An Update on Emerging Issues in Banking 

FDIC Looks to Research Used in Private Sector for 

Pricing and Managing Risk

October 3, 2002 

The FDIC continued to follow up on its April 2001 Recommendations for Deposit 

Insurance Reform by tackling perhaps the most complex question -- how to price 

deposit insurance. At a recent Conference sponsored jointly by the FDIC and 

Journal of Financial Services Research (JFSR), leading scholars and 

researchers examined the implications of the latest developments in credit risk 

modeling and related risk measurement methods for pricing federal deposit 

insurance.

In order to address fundamental flaws in our system of providing deposit 

insurance, the FDIC recommended a comprehensive set of reforms. Among 

these recommendations was a request for new authority to charge premiums that 

are more closely tied to banks' actual risk profiles. While this is sound theory --

consistent with policies implemented by private-sector insurance companies --

there are nonetheless legitimate questions about how specifically the FDIC would 

determine and price the risk in banks. Another recommendation in last year's 

package was a request to move beyond the static fund target in current law 

toward a more dynamic target that reflects the aggregate risk on the FDIC's 

balance sheet. This also poses a challenge for the FDIC as it seeks to determine 

how best to adjust the size of the insurance fund in response to changes in the 

economy and other risk factors. 

In an effort to seek solutions to these challenging questions, the FDIC is 

increasingly looking to pricing techniques that have been successful in the private 

sector. The recent Conference was in keeping with this effort, as the FDIC joined 

with the JFSR to invite academics, fellow bank regulators, and other industry 

experts to submit advanced research focused on the specific pricing and risk 

measurement issues posed by federal deposit insurance.

Research presented at the Conference centered around three basic issues: the 

FDIC's loss exposure, the probability of default for individual banks, and 

"severity," or the loss rate given default. The research offered new approaches 

for the Corporation's risk measurement and deposit insurance pricing. 

Participants discussed the feasibility of using private-sector models to gauge the 

risks to the insurance fund, as well as the potential sensitivity of these models to 

changes in underlying economic conditions and other factors that influence risk 

exposure. They also explored a wide range of practical policy considerations 

concerning cost burden, the limitations of risk measurement methods, and 

incentives relating to pricing deposit insurance. 

Three papers presented at the Conference broke new ground in applying the 

latest generation of credit risk models to the problem of pricing federal deposit 

insurance. These models are similar to those used by the most sophisticated 

banking and financial institutions, and this class of models is currently under 

review by the Basel Committee on Bank Supervision for use in measuring capital 
adequacy.

In addition, two papers investigated the use of yield spreads on the publicly 

traded subordinated debt of insured institutions as a possible indicator of default 

risk. The final two papers explored new ways of using supervisory information 

and bank financial data to price deposit insurance. One of these papers 

presented a novel proposal to use the interest rates that banks charge their 

commercial borrowers to gauge the default risk posed to the insurance fund.

The Conference proved most useful in identifying promising approaches for 

enhancing the measurement of FDIC risk exposure and laying the groundwork 

for future research in this area. According to the Director of the FDIC's Division of 

Insurance and Research, Art Murton, "From the FDIC's perspective, the 

Conference was a major success. The research presented represents the state 

of the art in risk measurement and pricing, and the authors were successful in 

adapting those techniques to the FDIC's business problems. We plan to pursue 

an aggressive research agenda in partnership with these and other experts in 

this field, building on the foundation of the work presented at this Conference." 

Last Updated 06/12/2007