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Federal Deposit Insurance Corporation

FDIC
 

Banking


Review
 

1999
 

Volume 12, No. 3
 

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Table of Contents

FDIC 

Banking

Review 

1999 

Volume 12, No. 3 

Chairman

Donna Tanoue

Division of Research

and Statistics,

Director Deposit Insurance Reform: State of the Debate

Wm. Roger Watson by George Hanc Page 1 Deputy Directors

Barry Kolatch

Steven A. Seelig This article examines several main deposit insurance issues and analyzes the

Editor trade-off that deposit insurance requires between certain public-policy Steven A. Seelig

Editorial Committee objectives and the attendant costs and risks.

Jack T. Reidhill

Detta Voesar

Managing Editor

Detta Voesar Conduits: Their Structure and Risk

Editorial Secretary by Peter J. Elmer Page 27 Cathy Wright

Design and Production

Geri Bonebrake The author traces the development of conduits and analyzes their

advantages and disadvantages.

The views expressed are

those of the authors and do

not necessarily reflect official positions of the Federal

Deposit Insurance Corpora- Recent Developments Affecting Depository Institutions

tion. Articles may be

reprinted or abstracted if by Lynne Montgomery Page 41

the FDIC Banking Review

and author(s) are credited. This regular feature of the FDIC Banking Review contains information on

Please provide the FDIC's

Division of Research and regulatory agency actions, state legislation and regulation, and articles and

Statistics with a copy of any

publications containing re- studies pertinent to banking and deposit insurance issues.

printed material.

Single-copy 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.
Deposit Insurance Reform

Deposit Insurance Reform: 

State of the Debate 

by George Hane*

Fundamental issues of deposit insurance are be­ and principal/agent problems inherent in deposit insuring debated in the United States and abroad. In ance. Part 2 surveys and analyzes specific proposals to

the United States, the debate was stimulated by reform deposit insurance, grouping them according to

the upsurge in bank failures in the 1980s and dissatis­ whether they increase depositors' risk, increase bank

faction with the record of depository institution regula­ owners' costs, rely on increased use of market mechation during that period. One result of the experience nisms to ensure prompt regulatory action, or restrict the

of the 1980s was passage of the Federal Deposit range of banking activity financed by insured deposits.

Insurance Corporation Improvement Act of 1991 Part 3 analyzes the trade­off that deposit insurance re­

(FDICIA). Further reforms are being debated, partly quires between certain public­policy objectives and

reflecting the view of some observers that FDICIA did the attendant costs and risks. In this concluding part,

not go far enough.1 Although the present favorable differences in views on reform issues are attributed

banking climate makes comprehensive reform unlike­ mainly to differences in views on the following matters:

ly, public discussion of deposit insurance issues could public­policy priorities, the economic role of bank insignificantly influence the shape of any future action. termediation, the cost of bank risk monitoring, and the

Among other countries, an increasing number have relative efficacy of government supervisory authorities

adopted deposit insurance in recent years, which often and private­sector agents in identifying and restraining

replaced the informal practice of providing ad hoc pro­ risky bank behavior.

tection for bank depositors when crises arise. The

spread of explicit deposit insurance has partly been a

response to a series of banking crises in various countries.2 In 1994, a European Union (EU) directive re­ • George Hanc is an Associate Director in the FDIC's Division of

Research and Statistics. The author acknowledges the valuable in­ quired each member nation to adopt an explicit system put from Frederick Carns, Lee Davison, Robin Heider, Kenneth

of mandatory deposit protection with specified mini­ Jones, James Marino, Daniel Nuxoll, Jack Reidhill, Marshall

mum levels of coverage.3 Reinsdorf, Steven Seelig, and Ross Waldrop. Editing and production In Eastern Europe, deposit of the manuscript were expertly handled by Jane Lewin, Detta insurance was adopted as countries in this region Voesar, Geri Bonebrake, Kitty Chaney, and Cora Gibson.

moved from state­owned to privately owned banks. In 1 Proposals for reforming the deposit insurance and bank regulatory

establishing formal deposit insurance de novo, these systems have recently been advanced by bankers and banking

groups, Federal Reserve Board governors and reserve bank officials, countries have had to address issues that, for many bank consulting firms, think tanks, academics, and others. Some of

years, confronted (and still confront) U.S. policymak­ the recent proposals are variations of ideas advanced much earlier.

ers.4 2 Garcia (1999). 

3 Commission of the European Communities (1994). This article examines several main deposit insur­ 4 Many of the issues associated with maintaining an effective deposit ance issues. Part 1 discusses the role and functions of insurance system were explored in an FDIC symposium (FDIC

deposit insurance and the nature of the moral­hazard [1998]).

1
FDIC Banking Review

PART 1. DEPOSIT INSURANCE: PURPOSE AND RISKS

An alternative view of banking holds that some Role of Deposit Insurance banks are, and more banks are becoming, merely hold­ In the United States bank insurance dates back to ers and traders of marketable instruments. This view

1829, when the first program to protect bank creditors tends to diminish the "specialness" of banking and im­ was established in New York State. Among the main plies that the safety net needed for its protection purposes of this and subsequent programs were pro­ should be changed. tecting the local economy from the disruptions in the

money supply that resulted when banks failed and pro­ Insurance Limits tecting holders of bank liabilities against loss. For

many proponents of bank insurance, another important The importance of financial­market stability and

objective was to support a predominantly unit banking other broad objectives of deposit insurance is suggestsystem. Although public discussions have often em­ ed by the insurance limits prescribed under the various

phasized protecting the small saver, promoting finan­ insurance programs adopted or proposed in this councial­market stability and achieving other broad try. Insurance coverage in the United States has selobjectives have become major rationales for bank de­ dom if ever been limited to "small" savers. None of

posit insurance in this country. the 14 pre­FDIC state­sponsored bank insurance programs limited the amount of insurance that was pro­ In all, six states established bank insurance systems vided to an individual note­holder or depositor. during the pre-Civil War period; some of them experi­ Furthermore, of the 150 deposit insurance bills intro­ enced financial difficulties, and all of them were effec­ duced in Congress between 1886 and 1933, 120 pro­ tively put out of business by the creation of the vided for insuring all, or essentially all, deposits national banking system in 1863.5 In the early 1900s without limiting the amounts insured.7 eight bank deposit insurance programs were established, mainly in farm states; during the agricultural The Banking Act of 1933, which established the

depression of the 1920s these systems became insol­ FDIC, departed from previous practice with respect to

vent or inoperative. In the U.S. Congress, 150 deposit insurance limits by establishing a coinsurance feature

insurance bills were introduced between 1886 and that limited the amount of coverage provided to large

1933; these attempts culminated in the establishment depositors. The initial "permanent" deposit insurance

of the Federal Deposit Insurance Corporation in 1933. plan adopted as part of the 1933 Act provided for 100

Currently, deposit insurance is often described as percent coverage up to $10,000 for each depositor, 75

percent for deposits in excess of $10,000 up to $50,000, one element-the others are access to central bank adand 50 percent for deposits above $50,000. Relative to vances and payments system guarantees-in a federal the financial resources of the vast majority of people at government safety net extended to the banking system

because banks are deemed "special." The special na­ the time, however, the limit on 100 percent coverage

was set high.8 Moreover, the coinsurance feature nev­ ture of banks lies in their vulnerability to sudden withdrawals of funds from demand accounts, the central er actually went into effect but was replaced by a temrole of bank accounts in the payments system, and the porary overall ceiling of $2,500 that was raised to $5,000

in 1934, a ceiling that was adopted in the revised per­ role of banks in financial intermediation. With respect

to the last of these, the dominant view is that banks

specialize in lending to idiosyncratic borrowers who

lack cost­effective access to capital markets and, in so 5 FDIC (1950), 63-101; (1952), 59-72; (1953), 45-67; (1956), 47-72;

and (1983), appendix G. Also Golembe and Warburton (1958), doing, develop borrower­specific information on these English (1993), and Calomiris (1990). The demise of the pre­Civil borrowers. This view implies that many bank loans are War state insurance programs was partly the result of conversions

illiquid and "opaque" to investors, analysts, and others from state to national bank charters after 1863 and the prohibitive tax

Congress levied in 1865 on state bank notes, a principal bank liabili­ outside the bank. Another way to describe the special ty at the time. nature of banks is to say that they specialize in trans­ 6 Rajan (1998), 14-18; Bhattacharya and Thakor (1993); Murton (1989), forming liquid deposits into illiquid loans. Banks pro­ 1-10; and U.S. Department of the Treasury (1991), I­1 to I­11. 

vide liquidity not only to depositors but also to 7 The remaining 30 bills would have generally covered less than 100

borrowers, who draw down loans on demand against percent of deposits, excluded interest­bearing accounts, or excluded

accounts paying more than a specified rate of interest (FDIC [1950], outstanding commitments.6 Any assessment of pro­ 73).

posed changes in deposit insurance must give due 8 In constant dollars, the $10,000 limit on 100 percent coverage in 1933

weight to the special role of bank intermediation. was approximately 25 percent higher than the $100,000 limit in 1998.

2
Deposit Insurance Reform
 

manent plan of the Banking Act of 1935. According to

FDIC estimates at the time, the $5,000 limit provided

full coverage for more than 98 percent of all depositors.9 The ceiling was subsequently raised in several

steps. The most recent increase in the insurance limit,

from $40,000 to $100,000 in 1980, was apparently designed to help depository institutions, particularly thrift

institutions, compete for funds.10

Deposit Insurance and 

the Unit Banking System 

Deposit insurance has long been perceived as providing important support for a banking system made

up of a large number of independent institutions.11

Over the years, adherents of a predominantly unit

banking system sought deposit insurance in order to

provide a viable alternative to branch banking systems,

which benefit from geographic diversification.

According to one prominent view, the reason federal

deposit insurance was finally adopted in the 1930s was

the support it drew from two groups that until then had

pursued divergent aims: those who sought to avoid the

adverse effects of bank failures on the money supply,

and those who sought to preserve the existing banking

structure.12

Much has changed since the early days of federal deposit insurance; in particular, branching restrictions

have been dismantled and the banking industry has

experienced ongoing consolidation. A plausible

hypothesis is that without deposit insurance, consolidation would have proceeded more rapidly.13 Nevertheless, the banking system continues to be made up

of a large number of independently owned banks and

thrift institutions.14 Moreover, the old conflicts between adherents of unit banking and adherents of

branch banking find an echo in current discussions of

possible reforms of deposit insurance. It seems more

than coincidental that within the banking industry, the

institutions that favor privatizing deposit insurance are

mainly large and geographically diversified, whereas

community banks are generally staunch supporters of

federal deposit insurance.

MorallHazard and Principall

Agent Problems

Federal deposit insurance has been enormously successful in averting banking panics and preventing bank

failures from adversely affecting the nonfinancial economy. Inherent in deposit insurance, however, are what

have come to be called "moral­hazard" and "principal/agent" problems. Most proposals for reforming deposit insurance seek to address these problems. 

Moral Hazard

When applied to deposit insurance, the term moral

hazard refers to the incentive for insured banks to engage in riskier behavior than would be feasible in the

absence of insurance.15 Because insured depositors are

fully protected, they have little incentive to monitor

the risk behavior of banks or to demand interest rates

that are in line with that behavior. Accordingly, banks

are able to finance various projects at interest costs that

are not commensurate with the risk of the projects, a

situation that under certain circumstances may lead to

excessive risk taking by banks, misallocation of economic resources, bank failures, and increased costs to

the insurance fund, to solvent banks, and to taxpayers.

Moral hazard is present because (1) a stockholder's

loss, in the event a bank fails, is limited to the amount

of his or her investment; and (2) deposit insurance premiums have been unrelated to, or have not fully compensated the FDIC for, increases in the risk posed by

9 FDIC (l934), 34. In constant dollars, the value of the 1935 ceiling of

$5,000 was equivalent to approximately 59 percent of the $100,000

ceiling in 1998.

10 Before passage of the 1980 legislation that provided for a $100,000

limit, the FDIC testified that an accurate adjustment for inflation

would raise the limit to only approximately $60,000 (FDIC [1997],

1:93). Since then, price increases have once again eroded the real

value of the insurance limit. In constant dollars, the value of the current $100,000 ceiling is equivalent to approximately 59 percent of

the 1980 ceiling after it was raised to $100,000 and is approximately

76 percent of the 1974 ceiling after it was raised to $40,000. 

11 It may be noted that all 14 of the states that adopted bank liability

insurance before 1933 had unit banking systems and that in the

ante­bellum South, where branch banking prevailed, deposit insurance did not take root. Furthermore, of the 150 deposit insurance

bills introduced in Congress from 1886 to 1933, the largest number

were introduced by legislators from predominantly unit banking

states (Golembe [1960]; Calomiris [1990]).

12 Golembe (1960), 182.

13 FDIC (1984), 5.

14 At the end of 1998 there were 10,461 FDIC­insured banks and thrift

institutions. If multibank holding companies were counted as single units, the number of independent institutions would drop to

8,554.

15 The Nee Palgrave: A Dictionary of Economics defines moral hazard as

"actions of economic agents in maximizing their own utility to the

detriment of others, in situations where they do not bear the full

consequences or, equivalently, do not enjoy the full benefits of their

actions due to uncertainty and incomplete or restricted contracts which

prevent the assignment of full damages (benefits) to the agent responsible" (Kotowitz [1987], 549-51). In the context of deposit insurance, moral hazard has been defined as "the incentive created by

insurance that induces those insured to undertake greater risk than

if they were uninsured because the negative consequences are

passed through to the insurer" (Bartholemew [1990], 163).

3
FDIC Banking Review
 

a particular bank. Moral hazard is particularly acute for

institutions that are insolvent or close to insolvency.

Owners of insolvent or barely solvent banks have

strong incentives to favor risky behavior because losses

are passed on to the insurer, whereas profits accrue to

the owners. Owners of nonbank companies with little

capital also have reason to favor risky activities, but attempts to shift losses to creditors are restrained by demands for higher interest rates, refusal to roll over

short­term debt, or, in the case of outstanding longterm bond indebtedness, restrictive covenants required when the bonds were issued.

Probably the most effective counterforce to moral

hazard is a strong capital position. Because losses will

be absorbed first by bank capital, the likelihood (other

things being equal) that they will be shifted to the

FDIC diminishes as the capital of the bank increases.

In addition, increased capital serves to protect creditors

and helps reduce distortions in bank funding costs

caused by deposit insurance. Capital regulation, therefore, tends to curb moral hazard, as do other forms of

supervisory intervention-specifically the examination, supervision, and enforcement process.16 Moreover, risk­based capital standards and risk­based

insurance premiums attempt to impose costs on banks

according to the institutions' risk characteristics.

Forces operating within the bank may also restrain

moral hazard.17

The view that moral hazard is restrained by counterforces is supported by some studies of experience in

the 1980s, which suggest that actual bank and thrift behavior differed from the behavior expected on the

basis of the moral­hazard principle.18 It is also noteworthy that from the early 1930s through the 1970s few

banks failed, even though flat­rate deposit insurance

premiums presumably encouraged risk taking by

banks. Apparently other factors (for example, legal restrictions on entry, deposit interest­rate payments, and

other activities) had an offsetting effect by insulating

many banks from competition and limiting their incentive and ability to take on more risk.

Nevertheless, it is clear that regulatory practices in

the 1980s imposed inadequate restraints on moral hazard. Most bank failures were resolved without losses to

uninsured depositors and nondeposit creditors, although shareholders' investments were generally

wiped out. Such transactions contributed to the stability of the banking system but also enabled large institutions to finance risky activities with both insured and

nominally uninsured deposits at low interest rates. In

the case of savings­and­loan associations, many thrifts

were permitted to operate with little or no capital and

therefore had strong incentives for risky behavior.

Principal/Agent Issue

Closely related to moral hazard is the principal/agent

issue. This term refers to situations in which an agent

binds the principal but acts in a manner not in the best

interest of the principal, either because the two parties'

compensations are not aligned or because the principal

lacks the information or power needed to effectively

monitor and control the actions of the agent.19

According to some writers, regulators and elected officials (agents for the taxpayer) have an incentive to ignore the problems of troubled institutions under their

jurisdiction and delay addressing them in order to cover up past mistakes, wait for hoped­for improvements

in the economy, avoid trouble "on their watch," or

serve some other purposes of self­interest.20 Because

insured depositors are protected, an insolvent institution with few uninsured depositors can continue to operate for a lengthy period unless supervisory authorities

take action to close it. However, partly because operating losses still accrue, delay in closing the institution

often increases the cost when the institution is finally

resolved. Thus, the agent (regulator or elected official)

has different incentives with respect to the timing of

action from the principal (taxpayer), and deposit insur16 The effectiveness of the examination and enforcement process in

addressing problem banks is assessed in Curry et al. (1999).

17 Owners of an insolvent or barely solvent bank may conclude that

the bank has some franchise value as a going concern (resulting, for

example, from existing lending relationships) that is not transferable to new owners and may therefore follow more­conservative

policies than would be expected on the basis of the moral­hazard

principle. Owners of such banks may also be restrained by managers who seek to preserve their reputations and employment

prospects by pursuing more­conservative policies than are in the interests of owners (Demsetz, Saidenberg, and Strahan [1997],

278-83; Keeley [1990], 1183-200). 

18 One study of savings institution failures in 1985-1991 concluded

that, among thrifts that failed, risky strategies of rapid growth and

nontraditional investment were adopted mainly by thrifts that were

initially eelllcapitalized, rather than by institutions that were already

close to insolvency (Benson and Carhill [1992], 123-31). A study of

Texas commercial banks concluded that for banks with high­risk

profiles (as measured by loan­to­asset ratios), slower growth of capital was not accompanied by more rapid loan growth, contrary to

what the moral­hazard principle would lead one to expect (Gunther

and Robinson [1990], 1-8). 

19 Stiglitz (1987), 966-71. 

20 See, for example, Kane (1995).

4
Deposit Insurance Reform
 

ance enables the agent to pursue policies not in the interest of the principal.21

This view is based heavily on the performance of

savings­and­loan regulators during the early 1980s in

failing to close barely solvent and insolvent savings institutions. This practice partly reflected the depleted

state of the S&L deposit insurance fund (the former

Federal Savings and Loan Insurance Corporation) and

the initial unwillingness of S&L regulators, the S&L

industry, Congress, and the administration in the early

1980s to provide, or support provision of, the funds

necessary to close insolvent thrifts. Also important

were historical conflicts between the objective of promoting housing (the function of S&Ls) and that of

maintaining the institutions' safety and soundness, the

virtual control of the S&L insurance agency by the

S&L chartering agency, and the undue influence the

S&L industry exerted on its regulator.

The bank regulatory agencies did not suffer from

similar deficiencies, and their experience in the 1980s

was better. Most failed banks were resolved within the

time frames later prescribed by FDICIA, although in

some large­bank exceptions resolution was significantly delayed.22 Nevertheless, the fact remains that unless other forces intervene, deposit insurance makes it

possible for regulators to delay the resolution of insolvent banks and thrifts if they so choose, and such delay

runs the risk that, when the institutions are finally resolved, losses to the insurance fund will have been unnecessarily increased.

Efforts to Curb Moral-Hazard and
 

Principal/Agent Problems 

Concern about bank risk taking and what is now

called the moral­hazard problem is by no means new.

A few of the earlier insurance programs incorporated

stringent provisions to restrain risk taking by insured

banks.23 Bank stockholders were subject to double liability until the 1930s. The Banking Act of 1933, while

phasing out double liability for national banks, introduced other restraints on bank risk taking. As noted

above, the initial permanent plan for federal deposit insurance (adopted in 1933) set the insurance limit at less

than 100 percent for deposits over $10,000. In addition, the 1933 Act authorized insured­deposit payoffs

as the sole method of resolving bank failures. Finally,

both the initial permanent plan and the temporary plan

that replaced it provided for "insured depositor preference" in the settlement of receivership claims: the

FDIC was to be made whole for its obligation to holders of insured deposits before any receivership dividends were available to holders of uninsured

deposits.24 These initial FDIC provisions have special

significance for current discussions of various deposit

insurance issues, including the "too­big­to­fail" problem. Had these provisions been retained beyond 1935

and had they been uniformly applied without government intervention to protect creditors of large institutions, uninsured depositors of failed banks would have

been subject to virtually automatic losses, and federal

deposit insurance and bank regulation might have developed quite differently from the way they have in the

United States. In fact, however, these provisions were

abandoned in the Banking Act of 1935.25

FDICIA is the latest attempt to deal comprehensively with the moral­hazard and principal/agent problems.26 The rules adopted in FDICIA were aimed at

preventing a recurrence of certain regulatory policies

21 Principal/agent issues may also exist within a bank-between owners and managers-and may affect the bank's risk behavior. As

mentioned above, managers of insolvent banks may seek to preserve their reputations and future employment prospects by following less­risky policies than would be preferred by owners who have

nothing left to lose. On the other hand, managers of solvent institutions may favor more­risky policies than owners if their compensation is tied to the growth of the institution rather than to

profitability. See Demsetz, Saidenberg, and Strahan (1997); and

Gorton and Rosen (1995).

22 See FDIC (1997), 1:51-56 and 452-62. 

23 For example, in the pre-Civil War Indiana program (generally regarded as the most successful bank insurance program of that era),

each bank was liable to an unlimited extent for any losses suffered

by insured creditors of any other bank in the system. In addition to

unlimited mutual liability for banks, stockholders of failed banks

were subject to "double liability," and officers and directors of failed

banks were deemed by statute to be guilty of fraud and had the burden of proving their innocence; if unable to prove their innocence,

managers were subject to unlimited personal liability. Insured

banks were technically branches of a state bank that exercised considerable supervisory authority over the individual "branches," including authority generally associated with central banking

organizations (Golembe and Warburton [1958], IV­1 to IV­30). 

24 FDIC (1934), 117-21; Marino and Bennett (1999).

25 The Banking Act of 1935 authorized mergers as a method of resolving distressed banks, thereby making it possible to protect all

depositors and general creditors in the event of failure. Specifically,

the Act authorized the FDIC to facilitate the consolidation of a

weak bank with a stronger one and the purchase of the weak bank's

assets and the assumption of its liabilities, by making loans secured

by the bank's assets, by purchasing its assets, or by guarantying the

acquiring bank against loss. The Act also put uninsured depositors

and general creditors on a par with the FDIC for purposes of receivership claims.

26 The rules adopted in FDICIA require the following: the maintenance of the FDIC insurance funds at a specified target level; annual on­site examinations except for small, highly rated banks and

thrifts; risk­based insurance premiums; increasingly severe regulatory restrictions on risk taking by a bank as its capital position declines; closure of institutions whose capital positions fall below a

specified minimum; restrictions on Federal Reserve advances to

undercapitalized banks; and least­cost resolution of failed banks

and thrifts except if this were to pose systemic risk as determined

by the FDIC, the Federal Reserve Board, the Secretary of the

Treasury, and the U.S. president.

5
FDIC Banking Review

and actions of the 1980s that had come to be regarded tionary authority in using these tools. Although the

with extreme disfavor. These included the failure to FDICIA rules have not been tested by adverse finanrecapitalize the Federal Savings and Loan Insurance cial­market conditions, proposals for further reforms

Corporation (FSLIC) promptly, cutbacks in bank ex­ generally assume that they are inadequate to restrain

amination forces, capital forbearance and delays in re­ moral hazard or that they still leave too much discretion

solving troubled institutions, and protection of in the hands of regulators. In general, most of these

uninsured depositors in failed­bank transactions. proposals would subject banks and/or bank regulators

Major provisions of FDICIA sought to strengthen the to greater market discipline by shifting to the private

tools available to regulators in curbing risky behavior sector responsibilities, costs, and risks now borne by

while at the same time restricting regulators' discre­ the regulatory and deposit insurance agencies. 

PART 2. SPECIFIC DEPOSIT INSURANCE REFORM PROPOSALS

Reform proposals have been designed primarily to depositors to greater risk, but also to many other reform

(1) increase depositors' risk exposure; (2) impose in­ proposals that seek to increase market discipline and

creased costs on bank owners in line with their banks' private­sector monitoring of bank risk. risk characteristics; (3) use market mechanisms to ensure that prompt action is taken with respect to trou­ Reduced Insurance Limits bled banks; or (4) restrict the range of banking Reducing the maximum amount of insurance avail­ activities financed by insured deposits.27

able to an individual depositor has been suggested as a

means not only of giving more depositors incentives to Proposals to Increase Depositors' monitor the risk behavior of banks but also of reducing Risk EEposure failure­resolution costs while still providing protection

Proposals for exposing depositors to greater risk seek for truly "small" savers.28 Most countries with explicit

to induce depositors to increase their monitoring of deposit insurance programs have insurance limits repbank risk and, by means of their deposit and with­ resenting only a fraction of $100,000.29 In the United

drawal activity, discipline and restrain risky banks. States reductions in insurance limits were considered

However, increasing depositors' risk could defeat the in the early 1990s, but no action was taken. As price

very purpose of deposit insurance. Therefore, propo­ levels have risen, however, the real value of the

nents of such action generally seek to limit its applica­ $100,000 limit adopted in 1980 has declined to approxtion to some particular group of depositors, chiefly imately $60,000 in constant dollars.

those who are deemed to have the knowledge and re­ As indicated above, three main considerations are sources to assess the riskiness of different banks. The important in assessing proposals to increase depositors' main proposals to increase depositors' risk are reduction of deposit insurance limits, coinsurance for insured

depositors, mandatory losses for uninsured depositors, 27 Deposit insurance issues and reform proposals are discussed in de­ insured­depositor preference in receivership claims, tail in U.S. Department of the Treasury (1991). 

abolition of "too big to fail," and restriction of insur­ 28 Effective insurance limits might be directly reduced by lowering

ance coverage to particular classes of depositors. the present $100,000 ceiling, by aggregating (for purposes of the

$100,000 ceiling) the accounts held by a single depositor in more In assessing such proposals, one should bear in mind than one bank, or by restricting the total amounts that could be inthe following considerations: (1) the relative cost of ac­ sured by a depositor under various rights and capacities. (And in

any case, because insurance ceilings are typically allowed to remain quiring the information and analytical skills needed to constant for periods of years, their real value declines during inter­ monitor bank risk as compared with the cost and/or in­ vals between adjustments.) With respect to aggregating deposits

convenience of shifting funds to alternative invest­ held in different institutions, the FDIC conducted a study, as required by FDICIA, of the cost and feasibility of tracking the in­ ments entailing little risk; (2) the ability of depositors sured and uninsured deposits of any individual and of the exposure

(and other market participants) to monitor bank risk ef­ of the federal government to all insured depository institutions

(FDIC [1993a]). fectively on the basis of publicly available data, given

29 Of 68 countries identified by the International Monetary Fund as the "opaque" quality of bank loan portfolios; and (3) having explicit deposit insurance systems, most had insurance lim­ the threat to the stability of the banking system result­ its below $100,000, based on June 1998 exchange rates (Garcia

ing when potentially ill­informed depositors have [1999]). This information refers to ongoing, explicit insurance programs. Some countries have implicit guarantees or have introduced greater risk exposure. The first two considerations are guarantees as emergency measures to meet current banking crises, central not only to the appraisal of proposals to expose with no limits on the amounts protected. 

6
Deposit Insurance Reform
 

risk-the relative cost of risk monitoring, the opaque

quality of many bank loans, and threats to financialmarket stability from potentially ill­informed depositors. With regard to the first consideration, tracking

and analyzing bank risk-whether done by ordinary

depositors, "professional" financial­market participants

(for example, rating agencies, uninsured depositors and

creditors, security analysts), or government supervisory

authorities-requires the expenditure of substantial resources. Among the available alternatives, relying on

individual depositors to carry out the monitoring function would probably be more costly than would centralizing such activity in either public or private

facilities. With regard to the second, most individual

depositors are probably less able than government supervisors or professional private­sector analysts to penetrate the opaqueness of bank portfolios and would

therefore be less able to distinguish accurately between weak and healthy banks.30 With regard to the

third, individual depositors' assessments of bank risk

would therefore be more likely to lead to contagious

runs than would more­informed judgments. This

evaluation of what is involved in increasing depositors'

risk is part of the rationale for government deposit insurance and bank supervision, as well as for proposals

for increased monitoring by professional investors and

analysts. Exposing ordinary depositors to greater risk

might lead to demands that insured banks and thrift institutions disclose more meaningful and detailed information, but professional market participants would

undoubtedly make better use of such information in

monitoring bank risk.

Given the potential costs of tracking and analyzing

bank risk, a reduction in deposit insurance limits

probably would lead most affected depositors not to

increase their risk­monitoring activity but to adjust

their deposit balances in line with the new limits.

The prospect of this outcome is heightened by the

widespread availability in the United States of relatively risk­free alternatives for individuals' funds.

Thus, existing accounts could be divided among two

or more banks, and uninsured balances could be

shifted to money­market funds and to large banks

considered "too big to fail" (TBTF). As for the expense of resolving failed institutions, lower deposit

insurance limits might reduce it temporarily because

uninsured depositors would share more of the costbut any such cost savings would result mainly from

depositor ignorance and inertia and would be largely

eliminated as depositors adjusted their holdings to

the new insurance limits.

Coinsurance for Insured Depositors

As noted above, the initial permanent plan for federal deposit insurance, adopted as part of the Banking

Act of 1933, provided for coinsurance for deposits from

$10,000 to $50,000.31 Although coinsurance has precedents in deposit insurance and has been applied extensively in other insurance markets, it is doubtful

whether it would in fact induce many individual depositors to invest the time and knowledge necessary for

tracking and analyzing bank risk effectively. Here

again, the behavior of depositors is likely to be influenced heavily by the cost of tracking and analyzing

bank risk and the availability of alternatives for holding

liquid funds. If coinsurance applied only to relatively

large balances, depositors presumably would reduce

balances below the maximum level at which 100 percent coverage applied (for example, $10,000 in the case

of the 1933 Banking Act provision). If coinsurance applied to all insured deposit balances however small, deposits would become less attractive relative to other

financial instruments; as a result, individuals would

presumably shift some savings away from deposits

rather than increase their monitoring of bank risk. At

the same time, however, a system of coinsurance for all

insured deposits would cause some reduction in resolution costs because depositors would not be able to

avoid the risk of losses from bank failures as long as

they continued to hold bank deposits. 

Mandatory Loss for Uninsured Depositors 

A related proposal would restrict the automatic loss

imposed at the time of failure to uninsured deposits

and similar nondeposit credits. One variation of this

idea would require a mandatory "haircut" of up to a

stated percentage (x percent) of uninsured deposits

30 Kane (1987) states that before and during the 1985 state insurance

crisis in Ohio, a group of uninsured thrifts were able to attract deposits in competition with state­insured institutions; he attributes

this to the uninsured institutions' conservative lending policies and

the quality of information these institutions passed on to customers

about their policies. Better information would surely facilitate bank

risk monitoring by individual depositors, but as noted above, would

probably be used more effectively by professional market participants. Calomiris and Mason (1997) and Saunders and Wilson (1996)

concluded that during bank runs in the early 1930s, depositors were

able to distinguish between solvent and insolvent banks. Neither

study differentiated between "small" depositors-those who would

be affected by a reduction in the insurance limit-and larger, more

sophisticated depositors. Nor is it clear how applicable these conclusions may be today, given the more complex operations of present­day banks.

31 Of the 68 countries identified by the IMF as having explicit insurance programs, 16 have put coinsurance features into their plans

(Garcia [1999]).

7
FDIC Banking Review
 

and similar credits at failed banks. The maximum loss

rate to be suffered in the event of failure would be

known in advance. Uninsured depositors would bear

in full losses below the stated rate (that is, less than the

hypothetical x percent) but would be protected against

losses above that rate.32

This proposal is aimed largely at addressing the

TBTF and moral­hazard issues. Proponents argue that

limiting the loss the uninsured depositor might otherwise bear will reduce the risk of contagious runs and

banking panics and lessen the temptation of regulators

and elected officials to bail out large institutions.

However, it is not obvious that capping losses of uninsured depositors would significantly diminish the

threat of contagion and instability unless the cap were

set low-at which point, uninsured depositors might

have little incentive to monitor risk. Prescribing a loss

rate that would materially reduce the risks of contagion

while preserving strong risk­monitoring incentives

would indeed be difficult. Gradual implementation of

the proposal would be helpful, but ultimately the selection of an appropriate loss rate would be a matter of

guesswork with uncertain consequences. At some

point, increased market discipline might spill over into

disruptive bank runs, and that point is hard to locate in

advance.

The mandatory loss proposal may be attractive on

grounds of equity. If all uninsured depositors faced the

prospect of loss when a bank failed, incentives to move

funds to the very largest banks would decrease, as

would complaints that small banks were treated unfairly. However, imposing losses on all uninsured depositors would require regulators and elected officials to be

willing to allow large banks to fail in some future crisis

and to apply the promised haircut to their uninsured

depositors. In short, regulators and elected officials

would have to be willing to treat troubled large banks

the same as troubled small banks. As suggested below,

however, regulators and elected officials may wish to

retain the option of treating large banks differently.

With respect to moral hazard, it is uncertain what effect the mandatory loss proposal might have on privatemarket risk monitoring. Uninsured depositors would

face the certainty of a loss in the event a bank failed,

but the magnitude of the loss would be capped. Under

the present system, uninsured depositors face losses of

uncertain magnitude (either greater or less than the hypothetical x percent loss) if a bank fails unless they

happen to choose a TBTF bank, in which case they

will suffer no loss. As long as it is uncertain which

banks may be deemed TBTF and under what circumstances, uninsured depositors are at risk in the event of

a bank failure. Indeed, the range of potential losses is

wider under the present regime, from zero to something in excess of x percent, than under the mandatory

loss proposal. It is unclear whether the prospect of

mandatory but capped losses would produce moreeffective market discipline than the present system of

potentially unlimited losses that may or may not be imposed in particular cases.

As suggested above, the end result of a mandatory

loss regime would also depend on the magnitude of

monitoring costs relative to the cost and/or inconvenience of shifting funds to collateralized obligations or

other alternatives to uninsured deposits. The large depositors and nondeposit creditors who supply unprotected short­term credit to large banking organizations

presumably have the resources and analytical ability to

distinguish among banks according to risk. However,

they may not conclude that expending additional resources for this purpose is useful, on a cost­benefit basis. Responses may differ among individual depositors

and nondeposit creditors, depending partly on their existing cost structures.33 Nevertheless, instead of moreactive risk monitoring and greater attempts to

discriminate among banks according to risk, some or

many may elect to keep their deposits to a minimum

and shift funds to collateralized obligations.34 Or, by

keeping their deposits and loans at all or most banks in

short maturities, they may simply rely on their ability to

move funds quickly once a bank's troubles become

32 Stern (1999). An alternative method of introducing coinsurance

would be to impose on uninsured depositors only a specified fraction (known in advance) of the loss they would otherwise suffer in

the absence of any protection. Under this alternative, uninsured

depositors would suffer a loss in the event of a bank failure but

would always recover more of their funds than they would if the

bank's assets were simply liquidated. Both alternatives are proposed in Feldman and Rolnick (1998).

33 Some depositors and nonbank creditors may already have made

substantial investments in monitoring capabilities, while others

would face significant start­up costs. Accordingly, incremental costs

for expanded monitoring activities might be considerably different

in the two cases.

34 One may argue that decisions by uninsured depositors and nondeposit creditors to keep maturities short or to reduce risk by shifting

to secured lending are themselves instruments of market discipline.

They are if these decisions are made selectively depending on the

basis of the depositor/creditor's assessment of the risk posed by individual institutions and if they are made on a timely basis before a

bank's troubles have become a matter of public knowledge and supervisory intervention has been initiated. A shift to secured lending after a bank's problems are widely known is merely a form of

run. 

8
Deposit Insurance Reform
 

obvious and a matter of public

knowledge.35 In that event,

the uninsured depositors left

behind to suffer losses when a

bank fails are likely to be

those who are not informed or

alert enough to make the necessary moves to protect themselves. 

Insured-Depositor

Preference in

Receivership

Claims

Legislation passed in 1993

requires that depositor claims

(including both those of uninsured depositors and those of

the FDIC standing in place of

insured depositors) be satisfied in full before unsecured,

nondeposit creditors receive

any of the proceeds of failedbank asset liquidations. National depositor preference

was adopted in 1993 budget

legislation apparently in the

belief that it could lead to substantial FDIC cost savings,

particularly at large banks that

are heavily funded by unsecured, nondeposit liabilities.

It was also believed that national depositor preference

would create incentives for

nondeposit creditors to monitor depository institutions

more carefully.

36 

Under insuredldepositor

preference (which, as noted

above, was provided in the

Banking Act of 1933), uninsured depositors and unsecured, nondeposit creditors

would not receive any funds

until the FDIC had been

made whole for meeting its

obligation to insured depositors. The effect of insureddepositor preference on losses

of uninsured depositors is suggested by table 1. Insured­depositor preference would tend to reduce FDIC costs

and increase the losses of uninsured depositors when banks fail, as compared with

the present system of depositor preference. As a result, uninsured depositors

would have increased incentives to protect themselves-whether by increasing

their risk­monitoring activities or by moving funds out of deposits and into collateralized and other relatively low­risk obligations.37 Again, the potential effect on

market discipline is unclear.

Abolition of "Too Big to Fail" 

At the heart of the misnamed "too­big­to­fail" controversy is the question of

whether losses should be imposed on uninsured depositors and nondeposit creditors of large failed banks. During the 1980s bank regulators feared the possibility

that imposing such losses might trigger runs on other large banks that were heavily dependent on uninsured funding. Accordingly, large troubled banks were resolved in ways that protected all depositors and other creditors. 

Aside from contagion effects on other banks, the failure of a large bank may

have serious domestic and international economic consequences if credit flows are

reduced to borrowers who lack cost­effective funding alternatives. The failure of

a large bank may also disrupt the payments system, cause losses to correspondent

35 Marino and Bennett (1999) discuss the behavior of uninsured depositors and creditors of a number of

large banks before the banks failed in the 1980s, and potential changes in pre­failure behavior resulting from the adoption of FDICIA in 1991 and national depositor preference in 1993.

36 Marino and Bennett (1999).

37 Losses of unsecured, nondeposit creditors under an insured­depositor preference regime would depend on how they were treated relative to uninsured depositors. If the two groups were treated alike,

unsecured, nondeposit creditors could suffer lower losses in some cases than they do under the present

system of depositor preference; this is illustrated in table 1.

Table 1
 

Loss Rates on Claims
 

No Depositor Insured-Depositor

Assets Claims Preferenee Preferenee Prefereneea

Total Loss = 10% of Total Claims, FDIC Share of Total Claims = 70%
 

FDIC 70% 10% 0% 0%

Uninsured Deposits 20 10 0 33

General Creditors 10 10 100 33

90% Total 100% 10% 10% 10%

Total Loss = 10% of Total Claims, FDIC Share of Total Claims = 50%

FDIC 50 10 0 0

Uninsured Deposits 30 10 0 20

General Creditors 20 10 50 20

90% Total 100% 10% 10% 10%

Total Loss = 20% of Total Claims, FDIC Share of Total Claims = 70%

FDIC 70 20 11 0

Uninsured Deposits 20 20 100 67

General Creditors 10 20 100 67

80% Total 100% 20% 20% 20%

a Assumes that uninsured depositors and unsecured, nondeposit creditors are treated alike.

9
FDIC Banking Review
 

banks, and generate counter­party credit losses in derivatives markets.

FDICIA took two steps to reduce the likelihood

that uninsured depositors would be protected in bank

failures: it strengthened the least­cost test, and it prohibited protection of uninsured depositors if such protection would increase the cost to the FDIC, subject

to a systemic­risk exception.38

Some scholars have argued, on the basis of preFDIC experience in the United States or of experience

in countries without deposit insurance, that the likelihood of a contagious run bringing down healthy banks

is small.39 Even so, "abolishing" TBTF in any meaningful sense may be impossible. The likelihood that a

systemic crisis will be caused by a least­cost resolution

of a large bank may be small, but if such a crisis were to

occur, the consequences might be great. This is especially true in light of recent mergers among some of the

largest banks in the country, with the possibility of additional such mergers. Consolidation into fewer, larger

banks may reduce the risk of individual bank failures

because of greater geographic and product diversification-assuming that the larger size of the resultant institutions does not encourage them to assume

additional risk.40 However, the failure of only one of

several currently existing megabanks could deplete or

seriously weaken the deposit insurance fund, with potentially adverse consequences for the stability of financial markets. Accordingly, regulators, administration officials, and Congress may want to retain the

option of treating troubled large banks differently from

troubled small banks. Moreover, given the past treatment of troubled large banks, one may question

whether a ban adopted in good times would be a credible restriction on the behavior of regulators and elected officials in some future crisis. 

Although outright abolition may be difficult or impossible, some degree of uncertainty as to which banks

may be treated as TBTF, and under what circumstances, is needed to encourage creditors of large institutions to apply market discipline. Under almost any

reasonable resolution scenario, stockholders face the

prospect of losses-but if uninsured depositors in a

bank believe the bank TBTF and expect to be protected, they will have little incentive to monitor its risk. 

Restriction of Coverage to Particular
 

Types of Depositors
 

Insurance coverage could be confined to individual

savers or some other narrowly defined group of depositors, excluding from protection the accounts owned by

depositors who may be presumed capable of assessing

the risk characteristics of banks. Two­thirds of the

countries that have explicit deposit insurance programs

exclude interbank deposits from protection, and a few

countries limit deposit insurance to households and

nonprofit organizations.41 In countries that recently

adopted explicit deposit insurance de novo and therefore were not breaching longstanding protections, limited coverage may be feasible. The United States, in

contrast, has a long history of insuring deposits of all

types of account holders, and efforts to scale back such

coverage would probably meet strong political resistance.

Proposals to Impose Increased Costs on

Bank Owners Commensurate with 

Their Banks' Risk Characteristics

Given the problems associated with increasing depositors' risk, numerous proponents of reform seek to

create substantially stronger incentives for bank owners to restrict risk taking by their institutions. The rationale for such proposals is that bank stockholders

have the knowledge to assess risk­return relationships

accurately and, if provided appropriate incentives, have

the power to require prudent policies on the part of officers and directors. The main proposals have been to

increase losses of owners of failed banks beyond the

value of their investments (contingent liability), require substantially increased capital, and increase funding costs associated with risky lending activities.

38 Any decision to invoke the systemic­risk exception under FDICIA

is to be made by the Secretary of the Treasury, upon the recommendation of two­thirds of the Board of Directors of the FDIC and

of the Federal Reserve Board, after consultation with the U.S. president. Any additional cost to the FDIC is to be financed by a special assessment on the banks or thrifts in the same insurance fund.

Unlike the case of regular assessments, the base for this special assessment would include foreign deposits, with the result that the

burden would fall more heavily on large banks, which have a disproportionate share of such deposits. With respect to least­cost resolutions, before FDICIA various types of resolution transactions

were permissible if they were less costly than an insured depositor

payoff or if the bank's services were determined to be "essential" to

the community. 

39 Kaufman (1994); Calomiris and Gorton (1991).

40 The effect of consolidation on bank risk is discussed in Berger,

Demsetz, and Strahan (1999).

41 Of the 68 explicit deposit insurance programs identified by the

IMF, 45 excluded interbank deposits (Garcia [1999]).

10
Deposit Insurance Reform
 

Contingent Liability for Bank Stockholders 

The most direct means of increasing bank stockholders' aversion to risk is to impose additional losses

on them, beyond the amount of their investment, if recoveries on receivership assets cannot meet the claims

of creditors of failed banks. As noted above, "double

liability" of stockholders applied to national banks

from 1863 to 1933.42 Under double liability, owners of

a failed bank could lose both the value of their stock

and the cost of an additional assessment up to the par

value of their shares. A more recent proposal is to require a "settling up" process that would impose additional charges on stockholders and managers of failed

banks after the banks were resolved. However, despite

the long history of double liability in the United States,

proposals to restore some form of increased or contingent stockholder liability in bank failures have attracted little attention outside of academic circles. Any

serious effort in this regard would have to address the

prospect that the flow of equity funds to the banking

industry would be curtailed, with potentially adverse

effects on new bank entry, competition, and availability of credit to bank borrowers.

Increased Capital Requirements 

As noted above, higher capital requirements are perhaps the strongest restraint on moral hazard because

they force stockholders to put more of their own money at risk (or suffer earnings dilution from sales of

shares to new stockholders) and provide a larger deductible for the insurer. Higher capital requirements

also tend to reduce returns on equity because banks

must substitute equity for lower­cost deposits, and this

substitution increases their average cost of funds.

Reduced leverage may slow the growth of the banking

sector and bank credit, discourage entry of new banks,

and reduce competition.43 Pushed too far, therefore,

higher capital requirements could have adverse effects

on banking and the nonfinancial economy. Moreover,

some theoretical analyses suggest that higher capital

requirements may actually lead to increased risk taking

under certain conditions, as banks with reduced leverage seek to offset the reduction in expected returns by

increasing their higher­risk, higher­return lending.44

Risk-Based Capital Requirements

Risk­based capital standards were designed partly to

overcome any incentives on the part of banks to offset

the effects of flat­rate capital requirements by assuming greater risk. The risk­based standards presently in

effect in the United States were adopted in the early

1990s in conformity with the "Basel Accord" of 1988.

They prescribe different minimum capital ratios for

four asset categories, or "buckets," and for off­balancesheet activities. But almost from their inception these

standards have been criticized on the grounds that they

consider only credit risk; take no account of diversification or hedging; set inappropriate capital requirements

for the various risk buckets; and prescribe the same

minimum capital levels, within a particular asset bucket, for loans having very different risk characteristics.

As a result of these shortcomings, opportunities exist

for "regulatory capital arbitrage," whereby capital requirements may be reduced while underlying risk is

not materially changed.

The growing complexity of bank operations and the

rapid changes taking place in financial technology, both

of which particularly affect large institutions, have focused attention on banks' internal risk­management

systems as a means of helping regulators set risk­based

capital requirements for individual institutions.45

Minimum standards have been established for calculating "value­at­risk," a calculation based on the behavior of underlying risk factors such as interest rates or

foreign­exchange rates during a recent period. Valueat­risk represents an estimate, with a specified degree

of statistical confidence, of the maximum amount that

a bank may lose on a particular portfolio because of

general market movements.

So far, this approach has been confined mainly to

large banks' trading activities. The application of these

techniques to risk­based capital requirements for credit risk comes up against significant problems of data

availability, including the fact that serious credit problems have developed infrequently over a long time period, the absence at many banks of consistent internal

credit­rating systems covering such periods, and the

42 Esty (1997); Kane and Wilson (1997). 

43 A more precise formulation of the potential effect of capital requirements can be found in Berger, Herring, and Szego (1995).

Under conditions spelled out in that article, increasing equity beyond market requirements reduces the value of the bank and raises

its weighted average cost of financing, so that in the long run the

size of the banking industry and the quantity of intermediation may

be reduced.

44 Calem and Rob (1996); Gennotte and Pyle (1991). A contrary view

is presented in Furlong and Keeley (1989).

45 Federal Reserve Bank of New York (1998); Jones and Mingo (1998);

Nuxoll (1999).

11
FDIC Banking Review
 

questionable accuracy of bond­market data as proxy

measures of loan quality. Efforts to solve these problems are under way, but at present internal models apparently do not provide a reliable basis for setting

regulatory capital requirements for credit risk.

Risk-Based Insurance Premiums 

Risk­based premiums are designed to raise the explicit cost of funding risky activity. In an ideal world,

premiums would be assessed on the basis of risky behavior, not on unfavorable outcomes such as loan losses and reductions in capital. However, under the

present system as adopted in the early 1990s, assessments vary with capital ratios and supervisory ratingsthat is, premiums are increased after the bank

experiences losses, reductions in capital, or other discernible reductions in quality. Initially the best­capitalized, highest­rated banks paid an assessment of 23

basis points on assessable deposits, and the worst­capitalized, lowest­rated banks paid 31 basis points.46

Currently the assessment rate ranges from 0 to 27 basis

points, with more than 90 percent of all insured banks

and thrifts paying no premiums. Many observers

doubt that existing differences in premiums accurately

reflect differences in bank risk or provide a sufficient

incentive to reduce moral hazard significantly.47

Banks with little capital and poor supervisory ratings

are, of course, more likely to fail than stronger banks

and thus pose a greater danger to the insurance fund.

However, bank regulators have not attempted to extract sharply higher insurance premiums from these

banks, partly because doing so might hasten their descent into insolvency. Rather, regulators have pressured or encouraged problem banks to strengthen their

capital positions by reducing asset growth, cutting back

dividends, and increasing their infusions of external

capital. In this regard, it should be noted that even in

the 1980s three­fourths of all problem banks (banks

with CAMELS ratings of 4 or 5) survived as independent institutions or were merged with healthier banks

without FDIC financial assistance.48 These rehabilitation efforts might have been impeded if problem banks

had been assessed deposit insurance premiums commensurate with the risk the banks posed to the insurance fund.49

The chief problem is that some types of risky bank

behavior are hard to assess in advance of losses, when

banks are still profitable and able to absorb sharply increased premiums and when there is still an opportunity to modify risky behavior. For example, few

observers recognized the magnitude of the risks present in farm, energy, and commercial real­estate lending before losses were incurred as a result of regional

and sectoral recessions during the bank and thrift crises

of the 1980s. Ideally, risky behavior should be accurately identified and distinguished from new, innovative, and other unfamiliar but acceptable activity.

Moreover, the probability of adverse outcomes and the

potential magnitude of the resultant loss should be estimated in order to gauge the seriousness of the risk.

Because this is difficult to do in advance of actual losses, deposit insurers are loath to charge the sharply higher premiums that might be appropriate in particular

cases.50

Proposals have been made to get around this difficulty by basing premiums on market indicators, such as

prices that private reinsurance companies require to

compensate them for bearing a portion of the risk of

failure of individual institutions, or prices of subordinated or other debt issued by banks.51 However, it is

not obvious that private market participants would be

more successful than supervisory authorities in accurately assessing and weighing risky behavior in advance

of losses. More realistically, such market signals could

serve, along with other information, as input in the assessment process.

46 This narrow 8 basis point spread reflected another FDICIA requirement (that assessments were to be maintained at an average

annual rate of 23 basis points until the Bank Insurance Fund was

fully recapitalized) as well as a reluctance on the part of the FDIC

to impose additional burdens on weaker banks-burdens that

would interfere with their efforts to restore their capital positions. 

47 Options­pricing models generally yield wider estimates of fair insurance premiums among individual banks. In general, fair premiums have been estimated to be very low for a majority of banks, but

much higher for a minority (Ronn and Verma [1986]; Kuester and

O'Brien [1990]). See also Pennacchi (1987). 

48 FDIC (1997), I:62 and 443-48. 

49 A 1995 simulation of the effect of a 20 basis point assessment differential between BIF­insured banks and SAIF­insured thrift institutions found that the number of thrift failures and failed­thrift

assets would increase by as much as one­third, depending on the assumptions in a particular economic scenario (FDIC [1995], 20). 

50 One reason some types of bank risk are hard to assess in advance of

losses is the influence of overall economic conditions. For example,

lending practices that lead to losses in a serious recession may pose

no problem if the economy stays strong. In addition, losses on loans

of different types are often correlated. Furthermore, many banks

remain specialized in particular regions or economic sectors, and

this concentration of risks may aggravate (or alleviate) the effects of

changing economic conditions on loan losses, depending on regional and sectoral differences in the pace of economic activity.

Therefore, the probability and potential magnitude of loss from a

particular lending practice depend heavily on factors outside the

practice itself. The relationship between risk factors and actual

losses is less stable and predictable in bank lending than, say, in life

insurance.

51 Stern (1999). 

12
Deposit Insurance Reform
 

Proposals to Use Market Mechanisms to

Ensure Prompt Action with Respect to

Troubled Banks

In view of the potential principal/agent problems inherent in deposit insurance, a number of reforms have

been proposed to reduce reliance on government supervisors to assess and restrict bank risk and to resolve

failing institutions promptly. These include the substitution of market value accounting for historical cost

accounting, outright privatization of deposit insurance,

and the privatization (in varying degree, depending on

the proposal) of the risk­monitoring function. The latter includes proposals to require the FDIC to purchase

reinsurance from private sources or to issue its own capital notes, and proposals to require large banks to issue

subordinated debt or purchase private insurance for a

portion of their deposits.

A basic purpose of these proposals is to obtain assessments of the condition and risk exposure of banks

from private financial­market participants. The underlying assumptions are that private market participants

are better able, and more willing, than government regulators to recognize developing problems and to act

promptly to minimize losses. This is believed to be so

because the compensation of these private­sector parties is based on their success or failure in assessing

bank risk and in forcing timely supervisory action to cut

the losses developing in troubled institutions. As it

now stands (so the argument goes), private market participants have limited incentives to undertake this

monitoring role; reduced reliance on government surveillance would encourage increased private­sector

monitoring. Also, private market participants might

demand fuller disclosure of bank information to support their risk assessments. As noted above, however,

for market discipline by debt­holders to be effective,

there must be some degree of uncertainty as to

whether and to what institutions the TBTF doctrine

might be applied.

Market Value Accounting 

The purpose of substituting market value accounting (MVA) for historical cost accounting would be to

depict more accurately the condition and riskiness of

banks and to force both regulators and bankers to act

more promptly to cure problems. Although MVA has

considerable support among academic writers, several

major issues remain unresolved. 

First, it is unlikely that the market can accurately access the kind of information on individual loan quality,

internal controls, and other internal risk­related matters

that supervisory authorities gather in on­site examinations. If comprehensive MVA were adopted, therefore,

supervisory assessments would still be necessary to

provide information on risk factors not apparent from

reported asset and liability values as well as to ensure

the accuracy and consistency of the information that insured institutions released to the public. 

Second, some types of bank assets and liabilities

have no active secondary markets. Proponents of MVA

deal with this fact by holding that prices of bonds, securitized loans, or other traded instruments could be

used as proxies, or that nontraded assets and liabilities

could be priced by discounted cash­flow techniques.

They also point out that values of nontraded balancesheet items are routinely determined through competitive bidding or by agreement of the parties engaged in

mergers, whole­loan sales, or failed­bank transactions. 

The accuracy of the values that would be produced

by these proposed approximations cannot be known.

If one holds that banks specialize in lending to borrowers who lack practical access to capital markets and that

such loans are fundamentally nonmarketable, assets

that are securitized or traded whole do not necessarily

represent banks' nontraded assets. Furthermore,

whereas in merger and other transactions values of

nontraded assets and liabilities are determined by bidding or by agreement, in more adversarial situations

(such as supervisory actions that result in penalties or

burdens on the bank) similar procedures may not be

feasible. If proxies for market values are to serve as an

effective trigger for supervisory intervention, they

must be widely accepted as accurate and must be capable of being readily defended by the regulators; this

may not always be feasible, given the opaque nature of

many bank loans. However, many writers would argue

that proxy measures of market values could still play

the less­ambitious role of indicating the true condition

of banks better than historical cost does. 

To avoid the problem of valuing nontraded balancesheet and off­balance­sheet items, some observers

have suggested that MVA be applied only to items for

which active secondary markets exist. However, critics

of this view have argued that a partial approach might

lead to greater volatility and inaccuracy of reported net

worth than either historical cost or comprehensive

MVA.52 This, in turn, could discourage prudent riskmanagement activities. An example is when banks use

52 U.S. Department of the Treasury (1991), XI­31 to XI­32. Carey

(1995) concluded that any net benefits of market valuation of securities only (or of a portion of securities as required by the Financial

Accounting Standards Board in 1993) would be small. Federal

Reserve Board Chairman Alan Greenspan criticized both a "piecemeal" approach to fair value accounting and a "sudden" adoption of

comprehensive market value accounting, stating that either one of

them could produce unreliable information and cause an inappropriate increase in the volatility of reported income and equity measures (Greenspan [1997]).

13
FDIC Banking Review
 

securities and other marketable instruments to hedge

positions in nonmarketable assets and in liabilities: under partial market valuation, changes in market prices

might result in gains or losses in market­valued items

without recognition of offsetting changes in values of

items carried at historical cost. In fact partial MVA currently prevails, since reported amounts for trading assets, securities­held­for­sale, and certain other items

reflect market prices; it is not clear that the effects have

been significant.53

A third issue is the concern of many observers that

MVA (comprehensive as well as partial) might lead to

wide short­run variation in the stated value of a bank

and that such variation would obscure underlying

trends in the banks' condition. According to this view,

prices of bonds and other proxies might reflect transitory changes in market conditions rather than the value of the nonmarketable loan portfolios they were

being used to represent, and might be more volatile

than was warranted. This objection also reflects the

absence (in the opinion of critics) of specific guidance

and standards for estimating fair market values of some

balance­sheet items. Finally, it reflects a concern that

banks engaging in even moderate interest­rate risk

might experience volatile capital values in periods of

rapid interest­rate changes.

With respect to the last point, the adoption of comprehensive MVA could have substantial economic effects. The acquisition of long­term assets might be

discouraged because they would lose value in periods

when equity and debt prices were declining, whereas

values of shorter­term liabilities would remain relatively stable. Proponents of MVA might retort that the hazards of a "borrow­short, lend­long" balance­sheet

structure are precisely the type of risk that historical

cost accounting has obscured and that marking to market would clearly reveal. As a result, they would argue,

MVA would reduce bank risk by discouraging maturity

mismatches. However, as with other reform proposals,

the reduction in bank risk would come at a price.

Depending on how bank assets and liabilities were adjusted, adoption of comprehensive MVA might be accompanied by increased costs to long­term borrowers

and/or a shift of risk from banks to borrowers or other

segments of the public.

Given these problems, MVA may be feasible only

for wholesale banks that invest heavily in marketable

or securitizable instruments and engage in extensive

trading activity. At present such banks constitute a

small minority of all U.S. banks, although their share of

total bank resources is more substantial. These banks

are already subject to the kind of market discipline envisioned by proponents of market value accounting.

They tend to rely heavily on funding through uninsured deposits and nondeposit credits, and their total

assets are heavily weighted by assets that reprice frequently or are carried at market prices.54 Like other

publicly traded banking organizations, they are also

subject to market discipline on the part of equity investors. Conceivably the number of wholesale banks

may grow as bank powers are broadened and secondary

markets continue to develop, but most banks will probably continue to specialize in nonmarketable loans,

with this specialization remaining an obstacle to the

adoption of comprehensive MVA.

Privatizing Deposit Insurance 

Those who propose privatizing deposit insurance

sometimes argue that eliminating federal deposit insurance would make it politically feasible to eliminate

restrictive federal bank regulations. Over the years numerous private deposit insurance programs have been

organized by various states for mutual savings banks,

savings­and­loan associations, credit unions, and other

depository institutions operating in those states.55 As

of 1982, 30 such programs existed, but since then most

have failed because they could not meet their obligations or have been phased out because adverse public

reactions were feared. Historically, many private, statelevel insurance programs suffered from one or more of

53 Barth et al. (1995) concluded that fair value accounting for investment securities gains and losses increased the volatility of bank

earnings relative to historical cost but that this increase was not reflected in bank share prices. 

54 Trading assets, securities available for sale, and other real estate are

carried for the most part at values that reflect market prices. Assets

that reprice daily or frequently include noninterest­bearing deposits, fed funds sold, and repos. For all insured commercial banks,

the total of all such assets represented 30 percent of total assets at

the end of 1998. The percentages were much higher for a few

banks, such as Bankers Trust Co. (71 percent) and Morgan

Guaranty Trust Company of New York (78 percent). On the other

hand, total loans and leases represented 58 percent of total assets for

all insured commercial banks but only 20 percent for Bankers Trust

and 15 percent for Morgan Guaranty Trust.

55 English (1993) classifies these programs as "private" because they

had no financial backing from state governments, although states

sometimes provided funds when the deposit insurance agency

could not meet its obligations. Even so, in a number of cases the

state allowed "insured" depositors to suffer losses-attesting to the

essentially private nature of the programs. See also FDIC (1983).

Proposals to privatize deposit insurance are discussed in FDIC

(1998), 53-89.

14
Deposit Insurance Reform
 

the following weaknesses: lack of risk diversification

because of geographic limitations or the dominance of

a few large institutions, adverse selection resulting

from the fact that the stronger institutions were able to

withdraw from the program, insufficient funding to

meet systemic losses, inadequate supervision, and conflicts of interest. Some of these weaknesses would be

eliminated if a private fund were organized on a national basis and if membership were mandatory.

The chief questions raised by privatization proposals are these: (1) Why would a private deposit insurance system be superior to federal deposit insurance?

(2) How would a private system deal with catastrophic

losses? (3) How would a private system deal with a potential credibility problem-the belief that in extremis

the federal government would come to the rescue and

bail out the private fund in order to ensure protection

of depositors? 

With respect to the first question, it seems clear that

private insurance organizations would face the same

problems in assessing bank risk and would have to use

the same techniques for this purpose that government

supervisory agencies do. Private insurance organizations might have stronger incentives to assess risk accurately if they stood to profit from correct assessments

and to suffer losses from incorrect assessments. Strong

incentives to restrain risk taking would also exist if the

insurance arrangements were organized on mutual

lines, whereby all insured members were mutually liable for all insurance losses.56 It has also been argued

that private organizations would have greater incentives to act promptly in the case of troubled banks in

order to minimize failure resolution costs, whereas action by regulators may be delayed by bureaucratic procedures. Although the "prompt corrective action"

provisions of FDICIA seek to prevent undue regulatory delay, many proponents of privatizing deposit insurance or of other comprehensive reforms have

apparently concluded that these provisions are inadequate. 

One consideration generally ignored by supporters

of the proposal is that a private deposit insurance organization would presumably pursue different goals from

those a government agency pursues. As noted above,

federal deposit insurance has been provided partly to

promote the stability of banking and financial markets.

Federal regulators must also be mindful of how their

supervisory actions affect the economy-witness the

"credit crunch" of the early 1990s, when regulators

were severely rebuked by elected officials for

"overzealously" applying new capital standards.

Public policy also favors entry of newly chartered institutions into banking markets and vigorous competition

among banks. In keeping with such public­policy objectives, federal deposit insurance is broadly available

to all qualifying banks through long­term contracts

that, once issued, are seldom terminated.

In contrast, a private deposit insurance company

would presumably focus more narrowly on the objective of earning maximum profits from the business of

insuring deposits, and a mutual guaranty organization

might concentrate on minimizing costs to the existing

body of insured members. The private company or

mutual organization might achieve these objectives by

assessing the insurance risks posed by individual banks

and charging commensurate premiums-or instead

might seek to deny coverage to banks that would strain

the insurers' or guarantors' financial capacity or banks

whose risk characteristics were too difficult or expensive to monitor.57 Unlike government insurers, they

56 Calomiris (1990) and others have argued that unlimited mutual liability in mutual deposit insurance systems (like the pre-Civil War

Indiana system) provided strong incentives to member institutions

to monitor each other and to require strict supervision. A similar

conclusion has been drawn from the experience of private clearinghouses. English (1993) attributed the success of these arrangements to the small number of members involved (which facilitated

monitoring and prevented "free­riding" by risky institutions),

strong supervisory powers, high exit costs for insured members, and

the fact that these arrangements included central­bank features.

The chief problem with such private­sector arrangements is that

the necessary assessments to protect depositors at failed institutions

may, under extreme conditions, cause other institutions to fail or

may be effectively resisted by them. This is particularly true if the

initial failures are at large institutions that hold a disproportionate

share of the system's resources.

57 Unlike some other types of insurance, losses on deposit insurance

are not independent of one another; in serious national or regional

economic recessions they tend to be bunched and have the potential to reach "catastrophic" proportions. Private insurers often seek

protection against bunched or catastrophic losses by excluding such

losses from coverage. This option is generally not available to government deposit insurers except in extreme cases, and it might be

inconsistent with important public­policy objectives of government

deposit insurance. For example, municipal bond insurance companies, which arguably are subject to a similar risk of loss bunching because of adverse business conditions, have generally protected

themselves by denying coverage to low­quality bond issues.

According to Sweeney (1998), premiums are based on the assumption of zero loss, and 53 percent of the municipal bond issues floated in 1996 were uninsured. Other examples are the "wartime

exclusion" in life insurance policies and the "hostile action or insurrection exclusions" in fire insurance. In property/casualty insurance, many exposures faced by corporations and households are

retained and never reach insurers, and very little of the reinsurance

in place provides protection against industry­wide losses for catastrophic events greater than $5 billion, at a time when prospective

losses can easily exceed $50 billion (Froot [1999], 2). Froot and

O'Connell (1999) conclude that in the 1990s, a period of unprecedented catastrophic losses, there was evidence that "capital market

imperfections" impeded the flow of capital into the property/casualty reinsurance sector.

15
FDIC Banking Review
 

might choose to offer only short­term contracts that are

easily cancelled, or might take other steps to limit their

exposure. Private insurers who pursued such low­risk

strategies would, of course, have to accept lower expected returns, but from their standpoint this might be

preferable.58

Thus, whether a private deposit insurance system or

the present federal system would be preferable depends partly on one's view of the purpose of deposit insurance. If one construes the purpose narrowly,

holding that deposit insurance should do no more than

provide depositors with some measure of protection at

minimum cost to insurers and taxpayers, then in principle a private system might have merit. However, if

one construes the purpose more broadly and believes

deposit insurance should also promote financial­market stability, new bank entry and competition, and perhaps other broad objectives, then the appropriate

vehicle for providing deposit insurance is a public

agency subject to oversight by elected officials.

Reconciling broad and sometimes conflicting publicpolicy objectives is preeminently a governmental function.

With respect to the second question (how would a

private system deal with catastrophic losses), most observers agree that a federal deposit insurance fund

commands greater resources than a private insurance

facility would. The availability of resources that can be

mobilized in an emergency is critical in protecting

against bunched or catastrophic losses; to many people,

providing such protection is a principal function of deposit insurance. Private insurers might seek to increase

their capacity through reinsurance arrangements and

catastrophe securities, as casualty insurance providers

have tried to do. Even with such arrangements, however, the resources available to private insurers would

probably fall short of the resources available to a government deposit insurer. Although one can design on

paper a private system with sufficient capital for catastrophic losses, experience in existing private insurance

markets suggests that, in practice, the supply of private

capital for such losses is limited. As a result, it might be

hard to maintain public confidence in the ability of a

private fund to protect depositors under extreme conditions. In this regard, one proponent of privatization

would assign a back­up, or reinsurance, role for the

FDIC.59

With respect to the third question (how would a private system deal with a potential credibility problem),

proposals for private deposit insurance assume that

losses from bank failures would in fact be borne by private insurers or guarantors who would not be able to

pass them on to the federal government or other parties. This assumption might be questionable, however, if the public continued to regard the protection of

deposits as ultimately a government responsibility, or if

the remaining insured members would be seriously

weakened by increased assessments, or if the remaining insured members were successful in exerting political pressure for governmental relief. Federal

sponsorship of a private deposit insurance system

might lead to expectations that the federal government

would come to the rescue if the private system could

not protect depositors. Such expectations might be

heightened if the FDIC formally reinsured the private

program. An explicit or implicit federal backstop could

generate moral­hazard problems comparable to those

existing in the present system and therefore defeat the

purpose of privatizing deposit insurance.60

Privatizing the Risk-Monitoring Function 

Less­drastic approaches would be to privatize the

risk­monitoring function of bank supervisory agencies

or (perhaps more realistically) to increase substantially

reliance on market indicators of bank risk as compared

with supervisory assessments. Currently regulators do,

of course, track bond and stock prices, rating agency

downgrades and upgrades, and other market information pertaining to large, publicly traded banking organizations. An extension of current practice would be to

formally incorporate market indicators in the failureprediction and CAMELS­rating­deterioration models

currently used by regulatory agencies in off­site monitoring activities.

58 The government might intervene, as it has in other insurance markets, to require that coverage be extended to banks and risks that

private insurers would prefer to exclude. Depending on how extensive this intervention might be, the perceived advantages of private deposit insurance might be obviated.

59 Ely (1998) and H.R. 4318: The Deposit Insurance Reform,

Regulatory Modernization, and Taxpayer Protection Act of 1996. In

this proposal, bank deposits and certain other debt obligations

would be protected by cross­guarantee contracts negotiated with direct guarantors whose obligations would, in turn, be guaranteed by

other guarantors. Thus the entire guarantee system would, in principle, stand behind every guaranteed deposit. In addition, FDIC

insurance would remain in place, at least initially, as a backstop.

60 One study of property/casualty insurance companies that are implicitly backed by state governments (through quasi­governmental

guaranty funds) observed behavior on the part of the companies

that was consistent with the moral­hazard principle (Bohn and Hall

[1999]).

16
Deposit Insurance Reform
 

Reform proposals, however, would rely more fundamentally on market signals. As noted above, they

would use market indicators to help set deposit insurance premiums, trigger supervisory intervention, or

force market­driven changes in bank risk taking. In

general, they would induce some group of relatively sophisticated investors (in addition to stockholders) to assume a portion of a bank's or the insurer's risk; the

prices or investment returns required by these investors would indicate their risk assessments. In one

alternative, the FDIC would be required to obtain

reinsurance from private firms for a portion of the losses it incurred as a result of the failure of a bank or thrift.

In another, large banks would be required to obtain private insurance for a portion of their deposits. In a third,

insured institutions would be required to issue subordinated debt. Finally, the FDIC would be required to

issue capital notes to the public.

Unquestionably, markets can be helpful in supplementing supervisory risk assessments of large banks.61

In the case of Continental Illinois and the Bank of New

England in the 1980s, for example, adverse market reactions triggered supervisory action that many believe

should have been taken earlier. Furthermore, many institutions appear to be already subject to some degree

of market discipline through equity and debt markets.

Presumably this is true of publicly traded banking organizations, which represent only a fraction of the

number of banks but a predominant share of total bank

assets.62 Moreover, many large banks rely heavily on

uninsured funding. For the 25 largest commercial

banks, insured deposits represented only 30 percent of

total liabilities at the end of 1998. For the top decile in

terms of asset size (874 commercial banks), the corresponding percentage was 52 percent; for the bottom

nine deciles, it ranged from approximately 75 percent

to nearly 90 percent. As noted below, most of the

largest banks have outstanding subordinated notes and

debentures that were issued mainly by parent holding

companies.

Although market discipline is a valuable supplement to supervisory monitoring, the two are not necessarily interchangeable, even in the case of large,

publicly traded banks. Some studies suggest that the

bank examination process uncovers relevant information on the current condition of large banks that is not

reflected in contemporaneous market information.63

Moreover, as noted above, on­site examinations are

needed to ensure the accuracy of the financial data

banks release to the public. For small banks, of course,

because they do not rely heavily on uninsured funding

and generally do not have widely traded stock, there is

often no effective market alternative to supervisory examinations in providing an independent risk assessment.

Private Reinsurance 

In keeping with a provision of FDICIA, the FDIC

explored the feasibility of establishing a private reinsurance system for deposit insurance. According to the

proposal studied, the FDIC would obtain private reinsurance covering up to 10 percent of any loss it might

incur in the event a bank failed. The bank's deposit insurance premium would be based wholly or partly on

the cost of reinsurance and would reflect a market assessment of the risk posed by the bank. In principle

private reinsurance has certain advantages from the

standpoint of market discipline because the reinsurers,

like the FDIC, would not benefit from the upside potential of risky situations. Moreover, unlike mandatory

sub­debt, private reinsurance could arguably be required of banks of all sizes. The study found, however, that potential reinsurers had only limited interest in

engaging in reinsurance contracts on terms acceptable

to the FDIC.64

One reason for the limited interest might have been

conflicts between the goals of federal deposit insurance

and the goals of private reinsurers (the latter are discussed above in connection with proposals for private

deposit insurance). For example, private reinsurers

may prefer to limit their risk (and accept lower prices)

by reinsuring only the soundest banks. If private reinsurers were permitted to "cherry pick" deposit insurance risks, reinsurance prices would not accurately

reflect the risk that many insured institutions pose to

the FDIC. On the other hand, the prices demanded

by private reinsurers would reflect regulatory risk because the magnitude of their losses could be affected

by the FDIC's actions in regulating bank activities, resolving failed institutions, and liquidating their assets.

61 Flannery (1998) reviews the evidence on the relative efficacy of

market signals and government supervision. 

62 Publicly traded banking organizations represented an estimated 20

percent of the total number of banks and approximately 90 percent

of total bank assets at the end of 1998. These estimates are based

on information furnished by the Office of the Comptroller of the

Currency, the Federal Reserve Board, and SNL Securities; they refer to banks, and banks owned by holding companies, whose equity was traded on the New York Stock Exchange, American Stock

Exchange, or NASDAQ as of December 31, 1998.

63 Berger et all (1998); De Young et al (1998); Simons and Cross (1991). 

64 FDIC (1993b). 

17
FDIC Banking Review
 

So for this reason as well, reinsurance prices might not

accurately reflect risks to the FDIC. Nor is it obvious

how the FDIC might use reinsurance prices in setting

deposit insurance assessments and in conducting other

supervisory processes; further exploration would be

needed.

Proposals to require large banks to buy private insurance for a portion of their deposits raise broadly similar issues. Risk aversion on the part of private insurers

might lead them to deny insurance or to charge prohibitive premiums to banks whose activities posed

above­average risk or required expensive monitoring

activities. Although providing insurance for only the

best risks, at relatively low premiums to the banks and

low monitoring expenses to the insurer, might be an effective use of private insurance capital, it would be of

limited value in supervisory processes.

Mandatory Subordinated Debt

Of the various alternatives for private bank monitoring, proposals to require the issuance of subordinated

debt have received the most attention. In 1984

William Isaac, then­Chairman of the FDIC, proposed

that banks be required to have subordinated debentures up to 3 percent of assets, on top of 6 percent in

equity. Since then, the proposal for mandatory subordinated debt has been periodically revived in order to

promote private­sector monitoring of bank risk, to increase bank capital, and to provide greater protection

for the insurance fund. From a regulatory standpoint,

sub­debt has a number of advantages. Unlike shortterm creditors, investors in long­term sub­debt must

rely on their assessment of the institution's condition

and prospects rather than on their ability to shift funds

quickly in the event of trouble.65 Unlike equity investors, moreover, holders of subordinated debt cannot

expect to profit significantly from increases in value

and are likely to view bank risk somewhat as regulators

and deposit insurers view it. From the standpoint of

banks, sub­debt is a relatively cheap form of regulatory

capital, especially given the deductibility of interest for

income tax purposes.

Sub­debt might assist bank risk monitoring in a

number of ways. Movements in prices of outstanding

sub­debt, and in differentials among individual banks,

would presumably reflect changing market perceptions

of the condition of the issuing banks collectively, as

well as the relative risk of individual institutions.

Furthermore, banks might be required not only to have

outstanding sub­debt but also to issue new debt periodically, perhaps in keeping with a staggered­maturity

requirement. In that case, banks would be subject to

periodic evaluation by new­issue investors as well as by

traders. Sub­debt issued by a bank holding company

would serve the purpose if the company's principal asset were a bank. In the case of companies with major

nonbank subsidiaries, banks might be required to issue

the sub­debt directly to the public.

The principal disadvantage of this proposal is that

small banks do not have practical access to the market

for sub­debt: securities issuance involves high fixed

costs, and interest in small­bank issues on the part of

investors and analysts would be limited. Most large

banking organizations, in contrast, have issued subdebt voluntarily, presumably because doing so was

profitable. At the end of 1998, 23 of the 25 largest commercial banks had subordinated notes and debentures

outstanding, ranging up to 3.7 percent of total assets for

individual institutions and averaging 2.0 percent of total assets. For the 9,672 individual banks and thrifts

with less than $500 million in assets, the corresponding

percentage was .01 percent of total assets. In the case

of small institutions, market prices would not necessarily reflect the condition and prospects of the issuer but,

rather, the thinness of the market for small­bank issues.

Under these circumstances, mandatory sub­debt issues

would be an effective monitoring device only for large

banks; these banks, however, do represent a major

share of total bank assets in the country.66

Some proponents of mandatory sub­debt-and of

increased reliance on market discipline generally-recognize that such measures would be feasible mainly for

large, publicly held banking organizations that make

heavy use of unsecured, uninsured financing. They

propose a two­tier regulatory system. Large, publicly

traded banks would be subject to a combination of increased reliance on market discipline and supervisory

monitoring, whereas small, closely held banks that

generally rely on insured deposit funding would be

65 Most proposals for mandatory subordinated debt envision intermediate­term securities. Current regulations require that subordinated debt have an original average maturity of at least five years to

qualify as part of Tier 2 capital. However, one proposal would require large banks to issue puttable subordinated debt. The put feature would require redemption at par after 90 days. If the

institution could not redeem the put debt in 90 days while continuing to meet regulatory capital standards, it would be deemed insolvent (Wall [1989], 2-17).

66 In 1995, banking firms with traded debentures outstanding represented 1 percent of all U.S. banking firms but more than one­half of

total bank assets (Flannery [1998], 283).

18
Deposit Insurance Reform
 

subject only to supervisory monitoring. (Differential

treatment for small and large banks might also be applied to capital requirements, closure rules, and other

regulatory provisions.) To date there has been little

discussion of the competitive and political issues that

might arise if large and small banks were subject to different supervisory provisions, or of technical issues,

such as how to distinguish objectively between the two

groups of banks.

FDIC Capital Notes

Another proposed way to encourage prompt and effective supervisory action is to require the FDIC to

periodically issue capital notes to the public. Interest

on the notes would be terminated if the insurance fund

dropped to zero and taxpayer funds had to be appropriated by Congress to meet insurance losses.67

Furthermore, part of the pension funds provided for

FDIC directors would be invested in FDIC capital

notes while they were in office, to reinforce incentives

to avoid policies that might weaken the insurance

fund.

The purpose of the proposal is to enlist private­sector assistance in monitoring the condition of the insurance fund and to make sure that the FDIC will avoid

taxpayer funding. However, little in the history of the

FDIC suggests insufficient concern on this score.

Considering the fate of the Federal Savings and Loan

Insurance Corporation and the intensity of congressional oversight of the taxpayer­funded Resolution

Trust Corporation, bureaucratic self­interest (if nothing

else) should ensure the FDIC's strong commitment to

minimizing the danger that taxpayer funding would be

needed. 

If the FDIC were to be subject to market discipline,

as this proposal contemplates, then the FDIC should

have the powers appropriate to its new status. Such

powers would presumably include greater freedom to

increase the size of the insurance fund to levels dictated by the market for its capital notes. (Currently the

fund is constrained by a statutory reserve target of 1.25

percent of insured deposits.) It would also be appropriate to give the FDIC increased supervisory authority over national and state member banks so that it

could better control its risk exposure and could avoid

principal/agent problems with other federal regulators.68

Proposals to Restrict the Range of 

Banking Activity Financed by 

Insured Deposits

Proposals to restrict the range of banking activity financed by insured deposits would address the moralhazard and principal/agent problems quite differently

from the reform proposals already discussed. The narrow­bank proposal would essentially prevent the use of

insured deposits to fund investments with more than

minimal risk. The traditional­bank proposal would

confine the use of insured deposits to the banks' liquidity transformation function; insured deposits would

be used primarily for funding illiquid loans, but generally not for funding investments or products traded in

established markets.

Narrow Banks 

The narrow­bank proposal calls for a drastic reduction in, if not outright elimination of, deposit insurance.69 If deposit insurance were retained at all, it

would be restricted to deposits held in banks that invest solely in liquid, risk­free assets and operate like

money­market funds. And if runs on narrow banks occurred at all, the bank would be able to meet them by

liquidating a portion of its assets without delay, significant cost, or disruptive effects on capital markets.

Deposit insurance would be needed only for failures

caused by fraud or external disasters; premiums would

be low; and the risk that taxpayer funds would ever be

required would be very small. Assuming that asset restrictions were strictly enforced, moral hazard would be

67 Interest on these notes would be suspended if the FDIC were to

borrow from the Treasury to obtain sufficient liquidity. The purpose of this provision is "to make sure that solvency problems are

not hidden by the FDIC under the pretense that the only issue is

the liquidity of the fund" (Wall [1997], 21).

68 Wall (1997) states that the FDIC could seek permission from

Congress to increase the insurance fund and that the FDIC should

be able, at its own discretion, to examine banks supervised by the

Federal Reserve Board or the Comptroller of the Currency.

However, if Congress did not heed the agency's petition to increase

the fund, the FDIC's ability to maintain a strong market for its capital note obligations might be undermined. Furthermore, other

federal banking agencies have sometimes resisted the FDIC's efforts to exercise its currently existing back­up examination authority.

69 The narrow­bank proposal has a long history and numerous precursors, which Wallace (1996) traces back to Adam Smith's 1789 Wealth

of Nations. Recent examples of narrow­bank proposals are Litan

(1987), Bryan (1991), and Pierce (1991). 

19
FDIC Banking Review

largely eliminated. Lending to businesses and con­ regulatory concerns, because of the profitability of desumers would be conducted by uninsured, nondeposit posit­funded lending. Owners of narrow banks might

institutions, perhaps holding­company affiliates of nar­ seek to circumvent (or, by exerting political pressure, to

row banks, which would fund their lending activity obtain relief from) asset restrictions in order to earn

through various uninsured debt and equity instru­ higher profits from lending low­cost insured deposits to

ments and would be subject to market discipline like private­sector borrowers than they could earn on liquid

investments. any other nonbank borrower.

There have been numerous examples of narrow Traditional Banks banks in the United States and other countries: postal

savings systems, government savings banks, and na­ A less­drastic alternative would be to restrict deposit

tional banks in their operations as issuers of notes insurance to banks engaged primarily in liquidity transbacked by U.S. government securities early in their formation-intermediating between liquid deposits

history. These institutions operated alongside other and illiquid loans.71 Except when synergies exist with

banks that provided credit to the private sector funded traditional intermediation, other activities would be

by equity and deposits-in some cases, by insured de­ carried on in affiliates or subsidiaries not funded by inposits. In the context of deposit insurance reform, sured deposits. Financial transactions between the

however, the narrow­bank proposal would apply to all bank and these nondeposit entities would be at "arm's

presently insured banks and is designed to reduce the length" and enforced by "firewalls" so that the benescope of deposit insurance or eliminate it altogether. In fits of the federal safety net would not be extended beeffect, the narrow­bank proposal would eliminate one yond the traditional function of bank intermediation.

of the main features that is believed to make banks Implementing this approach would require distin­ special and that justifies the existence of a federal safe­ guishing on some rational economic basis between so­ ty net-the use of liquid deposits to finance relatively called traditional and nontraditional banking activities. illiquid loans. In addition, bankers might resist the change because Like many other deposit insurance reform propos­ reorganizing existing activities into insured and unin­ als, the narrow­bank concept involves a trade­off be­ sured entities would be costly and because they would tween benefits and costs. Adoption of the narrow­bank prefer to finance a variety of investments with low­cost concept would largely eliminate the risk of bank runs insured deposits. If the traditional­bank approach were and the consequent need for deposit insurance, but at successfully implemented, however, it would limit the the cost of potentially reducing the supply of credit to scope of deposit insurance and the federal safety net. borrowers who lack direct, cost­effective access to the It would reduce the risk of losses to the insurance fund

capital markets. Many savers who seek safe and liquid from nontraditional activities, prevent unfair competi­ accounts would gravitate to the narrow banks, where tion between banks and nonbank organizations, inhib­ their savings would be channeled solely into liquid it the spread of bank­type regulation to nonbank government and high­quality corporate obligations. companies, and lessen moral­hazard and TBTF prob­ Credit flowing to other borrowers would be funded by lems in nontraditional activities. In traditional lending higher­cost equity and uninsured borrowings of nonde­ activities financed by insured deposits, moral­hazard posit lending institutions. In contrast, the present sys­ problems would remain. tem potentially results in more and/or cheaper credit

for borrowers who lack direct access to capital markets, 70 Two past or present exceptions are Argentina (which abolished de­ but at the risk of socially harmful bank runs and at the posit insurance in 1991, only to reinstate it in 1995) and New

cost of maintaining a deposit insurance system to pre­ Zealand (which has no explicit or implicit deposit insurance system)

(World Bank [1996]). Certain other countries do not have explicit vent such runs. This is the trade­off that the United

systems but may introduce some form of protection in the event of States and most other countries have chosen.70 a crisis.

A narrow banking system would also present some 71 FDIC (1992); Carns (1995); Hoenig (1996).

PART 3. CONCLUDING REMARKS

As has often been stated, here and elsewhere, de­ market stability and protecting savers) and various

posit insurance involves a trade­off between certain risks and costs. Deposit insurance creates incentives

public­policy objectives (such as promoting financial­ for insured banks to take increased risks, and it gener20
Deposit Insurance Reform
 

ates substantial costs for monitoring and restraining

bank risk. To the extent that mechanisms for restraining bank risk are ineffective, low­cost funds will flow to

high­risk ventures, and the result will be a misallocation of resources, bank failures, and increased insurance costs for banks that operate safely. In extreme

cases, the cost of insurance losses may fall on taxpayers.

Proposals for reforming deposit insurance are generally based on the view that the present balance between the terms of the trade­off is inappropriate.

These proposals put greater weight on the side of restraining bank risk, and their proponents generally attach less importance to the public­policy objectives of

deposit insurance than do defenders of the present system. For example, proponents of increased market

discipline (to be achieved by market value accounting,

increased depositor risk exposure, or other means) appear willing to accept greater volatility in financial markets, considering it a necessary price to pay for

ensuring prompt action by bankers and regulators to

correct weaknesses in individual institutions.

Similarly, proponents of increased burdens on bank

stockholders (to be achieved, for example, with sharply

increased capital requirements or a return to double liability of stockholders) appear willing to accept a

smaller, less­competitive banking sector and a potential reduction in the availability of credit to borrowers

who are dependent on banks, as a necessary price for

restraining risk. And proposals for privatizing deposit

insurance generally all but ignore the possibility that

coverage might be denied to particular classes of banks

or types of risk, and generally disregard the public­policy implications of such action. In general, many reform proposals ignore or discount the prospect that

reducing bank risk may effectively increase costs

and/or risk to borrowers, creditors, or other sectors of

the economy.

Besides differing on how to balance conflicting objectives, opposing sides on specific reform proposals

(or on reform generally) also differ on certain critical issues: the cost of monitoring bank risk; the relative efficacy of risk monitoring and restraint by creditors,

investors, and government supervisory authorities; and

the economic significance of bank intermediation.

Thus, proposals for increased discipline by depositors

and nondeposit creditors appear to assume that the

cost of effectively monitoring banks is low relative to

the cost (or foregone income) of shifting to investments that are less risky and need less monitoring. 

With respect to the relative effectiveness of different agents for identifying or restraining bank risk, differences in judgment appear to be based on factual,

historical, and ideological considerations. Factually,

until recently few efforts had been made to compare

rigorously the relative predictive powers of market signals and supervisory assessments of the condition of

banks. Historically, regulatory lapses during the bank

and thrift crises of the 1980s and skepticism that

enough has changed since then have provided part of

the rationale for proposals to shift to the private sector

responsibilities now borne by government supervisors.

For some proponents of reform, the S&L debacle was

not an aberration but a true reflection of the fundamental deficiencies of depository institution regulation. Ideologically, faith in free markets and suspicion

of any government intervention have also been a factor

in judgments about which agents are more effective or

less in restraining bank risk. For many proponents of

reform, market discipline is the preferred tool for restraining risk, followed by statutory rules that largely

eliminate the discretionary authority of regulators.

This preference for rules over discretion reflects a distrust of regulatory action and leads to the conclusion

that FDICIA did not go far enough in restricting regulatory discretion.

With respect to bank intermediation, proponents of

narrow banks tend to downplay the importance of the

liquidity­transformation function (which some people

regard as fundamental to banking), while advocates of

market value accounting generally dismiss the significance of inherently nonmarketable loan portfolios,

viewing their existence as a readily surmountable obstacle. In short, one's view of many reform proposals

depends on one's view of the nature and economic significance of bank intermediation. If the appropriate

model is that of banks as lenders to idiosyncratic borrowers, then bank runs (rational or irrational) can have

serious economic consequences because they may result in the dumping of essentially nonmarketable assets or an interruption of credit flows to borrowers who

lack practical alternatives. In this model, market discipline will have limited effectiveness because market

participants will lack relevant information on borrower

characteristics. But if the more appropriate model, at

least for a major segment of the banking industry, is

that of banks as holders/traders of marketable or securitizable instruments, it would be logical to reach quite

different conclusions on reform proposals. 

21
FDIC Banking Review
 

In assessing reform proposals, one should always remember that no regulatory regime, existing or proposed, is or will be perfect; all are likely to have

occasional unforeseen and unintended consequences,

and all are likely to fall short of their objectives at

times. Proponents of reform sometimes draw a comparison between the present system, with all its shortcomings in practice, and an idealized proposed system

that works perfectly on paper. Proponents of greater

market discipline, while emphasizing major errors of

judgment by regulators, ignore the fact that markets,

too, make mistakes; and more important, they ignore

the fact that both market participants and regulators

operate with limited information and their own particular biases, and that they pursue sometimes divergent

objectives. So the essential but difficult task is to compare the actual operations of the existing regime with

the likely behavior of a proposed substitute.

Some of the deposit insurance questions raised in recent years may be settled by research on factual matters or by extensive debate. Many other questions will

probably not be settled by these means, because they

reflect the various participants' divergent "world

views" of the efficacy of markets and government intervention. These questions may remain unresolved

unless another round of serious bank and thrift problems subjects the existing deposit insurance and bank

regulatory systems to a new and challenging test.

22
Deposit Insurance Reform

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26
Conduits: Their Structure and Risk

Conduits: 

Their Structure and Risk 

by Peter J. Elmer*

One of the most important financial develop­ The First Conduit

ments of the past two decades has been the Rumor has it that the first conduit was conceived on growth of asset securitization. This growth has a napkin over dinner by three major players in the effectively created a new dimension of banking, simul­ mortgage markets of the early 1980s: Lew Ranieri of taneously allowing banks to liquefy or sell financial asSalomon Brothers, David Beal of Banco Mortgage sets more easily and opening new investment

opportunities. Company, and Bill Lacy of the Mortgage Guarantee

Insurance Corporation (MGIC). The idea seemed Two trends have combined to create these opportu­ simple: a firm could carve a niche for itself by buying nities for banks. One is the spread of securitization to loans from originators, then pooling and selling the virtually all types of loans, leases, and financial con­ loans as securities. The firm could have minimal as­ tracts; the other is the increase in banks' securities bro­ sets as long as it maintained access to funding and kerage, dealer, and other capital markets activities. could quickly bring together the many players needed Thus, banks now have new business opportunities in­ to underwrite the loans, guarantee loan quality, then volving the origination of loans for the purpose of pool the loans and sell the pools as securities. Several packaging and selling them as securities, at the same government agencies, such as the Federal Home Loan time that the infrastructure to engage in these activi­ Mortgage Corporation (Freddie Mac) and the Federal ties is more readily available. Securitization has not National Mortgage Association (Fannie Mae), had al­ only changed investment and asset sale options but ready proved that this could be done, so why not try it also created new types of businesses specializing in from a private base? the acquisition of loans for the purpose of packaging

them as securities. Given the growing importance of Freddie Mac and

Fannie Mae, the first conduit initially focused on buy­ Entities that focus on generating a profit by buying ing and securitizing single­family mortgages with loan or originating loans at one price, then selling them balances above the purchasing authority of these two through securitization at a higher price, have come to agencies-in other words, "jumbo" mortgages. This be called conduits (see sidebar). In this regard, their conduit was aptly named Residential Funding function is sometimes thought of as a type of arbitrage. Corporation (RFC) because it targeted residential However, the substantial time, resources, and risk re­ mortgages as its primary product line. It was formed in quired to execute the strategy suggest that conduits 1982 as a subsidiary of Banco Mortgage Company, an are more appropriately viewed as performing a business function than an arbitrage. Indeed, the host of

problems encountered by conduits over the past two • Peter J. Elmer is a senior financial economist in the FDIC's Division years suggests that their structure is relatively risky of Research and Statistics. The author would like to thank Mark

and difficult to manage. Iverson of GMAC-RFC for valuable assistance.

27
FDIC Banking Review
 

When Is a Conduit Not a Conduit?

Analysts new to securitization often encounter

a confusing set of terms. This is especially true

for "conduit."

In most cases, "conduit" refers to a financial organization or entity whose business purpose is to

buy loans or other financial assets from correspondents, with the goal of earning a profit by repackaging and selling the assets as securities. That is,

a conduit is a type of business that specializes in

securitizing loans and other types of financial assets.

A "pure" conduit minimizes its involvement in

complementary activities. For example, this type

of structure can be found in the early development of RFC or, more recently, in Wall Street brokers and dealers. Conduits that expand by adding

servicing or other functions to their core activities,

such as GMAC-RFC during the 1990s, can be

difficult to classify accurately, although in practice

they may be referred to as conduits.

Unfortunately, the term conduit has also been

used to describe other entities. For example, it

has been used to describe bankruptcy­remote

companies formed for the special purpose of issuing securities that are effectively collateralized by

loans or other assets held by the companies, such

as asset­backed commercial paper. These conduits act more like trusts or financial vehicles for

issuing securities than independent organizations

seeking a profit. 

The 1986 Tax Reform Act added to the confusion by giving the name Real Estate Mortgage

Investment Conduit (REMIC) to another type of

vehicle for structuring securities. Unfortunately,

while "conduit" appears in the REMIC acronym,

the term REMIC has since been used to describe

not only legal structures that elect to be REMICs

but also the securities these structures issue.

These legal structures are generally not taxed,

and when their mortgage or MBS collateral is paid

off, their life is over. Thus, REMICs are best

thought of as a special class of securities rather

than as ongoing business enterprises. That is, a

REMIC is a conduit in name only, and should not

be confused with conduits formed as business enterprises focused on buying and securitizing

loans.

affiliate of Northwestern National Bank, the predecessor of Norwest Bank.1

RFC soon learned that buying and securitizing loans

required many activities. As illustrated in figure 1, loan

purchase programs must be set up with any of a variety

of originators, such as banks, thrifts, and mortgage

bankers, and a securities sales function must be established with securities brokers and dealers. However,

even with the origination, servicing, and security­sale

functions performed by others, a host of activities remain the responsibility of the conduit. For example,

underwriting guidelines must be established, qualitycontrol procedures implemented, funding secured, and

interest­rate risk managed while the loans are held in

portfolio. Long after the securities are sold, a variety of

commitments may remain relating to representations

(reps) and warranties, investor relations, and the maintenance of residual interests retained in the security.2

RFC began as a relatively simple, or "pure," conduit

by purchasing jumbo mortgages from established originators, especially mortgage bankers. The existence of

Freddie Mac and Fannie Mae proved useful because

their loan underwriting and seller/servicer approval requirements were widely recognized standards that

could be easily referenced in prospectuses and other

documents. Moreover, originators approved to do business with Freddie Mac and Fannie Mae were typically

familiar with selling loans to the secondary market, servicing securitized loans, and performing related functions.

In its formative years, RFC developed the primary

relationships required of a pure conduit. Since it was

initially affiliated with a mortgage company and a commercial bank, it had access to established origination,

servicing, and funding relationships as well as to expertise in selling loans in the secondary market. RFC purchased mortgage insurance from mortgage insurers to

cover default risk in the mortgage pools created.

1 Banco and Northwestern changed their names to Norwest in 1983.

As is often true of new firms, aspects of RFC existed in one form or

another before 1982. For example, Brendsel (1985) points out that

private firms began issuing mortgage­backed securities in 1977, and

the number of such firms had grown to approximately 50 by 1982.

Wholesale mortgage bankers were also established buyers of previously originated loans, for the purpose of reselling them in the secondary markets. However, RFC's focus on the wholesale acquisition

of mortgages with an eye toward packaging and selling them as securities was unique and inspired the term "conduit."

2 For a discussion of reps and warranties, see Moreland­Gunn, Elmer,

and Curry (1995).

28
 

Conduits: Their Structure and Risk

Salomon Brothers provided not only the investment often occurred through affiliate relationships within the

banking expertise needed to pull together rating GMAC holding company "family").4

agency, legal, and other components required for secu­ Conduit expansion can take many avenues. Since ritization but also the dealer expertise required to sell the lifeblood of a conduit is a steady supply of loans,

the securities and support trading. the origination side of figure 1 offers one appealing avAs RFC grew, its strategic options expanded along enue by allowing conduits to control and enhance the

with a need for internal support functions. Elements of flow of incoming loans. Although some conduits have

risk management and quality control had to be set in enhanced this flow by purchasing origination capabiliplace. A strategic decision was made to begin per­ ties directly, GMAC-RFC expanded into a related

forming master­servicer services.3 As more investors function-warehouse lending.5 To generate similar

held RFC securities, investor­relations personnel were synergies, it started a construction finance division in

added. Growth of internal staff implied a need for 1992.

more extensive accounting and personnel functions.

Thus, even a relatively simple conduit with a narrow 3 As discussed by Fitch (1999b), master servicers are responsible for

product focus can quickly become a sizable operation. protecting the interests of security investors by overseeing primary

servicers and otherwise ensuring that cash flows smoothly from servicing to trustees. Trustees ensure that the correct amounts are received from servicers; then they break the collected cash into the Recent Conduits and Their Structures amounts promised investors, per the requirements of the security.

As an industry matures, its members often merge 4 For a more complete report on GMAC-RFC's current structure and

operations, see Fitch (1999a). with closely related institutions in an effort to reduce 5 In 1991, GMAC-RFC purchased the Warehouse Lending Division costs or otherwise enhance efficiency. In this regard, of American Security Bank, thereby strengthening its ties to origina­ the acquisition of RFC by General Motors Acceptance tors and the flow of incoming loans. Bear Stearns (1999) notes that

Corp. (GMAC-RFC) in 1990 was a harbinger of conduits continue to place primary reliance on loans purchased either in bulk or on a flow basis. Even with loans ostensibly "originat­ change reflecting the expansion of conduits into many ed" by conduits, substantial portions may be refinancings of loans

of the functions shown in figure 1 (although expansion that are serviced by the conduit or by an affiliated servicer.

Figure 1

Conduits and Securitization

Primary Functions of a Conduit 

Buy Side Sell Side: Securitization requires many players and commitments Loan Originators Securities brokers and

- set purchase guidelines - investment banker underwrites and structures the securities dealers sell the securities, (may or may not - set underwriting guidelines - trustee holds the securitized assets then support trading in retain the servicing) - fund commitments - master servicer oversees servicing the aftermarket 

- buy loans - servicers, sub-servicers, and/or special servicers service the loans 

Mortgage - manage loans while in - certificate custodian

portfolio awaiting - certificate registrar and paying agent Bankers Security 1 

dispositon - third-party credit support (pool insurance, etc.) to market 

- extensive legal support in all areas 

- control credit and cash-flow risk of ongoing commitments 

Mortgage - investor relations supports securities in aftermarket 

Brokers Secondary Security 2 market for 

to market securities 

Banks Buy loans Sell as securities 

Security 3 

Portion of to market 

Thrifts collateral cashflow returns as

 part of profit 

Non-Originators Security 4? May be sold or

Sell Side: Whole-loan sale requires few players or commitments held by a conduit 

- “flip” loans back to the secondary market Secondary in many ways 

Market 

Secondary 

Sell as whole loans market for 

whole loans 

29
FDIC Banking Review
 

A second cornerstone of loan activity representing a

natural avenue for conduit expansion is servicing.

Servicer affiliates enable conduits to expand their purchases to include acquisition of loans on either a servicing "released" or a servicing "retained" basis. That

is, affiliating with a servicer allows a conduit to offer a

premium for loans that are sold with their servicing, or

pay a lower price and let the originator retain the servicing.6 On the one hand, this flexibility appeals to

sellers with little interest in servicing the loans after

origination, such as loan brokers, while on the other

hand it generates a flow of new servicing to servicer affiliates. Developing an extensive servicing network

has other strategic advantages, such as providing opportunities to refinance loans and to cross­sell other

products. These advantages have led GMAC-RFC to

maintain a servicing operation that acquires "released"

servicing for about two out of every three jumbo mortgages purchased.

Conduits can also expand by affiliating with securities­related firms. As shown in figure 1, conduits may

sell some loans as whole loans while pooling and selling others as securities. For example, loans with exceptionally high quality may fetch a higher price if sold

as whole loans, while loans with very poor quality, such

as those with legal problems or unique characteristics,

may be preempted from inclusion in a security. In this

regard, conduit securitization activities constantly compete with whole­loan sales to achieve the highest possible value ("best" execution) for any package of loans.

Indeed, the link between conduits and the capital markets is so close that Wall Street dealers often maintain

their own conduits, which may be run in an independent fashion or alongside whole­loan or securities trading functions. This tie is illustrated by the central role

of Salomon Brothers in RFC's formative years. More

recently, GMAC-RFC counts two broker­dealer subsidiaries as affiliates in its holding company family.

Apart from expanding into complementary businesses, conduits throughout the 1990s expanded into

complementary loan product lines. Given their start

with jumbo mortgages, conduits were quick to begin

other mortgage programs that lay outside the domain of

Freddie Mac and Fannie Mae, such as home­equity

loans and manufactured housing, as well as other types

of consumer loans, such as credit cards and auto loans.

From these roots in mortgage and consumer loans, conduits branched into all types of commercial loans and

receivables.

Somewhat surprisingly, bank and thrift conduit activities have been relatively limited. Banks and thrifts,

either on their own or through subsidiaries, have always

been among the largest originators and servicers of all

types of mortgage, consumer, and commercial loans;

banks are also the primary source of trustee services;

and a number of larger banks have developed sophisticated securities sales capabilities. Nevertheless, as figure 2 shows, the bank and thrift share of private­label

mortgage­backed securities is only 15 percent, whereas

private conduits at 24 percent represent the largest single class of issuers. Figure 3 shows a similar pattern for

the issuance shares of "asset­backed" securities (securities backed by credit­card, auto, home­equity, and

other consumer loans outside the area of first mortgages). Although several large credit­card banks boost

the bank and thrift share of asset­backed securities issued to almost one­quarter (23 percent) of the market,

this share falls far below the 44 percent share claimed

by finance and nonbank credit­card companies. And

even in the area of commercial loans (figure 4), banks

and thrifts claim only 13 percent of the market. Thus,

bank and thrift direct participation in conduit operations appears relatively modest, although banks and

thrifts remain primary providers of origination, servicing, warehouse lending, and trustee services.

In summary, after beginning as streamlined businesses focused on buying and securitizing loans, conduits expanded in structure and became more

complex, affiliated and integrated with a variety of

complementary businesses. Pure conduits may still exist, but they are commonly not independent organizations; rather, they tend to be narrowly defined affiliates

or groups residing in larger organizations.

Despite the wide range of activities that conduits

may engage in, their most basic economic function is

defined by two characteristics:

� they are engaged in the business of buying or accumulating financial assets for the purpose of

packaging and selling them as securities, and 

� they maintain close ties to the many players required in assembling and securitizing financial assets.

6 The idea that servicing has value is confusing outside of the area of

mortgage finance, because servicers incur significant expense in collecting and managing loan cash flows. However, standard servicing

fees paid to servicers tend to exceed the cost of servicing loans by a

considerable margin, and this differential implies that the "right" to

service loans has value. Selling loans on a servicing­released basis allows an originator to collect at least a portion of the value associated

with servicing at the time the loan is sold.

30
Conduits: Their Structure and Risk

Figure 2 Figure 3

Mortgage-Backed Securities, 1998 Asset-Backed Securities, 1998

Banks/Thrifts Banks/Thrifts Other 15% Other 

24% 23% 22% 

Investment Banks Private Conduits 

17% Finance/Credit-Card Companies 44% 48% 

Private 

Conduits 

7% 

Figure 4

Commercial Loan-Backed Securities, 1998

Banks/Thrifts Private 13% Conduits 

6% Other 

54% Investment Banks 

27% 

Source: The Mortgage Market Statistical 

Annual for 1999. 

These core activities generate two primary sources of million to $200 million of relatively homogeneous

income-the income that derives from holding per­ loans. Unusual and heterogeneous loans are placed

forming loans in inventory and, especially, the income into securities with "miscellaneous" loans or are sold as

generated when loans are packaged and sold as securi­ whole loans.

ties.7 The sawtooth pattern can vary considerably, depending on the types of loans accumulated and market

Conduit Economics (I/: lending trends. For example, in 1998 the GMACRFC pipeline of high­volume single­family "jumbo" Inventorr and the Value of Spread mortgages produced an average of one new security The starting point of the value created by conduit every two weeks, whereas the same company's activities is the accumulation of inventory in anticipa­ pipeline of low­volume home­equity loans produced tion of packaging and sale as a security. The most com­ an average of one new security only every three mon approach involves linking to a source of newly months. Generic loans that are easily acquired and se­ originated loans or receivables, then waiting for the curitized tend to offer less opportunity for profit than flow of loans purchased to build an inventory sufficient unusual loans that are difficult to acquire and securi­ to issue a security. The flow of loans can come either tize. At the end of quarterly or yearly accounting cy­ from internal originations or from a variety of external cles, a special effort may be made to reduce inventory sources, such as networks of correspondent originators, by either securitizing or selling the excess loans. a limited network of wholesalers, or Wall Street. Most Loans in inventory give rise to one source of conduit commonly, conduits cultivate networks of originators in income, which is the interest­rate spread, or "carry," an effort to ensure a steady flow of product. Buying from loans held in portfolio. This income varies direct­ loans from Wall Street dealers is problematic because ly with the length of time the loans are held. Since the dealer markets are very competitive and the flow of most loans held by conduits are newly originated, there loans is erratic. Moreover, Wall Street dealers often use

their own conduits to securitize blocks of whole loans

7 The two sources of income discussed in this article are the purchased through the capital markets. primary-but not necessarily the only-sources of income arising

The level of loans in inventory traces a sawtooth pat­ from conduit activities. Conduits involved in other activities will

generate other types of income. For example, conduits that directly tern: inventory builds, then drops at each securitiza­ originate loans earn income from origination fees, while those in­ tion or whole­loan sale. At any point the base volved in warehouse lending, servicing, or other activities generate

inventory of loans may be substantial because not all income from these endeavors. It is also possible for conduits to simplify their operations to the point that they earn income from only loans may fit or work well in every securitization. The one source, for example, by not holding loans in portfolio before sebulk of the loans are packaged in pools of at least $100 curitization.

31
FDIC Banking Review
 

is little likelihood of default during the several months they may be held in

the conduit's inventory "pipeline" awaiting securitization. During this period of low credit risk, conduits earn the difference between the interest income received from loans held in portfolio and the interest expense paid to

fund those loans, net of hedge costs. 

Carry = Interest Inc. – Interest Exp. – Hedge Cost (1) 

To further simplify, one can reasonably assume that the cost of hedging

some types of risks, such as the risk of a general rise in interest rates, is relatively small, so these risks can be ignored for this analysis. Other risks that

are difficult or expensive to hedge will be considered below in a discussion

of conduit risks.

Figure 5 illustrates spreads earned during the 1997-1999 period by conduits carrying commercial mortgages. That is, the spreads reflect the difference between the interest income earned on long­term fixed­rate

commercial mortgages and the interest expense paid on three­month commercial paper, net of 20 basis points for servicing, hedging, or administrative expenses. The two series reflect the different net yields earned by

conduits with relatively high versus low commercial paper funding costs.

The spreads in figure 5 suggest that over the past two years, the carry

earned by commercial mortgage conduits with relatively low funding costs

fell in the 1.0-2.0 percent range, averaging approximately 1.50 percent.

This translates to a value of approximately 50 basis points (0.50 percent)

when the loan is carried for four months, or a value of one­eighth point

(0.125 percent) if it is carried for only one month. The spreads were approximately 50 basis points lower for conduits that funded at the more expensive end of the commercial paper market. However, the 50 basis points

of higher interest expense appear modest, given the fact that the total carry remained positive throughout the past two years and that the carry represents only one of two sources of conduit income. Moreover, funding

Figure 5
 

Spreads from "Carrying" Commercial Mortgages,
 

May 1997-September 1999 Spread (%)

3.0

2.5

2.0

1.5

1.0

0.5

0.0

5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9

Commercial Mortgage

Commercial Mortgage

Spread to

High-Quality

Commercial

Paper

Low-Quality

Commercial

Paper

Spread to

1997 1998 1999

Note: The spread between the commercial mortgage and commercial paper rates is calculated as

the difference between the Levy commercial mortgage rate and either the high- or low-quality

commercial paper rate, net of twenty basis points servicing fee. The Levy commercial mortgage

rate is reported monthly by Barron’s. Commercial paper rates are reported by Bloomberg

Financial Markets. All yields are computed on a bond yield basis.

expenses should not significantly

limit competition, as hundreds of

firms can fund within the highand low­cost ends of the commercial paper market.

Conduit Economics (II): 

The Value of the Deal

The primary source of conduit

income is the value of the "deals"

created by packaging loans and

selling them as securities. What

often makes this value seem

anomalous is that securitization

represents simply a repackaging of

cash flows. In fact, some securities, known as "pass­throughs,"

are structured to have almost no

effect on the cash flows of the underlying loans. Nevertheless, the

additional liquidity and other advantages of securitized pools enhance value to the point that the

value of the securities and other

assets created from a pool exceeds

the value of the corresponding

loans; if it does not, the pool will

be either held in portfolio or sold

as whole loans.

Securitization deals have two

basic structures. The most commonly used structure grants security investors an interest in the

specific assets placed in a securitization "trust," which is administered

by the trustee. This structure is

used for "closed­end" loans, such

as mortgages or auto loans, because their maturates and payments are well defined. As the

principal balance of the loans in

the trust is paid down, so is the

principal of the securities created

by the trust. When the initial assets are paid off, the securities

must also be paid off and the trust

is dissolved. The second type of

securitization structure grants investors an interest in a pool of assets

without listing the specific assets

32
Conduits: Their Structure and Risk

that will be in the pool throughout its life. This structure is designed to into easily sold securities because

hold loans with loosely defined maturates and/or highly variable character­ of their higher risk. Therefore, the

istics, such as credit cards. This structure permits a "revolving asset" higher­risk cash flows are used to

arrangement whereby paid­off loans are replaced with new loans possess­ produce several other types of asing similar characteristics. Generally speaking, the total balance of the sets, such as excess interest, excess

loans is maintained even though the specific loans in the pool change. servicing, and residuals. A deal

Since the payoff of the initial collateral bears no particular relation to the makes economic sense when the

payoff of the securities, the principal balance of the corresponding securi­ total value of the securities and

ties remains relatively stable until the trust permits the payoff of principal. other assets created exceeds a minRegardless of the differences between structures, the generation of val­ imum threshold required to comue is relatively consistent. That is, in both structures the value created by pensate a conduit for its various

securitization is the difference between the value of the securities ("class­ expenses, including equity.

es," or "tranches") and other assets created by the deal, and the value of Figure 6 depicts the creation of

the loans or receivables placed in the deal, net of underwriting and sale­ value that arises when the two prirelate. mary components of a package of

commercial­loan cash flows-prin­ Value of Securitization = Value of Class A + Value of Class B + .... 

cipal and interest-are split.8 The

+ Value of Excess Interest total principal balance of all loans

+ Value of Excess Servicing 

+ Value of the Residual (or Seller’s Interest) Class 8 Figure 6 represents a security created from – Cost of Assets a specific pool of commercial­loan assets.

– Underwriting/Sale Expenses (2) However, securities created for revolving

loan products, such as credit cards, tend to It is common to create in one deal several or more classes of securities produce many of the same unusual assets,

with different credit ratings, because doing so broadens the market for the such as excess interest and excess servicing.

One asset unique to a revolving loan deal, securities and therefore enhances the total value of the package. the "seller's interest," is similar to the residUnfortunately, however, some cash flows in a deal cannot be incorporated ual in a specific asset structure.

Figure 6

Sample Principal and Interest Distribution

for Commercial Mortgage Senior/Subordinated Securitization

7.70% Coupon -- .20% Servicing Fee 

$100 Principal = 7.50% Net Coupon for Security Holders 

Last 

$75 Class “A” Senior Bond Interest on AAA-Rated “A” Bond = 6.40% 

Rated AAA (Sold at Par) 

Interest on AA-Rated “ B” Bond = 6.65% 

(Sold at Par) 

$8 Class “B” Bond Interest on A-Rated “C” Bond = 7.00% Rated AA (Sold at Par) 

$5 Class “C” Bond Interest on BBB-Rated “D” Bond = 8.00% 

Rated A (Sold at Par) 

Interest on BB-Rated “E” Bond = 11.00% $5 Class “D” Bond Loss Priority (Sold at Par) Rated BBB 

Interest on Unrated “F” Bond = 6.00% $4 Class “E” Bond (Sold at Discount) Rated BB 

Excess Interest (IO Strip) = 0.80%* $3 Class “F” Subordinated Bond (Retained by Conduit or Other Use) First Not Rated 

Residual or “R” Class (Retained by Conduit) 

*Excess interest = net coupon (7.50%) less the combined interest expense of the bonds, 

((0.75*6.40)+(0.08*6.65)+(0.05*7.00)+(0.05*8.00)+(0.04*11.00)+(0.03*6.0)). 

33
0

• • •

FDIC Banking Review
 

in the pool is allocated to at least one class of bonds.

Typically the principal is divided into one or more large

pieces with AAA or AA credit ratings and the highest

seniority in loss priority. Several intermediate or "mezzanine" classes may be created with ratings in the

BBB­AAA range, followed by other classes with lower

loss priority and lower credit ratings. For example, figure 6 shows a $75 AAA­rated senior security created by

subordinating 25 percent of the principal among five

mezzanine and other classes of securities with varying

sizes and credit ratings. The residual, or "R," class

claims bits and pieces of cash flows that are not

claimed by any other class.

Subordinated bonds have lower ratings than senior

bonds because they stand ready to absorb default­related losses before those losses can be applied to bonds

with senior priority. The subordinated bonds are often

sliced into several classes with varying credit ratings

that depend on the level of subordination supporting

each bond. Bonds in the BBB and higher "investment

grade" rating range are normally easier to price and

sell. The bond with the lowest priority has the highest

risk of loss and, if rated, has the lowest credit rating.

However, the highest­risk bonds may not be rated because they are either retained by a conduit affiliate or

are privately placed to sophisticated investors. Since

only a limited number of buyers purchase the highestrisk bonds, selling these components of the securitization can be the pivotal factor in consummating a deal. 

The level of credit support or subordination varies

with the risk of the underlying loan collateral.

Securitizing loans with higher levels of default risk results in higher levels of subordination and therefore a

smaller senior class of AAA­rated securities. Similarly,

loans with lower default risk require lower levels of

subordination, leaving a larger senior class. Thus, the

risk of the underlying loans is directly related to the

level of subordination required to secure the senior

class.9 In this regard, it is a mistake to interpret relatively high levels of subordination as suggesting a lower­risk security, as they actually indicate higher­risk

loans in the underlying collateral.

Splitting the interest component of the cash flows is

distinct from splitting the principal cash flows.

Whereas all principal is allocated to the bonds, all interest may not be. In essence, the coupon rate on the

loan collateral, net of servicing fees, tends to exceed

the weighted average interest rate required by the

market on the securities backed by the loans, and this

generates "excess interest." Excess interest can be

lumped into servicing contracts to generate excess servicing; it can be formally structured as an interest­only

(IO) strip; it can be used to cover losses; or it can be allocated in a variety of ways to the residual. Portions of

the excess interest may be held by a conduit, in which

case accounting and valuation issues arise (see below).10 Thus, excess interest is central to an understanding of the most problematic issues associated

with securitization. 

Figure 6 illustrates the creation of excess interest in

a deal that allocates the excess to a separate claim retained by the conduit. In the example, the AAA­rated

class pays a rate of only 6.40 percent, which represents

an interest savings of 110 basis points vis-a-vis the 7.50

percent net coupon received from the loan collateral.

The AA­rated class pays 6.65 percent for an interest

savings of 85 basis points. Bond yields do not rise

above the net loan coupon until the class "D" bond,

rated BBB. This and other lower­rated bonds use up

some, but not all, of the interest savings associated

with the higher­rated bonds. The end result of receiving 7.50 percent net interest from the loan, then paying between 6 and 11 percent on the bonds, is an IO

strip equaling 80 basis points (0.80 percent). 

As we have said, excess interest may be formally

structured as an IO strip, in which case the value of the

IO strip represents most of the profit available to compensate conduits for their efforts. For example, in figure 6 the value of the 0.80 percent IO strip is

approximately 3.10-4.50 points, which is much larger

than the 0.12-0.50 points estimated above as the value

of the pipeline "carry."

9 Since the credit risk of other types of loans differs significantly from

the risk of commercial mortgages, the subordination levels of securities backed by other types of loans may be very different from

those shown in figure 6. For example, single­family mortgages have

very low credit risk, to the point that only 5 percent subordination

of principal may be required to create an AAA­rated senior class security. High­risk commercial mortgages may require 30 percent or

more subordination to create an AAA­rated class.

10 The IO strip adds significant complexity to a deal because it can be

structured in many ways. For example, the IO strip may be formed

into a separate security (as suggested by figure 6); used as first­loss

credit support; included as a portion of the residual; or made a part

of excess servicing. The easiest way to use the strip is simply to sell

it and collect its value up front. However, since the strip often has

very high risk, especially before the underlying pool has established

a payment history, its market value tends to be relatively low when

the security is created. Holding either all or a portion of the strip

avoids a deep market discount while generating cash flow and assuring investors that the conduit retains an interest in the deal.

34
 

Conduits: Their Structure and Risk
 

We can now estimate the

value that securitization creates. To simplify matters, assume that (1) the carry is used

to cover sale expenses, (2) the

rated classes ("A" through

"E") are sold at par, and (3) the

class with no rating (class "F")

is sold at 50 percent of its face

value. Given these assumptions, the value created by the

securitization shown in figure

6 falls in the range of 1.60-3.00

percent of the original balance

of the securitized loans.11

This estimate suggests that

the profit margin accruing to

the securitization of mortgagerelated assets is surprisingly

"thin."

The tendency to hold, in

one form or another, significant portions of excess interest

adds a layer of complexity to

conduit operations. That is,

conduits often become involved in the investment and

management of unusual cash

flows, residuals, and other

remnants of the securitization

process. During periods of stability these unusual arrangements can generate a

rewarding flow of income that

can be valued and accounted

for in an acceptable fashion.

During times of stress, however, cash flow, accounting, valuation, and other issues can

quickly overwhelm conduits.

Elements of Risk

Conduits enjoyed remarkable success during much of

the 1990s. As shown in figure

7, the value of publicly traded

conduit equity increased

much faster than the value of

the stock market until early

1997. This conduit success

was attributable to a robust economic environment, a relatively stable financial

environment, and a broadening range of financial products securitized by conduits. During the mid­1990s, conduits quickly carved niches for themselves by

learning to securitize new loan products, such as commercial mortgages, mobile

home loans, and home­equity loans. As securitization brought new funds to

well­established loan products, some conduits ventured into riskier types of

loans, thereby setting the stage for additional securitizations, but at the cost of

additional risk. 

The stock index shown in figure 7 suggests that conduits began encountering

problems in early 1997, followed by a nearly complete recovery. A second round

of problems developed in the latter half of 1997, but this was followed by only a

modest recovery. The industry has yet to recover from a third, disastrous drop

in the second half of 1998. The problems encountered by conduits during the

1997-1998 period serve to illustrate nine elements of conduit risk.12

11 This calculation values an 0.80 percent strip from a commercial mortgage with a 30­year amortization schedule, a balloon at the end of 15 years, a gross coupon of 7.70 percent, and a prepayment rate

that begins at 0 and then rises to 5 percent at the 30th and following months. For this scenario, the

strip value equals 4.49 and 3.07 points at discount rates of 10 and 20 percent, respectively.

Subtracting 1.50 points for a 50 percent discount on class "F" results in an approximate range of

1.60-3.00 points.

12 Comments about the risk­related problems of individual financial institutions were gathered from

news articles reported on Bloomberg Financial Markets. The elements of risk presented here provide an overview of the topic, with special emphasis on problems observed in the 1997-1998 period.

Thus, this list of risks is by no means comprehensive.

Figure 7

Value of Public Conduit Equitr versus S&P 500,

Januarr 1993-September 1999

Conduit Stock Value Index S&P 500 

- SFAS 125 

14 - Rising delinquencies raise asset-quality and 

prepayment issues 2,000 

- Cityscape problems begin 

12 

market conditions 

spreads and hedge risk 

the value of IO strips 

S&P 500 

Equity Value 

Conduit 

Index of 

- Conduits generally confront less-favorable 

- Widespread financial problems raise credit 

- High prepayments reduce 

- Cityscape problems deepen 

1,600 

10 

1,200 8 

6 

800 

4 

400 

2 

0 0 

3 6 9 12 3 6 9 12 3 6 9 12 3 6 9 12 3 6 9 12 3 6 9 12 3 6 9 

1993 1994 1995 1996 1997 1998 1999 

Note: The index of conduit equity, set with January 1993 = 1, is calculated by summing the value of public equity of 7 public 

conduits listed in the top 25 conduits by The Mortgage Market Statistical Annual for 1998: Firstplus Financial Group, Advanta 

Corp., Aames Financial Corporation,AMRESCO, Cityscape Financial Corporation, IMC Mortgage, and Southern Pacific. Two 

other public conduits in this listing, Greentree Financial Corp. and the Money Store, Inc., were omitted from the index because 

they were purchased by other institutions in 1998 before the decline in the stock market in July 1998. 

35
FDIC Banking Review
 

Accounting Risk

At the start of 1997, conduits had to confront a fundamental change in their accounting practices because

of a new accounting rule, Statement of Financial

Accounting Standards No. 125 (SFAS 125). SFAS 125

requires that entities recognize, or "book," the value of

financial and servicing assets and liabilities that remain

under their control after a securitization. In particular,

conduits are required to estimate and record as a gainon­sale the value of excess servicing fees and related

IO strips. IO strips are treated like marketable equity

securities, so they must be carried at fair market value

throughout their lives-a requirement that implies the

possibility of adjusting entries in the event the value of

the asset changes.

SFAS 125 affected conduit financial reporting in two

ways. First, conduits began recognizing the value of

IO strips as gains­on­sale.13 The ramifications of this

are noteworthy. Although this reporting necessarily

improves the transparency of conduit financial statements with respect to the types of assets held, it significantly raises reported earnings and equity at the

issuance date of each securitization. In addition, the

reported gains reflect projections of uncertain cash

flows. The fact that the cash flows are often irregular

and may not begin until several years after a securitization is completed gives rise to financial management

problems. Second, the need to recognize changes in

IO strip values often results in profit adjustments that

bear little relation to operating performance during the

same period. Because benchmark market values are

often not available on IO strips and other related assets, the only way to determine IO strip value is to perform present­value calculations. But these estimates

are notoriously sensitive to a variety of underlying assumptions (ranging from loan payoff and default rates

to the present­value discount rate), and considerable

discretion exists in the setting of these assumptions.

Thus, interpreting reported values is difficult. Even

modest changes in the assumptions can produce significant adjustments to earnings and capital-adjustments that bear little relation to current operating cash

flows.

Asset-Quality Risk

A spate of unexpected credit­card losses reported in

early 1997 helped fuel the first downturn in conduit

stock prices. Although portfolio lenders continued to

more than cover their losses with the high interest rates

received on loans, the asset­quality problems that had

surfaced raised special issues for conduits.14 The IO

strips, residuals, and other remnants of a securitization

are often exposed to much higher levels of credit risk

than are found in traditional portfolio structures.

Conduits that elect to hold subordinated and other

remnants used as credit support probably carry much

more credit risk in a given level of assets than does a

traditional lender holding a comparable level of loans.

Moreover, the value of other remnants that ostensibly

have no credit risk can also be adversely affected by

credit problems. For example, a rise in delinquencies

can squeeze the excess interest generated by a pool,

thereby reducing the value of IO strips that might otherwise have no credit risk. Per SFAS 125, a drop in excess interest can force a downward adjustment of IO

asset values and of a firm's capital.

Servicing Risk

In the spring of 1997 asset­quality problems at

Cityscape Financial Corp. (Cityscape) highlighted another dimension of risk. In April of that year Moody's

downgraded Cityscape's bonds, citing asset­quality

problems and the fear that Cityscape's servicing capabilities were not prepared to deal with higher levels of

problem assets.15 As noted earlier, there are sound

business reasons for conduits to integrate servicing into

their internal operations. Nevertheless, servicing is a

distinct business function with its own risks and efficiencies. For example, significant economies of scale

accrue to larger servicing operations, and the quality of

the assets serviced plays an important role in the determination of servicing expenses. Delinquent and

defaulted loans are much more expensive to service

than performing loans, especially for smaller and inexperienced servicers in nontraditional loan products.

High­cost servicing can directly reduce excess interest,

and inefficient servicing can raise default rates.

Conduits that service the loans backing the securities

they issued risk higher expenses and, if delinquencies

rise above the expected levels, these higher expenses

will coincide with a drop in the value of IO strips and

other assets.

13 See Duff & Phelps (1997) and Baskin and Gregoire (1997) for more

discussion of SFAS 125 and its effect on entities that securitize assets. Moody's Investors Service (1997) points out that gain­on­sale

accounting can result in significantly higher earnings without materially changing the economics of the underlying risk.

14 Credit­card losses at Advanta Corp. in March 1997 were responsible

for a decline in Advanta's stock price and a bond downgrade by

Fitch Investors Service.

15 As reported by Bloomberg News, April 21, 1997.

36
Conduits: Their Structure and Risk
 

Regulatory Risk 

In mid­1997 Cityscape encountered a second round

of problems, this time with a regulatory and political

origin in the United Kingdom.16 Several years earlier

Cityscape had grown its operations in the United

Kingdom through loans to individuals with high credit

risk (sub­prime loans). In addition to requiring high interest rates, these loans also imposed high penalties for

delinquency. As delinquencies rose so did the penalties, along with political pressure in the United

Kingdom for consumer relief. Cityscape finally acquiesced by reducing its penalties, but these reductions

cut into Cityscape's anticipated income. In the end,

uncertainty enveloped earnings from loans originated

in the United Kingdom, forcing write­downs of IO

strips and similar assets per SFAS 125. 

Cityscape's problems in the United Kingdom illustrate the influences that political and regulatory factors

may have on the management and value of outstanding

loans. Sovereign authorities always retain the ability to

change or otherwise affect a variety of elements in the

lending and loan­management environment, ranging

from fair lending practices to bankruptcy laws. This intervention is especially likely in high­risk consumer

lending, an activity embraced by many conduits in the

1990s but nevertheless a relatively new area and one

where regulatory concerns were uncharted.

Originator (Rep and Warranty) Risk 

Fraud by originators is an especially sensitive issue

for conduits because their core business involves purchasing loans originated by other entities. Association

with inappropriate origination procedures not only reflects badly on a conduit's ability to control the quality

of the loans it has securitized but also raises questions

about the quality of loans in any of its securities. Of

course, conduits rely on the reps and warranties made

by originators before they make similar reps and warranties on the loans they place in securities, so they

have recourse to originators if problems are detected.

However, this recourse has little value if the originator

is small or otherwise unable to repurchase problem

loans. Moreover, smaller conduits may have little capacity either to deal with legal problems related to bad

loans or to manage the bad loans themselves. SFAS

125 may enter the picture as well by requiring writedowns to IO strip and similar asset values.

Prepayment Risk

Falling interest rates during the second half of 1997

raised concerns about prepayment risk. The decline in

interest rates inevitably raised prepayment rates for

many types of consumer loans and, accordingly, raised

the possibility of adjusting IO strip, excess servicing,

and other related asset values, per SFAS 125.

However, prepayment risk was especially uncertain for

home­equity, sub­prime, and other types of consumer

loans that had been originated in volume, and through

conduit channels, for only a few years. The prepayment characteristics of borrowers found through direct

mail, borrowers with credit problems, and borrowers

having no ongoing relation with the originating lender

could simply not be known until a cycle of prepayments had run its course.17 Complicating matters was

the fact that after years of increasing competition for

home­equity and high­risk borrowers, market interest

rates for these types of consumer loans fell, thereby increasing the potential savings to these borrowers from

refinancing. In the end, several types of consumer

loans securitized by conduits responded to falling rates

with substantial refinancing activity, and this activity

generated write­downs of IO strip­related assets, per

SFAS 125.18

Hedge Risk 

Global financial stress and the stock market meltdown in mid­1998 marked the start of new problems

for conduits. The financial problems of mid­1998

helped motivate a rise in the market cost of credit risk,

causing spreads­to­Treasuries to rise, even as the general level of interest rates fell. This market anomaly

exposed the true meaning of "hedge risk." For most

changes in interest rates, standard hedging practices

mitigate risk for a reasonable cost. However, when

spreads­to­Treasuries widen, hedging activities often

fail to mitigate interest­rate risk. In such cases, holding

substantial amounts of loans can result in losses many

times greater than the modest "carry" that carrying

loans with lower­cost financing earns. For example,

figure 8 shows commercial mortgage spreads increasing

over 100 basis points (1.0 percent) in the fall of 1998, an

increase that could easily cause hedge losses to exceed

the full benefit expected from a securitization. This

problem of hedge losses was encountered by conduits

16 As reported by Bloomberg News, July 14, 1997.
 

17 Higher prepayment speeds for loans originated by loan brokers and
 

other third­party originators have only recently been formally documented (see Lacour­Little and Chung [1999]).

18 Unexpected prepayments caused Aames Financial to write down

sub­prime loans in September 1997, and Green Tree Financial to

write down mobile­home loans in November 1997.

37
 

 

• • •

FDIC Banking Review
 

with many types of loans, including products such as commercial loans that had

largely escaped the consumer finance trials of 1997.

�arket Risk

Figure 8 also illustrates the less­favorable market conditions conduits confronted after the jump in spreads in October 1998. One can see this by comparing the spread between the two lines in figure 8 before October 1998 with

the spread after that date. Before October 1998, commercial mortgage rates

were very close to the rates on securities created from loans in the AAA to BBB

range, but after that date the spreads between the rates were much wider. Wider

spreads imply that conduits will probably find it harder to securitize loans profitably. They will have to earn a larger profit from each deal to compensate them

for the higher risk that is effectively assessed by financial markets, especially after a period of substantial hedge­related losses. The immediate effect is that

conduits need to make a higher profit on each securitization to justify continued

activity. Moreover, higher spreads for investment­grade securities are often associated with much higher spreads for non­investment­grade securities, as well

as greater difficulty finding buyers for the non­ investment­grade classes of each

deal. In short, conduits' close proximity to the financial markets makes them especially susceptible to financial ebbs and flows, even apart from the hedge risk

associated with an isolated spike in spreads.

�e�-Product Risk

Once a conduit has drawn together the many players needed to securitize assets, it can often apply its experience easily to other loan products. As conduits

Figure 8
 

Spreads-to-Treasurr Rates for Commercial Mortgages versus
 

AAA and BBB Commercial Mortgage Securities,
 

Mar 1997-September 1999 Spread (%) 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 

1997 1998 1999 

Spread 

Mortgage 

Commercial 

Levy 

Spread 

AAA 

Spread 

BBB 

Note: AAAand BBB spreads are calculated relative to ten-year Treasury rates by Morgan Stanley for conduit commercial 

mortgage securities, as reported by Bloomberg Financial Markets. The Levy commercial mortgage rate is spread to tenyear Treasury rates, net of twenty basis points servicing fee. 

matured in the 1990s, established firms gained control

over origination networks, and

profit margins for established

and lower­risk loan products

thinned. Accordingly, many

conduits began to securitize

higher­risk loan products that

had never been originated on

a nationwide scale, such as

"B/C" quality loans and mortgages with loan­to­value ratios

as high as 125 percent. Even

if the credit risk of these new

products is ignored, the refinancing and other payoff characteristics of these products

remain largely unknown.

Because a significant portion

of the value of securitization

can be traced to the value of

the excess interest and because this value is heavily influenced by loan payoff

patterns, an additional level of

risk arises for conduits in new

loan products with unknown

payoff characteristics.

The experiences of 1997-

1998 underscore many (not

all) of the risks faced by conduits. These risks seem especially problematic for

independent conduits because of the complex nature of

the conduit business. Conduits that affiliate with larger

institutions seem better suited

to focus on the core "middleman" role they were initially

intended to play. Affiliating

with larger organizations also

increases the possibility of

synergies with affiliates, provides a steadier source of

funding, and ensures a degree

of insulation from the market

during periods of stress. For

these reasons it is not surprising that, as table 1 shows, large

38
Conduits: Their Structure and Risk
 

conduits affiliated with larger institutions have survived the stress of

the past several years, whereas independent conduits have fared poorly. 

Conclusions

In many respects, conduits have been remarkably successful. They

now function as a small industry, operating in a variety of forms ranging from independent to affiliated entities. Conduits have grown

Table 1
 

Transformation of Affiliated versus Independent Conduits,
 

1997-1999
 

Rank Rank

Name in 1997 in 1998 Status in 1999

Top 5 Affiliated Conduits in 1997

GMAC-RFC 1 1 Continuing operations.

Norwest Asset Securities Corp. 2 2 Continuing operations.

GE Capital Mortgage Services 4 3 Continuing operations.

Salomon Brothers 8 10 Continuing operations.

Countrywide Mortgage Securities 9 5 Continuing operations.

Top 5 Independent Public Conduits in 1997

ContiMortgage 3 8	 Severe financial problems

in 1998. Proposed buyout

by GMAC in 1999 never

consummated. Seventy

percent decline in stock

price in year before proposed merger.

IMC Mortgage 5 9	 Severe financial problems

in 1998 motivate agreement to merge with

Greenwich Street Capital 

Partners. Stock price 

declined over 95 percent

during year before merger.

The Money Store 6 14	 Purchased by First Union

6/30/98 (before market fallout). Before merger, stock

price was trading near the

year's high.

Firstplus Financial 7 19	 Severe problems; portions

placed in Chapter 11 in

3/99. Stock price trading

below $1 as of 5/99.

Advanta Corp. 11 13	 1998 earnings dropped but

remained positive. Revised

business strategy by selling

core credit­card business in

2/99. Stock price rose in

5/99 to 50 percent of previous year's high.

Note: 1997 and 1998 conduit rankings are from The Mortgage Market Statistical Annual for 1998

and 1999, respectively.

throughout the 1990s, to the point that

their operations account for a large proportion of the private­label securitization market. Conduits have also led the

way in securitizing commercial loans as

well as many other popular products

that lie outside the domain of Freddie

Mac and Fannie Mae, and they have

done so without federal intervention.

For banks and thrifts conduits also

offer new strategic options in the form

of securitization, which represents an

alternative to traditional forms of financing for the institutions' many types

of loan products. The new technology

also facilitates the ability of banks and

thrifts to specialize in component activities, thereby enhancing their strategic

flexibility. If credit risk and loan default become problems for institutions,

securitization also offers innovative options for disposing of troubled assets.

Nevertheless, although conduits

were very successful in the early and

mid­1990s and the benefits of securitization were considerable, recent experience has illustrated many risks. In

particular, the 1997-1998 period exposed risks ranging from regulatory and

accounting problems to prepayment

and market issues. During this period

almost every independent conduit had

severe problems, as evidenced by stock

prices languishing at small fractions of

the values that had been observed only

one and two years earlier. This experience suggests that conduits are more

successful when they are affiliated with

larger entities engaged in related activities, such as securities­brokerage or

banking­related enterprises. In these

institutional contexts conduits appear

sufficiently viable that they can be

counted on to play a central role in securitization well into the next century.

39
FDIC Banking Review
 

REFERENCES
 

Baskin, Dorsey L., Jr., and Keri N. Gregoire. 1997. SFAS No. 123 Gives New Flexibility in

Accounting for Retained Interests. Bank Accounting and Finance 10, no. 3:11-22.

Bear Stearns. 1999. Whole Loan Securitization: It's All in the Collateral. Mortgage Research,

January 4.

Brendsel, Leland C. 1985. Conventional Mortgage­Backed Securities. In The Handbook of

Mortgage Banking, edited by James M. Kinney and Richard T. Garrigan. Dow­Jones Irwin.

Duff & Phelps Credit Rating Company. 1997. Securitization and Corporate Credit Risk. Special

Report Financial Services Industry, July.

Fitch IBCA. 1999a. GMAC-RFC. Residential Mortgage Special Report, April 14.

---. 1999b. Rating Residential Loan Servicers. Residential Mortgage Servicer Report, August 3.

Lacour­Little, Michael, and Gregory H. Chung. 1999. Third Party Originators and Mortgage

Prepayment Risk: An Agency Problem? Journal of Real Estate Research 17, no. 1/2:55-70. 

Moody's Investors Service. 1997. Alternative Financial Ratios for the Effects of Securitization:

Tools for Analysis. Structured Finance Special Report, September 19.

Moreland­Gunn, Penelope, Peter J. Elmer, and Timothy J. Curry. 1995. Reps and Warranties.

FDIC Banking Review 8, no. 3:1-9.

40
Recent Developments

Recent Developments 

Affecting Depository 

Institutions 

by Lynne Montgomery*

REGULATORY AGENCY ACTIONS

lion and total assets of approximately $70.6 million. Interagency Actions All the deposits were purchased by Third Federal Financial Institutions Help Identify Child­ Savings and Loan Association of Florida in North Support Debtors Miami Beach, Florida, for a premium of $12.5 million.

Beginning July 1, 1999, financial institutions must The acquirer also purchased $6.3 million of

help state and local authorities identify accounts held Oceanmark's assets. The FDIC retained the remainby "deadbeat parents." The "data match program" is ing assets for later disposition. The FDIC estimates

part of a 1996 welfare reform law and requires banks, this transaction will cost the Savings Association

thrifts, credit unions, and brokerages to match Insurance Fund (SAIF) $4.4 million. This was the

account holders' Social Security numbers against a first failure of a SAIF­insured institution in the

database of child support debtors provided quarterly United States since August 1996. PR-39-99, FDIC, 7/9/99.

by the government. The first copy of the national The Office of the Comptroller of the Currency database was sent to participating banks at the end of (OCC) closed East Texas National Bank of Marshall June 1999. After receiving the government's quarter­ in Marshall, Texas, on July 9, 1999, and the FDIC was ly list of debtors, financial institutions will have 45 appointed as receiver. The OCC declared that the days to report back any matches with demand failed bank was "critically undercapitalized," that is, deposit, savings, time deposit, checking, or money­ tangible equity capital was less than 2 percent of its market account holders. The state agencies will then total assets. The bank's asset quality had deteriorat­ decide whether to place liens on the accounts. AB, ed as a result of poor credit underwriting and loan

7/1/99. administration practices by management and inadequate supervision by the bank's board of directors. Federal Deposit Insurance Corporation The FDIC entered into an agreement with Fredonia

Bank and Thrift Failures State Bank in Nacogdoches, Texas, to assume all of

On July 9, 1999, the Office of Thrift Supervision the failed bank's $113.0 million in total deposits.

(OTS) closed Oceanmark Bank, a FSB, in North

Miami Beach, Florida, and the Federal Deposit *Lynne Montgomery is a senior financial analyst in the FDIC's Division

of Research and Statistics. Insurance Corporation (FDIC) was named receiver. Reference sources: American Banker (AB); The Wall Street Journal (WSJ);

The failed institution had total deposits of $64.2 mil­ BNA's Banking Report (BBR); and Federal Register (FR).

41
 

FDIC Banking Review
 

Fredonia State Bank also purchased $127.3 million of

the assets at a discount of $5.5 million. The FDIC

retained the remaining $13.6 million in assets for later

disposition. The FDIC estimates this transaction will

cost the Bank Insurance Fund (BIF) $6.2 million.

This was the third bank failure of a BIF­insured institution in the United States this year. PR-38-99, FDIC,

7/9/99.

The First National Bank of Keystone in Keystone,

West Virginia, was closed by the OCC on September

1, 1999, and the FDIC was named receiver. The

OCC found evidence of fraud that resulted in the

depletion of the bank's capital. As of June 30, 1999,

the failed bank reported approximately $1.1 billion in

assets and $880.9 million in deposits. Ameribank,

Incorporated in Welch, West Virginia, assumed

approximately $135.0 million of the local insured

deposits at a discount of $105,000. Ameribank also

purchased $74.1 million in assets, and the FDIC

retained the remaining assets for future disposition.

The remaining out­of­area insured deposits, which

are primarily brokered deposits, will be paid directly

by the FDIC. This was the fourth failure of a BIFinsured institution in the United States this year. PR49-99, FDIC, 9/1/99; PR-52-99, FDIC, 9/3/99.

On September 10, 1999, the OCC closed Peoples

National Bank of Commerce in Miami, Florida, and

appointed the FDIC as receiver. The OCC declared

that the failed bank was "critically undercapitalized"

and was in an unsafe and unsound condition to transact business. The bank suffered from poor lending

practices, improper record keeping and accounting,

and ineffective board and management supervision.

As of June 30, 1999, the failed bank had total assets of

$37.6 million and total deposits of $36.1 million. The

FDIC entered into an agreement with Boston Bank

of Commerce, a minority­owned bank based in

Boston, Massachusetts, to assume all of the failed

bank's deposits and approximately $34.0 million of

the failed bank's assets at a discount of $1.8 million.

The FDIC as receiver retained the remaining $3.6

million in assets for later disposition. This was the

fifth bank failure of a BIF­insured institution in the

United States in 1999. The FDIC estimates the cost

of this transaction to the BIF will be approximately

$2.2 million. PR-55-99, FDIC, 9/10/99.

Real­Estate Survey - July 1999

The July 1999 issue of the Survey of Real Estate

Trends reported that the nation's commercial and residential real­estate markets continued to show

improvement in the early summer. The quarterly

survey polled 293 senior examiners and asset managers from the FDIC, the Federal Reserve System,

the OCC, and the OTS. Survey respondents noted

robust home sales and higher home sale prices

despite recent rises in mortgage interest rates. Fortyfive percent of the survey respondents said local

housing market conditions were improving, while

only 3 percent noted deterioration. The respondents

also indicated that improvements in commercial markets reported in the April survey continued into the

summer. Thirty­five percent of the July respondents

noted gains in local commercial markets, up from 33

percent in April.

The national composite index used by the FDIC

to summarize results for both residential and commercial real­estate markets remained at 69 in July,

unchanged from the April index. Index scores above

50 indicate improving conditions, while index scores

below 50 indicate declining conditions. Survey of Real

Estate Trends, FDIC, July 1999.

Financial Results for 

Second­Quarter 1999
 

The FDIC reported that the Bank Insurance Fund

(BIF) earned $219 million during the first six months

of 1999, and the Savings Association Insurance Fund

(SAIF) earned $226 million for the same period. The

BIF closed the second quarter of 1999 with a fund

balance of $29.8 billion. The SAIF closed the quarter

with an unrestricted fund balance of $9.1 billion and

$978 million in the restricted SAIF Special Reserve,

which was established on January 1, 1999, and contains the amount by which the SAIF exceeds the

Designated Reserve Ratio of 1.25 percent. Revenue

for the BIF totaled $902 million for the first six

months of 1999, including $857 million in interest on

investments in U.S. Treasury obligations and $16 million in deposit insurance assessments. The SAIF

earned $292 million in revenue during the first half of

1999, consisting of $286 million in interest on investments in U.S. Treasury obligations and $6 million in

42
Recent Developments
 

deposit insurance assessments. The low numbers of

bank and thrift failures contributed to the strong

financial results.

The FSLIC Resolution Fund (FRF) assets in liquidation were reduced by $1.092 billion during the

previous twelve months, with a remaining balance of

$714 million on June 30, 1999. The FRF was established in 1989 to assume the remaining assets and

obligations of the former Federal Savings and Loan

Insurance Corporation. On January 1, 1996, the former Resolution Trust Corporation's financial operations were merged into the FRF. PR-47-99, FDIC, 8/31/99.

New Deposit Insurance Guide for Employees

On August 24, 1999, the FDIC released a revised

version of its deposit insurance guide for employees

of insured financial institutions. The revised publication, The Financial Institution Employee's Guide to

Deposit Insurance, is a comprehensive guide that

explains federal deposit insurance rules in a nontechnical manner. The publication includes instructional

materials to assist in developing training programs for

staff at financial institutions, operations and savings

officers, and others who require knowledge of the

federal deposit insurance system. FIL-76-99, FDIC, 8/25/99;

BBR, 8/30/99, p. 335.

Federal Reserve Board

Interest Rates

On June 30, 1999, the Federal Open Market

Committee voted to raise the targeted federal funds

rate by 25 basis points, increasing the rate from 4.75

percent to 5.0 percent. At that time, the Committee

voted to keep the discount rate unchanged. At the

Federal Open Market Committee meeting on August

24, 1999, the policymakers voted to increase the federal funds rate an additional 25 basis points, raising

the rate from 5.0 percent to 5.25 percent. The discount rate was also increased by 25 basis points, bringing the rate to 4.75 percent. The federal funds rate is

the fee that banks charge each other for overnight

loans, and the discount rate is the fee charged to

financial institutions for borrowing from their district

Federal Reserve Banks. BBR, 7/5/99, p. 24-25; BBR, 8/30/99, p.

330-331.

President Clinton Announces Two

Nominations for Federal Reserve Board

On August 5, 1999, President Clinton announced

his plan to nominate Carol J. Parry to fill one of the

two vacant positions on the Board of Governors of the

Federal Reserve System. Ms. Parry was formerly an

executive vice president of Chase Manhattan Bank

and was also a member of the bank's Policy Council.

Ms. Parry has a background in lending to low­ and

moderate­income communities. If confirmed by the

Senate, Ms. Parry's term on the Board of Governors

would expire January 31, 2012. She will fill the seat

vacated by former Federal Reserve Governor Susan

Phillips. BBR, 8/9/99, p. 222-223.

On August 6, 1999, President Clinton announced

his plan to nominate Roger W. Ferguson Jr. to be vice

chairman of the Federal Reserve Board. Although

Mr. Ferguson is already a Board member, his term was

slated to expire on January 31, 2000. If the Senate

approves his nomination, he would serve a 14­year

term that would expire on January 31, 2014. BBR,

8/23/99, p. 279.

New Approach for Oversight of Large
 

Banking Organizations
 

On June 24, 1999, the Federal Reserve Board

issued guidance to supervisory staff and bankers on

the oversight of large, complex banking organizations.

The guidance calls for bank supervisors to use key

risk­management processes and closely monitor the

risk profiles of large, complex banking organizations.

The guidance requires the regulators to form supervisory teams to focus more closely on the banking organizations' business and risks. Each team of regulators

should have specialized skills and experience suited

to the assigned institution, and the team should designate a senior supervisor as the central point of contact for the institution. In addition, each team should

update its supervisory plan at least quarterly by continually reviewing the institution's current information, such as management reports and internal and

external audits. To minimize duplicative regulatory

effort, the guidance calls for close consultation with

other domestic banking agencies, state insurance

commissioners, securities regulators and foreign bank

43
FDIC Banking Review
 

supervisors. The Federal Reserve Board stressed the

need for a different approach to supervision of large,

complex banks because these institutions account for

a considerable and growing share of total banking

assets. In addition, these banking organizations are

entering into more nontraditional activities, such as

securities underwriting, and they are growing nationally and internationally. BBR, 6/28/99, p. 1150.

Liquidity Facility Established for
 

Year 2000 Cash Problems
 

On July 20, 1999, the Federal Reserve Board

approved a proposal to set up a special lending program to ensure that banks have enough liquidity to

meet high cash demands caused by the century date

change. The Century Date Change Special Liquidity

Facility will be available from October 1, 1999

through April 7, 2000, to make extra loans to banks

and other depository institutions experiencing liquidity problems. The Federal Reserve will charge interest at a rate equal to 1.50 percentage points above the

fed funds rate. PR-FRB, 7/20/99; BBR, 7/26/99, p. 125.

Deposit Reporting Schedules 

Unchanged
 

In order to help banks manage the upcoming century date change, the Federal Reserve Board

announced on July 15, 1999, that it will not change its

deposit reporting schedules this year. Regulation D

stipulates reserve requirements for depository institutions and also requires some institutions to file reports

on deposit data on an annual, quarterly, or weekly

basis. Each September, the Federal Reserve staff

reviews the institutions' deposit levels and reserve

liabilities, and then assigns the institutions to a reporting schedule. The reporting schedules are determined by the size of the institution, with the larger

institutions filing reports more frequently. Normally,

institutions may be required to switch to a new

reporting category in September, depending on

growth in their level of deposits and reservable liabilities. Holding the reporting schedules constant this

year ensures that depository institutions will not need

to alter their deposit data processing, and allows institutions to focus on century date issues. PR-FRB, 7/15/99;

BBR, 7/26/99, p. 127.

Regulation DD

On August 31, 1999, the Federal Reserve Board

published an interim rule to Regulation DD, which

implements the Truth in Savings Act. The interim

rule, which is effective September 1, 1999, permits

depository institutions to deliver disclosures on periodic statements to a consumer's e­mail account or post

them on a Web site, if the consumer agrees. Under an

earlier interim rule published by the Federal Reserve

Board in March 1998, periodic statements and other

disclosures required under Regulation E (which

implements the Electronic Fund Transfer Act) may

be delivered electronically if the consumer agrees.

Institutions commonly provide a single periodic statement that complies with Regulations E and DD.

Therefore, this interim rule for Regulation DD

should allow depository institutions to deliver deposit

account statements electronically under a single set of

procedures, and avoid the cost of printing and mailing

the information. PR-FRB, 8/31/99.

Office of tte Comptroller of tte Currency

Information­Sharing Accord

On September 15, 1999, the OCC announced that

it had reached an agreement with state insurance regulators from Alabama, Arizona, Arkansas,

Connecticut, Indiana, Maryland, and West Virginia, to

share information about customer complaints that

may arise in connection with sales of insurance by

banks. The agreement calls for the OCC and the

insurance departments to send copies of complaints

to each other and also to communicate on other matters, including regulatory and policy initiatives. The

OCC now has agreements with 16 state insurance regulators. The agreements enhance consumer protection and ensure compliance with appropriate

insurance sales standards. PR-99-80, aCC, 9/15/99. 

44
Recent Developments

Office of Ttrift Supervision Federal Housing Finance Board

Final Rule on Surety and Guarantee Risk­Split Pilot Program

Obligations On August 19, 1999, the Federal Home Loan Bank

The OTS issued a final rule on August 26, 1999, of New York won approval for a pilot program that will

which clarifies a federal savings association's authori­ split the credit and interest­rate risk between privatety under Section 5(b)(2) of the Home Owners' Loan sector mortgage lenders and the Home Loan Bank.

Act. The final rule states that a federal savings asso­ Under the pilot program, named the Community

ciation's authority to act as surety also includes the Mortgage Asset, the Home Loan Bank will purchase

ability to act as a guarantor. Surety agreements bind single­family mortgages at market value from memthe surety, along with its principal, to pay funds to a ber banks and thrifts, and will package these mortthird party. Guaranty agreements bind the guarantor gages into pools. For the first seven years, member

to pay the third party on the principal's behalf only if banks and thrifts will receive 97 percent of the princithe principal fails to perform its side of the contract pal payments and 48.5 percent of the interest paywith the third party. The rule also reduces minimum ments. After seven years, the Home Loan Bank will

collateral requirements on suretyship and guaranty take on 97 percent of the risk as well as collect that

agreements from 110 percent to 100 percent of the much of the cash flow. Member banks and thrifts will

surety or guarantee, provided the collateral is cash or collect just 3 percent of the cash flow, but will only be

a similar safe obligation. liable for 3 percent of any losses. The pilot qualifies

In addition, the new rule clarifies that a federal sav­ as an acceptable investment by Home Loan Banks

ings association may issue letters of credit, eliminat­ under a July 28, 1999, proposal by the Federal

ing confusion regarding the scope of activities Housing Finance Board. That proposal limits Home

authorized for federal savings associations that was Loan Banks' investments and curtails purchases of

caused by the deletion of a regulation in 1996. aTS 99- mortgage­backed securities by the year 2005. The

57, 8/26/99; BBR, 8/30/99, p. 342. intent of the proposal is to get the Home Loan Banks

focused on their mission of financing affordable housing. AB, 8/20/99.

STATE LEGISLATION AND REGULATION

Florida ing a requirement of written disclosure to customers

Effective July 1, 1999, insurance agents in Florida stating that their choice of insurance would not affect

are permitted to sell insurance products on the credit decisions. Financial institutions are also

premises of financial institutions, repealing a law that required to provide written disclosure to their cusbanned agents from engaging in such activities tomers stating that the insurance products are not

except in towns with populations of 5,000 or fewer. guaranteed deposits and may involve investment

The new law provides a number of consumer safe­ risk. BBR, 7/5/99, p. 18.

guards relating to disclosure and advertising, includBANK AND THRIFT PERFORMANCE

Second­Quarter 1999 Results for were $1 billion lower than earnings in the first quarCommercial Banks and Savings ter of 1999, primarily because of higher expenses at

Institutions one large institution that was acquired during the secFDIC­insured commercial banks earned $17.0 bil­ ond quarter. Noninterest expenses were $1.2 billion

lion during the three months from April through June higher than in the first quarter and merger­related

1999, which represents the second­highest quarterly expenses at that one institution caused all but $52

earnings ever reported by the industry. The earnings million of the increase. Banks' annualized return on

45
FDIC Banking Review

assets (ROA) was 1.25 percent in the second quarter, expenses for future loan losses were two of the main

which is the same as in the second quarter of 1998, sources of improved earnings. The industry's ROA

but down from 1.32 percent in the first quarter of for the second quarter was 1.03 percent, an improve1999. The number of problem banks dropped to 62 ment from the 0.98 percent average of the first quarfrom 64 in the first quarter of 1999. There was one ter of 1999, but below the 1.09 percent average in the

bank failure during the quarter. second quarter of 1998. The number of problem

FDIC­insured savings institutions reported profits thrifts decreased from 16 institutions at the end of the

of $2.9 billion in the second quarter, which is the sec­ first quarter to 14 institutions at the second­quarter

ond­highest quarterly total in the industry's history. end. The FDIC Quarterly Banking Profile, Second Quarter 1999.

Strong growth in noninterest income and lower

RECENT ARTICLES AND STUDIES

According to an FDIC study released to the House entitled Merging the BIF and the SAIF: Would a Merger

and Senate Banking Committees on September 7, Improve the Funds' Viability? Working Paper 99-4, FDIC, 9/7/99.

1999, consolidation in the banking industry during An August 1999 study from the Federal Reserve

the 1990s has made the Bank Insurance Fund (BIF) Bank of New York concludes that large companies

two­thirds more likely to fail than it was at 1990 bank have come to rely less on banks for their day­to­day

consolidation levels. The study concludes that the credit needs, however they still utilize banks when

consolidation that took place between 1990 and 1997 economic conditions are bad. The report, entitled Are

increased the risk of BIF insolvency by approximate­ Banks Still Important for Financing Large Businesses?,

ly 50 percent, and megamergers that took place was written by Marc R. Saidenberg and Philip E.

between year­end 1997 and midyear 1999 increased Strahan. They found that, as securities markets have

the risk of insolvency further. The paper was written grown over the past 25 years, businesses depend less

by Robert Oshinsky, a financial economist in the on banks. More companies use commercial paper

FDIC's Division of Research and Statistics. Working instead of bank loans because the rates are usually

Paper 99-3, FDIC, 9/7/99; AB, 9/8/99. better. The share of credit extended to non­financial

A companion study released by the FDIC on businesses from bonds and commercial paper grew

September 7, 1999, and also written by Robert from approximately 45 percent in the mid­1970s to

Oshinsky, concludes that a merger of the BIF and the approximately 55 percent in the mid­1990s. In addiSAIF would reduce the chances of either fund tion, banks' share of assets held by financial intermebecoming insolvent. The study reports that a larger, diaries declined approximately 50 percent in the past

combined insurance fund would be less at risk than 15 years. BBR, 8/23/99, p. 279.

either the BIF or the SAIF separately. The study is

INTERNATIONAL DEVELOPMENTS

Basel Committee Committee is seeking comment on the three other

On July 27, 1999, the Basel Committee on Banking papers. One of the three papers, Principles for the

Supervision released four papers providing guidance Management of Credit Risk, offers 17 risk­reduction

to banks and banking regulators on credit risk. The practices that banks are advised to adopt. The secguidance is part of the Basel Committee's ongoing ond paper, Best Practices for Credit Risk Disclosure, receffort to improve risk­management procedures in ommends 24 ways for banks to help investors and

banks and create a sounder global banking system. other market players judge asset quality. The third

The first paper, Sound Practices for Loan Accounting and paper, Supervisory Guidance for Managing Settlement

Disclosure, was issued in final form and addresses a Risk in Foreign Exchange Transactions, recommends

range of issues facing banks and bank supervisors in that banks have a formal process for handling settlethe accounting for loans and loan losses. The Basel ment risk. NR 99-69, aCC, 7/27/99; AB, 7/27/99; BBR, 8/2/99, p. 197. 

46
Recent Developments
 

Canada

Canadian legislation permitting the direct operation of foreign bank branches took effect on June 28,

1999, allowing foreign banks to set up commercially

focused branch operations in Canada. Under the new

legislation, foreign banks are able to open full­service

or lending branches that would have the same powers

as branches of domestic banks except for restrictions

on deposit­taking. The full­service branches would

be restricted to accepting deposits larger than

C$150,000, and lending branches would not be permitted to accept any deposits or to borrow money

other than from other financial institutions. The

Bank Act had previously required foreign banks to

operate branches in Canada through a separate

Canadian subsidiary. BBR, 7/5/99, p. 34.

�e�ico

On July 7, 1999, the president of Mexico's bank

bailout agency announced that the agency will inject

13 billion pesos (approximately $1.4 billion) into

Banca Serfin in order to recapitalize the bank, which

is the third­largest bank in Mexico. The bailout

agency, Instituto para la Proteccion al Ahorro Bancaria

(IPAB), will assume temporary control of Serfin, and

will determine the bank's status and ready it for sale.

BBR, 7/19/99, p. 114.

47