Federal Deposit Insurance Corporation 

Chairman 

L. William Seidman 

Office of Research 

and Statistics. 

Director 

Wm. Roger Watson 

Editor 

John F Bovenzi 

bAlitorist] Committee 

Predenck S. Cams 

Alan S. MuCall 

Lynn A. Nejezchleb 

Administrative 

Manager 

Den a Voesar 

Eilitorin] Secretary 

Cathy Wright 

Design and Production 

Design and Printing 

Unit 

The views expressed are 

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FDIG 

Bankin: 

view 

Spring/Summer 1989 

Vol. 2, No. 1 

Bank Intermediation, Bank Runs, and Deposit Insurance page 1 

by Arthur .!. Murtnn 

This article examines the reasons why the government provides deposit insurance and how the 

provision of deposit insurance can improve economic performance. It is argued that the primary 

reason for deposit insurance is to promote financial stability by preventing bank runs. Deposit 

insurance, however, may allow excessive risk-taking and there exists a trade-off between the 

benefits of financial stability and the costs of possible misallocation of resources associated with 

excessive risk-taking. The terms of this trade-off depend on the availability of alternatives to bank 

deposits as sources of liquidity, the importance of bank lending activities, and the difficulty 

associated with monitoring bank asset values and risk-taking. Finally, alternatives to deposit in 

surance and reforms of deposit insurance are considered. 

Should the $100,000 Deposit Insurance Limit Be Changed? page 11 

by Frederick S. Cams 

In considering how to harness market forces to better control bank risk-taking, it often is recom 

mended to alter the £100,000 statutory limit on deposit insurance coverage. The most common 

suggestion is to reduce the scope of coverage—and thus promote "depositor discipline"—either 

by lowering the dollar amount of coverage per deposit or restricting coverage to particular deposit 

classes. Occasionally, however, it also is suggested that deposit coverage be expanded in order 

to facilitate methods of failure resolution that may elicit stronger discipline from nondeposit 

creditors. This article considers the merits of proposals to enhance market discipline through 

changes in the statutory limit on deposit insurance coverage. 

Forbearance: Practices and Proposed Standards page 20 

by Dean Forrester Cobos 

Forbearance is a word with different meanings to different people. Because in recent years 

forbearance often has been associated with the delayed closure of insolvent institutions, it has 

become a dirty word in many places. However, there are many forms of forbearance that have 

long been accepted supervisory practices. Forbearance is not something to be avoided under 

all circumstances. This article discusses appropriate uses of supervisory forbearance. 

Recent Developments Affecting Depository Institutions page 29 

by Benjamin B. Christopher 
Bank Intermediation 

Bank Intermediation, 

Bank Runs, and 

Deposit Insurance 

by Arthur J. Murton* 

This article examines the 

reasons why the government 

provides deposit insurance 

and how the provision of deposit in 

surance can improve economic per 

formance. It is argued that the 

primary reason for deposit insurance 

is to promote financial stability by 

preventing bank runs. Deposit in 

surance, however, may allow ex 

cessive risk-taking and there exists a 

trade-off between the benefits of 

financial stability and the costs of 

possible misallocation of resources 

associated with excessive risk-taking. 

The terms of this trade-off depend on 

the availability of alternatives to 

bank deposits as sources of liquidity, 

the importance of bank lending ac 

tivities, and the difficulty associated 

with monitoring bank asset values 

and risk-taking. Finally, alternatives 

to deposit insurance and reforms of 

deposit insurance are considered. 

Banking and the Cost 

of Bank Runs 

Deposit insurance is a form of 

government intervention into the 

marketplace. Government provision 

of deposit insurance is predicated on 

[he existence of social benefits 

associated with insurance of bank 

deposits. The major social benefit 

that deposit insurance is intended to 

provide is the prevention of 

widespread bank deposit runs and 

the damage that they cause.1'2 In 

order to justify deposit insurance, it 

is necessary to specify why and how 

bank runs impose social costs. Much 

attention has been focused, par 

ticularly through the efforts of Fried 

man and Schwartz (1963), on the 

damage to the money-supply process 

caused by bank runs. This channel 

requires a systemic run to currency 

and a failure of the monetary authori 

ty to offset the collapse of the money 

multiplier. Bernanke (1983), while in 

no way dismissing the importance of 

the monetary channel, argues that 

bank runs impose an additional cost, 

the loss of credit intermediation. 

The argument for deposit in 

surance put forth here follows Ber 

nanke by focusing on the creditallocation role of banks. Bank runs 

are costly, it is argued, in part 

because runs can disrupt or destroy 

an important conduit of investment 

funds in the economy. This argument 

therefore focuses on the role of 

banks as intermediaries in the 

economy. 

Bernanke's framework was built on 

two foundations. The first is the 

seminal article by Diamond and Dyb

vig (1983). Banks are a special class 

of intermediaries, distinguished 

primarily by their funding of illiquid 

assets with liquid liabilities. This 

feature is critical to both the produc 

tive role of banks and their suscep 

tibility to damaging bank runs. The 

second foundation is the literature 

that focuses on banks as a 

mechanism to overcome information 

problems associated with certain 

assets. 

For purposes of this discussion, 

"bank" will refer to a stylized entity 

which issues liabilities that are 

redeemable at par either on demand 

or after some short maturity and 

holds assets that are illiquid because 

banks have private information 

about the quality of the assets. The 

first part of the discussion will focus 

on an important and controversial 

question: namely, whether there is 

essential interaction between the 

liability and asset sides of the bank, 

or conversely, whether it is in 

nocuous, in theory and in practice, 

to separate the two sides of the 

balance sheet. The second part of the 

discussion focuses on the 

characteristics of bank assets. 

* Arthur J. Murton is a financial economist 

in the KUIC's Office of Research and Statistics. 

The author is grateful to Fred Cams, Chris 

James, and Lynn Nejezchleb for helpful discus 

sions and comments 

1 See Edwards and Scott (1979) for a 

thorough discussion of the reasons for govern 

ment intervention into depository institutions 

and an assessment of the appropriateness of 

various forms of intervention. 

2 Government action is often triggered by 

the desire to help a particular group that is 

perceived to be disadvantaged in some way. 

In the case of deposit insurance, the argument 

is that there are people who are relatively un 

sophisticated financially who should have easy 

access to a safe means for both mailing 

payments and for storing wealth. (See Gorton 

and Pennacchi (1988).) If this were the sole 

reason for government intervention, it would 

seem that the current system represents a 

sledgehammer approach, and that either lower 

deposit insurance coverage or a more limited 

alternative form of protection would be 

appropriate. 
FDIG Banking Review 

The Unique Intermediary 

Role of Banks: What Is the 

Sound of One Hand 

Clapping? 

An important question is whether 

there is some economic function that 

is served by having the liabilities and 

assets which characterize banks com 

bined in one entity. Is it possible to 

separate the two sides of the balance 

sheet without causing a reduction in 

useful economic activity? For exam 

ple, one could picture a system 

which required liquid liabilities to be 

funded by liquid assets only, while il 

liquid assets were funded by long

term debt or equity only. The follow 

ing discussion argues that such a 

system would likely be unable to pro 

vide the same level of economic 

welfare as a system that lacked that 

requirement, 

Diamond and Dybvig have argued 

that the special role of banks derives 

from the social-welfare enhancement 

that can be realized when banks 

coordinate the funding of these illiq 

uid assets with highly liquid 

liabilities. Banks issue deposits that 

satisfy depositors' liquidity needs. By 

pooling liquidity risk across in 

dividuals, the bank will need to hold 

fewer liquid assets than the 

depositors would hold if they lacked 

access to the bank. To the extent that 

the bank can meet the liquidity 

needs with fewer liquid (and less pro 

ductive) assets, there are more funds 

available to support productive illiq 

uid investment.3 

By combining the holding of illiq 

uid assets with the issuing of liquid 

liabilities, banks provide real 

economic services that could not 

otherwise be obtained. 

The main functions of banks can 

be described in terms of the balance 

sheet items described above. Asset ser 

vices are provided to the "issuers" of 

bank assets (the borrowers); these ser 

vices include evaluating, granting and 

monitoring loans. Liability services are 

provided Co the "holders" of bank 

(iabiiities (the depositors); these ser 

vices include holding deposits, clearing 

transactions, maintaining an inventory 

of currency, and service flows arising 

from conventions that certain liabilities 

are acceptable as payments for goods. 

Transformation services require no ex 

plicit service provision to borrowers or 

depositors but instead involve pro 

viding the depositors with a pattern of 

returns that is different from (and 

preferable to) what depositors could 

obtain by holding the assets directly 

and trading them in a competitive ex 

change market. Explicitly, this means 

the conversion of illiquid loans into li 

quid deposits, or more generally, the 

creation of liquidity.4 

The liquidity transformation that 

enables banks to provide useful ser 

vices is also the source of banks' 

susceptibility to destructive deposit 

runs. 

What is meant by destructive bank 

runs? Bank runs are caused by a 

combination of two factors. As 

discussed above, loans, the primary 

asset of banks, are illiquid in that 

they can not be sold quickly without 

a loss in value. The second factor that 

causes bank runs is the ability of 

most depositors to withdraw their 

deposits either on demand or on 

short notice. These two factors vir 

tually guarantee that a bank will be 

unable at any time to fulfill its poten 

tial obligation to convert all or most 

of its liabilities to cash. Of course, 

under normal circumstances the 

bank will never be called upon to 

fulfill all of its obligations; this is what 

allows the bank to invest in illiquid 

assets. 

If, however, a depositor believes 

that the bank will be called upon to 

fulfill more than the normal amount 

of withdrawals, that depositor will 

have the incentive to attempt to 

withdraw his or her funds. This is 

because once the bank has depleted 

its inventory of liquid assets, it must 

begin to sell illiquid assets to meet 

further withdrawal demands. By 

definition, each such sale means the 

bank is realizing a liquidation loss on 

the asset. At some point the bank will 

have suffered enough losses to 

render it unable to fulfill its obliga 

tion to the remaining depositors. 

The reader should note that it is 

the "first come, first served" nature 

of the process that provides 

depositors with the incentive to run. 

Those depositors at the beginning of 

the withdrawal line lose nothing 

while those at the end lose 

everything. A depositor who merely 

suspects that other depositors are go 

ing to run will get in line whether he 

or she desires liquidity at that time 

or not. This leads to "panic" runs. 

If there were some mechanism to 

ensure that all liquidation losses 

would be shared equally by all 

depositors, then there would be no 

incentive to participate in panic runs. 

This is because, from any given 

depositor's point of view, the action 

of other depositors has no impact on 

his or her eventual wealth. In an ideal 

world, because this mechanism 

would eliminate panic runs, there 

would never be liquidation losses to 

be shared and the mechanism would 

never need to be used. 

The Special Nature of 

Bank Loans 

Broadly speaking, loans are the 

asset class that distinguishes banks 

because the transactions which pro 

duce bank loans require not only that 

borrowers and lenders find one 

another, but also that lenders must 

evaluate and monitor potential bor 

rowers. Lenders face two problems 

because they have imperfect infor 

mation. First, they face the (ex ante) 

adverse selection problem of assess 

ing the quality of potential bor 

rowers. Second, lenders face the (ex 

post) moral hazard problem of 

monitoring and controlling the 

behavior of borrowers. By gaining ex 

pertise in evaluating and monitoring, 

and by accumulating a body of 

private information, banks are able 

to reduce information costs. 

Put differently, banks specialize in 

lending to a unique class of bor

3 Note that the illiquidity of the assets is 

essential for the argument: ii all productive 

assets were liquid, people could provide their 

Own liquidity without the need for the bank, 

4 Diamond and Dybvig (3986), pp. 57-58. 
Bank Intermediation 

rowers. For these borrowers, "public 

information on the economic condi 

tion and prospects of such borrowers 

ts so limited and expensive that the 

alternative of issuing marketable 

securities is either nonexistent or 

unattractive.1'5 Because these bor 

rowers cannot easily convey informa 

tion about their own creditwor

thiness to lenders (or conversely, 

because lenders cannot easily ascer 

tain the creditworthiness), there are 

agency costs associated with the bor 

rowing and lending arrangements 

available to them. Banks alleviate 

these costs by specializing in 

evaluating and monitoring this class 

of borrowers.6 In essence, banks' 

information-gathering and monitor 

ing expertise of this class of bor 

rowers allows them to find profitable 

investment opportunities in essen 

tially nonmarketable assets. 

Once the loans have been made, 

the agency problem now extends to 

any potential saJe of the assets by the 

bank. This results in illiquidity 

because the value of the project is 

known only to the monitor (the 

bank); a prospective buyer must in 

cur costs to evaluate the project and 

these costs will result in a lower 

value. The important implication is 

that there are liquidation costs 

associated with these assets. Social 

welfare is enhanced if these loans are 

allowed to mature. 

The Cost of Bank Runs 

As stated earlier, the fact that illiq 

uid bank assets are funded with more 

liquid liabilities redeemable at par 

means that banks are susceptible to 

runs. The belief that a panic run will 

occur is self-fulfilling. 

When runs occur, they may force 

"fire-sale" liquidations of bank assets 

that impose social costs. Again, these 

costs arise because most bank assets 

(loans) are inherently difficult to 

value and, hence, are ill-suited to 

trading in spot markets. Bankers 

possess specialized information 

about the nature of their assets that 

cannot be quickly or easily transfer 

red. This makes spot trading pro 

hibitively costly for the establish 

ment of a broad secondary market, 

with the result that forced liquida 

tions typically yield asset prices that 

are below "equilibrium" values.7 In 

the process, creditworthy borrowers 

lose financing (often for extended 

periods, given the information costs 

noted), production is interrupted, 

and consumption plans are 

frustrated. Runs can be socially cost 

ly because they force a market valua 

tion of assets that are not ordinarily 

valued in markets. The assets are not 

traded voluntarily precisely because 

their characteristics make markets 

inefficient devices for valuing them. 

The results are understandably cost 

ly when the banking organization is 

recognized as (in part) a device for 

avoiding the excessive costs of 

market organization (for trading such 

assets) in the first place.8 

The informational problems 

associated with bank assets effective 

ly mean that there is a discontinuity 

in bank asset values when moving 

from states of the world in which 

assets are allowed to mature to states 

in which assets are liquidated. This 

difference between "going-concern" 

value and liquidation value is a 

critical element in explaining why 

bank runs occur and why they are 

costly.s 

To summarize, bank runs are cost 

ly because runs adversely affect the 

financial intermediation performed 

by banks. Economic activity is 

adversely affected when loans are li 

quidated prematurely in order to 

meet depositors' claims. More impor 

tantly, if bank runs are widespread 

there may be a general contraction 

of these special intermediary ser 

vices.10 Borrowers who may other 

wise receive bank loans in a more 

favorable environment may not be 

funded as banks are forced to main 

tain high levels of liquid assets. 

Bernanke has provided some 

evidence that, in addition to the 

adverse consequences of a declining 

money supply, the banking system's 

reduced effectiveness in performing 

its unique intermediary function 

helped to convert the severe 

downturn of 1929-30 into a pro 

tracted depression. Bernanke argues 

that the fear of runs during 1930-33 

caused banks to increase their 

precautionary reserves and general 

ly increased their desire to hold li 

quid assets. According to Bernanke, 

these factors, plus the actual failures, 

forced a contraction of the banking 

system's role in the intermediation of 

credit. Some of the slack was taken up 

by the growing importance of alter 

native channels of credit.... However, 

the rapid switch away from the banks 

(given the banks' accumulated exper 

tise, information, and customer rela 

tionships) no doubt impaired financial 

efficiency and raised the cost of credit 

intermediation.11 

Diamond and Dybvig did not need 

to model the conditions under which 

bank runs will occur in order to 

make their point that the inferior 

s Goodhart (1987), p.86. Fama (1985) and 

James (1987) take this one step further by 

arguing that banks' interaction with their 

customers as both depositors and borrowers 

enhances their ability to monitor the repeattype, short-term loans that banks offer. 

Knowledge of a customer's history as a 

depositor allows the bank to evaluate the credit 

risk of the same customer more cheaply than 

other lenders. Thus, there may be a synergy 

between deposit-taking and the special types 

of loans that banks offer. 

o See Rernanke and Gertler (1988); Ber

nanke (1983); Diamond (1984) and (1988); 

and Boyd and Prescott (1986). 

7 "Equilibrium" value as used here refers 10 

the price obtainable given the normal amount 

of time for the necessary information-gathering 

by prospective buyers (see Kaufman (1988)). 

s Coase (1937) characterizes the firm as a 

device for avoiding the excessive transactions 

costs associated with spot-market trading. This 

notion is widely recognized as essential to the 

explanation of banking's original development 

in free markets. See Woodward (1988), Ber 

nanke (1983), Goodhart (1987), and the 

literature cited therein. As noted in the follow 

ing text, this notion is necessary but not suffi 

cient to describe what may be unique about 

banks. I thank Fred Cams for this point. 

'' The discontinuity issue surfaces in a world 

with deposit insurance when considering both 

bank-closure rules and methods used to resolve 

failed banks. See Bovenzi and Murton (1988) 

and .lames (1988). 

1U Even if runs are not widespread, bank 

runs can disrupt the communities in which 

they occur. This local externalities problem 

also has been offered as a reason for providing 

deposit insurance. 

11 Bemanke (1983), p. 264. 
FDIG Banking Review 

bank run equilibrium is a conse 

quence of the liquidity transforma 

tion performed by banks. For exam 

ple, the Diamond-Dybvig model can 

be modified by introducing a 

random-selection mechanism that 

determines whether a run occurs and 

then focusing on the initial invest 

ment decision of households. One of 

the simple results is that, in the face 

of the threat of bank runs, depositors 

will require banks to hold more liq 

uid assets than if bank runs were not 

a threat. This means, as Bernanke 

describes above, that banks will pro 

vide less funding of the type of invest 

ment in which banks specialize. The 

greater the likelihood of a panic run, 

the less investment will be under 

taken by the special class of bor 

rowers to which banks cater. Ex ante, 

in a world without deposit insurance, 

the threat of runs reduces productive 

investment. 

The primary purpose of deposit in 

surance is to promote financial 

stability by preventing destructive 

bank deposit runs. Deposit insurance 

is designed to reduce the possibility 

of runs and to thereby avoid the 

damage that runs cause and to 

facilitate the funding of the lending 

that is characteristic of banks. 

Deposit insurance works by directly 

guaranteeing depositors that they 

will not suffer losses, thus removing 

the incentive to participate in a bank 

run. In order for deposit insurance to 

be effective, the guarantee must be 

credible. 

Distortions Created by 

Deposit Insurance 

Whatever the motivation for its ex 

istence, deposit insurance affects the 

allocation of resources in an 

economy. The previous sections 

described possible beneficial effects: 

protection of unsophisticated 

depositors, protection of the money 

supply, and protection of the 

financial-intermediary function. As 

with any government intervention 

designed to enhance the market 

mechanism, there are potentially 

adverse effects from the implemen 

tation of deposit insurance. This sec 

tion will describe the nature of the 

problem and will discuss the factors 

that determine the severity of that 

problem. 

Deposit Insurance Removes 

Depositor Discipline 

By providing a guarantee that 

deposits are not subject to loss, 

deposit insurance has two principal 

effects: it removes the incentive to 

participate in a bank run and it 

eliminates the need for depositors to 

police bank risk-taking. This latter ef 

fect introduces the potential for 

substantial costs to arise from the 

provision of deposit insurance. 

Deposit insurance therefore involves 

a basic trade-off between depositor 

discipline and the possibility of 

destructive bank runs. 

In any financial transaction the 

borrower must compensate the 

lender for risk that is borne by the 

lender. borrower whose repayment 

is more uncertain must provide a 

higher expected return to the lender. 

In the case of banking, the repay 

ment depends on the return on the 

portfolio held by the bank and by the 

level of bank capital that serves as a 

cushion to absorb losses. In the 

absence of deposit insurance, a bank 

that wished to hold a riskier portfolio 

of assets or a smaller amount of 

capital would have to offer a higher 

expected return to depositors.12 

In the presence of deposit in 

surance, depositors would be indif 

ferent to the riskiness of the repay 

ment. The rate on deposits would not 

be sensitive to asset choice or capital 

levels. This lack of depositor 

discipline may provide an unfettered 

bank with the opportunity to arrange 

its portfolio so as to increase its ex 

pected profits at the expense of the 

insurer. This possibility is at the heart 

of the concern over the current state 

of deposit insurance. 

Incentives for Excessive 

Risk-Taking 

With deposit insurance the FDIC 

bears the risk of any loss. The FDIC's 

position is therefore similar to that 

of an uninsured depositor's in that 

the FDIG bears the risk of loss aris 

ing from a bank's investment deci 

sions. However, unlike other 

creditors, the FDIC cannot vary the 

premium it charges for insurance on 

the basis of risk.13 This flat-rate in 

surance pricing structure, it is argued, 

creates an incentive for excessive 

risk-taking. 

The following simple example 

presents the argument more direct 

ly.14 Suppose a bank is funded with 

$90 of deposits. The bank has a 

choice between two asset portfolios. 

The "safe" portfolio will return glOO 

with certainty. The "risky" portfolio 

will pay $80 half the time ("bust") 

and will pay $120 the other half 

("boom"). Notice both portfolios 

have the same expected value. The 

value of the bank if it chooses the 

safe portfolio is $1015. The value of 

the bank to the shareholders if it 

chooses the risky portfolio is: 1) zero 

if the portfolio busts or 2) equal to 

$3016 if the portfolio is successful. 

The expected value of the bank is 

#1517. Therefore, if the banker wants 

to maximize the expected return to 

shareholders, he or she should select 

the risky portfolio. 

Obviously, what drives the exam 

ple is that the insurer bears the cost 

when the portfolio busts. Consider 

the cost of providing the insurance. 

If the bank chooses the safe portfolio, 

there is no cost because the bank 

cannot fail. If the bank chooses the 

12 The risk premium required by depositors 

could be decomposed into two components; 

one compensating for the "normal" risk, i.e., 

credit, interest-rate, and operating risk, and one 

compensating for the risk of losses resulting 

from being last in line in a bank run. 

13 Note that the risk premium the insurer 

would charge would not need to include the 

component associated with the risk of runs (as 

discussed in the previous footnote) because 

deposit insurance has eliminated that risk. That 

component can be viewed as the measure of 

the social benefit of a mechanism that 

eliminates bank runs. There are, of course, 

costs associated with such mechanisms. 

14 This is similar to an example given by 

Flannery (1982). 

is = glOO — 890. 

'f> #120 — S90. 

»' = Vi y. SO + Vi x #30, 
Bank Intermediation 

risky portfolio, the cost is: 1) $10 if 

the portfolio busts18 and 2) zero if 

the portfolio booms; this gives an ex 

pected cost of $519. By allowing the 

bank to freely choose the portfolio, 

the insurer has, directly at its own ex 

pense, increased the bank's expected 

value from #10 to $15. 

Controlling Bank RiskTaking: The Present System 

In the context of the example 

presented above the insurer can do 

several things to protect itself. First, 

it can prevent the bank from choos 

ing the risky portfolio (supervision 

and regulation); it can charge the 

bank #5 if the bank chooses the risky 

portfolio (risk-based deposit in 

surance); or it can require the 

shareholders to replace $10 of 

deposits with equity, which would 

eliminate the insurer's cost even in 

a bust (capital requirements).20 

The present system of deposit in 

surance relies primarily on three 

mechanisms to limit risk-taking. The 

first mechanism is bank supervision, 

examination and regulation. FDIG 

regulations have a purpose similar to 

the covenants that are found in vir 

tually every debt contract: to prevent 

bank management from undertaking 

activities that increase risk to the 

detriment of existing creditors or the 

insurance fund. 

The second mechanism used to 

limit risk-taking is bank capital re 

quirements. Capital serves to reduce 

the incentives of owners to increase 

risk since the greater the amount of 

capital the larger is the owners' loss 

in the event of failure. Currently, 

banks are required to maintain a 

minimum of 5.5 percent primary 

capital relative to bank assets. 

The third and final mechanism us 

ed to limit bank risk-taking is the 

discipline exerted by uninsured 

depositors and nondeposit creditors 

of the bank. Because uninsured 

claimants risk loss in the event of the 

bank's failure, they have an incentive 

to monitor the bank's investment ac 

tivity and to adjust the return they 

require on their investment to the 

asset and financial risk of the bank. 

In addition to regulation, capital re 

quirements, and the discipline unin 

sured depositors and creditors pro 

vide, whether banks have the incen 

tive to undertake excessive risks will 

depend on several other factors, in 

cluding: risk aversion on the part of 

bank owners, the presence of signifi 

cant bankruptcy costs and the costs 

imposed on bank managers 

associated with a bank's failure. If 

bank owners are risk averse, they 

may not be willing to accept higher 

risk for higher return. This may not 

be relevant for banks with widely 

held stock because the shareholders 

can diversify their portfolio. 

However, for institutions where the 

owners may have sizable portions of 

their wealth invested in the bank, 

risk aversion may be a reasonable 

assumption. As for larger banks, they 

are typically owned by holding com 

panies which are funded with both 

equity and debt. Debt holders will 

have the incentive to police the 

riskiness of the holding company 

asset, i.e., the bank. 

If there are significant bankruptcy 

costs associated with bank failures, 

then the bank may choose a safer 

portfolio in order to avoid them. A 

potential bankruptcy cost is the loss 

of the bank charter, assuming that a 

charter enables one to earn supranor

mal profits.21 

Finally, if bank managers control 

the bank's investment decisions they 

may choose not to pursue 

excessively-risky strategies. This will 

occur if bank managers do not share 

fully in the successes of the bank; 

but, in the event of failure, bank 

managers do incur significant costs, 

i.e., loss of career opportunities. In 

this situation, managers will be reluc 

tant to take excessive risks. 

Alternatives to Deposit 

Insurance 

Deposit insurance is not the only 

means available to safeguard the 

financial system from bank runs. 

How one evaluates these alternatives 

depends on what role banks are 

assumed to play in the economy and 

the costs associated with bank 

failures. 

Suspension of Convertibility 

Throughout the nineteenth cen 

tury and early twentieth century, 

suspension of convertibility was us 

ed to halt bank runs. Suspension of 

convertibility temporarily relieves 

banks of their obligation to satisfy 

withdrawal demands and, thus, 

prevents the costly liquidation of 

assets. Once the panic has subsided 

and action has been taken to prevent 

a recurrence, the bank returns to 

business as usual. A problem with 

this mechanism is that the incentive 

to run remains in order to avoid the 

temporary inaccessibility of funds. 

Lender of Last Resort 

Bank runs are costly to the extent 

that they cause a significant contrac 

tion of the money supply, disrupt the 

workings of the payments system, or 

disrupt the financial intermediation 

performed by banks. One possible 

solution to the problem is the 

presence of a lender of last resort. 

In terms of protecting the money 

supply, an effective lender of last 

resort is capable of offsetting any 

contraction of the money supply 

caused by bank runs by the injection 

of reserves, either through purchase 

of securities or loans to banks. This 

requires the lender of last resort to 

be able to measure the contrac 

tionary effect of the runs and to 

gauge the amount of reserves 

necessary to inflate the money sup 

ply to the appropriate level. Both of 

these require determining the extent 

to which the runs represent a flight 

to currency. Protection of the money 

supply does not have to involve pro

"* The payment to depositors net of the 

value of the assets. 

v> = Vfc x SO + V4 x j$I0. 

20 Sec Ruser, Chen and Kane (1981); 

Benston, et. al. (1986); and Kim and San

tomcro (1988). Actually, there are more op 

tions. The insurer can require coinsurance, ex 

tended shareholder liability, or capital punish 

ment for unsuccessful bankers. 

31 Marcus (1984); and Buser, Chen and 

Kane (1981). 
FDIG Banking Review 

tecting individual banks; it merely re 

quires the replenishment of systemwide reserves. 

While protecting the money sup 

ply does not require preventing in 

dividual bank runs, protecting both 

the payments system and financial 

intermediation does require atten 

tion to individual banks. The inabili 

ty of a bank participating in the 

payments system to repay its obliga 

tions can have systemic effects. A run 

on an individual bank can force the 

costly liquidation of assets. The 

lender of last resort can prevent, the 

disruption by stepping in to fulfill the 

obligation of the deficient bank. 

Essentially the lender of last resort 

must be willing to transfer the risk 

of insolvency from participating 

banks to itself. 

At this point, let us define what we 

mean by lender of last resort and 

deposit insurer so as to make clear 

the distinction between them. A 

deposit insurer provides a guarantee 

on certain deposits that is noncon

tingent; a lender of last resort will 

fund the withdrawals from solvent in 

stitutions only.22 When a run oc 

curs, the lender of last resort must 

make a judgement regarding the 

solvency of the bank experiencing 

the run, 

If bank assets are difficult for out 

siders to value, then depositors will 

have difficulty determining whether 

or not they should participate in the 

run. Presumably, they would err on 

the side of safety, and participate in 

the run even if their best estimate 

was that the bank was solvent. Runs 

would occur on solvent institutions, 

and thus the lender of last resort 

would not be expected to be as effec 

tive in preventing this type of finan 

cial instability as would a deposit 

insurer. 

Another drawback arises from the 

conflict between protecting the finan 

cial system and avoiding inflationary 

growth of the money supply. To be 

effective, the lender of last resort 

must provide a credible commitment 

to freely fund withdrawals from sol 

vent banks. Providing this commit 

ment requires relinquishing control 

over the creation of reserves and, 

thus, the money supply.23 

Narrow Banks 

One way to prevent bank runs is 

to prohibit banks from funding illiq 

uid assets with liquid liabilities. This 

is the heart of the "narrow-bank" pro 

posals put forth by Litan (L987), 

Bryan (1988) and advocates of 100 

percent reserve banking. These pro 

posals substitute structural reform of 

the financial-services industry for 

deposit insurance reform. The goal of 

the narrow bank is twofold. First, to 

provide for a completely safe 

payments system; and second, to per 

mit banking organizations to expand 

into other activities, such as 

securities underwriting, without ex 

tending the federal safety net and 

creating potential conflicts of in 

terest. 

One problem with these proposals 

is feasibility. Currently, the 

checkable account portion of the 

money supply is over #550 billion. 

There are $381 billion in short-term 

Treasury bills outstanding. Given this 

shortfall, either commercial paper or 

long-term Treasury instruments 

would need to be included as eligible 

reserves. Once the range of eligible 

investments is broadened, the 

resulting risk poses a threat to a safe 

payments system, thereby defeating 

one of the major purposes for the 

narrow bank.24 

Putting aside the question of 

feasibility, the problem remains that 

enhancing the payments system is 

not the only potential role for banks 

in the economy. Banks facilitate in 

termediation between savers who 

desire liquidity and borrowers who 

lack direct access to credit markets. 

Also, there may be important 

synergy between the deposit-taking 

and lending function of banks.25 If 

these are important aspects of the 

economic role that banks play, then 

the imposition of a narrow-bank 

financial structure will have one of 

two undesirable results. 

The first occurs if firms are suc 

cessful in circumventing the impos 

ed structure. The narrow-bank struc 

ture severely restricts the type of 

assets that can be held by firms issu 

ing "runnable" liabilities. If there are 

profits to be earned from circumven 

ting this restriction, then firms will 

act accordingly. If they are suc 

cessful, there will be a class of firms 

that is susceptible to runs and 

presumably poses a threat to finan 

cial stability.26 

The second case occurs if firms 

desire to, but are not successful in, 

circumventing the restrictions. The 

flow of savings to a desirable form of 

financial intermediation will have 

been diminished. Borrowers for 

whom it is costly to tap the credit 

markets directly will have access to 

less funding. If, as Diamond (1988) 

suggests, these borrowers represent 

young, profitable enterprises which 

have not yet established a favorable 

reputation, then the narrow-bank 

structure may place a severe drag on 

future growth. Further, whatever 

synergies exist between deposittaking and lending will not be 

realized.27 

22 If the lender of last resort agrees to fund 

withdrawals from all institutions, then it bears 

the loss when an insolvent bank is closed (just 

as the FDIC does now). Presumably, it would 

charge banks for this risk-bearing, and would 

require examination and supervisory powers 

similar to those currently held by the FDIG. 

It would at this point be more than Bagehot's 

lender of last resort; it also would he a deposit 

insurer. 

23 Friedman and Schwartz (1963) argued 

that the Federal Reserve's failure to offset 

withdrawals in 1930, and again in 1931, allow 

ed a severe, but not atypical, recession to 

develop into the Great Depression. 

24 This static analysis is intended only to 

provide an idea of the relative magnitudes in 

volved. If the narrow-bank structure were 

adopted, one would expect the price of shortterm debt to rise relative to long-term debt, 

thus steepening the yield curve. 

2s See James (1987). 

26 Note that these firms will be neither 

regulated nor supervised. 

27 A third alternative to deposit insurance 

is to eliminate the debt features of bank 

deposits. In particular, banks could offer an ac 

count similar to a claim on a mutual fund, with 

a value that fluctuated with the value of the 

bank's assets. A deposit run that forced a bank 

to liquidate its assets would result in claims 

of the bank being revalued at a price determin 

ed by the liquidation value of the bank's asset 

portfolio. (See Jacklin (1988).) 
Bank Intermediation 

Proposals for Reforming 

Deposit Insurance 

If (absent deposit insurance) bank 

runs are either unlikely or innocuous 

and bank risk cannot be contained 

without depositor discipline, then 

deposit insurance is unnecessary or 

at least coverage should be kept to 

a minimal amount to protect only 

small savers. Conversely, if (absent 

deposit insurance) bank runs are like 

ly and destructive and bank risk can 

be contained without depositor 

discipline, then deposit insurance 

with more than minimal coverage is 

desirable. 

As stated earlier, the two principal 

effects of deposit insurance are to 

eliminate both bank runs and 

depositor discipline. The elimination 

of bank runs enhances financial 

stability because it lessens the threat 

of disruptions to the money-supply 

process, the payments system, and 

financial intermediation. The 

removal of depositor discipline can 

reduce financial stability because it 

provides incentive for banks to take 

excessive risks. This presents soci 

ety with a cost-benefit trade-off 

regarding deposit insurance. 

While some reform proposals have 

focused on restructuring the financial 

system to alleviate the need for 

deposit insurance, most reform pro 

posals focus on redesigning the way 

deposit insurance is provided. These 

reform proposaJs typically call for 

greater reliance on market discipline, 

risk-related pricing of deposit in 

surance and less reliance on 

regulatory discretion in closing 

institutions. 

Conclusion 

Deposit insurance enhances the 

workings of the financial system by 

all but eliminating bank runs as a 

means of closing banks. Bank runs 

are viewed as a form of market 

failure that can have deleterious ef 

fects on the money supply, the 

payments system, and financial in 

termediation. Bank runs can inflict 

systemic damage when contagion 

arises, and isolated damage when 

runs on individual banks occur. In ad 

dition to these ex post effects, there 

are ex ante costs in the form of 

underproduction of bank services in 

response to the threat of runs. 

The potential for bank runs arises 

because banks issue liquid liabilities 

to fund assets that are not easily 

marketable because outsiders cannot 

value them easily. This intermedia 

tion is a valuable source of liquidity 

in the economy, but it carries with 

it the potential for bank runs. 

Depositors who simply believe that 

other depositors may withdraw their 

funds have an incentive to do so also. 

This fragility can lead to systemic ef 

fects if a run on a bank triggers runs 

on other banks. Contagion can 

disrupt the payments system, 

thereby impeding the flow of goods 

and services throughout the 

economy. If contagion involves a 

flight to currency, remedial action is 

necessary by the central bank to 

avert a collapse of the money supply. 

Even if contagion does not result, 

there are costs of isolated bank runs. 

These costs arise because, once the 

bank has drawn down its normal in 

ventory of liquid assets to satisfy 

withdrawals, it must begin to sell off 

its illiquid assets. These are assets 

that banks fund which allow produc 

tive investment by borrowers who do 

not have direct access to credit 

markets because of the informational 

costs of evaluating and monitoring 

their creditworthiness. As a result, 

banks have private information 

about these assets and, because effi 

cient markets for these assets do not 

exist, there are deadweight losses 

associated with their premature sale. 

In addition to the ex post costs of 

bank runs, contagion and liquidation, 

there are ex ante costs arising from 

the threat of bank runs. To avoid the 

liquidation costs resulting from a run, 

a bank may choose (or depositors 

may require a bank) to hold more liq 

uid assets. This will reduce desirable 

investment by the class of borrowers 

lacking direct access to markets. 

Alternatively, the bank may respond 

to the threat of runs by funding illiq 

uid assets with fewer liquid liabilities, 

thus reducing the liquidity available 

in the economy. 

The externalities and information 

costs inherent in banking are market 

failures which prevent an economy 

from achieving the "first-best" alloca 

tion of resources associated with 

perfect markets. Consider a fictional 

economy from which bank runs had 

been exorcised without cost. In this 

first-best economy, banks would pro 

vide liquidity and hold assets for 

which markets had not arisen. The 

activities of banks would also include 

those activities that were com 

plementary to this intermediation. 

Bank owners would earn a com 

petitive return on capital, borrowers 

would pay loan rates reflective of the 

risk of the loans, and depositors 

would demand deposit rates reflec 

tive of the riskiness of the bank's 

portfolio. 

The presence of the threat of bank 

runs makes this result unattainable. 

In an economy without government 

intervention, market participants 

would take steps to mitigate pro 

blems arising from bank runs. 

Depositors would require banks to 

choose portfolios that made bank 

runs either less likely or less damag 

ing; as a result, banks would 

substitute marketable assets for nonmarketable assets. In addition, 

depositors would charge banks a risk 

premium that reflected not only the 

portfolio risk mentioned above, but 

also included a component to reflect 

the risk arising from the threat of 

bank runs. Bank closings would be 

triggered by the actions of nervous 

depositors and would likely spill over 

into other areas of the economy, 

Closure and bankruptcy laws would 

need to address the discontinuity in 

the value of bank assets, i.e., the 

distinction between going-concern 

and liquidation value; this may in 

volve higher capital levels, early 

closure, or extended liability for bank 

owners. All of these effects imply a 

diminution of bank services relative 

to the first-best economy. 
FDIC Banking Review 

Credible deposit insurance 

removes the incentive of depositors 

to participate in bank runs; if it could 

be provided free of cost, the first-best 

allocation would result. Of course, 

deposit insurance cannot be provid 

ed free of cost, because the problems 

that create the need for deposit in 

surance also hamper the insurer's 

ability to provide perfect insurance, 

Ideally, the insurer would like to 

have depositors charge banks a risk 

premium that included only the 

portfolio-risk component, and not the 

"bank-run" risk component. Unfor 

tunately, the insurer is not able to ex 

pose depositors to the one risk 

without also exposing them to the 

other. To the extent that depositors 

charge banks for that risk, the costs 

of bank runs, even if runs do not oc 

cur, are implicit in the system and 

the economy moves away from the 

first-best allocation. Alternatively, the 

insurer itself would like to charge 

banks the portfolio-risk component 

as an insurance premium; however, 

the insurer cannot know what that 

premium is. Nor can the insurer 

solve the problems resulting from the 

discontinuity of the value of bank 

assets. 

The result of these factors is that 

banks do not face the same deposit 

costs nor hold the same assets that 

banks in the first-best world would. 

This is the distortion that results 

from deposit insurance. Depending 

on the corrective steps the insurer 

takes, the deposit insurance 

economy may have, relative to the 

first-best economy, more or less fun 

ding of nonmarket assets, more or 

less provision of liquidity, and more 

or less risk-taking. 

To minimize the distortions of 

deposit insurance while maintaining 

stability, the insurer seeks to rely on 

market forces that are not associated 

with bank runs. This means putting 

owners and managers at risk for port 

folio choices. However, because 

these parties' risk-return decisions 

will not coincide with the insurer's, 

the insurer must employ nonmarket 

measures to prevent banks from 

transferring risk from themselves to 

the insurer without compensation. 

These measures include the monitor 

ing of banks through bank examina 

tions, the implicit pricing of deposit 

insurance through regulation and 

supervision, forbearance, and closure 

policies that enforce desirable 

market discipline and that recognize 

and ameliorate the problems arising 

from the discontinuity of bank asset 

values. 

Can deposit insurance work well? 

If the criterion is the first-best world, 

the answer is no—unless the prob 

lems faced by the insurer are in 

significant, in which case deposit in 

surance is unnecessary. If the 

criterion is the laissez-faire world, it 

seems reasonable to believe that the 

benefits of eliminating bank runs 

could outweigh the costs of a well-run 

insurance system. Of course, a poor 

ly administered system could inflict 

costs in excess of its benefits. 

Does deposit insurance work well? 

The past decade has raised doubts in 

many minds. Many observers feel the 

current system is fundamentally 

unstable and that major reform is 

necessary to prevent complete col 

lapse of the system. This view typical 

ly holds that the instability has arisen 

over the past decade because 1) 

deregulation has removed explicit 

controls on risk-taking, 2) increased 

competition has reduced the charter 

value of banks, thus reducing selfcontrol on risk-taking and 3) deposit 

insurance has not responded to the 

need to replace these controls. The 

empirical evidence for this view cur 

rently derives primarily from the 

plight of the FSLIG. This view holds 

that while the FDIC may appear 

healthy at this point, the FDIG is in 

fact on the same path as the FSLIC, 

simply a few steps behind. This view 

has understandably led to calls for 

major reform. The impact of many 

of these reforms would be a move 

ment toward the laissez-faire world, 

either by imposing depositor 

discipline, lowering the return on 

bank capital, or prohibiting the in 

termediation performed by banks 

(the narrow-bank proposal). This im 

plicitly reflects a judgment that the 

costs of the current system outweigh 

the benefits. 

An alternative, opposing view is 

that over the past decade, the bank 

ing and thrift industries have been 

subjected to major economic shocks 

and that the difference in the condi 

tion of the two insurance funds 

reflects both the different problems 

faced and responses taken by the 

respective regulatory authorities.28 

When a situation exists in which 

reasonable observers can hold stark 

ly contrasting views, it is fair to ask 

under what conditions the subscriber 

of a particular view would change his 

or her view. Regarding the issue at 

hand, the relevant questions are as 

follows: What events would have to 

occur in order for proponents of ma 

jor reform to find the current system 

imperfect, but acceptable? Converse 

ly, what events would lead opponents 

to conclude that major reform is 

necessary? While it is doubtful that 

any events could lead to clear and 

complete conversions, it seems 

reasonable to focus on the perfor 

mance of the banking industry over 

the next several years. Proponents of 

major reform presumably expect the 

situation to deteriorate, with bank 

failures becoming more frequent, 

more costly, and leading to further 

erosion of the insurance fund. Those 

who call for modest reform expect, 

assuming that reform is achieved, the 

situation to stabilize, with fewer bank 

failures and a return to growth of the 

2li While it is useful to compare the FSLIC 

and the FDIC, one has to guard against belabor 

ing the comparison. The circumstances faced 

by the two insurers were not identical, and one 

cannot draw ironclad conclusions. Suffice it to 

say that the recent experience of both agen 

cies can provide insight into the conditions 

necessary for effective deposit insurance. 
Bank Intermediation 

insurance fund.29 Thus, the issue ing industry, feeling instead that the system of second-best; 2) appeal to models that derive 

should and presumably will be is' a Priori> unstable, and that any calm will instability by ignoring constraints and objec

' " _ be temporary. At that point, however, the tives that, in fact, are present in the system; 

revisited in the coming years. burden is on those observers to clarify their or 3) point to a limited period during which 

position. It is not enough to: 1) point out that the insurer suffered losses; presumably a 

25 Some proponents of major reform will a deposit insurance economy does not achieve deposit insurer provides intertemporal 

not be persuaded by a resurgence of the bank- the first-best allocation; that is the definition insurance. 

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presented at the Garn Institute Symposium on Federal Deposit Insurance and the Struc 

ture of Financial Markets, 18 August 1988. 

Bovenzi, John F., and Arthur J. Murton. "Resolution Costs of Bank Failures." FDIC Banking Review 

(Fall 1988):1-13. 

Bryan, Lowell L. Breaking Up (he Bank. Homewood, IL: Dow Jones-lrwin, 1988, 

Bryant, John. "A Model of Reserves, Bank Runs, and Deposit Insurance." Journal of Banking 

and Finance (December 1980):335-44. 

Buser, Stephen A., Andrew H. Chen, and Edward J. Kane. "Federal Deposit Insurance, Regulatory 

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1982. 

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"Monitoring and Reputation: The Choice Between Bank Loans and Directly 

Placed Debt." Paper presented at the Garn Institute Symposium on Federal Deposit In 

surance and the Structure of Financial Markets, 18 August 1988. 

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Regulation." Journal of Business 59 (January T986):55-68. 

Diamond, Douglas W., and Philip H. Dybvig. "Bank Runs, Deposit Insurance, and Liquidity." 

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Edwards. New York: McGraw-Hill, 1979. 

Fama, Eugene F. "Banking in the Theory of Finance." Journal of Monetary Economics 6 (January 

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.. "What's Different About Banks?" Journal of Monetary Economics 15 (1985): 

29-37. 

Flannery, Mark J. "Deposit Insurance Creates a Need for Bank Regulation." Federal Reserve Bank 

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75-89. 

Gorton, Gary. "Banking Panics and Business Cycles." Working Paper No. 86-9, Federal Reserve 

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FDIC Banking Review 

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1985). 

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10 
Deposit Insurance Coverage 

Should the $100,000 

Deposit Insurance Limit 

Be Changed? 

by Frederick S. Cams* 

In considering how to harness 

market forces to better control 

bank risk-taking, it often is 

recommended to alter the §100,000 

statutory limit on deposit insurance 

coverage. The most common sugges 

tion is to reduce the scope of 

coverage—and thus promote 

"depositor discipline"—either by 

lowering the dollar amount of 

coverage per deposit or restricting 

coverage to particular deposit 

classes. Occasionally, however, it also 

is suggested that deposit coverage be 

expanded in order to facilitate 

methods of failure resolution that 

may elicit stronger discipline from 

nondeposit creditors. This article 

considers the merits of proposals to 

enhance market discipline through 

changes in the statutory limit on 

deposit insurance coverage. 

Market discipline—the presence of 

market-determined incentives to 

control risk-taking—has many dimen 

sions in banking. At the bank level, 

the potential sources of discipline in 

clude depositors, shareholders, 

managers, subordinated debt holders, 

and other nondeposit creditors. The 

bank holding company also is a 

potentially important source of 

discipline for the bank. Holding com 

pany shareholders and creditors have 

wealth at stake and, hence, have in 

centives to constrain the bank's ac 

tions. While this article focuses on 

discipline at the bank levei and 

primarily on depositor discipline, any 

complete analysis of market 

discipline in banking must consider 

the role of nondeposit bank creditors, 

holding company creditors, and the 

incentive effects created by alter 

native failure-resolution methods 

(see FDIC (1989, forthcomingChapter 7)). 

As indicated in Murton (1989), it 

is the asymmetric information 

associated with bank assets and the 

combination of these assets with 

callable liabilities that make ex 

clusive reliance on market 

discipline—particularly depositor 

discipline—potentially problematic. 

Ideally, the market restrains risktaking by imposing premiums (or, 

when necessary, covenants in loan 

contracts) that raise a bank's cost of 

funds commensurately with the 

assumed risk. In reality, the asym 

metric information problem is a 

potential impediment to accurate 

pricing (or complete contractwriting) and, hence, to reliable 

discipline via market mechanisms 

alone. 

Technically, the ideal goal of 

deposit insurance is to eliminate that 

portion of the market-determined 

risk premium reflecting the threat of 

bank runs without altering the por 

tion reflecting other risks. If achiev 

ed, this result would retain all the 

market discipline exercised in the 

absence of deposit insurance, but 

without the social costs posed by 

bank runs (Murton (1989)). 

Moreover, in this ideal deposit in 

surance system, there would be no 

over-restriction of risk-taking through 

market mechanisms, i.e., market 

devices would not be used to impose 

artificially-restrictive constraints 

which unnecessarily raise the social 

costs of intermediation.1 The nature 

of bank assets makes it difficult to 

determine when the optimum 

balance has been reached, since the 

need for specialized information 

makes market assessments of bank 

risk (and, hence, asset-value deter 

minations) costly, complex, and sub 

ject to error. 

With these caveats and considera 

tions as a backdrop, the remainder of 

this article explores the potential for 

enhancing market discipline through 

changes in deposit insurance 

coverage. The focus is on developing 

appropriate criteria with which to 

decide whether stronger market in 

centives are warranted. 

Enhancing Depositor 

Discipline: The Trade-Off 

Given broad agreement that the 

present coverage limit is adequate to 

provide a safe haven for small savers' 

funds, and given no realistic 

legislative prospect of a rollback large 

enough to threaten the adequacy of 

the statutory limit for this purpose, 

* Frederick S. Cams is a financial economist 

in the FDIG's Office of Research and Statistics. 

Panos Konstas made essential contributions to 

the initial formulation of ideas presented here. 

The author also thanks Lynn Nejezehleb and 

Arthur Murlon for valuable suggestions. Any 

remaining errors are the author's. 

i Excessive capita) requirements or extend 

ed liability rules might be examples. 

11 
FDIC Banking Review 

the issue of the proper coverage level 

turns largely on the matter of finan 

cial stability.2 In determining the 

proper statutory limit for insurance 

coverage, policymakers face a trade 

off between two potential sources of 

financial instability: bank runs, which 

may be contagious, and excessive 

risk-taking by banks. While insurance 

coverage enhances stability in wellknown ways, it simultaneously 

weakens two potential sources of in 

centives to limit bank risk-taking: the 

threat of runs and the demands of 

depositors for higher yields from 

riskier banks. The terms of the trade 

off between bank runs and risk-taking 

are determined by the likelihood of 

runs and the magnitude of the threat 

they pose, as well as the comparative 

effectiveness of depositor discipline 

and its substitutes under deposit in 

surance. These are considered in 

turn. 

Runs by uninsured depositors re 

main a real possibility today 

whenever a bank is widely perceiv 

ed to be imperilled. Runs have occur 

red at large banks despite apparent 

ly broad recognition of a defacto 100 

percent guarantee of their deposit 

liabilities.3 This may suggest that 

large-depositors' potential costs in an 

insolvency proceeding remain suffi 

ciently high under full insurance to 

cause withdrawals; or it may indicate 

that, at the time a large bank 

develops problems, the market 

perceives the FDIC's guarantee of 

large deposits as "conjectural" (Flan

nery (1986)) rather than de facto 

100 percent. Some have interpreted 

the finding of differential risk 

premiums for large CDs as suppor 

tive of the latter explanation (Macey 

and Garrett (1988)), though the 

evidence is mixed (James (1988); 

Hannan and Hanweck (1988)). 

Regardless, it is apparent that cur 

rently a real threat of runs remains. 

At the same time, it is important 

to note that today's bank runs are 

confined to institutions that are insol 

vent, or virtually so. So-called "pure 

panic" runs by depositors, which are 

not based on any determination of 

the bank's longer-run viability, are 

not observed in the current setting. 

Thus, while present arrangements 

clearly do not foreclose the possibili 

ty of bank runs based on false infor 

mation or occurrences unrelated to 

a bank's true condition, the empirical 

evidence suggests little to fear for in 

stitutions that avoid real financial dif 

ficulty (Kaufman (1988)). 

The policy question is whether the 

trade-off represented by the present 

statutory limit is optimal. Difficulties 

arise in weighing the costs and 

benefits associated with changes in 

coverage in either direction. In the 

direction of lower coverage, for ex 

ample, perceptions of the costs 

associated with nonsystemic bank 

runs differ. The costs associated with 

isolated runs as well as the probabili 

ty of contagion are hard to measure 

objectively, despite rich historical ex 

perience. For similar reasons, there 

are differing views on the historical 

reliability of depositor discipline. 

This suggests that historical reex

aminations of pre-FDIC bank runs 

and depositor discipline are of 

limited value for the current policy 

decision concerning statutory 

coverage.4 

The different perspectives through 

which history is filtered lead to dif 

ferent interpretations of the facts for 

the purposes of present-day 

policymaking.5 Some view the pre

insurance era as a healthy one for 

banking, on balance, and advocate 

more reliance on the market, i.e., on 

the threat of runs and depositor 

discipline (Kaufman (1988); 

Schwartz (1987)). Others see the 

period as excessively unstable due to 

the frequency and high economic 

cost of bank runs (based on evidence 

such as Bernanke's (1983) or 

Tollman's (1988)). These different 

perspectives do not reflect disputes 

over the factual consequences of 

bank runs and depositor discipline, 

so much as differing implicit 

judgments about the relative cost and 

viability of the alternatives (namely, 

constraints on risk-taking applied by 

nondepositors). 

Such implicit judgments, and not 

the historical "facts," are most prop 

erly the focus of the policy debate. 

The crucial question is not whether 

the facts prove that historical (more 

market-oriented) arrangements were 

good or bad, it is whether some level 

of deposit insurance coverage 

represents a viable, long-run alter 

native to these arrangements that is 

clearly better. Thus, a fundamental 

issue is how this judgment should be 

made.6 Two perspectives merit 

consideration. 

2 Other issues are relevant, such as the 

FDIC's costs in handling bank failures, and 

equity in the treatment of large- and small-bank 

depositors. These issues affect the decision on 

whether to alter the coverage limit in a par 

ticular way, but do not bear on the original pur 

poses of insurance coverage. The primary func

tion of deposit insurance coverage is 

presumably not to minimize the FDIC's costs 

or redress inequities, but to correct a perceiv 

ed market failure, i.e., to provide a setting that 

unambiguously improves upon the results of 

a free-market arrangement (as determined by 

Paretian analysis of economic welfare). It 

follows that this primary policy goal takes 

precedence in determining the optimal level 

of statutory coverage. 

J In virtually every failing-bank case, some 

uninsured deposits leave the bank in the 

period immediately preceding failure (defin 

ed by the declaration of the chartering authori 

ty). Cases such as Continental Illinois, First 

Republic, and others, demonstrate that such 

withdrawals may develop into runs that create 

a terminal liquidity crisis for the affected 

institution. 

4 The fundamental historical facts are well 

known, e.g., that there were seven or so discer 

nible banking "panics" (contagions of varied 

origin) prior to the establishment of deposit 

insurance in the U.S. and that, while not the 

norm, runs originally confined to one bank did 

sometimes precipitate runs on other institu 

tions even in the absence of a generalized 

panic. 

5 See both Kaufman (1988) and Schwartz 

(1987) versus Goodhart (1987). 

6 The choice involves the conceptual 

framework, or analytical "paradigm," that 

should be used for understanding, evaluating, 

and selecting among alternative banking ar 

rangements. All paradigms embody two com 

ponents: a theory of economic behavior (a 

system of reasoning by which the expected 

economic effects of actual or proposed ar 

rangements are inferred), and a set of prioritiz 

ed policy objectives (a preference ordering by 

which the costs and benefits of the expected 

effects are weighed so that alternative ar 

rangements can be ranked). Recognition of the 

paradigm behind a policy proposal is necessary 

in order to determine whether there is a defen 

sible logic and a consistent value system—a 

sound analytical infrastructure—that form a 

coherent policy strategy. (This usage of 

"paradigm" follows that of Kuhn (1970).) 

12 
Deposit Insurance Coverage 

First, the recognition of banks as 

"special" intermediaries creates a 

predisposition to avoiding bank runs, 

as noted by Mutton (1989). Runs im 

pose the very costs (of spot-market 

valuation) that banking serves to 

avoid. They interrupt transformation 

services directly, while the threat of 

runs causes bankers to underproduce 

liquidity, thereby precluding the 

realization of aggregate economic 

potential. In effect, runs nullify bank 

ing's unique contribution to 

economic activity. It follows that any 

form of depositor discipline creating 

a susceptibility to bank runs is to be 

avoided, absent convincing evidence 

that reliance on alternative 

(nondeposit) risk controls is poten 

tially more costly than bank runs. Ac 

cording to this view, there is "a much 

stronger case" for 100 percent 

coverage than for any reduction in 

the statutory limit (Diamond and 

Dybvig (1986)). 

An alternative perspective on bank 

uniqueness regards the cost of bank 

runs as the short-run price that 

necessarily must be paid for long-run 

stability.7 The crucial judgment here 

takes one of two forms: (1) the con 

tainment of bank risk-taking is 

technically infeasible without 

greater reliance on depositor 

discipline, due to inadequacies in 

available analytical tools or logistical 

impossibilities; or (2) without 

substantial depositor discipline, 

deposit insurance necessitates 

reliance on forms of risk control that 

are self-defeating in the long run, due 

to incentive problems created both 

by insurance coverage and institu 

tional arrangements in public 

bureaucracies. The first type of argu 

ment appears to be contradicted by 

FDIC supervisory experience and by 

other types of evidence presented 

elsewhere in the FDIC's forthcoming 

study on deposit insurance reform 

(particularly Chapters 3 and 5). Thus, 

only the second type of argument is 

examined here. 

Incentives are distorted by in 

surance coverage such that deposits 

tend to now away from the most con 

servatively managed institutions 

toward the most risky. This occurs 

because insured depositors can ob 

tain higher yields (implicit or ex 

plicit) from the latter with no added 

risk. When coverage is extensive, the 

insurer's supervision becomes essen 

tial to preventing an increasing 

overexposure to risk in the industry. 

According to this perspective, such 

supervision is unlikely to be suc 

cessful without the aid of depositor 

discipline to signal difficulties. The 

reason is that the economic incen 

tives inherent in this supervisory ar 

rangement work against the contain 

ment of banking risk. Allegedly, 

bankers have stronger economic in 

centives to innovate around con 

straints than the insurer has to pre 

vent this. The reason is that bankers' 

wealth is more directly at stake in the 

outcome than is the wealth of deposit 

insurer employees and manage 

ment,a Combined with the fact that 

incentives favor the placement of in 

sured deposits with the most daring 

bankers, this suggests that excessive 

reliance on insurance coverage poses 

a long-run threat to the stability and 

efficiency of the banking industry.9 

The unique economic value of li 

quidity transformation may be used 

as an argument for higher levels of 

statutory coverage, while the 

"depositor discipline" approach may 

be used to suggest the opposite (Dia 

mond and Dybvig (1986); Kane 

(1986a)). Neither argument can be 

completely convincing, because each 

considers only one side of the trade 

off between bank runs and bank risktaking. The first presents a strong 

theoretical case against bank runs as 

a form of discipline, but fails to 

establish convincingly that there ex 

ist feasible real-world alternatives to 

bank runs that are better (less cost 

ly). The "depositor discipline" argu 

ment makes a plausible case that 

some threat of bank runs is a 

necessary evil, but fails to establish 

convincingly that reliance on 

nondeposit sources of discipline 

poses greater economic risks than 

does the threat of runs.10 

7 Stated differently, according to this 

perspective the moral hazard problem is 

dynamically unstable and uncontainable in the 

absence of depositor discipline. 

8 For example, the examiner's wealth (pro 

motion, success, etc.) does not depend nearly 

so much upon "results"—that is, upon the ac 

tual frequency with which the examiner 

detects excessive risk-taking in time to avoid 

losses to the insurance fund—as it does upon 

following prescribed procedures. 

Bankers, or the stockholders for whom the 

bank is managed, stand to gain personally and 

directly by actually winning the hide-and-seek 

game played with examiners. Thus, they 

generally seek out new, unregulated forms of 

risk-taking, i.e., forms that the examiner has 

not yet been expected to identify (Kane 

(1981)). The banker can remain one step 

ahead of the supervisor in this manner. 

Diluted and conflicting incentives place the 

insurer's management at a similar comparative 

disadvantage, as described in the economic 

theories of regulation and public bureaucracy 

(Buchanan (1975); Tullock (1965); Stigler 

(1971); Posner (1974); Kane (1931); Gwartney 

and Stroup (1982)). Again, private-wealth in 

centives favor a long-run outcome in which 

banks successfully innovate around con 

straints. Moreover, public-sector incentives are 

such that regulated firms may have an advan 

tage in the bargaining that shapes regulatory 

policy. The incentives in the public sector are 

biased in favor of policies with clearly visible, 

short-term benefits, but hidden or long-run 

costs. This ensures a record of identifiable "suc 

cesses" under the reigning leadership, which 

may be promoted to its further advantage. 

There is evidence to suggest that private firms 

are able to exploit this public-sector bias 

(Gwartney and Stroup (1982)). Thus, incen 

tives are such that the "compromises" work 

ed out between regulators and regulated firms 

are likely to produce visible, short-run benefits 

to the economy, but at the risk of hidden or 

longer-run costs that grow out of unconstrained 

profit opportunities successfully negotiated by 

the regulated firms. 

1J This is not to suggest that supervision can 

not be effective in combination with depositor 

incentives to monitor risk. There is clear 

evidence—55 years of FD1C experience—that 

it can be. The argument here refers to reliance 

on supervision in place of depositor discipline. 

It is an argument against "too much" insurance 

coverage and not against deposit insurance per 

se. 

10 Note that neither view necessarily calls 

for changes in the statutory limit. For exam 

ple, it is consistent with the "depositor 

discipline" approach to hold that the present 

limit would be satisfactory if it were enforc 

ed. A perspective based solely on bank "uni 

queness" (liquidity transformation) might also 

accept the present limit as the practical max 

imum in light of the occasional failures to find 

buyers for defunct banks and the implications 

of this for the insurance fund. Acceptance ol' 

bank uniqueness also leaves room to recognize 

the incentive problems identified in the 

"depositor discipline" approach, thus sug 

gesting that the existing level of coverage could 

potentially represent an acceptable trade-off. 

13 
FDIG Banking Review 

Neither approach can "prove" its 

case, because the relative 

magnitudes of the alternative costs, 

as well as the probabilities of incur 

ring them, are not objectively 

measurable. Both approaches also ig 

nore empirical realities that weaken 

the support for their implications. 

Most notably, the uniqueness (or 

"special intermediary") argument 

fails to consider that present 

coverage has been sufficient to 

eliminate runs on healthy institu 

tions. Given this reality, it is difficult 

to argue that the threat of runs cur 

rently presents an obstacle to liquidi 

ty transformation, and thus it is dif 

ficult to conclude that there is much 

to be gained by increasing 

coverage.11 Similarly for the 

depositor discipline argument, it is 

not at all clear that depositor 

discipline is somehow insufficient.12 

Thus, in light of the potential costs 

cited in the uniqueness paradigm, it 

is not evident that lower coverage 

would produce net economic 

benefits. 

Nonetheless, there are no obvious 

analytical errors or inconsistencies to 

serve as a basis for neglecting the im 

plications of either approach; nor is 

it necessary to choose between them. 

Both are plausible, and if the 

coverage issue is viewed as a mutual 

ly exclusive selection between these 

views, then there can be no clear 

choice, no credibly "coherent" policy 

strategy (see footnote 6). Given our 

current understanding, the reality is 

that any selection of a coverage limit 

must be uncomfortably arbitrary 

and, for any amount of coverage 

greater than zero but less than 100 

percent, there will be an unavoidable 

risk (of uncertain proportions) that 

neither bank runs nor bank risktaking is sufficiently contained to 

preserve stability.13 A more reason 

ed response is to acknowledge these 

uncertainties and adopt an approach 

aimed at minimizing the potential 

costs associated with them. 

Since it is unclear that any change 

in the dollar amount of coverage 

would vield a more favorable trade 

off than that implied by the present 

limit, it seems reasonable to seek 

alternative means of dealing with the 

respective risks. In other words, since 

both approaches identify potential 

costs that cannot reasonably be ig 

nored, yet neither removes enough 

uncertainty about these costs to in 

dicate precisely how they should be 

traded off via the coverage limit, an 

appropriate alternative approach 

might be to lower the stakes of the 

trade-off through measures that limit 

the potential magnitude of both 

types of costs. Remaining sections of 

this article consider several marketbased policy options that may be 

consistent with this goal.14 

To summarize, selection of a 

statutory insurance limit poses a 

trade-off between two potential 

sources of financial instability: bank 

runs and bank risk-taking. The direc 

tion in which coverage should be 

altered, if any, depends upon which 

of the alternative risks is greater. This 

determination calls for a cost com 

parison, but measurements conflict 

for even the most "objective" com 

ponents of the relevant costs, and the 

largest components are inherently 

subjective, therefore immeasur 

able.15 Hence, proposed rankings of 

the relative risks necessarily reflect 

the subjective emphasis of a par 

ticular analytical approach more 

than any detached weighing of em 

pirical data. Neglecting either of the 

potential risks may produce financial 

instability of one type, yet attempting 

to balance the two risks by selecting 

a particular trade-off will not 

guarantee financial stability of either 

type. This suggests that policies aim 

ed at improving the terms of the 

trade-off (limiting the potential costs 

associated with both types of risks) 

may be most productive. Marketbased policy options of this variety 

are considered below. 

Deposit Size versus 

Deposit Maturity 

The terms of the trade-off between 

bank runs and bank risk-taking might 

be altered favorably by insuring 

deposits on the basis of maturity 

rather than size. Conceptually, 

maturity-based deposit insurance has 

distinct advantages over the current 

system. Short-term deposits, par 

ticularly transactions deposits that 

are made available on demand, are 

1' Formally, it is true that so long as there 

is depositor discipline, there is also the 

theoretical threat of runs with its deleterious 

effect on liquidity transformation. However, 

the theoretical possibility of runs on solvent 

institutions has not been bonie out in practice, 

as noted. This may be because of "conjectural" 

(de facto) guarantees or it may be that the rela 

tionship between coverage levels and the prob 

ability of runs is more step-like than linear. 

Regardless, there is reason to believe that the 

present setting succeeds in providing run-free 

risk premiums on deposits without destabiliz 

ing the balance of bank-portfolio risks (Mut 

ton (1989)), and this warrants considerable 

weight in contemplating proposed changes in 

the coverage limit. 

12 This follows from the suggestion in 

Chapter 2 of the FDlC's forthcoming study that 

moral hazard is not necessarily unstable 

dynamically and does not appear to be out of 

control. 

'-1 This statement assumes that the coverage 

limit is enforced and that the criteria defining 

an insurable deposit remain the same. 

14 The inflation-unemployment trade-off 

provides a useful analogy. There is no par 

ticular point on the short-run Phillips curve 

that is unambiguously preferred to all others. 

The relative magnitudes of the social costs 

generated by inflation and unemployment are 

not objectively quantifiable. Thus, we never 

could decide conclusively which point on the 

curve is the optimum selection, even if we 

knew the shape and position of the curve at 

any given moment (which we do not). A 

reasonable policy response is to alter the terms 

of the trade-off so that, whatever our current 

position on the curve, the consequences of the 

associated inflation and unemployment are 

both less harmful than they would be other 

wise. Examples might include the provision of 

job-information services to speed the rehiring 

of displaced workers, tax indexation to mitigate 

the real effects of inflation and, more general 

ly, the removal of distortions to facilitate 

speedier and more efficient market 

adjustments. 

15 Strictly speaking, no component of true 

economic costs is fully objective. See 

Buchanan (1966). Here, "objective" means 

costs that are routinely measured by 

economists using widely-accepted estimation 

techniques. 

14 
Deposit Insurance Coverage 

the primary source of bank runs.16 

Restricting insurance coverage to 

short-term ("runnable") deposits, 

regardless of size, is clearly consis 

tent with the primary objective of 

deposit insurance—to avoid the costs 

of bank runs without inducing ex 

cessive risk-taking—and appears to 

have a clearer rationale on this basis 

than does coverage based on deposit 

size. That is, while the threat posed 

by instantly callable deposits is well 

established, there appears to be no 

such connection between the size of 

deposit accounts and the probabili 

ty (or social cost) of bank runs 

(Furlong (1984)). 

Moreover, coverage based on 

maturity could, in principle, 

eliminate bank runs without the 

complete sacrifice of depositor 

discipline entailed by 100 percent 

coverage; the latter being the only 

available option for eliminating runs 

(with certainty) when coverage is 

based on deposit size. Longer-term 

deposits would be at risk under a 

maturity-based system, thus preserv 

ing some incentive for monitoring by 

depositors. 

Despite its conceptual appeal, 

maturity-based insurance coverage 

would entail formidable transition 

costs and difficult implementation 

problems. The initial difficulty arises 

in selecting the appropriate defini 

tion of a "short"-maturity deposit. It 

is clear that the maximum maturity 

deemed eligible for coverage should 

allow sufficient time for determining 

the financial condition of the bank, 

and thus the definition might reflect 

the frequency of bank examinations 

(Furlong (1984)). Beyond this 

minimal constraint there is little to 

guide the decision, since the degree 

of "runnability" of different 

maturities is not obvious and prob 

ably would not be uniform across 

deposits of the same maturity, given 

the different conceivable terms for 

withdrawal. The final selection of a 

maturity limit may not be significant 

ly less arbitrary than the current 

dollar limit based on deposit size. 

There also may be more fun 

damental problems with maturitybased coverage. Maintaining an effec 

tive distinction between short- and 

long-maturity deposits depends upon 

the severity of prepayment penalties 

and other disincentives to cash in 

early. Banking stability may be 

threatened if longer-term deposits 

are too easily withdrawn, while bank 

profitability may be impaired if there 

are high costs associated with enfor 

cing the withdrawal penalties 

necessary for stability. It remains 

unclear whether a viable maturitybased structure could be devised. 

Switching to a maturity-based in 

surance system also would affect the 

maturity structure of bank deposits, 

as more funds could be expected to 

flow to short-term accounts. This 

could encourage maturity mismat 

ching to excessive degrees, thus mak 

ing bank supervision more difficult. 

Although it is not clear that the 

supervisory task would be impossible 

under such a system, it is probable 

that a greater commitment of super 

visory resources would be necessary. 

Of perhaps greater concern are the 

uncertain macroeconomic conse 

quences of providing an effective 

government subsidy to short-term 

accounts. 

In any case, these added costs must 

be weighed against the potential 

benefits of such a switch, and it is not 

fully clear that the gains would be 

large. Certainly, there could be no 

fewer runs on solvent institutions 

than presently, and the effectiveness 

of depositor discipline could not be 

greatly improved unless failureresolution methods also were altered 

to weaken existing de facto 

guarantees. Since the constraints on 

the FDIC's options for failure resolu 

tion are unlikely to change in the 

near future (FDIG (1989, forthcom 

ing)), the depositor-discipline effect 

of any change in the basis for 

coverage is likely to be limited. In the 

longer run, if failure-resolution 

methods are modified to reduce the 

scope of de facto guarantees at the 

bank level, the potential benefits of 

a maturity-based system may appear 

greater. At this time, however, the 

uncertainty surrounding the costs 

and the lack of a clear prospect for 

significant gains suggest there is in 

sufficient evidence to warrant a 

switch to maturity-based coverage. 

One-Hundred-Percent 

Coverage 

The statutory coverage limit is in 

dicative of the prevailing balance be 

tween run prevention and depositor 

discipline only in the absence of im 

plicit types of coverage for 

depositors. Recognizing this, some 

have concluded that the FDIC's 

stated policy of resolving failures (the 

use of P&As whenever feasible) has 

effectively reduced depositor 

discipline to miniscule proportions 

and has weakened nondeposit 

sources of market discipline in the 

process. In other words, this view 

suggests that the real trade-off of run 

prevention for depositor discipline 

reflected in the current operation of 

the deposit insurance system is 

essentially a wholesale trade of all 

market discipline at the bank level 

for virtually complete protection 

against runs on solvent institutions, 

despite appearances created by the 

statutory limit.17 

This type of argument typically 

leads to a conclusion that explicit, 

100 percent coverage is ap 

propriate.18 It suggests there is 

nothing to be lost in the way of 

16 Longer-term deposits also can be a source 

of "runs" in that depositors may decline to "rolJ 

over" this type of bank debt. This is different 

from the traditional notion of a bank run and 

it entails different costs than those that form 

the basis for deposit insurance protection. As 

described by Murton (1989), it is the im 

mediate, forced liquidation of bank assets en 

tailed by a (traditional) run that generates the 

types of costs that provide a rationale for 

deposit insurance. 

17 In the framework of footnote 14, it is 

alleged that the present operation of the 

deposit insurance system amounts to the selec 

tion of a "corner solution" on the curve, cor 

responding to a maximum protection against 

runs and zero depositor discipline. 

« See Humphrey (1976), Field (1985), 

Silverberg and Fleschig (1978), Leff (1976), 

and the references there cited for more details 

and alternative arguments. 

15 
FDIC Banking Review 

depositor discipline, and there are 

several gains to be made.19 First, full 

coverage could result in somewhat 

greater stability than is now com 

mon, eliminating some uncertainty 

and perhaps providing an environ 

ment that would allow for a more 

orderly resolution of failures. Recall 

ing that a major function of deposit 

insurance is to remove the economic 

inefficiency associated with the 

threat of runs, full coverage does this 

most certainly and completely. Sec 

ond, it would produce a more 

equitable system in the sense that 

large depositors would be treated 

equally regardless of the cir 

cumstances surrounding a bank 

failure, and small banks could com 

pete for large deposits on more equal 

footing with big banks. Third, 

although full coverage would 

possibly reduce depositor discipline, 

it could increase market discipline 

overall (say, if deposit transfers were 

to replace P&As as the primary 

method of failure resolution—see 

FDIC (1989, forthcoming—Chapter 

7) on this point). Finally, full 

coverage would not change the 

FDIG's failure-resolution costs ap 

preciably under current methods of 

handling failures and, with minor 

changes in failure-resolution pro 

cedures under a full-coverage 

scheme, the fund's risk exposure 

could probably be reduced. (Again, 

see Chapter 7 of the forthcoming 

FDIC (1989) study for details, as well 

as Silverberg (1988).) 

The major difficulty with this argu 

ment is the assumption that 

depositor discipline is completely ab 

sent from the current environment. 

While the evidence is mixed, some 

recent studies contradict this, sug 

gesting that CD markets are fairly 

sensitive to bank-specific risk and act 

as a constraint on banks wishing to 

pursue riskier positions.20 This con 

straint may be necessary for control 

of bank risk-taking in a deposit in 

surance environment, given the ar 

tificial incentives to incur risk. 

Even in the absence of this 

evidence, however, it may be argued 

that another aspect of depositor 

discipline—the inevitable flight of 

uninsured funds from troubled in 

stitutions (footnote 3)—provides 

some net benefits to the system. 

First, though after-the-fact discipline 

may come too late to help the af 

fected institution, it still may act as 

a deterrent to other banks pursuing 

similarly risky positions. Second, the 

after-the-fact flight of funds from 

floundering institutions may alert 

supervisors to problems that deserve 

closer attention or to institutions that 

require closing. Absent such runs, 

troubled institutions may go unnotic 

ed for some time, thereby increasing 

eventual losses to the insurance fund. 

Finally, such liquidity pressures may 

force chartering authorities to deal 

with problems (in the form of bank 

closings) they might otherwise be 

reluctant to address. In effect, unin 

sured depositors may act as a check 

on regulators, forcing them to deal 

with problems soon after the prob 

lems are identified. 

These considerations suggest that, 

despite a standing failure-resolution 

policy that generally results in full 

coverage, there remains some 

valuable depositor discipline in bank 

ing. Thus, the proposal for 100 per 

cent coverage may amount to a 

trade-off of discipline for little, if any, 

added protection against damaging 

runs.21 To the extent that P&As 

become feasible for a larger propor 

tion of failure resolutions in the 

future, depositor discipline may 

weaken and the case for full coverage 

may appear stronger. At this time, 

however, the complete removal of 

deposit exposure presents excessive 

ly uncertain, and potentially hazar 

dous, implications for the control of 

bank risk-taking. 

Limits on Brokered-Deposit 

Coverage 

It often is suggested that market in 

centives for controlling risk are un 

necessarily weakened with the near 

ly limitless extension of insurance 

coverage made possible by deposit 

brokerage. Weak institutions always 

can obtain funding by offering a 

small premium above insureddeposit rates because brokers 

package deposits into hundredthousand-dollar bundles for sale to 

the highest bidder. Depositors can 

use brokers to economically achieve 

complete insurance protection 

($100,000, times the number of in

surable accounts per institution, 

times the number of insured institu 

tions), and this ability allows risktaking institutions to acquire funds 

for far less than the true market price 

of the assumed risk. One way to 

reharness market forces to control 

risk-taking would be to limit in 

surance coverage for brokered 

deposits. Another might be to restrict 

coverage to some maximum amount 

per individual rather than per ac 

count; and a third might be to limit 

the rates banks may pay for insured 

funds.22 

These proposals ignore FDIC ex 

amination experience, which sug 

gests that supervision can, in general, 

effectively discriminate between 

sound and unsound uses of brokered 

funds (Harless (1984)). Moreover, 

recently proposed changes in report 

ing requirements should enhance ex 

aminers' ability to detect brokereddeposit abuses early. Supervisors will 

get clear signals that closer scrutiny 

is warranted. Additional signals may 

take the form of increases in offering 

rates and the growth of brokeredfunds purchased. Once in the bank, 

supervisors can evaluate the quality 

of lending in the usual manner. This 

indicates that the brokerage of funds 

is not a special problem, but part of 

the more general incentive problem 

in deposit insurance. 

19 The remainder of this section borrows 

heavily from Nejezchleb (1987). 

20 See Baer and Brewer (1986); and Hannan 

and Hanweck (1988). 

21 Following the analysis described in foot 

note 14, this appears merely to result in a dif 

ferent location on the same trade-off curve, 

rather than to alter the terms of the trade-off 

in the desired manner. 

22 See Mussa (1986a), Kane (1985a), FDIC 

(1983), and their references. 

16 
Deposit Insurance Coverage 

Given the same incentive struc 

ture, the same allocation of funds 

would tend to result in a world 

without deposit brokerage, but it 

may evolve less quickly and less ef 

ficiently (this is examined below). If 

there is a control problem concern 

ing the competition for and uses of 

brokered deposits, it reflects a more 

systemic influence (uncontained 

moral hazard) that calls for fun 

damental changes in the structure of 

deposit insurance. As noted earlier, 

the evidence does not warrant such 

a structural overhaul, but suggests 

that supervisory resources can 

monitor risky behavior—including 

brokered-funds activity—sufficiently 

to contain the exposure of the in 

surance fund. 

The above proposals to curb 

brokered funding also assume that 

higher-than-market rates for insured 

deposits are reliable signals of ex 

cessively speculative lending by 

banks rather than reflections of 

sound lending opportunities with 

superior profit prospects. While it 

does appear that the size of the 

premium is positively related to the 

degree of speculation, this relation 

ship is not uniform, and there is no 

indication that speculative uses of 

brokered funds predominate. 

Deposit brokers perform a valuable 

economic function to the extent that 

they allocate funds to the banking 

system's highest-valued uses at a 

smaller cost than could otherwise be 

achieved.23 Thus, proposals that 

would alter insurance coverage in 

order to curtail abuses of insureddeposit brokerage may also reduce 

the efficiency of deposit allocation in 

the financial system. At the same 

time, such proposals threaten to in 

crease instability, reduce total liquidi 

ty, and raise the costs of intermedia 

tion by placing more deposit funds 

at risk. Given the supervisory ex 

perience with brokered funds, it is 

not clear that the proposals to alter 

coverage offer a benefit of sufficient 

size to warrant the potential costs. 

Similarly, the suggestion to cap 

rates payable for insured funds lacks 

any clear economic benefits. Propos 

ed rate caps typically take the form 

of a limit (X number of basis points) 

above the Treasury bill rate, adjusted 

for the maturity of the deposit 

(Mussa (1986a)). This is often ra 

tionalized by noting that the govern 

ment guarantee applied to insured 

deposits is virtually as firm as that 

carried by Treasury bills. Thus, there 

is presumably no economic reason, 

other than differences in liquidity 

and perhaps state-tax treatment of in 

terest income, for insured-deposit 

rates to contain a significant 

premium. 

This argument clearly has some 

merit, but if there are regional or 

other differences in lending pros 

pects that warrant vigorous com 

petition for funds, and if competition 

via pricing is most efficient, then 

there may be some economic 

justification for premiums beyond 

those noted in the argument. 

Regardless, the proper size of the 

premium is unknown, and thus, the 

allocative implications of a rate cap 

are uncertain. Moreover, experience 

with Regulation Q. and other price 

controls suggests that these are 

among the easiest proscriptions to 

circumvent: numerous forms of nonprice competition are available (and 

innovation certainly will create 

others), and fees to deposit suppliers 

may be substituted for higher yields. 

It is therefore not obvious that a rate 

cap would alter the outcome and, if 

it did, it is not obvious that this would 

be preferable to the outcome 

achievable via supervisory efforts. 

In sum, brokered-deposit abuses 

represent one manifestation of the 

larger moral hazard problem in 

herent in the provision of deposit in 

surance. Proper monitoring systems 

and supervisory resources are 

necessary to contain any misuse of 

funds, but the evidence does not in 

dicate that any broader structural 

reform is required. In particular, 

given the inherent costs associated 

with depositor discipline, there is lit 

tle to suggest that brokered-funding 

activity warrants placing depositors 

at greater risk. 

Concluding Remarks 

The complex nature of bank assets 

narrows the scope for expanding the 

role of market discipline at the bank 

level. Where assets have significant 

idiosyncracies and large information 

costs, markets do not arise spon 

taneously and it is efficient that they 

do not (Woodward (1988), p. 687). 

Real social costs may be incurred if 

market mechanisms are forced upon 

activities that inherently are better 

suited to alternative institutional 

arrangements. 

In the absence of concrete informa 

tion regarding which institutional ar 

rangements are optimal at a given 

time, or knowledge of the pace at 

which evolution is changing the op 

timal arrangements (if at all), it is im 

portant to avoid premature ex 

periments that may have irreversible 

consequences.24 While market 

discipline clearly plays an important 

role in controlling risk, it is not clear 

that present circumstances warrant 

altering insurance coverage to create 

an expanded role for the market. It 

is not apparent that greater market 

discipline of this type is now 

necessary or potentially more 

beneficial than existing arrange 

ments. 

Greater reliance on the market is 

most questionable in the area of 

depositor discipline. The primary 

goal of deposit insurance is to 

remove the untoward effects of bank 

runs without otherwise altering the 

unfettered market outcome. This sug 

gests that escalating the threat of 

23 It is not certain that deposit brokerage 

enhances the efficiency of the deposit alloca 

tion process but, in the absence of evidence 

to the contrary, efficiency-enhancement seems 

a likely source of its economic viability. 

34 As long as there remains a plausibly 

sound reason for treating banks specially via 

deposit insurance, then the fact that deposit 

insurance is already in place supports a con 

servative posture in considering measures that 

may impact banks' special intermediation func 

tion. Only clear evidence that this latter func 

tion is obsolete, or changing in its fundamen 

tal nature, would warrant a fundamental 

change in posture. 

17 
FDIG Banking Review 

runs by exposing depositors to to the same thing, that present supportable by the arguments or 

greater risk is unwarranted unless it coverage levels excessively or un evidence adduced here. 

can be shown that this is imperative necessarily distort the free-market 

for controlling risk (or, what amounts outcome). No such finding is clearly 

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of Banking and Finance 10 (1986a):175-88. 

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1985a. 

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and Robert P. Shay. Cambridge, MA: Ballinger Publishing Company, 1986b. 

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1988):559-98. 

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1982. 

Left', Gary. "Should Federal Deposit Insurance Be 100%?" The Bankers Magazine 159 (Summer 

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the Theoretical and Empirical Arguments." Yale Journal of Regulation 5 (Winter 

1988):215-39. 

Murton, Arthur J. "Bank Intermediation, Bank Runs, and Deposit Insurance." FDIC Banking Review 

(Spring/Summer 1989):l-10. 

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C. Kormendi. Cambridge, MA: Ballinger Publishing Company, 1986a. 

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1974):335-58. 

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Reserve Bank of Dallas Economic Review (September 1983):ll-22. 

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Corporation, October 1988. (Mimeographed.) 

Silverberg, Stanley C, and Theodore G. Flechsig. "The Case for 100% Insurance of Demand 

Deposits." Issues in Bank Regulation 1 (Winter 1978):38-44. 

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Management Science 2 (Spring 1971):3-21. 

Tallman, Ellis. "Some Unanswered Questions About Bank Panics." Federal Reserve Bank of Atlanta 

Economic Review 73 (November/December 198S):2-21. 

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Woodward, Susan. "A Transaction Cost Analysis of Banking Activity and Deposit Insurance." Cato 

Journal 5 (Winter l988):683-700. 
FDIC Banking Review 

Forbearance: Practices 

and Proposed Standards 

by Dean Forrester Gobos: 

Forbearance is a word with dif 

ferent meanings to different 

people. Because in recent 

years forbearance often has been 

associated with the delayed closure 

of insolvent institutions, it has 

become a dirty word in many places. 

However, there are many forms of 

forbearance that have long been ac 

cepted supervisory practices. 

Forbearance is not something to be 

avoided under all circumstances. 

This article discusses appropriate 

uses of supervisory forbearance. 

Forbearance, or more specifically 

supervisory forbearance applied to 

federally insured depository institu 

tions, is broadly defined for the pur 

pose of this discussion. Forbearance 

is any program or set of procedures 

whereby supervisory restraint is ex 

ercised toward an insured depository 

institution that fails to meet establish 

ed safety-and-soundness criteria. 

Such forbearance may be either for 

mal or informal, and may be applied 

to individual or to broad categories 

of financial institutions. Under this 

definition, supervisory forbearance is 

a deliberate and intentional policy 

choice; not merely the consequence 

of inaction, inability or unwillingness 

to address a particular high-risk 

situation. 

Background 

Tiered Supervisory 

Forbearance 

Since the 1930s, a complex struc 

ture of "tiered" supervisory reactions 

co a given set of problems has evolv 

ed for use by the FDIC. These tiered 

responses are applied, on a case-by

case basis, depending upon the 

perceived severity or level of risk ex 

posure posed in a particular situation. 

They also can be imposed in a pro 

gressive series of escalating actions 

as may be deemed appropriate in 

order to lower risk levels and control 

losses arising from the actions of an 

insured institution.1 

When supervisory enforcement 

mechanisms are applied only to the 

maximum extent necessary to ad 

dress the specific level of risk ex 

posure in each situation, this ap 

proach has proven to be quite effec 

tive in both reducing failures and 

limiting losses to the insurance fund. 

The FDIC takes pride in this success 

and in the fact that this generally can 

be accomplished without unduly in 

terfering in the management deci 

sions or operation of individual finan 

cial firms. The key ingredient is to 

have the independence and flexibili 

ty to impose the optimum level of 

pressure needed to achieve the 

desired risk reduction. The manner 

in which the institution's manage 

ment accomplishes this end is their 

choice so long as the FDIC's ex 

posure level is lowered. Thus, risktaking need not be prohibited or 

even tightly regulated; only held 

within manageable limits. 

The simple fact is that most FDICinsured depository institutions iden 

tified as posing a definite threat of 

loss to the insurance fund are suc 

cessfully restored to a safe-and-sound 

operating condition and do not 

ultimately fail. Effective supervision, 

including the use of discretionary 

supervisory forbearance, has proven 

to be a very cost-effective lossprevention mechanism for the 

deposit insurance fund. In the oneyear period ending June 30,1988, for 

example, 181 FDIC-insured banks 

were closed or granted financial 

assistance. At the same time, 

however, almost one-third, or more 

Chan 500, of the 1,624 banks on the 

FDIC's problem-bank list were 

removed because of their substantial 

ly improved condition or their 

nonassisted merger into a sound 

financial institution.2 

* Dean Forrester Gobos is the Special Assis 

tant to FDIC Director C.C. Hope, Jr.. George 

Masa and Detta Voesar made useful contribu 

tions to the development of this article. 

1 description of supervisory enforcement 

authority and related powers available for use 

by the KD1C can be found in Section 8 of the 

federal Deposit Insurance Act (codified to 12 

U.S.C. 18:8(a) through 181S(r) and 18280)). 

2 During the twelve-month period ending 

June 30, 1988, a total of 542 insured institu 

tions were added to the FDIC's "problem-bank' 

list while 690 were removed. The removals 

may be categorized as follows: 181 were clos 

ed or granted financial assistance; 87 entered 

into a nonassisted voluntary merger with 

another institution; and 422 showed significant 

improvement in condition and no longer 

presented an undue risk to the deposit in 

surance fund. The total number of problem 

banks as of June 30, 1987 was 1,624; the 

number as of June 30. 1988 was 1,476. 
Forbearance 

Exercising Supervisory 

Discretion 

The most prevalent form of 

forbearance is the exercise of volun 

tary restraint in the application of the 

vast array of supervisory and enforce 

ment mechanisms available to con 

trol risk in individual insured institu 

tions. Over several decades it has 

evolved from an informal, largely 

undefined, practice into an important 

operating procedure with extensive 

guidelines for its application. The 

goal of this supervisory restraint is, 

of course, to achieve control over ex 

cessive risk exposure without having 

to resort to costly and timeconsuming, court-imposed legal sanc 

tions or more Draconian measures 

such as insurance termination 

proceedings. 

The key to the discretionary exer 

cise of such restraint by the FDIG is 

the rendering of an independent 

judgment about the institution's 

management; that is, its competence, 

its cooperativeness, its capacity to 

correct weaknesses and its ability to 

change any behavior perceived as be 

ing unduly risky or undesirable. That 

judgment is essentially a balancing of 

supervisory extremes. At one ex 

treme, the supervisor could take ac 

tion that can be expected to lead to 

the closure of what may well be a 

viable institution. The other extreme 

is that of inaction which can result 

in the complete disregard of unsafe 

and unsound operating practices. 

Both extremes are usually 

undesirable and, in virtually all in 

stances, will increase the loss 

ultimately borne by the deposit in 

surance fund.3 

The importance of this judgment 

being rendered independently of ex 

ternal, political or industry influence 

cannot be overemphasized. So long 

as independence and flexibility are 

retained by the supervisor, 

forbearance can be granted or not 

granted, based, at least in part, on 

fundamental safety-and-soundness 

criteria and for the purpose of 

managing risk. This ability to operate 

with independence from external 

considerations is essential if the 

deposit insurance fund is to be effec 

tively protected against unnecessary 

loss. 

An excellent case can be made that 

exercising forbearance in supervisory 

matters is quite often in the deposit 

insurer's own self-interest. This 

assumes, of course, that the primary 

purpose of supervision is to promote 

systemic stability and achieve the 

safe-and-sound operation of financial 

institutions, rather than to punish 

undesirable behavior. Given the 

discretion to apply forbearance for 

the purpose of managing risk, it is 

highly likely that the supervisor will 

(in the absence of fraud or 

mismanagement) almost always 

choose such a course of action, at 

least as the most expedient initial 

approach. 

Correction of weaknesses at an ear 

ly stage is the deposit insurance 

fund's equivalent to the risk-control 

measures taken by many privatesector insurance firms in an attempt 

to lower potential liability claims and 

avoid losses. As in the private sector, 

the supervisors of financial institu 

tions have found that reduction of 

risk through early correction of 

weaknesses is cheaper and less 

disruptive than waiting for losses to 

develop. It is, therefore, a far more 

desirable course of action. Simply 

put, a financial institution that has 

been restored to a safe-and-sound 

operating condition no longer poses 

an unacceptable risk of loss to the 

deposit insurance fund, 

Congressionally Inspired 

and Mandated Forbearance 

In recent years, the Congress has 

mandated specific supervisory 

restraints aimed at shielding a large 

number of commercial banks and 

thrifts from the more severe federal 

supervisory actions. These individual 

forbearance programs, when enacted 

into law, have taken several different 

forms. Some of the programs have 

provided valuable time for weaken 

ed private-sector firms to work 

through their difficulties, recoup 

short-term losses and restructure. All 

too often, however, forbearance pro 

grams have been enacted with the 

primary aim of preserving specific 

types of institutions in specific 

markets. Other programs, such as the 

FDIG's Income Maintenance and 

Capital Forbearance Programs, were 

voluntarily developed, at least in part, 

in anticipation of Congressional ac 

tion which might have proven to be 

less flexible in its approach. The 

granting of forbearance of any kind, 

however, may interfere with normal 

market mechanisms. It often has 

created competitive inequalities and 

may, or may not, increase the deposit 

insurance fund's exposure to loss. 

In the last decade, supervisory 

forbearance increasingly has been 

made available to depository institu 

tions that have been adversely im 

pacted by natural catastrophe, 

economic trends or some other ex 

ternal shock. The key consideration 

for granting forbearance has been 

that such events were generally con 

sidered to be beyond the control of 

the institution's management and of 

relatively short duration. This 

forbearance has been legislated as a 

temporary measure and made 

available to relatively large numbers 

of institutions adversely impacted by 

external events. 

The group of financial institutions 

so categorized usually has been 

homogeneous, in that they operate 

in a particular geographic area or 

with similar investment characteris 

tics. Also, the problems that prompt 

ed the Congressional action were 

widespread and concern had been 

raised that the banking public might 

view a large number of failures 

3 A loss wil] probably be sustained by the 

deposit insurance fund even if the closed in 

stitution were "book solvent" at the time of 

its closing. This arises because the liquidation 

value of moat banking firms is significantly 

lower than their value as a "going" concern. 

At the other extreme, the supervisory 

disregard of unsafe and unsound operating 

practices creates substantially greater risk and 

will always lead to an increased probability 

of loss to the deposit insurance fund. 

21 
FDIG Banking Review 

among the group as a regional or na 

tional calamity. Recent examples of 

groups receiving broad-based super 

visory forbearance include thrift in 

stitutions impacted by high and 

volatile interest rates in the late 

1970s and early 1980s and 

agricultural-based lending institu 

tions impacted by the more recent 

sustained downturn in the 

agricultural sector. 

The primary goal of such 

forbearance, like other forms of 

supervisory restraint, should be the 

management and reduction of ex 

cessive risk-exposure levels. This 

favorable result often can be achiev 

ed by permitting well-managed, 

viable institutions some reasonable 

period of time to recover from a 

weakened, but not insolvent, condi 

tion caused by a sudden unexpected 

shock.4 Once again, however, it is the 

independence and discretion in gran 

ting supervisory restraint, and the 

ability to deny forbearance to 

specific high-risk institutions, that 

determine its potential for success in 

limiting loss to the insurance fund. 

FDIC Experience with 

Forbearance Programs 

Agricultural Loan-Loss 

Amortization Program 

During the mid-1980s, many areas 

of the United States experienced a 

protracted downturn in agricultural 

activity that adversely impacted both 

the agricultural sector and many 

related businesses, including finan 

cial institutions. Particularly hard hit 

were agricultural creditors whose in 

creased inability to collect contrac 

tual debt led to increased numbers 

of bank failures. 

The Congress, seeking to offer 

some form of relief for beleaguered 

agricultural creditors, debated a 

variety of possible measures. These 

concerns were addressed, indirectly, 

under Title VII of the Competitive 

Equality Banking Act of 1987. This 

legislation permitted banks serving 

predominately agricultural cus 

tomers to defer accounting recogni 

tion (for reporting purposes) of 

agricultural-related loan losses, In 

stead of prompt loss recognition, 

banks were authorized to amortize 

such losses over succeeding years. 

The new legislation applied only to 

institutions of less than $100 million 

in total assets which had at least 25 

percent of their total loans in 

qualified agricultural credits. The 

banking agencies were charged with 

developing and implementing ap 

propriate regulations within a 90-day 

period after enactment. Effective Oc 

tober 27, 1987, the FDIC im 

plemented its agricultural loan-loss 

amortization program. Similar pro 

grams also were adopted by the Of 

fice of the Comptroller of the Curren 

cy (OCC) and the Federal Reserve. 

From the program's inception 

through December 31, 1988, the 

FDIC received 81 formal requests for 

consent to defer agricultural loan 

losses under this program. As of that 

date, there were 35 institutions, 

located in eleven mid western, 

southern, and southwestern states, 

which had been approved for par 

ticipation.5 While the approval rate 

may seem quite low, in fact, only 19 

of the applications have been denied. 

The focus of the review process has 

been on judging the management's 

ability to develop and implement a 

realistic capital augmentation plan 

aimed at ensuring the institution's 

future viability.6 

It was the clear intent of the Con 

gress that losses sustained as a con 

sequence of fraud or criminal abuse 

fall outside of the scope of the pro 

gram. The enabling legislation also 

required the submission of a plan 

aimed at restoring the bank's capital 

to an acceptable level as an essential 

condition of eligibility. Banks that 

have experienced capital declines, 

but which still have an acceptable 

level of capital, cannot elect to be in 

cluded in the program unless there 

is a reasonable expectation of further 

capital erosion.7 The capital plan also 

must be based upon reasonable, 

realistic projections that take into 

consideration the institution's earn 

ings, local market conditions and 

other material facts. 

Inherent in these criteria is a 

"viability" test for all institutions 

seeking supervisory forbearance. In 

order to gain approval for admission 

to the loan-loss amortization pro 

gram, the applicant bank must be 

judged to be economically viable and 

fundamentally sound, except for the 

need for additional capital to carry 

existing weak agricultural credits. 

Thus, a "reasonable prospect of 

future viability" standard is at the 

heart of the program. This standard 

cannot be uncoupled or compromis 

ed in the program's actual implemen 

tation without substantially changing 

the risk equation. Otherwise, the 

deposit insurance fund would be 

greatly hampered in its efforts to con 

trol its risk exposure and to limit its 

potential loss. 

The Congressional intent, the 

FDIC's goals and the banking in 

dustry's interests appear to be in har 

mony on this point. For example, the 

legislative history of the implemen 

ting legislation indicates that the 

agricultural loan-loss deferral pro 

gram was intended to allow "fun

4 It is interesting to note that several other 

desirable results often can be achieved. These 

include fewer bank failures, less disruption in 

local communities and a reduced loss to be 

borne by the deposit insurance fund. The ques 

tion of competitive inequalities that arise when 

forbearance is granted to relatively high-risk 

institutions, however, has not been addressed 

in many of the prevalent forms of supervisory 

forbearance. 

5 These states are: Colorado, Illinois, Iowa. 

Kansas, Louisiana, Minnesota, Mississippi, 

Nebraska, Missouri, Oklahoma and Tennessee. 

6 Fourteen applications were returned un 

processed because of the institution's in

eligibility for participation in the program and 

an additional eight were withdrawn by the ap 

plicants during the review process. The FDIC 

has terminated four institutions from participa 

tion in the program because of their manage 

ment's failure to comply with one or more 

aspects of the program. The primary reason 

for denial is the failure of the institution's 

management to develop a realistic operating 

plan which provides for restoration of the 

capital base over several years. 

7 The "threshold" test for eligibility is the 

absence of capital adequacy. In actual practice, 

most institutions that experience serious assetquality problems soon dissipate their capital 

and are judged to be inadequately capitalized. 

22 
Forbearance 

damentaUy sound banks to weather 

(the current) storm."8 There is no in 

dication of any intent to artificially 

sustain institutions that are clearly in 

solvent or that are not viable over a 

reasonable time horizon. 

Viability was not defined by the 

legislation and a rigid definition was 

intentionally excluded from the 

subsequent regulations which were 

adopted. Thus, like most supervisory 

decisions made by the banking agen 

cies, it is a judgment based on 

available information tempered by 

traditional practice. Such judgments 

focus on variables such as the current 

financial condition, future earnings 

potential and available funding 

sources. 

In this sense, viability is an 

economic concept independent of 

the management factor. If an institu 

tion is not viable, given a reasonable 

set of economic assumptions, then 

even the best, most astute and 

dedicated, management team cannot 

turn the situation around and losses 

will only increase. Thus, the FDIC 

has adopted a posture that essential 

ly requires that an applicant have a 

reasonable prospect of remaining a 

"going concern" throughout the en 

tire program and a good probability 

of returning to healthy operation 

before the end of the forbearance 

period. 

There is a long tradition of impos 

ing similar criteria (plus an assess 

ment of the management) in judging 

requests for bank and thrift charters. 

the granting of deposit insurance pro 

tection, and most mergers, acquisi 

tions or other expansion proposals. 

The approval or denial of 

forbearance requests, under this and 

similar programs, generally is consis 

tent with traditional operating and 

statutory practices. In fact, several 

landmark pieces of banking legisla 

tion, spanning several decades, have 

used almost identical language in set 

ting forth these fundamental safety

and-soundness considerations.^ 

The eligibility criteria established 

by the FDIC for granting consent to 

insured banks to defer agricultural 

loan losses are relatively simple, but 

have proven to be quite effective. 

First, they have provided temporary 

comfort for many small banks and, 

thus, indirectly helped agricultural 

creditors in rural communities. Sec 

ond, while individual institutions 

have been subjected to close super 

visory oversight, there has not been 

significant interference in the day-to 

day operating decisions. Crucial, 

however, is the fact that this has been 

accomplished without structurally 

weakening the banks involved or in 

creasing the risk of loss to the deposit 

insurance fund.10 

The FDIC has opposed one aspect 

of the loan-loss amortization pro 

gram: namely, the deviation from 

normal accounting practices. As a 

bank supervisor and insurance agen 

cy, the FDIC is reluctant to embrace 

any program that hides or obfuscates 

the actual results of an institution's 

operation. The mere fact that the 

agricultural losses are not disclosed, 

per se, does not alter the fact that 

such losses exist. The FDIC believes 

that a cleaner and more forthright ap 

proach is to adhere consistently to 

traditional accounting practices and, 

when material losses are in evidence, 

then make the choice to grant or not 

to grant supervisory forbearance. 

Capital Forbearance 

Program 

In March 1986, the FDIC instituted 

a temporary capital forbearance pro 

gram for the benefit of insured banks 

weakened as a consequence of their 

lending to the troubled agricultural 

and energy sectors. This program 

was developed and in operation 

before Congressional action on the 

agricultural loan-loss deferral pro 

gram and attempted to address many 

of the same concerns. Because it was 

developed primarily by bank super 

visors, its provisions and implemen 

tation were consistent with tradi 

tional approaches and it contained a 

strong "safety-and-soundncss" focus. 

Perhaps, it even may have had some 

influence on the supervisory flexibili 

ty built into the subsequent legisla 

tion authorizing agricultural loan-loss 

deferral. 

In the initial stages, participation 

was limited, in large measure, 

because the application process was 

somewhat cumbersome and a fixed 

minimum capital ratio was establish 

ed as a criterion for acceptance. The 

program was substantially revised in 

July 1987. It was extended to 

January 1995, and made available to 

all FDIC-insured banks that were ex 

periencing financial difficulty due to 

underlying economic conditions 

beyond their control. 

Like the agricultural loan-loss 

deferral program, the FDIC capital 

forbearance plan was aimed at banks 

with inadequate capital. The pro 

grams are quite specific on this point. 

The capital deficiency must be the 

result of adverse economic condi 

tions rather than the consequence of 

losses arising from poor lending deci 

sions by bank management. While 

the loan-loss amortization program is 

limited, by statute, to agricultural 

loan losses in small agriculturally 

oriented banks, the FDIC capital 

forbearance program is available to 

any insured bank meeting the 

relatively broad criteria. As with the 

mandated loan-loss amortization pro 

gram, reasonable recapitalization 

plans and a future viability standard 

of the institution are keystones of the 

program. 

9 The Congressional Record, March 26. 

1987, p. S.3941. 

9 Reference is made to the "statutory fac 

tors" enumerated originally in the Federal 

Reserve Act and adopted as Section 6 of the 

new Federal Deposit Insurance Act (12 U.S.C. 

1816) effective September 21, 1950. This 

language setting forth essentially the same 

safety-and-soundness factors for consideration 

is repeated in Section c(5) of the Bank Merger 

Act (12 U.S.C. I828(c)), Section 3(a) of the 

Bank Holding Company Act (12 U.S.C. 

J 842(cJJ and other banking legislation such as 

the Change in Bank Control Act (12 C.F.R. 

225.13). 

10 It is noted that three of the institutions 

denied entrance to the Agricultural Loan-Loss 

Amortization Program have subsequently fail 

ed. While it is recognized that it is not in 

dicative ot' the Success or failure of the Pro 

gram, to date, no insured bank granted super 

visory consent by the FDIC to amortize its loan 

losses has failed. 
FDIC Banking Review 

The acceptance of and participa 

tion in this broader capital 

forbearance program have been 

noticeably greater than the Congres

sionally mandated loss deferral plan. 

From inception in March 1986 

through December 31, 1988, a total 

of 312 applications have been made 

to the FDIG by insured banks seek 

ing forbearance from normal super 

visory capital standards. Of these, 

181 have been approved. The denial 

rate has run at about 25-30 percent 

of those submitted. Denial has been 

for the same primary reason as with 

the loan-loss deferral program; that 

is, failure of the institution's manage 

ment to convince the FDIC that they 

can, over time, augment the capital 

structure and become a viable, prof 

itable entity. 

total of 125 capital maintenance 

plans are in place in 13 midwestern 

and southwestern states and Alaska 

as of December 31, 1988.H Unlike 

the record with the agricultural loanloss deferral program, however, there 

have been 56 terminations of par 

ticipation in the capital forbearance 

program. The reasons for termina 

tion include eight because of the clos 

ing of the bank, nine as a result of 

significantly improved financial con 

dition and fourteen due to charter 

conversion or merger into another 

institution. 

Forbearance Practices 

for FDIC-insured Thrifts 

During the late 1970s and early 

1980s, many mutual savings banks 

and other thrift institutions ex 

perienced a significant diminution of 

their capitalization or net worth 

cushion. This was, in large part, as a 

consequence of the sustained period 

of high and volatile interest rates 

coupled with an erosion of traditional 

funding sources. An accelerating in 

flation rate in 1978, and a monetarypolicy shift in the following year, led 

to an almost continuous rise in in 

terest rates through early 1980. In 

terest rates remained at or near 

record levels for several years.12 

At this same time, interest-rate ceil 

ings on time deposits and restrictions 

on the payment of interest on trans 

actions accounts were still in place. 

With an extreme inflationary spiral, 

the resulting disintermediation 

severely impacted both commercial 

banks and thrifts, as small savers 

became increasingly yield-sensitive. 

This was particularly the case for 

FDIC-insured institutions competing 

in large eastern urban markets where 

new forms of financial intermediaries 

such as money market mutual funds 

emerged as significant competitors, 

capturing billions of dollars of former 

bank and thrift deposits. 

The situation was further exacer 

bated by the limited investment flex 

ibility available to some thrifts under 

their governing statutes, which varied 

widely by individual state. Relative to 

commercial banking powers, thrifts 

were generally, but not always, sub 

ject to greater restrictions. Some 

thrifts, like those operating in New 

York state, also were subject to 

deposit-based "franchise taxes" 

which were payable to the state 

whether or not the institution was 

profitable. Many of these restrictions 

resulted in an additional drain on sav 

ings bank capitalization. In extreme 

cases, these restrictions substantial 

ly increased the potential loss to the 

deposit insurance fund. 

Many in the industry and 

elsewhere believed that the losses 

and increased risk exposure of the 

thrift institutions were a temporary, 

cyclical problem, attributable to the 

then-current hostile business en 

vironment. Such events, it was voic 

ed, were beyond the control of thrift 

institutions' management. Further, 

the mandated public-policy respon 

sibility of savings banks and other 

thrifts to provide home mortgage len 

ding had been a driving force in the 

financial structure of many of these 

institutions and was now con 

tributing to their current difficulty. At 

least one experienced Washington 

legislator believed that "Thrift institu 

tions . . . (had) fulfilled their public 

responsibilities too well by providing 

a stable source of low-cost, long-term 

financing to the home mortgage 

market."13 

These structural factors proved to 

be a significant weakness that was 

further aggravated by the impact of 

the unfavorable economic environ 

ment and restrictive investment con 

straints. By early 1982, the aggregate 

losses experienced by FDIC-insured 

savings banks reached $2 billion an 

nually. Some of the weaker institu 

tions in New York City were ex 

periencing losses at an annual rate of 

3.5 percent of assets.1'1 

Income Maintenance 

Agreements 

The difficulty experienced by the 

thrift industry presented a unique 

situation and new challenges to the 

FDIC. Unlike most previous concerns 

with weakened depository institu 

tions in its then 49-year history, asset 

quality was not the primary problem. 

In virtually all troubled savings banks 

at the time, the overall quality of the 

assets from a credit-risk perspective 

was excellent, if not spotless. In fact, 

asset quality was generally higher in 

FDIC-insured thrifts than in most 

commercial banks. Yet, many very 

large institutions faced "insolvency" 

as the market value of their assets 

rapidly dropped to some 25 to 30 

percent below outstanding liabilities 

on any given business day. This could 

have resulted in enormous losses to 

the FDIC and, in fact, did represent 

a major multibillion-dollar potential 

claim on the FDIC's capabilities and 

resources at the time.15 

The course of action chosen by the 

FDIC was to directly address the 

problem by forcing the weaker thrift 

institutions to merge into healthier 

11 These states are: Colorado, Illinois, Iowa, 

Kansas, Louisiana, Minnesota, Missouri, 

Nebraska, North Dakota, Oklahoma, South 

Dakota, Texas and Wisconsin. 

12 FDIC (1984), p. 99. 

13 The Congressional Record, September 

24, 1982, p. S. 12214 (remarks by Senator 

Donald W. Riegle, Jr.). 

« FDIC (1984), p. 99. 

15 Federal Deposit Insurance Corporation, 

Annual Report, 1982 (1983), pp. 3-5. 

24 
Forbearance 

banks or thrifts. The quid pro quo, 

to entice a potential merger partner, 

was the offer of a "floor" or guarantee 

of a market rate of return on the ac 

quired assets through the use of In 

come Maintenance Agreements. 

Essentially, the FDIC agreed to pay 

the assuming institution the dif 

ference between the yield on ac 

quired "earning" assets (primarily 

mortgages and securities) and the 

average cost of funds to savings 

banks. The agreements, however, 

were structured so that such interestrate protection was not just one 

sided. In the event rates declined, 

these savings banks would be re 

quired to make payments to the 

FDIC. 

The time frame for protection 

under the Income Maintenance 

Agreements was negotiable, but 

typically ran for several years. As 

sophistication grew with experience, 

the FDIC was able to better segment 

the existing asset base and make 

more realistic prepayment assump 

tions. Successful bidders for a 

weakened thrift would be paid the 

spread between defined asset yields 

and the cost of funds, whether they 

subsequently chose to hold or sell 

the thrift's assets. 

What the FDIG sought to achieve 

was a permanent solution to the sav 

ings bank problem at a reasonable 

cost to the deposit insurance fund 

without raising public concern over 

systemic stability. The primary 

criteria in making individual deci 

sions, however, were that the 

resulting institution must be "finan 

cially sound, with the ability to com 

pete effectively in its market, and 

would (be able to) continue to serve 

. . .its community free of excessive 

government control."16 Thus, the 

keystone of this early forbearance 

program was a form of "viability" 

standard, arrived at independently of 

considerations regarding the poten 

tial impact on the structure of savings 

banks or the thrift industry. 

Between 1981 and early 1983, In 

come Maintenance Agreements were 

utilized in nine of the 12 assisted 

mergers of troubled savings banks. It 

should be noted that these insolvent 

institutions did not technically "fail" 

and were not closed, per se; they 

were merged into operating firms. 

Depositors and general creditors, 

therefore, experienced no loss. 

Because these were mutual institu 

tions there were no stockholders 

with a receivership interest. Subor 

dinated note holders, generally 

through negotiation, received some, 

but diminished, value for their invest 

ment. The FDIG also insisted on the 

removal of senior management and 

most of the trustees of acquired in 

stitutions. These "conditions" for the 

granting of forbearance mitigated, to 

some extent, the charges that the 

FDIG was supporting institutions 

whose management had failed to 

compete effectively in the market. 

Net Worth Certificate 

Program 

It was in this atmosphere that the 

Congress enacted the first extensive 

modern form of supervisory 

forbearance, called the Net Worth 

Certificate Program, as Title II of the 

Garn-St Germain Act of 1982. Under 

this Title, the FDIG was empowered 

to increase or maintain the capital of 

a qualified thrift institution by mak 

ing periodic purchases of capital in 

struments to be known as "net worth 

certificates." The program was in 

tended to "provide thrift institutions 

with additional time to restructure 

their portfolios and streamline their 

operating costs."17 

The mechanics of the plan adopted 

by the FDIC called for eligible thrift 

institutions to receive promissory 

notes from the FDIC representing a 

portion of current-period losses in ex 

change for certificates which were to 

be considered as part of the institu 

tion's capital base for reporting and 

supervisory purposes. The purchases 

were made semiannually according 

to a formula based on book capital 

levels. While the enabling legislation 

granted broad authority to set capital 

levels, the PDIG established a work 

ing formula to purchase certificates 

equal to between 50 percent and 70 

percent of the institution's net 

operating loss. 

In no event did the FDIG purchase 

certificates in an amount which 

would raise the institution's 

capitalization level to more than 

three percent of total assets. On the 

other hand, such assistance was on 

ly provided to "book solvent" institu 

tions with a positive level of capital 

funds as calculated by the FDIG. A 

"floor" was subsequently set for 

eligibility, equal to one-half of one 

percent or more of total assets. 

As with the subsequent forbear 

ance programs designed primarily 

for commercial banks, the FDIG 

established criteria, beyond the basic 

solvency and future viability tests, re 

quired to be met by all participants. 

The eligibility criteria included the 

development of a satisfactory 

business plan based on reasonable 

economic assumptions over realistic 

time parameters. The criteria for ac 

ceptance also specified the absence 

of significant insider dealing or abuse 

and the absence of speculative 

management activity. The FDIG also 

imposed a restrictive covenant re 

quiring the institution to convert 

from mutual to stock form at the 

subsequent request of the FDIG. This 

was intended to be used only as an 

alternate means of soliciting new 

capitalization, and only if it should 

subsequently be needed. 

After the first full year of the pro 

gram (December 1983), approx 

imately $377 million in certificates 

were outstanding. During 1985, that 

figure reached its highest level at 

more than $700 million. total of 29 

weakened savings banks have par 

ticipated in the program since 1982. 

The overwhelming majority of the 

participants have been mutual sav 

ings banks based in New York state 

and specifically those based in New 

York City. Net worth certificates also 

16 Ibid., p. 4. 

17 The Committee Report to Accompany 

S. 2879, 97th Congress, Depository Institu 

tions Amendments of 1982, September 3, J982, 

p. 19. 

25 
FDIC Banking Review 

have been issued to savings banks in 

Oregon, New Jersey and Pennsyl 

vania. 

The Net Worth Certificate Program 

is scheduled to expire on October 13, 

1991. There have been no requests 

for certificates since 1986, however. 

Retirements and reductions in 

outstanding certificates have occur 

red primarily as the result of subse 

quent merger transactions rather 

than as the result of the institution's 

return to profitability. The value of 

certificates currently outstanding (as 

of the semiannual period ending 

June 30, 1988) has dropped to 

$296.9 million and the number of 

participants to only three, 

Standards for Forbearance 

Programs 

Defining Successful 

Forbearance Practices 

The acceptance of supervisory 

forbearance by an insured depository 

institution carries with it a correspon 

ding obligation to cease unsafe and 

unsound practices and curtail ex 

cessive risk-taking. Ideally, 

forbearance grants the receiving par 

ty valuable time to correct deficien 

cies and an opportunity to restore 

the institution to sound-and

profitable operation. If successful, the 

franchise to operate the institution 

will likely increase in value. The op 

portunity to reap such gain should 

have certain conditions and cor 

responding "costs." 

First and foremost, the acceptance 

of forbearance should almost always 

require a clear change in the institu 

tion's policies and operating 

philosophy. If the problem is serious, 

the new focus must become one of 

institutional survival and improve 

ment, rather than working for 

growth, profits, shareholder 

dividends or even expanded service 

to the community. This means that 

some independence will be lost and 

there will be chafing restrictions on, 

or at least close oversight of, the 

management's future actions. 

Supervisory forbearance should 

not be used as an indirect govern 

ment shield to support high-risk 

endeavors or to perpetuate weak 

management practices which con 

tributed to the existing troubled 

status of the institution. Further, 

forbearance must not provide an op 

portunity for new expansion efforts 

or indirectly provide the financial in 

centives for additional or greater risktaking. Quite simply, supervisory 

forbearance must not underwrite ex 

isting unsuccessful policies, specula 

tion or new growth. 

Addressing Competitive 

Inequalities 

An important consideration in the 

granting of supervisory forbearance 

should be the adverse impact it may 

have on other institutions not receiv 

ing such favor. It can be argued that 

the mere granting of supervisory 

forbearance invariably creates in 

equities and represents an unwar 

ranted interference with normal 

market forces. First, since only 

troubled institutions are generally 

eligible for forbearance, the wellmanaged, nontroubled institutions 

may see themselves as being penaliz 

ed for their own success while failure 

by others is rewarded. Second, 

weaker institutions, effectively shield 

ed from failure by the forbearance, 

are provided with an opportunity to 

operate with a highly leveraged posi 

tion. This is a valuable "subsidy" not 

generally enjoyed by most com 

petitors in a market. Further, the in 

stitutions receiving relief are en 

couraged to restructure and become 

formidable new competitors. Such 

consequences often place the 

healthy counterparts of those receiv 

ing the relief at a distinct competitive 

disadvantage, 

It is difficult to dismiss the poten 

tial for adverse impact on healthy, 

well-managed firms when lesssuccessful institutions are singled out 

for special treatment and granted 

some benefit. Further, it must be 

recognized that the granting of 

forbearance to weakened institu 

tions, unfortunately, has the potential 

to become a disincentive to the pur 

suit of safe-and-sound practices by 

others. To the extent that increased 

risk-taking behavior is encouraged 

because of forbearance, such prac 

tices work to the disadvantage of the 

deposit insurance agency in that risk 

exposure will ultimately be 

increased. 

In individual situations, however, 

supervisory forbearance can be an ef 

fective loss-control mechanism 

whose use should not be automatical 

ly foreclosed. It may be the leastcostly policy choice to meet some of 

the FDIG's primary objectives. To the 

extent that these objectives conflict 

with market mechanisms and result 

in inequality or greater risk-taking, 

every possible effort should be made 

to eliminate or substantially negate 

that impact. 

In many respects, the FDIG's focus 

on containing or managing risk does 

not have to be at odds with the con 

cerns of those who seek to reduce 

the market interference resulting 

from forbearance practices. For ex 

ample, supervisory controls can be 

placed on growth, speculation pro 

hibited, and management policies 

limited, all within a closely supervis 

ed framework. Thus, the institution 

in question will have lost some of its 

freedom and much of the incentive 

and ability to reap quick profits. A 

very sizable "cost" will have been ex 

tracted while the institution's 

management is forced to adopt lessrisky practices. 

If specific restrictive covenants are 

placed in forbearance agreements at 

the time of negotiation, multiple con 

cerns can be successfully addressed. 

Other restrictions on preferential in 

sider transactions, dividend 

payments, management compensa 

tion and similar items can help to en 

sure that the institution's owners and 

managers will not unduly profit or 

gain personal benefit from the grant 

ing of forbearance. Once again, such 

measures, if prudent from a safety

and-soundness perspective and if 

followed, will help in restoring the in 

stitution to health. Through the use 

of carefully crafted restraints, ap

26 
Forbearance 

propriate to each individual situation, 

safe-and-sound operating policies can 

be encouraged, while at the same 

time concerns over competitive ad 

vantages, unjustified enrichment of 

insiders and other inequities can be 

largely ameliorated. 

Basic Forbearance Standards 

broad framework for supervisory 

forbearance has evolved through trial 

and error. This experience has shown 

that there are some basic, fundamen 

tal tenets of successful supervisory 

forbearance programs that always 

should be followed. These are: 

Forbearance should be discre 

tionary. The supervisor must be free 

to independently judge each situa 

tion on its own merits and to grant 

or not grant forbearance. This is in 

contrast to "rules-based" forbearance, 

where such discretion is largely 

precluded, as specific criteria are 

established by statute or regulation. 

The primary distinction between the 

two approaches is that discretionary 

forbearance provides an ability to 

control risk and limit losses. 

Forbearance should focus on 

viability. No matter what social, 

political or economic objectives are 

inherent in a particular forbearance 

program, a reasonable viability test 

for the resulting entity must be a key 

component. If there is no realistic ex 

pectation that the institution will 

achieve profitable and sound opera 

tion within a reasonable time frame, 

Lhen forbearance could become an 

extremely costly policy option. 

Forbearance only should be granted 

to institutions with favorable future 

prospects. This is considered to be a 

fundamental tenet of any supervisory 

forbearance program in which some 

control over ultimate cost is desired. 

Forbearance terms should be 

negotiated. Supervisory forbearance 

should not become the automatic 

first option when problems surface; 

rather, management of each in 

dividual institution should carefully 

consider a variety of alternatives and 

devise a realistic plan to address the 

problems. If that plan requires super 

visory forbearance, then the specific 

terms should be negotiated with the 

supervisor and clearly understood by 

all parties. 

Forbearance should be re

vokable. The supervisor must be 

able to terminate forbearance should 

the negotiated agreement not be 

adhered to, or in the event greater 

losses are discovered. Any significant 

change in circumstances or the 

economic environment should com 

pel a renegotiation, or termination, 

of the transaction. In all instances, 

forbearance should be terminated in 

the event of subsequent fraud or 

significant insider abuse. It is the 

ability to terminate an institution's 

participation in a forbearance pro 

gram that will compel compliance 

with negotiated terms. This ability is 

considered to be a necessary compo 

nent of any discretionary forbear 

ance program. 

Forbearance should be a tem 

porary measure. Survival of the in

stitution receiving forbearance 

should not require a permanent 

reliance on the waiving of normal 

supervisory or enforcement prac 

tices. Also, the supervisor should 

have the flexibility to put a 

reasonable time limit on achieving 

positive results. The continuation of 

forbearance should correlate direct 

ly with the actual (initial and interim) 

success of management's efforts to 

address problems. 

Forbearance should have no 

permanent structural impact. 

Great care should be taken so as not 

to provide supervisory or regulatory 

exemption from basic rules or in 

dustry practices that will change the 

nature or structure of the industry or 

the scope of its activity. Further, any 

forbearance that will result in 

changes which are, in fact or prac 

tice, irreversible should be avoided. 

The goal of forbearance, absent a 

Congressional mandate to the con 

trary, should be neutrality in struc 

tural matters; not to effect perma 

nent change. 

Forbearance should be coupled 

with some limits on growth, specu 

lation and new risk-taking ac 

tivities. While the supervisor needs 

to retain flexibility in the actual im 

plementation, general growth and ex 

pansion limits are considered to be 

a necessary precaution when gran 

ting forbearance. Such limits can be 

periodically modified (made either 

more severe or more liberal) as in 

dividual circumstances may warrant; 

however, they generally should re 

main in place as long as forbearance 

is exercised. In extreme situations, 

the supervisor may be justified in im 

posing more severe conditions which 

mandate a reduction in the size of 

the institution and the scope of its 

activity. 

Forbearance should never 

reward insiders. An institution's 

shareholders, managers and insiders 

(broadly defined) should not receive 

direct benefit or personal profit as a 

consequence of an institution being 

granted forbearance. Restrictions or 

an outright prohibition should be 

placed on dividend payments, 

management fees, increases in 

management compensation, prefer 

ential credit concessions available 

only to insiders, and consulting-type 

fees paid to affiliates or similar 

transactions. 

Forbearance should not be 

granted unless other reasonable 

risk-control restrictions can be im 

posed on the institution's activity, 

its management and its policies. 

Such restrictions need not be applied 

in all cases and, in fact, may or may 

not even be appropriate when con 

sidered on a case-by-case basis. Care 

also should be exercised so that while 

an institution's business policies and 

direction are closely monitored, 

there is the least possible in 

terference in its actual day-to-day 

operations. The supervisor does, 

however, need the flexibility to im 

pose reasonable controls as a condi 

tion for granting forbearance. 

The following restrictive covenants 

are examples which might be con 

sidered for inclusion when crafting 

forbearance proposals for specific 

institutions: 

27 
FDIG Banking Review 

Supervisory approval is re 

quired before exercising any 

powers authorized, but not cur 

rently used. 

Supervisory notification is re 

quired regarding any change in 

senior management officials, 

established management 

policies or the employment of 

an outside auditor. 

Supervisory notification is re 

quired regarding any significant 

change in asset composition, 

liability structure or volume of 

off-balance-sheet activity. 

Supervisory notification is re 

quired regarding significant ex 

ternal events such as the 

cancellation of blanket bond 

coverage or involvement in 

substantive defensive litigation. 

Periodic submissions of 

business and operating plans 

must be made to the supervisor. 

Periodic submission of detailed 

"progress" reports must be 

made to the supervisor, sum 

marizing the local economic 

and competitive environment, 

the institution's current financial 

status and the success to date in cor 

recting weaknesses. 

Conclusions 

Forbearance can be mutually 

beneficial to both the recipient and 

the deposit insurer. It provides an op 

portunity for survival and renewal for 

the former and can be an expedient, 

low-cost alternative to failures or 

lengthy enforcement procedures for 

the latter. Further, many other 

favorable benefits often accrue to 

communities and bank customers 

when financial institutions can be 

returned to a healthy, sound 

operating basis. 

The objectives of forbearance pro 

grams vary widely. For those seeking 

relief from what may seem to be 

adverse supervisory action, the objec 

tive may be as simple as a nonadver

sarial opportunity to restructure. For 

some, forbearance is a means by 

which particular social and economic 

goals can be achieved. In other cases, 

REFERENCES 

proponents seek the preservation 

and perpetuation of a particular in 

dustry grouping or specialized credit 

source. No matter what the desired 

result of a forbearance program, 

however, all parties should share at 

least one primary goal—that is, the 

return of the institution to a healthy, 

profitable status through the reduc 

tion and control of risk. 

Given this safety-and-soundness 

focus as an underpinning, discre 

tionary supervisory forbearance pro 

grams can be crafted to address 

multiple concerns. First, and most 

basic, the supervisor needs in 

dependence from external, political 

or industry influences and the discre 

tion to tailor forbearance to the 

characteristics unique to each situa 

tion. In addition, reasonable precau 

tions need to be taken, some riskcontrol limits set and, perhaps, a cost 

exacted in the pursuit of competitive 

equity and limiting market in 

terference. Forbearance, however, 

has proven to be, and should con 

tinue to be, a useful, cost-saving and 

effective supervisory mechanism. 

Federal Deposit Insurance Corporation. Annual Report, 1982. Washington, DC: Federal Deposit 

Insurance Corporation, 1983. 

. Deposit Insurance in a Changing Environment. Washington, DC: Federal 

Deposit Insurance Corporation, 1983. 

. FDIC: The First Fifty Years. Washington, DC: Federal Deposit Insurance 

Corporation, 1984. 

28 
Recent Developments 

Recent Developments 

Affecting Depository 

Institutions 

by Benjamin B. Christopher* 

The study outlined three options 

for revitalizing and focusing the mis 

sion of the FSLIC. PR-i-89; 1/4. 

Policy Statement On 

Risk-Based Capital 

The Board of Directors approved a 

framework for bank capital standards 

that would reflect the relative invest 

ment risks of various assets banks 

hold in their portfolios. The riskbased capital policy statement ap 

plies to all state-chartered banks 

supervised by the FDIC. It does not 

replace or eliminate existing 

minimum capital requirements. 

Similar risk-based capita! standards 

have been adopted by the OCG and 

by the FRB. PR-53-89, 3/i4: fr, 3/21, v. 

1150. 

The FDIC notified insured state 

nonmember banks that although an 

explicit minimum risk-based capital 

ratio will not be in effect until 

December 31, 1990, banks are en 

couraged to immediately begin 

monitoring their own risk-based 

ratios. To aid banks in this endeavor, 

the FDIC developed a worksheet and 

distributed it to the banks. The 

worksheet will provide a conser 

vative estimate of a bank's risk-based 

capital ratio. BL-13-89, 4/14. 

Prior Notice From Banks 

Planning Rapid Growth 

The Board of Directors requested 

comment on a proposal to require 

advance notice by any insured bank 

Regulatory Agency Actions 

Federal Deposit Insurance Corporation 

Joint Regulatory Teams For 

Troubled Thrifts 

On February 7, the FDIC announc 

ed that joint regulatory teams had 

begun overseeing the operation of 

four troubled savings institutions, a 

move intended to help conserve the 

institutions' assets and preserve 

banking services to their deposit and 

loan customers until a permanent 

resolution of the institutions' prob 

lems can be developed. Basic 

customer services will not change, 

and all insured deposits will continue 

to be protected. 

The Federal Savings and Loan In 

surance Corporation (FSLIC) ap 

pointed the FDIG conservator for 

these institutions as part of a new in

teragency program announced 

February 6 by President Bush to help 

develop solutions for the FSLIC's in 

ventory of insolvent savings and loan 

associations. Other regulatory par 

ticipants in this interagency initiative 

are the Federal Home Loan Bank 

Board (FHLBB), the Office of the 

' Benjamin B. Christopher is a financial 

economist in the FDIG's Office of Research 

and Statistics. 

Reference sources: American Banker (AB); 

Wail Street Journal (WSJ); BNA's Banking 

Report (BBR); Federal Register (FR); Com 

merce Clearing House, Inc., Electronic 

Legislative Search System (EU3S). All ELSS 

items have been enacted into law when includ 

ed in this report. 

Comptroller of the Currency (OCC) 

and the Federal Reserve Board 

(FRB). 

As of April 15, 1989, there were 

219 savings and loan associations 

(S&Ls) for which the FDIC had been 

appointed conservator, pr-21-89, 2/7; 

PR-99-89, 5/18. 

Deposit Insurance Study 

The FDIG released a preliminary 

report on the federal deposit in 

surance system. Chairman Seidman 

said the study was undertaken by the 

FDIC "because of a growing realiza 

tion that deposit insurance needs 

some fundamental changes if it is to 

continue to meet its vital objectives." 

Among the key conclusions of the 

report is that deposit insurers should 

be organizationally independent and 

self-funded, with continuing accoun 

tability to the Congress. The insuring 

agency should have the authority to 

examine all institutions it insures, to 

withdraw deposit insurance quickly 

when necessary, and to adjust in 

surance premiums to reflect recent 

loss experience. In addition, the in 

surer should be able to require that 

all institutions owned by a common 

parent indemnify the insurer against 

losses resulting from the failure of a 

bank affiliate. The Chairman noted 

also the need to improve the agen 

cy's supervisory capabilities. 
FDIG Banking Review 

planning to use special funding pro 

grams such as brokered deposits, outof-area solicitations or borrowings to 

finance a rapid expansion of its 

assets. Under the proposal, advance 

notice would be required of any in 

stitution anticipating asset growth of 

nine percent or more during any con 

secutive three months. A report to 

the agency would be required within 

seven days if a bank's assets grew by 

more than nine percent over three 

consecutive months without advance 

notice to the FDIC. Most new banks 

and recently merged institutions 

would be excluded from the repor 

ting requirements, as would institu 

tions where the growth is in line with 

normal seasonal changes. 

If adopted, the proposal would 

replace a reporting requirement now 

applicable to banks accepting signifi 

cant amounts of brokered deposits 

and fully insured deposits from other 

depository institutions. BL-18-89, 4/7; 

FR, 4/5, p. 13693. 

Concentrations Of Credit 

In a bank letter the FDIG said ex 

perience has shown that concentra 

tions of credit within an institution's 

portfolio may represent an excessive 

risk to the institution and the FDIG. 

Banks should have written loan 

policies that address this point. These 

policies should be stated clearly and, 

at a minimum, should address goals 

for portfolio mix and place limits 

within loan and other asset 

categories. In formulating policies on 

risk diversification, management also 

should consider the need to track 

and monitor the economic and finan 

cial condition of specific geographic 

locations, industries and groups of 

borrowers in which a bank has in 

vested heavily. Banks are encourag 

ed to use standard industrial 

classification (SIC) or similar codes 

to track industry concentration. 

BL-12-89, 4/25 (revised). 

Community Reinvestment 

Act Statement 

The FDIG, the FRB, the OGG, and 

the FHLBB jointly issued a Com 

munity Reinvestment Act (CRA) 

Statement. The Joint Statement, 

which revises a 1980 statement 

issued by the agencies, is designed to 

provide federally insured financial in 

stitutions and the public with 

guidance regarding the requirements 

of the CRA and the policies and pro 

cedures the agencies will apply dur 

ing the applications process. 

The Statement strongly en 

courages financial institutions to ex 

pand the CRA statements that are 

presently required to include infor 

mation regarding the institution's 

past record of meeting its obligations 

under the CRA. It also discusses the 

role of private meetings between 

financial institutions and communi 

ty groups in the applications process, 

the policy of the agencies regarding 

private CRA agreements, and the 

views of the agencies regarding ex 

tensions of the public comment 

period for applications. PR-62-89,3/2i; 

FR, 4/5, p. 13742. 

Audit Policy Statement 

The Board of Directors adopted a 

new policy statement that strongly 

encourages all state nonmember 

banks to adopt an annual indepen 

dent external auditing program, and 

also suggests that all state 

nonmember banks establish an audit 

committee composed entirely of out 

side directors. It reiterates that new 

ly insured banks are expected to ob 

tain an outside audit for at least the 

first three years after deposit in 

surance is granted. strong internal 

auditing function, the FDIC said, 

combined with an annual external 

auditing program performed by an 

independent auditor, substantially 

lessens the risk that potentially 

serious problems in a bank will go 

undetected. 

It is recommended that annual ex 

ternal auditing programs be perform 

ed by either independent public ac 

countants or other qualified indepen 

dent parties. Copies of the external 

auditors' reports should be sent to 

the appropriate FDIC regional office 

as soon as possible after their receipt. 

If a bank's audit committee or 

board of directors decides not to 

have an independent public accoun 

tant perform an annual audit of the 

bank's financial statements, the 

reasons for the committee's or 

board's decision to use one of the ac 

ceptable alternatives or to have no 

external auditing program should be 

documented in its minutes. PR-210-88, 

11/16. 

The Board of Directors proposed a 

new policy recommending auditing 

procedures to be performed annual 

ly at each FDIC-supervised bank that 

elects to forego an annual audit by 

an independent public accountant. In 

those cases where banks do not 

engage a certified public accountant 

to perform an opinion examination, 

the FDIC recommends that each 

bank, at a minimum, have certain 

specific auditing procedures perform 

ed annually by a qualified indepen 

dent external party. The proposed 

policy statement contains specific 

recommended auditing procedures 

for five high-risk areas: securities, 

loans, allowance for loan losses, in 

sider transactions and internal con 

trols. PR-98-89, 5/16. 

Flood Insurance 

Insured nonmember banks were 

notified that they should review their 

procedures to ensure that they are 

not making, increasing, extending or 

renewing any loan (including home 

equity loans) secured by improved 

real estate or a mobile home located 

in a flood hazard area of a communi 

ty participating in the National Flood 

Insurance Program unless flood in 

surance has been purchased by the 

borrower. Banks also must ensure 

that coverage is renewed and main 

tained for the duration of the loan. 

A recent Flood Insurance Ad 

ministration study revealed that on 

ly 13 percent of insurable household 

units in special flood hazard areas are 

covered by flood insurance. BL-39-88, 

12/5. 
Recent Developments 

Revised Regulations Under 

Bank Control Act 

The FDIC amended its regulations 

governing submittals and notice 

publication under the Change in 

Bank Control Act primarily to imple 

ment the 1986 amendments. Under 

the rule, the FDIC may waive 

newspaper publication or comment 

solicitation requirements or act on a 

proposed change in control prior to 

the expiration of the public comment 

period only if the FDIC makes a writ 

ten finding that newspaper publica 

tion or comment solicitation would 

seriously threaten the safety or 

soundness of the bank to be ac 

quired. In some circumstances the 

FDIC may shorten the public com 

ment period to not less than ten days. 

Effective date: 12/27/38. FR, 12/27, p. 

52111. 

Deposit Liabilities 

The FDIC proposed to find that a 

bank's liability on a promissory note, 

bond, acknowledgement of advance, 

or similar obligation that is issued or 

undertaken by the insured bank as 

a means of obtaining funds, is a 

deposit liability. Under a provision of 

the Federal Deposit Insurance Act, 

the FDIC may find and prescribe by 

regulation that certain liabilities of a 

bank are deposit liabilities by general 

usage. There would, however, be a 

number of enumerated exceptions to 

the general proviso. f!L-43-88, 12/21. 

Equal Opportunity For 

Minority Lawyers 

The FDIC has committed itself to 

steering a portion of its outside legal 

work to minority-owned law firms. 

The announcement was made in con 

nection with an American Bankers 

Association pilot program to en 

courage opportunities for minorityowned firms and minority lawyers 

who work for large firms. The pro 

gram involves a voluntary commit 

ment by a number of large corpora 

tions to direct legal business to a list 

of law firms owned by black. 

Hispanic, native American and AsianAmerican lawyers. An FDIC official 

said the agency, which used over 600 

law firms last year, is reviewing and 

redrafting how it assigns legal work, 

and exploring ways of providing 

equal opportunity to minority-owned 

firms and minority partners in large 

firms. Legal Division, FDIC. 

Federal Reserve Board 

Risk-Based Capital 

Guidelines 

The FRB approved risk-based 

capital guidelines for state member 

banks and bank holding companies. 

In the final guidelines the number of 

risk categories is reduced to four, 

from five in earlier drafts (see the Fall 

1988, Banking Review, p. 37). The 

ten-percent risk category for long

term government securities was 

eliminated and these securities are 

assigned a zero risk weighting, 

Institutions must have a 7.25 per 

cent capital to weighted-risk asset 

ratio by the end of 1990, and eight 

percent by year-end 1992. AB, 

12/27/88, p. 8; 1/20/89, p. 8; FR, 1/27/89, 

p. 4186. 

FRB Will Provide Temporary 

Assistance To S&Ls 

FRB Chairman Alan Greenspan 

and FHLBB Chairman M. Danny 

Wall announced a plan for liquidity 

support to S&Ls. The Federal Home 

Loan Banks, which are the first line 

of liquidity support for S&Ls, will 

continue to provide liquidity for 

thrifts that meet normal collateral 

standards. The Federal Home Loan 

Banks and Federal Reserve Banks 

will participate in a shared lending 

program to meet the liquidity needs 

of S&Ls that do not have access to 

normal sources of liquidity, including 

not only Home Loan Bank advances, 

but also brokered funds and funding 

derived from repurchase agreements. 

Loans made by the Federal 

Reserve Banks and Federal Home 

Loan Banks, under the shared lend 

ing program, will be collateralized by 

assets held by the borrowing thrift, 

and guaranteed by the FSLIC. 

Under the S&L reform and restruc 

turing legislation proposed by the 

Administration, the guarantees made 

by the FSLIC under this shared lend 

ing arrangement would be assumed 

by the Resolution Trust Corporation. 

The announcement noted that the 

Treasury is also participating in this 

program by advancing funds under 

its statutory line of credit to the 

FSLIC, and these funds will, in turn, 

be made available to thrifts as part 

of the shared lending. AB, 2/24/89, p. 2. 

As of mid-May, 20 S&Ls had been 

certified and eight were in process to 

participate in funding arrangements 

provided by the Federal Reserve, 

Federal Home Loan Banks and the 

Treasury. Only two S&Ls were cur 

rently using this funding. PR-99-89, 

5/18 (FDIC). 

Restrictions On Bank Holding 

Companies' Tandem Thrift 

Operations 

The FRB requested comments on 

whether certain conditions restric 

ting transactions between thrift in 

stitutions acquired by BHCs and 

other holding company subsidiaries, 

which the FRB has imposed since 

1982, should be retained, modified, 

or removed. The rules prohibit a 

BHCs banking and other subsidiaries 

from acting in tandem with a thrift 

subsidiary in deposit-taking and loan 

solicitations. Citicorp requested relief 

from the restrictions, arguing that 

they impose unnecessary costs and 

burdensome inefficiencies, limit ser 

vices to consumers, and deter thrift 

acquisitions by BHCs which could 

help to fulfill the thrift industry's 

critical need for outside financial and 

managerial resources. Press Release, 

Federal Reserve Board, 4/14/89. 

LBO Financing 

New guidelines for examiners on 

treatment of bank loans to finance 

leveraged buyouts state that "bank 

ing organizations should establish 

policies, procedures and controls 

before becoming involved" in highly 

leveraged financings. HLFs are defin 

ed as loans to borrowers whose debt 
FDIG Banking Review 

is more than three times their equi 

ty. An official said that examiners 

would look at loans to HLF bor 

rowers with greater scrutiny, but 

such loans will not necessarily be 

criticized. Among the specific 

guidelines was that borrowers' cur 

rent and future cash flows should be 

evaluated "under varying economic 

scenarios, including the possibility of 

an economic decline." WSJ, 2/23/89, p. 

A4. 

Truth-In-Lending Disclosure 

Credit Cards: The FRB adopted 

amendments to its Regulation Z to 

implement charge card and credit 

card disclosure requirements con 

tained in the 1988 Fair Credit and 

Charge Card Disclosure Act. The 

revised regulation requires banks and 

other card issuers to disclose interest 

rates, grace periods, and annual fees 

at the time of customer solicitation. 

Also, issuers will be required to 

disclose clearly the methods they use 

to compute outstanding balances, 

and to disclose late fees, over-the

limit fees, and minimum finance 

charges. BBR, 4/3/89, p. 775; FR, 4/6, p. 

13855. 

Home Equity Loans: The Board 

proposed revisions to Regulation Z to 

implement provisions of the Home 

Equity Loan Consumer Protection 

Act Of 1988. FR, 1/23/89, p. 3063. 

The HELCP Act requires lenders to 

disclose the rates and terms of home 

equity loans at the time a loan ap 

plication is provided and before the 

consumer pays a non-refundable fee. 

Lenders are prohibited from making 

unilateral changes in the terms of a 

home equity loan contract, but may 

suspend access to a home equity loan 

account or reduce a credit line if the 

underlying property's value declines, 

and under other specified conditions. 

Lenders are permitted to require full 

payment of a home equity loan 

balance only if the borrower fails to 

meet the repayment terms, and 

under certain other specified 

circumstances. 

The law bars lenders from control 

ling the home equity loan interest 

rate index, and also restricts adver 

tising of the loans. BBR, 12/5/88, p. 940. 

Banks' Financial Disclosures 

The FRB amended its Regulation H 

to require state member banks to 

make available to shareholders and 

any member of the public, upon re 

quest, information regarding each 

such bank's financial condition in the 

form of the bank's two most recent 

year-end Reports of Condition and 

Income (Call Reports). As alter 

natives to furnishing the Gall 

Reports, at each bank's option, per 

sons requesting such information 

may be given other reports as 

specified in the amendments. 

The amendment also requires 

state-licensed agencies of foreign 

banks and state-licensed branches of 

such banks that are not insured by 

the FDIC to make available, upon re 

quest, certain schedules from the two 

most recent year-end Foreign Branch 

and Agency Gall Reports. Effective: 

4/1/89. FR, 2/8/89, p. 6115. 

State Bank Affiliates OfBHCs 

May Have To Obtain FRB 

Approval Of Nonbank 

Subsidiaries 

The FRB proposed that state bank 

subsidiaries of bank holding com 

panies be required to obtain FRB ap 

proval to acquire or hold nonbank 

businesses as subsidiaries. 

The FRB also asked for comment 

on a proposal to grandfather all or 

most existing subsidiaries of holding 

company banks acquired in accord 

with its existing rule. WSJ, 11/22/88, p. 

C15; FR, 12/5, p. 48915. 

Banks Acquired By BHC May 

Continue Insurance 

Activities 

The FRB approved an application 

by Merchants National Corp., In 

dianapolis, to own and operate two 

Indiana state-chartered banks which 

are permitted under the state law to 

sell property and casualty insurance. 

In its decision the FRB said that the 

Bank Holding Company Act does not 

give it authority over the direct ac 

tivities of a state bank. As a policy the 

FRB has favored having the nontradi

tional banking activities conducted 

by subsidiaries of BHGs and not by 

the banks themselves. AB, 3/7/89, p. 1. 

Securities Underwriting, 

Brokerage Powers 

The FRB granted approval for 

Bankers Trust New York Corp., 

Chase Manhattan Corp., Citicorp, J.P. 

Morgan & Co., and Security Pacific 

Corp. to underwrite and deal in cor 

porate debt, and to sell common 

stock within a year. FRB officials said 

reviews would begin promptly to en 

sure that the institutions have suffi 

cient capital, internal controls and 

expertise before being permitted to 

begin the corporate debt under 

writing activities. BHCs entering this 

business must have capital that is 

"substantially above" required 

minimums. 

In its approval the Board specified 

several restrictions on transactions 

between the parent firms, subsidiary 

banks, and the securities and other 

nonbank subsidiaries. Prohibited are 

loans from the holding companies' 

banks to the securities underwriting 

subsidiaries, with some exceptions 

such as loans to clear government 

securities. Banks cannot purchase or 

sell for their own account securities 

which the subsidiary is selling. 

though the subsidiary may act as the 

bank's agent. The BHCs will be re 

quired to deduct from capital any in 

vestment in or credit extended to the 

securities unit. BHC will not be per 

mitted to transfer its capital to the 

securities unit unless its capital 

substantially exceeds the eight per 

cent minimum set recently in the 

FRB's risk-based capital guidelines. 

Revenues from the new powers, in 

cluding those from previously ap 

proved underwriting and dealing in 

commercial paper, mortgage-backed 

securities, municipal bonds, and 

consumer-related receivables, may 

not exceed five percent of the 

securities subsidiary's gross revenue. 

FRB officials said the FRB will con

32 
Recent Developments 

sider raising this ceiling to ten per 

cent later this year. AB, 1/19/89, p. 1. 

CRA Cited In Application 

Denial 

An application by Continental 

Bank Corp. to purchase the #19 

million-asset Grand Canyon State 

Bank, Scottsdale, Arizona was denied 

by the FRB on the grounds that Con 

tinental had not met its performance 

responsibilities under the Communi 

ty Reinvestment Act. It was the 

FRB's first CRA-based denial. In its 

decision the FRB also questioned the 

propriety of Continental's plans to 

expand while it is still partly owned 

by the FDIC. Since 1986 the FRB has 

permitted Continental to acquire 

three suburban Chicago banks. WSJ, 

2/16/89, p. A3. 

Owning Stock Of 

Mutual Funds 

By amendment to its Regulation H 

the FRB will allow state member 

banks to purchase and hold for their 

own account stock in investment 

companies, if the companies' port 

folios contain only securities that 

state member banks are permitted to 

purchase directly. These include 

government securities, corporate 

debt, and other securities authorized 

for national banks. Other permissible 

investments include "futures, for 

wards, options, repurchase 

agreements, and securities lending 

contracts" relating to securities that 

state member banks may purchase 

for their own account. State member 

banks also are permitted under the 

amendment to invest in stock of 

money market mutual funds. BBR, 

2/20/89, p. 416; FR, 2/17, p. 7180. 

Title Insurance 

The FRB approved the acquisition 

of Milwaukee Title Insurance Ser 

vices Inc. by First Wisconsin Corp., 

a BHC with 33 subsidiary banks. The 

acquisition was challenged on the 

grounds that the 1982 Garn-St Ger 

main Act permits First Wisconsin to 

provide only the services authorized 

by the FRB prior to 1971, of which 

title insurance was not one. The FRB, 

citing First Wisconsin's subsidiaries' 

activities in the selling of credit life 

insurance that were grandfathered 

under Garn-St Germain, said the 

holding company could expand its in 

surance services to include title in 

surance. ABA Bankers Weekly, 11/29/88, 

p. 4. 

Own Account Trading Of 

Foreign-Exchange Futures 

The FRB granted approval for Car 

roll McEntee & McGinly Inc., New 

York, a primary dealer owned by 

three BHCs, to engage in foreignexchange options, futures, and 

related transactions for its own ac 

count. For the first time the FRB ap 

proved foreign-exchange forwards, 

options, and options on futures tran 

sactions for a company's own ac 

count for other than hedging pur 

poses. BBR, 1/30/89, p. 217. 

Currency-Swap Advisory 

Services Permitted 

The FRB granted approval for Nip 

pon Credit Bank, Tokyo to purchase 

Eastbridge Capital Inc., New York to 

engage in certain securities activities 

previously approved for BHCs, and in 

addition, to advise customers on 

structuring currency swaps. The FRB 

said that while providing such advice 

is a new activity, it is essentially the 

same as advising on interest-rate 

swaps. Both transactions have the 

common objectives of securing lowcost funds and converting one type 

of risk to another. AB, 2/17/89, p. 15. 

Foreign-Currency Deposits 

At U.S. Banks 

The FRB, in a reversal of policy, 

decided to allow deposits of foreign 

currency in U.S. banks, beginning 

January 1, 1990. The FRB said it 

"does not expect such deposits to in 

crease rapidly, or ultimately to ac 

cumulate to a large amount given the 

existing availability of effectively 

similar instruments. BBR, 1/9/89, p. 66; 

FR, 12/29/88, p. 52787. 

BHC Allowed To Acquire 

Failing Thrift, 

Branching Restricted 

The FRB granted approval for 

Barnett Banks Inc., Jacksonville, 

Florida's largest BHC, to acquire the 

failing $41.4 million-asset First 

Federal Savings and Loan Associa 

tion, Summerville, Georgia. The 

FRB's decision requires Barnett to 

operate First Federal "as a federal 

savings bank having as its primary 

purpose the provision of residential 

housing credit." Barnett may not 

change First Federal's name to "any 

title that might confuse the public 

regarding its status as a nonbank 

thrift institution." Among other 

restrictions, the Board said that First 

Federal may not operate branches at 

locations where national or state 

banks may not branch in Georgia. 

BBR, 1/2/89, p. 9. 

Pricing Policies 

The FRB proposed revisions in its 

services-pricing policies, centering on 

the "private sector adjustment fac 

tor" used to estimate the overhead of 

banks with which the FRB competes 

in providing payment and other ser 

vices. The factor includes estimates 

of taxes and deposit insurance 

premiums which the FRB does not 

pay. Specific changes which are pro 

posed include expanding from 25 to 

50 the number of BHCs in the costaccounting sample; increasing the 

averaging period of firms' results 

from three to five years; changing the 

FRB's pro forma balance sheet to 

reflect the same risk-based capital 

standards with which banks must 

comply; and calculating FDIC 

premiums similar to the way they are 

calculated for banks, including cer 

tain deferred credits that have not 

been part of the FRB's formula. AB, 

1/19/89, p. 2. 

Delayed Disbursement Policy 

A FRB policy statement urged 

issuers of teller's and cashier's 

checks, and check service providers, 

to adopt practices to ensure that col
FDIG Banking Review 

lection delays and returns of these 

items are minimized. The policy 

statement was issued in lieu of plac 

ing certain restrictions on delayed 

disbursement practices. 

Regulation CC requires that banks 

make funds available for withdrawal 

on cashier's and teller's checks on 

the next business day after deposit. 

When disbursements are delayed the 

paying banks may have to make 

these funds available before they 

receive credit for the checks. The 

FRB said it would monitor voluntary 

compliance, and may approve 

restrictions if abusive practices con 

tinue. BBR, 4/3/89, p. 775; AB, 3/31, p. 3; 

FR, 4/6, p. 13839. 

Office Of The Comptroller 

Of The Currency 

Risk-Based Capital 

Guidelines 

The OGC approved risk-based 

capital guidelines similar to those 

which have been approved by the 

Federal Reserve Board. ABA Bankers 

Weekly, 1/31/89, p. 4; FR, 1/27, p. 4168. 

LBO Lending Controls 

The OCC issued guidelines to na 

tional banks indicating that leverag 

ed buyout lending will be closely 

scrutinized. 

The guidelines said that banks 

should have separate and specific 

policies and rules for approving loans 

for highly leveraged transactions, and 

explained what they should encom 

pass. Also, separate management in 

formation systems should provide 

periodic reports on the size, quality, 

and performance of the bank's LBO 

portfolio. 

Individual and aggregate limits 

should be set on loans for highly 

leveraged transactions. Where banks 

and affiliates are participating, limits 

also should be set on the group ag 

gregate amounts. All entities should 

conduct individual credit approvals. 

AB, 12/16/88, p. 1. 

National Banks' Equity 

Investments 

The OCC proposed amendments 

to its regulations that require na 

tional banks to notify the agency of 

plans to make certain equity in 

vestments which are authorized by 

statute. The amendments also 

describe the OGC's existing policies 

on imposing controls on transactions 

between a bank and its subsidiaries. 

FR, 1/27/89, p. 4038. 

Compliance Actions 

To Be Publicised 

The OGC announced a plan for 

public disclosure of bank compliance 

enforcement actions on a case-by

case basis. Agency officials said deci 

sions on whether to publicize would 

take into account the need to 

educate the public about banks' 

responsibilities, to protect bank 

customers, thwart future problems. 

and the potential adverse effects of 

disclosure, BBR, 1/23/89, p. 155. 

Expanded Branching 

Permitted 

Illinois: The OGC decided that a 

national bank could establish a sub 

sidiary which can accept deposits, 

close loans, and offer other bank ser 

vices at offices throughout Illinois. 

The state's law permits a statechartered bank to establish up to five 

offices "within certain limited 

distances from the bank's main 

premises." However, banks also are 

allowed to set up corporations that 

can engage, anywhere in the state, in 

any bank functions except taking 

deposits and paying checks. Courts 

invariably have held, said an OGC of 

ficial, that when such offices are clos 

ing loans they are engaging in branch 

banking. BBR, 12/12/88, p. 996. 

Missouri: The OCC granted ap 

proval for First National Bank & 

Trust Co., of Columbia, Missouri to 

open branches in Jefferson City and 

Fulton. State-chartered banks would 

not be allowed to branch in that man 

ner under Missouri's law which 

restricts branching by commercial 

banks to the same county as their 

main office, and to the adjoining 

county if certain conditions are met. 

The OCC cited Missouri's law giving 

broader branching authority to S&Ls 

which may offer many of the same 

products and services as commercial 

banks in the state. 

Similar decisions by the OCC (see 

the Fall 1988, FDIG Banking 

Review, pp. 42-43) have been upheld 

by the U.S. Supreme Court in the 

Deposit Guaranty case (Mississippi) 

and by federal district courts in 

Florida, Tennessee and Texas. 

Several states, including Arkansas, 

Florida and Texas have expanded 

banks' branching authority to avoid 

putting state-chartered banks at a 

competitive disadvantage. 

The Independent Bankers Associa 

tion of America has sued the OCC to 

block the FNB&T branching order. 

BBR, 2/6/89, p. 341. 

Wisconsin: The Comptroller of 

the Currency allowed two national 

banks to open branches in locations 

where state-chartered banks would 

not be allowed to branch. The OCG 

said that because Wisconsinchartered S&Ls are permitted to of 

fer many of the same products and 

services offered by commercial 

banks, they are "state banks" for pur 

poses of the McFadden Act. Wiscon 

sin's law permits state-chartered 

S&Ls to branch statewide. ABA 

Bankers Weekly, 4/18/89, p. 6. 

Title Insurance And 

Related Activities 

The OGC said that national banks 

may act as agents in the sale of title 

insurance, and, in addition, may con 

duct title searches, write legal title 

opinions, and survey land in connec 

tion with real-estate loans. An official 

said a 1972 court decision permits 

national banks to engage in activities 

that are "convenient or useful in the 

performance of one of the bank's 

established activities pursuant to its 

express powers." In 1987, national 

banks were authorized by the OCG 
Recent Developments 

to sell title insurance as an activity 

"incidental to the business of bank 

ing." BBR, 11/14/88, p. 844. 

Software Subsidiaries 

The OCG permitted Mellon Bank 

N.A. to establish a subsidiary to of 

fer software applications and systems 

for financial institutions' backroom 

operations. National banks already 

are permitted to provide data pro 

cessing for services "expressly or in 

cidentally authorized to national 

banks." The OCC's Mellon ruling dif 

fers from its denial in 3 984 of a 

bank's request "to market software 

separately as a by-product of its other 

data processing activities," because 

in this case the subsidiary "will be 

selling software on a stand-alone 

basis only to other financial institu 

tions." BBR, 11/14/88, p. 844. 

Credit Card Fees 

The OGC said the fees that national 

banks can charge for their credit 

cards are determined by the bank's, 

not the customer's, address. The let 

ter to Iowa's Attorney General said 

that national banks based in other 

states did not have to comply with 

fee guidelines established under 

Iowa's laws. ABA Bankers Weekly, 

1/10/89, p. 4. 

Guidebook On Community 

Development Lending 

The OGG released a 34-page report 

on methods and organizational 

models used by banks and other 

financial institutions to help facilitate 

community revitalization. Community 

Development Finance: Tools and Techniques 

For National Banks, OCC, March 1989. 

Federal Home Loan 

Bank Board 

Risk-Based Capital 

Requirement Proposal 

The FHLBB proposed a regulation 

that would base the minimum capital 

required of a S&L on its risk level. 

For the credit-risk component of the 

minimum capital requirement, each 

asset would be assigned one of six 

risk categories. 

The proposal would require all 

FSLlG-insured thrifts to maintain 

capita] of six percent of risk-weighted 

assets, plus 50 percent of the poten 

tial change in market value of the 

assets that would be caused by a two 

percent change in interest rates. 

Together the six percent credit-risk 

component and the 50 percent 

change in value interest-rate-risk 

component are expected to average 

approximately eight percent of riskweighted thrift industry assets. Assets 

held by thrift subsidiaries would be 

subject to the capital requirement. 

With respect to collateralized bor 

rowing, additional capital equal to 

three percent of the liabilities against 

which specific assets are pledged 

would have to be held, 

A four-year phase-in period is pro 

vided before thrift institutions would 

have to be in full compliance. 

In conjunction with its capital pro 

posal the FHLBB also raised the issue 

of whether the final regulation should 

define a particular level of regulatory 

capital (1.5 percent of assets) as an 

"unsafe and unsound condition to 

transact business" for purposes of 

triggering the FHLBB's statutory 

authority to appoint a conservator or 

receiver for the institution. News, 

FHLBB, 12/19/88; FR, 1/10/89, p. 826. 

Restrictions On Rate 

Sensitivity 

New FHLBB guidelines require all 

savings institutions' boards of direc 

tors to adopt a formal interest-rate

risk policy containing specific 

elements. These include explicit 

limits on the institution's interestrate-risk exposure, in terms of the 

maximum acceptable potential 

reduction in net interest income and 

market value of portfolio equity caus 

ed by hypothetical increases or 

decreases in interest rates of up to 

four percent. 

Management reports to the direc 

tors should include an analysis of 

how the institution's net interest in 

come and portfolio equity would be 

affected by the hypothetical interestrate changes. Most institutions will be 

permitted to rely on the estimate of 

those measures calculated by the 

Federal Home Loan Bank System. In 

stitutions with assets of more than 

$500 million, those investing in highrisk mortgage derivative products, 

and other institutions designated by 

regulatory staff should generate their 

own exposure measures. 

Institutions generally will be ex 

pected to amend their current 

interest-rate-risk policy by June 30, 

1989 to meet the guidelines and to 

implement their revised interest-rate

risk management improvements by 

December 31, 1989. News, FHLBB: 

1/30/89. 

Derivative Mortgage 

Securities Activity 

Guidelines 

The FHLBB issued mortgage 

securities guidelines under which 

troubled savings institutions insured 

by the FSLIC must have special per 

mission from their principal super 

visory agent in order to hold certain 

mortgage derivative securities or 

mortgage swaps. Healthy institutions 

may engage in transactions involving 

these securities "only after putting in 

place internal controls and pro 

cedures specified . . ."(in the 

guidelines). The instruments include 

the residual interest in collateralized 

mortgage obligations (CMOs) and 

real-estate mortgage investment con 

duits (REMICs), and other specified 

derivative products with high-risk 

characteristics. 

"In general the use of these pro 

ducts should be limited to transac 

tions and strategies that do not in 

crease an institution's exposure to in 

terest rate risk," an agency official 

said. Thrift Bulletin TB-12, FHLBB; BBR, 

12/19/88, p. 1022. 

Insolvent Thrifts' Investment 

In High-Risk Securities 

The FHLBB issued guidelines that 

prohibit insolvent S&Ls from new in 

vestments in high-risk, or so-called 

junk bonds. The guidelines also re

35 
FDIG Banking Review 

quire those S&Ls to divest their cur 

rent investments in such securities 

unless an association's FHLBB super 

visor permits them as being in the 

best short-term interests of the 

FSLIC. 

At present, thrifts' investment in 

high-risk bonds is restricted to 11 

percent of their total investments, 

and to five percent of total assets in 

any one high-risk mutual fund. WSJ, 

2/1/89, p. A8. 

Thrifts To Be Told 

Examination Ratings 

The FHLBB, in a change of policy, 

will tell thrift institutions the overall 

numerical value of their MACRO 

ratings, starting with examinations 

begun after December 1, 1988. 

Management, asset quality, capital 

adequacy, risk management, and 

operating results are rated separate 

ly on a scale of one (highest) to five, 

and the results combined into a one

to-five composite rating. Institutions 

will not be permitted to disclose their 

ratings "in any form" to the public, 

BBR, 12/12/88, p. 968. 

Disclosure Of Customer 

Information 

Federally chartered savings institu 

tions would be permitted to release 

the names and addresses, but not ac 

count information, of their customers 

to any party, unless the customer for 

bids it "affirmatively and in writing," 

under the proposal released for com 

ment by the FHLBB. A customer list 

released under the proposed rule 

would have to be a complete list of 

all customers not objecting to the 

release. For example, a list of only 

customers having an account 

balance over a specified amount 

would not be permitted. Thrifts 

would be required to notify 

customers "in a timely manner" of 

the institution's intent to release the 

information, and to delay the release 

of information for 30 days following 

the customer notification. 

The proposal would also amend 

current regulations that require an 

association, before it releases 

customer information, to have ap 

proval from the FHLBB or the thrift's 

principal supervisory agent. BBR, 

2/13/89, p. 381; FR, 2/6, p. 5629. 

Guidance To S&Ls On 

Environmental Liability 

A statement by the FHLBB iden 

tified potential environmental 

liabilities for S&Ls, and urged them 

to adopt environmental-risk policies. 

A good environmental-risk policy, 

the FHLBB said, should establish a 

due diligence level for all real-estate 

transactions, establish a means for 

identifying environmental risk, and 

minimize contamination of collateral 

by providing for monitoring and 

property inspections. The policy 

should be sufficient to qualify for the 

"innocent landowner" defense under 

federal environmental law, and "sup 

port the institution's adherence to 

the principles of safety and sound 

ness." 

An official said there is no require 

ment, nor a time frame specified, for 

S&Ls to adopt the FHLBB's sug 

gested guidelines. However, thrift ex 

aminers will comment adversely if an 

institution has taken no action to pro 

tect against environmental liability. 

BBR, 4/3/89, p. 182. 

Federal Financial 

Institutions Examination 

Council 

Interest-Rate 

Swap Reporting 

The FFIEG issued for public com 

ment a proposal, developed jointly 

by the OGG, the FRB and the FDIG, 

that would prohibit FDIG-insured 

commercial banks and statechartered savings banks from 

recognizing, for purposes of the 

Reports of Condition and Income 

(Call Reports), arrangement fees and 

spread income at the inception of a 

swap. Instead, this income would be 

recognized over the life of the swap. 

It also would require that subsequent 

changes in the market value of 

swaps, except for most swaps ac 

counted for as hedges, be reflected in 

income during the period in which 

the changes occur, FR, u/9/88, p, 

45386

Risks From Large-Scale 

Integrated Financial 

Software Systems 

The FFIEC notified all federally 

supervised financial institutions of 

concerns about the risks associated 

with large-scale integrated financial 

software systems. Institutions were 

alerted to the potential risks of these 

systems and the possible controls ap 

propriate for their development, im 

plementation and use. BL-35-88,12/5, 

FDIC. 

National Credit Union 

dministration 

Proposed Tighter 

Membership Rules 

The NCUA proposed chartering 

regulations and a membership policy 

that would discourage the creation of 

national credit unions, such as the 

GU formed last year by the 28 

million-member American Associa 

tion of Retired Persons. To meet the 

common bond requirements, under 

the proposal a CU must have at least 

one meeting annually open to all 

members, sponsor other activities 

providing for regular contact among 

members, and provide a definition of 

who is eligible for membership. A 

charter would have to be based at the 

"lowest economically feasible level," 

as between a local, regional or na 

tional charter. Before a regional or 

national charter could be granted all 

the regional directors involved would 

have to give approval. ABA Bankers 

Weekly, 3/28/89, p. 4. 

CU Nonmember Deposits 

Limited 

Credit unions may not have more 

than 20 percent of their total shares 

in nonmember accounts under an 

emergency rule adopted by the 

NCUA. The rule applies to federally 

insured state and federal CUs that are 

authorized to accept public-unit and 

nonmember funds. An NCUA 
Recent Developments 

memorandum said that "recent prob 

lem cases have shown that these 

types of accounts, when they repre 

sent a large portion of total shares, 

lead to unsafe and unsound practices 

and conditions in the credit unions 

accepting them and have resulted in 

significant losses to the NGUSIF and 

some credit unions." BBR, 12/19/88, p. 

1024: FR, 12/19, p. 50918. 

Federal Credit Unions 

Permitted To Buy 

Put Options 

The NCUA amended its rules to 

permit federal CUs to purchase put 

options on Government National 

Mortgage Association, Federal Na 

tional Mortgage Association, and 

Federal Home Loan Mortgage Cor 

poration securities. It enables CUs to 

offer locked-in interest rates when 

home mortgage applications are fil 

ed and be protected against increases 

in market rates which may occur 

before the loan is sold on the secon 

dary market. 

An interim amendment required 

credit unions to obtain approval from 

the appropriate NCUA regional office 

before starting a put-option program, 

and subsequent monthly reports on 

such activities. The final rule gives 

NCUA regional directors the option 

of waiving the monthly reporting re 

quirement on a case-by-case basis. 

BBR, 5/1/89, p. 951. 

State Legislation 

And Regulations 

interstate Banking 

And S&L Operations 

Illinois: New legislation, effective 

September 16, 1988, permits a state 

bank, when necessary for the protec 

tion of its depositors, to sell its assets 

to a qualified midwest or out-of-state 

BHC. This may be necessary when 

no qualified state or national bank 

located in the same county, surroun 

ding counties or state will purchase 

the assets. ELSS, 12/2/88. 

New Jersey: The Banking Commis 

sion said that acquisitions of federal

ly insured S&Ls and their holding 

companies in New Jersey by out-of

state thrifts would be permitted on 

a nationwide, reciprocal basis, effec 

tive November 15. The Commis 

sion's action was triggered by the 

1987 interstate banking law's provi 

sion for such acquisitions when 13 

other states had enacted a similar 

law. 

New Jersey's commercial banks 

were authorized two years ago to 

engage in nationwide reciprocal in 

terstate banking. BBR, 11/28/88, p. 90S. 

New Mexico: New legislation per 

mits the acquisition of savings institu 

tions and holding companies of sav 

ings institutions by out-of-state 

depository institutions and holding 

companies, effective January 1, 

1989. Until July 1, 1992, an institu 

tion to be acquired must have been 

in operation for at least five years. 

ELSS, 4/25/89. 

Intrastate Branching 

Florida: Regulators granted ap 

proval for the Bank of Central 

Florida, Orlando, to establish a 

branch in Seminoie County. The 

state Comptroller was given authori 

ty to approve cross-county banking 

by 1988 legislation that became ef 

fective 45 days after the establish 

ment of the first national bank 

branch outside the bank's home 

county. The OCG in May allowed 

Consolidated Bank, N.A., based in 

Dade County, to establish a branch 

in neighboring Palm Beach County, 

and since has approved 11 more 

cross-county branches for national 

banks. BBR, 12/5/88, p. 948. 

Illinois: A state judge ruled that 

the state Banking Commissioner 

may no longer approve purchases by 

state-chartered banks of inactive 

bank charters. State banks had been 

buying charters of closed or merged 

banks, then reopening them at dif 

ferent locations to get around the 

state's restrictive branching rules. Il 

linois state banks may relocate 

anywhere within the state, while 

national banks under federal law are 

restricted to relocating within 30 

miles of their original main office. 

BBR, 2/6/89, p. 323. 

Another circuit judge in Illinois has 

ruled that the Banking Commis 

sioner's policy of permitting the pur 

chase and reactivation of charters is 

legal. BBR, 2/27/89, p. 492. 

Montana: Beginning January 1. 

1990, banks in the state are permit 

ted to branch by acquiring other 

banks and converting them to bran 

ches, or by establishing a branch in 

a town that has no bank. 

The three out-of-state companies 

which already own banks in Montana 

are not permitted to branch, but 

under the new law may merge their 

banks into one company and convert 

the remaining offices into branches. 

They are not permitted to buy addi 

tional banks in Montana. AB, 3/30/89, 

p. 15. 

Insurance Powers 

California: The California 

Supreme Court upheld Proposition 

103, which was approved by the 

state's voters last year. The decision 

allows rollbacks in insurance rates, 

provided that insurers are not depriv 

ed of due process or forced to accept 

"inadequate" profit. WSJ, 5/5/89, p. Bi. 

The initiative also gives statechartered banks the right to seil in 

surance products. It requires that the 

state's Insurance Commissioner be 

elected, rather than appointed by the 

Governor, and provides that future 

rate increases are subject to the Com 

missioner's approval. 

The measure repeals the insurance 

industry's exemption from state an 

titrust laws, applies consumer protec 

tion laws to insurance sales, and 

repeals anticompetitive laws that 

prohibit insurance agents and 

brokers from giving discounts to con 

sumers. AB, 11/10/88, p. 2; WSJ, 11/10, 

p. Bl. 

The California Supreme Court 

earlier granted an emergency stay 

preventing Proposition 103 from tak 

ing effect, which it later lifted except 

37 
FDIG Banking Review 

for the provision requiring (1) a 

minimum 20 percent rollback in pro 

perty and casualty rates, and (2) set 

ting up a publicly funded consumer 

watchdog agency. WSJ, 11/11/88, p. C7; 

12/8, p. BIO. 

The California Department of In 

surance granted approvals for a sub 

sidiary of Security Pacific Corp., and 

First Interstate Bank of California, to 

begin selling insurance products. AB, 

1/31/89, p. 12; WSJ, 2/31, p. B3. 

Securities Underwriting 

Powers Of Banks, 

Thrifts Expanded 

Georgia: The Governor is ex 

pected to sign legislation, to take ef 

fect July 1, which will allow banks to 

invest 25 percent of equity in real 

estate they finance, though the total 

of such ownership could not exceed 

60 percent of a bank's capital. Also, 

the bill broadens the authority of 

banks to invest in corporate debt 

securities, and clarifies their authori 

ty to invest in mutual funds compos 

ed of debt securities. The banks still 

would not be allowed to buy mutual 

funds consisting of stocks or buy 

stocks directly. 

An official said the legislation 

would give state regulators broad 

authority to consider new financialservice powers for banks by regula 

tion and avoid the lengthy legislative 

process. BBR, 4/10/89, p. 820. 

Pennsylvania: Effective January 

22, 1989, commercial and savings 

banks may underwrite municipal and 

mortgage-backed securities and in 

vest up to one percent of their assets 

in real-estate development, and make 

investments in new areas to be 

outlined by the state banking depart 

ment. This is one of three new laws 

that will "allow those state-chartered 

institutions to offer more services 

and become more competitive," and 

will "provide a more level playing 

field," Governor Robert Casey said. 

BBR, 1/9/89, p. 77. 

Utah: Recently enacted legislation 

allows state-chartered banks, begin 

ning April 24, to underwrite and sell 

short-term money market funds, 

short-term municipal debt and cor 

porate commercial paper through a 

subsidiary. The law limits a holding 

company's investment in the sub 

sidiary to ten percent of its capital, 

and requires the subsidiary's 

employees to register with federal 

and state authorities. Bank Letter, 

3/20/89, p. 8. 

Parity Powers For 

Savings Banks 

Vermont: New legislation grants 

trust powers to state-chartered sav 

ings banks and clarifies that savings 

banks have parity of powers with 

commercial banks. ELSS, 4/25/89. 

Lender Liability Restrictions 

California: New banking legisla 

tion provides that a commerciaJ loan 

of more than $100,000, in order to 

be considered a valid contract, must 

be agreed upon in writing. The law 

is intended to prevent borrowers 

from suing banks based on oral 

statements made during the negotia 

tion process. Commercial loans, as 

defined in the law, do not include 

some small-business credits, for ex 

ample, loans secured by an en 

trepreneur's home. Effective date is 

January 1, 1990. AB, 5/16/89, p. 2. 

Kansas: A new law, effective 

January 1, 1989, bars bank customer 

lawsuits, the Kansas Bankers Associa 

tion said, "for failing to carry out a 

particular promise relating to exten 

sion of credit or a financial ac

comodation unless that promise was 

specifically in writing and signed by 

both parties." The law will afford pro 

tection to the state's banks in that "it 

virtually eliminates lender liability 

lawsuits based on the bank's failure 

to carry out an alleged oral agree 

ment." The law requires that loan 

agreements include "a clear, con 

spicuous and printed notice to the 

debtor that states that the written 

agreement is a final expression" of 

the loan agreement, bbr, h/28/88, p. 

918. 

State Regulator Gets Stronger 

Thrift Take-Over Powers 

California: The Governor signed 

legislation which authorizes the 

state's commissioner of savings and 

loans to seize without prior hearings 

or examinations and place into con

servatorship for up to one year any 

institution under his jurisdiction 

which is engaging in unsafe or un 

sound practices. The new law per 

mits the commissioner to take over 

institutions before they become in 

solvent more quickly than under the 

prior law. The state department of 

banking already has similar powers 

with respect to state-chartered banks. 

BBR, 5/1/89, p. 953. 

Eligibility To Hold 

Public Deposits 

Indiana: A new law provides that 

a financial institution is ineligible to 

become a depository of public funds 

and, if already a depository, will have 

its eligibility revoked, if the institu 

tion's most recent statement of con 

dition shows a ratio of total capital 

to total assets of less than three per 

cent. ELSS, 4/25/89. 

New Fees Permitted 

On Credit Cards 

New York: New legislation permits 

the state's banks to impose certain 

charges on credit cards and con 

sumer credit accounts. As a result. 

the banks will be on a more equal 

footing with institutions in states like 

Delaware and South Dakota, into 

which a number of large New York 

City banks have already moved their 

credit card operations. 

The new law, which sunsets on 

June 30, 1993, permits credit card 

issuers and other lenders to charge 

a fee when customers exceed their 

credit limits. The charges must be 

disclosed. Also, a late fee may be 

charged if a customer's payment is 

more than ten days overdue. 

Previously, the late fee could be 

charged on cash advances and other 

loans but not on purchases. BBR, 

5/1/89, p. 954. 
Recent Developments 

Miscellaneous 

President's S&L Plan 

President Bush in early February 

released a plan calling for the separa 

tion of the FSLIC from the FHLBB, 

and placing it under the administra 

tion of the FDIC. The two deposit in 

surance funds would be maintained 

separately. The FHLBB would be 

replaced by a single Chairman, sub 

ject to oversight by the Treasury 

Department. The twelve regional 

Federal Home Loan Banks would be 

maintained. 

The status of S&Ls that are already 

insolvent would be resolved by a 

newly created "resolution trust cor 

poration," which would have an over 

sight board consisting of the 

Secretary of the Treasury, the Chair 

man of the FRB, and the U.S. Comp 

troller General. A separate funding 

corporation would be created. 

By June 1, 1991, S&Ls would have 

to meet the capital requirements that 

apply to FDlC-insured banks. 

Regulators would have greater 

authority to impose penalties on 

bank and thrift managements. AB, 

2/7/89, p. 19. 

Risk-Based Capital 

Guidelines 

The risk-based standards developed 

by the Basle Committee, and approv 

ed recently by the central banks of 

the Group of 10 countries, arc likely 

eo have fundamental effects on the 

way banks operate, particularly in 

regard to lending, according to this 

article. 

A survey of capital-allocation 

mechanisms among major U.S., U.K. 

and Canadian banks found that while 

institutions differ considerably in the 

extent to which they now use riskbased capital allocation. 80 percent 

think such allocation will become an 

increasingly important management 

tool. Growing numbers of banks are 

planning to use return on riskadjusted capital to measure businessunit profitability. At present, few 

banks carry capital allocation below 

the divisional level, or apply it to 

business lines. While most capital 

allocations are performed according 

to regulatory requirements, banks 

are slowly beginning to use return on 

capital or risk-adjusted return on 

capital as a method of performance 

measurement. Institutions are cau 

tioned, however, against completely 

adopting the G-10 framework for 

their own internal performance 

measures. 

The article concludes that bank 

management must consider the 

relative risk when comparing returns 

in different business areas (and dif 

ferential allocation of capital is one 

method of ensuring this) if resources 

are to be allocated effectively and 

shareholder returns maximized over 

the longer term. Issues in Bank Regula 

tion, Fall 1988, pp. 5-7. 

Appeals Court Vacates 

Decision In AMBAC Case 

A three-judge panel of the U.S. 

Court of Appeals for the District of 

Columbia vacated a portion of its 

earlier decision in the case of the 

American Municipal Bond Assurance 

Corp (AMBAC). The Court had rul 

ed in August 1988 that the FRB has 

approval authority over applications 

by a bank within a holding company 

to establish or acquire a subsidiary. 

The case arose from the OCC's ap 

proval in 1985 for Citicorp to own 

AMBAC, a municipal bond insurance 

company. AB, 9/23/88, p. 2; 1/9/89, p. i; 

BBH, 1/16, p. 126. 

Court Bars Banks' Sale Of 

Investment Certificates 

A federal district court decided 

against Security Pacific National 

Bank and the OCC on the bank's 

issue of investment certificates back 

ed by pools of its residential mort 

gages. The court noted that a trustee 

services the certificates, and thus the 

activity is underwriting securities in 

violation of the Glass-Steagall Act of 

1933. 

The court decision affects only 

securities issued by banks and not 

those underwritten by separate 

securities affiliates. Under a FRB rule. 

which was upheld by the U.S. 

Supreme Court in June 1988, the 

securities affiliates of BHCs are allow 

ed to engage in underwriting certain 

securities, including those backed by 

consumer receivables. However, not 

more than five percent of an af 

filiate's revenues can come from socalled "ineligible" securities, while 

under a ruling by the OCC in June 

1987, banks are not limited on the 

amount of asset-backed certificates 

they may issue. 

The court ruling also affects a 

number of other banks that have 

issued similar certificates. WSJ, 

12/20/88, p. C19. 

Leveraged Buyouts 

A survey of ten big banks found 

that as of November, 1988 they held 

a total of about #19 billion in senior 

debt for leveraged buyouts and have 

sold many times that amount to in 

vestors. Holdings amount to about 20 

percent of total volume for several of 

the banks, and less for some others. 

Buyout loans are attractive to institu 

tions because of the large fees they 

earn from assisting in this financing. 

LBOs, for purposes of this survey, in 

clude all highly leveraged transac 

tions that have been funded, where 

generally the borrower's equity 

represents ten percent or less of the 

acquired company's capitalization. 

Buyout portfolios generally repre 

sent a far smaller portion of the 

banks' total loan portfolios than 

other categories, such as loans to 

developing countries, which total 

about $55 billion at the ten big 

banks. WSJ, 12/13/88, p. A3. 

FDIC Reports Net Loss 

In 1988 

The FDIC experienced a net 

operating loss of g4.2 billion in 1988, 

the first yearly loss in the FDIC's 

history. At the end of 1988 the 

deposit insurance fund stood at $14.1 

billion, down 23 percent from yearend 1987. During 1988 the FDIC 

handled 221 bank failures, including 

200 closings and 21 assistance tran 

sactions, compared to 184 closings 
FDIC Banking Review 

and 19 assistance transactions during 

1987. prsi-89, 3/U. 

Commercial Banks Report 

Record Profits In 1988 

Commercial banks earned a record 

$25.3 billion in 1988, up from $2.8 

billion in 1987, and exceeding the 

previous high of #18.1 billion in 

1985. 

Provision for loan losses largely ac 

counted for last year's improvement. 

Total provision by commercial banks 

was $20.9 billion less than in 1987. 

However, the coverage of banks' non

performing loans and leases by loss 

reserves rose, to 82.6 percent at the 

end of 1988 from 78.0 percent a year 

earlier. 

Some of the improvements in 

1988 in banks' financial performance 

are attributable to the resolution of 

failed-bank cases. The closing of the 

banks of First RepublicBank Cor 

poration in July resulted in the 

removal of $2.3 billion in pre-failure 

losses from industry aggregates, and 

a #1.4 billion net addition of equity 

capital. The FDIC Quarterly Banking Pro 

file, Fourth Quarter, 1988. 

Thrift Losses Set Record 

In 1988 

The thrift industry lost a record 

#12.1 billion in 1988, according to 

the FHLBB. The previous record loss 

was g7.8 billion in 1987. Industry 

losses in the fourth quarter were #2.3 

billion, up from #1.8 billion in the 

previous quarter. About $1.3 billion 

of the fourth-quarter loss was at 

tributed to 77 insolvent thrifts in 

Texas. 

Analysts said the industry loss 

figure for 1988 reported by the 

FHLBB may be too low because it 

does not include fourth-quarter in 

terest expenses or other losses in in 

solvent thrifts that were merged or 

liquidated. AB, 3/22/89, p. 1. 

Withdrawals Of Deposits In 

S&Ls At Record Level 

Early In Year 

Net withdrawals from deposit ac 

counts in S&Ls were $9.3 billion in 

February, following a record $10.7 

billion in January, the FHLBB 

reported. An official said the deposit 

losses were being caused primarily 

by the higher rates being offered by 

money market mutual funds. 

Most of the withdrawals were from 

retail accounts of $100,000 or less, 

and withdrawals from thrifts in the 

Southwest have accounted for about 

30 percent of the total. Reportedly 

many of the insolvent thrifts in the 

Southwest were not raising their 

deposit interest rates to competitive 

levels because of being under 

regulatory directives to reduce their 

deposit base because of insufficient 

capital. WSJ, 3/15/89, p. A3; AB, 3/15. p. 1. 

Withdrawals from S&Ls exceeded 

new deposits (not including interest 

credited) by $8.5 billion in March, 

bringing the net withdrawals to #28.5 

billion in the first quarter. A FHLBB 

official said that, except for a few in 

stances, there is no evidence that the 

outflows reflect a loss of confidence 

by depositors. About #5 billion of 

March's net outflow occurred in 20 

thrifts—located mostly in the 

Southwest and West. Money market 

mutual funds in March paid an 

average rate of more than one 

percentage point above rates paid by 

S&Ls on three-month certificates of 

deposit. WSJ, 5/12/89, p. A8. 

Costs To FSLIC Of Assisted 

Acquisitions Versus 

Liquidations 

A study commissioned by the 

FHLBB found that the total costs of 

FSLIG-assisted acquisitions in as 

many as 24 cases last year were 

underestimated. The tax benefits, for 

example, involved in these transac 

tions improved the agency's net 

revenues but were actually in

tragovernment transfers. In addition, 

the report said, because the FSLIC 

often offers bidders different forms of 

assistance, it could not always be cer 

tain of obtaining the lowest bid for 

a failed thrift. The report found no 

evidence that deals which the FSLIC 

completed in December 1988, or 

those transacted in Texas, were more 

costly than the agency's other deals. 

A Government Accounting Office 

report concluded that because of the 

tax benefits the costs of assisted ac 

quisitions may have exceeded what 

the costs of liquidation would have 

been in one-third of the FHLBB's 

sales of insolvent thrifts last year. 

Also, questions were raised about the 

adequacy of procedures for handling 

bids. The report found that the new 

thrifts are "thinly capitalized," and 

"there is a lack of sufficient incen 

tives for the new thrifts to effective 

ly manage and liquidate the 

guaranteed assets" to minimize the 

government's assistance costs. AB, 

3/10/89, p. 3; 3/15, p. 2. 

Borrower Bankruptcy 

Costly To Banks 

Commercial banks are paid an 

average of only 78 percent of what 

they are owed when a company goes 

bankrupt, according to a study. On 

ly one bank in three is paid in full. 

The analysis included 38 bankrupt 

companies with claims averaging 

#275 million. 

The claims of several groups, in 

cluding lawyers and accountants 

whose fees were incurred after the 

bankruptcy filing, employees and 

governments, and small unsecured 

claims, all of which receive some of 

any assets before the banks, averag 

ed 13.5 percent of the total distribu 

tions. While banks received only 14 

percent of their distributions in cash, 

creditors as a whole received 44 per 

cent in cash. The time from filing the 

bankruptcy to the disbursement of 

assets averaged two years. 

In 1987 there were over 61,000 

business failures, up 17 percent from 

1984. The liabilities of those com 

panies totaled $36.3 billion. AB, 

11/1/88, p. 10. 

Trends In Banking Structure 

Since the mid-1970s the number of 

banking organizations has declined 

considerably, while the share of 

banking assets controlled by the 

largest banking organizations (100 

largest) has risen substantially. The 

40 
Recent Developments 

changes in banking structure, this ar 

ticle says, have been made possible 

by recently enacted legislation, prin 

cipally in those states allowing 

organizations to expand geographi 

cally. Legislative and regulatory 

changes have facilitated mergers and 

acquisitions among banking 

organizations located in the same 

geographic area. During the 1980s 

the implementation of the antitrust 

laws changed with the passage of 

legislation that reduced the dif 

ference between commercial banks 

and nonbank financial firms, 

Decreases nationally in the 

number of banking organizations and 

increases in banking concentration 

have occurred primarily because of 

the growth of very large regional and 

superregional BHGs, often through 

mergers or acquisitions. The changes 

in regional and state concentration 

have varied, with the Northeast and 

Southeast having the greatest in 

creases. Concentration in local bank 

ing markets decreased slightly over 

the 1976-82 period, with smaller in 

creases occurring since then. Greater 

competition for banks from thrift in 

stitutions and other firms and the 

lack of any substantial increase in 

concentration at the local level 

should mitigate antitrust concerns 

raised by structural changes, the ar 

ticle concludes. Federal Reserve Bulletin, 

March 1989, pp. 120-133. 

Commercial Banks And 

Investment Banking 

This article discusses commercial 

banks' investment banking activities, 

analyzing the profitability of per 

missible as well as currently pro 

hibited activities. The principal areas 

of investment banking included are 

the underwriting of municipal bonds 

and other securities, private 

placements, merger and acquisition 

advisory services, and overseas in 

vestment banking operations. 

It is concluded that bank expan 

sion and profitability in these areas 

will be limited generally by the huge 

start-up costs, and in some instances 

the level of capitalization required. 

Thus, it is quite possible that only a 

handful of the nation's commercial 

banks will be able to establish signifi 

cant investment banking operations. 

Moreover, banks' entry into current 

ly proscribed activities could be ex 

pected to reduce spreads somewhat. 

While investment banking divi 

sions at large commercial banks have 

operated for less than ten years, 

these banks already have some of the 

necessary ingredients to succeed. For 

most, this expansion has contributed 

only marginally to profitability. 

Banks that have developed a strong 

presence have done so in specific 

market niches, largely because they 

developed strategies that reflected 

their existing customer base and 

areas of expertise. Economic Perspec 

tives, Federal Reserve Bank of Chicago, 

November/December 1988, pp. 3-13. 

Market Discipline, Bank Risk 

And SNDs 

This study analyzes the potential 

for subordinated notes and deben 

tures (SNDs) to impose market 

discipline in regulating bank risk, and 

whether such SND-imposed 

discipline is consistent with bank 

regulatory agency objectives. The 

SND potential for market discipline 

is examined on the basis of the 

interest-rate spread between SNDs 

and comparable Treasury securities. 

It focuses on the 100 largest U.S. 

BHCs, as all of these institutions have 

publicly traded SNDs. The spread, or 

default-risk premium, is modeled as 

a function of various balance-sheet 

measures of risk, bond ratings, and 

an index proposed by the FDIC for 

the pricing of risk-based deposit 

insurance. 

The study finds that SND risk 

premiums are weakly related to 

Moody's and Standard and Poor's 

ratings, but uncorrelated with the 

FDIC index and any balance-sheet 

variables. Also, the FDIC Index is 

found to be negatively related to the 

public bond ratings. It is concluded 

that in the current environment, the 

impact of the cost of SNDs on bank 

risk-taking behavior is unlikely to 

coincide with the directions desired 

by bank regulators. Journal of Money, 

Credit and Banking, November 1988, p. 

597-610. 

Reforming Deposit Insurance 

In this article a fail-proof banking 

system is discussed that would break 

the link between banks' deposit func 

tions and their risk-taking activities. 

Banks' investments would be 

restricted to short-term, risldess, or 

near-riskless assets, such as Treasury 

bills. Their risk-taking activities 

would be shifted to the nonbanking 

subsidiaries of the parent holding 

companies. The capital requirement 

on these banks could be greatly 

reduced. They would retain federal 

deposit insurance, and the Federal 

Reserve Banks would continue as 

"last resort" lenders to them, further 

enhancing the safety of the institu 

tions. Regulation of the banking 

system could be greatly reduced. At 

the same time, the nonbank sub 

sidiaries would be better positioned 

to expand into new financial ac 

tivities. Transactions between bank 

affiliates and nonbank affiliates 

would have to be severely restricted. 

The fail-proof banks should be 

viable institutions. Because they 

would be the only institutions allow 

ed to have federal deposit insurance, 

and full payment transactions, they 

should be able to retain most of their 

existing deposit business. Given their 

low-yield asset portfolio the banks 

would probably lose some largeinvestor CD deposits. Their operating 

costs, however, would be relatively 

low. 

To accommodate the greatly in 

creased need for high-grade, shortterm investments in the financial 

system, the Treasury could make 

some alterations in the maturity 

structure of the federal debt, 

substituting shorter-term for longerterm debt. A "more controversial" 

proposal is to allow the fail-proof 

banks to hold short-term debt in 

struments of blue-chip firms as well 

as Treasury securities. Issues in Bank 

Regulation, Fall 1988, pp. 20-24. 

41 
FDIG Banking Review 

staff study of the Federal Reserve 

Bank of Minneapolis argues for re 

forming the deposit insurance 

system through higher capital re 

quirements, and co-insurance, in 

which banking risk would be shared 

by the depositors. Alternate pro 

posals for reform, including "narrow" 

banking, closing banks before they 

fail, and risk-adjusted insurance 

premiums, are discussed. In the 

writers' view, for any of these alter 

natives the costs or other problems 

would be likely to outweigh their 

benefits. 

Under co-insurance, there could be 

100 percent deposit insurance up to, 

say, $10,000 per depositor (not ac 

count), and partial protection for 

larger deposit balances. The system 

would be phased in, with the un 

protected portion starting, for exam 

ple, at two percent and increasing by 

a percent or so each year after that. 

The writers do not suggest how large 

the fractional co-insurance burden of 

depositors should ultimately 

become. Annual Report 1988, Federal 

Reserve Bank oj Minneapolis, pp. 3-16. 

Community Bank 

Regulatory Burden 

A former official of the Federal 

Reserve Bank of Minneapolis finds 

that while no single regulation 

presents an unmanageable burden 

for community banks, the 

cumulative effect of the laws and 

regulations is very great and may af 

fect the ability of small banks to 

compete. 

Community banks are placed at a 

disadvantage in some cases by 

economies of scale in regulatory 

compliance. The use of complex 

legal language, and an apparent 

reluctance on the part of the agencies 

to provide interpretations and com 

pliance guidelines, worsen the situa 

tion. The burden of regulatory 

change also is high. Changes in for 

mat of the quarterly Call Reports 

make it impossible for many banks 

to handle the function internally. Ma 

jor changes can cause difficulty even 

when the purpose of the change is to 

ease compliance. The regulatory 

push for increased formality, such as 

the requirements in some cases for 

formalized organization structures, 

and putting bank policies into 

writing, can be a significant burden 

on small banks. Aside from the 

development and implementation 

costs involved, there is also the 

danger that formality will deprive 

community banks of their natural ad 

vantages of flexibility and 

responsiveness. 

The author finds inadequate the 

Regulatory Flexibility Act, which re 

quires that agencies analyze the im 

pact of each rulemaking on smaller 

institutions from a cost-benefit 

perspective unless the agency head 

finds that the impact will be insignifi 

cant. The Act does not deal with the 

cumulative effects of the body of 

regulations, and also it applies only 

to formal rulemakings, not to infor 

mal policies (for example, the formal 

written policies requirement) and 

minor changes in rules. Illinois Banker, 

November 1988, pp. 16-18. 

Banks' LDC Debt Exposure 

Declines 

Banks were able to make con 

siderable reductions in their lessdeveloped-country debt in 1988, ac 

cording to a study. Fifty of the na 

tion's largest BHCs reduced their 

LDC debt exposure by 14.3 percent. 

Their average exposure is now 25 

percent of equity, and 23 companies 

have net exposure of less than five 

percent. Several large money-center 

institutions still have exposure well 

in excess of equity. Bank Letter, 

4/24/89, p. 2. 

Report Says Federal Rules 

Permit Foreign Debt 

Restructuring 

A report to Congress by the FRB, 

the FDIC and the OCC says, "The 

regulatory agencies under existing 

statutes have permitted banking 

organizations to exercise a wide 

range of options to negotiate reduc 

tions in the debt of foreign bor 

rowers, while maintaining basic 

regulatory principles regarding safe 

ty and soundness. Policies have been 

adopted to facilitate the conversion 

of outstanding bank debt into equity 

interests in foreign countries. Recent 

ly published estimates by the World 

Bank indicate that more than #20 

billion face value of commercial bank 

debt was eliminated in the last two 

years (1987-88) through debt set 

tlements and conversions." 

Over the past several years, banks 

have significantly increased their 

capital relative to developing-country 

debt exposure, and "are now much 

stronger financially in relation to this 

problem," the report states. However, 

the exposure is still high in relation 

to equity capital, particularly for the 

ten largest U.S. banking institutions. 

BBR, 3/6/89, p. 600. 

Home Equity Lines Increase 

The amount of approved home 

equity lines of credit in banks with 

$100 million or more in assets in 

creased by 57 percent in 1988, accor 

ding to the Consumers Bankers 

Association. The average amount 

outstanding of IIELCs rose to 

$24,710 at year-end 1988 from 

$21,989 a year earlier, representing 

65 percent and 67 percent, respec 

tively, of the maximum credit lines 

approved. HELC payment delinquen 

cies rose in 1988, reflecting the 

maturation of the product, but re 

mained well below those of all other 

types of consumer credit, the report 

said. 

Ninety-eight percent of HELCs had 

a variable interest rate, and 27 per 

cent allowed conversion of a credit 

line to a fixed rate at the borrower's 

Option. Bank Lcuer, 5/8/89, p.8. 

Banks Find Analysis 

Techniques Deficient 

A survey of 61 large commercial 

banks found that only five percent 

were satisfied with their current abili 

ty to calculate return-on-equity by 

line of business. Just three percent 

expressed satisfaction with how 

resources for growth are allocated 

per business unit. The findings sug

42 
Recent Developments 

gest a limited ability to allocate 

capital so that returns and stock price 

are maximized. Only seven percent 

of the institutions said their current 

risk-assessment techniques were 

satisfactory, and 50 percent said the 

need to improve those techniques 

were critical or very important. Bank 

Letter, 3/13/89, p. 2. 

ATMs 

Pour major electronic banking 

systems—Most, Honor, Relay, and 

Avail—operating in the Southeast are 

expected to consolidate before 

midyear, creating a network of more 

than 8,500 automated teller 

machines over a 13-state area. About 

1,000 financial institutions with 16 

million cardholding customers will 

share the system. In numbers of 

ATMs the new system would be the 

largest regional ATM network in the 

U.S., surpassing New York Gash Ex 

change, which has 7,400, the 

California-based Star System, now 

ranking second with about 7,200, and 

Mac, owned by Philadelphia National 

Bank, with 5,500 ATMs in seven 

states. AB, 1 /JO/89, p. i. 

Check Volume Will Peak 

In 1992, Study Says 

About 51 billion checks were writ 

ten on deposit accounts in the U.S. 

in 1988, and the number is expected 

to increase each year through 1992, 

according to a recent study. The 

growth rate in numbers of checks 

will peak in 1990 at 4.2 percent, up 

from 3.8 percent in 1988 and 3.4 per 

cent in 1987. After 1992 the absolute 

number of checks written is expected 

to decline, falling to 48.3 billion in 

the year 2000. Checks written by 

consumers will peak at 30 billion in 

1994, up from 28 billion in 1988, 

when consumers wrote checks to 

cover about 55 percent of their per 

sonal expenditures. 

It is noted that previous studies 

have tended to overestimate the im 

pact of alternatives to checks, such 

as automated clearing houses, 

automated teller machines, and 

point-of-sale systems in reducing 

total check volume in the near term. 

AB, 2/22/89, p. 2. 

43