Federal Deposit Insurance Corporation 

FDIC


Banking
 Banking

Review
 Review

1999


Volume 12, No. 1
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Table of Contents

FDIC
 

Banking


Review
 

1999
 

Volume 12, No. 1
 

Chairman

Donna Tanoue

Division of Research

and Statistics,

Director

Wm. Roger Watson 

Deputy Directors

Barry Kolatch
 

Steven A. Seelig
 

Editor

Steven A. Seelig

Editorial Committee

Jack T. Reidhill
 

Detta Voesar
 

Managing Editor

Detta Voesar

Editorial Secretary

Cathy Wright

Design and Production

Geri Bonebrake 

The views expressed are

those of the authors and do

not necessarily reflect official positions of the Federal

Deposit Insurance Corporation. Articles may be

reprinted or abstracted if

the FDIC Banking Review

and author(s) are credited.

Please provide the FDIC's

Division of Research and

Statistics with a copy of any

publications containing reprinted material.

Single­copy subscriptions

are available to the public

free of charge. Requests for

subscriptions, back issues

or address changes should

be mailed to: FDIC Banking

Review, Office of Corporate

Communications, Federal

Deposit Insurance Corporation, 550 17th Street, N.W.,

Washington, DC 20429.

ThefFederalfSafetyfNet,fBankingfSubsidies,fand

ImplicationsfforfFinancialfModernization

by Kenneth Jones and Barry Kolatch Page 1

This article examines whether there is a subsidy to banks from the federal

safety net. The authors also discuss the public­policy implications of their

findings with respect to the debate on financial modernization.

InternalfRisk-ManagementfModelsfasfafBasisffor

CapitalfRequirements

by Daniel A. Nuxoll Page 18

The author describes the Value at Risk models in use and discusses their

limitations, especially in setting capital requirements.

RecentfDevelopmentsfAffectingfDepositoryfInstitutions

by Lynne Montgomery Page JO

This regular feature of the FDIC Banking Review contains information on

regulatory agency actions, state legislation and regulation, and articles and

studies pertinent to banking and deposit insurance issues.
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

The Federal Safety Net,
 

Banking Subsidies, and
 

Implications for
 

Financial Modernization
 

by Kenneth Jones and Barry Kolatch*
 

Many policymakers and economists have long

maintained that the federal safety netbroadly defined as federal deposit insurance

and access to the Federal Reserve's discount window

and payments system-endows insured depository institutions with a financial subsidy and with certain other, nonfinancial, competitive advantages. Some have

also asserted that banks could conceivably pass cost advantages on to their bank subsidiaries and affiliates-in

essence, extending the safety net (and taxpayer liability) to activities for which it was not intended. Indeed,

this latter argument has long been used to justify constraints on permissible banking activities, and it has recently been echoed in Congressional hearings on

financial modernization.1 During hearings on proposed financial modernization legislation, the presumed existence of a government subsidy and a bank's

ability to pass it to its subsidiaries led some witnesses

to recommend that the proposed legislation mandate

the bank holding company structure in preference to

the bank subsidiary structure: they argued that transferring a subsidy from a bank to an affiliate within the

holding company structure is harder than transferring a

subsidy within the bank subsidiary structure. Other

witnesses countered that the evidence did not support

the notion that banks receive a significant safety

net-related subsidy at the present time and that, in any

case, organizational structure was unlikely to have a

marked effect on a bank's ability to transfer a subsidy.

Members of Congress believed that resolving the subsidy question was particularly important because, aside

from its competitive implications, the answer would

largely determine the future legal and operational

structure of diversified financial­service providers in

the United States as well as the regulatory regime responsible for their oversight.

Because of the importance of the subsidy question,

this article reexamines the issue, but does so in light of

recent regulatory reforms prompted by the thrift and

banking crises of the 1980s. A number of these reforms

were designed specifically to do two things: reduce the

safety net-related advantages that had been accruing

to insured depository institutions, and correct perverse

incentives created by the safety net's existence. After

reassessing the traditional arguments supporting the

existence of safety net-related subsidies and their

competitive implications, the article argues that for

public­policy purposes the relevant question is not

whether a gross subsidy exists, but whether a net marginal subsidy remains after full account is taken of all

offsetting costs of government regulation, costs both

explicit and implicit. Finally, the article discusses the

effectiveness of firewalls and other regulatory efforts to

prevent the transfer of any subsidy and to limit taxpayer exposure.

* Kenneth Jones is a financial economist and Barry Kolatch is a

Deputy Director in the FDIC's Division of Research and Statistics.

1 U.S. House (1997) and U.S. Senate (1998). 

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FDIC Banking Review

Our analysis will indicate that the federal safety net

and its related gross subsidy have been significantly

constricted in recent years and that any funding advantage derived from the safety net appears to be largely

offset by the direct and indirect costs associated with

government regulation. Although not all these costs

are incurred on the margin, the evidence indicates that

if a net marginal subsidy exists at all, it is very small.

Moreover, regulatory firewalls (such as those embodied

in the Comptroller of the Currency's operating subsidiary rules and in Sections 23A and 23B of the

Federal Reserve Act) serve to inhibit a bank from passing a net marginal subsidy either to a direct subsidiary

or to an affiliate of the holding company. In both cases, any leakage of a net marginal subsidy would be de

minimis. Consequently, unless there are other compelling public­policy reasons for mandating a particular

organizational form, we conclude that financial institutions should be given the flexibility to choose the corporate structure that best suits their needs, provided

adequate safeguards remain in place to protect the insurance funds and to guard against undue expansion of

the safety net.

This article first discusses the sources of the safety

net-related gross government subsidy and the recent

legislative, regulatory, and market developments designed to reduce the size of the safety net and its related gross subsidy. The second section reviews efforts to

measure the subsidy; introduces the importance of differentiating among gross, net, and net marginal subsidies; and discusses how offsetting costs associated with

deposit insurance, reserve requirements, regulatory

burden, and other operating expenses serve to minimize any gross subsidy that banks may receive. The

third section discusses how regulatory firewalls inhibit

the transfer of any safety net-related subsidy under

both the bank subsidiary structure and the bank holding company structure. The article concludes with the

policy implications of our analysis. 

The Safety Net and Government

Subsidization of Banking: 

Sources and Recent Restrictions

It is widely recognized that banks receive a gross subsidy from the federal safety net. In terms of funding

costs, this means that, for any given level of capital,

banks can borrow funds at a lower interest rate than

they could in the absence of the safety net. During the

past decade, however, a number of statutory and regulatory changes have lessened the subsidy considerably.

Sources of the Gross Subsidy

The three primary sources of the gross subsidy enjoyed by commercial bank and thrift institutions are

deposit insurance, the discount window, and access to

Fedwire, the Federal Reserve's large­dollar electronic

payments system. 

Deposit Insurance. The purchase of deposit insurance allows a bank to lower its risk profile and therefore operate with less capital and a lower cost of funds

(lower, because some of the risk premium previously

paid on borrowed funds is recaptured). However, the

lower cost of funds would not in and of itself constitute

a subsidy as long as the bank paid an actuarially fair

"market premium" for the insurance. For example,

municipalities often purchase municipal bond insurance to enhance municipal bonds. The savings, in

terms of lower yields on the bonds, exceed the cost of

purchasing the insurance (otherwise municipalities

would not buy it). Nonetheless, the municipalities are

not receiving a subsidy. By purchasing insurance from

a AAA­rated company, they are merely capturing some

of the risk premium they would have had to pay to get

investors to purchase their riskier securities. Only if

the insurance is mispriced (underpriced) does a financial subsidy begin to appear. In the case of depository

institutions, the existence of underpriced deposit insurance would allow an insured institution to gather

funds (deposits) more cheaply than a noninsured financial institution with a similar capital structure.

Moreover, to the extent the public believes that uninsured deposits and other bank liabilities will also be

protected by deposit insurance or other implicit government guarantees, the cost of other bank liabilities

could be lower than they would be without the safety

net.2 Since banks are not charged for this credit enhancement, a gross subsidy can be said to exist.

In addition to the funding advantage, other dimensions of deposit insurance allow a gross subsidy to accrue to insured depository institutions. This is because

deposit insurance differs from market­provided insurance in two important ways. First, the premium is not

set by the market. As we discuss below, it is very difficult to measure what a market rate for deposit insurance should be. Second, there are two parts to deposit

insurance: the insurance funds administered by the

2 One example of an implicit government guarantee is the so­called

too­big­to­fail policy, under which it is believed that the government

would protect extremely large money­center banks from failure in

order to maintain the stability of the U.S. financial system.

2
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

Federal Deposit Insurance Corporation (FDIC),3 and a

call on the "full faith and credit" of the U.S. government. This call is similar to a standby letter of credit

provided by the government. There has never been an

explicit charge for this call. But measuring the value of

this call is also quite difficult, since the call is "in the

money" only if one of the insurance funds becomes insolvent. Hence its value varies over time with the

health of the banking industry and the strength of the

insurance funds. In the more than 60­year history of

deposit insurance, reliance on the "full faith and credit" of the U.S. Treasury has been necessary only once

-to clean up the savings­and­loan (S&L) debacle of

the 1980s.4 Nevertheless, the fact that credit from the

U.S. government is available for deposit insurance

purposes enables insured institutions to borrow in the

marketplace at lower interest rates than uninsured financial institutions. 

The Discount Window. The Federal Reserve's

discount window provides credit to solvent but illiquid

banks. Although discount window loans must be fully

collateralized, the window's existence in periods when

other sources of credit may not be available under any

terms means this backup source of credit provides a

subsidy to depository institutions. Moreover, a depository institution does not have to borrow from the

window to derive some benefit from its existence.

Because of the discount window, banks may be able to

fund riskier and less­liquid asset portfolios at a lower

cost and on a much larger scale than would otherwise

be possible. As with deposit insurance, the subsidy

provided by access to the discount window is extremely hard to quantify because the value varies with the

health of individual institutions and of the banking industry.

Access to Payments System. The Federal Reserve District Banks operate Fedwire, through which

banks and thrifts with reserve or clearing accounts at a

Federal Reserve Bank may transfer balances to other

institutions that have similar accounts. For many institutions, payments made on a given day may exceed

that day's opening balance; when a bank's account goes

into a negative position, a daylight overdraft occurs.

Because Fedwire transfers are "guaranteed" by the

Federal Reserve at the time they are initiated, the

Federal Reserve assumes the intra­day credit risk that

a participating bank will not have enough funds at the

end of the day to discharge its obligations. When

banks that incur intra­day overdrafts do not pay a market rate for the Fed's overdraft protection, the difference between the market rate and the Fedwire rate

represents a government­provided financial subsidy.

Again, determining what the market rate for such overdraft protection would be is difficult, but many contend that the current rate charged banks for use of

Fedwire is less than the rate a private provider would

impose.

Legislative, Regulatory, and Market

Developments Affecting the Size of the

Gross Subsidy 

Although the federal safety net continues to provide

banks with a gross subsidy, the subsidy has been lessened considerably in the past decade by a number of

statutory and regulatory changes designed specifically

to reduce the safety net-related advantages that had

been accruing to insured depository institutions.

Capital Regulation. Bank capital serves as a cushion to absorb unanticipated losses and shrinkages in asset values that could otherwise cause a bank to fail.

Capital levels can be likened to a deductible for federal deposit insurance. As such, the higher the level of

capital, the lower the "market" rate for deposit insurance. In addition, all other things being equal, the

higher a bank's capital level, the greater its creditworthiness. Thus, higher capital levels imply a lower

gross subsidy from the discount window and Fedwire.

In 1988, the major industrialized nations, concerned

about declining levels of bank capital, adopted uniform

standards for capital adequacy. The Basle Accord established an international capital measure (total capital

to risk­weighted assets) and set 8 percent as the minimum acceptable level of risk­based capital. Adoption

of minimum capital standards and of capital requirements tied to the risk profiles of banks has resulted in

banks holding more capital and has moved industry

3 These include the Bank Insurance Fund (BIF) and the Savings

Association Insurance Fund (SAIF), both of which are maintained by

premiums assessed on insured banks and savings associations. Both

funds are currently fully capitalized and exceed the statutorily mandated level of $1.25 per $100 of insured deposits.

4 Total taxpayer cost for resolution of the S&L crisis has been estimated at approximately $126 billion, excluding interest on the national

debt. In contrast, the commercial banking industry has never had to

exercise its call on the U.S. Treasury. Although the FDIC borrowed

working capital from the Federal Financing Bank in 1991, it used deposit insurance funds to resolve bank failures and repaid the Treasury

borrowings in 1993 with interest. Thus, there was no net cost to the

U.S. taxpayer for deposit insurance for commercial banks insured by

the FDIC.

3
FDIC Banking Review

capital levels closer to the levels the market might impose in the absence of the federal safety net. Capital

regulation, therefore, has significantly reduced the subsidy from the safety net.

Prompt Corrective Action. In 1991, Congress

passed the Federal Deposit Insurance Corporation

Improvement Act (FDICIA) that, among other things,

included provisions designed to limit regulatory forbearance by requiring more­timely and less­discretionary intervention, with the objective of reducing

failure costs. Under these Prompt Corrective Action

(PCA) provisions, as an institution's capital position declines, the appropriate bank regulator is required to increase the severity of its actions. These actions range

from restricting asset growth (for undercapitalized institutions) to closing banks (those that are critically undercapitalized for a prescribed period).5 Since PCA

requires regulatory action while an institution still has

some tangible capital remaining, in theory the deposit

insurance funds are less likely to suffer large losses

should an institution eventually fail. Moreover, the

value of the "call" on the full faith and credit of the

U.S. Treasury is reduced.

The Least-Cost Test. FDICIA also instituted the

"least­cost test." With rare exceptions, the FDIC may

meet its insurance obligations by means other than a

payoff only if the other method is deemed "least costly" to the deposit insurance funds. Before this requirement, the FDIC could choose any method that

was cheaper than the estimated cost of liquidation;

most institutions with over $100 million in assets were

resolved through a purchase­and­assumption transaction in which all liabilities except subordinated debt

were assumed by an acquirer. The least­cost test

caused the FDIC to change the way it structured resolutions, so that uninsured depositors or other general

creditors often suffer losses in a resolution.

In the five years leading to the enactment of FDICIA (1987-1991), uninsured depositors and other general creditors suffered losses in only 17 percent of the

927 bank failures. From the enactment of FDICIA

through 1998, the comparable figure has been 63 percent (of 191 bank failures). With the least­cost test requiring uninsured depositors and other general

creditors to bear greater risk, the resultant market discipline serves to reduce the subsidy from the safety

net.

Risk-Based Deposit Insurance. FDICIA also required the FDIC to develop and implement a system

of risk­based deposit insurance premiums. Since the

market rate for insurance is related directly to the

amount of risk an institution takes, flat­rate insurance

provided the greatest subsidy to the riskiest institutions. The aim of risk­based premiums is to make the

price of insurance a function of an institution's portfolio risk, thus not only reducing the subsidy to risk taking but also spreading the cost of insurance more fairly

across depository institutions. Though the magnitude

of the subsidy's reduction is not easily quantifiable,

risk­based insurance premiums should have reduced

the size of the gross subsidy accruing to depository institutions because of fixed and often underpriced deposit insurance.

National Depositor Preference. In 1993, as part

of the Omnibus Budget Reconciliation Act, Congress

passed a national depositor preference statute that

changed the priority of claims on failed depository institutions.6 Under depositor preference, a failed bank's

depositors, and by implication the FDIC, have priority

over the claims of general creditors. In theory, depositor preference would reduce losses to the insurance

fund from bank failures by increasing the value of the

FDIC's claims and reducing the average cost of resolutions. Moreover, since the claims of general creditors

are now subordinated to those of insured depositors

and the FDIC, it is anticipated that these groups will

demand higher interest rates on their funds, more collateral, or both, to compensate for their increased risk

of loss-effectively raising a bank's overall cost of funds

and lowering the gross subsidy associated with underpriced deposit insurance and the federal guarantee.

Changes to Discount Window Policy. To enhance market and regulatory discipline in the banking

sector and to protect the deposit insurance funds,

FDICIA also restricted the ability of the Federal

Reserve to lend to undercapitalized institutions

through the discount window. In particular, FDICIA

restrained the Federal Reserve from lending to institu5 Critically undercapitalized institutions are those with tangible capital

ratios of 2 percent or less. Under FDICIA, a receiver must be appointed for any institution that is critically undercapitalized for 90

days, although an extension is possible to 270 days if the regulator

and the FDIC concur and document why the extension would better

serve the purposes of the provision.

6 Public Law 103­66, Title III, instituted national depositor preference

for all insured depository institutions by amending Section 11 (d)(11)

of the Federal Deposit Insurance Act.

4
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

tions that fall below minimum capital standards, setting

time periods beyond which the Federal Reserve may

not lend to undercapitalized institutions without incurring a potential limited liability to the FDIC. The liability is incurred if an undercapitalized institution

borrows for more than 60 days in any 120­day period.

Because undercapitalized institutions have the most

difficulty obtaining credit at attractive rates elsewhere

and thus benefit most from access to the discount window, restricting their access to the discount window reduces the gross subsidy that flows from such access.

Changes to Payments System Policies. Two

changes to payments system policies have reduced the

subsidy arising from the Federal Reserve's guarantee

of transactions on Fedwire. First, in 1988, the Federal

Reserve instituted a system of net debit caps (credit

limits) on an institution's daily Fedwire overdrafts.

Then in April 1994 the Federal Reserve started charging fees for daylight overdrafts incurred in accounts at

Federal Reserve Banks. Since April 1995 the fee has

been set at an annual rate of 15 basis points of chargeable daily overdrafts. (A chargeable overdraft is an institution's average per­minute daylight overdraft for a

given day, less a deductible amount equal to 10 percent

of its risk­based capital.) From April 1995 through

December 1995, overdraft charges averaged $27 million at an annual rate. During that period, approximately 120 institutions incurred fees regularly, with the

largest banks (those with assets of more than $10 billion) accounting for, on average, 92 percent of total

charges.7 The debt limits and daylight overdraft fees

together led to a dramatic decline in total daylight overdrafts-averaging 40 percent in the six months following the initial imposition of fees in April 1994. This

reduction in daylight overdrafts has reduced the

Federal Reserve's intra­day credit risk and its liability

as guarantor of all Fedwire transactions and has thus reduced the subsidy accruing from the government­operated payments system. In addition, technological

changes that are rapidly transforming the payments

system-changes such as real­time settlement and alternative means for settling payments-are likely to

erode the subsidy still more.

In summary, although banks still receive a gross subsidy from the safety net, statutory and regulatory

changes have reduced it significantly during the past

decade.

Gross Subsidy, Net Subsidy, and 

Net Marginal Subsidy

The federal safety net for banking, besides extending certain benefits (including a gross subsidy in the

form of a funding advantage), also imposes direct and

indirect costs. The current system of regulation and

supervision of the banking industry, for example, has

arisen in part because of the externalities created by

the intrusion of government into the financial marketplace. In addition, the banking industry has been restrained from engaging in certain potentially profitable

activities because they were deemed too risky, while simultaneously it has been forced to pursue other endeavors in the interest of societal goals. Therefore, in

examining the question of whether a subsidy exists

and, if so, whether it can be transferred beyond the

core bank, one must recognize that the relevant question is not whether a gross subsidy exists, but whether a

net subsidy remains after all the offsetting costs, both

explicit and implicit, are taken into account.

In some instances, moreover, it is critical to determine whether a net subsidy exists at the margin. That

is, do the benefits of adding an additional dollar of deposits exceed the costs? In the case of deposit insurance, for example, if the benefit (subsidy) from each

additional dollar of insured deposits exceeds the costs,

then an institution will have an incentive to increase its

use of deposits in order to maximize the deposit insurance subsidy. However, if the benefit from each additional dollar of deposits is offset-say, by regulatory

costs that are linked directly to the level of insured deposits-then the marginal subsidy is reduced or eliminated. As the net marginal subsidy approaches zero, a

bank's choice of funding will increasingly depend on

the relative costs of funds as determined in the market,

as is the case for uninsured financial firms. In practice,

some regulatory costs are indeed tied directly to the

level of deposits and thus serve to reduce the gross subsidy at the margin. Among these offsetting marginal

costs are deposit insurance premiums, payments to the

Financing Corporation (FICO), and reserve requirements.

7 See Richards (1995). 

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FDIC Banking Review

Measuring the Gross Subsidy 

The first step in answering the question of whether

a net subsidy exists is to measure the magnitude of the

gross subsidy. But doing so is quite difficult, and few

estimates exist. Those few, however, suggest that it is

not large.

One method of measuring the gross subsidy from

the safety net-or at least from the deposit insurance

portion of it-is to estimate the market rate for deposit

insurance. Unfortunately, calculating what that rate

should be is very hard to do. The bulk of the studies

that estimate a market rate for deposit insurance have

applied an option­pricing model to deposit insurance

data from the 1980s.8 The rationale for applying this

model to deposit insurance is that if a bank is found to

be insolvent, depositors can, in effect, "sell" their share

of the bank's liabilities to the FDIC in exchange for

cash. Thus, the value of this option to sell would be

the appropriate price for insurance. If insurance premiums are set lower than the option price, the bank can

be said to receive a subsidy.

Unfortunately, using option­pricing theory as a basis

for valuing deposit insurance involves numerous

methodological problems. Most notably, option theory

deals with finite time contracts, contracts that expire in

a year or at the end of some other finite period of time,

whereas the deposit insurance guarantee is theoretically open­ended. In addition, the value of insurance as

calculated by these models also depends critically on

(1) the timing of bank examinations (greater frequency

of examinations lowers the risks to the insurance funds

and therefore lowers the value of insurance), (2) the actual recovery on the assets of the failed bank, and (3)

the actual or assumed degree of regulatory forbearance.

Hence, as computed by these models, the estimated

fair value of deposit insurance varies widely depending

on the model's assumptions. 

Given these caveats, most option­based models estimated that for the majority of banks, the fair value of

deposit insurance in the 1980s was less than the explicit insurance premium applicable at that time-implying a negative deposit insurance subsidy. Only for

the weakest banks were estimated deposit insurance

values found to be above the premium rate charged by

the FDIC (8.3 cents per $100 for most of the 1980s).9

The widespread finding that most banks received

only a minimal gross subsidy from deposit insurance in

the 1980s has recently been corroborated by Whalen

(1997), who estimated fair deposit insurance premiums

for the 50 largest domestically owned bank holding

companies for 1996. Like the authors of many of the

earlier studies that used option­pricing models,

Whalen found the estimates of the value of deposit insurance to be highly sensitive to the assumed values of

key explanatory variables. For example, the mean value of the estimated fair premia is only 1 basis point

when depository institutions are assumed to be closed

at the time the market value of their assets is 95 percent of the value of their liabilities, and 30 basis points

when the closure threshold is allowed to slip to 90 percent (that is, when the market value of their assets is 90

percent of the market value of their liabilities). But,

consistent with the findings of earlier studies, Whalen

also found the estimated premia values to be highly

skewed, with the median value significantly less than

the mean. For example, assuming a closure threshold

of 90 percent, the median deposit insurance value for

the sample was roughly 4 basis points, while the mean

was 30 basis points. In this scenario, almost 80 percent

of the sample banks had estimated fair premia below

the mean value, suggesting that the median rather than

the mean value is a better indicator of the fair premium

for a "typical" bank. Median (as well as mean) values

for closure thresholds above 90 percent are extremely

small, suggesting that the typical bank in the sample

received only a small gross subsidy from deposit insurance.

Another measure of the gross subsidy from the safety net was noted by Federal Reserve Board Chairman

Alan Greenspan in testimony before the House

Banking Committee in February 1997. In his remarks,

Greenspan observed that the debt of a bank holding

company generally has a lower credit rating than comparable debt of the holding company's lead bank, and

suggested that the resultant difference in bond yields

may offer one measure of the subsidy from the safety

net.10 According to data collected by the Federal

Reserve, in 1990 this difference was 10 to 15 basis

8 The connection between option pricing and deposit insurance was

first noted by Merton (1977). For empirical estimates of the fair value of deposit insurance, see, for example, Flood (1990), Marcus and

Shaked (1984), McCulloch (1985), Ronn and Verma (1986),

Pennacchi (1987), Kuester and O'Brien (1990), Epps, Pulley, and

Humphrey (1996), and Whalen (1997).

9 However, it should be noted that, on average, the premium rates estimated in most of the studies employing option­pricing models

would have been grossly insufficient to cover FDIC losses during

the 1980s and early 1990s.

10 See Greenspan (1997), 3.

6
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

points, but since 1994 it has been in the 4 to 7 basis

point range. Moreover, Greenspan asserted, this ratings differential could also be considered evidence that

the safety net provides the bank with a funding subsidy that is not transferred to the bank's parent holding

company. Because it allegedly shows that the holding

company structure is more effective than a bank subsidiary structure in limiting the advantages of the safety net, this assertion is considered particularly

important evidence by those who favor mandating the

bank holding company structure in proposed financial

modernization legislation.

In interpreting the data Greenspan alluded to, one

must remember two things. First, the ratings differential captures only the difference between the bank and

its holding company. If the holding company's debt

rating is enhanced by the safety net, then the ratings

differential would underestimate the magnitude of the

gross subsidy. Second, besides the safety net, other

very good reasons exist for the ratings differential between the bank and its holding company. Indeed, it is

not clear that the safety net plays a significant role in

the 4 to 7 basis point discrepancy between the cost of

bank debt and the cost of bank holding company debt.

In fact, both Moody's and Standard and Poor's credit

rating manuals cite the priority structure in debt servicing and in bankruptcy as the primary reason that bank

debt typically carries a higher credit rating than BHC

debt. In most bank holding companies, for example,

the subsidiary bank is the primary operating unit that

generates debt service payments. But in times of

stress, banking regulators can restrict a bank's ability to

pay dividends to its holding company-thereby endangering the holding company's source of funds to

service its debt. Furthermore, during periods of financial distress or adversity federal regulators may even be

able to require a bank holding company to use its available resources to provide adequate capital funds to its

subsidiary bank(s). 

In any event, under no circumstances can the entire

ratings discrepancy be attributed to the safety net.

This is an important point. It means that when the

nondeposit funding costs of banks and bank holding

companies are compared, any subsidy­related difference is less than 4 to 7 basis points even before offsetting costs are taken into account.

Offsets to the Gross Subsidy

As just discussed, estimating the size of the gross

subsidy is hard to do, and no good estimates exist.

After careful evaluation, however, one can reasonably

assume that for well­capitalized banks under all but the

most severe economic conditions, the gross subsidy derived from the three components of the safety net is

not particularly large-perhaps only a few basis points.

But whatever its magnitude, the gross subsidy is at

least partly offset by both direct and indirect costs.

These include deposit insurance premiums, interest

payments on bonds issued by the FICO, reserve requirements, regulatory­burden expenses, and operational costs associated with collecting deposits.

Risk-Based Deposit Insurance Premiums. The

fair value of deposit insurance, as estimated by optionpricing models, is not a measure of the subsidy from

deposit insurance, because banks pay premiums for the

insurance. Historically, all banks paid a flat rate.

Between 1935 and 1988 this rate was never more than

8.3 basis points per dollar of insured deposits (or 8.3

cents per $100). Beginning in 1989, the FDIC began

to raise rates.11 From 1990 through 1996, banks and

thrifts paid higher premiums to recapitalize the insurance funds, with the premium assessment ranging as

high as 31 basis points for some institutions. In 1990,

the assessment rate was increased from 8.33 basis

points to 12 basis points; in 1991, to 19.5 basis points for

the first six months and to 23 basis points for the second six months. Until the two funds reached full capitalization at 1.25 percent of total estimated insured

deposits (May 1995 for the BIF, late 1996 for the SAIF),

assessment rates for insured institutions were kept

within the range of 23 to 31 basis points. Effective

January 1, 1996, insurance premiums for BIF­insured

11 The Financial Institutions Reform, Recovery, and Enforcement Act

of 1989 (FIRREA) granted the FDIC limited authority to increase

assessment rates as needed to protect the insurance funds, and

specified certain flat annual assessment rates that were to be in effect for each of the two deposit insurance funds through 1991. In

1990, the FDIC Assessment Rate Act introduced greater flexibility

in the timing and amount of assessment rates. FDICIA (1991) fundamentally changed the assessment process by (among other

things) establishing a system of risk­based deposit insurance premiums and requiring that rates be set semiannually to maintain a

fund reserve ratio of at least 1.25 percent. The current system of

risk­based premiums became effective on January 1, 1994.

7
FDIC Banking Review

institutions were lowered to a range of 0 to 27 basis

points. For most SAIF­insured institutions, the assessment rate for calendar year 1996 averaged approximately 20.4 basis points. In the third quarter of 1996,

SAIF members paid an additional one­time special assessment of almost 65 basis points to capitalize the

SAIF. Following full capitalization of the SAIF, premiums paid by SAIF­insured members were reduced to a

range similar to the range for premiums paid by BIFinsured members.12

Because of the recapitalization of the insurance

funds and the current health of the banking industry,

approximately 95 percent of BIF­insured depository

institutions and 90 percent of SAIF­insured institutions now pay no explicit premium for deposit insurance. However, in general any insured depository

institution that does not achieve the highest supervisory and capital ratings still pays an explicit premium for

deposit insurance.13 Even though most banks and

thrifts now pay no explicit premium for deposit insurance, it is important to remember that these institutions have the highest supervisory and capital ratings

and thus are least likely to receive a material subsidy

from deposit insurance and from the discount window.

Furthermore, the FDIC Board of Directors can raise

the reserve ratio whenever it determines there is significant risk of substantial future losses to the insurance

funds. In other words, the Board can reach a higher ratio well in advance of a severe crisis, thereby decreasing the likelihood that the call on the U.S. government

will have to be exercised in the future and reducing

both the gross and the net subsidy attributable to federal deposit insurance.

FICO Assessments. In 1987, Congress created

the Financing Corporation (FICO) to sell bonds to

raise funds to help resolve the thrift crisis. The interest payment on FICO bonds is $793 million annually,

and the last of the FICO bonds matures in 2019.

Beginning in 1997, the annual interest has been paid

by all FDIC­insured institutions, not just by SAIFmember savings associations. Because commercial

banks share in the benefits of deposit insurance, they

were asked also to share the burden of these payments.

Thus, banks' payment of this fee is a direct result of

their access to the safety net. For the fourth quarter of

1998, the FICO assessments were 5.8 basis points (annualized) for SAIF members and 1.2 basis points for

BIF members. Beginning in 2000, all institutions will

pay a pro rata share for FICO, presently estimated to

be 2.2 basis points per dollar of deposits.

Reserve Requirements. Under current regulations, all depository institutions-commercial banks,

savings banks, thrift institutions, credit unions, agencies and branches of foreign banks, and Edge Act corporations-are required to hold reserves against

transaction accounts (see table 1). These noninterestbearing reserves must be held either as vault cash or as

a deposit at a Federal Reserve District Bank. Although

most institutions are able to satisfy their entire reserve

requirement with vault cash (which they would probably hold in any case to meet the liquidity needs of their

customers), approximately 3,000 larger depository institutions also maintain deposits, called required reserve

deposits, at a Federal Reserve District Bank.14

Table 1

Reserve Requirements of
 

Depository Institutions, 1998
 

Amount of Net Requirement

Transaction Accounts (percent)

$0 million­$47.8 million 3

More than $47.8 million 10

Nonpersonal time deposits 0

Since reserves are required only on transaction accounts, that is, only on specific types of deposits, it is

possible to calculate the marginal cost associated with

each additional dollar deposited in a reservable account. One can compute the marginal cost of the reserve requirement by multiplying the required reserve

ratio (3 percent or 10 percent) by the opportunity cost

of idle balances (assumed to be 5 percent-the federal

funds rate through most of 1998). This calculation produces a pre­tax marginal cost of 15 basis points for

these deposit balances up to $47.8 million, and 50 basis

points for each dollar of deposits above $47.8 million.

If one assumed a reinvestment rate higher than the

federal funds rate, the opportunity cost of reservable

funds would be even higher.

12 As of December 31, 1998, the BIF balance was $29.6 billion and the

SAIF balance was $9.8 billion. These amounts represented 1.38

percent and 1.36 percent, respectively, of all insured deposits.

13 For current rate schedules and a risk distribution of insured institutions, see Federal Deposit Insurance Corporation (1998).

14 See Feinman (1993).

8
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

In recent years, the burden of this "reserve tax" has

led many depositories to expend resources developing

new financial products whose sole purpose is to deliver transaction services without creating reservable liabilities. Depositories have been quite successful at

this, and the required reserve balances at Federal

Reserve District Banks have dropped considerably.

Nevertheless, managing account balances to avoid the

reserve tax incurs its own costs and leads to a less than

optimal allocation of a bank's resources.

Regulatory Burden. Perhaps the greatest offset to

the gross subsidy banks receive from the safety net is

regulatory costs. Unfortunately, good estimates of the

full cost of the regulatory burden do not exist. A 1992

Federal Financial Institutions Examination Council

(FFIEC) study reviewed the literature on regulatory

burden and found that "despite differences in methodology and coverage, findings are reasonably consistent:

regulatory cost may be 6-14 percent of noninterest expenses, not including any measurement of the opportunity cost of required reserves."15 These estimates

are for the period before the 1991 passage of FDICIA

and therefore do not take into account the regulatory

burden imposed by many of the market­oriented reforms of the 1990s, including risk­based capital requirements and risk­based deposit insurance

premiums. Nor do the estimates include the additional costs associated with performance­based revisions to

the Community Reinvestment Act or stricter application of the fair lending laws. Nevertheless, even the

low end of the FFIEC range-6 percent-still yields

substantial regulatory costs. For example, 6 percent of

the approximately $186 billion of noninterest expenses

incurred by FDIC­insured institutions during 1996

yields an estimated $11 billion in regulatory costs.

Expressed in terms of average total deposits at FDICinsured institutions during 1996 of more than $3.8 trillion, this amounts to roughly 29 basis points (or 29

cents per $100 of deposits).

To be sure, not all of these costs are marginal costs,

but neither are all of them fixed costs. Many regulatory costs might best be characterized as "lumpy"-that

is, although they do not increase with each dollar of

new liabilities, they do increase with bank size. Thus

a bank could not use bank borrowings to finance a significant new activity in either an operating subsidiary

or a holding company affiliate without incurring additional regulatory costs.

Costs of Raising Retail Deposits. It is also important to remember that collecting retail deposits is

not costless. In contrast to nonbank financial companies that obtain funds through the capital markets,

commercial banks and thrifts generally must support

an extensive network of branch banks and offer numerous services to customers in order to obtain and retain insured deposits. Consequently, the "subsidized"

marginal cost of deposits is not as low, relative to a nonbank financial firm's market cost of funds, as some

might think. Passmore (1992), for example, found that

the "all­in" costs of collecting retail deposits were

roughly 47 basis points above the three­month

Treasury bill rate.16 Hence, assuming the accuracy of

his data, even at the margin one finds significant offsetting costs to the safety net-related gross funding advantages.

Measuring the Net Subsidy and the Net

Marginal Subsidy

Measuring whether banks receive a net subsidy requires reliable estimates of the gross subsidy and the

offsetting costs, and both of these are hard to determine. Moreover, most economists agree that the value

of the subsidy-net, gross, or marginal-varies over

time and from bank to bank. Riskier banks clearly receive a larger subsidy than safer banks, while across the

industry the value of the subsidy rises and falls countercyclically with the financial business cycle.

Nonetheless, with most estimates putting the gross

subsidy attributable to deposit insurance at only a few

basis points for all but the weakest of banks, the average regulatory costs alone would appear to outweigh

this portion of the subsidy significantly. Even if the

contributions of the other two components of the federal safety net were quantifiable and could be added to

the gross subsidy from deposit insurance, for most

banks it is not at all certain that the monetary benefits

would exceed the costs.17

15 Federal Financial Institutions Examination Council (1992).

16 Included in Passmore's estimated "all­in" cost of retail deposit

funding were interest and noninterest expenses, deposit insurance

premiums, and the opportunity cost of reserve requirements. His

estimate of the cost of retail funds is slightly below the estimates of

other, earlier researchers, who put the cost in the range of 50 to 159

basis points above Treasury rates. See Passmore (1992) for a survey

of these other studies.

17 Our conclusion that the net subsidy is small for most banks is supported by the recent work of Whalen (1997). Using a standard option­pricing approach, a conservative set of assumptions, and

current data (including a value of zero for the explicit deposit insurance premium), he found that for the 50 largest domestically

owned bank holding companies in the United States in 1996, the

net subsidy associated with the deposit insurance portion of the

federal safety net was minimal or negative.

9
FDIC Banking Review

In determining whether banks receive a net subsidy,

some economists have correctly emphasized the importance of marginal costs. This is because it is marginal benefits and costs that are relevant for a bank's

profit­maximizing calculations and for an understanding of how a bank might be able to exploit any safetynet subsidy.18 Even at the margin, however, the gross

subsidy derived from the safety net appears to be significantly reduced by costs that are directly related to

an institution's level of deposits. Deposit insurance

premiums (still assessed on "risky" banks), FICO payments, and reserve requirements, for example, are all

assessed directly on deposits. Although most banks

and thrifts currently pay no explicit deposit insurance

premiums, FICO payments are estimated to cost

banks and thrifts 1.2 and 5.8 basis points per dollar of

deposits, respectively; and on some reservable balances, the marginal cost of reserve requirements can be

as high as 50 basis points. Additionally, some regulatory costs can be deemed to vary on the margin.

Examination costs, for example, are often considered a

fixed cost, but in fact they may be "lumpy" and vary

depending on such things as bank size.

Evidence of a Net Marginal Subsidy

Given the difficulty of obtaining reliable estimates

of a net subsidy, it is helpful to look at other indicators

that might aid us in determining whether banks receive a safety net-related net marginal funding subsidy

that affects the business judgments they make.

Theoretically one could argue, for example, that the

gross subsidy must be offset at the margin, for otherwise the competitive advantage it provided would allow banks to gain an ever­increasing share of financial

assets, but that is not happening. In a 1994 study, Boyd

and Gertler found, after correcting for a number of

measurement issues, that commercial banks' share of

total financial intermediation in the United States has

been roughly stable over the last four decades, even

though financial sector activity has been growing

steadily relative to GDP. This finding, plus similar

findings by Kaufman and Mote (1994), is not consistent with the argument that banks have enjoyed a

meaningful competitive advantage because of safetynet subsidies.

It is also informative to consider how a banking organization would best fund and organize itself to exploit a net marginal subsidy if one existed. If, for

example, a deposit insurance subsidy were important,

one would expect banks to exploit it by using insured

deposits as their primary source of funds. However,

bank financial data indicate that depository institutions

are relying less on insured deposits and more on uninsured deposits and nondeposit funding. In fact, for all

FDIC­insured institutions, insured deposits now represent less than half of all liabilities, compared with 60

percent in the early 1990s. In 1997, only 45 percent of

commercial bank assets were supported by insured deposits, and currently a significant number of banks

hardly use them at all. This is especially true of the

largest banks, those most likely to engage in nonbanking activities and where one would suspect that the

greatest potential for exploitation of any net marginal

subsidy would exist. Commercial banks with assets

greater than $1 billion, for example, fund on average

only approximately 38 percent of their liabilities with

insured deposits.

Furthermore, as Acting Comptroller of the Currency

Julie Williams observed, if banks enjoyed a lower cost

of funds in the capital markets because of safety

net-related benefits, one would expect banking organizations to issue debt exclusively at the bank level.19

Instead, it is quite common for banking organizations

to issue debt at all levels of the organization, including

the lead bank and the bank holding company parent.

This is not what one would expect if an exploitable

funding advantage existed at the bank level.

Nor do banks seem to organize themselves as if a

safety net-related net marginal subsidy were important. As Federal Reserve Board Chairman Greenspan

explained in recent testimony before the House

Subcommittee on Financial Institutions, "One would

expect that a rational banking organization would, as

much as possible, shift its nonbank activity from the

bank holding company structure to the bank subsidiary

structure. Such a shift from affiliates to bank subsidiaries would increase the subsidy and the competitive advantage of the entire banking organization

relative to its nonbank competitors."20 Yet, in the real

world, banks can be observed using holding company

affiliates to engage in a wide range of activities, even

though these units are subject to firewalls and other

regulatory restrictions that could have been avoided if

the activity were conducted through the bank or in a

bank subsidiary. As of September 30, 1996, the 50

largest bank holding companies had 155 mortgage

18 See, for example, Kwast and Passmore (1997).

19 See Williams (1998), 10, A22.

20 See Greenspan (1997), 3-4.

10
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

banking affiliates, 98 commercial finance affiliates, and

263 consumer finance affiliates. At the same time, the

bank subsidiaries of these holding companies had 104

mortgage banking subsidiaries, 24 commercial finance

subsidiaries, and 89 consumer finance subsidiaries. In

addition, the banks conducted mortgage, commercial,

and consumer finance activities directly through the

bank-and, moreover, were empowered to do so nationwide.21

Following the logic that a rational banking organization would choose its funding and organizational structure so as to maximize its competitive advantage from

the subsidy, one sees only three possibilities: (1) the

subsidy is the same whether an activity is conducted in

a holding company affiliate or in the bank proper, (2)

there is no net subsidy, marginal or otherwise, or (3) the

net marginal subsidy is so small that other considerations outweigh it. Because Sections 23A and 23B of the

Federal Reserve Act make the first possibility highly

unlikely, the fact that banking organizations choose all

three forms of organization-holding company affiliate, bank subsidiary, and bank proper-suggests that

there is not a net marginal funding subsidy, or that if

one exists, it is so small as to be outweighed by other

considerations.22

Although we believe our observations make a strong

case for concluding that no significant net marginal

subsidy exists, we recognize that Federal Reserve officials and staff have consistently offered alternative evidence which they argue supports their position that a

net marginal subsidy does exist and is large enough to

influence behavior. As evidence of the subsidy advantage, for example, Kwast and Passmore (1997) point

out that (1) banks have historically had lower leverage

ratios (equity­to­asset ratios) than their nonbank competitors, and (2) according to their analysis, there has

been a trend among bank holding companies toward

shifting assets and activities that could be conducted in

banks from BHC subsidiaries back into the bank proper.

The first argument, that banks hold proportionally

less capital than competing nonbank financial institutions, is not persuasive evidence of a safety­net subsidy

for several reasons. As others have pointed out, it is

problematic to make comparisons of capital ratios in

different industries in isolation from the industries' relative risk profiles. Markets permit firms with lower risk

to hold less capital. So lower capital ratios at banks

could simply reflect an overall lower degree of risk in

banking than in securities underwriting, for example.

In addition, as Kaufman (1994) has suggested, the lower capital ratios maintained by banks could partly result

from the relatively more efficient resolution process in

banking and the consequently smaller losses suffered

by bank creditors compared with creditors of nonbank

firms. Finally, the fact that banks operated with substantially lower capital ratios than nonbank firms even

before deposit insurance was introduced (in 1933) suggests that the existence of the federal safety net is not

what underlies the banking industry's ability to operate

with lower equity­to­asset ratios than other industries.

The second argument put forward by Kwast and

Passmore (1997) as evidence of a net marginal subsidy

is a reported decline over the period 1986-1996 in the

share of total BHC assets in nonbank subsidiaries that

are engaged in selected activities that can be conducted in both a bank and a BHC subsidiary.23 According

to their data, the percentage of assets in the included

activities in BHC subsidiaries fell from approximately

3.8 percent in 1986-1988 to approximately 1.8 percent

in 1993-1994. This trend, the authors contend, is evidence that BHCs have been shifting these assets into

the bank proper in order to take advantage of a safetynet subsidy. However, there are at least two major

problems with their analysis. 

First, because of inconsistencies in the data over the

period studied, it is not clear that such a shift has actually occurred. As Acting Comptroller of the Currency

Williams testified before the U.S. Senate Banking

Committee, "Between 1994 and 1995 the Federal

Reserve changed the instructions governing the filing

of the asset data used in the calculation of the reported

shift to reduce, if not eliminate, apparently widespread,

year­by­year, reporting errors."24 Such data errors and

the changes made in the reporting instructions certainly call into question the validity of any trend analysis

for the period discussed.

Second, even if the share of BHC assets held in nonbank financial subsidiaries did decline over the period

discussed, there is nothing to indicate that the assets

were necessarily shifted into the bank proper or to direct bank subsidiaries. Indeed, a number of other explanations besides a safety net-related subsidy are

21 See Helfer (1997).
 

22 The observed choices of organizational structure, for example,
 

could partly reflect the effect of the geographic restrictions that existed until passage of interstate banking in 1994.

23 Kwast and Passmore (1997) examined nonbank subsidiaries engaged in commercial finance, mortgage banking, consumer finance,

leasing, data processing, and insurance agency.

24 See Williams (1998), 11.

11
FDIC Banking Review

possible for the observed differences over time in the

percentage of BHC assets devoted to the selected activities. For example, the 1980s saw an unprecedented

wave of innovations in the nation's financial markets.

In particular, the development of both securitization

techniques and a functioning secondary market for

many types of loans fundamentally changed how many

mortgage, consumer, and business finance subsidiaries

operate. By selling mortgages and other loans into the

secondary market, finance companies could increase

their lending volumes and earnings while holding fewer assets in portfolio. Hence a decline in the ratio of

BHC assets in nonbank subsidiaries engaged in the selected activities to total BHC assets may reflect nothing more than developments in the financial markets

and related changes in the operations of nonbank financial subsidiaries.

Data from the FR­Y11AS reports25 also suggest that

BHCs may have simply reallocated assets from subsidiaries engaged in the more traditional nonbank activities examined by Kwast and Passmore to

subsidiaries engaged in relatively more profitable nonbank activities, such as securities brokerage and securities and insurance underwriting. Assets of subsidiaries

engaged in securities brokerage and underwriting, for

example, grew from $19 billion in 1986 to $127 billion

in 1994-an increase of 541 percent. BHC assets invested in insurance underwriting subsidiaries and small

business investment companies also increased dramatically during the period, rising 220 percent and 1,450

percent, respectively. Indeed, the reallocation of assets

during this period is startling. In 1986, nonbank subsidiaries' assets in these three activities accounted for

only approximately 13 percent of all assets of nonbank

subsidiaries of bank holding companies. By 1994 the

comparable figure was nearly four times as much, or 47

percent.

BHCs may have been encouraged to shift assets into

securities subsidiaries not only by expectations of higher profits but also by regulatory rules that limit revenues derived from underwriting and dealing in bank

"ineligible" securities (such as corporate debt and equity) to a fixed fraction of the gross revenues of the securities subsidiary.26 Given this restriction, BHCs have

an incentive to move additional activities into the securities subsidiary, thereby enlarging the revenue base

and allowing more revenue to be generated through

the underwriting of "ineligible" securities.

Finally, even if assets were moved from holding

company affiliates to the banks and direct bank subsidiaries, that is entirely consistent with the gains in efficiency expected after the removal of geographical and

other barriers to interstate banking and with a bank's

increasing opportunities to offer "one­stop" customer

service. In other words, if the shifting of assets as perceived by Kwast and Passmore did take place, it may

simply reflect a BHC's desire to reallocate resources to

relatively more profitable activities and achieve greater

operational efficiencies. In short, it may have nothing

to do with capitalizing on a safety­net subsidy. 

In summary, the alleged decline in the ratio of assets

in selected BHC activities to total BHC assets is based

on questionable data, but even if it did take place,

there is no reason to believe it was the consequence of

BHCs shifting assets into the bank or a direct bank

subsidiary in order to take advantage of a net marginal

subsidy accruing to the bank.

Firewalls and the Transferability 

of a Net Subsidy

Despite what we consider to be evidence to the contrary, some policymakers maintain that the safety

net-related net marginal subsidy is significant, and

have expressed concern that banks could pass a funding advantage on to their bank subsidiaries and affiliates-thereby giving the banking industry an unfair

competitive advantage vis­a­vis its financial­services

competitors and creating an unwarranted extension of

the federal safety net. Setting aside the issue of

whether a net marginal subsidy exists and, if so, how

large it is, we find it instructive to consider the channels

through which banks might be able to transfer a subsidy beyond the parent bank. In theory, there are primarily two such channels: a bank could transfer the

subsidy through capital infusions to its subsidiary or to

an affiliate, or it could transfer the subsidy to a subsidiary or affiliate by extending loans or engaging in the

purchase or sale of assets at terms favoring the subsidiary or affiliate. In practice, however, reasonable

firewalls-designed to protect insured banks and the

25 Before being replaced in 1995 by forms FR Y­11Q and FR Y­11I,

the FR­Y11AS reports were required to be filed annually by any domestic or foreign­owned bank holding company that operated a

subsidiary engaged in a permissible nonbank activity.

26 From 1987 to 1989, BHC securities subsidiaries were allowed to derive 5 percent of their gross revenues from underwriting and dealing in bank "ineligible" securities. This ratio was raised to 10

percent in 1989 and to 25 percent in 1997.

12
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

deposit insurance funds-make the transfer of any

subsidy difficult, though not necessarily impossible under all circumstances.27

Transferring a Subsidy from a Bank
 

to an Operating Subsidiary 

To conceptualize the difficulty of passing a subsidy

on to an operating subsidiary, consider that the

Comptroller of the Currency's operating subsidiary

rule28 requires that for a bank subsidiary to engage as

principal in an activity not permissible to the insured

bank, (1) the bank must be "well­capitalized"; (2) the

bank's equity investment in the subsidiary must be deducted from regulatory capital (and assets); (3) the subsidiary must not be consolidated with the bank for

regulatory capital purposes; and (4) "covered transactions" between the bank and its subsidiary must be

subject to restrictions similar to those of Sections 23A

and 23B of the Federal Reserve Act. These four requirements make it quite difficult to pass on a net subsidy. For example, requirements (1) and (2) permit

only excess capital to be invested as equity in a subsidiary. That is, a bank would need capital beyond the

amount the regulators required it to have for its own

level of risk assumed. This restriction ensures that

even if the total investment in the operating subsidiary

were lost, the regulatory capital of the parent bank

would not be impaired.29

These firewalls are not impenetrable, however. If a

bank had excess regulatory capital-capital above the

well­capitalized level-it could theoretically pass a portion of any net marginal subsidy to a bank subsidiary by

borrowing additional "subsidized" funds at the bank

and investing these funds as "equity" in its subsidiary.

The bank's consolidated costs of funds would fall because subsidized funds borrowed at the bank would replace unsubsidized liabilities at the subsidiary. The

bank could make such an investment even if it had decided for business reasons to hold more capital in the

bank than required by regulatory standards, since its

consolidated (GAAP) capital level would remain unchanged. However, unless all of the liabilities of a bank

subsidiary were replaced with equity investments

funded by subsidized bank borrowings, only a portion

of a subsidy could be passed to the subsidiary. Since

we are talking about a net marginal subsidy that may

not exist at all or that, at most, is very small, a portion

of it would be a de minimis amount.

The second possible channel, in theory, is for a bank

to extend a net subsidy to a subsidiary through loans or

other extensions of credit on terms favorable to the

subsidiary. However, under the OCC's operating subsidiary rule, a subsidiary that is conducting activities as

principal is subject to Sections 23A and 23B of the

Federal Reserve Act, which (1) limit extensions of

credit to any subsidiary to no more than 10 percent of a

bank's capital, (2) require that such extensions be overcollateralized, and (3) require that such extensions be

made on an "arm's­length" basis.30

Transmitting a Subsidy to a BHC
 

Affiliate
 

Sections 23A and 23B would also prohibit the direct

transmission of a net marginal subsidy from a bank to a

nonbank affiliate within the same holding company.

However, if a bank had excess capital, it could indirectly provide "subsidized" funding to a nonbank affiliate

within the holding company by borrowing additional

subsidized funds and declaring additional dividends

payable to the parent holding company. The BHC

could then downstream the dividends to another member of the holding company, which could then use

those funds to pay off market­rate liabilities. Consequently, the nonbank affiliate's cost of funds and the

overall cost of funds of the holding company would decline. However, in this case the bank's consolidated

capital ratio would fall. Thus it might hesitate to pay

these dividends if it had business reasons to hold additional capital at the bank level. In addition, there are

statutory and regulatory impediments to this "upstream" transmission of funds from a bank to its hold27 Firewalls are statutory and regulatory limitations on financial transactions between banks and their affiliates. Firewalls are intended

primarily to prevent a banking company from shifting financial losses from its nonbank subsidiary to its insured bank subsidiary and,

potentially, to the federal deposit insurance funds. However, firewalls also serve to limit opportunities for the bank to subsidize its

nonbank affiliates by making loans at below­market rates or by providing funds or services at terms favorable to such affiliates. For a

thorough discussion of firewalls, see Walter (1996).

28 12 C.F.R. Part 5.

29 According to Longstreth and Mattei (1997), this restriction amounts

to preemptive corrective action whereby the capital necessary to absorb a 100 percent loss of the investment must be in place before the

subsidiary is established. The corrective mechanism is self­executing and operates without regulatory intervention in the wake of a

loss.

30 See 12 C.F.R. § 5.34(f)(3)(ii).

13
FDIC Banking Review

ing company parent.31 For example, FDICIA's

Prompt Corrective Action provision prohibits the payment of dividends when a bank is deemed undercapitalized or when the payment of the dividend would

make the bank undercapitalized. A bank's dividendpaying capacity would be further limited by law and

regulation if the dividend payments exceeded a bank's

retained earnings for the period or if the total of all dividends declared during the calendar year exceeded the

sum of net income plus the retained net income of the

prior two calendar years. In contrast to the bank­subsidiary model, however, such a transfer could take

place even if the bank were not well­capitalized, since

there is no requirement that a bank be well­capitalized

to pay dividends to its parent holding company. Do

BHCs employ this technique to transfer a subsidy to

their nonbank affiliates? Unfortunately, despite

Greenspan's assertion that they do not,32 the fungibility of money and the mixing of funds at the holdingcompany level prevent us from determining whether

bank dividends actually do make their way to nonbank

affiliates within the holding company.

In summary, although we find it theoretically possible for banks to pass at least a portion of a net marginal subsidy (if one exists) from the bank to either a direct

subsidiary or to a holding company affiliate, we also

conclude that the firewalls currently in place under both

organizational models inhibit such transfers. The evidence appears to bear out this conclusion. The FDIC,

for example, has allowed securities subsidiaries of state

nonmember banks for just over a decade; these bona

fide subsidiaries are subject to restrictions to protect

the insured bank, much like the firewalls outlined

above; and if there were a substantial net marginal subsidy that could be transferred, one would expect at

least some large bank holding companies to conduct

their securities activities through bona fide subsidiaries

rather than through Section 20 subsidiaries of the holding company. One would expect this especially since

1991, when the U.S. Court of Appeals for the Second

Circuit ruled that the Federal Reserve Board does not

have jurisdiction under the Bank Holding Company

Act over bank subsidiaries of a bank in a bank holding

company.33 Yet all large bank holding companies continue to conduct their underwriting activities through

bank holding company Section 20 subsidiaries. This

fact seems to indicate that if there is a net marginal subsidy, the bona fide subsidiary structure is just as effective as the bank holding company structure in

preventing the subsidy's transfer out of the bank.

In times of stress, of course, firewalls tend to weaken, and transgressions have occurred both within and

beyond the reach of the regulators. But the FDIC's experience with the financial crises of the 1980s and early 1990s indicates that at such times, pressure can be

exerted on a bank by its holding company as well as by

subsidiaries. This potential problem is likely to be unaffected by organizational structure.

Effect of Organizational Structure 

on a Subsidy
 

To the extent that a net marginal subsidy exists, it is

not independent of organizational structure. In particular, the operating subsidy structure may help to

contract any net marginal subsidy. If appropriate safeguards are in place, having the earnings from new activities be in bank subsidiaries (where profits accrue to

the parent bank) provides the insurance funds with

greater protection than they would have under the

holding company structure. Moreover, since the fair

market price for deposit insurance is tied to expected

insurance losses, allowing banks to put new activities in

a bank subsidiary and thereby reduce the expected

losses of the insurance funds would also lower the fair

market price for deposit insurance. It would, as well,

lower the value of the banking industry's access to the

full faith and credit of the U.S. government. Accordingly, if banks do receive a net marginal subsidy, allowing them to put new activities in bank subsidiaries

would lower such a subsidy.

Conclusion and Implications

for Financial Modernization

It has long been widely accepted that banks receive

a gross subsidy from the federal safety net. As we have

shown, however, recent legislative and regulatory

changes have significantly constricted the federal safety net and its related gross subsidy. In addition, banks

incur costs, both direct and indirect, that appear to

largely outweigh any funding advantage derived from

31 Three major federal statutory limitations govern the payment of

dividends by banks (see 12 U.S.C. Sections 1831o, 56, and 60).

State law, too, may govern bank dividend payments. See also

Federal Reserve Board Policy Statement on Cash Dividend

Payments, November 14, 1985.

32 See Greenspan (1997), 3.
 

33 Citicorp v. Board of Governors of Federal Reserve System, 936 F.2d 66
 

(1991).

14
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

the safety net. On the basis of the evidence available,

we conclude that if banks receive a net subsidy at all, it

is small. And even at the margin, any subsidy is at least

partially offset by regulatory and other costs.

Moreover, under the OCC's operating subsidiary rule,

the only banks that can use a direct subsidiary to engage in activities not permissible to banks themselves

are well­managed and well­capitalized banks-those

for which, by definition, any safety net-related subsidy

is smallest. Indeed, most evidence suggests that the

net marginal subsidy received by these banks is insignificant or even negative. Even if a net marginal

subsidy did exist, regulatory firewalls (such as those

embodied in the OCC's operating subsidiary rule and

in Sections 23A and 23B of the Federal Reserve Act)

serve to inhibit a bank from passing it either to a direct

subsidiary or to an affiliate of the holding company. In

both cases, any leakage of a net marginal subsidy out of

the insured bank would be de minimis.

The true question, then, is whether the theoretical

possibility of passing on a net marginal subsidy makes

any real­world difference. Is there a reason, for example, to favor one bank organizational structure over the

other for the sole purpose of containing a subsidy within the bank? Given the existing firewalls and incentives outlined above, we find no compelling reason to

favor the bank holding company model over the bank

subsidiary structure or vice versa. Notwithstanding

Kwast and Passmore (1997), the literature is in almost

universal agreement with us on this point. Longstreth

and Mattei (1997), Santos (1997), Schull and White

(1998), Walter (1998), and Whalen (1997), among others, all conclude that firewalls such as those currently in

place inhibit the transfer of any subsidy under both

structures. Neither structure has advantages and disadvantages so dominant as to justify the mandating of

that organizational form for expanded banking activities.

15
FDIC Banking Review

References

Boyd, John H., and Mark Gertler. 1994. Are Banks Dead? Or Are the Reports Greatly

Exaggerated? Federal Reserve Bank of Minneapolis Quarterly Review 18

(Summer):2-23.

Epps, T. W., Lawrence B. Pulley, and David B. Humphrey. 1996. Assessing the FDIC's

Premium and Examination Policies Using "Soviet" Put Options. Journal of Banking

and Finance 20:699-721.

Federal Deposit Insurance Corporation (FDIC). 1998. The FDIC Quarterly Banking Profile.

4th quarter. FDIC.

Federal Financial Institutions Examination Council (FFIEC). 1992. Study on Regulatory

Burden. FFIEC. 

Feinman, Joshua N. 1993. Reserve Requirements: History, Current Practice, and Potential

Reform. Federal Reserve Bulletin 79, no. 6:569-589.

Flood, M. 1990. On the Use of Option Pricing Models to Analyze Deposit Insurance.

Federal Reserve Bank of St. Louis Economic Review 73, no. 1:19-35.

Greenspan, Alan. 1997. Testimony before the U.S. House Committee on Banking and

Financial Services, Subcommittee on Financial Institutions and Consumer Credit.

105th Cong.,1st sess. February 13.

Helfer, Ricki (Chairman, FDIC). 1997. Testimony before the U.S. House Committee on

Banking and Financial Services, Subcommittee on Capital Markets, Securities and

Government Sponsored Enterprises, 105th Cong., 1st sess., March 5, Attachment 5.

Kaufman, George G. 1994. Bank Contagion: A Review of the Theory and Evidence. Journal

of Financial Services Research 8, no. 2:123-150.

Kaufman, George G., and Larry R. Mote. 1994. Is Banking a Declining Industry? A Historical

Perspective. Federal Reserve Bank of Chicago Economic Perspectives 18, no. 3:2-21.

Kuester, K., and J. O'Brien. 1990. Market­Based Deposit Insurance Premiums. In Game

Plans for the 90s, Proceedings of the Conference on Bank Structure and Competition, 62-95.

Federal Reserve Bank of Chicago.

Kwast, Myron L., and S. Wayne Passmore. 1997. The Subsidy Provided by the Federal Safety

Net: Theory, Measurement and Containment. Finance and Economic Discussion

Series, no. 97­58. Federal Reserve Board of Governors.

Longstreth, Bevis, and Ivan E. Mattei. 1997. Organizational Freedom for Banks: The Case

in Support. Columbia Law Review 97:1895-1922.

Marcus, A., and I. Shaked. 1984. The Valuation of FDIC Deposit Insurance Using OptionPricing Estimates. Journal of Money, Credit, and Banking 16, no. 4, part I:446-460.

McCulloch, J. Huston. 1985. Interest­Risk Sensitive Deposit Insurance Premia: Stable ACH

Estimates. Journal of Banking and Finance 9, no. 1:137-156.

Merton, Robert C. 1977. An Analytic Derivation of the Cost of Deposit Insurance and Loan

Guarantees: An Application of Modern Option Pricing Theory. Journal of Banking and

Finance 1, no. 2:3-11.

Moody's Corporation. 1996. Moody's Bank Ratings Criteria. Moody's Corporation.

Passmore, Wayne. 1992. Can Retail Depositories Fund Mortgages Profitably? Journal of

Housing Research 3, no. 2:305-340. 

Pennacchi, George G. 1987. A Reexamination of the Over­ (or Under­) Pricing of Deposit

Insurance. Journal of Money, Credit, and Banking 19, no. 3:340-360.

16
The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization

Richards, Heidi Willman. 1995. Daylight Overdraft Fees and the Federal Reserve's Payment

System Risk Policy. Federal Reserve Bulletin 81, no. 12:1065-1077.

Ronn, Ehud, and Avinash Verma. 1986. Pricing Risk­Adjusted Deposit Insurance: An

Option­Based Model. Journal of Finance 41, no. 4:871-895.

Santos, Joao dos. 1997. Securities Activities in Banking Conglomerates: Should Their

Location Be Regulated? Working Paper Series, no. 97­04. Federal Reserve Bank of

Cleveland.

Schull, Bernard, and Lawrence J. White. 1998. The Right Corporate Structure for Expanded

Bank Activities. Banking Law Journal 115, no. 5:446-476.

Standard and Poor's Corporation. 1996. Debt Ratings Criteria: Financial Institutions. Standard

and Poor's Corporation.

U.S. House Committee on Banking and Financial Services. 1997. Financial Modernization:

Hearings before the Subcommittee on Capital Markets, Securities and Government

Sponsored Enterprises. 105th Cong., 1st sess., March 5.

U.S. Senate Committee on Banking, Housing, and Urban Affairs. 1998. Hearings on H.R. 10,

The Financial Services Act of 1998. 105th Cong., 2d sess., June 17.

Walter, John R. 1998. Firewalls. Federal Reserve Bank of Richmond Economic Quarterly 82,

no. 4:15-39.

Whalen, Gary. 1997. The Competitive Implications of Safety Net-Related Subsidies.

Economics Working Paper, no. 97­9. Office of the Comptroller of the Currency.

Williams, Julie L. 1998. Testimony before the U.S. Senate Committee on Banking, Housing,

and Urban Affairs, 105th Cong., 2d sess., June 25.

17
FDIC Banking Review

Internal Risk-Management
 

Models as a Basis for
 

Capital Requirements
 

by Daniel A. Nuxoll*
 

I

n 1988, after extensive negotiation among the G­10

central­bank governors, the Basle Committee on

Banking Regulations and Supervisory Practice

agreed on uniform capital standards. The agreement,

known as the Basle Accord, was an attempt to produce

uniform capital standards for internationally active

banks.1 Until then, different countries had set different capital standards for their banks. In some countries, lower standards were thought to give a

competitive advantage to banks headquartered in

those countries.

Although the focus of the Basle Accord is on uniform

capital requirements, the Accord also establishes riskbased capital requirements that supposedly reflect the

actual credit risks faced by a bank. The Basle Accord

assigns risk weights to all assets, weights that should

reflect the relative risks of those assets. For example,

commercial and industrial loans have a 100 percent

weight, while home mortgages have a 50 percent

weight. Weights are also assigned to off­balance­sheet

activities, such as loan commitments and standby letters of credit.

Banks are required to hold 8 percent of the riskweighted assets as capital.2 This means, for instance,

that banks are required to hold 4 percent (= 8 percent

x 50 percent) capital for home mortgages, and 8 percent

(= 8 percent x 100 percent) capital for commercial and

industrial loans.

From the start, however, analysts have repeatedly

demonstrated that the risk­based capital requirements

do not accurately reflect risk. First, the risk weights

themselves are not accurate: while studies generally

indicate that the risk weights are not completely unreasonable, these same studies inevitably find that

some category of loan has the wrong weight. Second,

loans within a given category are not equally risky-yet

a 90­day inventory loan to a profitable company with a

solid credit record has the same risk weight as a fiveyear loan to develop commercial real estate. Third, the

requirements ignore risk­reduction activities like diversification and hedging; thus, a portfolio of loans to

borrowers in the same industry and the same area (for

example, farmers in the same county) has the same

capital requirement as a portfolio diversified across industries and regions of the country. Presently, therefore, almost everyone acknowledges that the Basle

risk­based capital standards have very little to do with

actual risk.

But although the Basle standards fail to reflect accurately the risk in a bank's portfolio, banks do have definite incentives to measure accurately the risk of their

activities. In the past decade, banks have developed

internal risk­management models to measure their

risks systematically. These models are based on the

* Daniel A. Nuxoll is a financial economist in the FDIC's Division of

Research and Statistics. Conversations with Jack Reidhill, George

Hanc, Steven Seelig, Miguel Browne, and John Feid resulted in significant improvements in this paper.

1 U.S. regulators have imposed these requirements on all banks.

2 The bank also has a 4 percent Tier I capital requirement; Tier I capital is approximately equal to equity. Total capital includes Tier I and

Tier II capital; the latter consists of loan­loss reserves and certain

forms of nondeposit debt.

18
Internal Risk-Management Models

best statistical estimates of the particular risks being

measured, and most models consider the effects of diversification and hedging. The possibility of replacing

the Basle capital standards with these models has been

widely discussed.3

This article considers three proposals to revise the

Basle Accord. The first, which was adopted in 1996,

permits banks to use internal models to estimate one

kind of risk-the risk of trading activities. The second

would permit banks to use somewhat different, but basically fairly similar, models to evaluate the risk of making loans. The third would permit banks to use any

method to estimate their own risk, but-in contrast to

the current systems-banks that underestimated the

risk of their activities would be penalized.

Trading-Book Models 

(Market-Risk Models)

Regulators had long recognized that the Basle standards for market risk were inadequate, even while

banks and securities firms had developed sophisticated

methods of measuring the risk of their portfolios.

Accordingly, the 1996 amendments to the Basle Accord

permitted regulators to accept the calculations of the

banks' internal risk­management models in setting

capital requirements for the market risk in banks' trading portfolios. 

Trading­book models have become increasingly

common in banks, especially since 1994, when J. P.

Morgan released its RiskMetrics model.4 J. P. Morgan

has distributed this model widely; some components

are available over the Internet. Although other riskmanagement models are available, RiskMetrics has become the standard of comparison, and the other models

use very similar methods. Thus, most of the discussion

below applies directly to RiskMetrics; nevertheless, it

ignores many aspects of this model and focuses on the

deficiencies of the simplest configuration of the

RiskMetrics models. The discussion also mentions

different methods RiskMetrics can use to avoid some

of those deficiencies.

Internal risk­management models generally estimate the value at risk; hence they are often called VaR

models.5 The value at risk is the amount of money

that would be sufficient to cover most potential losses.

Because VaR models focus on risk, they generally ignore profit.6

Trading­book VaR models use estimated probabilities of price movements to estimate the probability of

losses for the whole portfolio. The data might show, for

example, that over the past 20 years, the price of 10­

year Treasury bonds decreased by more than 0.2 percent on only 5 percent of the days. The data might also

indicate that the price decreased by more than 0.75

percent on only 1 percent of the days.

Given these data, if a portfolio consists solely of $100

million of 10­year Treasury bonds, then the VaR model would estimate that losses would exceed $200,000 (=

$100 million x 0.2 percent) in a day less than 5 percent

of the time. This number could be called the 5 percent

value at risk because losses would exceed $200,000 less

than 5 percent of the time. The model would forecast

that losses would be greater than $750,000 (= $100 million x 0.75 percent) less than 1 percent of the time.

Similarly, this number could be called the 1 percent

value at risk-a bank could be 99 percent certain that

this investment would never lose more than $750,000.

To estimate a Value at Risk model, one needs not

only a probability level but also a time horizon. For

regulatory purposes, the time horizon is ten trading

days and the relevant probability is 1 percent, so the

losses within ten days would exceed the value at risk

less than 1 percent of the time.

The 1996 Basle amendments require that capital

equal three times the value at risk.7 If the bank's in3 This topic was extensively discussed at a 1998 conference in New

York City sponsored by the Federal Reserve Bank of New York, the

Bank of England, the Bank of Japan, and the Board of Governors of

the Federal Reserve System (Federal Reserve Bank of New York

[1998]). In addition, John J. Mingo (1998) has critiqued the current

standards and spelled out the benefits of a models approach to bank

capital. The International Swaps and Derivatives Association has endorsed an approach that is a definite step toward using internal models to set capital requirements (summarized in Elderfield [1998]). 

4 For the definitive description of RiskMetrics methodology, see

Longerstaey and Zangari (1996).

5 The explanation here of trading­book VaR models applies generally

to banking­book VaR models as well, except that the emphasis in the

latter is on loans, not securities. Throughout this section, the terms

"trading­book model" and "VaR model" are used interchangeably to

refer to the trading­book subset of VaR models.

6 Jorion (1997) discusses VaR models in detail. VaR models are closely related to risk adjusted of return on capital (RAROC) models,

originally developed by Bankers Trust; for a summary of Bank of

America's RAROC model, see Zaik, Walter, Kelling, and James

(1996).

7 This multiplication factor has been vociferously criticized as arbitrary, usually by banks that want a lower factor. However, the usual

rule is that the risk increases with the square root of time because

standard deviation increases with the square root of time.

Consequently, if the relevant horizon is one year (250 trading days)

instead of ten trading days, the multiplication factor should be five.

This multiplication factor, too, is undoubtedly incorrect. See

Danielsson, Hartmann, and deVries (1998) and Stahl (1997) for opposite sides of the debate. The whole debate demonstrates that no

one really knows the "correct" multiplication factor and that the

bank regulators have probably been conservative.

19
0

0

FDIC Banking Review

ternal model is discovered after­the­fact to have been

inadequate, the capital requirement can be increased,

reaching a maximum of four times the value at risk. If

the performance of the model turns out to have been

grossly inadequate, regulators can refuse to use it to set

capital requirements.

VaR models can include the effects of both diversification and hedging, which are common methods of

controlling risk. Diversification and hedging are possible because prices do not necessarily move together.

On the one hand, if prices always moved together, losses from one investment would never be offset by profits from another investment, and neither diversification

nor hedging would be possible. On the other hand, if

prices always moved in opposite directions, losses from

one investment would always be offset by profits from

the other, and perfect hedging would be possible. The

usual case is that prices sometimes move in opposite

directions and sometimes in the same direction, so that

losses are sometimes offset by profits from other investments.

The way VaR models incorporate the effects of diversification and hedging is by estimating the correlations between price changes. If two prices always

move together, the correlation equals one; if they always move in opposite directions, the correlation is

negative one. In fact, securities prices tend to move

together, but they do not always move together, so almost all estimated correlations are greater than zero,

but less than one. Consequently, diversification generally reduces risk.8 Importantly, assumptions or estimates of these correlations amount to measurements of

the effects of diversification and hedging, and they

translate directly into estimates of the riskiness of the

portfolio.

The significance of diversification and hedging was

evident in the first stages of the thrift crisis (before

1983). Thrifts held a large number of very safe securities, namely fixed­interest­rate mortgages. However,

thrifts were not well diversified, because changes in interest rates affect the value of all fixed­rate mortgages.

The high interest rates in the late 1970s and early

1980s drove the value of these mortgages down. At the

same time, thrifts had to pay higher interest rates to obtain deposits. The result was that many thrifts faced

insolvency by 1983.9 (Of course, the evolution of the

thrift crisis after 1983 had little to do with interest

rates.)

* * *

Because of the large number of traded securities,

trading­book VaR models inevitably use a large number of simplifying assumptions. We now examine five

of them, noting any evidence on whether they produce

overly large or overly small estimates of value at risk. 

The first simplifying assumption VaR models commonly make is that price changes are distributed normally (they make this assumption because the normal

distribution is easy to handle mathematically). The actual distribution of price changes and financial data,

however, is generally not normal. Specifically, the normal distribution understates the probability of large

price changes. VaR models that use the assumption of

normality therefore understate the probability of large

price declines, thereby understating the probability of

large losses. 

Many fixes have been suggested to solve this problem, but for regulators the problem is nothing to worry

excessively about: VaR models estimate the probability of large losses during a day, whereas regulators are

undoubtedly more concerned about the long run.

Though the normal distribution might be misleading

for managing risk on a daily or weekly basis, in the long

run even financial data are distributed normally.

10

8 Mathematically, diversification is possible when a correlation is positive and less than one. Hedging is possible when a correlation is

negative. Hedging often depends on instruments like futures

which permit a trader to sell "short," that is, sell for future delivery

at a fixed price. The value of these contracts moves in the opposite

direction to the current price. Short selling essentially turns a positive correlation into a negative correlation. Most descriptions of

hedging assume that the correlation is negative one, though most

actual hedges involve basis risk, which occurs because the correlation does not equal negative one.

9 This is an instance of a classic problem, sometimes called interestrate risk, sometimes called the mismatch of maturities. Because deposits have short maturities and mortgages have long maturities, an

increase in interest rates drives up the cost of borrowing without affecting the return on loans. The classic solution to the problem is

to fund long­term loans with long­term deposits. This solution

could be considered a hedging program that protects a bank from

interest­rate risk. The bank's interest costs and interest income are

more closely correlated when maturities are closely matched.

10 Jackson, Maude, and Perraudin (1997) use portfolios from actual

banks to illustrate the nature of the problem. Conventional wisdom

is that alternative techniques known as historical simulation or

structured Monte Carlo simulation can solve the problem (Jorion,

[1998]). However, these methods have problems of their own,

which have motivated the development of more exotic fixes (see

Danielsson and de Vries [1997]; Zangari [1997]; Hull and White

[1998]; and Rubinstein [1998]). Duffie and Pan (1997) note that the

central limit theorem implies that, in the long run, returns from

even a fat­tailed distribution are normal.

20
Internal Risk-Management Models

A second simplifying assumption, one made by most

VaR models, is the use of only a small number of estimated correlations between price changes. The number of actual correlations increases dramatically with

the number of securities because for each pair of

stocks, a different correlation must be estimated. For 2

securities, there is 1 correlation; for 4 securities, 6 correlations; and for 100 securities, 4,950 correlations.11

To avoid estimating a multitude of correlations,

some models arbitrarily specify some correlations to be

zero or one. Because most true correlations are probably somewhere in this range, using a correlation of one

overstates the risk because it neglects the effects of diversification; but zero correlations understate the risk

by overstating the possibilities for diversification.

Other VaR models avoid estimating a multitude of

correlations by using the results of multifactor models

of prices. Multifactor models assume that securities

prices are driven by a limited number of factors. If the

prices of two securities both respond to some factor,

then the prices are correlated. Often, multifactor models assume that the prices of all firms in an industry

move together, so they treat a firm's industry as a factor. The correlations between price changes are then a

function of a handful of factors.

These methods of avoiding having to estimate a

multitude of correlations might produce high or low estimates of correlations, so they might produce an understatement or overstatement of the risk eliminated

by diversifying and hedging. Regulators must be concerned because systematic underestimation of the correlations produces an overestimation of the benefits of

diversification, an underestimation of the amount of

risk, and a consequent underprovision of capital.

A third simplifying assumption is the use of historical data to estimate the relationship between prices.

Historical data often significantly understate some

risks. Options prices, in particular, behave very differently when they are substantially out­of­the­money

from when they are in­the­money. (Out­of­the­money

options are options that will be exercised only if there

is a big price change, in­the­money options will be exercised even if there is no price change.) The price of

a call option on a stock might be very stable, if the current stock price were substantially below the strike

price. However, if the stock price were to rise above

the strike price, the price of that option would fluctuate much more.12

A more mundane example of the understatement of

risk when historical data are used concerns prepayments of home mortgages and the price of mortgagebacked securities. Interest rates can affect prepayments of home mortgages, and prepayments are a

major determinant of the price of mortgage­backed securities. When interest rates decline modestly, the cost

of refinancing prevents most home owners from refinancing, but when rates decline significantly a wave of

prepayments is almost certain to follow. A 0.5 percent

decrease in interest rates would probably have a small

effect on prepayments, but a decrease of 2 percent

would almost certainly increase prepayments substantially. The effect of a 2 percent decrease in interest

rates is not simply four times the effect of a 0.5 percent

decrease. Thus, one cannot directly infer how a 2 percent decrease in interest rates will affect the price of

mortgage­backed securities from the results of a 0.5

percent decrease. A period of relatively stable interest

rates without any dramatic changes does not reveal the

true risk of mortgage­backed securities.

What makes the problem created by the use of historical data especially acute is that many VaR models

are estimated on the basis of only the most recent data.

RiskMetrics can use long data series, but the most recent data receive more weight when the model is estimated-practitioners argue that only the most recent

data reflect current market conditions. Recent periods,

however, like most periods, tend to be relatively stable,

with no dramatic changes. This complicates things for

VaR models, which attempt to estimate a firm's losses

as a result of unlikely events (a 1 percent VaR estimate

is concerned only with events that happen less than 1

percent of the time). For many assets, the small price

changes that occur in a stable market simply cannot

serve as the basis for an estimation of the effect of market turmoil.

Again, there are ways of correcting for this problem.

The data can be chosen to include periods when prices

were extremely unstable. Such data exist, but only for

11 With 4 securities, each can be compared with the 3 others for a total

of 12 combinations, although this number must be divided by two

to eliminate duplicates (the correlation between x and y is the same

as between y and x), so there are 6 possible comparisons. With 100

securities, each is correlated with 99 others, for a total of 9,900 correlations; after duplicates are eliminated, the total is 4,950.

12 This phenomenon is sometimes explained in terms of prices being

"non­linear." A call option on a stock, for example, has value only

if the stock price is above the strike price on the exercise date. That

value changes dollar for dollar with the stock price. On the other

hand, the actual stock price is completely irrelevant if it is below the

strike price because the option has a value of zero. The relationship

of the stock price on the exercise date to the option value is very different in the two cases.

21
FDIC Banking Review

some assets. More commonly, VaR models correct for

this problem by incorporating explicit pricing models.

For example, a VaR might use a Black-Sholes optionspricing model to estimate the effect of a large change in

prices. Or a VarR might use a model to estimate the effect of a large interest­rate change on mortgage prepayments and the price of mortgage­backed securities. 

Pricing models are also used to price securities that

do not have a directly observable market price. The

problem of pricing such securities is especially pronounced in the over­the­counter derivatives market,

where derivatives contracts are customized to the

needs of the various parties and therefore cannot be

readily traded. Consequently, many derivatives have

to be priced according to a model.

But pricing models have one major pitfall. There is

no standard method for pricing many assets, and even

for simple assets, the existing models do not always

agree with observed prices. For example, the standard

options­pricing model, the Black-Sholes model, tends

to misprice out­of­the money options. This model assumes that price changes are distributed normally, so it

systematically underestimates the probability of large

price changes.13

A study by the Bank of England indicates the extent

of the pricing problem. The Bank of England surveyed 40 institutions with major trading activities in

London, asking them to price a number of standard derivatives as well as some more­exotic products. The 40

firms did not agree even on the value of a completely

standard foreign­exchange option, and they disagreed

on the extent to which prices would change with a

change in the exchange rate.14 As might be expected,

the disagreement on the value of the more sophisticated derivatives was even greater.

So even though the pricing models are used to compensate for the fact that the risk of some securities is

not always revealed in the historical data, the price

models themselves disagree, and this disagreement

would produce differences among the VaR models that

use the pricing models. The differences in pricing

models would translate directly into different capital

requirements for banks, even if they held identical

portfolios.

The fourth simplifying assumption is that the portfolio is fixed-does not change-during any one day,

an assumption that is tenuous at best for a trading

book. VaRs could, in principle, be calculated for every

minute of the day, but such a calculation would be difficult for a large trading operation and of uncertain usefulness. In fact, VaRs are almost always calculated on a

daily basis, so they measure the risk of the portfolio

only at the end of the day. They completely ignore all

risk that traders take during the course of the day.

The fifth simplifying assumption is that the numbers that go into the VaR model are known with certainty. Even if the other four simplifying assumptions

are innocuous, VaR models still estimate risk using estimated probabilities of price changes. And even if

these probabilities are estimated with the most sophisticated techniques, they are estimates-not known

with precision. Significantly, VaR models do not allow

for the uncertainty in the numbers they use. Nevertheless, taking an estimate as certain generally leads to

an understatement of risk.15

Duffee (1996) pointed out that properly accounting

for VaR models' use of estimates, not known numbers,

generally increases the estimated level of risk. In his

study he found the VaR which neglected this fact underestimated exposures by 33 percent.16

Another study, one by Marshall and Siegel (1997),

examined the variation in the VaR estimates from four

risk­management consultants, all of whom use the

RiskMetrics model. Although the consulting firms all

used the same model and were given the same data for

the same portfolio, the VaR estimates for the four firms

ranged between $3.8 million and $6.1 million.17

13 Kupiec and O'Brien (1995a) stress this point.

14 Specifically, for a European­style sterling/Deutschmark straddle,

10­month forward option at­the­money, they found a 2.7 percent

standard deviation in the value, a 5.3 percent standard deviation in

the delta, a 3.5 percent standard deviation in the gamma, and a 0.4

percent standard deviation in the vega. The last three terms would

be used by a VaR model. For additional details see Walwyn and

Byres (1997).

15 This is an example of what is sometimes called "model risk."

Model risk occurs because even if one is aware of all the possible

problems in formulating a model, there is seldom an obvious solution to these problems, and sometimes a solution to one problem

brings with it additional difficulties. Consequently, any model is a

series of compromises based on well­informed judgment and any

exercise of judgment oversimplifies or ignores potentially important

aspects of reality. (The text discusses the fact that model­builders

often ignore the reality that the numbers going into the model are

estimates which are only more or less accurate.) At best, a model

is an approximation of reality. "Model risk" is the risk of using an

approximation.

16 Dufee examined credit risk, not price risk, and he looked only at parameter uncertainty. Nonetheless, his argument applies to all VaRs

because all VaRs are estimated. The 33 percent number is for the

credit risk on the fixed side of a five­year U.S. dollar interest­rate

swap; the estimate is specific to the model and should not be applied to other models.

17 One firm submitted six different estimates of the VaR, all of which

used methods slightly different from those specified by the authors.

These estimates ranged from $3.0 million to $3.8 million.

22
Internal Risk-Management Models

This problem of taking estimates for reality is likely

to be even more severe if the past turns out not to be

prologue to the future, for all VaR models assume that

future prices will behave as past prices did. Yet there is

no reasonable alternative to using historical risks to

forecast future risks.

All five of the simplifications discussed above are

significant simply because statisticians have not developed the tools necessary to assess whether VaR models

are reasonably accurate. These models are concerned

with extreme events, namely very large losses, but by

definition, extreme events do not occur frequently.

Because the data are so sparse, statistical techniques

have difficulty determining whether forecasts of extreme events are accurate.

The point can be made with the Basle Accord's

method of evaluating the accuracy of VaRs. A portfolio

should experience excess losses that exceed the 1 percent value at risk, on average 2.5 days a year (1 percent

x 250 trading days). However, this is an average, and

the actual number will obviously be higher or lower.

The current Basle rules deem a model "acceptably accurate" if losses exceed the 1 percent VaR fewer than 4

of 250 days. A true 1 percent VaR model will meet this

criterion approximately 89 percent of the time.

However, a 2.5 percent VaR model will meet this criterion approximately 25 percent of the time. By definition, losses exceed the 2.5 percent VaR approximately

two and a half times more often than they exceed a 1

percent VaR. Thus, a 2.5 percent VaR consistently understates the risks that interest regulators, yet it can

pass the Basle tests for accuracy approximately 25 percent of the time.18

Work has been done to develop more powerful tests

of VaR accuracy. Lopez (1998) discusses the most recent efforts. Nonetheless, these tests still are not very

powerful, because by definition there are few data on

extreme events.

In other words, this problem of determining the VaR

forecasts' accuracy is completely independent of the

method used to calculate the VaR. Unlike many of the

problems discussed above, which can be avoided if

slightly different methods are used (usually at the cost

of creating some additional complexity and perhaps

new problems), this problem is innate: whatever its

methodology, a VaR model forecasts an extreme event;

the accuracy of these forecasts therefore cannot be assessed without data; but by definition, the data are

lacking. 

Banking-Book Models 

(Credit-Risk Models)

Models have also been developed to estimate the

credit risk of loans, and some economists and bankers

have proposed using such models internally to set capital requirements for banks' banking books. J. P. Morgan also developed the standard credit model,

CreditMetrics, which was released in 1997. By the end

of 1998, competitors had entered the field: Credit

Risk+ from Credit Suisse Financial Products, CreditPortfolioView from McKinsey, and Portfolio Manager

from KMV. These products differ widely in approach;

most of the discussion below relates to the approach

used by CreditMetrics. Again, the discussion highlights deficiencies of the simplest configuration of the

model; and this model, too, can be configured to circumvent some of the problems discussed below.19

Loans differ substantially from securities, so banking­book VaR models differ substantially from tradingbook models.20 For loans the primary risk is credit risk,

the risk that a loan will not be repaid. Lenders know

that some fraction of their loans will not be repaid;

these losses are sometimes referred to as expected losses. The difference between actual losses and expected losses is unexpected losses. Although unexpected

losses are on average zero, they can be quite large.

Banking­book VaRs attempt to estimate upper

bounds for unexpected losses and thereby upper

18 The potential understatement of the VaR is not proportionate to the

probabilities. If losses are distributed normally with a zero mean, a

2.5 percent VaR is 13 percent lower than a 1 percent VaR (2.33 standard deviations from the mean, as opposed to 2.715). However, if

losses are distributed according to a Student's t distribution with

four degrees of freedom (a distribution with fat tails), then the difference is approximately 26 percent.

19 As with fixes to the trading­book models, the fixes to specific problems with the banking­book models generally add complexity and

inevitably involve their own set of problems. Jones and Mingo

(1998) and Caouette, Altman, and Narayan (1998) provide useful

overviews of these models. Gupta, Finger, and Batia (1997) provide the definitive statement of CreditMetrics methodology. It

should be noted that because of the methodological differences

with market­risk VaRs, some authors, such as Caouette, Altman, and

Narayan, explicitly deny that these models are Value at Risk models. However, because credit­risk and market­risk models have the

same objective, others (such as Gupta, Finger, and Batia) do refer to

credit­risk models as VaRs. Koyluogo and Hickman (1998) discuss

the differences between the various commercially available models.

20 In this section the terms "bank­book model" and "VaR model" are

used interchangeably to refer to the banking­book subset of VaR

models. 

23
FDIC Banking Review

bounds for the credit risk in the banking book. There

are two basic methods of estimating credit risk, and

they handle this question slightly differently. One

method estimates only the probability of default; VaR

models of this type are sometimes called two­state

models, or default­mode models. The other method

estimates not only the probability of default but also

the probability of a deterioration in the borrower's credit rating; these models are called multi­state, or markto­market, models. The mark­to­market models are

similar to trading­book VaRs in that they attempt to estimate potential losses because of changes in the value

of loans the bank has already made.

The basic versions of credit­risk models use bond

ratings to classify loans; for instance, a loan might be

compared with a BBB bond. VaR models then assume

that the probability of default and the probability of a

credit downgrade for the loan are the same as those for

a BBB bond. Two­state models use the probability that

bonds of a particular rating would default; approximately 0.18 percent of BBB bonds were actually in default a year later. Multi­state models consider, in

addition, the probability that ratings of bonds will

change; approximately 5.95 percent of BBB bonds

were rated A one year later, and approximately 5.30

percent were rated BB one year later. More sophisticated versions might use the bank's own rating system

as well as probabilities that are based on the bank's actual experience.21

As in trading­book models, the correlations are critical. In banking­book models, however, the relevant

correlations are between defaults or between rating

downgrades. In this case, however, treating each loan

individually is equivalent to assuming a zero correlation because the likely loss on one loan is completely

unrelated to the likely loss on another loan. On the one

hand this procedure of treating each loan individually

almost certainly overstates the benefits of diversification: recessions generally increase the probability of

default and adverse credit changes, so loan losses are almost certainly positively correlated.22 On the other

hand, adding the VaR from one loan to the VaR on another loan ignores the benefits from diversification: all

the loans in a portfolio will almost certainly not go into

default simultaneously. It is possible to calculate the

correlations between defaults and between credit rating changes from bond data.23

The basic difference between two­state and multistate models, as mentioned above, is their method for

evaluating the potential losses to the lender. Two­state

models consider only the losses that result from loans

going into default; the multi­state models, in addition,

consider the losses in the value of the loan because of

changes in the credit rating. Any loan's value depends

on the likelihood of repayment, and credit ratings are

based on estimates of that likelihood. Thus, once a

bank has made a loan, a deterioration in the creditworthiness of the borrower causes a decrease in the value

of the loan to the bank. Consequently, a loan that was

comparable to a BBB bond loses value when its rating

deteriorates to BB. The multi­state model considers

this lost value, implicitly doing a pseudo mark­to­market procedure.

In both kinds of models, calculation of the value at

risk is completely analogous to the calculation in trading­book models, except that because loans are not

repriced every day, banking­book VaRs usually use a

horizon of one year. The VaR is the amount of money

that would be sufficient to cover most potential losses

from the bank's loan portfolio.

But although the banking­book and trading­book

VaRs are conceptually similar, they use very different

probability models. This methodological difference

means that many of the criticisms of trading­book models discussed above do not apply to banking­book

models. For example, banking­book models do not

use normal distributions. However, two of the criticisms apply directly. First, banking­book VaRs, like

21 Carey (1998) analyzed a set of privately placed bonds, which he argues are very similar to large corporate loans. He found that more

poorly­rated, privately­placed bonds defaulted at a lower rate than

similar publicly­traded bonds. He suggests that the holders of the

former group of bonds closely monitor the activity of the issuing

companies because they, the holders, will bear any losses from default. Owners of public bonds have less incentive because they

typically hold a small fraction of the outstanding bonds. If this suggestion is correct, then a model that used bond default rates would

tend to overstate the amount of credit risk that a bank faces.

22 The Carey (1998) study indicates that the losses from a random

portfolio of non­investment­grade bonds increased significantly

during recessions. Losses for the investment­grade portfolio were

much less variable. Because bank loans are generally regarded as

more similar to non­investment­grade bonds, the Carey study suggests banks are especially vulnerable to large losses during recessions.

23 CreditMetrics actually uses correlations from stock market data. It

considers intra­industry correlations, inter­industry correlations,

and international correlations. For example, it considers the correlation between firms within the U.S. chemical industry, the correlation between firms in the U.S. chemical and U.S. insurance

industries, and the correlation between firms in the U.S. chemical

and the German insurance industries. The theory is that firms will

default when the value of their assets is less than their debt.

Movements in stock prices reflect the movement in asset prices,

and asset prices of firms in the same country or industry tend to

move together.

24
Internal Risk-Management Models

trading­book VaRs, estimate very few correlations.

Second, both banking­book and trading­book models

ignore uncertainty about the model. If the model is

imprecisely estimated, then the model is very likely to

understate the true risk.24

In addition, banking­book VaRs have their own special problems. In contrast to market­risk models, credit­risk models cannot use the mass of publicly available

data on securities prices. Consequently, credit­risk

models are difficult to implement and must make

more­questionable assumptions. Most important, to

use credit­risk models banks either must have extensive internal data or must make the very dubious assumption that bond­market data adequately reflect the

risk characteristics of their borrowers. Modern financial economics stresses that firms that issue bonds are

very different from firms that borrow from banks. Only

large firms can borrow in the bond and commercial paper market, while most borrowers from banks are

smaller companies. Most large firms have long histories and both national and international operations.

Many other firms have fairly short histories, and most

have geographically concentrated operations.

And even if a bank chooses to use bond data, it must

be able to translate its own internal underwriting standards into equivalent ratings for bonds. This is no

mean task.25

Theoretically, banks can avoid these problems by

estimating their own probabilities and correlations using internal data. But such estimation would demand

data on hundreds of loans, if not thousands; more important, the data would have to extend over many

years. In the past 10 years there has been one recession, and in the past 20 years there have been two (or

three-some economists consider the "double­dip" recession of 1980-82 as two recessions). Defaults and

credit downgrades increase during recessions, so even

with 20 years of data, a bank would have only two cases to estimate the likely effects of a recession. In addition, mergers complicate matters because the internal

rating systems of the two merged banks are likely to be

inconsistent. Probably only a handful of banks have

operated a consistent internal credit­rating system for

20 years.

Recent studies by Robert Morris Associates (1997)

and Treacy and Carey (1998) examined the credit­rating systems at very large banks operating in the United

States. Both studies found that these banks generally

have rating systems in place, but they noted a number

of problems even with these banks' systems. One of

the most severe is that many large banks apparently fail

to differentiate between the riskiness of different

loans.26

What makes these observations especially important

is the virtual impossibilty of validating any bankingbook VaR. As discussed in connection with tradingbook VaRs, any test of a VaR model necessarily

involves extreme events because VaR models are supposed to estimate potential losses under extreme circumstances. Trading­book models are hard to validate

even with daily data, and of course banks do not reevaluate credit ratings on anything like a daily basis. Even

if banks reevaluated credit ratings every month, there

would be only 12 observations a year. With monthly

reevaluations, a bank would take 20 years to gather as

much data about its banking­book VaR as it could gather about its trading­book VaR in one year (approximately 250 trading days). If credit ratings were

reevaluated once a quarter, a bank would need 80

years. If evaluating trading­book VaRs is difficult, assessing the accuracy of banking­book VaRs is virtually

impossible.

The Precommitment Approach

One current proposal to revise the Basle Accord with

respect to risk­based capital requirements would permit each bank to precommit to a maximum loss, and if

actual losses exceeded the maximum predicted loss, either the bank would be fined or its capital requirement

would increase in subsequent years.27

The maximum loss could be determined by an internal risk­management model or by some other technique. Most of the work that has been done on this

approach is theoretical and has generally assumed that

each banker actually knows the relevant risks. One

could interpret this assumption as expressing a belief

that each bank has a perfect internal model of risk.

Actually, however, under this approach a bank need not

have any model. Rather, a bank's capital requirement

24 As previously noted, Duffee (1996) made this point about credit

risk, not about price risk.

25 Treacy and Carey (1998) discuss the complications at some length.

The most important difference between bond ratings and bank rating systems is that bond ratings reflect long­run creditworthiness,

whereas bank rating systems focus on current financial health.

Probably the reason for the difference in emphasis is that bonds

typically have longer maturities than bank loans.

26 Treacy and Carey (1998), 902, observe that 36 percent of the banks

use systems that "assign half or more of their loans to a single risk

grade. Such systems appear to contribute little to the understanding and monitoring of risk posture."

27 This approach is closely identified with the work of Kupiec and

O'Brien (1995b, 1997, 1998).

25
FDIC Banking Review

would depend on that bank's own assessment of risk.

Probably the most rigorous method of assessing risk is

to use internal models, but the bank would be able to

use any method.

Required capital would equal some multiple of the

maximum predicted loss. In this respect, the precommitment approach closely parallels the current (since

1996) use of trading­book VaRs. The difference lies in

the fact that fines and increased capital requirements

could be imposed if a bank did not meet its commitment. The central issue of the precommitment approach is the strength and usefulness of sanctions as

incentives to banks not to understate their risk.28

The theoretical work in this area has assumed that

each bank has an incentive to decrease its capital. If a

bank decreases capital, its stockholders gain in two

ways. First, they receive cash either through dividends

or through stock repurchases. Second, if the bank can

decrease capital, shareholders have less money at risk.

Moreover, raising capital is costly to stockholders inasmuch as the bank itself has to pay underwriting costs (a

payment that lowers its profitability), and current

stockholders have to give the new stockholders a share

in future profits. On the other hand, a bank with less

capital is more likely to fail. If a bank fails, its stockholders lose any future profits from the bank.

Generally economists assume that despite the risk,

stockholders prefer low levels of capital. This assumption implies that banks-which act in the best interest

of the stockholder-prefer to understate their risk and

thereby be permitted to hold low levels of capital.

However, theory cannot determine whether the incentive to maintain a higher level of capital (an incentive

in the form of possible sanctions) is stronger than the

incentives to decrease capital.29 If a bank has good

lending prospects and is initially well­capitalized, then

the possibility of sanctions can prevent it from understating its risk. The possible loss of future profits and

the possible sanction together can act as deterrents.

On the other hand, if a bank has poor lending

prospects and is weakly capitalized, the threat of sanctions will be ineffective for a number of reasons. First,

the bank has few future profits to lose. Second, if the

bank gambles and wins, the bank will not have to pay

a fine. If the bank gambles and loses enough that it

fails, regulators will not be able to collect the fine.

Regulators can collect the fine only if the bank loses

money, but not enough money that the bank is forced

into insolvency. Third, if the bank accurately reports

its risk, the bank may have to raise more capital, imposing a cost on current stockholders. Under these

conditions, stockholders would prefer that the bank

mislead regulators.30

This analysis of the incentive to maintain a higher

level of capital assumes that the threatened sanctions

are credible. However, would regulators actually be

willing to levy a fine that would materially weaken a

bank that had already suffered substantial losses?

Would regulators actually levy a fine that would force a

bank into insolvency?

Bankers cannot be certain. They do not know that

regulators will actually implement the sanctions. This

uncertainty in itself weakens the incentives for banks

to produce accurate assessments of their own risk. A

penalty that might or might not be imposed is a much

weaker deterrent than a definite, unavoidable penalty.

A banker who doubts the regulators' resolve might decide to understate the risk of the bank, thereby reducing its capital requirement, whereas if the regulators

were completely credible the same banker would correctly report the level of risk.

The problem of uncertainty is likely to be most severe at these banks that have central roles in the financial system. A failure of one of these banks may well

cause financial chaos; and thus it is considered a "systemic risk." Would regulators in fact impose penalties

on one of these banks, possibly driving it into insolvency, and risk possible systemwide financial instability? Unless the clear answer is yes, these banks have

weak incentives to report their risks correctly.

And even if banks believe the sanctions are certain

and the banks are always forthcoming with regulators,

the precommitment approach still does not guarantee

the reliability of bankers' risk assessment. As observed

above, the theoretical work assumes that bankers are

fully informed about the bank's level of risk and that

the precommitment approach simply gives them incentives to convey this information to regulators. But

the discussion of VaR models above suggests that

banks do not have full information about their own

risks, especially the risks in their banking books.

28 The New York Clearinghouse is experimenting with a similar precommitment approach for its own members.

29 Most firms also face higher borrowing costs if they decrease capital,

because they are more likely to fail and less likely to repay their

loans. Deposit insurance significantly reduces this incentive for

banks.

30 This is a form of moral hazard, a problem in virtually all insurance

plans. The most noted advocates of the precommitment approach

concede this point. See Kupiec and O'Brien (1995b, 1997, 1998).

26
Internal Risk-Management Models

Although regulatory sanctions give banks an incentive

to develop this information, the costs of doing so are

substantial. For bankers to be willing to incur both the

costs of holding capital and the costs of developing reliable information on their risks, the potential sanctions

must be sufficiently onerous.

Concllsion: 

Sholld Internal Models Be Usedd

The preceding discussion has pointed out serious

deficiencies in the proposals that regulators use the

banks' own internal risk­management models in setting capital requirements. More important, the preceding discussion has argued that there is a substantial

difference between trading­ and banking­book VaR

models. That difference is simply the availability of

data. The large volume of data on securities prices has

permitted the development of reasonable trading­book

models. In contrast, data on loan performance are

sparse, and the preeminent banking­book VaR models

use bond data as a substitute. Furthermore, because

securities prices are available daily, evaluating the reliability of trading­book VaRs is feasible, though still difficult. In contrast, the available statistical tests do not

permit any sort of reasonable assessment of loan banking­book VaRs in the foreseeable future.

The precommitment approach does not solve the

basic problems with internal risk­management models.

Regulation cannot make inaccurate models accurate.

The precommitment approach does give most banks a

reason to develop such models and to report the results

truthfully. But for some banks, notably undercapitalized banks and banks that do not believe the threats of

regulators, this incentive is not sufficient.

Despite the problems and deficiencies, internal

models produce the bank's best estimate of its possible

losses, and internal models can incorporate the risk­reducing effects of diversification and hedging. These

models undoubtedly measure the adequacy of a bank's

capital more accurately than the current Basle standards.

Yet the Basle standards have some important advantages over internal models. Because capital standards-Basle or other-have legal standing, they must

be both verifiable and uniform across time and institutions. They must therefore be based on simple,

comprehensive calculations.31 The Basle standards

certainly meet all these criteria better than any approach that relies on internal risk­management models.

31 This is the argument of Estrella (1995).

27
FDIC Banking Review

References

Caouette, John B., Edward I. Altman, and Paul Narayan. 1998. Managing Credit Risk: The Next

Great Financial Challenge. John Wiley & Sons.

Carey, Mark. 1998. Credit Risk in Private Debt Portfolios. Journal of Finance 52, no. 4:

1363-1387.

Danielsson, Jon, Philipp Hartmann, and Casper de Vries. 1998. The Cost of Conservatism.

Risk 11, no. 1:101-103.

Danielsson, Jon, and Casper G. de Vries. 1997. Extreme Returns, Tail Estimation, and Valueat­Risk. Working paper, London School of Economics.

Duffee, Gregory R. 1996. On Measuring the Credit Risks of Derivative Instruments. Journal

of Banking and Finance 20, no. 5:805-833.

Duffie, Darrell, and Jun Pan. 1997. An Overview of Value at Risk. Journal of Derivatives 4,

no. 3:7-49.

Elderfield, Matthew. 1998. Ripe for Reform. Risk 11 no. 4:25-29

Estrella, Arturo. 1995. A Prolegomenon to Future Capital Requirements. Federal Reserve

Bank of New York Policy Review 1, no. 2:1-12.

Federal Reserve Bank of New York. 1998. Financial Services at the Crossroads: Capital

Regulation in the Twenty-First Century. Proceedings of a Conference on February 26-27.

Federal Reserve Bank of New York Economic Policy Review 4, no. 3.

Gupta, Greg M., Christopher C. Finger, and Mickey Batia. 1997. CreditMetrics-Technical

Document. J. P. Morgan.

Hull, John, and Alan White. 1998. Value at Risk When Daily Changes in Market Variables Are

Not Normally Distributed. Journal of Derivatives 5, no. 3:9-19.

Jackson, Patricia, David J. Maude, and William Perraudin. 1997. Bank Capital and Value at

Risk. Journal of Derivatives 4, no. 3:73-89.

Jones, David, and John Mingo. 1998. Industry Practices in Credit Risk Modeling and the

Internal Capital Allocations: Implications for a Models­Based Regulatory Capital

Standard. Federal Reserve Bank of New York Policy Review 4, no. 3:53-60.

Jorion, Philippe. 1997. Value at Risk. Irwin.

Koyluogo, H. Ugur, and Andrew Hickman. 1998. Reconcilable Differences. Risk 11, no.

10:56-62.

Kupiec, Paul H., and James M. O'Brien. 1995a. The Use of Bank Trading Risk Models for

Regulatory Capital Purposes. Finance and Economics Discussion Series, no. 95­11.

Federal Reserve Board.

--. 1995b. A Pre­Commitment Approach to Capital Requirements for Market Risk.
 

Finance and Economics Discussion Series, no. 95­36. Federal Reserve Board.
 

--. 1997. The Pre­Commitment Approach: Using Incentives to Set Market Risk Capital
 

Requirements. Finance and Economics Discussion Series, no. 1997­14. Federal

Reserve Board.

--. 1998. Deposit Insurance, Bank Incentives and the Design of Regulatory Policy.

Federal Reserve Bank of New York Policy Review 4, no. 3:201-211.

Longerstaey, Jacques, and Peter Zangari. 1996. RiskMetrics-Technical Document. J. P. Morgan/

Reuters.

Lopez, Jose A. 1998. Methods for Evaluating Value­at­Risk Estimates. Federal Reserve Bank

of New York Policy Review 4, no. 3:119-124.

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Internal Risk-Management Models

Marshall, Chris, and Michael Siegel. 1997. Value at Risk: Implementing a Risk Measurement

Standard. Journal of Derivatives 4, no. 3:91-111.

Mingo, John J. 1998. Toward an "Internal Models" Capital Standard for Large Multinational

Banking Companies. Journal of Lending and Credit Risk Management 80, no. 10:61-66,

and no. 11:49-55.

Robert Morris Associates (RMA). 1997. Winning the Credit Cycle. RMA.

Rubinstein, Mark. 1998. Edgeworth Binomial Trees. Journal of Derivatives 5, no. 3:20-27.

Stahl, Gerhard. 1997. Three Cheers. Risk 10, no. 5:67-69.

Treacy, William F., and Mark S. Carey. 1998. Credit Risk Rating at Large U.S. Banks. Federal

Reserve Bulletin 84, no. 11:897-920.

Walwyn, Howard, and Wayne Byres. 1997. Price Check. Risk 10, no. 11:18-24.

Zaik, Edward, John Walter, and Gabriela Kelling, with Christopher James. 1996. RAROC at

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Zangari, Peter. 1997. Catering for an Event. Risk 19, no. 7:34-36.

29
FDlC Banking Review

Recent Developments
 

Affecting Depository
 

Institutions
 

by Lynne Montgomery*
 

REGULATORY AGENCY ACTlONS
 

lnteragency Actions

NewfAgreementsfforfSupervisionfoff
 

ForeignfBanks
 

On December 4, 1998, the Conference of State

Bank Supervisors announced that federal and state

banking regulators have signed two new agreements

designed to improve supervision of foreign banks

operating across state lines. The first accord, the

Nationwide Foreign Banking Organization Supervision and Examination Coordination Agreement, is

aimed at helping states coordinate their examination

and supervisory responsibilities by sharing information about particular banks. Under this accord, each

foreign bank will be assigned one state banking

department that will coordinate scheduling and planning of exams and will prepare a single examination

report on all the foreign banking firm's U.S. operations. The second agreement, the Nationwide State/

Federal Foreign Banking Organization Supervision

and Examination Coordination Agreement, creates a

similar arrangement between the states, the Federal

Reserve Board, and the Federal Deposit Insurance

Corporation. Under this agreement, the Federal

Reserve Banks and regional FDIC offices will work

with the foreign bank's state bank coordinator. BBR,

12/14/98, p. 909-910.

FairfLendingfExamfProcedures

On January 5, 1999, the Federal Financial

Institutions Examination Council (FFIEC) released

Interagency Fair Lending Examination Procedures, a

document which establishes a uniform set of procedures to be used in the Equal Credit Opportunity Act

and Fair Housing Act compliance examinations conducted by the FFIEC member agencies. The Equal

Credit Opportunity Act prohibits discrimination in

any aspect of a credit transaction. The Fair Housing

Act prohibits discrimination in all aspects of residential real estate­related transactions. The new fair

lending examination procedures are intended to provide a framework for the majority of fair lending

examinations, but the procedures may be augmented

by each agency. The agencies may also provide their

examiners and the institutions they regulate with

additional procedures as needed to implement the

fair lending examination procedures effectively. The

FFIEC member agencies include the Office of the

Comptroller of the Currency (OCC), the Federal

Deposit Insurance Corporation (FDIC), the Office of

Thrift Supervision (OTS), the National Credit Union

Administration (NCUA), and the Federal Reserve

Board. BBR, 1/11/99, p. s0.

NewfRatingfSystemfforfInformation
 

TechnologyfSystems
 

On January 19, 1999, the FFIEC issued a revised

rating system for banks' and thrifts' data processing

*Lynne Montgomery is a financial analyst in the FDIC's Division of

Research and Statistics.

Reference sources: American Banker (AB); The Wall Street Journal (WSJ);

BNA's Banking Report (BBR); and Federal Register (FR).

30
Recent Developments

operations. The revised system, called the Uniform

Rating System for Information Technology (URSIT),

will track more closely the Uniform Financial

Institutions Rating System ratings definitions for

banks' and thrifts' safety and soundness, referred to

as CAMELS ratings. Previously, the FFIEC agencies rated financial institutions and their vendors on

the risks posed by information technology systems to

the institutions under a system called the "IS" rating

system. Under the IS system each provider is given

a composite rating from 1 to 5 on: the adequacy of

the institution's information technology audit ability;

the capability of the institution's information technology management; the adequacy of the institution's development and programming; and the

quality, reliability, availability, and integrity of the

institution's technology operations. The revised rating system places more emphasis on risk management, and contains four components that examiners

will assess: auditing; management; development and

acquisitions; and support and delivery. Under the

revised system the examiners will evaluate the functions identified within each component to assess the

institution's ability to identify, measure, monitor, and

control information technology risks. The Exam

Council recommends that the agencies implement

the revised URSIT by April 1, 1999. BBR, 1/2s/99, p.

13s-136.

NewfCallfReportfForm

On January 21, 1999, the federal banking agencies

issued a joint notice alerting insured depository institutions to new revisions to the quarterly Reports of

Condition and Income (Call Reports). Federally

insured banks are required to file quarterly Call

Reports detailing their financial condition, and thrifts

and credit unions submit similar reports. Most of the

Call Report revisions clarify filing instructions and

provide additional guidance in certain areas of the

Call Report form. In particular, the revised Call

Report eliminates the "high­risk securities" items

from the securities schedule, and expands the scope

of the existing "purchased credit­card relationships"

item to include "nonmortgage servicing assets."

Further, the updated form adds new items that will

apply to banks after they adopt new Financial

Accounting Standards Board guidance on financial

derivatives accounts. The revisions are effective for

the March 31, 1999, filing date. BBR, 2/1/99, p. 189.

NewfRisk-BasedfCapitalfRules

Federal banking and thrift regulators adopted final

rules making the treatment of certain loans and other

assets for banks' and thrifts' required capital calculations more consistent among the agencies. The final

rules cover the capital treatment of construction

loans on pre­sold residential properties, real­estate

loans secured by junior liens on one­ to four­family

residential properties, and investments in mutual

funds. The rules also set uniform Tier 1 leverage

ratios for banks and thrifts. The rules were adopted

by the Federal Reserve Board, the FDIC, the OCC,

and the OTS, and are effective April 1, 1999. BBR,

3/8/99, p. 424.

GuidancefonfSubprimefLending

On March 3, 1999, the FDIC, the Federal Reserve

Board, the OCC, and the OTS jointly issued

Interagency Guidance on Subprime Lending. The

guidelines are intended to remind banks and thrifts

of the risks inherent in subprime lending and to outline the types of controls the agencies expect banks

to have in place before engaging in subprime lending. PR-8-99, FDIC, 3/3/99.

Federal Deposit lnsurance Corporation

Real-EstatefSurveyf-fJanuaryf1999

The January 1999 issue of the Survey of Real Estate

Trends reported a slowdown in the expansion of the

nation's residential and commercial real­estate markets during the late fall and early winter. The

January survey contained an increased number of

respondents reporting "no change" in market conditions during the quarter. The survey polled 304

examiners and asset managers from federal bank and

thrift regulatory agencies about developments in

their local markets in the preceding three months.

The proportion of respondents reporting that housing markets were on the upswing during the threemonth period slipped to 29 percent from 36 percent

in October. Sixty­five percent characterized supply

and demand as "in balance" compared to 61 percent

in October, while 15 percent cited excess supply,

down from 17 percent in October. As for local commercial real­estate markets, assessments continued

to be positive, but not as positive as in earlier surveys.

Twenty­six percent of the survey respondents in

January observed better conditions than three

months earlier, down from 28 percent in October.

31
FDlC Banking Review

The national composite index used by the FDIC

to summarize results for both residential and commercial real­estate markets was 61 in January, compared to 62 in October. Index scores above 50

indicate improving conditions, while index scores

below 50 indicate declining conditions. Survey of Real

Estate Trends, FDIC, January 1999.

Trust-PreferredfStockfRule

On February 19, 1999, the FDIC clarified the

authority of state banks to invest in trust­preferred

securities. In a letter to bank chief executive officers,

the FDIC said that, as long as state law permits it,

state banks regulated by the FDIC may buy trustpreferred stock in unlimited quantities. Trust­preferred stock is issued by a trust, or tax­free subsidiary,

of a bank holding company. The trust issues common and preferred shares, keeping the former and

selling the preferred stock to investors. AB, 2/22/99.

Federal Reserve Board

SubpartfGfoffRegulationfY

A final rule, which revises Subpart G of Regulation

Y, permits bank holding company securities units to

underwrite and deal in mortgage­backed securities

without proving that the loans underlying the instruments are supported by appraisals that meet the

Federal Reserve Board standards. The final rule

applies only to banks' securities units established

under Section 20 of the Glass­Steagall Act, which are

given limited authority to engage in investment

banking activities. The new final rule, which

became effective on December 28, 1998, does not

affect the appraisal requirements for federally

insured depository institutions. BBR, 12/7/98, p. 864.

HMDAfDatafReportingfExemption
 

Unchangedfforf1999
 

The Federal Reserve Board announced that

depository institutions with assets of $29 million or

less as of December 31, 1998, would not be required

to report data on their housing­related lending activities in 1999. Provisions in the Economic Growth

and Regulatory Paperwork Reduction Act of 1996

require the Federal Reserve Board to adjust the

asset­size exemption threshold annually on the basis

of changes in inflation as measured by the Consumer

Price Index for Urban Wage Earners and Clerical

Workers (CPIW). The exemption threshold for 1998

was $29 million. The CPIW increase of 1.3 percent

for 1998 did not result in an adjustment large enough

to trigger a hike in the exemption level for 1999. BBR,

1/4/99, p. 9.

InterestfRatesfRemainfUnchanged

After trimming short­term interest rates three

times in the fall of 1998, the Federal Reserve Board

left rates unchanged when they met in December

1998 and again in February 1999. The federal funds

rate remains at 4.75 percent, and the discount rate

remains at 4.50 percent. WSJ, 2/4/99.

RevisedfLimitsfonfUsefoffSecuritiesfto
 

BackfLoans
 

A January 21, 1999, legal opinion by the Federal

Reserve Board will make it easier for Federal

Reserve member banks to make loans backed by

securities issued by corporate affiliates. The ruling

involved an interpretation of Section 23A of the

Federal Reserve Act, which is designed to maintain

arm's­length dealings between member banks and

affiliates. Since 1984, the Federal Reserve has considered loans backed by securities of an affiliate to be

backed entirely by those securities, even if the stock

only amounted to a fraction of the loan amount.

However, the new ruling permits loans to be valued

differently. Now, loans to unrelated third parties (not

affiliates) will be valued either at the fair market

value of the loan minus the amount of collateral

offered by the nonaffiliate, or the fair market value of

the affiliate's shares that are used as collateral,

whichever is less. In addition, if the nonaffiliate collateral, valued at its fair market rate, is enough to

cover the loan amount, then the loan would not be

included in the bank's quantitative limits for purposes of Section 23A. BBR, 2/1/99, p. 192-193.

SurveyfonfLendingfStandards

A February 1999 Federal Reserve Board survey of

senior loan officers concludes that domestic banks

are no longer tightening business lending standards

as they had done last fall, but institutions remain concerned about the effect of uncertain economic conditions on their lending activities. Compared to the

results of loan officer surveys conducted last

September and November, fewer U.S. banks reported stricter lending standards to businesses of all sizes.

Institutions continued to report stricter business loan

terms, but not as restrictive as the terms granted in

November. The survey is based on responses from

32
Recent Developments

55 domestic banks and 23 U.S. branches of foreign

banks. BBR, 2/1s/99, p. 287.

Office of tte Comptroller of 

tte Currency

UpdatedfRisk-ManagementfGuidance

On January 25, 1999, the OCC issued supplemental guidance on managing the risks of financial derivatives and securities trading activities. The new

guidance applies to a wide range of bank activities,

including extensions of credit to hedge funds and

other highly leveraged institutions that could threaten the stability of world financial markets if they

were to fail. The supplemental guidance highlights

existing shortfalls in the risk­management systems

within financial institutions, and identifies sound

risk­management practices that should be in place

for all significant derivatives trading activities. The

guidance, which is effective immediately, is intended

to help OCC examiners identify weaknesses in the

design of national banks' risk­management systems.

BBR, 2/1/99, p. 18s.

Office of Ttrift Supervision

LessfRestrictionfonfCashfDividends

Under a final rule issued on January 19, 1999, the

OTS will permit well­run, healthy thrift institutions

to pay cash dividends without first notifying their

federal regulator. Previously, all thrifts had to give

the OTS notice or apply to the agency to make a dividend distribution. Under the new rule, institutions

that are not subsidiaries of a savings­and­loan holding

company can qualify for a capital distribution without

a notice or application to OTS if they meet certain

conditions, including retaining their well­capitalized

designation following the distribution and having

CAMELS and compliance ratings of 1 or 2. Other

institutions either have to notify the OTS or obtain

the agency's approval, depending on the condition of

the institution and the amount and nature of the capital distribution, but they may now file a schedule of

proposed capital distributions for a year at a time,

rather than filing separate notices. The final rule is

effective April 1, 1999. PR-OTS-99-03, 1/19/99.

National Credit Union Administration

FinalfCharteringfRule

On December 17, 1998, the National Credit Union

Administration approved comprehensive changes to

its chartering and field of membership policies for

federal credit unions. The new rules implement the

requirements of the Credit Union Membership

Access Act, which was signed into law on August 7,

1998. The primary revisions concern the NCUA's

policy on various types of federal credit union charters, and the criteria necessary to amend a credit

union's field of membership. The final rule also clarifies overlap issues, mergers, low­income policies

regarding low­income charters and service to underserved areas, the definition of immediate family

member or household, and the "once a member,

always a member" policy. The new rules are included in the NCUA's revised Chartering and Field of

Membership Manual. PR-NCUA, 12/17/98; BBR, 1/4/98, p. 24.

On January 8, 1999, the American Bankers

Association (ABA) filed a lawsuit, claiming that the

Chartering and Field of Membership Manual oversteps the boundaries set by Congress in the Credit

Union Membership Access Act. The ABA is asking

the court for an injunction against any new credit

union approval. The ABA also wants the court to

rescind any expanded field of membership approval

previously granted. BBR, 1/2s/99, p. 16s.

LoanfRatefCeilingfMaintained

The NCUA approved a final rule to maintain the

current 18 percent interest­rate ceiling on loans by

federal credit unions, instead of allowing the ceiling

to revert to 15 percent. The rate ceiling was scheduled to revert to 15 percent on March 9, 1999; however, with the new ruling, the ceiling will remain at

18 percent for the period from March 9, 1999 through

September 8, 2000. The NCUA reported that a 15

percent ceiling would restrict certain categories of

credit and adversely affect the financial condition of

a number of federal credit unions. At the same time,

prevailing market rates and economic conditions do

not justify a rate higher than the current 18 percent

ceiling. The NCUA Board is prepared to reconsider

the 18 percent ceiling at any time should changes in

economic conditions warrant. BBR, 2/1s/99, p. 308.

33
FDlC Banking Review

STATE LEGlSLATlON AND REGULATlON
 

Oklahoma

On December 1, 1998, the OCC announced that it

has entered into an agreement with the Oklahoma

Insurance Department to share information about

complaints arising from national banks selling insurance products in Oklahoma. The agreement also

calls for the agencies to communicate with each other

on matters of common interest, such as regulatory

and policy initiatives. The agreement is the first

agreement between the OCC and a state insurance

department on these issues. BBR, 12/7/98, p. 861. 

Utah

On November 5, 1998, the Utah District Court

ruled that new membership in geographically­based

credit unions is limited under Utah law to identifiable areas, and Utah credit unions are prohibited

from soliciting or accepting members beyond those

geographic areas. The ruling resulted from a legal

case in which the Utah Bankers Association sued

Utah credit unions, seeking to stop them from adding

new members from outside their fields of membership. Judge William A. Thorne ruled in favor of the

Utah Bankers Association and stated that Utah legislation limits membership in a geographically­based

credit union to an identifiable neighborhood, community, rural district or county. He also stated that no

exception exists to extend that geographic limitation

beyond a single county. BBR, 12/7/98, p. 879.

BANK AND THRlFT PERFORMANCE
 

Fourth-Quarterf1998fResultsffor

CommercialfBanksfandfSavings

Institutions

The banking industry earned a record $61.9 billion in 1998, setting an earnings record for the seventh year in a row. However, the fourth­quarter 1998

earnings of $14.9 billion for commercial banks were

lower than the third­quarter earnings by $148 million. The earnings decline was caused by weaknesses in international operations and rising overhead

costs and other expenses related to merger and

restructuring of a few large banks. Banks' annualized

return on assets (ROA) was 1.11 percent in the fourth

quarter, compared to 1.15 percent in the third quarter of 1998 and 1.24 percent in the fourth quarter of

1997. The number of problem banks dropped from

70 in the third quarter to 69 in the fourth quarter, and

assets of problem banks were approximately $5.4 billion at the end of 1998. Although three insured commercial banks failed in 1998, there were not any

bank failures during the fourth quarter.

FDIC­insured savings institutions posted record

profits of $10.2 billion in 1998, despite a decline in

earnings in the fourth quarter. Savings institutions

earned $2.0 billion in the fourth quarter of 1998, $921

million less than in the third quarter. The industry's

average annualized ROA declined from 1.14 percent

in the third quarter to 0.76 percent in the fourth

quarter. Despite the fourth­quarter decline, the

industry's ROA for the full year rose to 1.01 percent

in 1998 from 0.93 percent in 1997. For the second

consecutive year, no federally insured savings institutions failed. The number of problem thrifts fell to

15 from 18 in the third quarter, but the assets of

problem thrifts rose from $2.9 billion in the third

quarter to $5.9 billion in the fourth quarter. FDIC

Quarterly Banking Profile, Fourth Quarter 1998.

RECENT ARTlCLES AND STUDlES
 State­chartered credit unions are as safe and sound

as federally chartered credit unions, according to a

study conducted by The Filene Research

Institution, a credit union research group at the

University of Wisconsin in Madison, Wisconsin. The

researchers examined 4,546 state­chartered credit

unions and compared them to 7,149 federally chartered credit unions over a ten­year period from 1986

to 1996. The researchers found many similarities

between state­chartered and federally chartered

credit unions, including similarities in: median numbers of members; assets; capital; delinquency;

charge­off ratios; net income ratios; loan­to­savings

ratios; and safety and soundness. The report is entitled Financial Strength: A Comparison of State and

Federal Credit Unions. BBR, 1/4/99, p. 27.

A study, conducted by Allen N. Berger of the

Federal Reserve Board and Rebecca S. Demsetz and

Philip E. Strahan of the Federal Reserve Bank of

New York, shows that bank mergers improve the effi34
Recent Developments

ciency of the payments system while allowing banks

to earn profits more efficiently and diversify their

loan portfolios. On the downside, consolidation

increases the risk that a bank failure could cause systemic problems and that the government would

expand the safety net to keep a really large institution from failing. The report is entitled The Consolidation of the Financial Services Industry: Causes,

Consequences, and Implications for the Future. AB, 1/8/99.

A paper entitled An Overview and Analysis of

Community Bank Mergers states that community

banks that undertake mergers often become more

profitable and operate more efficiently. Joe Van

Walleghem and Paul Willis of the Federal Reserve

Bank of Kansas City conducted a case study of 19

community banks. They find community banks cut

costs by consolidating back­office operations, rather

than by closing branches. After mergers, the banks

are also able to make larger loans and use personnel

more efficiently. AB, 1/29/99.

In a paper titled Bank Industry Consolidation:

What's a Small Business to Do?, Loretta J. Mester, an

economist at the Federal Reserve Bank of

Philadelphia, concludes that small businesses should

not fear consolidation of the banking industry. Ms.

Mester finds that businesses with hard­to­evaluate

financial conditions will be drawn to community

banks, which will continue to offer flexible loan

terms. However, these businesses will pay abovemarket rates for credit. Larger companies with easyto­evaluate financial conditions will increasingly turn

to big banks, which use credit scoring and automated

loan applications to keep loan rates down. AB, 2/12/99.

James T. Moser, an economics adviser to the

Federal Reserve Bank of Chicago, writes that credit

derivatives offer banks a low­cost alternative for managing risk. In his paper titled Credit Derivatives: Justin-Time Provisioning for Loan Losses, Mr. Moser

compares credit derivatives to loan­loss provisioning

and finds that their risk­reduction benefits are

approximately equal. However, credit derivatives

may also be used to reduce a bank's capital requirements, a cost saving not available with traditional

loan­loss provisioning. AB, 2/12/99. 

lNTERNATlONAL DEVELOPMENTS
 

BaslefCommittee

The Basle Committee on Banking Supervision

issued a report titled Banks' Interactions with Highly

Leveraged Institutions, which provides guidance on

the way banks deal with hedge funds and other highly leveraged institutions (HLIs). Among other

things, the Basle Committee's guidance encourages

banks to set meaningful credit limits for HLIs,

develop more accurate measures of exposures to

HLIs, and employ sound due­diligence practices.

Dow Jones Capital Markets Report, 1/29/99.

EurofLaunched

On January 1, 1999, the Euro was launched into

world financial markets. The Euro is a common currency that will replace the national currencies of

eleven countries, including Austria, Belgium,

Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. With

the introduction of the Euro, the bilateral exchange

rates between the 11 countries as well as against the

Euro were permanently locked, but the common

currency only came into being in electronic form.

Euro bills and coins will not start circulating until

2002. WSJ, 1/4/99; BNA, 1/18/99, p. 119. 

Mexico

In December 1998, both houses of Mexico's

Congress approved reform of the financial­services

sector, resolving an eight­month dispute over a $60

billion bank bailout plan. As part of the bailout package, lawmakers voted to lift remaining restrictions on

foreign ownership of large Mexican banks and to

give lenders an opportunity to swap illiquid bad­debt

paper off their books for bonds that should be easier

to trade. The result will allow Mexican banks to

restructure their balance sheets and strengthen their

capital base. WSJ, 12/1s/98.

Japan

On December 15, 1998, the Japanese government

inaugurated the Financial Reconstruction Commission, a new administrative office created to speed

the cleanup of commercial banks' bad­loan portfolios. The Commission is an independent government body that will provide stronger administrative

powers to dispose of bad loans and prevent intervention from the Ministry of Finance and other administrative offices. It is also responsible for formulating

long­term analysis and policies regarding the

Japanese financial industry and markets. One of the

35
FDlC Banking Review

first tasks of the Commission is managing two troubled banks, Long­Term Credit Bank of Japan, which

was nationalized in October 1998, and Nippon Credit

Bank, which was put under temporary nationalization

on December 13, 1998.

On February 15, 1999, the Commission granted

approval for a 7.45 trillion yen ($65 billion) bailout of

15 of the nation's largest banks. Under the bailout

plan, the government will buy preferred shares and

subordinated debt to rebuild capital in the banks. In

return, the banks will be required to cut costs and

improve businesses. BBR, 12/21/98; AB, 3/s/99.

36