that directly affects tens of millions of Americans by

insuring their deposits at banks and savings associations. The public relies on the Federal

Deposit Insurance Corporation (FDIC) to protect insured depositors, resolve banking

problems quickly, and help maintain public confidence in insured depository institutions.

Over the years, this program has worked well, but it has become evident that there are a

number of weaknesses in the system.

In August 2000, the FDIC issued an Options Paper that discussed weaknesses in the present

deposit insurance system and offered possible solutions. Since then, the FDIC has reached

out to hundreds of individual bankers, and the industry groups that represent them, to solicit

their opinions. Further, the FDIC has conducted intensive internal analysis, including

modeling insurance fund performance under various reform scenarios. This paper is the

result of these efforts.

The FDIC has identified four weaknesses with the current system that need to be corrected in

a timely fashion. Deposit insurance is provided by two insurance funds at potentially

different prices; deposit insurance cannot be priced effectively to reflect risk; deposit

insurance premiums are highest at the wrong point in the business cycle; and the value of

insurance coverage does not keep pace with inflation in a predictable fashion.

Recommendations

The FDIC recommends the following changes to address these weaknesses in the system:

The Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF)

should be merged now.

A combined fund would be stronger and would prevent the destabilizing effects that would

result if one fund required premiums while the other did not. Moreover, many banks and

thrifts today have commingled BIF- and SAIF-insured deposits. A merger of the funds also

would greatly simplify reporting and accounting responsibilities for both the institutions and

the FDIC.

The current statutory restriction on the FDIC's ability to charge risk-based premiums to

all institutions should be eliminated; the FDIC should charge regular premiums for risk

regardless of the level of the fund.

Current law restricts the FDIC from charging premiums to most banks that are wellcapitalized and highly rated by supervisors as long as the insurance fund is above a

Designated Reserve Ratio (DRR) of 1.25 percent of insured deposits, or $1.25 for every $100

of insured deposits. Today, 92 percent of the industry does not pay for deposit insurance,

and the more than 900 banks that were chartered within the last five years have never paid

any premiums. This system both underprices risk and does not adequately differentiate

among banks according to risk. The FDIC should be allowed to charge risk-based insurance
ii

premiums to all institutions, as Congress envisioned in its 1991 bank reform legislation

(FDICIA).

Sharp premium swings triggered by deviations from the DRR should be eliminated. If the

fund falls below a target level, premiums should increase gradually. If it grows above a

target level, funds should be rebated gradually.

As noted above, the law requires that the FDIC not charge premiums to well-rated banks

when the deposit insurance funds exceed the DRR. However, if a fund drops below the DRR

and cannot be replenished within one year, the law requires the FDIC to assess premiums

across-the-board at a rate of at least 23 basis points.

The emphasis of the current deposit insurance system on maintaining the 1.25 percent DRR

creates the potential for volatile premiums. This is likely to result in the industry paying high

premiums when both banks and the economy can least afford it. The deposit insurance

system should work to smooth economic cycles, not exacerbate them. It would be preferable

for the fund to absorb some losses and for premiums to adjust gradually. This can be

accomplished by establishing a target for the fund. If the fund varied from the target,

surcharges or rebates would be used to gradually bring the fund back to the target. The target

could be a range within which premiums would be constant. Alternatively, it could be a

fixed reserve ratio such as the current DRR.

Rebates should be based on past contributions to the fund, not on the current assessment

base.

Rebates are an important part of a deposit insurance system if the FDIC is to charge positive

risk-based deposit insurance premiums at all times and yet avoid excessive growth of the

insurance fund during long stretches of good years. However, it is important that rebates not

create perverse economic incentives. A rebate tied to the current assessment base could

create moral hazard problems by decreasing the cost of insurance and could even create a

situation in which banks would be paid to grow. Fairness dictates that rebates should be

based on past contributions to the fund.

The deposit insurance coverage level should be indexed to maintain its real value.

Over time, inflation eats away at the value of deposit insurance. Unlike other important

government programs such as Social Security, Medicare, and even taxes, deposit insurance is

not indexed to inflation. Although Congress has periodically adjusted the coverage level (the

current level of $100,000 was set in 1980), both the timing and the size of these adjustments

have been unpredictable. While it is for the Congress to decide the initial coverage level, that

level should be indexed to the Consumer Price Index in order to maintain its real value. This

would ensure more predictable adjustments in response to inflation, as compared with the ad

hoc changes made in the past.

* * *

These recommendations are not intended to alter the assessment burden on the industry

significantly; instead, they are designed to spread that burden more evenly over time in a way

that provides appropriate economic incentives.
iii

Table ES-1 – Assessment, Rebates and Surcharges Calculated for Two Typical Banks Current

System (Status Quo) Versus a System of Rebates and Surcharges

How Might These Recommendations Work? To illustrate how these reforms could affect

banks and the insurance fund, the FDIC performed numerous simulations on a merged fund

incorporating assessment and rebate scenarios in differing economic climates. The examples

below assume that the 92 percent of the industry currently not paying any premiums is

disaggregated into three groups (1a+, 1a, 1a-) paying risk-based premiums of 1, 3 and 6 basis

points, respectively. The fund is allowed to float in a range from 1.15 percent to 1.35 percent

of insured deposits. If the merged fund falls outside this range, there is a surcharge or rebate

equal to 30 percent of the difference between the fund and 1.15 and 1.35 percent,

respectively. Rebates are allocated on the basis of past payments to the fund. The FDIC

recognizes that there are many ways to implement these recommendations, and we anticipate

further discussion to work out the details. This example is for illustrative purposes only.

Table ES-1 shows the premiums and net payments in the example outlined above for a

hypothetical small and large bank, when the fund is at 1.40 percent and 1.10 percent,

respectively. At the 1.40 percent fund level, rebates are paid and the safest banks get back

slightly more than they pay. At a 1.10 percent fund level, there are surcharges for all

institutions, but in all cases total payments are considerably below what they would be under

the status quo. Note that while rebates and surcharges are similar, they are not identical.

This is because rebates are based on past contributions to the fund and surcharges are based

on the current assessment base. For the typical institution, this will yield similar results. For

a de novo institution, on the other hand, there would not be any rebates initially, since they

have never paid anything into the fund.

Chart ES-1 shows the net payments that would be paid by the institutions in the best risk

class in a high-loss scenario—in this case the percentage losses suffered by the BIF during

the last banking crisis—under the current premium system and under the example described

above. The difference is striking and demonstrates how the proposed system helps to

dampen volatile premiums. Instead of premiums rising abruptly from zero to 23 basis points,

remaining at 23 basis points for a number of years, and then falling back to zero, premiums

rise gradually from 1 basis point to about 10.5 basis points and then decrease gradually to

Insurance Payment Payment

Category Net Under Current Net Under Current

(Assessment Payment System Payment System

Rate) Premium - Rebate* = to FDIC** (Status Quo)*** Premium + Surcharge = to FDIC (Status Quo)***

Small Bank 1a+ (1 bp) $6,522 $7,237 ($715) $0 $6,522 $7,240 $13,762 $71,720

$81.0 million in assets  1a (3 bp) 19,566 7,237 12,329 0 19,566 7,240 26,806 $71,720

 65.2 million in assessable deposits 1a- (6 bp) 39,133 7,237 31,895 0 39,133 7,240 46,372 $71,720

Large Bank 1a+ $653,408 725,274 ($71,866) $0 $653,408 $725,283 $1,378,692 $7,187,400

$10.0 billion in assets 1a 1,960,225 725,274 1,234,951 0 1,960,225 725,283 2,685,508 7,187,400

 6.534 billion in assessable deposits 1a- 3,920,450 725,274 3,195,176 0 3,920,450 725,283 4,645,733 7,187,400

** ** Represents the median asset size for all FDIC-insured institutions.

** This example assumes that when the fund exceeds 1.35 percent, 30 percent of the excess would be rebated to banks; and when 

the fund falls below 1.15 percent, a surcharge of 30 percent of the shortfall would be assessed.

*** In today's system (status quo), the premium paid by 1A-rated banks is zero when the fund exceeds 1.25 percent. If the fund were 

to fall below this "hard target", the premium would be increased to either 23 basis points, or to the amount required to bring the fund 

back to 1.25 percent within one year, whichever amount is less.

Banks rated 1A in the current 

system would be divided into 3 

risk categories

Strong Economy (Rebates) Weak Economy (Surcharges)

(Designated Reserve Ratio at 1.4%) (Designated Reserve Ratio at 1.1%)
iv

about 2 basis points at the end of the 10-year period. Similar results hold for other

institutions. For example, for 1a– institutions, premiums would peak at about 15.5 basis

points as opposed to 23 basis points under the status quo. Because the insurance fund would

be allowed to absorb more losses under the proposed system, billions of additional dollars

would be available to the banking industry to help fuel economic growth in the trough of the

business cycle.

Rapidly Growing Institutions. Recent developments have highlighted the concern raised by

rapidly growing institutions that dilute the reserve ratio and pay nothing for deposit

insurance. The FDIC’s recommendations would address this issue in several ways. First,

under the assessment system described above, a decrease in the reserve ratio would have, at

most, a gradual effect on banks’ net payments to the FDIC. Second, regular risk-based

premiums for all banks would mean that fast-growing institutions would pay as they gathered

deposits. In particular, fast growth, if it posed greater risk, could result in additional

premiums through the operation of the FDIC’s expanded discretion to price risk. Finally, if

rebates are based upon past contributions, net payments to the FDIC from fast growers when

the FDIC is paying rebates would initially be greater than for established institutions or

institutions growing more slowly.

Conclusion

The FDIC’s proposed reforms will make the system function more efficiently and fairly, in a

way that provides the appropriate economic incentives for all participants and lessens the

burden on banks and bank borrowers during an economic downturn. These reforms are

interrelated and should be implemented as a package. Piecemeal implementation of

individual parts could introduce new distortions and aggravate the problems the

recommendations are designed to address.

Implementation of these reforms presents complicated issues. The FDIC looks forward to

working with the Congress, the banking industry and the public to improve the deposit

insurance system.

Chart ES-1 – Effective Assessment Rates under a HighLoss Scenario for Banks in the 1a+ Category

0.0

3.0

6.0

9.0

12.0

15.0

18.0

21.0

24.0

27.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Basis points

Alternative

Status Quo
1

I. INTRODUCTION

Deposit insurance is a federal program that directly affects tens of millions of Americans.

The public relies on the Federal Deposit Insurance Corporation (FDIC) to protect insured

depositors, resolve banking problems quickly, and help maintain public confidence in insured

depository institutions. Over the years, this program has worked well, but it has become

evident that there are weaknesses in the system that need to be addressed in a timely fashion.

In August 2000, the FDIC released a paper that discussed weaknesses in the deposit

insurance system and options for addressing them.1 Since the publication of the Options

Paper, the FDIC has conducted intensive analysis, including modeling insurance fund

performance under various reform scenarios. Further, the FDIC has engaged in aggressive

outreach to hundreds of individual bankers and the industry groups that represent them, as

well as surveyed consumers to solicit their opinions. This paper is the result of these efforts.

It presents a series of recommendations designed to provide deposit insurance more

efficiently and more fairly, in a way that provides the appropriate economic incentives to all

participants in the system.

In particular, the FDIC makes the following recommendations: (1) The Bank Insurance Fund

(BIF) and the Savings Association Insurance Fund (SAIF) should be merged. (2) The current

statutory restrictions on the FDIC’s ability to charge risk-based premiums to all institutions

should be eliminated; the FDIC should charge regular premiums for risk regardless of the

level of the insurance fund. (3) Sharp premium swings inherent in the current deposit

insurance system should be eliminated; instead, if the fund falls below a target level,

premiums should increase gradually; if it grows above a target level, funds should be rebated

gradually. (4) Those rebates should be based on past contributions to the fund, not the

current assessment base. (5) The coverage level should be indexed to keep pace with

inflation.

Section II briefly describes the current deposit insurance system, while Section III describes

the weaknesses of this system. Section IV sets forth the FDIC’s recommendations for

reforming the system. It also discusses some issues pertaining to implementing these

recommendations and provides numerical examples. It is important to note that the

numerical examples are for illustrative purposes only. They are intended to help the reader

understand the implementation issues involved in our proposals and the effect they may have

on banks and the insurance fund.2 We recognize the need for ongoing discussion to work out

the best implementation of these reforms. Section V contains concluding remarks.

 

1

 Federal Deposit Insurance Corporation. “Deposit Insurance Options Paper.” Washington, D.C., August 2000.

2

 Except where the context requires otherwise, the term “banks” will generally refer to all FDIC-insured

institutions.
2

II. THE CURRENT DEPOSIT INSURANCE SYSTEM

The FDIC currently administers two deposit insurance funds: the BIF and the SAIF.

Although originally intended to insure bank and savings association deposits separately,

today both insure deposits at banks and savings associations. In some cases, both insure

deposits at the same institution. Both provide identical insurance coverage of up to

$100,000, and both operate under the same statutory assessment system. An important

difference is that assessment rates for the BIF and the SAIF are set separately.

The current assessment system used by the BIF and the SAIF has its roots in the Federal

Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). FDICIA directed the

FDIC to implement a risk-based insurance system. It also required the FDIC to maintain

each fund at a designated reserve ratio (DRR), the ratio of mandated reserves to insured

deposits, of 1.25 percent. When a fund's reserve ratio—the ratio of its balance to insured

deposits—falls below the DRR, the FDIC must raise premiums by enough to bring the

reserve ratio back to the DRR within a year or must charge at least 23 cents per $100 of

deposits (23 basis points) until the reserve ratio meets the DRR.3

For example, a fund of $8 billion that insured $1 trillion in deposits would have a reserve

ratio of 0.8 percent. Since this is below the 1.25 percent DRR, the FDIC would be required

to charge premiums of at least 23 basis points unless it believed that lower premiums would

be sufficient to raise the reserve ratio to 1.25 percent within one year. For a bank with $100

million in assessable deposits, a 23-basis-point insurance premium would amount to

$230,000 a year.

To implement the risk-based pricing required by FDICIA, the FDIC placed institutions into

risk classes based on two criteria: capital levels and supervisory ratings. Three capital

categories—well capitalized, adequately capitalized, and undercapitalized—were based both

on leverage ratios and risk-based capital ratios. The well, adequately, and undercapitalized

categories were given the numbers 1, 2, and 3, respectively. Also, three supervisory

subgroups, termed A, B, and C, were developed. These supervisory subgroups were

generally based on a bank’s composite CAMEL rating, a rating assigned by bank supervisors

at the end of a bank examination, with 1 being the best rating and 5 being the lowest.4

Generally speaking, banks with a CAMEL rating of 1 or 2 were put in supervisory subgroup

A, those with a CAMEL rating of 3 were put in subgroup B, and those with a CAMEL rating

of 4 or 5 were put in subgroup C. Thus, in the current assessment system, the highest-rated

banks are assigned to group 1A and lowest-rated banks to group 3C.

 

3

 If the reserve ratio is not brought back to the DRR within a year, the FDIC must establish a schedule for

returning the reserve ratio to the DRR within 15 years. Rates under the schedule cannot be lower than 23 basis

points, but could be higher.

4

 CAMEL is an acronym for component ratings assigned in a bank examination: Capital, Asset quality,

Management, Earnings, and Liquidity. In 1997, an additional component, “S” for Sensitivity to market risk,

was added. A composite CAMELS rating combines these component ratings, again with 1 being the best

rating.
3

The three capital categories and three supervisory subgroups form a nine-cell matrix for riskbased premiums. When this system was implemented in 1993, both the BIF and the SAIF

were well below the DRR and the premiums ranged from 23 basis points for 1A institutions

to 31 basis points for 3C institutions. Table 1 shows the distribution of premium rates

applicable to banks and thrifts at the inception of the risk-based system in 1993.

The BIF reserve ratio surpassed the DRR in 1995 and the FDIC lowered premiums on BIF

deposits, ultimately reducing them to zero for 1A-rated banks. The SAIF reserve ratio

surpassed the DRR in 1996, after the SAIF collected a special assessment of more than 65

basis points in accordance with the provisions of the Deposit Insurance Funds Act of 1996

(Funds Act). The Funds Act prohibited the FDIC from assessing banks and thrifts unless

they “exhibit financial, operational, or compliance weaknesses ranging from moderately

severe to unsatisfactory, or are not well capitalized,” as long as a fund’s reserve ratio

exceeded (and was expected to remain above) the DRR. Translated, this means that, with a

few exceptions, as long as a fund’s reserve ratio exceeds 1.25 percent, the FDIC generally

may not charge premiums to well-capitalized institutions with CAMELS ratings of 1 or 2.

Table 2 shows the current rate matrix for both the BIF and the SAIF. As required by law,

since the reserve ratios for the BIF and the SAIF exceed 1.25 percent, the assessment rate for

1A institutions is zero. Since most institutions are well capitalized and have a 1 or 2

CAMELS rating, as of December 31, 2000, 92 percent of all institutions were not paying

premiums for deposit insurance.

Capital Group A B C

1. Well Capitalized 23 26 29

2. Adequately Capitalized 26 29 30

3. Undercapitalized 29 30 31

Supervisory Subgroup

Table 1 - Assessment Rates

As of January 1, 1993

Capital Group A B C

1. W ell Capitalized 0 3 17

2. Adequately Capitalized 3 10 24

3. Undercapitalized 10 24 27

Supervisory Subgroup

Table 2 – Current Assessment Rates
4

III. WHY CHANGE THE CURRENT SYSTEM?

Although the current deposit insurance system is working well in the current environment, it

has a number of weaknesses, including the following: (1) two deposit insurance funds

providing identical coverage at potentially different prices; (2) inadequate pricing of risk that

distorts incentives and increases moral hazard; (3) volatile premiums that are likely to rise

substantially during an economic downturn; and (4) coverage levels that do not keep pace

with inflation in a predictable fashion.

A. Two Deposit Insurance Funds.

The BIF and the SAIF provide an identical product to both commercial banks and thrifts.

Yet BIF and SAIF premiums are set separately. This raises the possibility of institutions with

similar risk characteristics paying different premiums. Under the current premium structure,

it would be entirely possible for one institution to be paying 23 basis points for deposit

insurance while a competitor across the street that posed similar risk to its insurance fund

was paying nothing. This is precisely what happened in late 1995 and 1996, when even the

best-rated SAIF institutions were still paying premiums while the best-rated BIF institutions

were not.

B. Inadequate Pricing Of Risk.

Insurers generally price their product to reflect their risk of loss. The further that pricing

deviates from expected loss, the greater the incentive for managers to take risks they would

have avoided if the insurance had been appropriately priced. A zero price for the FDIC’s

guarantee encourages new deposits to enter the system, allowing some banks to enjoy the

benefits of deposit insurance without shouldering any of the costs. Moreover, without riskbased pricing, safe banks unnecessarily subsidize risky banks.

FDICIA directed the FDIC to adopt risk-based pricing, but current law prevents it from doing

so effectively. As noted above, 92 percent of all institutions currently pay nothing for

deposit insurance. There are two problems with this. First, all institutions pose some risk to

the fund and should pay for deposit insurance. Second, there are large and identifiable

differences in risk exposure among these institutions. Nevertheless, the law prohibits the

FDIC from distinguishing among them for purposes of pricing insurance.

This inability to price risk appropriately has had a number of negative effects already. Since

very little in premiums has been collected since 1996, the deposit insurance system is almost

entirely financed by those institutions that paid premiums in the past. There are currently

over 900 newly chartered institutions that have never paid premiums. In addition, deposit

insurance that is underpriced creates an incentive for institutions to grow rapidly. Since they

are not paying for insurance, new institutions and fast-growing institutions are benefiting at

the expense of their older competitors and slower-growing competitors. Rapid deposit

growth lowers a fund’s reserve ratio and increases the probability that additional failures will

push a fund’s reserve ratio below the DRR, resulting in a rapid increase in premiums for all

institutions.
5

C. Volatile Premiums That Are Likely To Rise Substantially In An Economic

Downturn.

The rules governing the operation of the current deposit insurance system are focused on

maintaining the 1.25 percent DRR at the expense of volatile premiums. In particular, as

discussed above, when the DRR falls below 1.25, the FDIC must charge premiums of at least

23 basis points, unless a lower premium would be sufficient to restore the reserve ratio to the

DRR within one year. Since bank failures and hence FDIC insurance expenditures are most

likely to occur in an economic downturn, a fund is most likely to drop below the DRR in an

economic slowdown or recession.

This means that banks are likely to be faced with very steep deposit insurance payments

when earnings are already depressed. Such premiums would divert billions of dollars out of

the banking system and raise the cost of gathering deposits at a time when credit already

might be tight. This, in turn, could cause a further cutback in credit, resulting in a further

slowdown of economic activity at precisely the wrong time in the business cycle.

D. Deposit Coverage Does Not Keep Pace With Inflation in a Predictable Fashion.

One of the purposes of deposit insurance is to provide depositors with a safe place to invest

without the burden of monitoring their banks. Over time, inflation eats away at the value of

deposit insurance. Unlike other government programs such as Social Security, Medicare,

and even taxes, deposit insurance is not indexed to inflation. Although Congress has

periodically adjusted the coverage level (the current level of $100,000 was set in 1980), both

the timing and the size of these adjustments have been unpredictable.
6

IV. RECOMMENDATIONS FOR REFORMING

 THE DEPOSIT INSURANCE SYSTEM

To address the existing weaknesses in the deposit insurance system, the FDIC recommends

the following reforms:

• The BIF and the SAIF should be merged.

• The current statutory restrictions on the FDIC’s ability to charge risk-based premiums to

all institutions should be eliminated; the FDIC should charge regular premiums for risk

regardless of the level of the fund.

• Sharp premium swings triggered by deviations from the DRR should be eliminated. If

the fund falls below a target level, premiums should increase gradually. If it grows

above a target level, funds should be rebated gradually.

• Rebates should be based on past contributions to the fund, not the current assessment

base.

• The coverage level should be indexed to keep pace with inflation.

The FDIC does not view deposit insurance reform as a revenue-raising exercise. The FDIC’s

proposals related to pricing are not intended to increase the assessment burden, but to spread

that burden more evenly over time and more fairly across institutions.

All of the proposed reforms would require statutory changes.5 They should be implemented

as a package. Picking or choosing one part without the others could well weaken the deposit

insurance system. For example, raising coverage with no change to the pricing system would

exacerbate the distortion of incentives that already exists. Paying rebates without risk-based

pricing for all institutions would increase the need to raise premiums in bad times. And a

poorly designed rebate system could negate the benefits of any deposit insurance pricing

system, and make incentive problems much worse than they are now. For example, giving

rebates proportional to a bank’s current assessable deposits could give banks an incentive to

grow in order to increase the amount of their rebate.

This section presents the FDIC’s recommendations in more detail and discusses some of the

issues pertaining to implementing the reforms. The numerical examples are for illustrative

purposes, and are intended to help readers understand the implementation issues involved

with the proposals and the effect they might have on banks and the insurance fund. The

FDIC recognizes the need for an ongoing discussion to work out the best implementation of

these reforms and looks forward to working with the Congress, the industry and the public to

improve the deposit insurance system.

 

5

 The FDIC has the statutory authority to change at any time the assessment rates for institutions that are not

well capitalized or do not have one of the two best examination ratings. Changing the assessment rates for this

group of banks, which currently comprises about eight percent of insured institutions, would not address the

problems with the current deposit insurance system described in this paper.
7

Other important issues were raised in the Options Paper and merit further analysis. These

issues include the systemic-risk exception as provided by FDICIA, the pricing of the full

faith and credit guarantee for the insurance funds, simplification of the deposit insurance

rules, and opportunities for FDIC risk-sharing and price discovery through reinsurance and

the capital markets. The FDIC intends to do further work on these issues.

A. Recommendation: The BIF and the SAIF Should be Merged Now.

As discussed above, the BIF and the SAIF offer an identical product. Yet, as long as there

are two separate funds, the potential for a premium disparity and competitive inequality

exists. In addition, a merged fund, as depicted in Table 3, would be stronger and better

diversified than either fund standing alone.

Moreover, many institutions currently hold both BIF- and SAIF-insured deposits. The SAIF

has truly become a hybrid fund, with more than 40 percent of SAIF-insured deposits now

held by commercial banks. The costs to insured institutions associated with tracking their

BIF and SAIF deposits separately, and the complications this introduces for mergers and

acquisitions, could be eliminated by merging the funds.

B. Recommendation: The Current Statutory Restrictions on the FDIC’s Ability to

Charge Risk-Based Premiums to All Institutions Should Be Eliminated; the FDIC

Should Charge Regular Premiums for Risk Regardless of the Level of the Fund.

Under the current assessment system almost all banks pay the same premium, zero, when the

fund exceeds the DRR. This system both underprices risk and fails to differentiate

adequately among banks according to risk. Current law restricts the FDIC from charging

premiums to most banks that are well capitalized and highly rated. This restriction should be

eliminated.

Table 3 - A Merged Fund Would Be Stronger than Two Separate

Funds

(preliminary data, 12/31/00)

Bank Data BIF SAIF Merged BIF 

and SAIF

Number of Fund Member Banks 8,572* 1,333 9,905

Median Asset Size ($ millions) $81 $124 $86

Assessment Base ($ billions) $3,327 $823 $4,150

Total Insured Deposits ($ billions) $2,302 $753 $3,055

Insurance Fund Data

Fund Balance ($ billions) $31 $11 $42

Reserve Ratio 1.35% 1.44% 1.37%

*Excludes insured branches of foreign banks.
8

Deposit insurance premiums should reflect expected losses, that is, premiums from a risk

group should cover losses the group experiences on average.6 An implication of this

approach is that since all banks present some risk, all banks should pay at least some deposit

insurance premium.

Ideally, risk-based premiums should be forward looking. That is, premiums should be based

on expected future losses over a specified time horizon. A bank engaging in risky activity

may have a very low probability of failing within the next year but a much higher probability

of failing over a longer period that encompasses changes in the economic cycle or the

maturing of its risk assets—primarily loans. These considerations suggest that a time horizon

longer than one year, perhaps on the order of three to five years, is probably appropriate.

A second issue in determining risk-based premiums is estimating expected losses over a

longer time horizon, such as five years. There are a number of ways to do this. One could

extrapolate current economic conditions or try to predict the business cycle. However, such

an approach might lead to premium volatility as economic conditions change or change in

ways that are not anticipated. An alternative approach is to allow for a representative range

of past business conditions.

Table 4 shows estimated risk-based premiums for the current nine-cell pricing matrix based

on a five-year time horizon and failure and insurance loss rates over the 15-year period from

1984 to 1999. This period saw both banking crisis and economic boom and thus contains a

range of business conditions.

This simple example illustrates a fundamental consideration in pricing deposit insurance:

expected loss premiums for the riskiest banks are likely to be so high that they could cause

additional failures. As a realistic measure, such premiums will have to be capped and some

portion of the cost borne by less risky institutions.

The FDIC has devoted considerable attention to how best to differentiate banks by risk for

purposes of setting deposit insurance premiums—in particular, how to differentiate among

 

6

 This statement implicitly assumes that the FDIC is risk-neutral. We considered and rejected trying to impose

assessments that had a risk premium analogous to what a risk-averse private investor would demand. Such

premiums would be much higher and more volatile.

Table 4 – Unrestricted Risk-Based

Premiums in a Nine-Cell Matrix

(1984-1999)

Capital

A B C

1. Well Capitalized 3.7 8.9 17.8

2. Adequately Capitalized 10.3 20.7 50.3

3. Undercapitalized 19.8 41.6 96.8

Supervisory
9

banks currently assigned to the best, or 1A, risk category. A straightforward way would be

to use CAMELS ratings (1s versus 2s). There are, however, some drawbacks to this

approach. Because there is an 18-month statutory examination cycle, a system based

primarily on changes in CAMELS ratings may not be sufficiently responsive to changing

conditions. The CAMELS approach might also raise concerns about subjectivity in the

assignment of ratings.

Another approach to differentiating banks by risk is to use a statistical model that uses

examination ratings, financial ratios and, for large banks, possibly certain market signals as

inputs to project failure rates. Such a model could be used to develop a scorecard that would

slot banks into risk categories. In the private sector, similar modeling approaches are used to

score loan applicants or estimate default rates on obligations of public or private companies.

Table 5 provides an example of such a scoring model. The scorecard in Table 5 was derived

from a statistical failure-prediction model similar to those used to generate credit scores, with

the weights based on the explanatory power of the variables.7 Again, this scorecard is

presented for illustrative purposes. Many additional variables, such as loan concentrations,

off-balance-sheet exposures, and liability structures, are candidates for inclusion in the

model.8 New banks less than five years old were not scored by the model because of their

unique financial characteristics. For large, complex financial institutions, it may be

advantageous to develop a separate approach, possibly including market data such as stock or

bond prices. Finally, additional work is needed on the treatment of fast-growing institutions,

in particular whether risky growth should be determined objectively as it is in this example,

or subjectively through the supervisory process.

A scoring model developed along these lines could be used to score all institutions and

replace the current nine-cell matrix entirely. Such an approach is promising. However, to

keep things simple in the example below, the scorecard is used only to disaggregate the 1A

category into three separate risk categories as follows:

• Group 1a+: Score of 3 or less

• Group 1a (new): Score of 4 or 5

• Group 1a–: Score of greater than 5, plus all current 1A banks less than five years old

Table 6 gives an example of such a matrix.

 

7

 The weight on asset growth was assigned judgmentally. A 40 percent annual asset growth rate is

approximately the 98th percentile of asset growth for all banks during the years 1985 to 1999.

8

 James Marino and Rosalind Bennett, “The Consequences of National Depositor Preference,” FDIC Banking

Review 12(2), October 1999, pp. 19–38.
10

Table 5 - Pricing Deposit Insurance with a Scoring Model

The Risk Scorecard is intended for established banks and banks other than large, complex banking

organizations.

Scoring Factors Range of Scores Maximum Score

 CAMELS = 1 0

 CAMELS = 2 1

 CAMELS = 3 4

 CAMELS = 4 15

 CAMELS = 5 50 50

 Equity to Assets > 12% 0

 Equity to Assets = 6% to 12% 1

 Equity to Assets < 6% 14 14

 Net Income to Total Assets > 1.25% 0

 Net Income to Total Assets = 0.65% to 1.25% 1

 Net Income to Total Assets = 0% to 0.65% 2

 Net Income to Total Assets < 0% 10 10

 Nonperforming Loans to Total Assets < 1% 0

 Nonperforming Loans to Total Assets = 1% to 3% 2

 Nonperforming Loans to Total Assets > 3% 10 10

 ORE to Total Assets < 1% 0

 ORE to Total Assets = 1% to 3% 2

 ORE to Total Assets > 3% 6 6

 Noncore Funding to Total Assets < 15% 0

 Noncore Funding to Total Assets = 15% to 30% 1

 Noncore Funding to Total Assets > 30% 3 3

 Liquid Assets to Total Assets > 50% 0

 Liquid Assets to Total Assets = 30% to 50% 1

 Liquid Assets to Total Assets < 30% 2 2

 Asset Growth < 40% 0

 Asset Growth > 40% 5 5

 Total 100

 If Bank is 1A and Total Score is 3 or less classify as: 1a+

 If Bank is 1A and Total Score is 4 or 5 classify as: 1a 

 If Bank is 1A and Total Score is greater than 5 classify as: 1aApplication of Scoring Framework
11

In Table 6, the assessment rates for the riskiest institutions are considerably below those

shown in Table 4. The rates have been capped in this example to reflect the concern over

rates being so high as to cause additional failures, as discussed earlier.

By disaggregating the 1A category, 92 percent of the industry no longer pays the same

assessment rate. As shown in Table 7, 42.7 percent of institutions would still find themselves

in the lowest-risk category, 1a+; an additional 26.5 percent would be in the new 1a category;

while 23 percent would be in the 1a– category.

For purposes of illustration, Tables 6 and 7 include large, complex institutions. They also

include institutions chartered over the past five years, which were put in the 1a– category.

Premiums for new institutions, based on insurance losses from 1985 to 1999, would exceed

20 basis points during their first five years. This is much higher than the 6 basis points that

would be charged 1a– institutions in Table 6. The treatment of new banks in Table 6 is

intended to reflect a balance between the goals of risk-based pricing, on the one hand, and the

disinclination to deter new bank formation unduly, on the other.

Table 7 also shows the distribution of the assessment base by risk categories. On the basis of

this distribution, the FDIC would gather $1.4 billion in annual premiums, for an industry

average assessment rate of 3.5 basis points. Significantly, 3.5 basis points is just about the

effective premium rate the FDIC charged from 1950 to 1980.

Capital Group

1. Well Number of Banks 4,233 42.7% 2,634 26.5% 2,282 23.0% 485 4.9% 70 0.7%

Base ($ billions) 1,579.6 38.0% 1,323.7 31.8% 1,104.0 26.5% 85.6 2.1% 13.8 0.3%

2. Adequate Number of Banks 172 1.7% 25 0.3% 11 0.1%

Base ($ billions) 41.8 1.0% 5.4 0.1% 4.5 0.1%

3. Under Number of Banks 4 0.0% 2 0.0% 6 0.1%

Base ($ billions) 0.6 0.0% 0.2 0.0% 0.5 0.0%

Total Revenue ($ billions) = 1.4

Effective Rate (basis points) = 3.5

Supervisory Subgroups

Table 7 - Distribution of Banks and the Assessment Base with a Modified 1A Category, December 31, 2000

A B C

1a+ 1a 1aCapital Group B C

1a+ 1a 1a1. Well Capitalized 1 3 6 12 25

2. Adequately Capitalized 25 30

3. Undercapitalized 30 40

12

25

Supervisory Subgroups

Table 6 - Assessment Rates Based on Modified 1A Category

A
12

C. Recommendation: Sharp premium swings triggered by deviations from the DRR

should be eliminated. If the fund falls below a target level, premiums should

increase gradually. If it grows above a target level, funds should be rebated

gradually.

The emphasis of the current deposit insurance system on maintaining the 1.25 percent DRR

creates the potential for volatile premiums. This is likely to result in the industry paying high

premiums when both banks and the economy can least afford it. The deposit insurance

system should work to smooth economic cycles, not exacerbate them. It would be preferable

for the fund to absorb some losses and for premiums to adjust gradually. This can be

accomplished by establishing a target for the fund. If the fund varied from the target,

surcharges or rebates would be used to bring the fund back to the target gradually. The target

could be a range within which premiums would be constant. Alternatively, it could be a

fixed reserve ratio such as the current DRR.

For example, the reserve ratio could be allowed to vary between 1.15 percent and 1.35

percent. Banks would pay risk-based premiums such as those in Table 6 with no rebates or

surcharges so long as the reserve ratio remained within the range. If the fund fell below 1.15

percent of insured deposits, there would be a surcharge equal to, for example, 30 percent of

the difference between the reserve ratio and 1.15 percent. If the fund rose above 1.35

percent, there would be a rebate equal to 30 percent of the difference between the reserve

ratio and 1.35 percent. Thus, there would be a range of plus or minus 10 basis points around

1.25 percent within which the fund would be allowed to fluctuate without rebates or

surcharges. The range could be larger or smaller.

Alternatively, one can imagine a fixed reserve ratio of 1.25 percent, with rebates or

surcharges equal to 30 percent or some smaller percentage of the difference between the

reserve ratio and 1.25 percent. A smaller percentage may be appropriate given that the

adjustments start immediately.

There are trade-offs between a range on the one hand and a fixed reserve ratio on the other

(the same trade-offs exist to a lesser extent between a larger or smaller range). Other things

equal, a range has the advantage of generally being less procyclical. It takes longer before

surcharges kick in, and allowing the fund to build higher before rebates creates a bigger

cushion to absorb losses. On the other hand, a fixed reserve ratio results in surcharges

whenever the fund is below a particular ratio and rebates whenever the fund is above that

ratio. As discussed below, rebates based on past contributions to the fund are one of the

ways the FDIC’s reform proposal deals with fast growers and new entrants taking advantage

of a fund built up by others.

Whether the target is a fixed reserve ratio or a range, determining the target is equivalent to

asking what is the appropriate size of the insurance fund. There is no one correct answer to

this question, because it involves a trade-off between two important policy goals. The

smaller the fund, the higher premiums will need to be under adverse scenarios in order to

maintain the solvency of the fund. On the other hand, if the goal is to avoid any risk of

insolvency, even from the proverbial “hundred-year flood,” the fund would probably have to

be quite high. Although a large fund would protect the taxpayer from any loss, it would do
13

so at the cost of taking funds out of the banking system that could otherwise be used to

provide credit. On balance, the existing 1.25 percent reserve ratio target that Congress has

selected does not appear to be a bad starting place, either as a fixed target or as the midpoint

of a range.

The framework proposed by the FDIC relies on surcharges and rebates to bring the fund back

toward a target. The current statutory target, the DRR, is defined relative to insured deposits,

and for simplicity the examples presented here are based on targets tied to insured deposits.

The target could be expressed analytically, in terms of the risk exposure of the fund. For

example, something akin to a credit rating could be calculated and the FDIC could be

required to maintain an investment grade credit rating.

There is also the question of how surcharges and rebates should be allocated across banks.

With respect to surcharges there is no reason that they should not be assessed against the

current assessment base. For example, if there were a 2-basis-point surcharge, then the bestrated bank with $100 million in assessable deposits would pay a risk-based premium of 1

basis point, or $10,000 plus a $20,000 surcharge, for an effective premium rate of 3 basis

points. The one exception to this rule might be for the worst-rated institutions. As discussed

earlier, there is concern that premiums could get so high that they could push institutions that

might otherwise have survived into failure. Because of this concern, the surcharges for the

riskiest institutions may have to be capped or scaled back.

Rebates are a different matter. Tying rebates to the current assessment base could give

insured institutions an incentive to grow simply to get a larger rebate. This would exacerbate

moral hazard. In the next section, we discuss the FDIC’s recommendation that rebates not be

tied to the current assessment base.

Finally, one more issue should be addressed. What if the fund keeps on growing or shrinking

despite the rebates or surcharges designed to slow its movement away from the target? A

deposit insurance fund serves vital purposes—protecting taxpayers from loss, ensuring that

adequate resources are readily available when problems arise, and helping to smooth the

costs of deposit insurance over time. However, maintaining a fund involves a trade-off, as

noted earlier, since money in the fund could also be put to useful purposes by the banking

industry. At some point when the fund is growing, the balance may tip in favor of returning

funds to the banking industry rather than retaining them in the deposit insurance fund.

Similarly, as a fund continues to shrink, at some point it may be appropriate for banks to

provide more support for the fund. One might consider a cap on the fund above which all

funds are rebated to the industry or a floor below which all losses would have to be made up

by the industry quickly.

How would all this work? Chart 1 shows the level of the fund under three economic

scenarios—no loss, moderate loss, and high loss. The high-loss scenario is based on the

percentage losses suffered by the BIF during the last banking crisis. The moderate-loss

scenario is based on losses one-quarter the amount suffered during the last crisis. Losses do

not reflect the reserves set aside by the FDIC for losses on banks that did not actually fail

during the crisis period, and this fact moderates the effect on the reserve ratio in Chart 1. The

chart is based on the assessment structure with a target range as discussed above; the results
14

would be similar if it were based on a fixed reserve ratio. Base premiums are set in

accordance with the risk-based premium rates in Table 6. The fund is allowed to fluctuate

between 1.15 percent and 1.35 percent. When it falls outside this range, there are surcharges

and rebates equal to 30 percent of the difference between the reserve ratio and the lower and

upper bounds of the range, respectively.

Chart 1 illustrates that the fund fluctuates over a much larger range than the 1.15 to 1.35

percent range, depending on economic conditions. But, even with no insurance losses for 10

years the fund never quite reaches 1.5 percent of insured deposits. Gradual rebates are

sufficient to prevent the fund from growing without bound.

What happens to premiums, especially in the high-loss scenario, where there are substantial

surcharges? Chart 2 shows the effective premiums that would be paid by a 1a+ institution in

a high-loss scenario under the current premium system and under the revised system

proposed above. The difference is striking and demonstrates how the proposed system helps

to dampen volatile premiums. Instead of premiums rising rapidly from zero to 23 basis

points, remaining at 23 basis points for a number of years, and then falling back to zero,

premiums rise gradually from 1 basis point to about 10.5 basis points and then decrease

gradually to about 2 basis points at the end of the 10-year period. Similar results hold for

other 1A institutions. For example, for 1a– institutions, premiums would peak at about 15.5

basis points as opposed to 23 basis points under the status quo. Because the insurance fund

would be allowed to absorb more losses under the proposed system, billions of additional

dollars would be available to the banking industry to help fuel economic growth in the trough

of the business cycle.

Chart 1 - Merged Fund Reserve Ratios under

Various Loss Scenarios

The “ High-Loss Scenario” and the “ Moderate-Loss Scenario” assume losses at 100

percent and 25 percent, respectively, of the actual insurance losses (without reserves),

in the last banking crisis. Reserve Ratio (%)

0.50%

0.60%

0.70%

0.80%

0.90%

1.00%

1.10%

1.20%

1.30%

1.40%

1.50%

1.60%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Zero-Loss Scenario

High-Loss Scenario

Moderate-Loss Scenario
15

D. Recommendation: Rebates should be based on past contributions to the fund, not

on the current assessment base.

Rebates are an important part of a deposit insurance system if the FDIC is to charge positive

risk-based deposit insurance premiums at all times and yet avoid enormous growth of the

insurance fund during long stretches of good years. As demonstrated above, even gradual

rebates can serve to limit the growth of the fund. However, it is important that rebates not

create perverse economic incentives. Rebates tied to the current assessment base would, in

effect, represent a decrease in the cost of insurance. This would increase moral hazard. As

discussed earlier, with rebates tied to the current assessment base, banks that grew the fastest

would get the largest rebates, other things equal.

If premiums are not based on the current assessment base, there are two questions: (1) How

should rebates initially be allocated? (2) How should that allocation change over time as

more and different banks pay into the system?

With respect to the initial allocation, fairness dictates that it be based on past contributions to

the fund. Basing rebates on past contributions raises certain issues: how far back in time to

look for determining the past contributions (the data only go to 1984); how to treat mergers

and failing bank acquisitions; and how to account for the SAIF capitalization. None of these

problems is insurmountable, however, and one could come up with reasonable rules for

determining the initial allocation of any rebates.

The next question is how that allocation would change over time. One possibility is to track

premiums received and rebates paid, so that, at any point in time, rebates could be calculated

on the basis of past payments to the fund. A crucial issue here is how far back banks are

given credit for premiums they paid for purposes of calculating their rebates. If there is no

limit on this look-back period, it would take decades for a new bank’s rebate share to “catch

up” with its older competitors. An alternative would be to base rebates on a bank’s share of

total premiums paid over a period of years. Such a system might be based on premiums paid

Chart 2 – Effective Assessment Rates under a HighLoss Scenario for Banks in the 1a+ Category

0.0

3.0

6.0

9.0

12.0

15.0

18.0

21.0

24.0

27.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Basis points

Alternative

Status Quo
16

over the last five years, or to give current deposit growth less weight, rebates could be based

on premiums paid between five and 10 years ago. In such a case, rebates in, say, 2010 would

be based on premiums paid between 2001 and 2005. In any case, the longer the lag, the

longer it will take new institutions to catch up.

There are two additional factors to take into account in designing a rebate system. First, to

prevent anomalous results, each bank might be required to maintain a positive “net credit

balance” with respect to the FDIC. That is, premiums paid minus rebates received over some

defined number of years should never be negative. Second, there is a question whether the

additional premium a bank pays because of its above-average risk category should count

toward a rebate. One possibility is to give banks credit only for premiums they would have

paid had they been classified among the safest banks.

Table 8 contains an example that helps clarify how rebates might work. It compares

premiums and rebates for two banks under the moderate-loss scenario. As in the previous

examples, rebates equal to 30 percent of the difference between the reserve ratio and 1.35

percent are paid when the reserve ratio exceeds the upper end of the range. Rebates are

initially allocated by past payments to the funds. After five years, they are determined by

premiums paid in during the previous five to 10 years.

The first bank is a hypothetical 1a+ bank with $100 million in deposits that are growing at 3

percent a year. Base premiums are 1 basis point a year. Since, as can be seen in Chart 1,

under the moderate-loss scenario, the reserve ratio exceeds 1.35 every year, rebates are paid

every year. Initially, rebates for this institution exceed premiums so there is a net cash flow

from the FDIC to the bank. As the reserve ratio falls, rebates get smaller. For a number of

years, the bank pays the FDIC more than it receives in rebates. Then, as FDIC insurance

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Base Premium $10,000 $10,300 $10,609 $10,927 $11,255 $11,593 $11,941 $12,299 $12,668 $13,048

(Rebate) or Surcharge ($13,757) ($16,752) ($6,595) ($4,946) ($3,336) ($7,657) ($18,887) ($26,929) ($31,901) ($33,894)

Net Cash Flow ($3,757) ($6,452) $4,014 $5,982 $7,919 $3,936 ($6,947) ($14,630) ($19,234) ($20,846)

Net Cash Flow (bp) (0.4) (0.6) 0.4 0.5 0.7 0.3 (0.6) (1.2) (1.5) (1.6)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Base Premium $100,000 $103,000 $106,090 $109,273 $112,551 $115,927 $119,405 $122,987 $126,677 $130,477

(Rebate) or Surcharge ($13,757) ($16,752) ($6,595) ($4,946) ($3,336) ($15,314) ($75,549) ($161,575) ($255,210) ($338,939)

Net Cash Flow $86,243 $86,248 $99,495 $104,327 $109,214 $100,613 $43,857 ($38,588) ($128,533) ($208,461)

Net Cash Flow (bp) 0.9 0.8 0.9 1.0 1.0 0.9 0.4 (0.3) (1.0) (1.6)

$1 Billion 1a+ 

Previous Fast 

Grower

Moderate Loss (Last Crisis x 1/4)

Note: Rebate rule assumes banks' rebate shares are determined by the percentage of total premiums they paid during a period of time in the past, in this example the period 

between ten years before the current assessment period and five years before the assessment period.

Cash Flows for a Pevious Fast-Growing $1 Billion Institution Growing at 3 Percent per Year

(30% Rebate)

Table 8

(30% Rebate)

$100 Million 

1a+

Moderate Loss (Last Crisis x 1/4)

 Cash Flows for a $100 Million Institution Growing at 3 Percent per Year
17

losses decrease, rebates increase again and the bank once again gets a net cash flow from the

FDIC.

The second bank was once a $100 million bank, but it has grown very rapidly over the last

few years and now has $1 billion in deposits. Its growth has since slowed and it is now

growing at 3 percent a year. The bank is also rated 1a+, so it also pays premiums of 1 basis

point a year, but since it is 10 times the size of the first bank, its premiums are 10 times those

of the first bank. Rebates are based on past contributions to the fund, and since the bank used

to be a $100 million bank, we assume that it paid in the same amount as the first bank. Thus,

for the first five years, both banks receive identical rebates. The premiums paid by the

second bank far and away exceed its rebates for the first five years, and for those five years,

its net cash flow is not substantially lower than its assessments. After five years the second

bank begins to get credit for its higher premiums, and by the end of 10 years it has caught

up—both its premiums and rebates are 10 times those of the small bank.

Rapidly Growing Institutions

Recent developments have highlighted the concern raised by rapidly growing institutions that

dilute the reserve ratio and pay nothing for deposit insurance. The FDIC’s recommendations

would address this issue in several ways. First, under the assessment system described

above, a decrease in the reserve ratio has, at most, a gradual effect on net payments. This

means the effect of new deposit growth on other insured institutions would be substantially

diminished.

Second, regular risk-based premiums for all banks would mean that fast-growing institutions

would pay increasingly larger premiums as they gathered deposits. In addition, fast growth,

if it posed greater risk, could result in additional premiums through the operation of the

FDIC’s expanded discretion to price risk.

Finally, as described with respect to Table 8 above, with rebates based upon past

contributions, when the FDIC is paying rebates, net payments to the FDIC from fast growers

would be greater than for established institutions or slower growers. Over time, as all

institutions paid assessments (and as rebates were made on the basis of past assessments),

funds from more recent assessments would replace funds from older assessments and new

institutions would become eligible for rebates based on the premium they paid.

E. Recommendation: The deposit insurance coverage level should be indexed to

maintain its real value.

As noted earlier, a primary purpose of deposit insurance is to give depositors a safe place to

save, invest and manage their accounts without the burden of monitoring the financial

condition of their banks. Federal deposit insurance is important, not only to individuals and

families, but also to the many small businesses, charities and local governments that

commonly rely on local financial institutions. The level of coverage has been changed by

Congress six times since the inception of the system in 1934 and, generally, those increases
18

have kept pace with or exceeded inflation. However, in the past 20 years, the real value of

the current $100,000 coverage level has fallen by about half (based on the Consumer Price

Index, or CPI). The real value is now less than it was in 1974, when the nominal coverage

level was increased to $40,000.

Deposit insurance is an important element of the government’s overall effort to promote

public confidence in the banking system and, as such, it should not be allowed to erode in

value. There are two ways of maintaining the real value of the deposit insurance coverage

level. One way is through ad hoc increases. As shown in Table 9, this is what has been done

in the past.

The alternative is a more systematic method of maintaining the real value of the coverage

level through an indexing system. An indexing system can increase predictability and lessen

the potential for large, sudden increases. Bankers and depositors would be able to predict the

timing and magnitude of coverage level increases better. This predictability would enhance

financial planning on the part of depositors and facilitate bankers’ planning when coverage

changes occur, thereby lowering costs. Other important government programs, such as Social

Security, Medicare, and even taxes, are indexed to maintain their real value. Federal deposit

insurance should be treated in the same fashion, once the Congress determines the initial

coverage level.

Indexing

Given an initial coverage level, two questions must be answered in order to implement

indexing: What index should be used, and when should the level be adjusted? Possible

indices are numerous, and include price, wealth, and income indices. For pragmatic reasons

the FDIC believes the CPI would be appropriate. It is widely understood and accepted and is

quickly available. It also captures inflation reasonably well.

Year Amount

Percent 

Increase

Years 

from Last 

Increase

Value of 

Coverage 

(1980 Dollars)*

1934 (January) $2,500 --- --- $15,373

1934 (June) 5,000 100 0.5 30,746

1950 10,000 100 16 34,191

1966 15,000 50 16 38,148

1969 20,000 33 3 44,905

1974 40,000 100 5 66,856

1980 100,000 150 6 100,000

2000 100,000 --- 20 43,728

* Indexed using the CPI.

Table 9 – Nominal Deposit Insurance Levels
19

There are many possible rules for deciding when to increase the coverage level, including the

passage of time and significant declines in the level’s real value. A combination of a

minimum period of time between level increases and a minimum percentage decline in the

value of the level seems to work best. Because changing the level can impose burdens on

banks and thrifts (for example, by requiring new training for employees and changes to signs

and advertising materials), input from the industry is needed on what the minimum time

period and necessary percentage declines should be.

Chart 3 shows an example of a CPI-based indexing system. A number of starting points

could have been selected. Starting with today, the initial coverage level would be $100,000.

Starting with 1980, the level would be approximately $200,000. The example in Chart 3

shows how the system would have worked if implemented in 1974, when the coverage level

was $40,000. In the example, the coverage level is adjusted no earlier than every five years

and only if the real value drops below 80 percent of the previous level. Using these rules

with 1974 as a base year would have produced a coverage level today of approximately

$135,000.

Such a system could have a safety-valve feature for periods of extraordinary inflation. For

example, if coverage erodes in value by more than 25 percent over any three-year period, the

level could be adjusted.

The FDIC believes that coverage levels should be in round numbers (for example, to the

nearest $5,000) and should not be allowed to decrease. A decline in the coverage level

would put a burden on the public to monitor the level to avoid becoming uninsured, and, by

creating uncertainty, could undermine the purpose of deposit insurance.

Chart 3 – Deposit Insurance Indexing System that

Adjusts Coverage No Earlier than Five Years and

Only When the Real Value Drops below 80 Percent.

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

1974 1979 1984 1989 1994 1999

Dollars

Simulated Insurance Limits

Constant 2000 Dollars
20

The Starting Point for the Coverage Level

As noted earlier, one of the purposes of deposit insurance is to give depositors a safe place to

invest without the burden of monitoring the financial condition of their banks. What level of

coverage is appropriate for this purpose is open to debate and, in the view of the FDIC, is

appropriately reserved for the Congress to determine. In deciding the starting point for the

coverage level, there are a number of factors to consider. The remainder of this section

provides information and perspective on several of the relevant factors.9

Adequacy of the current level. As noted earlier, since 1980, the real value of the coverage

level, based on the CPI, has fallen by about half. The real value of the level is now less than

it was in 1974, when the nominal coverage level was $40,000

A recent household survey that the FDIC commissioned from the Gallup Organization found

that nearly half (47 percent) of households (specifically, those members most knowledgeable

about the finances of the household) believe the level should be raised, while only 27 percent

of households believe that the insurance level is at the appropriate level today. On the other

hand, in an American Bankers Association (ABA) survey of high-wealth households, only 30

percent said that the current level of FDIC insurance is too low.

Households are not the only depositors to consider. Many businesses, including small

businesses, have a need for deposit accounts exceeding $100,000. In a survey of smallbusiness owners conducted by the ABA, 49 percent thought that the $100,000 deposit

insurance level was too low.

Moral hazard. The 1980 increase in deposit insurance coverage to $100,000 is widely

viewed as playing a role in the ensuing savings-and-loan crisis. The increase in coverage to

$100,000, combined with lifting Regulation Q ceilings at the same time, facilitated an influx

of deposits into thrifts.10 Whether the higher coverage level increased moral hazard is

uncertain, however. Many factors contributed to the savings-and-loan crisis, and the

confluence of these factors likely explains the magnitude of the crisis.11

It is clear, however, that regulatory practices in the 1980s imposed inadequate restraints on

moral hazard,12 whether higher coverage levels increased moral hazard or not. FDICIA

attempted to address the regulatory failures of the 1980s by granting new tools to regulators,

while restricting their discretion in using the tools. Among other things, FDICIA introduced

prompt corrective action and higher capital requirements, and greatly restricted “too-big-tofail” practices. These tools have not been tested in a downturn, but are designed to

counteract moral hazard.13

 

9

 For additional information, see the FDIC “Deposit Insurance Options Paper,” pp. 35–49.

10 The Depository Institutions Deregulation and Monetary Control Act of 1980 began the process of lifting the

old Regulation Q ceiling on the interest rates that banks could offer depositors.

11 Federal Deposit Insurance Corporation. History of the Eighties—Lessons for the Future: An Examination of

the Banking Crises of the 1980s and Early 1990s. FDIC, 1997.

12 George Hanc, “Deposit Insurance Reform: State of the Debate.” FDIC Banking Review 12(3), 1999, p. 4.

13 As discussed earlier, FDICIA’s concept of a DRR (as altered by subsequent legislation) has increased moral

hazard by eliminating deposit insurance premiums for most banks.
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In addition, the deposit insurance reforms recommended in this paper would go a long way

toward mitigating any increase in moral hazard that might stem from raising the deposit

insurance coverage level. The primary problems associated with an increase in coverage

arise from underpriced deposit insurance. Raising coverage without addressing this issue

would exacerbate the pricing flaws in the system.

Nevertheless, the potential remains for higher coverage levels to facilitate deposit-gathering

by institutions that engage in high-risk activities. An increase in insurance levels would tend

to reduce the cost of rapidly gathering large amounts of insured funds and therefore might

accelerate the use of brokered funds and similar techniques. In principle, banks could gather

the same amount of funds under the existing level by attracting more brokered deposits, but

an increase in the level might make it easier for investors to place large amounts into insured

deposits directly without the use of brokers, a form of self-directed "hot" money.

Municipal deposits, IRAs, and excess coverage. Some have suggested that higher coverage

levels would be appropriate for certain types of deposits. The potential benefits and

consequences of favoring some deposits with higher coverage levels are uncertain. It is the

FDIC’s view that these proposals should be explored further, through additional analysis and

discussions among the interested parties.

• Public entities typically require banks to pledge low-risk securities to protect the portion

of municipal deposits that is not insured by the FDIC. Analysis of Call Report data

suggests that smaller institutions are pledging an increasing percentage of their securities

in order to hold public deposits. This trend may imply that smaller institutions are

becoming increasingly constrained in their investment options. Raising the coverage

level on public deposits could provide banks with more latitude to invest in other assets,

including loans. Higher coverage levels might also help community banks compete for

public deposits and reduce administrative costs associated with securing these deposits.

On the other hand, the collateralization requirement places a limit on the ability of riskier

institutions to attract public funds, while a high deposit insurance limit would not.

• Because retirement accounts tend to be long-term investments, over time they can reach

relatively large balances that exceed the coverage provided by FDIC insurance. Thus,

raising the coverage level on IRAs could encourage depositors to invest more of their

retirement savings in insured bank deposits. Because these deposits are usually held for

the long term, they may be less likely to shift to riskier institutions in response to higher

yields or other attempts to gather deposits quickly.

• A small number of private-sector insurance companies offer excess deposit insurance

coverage for a fee. The demand for this product is currently described by some providers

as minimal to moderate. However, demand was higher during the banking crises of the

1980s and early 1990s and could increase during future downturns. Some banks have

expressed a willingness to pay an additional premium to increase FDIC insurance

coverage in order to retain existing large deposits or obtain new deposits. The FDIC

believes that additional analysis is warranted to explore the possibilities for providing

excess coverage or backstopping the coverage provided by private insurers.
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V. CONCLUSION

The FDIC’s recommendations are as follows:

• The BIF and the SAIF should be merged.

• The current statutory restrictions on the FDIC’s ability to charge risk-based premiums to

all institutions should be eliminated; the FDIC should charge regular premiums for risk

regardless of the level of the fund.

• Sharp premium swings triggered by deviations from the DRR should be eliminated. If

the fund falls below a target level, premiums should increase gradually. If it grows

above a target level, funds should be rebated gradually.

• Rebates should be based on past contributions to the fund, not the current assessment

base.

• The coverage level should be indexed to keep pace with inflation.

These reforms will make the deposit insurance system function more efficiently and fairly, in

a way that provides the appropriate economic incentives for all of the participants.

As indicated earlier, this set of recommendations should be implemented as a package. The

proposed reforms are interrelated, so that picking and choosing could easily produce

unintended consequences or make things worse.

Implementation of these reforms presents complicated issues. The FDIC looks forward to

working with the Congress, the banking industry and the public to improve the deposit

insurance system.