Federal Deposit Insurance Corporation 

CI Minn: I n 

L. William Seidman 

OfHue of Research 

mid Stiitisties. 

Director 

Wm. Roger Watson 

Editor 

John F. liovenxi 

Editoriiil Conn 

Frederick S. Cams 

Man S. McCall 

Lynn A. Nejezchleh 

in ii i is trative 

Malinger 

Delia Voesar 

Editorial Secretary 

Ciithy Wright 

Design and PiiHluction 

Design anil Printing 

Unit 

The views expressed are 

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do not necessarily reflect 

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FDIG 

Bankin; 

Review Fall 1988 

Vol. 1, No. 1 

Resolution Costs of Bank Failures page 1 

by John F. Bovcnzi and Arthur J. Murton 

The FDIC's failure-resolution costs for small banks that failed in 1985 and 1986 are estimated to be 

roughly 30 percent of total failed-bank assets. Around that average there is a wide variance, ranging 

from a low of two percent to a high of 64 percent. This study presents a formula used by the FD1C to 

estimate the FDIC's failure-resolution costs for individual banks, based primarily on the banks' 

asset-quality characteristics. These costs reflect the FDIC's liquidation experience. The analysis docs 

not address the issue of determining what those assets would be worth in an ongoing institution. It is 

shown that geographic differences play an important role in determining the FDIC's failure-resolution 

costs. However, after accounting for differences in asset quality and location, other factors, such as the 

presence of fraud or insider abuse, bank size (up to about 8500 million in total assets), a dependence 

on agricultural lending, and different chartering authorities (state vs. national) are not important 

factors in determining differences in failure-resolution costs. Deposit payoffs were more costly than 

purchase-and-assumption agreements in 1985 and 1986 due to the relatively poorer asset quality of 

the banks that were handled as payoffs. The paper concludes with a general overview of how the FDIC 

uses this information to determine acceptable bids on different types of failure-resolution transac 

tions. 

Measuring the Interest-Rate Exposure of Financial Intermediaries page 14 

by George E. French 

This article explains the gap and duration methods of measuring the interest-rate exposure of financial 

intermediaries, and discusses the uncertainties surrounding the measurement of interest-rate 

exposure given the limited financial information regularly provided to regulators. Cap and duration 

estimates of interest-rate exposure for FDIC-insured commercial banks, savings banks and FSLICinsured thrift institutions also are presented. These estimates indicate considerable interest-rate 

exposure at some institutions, particularly thrift institutions; this indicates the need for continued 

offsite regulatory monitoring of interest-rate exposure despite the inherent difficulties. 

"Derivative" Mortgage Securities and Their Risk/Return Cliaracteristics page 2b 

by Panos Koristas 

The majority of residential mortgage loans originated in 1988 will be transformed into mortgagebacked securities, a large part of which subsequently will be turned into "derivative" mortgage 

instruments such as "strips," "REMICS," and "CMOs." In derivative products, cash flows from the 

mortgage-backed securities are rearranged to suit the risk and maturity preferences of investors. 

Some have viewed this process as not unlike the one in a supermarket where chickens are cut up 

and packaged into pieces—a practice that not only satisfies the customer, but often brings in 

more revenue than if the chickens had been sold whole. This article analyzes the risks and 

rewards embodied in these new instmments under changing market and economic conditions. 

Recent Developments Affecting Depository institutions page 34 

by Benjamin B. Christopher 
Bank-Failure Costs 

Resolution Costs 

of Bank Failures 

by John F. Bovenzi and Arthur J. Murton* 

Will Rogers once said: "The 

business of government is 

to keep the government 

out of business—that is, unless busi 

ness needs government aid." While 

this statement was made with tongue 

in cheek, there is little doubt that as 

it relates to the federal deposit insur 

ance agencies and our nation's bank 

ing system, government is involved 

in business in a big way. It is com 

monplace to see headlines such as 

the ones indicating a rescue opera 

tion for First City Bancorporation 

involving nearly Si billion in FDIC 

aid. Or the headlines indicating a $4 

billion cash outlay from the FDIC to 

facilitate the closing and sale of the 

banking subsidiaries of another large 

Texas banking organization, First Re

publicBank Corporation. Fortu 

nately, most failing banks are not the 

size of the First City and First Re 

public banking organizations, which 

have #12 billion and #28 billion in 

total assets. Nevertheless, even if the 

costs of most bank failures are mea 

sured in the millions of dollars rather 

than in the billions, we still are talk 

ing about significant amounts of 

money. 

Last year 203 banks failed or re 

quired FDIC assistance. This year again 

over 200 failures are anticipated. In 

each case, decisions must be made 

regarding the appropriate and least 

costly way of handling the situation, 

In order to make such decisions the 

FDIC must have a reasonably good 

idea of what the costs of a particular 

bank failure are likely to be and how 

those costs may change depending on 

how the situation is handled. The pur 

pose of this article is: (1) to describe 

some of the work being done at the 

FDIC to estimate bank-failure costs; 

[2) to ascertain which individual bank 

characteristics help to explain varia 

tions in costs among failed banks; and 

(3) to explain how this information is 

used to determine minimum accept 

able bids on various types of failureresolution transactions.' 

There are several important ben 

efits that may arise from studying 

resolution costs of bank failures. First, 

the FDIC can better reduce its failureresolution costs the more it under 

stands about the factors that influ 

ence those costs. Second, an 

understanding of bank-failure costs 

may help provide a clearer picture of 

the adequacy of the FDICfund. Third, 

the ability to provide more detailed 

information to the general public on 

bank-failure costs may eliminate 

some uncertainty in the minds of 

possible acquirers of failed or failing 

banks, thereby reducing the risk pre 

mium they may require to engage in 

such a transaction, which, in turn, 

reduces the FDIC's costs. Addition 

ally, this information may have im 

plications for bank-closure policies 

and the allocation and appropriate 

uses of bank supervisory forces. 

The paper is structured as follows. 

The first section provides background 

information on the FDIC's objectives 

and the various options available to 

the FDIC for handling bank failures. 

The second section discusses the data 

used in this study. Section three pro 

vides general information on bankfailure costs and discusses the rele 

vant factors that help determine bankfailure costs. In this section wedescribe 

a model that we developed that can be 

used to estimate bank-failure costs 

based on individual bank characteris 

tics. The fourthsection describes FDIC 

procedures for determining acceptable 

bids on various types of failureresolution transactions based on its 

"cost test." The final section discusses 

some of the implications of the results 

of this analysis and prospects for fu 

ture research. 

Background on FDIC 

Failure-Resolution 

Policies and Procedures 

The FDIC does not have the power 

to close a bank. That power resides 

with the chartering authority—either 

the state banking commissioner if the 

"John Bovenzi is the Deputy Director 

and Arthur Murton is a financial economist in 

the FDIC's Office of Research and Statistics. 

The authors would like to thank Christopher 

-lames for his help on this project. 

'For readers interested in bidding on 

failed hanks, we should note that while the 

models presented in this report are used in 

the FDIC's decision-making process, final de 

cisions on asset sales are based primarily on 

reviews conducted by the FDIC's Division of 

Liquidation. Given the substantial variance in 

bank-failure costs thai is not explained by the 

model, these onsite evaluations often diverge 

significantly from the cost estimates presented 

in this report. 
FDIG Banking Review 

bank has a state charter, or the Office 

of the Comptroller of the Currency 

(OCC) if the bank has a national char 

ter. After a bank is closed the FDIC is 

appointed receiver and is responsible 

for settling the affairs of the bank; that 

is, balancing accounts, collecting on 

the bank's assets and satisfying the 

claims against those assets. 

There are several primary objec 

tives the FDIC seeks to achieve in 

determining the most appropriate 

failure-resolution method. First and 

foremost, there is the need to main 

tain public confidence and stability 

in the banking system. The FDIC 

must be cognizant oi the possibility 

that how it handles a particular fail 

ure may have adverse implications 

for other banks, and it will seek to 

avoid failure-resolution methods that 

unnecessarily risk destabilizing the 

banking system. Second, the agency 

should try to be as equitable as pos 

sible in its failure-resolution policies. 

In recent years, the equity issue has 

become most prominent with re 

spect to the treatment of uninsured 

depositors and creditors in large ver 

sus small banks. Third, there is a 

need to maintain market discipline 

against risk-taking. How the FDIC 

handles a particular bank failure may 

have significant implications for the 

amount of discipline that will be 

exerted by the market against risktaking by other banks. Fourth, the 

failure-resolution procedure should 

be cost-effective. By law, the FDIC is 

required to meet a "cost test" in 

which it must be reasonably satisfied 

that the alternative it is choosing will 

be one that is likely to be less costly 

than a deposit payoff. 

There are at least two secondary 

objectives in handling bank failures. 

The first is to minimize disruption to 

the community. This requires trans 

actions that can be implemented swiftly 

and smoothly. The second goal is to 

minimize thegovemment's role in own 

ing, financing, and managing financial 

institutions. This is achieved by se 

lecting private-sector resolution of bank 

problems whenever possible, 

The objectives outlined above are 

not always mutually compatible. Sat 

isfying one objective may mean aban 

doning to some degree another ob 

jective, and decisions must be made 

regarding how to balance these trade 

offs in any given situation. 

There are several alternatives avail 

able to the FDIC in handling the 

affairs of a failed or failing bank. The 

following five major alternatives will 

be discussed; (1) deposit payoffs, (2) 

purchase-and-assumption transac 

tions, (3) insured-deposit transfers, 

(4) open-bank assistance, and (5) 

bridge banks. There also are varia 

tions on each of these basic alterna 

tives. Some of these will be briefly 

discussed as well. 

In a deposit payoff, as soon as the 

bank is closed by the chartering au 

thority, the FDIC is appointed receiver 

and steps in to pay all depositors the 

full amount of their insured claims 

and begins to liquidate the assets of 

the failed bank. Uninsured depositors 

and other general creditors of the bank 

generally do not receive either imme 

diate or full reimbursement on their 

claims. Soon after the bank is closed 

they receive what are called receiver's 

certificates which entitle the holders 

to their proportionate share of the 

collections received on the failed bank's 

assets.2 The FDIC also is entitled to a 

share of these collections since itstands 

in the place of the insured depositors. 

As receiver, the FDIC has a re 

sponsibility to creditors to maximize 

collections on the failed bank's as 

sets. Typically, this is achieved by 

selling all marketable assets to the 

highest bidders, generally other fi 

nancial institutions. Nonmarketable 

assets are subject to liquidation pro 

cedures. The proceeds first go to 

ward covering expenses incurred by 

the FDIC in its collection efforts. 

The remaining proceeds are distrib 

uted pro rata to the FDIC and other 

uninsured creditors in the form of 

dividend payments on the receiver's 

certificates. Rarely do the FDIG and 

the uninsured creditors receive the 

full amount of their claims since the 

market value of a failed bank's assets 

generally is less than the book value. 

This means owners of subordinated 

debt and stockholders usually re 

ceive nothing since their claims are 

subordinate to those of depositors 

and other general creditors.3 

second method used by the FDIC 

to handle bank failures is referred to 

as a "purchase<ind-<tssurnptiQn" or 

"P&A" transaction. Under this ap 

proach a buyer steps forward to "pur 

chase" all or some of the failed bank's 

assets and "assume" its liabilities. The 

usual procedure is for the FDIC to 

invite a number of possible acquirors 

to a bidders' meeting. A transaction is 

consummated with the highest accept 

able bidder. An important difference 

between a purchase-and-assumption 

transaction and a payoff is that in a 

P&A all depositors, uninsured as well 

as insured, receive full payment on 

their claims since their claims are 

"assumed" by the acquiring insti 

tution.4 

Generally, a purchase-and-assump 

tion transaction is preferable to a 

deposit payoff. Oftentimes it is less 

costly to the FDIC, particularly if the 

volume of uninsured liabilities is not 

high. A P&A transaction also is less 

disruptive to a community since it 

ensures that many of the failed bank's 

former borrowers and lenders will 

have another institution with which 

to conduct business. In fact, the failed 

bank's deposit customers rarely no 

tice any inconvenience whatsoever. 

The bank may be closed on an after 

noon after the close of business and 

2At times in the past the FDIG has paid 

uninsured creditors a portion of their claims 

at the time of failure. Cash outlays to unin 

sured creditors have been based on conserva 

tive estimates of what they ultimately would 

be entitled to. This variation of a payoff has 

been called a "modified payoff." 

^Some states have depositor preference 

statutes which elevate depositor claims over 

those of other general creditors in statechartered banks. 

4If a depositor preference statute is not 

applicable then all general creditors receive 

full payment on their claims in a P&A trans 

action. However, subordinated debt and cap 

ital are not transferred to an acquiring insti 

tution. The holders of such debt and bank 

capital generally receive no value on their 

claims. 
Bank-Failure Costs 

reopened the following morning at 

its regularly scheduled time. The only 

difference from the viewpoint of most 

customers is that there is a new 

name on the building. 

Traditionally, in a purehase-and

assumption transaction only a small 

portion of the failed bank's assets 

have been transferred to the acquir 

ing institution. Generally, these in 

clude the best of those assets: gov 

ernment securities that are markedto-market, cash, fed funds sold and 

perhaps the installment loan portfo 

lio. The remainingdifference between 

assets acquired and liabilities as 

sumed is covered by a cash transfer 

from the FDIC to the acquiring insti 

tution. It then falls to the FDIC to 

collect as much as it can on the 

balance of the assets it retains in 

order to reimburse itself for some 

portion of its cash outlay. 

More recently the FDIC has at 

tempted whenever possible to pass a 

larger portion of a failed bank's as 

sets to acquiring institutions in P&A 

transactions. In many cases all, or 

substantially all, of the failed bank's 

assets are now sold at a discount 

from book value to the acquiring 

institution. These are often referred 

to as "whole-bank" transactions or, 

more technically, as total-asset 

purchase-and-assumption transac 

tions. The first such transaction was 

completed in April of 1987. Alto 

gether, 19 whole-bank P&As were 

completed in 1987, 38 during the 

first half of 1988. 

Whole-bank transactions reduce 

the need for the FDIC to advance as 

much cash to the acquirer and min 

imize the FDIG's involvement in the 

liquidation of the failed bank's as 

sets. Such transactions can be costeffective for the FDIC and, com 

pared to the more traditional P&A, 

further reduce any disruption to lo 

cal economic activity by ensuring 

that a greater portion of the failed 

bank's customers continue to have 

access to banking services and their 

loans are not placed in a "liquidation." 

I lowever, since the aggregate market 

value of a failed bank's assets gener 

ally is considerably less than book 

value, estimating the loss on assets 

becomes a critical factor in deter 

mining the terms of such a transac 

tion and even whether such a trans 

action can be completed. 

A third type of failure-resolution 

transaction is called an insureddeposit transfer, (n an insureddeposit transfer only the insured de 

posits and secured liabilities are 

transferred to another institution. Un 

insured and unsecured liabilities re 

main in receivership. Sufficient cash 

is paid by the PDIC to the institution 

accepting the failed bank's insured 

and secured liabilities to equal the 

amount of those liabilities. Gener 

ally, the acquiring institution will 

use some of its cash to purchase 

certain of the failed bank's assets. An 

insured-deposit transfer is generally 

viewed as a variation of a deposit 

payoff because uninsured creditors 

are not protected and they usually 

suffer some loss. However, the trans 

action has some of the characteris 

tics of a P&A in the sense that an 

other institution assumes certain 

liabilities and, in recent years, usu 

ally acquires some of the assets of 

the failed bank. Often, when a bank 

has high-cost, volatile funds, bidders 

will opt for an insured-deposit trans 

fer because, unlike in a P&A, they 

have the ability to renegotiate the 

terms on debt instruments. 

The fourth type of transaction is 

called open-bank assistance. In 

many respects open-bank assistance 

has the same effects as a purchaseand-assumption transaction. The ma 

jor difference between a P&A and 

open-bank assistance is that with 

open-bank assistance a transaction 

occurs before the failing bank is tech 

nically declared insolvent and closed. 

Generally, the FDIG provides enough 

assistance to cover the difference 

between the estimated market value 

of the bank's assets and its liabilities 

(the bank's negative net worth). New 

capital is injected by private inves 

tors. As in a P&A, all depositors and, 

if there is no depositor preference. 

all general creditors are protected 

against loss. And, as with a P&A (and 

each of the other alternatives as 

well), management is usually re 

placed, bank stockholders are virtu 

ally wiped out, and, if a holding 

company is involved, its creditors 

are not protected by the FDIC (al 

though shareholders and junior cred 

itors must agree to the transaction if 

the bank remains open).' 

A fifth type of transaction is a 

bridge bank. As its name implies, 

this solution is temporary: it merely 

provides a "bridge" until a more per 

manent solution can be arranged. 

The idea is that when a bank fails, it 

may be advantageous for the FDIC to 

keep it operating for a brief period 

until prospective purchasers have 

enough time to assess the institu 

tion's condition and they can make a 

reasonable offer for the bank. If kept 

operational, the bank can retain 

much of its value. Moreover, there is 

likely to be less disruption to the 

local community if the bank is kept 

operational until the situation is re 

solved through a more permanent 

solution. The FDIC received author 

ity to operate bridge banks just last 

year and as of August 15, 1988 had 

used its new authority on two 

occasions/' 

There are many possible varia 

tions of these five basic options, but 

essentially deposit payoffs, pur 

chase-and-assumption transactions, 

insured-deposit payoffs, open-bank 

assistance, and bridge banks are the 

alternative types of transactions avail 

able to the FDIC for handling bank 

sThe FDIC's objective is to see that the 

federal "safety net" does not extend to hank 

holding companies and that holding company 

creditors receive no more than what they 

would be entitled to if the failed bank's assets 

were liquidated via a deposit payoff. While the 

FDIC has noi always adhered to this policy, it 

lias been fairly standard practice in recent 

years. 

''Capital Bank & Trust Co., National As 

sociation was formed on Octoher 30, 1487 as 

a bridge bank following the closing of Capital 

Bank & Trust Co. of Baton Rouge, Louisiana. 

On April 6, 19H8 the bank was sold to Grenada 

Sunburst. Systems Corporation of Grenada, 

Mississippi. On July 29, 1988, a bridge bank 

was established as part of the FDIC-assisted 

restructuring of First Republicliank Corpora 

tion in Dallas, Texas. 
FDIG Banking Review 

failures. Which of these transactions 

the FDIG engages in for any particu 

lar failed or failing bank, while de 

pendent on possible bidders' inter 

ests, also depends on the publicpolicy considerations enumerated 

earlier and the estimated costs asso 

ciated with each alternative. 

The FDIG's cost test for a pur

chase-and-assumption transaction 

where the acquirer does not assume 

many of the failed bank's assets (this 

is often referred to as a "clean-bank" 

P&A) hinges largely on the following 

determination: Does the premium 

the acquiror is willing to pay meet or 

exceed the loss that would be borne 

by uninsured creditors in a payoff? If 

so, the P&A generally is cheaper. For 

example, in a truly clean P&A, the 

FDIC retains all the risk assets (and 

essentially pays book value for them). 

Thus, the FDIG bears all of the loss 

on assets, save for the portion that is 

offset by the premium paid by the 

purchaser. In a payoff, the FDIG 

bears all the loss on assets (because 

it retains all of the assets), except for 

the portion of the loss that is borne 

by the uninsured creditors. Thus, 

the greater of the two offsets deter 

mines the least costly transaction. 

With respect to the amount of risk 

assets acquired by the purchaser, the 

totally clean-bank deal lies at one end 

of the (P&A) spectrum. At the other 

end lies the whole-bank transaction, 

in which the purchaser acquires all, or 

substantially all, of the assets. In be 

tween these extremes lie a variety of 

asset-sharing arrangements.7 As more 

assets are acquired by the purchaser, 

the loss on assets is transferred from 

the FDIG to the acquiror, and the 

acquiror will lower its bid (premium) 

to reflect this. The FDIC will be willing 

to accept a lower premium in recogni 

tion of the reduced loss it faces. Under 

some arrangements the purchaser will 

acquire enough assets to make the 

acceptable premium negative and the 

FDIG, in effect, will pay the purchas 

ing bank for its role in the transaction. 

This is the case in virtually all wholebank deals. 

Given that the premium should 

adjust to reflect the shifting of the 

loss on assets, is there any reason 

why the attractiveness of P&A would 

depend on the volume of assets ac 

quired by the purchaser? From the 

FDIG's perspective, there are several 

reasons for preferring that more as 

sets go to the purchaser: the desire 

to keep assets in the private sector 

rather than in a government liquida 

tion; the potential for cost savings; 

and, the needs of the community are 

better served as the acquiring insti 

tution has the incentive to nurture 

loan customer relationships. 

The trend toward whole-bank deals 

reflects a deliberate change in the 

method of handling bank failures. In 

fact, the bidding procedure reflects 

the FDIG's preferences in failed-bank 

transactions. Whole-bank transac 

tions and open-bank assistance are 

the preferred options. If none of the 

bids for these types of transactions 

are acceptable, a P&A is attempted 

with as many assets as possible be 

ing passed. The next option is an 

insured-deposit transfer, passing as 

sets if possible. If all of these are 

unsuccessful, a payoff is performed. 

If cost were not a consideration, 

then a particular bank failure could 

be handled in any way the FDIG 

chose; it would simply be a matter of 

paying whatever price necessary. 

However, the desire, and statutory 

obligation, to protect the insurance 

fund limit the FDIG's ability to choose 

the type of transaction. Moreover, 

whether open-bank assistance, a 

whole-bank deal or any other type of 

P&A takes place is not a unilateral 

decision on the FDIC's part; the mar 

ket plays an important role. The 

price that a bidder offers must be a 

price that the FDIG determines will 

be no more expensive to the fund 

than a payoff. The major purpose of 

this study is to furnish a method for 

estimating the price the FDIG should 

be willing to accept for a particular 

transaction. To the extent such an 

effort is successful, it should better 

enable the FDIC to maintain the 

deposit insurance fund while keep 

ing assets in the banking system. 

Data 

For most of the FDIG's history 

there was little outside interest in 

the costs associated with bank fail 

ures. Few banks failed and few bank 

creditors suffered significant losses. 

FDIG losses were small relative to 

income. Only in the 1980's has the 

number of bank failures been signif 

icant enough to raise important ques 

tions regarding bank-failure costs. 

Publicly available information on 

bank-failure costs prior to recent 

years is somewhat misleading be 

cause it often did not account appro 

priately for the time value of money. 

For example, one could look back at 

completed receiverships and see that 

the FDIG and the banks' other unin 

sured creditors often received 90 or 

95 percent, and in some cases 100 

percent, of their original claim. How 

ever, the collections on the failed 

banks' assets used to satisfy those 

claims generally occurred over many 

years. Thus, on a present-value ba 

sis, actual recoveries were less than 

the figures conveyed by accumu 

lated dividend payments (although 

recoveries may still have been around 

90 percent on average). 

In recent years the FDIG has ex 

pended a great deal of effort in de 

veloping systems to provide better 

information on all aspects of bankfailure operations. Systems currently 

in place record and monitor liquida 

tion expenses and collections on as 

sets as they occur. Information sys 

tems also provide estimates of future 

liquidation expenses and expected 

future collections associated with the 

remaining assets on all outstanding 

liquidations. These estimates of fu 

ture expenses and coUections are 

provided for the time periods in which 

they are expected to occur. 

7One alternative that has proven to be 

quite popular with bidders over the past year 

is called a "small-loan asset purchase agree 

ment." As its name suggests, the smaller loans 

are passed at a discount to the acquiring 

institution (with no option to put them back 

to the FDIG). 
Bank-Failure Costs 

The data on actual and expected 

collections and expenses are com 

bined for each bank in liquidation to 

provide individual bank estimates on 

expected collections net of expenses. 

For each individual bank it is then 

determined how those proceeds must 

be distributed amongst the various 

groups of bank creditors. At this 

point it is possible to estimate the 

final cost to the FDIC for each bank. 

The systems that provide this infor 

mation are being used to determine 

the FDIC's loss reserves for failed 

banks and for estimating expected 

costs associated with each new bank 

failure. 

Sample 

The data for this study are current 

through midyear 1987. The sample 

used for analysis was limited to banks 

that failed in 1985 and 1986. Banks 

that failed in the first half of 1987 

were not included in the sample in 

order to avoid banks with loss pro 

jections based on less than six 

months' actual liquidation experi 

ence. Banks that failed prior to 1985 

were excluded from the sample since 

the new data information systems 

for failed banks were implemented 

subsequent to that date and the tim 

ing of expenses and collections asso 

ciated with pre-1985 failures is not 

as easily determined from the data. 

Of the 120 banks that failed or 

required financial assistance in .1985, 

the two open-bank assistance trans 

actions and the two savings banks 

were excluded from the sample. Of 

the 145 failures in 1986, the seven 

open-bank assistance transactions 

were excluded from the sample. In 

complete data resulted in 36 other 

banks being dropped from the sam 

ple, leaving 218 banks altogether. Of 

these, 156 were state-chartered 

banks; 62 were nationally-chartered 

banks. These banks had average as 

sets of $32 million. Fifty of the banks 

were handled as deposit payoffs or 

insured-deposit transfers; 168 were 

handled as purchase-and-assump

tion transactions. 

Estimates of "Loss on 

Assets" and "Cost to 

FDIC" in Bank Failures 

It is necessary to emphasize the 

distinction between two important 

concepts regarding costs associated 

with bank failures. From the FDIC's 

viewpoint, it is primarily interested 

in its ultimate cost associated with 

any particular transaction. However, 

the "cost to PDIC" for any failure 

resolution will be different from the 

"loss on assets" realized for the same 

bank. When a bank fails, the cost to 

the FDIC depends on a number of 

factors including: the difference be 

tween book values of assets and lia 

bilities (book capital) of the bank, 

the levels of both uninsured and 

unsecured liabilities, the premium 

(if any) paid by an acquirer, losses 

on contingent claims and the real 

ized value of assets placed in liquida 

tion (by the FDIG). Because the last 

component, the realized value of as 

sets, is not known until the receiver 

ship is closed out, the cost to the 

FDIC is not known at the time of 

failure. Hence, the reserve set aside 

by the FDIC is necessarily based on 

a forecast of the loss on assets in the 

bank. As the liquidation proceeds, 

the forecast of the loss is updated, 

and eoncomitantly, the reserve fig 

ure is also updated. 

Viewed differently, while neither 

the cost of failure nor the loss on 

assets is known at the time of failure, 

the loss on assets is one of several 

factors that determines the cost of 

failure. Furthermore, of the compo 

nents of the cost, the loss on assets 

and the loss on contingent claims 

are the only ones that cannut be 

known at the time of failure and 

therefore must be forecast. Since 

losses on contingent claims vary tre 

mendously by bank, they are esti 

mated on an individual bank basis. 

Thus, only the loss on assets needs 

to be estimated from historical hankfailure cost data. These loss esti 

mates then can be combined with 

the other components affecting the 

FDIC's costs to produce a cost esti 

mate for current failures. 

The loss on assets is defined as the 

difference between the book value of 

the bank's assets and the value of the 

assets to the FDIC. For transactions 

in which the FDIC retains all the 

bank's assets (payoffs and some 

insured-de posit transfers), the value 

is the discounted cash flow from 

collections net of the discounted 

stream of liquidation expenses. For 

transactions in which some assets 

are passed to the acquiring bank, the 

value of the assets passed is the price 

paid for those assets by the acquiror.8 

For banks in the sample, the esti 

mated loss on assets as a percent of 

bank assets had a wide distribution, 

ranging from three percent to 64 

percent of assets, with the average 

bank failure showing a loss on assets 

of 33 percent. The distribution of 

costs to the FDIC of bank failures is 

given in Figure 1. These estimated 

costs range from two percent to 64 

percent of assets, with the average 

bank costing the FDIC 30 percent of 

the bank's assets. These costs reflect 

the FDIC's liquidation experience. 

The analysis does not address the 

issue of determining what those as 

sets would be worth in an ongoing 

institution. The cost to the FDIC is, 

on average, less than the loss on 

assets for several reasons. Typically, 

the book value of assets exceeds the 

book liabilities; this positive book 

capital directly reduces the FDIC's 

cost.'' In payoffs and insured-de posit 

transfers, a portion of the remaining 

loss is shared by the uninsured cred 

itors. In transactions with another 

institution a premium may be paid 

reflecting the bank's franchise value, 

further reducing the FDIC's cost, 

Tor present purposes all income and 

expense (lows were discounted back to the 

date of failure by a seven percent annual tale. 

This rale was roughly equivalent to the twoyear Treasury rate and represents the FDIC's 

opportunity cost. 

''liven though the bank is insolvent there 

may be positive buok capital if worthless 

assets were not written off prior to the hank's 

closing. Since "loss on assets" is calculated as 

the difference between ihe book value and 

realized value of the bank's assets, positive or 

negative "book" capital must he netted out of 

"loss On assets" in determining actual costs to 

the FDIC. 
FDIG Banking Review 

Figure 1 

Estimated Cost to FDIC of Individual Bank Failures 

(As a Percent of Bank Assets) 

No. of Banks 

50 

40 

30 

20 

10 

0 10 20 30 40 50 60 70 80 90 

Percent of Bank Assets 

While the average cost to the FDIC willing to pay an acquiring institution 

of handling bank failures in 1985 and to assume the liabilities and accept a 

1986 is expected to be about 30 per large portion of the failed bank's 

cent of total failed-bank assets, as assets."1 

shown above, for any individual bank The lass on assets was estimated, 

failure there is wide dispersion around using regression analysis, as a func 

the average. In order to meet its cost tion of individual bank characteris 

test in determining the appropriate tics. The loss figures and balancetype of bank-failure transaction, and sheet data were scaled by assets in 

to assess acceptable bids on bank- the bank at the time of failure. This 

failure transactions, the FDIC must be essentially gives equal weight to the 

able to reasonably determine the de experience of each bank in liquida 

gree to which banks arc likely to cost tion; alternatively, it prevents the 

more or less than the average. With experience of the larger bank fail 

the ultimate objective of trying to es ures from distorting the results. 

timate the FDIG's costs for individual One would expect that the major 

bank failures more precisely, we at factor determining the loss on assets 

tempted to develop a model that could would be the type and quality of as 

explain some of the variation in losses sets. As a first step in distinguishing 

on assets among individual failed between type and quality, assets were 

banks. divided into two groups: nonrisk (cash, 

The model estimates "loss on assets" securities and federal funds sold) and 

rather than "cost to the FDIC." Esti risk (everything else)." The risk as 

mates of losses on assets can be com sets then were further divided accord 

bined with the other directly measur ing to examiner classifications. Bank 

able costs incurred (or benefits examiners divide problem assets into 

realized) by the FDIC to obtain the three groups: substandard, doubtful 

total cost to the FDIC tor a particular and loss. These classifications provide 

bank failure. This information then information on asset quality as each of 

can form a basis from which the FDIC the three types of classifications indi 

can determine the amount it may be cates progressively deteriorating asset 

quality based on evaluations by the 

bank examiners. In our breakdown of 

asset groups, doubtful was combined 

with loss, due to the small amounts in 

the doubtful category. Thus, our asset 

groupings were nonrisk, nonclassified 

risk, substandard and the combina 

tion of doubtful and loss. In future 

work we intend to further refine these 

asset groupings. 

Additional indicators of asset qual 

ity are the nonperforming measures 

included in bank Call Reports. It is 

possible that one or more of these 

measures could augment or substitute 

for the asset-quality information pro 

vided by examiner classifications. At 

this stage of our analysis we have 

examined Call Report data on pastdue loans, nonaccruing loans and 

income-earned-but-not-collected. 

There are other factors that possibly 

could explain differences in loss among 

banks: bank size, year of failure, type 

of failure-resolution transaction, types 

of loans, whether the bank was an 

agricultural bank, regional differences, 

and whether fraud and insider abuse 

were present in the bank. While we 

are still exploring the possible signifi 

cance of these and other factors, some 

results are presented below. 

If we start by using only measures 

of asset quality as independent vari 

ables, Equation 1 provides the best 

results. The dependent variable is 

loss on assets (LOSS). The explana 

tory variables include assets classi 

fied as doubtful or loss (LSSDBT), 

assets classified as substandard (SUB

STD), nonclassified risk assets 

(NCLRSK) and income-earned-but

not-collected (IENC). The coeffi 

cients for each of these variables 

'"Even in a whole-bank transaction the 

FDIC will not he willing to pay an acquiring 

institution an amount equal to its estimated 

cost for handling the failures since some of 

those costs are "fixed" in the sense that they 

will be incurred by the FDIC (e.£>., closing 

sosts) evi^n if the entire bank is sold to an

ather institution. 

"Securities are grouped into the nonrisk 

category only because any appreciation or 

depreciation due to interest-rate changes is 

measured directly, it need not he estimated. 

There is little credit risk (which also Can be 

estimated on a case-by-case basis] since banks 

invest largely in federal, state and local gov 

ernment securities. 
Bank-Failure Costs 

indicate how the loss on assets varies with the respective variables, holding all 

other variables constant. Thus, the coefficient for NCLRSK indicates that an 

additional dollar of nonclassified risk assets contributes 19.8 cents to the loss 

estimate, each dollar of assets classified as substandard contributes 60.9 cents 

to the loss estimate and each dollar of assets classified as doubtful or loss 

contributes 91.8 cents to the loss estimate. A dollar of IENC signals an 

additional #1.98 in loss. The t-statistics (in parentheses) indicate that each of 

the variables is statistically significant at the 99 percent confidence level.12 

(1) LOSS =0.198*NCLRSK + 0.609*SUBSTD 0.918*LSSDBT 1.98*IENC 

(7.4) (9.8) (10.1) (4.2) 

While it is clear that asset classifications should provide valuable informa 

tion for estimating bank-failure costs, it is perhaps less clear why income

earned-but-not-collected is an important explanatory variable. We have iden 

tified two possible reasons why IENC is important. First, to the extent that a 

bank has risk assets that should have been classified but were not, the loss on 

these assets would be greater than the 19.8 cents per dollar estimate included 

in the equation for nonclassified risk assets. The IENC variable may be 

capturing these additional losses. This is somewhat comforting since the 

equation places a great deal of reliance on having good data on classifications. 

To the extent that classification data are incomplete or dated, the loss 

estimates would be less accurate unless there is another variable such as IENC 

to capture this difference. The IRNC variable may reflect such assets since a 

bank nearing failure may be unlikely to put these poorly performing assets on 

nonaccrual status and thus the IKNC category will grow as the number of 

poorly performing assets grows. 

second reason why IENC may be important has to do with another type of 

asset underlying uncollected earnings. Often, interest on certain loans, such as 

real-estate construction projects, is not paid until the project is completed. 

This does not mean the asset is a poor performer, but that interest does not 

have to be paid until completion of the project when revenue is available. In 

other words, income is earned but it is not collected until the project is 

completed. If a bank fails before the project is completed, the FDIC, in all 

likelihood, will have to sell a semicompleted project at a discount greater than 

the 19.8 cents per dollar estimate for all nonclassified risk assets even though 

the asset may be worth more if the project were completed. 

These explanations may not entirely account for the reasons why IENC is 

helpful in explaining variations in loss on assets in failed banks. Moreover, the 

measure is imprecise in the sense that not all assets underlying IENC fall into 

one of the above two categories and bank policies differ in ways that could 

affect the IENC category. For example, some banks utilize add-on loans rather 

than IENC; thus, uncollected income is added to principal rather than put in 

the IENC category. Also, income may be earned but not collected on a bank's 

government securities portfolio as well as on its loans. At this stage our analysis 

does not distinguish between the two types of IENC even though income

earned-but-not-collected on a securities portfolio is not reflective of losses that 

may result on those assets. 

The R-squared statistic for Equation 1 is 0.56. This represents the propor 

tion of the variation of loss on assets about its mean that is explained by the 

regression. For each bank in the sample, there will be an error term that equals 

the difference between the actual loss and the loss predicted from the 

regression. The standard error of the regression measures the dispersion of the 

errors. It indicates how often we can expect the actual loss to be within a 

certain range of the predicted loss. In this case the standard error for the 

equation is 8.3. Suppose that for a particular bank the predicted loss is 32 

percent of total assets. Adding the standard error to 32 percent gives an upper 

boundary of 40.4 percent. Similarly, 

subtracting the standard error from 

32 percent gives a lower boundary of 

23.6 percent. Assuming the errors 

are normally distributed, we expect 

the actual loss to be below the upper 

boundary 84 percent of the time. In 

the current sample, the actual loss 

did not exceed the predicted loss by 

more than one standard error for 

188 of the 218 banks (86 percent). 

Similarly, the actual loss did not fall 

short of the predicted loss by more 

than one standard error for 180 of 

the 218 banks (83 percent).1'1 

Although the actual loss on a failed 

bank generally will fall within one 

standard error of the predicted loss, 

the range between one standard er 

ror below the predicted loss and one 

standard error above the predicted 

loss still is quite large (16.6 percent 

of the bank's assets). Thus, even 

though the R-squared statistic tells 

us that 56 percent of the variance in 

average loss on assets between dif 

ferent failed banks is eliminated us 

ing Equation 1, a large amount of 

uncertainty remains. 

Type of Failure-Resolution 

Transaction 

After developing an equation to 

estimate loss on assets based on as 

set quality, our next area of investi 

gation was possible differences be 

tween loss on assets and cost to the 

FDIC in banks handled as P&As ver 

sus those handled as payoffs or 

insured-deposit transfers.14 Fifty of 

the banks in the sample were han 

dled as payoffs or insured-deposit 

transfers. These banks had average 

total assets of $25.5 million. As shown 

in Table 1, the average expected loss 

on assets for these banks is 35.9 

'-The suppression of the constant term 

in the regression imposes the restriction that 

in the absence of risk assets the loss on assets 

in the bank would equal zero. 

13Thc standard error can be used to 

develop n range for bids that may he accept 

able on whole-bank transactions. 

14For most of the insured-deposit trans 

fers conducted in 1985 and 1986, few, if any, 

risk assets were transferred to the acquiring 

institution. Thus, these transactions were 

much like payoffs and, for present purposes, 

have been grouped with the payoffs. 
FDIC Banking Review 

Table 1 

Estimated Loss on Assets and Cost to FDICI in Bank Failures 

During 1985 and 1986, by Type of Transaction1 

percent of total bank assets. This 

compares to an average expected 

loss on assets of 32.0 percent for the 

168 bank failures handled through 

pure has e-and-assumption transac 

tions. Therefore, on average, ex 

pected losses on assets were higher 

in payoffs and insured-deposit trans 

fers than in P&As by 3.9 percent of 

assets. 

Table 1 also indicates that payoffs 

typically are more costly to the FDIC 

than P&As by an average of seven 

percent of total assets. This difference 

should not be surprising since the 

FDIC's cost test requires that a 

pure has e-and-assumption transaction 

must be expected to be less costly 

than a payoff if it is to be attempted. 

The difference in loss on assets in 

P&As versus payoffs and insureddeposit transfers could arise for two 

reasons. First, there may be differ 

ences in the type and quality of 

assets. In other words, the typical 

bank handled as a payoff may have 

poorer-quality assets than the typi 

cal bank handled as a P&A. This is a 

reasonable priori expectation since 

failed banks are often handled as 

payoffs only when there is no inter 

est among possible bidders. A lack of 

interest among bidders may be due, 

in part, to the quality of the bank's 

assets. Second, there may be differ 

ences in the value of the same assets 

depending on whether they are left 

in an ongoing institution or whether 

they are liquidated. An acquiring in 

stitution can work with a borrower 

to fashion the best long-term solu 

tion. This may involve advancing 

additional funds or working with the 

borrower over a long period of time. 

The FDIC as receiver must maxi 

mize collections on assets over a 

relatively short time horizon. It liq 

uidates assets usually either by sell 

ing them or settling with the bor 

rower for some mutually agreed upon 

amount. While the FDIC does ad 

vance funds on occasion, it does so 

only when it clearly will result in a 

higher settlement. The FDIC does 

not function as a bank and generally 

does not advance additional funds to 

borrowers. These borrowers usually 

must secure new banking relation 

ships with another institution if they 

wish to obtain additional funds. Such 

differences in operating procedures 

between banks and the FDIC may 

contribute to differences in the aver 

age loss on assets in banks handled 

as P&As (where another financial 

institution generally retains at least 

some of the failed bank's assets) and 

payoffs (where the FDIC retains all 

of the failed bank's assets). 

For banks in the sample, it ap 

pears that most of the difference 

between loss on assets in payoffs and 

insured-deposit transfers relative to 

P&As is due to the quality of assets 

in the individual banks in each group. 

The data indicate that there are rel 

atively more classified assets in the 

banks that were handled as payoffs 

or insured-deposit transfers (sec Ta 

ble 2). Thus, losses would be higher 

in those banks regardless of the type 

of transaction that could be arranged. 

As further evidence that the differ 

ence in losses between the two groups 

was due primarily to differences in 

asset quality, when the regression 

was applied to the two samples inde 

pendently (P&As vs. payoffs and 

insured-deposit transfers) the coeffi 

cients on the asset categories were 

not significantly different, 

This result does not mean that 

there are not differences in the value 

of an asset remaining in an ongoing 

bank as opposed to being liquidated 

by the FDIC. However, for banks in 

the sample (those that failed in 1985 

or 1986), most of the transactions 

resulted in the FDIC retaining virtu 

ally all of the risk assets. Therefore, 

this sample may not be able to shed 

too much light on the value differen 

tial because it cannot show what the 

FDIC may have saved by transfer 

ring risk assets to an acquiring insti 

tution. The bank-failure transactions 

in the years subsequent to 1986 will 

provide more information in this re 

gard since the P&A transactions gen 

erally involved passing at least some 

risk assets to the acquiring institu 

tion. These transactions can be com 

pared with the payoffs in which the 

FDIC retains all risk assets.15 

In open-bank assistance and wholebank P&A transactions the FDIC 

passes virtually all of the failing or 

failed bank's assets on to the acquir 

ing institution. Looking only at the 

14 open-bank and 38 whole-bank 

transactions conducted in the first 

half of 1988 indicates that, on aver 

age, the cost to the FDIC for one of 

these types of transactions is about 

20 percent of the banks' assets com 

pared to 30 percent in transactions 

where the FDIC retains almost all of 

ls]n 1987 and 19H8 more risk assets were 

transferred to the acquiring institution in 

insured-deposit transfers as well as in P&As. 

Thus, for these years, insured-deposit trans 

fers cannot be grouped with payoffs if the 

intent is to examine what the FDIC may save 

by transferring risk assets to an acquiring 

institution. 
Bank-Failure Coses 

Che risk assets."' This suggests that Table 2 

there may be differences in the value Summary Statistics tor Average Bank in Sample 

of the same assets depending on (Percent of Total Assets in Parentheses) 

whether they are left in an ongoing 

institution or whether they are liqui 

dated. Moreover, it suggests that the 

FDIC is capturing some of this value 

differential through its bidding pro 

cess and negotiation procedures. 

However, one would have to look 

much more carefully at the bankfailure transactions in 1987 and 1988 

before any final determination could 

be made as to the extent of any 

possible value differential. 

Presently, it is safe to conclude 

that while there are differences in 

cost by type of transaction for banks 

that failed in 1985 and 1986, these 

differences are largely explained by 

differences in asset quality within 

the respective banks. However, it 

appears that for failure-resolution 

transactions subsequent to 1986, dif 

ferences in average costs between 

f'&As and payoffs also may be due to 

differences in the value of risk assets 

depending on whether they are left 

in an ongoing institution or are liq 

uidated. 

Fraud and Insider Abuse 

Of the 218 banks in the sample, 

there were 54 (25 percent of the 

total) where bank examiners detected 

the presence of fraud or insider abuse. 

This docs not mean that fraud or 

insider abuse was the cause of each 

of these failures, just that they were 

present. The 54 banks where fraud 

or insider abuse was detected had 

average total assets of about $29.5 

million, not substantially different 

from the $32 million average for all 

banks in the sample. 

In recent years the FDIC has ex 

pended greater effort to detect fraud 

and insider abuse. Indeed, in some 

quarters there exists the view that 

the detection of fraud and insider 

abuse should be the primary focus of 

bank supervision. This view is based 

at least in part on the idea that if 

fraud and insider abuse go undetec 

ted for substantial periods of time, 

when finally uncovered the bank may 

AJl Banks 

Number of Banks 218 

Cash S 1,889' (5.9) 

ftd Funds Sold 1,249 (3-9) 

Securities 5,315 (16.6) 

Nonrisk Assets 8,453 (26.4) 

Loans 21,069 (65.8) 

1ENC 736 (2.3) 

Other 1,761 (5.5) 

Risk Assets 23,566 (73-6) 

Total Assets 32,019 (100.0) 

Classified Assets 9,253 (28.9) 

Substandard 6,308 (19.7) 

Doubtful 640 (2.0) 

Loss 2.305 (7.2) 

Nonclassilied Risk 14,312 (44.7) 

Total Liabilities 31,635 (98.8) 

Capital 384 (1.2) 

'Dollar amounts shown are in thousands. 

be so insolvent that its cost to the 

insurance fund will be much higher 

than for the typical bank failure. 

The evidence from the 54 banks 

in our sample where fraud and in 

sider abuse were present indicates 

that, on average, losses are not higher 

than in banks where fraud and in 

sider abuse are not present. In fact, 

perhaps surprisingly, the average loss 

on assets is lower in banks in which 

fraud or insider abuse was present 

(Table 3). The average loss on assets 

for the 54 banks where fraud or 

insider abuse was present was 31.6 

percent of total assets. The average 

loss on assets for the remaining 164 

bank failures was 34.2 percent of 

assets. Correspondingly, the esti 

mated cost to the FDIC is 27.9 per 

cent of total assets in the former 

case, and 30.7 percent for the latter 

group of banks. 

These results suggest that the pres 

ence of fraud or insider abuse is not 

a significant factor in explaining dif 

ferences in bank-failure costs. As 

further evidence of the inability of 

the presence of fraud or insider abuse 

to explain differences in bank-failure 

costs, including the possible pres 

Payoffi? and 

insured

P&As Deposit Transfers 

168 50 

i 2,003 (5-9) S 1,635 (6.4) 

1,290 (3.8) 1,022 (4.0) 

5,635 (16.6) 4,240 (16.6) 

8,928 (26,3) 6,872 (26.9) 

22,269 (65.6) 17,013 (66.6) 

713 (2.1) 690 (2-7) 

2,037 (6-0) 971 (3.8) 

25,018 (73.7) 18,673 (73.1) 

33,946 (100.0) 25,545 (100.0) 

9,675 (28.5) 7,791 (30,5) 

6,586 (19.4) 5,339 (20.9) 

679 ° (2.0) 536 (2.1) 

2,410 (7-1) 1,916 (7.5) 

15,344 (45.2) 10,882 (42.6) 

33,437 (98.5) 25,571 (100.1) 

509 (1.5) -26 (-0.1) 

ence of fraud and insider abuse as an 

independent variable in Equation 1 

does not improve the explanatory 

power of the equation. 

Testing Equation 1 only for banks 

where fraud or insider abuse was 

present yields an R-squared statistic 

that is much higher (at .68) than was 

the case when all banks are included 

(.56). However, the standard error 

also is higher at 8.9 (compared to 8.3 

for all banks), indicating a greater 

dispersion in losses on assets among 

banks where fraud and insider abuse 

are present. 

These results do not necessarily 

contradict the notion that examiner 

resources should be allocated more 

toward the detection of fraud and 

insider abuse. The fact that the av 

erage loss on assets is less in banks 

where fraud or insider abuse was 

present may indicate that examiners 

"'First City Bancorporation, with 

SI l,2()0,0()Q in total assets, cost the FDIC an 

estimated 8970,(100, or less than nine percent 

of total assets. Because of this the FDIC's 

actual eost for open-bank assistance and wholebank transactions in the first half oi' 198S was 

only about 11 percent of the hanl<s' tola/ 

assets. Nevertheless, the average transaction 

has a cost closer to 20 percent of bank assets. 
FDIC Banking Review 

Table 3 

Effect of Fraud and Insider Abuse 

on Bank-Failure Cost Estimates 

Was Fraud 

or Insider 

Abuse Number 

Present? of Banks 

Yes 54 

No 164 

are doing a reasonably good job in 

detecting fraud and insider abuse. 

Examiners tend to be more critical 

and more alert to weaknesses in 

institutions where fraud and abuse 

are prevalent. Frequently, this leads 

to quicker removal of abusive man 

agement. This introduces afresh per 

spective into the bank, which may 

hold down losses in the future. The 

fact that there is a greater dispersion 

of average losses among these banks 

may indicate that when fraud and 

insider abuse are not detected in a 

reasonably timely fashion losses can 

be much greater than for the typical 

bank failure. 

Average Loss 

on 

Assets 

(% of Assets) 

Average Cost 

to FDIC 

(% of Assets) 

31.6 

34.2 

27.9 

30.7 

Bank Size 

As indicated earlier, the banks in 

the sample had, on average, S32 

million in total assets. Table 4 pre 

sents the loss on assets and cost to 

the FDIC for banks of various sizes. 

The table docs not present compel 

ling evidence that asset size is a 

major determinant of the cost to the 

PDIC (as a percent of assets). 

However, only ten of the banks in 

the sample had assets greater than 

8100 million and none had as much 

as $600 million in total assets. Thus, 

while the data suggest that there are 

not cost savings per dollar of asset 

for banks with less than g600 million 

in total assets, it doesn't provide 

information on potential cost sav 

ings per dollar of total assets for the 

largest bank failures. The FDIC's ex 

perience with Continental Illinois (in 

1984), BancTexas (in 1987) and First 

City Bancorporation (in 1988) sug 

gests that FDIC costs as a percentage 

of total assets are signihcantly less in 

the billion-plus dollar bank failures.17 

Geographic Differences 

Table 5 indicates that there are 

some differences in estimated bankfailure costs across geographic re 

gions. Not surprisingly, the South 

west has the highest average 

estimated loss on assets and highest 

average estimated cost to the FDIC, 

The East has the lowest average cost 

experience, reflecting the relatively 

healthy regional economy. 

The fact that there are some rea 

sonably wide differences in average 

loss on assets and cost to the FDIC 

among bank failures in different re 

gions suggests that Equation 1 could 

be improved by adding regional vari 

ables. This proved to be the case. 

The R-squared statistic increased 

from .56 to .58 and the standard 

error dropped from 8.3 to 8.1. For 

estimation purposes we divided the 

country into six regions correspond 

ing to the regional office structure of 

the FDIC's Division of Liquidation, 

Only the Dallas (Southwest) and San 

Francisco (West) regions produced 

results significantly different from the 

national averages. On average, banks 

in the Dallas region had losses higher 

than the national average by 2.2 

percent of their total assets. Banks in 

"CominentaI Illinois had about S37 hil

lion in total assets just prior to when the FDIC 

arranged its assistance plan for the bank. 

Presently, the reserve for FDIC losses is SI.7 

billion, which is 4.6 percent of bank assets. 

BancTexas had #1.3 billion in assets, and cost 

the FDIC aiSO million (11.5 percent of the 

banks'assets). FirstCity Incorporation, with 

S11.2 billion in assets, cost the FDIG S97U 

million (nine percent of assets). The differ 

ence in cost between small- and large-bank 

failures may reflect the fact that puhlicly

awned and audited companies are identified 

as problems earlier and forced to close earlier 

Jue to funding problems. 

10 
Bank-Failure Costs 

the San Francisco region had losses lower than the national average by 3.6 

percent of total assets. See Equation 2 for the results when these regional 

variables are added to the equation. 

(2) LOSS = 0.213 *NCLHSK 0.619 " SUBSTD 0.923 * LSSDBT 

(7.6) (10-1) (10.2) 

+ 1.65 * IENC -.0356 * SANFRN + .0237 * DALLAS 

(3-5) ( -1.5) (1.8) 

State vs. National Charter 

A hank is issued a charter either by the state in which it operates or by the 

federal government through the Office of the Comptroller of the Currency. The 

respective chartering authorities also are responsible for closing insolvent 

banks, in addition, the OCC is responsible for examining national banks; state 

banks are examined hy their state chartering authority and either by the 

Federal Reserve if they are members, or by the FDIC if they are not memhers 

of the Federal Reserve. Any differences in supervisory procedures or closure 

policies between the various state and federal regulators could show up in 

differences in average bank-failure costs. Here we looked only at the differ 

ences in estimated costs between state- and nationally-chartered banks. 

Table 6 shows these results. On balance, state-bank failures were slightly 

more costly than were national-bank failures. However, the difference is not 

significant. Including variables in Equation 1 according to whether a bank had 

a state or national charter did not improve the equation's explanatory power. 

Table 6 also presents the estimated cost to the FDIC according to whether 

the bank was handled as a deposit payoff or as a purchase-and-assumption. 

The difference, in terms of cost, hetween a payoff and a purchase-and

assumption was much greater for national banks. Without looking at the 

individual banks in more detail it is not clear why such a difference would 

exist. 

Table 7 

Estimated Loss on Assets and Cost to FDIC 

in Bank Failures, Farm vs. Nonfarm Banks 

Loss on Book Cost to 

Number Assets Capital PDIC 

of Banks (% of Assets) (% of Assets) (% of Assets) 

Farm 66 34.3 2.9 30.0 

Nonfarm 152 32.3 0.4 30.0 

Farm vs. Nonfarm Banks 

A farm bank is defined here as a 

bank in which 25 percent or more of 

the loans are related to agriculture. 

As is well known, the sharp decline 

in farm commodity prices in the 

early 1980s contributed to the fail 

ure of a large number of farm banks, 

primarily in the Midwest. Table 7 

compares the estimated cost to the 

FDIC of farm and nonfarm bank 

failures. Notice that despite higher 

estimated losses on assets in farm 

hanks, the astimated cast to the FDIC 

for each group is the same. As the 

table shows, this is because farm 

banks had more book capital at the 

time of failure to absorb the higher 

losses. The difference between esti 

mated loss on assets in farm banks 

relative to nonfarm banks is not re 

ally noteworthy given that cost to 

the FDIC is the same; that is, if a 

greater portion of nonperforming as 

sets at farm banks had been written 

off prior to their failures then their 

average loss on assets would have 

been lower as would book capital 

(which would put their figures more 

in line with nonfarm banks). 

Ongoing Research 

Presently, efforts are underway to 

further refine the results presented 

in this section. More recent collec 

tion experience will be factored into 

the analysis. Additionally, it may be 

possible to add greater precision to 

the asset-quality categories included 

in the model. At regular intervals the 

equations presented in this section 

will have to be modified to account 

for these and other factors that may 

impact the FDlC's failure-resolution 

costs. The results presented here 

represent the first phase of an ongo 

ing process. 

FDIC Procedures for 

Determining Minimum 

Acceptable Bids 

The current policy of the FDIC is 

to try to keep as many of the assets 

of failed banks in the private sector. 

This is accomplished by attempting 

whole-bank transactions whenever 

possible and, failing that, by passing 
FDIC Banking Review 

assets in both purchase-and-assump

tion transactions and insured-deposit 

transfers. Of course, the desire to 

pass assets is tempered by the need 

to protect the insurance fund; the 

FDIG must ensure that it sells assets 

at prices at least equal to liquidation 

values. The application of that sim 

ple guideline poses a knotty problem 

for the FDIG. 

Consider the sequence of events 

when the FDIC attempts a wholebank transaction. The FDIC seeks 

another bank to assume the liabili 

ties and to acquire substantially all 

of the assets of the failed bank. Be 

cause the liabilities of the failed bank 

exceed the market value of the as 

sets, the acquiring bank will be un 

willing to engage in a whole-bank 

transaction unless the FDIG makes a 

payment to compensate for the dif 

ference between the market value of 

assets and the bank's liabilities. (This 

payment is actually a combination of 

the premium the bank is willing to 

pay and the discount on the assets.) 

Prior to a bank's closing, the FDIC, 

in concert with the other regulators, 

selects a list of potential acquirers. 

The list typically includes healthy 

banks and holding companies, as 

well as individuals with the financial 

capacity to handle the transaction. 

The universe of bidders is generally 

governed by applicable laws or regu 

lations. That is, the number of eligi 

ble bidders may be restricted in some 

states because of branching limita 

tions or other regulations. Con 

versely, some states allow acquisi 

tions on a nationwide basis. Potential 

bidders must be large enough or 

have the capacity to take on the 

failed bank without impairing the 

surviving institution's future viabil 

ity. 

The potential bidders are usually 

given a "core" or basic bid package at 

a bidders' meeting. This package con 

tains financial and other relevant 

information on the failing bank. De 

pending on the circumstances, the 

bidders typically have several days 

or, in most cases recently, up to two 

or three weeks to evaluate the infor 

mation before submitting their bids 

(simultaneously). During the pastsev

eral months the FDIC has actually 

attempted to allow potential bidders 

into the failing institution to perform 

a careful review of the bank's condi 

tion. This allows the bidders more 

complete information on which to 

base their bids. However, in order to 

do this the cooperation of the char 

tering authority and the failing bank's 

board of directors is required. 

After receiving the bids the FDIG 

must determine whether the lowest 

bid is acceptable according to the 

standard required by the statutory 

cost test: the premium or discount 

must result in a transaction which is 

less costly than the cost of paying off 

the bank. That determination largely 

hinges upon the estimated loss on 

assets in the failed bank. The FDIG 

currently considers two sources of 

the estimate of loss on assets, one 

based on the information in this 

study and the other based on onsite 

estimates provided by personnel from 

the FDIC's Division of Liquidation. 

Prior to the failure, a team of FDIC 

liquidators is sent to review the as 

sets. Time constraints generally pre 

vent the team from assessing every 

asset, so an extensive sampling pro 

cedure is used. Loans are divided 

into categories such as real estate, 

commercial, and installment. Within 

each category the loans are identi 

fied as classified, nonperforming or 

current. For each of these subgroups, 

a sample of loans is reviewed care 

fully to determine an estimated liq 

uidation value. Some adjustments 

are made to discount future cash 

flows and to account for liquidation 

expenses. The loss factor that results 

from this estimate is then applied to 

the loans in the group that were not 

reviewed. Risk assets other than loans 

are evaluated on an individual basis. 

Securities are marked to market. 

The onsite valuation yields a figure 

that, with some minor adjustments, 

can be used as an upper bound on 

the amount that the FDIG should be 

willing to pay for a whole-bank trans 

action. The greater the loss that the 

liquidators estimate, the more the 

FDIC is willing to pay. 

Another recommendation for the 

maximum acceptable payment is de 

rived from the model presented in 

the earlier discussion. Applying the 

regression results in Equation 2 to 

[he balance sheet and asset classifi 

cations of the failing bank yields an 

estimate of the loss on assets. The 

liabilities and the levels of uninsured 

and unsecured creditors are factored 

in to determine the expected cost to 

the FDIC of paying off the bank. 

Adjustments then are made to en 

sure that the FDIG is not paying an 

acquiror for "fixed" costs that it will 

incur regardless of the type oi trans 

action that is conducted. These and 

a few other minor adjustments help 

provide a second estimate of the 

maximum acceptable bid. 

To the extent that two bid esti 

mates are better than one, this twotracked approach should enhance 

the decision-making process. In prac 

tice, however, when the estimates 

differsubstantially the question arises 

as to which provides a better guide. 

The onsite estimate has an obviously 

attractive feature: assets are actually 

looked at and valued firsthand. The 

onsite estimate incorporates infor 

mation that is specific to the bank in 

question in a way that a simple re 

gression model based on a handful of 

bank characteristics cannot. 

The regression model, on the other 

hand, has the virtue that it is derived 

from actual liquidation experience. 

If the estimated relationship between 

asset classifications and loss rates 

has not changed dramatically from 

the sample period, the estimate ob 

tained from the model will, on aver 

age, coincide with the actual losses. 

In other words, these estimates will 

not systematically understate nor 

overstate the actual losses. The liq 

uidators' estimates do not necessar 

ily share this virtue. To the extent 

that liquidators tend to be either 

optimistic or pessimistic about col 

lections, the FDIC would be guided 

to either retain too many assets or to 

sell banks too cheaply. 

12 
Bank-Failure Costs 

The current FDIC policy approxi 

mates the following. If the two esti 

mates are reasonably close, the onsite estimate is used. If the estimates 

diverge significantly, further exten 

sive review of both estimates is con 

ducted to determine the reasons for 

the difference and to better ascer 

tain the appropriate loss estimate. 

To protect against the potential 

systematic bias in the onsite esti 

mates, a system is in place to moni 

tor the differences between the two 

approaches. If onsite estimates 

should prove to be systematically 

lower or higher than the regression 

estimates, adjustments can be made 

to the onsite estimates. Thus, to 

summarize, whenever possible the 

onsite estimate is used to determine 

minimum acceptable bids, and the 

regression results, in effect, provide 

a back-up estimate to allow for some 

greater degree of confidence in the 

decision-making process. 

Conclusion 

The FDIG's failure-resolution costs 

for banks that failed in 1985 and 

1986 are estimated to be roughly 30 

percent of total failed-bank assets. 

Since there are assets in these banks 

that remain to be liquidated, the 

final cost may change, but probably 

not significantly. Moreover, since 

there was only one large-bank failure 

(greater than $500 million in total 

assets) in the sample and the largest 

banks typically have lower failureresolution costs per dollar of asset, 

the FDIC's overall cost for handling 

bank failures over the past few years 

is well below 30 percent of all failedbank assets. 

In looking at a 30 percent-of

assets average cost estimate, one 

question that may come to a read 

er's mind is: If failure-resolution 

costs are this high for the typical 

bank failure, is it because banks 

are not being closed until they are 

well past the point of actual insol 

vency? Some may view such high 

failure-resolution costs as a clear 

indication that banks are not being 

closed soon enough. However, this 

is not necessarily the case. 

Clearly, assets are worth consider 

ably more in an ongoing institution 

than in a liquidation. If this were not 

true, contrary to FDIG experience, 

most problem banks would become 

insolvent as they ultimately lost 20

30 percent on their asset portfolio. 

To the extent that such a value dif 

ferential exists, it means that even 

the liquidation of a marginally insol 

vent bank could cost the FDIG a 

substantial amount. 

The sample used in this study 

consists almost exclusively of failed 

banks for which the FDIG retained 

virtually all of the risk assets, One 

could look at banks where the ac 

quiring institutions purchased a large 

portion of the risk assets to get a 

sense of whether those assets were 

worth more in an ongoing institution 

than in a liquidation. 

While some value may be lost in 

transferring assets from one insti 

tution to another, our expectation 

is that risk assets are worth more in 

another ongoing institution than in 

a liquidation. During the first half 

of 1988 the FDIC completed 52 

open-bank assistance transactions 

and whole-bank P&A transactions 

in which the acquiring institution 

retained most of the failed (or fail 

ing) bank's risk assets. On average, 

in these transactions the FDIG's 

cost as a percentage of failed-bank 

assets was about 20 percent. While 

there are likely to be other factors 

involved in creating the 10 percentof-total-assets difference for the 

transactions examined in this study 

versus those where the FDIC did 

not retain the failed bank's risk 

assets, it is quite likely that much 

of the difference may be due to the 

possibility that assets are worth 

more in an ongoing institution ver 

sus a liquidation. Nevertheless, the 

issue needs to be examined much 

more carefully, since there may be 

differences in asset quality between 

the two groups and acquiring insti 

tutions may realize gains or losses 

on their asset purchases. 

The results of such an analysis will 

have important implications for FDIC 

failure-resolution transactions and for 

failing-bank closure policies. At this 

time, however, it should be made 

clear that the cost estimates pre 

sented in this report relate almost 

exclusively to failure transactions 

where the FDIC retained virtually all 

of the risk assets. At least at first 

glance, it does not appear that these 

results are directly applicable to trans 

actions where the FDIG sells those 

assets to another financial institu 

tion as part of a failure-resolution 

transaction. 

It also is likely that some portion 

of the FDIC's resolution costs for 

failed banks is due to imperfect 

markets. If the market for failed 

banks were perfect, that is, if there 

were many risk-neutral buyers with 

complete information, the bids they 

put forth would represent the best 

measure of the value of the failed 

bank and the FDIC always would 

be willing to accept the best bid. In 

fact, there would be no need for the 

FDIC to make independent esti 

mates of the value of failing banks. 

However, because bidders often are 

few in number, risk-averse, and 

lacking complete information about 

asset quality, there are instances 

where the best bid entails a cost to 

the FDIG that exceeds the cost of 

liquidating the bank. Thus, inde 

pendent estimates are necessary. 

Currently, the FDIC is pursuing pol 

icies designed to enhance the bidding 

process. The time period during which 

potential bidders can review the finan 

cial records of a failing bank has been 

extended. Articles such as this one 

also help provide potential bidders with 

greater information. In addition, ef 

forts are being made to attract as many 

eligible bidders to the bidders' meet 

ings as is possible. Each of these ef 

forts should help to develop a better 

market for failed banks and enable the 

FDIC to receive bids on failed banks 

that better reflect the true condition of 

those banks. 

13 
Interest-Rate Risk 

Measuring the 

Interest-Rate Exposure 

of Financial Intermediaries 

by George E. French* 

US. federally insured deposi 

tory institutions at year-end 

1987 held #1.7 trillion of 

"long-term" assets maturing or re

pricing after one year. These assets 

were acquired mostly by short-term 

borrowing; liabilities maturing after 

one year totaled only $500 billion. 

Borrowing short term and lending 

long term has traditionally been the 

province of thrift institutions, but 

banks also engage in this to a limited 

extent. In both cases, this "maturity 

intermediation" serves to meet the 

needs of borrowers for long-term 

funds while allowing depositors to 

hold shorter-term assets. 

Part of banks' and thrifts' spread 

between interest income and inter 

est expense is earned precisely be 

cause they borrow short tenn and 

lend long term. At year-end 1987, 

for example, the yield on 91-day 

Treasury bills was 6.07 percent, that 

on one-year notes was 7.38 percent, 

and that on ten-year bonds was 8.85 

percent. This situation is not atypi 

cal; yields on long-term financial as 

sets usually are higher than those on 

short-term assets. 

The attitude towards interest-rate 

risk of a financial intermediary's cus 

tomers may also encourage it to bor 

row short term and lend long term. 

Specifically, borrowers generally are 

willing to pay a premium for long

term, fixed-rate mortgages because 

they want to avoid unpredictable 

changes in their monthly payments 

caused by interest-rate fluctuations. 

On the liability side of the balance 

sheet, depositors prefer short-term 

deposits to long-term deposits and 

are willing to accept less interest in 

return. This, of course, is the reason 

borrowing short term and lending 

long term is potentially profitable: 

the market rewards the bank or thrift 

for bearing risk. 

This "interest-rate risk" is the risk 

intermediaries incur when the ma 

turity structures of their assets and 

liabilities are different—roughly 

speaking, when they either borrow 

short term to lend long term or vice 

versa. In such situations unexpected 

changes in interest rates can have 

adverse effects on institutions' net 

interest income and net worth. 

For example, consider a bank that 

sells a 9-0-day certificate of deposit 

(CD) and uses the proceeds to make 

a one-year business loan at a speci 

fied interest rate. The yield on this 

asset is "locked in" for one year at 

the specified rate. Meanwhile, after 

90 days the cost of funds will be 

market-determined. If interest rates 

rise the bank's interest spread on the 

loan will decline. At the same time, 

the resale value of the loan and of all 

the bank's other fixed-rate assets will 

fall. 

On the other hand, suppose the 

bank issues a one-year CD and uses 

the proceeds to make a 90-day busi 

ness loan. The bank's cost of funds 

for this liability is locked in for one 

year; it cannot benefit from a decline 

in interest rates. On the asset side, 

however, yields will be marketdetermined after 90 days and vul 

nerable to a decline in interest rates. 

At the same time, however, the de 

cline in rates will increase the value 

of the bank's other fixed-rate assets, 

The bank in the first example is 

said to be "liability-sensitive." Since 

its liabilities reprice sooner than its 

assets, its net interest income and 

net worth are vulnerable to increases 

in interest rates. The bank in the 

second example is "asset-sensitive" 

and vulnerable to reductions in in 

terest rates. 

A liability-sensitive balance sheet 

(again, one characterized by shortterm borrowings and long-term as 

sets) poses a far more serious risk to 

the health of a financial institution 

than an asset-sensitive balance sheet. 

The reason is that the increase in 

interest rates which adversely affects 

a liability-sensitive institution's net 

interest income also reduces its li 

quidity by reducing the market value 

of its assets, and especially since 

these assets tend to have long 

maturities.' On the other hand, the 

reduction in interest rates that im 

pairs an asset-sensitive institution's 

net interest income has the offset 

ting effect of increasing the value of 

"George French is a financial economist 

in the FDIC's Office of Research and Statis 

tics. Comments and suggestions by Man McGall are greatly appreciated. 

'The value of long-term assets is more 

sensitive to interest-rate movements than is 

that of short-term assets. 

\A 
f'DIC Ranking Review 

the institution's fixed-rate assets, 

thereby improving liquidity. 

The purpose of this paper is to 

discuss gap and duration methods of 

measuring the interest-rate exposure 

of financial institutions, along with 

the advantages and shortcomings of 

each method. Estimates of the 

interest-rate exposure of commer 

cial banks, FDIC-insured savings 

banks and FSLIC-insured thrift insti 

tutions, using both gap and duration 

measures, are presented in the last 

section of the paper. 

Methods of Measuring 

Interest Exposure 

Gap Measures of Interest 

Exposure 

Gap analysis examines how a 

change in interest rates would affect 

the net interest income generated by 

a portfolio of assets and liabilities, 

other things held constant. The di 

rection, timing and magnitude of the 

change in net interest income can be 

estimated using information on the 

if e re ces—or ga ps—betwe n as sets 

and liabilities repricing in different 

time intervals and on the assumed 

change in interest rates. 

gap for a particular time interval 

is the difference between assets re

pricing during that time interval and 

liabilities repricing during that time 

interval. The idea underlying gap 

analysis is simple, intuitively appeal 

ing, and best understood by using an 

example. Suppose a bank has $100 

of assets and 8500 of liabilities that 

are reprieeable during the next year. 

Then a 100 basis point (or .01) in 

crease in market yields on assets 

would enable the bank to increase 

gross interest income by 1/2 x [.0.1 x 

SlOO] = g0.50 during the year.2 

Similarly, the 100 basis point in

2This assumes ill I the assets reprite 

evenly throughout the year; if they all re

priced immediately at the beginning of the 

year the increase in income would be 81. If 

the assets repriced at the cud of the year the 

change in income during the first year would 

be zero. 

'Much of this reprising information is no 

longer available as of the March, I'MiH Call 

Report. More detailed information will still be 

collected for FSLlC-msured S&Ls. 

crease in liability interest rates would cause an increase in gross interest 

expense of 1/2 x (.01 x S500| = S2.50 during the year. On balance, net 

interest income falls by $2—which is the result obtained by multiplying the 

change in interest rates, .01, by one-half the "one-year gap" of $400: 

(1) Change in Ml 

During Year 1 = 1/2 x I(.01 x $100) (.01 x 

= 112 x (.01 x (glOO—$500)1 

1/2 x change in interest rates X "one-year 

cumulative gap," 

where Nil is net interest income. Dividing both sides of equation (1) by the 

average assets of the bank during the year, and assuming the only change in 

net income is from the change in net interest income, one obtains an 

expression for the change in ROA: 

Change in ROA 

During Year 1 = 1/2 x change in interest rates 

x (one-year cumulative gap-to-a-verage assets). 

An Example of Gap Analysis. An example of gap analysis is presented in 

Table 1. Repricing information for a U.S. commercial bank from Schedule J of 

the commercial bank Reports of Condition and Income (Call Reports) appears 

in condensed form along with selected deposit items."1 

The purpose of the analysis is to estimate the change in net interest income 

that would result from a given change in interest rates, given the assumption 

that all rates change by equal amounts. It is assumed that all other factors 

relevant to the determination of the bank's net income remain constant—only 

the level of interest rates changes. As will be discussed later, this assumption 

is not nearly as objectionable as it appears. 

Banks are required to identify assets and liabilities according to final 

maturity or earliest time to repricing. For example, if the interest rate on a 

variable-rate mortgage could be adjusted eight months from now, the current 

amortized value of the asset would be entered in the six-month to 12-month 

"maturity bucket." If a bank bought federal funds it would record these as 

liabilities repriceable immediately. Summing the asset row would give total 

"rate-sensitive assets." Liabilities classified as demand or savings deposits are 

not recorded on Schedule J. Some of these items—NOW accounts and money 

market deposit accounts (MMDAs)—are included in the table as being reprice 

able within three months but more than one day. Adding these two items to 

the liabilities row gives total "rate-sensitive liabilities." 

An "incremental gap" is the difference between assets repricing within a 

given time interval and liabilities repricing within that interval. A "cumu 

lative gap" is the difference between assets and liabilities repricing between 

the present and some specified future date, and is also the sum of the 

incremental gaps for the time intervals prior to the specified date. For 

example, the cumulative six-month gap is the difference between ratesensitive assets and liabilities in the zero- to six-month time interval, and 

equals the sum of the one-day, one-day to three-month, and three-month to 

six-month incremental gaps. 

The cumulative and incremental gaps can be used to estimate the changes 

in net interest income for each time interval caused by a 100 basis point 

interest-rate increase, as shown in the formulas at the bottom of Table 1. For 

example, consider the three-month to six-month interval. All assets and 

liabilities that repriced or matured within the first three months will be 

yielding or costing an additional K)0 basis points per annum during months 
Interest-Rate Risk 

three through six. This represents 

an increment to Nil of (,01/4)Gap0d3, 

where Gap0d3 is the three-month 

cumulative gap. The idea is that as 

sets earn .01 more per annum, or 

.01/4 more for the quarter; liabilities 

cost .01 more per annum, or .01/4 

more for the quarter. The net change 

in income in quarter two due to the 

repricing of assets and liabilities dur 

ing quarter one is (.01/4}Gap0d3. In 

addition, assets and liabilities repric 

ing from months three through six 

will yield or cost .01/4 more during 

the quarter. Just as in equation (1), 

however, we must multiply by 1/2 

because on average these assets and 

liabilities will be yielding the higher 

rates tor only half the quarter. The 

total change in Nil during months 

three through six is the sum of these 

two components, or (.Ol/4)GapOd3 

+(l/2)(.01/4)GaP3d6, where Gap3dt5 

is the incremental gap for months 

three through six. 

Estimated changes in Nil per 100 

basis point increase in interest rates 

are presented in Table 1. The table 

illustrates the importance of using 

the shortest available repricing in 

tervals in estimating changes in Nil. 

For example, even though the cumu 

lative three-month gap is negative 

(-81121), Nil is estimated to in 

crease by 81.4 million per 100 basis 

point increase in interest rates, be 

cause of the large volume of assets 

repricing immediately.11 

Duration Measures of 

Interest Exposure 

Duration is a number measuring 

the sensitivity of the market value of 

an asset or liability, or portfolio of 

assets or liabilities, to changes in 

interest rates. It is potentially useful 

in evaluating the sensitivity of the 

net worth of a financial institution to 

changes in interest rates. 

""'Immediately" refers to the one-day re

pricing interval. Since these assets earn higher 

yields throughout the first three months while 

liabilities pay more only during half that (ime 

(on average), the net effect is an increase in 

Nil when interest rates rise. 

Table 1 

Gap Analysis for a U.S. Commercial Bank 

September 30, 1987 

(^millions) 

Maturity or Earliest Time to Repricing 

1 day- 3 mos.- 6 mos.- 1 year- Over 5 

1 day 3 mos. 0 mos. 12 mos. 5 years years 

Assets S3666 & 2263 $ 1S4 S 229 8 1414 S1864 

Liabilities 

a) Schedule ,1 1494 5209 210 176 948 258 

b) NOW Accounts 184 

c} MMDAs 163 

Incremental SGap 2172 3293 26 53 466 1606 

Cumulative SGap 2172 -1121 -1147 -1094 -628 978 

Change in Nil1 

during period 0.1 1.3 -2.8 -5.6 -34.4 n.a. 

Cumulative 

Change1 

(incremental gap 

method) 0.1 1.4 -1.4 -7.0 -41.4 n.a. 

Cnmultive 

Change1 

(uuiti ulative gap 

method) 0.1 -1.4 -2.9 -5.5 -12.6 n.a. 

M'er 1(10 basis point increase in interest rates. Changes in Nli during each period (denoted 

"d(Nl[)") are estimated as follows: 

Day 1: d(N|M = f .0.1/3 60 )GapOdl 

Day 1-3 Mos.: d(NII = ()p.01/4)GapOdl + f 1/2)1.)1. .(>L'4)Gap]tl3 )p 

3 Mos.—6 Mos.: dINIf = (.01/4)Gap0d3 (01/4G0d3 (l/2X0l/4JG3i6 (l/2X.0l/4JGap3(i6 6 Mos.-12 Mos.; d(NII = f.0U2)Gap«dG ( (1/2V 0$/2)GMl2 $)p

I year-5 years: dfNII = (4)(.01)Gap0dl2 (l/2l/2)(4)(.01)Gapl2d60, 

where GapOdl is the cumulative one-day gap, Gapl)d3 is the cumulative three-month gap, 

Gup0d6 the cumulative six-month gap, etc., and Gapld3 is the incremental one-day to 

three-month gap, Gap3d6 the incremental three-month to six-month gap, etc. Cumulative 

changes in Nil using the "incremental gap method" are obtained by adding the figures in the 

preceding row; with tlie "cumulative gap method" the changes are estimated by multiplying 

one-half the cumulative gaps by .ill, as in equation (1) in the text. No attempt is made to 

estimate d(NH) tor die "over S years" maturity bucket. 

Measurement of Duration. The calculation of the duration of a security is 

straightforward, although tedious. Let c,, c2, ... , cn be the cash flows, 

including both interest and principal, promised by a security one period from 

now, two periods from now, and so on. The "period" or time interval between 

cash flows might be one month as in a mortgage, six months as in most bonds, 

one year, or any other length. Let r' be the one-period interest rate which 

discounts the cash flows back to the market value of the security. That is, 

(2) P = cj/(l +T1) + c2l(l +r')2 + ... + c,J(l +r')n, 

where P is the price of the security and n is the date (measured in periods from 

the present) of the last cash flow. For a mortgage, r' would be a one-month 

interest rate; for a bond, r' would be a six-month interest rate; and so on. When 

r' is expressed as an annual rate it is usually called the "yield to maturity.'1 

The price of the security is the sum of n components, namely the present 

values of each of the n cash flows. One could measure the percentage of the 

price of the security contributed by each of the cash flows. Thus, 

to, = Ic/d +r'?]fP 

is the percentage of P which is contributed by the i'h cash flow c,. Naturally, 

H), W2 + . . . + TO,, = 1, 

since together the n cash flows contribute 100 percent of the price of the 

security. 
PDIG Banking Review 

The duration of the security is a weighted average of the dates at which cash 

flows are received, using the numbers wt as weights: 

Duration, using this formula, is a weighted average time to repricing. It tells 

"on average" how soon the investor gets his money back to reinvest at new 

interest rates. When applied to liabilities, the duration measure tells how soon 

"on average" the liability must be refinanced. 

For all securities other than zero-coupon bonds, duration must be less than 

the time n to maturity. The reason is that an average of the date n with other 

dates less than n must be less than n. For zero-coupon bonds, however, there 

is only one payment cn and only one weight wn = 1. The duration is thus n, the 

time to maturity. 

For a fixed-rate mortgage with equal payments every month, the duration 

would be less than half the time to maturity. For example, a newly issued 

30-year mortgage would have a duration of less than 15 years. The reason is 

that each successive equal monthly payment has a smaller present value and 

contributes less to the price of the mortgage. In the averaging process 

(equation (3)) which computes the duration, then, dates less than 15 years get 

higher weights than dates more than 15 years, and the result must be less than 

15 years. 

The duration of adjustable-rate assets or liabilities which are fully repriceable immediately is zero or close to it. This is because there is little time until 

repricing—and the more quickly the interest rate is adjusted, the less change 

there is in the present value of such assets and liabilities.5 

Duration as a Measure of the Interest Sensitivity ofAsset Values. At the 

beginning of this section it was stated that duration measures the sensitivity of 

the value of a security or portfolio to changes in interest rates. Equation (3), 

however, defines duration as a weighted average time to repricing. The relation 

between the definition of duration as a weighted average time to repricing and 

as a measure of price sensitivity to changes in interest rates is shown in the 

following formula which is of great importance: 

(4)d/VP =* -D(dr')/(l+r') =* -D(dr'), 

where dP is the change in the price P of a security from its previous value, r' 

is the interest rate appropriate for the time interval between the security's cash 

flows, dr' is the change in this interest rate from its previous value, and D is the 

duration defined in equation (3). The symbol " = a" means "approximately 

equal."6 For equation (4) to be valid, D and r' must refer to the same time 

intervals. For example, if D is expressed in months, then r' must be the 

one-month interest rate. 

According to equation (4), the percentage change in the price of a security 

is (approximately) inversely proportional to the change in its yield to maturity, 

and duration is the factor of proportionality. The term dP/P—the absolute 

change in price divided by its original value—is the percentage change in the 

price of the security caused by the interest-rate change drf. The negative sign 

reflects the fact that security prices are inversely related to interest rates. 

As an example of the usefulness of equation (4), suppose the duration of a 

security is 5 years, and the annual yield to maturity of a security with similar 

or identical characteristics falls from 8 percent to 7.5 percent. Then 

dr' = .075-.08 —.005, and the percentage change in the price of the 

security would be approximately (-5)(-.OO5) = +.025, i.e., a 2.5 percent 

increase. As indicated in equation (4), a better approximation could be 

obtained by dividing this figure by 1 r', or 1.08. The result would indicate a 

2.31 percent increase. While even this latter figure is an approximation, it is a 

very good one. 

What is clear from equation (4) is 

that the longer the duration, the 

greater will be the percentage change 

in the price of a security resulting 

from any given interest-rate change. 

The equation simply formalizes what 

is well known to financial practitio 

ners, namely that the value of long

term assets—i.e., those with long 

durations—is more sensitive to 

interest-rate changes than that of 

short-term assets. 

The Duration of a Portfolio of 

Assets or Liabilities. The duration 

of a portfolio of assets is a weighted 

average of the durations of the indi 

vidual assets in the portfolio, where 

each asset receives a weight equal to 

its share of the value of the portfolio. 

For example, suppose a portfolio con 

sists of a bond currently worth 

810,000 with a duration of six years 

and an auto loan worth 85,000 with 

a duration of one year. The value of 

the portfolio is 815,000, of which the 

bond contributes 2/3 and the loan 

1/3. The duration of the portfolio is 

(2/3X6) + (1/3)(1) 4.33 years. 

Similarly, the duration of a portfolio 

of liabilities is a weighted average of 

the durations of the individual liabil 

ities in the portfolio, where each 

liability receives a weight equal to its 

share of the value of total liabilities. 

Measuring the Interest-Rate Ex 

posure of Depository Institutions 

Using Duration. Duration can be 

used to estimate the change in the 

market value of a depository institu 

tion's net worth resulting from a 

given change in interest rates using 

the following approximation: 

sAs an idealized example consider the 

duration of a consol or perpetuity that pays a 

market rate of interest r' on a principal value 

F every period, forever. The present value of 

the future payments is 

P = r'F/(l r') + r'F/(l+r')- + 

. . . + r'P/(l + r')" + . . . = F, 

as can easily be demonstrated. The value of 

this adjustable-rate security is thus indepen 

dent of interest rates and its duration is zero. 

Other immediately adjustable instruments may 

have values that depend on interest rates if 

the rate paid on the principal balance, while 

variable, is different from the rate at which 

the cash flows are discounted. 

r'A derivation and further explanation of 

equation (4) are contained in Appendix A. 

17 
Interest-Rate Risk 

(5) dN = = • -A(GAPN)(drA). 

In [his equation dN is [he change in the market value of net worth from its 

original value, A is the market value of assets, rA is the yield on assets, drA is 

the change in this yield from its original value, and GAPN is the "net worth 

duration gap" defined by 

(6) GAPN = DA -DL(L/A)t(l 

where DA and DL are the durations of the asset and liability portfolios in years, 

L is the market value of liabilities and rL is the rate paid on liabilities.7 

To illustrate the usefulness of equation (5), suppose the market value of a 

bank's assets is SI billion, its duration gap GAPN is three years, and asset yields 

increase from 10 percent to 11 percent. Then drA = .01, and dN =" -{$1 

billion)(3 years)(.OI/year) = $.03 billion, or three percent of assets. If this 

hypothetical institution had a market value of six percent of assets, half this 

value would be wiped out—instantaneously—by an unexpected 100 basis 

point jump in interest rates. 

For the bank to immunize itself against changes in net worth resulting from 

unexpected interest-rate movements, equation (5) indicates that the duration 

gap must be zero. This duration gap, defined in equation (6), would typically 

be close to DA-DL, the difference between the duration of assets and liabilities. 

In other words, protecting market value from interest-rate changes requires 

that the average time to repricing of assets be about the same as that of 

liabilities. 

Estimating Duration with Limited Information. The most important 

determinants of the duration of a typical financial instrument are its remaining 

maturity or time to next repricing, and whether it is amortizing or bond-like in 

its pattern of cash flows. For example, a five-year zero-coupon bond has a 

duration of five years. A five-year Treasury bond with ten percent coupon rate 

and yield to maturity has a duration of 4.05 years. A five-year amortizing loan 

with equal monthly payments and a ten percent yield to maturity has a 

duration of 2.34 years. 

Knowledge of coupon rates and market interest rates is not nearly so 

important to estimating duration—and this is fortunate for regulators, who 

receive reports only on average yields, if that much. In the above example, if 

the coupon rate on the five-year bond was 12 percent rather than ten percent, 

the duration would fall from 4.05 years to 3.95 years. If the yield on the 

five-year bond rose to 12 percent from ten percent, its duration would fall from 

4.05 years to 4.01 years." 

The durations in these examples were computed using formulas that avoid 

the cumbersome method of equation (3), at least for certain important classes 

of financial instruments. Durations of amortizing assets or liabilities—those 

which are paid off in equal periodic payments—can be calculated using 

equation (9a) of Appendix B, which requires only knowledge of the maturity 

and market interest rate of the instrument. Durations of bond-like instru 

ments—those with periodic payments of interest—can be calculated using 

equation (10a) of Appendix B, which requires knowledge of the coupon rate, 

market interest rate and maturity of the instrument. As illustrated in the 

examples just given, however, using rough estimates of coupon rates and 

market interest rates, even if they are off by several hundred basis points, will 

not result in too great an error in measuring duration. Offsite estimates of 

duration from financial reports of federally insured depository institutions 

might proceed as follows.9 The amounts in each asset and liability category 

from the repricing schedules are treated as single financial instruments with 

maturity equal to the midpoint of 

the repricing interval. Depending on 

the category being considered, the 

formulas for durations of zerocoupon, bond-like or amortizing in 

struments are used, with estimates 

of average coupon rates and market 

interest rates used where required. 

Difficulties of Measuring 

Interest-Rate Exposure 

Measuring the interest-rate ex 

posure of financial intermediaries 

is subject to considerable difficul 

ties, especially given the limited 

financial information regularly re 

ported to their federal regulators. 

The fundamental difficulty is in es 

timating the timing and magnitude 

of cash flows, whether for the pur 

pose of determining correct 

amounts of rate-sensitive assets and 

liabilities to compute gaps or for 

the purpose of determining dura 

tions. Problems encountered in es 

timating the interest-rate exposure 

of financial intermediaries are dis 

cussed in this section. 

One problem facing regulators 

attempting to measure interest-rate 

exposure is a lack of accurate knowl 

edge of maturities or times to re 

pricing. For example, changes in 

net interest income for each time 

interval in Table 1 were computed 

by assuming that assets and liabil 

ities repriced evenly throughout the 

interval. This introduces potential 

inaccuracy: conceivably all the lia 

bilities repricing during an interval 

could reprice on the first day of the 

interval and all assets on the las[ 

day of the interval, or vice versa. 

For example, recall that in Table 1 

it was estimated that Nil would in 

crease during the first three months 

following an interest-rate increase 

'Equation (5) and the assumptions ncc

essary for its validity are derived and dis 

cussed in Appendix A. 

"The slight reduction in duration occurs 

because higher interest rates increase the 

yield from reinvestment of coupon income, su 

that the initial investment is recouped sooner. 

''Further details on the duration esti 

mates used in this paper are provided in 

Appendix li. 
FD1C Banking Review 

even though the cumulative threemonth gap was negative, because of 

the large positive one-day gap. Sim 

ilarly, the changes estimated for each 

incremental gap might differ sub 

stantially from the "true" figures. This 

source of error can only be elimi 

nated by collecting repricing infor 

mation for intervals of increasingly 

shorter length. In fact, some asset/ 

liability management simulation pro 

grams allow financial institutions to 

divide their repricing periods into 

intervals of only one day. 

Interest-rate risk measurement suf 

fers from a further source of poten 

tial inaccuracy—ignoring or incor 

rectly estimating the intermediate 

cash flows generated by assets and 

liabilities.10 For example, a fixedrate mortgage maturing in 15 years 

will generate substantial cash inflows 

in the form of monthly payments of 

principal and interest. These cash 

flows are rate-sensitive assets and 

should be included in calculating each 

incremental gap or in estimating du 

rations. Similarly, scheduled pay 

ments of principal and interest on, 

say, Federal Home Loan Bank ad 

vances ideally should be counted as 

rate-sensitive liabilities. 

The difficulty of estimating the 

"true" amounts of assets and liabil 

ities repricing during a given time 

interval is compounded when de 

posits can be withdrawn or loans 

prepaid at the customer's option. 

This introduces an element of un 

certainty to the timing and magni 

tude of the bank's cash flows, and 

has important implications for 

interest-rate exposure. Declining in 

terest rates, for example, are likely 

to increase loan prepayment rates, 

causing high-yielding assets to be 

replaced on the books by loweryielding assets. Rising interest rates 

can trigger deposit withdrawals from 

fixed-maturity deposits, which must 

be replaced at higher rates. Such 

considerations are absent from gap 

or duration analysis. 

In addition, the degree to which 

some assets are rate-sensitive may 

be impossible to assess. The wide 

spread use of periodic and lifetime 

interest-rate caps on variable-rate 

mortgages, for example, limits the 

degree to which institutions' interest 

income on such mortgages can re 

spond to increases in interest rates. 

Por some large institutions, an im 

portant problem may be that infor 

mation on repricing schedules does 

not reflect participation in the fu 

tures, options or swaps markets." 

Such activities can substantially al 

ter institutions' interest-rate expo 

sure—as they are designed to do. 

Another problem with the basic 

gap and duration models is that they 

assume that interest rates on all as 

sets and liabilities change by equal 

amounts—an unlikely occurrence. 

Rates on federal funds and large CDs, 

for example, are likely to be much 

more volatile than rates on small 

savings deposits. 

A related problem is that the 

assets and liabilities being repriced 

may have coupon rates different 

from current market rates. In this 

case the changes in net interest 

income computed from the gap for 

mulas would be incorrect. For ex 

ample, suppose current mortgage 

rates are ten percent and increase 

to 11 percent. An old 16 percent 

mortgage matures and reprices at 

11 percent. This is a reduction in 

gross income of five percent, not an 

increase of one percent as the gap 

formulas would indicate. Similarly, 

accurate duration calculations re 

quire knowledge of the actual cou 

pon rates of assets or liabilities. 

further problem is that gap anal 

ysis and duration analysis typically 

do not distinguish between the ex 

pected and unexpected components 

of interest-rate changes. This may 

lead to a fundamental error: assert 

ing that an interest-rate increase 

would adversely affect an institution 

when actually the institution bene 

fits. For example, consider the fol 

lowing example provided by Sanford 

Rose.12 

Suppose the current three-month 

interest rate is 5.5 percent per an 

num, and the current six-month in 

terest rate is 6.0 percent per annum. 

Suppose a bank borrows #1 million 

for three months and lends the pro 

ceeds for six months. Its cumulative 

six-month gap for this transaction is 

-Si million: the asset does not rc

price during the period while the 

liability reprices in three months. If 

annual interest rates rise 50 basis 

points, gap analysis would indicate 

an adverse income effect for months 

three through six of (.005)(l/4)( -$1 

million) = -#1,250. 

The gap calculation indicates the 

bank to be Si,250 worse off if rates 

increase 50 basis points than if they 

don't change at all- similarly, dura 

tion analysis would show a decline in 

net worth as compared with the sit 

uation in which interest rates don't 

change. Although accurate, this is 

somewhat misleading since the bank 

will actually show a profit from the 

entire transaction. This profit de 

rives from earning a yield of six 

percent for six months while paying 

5.75 percent on average. 

The consensus of the market, 

however, was that borrowing for 

three months and lending for six 

months would not earn a riskless 

profit. In other words, the market's 

forecast of the three-month inter 

est rate three months from now 

was 6.5 percent. If this forecast had 

proved correct the bank would have 

paid six percent on average and 

broken even. Since rates rose by 

only 50 rather than 100 basis points, 

however, the bank profited. 

This example makes it clear that 

whether a bank profits or loses from 

borrowing short term and lending 

long term depends on the movement 

of interest rates over the life of the 

long-term asset. Banks with negative 

gaps or long durations will suffer 

'"This problem can be corrected par 

tially by estimating these cash flows from the 

available data. In Appendix G an example is 

presented indicating how this might be done. 

In the next section, estimates of the effects of 

these adjustments on institutions' £aps are 

presented. 

"The "impact of hedging activities" is, 

however, reported on S&Ls' repricing sched 

ules. 

}2Ainerioan Banker, February 2, 1988, 

p.l. 
Interest-Rate Risk 

adverse effects not from interest-rate 

increases per se, but from interestrate increases that are unexpectedly 

large relative to the consensus of the 

market at the time the bank made its 

initial interest-rate bet. 

Even with complete and perfect 

financial information about every 

asset and liability on an institu 

tion's balance sheet, there would 

still be difficulties in measuring 

interest-rate exposure because the 

market yield curve (which summa 

rizes the interest rates prevailing 

tor different maturities) is likely to 

shift in ways which do not corre 

spond to the simple cases analyzed 

in this paper. For example, equa 

tions (4) and (5) are the basis of 

estimating changes in values using 

duration in this paper. These equa 

tions are derived from equation 

(2), which assumes that all future 

cash flows are discounted at the 

same rate; that is, it assumes a flat 

yield curve. In addition, the deriva 

tion of equations (4) and (5) in 

volves assuming that this flat yield 

curve shifts in a parallel fashion. 

Gap analysis also assumes the yield 

curve to shift in a parallel fashion, 

but does not require it to be flat. 

An important criticism of gap 

analysis alone is that it focuses 

exclusively on changes in net inter 

est income, and not at all on mar 

ket value. This encourages a view 

of the effects of adverse interestrate changes which may be mis 

leading in some cases. The "output" 

of gap analysis is a series of num 

bers indicating changes in net in 

terest income from what it would 

have been without an interest-rate 

change. It is tempting to conclude 

that the effect of these successive 

income changes is agradual change 

in the institution's capital position. 

In market-value terms, however, 

all these future changes in income 

are discounted back to the present; 

the full change in market value 

occurs immediately, not gradually. 

If an institution adversely affected 

by an interest-rate change is solvent 

and does not face liquidity pressures, 

then the change in its cash flows 

may adequately describe the effects 

of the interest-rate change. If, how 

ever, the institution is or becomes 

insolvent on a market-value basis— 

or worse, on a book-value basis—as 

a result of a rate change, its incen 

tives to take risks are affected imme 

diately. Such insolvent institutions 

may be tempted to try to get out of 

their difficulties by undertaking highyielding, risky activities with the at 

titude: "Heads I win, tails the federal 

insurer loses." This of course de 

pends on managements' view of 

whether the institutions' problems 

are temporary or permanent. 

The situation is even more clear

cut for problem institutions that fed 

eral insurers are trying to close or for 

which they are trying to find a buyer: 

the market-value implications of ev 

ery interest-rate change are felt dollar

for-dollar—immediately—by the in 

surers. This is particularly so if the 

adversely affected institution must 

sell assets as a result of liquidity 

pressures. In this case, capital losses 

or a deterioration in asset portfolio 

quality would be sustained in addi 

tion to the adverse cash flow effects 

described by gap analysis. 

The criticism that gap analysis 

does not attempt to estimate 

changes in net worth is really only 

a criticism of how the "output" of 

the analysis is typically used. To 

estimate changes in net worth re 

quires knowledge of both changes 

in net income and changes in the 

rates at which this income is dis 

counted. Gap analysis generates the 

first set of numbers—the changes 

in net income. There is no reason 

these numbers could not be com 

bined with estimates of discount 

factors to estimate changes in net 

worth, a procedure currently used 

by the FDIG as part of its offsite 

monitoring of interest-rate expo 

sure. In principle, such a proce 

dure should give the same results 

as duration analysis. In practice 

the net worth estimates are not 

likely to be identical: due to the 

substantial uncertainties associated 

with the measurement of interestrate exposure outlined in this sec 

tion, any method of estimating 

interest-rate exposure should be re 

garded as an approximation. 

An invalid criticism of gap analy 

sis and duration analysis is that they 

do not adequately examine the evo 

lution of interest-rate exposure over 

time. The maturities and repricing 

characteristics of a financial institu 

tion's assets and liabilities are apt to 

change significantly over time as it 

reinvests cash flows and refinances 

liabilities. This is particularly true if 

changes in the level of interest rates 

or the shape of the yield curve dic 

tate changes in the institution's in 

vestment strategies and cash flows 

on existing assets and liabilities. The 

interest exposure of the institution 

thus also can change significantly 

over time. 

This means that financial institu 

tions wishing to manage their inter 

est exposure must monitor this ex 

posure on a regular basis. It means 

that regulators' offsite or onsite ex 

aminations of interest exposure may 

become dated very quickly. It does 

not mean, contrary to what some 

would say, that analyses of current 

interest exposure that do not ac 

count for a bank's future reinvest 

ment and funding strategies are in 

valid. 

To measure current interest expo 

sure it is unnecessary and mislead 

ing to try to simulate the effects of 

future operations. For a bank with 

exposure to rising interest rates as 

determined by its current balance 

sheet position, a Monday afternoon 

jump in interest rates will have ad 

verse effects which cannot be cor 

rected by operations commencing 

on Tuesday morning. 

Gap analysis estimates the changes 

in net income resulting from an 

interest-rate change based upon the 

bank's current balance sheet. Dis 

counting these changes in income 

provides an estimate of the change 

in net worth. There is no doubt that 

the future pattern of cash flows may 

be different from that implied by the 

20 
FDIC Banking Review 

current balance sheet, but that is 

irrelevant. What is important is the 

change in the present value of these 

cash Hows, and that can be approx 

imated using gap or duration analy 

sis applied to the current balance 

sheet. 

The bank has tremendous lee 

way to change the timing and re

pricing characteristics of its net 

income by buying or selling assets 

and liabilities, trading in futures or 

options, entering into interest-rate 

swaps, and so on. These activities 

can certainly change the bank's 

future interest exposure and cash 

flows, but cannot affect the value of 

these cash flows. In short, the 

present value of the bank's income 

stream, and changes to that value 

resulting from a current shift in 

interest rates, depends only on the 

current balance sheet and not on 

future operations. 

The Usefulness of Gap and Du 

ration Measures of Interest Expo 

sure. If one thing is clear by this 

point, it should be that measuring 

the interest-rate exposure of finan 

cial intermediaries is very difficult. 

Institutions' cash flows are the build 

ing blocks of any analysis of interestrate exposure, and these cash flows 

depend in a very complicated way 

on the shape and movements of the 

market yield curve as well as on the 

idiosyncrasies of individual institu 

tions' balance sheets. 

These factors sometimes can 

make measured gaps and durations 

differ substantially from their "true" 

values. Over time and on average, 

however, both gap analysis and du 

ration analysis provide serviceable 

tools to compare the degree to which 

institutions are exposed to adverse 

interest-rate movements and to alert 

regulators to excessive interest-rate 

exposure in particular cases. 

Duration analysis has the advan 

tage of attempting to measure 

changes in net worth resulting from 

interest-rate movements. The cash 

flows which are often the sole focus 

of gap analysis can be modified dras 

tically by the purchase and sale of 

traditional assets and liabilities as 

well as by operations in the markets 

for futures, options and swaps. These 

transactions car alter the timing and 

magnitude of cash flows but not their 

total presentvalue, which is the more 

fundamental and important quantity 

to measure. 

The "output" of duration analy 

sis—a change in the capital-to-asset 

ratio per change in interest rates—is 

easier to understand and more use 

ful than an assortment of one-day, 

three-month, six-month, one-year, 

two-year, three-year and five-year 

gaps. Gap analysis is probably most 

useful when its estimates of changes 

in net interest income are discounted 

to produce estimates of changes in 

net worth. Such a procedure has the 

advantage, like duration analysis, of 

emphasizing that the full marketvalue effects of interest-rate changes 

occur immediately upon a rate 

change and will be felt immediately 

by institutions that face liquidity pres 

sures, or by regulators whoare search 

ing for the least-cost method of clos 

ing insolvent institutions, 

All this does not mean that one 

should dispense with gap analysis 

per se. In light of all the uncertain 

ties surrounding the measurement 

of interest-rate exposure, one should 

not put too much stock in a singlenumber index of risk like duration. 

As in the example in Table 1, gap 

analysis can put considerable 

balance-sheet information before the 

analyst in a compact form which is 

readily understandable. This allows 

an overall impression of an institu 

tion's balance sheet which could not 

be obtained simply by feeding infor 

mation into a computer to obtain a 

single "magic number." 

Interest-Rate Exposure of 

Federully Insured 

Dejxisitory Institutions 

Gap and duration measures of 

interest-rate exposure at yenr-end 

1987 indicate considerable exposure 

exists at many thrift institutions. The 

savings and loan (S&L) industry ap 

pears to have the greatest exposure 

to rising interest rates, followed by 

FDIC-insured savings banks, and both 

have greater exposure than commer 

cial banks (although data shortcom 

ings make it extremely difficult to 

estimate meaningfully commercial 

banks' exposures). This conclusion 

holds whether one examines the 

weighted average industrywide gaps 

in Tables 2 through 4 or the quartile 

distributions of gap and duration mea 

sures in Table 5. 

These differences in interest-rate 

exposure are largely related to the 

traditional role of thrift institutions 

as providers of mortgage funds. At 

year-end 1987, FSUC-insured 

thrifts had 71 percent of their as 

sets in the form of mortgages, com 

pared to 55 percent for FDICinsured savings banks and 19 

percent for FDIC-insured commer 

cial banks. Not only do S&Ls have a 

higher proportion of mortgages than 

FDIC-insured savings banks or com 

mercial banks, but a greater pro 

portion of those mortgages are fixedrate. Forty-seven percent of the 

S&L industry's mortgage portfolio 

was adjustable-rate at year-end, 

compared to 58 percent of the sav 

ings banks' mortgage portfolio.1'1 

Gap Measures of 

Interest-Rate Exposure 

In the aggregate, thrifts borrow 

short term and lend long term to a 

greater extent than commercial 

banks. If one assumes that passbook 

savings accounts do not re price 

within one year,14 then 70 percent 

of S&L liabilities matured or re

priced within one year at year-end 

1987 (Table 2),15 while only 38 per 

cent of S&L assets matured or re

priced within one year. The weighted 

"Breakdowns of mortgages between fixedrate and adjustable-rate are not reported hy 

commercial banks. 

'""The Federal Financial Institutions Ex 

amination Council's definitions of one-year 

and live-year gaps assume that passbook sav 

ings accounts do not reprice for at least five 

years after an interest-rate change. 

'^Passbook savings accounts constitute 

only seven percent of S&Ls' liabilities; if "pass 

books" repriced in less than one year, 77 

percent of S&L liabilities would be reprieeafile 

in less than one vear. 

21 
Interest-Rate Risk 

Table 2 

Reprieing Information for FDIC-Insured Commercial Banks, Year-end 1987 (Sbillions) 

Mnturily or RiirHdil Time Hi Reprising 

Total NOW + MMIM +■ Schedule .1 Gill Deport Totals 

Selected Assets1 £2574 M0OO 

Selected Liabilities2 2032 2819 

Incremental Gap 

Cumulative Gap 

As percent of total assets: 

Cumulative Gap 

Plus: Estimated Amortization'1 

Estimated Prepayments4 

Estimated Repricing of Passbook Savings" 

Adjusted Gaps -9.2 9.7 

Table 3 

Reprieing Information for FDIC-Insured Savings Banks, Year-end 1987 (Sbillions) 

Maturity uc r-'nrlk'si Time m 

] 

ii

year 

rtess 

I year

ymjs 

Over 5 

yeaia fuUiltiOW + MMilA > Schedule J Call Ropurt Totals 

Selected Assets1 

Selected Liabilities6 

Incremental Gap 

8199 

157 

S217 

200 

Cumulative Gap 

As percent of total assets: 

Cumulative Gap 

Plus: Estimated Amortization7 

Estimated Prepayments4 

Estimated Repricing of Passbook Savings5 

Adjusted Gaps -17.1 17.4 

Table -I 

Repricing Information for FSLIC-Insured S&Ls and Savings Banks, Year-end 1987 (Sbillions) 

Maturity or IvsirliiwL Time lo 

Selected Assets1 

Selected Liabilities 

Incremental Gap 

Cumulative Gap 

As percent of total assets: 

Cumulative Gap 

Plus: Estimated Amortization' 

Estimated Prepayments4 

"Impact of Hedging Activities'* 

Estimated Repricing of Passtxiok Savings5 

Adjusted Gaps -17.6 -5.0 

'Bxduiles nsseis held in trading accounts, equity securities, tionacuruing assets, Uitangihle asseis, fixed asseis and1 miscellaneous other assets. 

-Excludes S456 billion in demand deposits and j$177 billion in "passbook" savings deposits us well as SI 54 billion of miscellaneous liabilities. Includes 

NOWs and MMUAs in the "less than one year" repricinft Interval. 

'The "preferred method" for banks to use in 'eportliig mortgage loans and loans to individuals is by scheduled amortisation. Banks noi using this 

method report these principal payments (bu( not interest payments); for the purposes of tills table these reported payments are used to estimate 

amortization, 

'Prepayments are assumed to be four percent pur yuar (if total mortgages held by each institution. 

'One-hall of "other savings deposits" ("passbook savings" in the case of S&Ls) is assumed-to reprice during year one and none thereafter. 

''Excludes JW> billion in "pa-ssbook" savings deposits us well as $7 billion of miscellaneous liabilities. Includes NOW and MMDAs in the "less than one 

year" reprieing interval. 

'Savings hanlis report all loans and leases and all certificates of participation in residential mortgages according to Jinal maturity or earliest time to 

repricing. Principal payments received on these items are reported and used to estimate amorliKation. 

"As reported on Section 11 of S&Ls' Quarterly Financial Reports. 
FD1C Banking Review 

average (unadjusted"') one-year gap 

for the industry was 29 percent at 

year-end. The corresponding figures 

were —19.8 percent for savings banks 

and —7.8 percent tor commercial 

banks. 

Interestingly, S&Ls also had more 

liabilities in the one-year to five-year 

repricing interval than assets, mak 

ing the industry's five-year gap larger 

than its one-year gap. The weighted 

average unadjusted five-year gap-to

asset ratio for the S&L industry was 

34.2 percent at year-end 1987, 

compared to — H percent for the 

savings banks and 7.3 percent for 

the commercial banks. These figures 

overstate the degree of interest-rate 

exposure, however, since they take 

no account of the effects of, espe 

cially, mortgage prepayments and am 

ortization of assets. 

The "adjusted gaps" presented at 

the bottom of Tables 2 through 4 

attempt to correct the unadjusted 

figures for the effects of scheduled 

amortizations of assets, mortgage pre 

payments, hedging activities (in the 

case of S&Ls, which report the ef 

fects oi such operations) and reprie

ing of "passbook" or "other nontransaction savings" accounts—also 

referred to as core deposits.17 These 

adjustments are substantial, reduc 

ing the S&L industry's one-year gap 

from —29 percent to —17.6 percent 

and its five-year gap from 34 per 

cent to —5 percent. The savings 

banks' industrywide one-year gap is 

reduced from —19.8 percent to 

— 17.1 percent, and its five-year gap 

from — 11 percent to a positive 17.4 

percent. The commercial banks'one

year gap increases from -7.8 per 

cent to —9.2 percent, and its fiveyear gap from 7.3 percent to 9.7 

percent. 

Using equation (1), and keeping in 

mind that it produces only the rough 

est of estimates, the weighted aver 

age adjusted one-year gaps just given 

imply about a nine basis point re 

duction in S&L industry ROA per 

100 basis point increase in interest 

rates during the first year after such 

a rate increase. The corresponding 

Table 5 

Quartile Distribution of Gap and Duration Estimates 

of Interest-Rate Exposure1, Year-end 1987 

FDIC-lnsured Savings Banks 

As percent of assets: 

1-year unadjusted gap 

1-year adjusted gap 

5-year unadjusted gap 

5-year adjusted gap 

Net worth duration gap (years) 

Lower Median Upper 

-27.6 -14.9 -2.a 

-29.0 -16.0 -0.7 

-9.6 0.5 10.1 

3.5 16.2 29.0 

0.6 1.1 1.9 

FSLIG-Insured S&Ls and Savings Banks 

As percent of assets: 

1-year unadjusted gap 

1-year adjusted gap 

5-year unadjusted gap 

5-year adjusted gap 

Lower Median Upper 

-41.0 -28.7 -16.8 

-33.9 -21.0 -8.6 

-45.5 -30.3 -16.7 

-3.4 7.1 17.3 

Net worth duration gap (years) 1.2 2.1 3.1 

'"Unadjusted gaps" use Schedule.! information for PI)IC-insured institutions and Section IE 

information for FSLIC-insured institutions as is, except that i) "passbook" and "other 

savings deposits" are not included as repriceable liabilities; and ii) NOW accounts and 

MMDAs arc included as repriceable in year one. "Adjusted gaps" attempt to correoi for 

scheduled amoitijjation, mortgage prepayments and reprising of some passbook savings 

accounts in a manner described in Appendix G. The duration estimates are described in 

Appendix li. 

reductions in ROA arc nine basis 

points for savings banks and five 

basis points for commercial banks. 

As percentages of 1987 net interest 

margin (NIM), the reductions in in 

come are 5.6 percent for S&Ls, 3.1 

percent for savings banks and 1.3 

percent for commercial banks. Dur 

ing years two through five following 

such a rate increase, one would pre 

dict reductions in S&L industry ROA 

of 11 basis points per year per 100 

basis point increase in interest rates. 

Because of their large positive incre 

mental one-to-five year gaps, no 

change in ROA during years two 

J 

through five following an interestrate increase would be estimated to 

occur for savings banks and com 

mercial banks.lts 

""Unadjusted" gaps are computed by 

subtracting rate-sensitive assets and liabilities 

from the repneinfi schedules reported by (he 

institutions, except I hat i) NOW accounts and 

MMDAs are counted as repricing in less than 

one year; ii) "passbook" or "other nontnins

aetkin savings" accounts are assumed never 

to reprice. 

"Details of the adjustments are presented 

in Appendix C. 

""The above figures assume assets and 

liabilities reprice evenly during years one 

through five following an interest-rate change, 

and use the formulas al [he bottom of Table !. 
Interest-Rate Risk 

T//e Duration Measure of 

Interest Exposure 

The duration measure gives a sim 

ilar ranking of institutions' interestrate exposure. The median estimated 

net worth duration gap denned in 

equation (6) was 2.1 years at S&Ls, 

1.1 years at savings banks, and 0.7 

years at commercial banks. Inter 

pretation of these figures is made 

easy by equation (5); the duration 

gap in years is approximately equal 

to the percentage point reduction in 

market value capital-to-asset ratio 

per 100 basis point increase in inter 

est rates. For example, the median 

S&L (by duration) would be esti 

mated to lose 2.1 percentage points 

(e.g., from 7.0 percent to 4.9 per 

cent) of its market value net worthto-asset ratio per 100 basis point 

increase in interest rates. A typical 

mutual savings bank would be pre 

dicted to lose about 1.1 percentage 

points of market value capital-to

asset ratio and a typical commercial 

bank would be expected to lose about 

0.7 percentage points of capital-to

asset ratio per 100 basis point in 

crease in interest rates. 

The significance of interest-rate 

exposure depends in part on insti 

tutions1 capital ratios. In this re 

gard, the relatively low levels of 

capital at some solvent S&Ls may 

be cause for concern. For these 

institutions, the percentage point 

reductions in their capital-to-asset 

ratios outlined in the preceeding 

paragraph would represent a large 

share of their total capital. 

Quartile distributions for the du 

ration gap measure (Table 5) indi 

cate that considerable interest-rate 

exposure apparently exists at many 

thrifts. The "worst" 25 percent of the 

savings banks (with respect to 

interest-rate exposure) would be ex 

pected to lose at least 1.9 percentage 

points of market value capital-to

asset ratio per 100 basis point in 

crease in interest rates; the "worst" 

25 percent of S&Ls would be ex 

pected to lose at least 3.1 percentage 

points per 100 basis point increase 

in interest rates. 

Conclusions 

The figures in the last section 

indicate substantial exposure of 

earnings and net worth to rising 

interest rates on the part of some 

savings banks and, to a much greater 

extent, S&Ls, 

As emphasized throughout this pa 

per, however, measuring interest-rate 

exposure is very difficult without de 

tailed and reliable financial informa 

tion. With the information currently 

reported to federal regulators (and 

this is especially true of commercial 

banks), offsite analysis of interestrate exposure can produce only the 

roughest of estimates, for the rea 

sons discussed at length. 

Therefore it is not a "conclusion" 

of this paper that, for example, "25 

percent of the savings bank industry 

would lose at least 1.9 percentage 

points of their capital-to-asset ratios 

per 100 basis point increase in inter 

est rates." Rather, the conclusion is 

that available offsite measures of 

interest-rate exposure suggest that 

such exposure is considerable at some 

institutions. These measures provide 

a useful means for directing atten 

tion to institutions that warrant closer 

review. 

24 
■ ■ ■ 

FDIC Banking Review 

Ajipendix A 

Derivation of Equations (4) and (5) 

The following derivations can be found in G. 0. Bierwag's Duration Analysis (pp. 72—73 and pp. 193—194). 

Recall from equation (2) that the price of a security with cash flows c,, c2, , cM is 

(la) P = Cj/(l+r') + C2/(l+r')2 + . . . + cM/(l+r')M, 

where r' is the interest rate appropriate for the time interval between cash flows. Differentiating this expression with 

respect to r' one gets 

(2a) dP/dr'= -C]/(l +r'f—2c2l(l +r')3— . . . —McMf(l +r'/1 

= -(l+r')-]PfcI/(l+r')P+2c2/(l+r')2P+ ... +McM/(l+r')MP) 

= -(l+r')~iPfw1+2%v2+ . . . +M<wM} 

= -PDf(l 

using the definition of the weights Wj and duration D given earlier in the text. 

One can regard the price of the security as a function of the interest rate r', holding other things constant. Graphing 

this function would produce a downward sloping curve: the higher the rate of interest, the lower the price of the security. 

This curve would not be a straight line. Evaluating the right-hand side of (2a) for a given r' gives the slope dP/dr' of the 

curve at that particular value of r'. This slope measures how much P changes per unit change in r', at that particular point 

on the curve, and can be regarded as the slope of a straight line just tangent to the curve at that point. 

Dividing equation (2a) by P and multiplying by dr' gives equation (4) in the text, reproduced here: 

(3a) dP/P =* -D(dr')/(l+r'). 

The new price resulting from a change in interest rates predicted by equation (3a) lies on the tangent line just 

mentioned. The smaller is the change dr', the closer is the tangent line to the curve and the better is the approximation 

in equation (3a). The second part of equation (4) is an approximation obtained by assuming that 1 r' = 1. 

To derive equation (5), let the market value of assets be a function of the annual interest rate rA on assets, and the 

market value of liabilities a function of the annual interest rate rL on liabilities. Then the market value of a depository 

institution's net worth is a function of both interest rates: 

N(rA,R,J = A(rA)-Url). 

Differentiating (4a) with respect to rA gives 

(4a) dNidrA = A^rJ—L' 

where A'(rA) and L'(rL) are the derivatives of the market values of assets and liabilites with respect to a change in the 

relevant interest rates, dN/drA is the derivative of net worth with respect to the interest rate on assets, and drL/drA is the 

derivative of liability interest rates with respect to asset interest rates. One can regard the portfolios of assets and 

liabilities, respectively, as single securities with cash flows equal to the cash flows of the portfolios. The market values 

A and L would then take the role of P in equation (2a), and equation (2a) would imply that 

(5a) A'frJ = -0^(^/(1 +rA)J and L'frJ = -DjLfrJ/fJ+rj. 

where DA and DL are the durations of assets and liabilities in years (since rA and rL are annual rates of interest). 

If one assumes that rA and rL change by the same amount, then drL/drA = 1. Substituting (5a) into (2a) would then 

give 

(6a) dN/drA = 

This equation can be rewritten 

(7a) dNldrA = [A(Xa)1{1 rj// -DA +DLLrL(l 

= -A(r,JGAPN/(l 

where 

(8a) GAPN = D^ 

Equations (7a) and (Sa) are equations (5) and (6) in the text. 

25 
Interest-Rate Risk 

Appendix B 

Duration Estimates 

For all duration estimates in this paper, the annual rate of interest was 

assumed to be eight percent. All maturities were assumed equal to the 

midpoints of the repricing intervals. Maturities for the "over five years" interval 

(commercial banks) were assumed equal to 10 years, for the "over ten years" 

(mutual savings banks) interval were assumed equal to 20 years, and for the 

"over 20 years" (S&Ls) interval were asssumed equal to 25 years. 

All assets and liabilities with maturities of six months or less were assumed 

to have durations equal to their maturities. Thus, duration for the one-day 

interval was assumed equal to zero, duration for the zero- to three-month 

interval was assumed to be 1.5 months, for the three- to six-month interval was 

assumed to be 4.5 months, and for the zero- to six-month interval was assumed 

to be three months. For such short maturities, intermediate cash flows, if any, 

would not reduce durations by much, so these assumptions seem reasonable. 

For assets of greater maturity than six months, all loans and leases and 

certificates of participation in residential mortgage pools were assumed to 

amortize monthly. Under this assumption the formula for the duration of a 

mortgage19 could be used to estimate their durations. The duration of 

mortgages having fixed identical monthly payments is given by 

(9a) D = t(l+ryr'I-[Mtt(l+r')M-lIL 

where D is the duration in months, r' is the one-month interest rate and M is 

the number of months to maturity. Again, the annual interest rate was 

assumed to be eight percent. 

Investment securities, debt seeurities and other interest-bearing assets were 

assumed to pay interest every six months. Under this assumption their 

durations could be estimated using the formula for the duration of a bond. The 

duration of bonds paying semiannual coupons is given by 

(10a) D = l(l+r')lr'J—m(cl2)-r')M + (l+r')I/t(l+r')M(d2)-((cI2)-r-)H, 

where D is the duration in six-month 

intervals (for example, 3 would 

indicate a duration of 1.5 years), r' is 

the six-month interest rate, c is the 

annual coupon rate and M is the 

number of six-month intervals re 

maining until maturity. The annual 

coupon rate e was assumed to be 

eight percent (the same as the an 

nual interest rate). 

Half of all "passbook savings" or 

"other savings deposits" were as 

sumed to have durations of one year. 

The other half were assumed to have 

durations of five years. The dura 

tions of NOW accounts, and MMDAs 

were assumed to be three months. 

Liabilities other than MMDAs, NOW 

accounts and passbook savings ac 

counts were assumed to pay interest 

quarterly. Under this assumption 

their durations could be estimated 

using equation (9a), where all units 

are expressed on a quarterly rather 

than a semiannual basis. 

'''This ami the next formula are derived 

in Duration Analysis, by Gerald O. Bierwag, 

pp. 72-78. 
Appendix C 

Adjusted Gap Estimates 

Savings banks report scheduled 

payments of principal received dur 

ing each quarter on most of their 

assets. This amount multiplied by 

four and divided by total assets listed 

on the repricing schedule was as 

sumed to be an institution's "annual 

amortization rate." The weighted av 

erage rate for all savings banks was 

9.5 percent. To estimate amortiza 

tion occurring during each of years 

one through five, each institution's 

amortization rate was multiplied by 

the assets remaining on its repricing 

schedule from that time forward. For 

this purpose it was assumed that 

assets repriced evenly over each re 

pricing interval. 

Commercial banks also report 

scheduled principal payments on 

mortgages and installment loans to 

individuals if they have elected to 

PD1C Banking Review 

report items on their repricing sched 

ule by final maturity or earliest time 

to repricing rather than by sched 

uled amortization. For these banks 

amortization was estimated in the 

same way as it was for savings banks. 

S&Ls report all items on their re 

pricing schedules by final maturity 

or earliest time to repricing, and do 

not report principal payments re 

ceived at all. For S&Ls, amortization 

was estimated by assuming a 9.5 

percent annual amortization rate— 

the rate derived from mutual savings 

bank data. 

Prepayments were assumed to 

amount to four percent per annum 

of total mortgages held by an insti 

tution. This figure is toward the 

lower end of historical experience, 

but this seems appropriate if the 

intent is to consider "worst-case 

scenarios" in which interest rates 

rise suddenly and by substantial 

amounts. In such scenarios, pre 

payments would be expected to be 

at their base levels determined by 

demographic factors rather than by 

demand for refinancing. 

Finally, one-half of "passbook" or 

"other nontransaction savings" ac 

counts were assumed to reprice dur 

ing the year-one repricing interval, 

and not at all thereafter. This as 

sumption is somewhat arbitrary. If 

the remaining half of "core deposits" 

were assumed to reprice during years 

one through five, savings banks' fiveyear gaps would be reduced by 8.3 

percentage points, S&Ls' five-year 

gaps by 3.5 percentage points, and 

commercial banks' five-year gaps by 

2.9 percentage points. 

27 
''Derivative" Mortgage Securities 

Derivative Mortgage 

Securities and Their 

Risk/Return Characteristics 

by Panos Konstas* 

Market innovation and recent 

federal legislation have led 

to the development of new 

instruments in the mortgagesecurities market that now make it 

possible to implement investment 

strategies that only months ago would 

have been thought of as out of the 

question. The new securities often 

are referred to as "derivative" prod 

ucts because they are derived, gener 

ally, from ordinary mortgage-backed 

securities (MBSs) which have existed 

since the early 1970's. These new in 

struments, which include "Stripped 

Mortgage-Backed Securities" (SMBSsJ, 

"Collateral ized Mortgage Obligations" 

(GMOsJ, and "Real-Estate Mortgage In 

vestment Conduits" (REMICs), facili 

tate a more efficient flow of funds into 

the mortgage market. They also pro 

vide increased flexibility to financial 

institutions in managing their asset/ 

liability mix and hedging against 

interest-rate risk. However, it is essen 

tial that market participants under 

stand the underlying characteristics of 

these investments, because if they are 

not used properly they can greatly 

increase risk for a financial institution. 

The general structure and main 

features of SMBSs, CMOs, REMICs 

and related securities were discussed 

in an article in the May/June 1987 

issue of the FDlC's Banking and 

Economic Review.' The present dis 

cussion focuses on analyzing the risk 

characteristics of these securities un 

der changing economic and market 

conditions. The discussion begins 

with stripped Treasury bonds, pro 

ceeds into stripped mortgage-backed 

bonds, and concludes with GMO and 

REMIC securities, including the lat 

est development in this group—the 

floating-rate CMO. 

Stripped Treasury 

Securities 

Introduced about 10 years ago, 

this type of security involves divid 

ing an individual Treasury bond into 

two separate securities (strips). One 

security, the "interest-only" (10) 

strip, consists of all interest pay 

ments contained in the original Trea 

sury bond; the other, the "principal

only" (PO) strip, is a zero-coupon 

bond which is sold at a discount and 

is redeemed at maturity at the par 

value of the original bond. The ma 

turities and the credit risks associ 

ated with either the IO or the PO 

strip are the same as those of the 

Treasury bond. 

The price of Treasury strips in the 

secondary market is influenced solely 

by market interest rates. As market 

interest rates change, the periodic 

payments of the IO strip and the 

final payment of the PO strip remain 

constant. However, the rate used to 

discount the payments of the two 

strips changes, which alters the 

present values (or market prices) of 

the two strips.2 

The market values of Treasury 

bonds and their IO/PO strips under 

various interest-rate changes are il 

lustrated in Figure 1. As interest 

rates change, the market values of 

the 10 and PO strips tend to move in 

almost parallel ways. In general, there 

is an inverse relationship between 

changes in interest rates and the 

market values of strips and Treasury 

honds—the larger the increase in 

interest rates, the lower the market 

value, (and vice versa). 

Separating a Treasury bond into 

interest-only and principal-only strips 

can increase the overall market value 

of the underlying security. The price 

of a Treasury bond represents the 

present values of two future pay 

ments: the discounted values of the 

semiannual coupon payments and 

the discounted value of the final (par 

value) payment at maturity. The 

same two payment streams are dis 

counted by the same factor when 

the bond is stripped; hence, it may 

be thought that the sum of the two 

parts would equal the price of the 

bond. In practice, however, the total 

'Panos Konstas is a Senior economist in 

(he ['"DIC's Office of Research and Statistics. 

James Booth, John ljovenzi and Lynn Ne

jesschleh contributed useful comments and 

suggestions in the development of this paper. 

'See Panos Konstas, "REMICS; Their Role 

in Mortgage Finance and the Securities 

Market," Banking and EconomicRevLusii, Vol. 

5, No. 3 (May/June 1987): 11-18. 

"The discount rate used in calculating 

the present value of a security is generally the 

current market rate on an issue of similar 

maturity and credit risk. 
KDIC Banking Review 

price for the two parts ordinarily 

exceeds the price of the whole bond 

because the issuer is able to cater to 

two different sets of investor prefer 

ences. Some investors desire the 

steady flow of payments in an 10 

Strip without the one-time payment 

at redemption, while others prefer to 

purchase the long-term, zero-coupon 

security embodied in the PO strip. 

Naturally, investors will pay a little 

more for their individual preferences, 

and this accrues as additional reve 

nue to the issuer. 

Striftped MortgageBacked Issues 

Stripped mortgage-backed securi 

ties were introduced in July 1986, 

when the Federal National Mortgage 

Association (FNMA)"stripped"aS200 

million pool of 11 percent mortgages 

into two distinct classes of securi 

ties. Unlike Treasury strips, how 

ever, this offering was not bisected 

strictly on an IO-PO basis. Instead, 

each strip contained portions of both 

principal and interest. Class 1 was 

allocated a coupon rate of five per 

cent and 99 percent of the principal 

payment, while Class 2 consisted of 

the remaining coupon rate of six 

percent and one percent of princi 

pal. More recently, FNMA has intro 

duced offerings that are similar to 

U.S. Treasury issues, with Class 1 

receiving all of the principal and 

Class 2 all of the interest. 

A typical FNMA issue of stripped 

securities is backed by a pool of 

mortgages with varying coupon rates. 

For example, a $2.0 million FNMA 

issue dated June 31,1987 was backed 

by a pool of individual mortgage loans 

with coupon rates varying from 9.8 

percent to 11 percent. The weightedaverage coupon rate for the entire 

pool was 10.2 percent. Interest pay 

ments of 9.5 percent were earmarked 

for pass-through to the SMBS certif 

icate holders—the 70 basis-point dif 

ference was retained by FNMA as 

compensation for servicing and in 

suring the underlying pool of mort 

gages. 

Price (S) 

200 

150 

100 

50 

Figure 1 

Interest-Rate Changes and Market Prices 

of a Treasury Bond and Its Strips 

Treasury bond 

~ 2.0 0 + 2.0 + 4.0 

Change in Interest Rales (%) 

There are several basic differences 

between stripped mortgage-backed 

securities and Treasury strips. First, 

a Class 1 or principal-only (PO) mort 

gage strip offers the holder monthly 

payments of principal, whereas the 

zero-coupon Treasury strip offers a 

lump-sum payment at maturity. 

Based on this difference alone the 

risk from changing market interest 

rates (interest-rate risk) for a PO 

Treasury strip is greater than that 

for a PO mortgage strip of the same 

maturity. This is because the effec 

tive maturity of the mortgage strip, 

which generates monthly payments, 

is about half of the maturity of the 

zero-coupon strip which pays the 

principal in one lump sum. 

However, mortgage strips (both the 

PO and IO portions) are subject to 

another type of risk called prepay 

ment risk, which does not apply in 

the case of Treasury strips. With a 

Treasury strip, it is known for cer 

tain that the principal and interest 

portions will be paid on the specified 

dates. Due to home sales and refi 

nancings, however, mortgages typi 

cally are paid off prior to their matu 

rity dates. Because of the uncertainty 

involved in determining when home 

sales or refinancings may occur, the 

time period over which the holder of 

a mortgage strip will receive the total 

principal and accrued interest pay 

ments is uncertain. This uncertainty 

creates what is called "prepayment 

risk." 

When mortgage strips are sold, 

they are priced at discount of their 

par values, and implicit in their prices 

is an assumed prepayment pattern. 

If the prepayment rate turns out to 

be higher than expected, the holders 

of the principal-only class will real 

ize increased yields since they will 

be paid at a faster rate than origi 

nally anticipated. The opposite holds 

true for the holders of the interestonly class. Yields will decline as pre 

payments increase, since higher pre 

payment rates mean fewer interest 

payments over the life of the secu 

rity. 

Prepayment risk for interest-only 

and principal-only mortgage-backed 

strips can be illustrated by looking at 

a specific example. In the prospectus 

for the June 1987 offering, FNMA 

calculated the relationship between 
"Derivative" Mortgage Securities 

purchase prices for strips and effective 

yields under different prepayment as 

sumptions. The prepayment rate was 

measured on a standard developed by 

the Public Securities Association, a 

standard that is commonly known as 

the PSA assumption. This information 

is shown in Table 1. 

Table 1 indicates that changes in 

prepayment rates can result in widely 

varying yields. For example, the ef 

fective yield on the 10 strip would 

vary from 12.83 percent if the pre 

payment rate is equal to the stan 

dard assumption, to -11.00 percent 

if the prepayment rate is five times 

faster than the standard assumption. 

Changes in market 

interest rates 

Two distinct forces on the values 

of stripped issues come into play 

when interest rates change. The first 

force is changes in the rate against 

which the future cash flows from 

both the PO and 10 strips are dis 

counted. If interest rates decline (rise) 

the present value of the future cash 

flows increases (declines), which is 

another way of saying that the mar 

ket prices of the two strips will rise 

Table 1 

Effective Yields of Stripped Mortgage-Backed Securities 

under Alternative Prepayment Rates 

Prepayment Assumptions (PSA basis) 

Class 1 Certificates (PO) 

Class 2 Certificates (IO) 

NOTE: The prepayment race is the amount of prepaid principal in a given month over the 

total remaining balance of the pool tor the same month. In the above table. 100% PSA 

reflects a constant aniiuaJlzed prepayment rate of .2% per month in the first month, 

Increasing by .2% eauh month until the thirtieth month iinit leveling off at a 6% rate 

thereafter. A PHA of 200% reflects prepayments sit twice that rate. 

SOURCE: Federal National Mortgage Association. 

(decline). As noted before, Treasury 

strips would be similarly affected. 

A second force applies only to 

mortgage securities. When interest 

rates decline, it becomes more ad 

vantageous to refinance existing mort 

gages and, thus, prepayment rates 

increase. For holders of PO strips, 

faster prepayment rates mean that 

they will be getting their expected 

future payments over a shorter pe

riod than originally expected. Thus, 

during periods of falling interest rates 

a lower discount rate and a higher 

prepayment rate both work to in 

crease the market value of PO mort 

gage strips. As shown in Figure 2, the 

combined positive effects of a lower 

discount rate and higher prepayment 

rate can significantly increase the 

market value of PO strips when in 

terest rates decline. 

It is a different story, however, for 

the holders of IO strips. Faster mort 

gage prepayments mean that IO in 

vestors will receive less interest in 

come, since there will be Jess 

outstanding principal at any point in 

time. Thus, the amount of future 

interest payments will be less than 

originally expected and this will lower 

the market values of IO securities. 

This negative effect overshadows the 

positive effect from the lower dis 

count rate and will result in declin 

ing market values for IO securities as 

interest rates decline. Since prepay 

ments can increase dramatically in a 

declining interest-rate environment, 

the decline in market value can be 

quite severe. 

As shown in Figure 2, the opposite 

results can be expected when mar 

ket rates of interest are rising. With 

IO securities, the positive effect of a 

lower prepayment rate will offset the 

negative effect of a higher discount 

rate, resulting in somewhat higher 
FDIC Banking Review 

returns for holders of 10 securities. 

A lower prepayment rate adversely 

affects PO securities, which rein 

forces the negative effect of a higher 

discount rate, resulting in a clear 

decline in market value.'1 

REMICs and CMOs 

Real-Estate Mortgage Investment 

Conduits (REMICs) and Collateralized 

Mortgage Obligations (CMOs) consti 

tute the newest developments in the 

mortgage-backed securities market. 

The word "development" should be 

stressed because, unlike the CMO, a 

REMIC is not a new innovation in the 

mortgage market. A REMIC is nothing 

more than an entry in the U.S. Tax 

Code created by the Tax Reform Act 

of 1986. The REMIC legislation does 

not specify how a security ought to be 

structured from a financial or a risk 

standpoint. Rather, it indicates how 

income from a mortgage security 

should be treated for Internal Revenue 

purposes. Any real-estate-backed se 

curity such as a CMO, a SMBS, a 

mortgage pass-through, or even group 

of ordinary mortgages may be treated 

as a REMIC for tax purposes if its 

issuers so choose. 

Up to now, most of the security 

instruments designated as REMICs 

have been CMOs. For this reason, 

REMICs currently are generally 

viewed as synonymous with CMOs. 

The REMIC designation affords cer 

tain tax advantages to the CMO is 

suer that otherwise are not available. 

Indeed, it was problems with the 

then-existing IRS rules on CMO tax 

ation that prompted the passage of 

REMIC legislation.4 

Analogies with stripped 

issues 

REMICs and CMOs contain many 

features and attributes that are sim 

ilar to those of Treasury strips and 

SMBSs. Some other features resem 

ble those of ordinary mortgage pass

throughs. Likestripped issues, which 

are divided into 10 and PO compo 

nents, REMICs contain two distinct 

types of securities. In REMIC termi 

nology these are called "regular" and 

"residual" interests. 

In some respects, regular interests 

resemble mortgage pass-through cer 

tificates. Like pass-throughs, they 

have a fixed rate of interest (pass

through rate) and similarly are sub 

ject to prepayment risk. They differ 

from pass-throughs, however, in that 

REMICs/CMOs have multiple matu 

rity classes (called tranches), whereas 

a pass-through is a single-maturity 

instrument. In a pass-through the 

cash flows from the underlying col 

lateral, whether in the form of inter 

est payments, principal payments, 

or advances from mortgage prepay 

ments, are all distributed pro rata to 

the certificate holders. In REMICs 

and CMOs the different payment 

flows are precisely prioritized. Cash 

generated from the underlying mort 

gage interest payments is used to 

pay the contractual interest obliga 

tion on all of the different tranches of 

the issue. The flows accruing from 

mortgage principal payments (as well 

as from any prepayments), however, 

are utilized in their entirety to retire 

the outstanding principal balance of 

the first tranche—the tranche with 

the shortest maturity. Once the first 

tranche has been paid, all principal 

payments (including prepayments) 

are directed toward paying off the 

second tranche, while the interest 

inflows continue to be distributed to 

all remaining tranches. The sequence 

continues until all tranches have been 

retired. 

Residual interests, in contrast, are 

similar to 10 strips, at least insofar as 

interest-rate risk is concerned. Re 

sidual holders receive the difference 

between the total interest payments 

emanating from the mortgage collat 

eral and the amount of interest pay 

ments required to service the regular 

interests (bond tranches) of the 

REMIC/CMO. In addition, residual 

securities receive any reinvestment 

income earned between the monthly 

receipt of interest and principal pay 

ments, and their subsequent disburse 

ment to the regular interests of the 

CMO. 

Residuals, like the interest-only 

portions of stripped mortgage-backed 

securities, stand to gain when inter 

est rates rise and lose when interest 

rates fall. When interest rates rise, 

prepayments tend to slow down. This 

lengthens the actual maturities of 

the bond tranches and, in turn, leads 

to the coupon differential being avail 

able to residual holders for a longer 

period of time. In addition, higher 

interest rates increase the income 

from the temporary reinvestment of 

the monthly mortgage payments, 

which further enhances the earnings 

of residual investors. Conversely, 

when rates fall, prepayments tend to 

increase, reducing the cash Hows to 

residua] holders. 

Floating-rate offerings 

Beginning in September 1986, a 

new type of CMO was introduced in 

the market: CMOs were structured 

to include floating-rate provisions. 

Previously, all CMOs that had been 

issued contained fixed coupon rates 

on their bond tranches. Initially, it 

was required that all interest pay 

ments be fixed at the issue date if a 

CMO were to obtain REMIC status. 

In June 1987, however, the U.S. 

Treasury Department changed this 

requirement, and it is now possible 

to issue REMIG securities with 

floating-rate provisions. 

Floating-rate CMO bonds allow in 

vestors to reduce the risk exposure 

of their portfolios resulting from 

interest-rate fluctuations. This is 

achieved by tying the coupon rate 

on the bond portions of a CMO to 

some market index of interest rates, 

^lt should be noted that prepayment risk 

will depend importantly upon the relationship 

between the original mortgage coupon of the 

underlying collateral and the prevailing mar 

ket rates of interest at the time the PO and 10 

strips were issued. If, for example, coupon 

rates on the mortgage collateral happen to be 

above interest rates in the mortgage market at 

the time of issue, prepayment risk would be 

high. This situation would he advantageous 

for the holders of PO strips. IO buyers would 

stand to lose under an accelerated prepay 

ment rate which would deprive them of future 

payment flows. Under these conditions, the 

risk premium commanded by the 10 investor 

on account of the prepayment factor would be 

considerable. 

'For more discussion on the tax advan 

tages of REMICs, see Konstas, op. tit., pp. 

13-15. 

31 
"Derivative" Mortgage Securities 

similar to the way rates are set for 

adjustable-rate mortgages. The large 

majority of floating-rate CMOs is 

sued so far have utilized the London 

Interbank Offered Rate (LIBOR) as 

an index for setting rates on CMO 

bonds. Floating-rate tranches, just 

like their fixed-rate counterparts, are 

paid off before any other tranches or 

residual interests receive any early 

prepayments. Unlike traditional 

CMOs, however, in which all princi 

pal payments from the underlying 

collateral firstgo to retire the tranche 

with the shortest maturity, in some 

floating-rate CMOs two or more 

tranches receive principal payments 

at the same time. 

By varying the floating-rate ad 

justment, the principal pay-down 

method, and possibly combining 

fixed- with floating-rate tranches, it 

is possible to create a wide variety of 

different types of CMOs. However, 

most of these fall into one of the 

following major categories: 

(a) Prioritised floaters—Often a 

floating-rate tranche is combined 

with other bond tranches that carry 

fixed rates. The floating-rate tranche 

is retired before any payments are 

made to the remaining tranches. One 

issue of this type, for example, con 

tained bonds with maturities of 2.1, 

5.6, 11.3, and 20.9 years, and corre 

sponding coupons of LIBOR plus 

.375%, 8.05%, 8.125%, and 8.95%, 

respectively. Floating-rate bonds gen 

erally have been offered at spreads of 

25 to 60 basis points over the 

month LIBOR rate. The interest rate 

on the floating bond (LIBOR plus 

spread) is generally calculated prior 

to each GMO payment date—usually 

three or six months. Since the un 

derlying mortgage collateral is com 

posed of fixed-rate mortgages, the 

coupon of the floating-rate tranche 

must be capped. In general, this type 

of a floating-rate bond is valuable to 

lending institutions seeking to match 

variable-rate liabilities with floatingrate assets. Alternatively, when a 

hedge for fixed-rate liabilities is de 

sired, the floating-rate CMO bonds 

can be swapped against fixed-rate 

mortgages to create fixed-rate assets. 

(b) The inverse floater arrange 

ment—In this form, the principal 

payments from a mortgage pool are 

directed simultaneously to two dif 

ferent bond classes of the CMO. The 

amount directed to each class is de 

termined by its share of the total 

issue. Interest payments from the 

collateral also are distributed simul 

taneously to the two classes. In both 

classes the coupon rate is tied to an 

index such as LIBOR rate. However, 

coupon rates for the two classes are 

designed to move in opposite direc 

tions. In one floating class the cou 

pon declines when LIBOR increases 

and rises when LIBOR decreases, 

while in the other floater class cou 

pon rates move in tandem with 

LIBOR. 

(c) Simultaneous jloater/jixed-rate 

combinations—Just as in the previ 

ous case, two classes of CMO bonds 

receive principal and interest pay 

ments simultaneously. One class car 

ries a floating coupon rate, and the 

other a fixed coupon rate. The fixed 

class is sold at a discount and its 

nominal coupon rate is set below 

that of the "pass-through rate," i.e., 

the rate flowing from the underlying 

collateral. The difference between 

the discounted coupon rate of the 

fixed-rate class and the rate on the 

mortgage collateral goes to fund the 

amount of interest that may be 

needed to pay the floating-rate class 

in the event the floating rate rises 

above the pass-through rate/ 

Effect offloating rates on 

residuals 

Residuals produced from CMOs 

with only fixed-rate bond classes gen 

erally increase in yield as interest 

rates rise, and decrease in yield as 

interest rates fall. Residuals derived 

from CMOs containing floating-rate 

classes may behave quite differently. 

In a floating-rate CMO with a pri 

oritized payment class, the residual 

behaves in a manner similar to re 

siduals of fixed-rate CMOs, i.e., the 

residual yield declines when interest 

rates fall. Two opposing forces are at 

work in a falling-rate environment. 

Returns on the residual are increased 

because of the lower coupon on the 

floating-rate class. But this increase 

is more than offset by the lower 

payments that accrue to the residual 

due to the increase in mortgage pre 

payments. In a rising interest-rate 

environment, residual returns are re 

duced somewhat by the increased 

coupon payments on the floatingrate class. But here again, the pre 

payment effect often dominates, and 

as interest rates rise residual yields 

increase. 

A floater/inverse floater combina 

tion produces a residual that shows 

comparatively small changes in yield 

regardless of interest-rate move 

ments. In a floater/inverse floater 

CMO, the effect of higher coupons 

for one regular class is offset by 

lower coupons for the other regular 

class, regardless of the direction of 

interest-rate movements. As a re 

sult, the cash flow to the residual is 

unaffected by changes in the coupon 

rates, although it does continue to be 

affected by changes in prepayments. 

The residual of a simultaneous 

floater/fixed-rate CMO affords greater 

protection against downside risk rel 

ative to the residual of a prioritized 

floater. In a falling-rate environment, 

the residual benefits both by the 

drop in the coupon of the floater 

class and by early prepayments if 

the CMO was issued usingdiscounted 

collateral. (These benefits would be, 

of course, balanced against the in 

creased prepayments in a falling-rate 

environment, which, as indicated, 

5The chree floating-rate categories de 

scribed above by no means exhaust the dif 

ferent types of securities that have evolved 

(and continue to evolve) in the CMO market. 

In some cases the evolution has led to more 

complex hybrids, combining features from all 

three types of CMOs discussed above. These 

are beyond the scope of the present discus 

sion, but there are several publications avail 

able for those interested in further explora 

tion of the subject. Sec especially, Gail M. 

Belonsky and Steven D. Meyer, "Floating Rate 

CMOs: the Floater, the Inverse Floater, and 

the Residual," Drexel Burnham Lambert, De 

cember 1986, and "The Developing Market 

for Residuals," Mortgage Banking, October 

1987, pp. 107-122. 

32 
FDIC Banking Review 

adversely affects residual returns.) 

In a rising-rate environment, how 

ever, the residual receives reduced 

returns because of the increased cou 

pon payments on the floater class. 

Concluding Comments 

Derivative mortgage products (de 

rived from traditional mortgagebacked securities), such as strips, 

REMIGs, and CMOs, have begun to 

capture the interest of a growing 

number of investors, including fi 

nancial institutions. They are valued 

not only for their unusually highreturn characteristics but, more im 

portantly, for their risk-hedging prop 

erties as well. 

In general, the cash flows from 

these new derivative mortgage secu 

rities are rearranged to reflect the 

interest-rate risk and maturity pref 

erences of potential investors. Some 

of these derivative instruments may 

contain considerable downside risk 

in a rising interest-rate environment, 

while under the same conditions oth 

ers may actually appreciate in value. 

Generally speaking, market values of 

derivative mortgage products are ex 

tremely sensitive to the prepayment 

experience of the underlying collat 

eral. Investors, therefore, not only 

run the risk of realizing lower than 

expected yields, but also in some 

cases the risk of not fully recovering 

the value of their initial investment. 

Consequently, derivative mortgage 

securities require careful consider 

ation by investors before inclusion 

in any portfolio strategy. For those 

who know what they are doing, de 

rivative products can prove highly 

instrumental in achieving desired 

goals in the asset and liability man 

agement of investors' portfolios. 

33 
Recent Developments 

Recent Developments 

Affecting Depository 

Institutions 

by Benjamin B. Christopher* 

Regulatory Agency Actions 

Federal Deposit Insurance Corporation 

New Approach To Handling 

Bank Failures 

The FDIC announced a new ap 

proach to handling bank failures, in 

which potential acquirors of failed or 

failing banks will have more options 

and more time to submit their bids. 

Whenever possible, potential bidders 

will be invited to submit competitive 

bids for a "whole bank," either on an 

"open" bank basis or a "closed" bank 

basis, at the bidder's option. In ei 

ther case, using the closed-bank ap 

proach or the open-bank assistance 

under Section 13(e) of the FDI Act, 

the acquirer would assume all of the 

assets and liabilities of the bank in 

return for a payment from the FDIC. 

The FDIC will try to give potential 

acquirors up to three or four weeks 

to analyze a failing institution before 

submitting their bids, removing much 

of the uncertainty under the present 

system which requires bids on short 

notice. Should it not be possible to 

arrange the preferred "whole bank" 

transaction on either an "open" or 

"closed" bank basis, the FDIC would 

then attempt a traditional purchaseand-assumption transaction, with the 

FDIC taking possession of certain 

problem assets. 

Chairman Seidman noted that the 

new approach was developed in close 

cooperation with the various state 

banking departments and the Comp 

troller of the Currency. i'R-79-88, 4/18. 

Guidelines For Financial 

Institution Directors 

The FDIC distributed a Pocket 

Guide For Directors, described as a 

''brief, plain-English reference 

source," to the chief executive of 

ficers of all insured financial institu 

tions. The guide was developed by 

the FDIC and has been endorsed by 

the Board of Governors of the Fed 

eral Reserve System, the Office of 

the Comptroller of the Currency and 

the Federal Home Loan Bank Board. 

PR-26-88, 2/11. 

Delinquent And Inaccurate 

Call Reports 

The FDIG and the Office of the 

Comptroller of the Currency issued 

a joint letter to banks stating that, 

effective with the March 31, 1988 

Call Report, the agencies will sub 

stantially increase money penalty as 

sessments against banks for submis 

sion of delinquent and inaccurate 

Call Reports and, if necessary, take 

appropriate enforcement action 

against the banks and/or individuals 

responsible. This action is necessary 

because more and more banks are 

submitting their Call Reports after 

the due date. Banks should make 

every effort to ensure that Call Re 

ports are mailed or electronically 

transmitted sufficiently in advance 

"lienjamin Christopher is a financial econ 

omist in the FDIC's Office of Research and 

Statistics. 

Reference sources1 American Banker 

(AD); Wall Street Journal (WS.I);BM's Bank 

ing Report (BBR)l Federal Register (FR). 

Acquisition OfFirst 

RepublicBank 

Subsidiaries Approved 

The FDIC, the Office of the Comp 

troller of the Currency and the Board 

of Governors of the Federal Reserve 

approved the acquisition by NCNB 

Corporation, Charlotte, North Caro 

lina, of subsidiary banks of First Re 

publicBank Corporation, Dallas, 

Texas. The arrangement, approved 

in principle by the regulators, ac 

complishes the restructuring and re 

capitalization of First Republic banks 

in Texas, and ensures the full protec 

tion of all depositors and general 

creditors. All of the banking offices 

will continue to operate without in 

terruption. 

The T banks of the First Republic 

system, including the S17.0 billion 

lead bank in Dallas, had total assets 

of approximately S32.5 billion. 

NCNB has agreed to infuse be 

tween 8210 million and $240 million 

in NCNB Texas National Bank, an 

amount equal to 20 percent of the 

new bank's total equity capital. The 

FDIC's initial outlay is expected to 

be approximately 82 billion, in addi 

tion to the SI billion advanced in 

March. Further outlays are expected 

to be about SI billion. Although it 

cannot be accurately estimated at 

this time, the FDIC's net cost for this 

transaction is expected to be signifi 

cantly lower than its total outlays. 

PR-■148-88, 7129 

34 
FDIG Banking Review 

ot' the due date to be in the hands of 

the regulator no later than 30 days 

following the Call date. BL-7-88, 3121. 

Agricultural Loan Loss 

Amortization 

The FDIC issued a regulation un 

der the Competitive Equality Bank 

ing Act of 1987 (CEBA) which per 

mits agricultural banks to amortize 

losses on qualified agricultural loans. 

The rule amends and makes final the 

interim regulation which had been 

in effect since November 9, 1987. It 

describes the procedures and stan 

dards applicable to banks desiring to 

amortize losses under that statute, 

and the manner in which such am 

ortizations are to be done. FR, 6/14/88, 

p. 22130. 

Crime Reporting 

Requirements 

The FDIC and the other financial 

institution regulatory agencies have 

revised the criminal reporting forms 

to reduce the reporting burden, in 

corporate additional criminal stat 

utes, and standardize the reporting 

basis. 

In addition to the mandatory re 

quirement to report suspected crimi 

nal activity, instructions on the re 

vised Short Form permit its use to 

report on a voluntary basis "suspi 

cious transactions" to law enforcement 

authorities, such as in connection with 

deposits and withdrawaJs of currency 

or official checks in amounts less than 

$10,000 where circumstances suggest 

an illegal purpose. 

Certain previously mandatory re 

porting requirements are made vol 

untary. For example, losses or ap 

parent violations aggregating less than 

$5,000, where the bank has no sub 

stantial basis for identifying a possi 

ble suspect, may be reported on a 

voluntary basis. The prior limit was 

#2,500. The revision also permits 

banks to report, at theiroption, losses 

under #1,000, where the bank has a 

substantial basis for identifying a pos 

sible suspect. 

When a bank employee or agent is 

suspected, a report must be submit 

ted regardless 0/ the amount. BL

18-88, 6116. 

Selection Of Securities 

Dealers—Unsuitable 

Investment Practices 

The Board of Directors (and the 

Federal Reserve Board) adopted a 

Federal Financial Institutions Exam 

ination Council (FFIEC) policy state 

ment regarding the selection of secu 

rities dealers and unsuitable 

investment practices. These guide 

lines were adopted because regula 

tors have become aware of a number 

of depository institutions engaging in 

speculative securities activities. The 

supervisory policy stresses the need 

for depository institutions to know 

the creditworthiness and reputation 

of the securities dealers with whom 

they transact business. Additionally, 

the statement points out various se 

curities transactions that are consid 

ered unsuitable for an investment 

account. 81-15-88,4/26; FR, 4/26, p. 14852. 

Country Risk Exposure— 

Branches Of Foreign 

Banks 

The FDIC extended from June 14, 

1988 until year-end the time for 

compliance with the new regulations 

on country risk exposures of insured 

domestic branches of foreign banks 

operating as such on November 19, 

1984. The new regulations were put 

in place in December 1987. FR, <■>/ 

13/88, p. 21986. 

Bank Audits 

The Corporation decided not to 

propose at this time a regulation 

requiring a full opinion "outside" au 

dit for banks subject to its regulatory 

authority. Chairman Seidman noted 

two reasons for the decision: first, 

practically all large banks already 

obtain such audits annually, and sec 

ond, many small banks may be un 

Office Of The Comptroller Of The Currency 

able to afford or obtain a full opinion 

audit. He said the FDIC staff is de 

veloping the framework for an inde 

pendent, "special review" of small 

banks as part of the agency's effort to 

encourage all banks to effectively 

audit their operations. 

Under current policies, indepen 

dent audits are expected from insti 

tutions with more than $50 million 

in assets that are converting to FDIC 

insurance coverage. Also, newly char 

tered banks insured by the FDIC 

must obtain an independent audit 

during their first three years of oper 

ation. PR-l-88, 1/5. 

The Board of Directors proposed a 

new policy under which state non

member banks are encouraged to 

obtain independent annual audits by 

certified public accounting firms. The 

proposed policy statement suggests 

that the outside annual audit should 

be conducted regardless of the na 

ture of the institution's internal au 

diting procedures. If a bank decides 

such an audit by an independent 

CPA firm is unnecessary, a more 

limited "review" of financial state 

ments and controls should be con 

sidered. Banks should send copies of 

the external audit reports to appro 

priate FDIC regional offices, and no 

tify such offices when an outside 

auditor is changed. 

Applicants for deposit insurance 

coverage after the effective date of 

the policy statement will be expected 

to obtain an external audit annually 

for at least the first three years after 

deposit insurance coverage is granted. 

The proposed statement also notes 

that an annual audit by an outside 

CPA firm will be a condition of fu 

ture enforcement actions under cer 

tain circumstances. PR-74-88, 4/13. 

National Banks7 Securities 

Brokerage And 

Adviser Authority 

The Office of the Comptroller of 

the Currency (OCC), in an interpre 

tive letter to First Union National 

Bank, Charlotte, North Carolina, said 

that a national bank can act as an 

investment adviser to a mutual fund, 

and at the same time may recom 

mend and transact buy/sell orders 

for customers in the shares of the 

same fund. 

35 
Recent Developments 

The OCC ruled [ast July that a 

subsidiary of Charlotte-based NCNB 

National Bank could recommend mu 

tual funds sponsored by a third party. 

The letter to NCNB affirmed that the 

banks could offer advice on a broad 

range of securities, including over

the-counter stocks and exchangetraded stocks. In each case it was 

noted that the bank's brokerage unit 

cannot direct trading in customer 

accounts with respect to making final 

decisions on purchases or sales. AB, 

1129188, p. 1. 

Securitizing Commercial 

Real-Estate Loans 

The OCC granted approval for 

Chase Manhattan Bank to set up a 

subsidiary to underwrite pools of its 

commercial real-estate loans. Chase 

and Security Pacific National Bank, 

Los Angeles, which received the 

OCC's approval last June to securi

tize its residential mortgage portfo 

lio, are the first national banks to be 

given federal approval to conduct 

underwriting through subsidiaries. 

Three other national banks have ap 

plied to the OGC for permission to 

form subsidiaries to underwrite assetbacked securities. 

A suit brought by the Securities. 

Industry Association against the OCC 

following the Security Pacific deci 

sion, now pending in a U.S. District 

Court in New York, charges that 

bank sales of securities violate the 

Glass-Steagall Act. AB, 3/22/88, p. 2. 

Futures And Options 

Trading 

The OCC, in an interpretive let 

ter, granted approval for the First 

National Bank of Chicago to operate 

an arbitrage business in interest-rate 

instruments through the bank's fu 

tures brokeragesubsidiary. FirstChi

cago Futures Inc. was given permis 

sion to expand its market-making 

and arbitrage operations to include 

Treasury bills and notes, obligations 

of the Government National Mort 

gage-Association, certificates of de 

posit, and Eurodollar time deposits. 

In addition, the subsidiary can act as 

market maker in derivatives of those 

instruments on various futures and 

options exchanges and in the spot, 

forward, and over-the-counter op 

tions markets. 

The approval, while expanding the 

approved nonhedging activities for 

national banks, specifies that only 

the dealer units of a bank can engage 

in speculative trading, and also gen 

erally restricts bankwide positions in 

options and futures to "a reasonable 

percentage" of outstanding con 

tracts. 

First Chicago Futures said it would 

fully coordinate its trading positions 

in derivative markets with its arbi 

trage operations, or else be fully 

hedged. It also assured the OGC that 

the parent bank would not be re 

sponsible for any liabilities that arise 

from exchange membership. AB, 

5119188, p. 161. 

Lending Limits And Loan 

Commitments 

The OCC issued a temporary rule 

revising national bank lending limits 

to provide relief for banks which 

have experienced a decline in their 

capital and, hence, their lending lim 

its after entering into commitments. 

Under the revision, a commitment 

within a bank's lending limit would 

be treated as a loan made at the time 

the bank entered into the commit 

ment. Thus, a subsequent decline in 

lending limits would not result in a 

violation when the commitment is 

funded. Although the temporary rule 

is effective immediately, the OCC is 

requesting comments from the pub 

lic prior to adopting a final regula 

tion. FR, 6124188, p. 23752. 

Bank Indemnification Of 

Officials 

The OGC released Interpretive 

Letter 401 stating that directors, of 

ficers and personnel of national banks 

can, under certain circumstances, 

be indemnified against legal and other 

expenses incurred in defending law 

suits. The indemnification must be 

authorized by the bank's articles of 

association. Criminal acts, willful mis 

conduct, and gross neglect of duty 

are excluded. ABA Bankers Weakly, 3/ 

15/88, p. 15. 

Crime Report Filing 

Requirements 

The OGC issued an interim rule, 

effective April 11, 1988, to clarify 

the filing requirement for reports of 

known or suspected crimes, and to 

reduce the number of criminal refer 

ral reports filed by national banks. 

The interim rule raises the threshold 

for filing criminal referrals where no 

suspect has been identified, and clar 

ifies the filing requirement for re 

porting financial crimes where no 

loss is incurred by the bank, such as 

money laundering, bank bribery, and 

Bank Secrecy Act violations. FR, 3/ 

11/88, p. 7885. 

Merger Approval Procedures 

Changes adopted by the OCC in 

the processing of applications from 

national banks for mergers, consoli 

dations, and purchase and assump 

tions will speed up substantially the 

approval time for such transactions. 

Included is an agreement with the 

Justice Department for streamlining 

its review of reorganization mergers. 

Also, the OCC will no longer require 

shareholder approval of a merger 

before approving the transaction. If 

the agency approves a transaction 

before shareholders do, the bank 

must disclose that fact to the share 

holders "in a timely manner." Such 

disclosures must include all "ma 

terial facts and circumstances sur 

rounding the approval." 

The processing changes are effec 

tive immediately for those banks fil 

ing merger applications after June 6. 

BBR, 6120/88, p. 1050; BC-230, 6/6, OCC. 

Federal Reserve Board 

Check-Hold, Processing Rules 

The Federal Reserve Board (FRBJ 

adopted final rules, to be effective 

September 1, that require banks to 

make check deposits available to cus 

tomers within specified time limits. 

They conform to the Board's original 

proposals with only minor changes. 
FDIC Banking Review 

The rules generally require that local 

check deposits be made available 

within three business days after de 

posit, and nonlocal checks within 

seven days. Local checks are chose 

drawn on a bank within the same 

Federal Reserve district. Next-day 

availability is required for the first 

$100 of all checks, and for all gov 

ernment checks, cashier's checks, 

and certified checks. 

On September 1, 1990 the maxi 

mum hold periods will be shortened 

to two business days on local checks 

and five on nonlocal items. 

Because the schedules and avail 

ability provisions were specified by 

the Expedited Funds Availability Act 

of 1987 the Board had limited flexi 

bility in its ruling. Continuing its 

efforts to speed the collection pro 

cess, the Board recently adopted mea 

sures on how banks should endorse 

deposited checks (see below), ab, 

5112/88, p. 1; FR, 5127, p. 19372, 

The FRB proposed amendments 

to its Regulation CC, including a 

restriction on certain delayed dis 

bursement practices, in further im 

plementation of the Expedited Funds 

Availability Act of 1987. Under these 

proposals, a bank would be permit 

ted to issue an official check drawn 

on another bank provided a deposi 

tory bank in the same community 

could receive credit for the item as 

early as a check drawn on the issu 

ing bank. Under Reg. GC the term 

"bank" includes all depository insti 

tutions. Federal Reserve Banks' avail 

ability schedules may be used to 

determine equivalentavailability. The 

draft rule would not prohibit banks 

from issuing official checks drawn 

on remote banks "to take advantage 

of improved processing and recon 

cilement capabilities." BBR, 6120188, p. 

1047; PR, 6/28, p. 24093. 

The Board published for comment 

proposed official Board interpretations 

concerning preemptions under its reg 

ulation of the availability of funds and 

collection of checks, with respect to 

the laws of Maine, New York, and 

Illinois. A state law that makes funds 

available for withdrawal in the same or 

a longer period than permitted under 

Regulation GG is preempted. State dis 

closure provisions regarding accounts 

covered by the Regulation are also 

SUpeT$eded.FR,6/28f88,p.24315;ABABank

era Weekly, 7/5, p. 4. 

The FRB, as part of a larger effort 

to speed the processing of bounced 

checks, adopted formal rules on how 

banks should endorse deposited 

checks, effective September 1, 1988. 

In addition, the Board issued for 

comment a proposal to ban present 

ment fees. When imposed, these fees 

encourage the collecting banks to 

hold checks until after 2 p.m. each 

day. FR, 4/J1/88, pp. 11832, 11911; 5/27, p. 

19490; AB, 4/5, p. 1. 

Risk-Based Capital 

Requirements 

The FRB approved final risk-based 

capital standards based on an agree 

ment signed last month by 12 coun 

tries to apply common risk-based 

capital rules to their banks. 

The Board agreed to some changes 

in its previous position, for example, 

to reduce the capital required to 

back home mortgages by placing the 

activity in the 50 percent risk-weight 

category. Also it agreed to redefine 

long-term securities as those matur 

ing in over one year, rather than 90 

days. The Board did not alter its 

position that long-term government 

securities should be supported by 

more capital than short-term gov 

ernment securities. 

The Board also said that all bank 

holding companies and their subsid 

iaries must meet the capital mini

mums, except securities underwrit 

ing subsidiaries where there are 

adequate firewalls between them and 

their holding companies. The secu 

rities underwriting subsidiaries must 

meet capital standards set by the 

Securities and Exchange Commis 

sion. AB, 8/4/88, p. 2. 

The FRB had previously proposed 

risk-based capital guidelines that 

largely conform to those accepted by 

bank regulators in 12 countries. Un 

der the proposal banks' assets would 

be grouped into five risk categories 

with different weights and requiring 

different amounts of capital. For the 

first time, capital would be required 

to support off-balance-sheet activi 

ties. In the new proposal there were 

some changes from the earlier plan 

in the assigned risk category of some 

assets. 

Until the end of 1990 the minimum 

capital guideline would be the current 

total capital-to-assets ratio of six per 

cent. From the end of 1990 to 1992, 

the minimum capital would be 7.25 

percent, with at least 3.25 percent in 

common equity. At the end of 1992 

minimum capital would increase to 

eight percent, of which four percent 

would have to be common equity. 

The FRB's risk-based plan, which 

was developed in cooperation with 

the FDIC and the Comptroller of the 

Currency, would require compliance 

by all U.S. banks. AB, 1/28/88, p. 1, 

Restrictions On Nonbank 

Banks 

The FRB proposed rules, imple 

menting provisions of the Competi 

tive Equality Banking Act of 1987 

(CEBA), to restrict the growth and 

activities of the 55 limited-service 

banks which were grandfathered un 

der the Act. CEBA allowed institu 

tions in existence on March 5, 1987 

to continue operating but imposed 

several restrictions, including sevenpercent cap on an institution's asset 

growth during any 12-month period 

beginning August 10,1987. The Board 

proposed two ways for an institution 

to calculate its asset base to deter 

mine growth—actual assets on Au 

gust 10, 1988, or average total assets 

as of the third quarter 1988. 

CEBA prohibits limited-service in 

stitutions from any new activity 

which they were not engaged in as of 

March 5, 1987, and to implement 

this provision the Board proposed 

subeategories, for example, different 

classes of deposits, to restrict expan 

sion. Each nonbanking activity such 

as data processing and investment 

advice would be treated as a separate 

activity. Also proposed were restric 

tions on cross-marketing among af 

filiates and caps on an affiliate's over

37 
Recent Developments 

drafts. CEBA prohibits limitedservice banks from incurring 

overdrafts with Federal Reserve 

Banks, and affiliates generally are 

not permitted to have overdrafts at 

the parent limited-service bank, ab, 

6/2/88, p. 1; FR, 5/26, p. 21462. 

Rules On Debt-Equity Swaps 

New rules issued by the FRB, ef 

fective February 24, allow U.S. banks 

to swap debt for stock in any privatesector nonfinancial companies in de 

veloping countries, and lengthen the 

maximum holding period to 15 years. 

The changes liberalize the FRB's 

guidelines issued last August which 

allowed U.S. banks to swap debt only 

for stock in a government corpora 

tion that is being privatized, and 

required that banks sell the stock 

within five years. While ownership 

in privatized government enterprises 

is not restricted, banks'share in other 

private-sector companies continues 

to be limited to 40 percent, or 25 

percent if the company has no larger 

stockholder. 

The requirement that debt-equity 

swaps be done through a bank hold 

ing company is continued. A re 

quirement that advance notice be 

given to the FRB when transactions 

exceed $15 million was amended to 

require notice only when the amount 

exceeds the greater of $15 million or 

one percent of a BHG's equity capi 

tal. WSJ, 2119/88, p. 40; BBR, 2/29, p. 367. 

State Member Banks' 

Disclosure Of 

Financial Condition 

The FRB proposed a change in its 

rules to require state member banks 

to make available to shareholders 

and any member of the public, upon 

request, information regarding each 

bank's financial condition in the form 

of the bank's two most recent yearend Reports of Condition and In 

come (Gall Reports). As an alterna 

tive to the Call Reports banks may 

provide, at their option, the speci 

fied schedules from the Call Reports, 

certain annual reports to sharehold 

ers, and independently audited fi 

nancial statements containing com 

parable information. FR, 5/27/88, p. 

1930S. 

Truth In Lending 

The FRB adopted revisions to its 

offical staff commentary for Regula 

tion Z (Truth In Lending). The 

changes address, for example, dis 

closure questions raised by the emer 

gence of conversion features in 

adjustable-rate mortgages, as well as 

the imposition of fees that are con 

sidered finance charges at the time a 

credit card plan is renewed. PR, 4/5/88, 

p. 11055. 

Mortgage Disclosure 

The FRB requested comments on 

its revised Regulation G, incorporat 

ing recent amendments to the Home 

Mortgage Disclosure Act (HMDA). 

The amendments permanently ex 

tended the Act and expanded its 

coverage to mortgage banking sub 

sidiaries of bank and savings and 

loan holding companies and also to 

savings and loan service corpora 

tions thatoriginate or purchase mort 

gage loans. Until now, the Act's cov 

erage has applied only to depository 

institutions and their majority-owned 

subsidiaries. 

Among other changes, the regula 

tion would require mortgage banking 

subsidiaries of depository institutions 

to itemize loan data by census tract 

(or by county, in some instances) for 

property located in metropolitan sta 

tistical areas where the subsidiary 

has offices for taking loan applica 

tions from the public. This informa 

tion is required at present only for 

an MSA where the parent institution 

has an office. FR, 5/13/88, p. 17061. 

Equal Credit Opportunity 

The FRB adopted revisions to the 

official staff commentary to Regula 

tion B (Equal Credit Opportunity). 

The revisions address issues con 

cerning consideration of age in eval 

uating creditworthiness, signature re 

quirements , record retention and 

collection of monitoringinformation. 

FR,4/5/88,p. 11044. 

BHC Allowed To Keep 

Insurance 

Subsidiary In Merger 

The FRB approved the merger of 

Hartford National Corp., Hartford, 

Connecticut, and Shawmut Corp., 

Boston. Shawmut National Corp., the 

resulting company, will acquire Hart 

ford National's ten subsidiary banks 

in Massachusetts, Rhode Island and 

Connecticut, and Shawmut *s nine 

subsidiary banks in Connecticut and 

Massachusetts. 

The Board allowed Shawmut to 

retain its insurance agency subsid 

iary, under the "grandfather clause" 

in Exemption D of the Garn-St Ger 

main Act that allowed BHCs and 

their subsidiaries to continue insur 

ance activities they were conducting 

on May 1, 1982. Following the FRB's 

requirements in an earlier decision 

involving Sovran Financial Corp., 

Shawmut will keep the insurance 

subsidiary separately incorporated, 

and not begin insurance activities in 

any other subsidiary following the 

merger. 

The FRB also permitted Shawmut 

to acquire Hartford National's trust 

subsidiary in New York, but the trust 

company will give up its FDIC insur 

ance. The Douglas amendment to 

the Bank Holding Company Act pro 

hibits a BHC from acquiring a bank 

in another state unless that state's 

laws expressly authorize the acquisi 

tion. New York's laws do not permit 

such acquisitions by Massachusetts 

banking firms. By dropping its FDIC 

coverage the trust company is no 

longer a "bank" under the BHC Act, 

as amended by CEBA. BBR, 2/8/88, p. 

198. 

Bank Acquisition Approved 

For BHC With 

Real-Estate Subsidiary 

The FRB granted approval for 

Napa Valley Bancorporation, Napa, 

California, whose bank subsidiary 

owns a real-estate investment sub 

sidiary that engages in real-estate 

activities permitted by California law, 

to own two proposed new banks in 
FDIC Banking Review 

the state. Napa Valley agreed to limit 

its subsidiary's real-estate develop 

ment activities and, in addition, the 

approval was conditioned on the hold 

ing company's compliance with the 

eventual results of the FRB's realestate development rulemaking. BBR, 

5/23188. p. 862. 

BHC Allowed To Acquire 

Savings Bank And 

Real-Estate Subsidiary 

The FRB approved an application 

by Citizens Financial Group, Provi 

dence, Rhode Island, to acquire 

Fairhaven Savings Bank, Fairhaven, 

Massachusetts, and its real-estate in 

vestment and development subsid 

iary. Provisions of CEBA authorizing 

savings banks to continue stateauthorized real-estate activities were 

cited by the Board. 

The approval was conditioned upon 

Citizens' agreement to comply if the 

Board should issue a rule requiring 

that approved real-estate develop 

ment activities be conducted through 

a holding company subsidiary, rather 

than a bank subsidiary. BBR, 519/88, 

p. 782. 

Underwriting Equity 

Securities Overseas 

The FRB, in a letter to Security 

Pacific Corp., clarified that the bank 

holding company's subsidiaries in 

London can join together to under 

write up to #15 million of equity 

securities from any one issuer. Fed 

eral law restricts each overseas sub 

sidiary to $2 million of such under 

writing. The subsidiaries also were 

allowed for one year to make subor 

dinated loans to one another to cover 

their underwriting commitments. 

However, the FRB must be given 

prior notice of such transfers to cover 

losses from adverse market moves. 

AB, 5125188, p. 1. 

Loan Strip Participations 

The FRB issued a clarification stat 

ing that the ostensible sale of a shortterm loan made under a long-term 

lending commitment, known as a 

loan strip or strip participation, is a 

"deposit" for the purposes of Regula 

tion D whenever the depository in 

stitution sells the loan at the end of 

the short-term period if the original 

investor does not wish to renew its 

interest and another investor cannot 

be located. 

The Board has issued a proposal 

for the reporting of these liabilities 

by depository institutions. The re 

porting and required reserve main 

tenance will begin after final approval 

of a new reporting form. 

The Board also has been concerned 

about the funding risks because in 

vestors may decide without warning 

to stop buying strips in a particular 

loan. 

It is believed that only seven or 

eight banks presently engage in loan 

stripping and thus would be affected 

by the requirement. FR, 7/1/88, p. 24930; 

AB, 6/28, p. 3. 

Federal Home Loan Bank Board 

Regulatory Capital 

Requirements 

The Federal Home Loan Bank 

Board (FHLBB) amended its regula 

tion setting the regulatory capital 

requirements for institutions insured 

by the Federal Savings and Loan 

Insurance Corporation (FSLIC), 

changing the method of computing 

the April calculation of industry prof 

its by basing it on the median return 

on assets of all insured institutions. 

With the change 12 years may be 

needed to reach the six percent 

capital-to-deposits target for the in 

dustry based on current earnings. 

This period is substantially less than 

the estimated time required under 

the previous method. FR, 3/29/88, p. 

11242; AB, 4/5, p. 2. 

Regulatory Capital GAAP 

Phase-In 

The FHLBB amended its regula 

tions, implementing a provision of 

the Competitive Equality Banking 

Act of 1987 (CEBA), to begin FSLICinsured institutions' phase-in of gen 

erally accepted accounting princi 

ples (GAAP) on January 1, 1989. 

The phase-in would end on Decem 

ber 31, 1993, at which time insured 

institutions would be required to re 

port virtually all components of reg 

ulatory capital in accordance with 

GAAP or the regulatory accounting 

practices employed by commercial 

banks, fr, 1/6/88, p. 324. 

Capital Forbearance 

The FHLBB adopted regulations, 

implementing a provision of CEBA, 

which set forth the requirements 

that FSLIC-insured institutions must 

meet to obtain capital forbearance 

under this program, the procedures 

for requesting forbearance, the pro 

cedures under which an applicant's 

Principal Supervisory Agent will con 

sider such requests, the effect of 

forbearance, and termination of a 

grant of forbearance. The effective 

date is January 1, 1988. FR, DOiSS, p. 

354. 

Enforcement Of Regulatory 

Capital Requirements 

The FHLBB adopted rules, to be 

come effective February 5, 1988, to 

set and enforce regulatory capital 

requirements for FSLIC-insured in 

stitutions under authority granted 

by CEBA and pursuant to the Board's 

authority to regulate those institu 

tions. Section 406 of CEBA autho 

rizes the Board to vary the minimum 

regulatory capital requirements of 

an individual insured institution as 

may be necessary or appropriate in 

light of the particular circumstances 

of the insured institution. The regu 

lations also establish procedures for 

implementing the authority granted 

by section 406 to issue a directive 

and enforce a plan for increasing an 

insured institution's capital level. FR, 

116188, p. 363. 

39 
Recent Developments 

Special Assessment 

Phase-Out Proposal 

The FHLBB proposed phasing out 

the special assessment which FSLICinsured institutions have paid quar 

terly since 1985 at an annual rate of 

1/8 of one percent. For thrifts with 

capital of at least six percent of as 

sets the special assessment would be 

reduced to 1/12 of one percent this 

year, and in steps to 1/48 of one 

percent in 1991, and zero in 1992. 

About 1,400 of the nation's 3,126 

thrifts would benefit from the pro 

posal. The Board also asked for com 

ments on whether to use another 

threshold for capital, or a sliding 

scale for reducing the special assess 

ment on well-capitalized institutions. 

GEBA requires the FHLBB to be 

gin phasing out the special assess 

ment within five years unless the 

Board can show a necessity for con 

tinuing it. 

An industry official said the Board's 

proposal could prevent the shift to 

FDIC insurance by many strong 

thrifts when conversion becomes pos 

sible. WSJ, 4113188, p. 18; BBR, 4/18, p. 651. 

Thrift Readmissions To 

FHL District Member 

Bank Status 

An advisory from the FHLBB to 

Federal Home Loan Banks states that 

applications for readmission to dis 

trict bank membership from any thrift 

that terminates FSLIC insurance of 

accounts must be reviewed in Wash 

ington. An application for readmis 

sion by an insured institution that 

converts to a state-chartered savings 

bank insured by the FDIG would 

raise substantial legal and policy is 

sues, the directive said. 

The FHLBB wants to decide 

whether to revoke a 1970 rule that 

permits immediate readmission to 

district bank membership of a thrift 

that switches from FSLIC insurance 

to FDIG coverage. A provision of the 

1982 Garn-St Germain Depository 

Institutions Act states that any insti 

tution withdrawing from FHLBB 

membership can be readmitted only 

alter five years has expired. News, 

FHLBB, 7121188. (Proposed rule change.- FR, 

8/9/88, p. 30665). 

Permissible Affiliate 

Transactions Proposal 

The FHLBB proposed a regulation 

to bring greater parity between oper 

ations of bank and thrift holding 

companies' subsidiaries. Comment 

is sought on the incorporation and 

application of two provisions of the 

Federal Reserve Act into thrift rules 

as directed by CEBA. The two provi 

sions govern transactions between 

bank holding company subsidiaries 

and their affiliates. Among other 

things, the sections impose restric 

tions on the dollar amount of permit 

ted transactions and require that 

transactions be conducted at arms' 

length. 

Before enactment of GEBA, trans 

actions between an insured thrift 

subsidiary and its affiliates were re 

stricted by the Bank Board's conflict 

rules, and insured thrift subsidiaries 

were prohibited from engaging in 

certain transactions and had to ob 

tain prior approval for affiliate trans 

actions. 

The proposal also seeks public com 

ment on how such terms as "affil 

iates" should be defined and whether 

the agency should have authority to 

exempt certain activities. News, FHLBB, 

6/9/88. 

Trading/Investment 

Proposed Rule 

And Policy Statement 

The FHLBB proposed a rule and 

policy statement to make clear that 

insured institutions must account for 

securities held for investment, sale 

or trading using documented gener 

ally accepted accounting principles 

(GAAP). The proposed rule and pol 

icy are in response to CEBA which 

mandates that the Bank Board pre 

scribe uniformly applicable account 

ing standards to be used by all FSL1C

insured institutions. 

Under the proposal thrifts could 

be barred from placing securities in 

the investment category unless they 

showed the intent and ability to hold 

them "for the foreseeable future." 

The rule if adopted would move thrift 

accounting closer to the methods 

required for banks. The FDIC allows 

banks to carry securities held for 

investment at cost, but requires that 

trading securities be marked to mar 

ket. Thrifts nevertheless would have 

much more flexibility than banks in 

justifying trading in their long-term 

investment portfolios. WSJ, 6/10/88, p. 

26; AB, 6/10, p. l;Ncws, PMLBB, 6/9. 

Securities Brokerage 

The FHLBB proposed changes in 

its regulations to enable service cor 

porations to commence certain types 

of securities brokerage activities with 

out preparing an application and ob 

taining individual Board approval, 

and to designate certain types of 

these activities as preapproved ser 

vice corporation activities. FR, 4/28/88, 

p. 16147. 

Securities Firm Acquires 

Troubled Thrifts 

The FHLBB permitted the States 

man Group, an Iowa insurance and 

securities firm, to acquire four trou 

bled thrifts with combined assets of 

nearly $700 million in Florida and 

Iowa, the first such acquisitions the 

agency has allowed in several years. 

Statesman's thrift and securities 

affiliates are permitted to cross mar 

ket each other's products and ser 

vices. However, the Board placed 

restrictions on certain transactions 

between the affiliates for 180 days, 

while it considers the imposition of 

longer-term safeguards. The tempo 

rary prohibitions relate to extensions 

of credit from the S&L to the secu 

rities affiliate and the purchase of 

assets by the thrift from the securi 

ties affiliate, in order to "prevent the 

insured institution from extending 

its resources ... to prop up or en 

hance the securities affiliate." BBR, 

3/21/88, p. 488. 

Adjustable-Rate Mortgage 

Disclosures 

Amendments to the FHLBB's reg 

ulations require lenders to provide 

to a prospective borrower a clear 

and concise description of the lend 

er's ARM program(s), including a his 

torical example, either when an ap 

plication form is given to the 

40 
FD1C Banking Review 

consumer or before the consumer 

pays a non-refundable fee, which 

ever is earlier, and contain other 

ARM provisions. The amendments 

enact the Federal Financial Exami 

nation Council's (FF1EC) recommen 

dations of August 1986. FR, 5123188, p. 

18261. 

New Powers For State 

Banks 

Securities Powers 

Indiana: The Governor signed leg

islation which permits statechartered banks that are not mem 

bers of the Federal Reserve System 

to underwrite municipal revenue 

bonds, and to sell mutual funds and 

mortgage-backed securities. The ex 

panded powers cannot be exercised, 

however, unless the Glass-Steagall 

Act, which separates commercial 

banking from the securities business, 

is repealed or amended, ah, 3/11/88, p. 

3. 

A new law permits state-chartered 

banks to invest up to ten percent of 

their total equity capital in invest 

ment securities beginning July 1, 

giving them parity with national 

banks in this respect. Total equity 

capital includes unimpaired capital 

stock, unimpaired surplus, undivided 

profits, and 100 percent of loan re 

serves. BBR, 3121188, p. 500. 

Kansas: A new law allows statechartered banks, beginning July 1, 

to establish a subsidiary that may 

engage in various securities activi 

ties, including selling or distributing 

stocks, bonds, debentures, and notes; 

issuing and underwriting municipal 

bonds; organizing, sponsoring, and 

operating mutual funds; and acting 

as broker-dealers for securities. AB, 

4115/88, p. 1. 

Michigan: Recent legislation re 

moves certain restrictions on state 

banks' securities activities, including 

a prohibition on a bank being affili 

ated with an organization principally 

engaged in the securities business, 

Also removed is the current prohibi 

tion on a person being an officer, 

director, employee or partner of both 

a bank and a securities firm. Existing 

provisions that an officer or employee 

of a bank may not act in an individ 

ual capacity as an agent to sell stocks 

or securities, and may not receive a 

commission for the sale of stocks or 

securities to the bank, continue in 

effect. 

The legislation also makes several 

changes to allow state banks to apply 

to offer new products and services 

and requires the Commissioner of 

Banking to act pro-competitively 

when making decisions on applica 

tions by state banks for new powers. 

These provisions are intended to cre 

ate parity in powers with competing 

financial-service providers. LvgislativcLegal Btdletin No. 4, Michigan Bankers Associ 

ation, 6130188. 

Leasing Powers 

Minnesota: A new law gives state 

banks leasing authority in partial par 

ity with national banks. A previous 

limitation on acquisition and leasing 

of personal property to 200 percent 

of the bank's capital and surplus no 

longer applies if the institution meets 

certain requirements related to the 

residual value of the property being 

leased. BBR, S/23/S8, p. 867. 

Surety Insurance Powers 

Tennessee: A new law, effective 

July 1, 1988, authorizes state banks 

to own, operate, or manage an insur 

ance company offering only surety 

insurance. The legislation must com 

ply with provisions of Tennessee law 

applicable to such insurance compa 

nies, and the activities will be regu 

lated by the Commissioner of Com 

merce and Insurance. BBR, 5/9/88, p. 

786. 

Interstate Banking 

Arkansas: The Governor signed a 

law which provides for interstate 

banking between Arkansas and 16 

states and the District of Columbia. 

The states are Tennessee, Missouri, 

Mississippi, Texas, Louisiana, Okla 

homa, Alabama, Florida, Georgia, 

Maryland, North Carolina, South 

Carolina, Virginia, Kansas, Nebraska 

and West Virginia. Reciprocity is re 

quired. The legislation is effective 

January 1, 1989. 

Before acquiring an Arkansas in 

stitution an out-of-state purchaser 

would have to provide to the Bank 

Commissioner certain community re 

investment information, and subse 

quently file reports yearly with the 

Commissioner on compliance with 

its community reinvestment plan and 

impact on the community. If an in 

stitution was found to be not meet 

ing its reinvestment commitments, 

the Commissioner would be empow 

ered to issue a cease-and-desis t or 

der, impose a fine of up to 810,000 

for each day of noncompliance, and 

may require divestiture in not less 

than two years. 

The legislation also provides for a 

phase-in of statewide branch bank 

ing (see below). BBR, 7/18/88, p. 88. 

Colorado: Legislation was enacted 

providing for regional, reciprocal in 

terstate banking until January 1, 

1991, when nationwide, non

reciprocal interstate banking will be 

permitted. The interstate banking 

region consists of the contiguous 

states of Nebraska, Kansas, Okla 

homa, New Mexico, Arizona, Utah 

and Wyoming. 

An out-of-state bank holding com 

pany may not acquire, until July 

1993, a Colorado banking organiza 

tion which has not been in operation 

for five years. 

The new law prohibits an inter 

state acquisition of a Colorado bank 

or BHC if the acquired institution 

would control more than 25 percent 

of the total deposits of banks, savings 

and loan associations, and other 

Cede rally-insured institutions in Col 

orado. An out-of-state BHC which 

has a total capita I-to-assets ratio of 

less than six percent may not ac 

quire a Colorado bank or BHC. 

In efforts to resolve the state's 

industrial bank crisis an amendment 

was added to permit two out-of-region 

41 
Recent Developments 

holding companies to make addi 

tional bank purchases in the state 

before 1991, provided they acquire 

the assets and liabilities of an indus 

trial bank or provide assistance. BBR, 

4/18/88, p. 661. 

The #26 billion-asset First Bank 

System, a Minnesota bank holding 

company, agreed to contribute #8 

million to depositors of Colorado's 

failed industrial banks, and received 

permission to acquire control of the 

$2 billion-asset Central Bancorp, Den 

ver. The acquisition is subject to 

approval by the Federal Reserve. AB, 

8/10188, p. 7. 

Hawaii: A new law permits the 

acquisition of a failing financial insti 

tution in the state by an out-of-state 

chartered institution. 

The legislation also permits bank 

ing institutions based in several Pa 

cific islands to acquire or control 

banks in the state, with reciprocity 

for Hawaiian institutions. Island 

states included in the banking region 

are Guam, American Samoa, Micro 

nesia, Palau, Northern Marianas and 

the Marshall Islands. BBR, 7/4/88, P.17. 

Minnesota: Legislation effective 

August 1 expands the state's inter 

state, reciprocal banking region to 

14 states, adding Illinois, Missouri, 

Kansas, Nebraska, Colorado, Wyo 

ming, Idaho, Montana and Washing 

ton. The region presently consists of 

Iowa, North and South Dakota, and 

Wisconsin. Within the expanded re 

gion, the states of South Dakota, 

Wisconsin, Wyoming, Idaho and 

Washington now have reciprocal, in 

terstate laws. 

Purchases are prohibited that 

would result in out-of-state financial 

institutions in the aggregate holding 

more than 30 percent of the deposits 

held in Minnesota financial institu 

tions. 

Out-of-state banking firms are per 

mitted to charter one de novo bank 

in Minnesota. BBR, 5/2/88, p. 751. 

Nebraska: The Governor signed 

legislation that provides for recipro 

cal interstate banking between Ne 

braska and the states of Iowa, Mis 

souri, Kansas, Colorado, Wyoming, 

South Dakota, North Dakota, Minne 

sota, Montana and Wisconsin, effec 

tive January 1, 1990. A nationwide 

interstate trigger goes into effect on 

January 1, 1991. 

Prohibited are acquisitions of Ne 

braska banks that would give an out

of-state banking organization the con 

trol of more than 12 percent of the 

aggregate bank deposits in the state. 

Also the state department of banking 

is authorized to deny an application 

for an acquisition if the out-of-state 

acquiror's community reinvestment 

record is deemed to be inadequate. 

AB, 4/13/88, p. 3; 4/11, p. 32. 

New Hampshire: The state's re 

gional, reciprocal banking law was 

amended to permit bank holding com 

panies in New England to enter the 

state even if they own affiliates out 

side the six-state region. The 

amended law requires that a BHC 

must have its principal place of busi 

ness in New England, and obtain a 

majority of its deposits from the re 

gion, in order to enter New Hamp 

shire. BBR, 4/18/88, p. 661. 

New Mexico: A new law permits 

out-of-state banking institutions any 

where in the U.S. to acquire New 

Mexico banks, beginning January 1, 

1990. Reciprocity is not required. 

Until July 1, 1992 a bank acquired 

by an out-of-state banking firm must 

have been in operation for at least 

five years. Out-of-state firms may 

establish new banks in the state start 

ing July 1, 1992. AB, 2/25/88, and New 

Mexico Financial Institutions Division. 

South Dakota: A new law, effec 

tive immediately, permits out-of-state 

bank holding companies anywhere 

in the U.S. to own banks in South 

Dakota. Reciprocity is required. The 

law follows a court decision in Janu 

ary that the state's limited-purpose 

interstate banking law was unconsti 

tutional. The new law also repeals all 

operating restrictions which were ap 

plicable only to banks acquired by 

out-of-state bank holding companies. 

BBR, 2/22/88, p. 308. 

Intrastate Branching 

Arkansas: New legislation, effec 

tive January 1, authorizes banks to 

branch in contiguous counties in the 

state after December 31, 1993, and 

statewide after December 31, 1998. 

The legislation was a result of the 

Deposit Guaranty case in Mississippi. 

Early in 1987 the OCC permitted a 

national bank in Mississippi to branch 

outside the 100-mile limit then ap 

plicable to commercial banks under 

that state's law. That decision was 

upheld by a federal appeals court. As 

in Mississippi, thrift institutions in 

Arkansas currently are allowed to 

branch statewide. However, the leg 

islation would prohibit new branch 

ing by state-chartered thrifts outside 

their home counties except on the 

same schedule that will apply to 

banks. BBR, 7/18/88, p. 88. 

Florida: The OCC granted ap 

proval for the $820 million-asset Con 

solidated Bank, Miami, to open a 

branch in Palm Beach County. Con 

solidated was the first national bank 

in the state to seek statewide branch 

ing powers after a Court of Appeals 

upheld similar powers for national 

banks in Mississippi. Florida's thrift 

institutions may branch anywhere 

in the state. 

Earlier this year legislation was 

enacted in Florida that gives state 

banks the same branch powers as 

national banks. This provision be 

comes effective 45 days after the 

establishment of the first national 

bank branch outside the bank's home 

office county. AB, 6/20/88, p. 3; Florida 

Division of Banking. 

Michigan: An amendment to the 

branching law, effective August 1, 

permits banks to open de novo 

branches throughout the state. Pre 

viously, statewide branching was per 

missible only by mergers, and de 

novo branching was restricted to the 

county where a bank's head office is 

located, or, to an adjacent county 

within 25 miles of the head office. 

Also branch home office protection 

is eliminated. Michigan Financial Institu 

tions Bureau, 7/6/88. 

42 
FDIC Banking Review 

Missouri: The deposit base has been 

broadened to include savings and loan 

associations and credit unions under 

the state law which prohibits mergers 

that would result in a banking institu 

tion having more than 13 percent of 

the aggregate deposits in the state. 

Previously the deposit base consisted 

of only deposits held in banks. The 

change increased the depositbase from 

842.8 billion to #63.6 billion. BBR, 6/ 

13/88, p. 1014. 

Oklahoma: Statewide branching 

through acquisition or merger is now 

authorized. Unchanged is a provision 

that allows up to two de novo branches 

to be established in a bank's main 

office city, and up to 25 miles away so 

long as the main office of another 

bank is not located in the town. 

The new law prohibits banks char 

tered after December 31, 1986 from 

being acquired until they have oper 

ated continuously for more than five 

years. Acquisitions are prohibited 

that would give the resulting institu 

tion direct or indirect ownership or 

control of more than 11 percent of 

the aggregate deposits of banks, sav 

ings and loan associations and credit 

unions in the state. BBR, 3/28/88, P. 541; 

Oklahoma Department of Banking, 6122. 

Tennessee: A U.S. District Court 

upheld a ruling by the Comptroller 

of the Currency permitting Memphisbased National Bank of Commerce 

to open five branches outside its 

home county. Tennessee's law re 

stricts branching of state-chartered 

banks to the county where a bank's 

main office is located; however, any 

thrift in the state that is at least five 

years old may branch statewide. 

Before the latest court decision 

the Tennessee banking commis 

sioner had approved statewide 

branching for state banks under a 

"wild card" statute that gives the 

banks parity with national banks in 

the exercise of powers in Tennessee. 

BBR, 5/23/88, p. 872. 

Texas: federal district court ruled 

that national banks can branch any 

where in the state because savings 

and loan associations in the state 

have statewide branching powers. 

The decision came in a suit brought 

by the Attorney General of Texas 

against the OCC, which late last year 

approved applications by two Texas 

banks. 

Banks are generally restricted by 

the state's constitution to countywide branching, except to acquire a 

failing bank, ab, 6/27/88, p. 2. 

Parity For State Banks 

Alabama: A new law grants to 

state banks the same powers that 

federally chartered banks may exer 

cise, subject to prior approval by the 

Superintendent of Banks. The legis 

lation was prompted by the Deposit 

Guaranty branching case in Missis 

sippi (see below). 

The new legislation gives state 

banks expanded leasing powers, and 

enables them to pledge assets to se 

cure deposits in trust departments. 

In other respects the powers of the 

state's banks already are equal to or 

exceed those of national banks, an 

official said. BBR, 5/23/88, p. 865. 

Mississippi: The Governor signed 

a law, to be effective immediately, 

which gives state-chartered banks 

parity with national banks in the 

state with respect to banking pow 

ers. 

A primary motivation for the leg 

islation was the Comptroller of the 

Currency's Deposit Guaranty deci 

sion, upheld by the courts in 1987. It 

permitted the bank to branch 100 

miles from its home office, because 

such a branch would be permissible 

under state law for savings and loan 

associations, though not for banks. 

Mississippi's existing law did not per 

mit state-chartered banks to branch 

statewide until 1991. 

The new parity law applies across 

the board to banking powers. For 

example, italso could give state banks 

more liberal lending limits. The new 

powers will expire on June 30,1991, 

unless reenacted. Before banks can 

take advantage of the newly autho 

rized powers the state banking board 

must issue implementing regula 

tions. BBR, 5/16/88, p. 819. 

Miscellaneous 

Bank Capital 

Requirements Do Not 

Increase Risk-Taking 

Some analysts have contended that 

higher bank capital standards lead to 

more asset risk because institutions 

that are required to increase capital 

will shift to higher-yielding, riskier 

assets to increase the rate of return 

on equity. The results of this study of 

98 large, publicly traded bank hold 

ing companies between 1981 and 

1986 "do not support the view that 

increases in regulatory capital stan 

dards lead banks to increase asset 

risk." Economic Review, Federal Reserve 

Bank of San Francisco, Spring 1988, pp. 

45-56. 

GAO Report On Supervision 

Of U.S. Banks' 

Foreign Lending 

A report by the General Account 

ing Office concluded that the OCC, 

FDIC, and Federal Reserve have re 

quired inadequate reserves for the 

country risk contained in U.S. banks' 

foreign loans. The principal reason 

for the inadequacy is that the agen 

cies have restricted use of their re 

serving authority to loans rated 

"value-impaired"—currently less 

than two percent of U.S. bank loans 

owed by less-developed countries 

(LDGs). The agencies have not re 

quired reserves for "other transfer 

risk problem" (OTRP) and "sub 

standard" foreign loans which con 

tain considerable country risk. In 

addition, required reserve rates for 

"value-impaired" loans are too low. 

GAO recommended that the OCC, 

FDIC and Federal Reserve: (1) re 

quire reserves for loans that cur 

rently have no reserve requirements, 

basing reserve requirements prima 

rily on secondary market prices for 

foreign loans; (2) ensure that fore 

casts are made for countries very 

likely to develop debt servicing prob 

lems; (3) eliminate deficiencies in 

the information used to determine 

loan ratings; and (4) ensure that 

bank examiners comply with require 

ments of the International Lending 

Supervision Act of 1983 (ILSA). 

43 
Recent Developments 

The report notes that the bank 

supervisory agencies disagreed with 

GAO's recommendations concern 

ing required reserves principally be 

cause they believe that prices for 

international debt on the secondary 

market are not a reasonable mea 

sure of this debt's real worth. "Super 

vision of Overseas Lending is Inadequate," 

U.S. General Accounting Office, May 1988. 

The Federal Reserve Board, com 

menting on the GAO report, criti 

cized the idea of using the secondary 

market to evaluate underdevelopedcountry loans. "The secondary mar 

ket basicalJy reflects the sale price 

for assets that are being sold on an 

expedited basis by banks exiting the 

business of lending to developing 

countries ... it provides little useful 

information about ultimate collect

ibility of the loans being sold," the 

Board said. 

In response to the GAO's call for 

more reserves against foreign loans, 

the FR stressed its work on improv 

ing overall capital levels, saying that 

"the emphasis on primary capital 

has been considered the more ap 

propriate focus of supervisory atten 

tion . . . since the reserving process 

per se involves only a transfer of 

funds and does not increase the total 

resources available to banks to ab 

sorb losses." The Board rejected an 

increase in the number of categories 

requiring reserves. It said that "the 

magnitude of any eventual loss is 

highly subjective," and bank man 

agement, not bank regulators, should 

decide whether a marginal borrower 

will remain current or default. AB, 

6123188, p. 2. 

Supreme Court Upholds New 

Securities Powers 

The U.S. Supreme Court let stand 

the Federal Reserve Board's approval 

for commercial bank affiliates to un 

derwrite commercial paper, munici 

pal revenue bonds, and securities 

backed by mortgages or consumer 

debt. The Court's ruling, against a 

challenge by the Securities Industry 

Association, clears the way for banks 

that have received the Board's ap 

proval to begin these activities. Sev 

eral have announced immediate plans 

to do so. 

Section 20 of the Glass-Steagall 

Act prohibits FR member banks from 

affiliating with firms "engaged prin 

cipally" in securities underwriting. 

The FRB's approvals restrict the 

newly approved activities to five per 

cent of an affiliate's gross revenues. 

The Court's action will probably 

increase the pressure on Congress to 

act on pending legislation that would 

amend Glass-Steagall in important 

respects. WSJ, 6/14/88, p. 3;AB, 6/14, p. 1. 

GAO Report On Condition 

Of S&L Industry 

A report of the General Account 

ing Office which details financial 

trends in the savings and loan indus 

try from 1977 to mid-1987 found 

that the thrifts' mortgage assets de 

clined from 85.6 percent to 69.7 

percent of their total assets during 

the period. The dominant nonmortgage asset category in 1987 was 

investment securities. The decline 

in the mortgage assets percentage in 

insolvent thrifts was even more dra 

matic, the report said. These institu 

tions, at mid-1987, were holding 

about 60 percent of assets in mort 

gage assets. They tended to hold 

more direct investments, repossessed 

assets, and deferred net losses than 

did other thrifts. 

Reliance on deposits as a source of 

funds has diminished, declining from 

86.9 percent of total assets in De 

cember 1977 to 74.7 percent in June 

1987. Other borrowed money and 

reverse repurchase agreements had 

die greatest increase in this period. 

Small deposits declined as a source 

of funds for the industry, and bro 

kered deposits increased. 

As of mid-1987 there were 491 

GAAP-insolvent thrifts and an addi 

tional 463 institutions with net worthto-assets of between zero and three 

percent, according to the report. 

The industry's total assets in 

creased from $434.3 billion to 

S1202.8 billion in the period, while 

the number of thrifts in the U.S. 

declined from 4,055 to 3,191. Thrift 

Industry Report, U.S. General Accounting 

Office, May 1988. 

Legislation Extends 

Moratorium On 

Thrifts Leaving FSLIC 

President Reagan signed a bill that 

extends the moratorium, imposed 

by CEBA, on thrift institutions in 

sured by the Federal Savings and 

Loan Insurance Corporation convert 

ing to FDIC insurance. The morato 

rium, scheduled to expire August 10, 

1988, was extended for one year. 

CEBA permitted 40 thrifts then in 

the process of conversion to FDIC 

insurance to continue, and under 

the new bill the 30 of these which 

have not converted would be allowed 

to do SO. BBR, 7/18/88, p. 80. 

Profitability And Risk Of 

New Banking Powers— 

Some Conflicting 

Conclusions 

A study by Federal Reserve Bank 

of Minneapolis staff focuses on 

whether the risk of bankruptcy will 

decrease or increase if bank holding 

companies are permitted to engage 

in the securities, insurance, and realestate businesses. The study, using 

data for 249 bank and nonbank fi 

nancial firms in 1971-1984, analyzes 

the effects of BHC expansion into 

currently prohibited activities by sim 

ulating mergers between actual BHGs 

and nonbank firms as if such merg 

ers had been permitted. Average rates 

of return, the variability of rates of 

return, and levels of capitalization 

are considered. 

The merger simulations suggest 

that BHC combinations with securi 

ties firms or real-estate developers 

would increase the volatility of re 

turns and the risk of failure. Combi 

nations of BHCs and life insurance 

companies, however, would reduce 

both the volatility of returns and the 

risk of failure. Quarterly Review, Federal 

Reserve Bank of Minneapolis, Spring 198S, 

pp. 3-20. 

A study by Federal Reserve Bank 

of Chicago staff found that a very 

small investment by bank holding 

44 
FD1C Banking Review 

companies in a few nonbank activi 

ties—insurance brokerage and prop 

erty and casualty and life insurance 

underwriting—would reduce their 

risk. Further, a ten percent invest 

ment in most activities, other than 

securities-related activities, would not 

increase their risk significantly. Eco 

nomic Perspectives, Federal Reserve Bank of 

Chicago, July/August, 1988, pp. 14-26. 

Home-Equity Loans 

A recent survey of home-equity 

loans by 248 major lenders con 

cludes that credit standards gener 

ally are high and foreclosures are 

rare. Consumers are using the loans 

conservatively, the report says, as 44 

percent of the loans were for debt 

consolidation, and 40 percent were 

for home improvements. The limit 

put by lenders on home-equity lines 

averaged 77 percent of a home's 

value, and they allowed total monthly 

debt payments up to 37 percent of a 

borrower's income. 

The report was concerned, how 

ever, that only 58 percent of lenders 

required full appraisals of property 

securing home-equity lines, down 

from 62 percent in 1986. Also noted 

was an excessive aggressiveness on 

[he part of some loan advertisers. AB, 

4121188, p. 6. 

At year-end 1987, outstanding 

credit on home-equity loans repre 

sented 2.7 percent of banks' loans. 

The delinquency rate continued to 

be the lowest of any loan product at 

0.67 percent, aba Bankers Weekly, 7/ 

12/8H, p. 6. 

The Senate passed legislation in 

March that requires uniform disclo 

sure of terms of home-equity loans 

and prohibits unilateral changes in 

loan terms by lenders. 

Recently enacted legislation in 

Connecticut limits the life of a homeequity loan to 30 years, and requires 

that all advances on equity take place 

within 10 years of the approval of 

the loan. The use of credit cards to 

draw on home equity loans is pro 

hibited. Connecticut State Library, 6/22/ 

88. 

Court Decides For 

Credit Unions On 

Check Holds 

decision of a U.S. District Court, 

District of Columbia, in favor of the 

Credit Union National Administra 

tion, effectively requires banks to 

treat local credit union share drafts 

as local checks, even if the draft is 

drawn on an out-of-town bank. CUNA 

said the FR's regulations as written 

would allow banks and thrifts to hold 

share drafts more than twice as long 

as local checks, making them less 

acceptable than checks as a means 

of payment. The court said that deem 

ing a share draft nonlocal because it 

is drawn on a remote institution, as 

Reg. CC stipulates, violates the lan 

guage of the Expedited Funds Avail 

ability Act. AB, 8/1/88, p. 1. 

Consumer Credit Leads 

Bank Lending 

Commercial banks now hold more 

consumer loans than business loans, 

according to data from the year-end 

1987 Call Reports. Consumer loans 

at FDIC-insured commercial banks 

grew more than 50 percent between 

year-end 1983 and 1987, while busi 

ness loans increased only 12.3 per 

cent. At the largest 300 banks, in 

1987, consumer loans grew 11.3 per 

cent, while at the 300 largest in 

business lending commercial loans 

fell twro percent. At alj other com 

mercial banks, consumer loans were 

up 10.1 percent, and business loans 

were down 1.9 percent. AB, 6/23/88, 

p. I. 

States To Coordinate 

Bank Supervision 

Banking officials of 12 western 

states issued a policy statement call 

ing for coordinated supervision of 

interstate banking activities and for 

the sharing of supervisory informa 

tion between state and federal agen 

cies. Participating states include 

Alaska, Arizona, California, Idaho, 

Montana, Nevada, New Mexico, Ore 

gon, Texas, Utah, Washington and 

Wyoming. The program will include 

interagency advice, examination 

scheduling, sharing and accepting 

each other's examinations, and in 

formation on compliance and en 

forcement activities. The state where 

a state-chartered institution is based 

will have the primary coordinating 

responsibility. 

The states have agreed to main 

tain confidentiality of information in 

accordance with their own laws. 

States may form separate agreements 

regarding disclosure of shared infor 

mation, but in the absence of any 

specific agreement they are asked 

not to disclose such information with 

out the consent of the state that 

provided that information. BBR, 5/2/ 

88, p. 751. 

45